ffirs.fm Page iii Thursday, March 15, 2007 7:35 PM
Joint Ventures Involving Tax-Exempt Organizations Third Edition Michael I. Sanders
John Wiley & Sons, Inc.
fabout.fm Page vi Thursday, March 15, 2007 2:18 PM
ffirs.fm Page i Thursday, March 15, 2007 7:35 PM
Joint Ventures Involving Tax-Exempt Organizations
ffirs.fm Page ii Thursday, March 15, 2007 7:35 PM
Update Service BECOME A SUBSCRIBER! Did you purchase this product from a bookstore? If you did, it’s important for you to become a subscriber. John Wiley & Sons, Inc. may publish, on a periodic basis, supplements and new editions to reflect the latest changes in the subject matter that you need to know in order to stay competitive in this ever-changing industry. By contacting the Wiley office nearest you, you’ll receive any current update at no additional charge. In addition, you’ll receive future updates and revised or related volumes on a 30-day examination review. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service. To become a subscriber, please call 1-877-762-2974 or send your name, company name (if applicable), address, and the title of the product to: mailing address:
Supplement Department John Wiley & Sons, Inc. One Wiley Drive Somerset, NJ 08875
e-mail: fax: online:
[email protected] 1-732-302-2300 www.wiley.com
For customers outside the United States, please contact the Wiley office nearest you: Professional & Reference Division John Wiley & Sons Canada, Ltd. 22 Worcester Road Etobicoke, Ontario M9W 1L1 CANADA Phone: 416-236-4433 Phone: 1-800-567-4797 Fax: 416-236-4447 Email:
[email protected] John Wiley & Sons, Ltd. The Atrium Southern Gate, Chichester West Sussex PO 19 8SQ ENGLAND Phone: 44-1243-779777 Fax: 44-1243-775878 Email:
[email protected] John Wiley & Sons Australia, Ltd. 33 Park Road P.O. Box 1226 Milton, Queensland 4064 AUSTRALIA Phone: 61-7-3859-9755 Fax: 61-7-3859-9715 Email:
[email protected] John Wiley & Sons (Asia) Pte., Ltd. 2 Clementi Loop #02-01 SINGAPORE 129809 Phone: 65-64632400 Fax: 65-64634604/5/6 Customer Service: 65-64604280 Email:
[email protected] ffirs.fm Page iii Thursday, March 15, 2007 7:35 PM
Joint Ventures Involving Tax-Exempt Organizations Third Edition Michael I. Sanders
John Wiley & Sons, Inc.
ffirs.fm Page iv Thursday, March 15, 2007 7:35 PM
This book is printed on acid-free paper. Copyright © 2007 John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Wiley Bicentennial Logo: Richard J. Pacifico Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at http://www.wiley.com.
Library of Congress Cataloging-in-Publication Data: ISBN 978-0470-037614 Printed in the United States of America 10
9
8
7
6
5
4
3
2
1
fabout.fm Page v Thursday, March 15, 2007 2:18 PM
About the Author
Michael I. Sanders heads the Tax Department at Powell Goldstein, LLP in Washington, D.C., Atlanta, Georgia and Dallas, Texas. He served with the U.S. Department of Justice (Attorney General’s Honors Program 1967–1968; Attorney advisor to the Assistant Secretary for Tax Policy, Office of Tax Legislative Counsel, 1968–1970) and was formerly Chairman of the Exempt Organizations Committee, Tax Section of the American Bar Association, Member of the Internal Revenue Service Commissioner’s Exempt Organizations Advisory Group. He is presently a member of the American Institute of Certified Public Accountants. Mr. Sanders is an adjunct professor of taxation at Georgetown University Law School, teaching tax treatment of charities and other nonprofit organizations, and at George Washington University Law School, teaching income taxation of partnerships and subchapter S corporations. Mr. Sanders has co-authored Private Foundations—Taxable Expenditures, Tax Management Portfolio, 293–3rd , and authored, "Exploring the Role of the Tax Attorney", Tax Settlements and Negotiations: Leading Lawyers on Issuing Tax Opinions, Managing Audit Situations, and Representing Clients before the IRS, 2006. Mr. Sanders was named by the Washington Business Journal as one of the City’s Top Ten Lawyers and the City’s Top Tax Lawyer in 2004. Mr. Sanders was selected for both the 2007 and 2006 editions of Best Lawyers in America and has also been honored as one of “Washington D.C.’s Legal Elite” by Smart CEO Magazine for 2006 and 2007. Mr. Sanders speaks at numerous conferences and forums around the country and regularly serves as an expert witness in complex cases involving federal income tax. Mr. Sanders earned his LLB at New York University, and his LLM at Georgetown University.
䡲
v 䡲
fabout.fm Page vi Thursday, March 15, 2007 2:18 PM
ftoc.fm Page vii Thursday, March 15, 2007 2:27 PM
Contents
Acknowledgments Preface xvii
xv
Chapter one: Introduction: Joint Ventures Involving Exempt Organizations Generally 1.1
Introduction
1.2
Joint Ventures in General
2
1.3
Healthcare Joint Ventures
5
1.4
University Joint Ventures
7
1.5
Low-Income Housing Joint Ventures
1.6
Conservation Joint Ventures
1.7
Joint Ventures as Accomodating Parties to Impermissible Tax Shelters
1.8
Joint Venture Structure
1.9
The Exempt Organization in a Joint Venture: Rev. Rul. 98-15
1.10
Ancillary Joint Ventures: Rev. Rul. 2004–51
1.11
The Exempt Organization as Limited Partner or Non-Managing Member
1.12
Partnerships with Other Exempt Organizations
1.13
Transfer of Control of Supporting Organization to Another Tax-Exempt Organization 19
1.14
The Exempt Organization as a Lender or Ground Lessor
1.15
Partnership Taxation
1.16
UBIT Implications From Partnership Activities
1.17
Use of a Subsidiary as Participant in a Joint Venture
1.18
Limitation on Preferred Returns
1.19
Sharing Staff and/or Facilities: Shared Services Agreement
1.20
“Intangibles” Licensed by Nonprofit to For-Profit Subsidiary or Joint Venture
1.21
Private Inurement and Private Benefit
1.22
Limitation on Private Foundation’s Activities that Limit Excess Business Holdings 35
1.23
International Joint Ventures
1.24
Other Developments
1
1
9
11 12
13 14
16 17
18
20
22 24 26
27 30
31
35
36
Because of the rapidly changing nature of information in this field, this product may be updated with annual supplements or with future editions. Please call 1-877-762-2974 or email us at
[email protected] to receive any current update at no additional charge. We will send on approval any future supplements or new editions when they become available. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service.
30
ftoc.fm Page viii Thursday, March 15, 2007 2:27 PM
CONTENTS
Chapter Two: Taxation of Charitable Organizations 2.1
Introduction
2.2
Categories of Exempt Organizations
2.3
Section 501(c) Organizations: Structural Elements
2.4
Statutory Requirements
2.5
General Requirements
2.6
Charitable Organizations
2.7
Structure of the IRS
2.8
Application for Exemption
2.9
Reporting Requirements
2.10
The IRS Audit
2.11
Charitable Contributions
2.12
Car Donation Programs
2.13
Sarbanes-Oxley and Exempt Organizations
2.14
State Laws
37
37 37 38
39 65 68
82 84
86
89 91 98 101
103
Chapter Three: Taxation of Partnerships and Joint Ventures 3.1
Scope of Chapter
3.2
Qualifying as a Partnership
3.3
Classification as Partnership
107
3.4
Alternatives to Partnerships
108
3.5
Pass-Through Regime: The Conduit Concept
3.6
Allocation of Profits, Losses, and Credits
3.7
Formation of Partnership
3.8
Tax Basis in Partnership Interests
3.9
Partnership Operations
3.10
Partnership Distributions to Partners
3.11
Sale or Other Disposition of Assets or Interests
3.12
Other Tax Issues
104
104 105
111
111
116 121
128 134 138
145
Chapter Four: Overview: Joint Ventures Involving Exempt Organizations 4.1
Introduction
4.2
Exempt Organization as General Partner: A Historical Perspective
4.3
Exempt Organizations as Limited Partner or LLC Non-Managing Member
4.4
Joint Ventures with Other Exempt Organizations
4.5
New Scheme for Analyzing Joint Ventures
4.6
Revenue Ruling 2004-51 and Ancillary Joint Ventures
4.7
UBIT Implications from Joint Venture Activities
160
160
䡲
viii 䡲
220
222 234
224
162 217
ftoc.fm Page ix Thursday, March 15, 2007 2:27 PM
CONTENTS
4.8
Use of a Subsidiary as Participant in a Joint Venture
236
4.9
Use of a Supporting Organization in a Joint Venture
251
4.10
The IRS Audit
4.11
Conversions from Exempt to For-Profit and from For-Profit to Exempt Entities 256
4.12
Exempt Organization as Lender or Ground Lessor
4.13
Issuance of Tax-Exempt Bonds
4.14
Reporting Requirements
Appendix 4A
255
258
265
266
Joint Venture Checklist
271
Chapter Five: Private Benefit, Private Inurement, and Excess Benefit Transactions 5.1
What are Private Inurement and Private Benefit?
5.2
Transactions in which Private Benefit or Inurement May Occur
5.3
Profit-Making Activities as Indicia of Nonexempt Purpose
5.4
Intermediate Sanctions
5.5
Case Law
5.6
Planning
5.7
State Activity with Respect to Insider Transactions
275
275 284
209
311
329 331 333
Chapter Six: The Exempt Organization as Lender or Ground Lessor 6.1
Overview
6.2
A Participation as a Lender or Ground Lessor
6.3
Types of Real Estate Loans
6.4
Participating Loans
6.5
Ground Lease with Leasehold Mortgage
6.6
Sale of Undeveloped Land
6.7
Guarantees
366
6.8
Conclusion
369
335
335 336
339
341 352
359
Chapter Seven: Exempt Organizations as Accommodating Parties in Tax Shelter Transactions 7.1
Introduction
370
7.2
Prevention of Abusive Tax Shelters
7.3
Excise Taxes and Penalties
7.4
Settlement Initiatives
7.5
Abusive Shelters and Tax Credit Programs
371
376
377
䡲
ix
䡲
378
370
ftoc.fm Page x Thursday, March 15, 2007 2:27 PM
CONTENTS
Chapter Eight: The Unrelated Business Income Tax
379
8.1
Introduction
379
8.2
Historical and Legislative Background of UBIT
8.3
General Rule
8.4
Statutory Exceptions to UBIT
8.5
Modifications to UBIT
8.6
Income from Partnerships
8.7
Calculation of UBIT
8.8
Governmental Scrutiny and Legislative Initiatives
380
383 398
407 439
441 444
Chapter Nine: Debt-Financed Income
447
9.1
Introduction
447
9.2
Debt-Financed Property
448
9.3
The §514(c)(9) Exception
454
9.4
Partnership Rules
9.5
The Fractions Rule
9.6
The Final Regulation
9.7
The Fractions Rule: A Trap for The Unwary
455 456 456 467
Chapter Ten: Limitation on Excess Business Holdings 10.1
Introduction
10.2
Excess Business Holdings: General Rules
10.3
Tax Imposed
10.4
Exclusions
468
468 469
474
474
Chapter Eleven: Impact on Taxable Joint Ventures: Tax-Exempt Entity Leasing Rules 11.1
Introduction
11.2
Types of Transactions Covered by 1984 Act Rules
11.3
Internal Revenue Code §168(h)
11.4
Tax-Exempt Use Property
11.5
Restrictions on Tax-Exempt Use Property
11.6
Partnership Rules
477
477 477
479
480 481
484
Chapter Twelve: Healthcare Entities in Joint Ventures 12.1
Overview of Economics
491
12.2
Classifications of Joint Ventures
12.3
Tax Analysis
12.4
Other Healthcare Industry Issues
493
496 䡲
549 x 䡲
491
ftoc.fm Page xi Thursday, March 15, 2007 2:27 PM
CONTENTS
12.5
Preserving the 50/50 Joint Venture
12.6
Valuation
12.7
Joint Operating Agreements
12.8
UBIT Implications of Hospital Joint Ventures
12.9
Government Scrutiny
12.10
Precautionary Steps: A Road Map
12.11
Conclusion
Appendix 12A
580
589 596 602
604 607
609
Sample Conflicts of Interest Policy
610
Chapter Thirteen: Low-Income Housing—New Markets, Rehabilitation, and Other Tax Credits Programs 13.1
Relationships Between Nonprofits and For-Profits in Affordable Housing—A Basic Business Typology 614
13.2
Low-Income Housing Tax Credit
616
13.3
Historic Investment Tax Credit
13.4
Empowerment Zone Tax Incentives
13.5
New Markets Tax Credits
13.6
Recent IRS Guidance Regarding Guarantees and Indemnifications
13.7
Reportable LIHTC/NMTC Transactions
13.8
Gulf Zone Opportunity Act of 2005
Appendix 13A
614
655 658
662 691
692
New Markets Tax Credits Project Compliance/Qualification Checklist
695
Chapter Fourteen: Joint Ventures with Universities 14.1
Introduction
14.2
IRS Focus on Universities
14.3
Special Statutory UBIT Rule
14.4
Research Joint Ventures Generally
682
697
697 704 706 707
14.5
Faculty Participation in Research Joint Ventures
14.6
Nonresearch Joint Venture Arrangements
715
14.7
Modes of Participation by Universities in Joint Ventures
14.8
Incentives Available to Taxable Joint Venturers
14.9
Conclusion
716 730
737
738
Chapter Fifteen: Business Leagues Engaged in Joint Ventures 15.1
Overview
739
15.2
The Five-Prong Test
15.3
Unrelated Business Income Tax
15.4
Corporate Sponsorship
744 752
757 䡲
xi
䡲
739
ftoc.fm Page xii Thursday, March 15, 2007 2:27 PM
CONTENTS
Chapter Sixteen: Conservation Organizations in Joint Ventures
762
16.1
Overview
762
16.2
Conservation and Environmental Protection as a Charitable or Educational Purpose: Public and Private Benefit 763
16.3
Conservation Gifts and §170(h) Contributions
16.4
Unrelated Business Income Tax Issues
16.5
Joint Ventures Involving Conservation Organizations and For-Profit Participants 775
16.6
Senate Finance Committee Investigation of the Nature Conservancy (TNC)
16.7
Emerging Issues
16.8
Conclusion
768
773
777
778
779
Chapter Seventeen: International Joint Ventures
781
17.1
Overview
781
17.2
Domestic Charities Expending Funds Abroad
17.3
Potential for Abuse: The Use of Charities as Accommodating Parties In International Terrorist Activities 786
17.4
Guidelines for U.S.-Based Charities Engaging in International Aid and International Charities 792
17.5
General Grant-making Rules
17.6
Foreign Organizations Recognized by the IRS as §501(c)(3) Organizations
17.7
Public Charity Equivalency Test
17.8
Expenditure Responsibility
17.9
Domestic Charities Entering into Joint Ventures with Foreign Organizations
17.10
Application of Foreign Laws In Operating a Joint Venture in a Foreign Country 806
17.11
Application of Foreign Tax Treaties
17.12
Current Developments in Cross-Border Charitable Activities
17.13
Conclusions and Forecast
783
794 797
799
800 802
807 811
816
Chapter Eighteen: Private Pension Fund Investments in Joint Ventures 18.1
Overview
18.2
Private Pension Fund Participation in Joint Ventures
18.3
Conclusion
817
817 818
828
Chapter Nineteen: Exempt Organizations Investing Through Limited Liability Companies 19.1
Introduction
829
19.2
The Basics of LLCs: State and Federal Income Tax Law
19.3
Comparison with Other Business Entities 䡲
xii
䡲
831
830
829
ftoc.fm Page xiii Thursday, March 15, 2007 2:27 PM
CONTENTS
19.4
Background and Development of LLCs
835
19.5
Tax Classification of LLCs Under Check-the-Box Regulations
19.6
Exempt Organizations Wholly Owning Other Entities
19.7
IRS Analysis: The Double-Prong Test and Rev. Rul. 98-15
19.8
Nonprofit-Sponsored LIHTC Project
19.9
Private Foundations as Members of LLCs
836
843 847
863 865
Chapter Twenty: Debt Restructuring and Asset Protection Issues 20.1
Introduction
20.2
Overview of Bankruptcy
20.3
Automatic Stay
20.4
Chapter 11 Plan of Reorganization
20.5
Discharge
20.6
Special Issues: Use of Cash
20.7
Special Issues: Consequences of Debt Reduction
867
867 869
880 890
899 901
Index
903
909
䡲
xiii
䡲
ftoc.fm Page xiv Thursday, March 15, 2007 2:27 PM
fack.fm Page xv Thursday, March 15, 2007 2:17 PM
Acknowledgments
It seems like yesterday that I was first invited by John Wiley & Sons to prepare an outline for a new book on partnerships and joint ventures involving tax-exempt organizations. Yet, 13 years have passed and I have just completed the draft of the third edition of Joint Ventures Involving Tax Exempt Organizations, a treatise that provides guidance and structure to a complex area in order to enable tax-exempt organizations to meet critical economic, political, and social challenges. There are many colleagues who must be acknowledged for their valuable technical assistance over the years, having given freely of their time in the research and development of an emerging subject matter. I have listed each of their names and the specific area of expertise that they have contributed to the book since its inception. Charlene McGinty and Gregory A. Petroff (healthcare joint venturer and federal fraud and abuse statutes); Jason Green, Michael Grace, Timothy J. Jessell, and Jeffrey D. Rashba (partnership taxation and limited liability company issues); Nancy Kuhn (intermediate sanctions, distance learning, and IRS procedure); Amber Wong Hsu, Susan Leahy, and Cynthia L. Gausvik (excess business holdings); Rick Arenberg, David Thomas, and Jude Carluccio (private pension fund investments); Jerome Breed, John Knapp, and Mark Siegal (low-income housing tax credit); Ron Stallings, Shelia Vaden-Williams, and Ava Healy (§501(c)(3) bonds); Jonathan Thoren (debt-financing income, partnership classification, debt-financed income, and fractions rules); Penn Nicholson, John A. Moore, Jonathan Jordan, and Lewis Saret (debt restructuring), Ronald Gart, Luann Sinclair, and Daniel Hodin (exempt organization as lender or ground lessor); Patrick Whaley and Carolyn Osteen (university tax issues); Kathryn T. Kanemori (international joint ventures); Wayne Zell (Internet company valuation); Charles C. LoBello (historical background of UBIT), Melissa Tai (branding); Colin Uckert (NMTC checklist); Lewis Kaster (structuring contingent interest debt); David Sanders (treatment of HUD deficiency claims in the context of bankruptcy workouts); William Kelly Jr. (affordable housing typology); and Todd Greenwalt (analysis of control test with chart). Editorial assistance was provided by: Casey A. Lothamer and Gayle Forst (editorial analysis of the “control” issues); Ellen Berick, Fran Mordi, Jonathan Becker, Brian R. Dinning, Susan Cobb, Douglas Giblen, Carol Hoshall, Julie Davis, Kimberly Crowder, and Larry Eisenberg. Research assistance was provided by Laura Hemly and Don Clardy. I want to particularly commend Brian Dinning, Susan Cobb, and Douglas Giblen as to the preparation of the first edition, and Gayle Forst as to the second edition, for their valuable editorial assistance, patience, and personal effort, assuming the difficult task of putting the manuscript together and working with the staff at John Wiley & Sons, Inc. I must also acknowledge Linda Schrader, whose overall dedication since the beginning was critical to the entire production process. And, of course, I wish to thank the dedicated staff at John Wiley & Sons for their assistance. 䡲
xv 䡲
fack.fm Page xvi Thursday, March 15, 2007 2:17 PM
fpref.fm Page xvii Thursday, March 15, 2007 7:33 PM
Preface
INTRODUCTION My interest in nonprofits engaging in joint ventures represents the convergence of two principal areas of expertise in my legal career. In the summer of 1964, I began my legal practice with the Justice Department, tax division, in Washington, DC. My first case involved the Founding Church of Scientology, introducing me to Internal Revenue Code (IRC) §501(c)(3) and the associated issues of private inurement and commercialism. In September 1968, I joined the office of Tax Legislative Counsel at the Treasury Department. There I was assigned charitable tax issues and worked on the Tax Reform Act of 1969, which created the distinction between private foundations and public charities. Since 1970, as a private practitioner and subsequently as an adjunct professor at both Georgetown University Law Center and George Washington University Law School, I have taught and represented diverse exempt organizations including large private foundations, public television stations, churches, medical organizations (including hospitals), low-income housing organizations, and trade associations. I also participated in the Foundation Lawyers’ Group, which in the early 1970s made recommendations to the Treasury Department regarding the Regulations in Chapter 42. Over the past 20 years, I have testified before the Oversight Committee of the House Ways and Means Committee on the Bob Jones case and on issues affecting television ministries. Beginning in the early 1970s as a private practitioner, I represented developers, syndicators, and investors involved in partnerships and joint ventures. I dealt with the dramatic changes in the taxation of partnerships, particularly the Tax Reform Act of 1986, which introduced the passive activity loss rules, eliminated the capital gains preference, reduced the personal income tax rates, extended the at-risk rules, and introduced the low-income housing tax credit. In this context, I represented hundreds of taxpayers in administrative proceedings with the Internal Revenue Service (IRS), many of which involved the use of the partnership structure for tax-sheltered investments. I have also served regularly as an expert witness in complex litigation and, since 2000, as a consultant in facilitating joint venture deals involving the New Markets Tax Credit. With my dual concentration in exempt organizations and in partnership taxation, it was only natural that, as joint ventures between exempt organizations and for-profits proliferated over the past decade, I became inextricably involved in counseling, negotiating, and structuring such entities.
䡲
xvii
䡲
fpref.fm Page xviii Thursday, March 15, 2007 7:33 PM
PREFACE
JOINT VENTURES: A MODEL ON THE BRINK? Aside from the conventional use of joint ventures in healthcare, universities, and low-income housing, in today’s dynamic economic, political, social, and ecological environment exempt organizations face innumerable challenges, including environmental uncertainty, social change, and political and economic instability. Partnerships between the exempt and for-profit communities often comprise the first and, over time, most long-lasting responses to these crises. As a notable recent example, efforts to revitalize areas ravaged by Hurricane Katrina in 2005 have employed the use of joint ventures between the exempt and for-profit communities. Taking advantage of the almost $8.6 billion allocated under the Gulf Zone Opportunity Act of 2005, exempt and for-profit partners have joined together to construct low-income housing and to restore historic buildings for economic revitalization in the affected Gulf states. These partnerships have allowed exempt organizations to fulfill their missions of economic and social rejuvenation while, at the same time, they have attracted necessary for-profit capital into the projects through the lucrative low-income housing, rehabilitation tax, and new markets tax credits available for the projects’ investors. In addition to domestic events, exempt and for-profit partners have joined together en masse in response to a recent and unprecedented series of exigent crises abroad including natural disasters, political upheaval, war, famine, and genocide. In response to these circumstances, such as in the global outpouring in the aftermath of the 2005 southeast Asian tsunami, which have involved casualties numbering in the hundreds of thousands and billions of dollars in economic loss, joint ventures between exempt organizations and the for-profit community have provided the essential combination needed to raise the capital and provide the infrastructure necessary to answer these challenges. While the need and demand for joint ventures may now be at its greatest level, at the same time, these endeavors have recently become an endangered resource, due in large part to the IRS’s prohibitively restrictive and, in some cases, inscrutable laws governing their formation and maintenance. Perhaps the most significant development to this end has been the marked increase in the government’s scrutiny of exempt organizations. Prompted by a 2005 Joint Committee on Taxation report finding that tax abuses cost the federal treasury more than $370 billion annually, members of both houses of Congress began inquiries into the activities of exempt organizations, including their participation in joint ventures. Although some congressional inquiry has focused on joint ventures in the healthcare industry (and continues to do so), recent national and world events have prompted a greater analysis of joint ventures and their potential to fund terrorist organizations and to participate in tax shelter schemes. This book will present the relevant IRS provisions and rulings, as well as pertinent judicial decisions, and legislative developments that affect and concern exempt organizations involved in joint venture partnerships with for-profit entities. Despite the growing scrutiny into the activities of exempt organizations, however, the use of joint ventures continues as to be a prominent vehicle for collaboration between exempt organizations and the corporate world. This book will discuss the many ways that exempt organizations have become more 䡲
xviii
䡲
fpref.fm Page xix Thursday, March 15, 2007 7:33 PM
PREFACE
entrepreneurial as government funding for the nonprofit sector has decreased and as competition for contributions from the general public has increased. In addition to the recent Congressional inquiries into joint ventures between nonprofit and for-profit partners, the IRS has shifted its spotlight from educating the exempt community about compliance to an affirmative assault on alleged abuses, ranging from impermissible benefits conferred on executives, to violations against the proscription against interference in political campaigns, to participation in tax shelter avoidance schemes. While the Service continues to evaluate joint ventures through a “two-prong” test (examining whether it preserves the exempt organization’s charitable purpose, and insulates the exempt organization from private benefits), it has provided no clear guidance indicating the requisite amount, or type, of control necessary for a venture between exempt and for-profit entities to be permissible. Moreover, in some recently published rulings, the IRS did not even consider control in its determination of the legitimacy of a joint venture. This discussion of “control” serves as a significant update to this edition. Consequently, at a time when unprecedented crises require the combination of corporate capital with the exempt communities’ organizational knowledge and infrastructure, the uncertainty of the Service’s guidance makes charities and their for-profit partners increasingly reluctant to combine efforts. Unless the IRS issues clear, precedential guidance that relaxes and clarifies the rules controlling the partnerships between the exempt and forprofit communities, the numbers of these ventures may decline, and countless opportunities for good charitable works may be lost. It is this author’s opinion, however, that joint ventures should not be abandoned for lack of general and specific guidance from the IRS on how they should be structured. This edition contains advice, interpretation of laws, and, in particular, a checklist that may be used as a guide when designing joint venture arrangements for approval of the IRS. FORMATION TRENDS While partnerships between exempt entities and for-profit parties continue to form across all industries, healthcare institutions, and namely, hospital systems, are the most frequent participants in joint ventures. In addition to raising capital, healthcare organizations engage in joint ventures to: (1) offer physicians a stake in a new enterprise in order to gain their loyalty and patient referrals; (2) to bring a new service or medical facility to a needy area; and (3) to ensure that physicians do not establish a competing healthcare provider. Like hospitals, universities are natural participants in joint ventures. Incentives to engage in joint ventures have increased as the availability of government funding has decreased and enrollment has declined. Almost all large colleges and universities conduct supported or sponsored research funded by private firms or by the federal government. Often, these research activities are structured as joint ventures between a university and a sponsor, and give the corporate sponsor access to the university’s vast resources. Recently, nature conservation groups have garnered attention from the government and the media for their use of joint ventures to creatively respond to the 䡲
xix 䡲
fpref.fm Page xx Thursday, March 15, 2007 7:33 PM
PREFACE
need to increase funds available for land and species preservation. Discussion of these efforts comprises a new chapter in this edition. The area of international joint ventures has virtually exploded, as nonprofit organizations join forces with corporate partners to tackle a host of issues including emergency response to exigent natural disasters such as tsunamis and earthquakes, and aid to countries engulfed by political turmoil, genocide, famine, and civil war. Over the past years, new federal housing programs have been designed to preserve existing housing with laws that allow nonprofit developers to be classified as “priority purchasers” and to be among the first to be given the opportunity to acquire properties that would otherwise be converted from low-income housing units to more expensive rental units or condominiums. Tax-exempt organizations that develop low-income housing projects typically need to obtain an allocation of the low-income housing tax credit for the project. Most of the low-income housing developed by tax-exempt organizations is financed, at least in part, with the tax credit. For-profit corporations including national banks and insurance companies often invest in tax-credit projects either through a direct investment or through syndicated equity funds. These funds, which are sponsored by national organizations such as the Enterprise Community Partners, Inc. and Local Initiative Support Corporation, have been organized to assist corporate investment in projects that qualify for the low-income housing tax credit. Indeed, the new markets tax credit has attracted billions of dollars in investment in commercial ventures in low income communitites since its enactment in 2000. ABOUT THIS EDITION The first edition of this book, which evolved out of materials developed from my courses in charities and partnership taxation at Georgetown University Law Center and George Washington University Law School, as well as lectures at New York University Conference on Tax Planning for §501(c)(3) Organizations and at Georgetown University Continuing Legal Education, was published in 1994. Since that time, there has been a virtual explosion in the joint ventures arena, both in terms of the creativity of nonprofit joint ventures and in the response of Congress, the IRS, and the courts to these changes. This experience, coupled by the constant and evolving IRS response to the joint venture form, has resulted in this third edition to the book. Several of the changes are of major importance, the first being the addition of IRC §4958, the intermediate sanctions provisions, and the promulgation of proposed regulations thereunder. As described in the book, the intermediate sanctions were adopted so that the IRS would have alternative means of penalizing persons who approved of and/or engaged in “excess benefit transactions.” Excess benefit transactions occur where a private party receives more than a reasonable financial benefit from a financial arrangement with §501(c)(3) and §501(c)(4) organizations. Until the adoption of the intermediate sanctions provisions, the only enforcement tool available to the IRS was revocation of a nonprofit’s exempt status, a penalty that was rarely utilized because of its severity. Perhaps most notably, the IRS raised the first legal challenge under §4958 against 䡲
xx
䡲
fpref.fm Page xxi Thursday, March 15, 2007 7:33 PM
PREFACE
a cluster of home healthcare agencies that it alleged had conveyed significant excess benefits upon the owners when they converted the agencies from exempt organizations to for-profit entities. The resulting case, Caracci v. Commissioner, is discussed at length in this edition. Code §4958 is discussed in depth in Chapters 5 and 12. Perhaps the two most significant developments in the field of joint ventures have been the issuances of Revenue Rulings 98-15 and 2004-51. In Revenue Ruling 98-15, the IRS addressed whole hospital joint ventures. While the ruling involves two examples of whole hospital joint ventures, the IRS has made it clear that the guidelines of the ruling apply to other types of joint ventures as well. In addition, there have been two significant court cases in the area of healthcare joint ventures, Redlands Surgical Center v. Commissioner and St. David’s Health Care System v. United States, which have applied Revenue Ruling 98-15. In Redlands Surgical Services v. Commissioner, a decision handed down in July 1999, the Tax Court upheld the IRS’s denial of exemption to a hospital that entered into a joint venture with a for-profit partner. While the Tax Court did not reference Rev. Rul. 98-15 in its opinion, it used an analysis similar to that of Rev. Rul. 98-15 in determining that the nonprofit had not retained sufficient control over the venture to ensure that charitable purposes, as opposed to private interests, would be fulfilled. As in Redlands, the government relied upon Rev. Rul. 98-15 in St. David’s Health Care System v. United States when it argued that St. David’s ceded control of its hospital system when it entered into a joint venture with Columbia/HCA Healthcare Corporation. In its decision, the Fifth Circuit Court of Appeals examined whether St. David’s had ceded control of its charitable operations to Columbia/HCA. The Fifth Circuit’s analysis, which provides a road map for consideration of the control issue as applied to these types of joint ventures, is discussed at length in Chapter 12. Because of its importance, Rev. Rul. 98-15 is discussed throughout the book and in great detail in Chapters 4 and 12. Soon after the St. David’s case, the IRS issued Rev. Rul. 2004-51, which provided the first published guidance in the area of ancillary joint ventures. In the ruling, the IRS analyzed an ancillary joint venture involving a non-healthcare charity and a for-profit management corporation. The ruling is also significant for expounding upon the issue of control raised in the Redlands case. Notably, the ruling demonstrates that total control of the entire venture by the exempt partner is not essential, so long as the exempt organization maintains exclusive control over all charitable aspects of the partnership. Because of its overall significance to the subject of joint ventures, Rev. Rul. 2004-51 is discussed throughout the book, and in particular in Chapters 4 and 14. Significantly, the two examples discussed in Rev. Rul. 98-15 involve limited liability companies. All 50 states have adopted LLC statutes and, as a result, LLCs are quickly becoming the entity of choice for joint ventures. Chapter 19 is devoted to this topic. Chapter 19 also discusses the “check-the-box” rules that simplified the ability for an entity to be taxed as a partnership. As Chapter 19 explains, along with simplification, new legal questions have arisen as a result of the rules. I have designed this book for use by attorneys and accountants, nonprofit organization executives, and students in the field. To this end, I have attempted 䡲
xxi 䡲
fpref.fm Page xxii Thursday, March 15, 2007 7:33 PM
PREFACE
to provide discussion of the most significant rulings and cases to give insight into the highly technical provisions of the IRC and Treasury Regulations. Accordingly, the reader will notice the illustrative materials throughout the text, including examples and practitioner-focused caveats. The materials in this book have been designed for use in a course at either the J.D. or L.L.M. level. In the book, I examine the liability of, and consequences to, exempt organizations participating directly and indirectly in joint ventures with taxable and exempt entities. Chapter 1 sets the stage for much of the subsequent materials by emphasizing how participation might affect the organization’s exempt status, as well as the tax treatment of income derived by exempt organizations as passive investors, as lenders, or as ground lessors. Chapters 2 and 3 are foundational chapters, exploring the fundamental law of exempt organizations and taxation of partnerships and joint ventures. Chapter 2 introduces the categories of exempt organizations with special emphasis on §501(c)(3) organizations and their structural elements, including an analysis of the organizational and operational tests that highlights intermediate sanctions, private benefit, and inurement of income, subjects that are expanded upon in Chapter 5. Chapter 2 also contains a brief discussion of the proscription against legislative and political activities, as well as an analysis of the different types of charitable, religious, educational, and scientific organizations that qualify for exemption under §501(c)(3), including low-income housing organizations and economic development organizations. The chapter concludes with a discussion of the application for exemption, the newly expanded reporting requirements, and the charitable contribution deduction rules. Chapter 3 contains an overview of the partnership tax rules (which also apply to limited liability companies that are taxed as partnerships), including an examination of the allocation of profits, losses, and credits under IRC §704(b)(2). Additional subjects include tax basis questions, loss limitations, transactions between partners and the partnership, distributions to partners, and the treatment of sales or other distributions of assets, as well as the consequences of bargain sales. Following this discussion of the fundamentals of exempt organizations, on the one hand, and partnership taxation on the other, the balance of the book analyzes in depth the issues that come into play when these two areas converge, as when exempt organizations participate in joint ventures. Chapter 4 offers a general analysis of joint ventures involving exempt organizations and the impact on tax exemption. Included is a detailed analysis of the double prong test that applies to exempt organizations as general partner or managing member of a limited liability company as well as an analysis of the criteria contained in Rev. Ruls. 98-15 and 2004-51. Separate sections discuss the exempt organization as investor and joint ventures involving two or more exempt organizations. There is also a discussion of the use of a subsidiary as a participant in a joint venture, as well as the exempt organization as a lender or ground lessor. Chapter 5 contains a more detailed discussion of private benefit and inurement involving compensation for services and incentive compensation arrangements, as well as other profit-making activities that may involve fees for services. Chapter 6 addresses exempt organizations’ participation in activities by 䡲
xxii
䡲
fpref.fm Page xxiii Thursday, March 15, 2007 7:33 PM
PREFACE
lending funds or becoming a ground lessor rather than taking an equity position. Such arrangements may replicate the economic functions and goals of partnerships. The chapter contains a general discussion of real estate loans, an analysis of participating loans (including a discussion of the debt–equity classification), and a discussion of the ground lease with a leasehold mortgage. Chapter 7, new to this edition, discusses the scrutiny that has recently been applied to joint ventures by the Congress and the IRS. Specifically, this new chapter addresses the use of nonprofit parties in joint ventures that may be tax avoidance schemes. This development has influenced and heightened the legislative inquiry into and response to the joint venture form. Chapter 8 focuses on the unrelated business income tax (UBIT), which is a recurring issue in the study of exempt organizations and is therefore critical in evaluating joint venture transactions. The chapter begins with a discussion of the historical and legislative background of unrelated business income, followed by an analysis of the fundamental criteria—that is, “trade or business,” “regularly carried on,” and “not substantially related” subject matter. The statutory exceptions to UBIT, and modifications including the exception for royalties, are also discussed. Chapter 9 examines the debt-financed income rules with particular attention to the partnership rules and the limitations imposed on qualified organizations, such as educational institutions and qualified pension trusts, which are involved in partnerships. Also included is an analysis of the so-called “fractions” rule, which was enacted to prevent disproportionate income allocations to qualified organizations and disproportionate loss allocations to taxable partners. The exceptions to the fractions rule (including preferred returns and guaranteed payments, which are analyzed using a series of examples) and the §704(b)(2) rules are discussed in this context. Chapter 10 contains a general discussion of the dichotomy between the tax treatment of public charities (such as churches, educational institutions, and publicly supported organizations) and private foundations (which receive primary financial support from a few individuals or corporations, or from income earned by their own endowments). Chapter 10 focuses primarily on a foundation’s permissible ownership interest in a business enterprise, such as a joint venture or partnership, the consequences of excess business holdings, and the statutory exclusions. Chapter 11 concerns the impact on taxable joint ventures with an examination of the tax-exempt entity leasing rules, which do not apply to the extent that the income is subject to UBIT. A qualified exempt organization that invests with taxable partners in leveraged real estate held to produce income will be subject to the debt-financed income rules, unless the use of the property is substantially related to the organization’s exempt purposes. The chapter focuses on direct leases of property by taxable organizations to tax-exempt organizations, as well as partnerships between taxable and tax-exempt entities, in which partnership items of income, gain, loss, deductions, credit, and basis are not allocated to the tax-exempt entity in the same percentage share during the entire period that the tax-exempt entity is a partner. 䡲
xxiii
䡲
fpref.fm Page xxiv Thursday, March 15, 2007 7:33 PM
PREFACE
The third part of the book focuses on specific types of joint ventures, beginning in Chapter 12 with a study of healthcare entities involved in joint ventures. Chapter 13 examines in detail the low-income housing, rehabilitation tax-credit issues, and new markets tax credit issues. Chapter 14 reviews joint ventures with universities and discusses the IRS’s university audit program. Chapter 15 analyzes business leagues engaged in joint ventures, with an examination of the corporate sponsorship rules. Chapter 16 examines the use of joint ventures in the context of conservation initiatives, casting particular attention upon the problems that these organizations face in attracting for-profit investors to their charitable missions. With increasing frequency, charitable organizations have expanded their operations to include projects involving foreign organizations designed to eliminate or alleviate problems of international concern. Following the September 11 tragedy, however, the use of U.S.-based exempt organizations involved in international joint ventures as potential conduits for terrorism financing has become an increasing concern to the Congress and the Treasury Department. Accordingly, these issues are addressed at length in Chapter 17. Chapter 18 discusses the issues involved in pension fund investments in joint ventures. Largely because of the final check-the-box entity classification rules, Chapter 19 examines LLCs, which are replacing traditional limited partnerships as the joint venture entity of choice. Not surprisingly, the IRS indicated that it will analyze joint venture LLCs involving exempt organizations under the Plumstead/ G.C.M. 39005 two-prong test. Although they remain less flexible than partnerships and LLCs, S corporations have attracted renewed attention because §501(c)(3) organizations now may own S corporation stock. However, an exempt organization’s entire income from an S corporation must be included in UBIT regardless of the underlying source. The check-the-box regulations also have expanded the choices available to an exempt organization choosing to own 100 percent of another entity. An exempt organization may choose to structure a single-owner entity as a regular corporation, disregarded passthrough entity, or S corporation, depending on the circumstances, although the IRS has stopped issuing rulings on single-member LLCs being treated as disregarded entities. In addition, the IRS recently issued a field directive that examined an exempt organization’s obligation to make guarantees, including credit adjusters, completion guarantees, environmental indemnification, and capital calls, and that provided a “safe harbor” for newly formed nonprofits. As of this writing, this field directive guidance has made a critical impact on the Low Income Tax Credit (LIHTC) industry, including for-profit venturers. RECENT DEVELOPMENTS AND FORECASTS The Nature Conservancy Ventures Existing laws governing exempt organizations have made it difficult for organizations to reconcile the Service’s control requirements with their need to attract forprofit investors to their charitable mission. This emerging problem was addressed in 2005 when the Senate Finance Committee examined two joint ventures entered 䡲
xxiv 䡲
fpref.fm Page xxv Thursday, March 15, 2007 7:33 PM
PREFACE
into by The Nature Conservancy (TNC), an international, nonprofit organization whose mission is to promote the conservation of biological diversity. At the heart of the Senate Finance Committee’s examination were two Nature Conservancy joint LLC ventures, Forest Bank and Conservation Beef, each designed to preserve the environment using unorthodox means. Although TNC structured both deals to comport with current laws by designing these ventures with clear, charitable purposes, and maintaining the requisite control over their property and operations so as to insulate them from potential conflicts between TNC and the partnerships, the ventures failed for lack of investors, capital, and profit. The Senate Finance Committee noted that there could have been other reasons for the failure of each venture to attract investors, but it acknowledged that the IRS rules for these types of joint ventures could be so tightly drawn that few for-profit partners would choose to participate. As the need for joint ventures grows, The Nature Conservancy lesson confirms this author’s view that many worthwhile projects could fail because of the parties’ unwillingness to work through IRS standards. Conservation joint ventures are addressed at length in Chapter 16. IRS Extends Joint Venture Purview to §501(c)(6) Business Leagues The IRS determined that a business league, exempt from federal income tax under §501(c)(6), was not adversely affected by its indirect investment in a forprofit joint venture and was not subject to unrelated business income tax (UBIT). Although this determination, released on August 15, 2005, in Private Letter Ruling 200528029, may not be relied on as precedential guidance, the decision may shed light on how the IRS will determine other exempt organizations’ investments in for-profit joint ventures. Notably, rather than reaching a result by relying on the “control” prong, the IRS based its decision on whether the activities of the venture furthered the nonprofit exempt purpose. The conspicuous absence of the control analysis could be an indication that §501(c)(6) organizations participating in joint ventures need only establish that the activities of the joint venture are sufficiently related to their exempt purpose. More likely, however, the issue of control will still be considered as a necessary element, even though it was not specifically addressed in PLR 200528029. Further discussion of this topic is found in Chapter 15. Branding As unpredictable world events highlight the need for easy donor access and competition for capital to respond in crises afflicts many in the nonprofit sector, some exempt organizations have shifted their focus into the development of a “branding” strategy. These strategies commonly involve an exempt affiliate of one or more for-profit subsidiaries and the creation of a new Web site. The commingling of nonprofit and for-profit activities on one Web site, without a clear indication as to which entity “owns” the particular page being viewed, is likely to raise significant tax implications. The IRS has provided very little substantive guidance regarding exempt organization’s use of the Internet; thus, nonprofits 䡲
xxv
䡲
fpref.fm Page xxvi Thursday, March 15, 2007 7:33 PM
PREFACE
structuring these branding arrangements should look for increasing guidance to develop while acknowledging, in the interim, the existing laws that apply to exempt organizations. Intermediate Sanctions and Excess Benefit Transactions On September 8, 2005, the IRS published proposed regulations detailing situations in which the intermediate sanctions imposed under §4958 may include the revocation of the organization’s exempt status. These proposed regulations reflect an important trend in IRS policy. Although they are broadly based, they are significant for their potential impact on joint ventures. These proposed regulations state that the IRS will consider all relevant facts and circumstances when deciding if revocation of exempt status is appropriate when §4958 excise taxes apply. This consideration includes: (1) the size and scope of the organization’s regular and ongoing activities that further its exempt purposes before and after the excess benefit transaction took place; (2) the size and scope of the excess benefit transaction in relation to the size and scope of the organization’s regular and ongoing activities that further its exempt purposes; (3) whether the organization has been involved in repeated excess benefit transactions; (4) whether the organization has established safeguards to prevent future violations; and (5) whether the excess benefits transaction has been corrected or the organization has made good-faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transaction. Although the proposed regulations contain several examples of suspect excess benefit transactions, they lack clear guidance about the payment of reasonable compensation. This omission occurs at the same time that the ousting of the American University president prompted members of the Joint Committee on Taxation and the IRS to increase their inquiry and enforcement efforts on executive compensation in exempt organizations. As of this writing, we are still awaiting the release of Final Regulations on §4958. IRC §4965 The Pension Protection Act of 2006 added a new section, 4965, to the Code and amended existing §§6033(a)(2) and 6011(g), providing an accommodation party penalty and disclosure provisions for exempt organizations involved as accommodation parties to tax shelter transactions. New §4965 applies to nonprofit entities, including not only those described in §501(c), but also a wide range of other tax-exempt organizations, governmental entities, plans, and accounts. In summary, if a nonprofit entity becomes a party to a prohibited tax shelter transaction, §4965 will impose a penalty tax on the entity itself and/or (depending on what type of entity it is) on the entity’s managers. Section 4965 and the greater topic of the use of nonprofit entities as potential accommodating parties to prohibited tax-shelter transactions is discussed at length in Chapter 7. Continued Scrutiny of Joint Ventures In 2006, the IRS began a concentrated effort to enforce oversight of nonprofit hospitals, adding to a stream of patient-initiated lawsuits and legislative and 䡲
xxvi 䡲
fpref.fm Page xxvii Thursday, March 15, 2007 7:33 PM
PREFACE
congressional hearings that have recently enveloped healthcare joint ventures. In June 2006, the IRS sent questionnaires to more than 500 tax-exempt hospitals and healthcare organizations seeking detailed information about their operations, and particularly, the community benefits they provide in the form of free, charitable care, in exchange for tax-exempt bond financing and other perks. The IRS questionnaire includes sections on uncompensated care, billing practices, community programs, the board of directors and, one of the most notable areas in the field, the problem of executive compensation for physician partners. It is believed that the IRS will use the responses to determine if nonprofit hospital systems are continuing to provide programs and services that promote health for the benefit of the community and whether they are complying with the rules for compensation of directors and other key employees. In addition to its investigation into nonprofit healthcare systems, the IRS continues to scrutinize several key areas involving joint ventures, including abusive tax shelters and, in particular, the potential use of exempt organizations as accommodating parties to these schemes. In concert with its efforts to improve compliance and to crack down on abusive shelters, the Service has announced plans to establish new examination units, hire new agents, and work to better its guidance and examination procedures. In 2005, Commissioner Mark W. Everson stated that “The threat to the integrity of our nation’s charities is real and growing [. ... ] If [the IRS] does not act, there is a risk that Americans will lose faith in our nation’s charitable organizations.” ADDITIONAL RESOURCES Because there are so many legal developments affecting joint ventures, the text of the book is more extensive than either the first or second editions. The growth of the Internet, however, has meant that many of the appendix documents included in the first and second editions are available on the IRS Web site and other Internet sources. Obtaining those documents from the Internet gives the reader the advantage of getting the most current version of a form. Here is a list of some useful Web site addresses: http://www.irs.gov/charities/index.html: The main IRS Web page for charities and other nonprofit organizations. http://www.irs.gov/businesses/small.article/0,,id=98981,00.html: Web page containing documents relevant to nonprofit organizations including, Form 1023, Form 990, and Form 990-T. http://www.guidestar.org: Web site providing a searchable database of more than 1.5 million IRS-recognized nonprofit organizations. http://www.independentsector.org: Nonpartisan coalition of more than 550 exempt organizations. http://www.cof.org: Web site for The Council on Foundations, a membership organization of grant-making foundations.
䡲
xxvii 䡲
fpref.fm Page xxviii Thursday, March 15, 2007 7:33 PM
c01.fm Page 1 Thursday, March 15, 2007 5:14 PM
C H A P T E R
O N E 1
Introduction: Joint Ventures Involving Exempt Organizations Generally 1.1
INTRODUCTION
The participation of tax-exempt organizations in partnerships and joint ventures with taxable entities and other nonprofits is an area of continuing growth and interest.1 Joint ventures allow nonprofits to utilize the resources of other organizations in the pursuit of their charitable goals. While charitable giving spiked notably in response to the September 11 tragedy, nonprofit groups have since been faced with steep competition among themselves for donor funds. In 2002, donations to the country’s largest charities declined for the first time in a dozen years, with some categories, like health and the arts, slipping by more than 20 percent, according to a survey by The Chronicle of Philanthropy.2 The Chronicle study attributed some of this decline to donors being forced to choose between the one or two charities that matter the most to them.3 As a result, charitable entities are looking to nontraditional means to attract donors, increase revenues from their missionrelated activities, and make the contributions that they have received work more effectively. In addition to exigent circumstances, such as the September 11 tragedy in the United States and the tsunami that ravaged southeast Asia in January 2005, numerous legislative and economic factors in the United States have led to the growth of joint ventures. Changes in the healthcare field, including mergers between nonprofit hospitals and for-profit chains, have been driven by the growth of managed care and the Medicare shift from a cost-based to a “fixed fee per case” system. Nonprofit organizations devoted to the arts have been affected by decreased government funding and by the record number of mergers of forprofit corporations; the successor entities often change the charitable giving strategies of their predecessors, with decreased corporate support of the arts as 1
2 3
See M. Sanders, C. Roady, and S. Cobb, “Partnerships and Joint Ventures: Alive and Well or Endangered Species?” NYU Eighteenth Conference on Tax Planning for §501(c)(3) Organizations (1990). Portions of this chapter are based on research from the author’s NYU article. Greg Winter, “Charitable Giving Falls for First Time in Years,” New York Times, B1 (October 27, 2003). Id.
䡲
1
䡲
c01.fm Page 2 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
an unfortunate by-product.4 In addition, although the stock market generally flourished in the 1990s, individual corporations that did not experience financial success paid lower dividends, which affected the income stream of nonprofit shareholders.5 The technology revolution has created a new stage and marketplace for nonprofits, as well as offering them new opportunities for joint venture activities. Universities and colleges have been at the forefront of creative planning to raise revenues, which often involves joint ventures—for example, affinity credit cards (whereby the nonprofit allows a commercial credit card issuer to use the organization’s logo on its cards), travel tours, and corporate “sponsorship,” whereby a company pays a fee for use of its logo or name at sporting events.6 Some exempt organizations have expanded these concepts into full-fledged branding relationships, whereby the exempt organization comingles its image with a for-profit entity through the creation of a new Web site featuring both parties. In this new type of partnership, however, an exempt organization must be mindful not to overly comingle with the for-profit party so as to blur the line of distinction between promoting its exempt functions and engaging in commercial activities and advertising. These activities, which are discussed in detail in this book, have spurred IRS rulings, court cases, and congressional hearings and legislation. The book focuses on nonprofit organizations that qualify for exempt status under the Internal Revenue Code (IRC or “the Code”)7 and that most commonly participate in joint ventures. A foundational analysis of IRC §501(c)(3) “charitable organizations” and the statutory and common law requirements pertaining thereto, a necessary predicate to a study of exempt organization participation in joint ventures, is provided in Chapter 2.
1.2
JOINT VENTURES IN GENERAL
A joint venture is an association of persons or entities jointly undertaking a particular transaction for mutual profit.8 A partnership is defined as an association of two or more persons to carry on, as co-owners, a business for profit9 and can be structured as a partnership or, as is increasingly more common, a limited liability company (LLC).10 A partnership is treated as a pass-through entity and is, therefore, not subject to taxation; the partners are liable for income tax in their individual capacities.11 The various items of partnership income, gain, loss, 4 5 6 7
8
9 10 11
Irvin Molotsky, “Corporate Medici Lost to Mergers, Arts Groups Fear,” New York Times, B1 (Jan. 5, 1999). Judith H. Dobrzynski and Geraldine Fabricant, “Passing On the Pain at the Met, As Charitable Funds Drop, Museum Visitors Pay More,” New York Times, B1 (April 14, 1999). See discussion in Section 1.4 and Section 13.6. All section references are to the Internal Revenue Code of 1986 as amended and the regulations promulgated thereunder, unless otherwise noted, and will hereinafter be referred to by section number and cited as “§.” Treasury Regulations will be cited as “Reg. §.” Black’s Law Dictionary 839 (6th ed., 1990); Harlan E. Moore Charitable Trust v. United States, 812 F. Supp. 130 (C.D. Ill. 1993), aff’d, 9 F.3d 623 (Nov. 3, 1993), acq. in action on decision, 95-3953 (Apr. 14, 1995) (Issues 1 and 2). Uniform Partnership Act, §6(1); Black’s Law Dictionary 120 (6th ed., 1990); see also §7701 (a)(2). See Chapter 17 for a detailed discussion of limited liability companies. §701; Reg. §1.701-1.
䡲
2 䡲
c01.fm Page 3 Thursday, March 15, 2007 5:14 PM
1.2 JOINT VENTURES IN GENERAL
deduction, and credit flow through to the individual partners and are reported on their personal income tax returns.12 A joint venture is treated as a partnership for federal income tax purposes,13 but unlike a partnership, a joint venture does not entail a continuing relationship among the parties. Courts have described joint ventures as follows: A joint venture contemplates an enterprise jointly undertaken; it is an association of such joint undertakers to carry out a single project for profit; there must be a community of interest in the performance of a common purpose, a proprietary interest in the subject matter, a right to direct and govern the policy in connection therewith, a duty, which may be altered by agreement, to share both in profit and losses. One member of the joint venture is liable to third parties for acts of the other venturer, especially payment of debts.14
Current economic and social conditions present exempt organizations with significant opportunities to further their charitable purposes through participation in joint ventures.15 EXAMPLE: An exempt organization, whose purpose is to provide food and shelter to homeless individuals as a significant part of its charitable and religious purposes under IRC §501(c)(3),16 seeks to better serve these individuals. To accomplish this objective, the exempt organization plans to operate a farm. The farm will be used to grow produce and raise livestock for use exclusively as provisions for the homeless shelter. However, the exempt organization, by itself, does not have sufficient capital resources to purchase the farm. Therefore, the exempt organization forms a limited liability company in which it will serve as the managing member. The other members will provide the necessary capital for the venture, and the exempt organization will operate the farm. This illustration exemplifies the creative strategies utilized by exempt organizations that seek to expand and diversify their activities while furthering their exempt purposes.17 Exempt organizations are also becoming more entrepreneurial as government funding for the nonprofit sector has decreased and rate reductions have made it more difficult to attract contributions from the general public.18 EXAMPLE: X, an exempt organization under IRC §501(c)(3), whose fundamental purpose is to expand access to scientific, educational, and literary information, engages in a joint venture with Z, another exempt organization under §501(c)(3), 12 13 14 15
16 17 18
§702; Reg. §1.702-1. §761(a); Reg. §1.761-1(a); §7701(a)(2). Harlan E. Moore, 812 F. Supp. at 132 (citations omitted) aff’d, 9 F.3d 623 (Nov. 3, 1993), acq. in action on decision, 95-3953 (April 14, 1995) (Issues 1 and 2). A joint venture vehicle that is rapidly becoming the entity of choice is the limited liability company, which offers many of the benefits of a partnership while providing limited liability to all of its members. In fact, the most important ruling in the joint venture area, Rev. Rul. 98-15, 1998-12 I.R.B. 6 (March 23, 1998), involved two limited liability companies as the joint venture vehicle. For an in-depth discussion of limited liability companies, see Chapter 17. §501(c)(3); Reg. §1.501(c)(3)-1. See generally Priv. Ltr. Rul. 93-08-034 (Nov. 30, 1992). See, e.g., Priv. Ltr. Rul. 92-49-026 (Sept. 8, 1992).
䡲
3
䡲
c01.fm Page 4 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
to produce an electronic journal. The electronic journal is intended to complement the traditional print publications and to facilitate rapid delivery of information. The exempt organization also enters into agreements with libraries to allow access to its database. This activity is seen as furthering the exempt organization’s charitable purposes. Furthermore, the fact that the information is furnished to both exempt and nonexempt libraries does not detract from the educational value of the information and, hence, does not affect the charitable purpose.19 The IRS has recognized the entrepreneurial, elemental change in the way many exempt organizations operate, particularly in the hospital context: [T]he joint venture arrangements . . . are just one variety of an increasingly common type of competitive behavior engaged in by hospitals in response to significant changes in their operating environment. . . . [t]he marked shift in governmental policy from regulatory cost controls to competition has fundamentally changed the way all hospitals, for-profit and not, do business.20
Of course, while the IRS has recognized many ways in which an exempt organization may participate in joint venture with a for-profit industry and not jeopardize its tax-exempt status, the Service has also recently provided important and illustrative guidance where an exempt organization may either lose or severely compromise its exempt status in the areas of down payment assistance programs and healthcare joint ventures. In a recent Revenue Ruling21 the IRS provided guidance to organizations that provide down payment assistance to homebuyers. The ruling was significant for providing that down payment assistance programs that are not sellerfunded can further exempt purpose by assisting low-income home buyers or by combating community deterioration. The ruling makes it clear, however, that organizations providing seller-funded down payment assistance will not qualify for exemption. This ruling is notable for all joint ventures, as it provides insight into what types of activities the Service will view as charitable when deciding it the nonprofit party to the venture is engaging in an exempt activity. Similarly, the IRS recently initiated a comprehensive compliance study of tax-exempt hospitals, focusing on the issue of the “community benefit” standard. The benefit standard was established in 1969 and identifies several criteria important to §501(c)(3) qualification for general, acute care hospitals, such as a community-based board without financial interests in the institution, a full-time emergency room open to all without regard to ability to pay, an open medical staff policy, treatment of Medicare and Medicaid patients without discrimination, and appropriate mission-related use of net earnings. None of these criteria is essential in every case, but rather, an overall facts and circumstances analysis is used to determine qualification, including the use of §501(c)(3) requirements 19
20 21
The example is based on the factual situation presented in Priv. Ltr. Rul. 92-49-026 (Sept. 8, 1992); see also Rev. Rul. 81-29, 1981-1 C.B. 329 (computer network for libraries furthered exempt purpose even if offered to nonexempt libraries). Rev. Rul. 81-29 amplified Rev. Rul. 74-614, 1974-2 C.B. 164. Gen. Couns. Mem. 39,862 (Nov. 21, 1991); see also Monica Langley, “Hospitals and Doctors Fight for Same Dollars in a Louisiana Town,” Wall Street Journal, A1 (Nov. 25, 1997). Rev. Rul. 2006-27, 2006-21 I.R.B. (May 22, 2006).
䡲
4 䡲
c01.fm Page 5 Thursday, March 15, 2007 5:14 PM
1.3 HEALTHCARE JOINT VENTURES
such as operating for the benefit of the public and avoiding individual private benefit, political campaign involvement, and excessive lobbying. In the investigation, the IRS sent questionnaires to approximately 600 hospital systems, asking many questions related to the healthcare system’s operations, including percentages of free cases and level of emergency room care for indigent patients. The IRS has indicated that it will use the results of this investigation when it revisits the community benefit issue, and it remains to be seen if the community benefit standard, or the exempt status of existing healthcare systems, will be redefined in light of the results.
1.3
HEALTHCARE JOINT VENTURES
Nonprofit hospitals and other healthcare institutions are historically the most frequent high-profile participants in joint ventures.22 Rev. Rul. 98-15,23 which was released in March 1998 and remains to date the most significant ruling in the field involved “whole hospital” joint ventures. In these ventures, both the charity and the private entity contribute one or more hospitals to an operating limited liability company. Often, because the charitable hospital is worth considerably more than the private hospital contributed by the for-profit entity, the forprofit will also contribute cash, which is distributed to the charity, to make up for the inequity in values. Thus, after the transaction, the charity has a membership interest in an LLC and a significant sum of cash. These arrangements can raise questions under the private inurement rules, the intermediate sanctions provisions, and Plumstead/Rev. Rul. 98-15, particularly if the operation of the hospital was the charity’s sole or primary charitable activity or lucrative “golden parachute” arrangements are offered to members of the hospital board.24 This trend toward joint ventures is due in great part to the 1983 shift in Medicare reimbursements from a cost-based to a fixed, per case system, a shift subsequently made by many private insurance companies. These Medicare changes radically altered the financial incentives of hospitals, in that higher reimbursement revenues were no longer linked to extended hospital stays but to increased numbers of patient admissions and outpatient services. During the same time period, the healthcare industry shifted toward “managed care.” Thus, the end of the century saw an expansion of activity in the healthcare area, coinciding with rapid changes in the economic and regulatory environment, including reduced federal funding, increased competition, deregulation, and cost containment efforts by employers and private insurers25 To survive in such an environment,
22
23 24 25
See Gen. Couns. Mem. 39,862 (Nov. 21, 1991) and Rev. Rul. 98-15, 1998-12 I.R.B. 6 (Mar. 23, 1998). For an in-depth analysis of joint ventures involving the healthcare industry, see Chapter 11. For a decision involving the formation of an LLC, see Priv. Ltr. Rul. 95-17-029 (Jan. 27, 1995) (joint venture through an LLC by two hospitals approved by IRS). See id Whole hospital joint ventures and other healthcare developments are discussed extensively in Chapter 11 See Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The IRS notes that “the marked shift in governmental policy from regulatory cost controls to competition has fundamentally changed the way all hospitals, for-profit or not, do business.” See also Priv. Ltr. Rul. 93-08-034 (Nov. 30, 1992); Priv. Ltr. Rul. 92-21-054 (May 22, 1992).
䡲
5
䡲
c01.fm Page 6 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
exempt healthcare organizations have been compelled to test the legal limits and to “venture” into broader, more businesslike activities. 26 There are multiple reasons for healthcare organizations to engage in joint ventures and other sophisticated financial arrangements with physicians or other entities. The most frequently stated reasons include the need to raise capital; to grant physicians a stake in a new enterprise or service, thereby gaining physician loyalty and patient referrals; to bring a new service or medical facility to a needy area; to share the risk that is inherent in a new enterprise; to pool diverse areas of medical expertise; to attract new patient admissions and referrals; to persuade physicians not to refer patients elsewhere; and to ensure that physicians do not establish a competing healthcare provider.27 To further these ends, hospitals, clinics, and other healthcare entities have begun to form more complex business structures. This book discusses these structures, the evolving rules governing their activities, and the potential effects of these changes on the tax-exempt status of the involved entities.28 Specifically, the merger trend may have hit a brick wall in reaction to the issuance of Rev. Rul. 98-15, in light of reports of the unwinding of numerous hospital ventures because of their inability to satisfy the requirements of the ruling.29 In 2006, the IRS launched its most expansive inquiry into the operations of tax-exempt hospital systems, sending approximately 600 compliance letters requesting information about the organizations’ community benefit activities and their compensation practices. The IRS indicated that it was hoping to compile information so as to spot trends and industry standards before moving forward with further examination of a smaller number of the organizations. Under the intermediate sanctions provisions, the IRS can impose a penalty tax on “disqualified persons” who receive an improper benefit from a §501(c)(3) or §501(c)(4) organization, as well as on the nonprofit’s officers or directors who approved the transaction.30 In addition, the issue of whether a nonprofit retains “control” in a joint venture is a major focus of the IRS. In Redlands Surgical Services v. Commissioner,31 the Tax Court upheld the IRS’s denial of exempt status to Redlands Surgical Services on the grounds that it did not retain sufficient control over its income and assets to ensure the continued fulfillment of its charitable purposes in an ancillary hospital joint venture.32 This case is also being closely followed because of IRS’s position that where a for-profit party has control of a venture, its ability to determine its compensation may itself constitute an impermissible activity.33
26 27
28 29 30 31 32 33
See generally Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). These reasons have all been offered to the IRS by healthcare organizations that are seeking IRS approval for joint venture arrangements. See generally, “Hermann Hospital Closing Agreement,” Exempt Organization Tax Reviews 10 (Nov. 1994): 1035–1041 (discussed in §11.3(a)(iii)); proposed physician recruitment guidelines, Ann. 95-25, 1995 I.R.B. 10 (discussed in §11.3(a)(iv)); final physician recruitment guidelines, Rev. Rul. 97-21, 1997-18 I.R.B. 1 (discussed in §11.3(a)(v)). See Chapter 12. See Section 12.1. See Sections 12.3(c) and 5.4. The IRS published Final Regulations on intermediate sanctions in January 2002. See Section 5.4 Tax Court Docket No. 11025-97(“X”), 113 T.C. No. 3 (7/19/99). 113 T.C. 47(1999). As discussed in Chapter 12, this analysis of control is the same applied in Rev. Rul. 98-15. See Section 12.3(b)(iv).
䡲
6 䡲
c01.fm Page 7 Thursday, March 15, 2007 5:14 PM
1.4 UNIVERSITY JOINT VENTURES
The Ninth Circuit adopted the reasoning of the Tax Court and endorsed the IRS position in Redlands.34 The Fifth Circuit, in St. David’s, has followed Redlands, and endorsed the IRS’s position that the relevant issue in a whole hospital joint venture is whether the nonprofit partner has ceded control to the for-profit partner.35 The Fifth Circuit affirmed the IRS’s restrictive position on participation by exempt organizations in joint ventures, and suggested a facts-and-circumstances test for determining whether the exempt organization has given up control to the for-profit partner in the context of a healthcare joint venture. Due to the Summary Judgment nature of this proceeding, St. David’s did not provide all of the factual evidence that was relevant to these tests regarding control. However, this Appellate Court opinion provided a road map for the District Court, resolve the only factual issue remaining, which is whether St. David’s ceded control over the partnership to HCA.
1.4
UNIVERSITY JOINT VENTURES
Like hospitals, universities are natural participants in joint ventures.36 Educational missions are often effectively advanced through association with major corporations and/or with individual members of a university’s faculty. In turn, the nonexempt venturer has much to gain through access to the university’s vast resources. The symbiosis is obvious. For example, Emory University expects one of its joint ventures with a biotech company to create 12,000 new jobs, and the University of Georgia in Athens, Georgia, anticipates becoming a “hotbed” for agricultural biotech firms.37 A threshold issue confronting university joint ventures is the IRS’s position, originally developed in the hospital context, that a nonprofit serving as general partner could jeopardize its IRC §501(c)(3) exemption if the venture conducts an “unrelated” commercial activity and the venture constitutes all or substantially all of the assets and/or activities of the nonprofit. In the university context, however, it is unlikely that the assets contributed to a joint venture would be material relative to the university’s total resources. Thus, where a joint venture does not further a university’s exempt purpose, the issue of UBIT will arise under the rubric of Rev. Rul. 98-15.38 Almost all large colleges and universities conduct supported or sponsored research, funded by private firms or the federal government. Often, these research activities are structured as a joint venture between the university and the sponsor, and the relatedness of research to the university’s scientific or educational purposes is a common theme regardless of whether the taxpayer is a university, whether the relationship is structured as a partnership, or whether the issue involves the basic exemption or unrelated business income tax (UBIT). Therefore, 34 35 36
37 38
242 F.3d 904, 904-5 (9th Cir. 2001) aff’g 113 T.C. 47 (1999). St. David’s Health Care System v. United States, 349 F.3d 232, 2003 WL 22416061 (5th Cir. 2003). See Chapter 4.2(f) for further discussion. Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook (7)(10)69, “Colleges and Universities” (Aug. 1994). There are currently 21 colleges and universities under CEP audit. See note 31. Roxana Guilford, “Technology in Focus,” Atlanta Business Chronicle (Jan. 15, 1999). See Sections 4.2(e) and 11.3(d).
䡲
7
䡲
c01.fm Page 8 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
regulations, cases, and rulings on the exempt status of separate research organizations, and UBIT for universities, are relevant. The IRS concerns here are, in theory, similar to those in regard to any other joint venture arrangement involving an exempt organization: The venture must be related to the university’s charitable purpose, whether scientific or educational; the venture must allow the university to further exclusively its charitable purposes; the venture arrangement must provide adequate protection for the university’s exempt assets; and the venture must comply with the prohibitions against private inurement and private benefit.39 Universities are again “pioneering,” this time by forming ventures with forprofit companies to provide distance learning opportunities over the Internet. Rather than watch their professors and students depart to experiment with distance learning elsewhere, many universities have entered into ventures in hopes of keeping control and participating in the anticipated rewards. Many of these ventures are structured as for-profit organizations primarily to reward key personnel with stock options and other forms of equity ownership. However, the for-profit structure may pose disadvantages in the long run.40 In perhaps the most significant recent development in the field, the IRS issued Rev. Rul. 2004-51, which analyzed an ancillary joint venture between a §501(c)(3) university and a for-profit entity to offer teleconference courses. The ruling, which is discussed at further length in Section 4.4, is significant for its discussion of bifurcated control by the exempt entity in an ancillary-type venture. A particular area of university joint ventures that has received increased attention in recent years is university-sponsored educational travel tours.41 Generally, such tours involve a joint venture between a university and a travel agency whereby the university provides the students, professors, itinerary, and educational curriculum, and the travel agency books and arranges the trip, while making a tax-deductible contribution to the university. Profits are sometimes shared with the university, either directly or in the form of free travel for the university professors. Travel tours present a potential UBIT problem for universities unless they are substantially related to such universities’ educational purpose. The IRS has often found the requisite educational content lacking in travel tour arrangements42 and has both officially43 and unofficially44 identified the travel tour area as a major focus of upcoming IRS audits of colleges and universities. In April 1998, the IRS issued proposed regulations on travel tours,45 which were expected to be finalized in 1999.46 The proposed regulations provide illustrations of tours that satisfy the educational requirements and those that do not. To satisfy the 39 40 41 42 43 44 45 46
See generally Chapters 4 and 5. See Chapter 14. University-sponsored travel tours are discussed in detail in Chapter 14. See, e.g., Rev. Rul. 78-43, 1978-1 C.B. 164; Tech. Adv. Mem. 90-27-003 (Mar. 21, 1990). Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook (7)(10)69, “Colleges and Universities” (Aug. 1994), §42(14)(2)(e). See Fred Stokeld, “Owens Briefs EO Reps on Guidance, Other Developments,” 97 Tax Notes Today (Sept. 26, 1997):187-3. Prop. Reg. §1.513-7. See Section 7.5(d). Fred Stokeld, “Keep Records of Travel Tours, Owens Advises,” Exempt Organization Tax Review (April 1999): 21.
䡲
8 䡲
c01.fm Page 9 Thursday, March 15, 2007 5:14 PM
1.5 LOW-INCOME HOUSING JOINT VENTURES
guidelines of the regulations, it is crucial that organizations institute a record keeping system at the initial planning stage so that they can establish on audit that their tours have an educational purpose and therefore do not generate UBIT.47 The final regulations for travel tour arrangements were published in February 2000. They are similar to the proposed regulations, with three additional examples to illustrate educational content and relation to the educational purpose of the university.48 The IRS is also examining incentive compensation paid by universities.49 For example, where a university agrees to pay a professor deferred compensation for developing software, the IRS will examine the transaction in light of the intermediate sanctions provisions.50 Finally, both the IRS and Congress have initiated aggressive investigations in recent years into compensation paid by universities.
1.5
LOW-INCOME HOUSING JOINT VENTURES
Tax-exempt organizations that desire to develop a low-income housing project typically need to obtain an allocation of low-income housing tax credits (LIHTC) for the project. Most of the low-income housing developed by tax-exempt organizations is financed, at least in part, with LIHTC.51 Because nonprofits are taxexempt entities and do not usually owe tax, the LIHTC is of little use to them. However, the nonprofit can “sell” the credits to a for-profit investor, which can use the credits to offset its tax liability. This is done by syndicating the project, that is, by selling an ownership interest in the project to the investor. Because widely held C corporations are not subject to either the passive loss or the at-risk rules, these corporations are the most likely investors in tax credit projects. Corporations invest in tax credit projects either directly or through syndicated equity funds. These funds, which are sponsored by such national organizations as the Enterprise Foundation and Local Initiatives Support Corporation, have been organized to assist corporations to invest in projects that qualify for LIHTC. Examples of such funds include the Housing Outreach Fund, Corporate Housing Initiatives, and the California Equity Fund. Corporate equity funds are structured as limited partnerships in which the sponsor or its affiliate is the general partner and the corporate investors are the limited partners. The funds invest in limited partnerships that own 47 48 49 50 51
See id. See Section 7.5(d). Carolyn Wright and Fred Stokeld, “Reconstructed EO Function Means More Help for Exempts, Owens Says,” Exempt Organization Tax Review (April, 1999):21. See id. The provision of low-income housing offers an excellent opportunity for exempt organizations to provide an invaluable social service in conjunction with taxable entities. This arrangement works well for partnerships that apply for the low-income housing tax credit provided in §42. Generally, §42 provides a tax credit annually for a period of 10 years based on the construction or rehabilitation cost of the project and the portion occupied by low-income tenants. For a detailed discussion of joint ventures involving low-income housing opportunities, see Chapter 13; see also Priv. Ltr. Rul. 92-40-011 (July 1, 1992) (§42 tax credits allocated to an exempt organization and one of its subsidiaries); Priv. Ltr. Rul. 91-48-047 (Sept. 5, 1991); Priv. Ltr. Rul. 93-49-032 (July 29, 1993). See Section 4.2(d)(i)(B) and Section 15.6 for a discussion of the final low-income housing safe harbor guidelines.
䡲
9
䡲
c01.fm Page 10 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
projects eligible for LIHTC. These local partnerships (which acquire, construct, own, and manage the low-income housing projects) are commonly referred to as operating or project partnerships. Operating partnerships generally consist of a local tax-exempt organization or its wholly owned for-profit subsidiary, which serves as general partner, and an equity fund (or a single corporate investor), which is admitted as a limited partner. The equity fund or other investor generally receives a 99 percent or more interest in partnership profits, losses, deductions, and credits (including LIHTC) in return for a capital contribution to the partnership. The tax-exempt or wholly owned for-profit subsidiary typically retains a 1 percent or less general partnership interest. In most cases, additional financing is necessary; it consists of a first mortgage loan and one or more “soft” mortgage loans that are subordinate to the first mortgage loan. The first mortgage loan is generally provided by a commercial lender or by a state or local agency. The soft mortgage loans are provided by state or local agencies or by one of the federal housing programs, such as the Community Development Block Grant Program, HOME Investment Partnerships Program, Hope VI Public Housing Revitalization Program, or the Federal Home Loan Bank’s Affordable Housing Program. Changes in federal law emphasize the significant role of exempt organizations as social providers.52 Although hospitals, universities, and low-income housing organizations are well-known participants in joint ventures, new types of nonprofit organizations have been created in response to economic and societal needs. Nonprofit entities of recent creation include local economic development corporations (LEDC) and community development corporations (CDCs).53 These organizations exemplify the partnership between the government, nonprofits, and private enterprise necessary to combat societal ills. Two other types of organizations that may qualify for exempt status under IRC §501(c)(3) are the small business investment company (SBIC) and the minority enterprise small business investment company (MESBIC).54 New federal programs may further accelerate the growth and activity of such ventures. The Bush administration established an Office of Faith-Based and Community Initiatives to strengthen religious and community groups engaged in social welfare projects. The Community Renewal Tax Relief Act of 2000 authorized expansions of housing and community development programs based on tax credits and tax-exempt bonds. The bill extended the provisions of the Empowerment Zone program; created a new Renewal Communities program that grants a collection of tax incentives to employers and developers in poor 52
53
54
See generally Small Business Investment Act, 15 U.S.C. §681(d); Hearings Before the Subcommittee on Housing and Urban Affairs of the Committee on Banking, Housing, and Urban Affairs, United States Senate, 102d Cong., 2d Sess. (Mar. 25, 1992) (hearings held to explore the origins of distressed public housing and ways to end its destruction and impact on families, communities, and potential for affordable housing agenda). See M. Cerny, “Tax-Exempt Organizations and Economic Development,” Exempt Organizations Panel, ABA Section on Taxation (Feb. 7, 1993). See also Rev. Rul. 74-587, 1974-2 C.B. 162; Rev. Rul. 76-419, 1976-2 C.B. 146 (nonprofit formed to assist in community development). Small Business Investment Act, 15 U.S.C. §681 (d). See also Rev. Rul. 81-284, 1981-2 C. B. 130; Gen. Couns. Mem. 38,841 (Apr. 22, 1981); Gen. Couns. Mem. 38,497 (Sept. 18, 1980).
䡲
10
䡲
c01.fm Page 11 Thursday, March 15, 2007 5:14 PM
1.6 CONSERVATION JOINT VENTURES
urban and rural areas; and increased the amount of low-income housing tax credits. The New Markets Tax credit, also a part of the bill, was designed to encourage investment in businesses located in low-income communities.55 In addition to the LIHTC, the New Market Tax Credit (NMTC), created by the Community Renewal Tax Relief Act of 2000, provides incentive for for-profit organizations to partner with exempt organizations to invest in communities that traditionally have had poor access to economic resources. The NMTC provides tax credits to for-profit equity investors in Community Development Entities (CDE). These investments, which are made to CDEs, allow the CDE organization to use the funds to finance economic development in eligible lowincome areas. An exempt entity may serve (through a for-profit subsidiary) as a CDE, be a leveraged lender in a project, or as a Qualified Active Low-Income Community Business (QALICB). Under the NMTC, the CDE applies for and receives a NMTC allocation from the Treasury Department under a highly competitive application process. Upon receiving an allocation, the CDE then markets the Credit for-profit entities. These investors then make an equity investment in the CDE in return for the NMTC, which totals 39% phased-in over seven years. With the proceeds from the NMTC, the CDE then makes loans or investments in business and community development projects in low-income communities. Since its inception, the NMTC program has provided over $15 billion in allocated credits. Although the current legislation is set to expire in 2007, there are several pieces of legislation that would extend the program through 2008 and later. The impact of these joint ventures, NMTC partnerships between exempt CDEs and for-profit investors, has expanded economic investment and revitalization in historically impoverished communities. In addition to rejuvenating notoriously poor areas, the NMTC has proven an effective means to respond to areas ravaged by natural disasters. In addition, exigent natural disasters have increased the availability of special funding set-asides aimed at low-income housing and New Market Tax Credit ventures. The Gulf Opportunity Zone Act of 2005, signed into law by President Bush on December 21, 2005, contains $1 billion in economic incentives to rebuild the Gulf Coast, as well as to attract new investments to the affected areas. Modeled after the New York Liberty Zone incentives created for parts of lower Manhattan after the September 11 tragedy, these incentives are intended to stimulate rapid growth. Private investment within the Gulf Opportunity Zone (GO Zone) within the window of time provided.
1.6
CONSERVATION JOINT VENTURES
Environmental concerns such as the greenhouse effect, global warming, deforestation, and commercial overdevelopment have resulted in an increase in the numbers of nonprofit organizations organized and operated to promote conservation and energy awareness. Relying on IRS pronouncements dating back to the 1960s and 1970s, many of these organizations have obtained federal income 55
See Section 13.5 for a detailed description of the new program and its implementation.
䡲
11
䡲
c01.fm Page 12 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
tax exemption on the basis that such conservation or preservation activities are charitable, educational, or scientific. However, while the environmental concerns prompting the creation of these charities have not, on the whole, improved, funding for these entities has decreased, particularly in light of terrorist attacks and natural disasters. Despite funding challenges, however, conservation organizations are among some of the largest and most prominent charities in the country. In coping with the need for funding, however, some of these charities have turned to unique joint venture paradigms with for-profit partners, such as the setting up conservation easements over forest lands, that have come under IRS and Congressional scrutiny. Areas currently under scrutiny include in-kind property fundraising strategies, joint ventures and similar arrangements with for-profit landowners and others, and ongoing monitoring and enforcement of conservation easements and similar restrictions to assure that the restricted property remains perpetually dedicated to its conservation purpose. Notwithstanding the recent scrutiny of certain program strategies, conservation organizations, including those determined to be exempt under §501(c)(3) and (c)(4), as well as state and local government agencies, increasingly must rely on joint ventures and similar arrangements to raise needed financial capital and obtain private market technical and transactional expertise to further exempt purposes. This book dedicates a chapter to these unique joint venture arrangements, which pays particular attention to the Senate Finance Committee’s recent investigation of several joint ventures entered into by The Nature Conservancy, one of the most prominent conservation groups operating in the United States. The chapter also offers an overview of the various venture structures and reporting guidelines for these unique partnerships.
1.7
JOINT VENTURES AS ACCOMODATING PARTIES TO IMPERMISSIBLE TAX SHELTERS
While a concerted focus on tax-exempt organizations as a whole has been one of the IRS’s top servicewide priorities for several years, recently the Service has focused its examination on parties using nonprofits to assist in tax-avoidance or tax shelter transactions. In Notice 2004-3056, the IRS examined the use of tax-exempt organizations by S corporations that structured joint venture transactions to improperly shift taxation away from themselves to a nonprofit party for the purpose of deferring or altogether avoiding taxes. This Notice was a significant first step in the IRS’s focus on nonprofits’ roles in tax avoidance transactions, as it specifically designated a nonprofit entity as a participant in an abusive tax-avoidance, or “listed,” transaction. Most recently, the Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA) added another dimension to the issue of the use of tax-exempt entities in prohibited transactions. Before TIPRA, tax-exempt organizations could 56
IR-2004-30 (April 1, 2004)
䡲
12
䡲
c01.fm Page 13 Thursday, March 15, 2007 5:14 PM
1.8 JOINT VENTURE STRUCTURE
engage in prohibited transactions without any penalty to the organization. Now, tax-exempt entities and their managers must comport with a stringent set of reporting rules provided by TIPRA and if they do not, both the organization and its manager may be subject to penalty taxes. A chapter of this book has been devoted to these latest developments.
1.8
JOINT VENTURE STRUCTURE
There are numerous structural techniques that an exempt organization may utilize in expanding its activities. A joint venture arrangement can be formed with taxable or exempt entities. Historically, when it was prudent or necessary to create a new entity for a venture, a limited partnership was the first choice; when the project furthered an organization’s exempt purposes, the organization could serve as a general partner, with operational responsibilities for the project.57 Now that all 50 states (and the District of Columbia) have adopted limited liability company (LLC) statutes,58 the LLC has become the entity of choice because it combines the corporate advantage of limited liability with the pass-through tax treatment of partnerships.59 The important ruling in the area of joint ventures, Rev. Rul. 98-15,60 involved two scenarios of hospital joint ventures between forprofit and nonprofit entities; both used an LLC as the venture entity. In Rev. Rul. 98-15, the IRS employs criteria similar to the double-pronged test of Plumstead61 to analyze whether joint ventures would jeopardize the exempt organization’s tax-exempt status. The IRS will closely scrutinize the structure of an LLC joint venture arrangement to determine whether the exempt organization’s duty to operate exclusively for exempt purposes conflicts with any duties it may have to advance the private interests of the LLC’s for-profit members.62 To determine whether the exempt organization’s assets benefit the LLC’s for-profit members, the IRS will carefully examine any guarantees, capital call provisions, the management and control of the LLC, and, for private foundations, excess business holding issues.63 Alternatively, because the IRS has established strict requirements for charitable organizations that serve as general partner or managing member of an 57
58 59 60
61 62 63
See Plumstead Theatre Society v. Commissioner, 675 F.2d 244 (9th Cir. 1982) (per curiam), aff’g 74 T.C. 1324 (1980). See also Rev. Rul. 68-655, 1968-2 C.B. 213 (development of lowand moderate-income housing as a means of lessening neighborhood tensions and combating neighborhood deterioration is a charitable purpose); Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Priv. Ltr. Rul. 91-48-047 (Sept. 5, 1991). But cf. Gen. Couns. Mem. 36,293 (May 30, 1975) (IRS prior position effectively overruled by later rulings). See Section 3.4(a). See Section 3.4(a). Rev. Rul. 98-15, 1998-12 I.R.B. 6. See also “Whole Hospital Joint Ventures,” Exempt Organizations Continuing Professional Educational Technical Instruction Program for FY 1999 (hereinafter “1999 CPE”), and Statement of IRS Exempt Organizations Division director Marcus Owens, “Exempt Organizations Get Plenty to Chew On in L.A.,” Tax Notes at 829 (Nov. 16, 1998). For details on how the two-pronged test applies to LLC joint ventures, see Section 17.6 See Section 4.2(c). See Gen. Couns. Mem. 39,005 (June 28, 1983). Remarks of Marcus Owens, Meeting of the ABA Tax Section (Aug. 5, 1995).
䡲
13
䡲
c01.fm Page 14 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
LLC,64 the exempt organization may instead form a subsidiary or affiliate to serve in the aforementioned roles.65 In other cases, particularly when a venture does not further the organization’s exempt purposes, it may serve as limited partner or non-managing member.66 Finally, the exempt organization’s role may be limited to that of a lender or lessor, with or without some participation in the profits of the venture.67 This book examines the viability of and consequences to exempt organizations participating directly and indirectly in joint ventures with taxable and exempt entities. In particular, it reviews how participation in a joint venture, by itself or through a subsidiary, may affect an organization’s exempt status.68
1.9
THE EXEMPT ORGANIZATION IN A JOINT VENTURE: REV. RUL. 98-15
The IRS guidelines for determining whether a tax-exempt organization jeopardizes its exempt status by participating in a joint venture are contained in Rev. Rul. 98-15.69 The IRS acknowledges that an exempt organization’s participation in a joint venture does not necessitate a per se denial of tax-exempt status.70 However, the IRS has stated that any partnership or other joint venture arrangement between an IRC §501(c)(3) organization and one or more for-profit entities requires “close scrutiny” to determine whether the potential conflict between the exempt organization’s duty to operate exclusively for exempt purposes and any duty it may have to advance private interests, places the organization’s exempt status in question. Thus, the initial focus is on whether the organization is serving a charitable purpose. Once charitability has been established, the venture arrangement itself is examined to determine whether the arrangement permits the exempt organization to act exclusively in furtherance of the purposes for
64 65
66
67 68 69 70
Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 39,005 (Dec. 17, 1982). See Section 4.2. See generally California Thoroughbred Breeders Ass’n v. Commissioner, 57 T.C.M. (CCH) 962 (1989). A tax-exempt organization, pursuant to §501(c)(5), replaced its joint venture horse auction operation with a for-profit subsidiary. The change in structure from a joint venture arrangement to a taxable subsidiary was made because the exempt organization was “at a crossroads” with the joint venturer, and the taxable subsidiary was the best alternative available. Previously, the tax-exempt organization, whose exempt purpose was to “encourage, assist, regulate, and protect the raising and breeding of thoroughbred horses,” had entered into a joint venture with a for-profit auction company. The Tax Court held that the joint venture auction activities were “substantially related” to the tax-exempt purpose. See also Gen. Couns. Mem. 39,598 (Jan. 23, 1987); Gen. Couns. Mem. 39,646 (June 30, 1987). See Priv. Ltr. Rul. 92-07-033 (Nov. 20, 1991). As a limited partner, the exempt organization may be subject to the unrelated business income tax on income from the partnership’s business activity that is unrelated to the exempt organization’s exempt purposes. See generally §§511–513. See Priv. Ltr. Rul. 91-12-013 (Mar. 22, 1991). See Chapter 4 for a detailed discussion of the impact on its tax exemption of an exempt organization’s participation in a partnership or joint venture. The Ninth Circuit Court of Appeals confirmed the position of the IRS in Redlands Surgical Serv. V. Commissioner (Mar. 15, 2001). See Section 4.2(f). See, e.g., Priv. Ltr. Rul. 97-09-014 (Nov. 26, 1996) (IRS stated that exempt hospital’s partnership arrangement with for-profit partners does not “per se” endanger its exempt status).
䡲
14
䡲
c01.fm Page 15 Thursday, March 15, 2007 5:14 PM
1.9 THE EXEMPT ORGANIZATION IN A JOINT VENTURE: REV. RUL. 98-15
which exemption was granted, and not for the benefit of the for-profit parties to the venture.71 Charitable is defined in the regulations in its generally accepted legal sense.72 Whenever a charitable organization engages in unusual financial transactions with private parties, the arrangements must be evaluated in light of the tax law and other applicable legal standards.73 Notwithstanding an established charitable purpose, conflicts with an organization’s charitable goals can arise when an exempt organization participates in a joint venture, because the organizational documents could impose certain obligations upon the joint venture entity that would benefit the for-profit participants to the detriment of the nonprofit.74 Those obligations include an assumption of liabilities by the general partner or managing member, which exposes the general partner’s or managing member’s personal assets to partnership debts and liabilities, as well as a basic profit orientation in furtherance of the interests of the investors.75 Thus, it is important that the venture be structured so as to give the exempt organization effective control over daily activities. Day-to-day control demonstrates to the IRS that the exempt organization can ensure that the joint venture is serving a charitable purpose; lack of control suggests the possibility of private benefit.76 With respect to an LLC, this means that except in rare circumstances,77 the charitable organization should always be a managing member, although not necessarily the only managing member. An example of how a joint venture may be structured to preclude a conflict of interests between the tax-exempt organization’s obligations and its charitable purposes78 can be found in a general counsel memorandum involving a 71
72 73 74
75 76 77
78
Gen. Couns. Mem. 39,005 (Dec. 17, 1982); see also Priv. Ltr. Rul. 93-49-032 (July 29, 1993). There is currently a debate as to the applicability of Rev. Rul. 98-15 in regard to ancillary joint ventures, that is, those ventures where a nonprofit contributes only a portion of its assets. For a detailed discussion of the exempt organization as a general partner, or member of an LLC, see Chapter 4. Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Reg. §1.501(c)(3)-l(d)(2); §501(c)(3). See Uniform Limited Partnership Act, §9 (approved by the National Conference of Commissioners on Uniform State Laws in 1916); Revised Uniform Limited Partnership Act, §403 (approved by the National Conference of Commissioners in 1976); See generally Mery v. Universal Sav. Ass’n, 737 F. Supp. 1000 (S.D. Tex. 1990) (general partner jointly and severally liable for partnership acts); Betz v. Chena Hot Springs Group, 657 P.2d 831 (Alaska 1982) (general partner personally liable on debts even after retirement from partnership). Gen. Couns. Mem. 39,005 (Dec. 17, 1982). See also Uniform Limited Partnership Act, note 54; see also Revised Uniform Limited Partnership Act, note 54. See 1996 CPE Housing Article, Part II, Topic B, Part II6. In certain situations, however, it may be acceptable for the charity to be a non-managing member. For example, in the case of an exempt organization that brings retail franchises to the inner city through the provision of financial support to individual minority entrepreneurs, who have substantial experience in such development, the project will provide jobs to the poor and underprivileged and serve to encourage minority business development. Under the circumstances, it may be important for the minority entrepreneur to be the managing member. Under this fact pattern, the IRS is likely to allow the charity to participate in a non-managing role, because substantial charitable purposes are being furthered by the activities of the LLC and the success of the project is dependent on the charity acting as a passive investor. (Note that this fact pattern closely resembles a program-related investment, discussed in Section 4.9). See also Section 4.3. See Reg. §301-7701-2(d)(2) (structuring limited partnership agreement to shield general partner). However, if the general partner is completely shielded from liability, the entity may be viewed as something other than a partnership. Gen. Couns. Mem. 39,546 (Aug. 15, 1986).
䡲
15
䡲
c01.fm Page 16 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
government-financed housing project for disabled and elderly persons. The venture averted significant conflict for the following four reasons:79 1. Only the for-profit general partners were obligated to protect the interests of the limited partners. 2. Other general partners reduced the exempt organization’s risk of exposure of its charitable assets. 3. The exempt organization had no liability on the mortgage, which was non-recourse. 4. Housing and Urban Development (HUD) income guidelines restricted the partnership’s pursuit of private profit.80 The IRS has also applied Rev. Rul. 98-15 and its reasoning to ancillary ventures in healthcare and other fields. Six private letter rulings describe appropriate structures in healthcare and nonhealthcare organizations. For example, a limited liability company (LLC) composed of a conservation organization and owners of forestland was approved to manage the timber rights of a number of small owners, primarily for improved conservation of the forest environment and secondarily for income. The exempt conservation organization was to be the managing member in what could be termed an ancillary joint venture.81 In another private letter ruling, the IRS explicitly relied on Rev. Rul. 98-15 to approve an ancillary joint venture between two exempt healthcare organizations.82 Joint venture arrangements between for-profit and exempt organizations can be structured within the framework set up by Rev. Rul. 98-15. Advice on how to retain sufficient control and protection of the charitable partner’s purpose and assets is contained in Section 4.2(h).
1.10
ANCILLARY JOINT VENTURES: REV. RUL. 2004–51
In Rev. Rul 2004–51,83 the IRS issued long-awaited guidance on the income tax consequences of the participation by tax-exempt entities in “ancillary” joint ventures with for-profit partners. The ruling involved a tax-exempt university that formed a limited liability company with a for-profit company to provide interactive video training courses. The university’s primary purpose in forming the partnership was to grow its existing curriculum of teacher-training courses by offering them at off-site locations. Under the facts, the ownership and the governing board of the partnership was equally divided between the for-profit and exempt parties; however, the operating documents granted the university an exclusive right to approve all of the aspects of the courses, including the curriculum and the hiring of the faculty. 79 80 81 82 83
Gen. Couns. Mem. 39,005 (Dec. 17, 1982). See id. Priv. Ltr. Rul. 200041038 (July 20, 2000). See Section 4.2(e). Priv. Ltr. Rul. 200102053 (Oct. 2000). See Section 11.3(d). Rev. Rul. 2004-51.
䡲
16
䡲
c01.fm Page 17 Thursday, March 15, 2007 5:14 PM
1.11 LIMITED PARTNER OR NON-MANAGING MEMBER
The for-profit corporation retained control of all administrative functions associated with holding the courses off-site, including the choice of venue and the types of equipment used. All other decisions required the mutual consent of both parties. In concluding that the activities entered into by the university were not a substantial part of its operations and therefore, not significant enough to jeopardize its tax-exempt status, the IRS appeared to condone the exempt organization’s concession of control over all of the aspects of the partnership where the exempt party expressly retained control over the educational aspects of the venture. The ruling is discussed at great length later in this book.
1.11
THE EXEMPT ORGANIZATION AS LIMITED PARTNER OR NON-MANAGING MEMBER
Because an exempt organization’s involvement as a general partner or managing member can often jeopardize its exempt status, it may prefer to invest in a limited partner capacity or in a non-managing member role. The exempt organization’s role, in this instance, would be as a passive investor.84 EXAMPLE: An exempt university becomes aware of the need for off-campus housing suitable for student living. To facilitate the construction of the housing, the institution forms a limited partnership with a local construction firm. The university will serve as a limited partner, contributing necessary monetary resources to capitalize the partnership. In return, the university receives a limited partner profits interest in the partnership. The construction firm serves as general partner with day-to-day responsibility for constructing and managing the housing. Under this arrangement, the university is acting solely as a passive investor in the housing project. As a limited partner or non-managing member, the exempt organization and its assets would not be exposed to unlimited liability. Furthermore, the exempt organization would not have a statutory or fiduciary obligation to maximize the profits for the investors. However, there may be tax consequences for the exempt limited partner or member, depending on the type of activity, charitable or forprofit, engaged in by the partnership. If the activity furthers the charitable purposes of the exempt organization, the income received by the exempt limited partner would not constitute UBIT.85
84
85
With the growing popularity of LLCs, the question as to whether an exempt organization may invest as a non-managing member has arisen on a frequent basis. Although, as a general rule, a charitable organization should be the managing member of the LLC in which it is involved, it is arguable that the non-managing member role can be analogized to that of a limited partner. Whether the analogy will be respected by the IRS will depend on the activity of the LLC, the reasons for the charity’s non-managing role, the degree to which the charity participates in the operations of the LLC despite its “passive” position, and the apparent control it exercises through contractual or operational restrictions. See Section 4.3 for a more in-depth discussion of the exempt non-managing LLC member. Priv. Ltr. Rul. 91-09-066 (Mar. 1, 1991) (exempt organizations served as limited partners in limited partnership and the limited partnership was a general partner in a partnership that engaged in charitable activities, so the income was not UBIT); Priv. Ltr. Rul. 92-07-032 (Nov. 20, 1991). See, e.g., Rev. Rul. 85–110, 1985-2 C.B. 166.
䡲
17
䡲
c01.fm Page 18 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
EXAMPLE: A limited partnership is comprised of 10 limited partners, all hospitals, exempt under IRC §501(c)(3). X is one of the exempt limited partners. The general partner is a for-profit entity. The limited partnership was formed to provide unique mobile medical services to a rural community. Because these medical services are needed, unique, and otherwise unavailable, the partnership is viewed as furthering exempt charitable purposes, the same charitable purposes shared by X and the other limited partners. The participation by X as an exempt limited partner will not jeopardize X’s tax-exempt status. Furthermore, the income received by X as a limited partner will not constitute UBIT, because the business activity of the limited partnership has a substantial causal relationship to the exempt purposes of X.86 An exempt organization may also invest, but only to an “insubstantial” degree, in real estate and other commercial ventures that have no charitable purpose.87 In that event, the exempt limited partner or member will be subject to UBIT on income derived from the activity.88 EXAMPLE: If an exempt educational institution serves as a limited partner in a partnership that operates a factory, the exempt organization must include, in computing its unrelated business taxable income, its share of the items of income, deduction, gain, and credit from the operation of the factory.89 This tax is imposed at the applicable corporate or trust rates, depending on whether the exempt organization is classified as a corporation or a trust for tax purposes.90
1.12
PARTNERSHIPS WITH OTHER EXEMPT ORGANIZATIONS
Partnerships composed wholly of exempt organizations must further the exempt purposes of the exempt partners in order for the income derived therefrom to be exempt from taxation.91 EXAMPLE: X, an exempt educational institution, has a large, well-respected communications department on its campus. Y is a tax-exempt public broadcasting organization. X and Y seek to co-develop a national communications center, to be located on X’s campus. This project will be formed using a joint venture partnership. The arrangement will entail the construction and sharing of facilities on X’s campus. X will also hold a ground lease on the land on which the new facility is situated. Under these circumstances, because the partnership will further the exempt purposes of both exempt organizations, the income will not constitute UBIT to either X or Y. 86 87 88 89 90 91
This example is based on the factual situation presented in Priv. Ltr. Rul. 91-09-066 (Mar. 1, 1991). See generally §513; Reg. §1.513-1(d)(2). §513; Reg. §1.51 3-1. §511(a)(1); Reg. §1.511-1. Reg. §1.512(c)-1. §511(a)(2)(A) (tax imposed on entities under §401(a) and §501(c)); and §511(b) (tax imposed on trusts). See Reg. §1.511-2. §512(c)(1); Reg. §1.512(c)-1. See Section 4.4A
䡲
18
䡲
c01.fm Page 19 Thursday, March 15, 2007 5:14 PM
1.13 TRANSFER OF CONTROL OF SUPPORTING ORGANIZATION
In the example, the joint venture partnership must further the exempt purposes of both X and Y. If it is not clear that the joint venture arrangement furthers the exempt purposes of both exempt partners, then the partners should consider seeking separate tax-exempt status for the joint venture. In this situation, X and Y should seek a ruling from the IRS on the issue of whether the joint venture furthers the exempt purposes of both X and Y. Clearly, the IRS is less concerned about joint ventures involving only exempt organizations because the risks of private benefit and inurement are not present. The IRS approved a venture between two charitable healthcare organizations that formed an LLC to jointly operate rehabilitation services. The operating agreement requires the LLC to operate in a manner consistent with the charitable purposes of the two members, and the LLC is equally controlled by the two members.92 Another private letter ruling approved a joint operating entity in the form of an LLC owned by two healthcare organizations. The operating agreement requires the organization to further the exempt purposes of its two members, and they are equally represented on the board. Approval of both members is required for all major decisions and transactions.93 However, to the extent that an exempt organization is a partner in a partnership or a member of an LLC that regularly carries on a trade or business that would constitute an unrelated trade or business if directly carried on by the exempt organization, the organization must include its share of partnership income and deductions in determining its UBIT liability.94
1.13
TRANSFER OF CONTROL OF SUPPORTING ORGANIZATION TO ANOTHER TAX-EXEMPT ORGANIZATION
It is often difficult to effect the transfer of control of properties used for charitable purposes because of the existence of tax-exempt financing. The transfer of “control” by the tax-exempt parent of its interest in a supporting nonmember corporation that is a general partner or managing member of a partnership to another IRC §501(c)(3) organization presents a novel set of issues. In the context of a deferred sale, an issue arises as to how adequately to protect or secure the interest of the seller that holds a promissory note, because the mechanics do not involve the transfer of title to the property (which is otherwise typical). The transaction would be accomplished by a “change in control” of the board of the existing nonmember supporting corporation. The change of control is documented in the articles of incorporation and/or bylaws of the supporting organizations. The IRS requires that when a tax-exempt organization amends either its articles of incorporation or its bylaws, it must notify the IRS of the change. The notification can be done at the time the organization files its annual information return (Form 990) for the year in which the change occurred, or the IRS can be notified through a process called a “no change” letter. By simply notifying the 92 93 94
Priv. Ltr. Rul. 200102053 (Jan. 12, 2001). See Section 11.3(d). Priv. Ltr. Rul. 200044040, 2000 WL 33122062 (Nov. 3, 2000). See Section 11.7(c). Reg. §1.512(c)-1.
䡲
19
䡲
c01.fm Page 20 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
IRS at the time the Form 990 is filed, an organization has no protection going forward that the IRS has agreed that the change has no effect on the organization’s tax-exempt status. Therefore, the recommended course would be to send a no change letter to the IRS district office indicating that the change in the supported organization has occurred, but this should not have any adverse effect on the tax-exempt status of the supporting organization. Accordingly, a security interest must be created in the purchaser-debtor’s entire right to elect members of the board of the nonmember corporation. The debtor would have to deliver a Uniform Commercial Code financing statement (Form UCC-1); documents would also have to be drafted effecting the substitution of the secured party for the debtor as a person with the power to vote for the election of the members of the board of directors of the non-member corporation. In addition, an escrow agent would be designated to hold the aforementioned documents pending a default under the note. The documents must prohibit the purchaser-debtor from selling, transferring, or pledging the collateral without the prior consent of the secured party. Moreover, it is essential that the seller give notice to, and negotiate any necessary consents from, lenders, issuers, bond counsel, trustees, and, where applicable, credit rating agencies and bond insurers. Provisions must prohibit the purchaser-debtor from making distributions other than the repayment of the loan unless otherwise agreed to by the seller. EXAMPLE: S, an exempt organization, develops multifamily housing for low-income persons in the inner city. It structures each project using a single-asset non-member corporation as a supporting organization under IRC §509(a)(3), thereby electing all its board members. Each supporting organization serves as a general partner in a joint venture with an equity fund or single corporate investor, which is admitted as a limited partner. T, another exempt organization, proposes to acquire the projects by a transfer of the control of the board of each of the existing non-member supporting corporations. The acquisition price is represented by a promissory note, secured by the right to control the board in the event of default in the payment of the purchase price, all pursuant to a security agreement and the filing of a UCC-1. The security agreement will contain further limitations on T’s right to make distributions or otherwise sell, transfer, or pledge the collateral without S’s consent.
1.14
THE EXEMPT ORGANIZATION AS A LENDER OR GROUND LESSOR
Exempt organizations are often advised to participate in an activity by lending funds or becoming a ground lessor, rather than taking an equity ownership position in a joint venture. Alternative arrangements may so closely replicate the economic functions and goals of partnerships, yet provide advantageous tax treatment, that they are frequently referred to colloquially as “joint ventures.” Precisely because exempt organizations often enter into loans and ground leases as alternatives to equity investments, lenders and ground lessors in such transactions often require a return beyond a flat rate of interest or rent. The yield 䡲
20
䡲
c01.fm Page 21 Thursday, March 15, 2007 5:14 PM
1.14 THE EXEMPT ORGANIZATION AS A LENDER OR GROUND LESSOR
may consist of two components: a fixed return in the form of interest or rent (but typically at a below-market rate), plus additional compensation, whether dubbed “interest” or “rent,” for the additional risk assumed by the lender or ground lessor. The second component, commonly referred to as an “equity kicker,” is the major source of tax difficulty for exempt lenders and ground lessors, because as reflected in its name, this form of yield may cause the loan or lease to be viewed in substance as an equity investment—and thus subject to UBIT and the other tax disadvantages. Recharacterization of debt or a ground lease as an equity investment is more likely to occur if the interest or rent is based on net income or profits of the borrower or lessee, and less likely to occur if the interest or rent is based on gross revenue or receipts. The advantages of a lender-borrower or ground lessee structure include the following: • The return on a loan or a ground lease comes in the form of interest or
rent, both of which are generally excluded from unrelated business taxable income under IRC §512(b)(1) and (3).95 • In the case of pension funds, an investment in a form other than an equity
interest may avoid the “plan asset” rules governing fiduciary liability.96 • A loan transaction or ground lease may, for the exempt organization,
secure the kind of preferred return which, under the tax-exempt leasing rules, is unavailable to an equity investor without loss of depreciation deductions for the taxable venturer and loss of exemption from the debtfinanced income rules.97 • A true lending transaction or ground lease cannot properly be termed a
“joint venture” and thus would not be subject to the IRS position that the tax exemption of the participating exempt organization is jeopardized, unless the joint venture itself pursues a “related activity.”98 However, against these advantages must be weighed certain advantages of equity ownership: • If the exempt organization has UBIT derived from business activities, ser-
vices, or debt-financed income, the depreciation deductions available to a property owner can be a valuable offset. • If the exempt organization invests in a venture through a corporate subsid-
iary that is partially capitalized with debt, or otherwise lends money directly or indirectly to a C corporation, the exempt organization must run the gamut of the “earnings stripping” rules of IRC §163(j), resulting in possible loss of deductibility of the interest paid by the borrower corporation.
95 96 97 98
See Chapter 6. See id See Chapters 6 and 11 See Chapters 4 and 6.
䡲
21
䡲
c01.fm Page 22 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
• If a debt or lease structuring is vulnerable to recharacterization as equity,
it may be preferable for non-tax reasons to structure the transaction ab initio as an equity investment. If loan or lease documentation is in place and there is then a recharacterization to equity, the exempt organization could lose the security position it holds as lender through possessory rights of foreclosure or eviction, while having forgone the protections it would have enjoyed as a party to a partnership agreement. Generally, a loan or ground lease arrangement is often more advantageous than a joint venture. This book explores these alternative structures and discusses certain guaranty devices, which are largely of financial rather than tax import. Another way in which an exempt organization (typically a foundation) may act as a lender is through the use of program-related investments (PRIs). PRIs typically take the form of below-market loans to debtors that would likely have trouble securing traditional commercial financing, and are made in furtherance of the organization’s exempt purposes. This book discusses the statutory requirements for PRIs and the circumstances under which PRIs may be most effectively utilized.99
1.15 (a)
PARTNERSHIP TAXATION Overview
Because the joint venture structure is typically used in arrangements between exempt organizations and for-profit partners, it is fundamental in an analysis of joint ventures to examine the rules of partnership taxation under Subchapter K of the Code. This subject is especially important because substantial funds are channeled into the charitable stream through public and private syndications— for example, low-income housing tax credit syndications. Partnership tax issues also arise under the tax-exempt entity leasing rules100 and under the IRC §514(c)(9) exception to the “debt financed property” in the UBIT context, which involves qualified allocations,101 and “substantial economic effect” under §704(b).102 The partnership itself is nontaxable under IRC §701. The partners, however, are liable for tax in their individual capacities; that is, each member is taxed separately on its distributive share of income, gain, loss, deduction, or credit. A partner is entitled to deduct its distributive share of partnership losses, if any, to the extent of the tax basis of its partnership interest, which may include its share of partnership liabilities subject to the at-risk and passive activity loss rules. The first step in the tax analysis of partnerships is determining whether a business enterprise will be classified as a “partnership” for federal income tax 99 100 101 102
See Section 4.13 for a discussion of PRIs. See Chapter 11. See Sections 9.1, 11.5. See Section 9.7.
䡲
22
䡲
c01.fm Page 23 Thursday, March 15, 2007 5:14 PM
1.15 PARTNERSHIP TAXATION
purposes.103 The term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a trust or estate or a corporation.104 If a partnership is treated for federal income tax purposes as an association, the partnership will be taxable as a corporation.105 In such a case, tax benefits, including losses and credits, would not flow through to the partners, and cash distributions to partners would be characterized as corporate distributions, some or all of which may be treated as dividends for federal income tax purposes, resulting in taxation at both the corporate and shareholder levels.106 State and local taxes may add to this double tax burden. The IRS issued regulations relating to the merger and division of partnerships, reflecting an increased pace of corporate restructuring.107 Consistent with its policy, the IRS confirmed that LLCs owned by multiple exempt owners would be treated as associations rather than partnerships for tax purposes if they apply for separate tax-exempt status.108 (b)
Bargain Sale Including “Like Kind” Exchange
Partnerships and partners may transfer properties or partnership interests to charitable organizations. Such transfers may be treated for tax purposes as part gift and part sale—that is, a “bargain sale.”109 A partnership would recognize taxable gain on the sale portion and would be entitled to deduct as a charitable contribution the excess of the property’s fair market value over its sale price.110 Under IRC §1011(b), the partnership’s adjusted basis for determining its gain on the transfer is that portion of the adjusted basis that bears the same ratio as the amount realized by the transferor bears to the property’s fair market value.111 If property subject to indebtedness is transferred to a charity, the
103
104 105 106 107 108 109 110 111
For periods beginning on or after January 1, 1997, the IRS “check-the-box” regulations determine the classification of business entities for federal tax purposes. Under the check-the-box regulations, unincorporated business organizations may generally choose to be classified for federal tax purposes as either partnerships or associations taxable as corporations. The regulations specifically provide that an eligible entity that has been determined to be, or claims to be, exempt from taxation under §501(a) will be treated as having elected to be classified as an association. Reg. §301.7701-3(c)(1)(v)(A). However, this deemed election rule does not prevent a joint venture from qualifying as a partnership merely because the venturers include one or more exempt organizations. For periods beginning before January 1, 1997, prior Reg. §301.7701-2 applies, which provides that the “major characteristics ordinarily found in a pure corporation which distinguish it from other types of organizations are (i) associates, (ii) an objective to carry on a business for profit, (iii) continuity of life, (iv) centralization of management, (v) limited liability for corporate debts, and (vi) free transferability of interests.” However, the prior regulations also provided that characteristics (i) and (ii) are common to corporations and partnerships, and therefore classification issues were determinative on factors (iii)–(vi) inclusive. See also Morrissey v. Commissioner, 296 U.S. 344 (1934). §7701(a)(2); Reg. §301.7701-3(a); Reg. §301.7701-1(e). Reg. §301.7701-2(a)(1). Reg. §301.7701-2(a)(3). See Sections 3.11(g) and 19.5. See Section 4.4. §170(e), Reg. §1.170(c)(1); §1011(b); Reg. §1.1011-2(a)(1). §170(e), §1011(b); Reg. §1.1011-2(a)(1). §1011(b); Reg. §1.1011-2(a)(1).
䡲
23
䡲
c01.fm Page 24 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
amount of the indebtedness is treated as an amount realized on the transfer, whether or not the charity agrees to assume or pay the indebtedness.112 However, from a planning standpoint, the benefits of nonrecognition under the “like kind” exchange rules (including deferred exchanges) may be available to minimize the tax on bargain sales while preserving the advantages of the charitable contribution deduction.113 No gain or loss is recognized when property held for productive use in a trade or business, or for investment, is exchanged solely for property of a like kind and is held for similar use.114 If the taxpayer receives cash or other property (that is not of like kind), at least part of the gain or loss may be recognized.115 Nonrecognition provisions will not apply to deferred like-kind exchanges unless the exchange meets a 180-day time limit on the completion of the exchange and a 45-day rule for identification of the property to be received in the exchange.116
1.16
UBIT IMPLICATIONS FROM PARTNERSHIP ACTIVITIES
Since its inception, the federal income tax law has provided an exemption from taxation for organizations operating “exclusively for religious, charitable, scientific . . . literary, or educational purposes.”117 Some organizations benefiting from the exemption, however, earn profits through means having little or nothing to do with the purposes for which their exemptions were granted. In this regard, an exempt organization that participates in a partnership or joint venture with taxable or nontaxable entities is subject to taxation on any income it receives from an unrelated business activity.118 The UBIT is generally applied to the gross income derived from any unrelated trade or business regularly carried on by the exempt organization,119 less allowable deductions that are directly connected with the carrying on of the trade or business.120 Income is subject to UBIT if • It is income from a “trade or business.”121 • The trade or business is “regularly carried on.”122 • The activity is not “substantially related” to the organization’s perfor-
mance of its exempt function.123 If an exempt organization is a member of a partnership that regularly carries on a trade or business that is an unrelated trade or business, the organization must include its share of the partnership’s gross income, less applicable deductions, 112 113 114 115 116 117 118
119 120 121 122 123
Reg. §1.1011-2(a)(3). §1031; Reg. §1.1031(a)-1(a)(1). §1031(a)(1); Reg. §1.1031(a)-1(a)(1). §1031(b); Reg. §1.1031(b)-1(a). §1031(a)(3); Reg. §1.1031(k)-1(b)(2)(i) and (iii). §501(c)(3); Reg. §1.501(c)(3)-1(a). §501(b); §511(a) and (b). The UBIT was intended to prevent unfair competition by nonprofit organizations that engage in a commercial activity. Clarence LaBelle Post No. 271 v. United States, 580 F.2d 270 (8th Cir. 1978). §512(A)(1); Reg. §1.512(a)-1(a). See generally Chapter 7 on UBIT. §512(b); Reg. §1.512(b)-1(b). §513(a); Reg. §1.513(a)-1(b). §512(a); Reg. §1.512(a)-(1)(a); Reg. §1.513-1(c)(1). §513(a); Reg. §1.513-1(a); Reg. §1.513-1(d)(1).
䡲
24
䡲
c01.fm Page 25 Thursday, March 15, 2007 5:14 PM
1.16 UBIT IMPLICATIONS FROM PARTNERSHIP ACTIVITIES
from these activities in calculating its UBIT.124 The same rule applies to interests held in a publicly traded partnership.125 IRC §512(b) sets forth exceptions to the definition of unrelated business income (UBI), which include dividends, interest, rents, royalties, and noninventory sales.126 However, if any of these items (except dividends) are derived from controlled subsidiaries127 or debt-financed property,128 they may not qualify for the UBIT exceptions. Generally, interest is excluded from the computation of an exempt organization’s UBIT unless it is interest from debt-financed property or from a controlled organization.129 A payment usually qualifies as interest if it is remuneration for the use of or forbearance of money.130 However, whether an item constitutes interest is determined by the “facts and circumstances of each case.”131 For example, in certain cases, an equity kicker may cause a loan to be viewed in substance as a joint venture, thereby subject to UBIT.132 Rent is generally excluded from UBI.133 However, the IRS has recently been challenging the classification of certain lease agreements as joint ventures rather than leases.134 The rent from real property is not excluded from UBI if the amount of rent depends, in whole or in part, on the income or profits derived by any person from the leased property (excluding amounts based on a fixed percentage of the gross receipts of sales).135 Furthermore, the regulations governing real estate investment trusts,136 which define rents based on income or profits, are incorporated into the UBIT regulations for determining whether the rental exclusion applies.137 Rent that is attributable to services other than those usually or customarily rendered in connection with the rental of rooms or other space solely for occupancy is not within the UBIT exclusion for rental income.138 Hence, payments for the use of space in parking lots, warehouses, or storage garages are generally treated as payments for services.139
124
125 126
127 128 129 130 131 132 133 134 135 136 137 138 139
§512(c)(1); Reg. §1.512(c)-1. Reg. §1.512(c)-1 provides that if an exempt organization is a member of a partnership engaged in a taxable trade or business, then the income received as its share from the partnership is UBIT. §512(c) as amended by §13145(a)(1) of the 1993 Act. §512(b); Reg. §1.512(b)-1. Additional categories of UBIT exclusions include payments with respect to securities loans; gains on the lapse or termination of options on securities; gains or losses from securities options (without regard to whether written by an exempt organization); gains from options on real property; gains from the forfeiture of good faith deposits for the purchase, sale, or lease of real property; and loan commitment fees. §512(b). §512(b)(13); Reg. §1.512(b)-1(I)(1). §512(b)(4); Reg. §1.512(b)-1(1)(1) and (ii). §512(b)(1)(a); Reg. §1.512(b)-1(a). See generally Chapter 7 on UBIT and Chapter 8 on debt financing. Deputy v. DuPont, 308 U.S. 488 (1940). See also Rev. Rul. 69-188, 1969-1 C.B. 54. Reg. §1.512(b)-1; Priv Ltr. Rul. 89-05-002 (Oct. 12, 1988). See Chapter 6. §512(b)(3); Reg. §1.512(b)-1(c)(2). Harlan E. Moore Charitable Trust v. United States, 812 F. Supp. 130 (C.D. Ill. 1993), aff’d, 9 F.3d 623 (7th Cir. 1993), acq. in action on decision, 95-3953 (Apr. 14, 1995)(Issues 1 and 2). §512(b)(3)(B)(ii); Reg. §1.512(b)-1(c)(2)(iii)(b). Real estate investment trusts will hereinafter be referred to as “REITS.” Reg. §1.512(b)-1(c)(2)(iii)(b), incorporating Reg. §1.856-4(b)(3) and (6)(i). Reg. §1.512(b)-1(c)(5). Rev. Rul. 69-69, 1969-1 C.B. 159. For a comprehensive discussion of the rental exclusion, see Chapter 8 on UBIT.
䡲
25
䡲
c01.fm Page 26 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
Importantly, while previously rents received by an exempt organization from its controlled entity were taxable as UBIT, the Pension Protection Act of 2006 altered this paradigm to the extent such payments either reduced the controlled entity’s net related income or increased its net unrelated loss. Under the Act, the payments of interest, annuities, royalties, and rents received by an exempt organization from a controlled entity between 2006 and 2008 will be included in the UBIT calculation only to the extent that the payments exceed a comparable fair market value as determined under §482 of the Code. The UBIT tax is imposed on gross income from any regularly carried on unrelated trade or business, less allowable deductions directly connected with the carrying on of the trade or business.140 If an exempt organization has UBI from a number of unrelated trades or businesses, the tax is imposed on the aggregate of gross income less aggregated deductions from all unrelated trades or businesses.141
1.17
USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
As an alternative to direct participation in a joint venture, an exempt organization may form a for-profit subsidiary to participate in the venture. Through the use of a subsidiary, the exempt organization can be indirectly involved in a forprofit activity without jeopardizing its exempt status. Furthermore, because the income of the subsidiary is generally taxable, the parent will not be subject to UBIT on the subsidiary’s income.142 Use of a for-profit subsidiary protects the status of the exempt parent and insulates its assets from possible liability. If the exempt parent were to undertake these activities, and if involvement in the activities were more than insubstantial, its tax exemption could be jeopardized.143 Furthermore, exempt organizations may choose to place an activity in a separate subsidiary to insulate the parent corporation from legal liability for the activity. A parent corporation is generally not liable for the debts or tortious acts of its subsidiary. Frequently, investors and creditors will more readily invest or lend capital to for-profit entities than to tax-exempt organizations. The main reason is that in the event of insolvency of the exempt organization, an involuntary bankruptcy cannot be filed against it by creditors.144 Furthermore, a for-profit entity has the capacity to raise capital from the general public through a conventional stock issue. With the creation of the MESBIC and the small business investment company (SBIC) 140 141 142 143
144
§512(a)(1); Reg. §1.512(a)-1. Reg. §1.512(a)-1(a). See Section 4.2 on exempt organizations as general partner. See also Tesdahl, “Avoiding UBIT with Two Subsidiaries,” Exempt Organization Tax Review 11 (Mar. 1995): 597. A recent private letter ruling involving the National Geographic Society provides an excellent illustration of the fundamental principles applicable to for-profit subsidiaries. The ruling is discussed in Section 4.8(b)(iii). See 11 U.S.C. §303(a), which provides that an involuntary case may be commenced only under chapter 7 or 11 of this title, and only against a person, except a farmer, family farmer, or a corporation that is not a moneyed business, or commercial corporation. The Senate Judiciary Committee specifically stated that “eleemosynary institutions, such as churches, schools and charitable organizations and foundations likewise are exempt from involuntary bankruptcy.” S. Rep. No. 95-989, 95th Cong. (1983).
䡲
26
䡲
c01.fm Page 27 Thursday, March 15, 2007 5:14 PM
1.18 LIMITATION ON PREFERRED RETURNS
programs, these capital sources are reinforced. For example, the MESBIC program involves tax-exempt organizations providing seed capital for the establishment of organizations to serve as catalyst to obtain loans for minority businesses. In this case, the government has guaranteed these funds, permitting further leveraging through financial institutions.145 The subsidiary will be viewed as a distinct entity from the exempt parent, thereby preserving the parent’s exempt status and limiting the liability of the parent. The use of a subsidiary also allows for growth within the subsidiary, whereas if the parent directly engaged in the activity and the operations were successful, its exempt status might be adversely affected.146
1.18
LIMITATION ON PREFERRED RETURNS
Under the tax law, certain preferred returns are unavailable to a tax-exempt equity investor without a limitation on depreciation deductions for the taxable venturer and a loss of exemption from the debt-financed income rules. (a)
Debt-Financed Property
The UBIT exclusions for interest, rents from real property, and so forth, do not apply to the extent that income is derived from “debt-financed property.”147 The term debt-financed property is defined as “any property which is held to produce income and with respect to which there is an acquisition indebtedness . . . at any time during the taxable year.”148 Debt-financed property includes property that was disposed of during the taxable year if there was “acquisition indebtedness” outstanding with respect to such property at any time during the 12-month period preceding the disposition (even though such 12-month period may cover more than one taxable year).149 Property is not debt-financed property if substantially all of its use is related to the exercise or performance of the organization’s exempt purposes.150 However, income from debt-financed property will be subject to UBIT even if that income is derived from an activity that is not a “trade or business regularly carried on.” In other words, the “trade or business” and “regularly carried on” tests are not relevant when debt-financed property is involved. Additional limitations are imposed on qualified organizations that invest in real property through partnerships that include as partners both qualified organizations and parties other than qualified organizations. These limitations apply to partnerships as well as to any other pass-through entities, including tiered partnerships. When a qualified organization is a partner in a partnership that holds real property subject to acquisition indebtedness, the debt-financed portion of the
145 146 147 148 149 150
M. Cerny, “Tax-Exempt Organizations and Economic Development,” Exempt Organizations Panel, ABA Section on Taxation (Feb. 7, 1993). For an in-depth discussion on the use of subsidiaries, see Section 4.8. See Chapter 9 on debt-financed property. See also §512(b)(4) and §514. §514(b)(1); Reg. §1.514(b)-1. §514(b)(1); Reg. §1.514(b)-1(a). §514(b)(1)(A).
䡲
27
䡲
c01.fm Page 28 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
qualified organization’s income from the partnership will be subject to UBIT unless the partnership meets one of the following three tests: 1. All partners must be qualified organizations, such as educational institutions and qualified pension trusts. 2. Each allocation to a qualified organization must be a qualified allocation, that is, an allocation that never varies (the “qualified allocations rule”). 3. The partnership meets the requirements of the “fractions rule.”151 These three tests operate to prevent the transfer of tax benefits from a qualified organization to a taxable partner. When all partners are qualified organizations, there is no potential for a transfer to taxable partners. Because allocations never vary under the qualified allocations rule, taxable partners are prevented from receiving any tax benefits in greater proportion than their underlying interest in partnership capital. Under the fractions rule, allocations may vary but only within certain prescribed limits, which under the Proposed Regulations allow reasonable preferred returns and guaranteed payments. (b)
The Fractions Rule
The fractions rule requires the following: • Allocations of items to any partner that is a qualified organization cannot
result in the qualified organization’s having a share of overall partnership income for any year greater than the qualified organization’s share of overall partnership loss for the year when the qualified organization’s loss will be the smallest—that is, a qualified organization can never have income greater than its smallest share of loss; and • All partnership allocations must have substantial economic effect under
IRC §704(b)(2). The function of the fractions rule is to prevent disproportionate income allocations to qualified organizations and disproportionate loss allocations to taxable partners. (c)
Tax-Exempt Entity Leasing Rules
Increased tax incentives that became available for the for-profit sector in the early 1980s (accelerated depreciation, investment tax credits, etc.) created new opportunities for nonprofit organizations to raise funds by, in effect, “selling” otherwise wasted tax benefits to for-profit organizations. However, the Deficit Reduction Act of 1984 (the “1984 Act”) contained new rules known as the taxexempt entity leasing rules, which significantly restrict the tax benefits of leasing property to tax-exempt organizations, as well as the tax benefits available to partnerships composed of taxable and tax-exempt entities.152 151 152
§514(c)(9)(E). See Chapter 11 on tax-exempt entity leasing rules.
䡲
28
䡲
c01.fm Page 29 Thursday, March 15, 2007 5:14 PM
1.18 LIMITATION ON PREFERRED RETURNS
The tax-exempt entity leasing rules do not apply to any property predominantly used by a tax-exempt organization if the income derived from that property by the tax-exempt organization is subject to tax as unrelated business income. If this exception does not apply, the 1984 Act is applicable to two basic types of transactions. The first category involves direct leases of property by taxable organizations to tax-exempt organizations. The second category involves partnerships with taxable and tax-exempt entities as partners when partnership items of income, gain, loss, deductions, credit, and basis are not allocated to the tax-exempt entity in the same percentage share during the entire period that the tax-exempt entity is a partner. For example, a partnership agreement may allocate only 1 percent of profits, losses, and net cash flow to a taxexempt partner but may allocate 50 percent of sale and refinancing proceeds to that tax-exempt entity. In either case—the direct lease to a tax-exempt organization or a partnership composed of taxable and tax-exempt entities—IRC §168(h) severely restricts depreciation deductions for many of these transactions that affect the taxable joint venturer. For example, the depreciation deduction for residential real estate based on a 40-year useful life would be approximately one-third less than under the Modified Accelerated Cost Recovery System (MACRS).153 These rules were designed to address the perceived abuses of the prior law, namely, that for-profit or taxable lessors indirectly made investment tax incentives available to tax-exempt entities through reduced rents; the Code encouraged tax-exempt entities to enter into sale/leaseback transactions with taxable entities, which resulted in substantial revenue losses, and partnerships that included tax-exempt and taxable entities could allocate all or substantially all of the tax losses to the taxable entities, although the tax-exempt entities could share in profits and cash distributions on a more favorable basis.154 CAVEAT The 1986 Act, by enacting longer depreciation periods, introducing the passive loss rules, and repealing the investment tax credit, reduced the available tax benefits to individuals and thus reduced the impact of the tax-exempt entity leasing rules. As a result, more joint venture opportunities have become available to taxexempt entities, especially with corporate investors that are not subject to the passive loss limitations. See Chapter 13 on the low-income housing tax credit.
153
154
See §168. However, under the Revenue Reconciliation Act of 1993 the depreciation period for nonresidential realty was lengthened from 31.5 years to 39 years. §168(c)(1), as amended by the Revenue Recognition Act of 1993 §1315(a), chapter 1 of Title XIII of the Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103–66 (Aug. 10, 1993) (hereinafter the “1993 Act”). Until recently, §1301 like-kind exchanges were occasionally used as a tax planning technique to circumvent the application of the alternative depreciation system (ADS)—a key aspect of the tax-exempt entity leasing rules. Regulations, finalized in 1996, essentially foreclose further use of this technique by ensuring that the ADS will be applied to tax-exempt-use property even if a like-kind exchange is made. See Chapter 10 for a more in-depth discussion of the regulations.
䡲
29
䡲
c01.fm Page 30 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
1.19
SHARING STAFF AND/OR FACILITIES: SHARED SERVICES AGREEMENT
A tax-exempt organization may form a wholly owned for-profit subsidiary to carry out activities that the parent corporation cannot or chooses not to perform itself. Moreover, a tax-exempt organization may share some employees and/or facilities with a for-profit affiliate. In both cases, it is important to provide corporate protection to the tax-exempt entity so the activities and the income of the for-profit subsidiary or affiliate will not be attributable to the nonprofit. Where there are nonprofit and for-profit affiliates sharing employees and facilities, it is important that there be a Memorandum of Understanding or a Shared Services Agreement setting forth the arrangement. The justification for the Shared Services Agreement should be contained in the document itself, by including “whereas” clauses that include economies of scale reasons, division of corporate functions, and allocation of costs, so as to make the payment a fair value to the appropriate entity. Where payments are based on a cost-reimbursement structure, actual time records or actual costs would be the appropriate supporting documentation, including the actual expense items such as lease agreements, receipts, and the like. If the exempt organization shares services and/or facilities with more than one entity, it is preferable to have an agreement with each for-profit. Where lobbying expenses are shared, it is important to note the difference in tax treatment between nonprofits and for-profits and, in particular, to make sure that any lobbying expenses attributable to the nonprofit are truly “lobbying” expenses within the meaning of §501(h) of the Internal Revenue Code. Where there is a shared use of Web sites, it is important that the cost be allocated appropriately between the two entities, so as to not inadvertently cause an exempt organization to generate income that could jeopardize its exempt status or be treated as unrelated business income tax.155
1.20
“INTANGIBLES” LICENSED BY NONPROFIT TO FORPROFIT SUBSIDIARY OR JOINT VENTURE
An affiliate for-profit entity may use, or plan to use, certain intangible assets of its nonprofit parent or co-venturer, including its name, trademarks, logo, donor (or member) database, domain name, and certain content from publications and/or directory of service providers. The licensee would pay a royalty as consideration.156 (Note: The listing of assets is used by means of example only. All of these assets 155
156
See Chapter 5 for a discussion of private inurement, private benefit, and excess benefit transactions and the result of an exempt organization engaging in such transactions, which may be avoided if the exempt organization forms a wholly owned for-profit subsidiary to carry out certain activities that the exempt organization is prohibited from performing. See also Chapter 8 and Section 2.4(c) for discussion of UBIT and lobbying rules, respectively. In PLR 200225046 (June 24, 2002), the royalty paid by a for-profit subsidiary to its tax-exempt parent was 10 percent of the subsidiary’s “gross revenues” (defined in the agreement). The author has reviewed several cases in which the royalty was calculated on 4 to 5 percent of the subsidiary’s gross income. We note that for several years, there has been a legislative effort to persuade Congress to amend §512(b)(13), so that no UBIT would be imposed on the exempt parent, if the payment were at fair market value, as required under §482. Such a provision was passed by the Senate in its version of the CARE Act of 2003, but as of this date that bill has not been enacted.
䡲
30
䡲
c01.fm Page 31 Thursday, March 15, 2007 5:14 PM
1.21 PRIVATE INUREMENT AND PRIVATE BENEFIT
were licensed by a tax-exempt entity to its wholly owned subsidiary in Private Letter Ruling 200225046 [June 24, 2002]). IRC §512(b)(2) excludes from the definition of unrelated business taxable income all royalties, whether measured by production or by gross or taxable income from the property. In numerous cases, for example, Common Cause v. Comm’r, 112 T.C. 332 (1999), and Planned Parenthood Federation of America, Inc. v. Comm’r, T.C. Memo 1999-206, the courts have held that so long as the exempt organization engages only in “royalty-related” activities (i.e., it exercises only quality control over the use of the intangible assets), the characterization of the payment as a royalty will not be challenged. The IRS has stated that it does not intend to litigate in this area, but it will apply an allocation theory, treating the income from any marketing and promotional services as UBIT. However, royalty payments from “controlled” subsidiaries (i.e., ownership by vote or value of more than 50 percent of the stock of the corporation) may constitute unrelated business taxable income to the exempt parent. Previously, interest, annuities, royalties, or rent (but not dividends) received by an exempt organization from a controlled entity were taxable as unrelated business taxable income (“UBTI”) to the extent such payments either reduced the controlled entity’s net unrelated income or increased its net unrelated loss. Under the Pension Protection Act of 2006, such payments received by an exempt organization during 2006, 2007, or 2008 from a controlled entity will only be included in the calculation of the exempt organization’s UBTI to the extent that the payments exceed a comparable fair market value payment, as determined using the principles of IRC §482. Given the related-party nature of this royalty arrangement, it is critical that the royalty payment be based on comparable arm’s-length transactions between unrelated parties. This approach is consistent with IRC §482, and should withstand any potential IRS challenge. The nonprofit must retain the services of an independent professional consulting service to conduct a valuation analysis in connection with the implementation of the license agreement. CAVEAT We recommend that the royalty arrangement be made prospective, but it may memorialize payments made in prior years, for which no royalty fee was paid.
1.21
PRIVATE INUREMENT AND PRIVATE BENEFIT
The prohibitions against private inurement and private benefit are fundamental to tax-exempt status and are among the key issues on which the IRS focuses in analyzing joint ventures involving exempt organizations. This book explores the parameters of the doctrines of private inurement, private benefit and “excess benefit transactions,” and the types of situations in which these issues may arise.157 Some of the most controversial transactions involve nonprofits which: provide educational and health services, derive income from television contracts for 157
See Chapter 5.
䡲
31
䡲
c01.fm Page 32 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
college sports, and earn income from selling and renting their mailing lists. One issue is whether the activity is too “commercial” and, to the extent the activity generates a profit, who is benefiting from the profit. Regardless of the presence of exempt entities as participants in a joint venture, nonexempt partners will face the same traditional issue of reasonable compensation that plagues many commercial entities—deductibility under IRC §162. However, the presence of an exempt organization as a joint venture partner introduces additional key concerns. The first concern is whether any of the financial or nonfinancial arrangements contemplated by the joint venture results in the inurement of any portion of the exempt organization’s earnings to an officer, director, or founder (i.e., an “insider”) of the exempt organization. The second concern is whether the participation of the exempt organization in the joint venture confers a benefit on private individuals and/or nonexempt entities that is substantial and provides evidence that the exempt organization is operating for private benefit rather than for its exempt purpose. The third concern is whether there has been an “excess benefit transaction” under the intermediate sanctions provisions.158 The intermediate sanction rules were enacted in response to perceived financial abuses in the world of nonprofit organizations in general and public charities specifically. Until the adoption of IRC §4958, the IRS’s only enforcement tool was revocation of a public charity’s exempt status, a result considered too severe in most circumstances. In addition to the severity of revocation as a penalty, revocation penalized the nonprofit itself; there was no mechanism to punish the wrongdoer in the context of public charities as there was for private foundations in the Chapter 42 excise tax provisions. Compliance with the guidelines of the intermediate sanctions provisions is particularly important in regard to joint ventures between for-profit and nonprofit organizations. First, such ventures by their nature attract greater scrutiny. Second, engaging in a transaction with one or more for-profit entities inherently raises the potential for impermissible benefit and inurement. Accordingly, this book explains the significant terms and definitions of the intermediate sanctions rules. Specifically, the proposed regulations apply to public charities that would be described in §501(c)(3) or (4) and exempt from tax under §501(a), as well as any organizations that were exempt from tax under §501(a) and that were described in §501(c)(3) or (4) at any time during the five years preceding the date of an excess benefit transaction (the “lookback period”).159 They do not, however, apply to private foundations,160 trade associations, or other types of exempt organizations. Foreign organizations receiving substantially all of their support
158 159
160
IRC §4958 and Proposed Reg. §§53.4958-0 through 53.4958-7 (Reg. 246256-96). With the exception of churches that, per statute, do not have to file Form 1023, only §501(c)(3) organizations that file Form 1023 are subject to the intermediate sanctions. State and local government organizations that would be described in (c)(3) or (c)(4) were they not governmental related are therefore not subject to the intermediate sanction regulations, absent a request for §501(c)(3) status. See Bernadette M. Broccolo et al., “Rules to Live By: IRS Releases Intermediate Sanctions Regulations,” Exempt Organization Tax Review 21 (1998): 287, 291. Because private foundations are subject to §4941 excise taxes, it would not be advantageous for a §501(c)(3) organization to seek private foundation status in order to avoid the intermediate sanctions.
䡲
32
䡲
c01.fm Page 33 Thursday, March 15, 2007 5:14 PM
1.21 PRIVATE INUREMENT AND PRIVATE BENEFIT
from sources outside the United States also are not subject to §4958, regardless of §501(c)(3) or (4) status.161 Compensation is one of the more sensitive and troublesome, yet common, contexts to which these basic proscriptions may apply. The law of exempt organizations has borrowed the nomenclature from the for-profit sector: Compensation is said to be “reasonable” when the total compensation package is found to be reasonable relative to the services provided to the exempt organization. Under the proposed intermediate sanctions regulations, organizations must ensure that their compensation arrangements are “reasonable”—reasonable being that which would be paid for similar services by similar enterprises under similar circumstances. In determining reasonableness, the IRS will consider those circumstances in existence when a contract for services is made, unless reasonableness cannot be determined from such circumstances, such as when an unspecified performance bonus is to be paid at a later date. Under these circumstances, a determination of reasonableness cannot be made as of the date of the contract, but, rather, will be based on all the facts and circumstances, up to and including the date of payment.162 Compensation consists of cash and noncash compensation, including the following: • Salary, fees, bonuses, and severance payments that are paid163 • All forms of deferred compensation that are earned and vested164 • Premiums paid for liability or other insurance, as well as payments or
reimbursement for expenses, fees, or taxes not covered by insurance165 • All other benefits, including dental, disability benefits, and life insurance
plans, as well as taxable and nontaxable fringe benefits166 • Any other economic benefit provided directly or indirectly (including any
benefits through joint venture arrangements)167 Compensation issues that are particularly relevant to nonprofits engaged in joint ventures and that are encompassed by the intermediate sanctions provisions include incentive compensation, deferred compensation, physician recruitment incentives, and gain sharing.168 Perhaps the most important event for exempt organizations in 2004 was publication of final regulations implementing IRC §4958.169 Persons in a position to exercise substantial influence over a charitable organization will be penalized for receiving from the organization a greater benefit than warranted by the consideration they provided. The definition of disqualified person is based 161 162 163 164 165 166 167 168 169
Prop. Reg. §53.4958-2. Prop. Reg. §53.4958-4(b)(3)(i). Prop. Reg. §53.4958-4(b). Prop. Reg. §53.4958-4(b)(3)(ii)(B). Prop. Reg. §53.4958-4(b)(3)(ii)(C). Prop. Reg. §53.4958-4(b)(3)(ii)(D). Prop. Reg. §53.4958-4(b)(3)(ii)(E). See Sections 5.4 (c), 12.3(c), and 12.4. T.D. 8978, 26 CFR Part 53.4958-0 through 53.4958-8. See Section 5.4 for a more complete discussion.
䡲
33
䡲
c01.fm Page 34 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
on facts that show the person actually had substantial influence over an organization, rather than on the person’s title. Notably, the Pension Protection Act of 2006 expanded the definition of “disqualified persons” to include donors to donoradvised funds, and classified disqualified persons in supporting organizations. The final regulations appear to adopt the view of the Seventh Circuit in the United Cancer Council170 case that a person who is an outsider when he or she negotiates a fixed-payment contract is allowed a “first bite.” In such a situation, it is assumed that the organization negotiated a fair contract at arm’s length, so it will not be subject to penalties under the intermediate sanctions regulations. However, several of the examples appear to restate the Service’s position in United Cancer Council that an outsider can become a disqualified person through a contract. Of particular interest to joint ventures, the regulations make it clear that indirectly conferred excess benefits are also prohibited. Thus, a subsidiary or joint venture may not provide excess benefits to a person who is prohibited from receiving them directly from the parent or limited partner. Another section of particular interest, that on revenue sharing, was withdrawn. The IRS concluded that revenue-sharing arrangements should be analyzed under the general facts-and-circumstances test used for all excess benefit transactions. If the revenue that is shared exceeds the property or services provided in exchange, it will be considered excess. The standards used for valuation are the familiar ones of market value for property and reasonable compensation (within the range of that paid for like services under similar circumstances). Two examples of initial contracts included in the regulations show that the Service will treat revenue-sharing arrangements as reasonable compensation if implemented in the form of fixed-payment contracts. The regulations provide a rebuttable presumption that gives organizations an assurance that they have not entered into excess benefit transactions as long as they follow designated procedures. The regulations also add specific guidelines and detail on what constitutes corrective action if an excess benefit transaction does occur.
1.22
LIMITATION ON PRIVATE FOUNDATION’S ACTIVITIES THAT LIMIT EXCESS BUSINESS HOLDINGS
This book focuses primarily on joint ventures involving IRC §501(c)(3) “charitable organizations.” All such charitable organizations are divided into two general categories, public charities (such as churches, nonprofit schools, and publicly supported organizations) and private foundations.171 Private foundations are charities
170 171
See Section 2.4(b)(ii). A private foundation is a §501(c)(3) charitable organization, other than the following four types of organizations: (1) an organization that is a church, hospital, government-supported organization, or educational organization; (2) an organization that receives more than one-third of its annual support from gifts, grants, contributions, membership fees, and receipts from admissions and sales of merchandise; (3) an organization that is operated, supervised, or controlled by an exempt organization; or controlled by an exempt organization; and (4) an organization which is organized and operated exclusively for testing for public safety. See §509(a).
䡲
34
䡲
c01.fm Page 35 Thursday, March 15, 2007 5:14 PM
1.23 INTERNATIONAL JOINT VENTURES
that receive their primary financial support from a few individuals or corporations, or from income earned by their own large endowments. Public charities and private foundations are subject to the same general tax law requirements: They must be operated exclusively for public as opposed to private purposes; their assets cannot be used to benefit private persons; and they cannot engage in any political activity. Public charities, however, may conduct an insubstantial amount of lobbying activity.172 Stringent though these general rules may appear, private foundations are subject to additional limitations. Private foundations must pay a tax on their net investment income, they cannot engage in any lobbying, they cannot undertake the simplest of commercial transactions with certain disqualified persons, they must distribute at least specified amounts to charity each year, their investments must meet strict standards of prudence, their grant-making procedures must be fair to all prospective candidates, and they must not own more than a minority interest in any business. Infractions of these rules are punished by the imposition of stiff excise taxes, both on the foundation and, in some cases, on the persons who run them. This book examines a foundation’s permissible ownership interest in a business enterprise and the consequences of excess business holdings. Generally, an excise penalty tax of 10 percent is imposed on a private foundation if it has excess business holdings in a business enterprise, including a joint venture.173 “Excess” business holdings are generally determined with reference to the foundation’s own holdings and the holdings of all “disqualified persons.” As a general rule, the combined holdings of a private foundation and all disqualified persons in any joint venture, partnership, or corporation that are not substantially related to the exempt purposes of the foundation are limited to 20 percent of the voting stock or profits interest.174 Furthermore, an additional tax of 200 percent of the value of such excess holdings will be imposed if the excess business holdings are not disposed of within a “correction period.”
1.23
INTERNATIONAL JOINT VENTURES
In the modern global community, news of human suffering, poverty, and natural disaster has been brought to the forefront of our attention. Accordingly, over the past 10 years, the United States has seen an increase in the number of domestic charities responding to the needs of other nations and their peoples by expanding their charitable activities into the international arena. This charitable work is often performed in cooperation with the host government, other international organizations, community organizations, private national or international groups, or nongovernmental organizations (NGOs). Current law provides for special rules governing the use and expenditure of charitable assets overseas, and practitioners must exercise care in the structuring of foreign charitable undertakings to ensure that neither the deductibility of contributions made to the charitable organization nor the organization’s tax-exempt status is endangered.175 172 173 174 175
See Section 2.4(d). §4943(a)(1); Reg. §53.4943-1. The Pension Protection Act of 2006 amended this section, increasing the penalty tax from 5% to 10%. Reg. §53.4943-1. See Sections 17.2 and 17.9.
䡲
35
䡲
c01.fm Page 36 Thursday, March 15, 2007 5:14 PM
INTRODUCTION: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
This book discusses, in the context of joint ventures, the different methods by which a domestic charitable organization may conduct overseas charitable activity.176 In addition, the use of (and interaction with) “friend” organizations,177 the application of foreign law to joint ventures involving domestic participants,178 and the strict grant-making provisions applicable to private foundations (major participants in the international charitable arena) are addressed.179 The United States and Canada finally implemented a treaty that grants automatic recognition of exempt status to religious, scientific, literary, educational, or charitable entities, provided that they have been recognized as charitable under the laws of the country in which they were organized.180 The United States government has embarked on a series of actions designed to address the use of U.S. charities by international terrorist groups to fund terrorist activities. While some of these actions may create cumbersome procedures for charities, including the use of joint ventures, the need for government intervention to curb instances of fraud and illegal uses of charitable contributions outweighs the need to retain the simplified procedures for obtaining and maintaining nonprofit status. (See Section 17.2A for discussion.)
1.24
OTHER DEVELOPMENTS
LLCs have become increasingly popular as a structure for joint ventures between exempt organizations and for-profit entities. The IRS continues to develop rules and guidelines for them. Announcement 99-102 provided a process for an LLC owned by one tax-exempt organization either to gain independent tax-exempt status or to opt for “disregarded” status.181 Under certain circumstances, the IRS is willing to grant recognition of tax-exempt status to LLCs owned by multiple exempt organizations.182 The growth of the Internet affects many aspects of exempt organization tax law. The IRS is considering the need for additional regulation of advertising, trade shows, lobbying, and political activity on the Internet.183 For example, the lines between corporate sponsorship and advertising may have to be clarified for a medium that can transport the reader of a sponsorship acknowledgment to a commercial environment with the movement of one fingertip.184 The IRS itself increasingly makes use of the Internet to communicate. The new reports required from §527 political organizations may be made entirely electronically. The annual reports of all exempt organizations are now readily available on several sites on the Internet. State charities officials have also made innovative use of the Internet to develop and disseminate recommendations for regulating charitable solicitations over the Web.185 176 177 178 179 180 181 182 183 184 185
See generally Chapter 17. See Section 17.2(b). See Sections 17.8 and 17.9. See generally §§4942-4946 and §170 and the regulations thereunder. See also Chapter 17. See Section 17.9(a). See Section 4.6(c). See Section 4.4. See Section 8.5(f). Id. See Section 2.10(e).
䡲
36
䡲
c02.fm Page 37 Thursday, March 15, 2007 3:46 PM
C H A P T E R
T W O 2
Taxation of Charitable Organizations 2.1
INTRODUCTION
Tax-exempt organizations are often called “nonprofits.” The term does not mean that the organizations are prohibited from earning a profit. Rather, the term nonprofits refers to the goals or purposes that the organization expects to accomplish with whatever earnings or profits it can accumulate. In general, status as a nonprofit necessitates that funds on hand (in excess of operating expenses) be used to serve an exempt purpose of the entity. Likewise, a joint venture involving a tax-exempt organization must seek to further the exempt purposes of the participating organization. This chapter highlights the types of nonprofit organizations that qualify for tax exemption under the Internal Revenue Code (IRC)1 and briefly addresses those types of organizations that most commonly participate in joint ventures. The thrust of the material focuses on IRC §501(c)(3) “charitable organizations”2 and the statutory and common law requirements pertaining thereto. The chapter also briefly describes the application for exempt status and the reporting requirements for exempt organizations. Finally, the chapter concludes with rules governing the deductibility of charitable contributions made by individuals.
2.2
CATEGORIES OF EXEMPT ORGANIZATIONS
IRC §501(a)3 sets forth the types of organizations entitled to operate on a taxexempt basis.4 Section 501(a) specifically grants tax-exempt status to organizations described in §401(a) (qualified pension, profit-sharing, and stock bonus 1 2
3 4
Sections of the Internal Revenue Code of 1986, as amended (herein “IRC”) will be referred to by “§” in the text and footnotes of this book. Treasury Regulations will be cited as “Reg.§.” Whereas §501(c)(3) includes eight types of exempt organizations, the Supreme Court held that all organizations described therein are charitable entities. Hence, throughout this book, the “charitable” designation may be generically used for organizations exempt from taxation under §501(c)(3). See Bob Jones University v. United States, 461 U.S. 574 (1983). §501(a); Reg. §1.501(a)-1(a). §501(a) provides: (a) Exemption from Taxation. An organization described in subsection (c) or (d) or §401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under §502 or §503.
䡲
37
䡲
c02.fm Page 38 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
plans), §501(c) (various entities generally promoting public welfare), and §501(d) (religious and apostolic organizations).5
2.3
SECTION 501(C) ORGANIZATIONS: STRUCTURAL ELEMENTS
IRC §501(c) enumerates 28 categories of organizations that qualify for exempt status,6 and §501(c)(3) describes eight of the most common types of exempt organizations.7 These eight exempt organization types are often collectively or generically referred to as “charities” or “charitable organizations.” A §501(c)(3) organization is generally defined as a community chest, fund, or foundation organized and operated exclusively to promote one or more of the following purposes: • Religious8 • Charitable9 • Scientific10
5
6 7
8
9
10
Other code sections exempt other types of organizations from taxation, such as §501(e)(cooperative hospital service organizations), §501(f) (cooperative educational investment organizations), §521 (farmers cooperatives), §528 (home owners associations), and §527 (political organizations). However, a detailed description of these organizations is beyond the scope of this book. See generally B. Hopkins, The Law of Tax-Exempt Organizations, 9th ed. (Hoboken, NJ: John Wiley & Sons, 2007). §501(c). §501(c)(3); Reg. §1.501(c)(3) provides: (c) List of Exempt Organizations. The following organizations are referred to in subsection (a): (3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office. There were approximately 800,000 IRC §501(c)(3) organizations operating during fiscal year 2000 (excluding those organizations that are not required to apply for recognition for exempt status) according to the IRS business master file. The courts have generally been cautious in any attempts to define religious activity. See Sherbert v. Verner, 374 U.S. 398 (1963); Thomas v. Collins, 323 U.S. 516 (1937). However, for purposes of attaining tax-exempt status, the IRS and the courts properly have granted substantial leeway to organizations and their religious beliefs. See Saint Germain Foundation v. Commissioner, 26 T.C. 648 (1956); Unity School of Christianity v. Commissioner, 4 B.T.A. 61 (1926). Furthermore, when the IRS attempts to recharacterize or redefine religious beliefs, the courts have stepped in to ensure and protect constitutional rights. See Bethel Conservative Mennonite Church v. Commissioner, 746 F.2d 388 (1984), rev’d 80 T.C. 352 (1983). “Charitable” purpose is the catchall of exempt purposes under §501(c)(3). It encompasses a wide variety of activities that can be classified as charitable. For example, an organization that seeks to provide affordable housing to low-income individuals would qualify for tax-exempt status as a “charitable” organization. See Gen. Couns. Mem. 39,005 (Dec. 17, 1982). Scientific organizations are generally research organizations. The term “scientific” is broad in scope, but there must be some public benefit to the research. For example, an organization engaged in research on human diseases, which then publishes the research and conducts educational seminars to disseminate the research, is exempt as both scientific and educational. See generally Rev. Rul. 65-298, 1965-2 C.B. 163.
䡲
38
䡲
c02.fm Page 39 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
• Testing for public safety11 • Literary12 • Educational13 • National or international amateur sports competition14 • The prevention of cruelty to children or animals15
There are special limitations and requirements that apply to IRC §501(c)(3) organizations, including the following: • Organizational and operational tests16 • Prohibition on inurement and private benefit17 • Proscriptions against substantial dissemination of propaganda or influ-
encing legislation18 • Prohibition against participation or intervention in political campaigns19 • Distinctions between a public charity and a private foundation20
2.4
STATUTORY REQUIREMENTS
To qualify for tax-exempt status under IRC §501(c)(3), an organization must be both “organized” and “operated” exclusively for one or more purposes specified in that section.21 If the organization fails to meet either the organizational or operational tests, it is not exempt.22
11
12
13
14
15 16
17 18 19 20 21 22
In response to a court decision that held that an organization that investigated the causes of losses that insurance companies insure against, Congress included the “testing for public safety” purpose in §501(c)(3). See Underwriters’ Laboratory, Inc. v. Commissioner, 135 F.2d 371 (7th Cir. 1943); Reg. §1.501(c)(3)-1(d)(4); Reg. §1.501(c)(3)-1(d)(1)(i)(D). Hence, an organization that tests the safety of consumer products, such as boats, is exempt under this provision. Rev. Rul. 65-61, 1965-1 C.B. 234. The IRS rarely rules that an organization qualifies for exempt status as a literary organization, presumably because such an organization would be subsumed under the definition of “charitable” or “educational.” See Reg. §1.501(c) (3)-1(d)(1)(i)(E). An “educational” organization can be more than a formal school; the term relates to the “instruction or training of the individual for the purpose of improving or developing his capabilities:, or to the “instruction of the public on subjects useful to the individual and beneficial to the community.” Reg. §1.501(c)(3)-1(d)(3)(i). This category of charitable organization was added by the Tax Reform Act of 1976. A qualified amateur sports organization is any organization organized and operated exclusively to foster national or international amateur sports competition. For example, an organization that seeks to protect children from hazardous working conditions is exempt as preventing cruelty to children. See Sections 2.4(a) and (b). The limitations in §501(c)(3) are stated in the conjunctive. If an organization fails to satisfy the organizational or operational tests, it is fatal to the organization’s chances for exemption under §501(c)(3). Levy Family Tribe Foundation v. Commissioner, 69 T.C. 615, 618 (1978). See Chapter 5 on private inurement. See Section 2.4(c)(i). See Section 2.4(c)(ii). For a discussion of limitations on excess business holdings, see Chapter 9. §501(c)(3); Reg. §1.501(c)(3)-1. Reg. §1.501(c)(3)-1(a)(1); Levy Family Tribe, 69 T.C. at 618.
䡲
39
䡲
c02.fm Page 40 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
An exempt organization may also have to satisfy the “commensurate test.”23 Although the commensurate test was first articulated by the Internal Revenue Service (IRS) in 1964, until recently it has seldom been used by the IRS. Under this test, the IRS may assess whether a charitable organization is maintaining program activities that are commensurate in scope with its financial resources.24 The commensurate test resurfaced in 1990 as the IRS began to examine more closely the fundraising practices of charitable organizations. In applying the commensurate test, the IRS attempts to ascertain whether the charitable organization is engaging in sufficient charitable activity in relation to its available resources.25 In 1990, the IRS revoked the tax-exempt status of a charitable organization partially based on the rationale that its fundraising costs were too high and thus had violated the commensurate test.26 The IRS found that the charity in question had expended only 4 percent of its revenue for charitable purposes; the balance was allegedly spent for fundraising and administration.27 (a)
Organizational Test
The organizational test relates to the rules for governing an organization. The determination of whether an organization meets the organizational test is made by reviewing the articles of incorporation,28 wherein the organization must restrict its purposes and powers to those exempt purposes enumerated in IRC §501(c)(3).29 Thus, the organizational test may be satisfied by carefully drafted articles of incorporation. A deficiency in the articles will likely result in the organization’s failing the organizational test.30 23 24
25 26 27 28
29 30
Rev. Rul. 64-182, 1964-1 C.B. (Part 1) 186. See B. Hopkins, The Law of Tax-Exempt Organizations, 9th ed. (Hoboken, NJ: John Wiley & Sons, 2007). (Although the commensurate test does not lend itself to rigid numerical tests, expenditures for administrative costs and fundraising that greatly exceed expenditures for charitable purposes will invite close scrutiny by the IRS.) See Priv. Ltr. Rul. 96-36-001 (Jan. 4, 1996). (An exempt organization operated several religious schools and engaged in substantial religious publishing activities. The IRS determined that income from the publishing, which far exceeded that which was necessary to educate the schools’ students was subject to UBIT. The IRS declined to pursue revocation of the organization’s exempt status, however, because although the publishing was a “substantial part” of the organization’s overall operations, there was no evidence that income generated by the publishing activity was used for purposes other than furthering the organization’s educational goals.) See id. Id. at 12 (citing Technical Advice Memorandum reproduced in Exempt Organization Tax Review 4 (July 1991):726). See id. Exempt Organizations Handbook, 4 I.R.M. Administration §322.1 (CCH 1977). See Reg. §1.501(c)(3)-1(b)(2) (the term “articles of organization” includes the trust instrument, the corporate charter, the articles of association, or any other written instrument by which an organization is created). Thus, §501(c)(3) status will not be granted by the IRS unless the organization has a written charter. This requirement is not met by a provision in the bylaws. Gen. Couns. Mem. 39,736 (May 24, 1988); see also Priv. Ltr. Rul. 94-25-006 (June 24, 1994); Priv. Ltr. Rul. 94-25-007 (June 24, 1994); Priv. Ltr. Rul. 94-25-008 (June 24, 1994) (in a series of rulings dealing with the reorganization of various hospital service organizations, the IRS held that the exempt organizations in question had substantial business purposes for reorganizing that were consistent with their charitable purposes. As a result, the IRS ruled that after the amendment to the certificate of incorporation and the bylaws of the exempt organizations and the proposed reorganization, the organizations continued to qualify for exemption under §501(c)(3)); Priv. Ltr. Rul. 95-17-029 (Jan. 27, 1995). Priv. Ltr. Rul. 96-15-031 (Jan. 4, 1996). See discussion of whole hospital joint ventures in Section 11.3(d)(v). See Section 2.3. See generally Gen. Couns. Mem. 39,736 (May 24, 1988).
䡲
40
䡲
c02.fm Page 41 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
An organization that fails the organizational test cannot cure the defects by operating in a charitable manner. Moreover, if an organization’s actual activities are not charitable in nature, the organization cannot qualify for exemption merely by virtue of the fact that charitable purposes are enumerated in the articles.31 (i) Exclusively Organized for Exempt Purposes. The regulations provide that an organization seeking exemption must be organized “exclusively” for one or more of the enumerated exempt purposes.32 An organization is organized exclusively for one or more exempt purposes only if its articles • Limit the purposes of such organization to one or more exempt purposes • Do not expressly empower the organization to engage, otherwise than as
an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes33 A single noncharitable purpose will jeopardize the tax-exempt status of an organization, regardless of the presence of other charitable purposes.34 Although the Code (IRC) requires the organization to be organized “exclusively” for charitable purposes, the regulations have been construed to require that the entity be organized “substantially” for charitable purposes.35 Under no circumstances may the organizational purposes be broader than the purposes enumerated in IRC §501(c)(3); they may, however, be narrower.36 EXAMPLE: The articles may recite the purposes as “charitable and educational purposes within the meaning of IRC §501(c)(3).” The articles may provide a narrow, specific purpose such as “granting scholarships to deserving junior college students residing in Gotham City.”37 When a specific purpose is set forth in the organization’s articles, it must be a purpose that falls within the categories enumerated in IRC §501(c)(3). CAVEAT A purpose to “operate a hospital” does not meet the organizational test, because it is not necessarily within IRC §501(c)(3). A hospital may or may not be exempt, depending on the manner in which it is operated.
31 32 33 34
35 36 37
Reg. §1.501(c)(3)-1(b)(1)(iv). See Reg. §501(c)(3)-1(b)(1)(i). Reg. §1.501(c)(3)-1(b)(1)(i). Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279 (1945); Universal Life Church, Inc. v. United States, 13 Ct. Cl. 567 (1987), aff’d, 862 F.2d 321 (Fed. Cir. 1988) (court utilized the single noncharitable purpose test to balance the charitable and noncharitable purposes, ultimately denying the tax exemption); Stevens Bros. Foundation, Inc., v. Commissioner, 324 F.2d 633 (8th Cir. 1963), aff’d 39 T.C. 93 (1962), cert. denied, 376 U.S. 969 (1964), reh’g denied, 377 U.S. 920 (1964); Copyright Clearance Center v. Commissioner, 79 T.C. 793, 804 (1982). See Reg. §1.501(c)(3)-1(b)(1)(i)(b). See Reg. §1.501(c)(3)-1(b)(1)(ii). Reg. §1.501(c)(3)-1(b)(1)(iv).
䡲
41
䡲
c02.fm Page 42 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
(ii) Dedication of Assets. Exemption under IRC §501(c)(3) is based on the exclusive dedication of the organization’s assets to its exempt purposes.38 Hence, the organizational test is not met unless a provision in the articles or local law precludes the possibility of a distribution of assets to private interests.39 Moreover, the required dedication does not exist if the assets may be distributed to the members upon dissolution or termination. (b)
Operational Test
The operational test is intended to ensure that an organization’s resources and activities are devoted primarily to furthering exempt purposes.40 An organization will generally be treated as operating exclusively for exempt purposes if it engages primarily in activities that accomplish one or more of the exempt purposes enumerated in IRC §501(c)(3).41 The operational test looks to the actual purpose for an organization’s activities, not to the nature of the activity or the organization’s statement of purpose.42 In testing compliance with the operational test, the court’s analysis looks beyond the four corners of the articles to discover “the actual objects motivating the organization and the subsequent conduct of the organization.”43 38 39
40
41
42 43
Gen. Couns. Mem. 39,736 (May 24, 1988). See Rev. Proc. 82-2, 1982-1 C.B. 367 (considered in Gen. Couns. Mem. 38,821 (Nov. 18, 1981)). The Revenue Procedure identifies particular states and the circumstances under which the IRS will not require an express provision for the distribution of assets upon dissolution in an exempt organization’s articles or charter, because the assets must be so distributed by operation of law. Reg. §1.501(c)(3)-1(c)(1); Rev. Rul. 72-369, 1972-2 C.B. 245. See Hammerstein v. Kelley, 349 F.2d 928, 930 (8th Cir. 1965) (when an organization’s primary activity furthers an exempt purpose, the organization is operating “exclusively” for exempt purposes). Thus, a slight and comparatively unimportant deviation from the exempt purposes is not fatal. St. Louis Trust Co. v. United States, 374 F.2d 427, 432 (8th Cir. 1967); Church of World Peace v. Commissioner, 67 T.C.M. (CCH) 2282 (1994), aff’d, 95-1 U.S. Tax Cas. (CCH) ¶ 50, 219 (10th Cir. 1995) (the requirement that a §501(c)(3) organization operate exclusively for exempt purposes does not mean solely or absolutely without exception, but that any nonreligious, nonexempt purpose furthered by the organization’s activities must be insubstantial as compared with the religious purposes served). See also Nationalist Movement v. Commissioner, 37 F.3d 216 (5th Cir. 1994), cert. denied, 513 U.S. 1192 (1995). Reg. §1.501(c)(3)-1(c)(1). Nationalist Movement v. Commissioner, note 40 (petitioner consistently argued that its activities, in one way or another, touched virtually all of the charitable categories listed in §1.501(c)(3)-1(d)(2). The court’s concern under the operational test, however, is not how diverse the petitioner’s allegedly charitable activities are, but whether the petitioner engages primarily in activities that accomplish exempt purposes). See Spanish American Cultural Association of Bergenfield v. Commissioner, 1994 T.C.M. 510 (1994) (organization was formed to preserve, promote, and enhance the cultural heritage of Spanish-American people, provide for the unification of the community, and establish a link to the community’s Spanish heritage. Activities consisted primarily of sponsoring dances, plays, cultural affairs, parties, and speakers, as well as planning eventually to construct a community center and set up a scholarship fund. Although the organization was granted exempt status as a social welfare organization under §501(c)(4), the IRS denied the association §501(c)(3) status. The Tax Court upheld the denial on the basis that the organization failed to meet the operational test. Although its charitable and educational purposes and activities were allowable under §501(c)(3), the social purposes of, and social activities actually engaged in by, the association were not insubstantial when compared with its charitable and educational purposes and activities). American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989); Kentucky Bar Foundation v. Commissioner, 78 T.C. 921 (1982); B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978). Taxation with Representation v. United States, 585 F.2d 1219, 1222 (4th Cir. 1978), citing Samuel Friedland Foundation v. United States, 144 F. Supp. 74, 85 (D.N.J. 1956); Christian Manner International v. Commissioner, 71 T.C. 661, 668 (1979).
䡲
42
䡲
c02.fm Page 43 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
The regulations enumerate three factors that must be satisfied in order for an organization to meet the operational test:44 1. The organization must be primarily engaged in activities that accomplish its exempt purposes.45 2. The organization’s net earnings must not inure in whole or in part to the benefit of private shareholders or individuals.46 3. The organization must not be an “action” organization—that is, one that devotes a substantial part of its activities to attempting to influence legislation, or participates or intervenes, directly or indirectly, in any political campaign, or advocates the adoption or rejection of legislation.47 Thus, the operational test includes a proscription against private inurement, a limitation on legislative activities,48 and a prohibition against political campaign activities.49 In addition, the regulations impose a general rule that an organization must be operated primarily to further public rather than private interests.50 (i) Operating Exclusively for Exempt Purposes. The Code and regulations require that an IRC §501(c)(3) organization must be “exclusively” operated for exempt purposes. However, in practice, exclusively has been interpreted to mean “substantially.”51 For example, the Eighth Circuit stated: [I]n order to fall within the claimed exemption, an organization must be devoted to [exempt] purposes exclusively. This plainly means that the presence of a single non[exempt] purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly [exempt] purposes.52
Thus, the operational test mandates that the organization not be engaged, except to an insubstantial degree, in any nonexempt activity. The regulations provide that an organization must be engaged in activities furthering “public” purposes rather than private interests.53 An organization is not organized or operated exclusively for one or more of the purposes specified . . . unless it serves a public rather than a private interest. Thus, to meet 44
45 46 47 48 49
50 51 52
53
Reg. §1.501(c)(3)-1(c). See Church by Mail, Inc. v. Commissioner, 765 F.2d 1387, 1391 (9th Cir. 1985), aff’d T.C. Memo 1984-349; American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989); Church of Scientology v. Commissioner, 823 F.2d 1310, 1315 (9th Cir. 1987), cert. denied, 486 U.S. 1015 (1988). Reg. §1.501(c)(3)-1(c)(1). Reg. §1.501(c)(3)-1(c)(2). See Chapter 5 on inurement and private benefit. Reg. §1.501(c)(3)-1(c)(3). §501(c)(3); Reg. §1.501(c)(3)-1(b)(3); Reg. §1.501(c)(3)-1(c)(3). See Baltimore Regional Joint Board Health and Welfare Fund, Amalgamated Clothing and Textile Workers Union v. Commissioner, 69 T.C. 554 (1978). In ruling that an organization providing day care services and health exams did not qualify for exempt status, the Tax Court recognizes that the operational test overlaps other tax requirements for charitable organizations. Reg. §1.501(c)(3)-1(d)(1)(ii). St. Louis Union Trust Co. v. United States, 374 F.2d 427 (8th Cir. 1967). St. Louis Union Trust Co. v. United States, 374 F.2d at 431. See Dulles v. Johnson, 273 F.2d 362, 368 (2nd Cir. 1959), cert. denied, 364 U.S. 834 (1959); Seasongood v. Commissioner, 227 F.2d 907, 912 (6th Cir. 1955); Estate of Thayer v. Commissioner, 24 T.C. 384, 391 (1955); Hammerstein v. Kelley, 349 F.2d 928, 930 (8th Cir. 1965); Better Business Bureau v. United States, 326 U.S. 279, 283 (1945). Reg. §1.501(c)(3)-1. See Gen. Couns. Mem. 39,716 (Mar. 29, 1988).
䡲
43
䡲
c02.fm Page 44 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.54
Hence, the organization must not be operated for the benefit of any private interests or any designated individual(s).55 This proposition is simply an expression of the basic principle underlying IRC §501(c)(3): Exempt assets must be devoted to purposes that are considered beneficial to the public rather than to particular individuals.56 The private benefit test is broader than the inurement proscription described in subsequent paragraphs; it encompasses any activity that benefits a private individual or group.57 The Tax Court has defined prohibited private benefits to include any “advantage; profit; fruit; privilege; gain; [or] interest.”58 The Tax Court has stated that [t]he questions whether an organization serves private interests within the meaning of [Reg. §1.501(c)(3)-I(d)(1)(ii)] and whether an organization’s activities are conducted for private gain . . . may be resolved . . . by examining the definiteness and charitable nature of the class to be benefited and the overall purpose for which the organization is operated.59
Determining whether a benefit flowing to a private individual evidences a substantial noncharitable purpose frequently requires a balancing of interests.60 An inquiry must be made as to whether the exempt organization serves a public rather than a private interest.61 If the public benefit derived from the exempt organization’s activity bears only a tenuous relationship to its underlying charitable purpose, then the risk of forfeiture of its exempt status is greatly increased.62 54 55
56 57 58 59 60
61
62
Reg. §1.501(c)(3)-1(d)(1)(ii). Gen. Couns. Mem. 39,862 (Nov. 21, 1991) (IRS analysis of staff physicians and their relationship to hospital; physicians are insiders). See also Rev. Rul. 69-175, 1969-1 C.B. 149 (nonprofit organization, formed by parents of pupils attending a private school, that provides school bus transportation for its members’ children serves a private rather than a public interest; exemption is denied). Gen. Couns. Mem. 37,789 (Dec. 17, 1978); 4A Scott on Trusts, §348 (3d ed. 1967). American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). See generally Chapter 5 on inurement. Retired Teachers Legal Fund v. Commissioner, 78 T.C. 280, 286 (1982). Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202, 215 (1978). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202 (1978) (public versus private benefits must be determined by examining the charitable purposes for which the organization is operated). §501(c)(3) (no portion of the net earnings may inure to the benefit of private interests); Reg. §1.501(c)(3)-1(d)(1)(ii). See also Announcement 92-83, 1992-22 I.R.B. 59 (June 1, 1992). Prohibited private benefits may include an “advantage; profit; fruit; privilege; gain; [or] interest.” Retired Teachers Legal Fund v. Commissioner, 78 T.C. 280, 286 (1982). Reg. §501(c)(3)-1(e)(1); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The memorandum reviews three letter rulings on the issue of whether an exempt organization jeopardizes its exempt status by forming joint ventures with hospital staff and selling to the joint venture the revenue stream from all or a portion of the hospital. The IRS noted that the exempt status was in jeopardy for three reasons: the organization allows inurement of part of a charitable organization’s net earning to the benefit of private individuals; it confers more than incidental benefits on private interests; and it may violate federal laws. See generally Chapter 5 on private inurement.
䡲
44
䡲
c02.fm Page 45 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
However, occasional economic benefits flowing to persons as an incidental consequence of an organization’s pursuing exempt charitable purposes will generally not constitute prohibited private benefits.63 Thus, an organization formed to provide substantial free legal services to low-income residents of economically depressed communities through the subsidization of recent law graduates who have been admitted to the bar was held to be exempt.64 The IRS dealt with the difficult issue of balancing the public interest against private benefit. The IRS held that the private benefit derived by the legal interns did not detract from, or override, the charitable purpose of providing free legal services. In other words, the private benefit was merely incidental. The benefits conferred upon private interests must be incidental to the charitable public interests in both a qualitative and quantitative sense.65 These two tests have been defined as follows: To be qualitatively incidental,66 a private benefit must occur as a necessary concomitant of the activity that benefits the public at large; in other words, the benefit to the public cannot be achieved without necessarily benefiting private individuals. Such benefits might also be characterized as indirect or unintentional. To be quantitatively incidental, a benefit must be insubstantial when viewed in relation to the public benefit conferred by the activity. It bears emphasis that, even though exemption of the entire organization may be at stake, the private benefit conferred by an activity or arrangement is balanced only against the public benefit conferred by that activity or arrangement, not the overall good accomplished by the organization.67
An organization was formed to accumulate funds for the purpose of acquiring land for and contributing to the cost of construction of the proposed Kentucky Bar Center headquarters. The headquarters housed offices and a public library and conducted other activities, such as a lawyer referral service. The Tax Court held that any benefit accruing to the legal profession through activities carried on at the headquarters was incidental to the broad public benefit resulting from the activity.68
63 64 65
66
67 68
Kentucky Bar Foundation v. Commissioner, 78 T.C. 921, 926 (1982); American Campaign Academy v. Commissioner, 92 T.C. 1053, 1066 (1989). Rev. Rul. 72-559, 1972-2 C.B. 247. Gen. Couns. Mem. 37,789 (Dec. 18, 1978); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). This private benefit must be “incidental” in both a qualitative and quantitative sense. See Rev. Rul. 70-186, 1970-1 C.B. 128 (example of qualitative aspect); Rev. Rul. 76-152, 1976-1 C.B. 151 (example of quantitative aspect). For an example of qualitatively incidental, compare Rev. Rul. 72-559, 1972-2 C.B. 247 (an organization is exempt which provides relief of the poor and distressed by providing training and salaries to recent law graduates who agreed to provide legal services to indigent clients) with Rev. Rul. 80-287, 1980-2 C.B. 185 (an organization is not exempt which provides assistance to persons in need of legal services by operating a lawyer referral service). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Kentucky Bar Foundation v. Commissioner, 78 T.C. 65 (1982).
䡲
45
䡲
c02.fm Page 46 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
(ii) Prohibition Against Inurement. IRC §501(c)(3) also requires that “no part of the net earnings . . . inures to the benefit of any private shareholder or individual.”69 This is an absolute proscription; there can be no inurement.70 This clause prohibits any situation in which profits or earnings are utilized by interested persons or “insiders.” The IRS seeks to prevent any dividend-like distribution of charitable assets or expenditures to benefit a private “insider” interest.71 Hence, “[i]nurement is likely to arise where the financial benefit represents a transfer of the organization’s financial resources to an individual solely by virtue of the individual’s relationship with the organization, and without regard to the accomplishment of exempt purposes.”72 Although the prohibitions against private inurement and private benefits have common and overlapping elements,73 the two are distinct requirements that must be independently satisfied.74 Inurement is a statutory requirement that applies to interested persons or insiders. Private benefit is a regulatory component of the operational test, which is directed at the broader public policy concern that exempt organizations should operate for public rather than the private benefit. The Tax Court has stated that the prohibition against private inurement of net earnings appears to be redundant.75 This is because the inurement of earnings to an interested party or insider would constitute the conferral of a private benefit inconsistent with an organization’s operating exclusively for an exempt purpose.76 Hence, when an organization permits its net earnings to inure to the benefit of a private shareholder or individual, it transgresses the private inurement prohibition and, in addition, operates for a nonexempt private purpose. The absence of private inurement of earnings to the benefit of a private shareholder or individual does not, however, establish that the organization is operated exclusively for exempt purposes. Therefore, although the private inurement prohibition may be subsumed within the private benefit analysis of the operational test, the reverse is not true. Accordingly, if one concludes that
69
70
71 72 73 74 75 76
§501(c)(3). The private inurement clause was introduced in 1909. The language was created as an exception to the corporate excise tax imposed under that Act. The Senate wanted to except charitable organizations from the tax, on the condition that such organizations not allow any earnings to be distributed to private interests. The Revenue Act of 1909, Chapter 7, §38 (1909). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The prohibition against private inurement applies to organizations exempt under §501(c)(3) (charitable); §501(c)(4) (social welfare); §501(c)(9) (employee beneficiary associations); §501(c)(10) (domestic fraternal societies); §501(c)(11) (teacher retirement funds); §501(c)(13) (cemetery companies); §501(c)(17) (supplemental unemployment compensation trusts); and §501(c)(18) (pension trusts). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Gen. Couns. Mem. 38,459 (July 31, 1980). Ethereal Joy v. Commissioner, 83 T.C. 20, 21 (1984); Goldsboro Art League, Inc. v. Commissioner, 75 T.C. 337, 345, n. 10 (1980). Canada v. Commissioner, 82 T.C. 973, 981 (1984); Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202, 215 (1978). American Campaign Academy v. Commissioner, 92 T.C. 1053, 1068 (1989). Western Catholic Church v. Commissioner, 73 T.C. 196, 209, n. 27 (1979), aff’d 631 F.2d 736 (7th Cir. 1980); Reg. §1.501(c)(3)-1(c)(2).
䡲
46
䡲
c02.fm Page 47 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
there is no prohibited inurement of earnings, the analysis does not end there. One must also determine whether a prohibited private benefit is conferred.77,78 The issues of private inurement, private benefit, and insiders were the subject of much attention in the 1980s and 1990s, culminating with the addition, in 1996, of the “intermediate sanctions” provisions to the Code.79 In 1998, the Treasury Department provided additional guidance by issuing Treas. Reg. §§53.49581-7, which interprets new IRC §4958.80 At the time of their proposal, these intermediate sanctions Regulations were called “the most significant development affecting charities” in nearly 30 years.81 In January 2002, the IRS published final regulations that differed only marginally from the temporary regulations of the year before.82 Until the enactment of intermediate sanctions, the only penalty the IRS could impose on an exempt organization (other than a private foundation) that had engaged in impermissible private benefit or private inurement transactions was revocation of the organization’s exempt status. Although revocation might have been appropriate in the most egregious cases, such instances were rare, and the IRS was left without a fair and effective way to discourage such misconduct. The passage of intermediate sanctions has created a more focused and equitable deterrent to excessive compensation, although numerous questions remain unanswered. Under the intermediate sanctions provisions, penalty taxes may be imposed on “disqualified persons” who benefit from an “excess benefit transaction” and on “organization managers” who “knowingly participate” in the excess benefit transaction.83 Disqualified persons are those who have been in a position to exercise “substantial influence over the affairs of” a tax-exempt organization as demonstrated by the facts and circumstances of each situation.84 Some categories of positions are deemed to have substantial influence: voting members of the governing body, presidents or those with ultimate responsibility for managing the organization, and those with ultimate responsibility for managing the finances of the organization.85 In other cases, substantial influence is determined by examining facts such as: whether the person founded the organization, is a substantial contributor, or manages a segment of the organization that represents a substantial portion of the whole organization. Although the term “insiders” is not used, disqualified persons and organization managers are analogous to insiders 77 78
79
80 81 82 83 84 85
American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). An organization’s conferral of benefits on disinterested persons may cause it to serve “a private interest” although that action may not violate the private inurement prohibition. Reg. §1.501(c)(3)-1(d)(1)(ii); Christian Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037 (1978). See also The Martin S. Ackerman Foundation v. Commissioner, T.C. Memo 1986-365. Pub. L. No. 104-168 (110 Stat. 1452), which added §4958 to the Code. The sanctions apply to §501(c)(3) and §501(c)(4) organizations, but not to trade associations or private foundations (the latter category has its own penalty excise taxes in Chapter 42). Reg. §§53.4958-0 through 53.4958-7 (Reg. 246256-96). Fred Stokeld, “Intermediate Sanctions Regs Are ‘Significant Change,’ Owens Says,” Tax Notes (Aug. 24, 1998): 885. Regs. §§53.4958-1 through 53.4958-8. Reg. §53.4958-1(a). See Section 5.4 for a more detailed discussion of the regulations. Reg. §53.4958-3. Reg. §53.4958-3(c).
䡲
47
䡲
c02.fm Page 48 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
in that they are all persons deemed to have sufficient control over an organization to cause it to render an inappropriate economic benefit to private parties.86 The “facts-and-circumstances” language of the regulations and the examples focus on the degree of control a person has over a nonprofit (or a segment thereof) as the key determinant of whether that person (who is not per se disqualified87) is disqualified. The regulations provide a rebuttable presumption of reasonableness; if compensation or payment is arrived at using the described process it will be presumed to be reasonable.88 Generally, the process requires a decision by people without conflicts of interest that is based on investigation into prevailing market prices or comparable situations. The concept of control has also been applied by the IRS to determine whether a party is an outsider in a retroactive denial of exempt status. In United Cancer Council, the IRS asserted that a third party who enters into a contract with a charity becomes an insider by virtue of obtaining control over a substantial portion of the nonprofits’ income through the contractual relationship.89 This position was rejected by the Seventh Circuit as having no basis in tax law or any other body of law. The regulations conform to the holding by the Seventh Circuit and create an exception for fixed payments made pursuant to an initial contract.90 Recently, the Service proposed Regulations enumerating specific factors that it will consider when determining whether a 501(c)(3) organization that engages in one or more excess benefit transactions as described in §4958 will retain its exempt status.91 Among the factors included in the proposed Regulations are the size and scope of the suspect organization’s exempt activities, and the steps taken, if any, by the organization to discover and correct excess benefit transactions on its own accord before recognition and enforcement by the Service.92 In Caracci v. Commissioner, 118 T.C. No. 25 (May 22, 2002) 93 the petitioners owned and operated, as tax exempt, three home-health agencies (“Sta-Home Home Health Agency” or “StaHome”); whereupon petitioners created three individual S corporations, transferring all of the assets in Sta-Home to the newly created S Corporations in exchange for an assumption of all liabilities of StaHome. The IRS determined that the fair market value of the transferred StaHome assets substantially exceeded the liabilities assumed, and petitioners were held liable for excise taxes under the intermediate sanctions provisions of section 4958. With deficiencies in excess of $256 million, the IRS recommended that the tax-exempt status of the three tax-exempt entities should be revoked. The Tax Court held that the value of the transferred assets exceeded the value of the consideration received, resulting in an excess benefit to petitioners of $5.2 million. Although the Tax Court determined that the Sta-Home entities 86 87 88 89 90 91 92 93
See Section 5.4. Reg. §53.4958-3(b) Reg. §53.4958-6 United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999), rev’g and remanding 109 T.C. 326 (1997). Reg. §53.4958-4 Prop. Reg. § 1.501(c)(3)-1(g)(2)(ii Prop. Reg. § 1.501(c)(3)-1(g)(2)(iii). Michael T. Caracci and Cindy W. Caracci, et al. v. Commissioner of Internal Revenue, 118 T.C. No. 25 (May 22, 2002).
䡲
48
䡲
c02.fm Page 49 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
engaged in excess benefit transactions, it ultimately held that revocation of the entities’ tax-exempt status was unwarranted, given the ramifications of the intermediate sanctions under section 4958. On July 11, 2006, the United States Court of Appeals for the Fifth Circuit 94 reversed the Tax Court’s holding in Caracci, concluding that a “cascade of errors” initially made by the IRS, including the use of an intermediate economic study (instead of a final study) to value the determined liability prevented the Caracci family from being allowed to correct the transactions, and thereby reduce the resulting intermediate sanctions. CAVEAT Although the Fifth Circuit’s holding in Caracci reversed the Tax Court decision, the IRS’ first major challenge under section 4958; the opinion was grounded on the inadequacies and incongruities with the IRS’ valuation methods, and not with the statute itself. The Caracci case emphasizes the importance in documenting the fair market value of assets in transactions with insiders, and diligence on the part of exempt entities to ensure that excess benefits do not result. (iii) An IRC §501(c)(3) Organization must not be an “Action” Organization. An organization does not satisfy the operational test (e.g., is not operated exclusively for one or more exempt purposes) if it is an “action” organization.95 An organization constitutes an action organization if a substantial amount of its activities is devoted to attempting to influence legislation by propaganda or otherwise.96 For purposes of this test, an organization is considered to be attempting to influence legislation if the organization contacts, or urges the public to contact, members of a legislative body for the purpose of proposing, supporting, or opposing legislation, or if it advocates the adoption or rejection of legislation.97 Here, the term legislation includes action by Congress, by any state legislature, by any local council or similar governing body, or by the public in a referendum, initiative, or constitutional amendment.98 Likewise, an organization is an action organization if it participates or intervenes, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office.99 The term candidate for public office refers to any individual who offers himself or herself, or is proposed by others, as a contestant for a national, state, or local elective public office.100 Finally, an organization is an action organization if it has the following two characteristics: 1. Its main or primary objective may be attained only by the enactment or defeat of legislation.101 94 95 96 97 98 99 100 101
456 F.3d 444 (2006). Reg. §1.501(c)(3)-1(c)(3)(i). See also Rev. Rul. 62-71, 1962-1 C.B. 85. Rev. Rul. 62-71, 1962-1 C.B. 85. See also Rev. Rul. 74-117, 1974-1 C.B. 128. Reg. §1.501(c)(3)-1(c)(3)(ii)(a) and (b). Reg. §1.501(c)(3)-1(c)(3)(ii). Reg. §1.501(c)(3)-1(c)(3)(iii). Id. This activity includes the “publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to such a candidate.” Reg. §1.501(c)(3)-1(c)(3)(iv).
䡲
49
䡲
c02.fm Page 50 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
2. It advocates or campaigns for the attainment of such primary objectives (as distinguished from nonpartisan analysis, study, or research, the results of which are made public).102 In making the determination of whether an organization has these characteristics, the IRS looks at all surrounding facts and circumstances, including the articles of incorporation and all activities of the organization.103 If the IRS concludes that the organization is an action organization, then the organization will fail the operational test and, therefore, not qualify for exempt status. Although it cannot qualify as a charitable organization under IRC §501(c)(3), an organization that is determined to be an action organization, for reasons other than a substantial amount of political activity, may nonetheless qualify as a social welfare organization.104 (c)
Proscription Against Legislative and Political Activities
(i) Legislative Activities. No substantial part of an IRC §501(c)(3) organization’s activities may constitute “carrying on propaganda, or otherwise attempting to influence legislation.”105 Influencing legislation includes direct lobbying, that is, contacting legislators directly; or grass roots lobbying, that is, urging the public to contact members of any legislative body for the purpose of supporting or opposing any legislation;106 advocating the adoption or rejection of legislation;107 studying legislation to formulate a legislative position in preparation of a public discussion;108 presenting testimony at public hearings held by legislative
102 103 104 105
106
107 108
See id. See id. 100 Reg. §1.501(c)(3)-1(c)(3)(v). Reg. §1.501(c)(3)-1(c)(3)(ii). This provision was originally enacted in the Revenue Act of 1934, §101(6), partially in response to the swell of controversy regarding legislative and political activities of exempt organizations. For example, in Slee v. Commissioner, 42 F.2d 184 (2nd Cir. 1930), Judge Learned Hand examined the American Birth Control League. The court focused on whether the organization’s activities were “exclusively” educational and charitable. In holding that the American Birth Control League was not operated exclusively for charitable and educational purposes, Judge Hand stated that the organization was primarily seeking repeal of birth control prohibitions. Judge Hand also noted that similar activities conducted by charitable organizations that are “ancillary” or “mediate” to its primary purpose, would be permissible, such as the lobbying activities of an association of book lovers or scientists. See 42 F.2d at 185. See Vanderbilt v. Commissioner, 93 F.2d 360 (1st Cir. 1937); Marshall v. Commissioner, 147 F.2d 75 (2nd Cir. 1945), cert. denied 325 U.S. 872 (1945); Noyes v. Commissioner, 31 B.T.A. 121 (1934); Forstall v. Commissioner, 29 B.T.A. 428 (1933). See also M. Sanders, “Private Foundations—Taxable Expenditures,” BNA Tax Mgmt. Portfolio (1992). The regulations accompanying the Revenue Act of 1934 provide: Associations formed to disseminate controversial or partisan propaganda are not educational within the meaning of the statute. However, the publication of books or the giving of lectures advocating a cause of controversial nature shall not of itself be sufficient to deny an organization the exemption, if carrying on propaganda, or otherwise attempting to influence legislation, form no substantial part of its activities, its principal purposes and substantially all of its activities being clearly of a nonpartisan, noncontroversial, and educational nature. Reg. 103, §19.101(6)-1 (1941); Reg. 111, §29.101(6)-1; Reg. 118, §39.101(6)-1 (1953). Reg. §1.501(c)(3)-1(c)(3)(ii)(a). The term legislation includes action by the Congress, by any state legislature, by any local council or similar governing body, or by the public in a referendum, initiative, constitutional amendment, or similar procedure. Reg. §1.501(c)(3)-1(c)(3)(ii). See also §4911(e)(2) Reg. §1.501(c)(3)-1(c)(3)(ii)(b). See League of Women Voters v. United States, 180 F. Supp. 379 (Ct. Cl. 1960).
䡲
50
䡲
c02.fm Page 51 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
committees, corresponding with legislators and staff members; and publishing activity that advocates specific legislative action.109 Legislative activity must be carried on by the organization itself to be viewed as activity of the organization. Thus, for example, the legislative activities of a student publication will not be attributed to the university.110 The IRS included questions about lobbying via the Internet in its announcement that it is considering guidance on application of EO regulations to activity conducted on the Internet.111 The IRS asked for comment on the following situations: • For charitable organizations that have not made the election under
§501(h), what facts and circumstances are relevant in determining whether lobbying communications made on the Internet are a substantial part of the organization’s activities? For example, are locations of the communications on the Web site (main page as opposed to subsidiary page) or the number of hits relevant? • Does providing a hyperlink to the Web site of another organization that
engages in lobbying activity constitute lobbying by a charitable organization? What facts and circumstances are relevant in determining whether the charitable organization has engaged in lobbying activity? Does it make a difference if the lobbying activity is on the specific Web page to which the charitable organization provides the hyperlink rather than elsewhere on the organization’s Web site? (A) S UBSTANTIALITY Attempts to influence legislation that are less than a substantial part of the organization’s activities will not jeopardize the organization’s exempt status. Whether a specific activity of an exempt organization constitutes a “substantial” portion of its total activities is a factual determination.112 In making a determination, one court, utilizing a quantitative analysis, held that attempts to influence legislation that constituted 5 percent of total activities were not substantial.113 Other courts have not attempted to ascribe a percentage limitation but have focused instead on whether certain activities, by definition, influence legislation, that is, performed a qualitative analysis.114 The Tenth Circuit held that prohibited legislative activity may occur even when the organization does not mention specific legislation.115 In Christian Echoes, 109
110 111 112 113 114 115
See Reg. §1.501(c)(3)-1(c)(3)(ii); Roberts Dairy Co. v. Commissioner, 195 F.2d 948 (8th Cir. 1952), cert. denied, 344 U.S. 865 (1952); American Hardware and Equipment Co. v. Commissioner, 202 F.2d 126 (4th Cir. 1953), cert. denied, 346 U.S. 814 (1953). See Rev. Rul. 72-513, 1972-2 C.B. 246; See also Field, “Tax Exempt Status of Universities: Impact of Political Activities by Students,” Tax Lawyer 24 (1970):157. Announcement 2000-84, 2000-42 I.R.B. 385. See Christian Echoes Nat’l Ministry, Inc. v. United States, 470 F.2d 849, 855 (10th Cir. 1973), cert. denied, 414 U.S. 864 (1973); Krohn v. United States, 246 F. Supp. 341 (D.Colo. 1965). Seasongood v. Commissioner, 227 F.2d 907 (6th Cir. 1955). League of Women Voters v. United States, 180 F. Supp. 379 (Ct. Cl. 1960), cert. denied, 364 U.S. 822 (1960); Haswell v. United States, 500 F.2d 1133 (Ct. Cl. 1974). Christian Echoes Nat’l Ministry, Inc. v. United States, 470 F.2d 849 (10th Cir. 1973), cert. denied, 414 U.S. 864 (1973).
䡲
51
䡲
c02.fm Page 52 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
an organization sought to influence legislation indirectly by seeking to mold public opinion—grass roots lobbying.116 Christian Echoes, a nonprofit corporation organized by Dr. Billy James Hargis, was exempt under IRC §501(c)(3) as a religious organization.117 The organization published a monthly magazine, Christian Crusade, and an “intelligence report,” Weekly Crusader, which contained articles encouraging people to “write their Congressmen in order to influence the political decisions in Washington” and to support or oppose various laws and issues.118 The court held that “the activities of Christian Echoes in influencing or attempting to influence legislation were not incidental, but were substantial and continuous.” Thus, the court held that Christian Echoes’ exempt status should be revoked.119 In determining substantiality, it is sometimes difficult to determine what ancillary or supporting activities should be included within the proscribed activities to influence legislation. Frequently, much time is expended by organizations on research, discussion, and similar supporting activities. Courts have held that time spent in discussing public issues, formulating and agreeing upon positions, and studying them in preparation to adopt a position should be taken into account in determining the “substantiality” test.120 (B) L OBBYING E LECTION Certain public charities may elect under IRC §501(h) and §4911 to engage in legislative activity under safe harbor expenditure limitations.121 The lobbying election may be made in the year in which it is to be effective.122 The amount of permissible lobbying expenditure is based on the aggregate amount of money the organization spends on general and grass roots lobbying.123 The graduated rates to determine the allowable annual lobbying expenditures are applied as follows: 20 percent of the first $500,000 of an organization’s exempt purpose expenditures, plus 15 percent of the second $500,000, plus 10 percent of the third $500,000, and 5 percent of any remaining expenditures.124 Furthermore, the organization can devote up to 25 percent of its allowable general lobbying expenditures to grass roots lobbying activity.125 The primary difference between general lobbying and grass roots lobbying is best understood 116
117 118 119 120 121 122
123 124 125
Id. See also Kuper v. Commissioner, 332 F.2d 562 (3rd Cir. 1964), cert. denied, 379 U.S. 920 (1964) (court denied deduction for contributions to a chapter of the League of Women Voters based upon the numerous grass roots lobbying activities). But cf. Liberty Nat’l Bank and Trust Co. of Louisville v. United States, 122 F. Supp. 759 (W.D.Ky. 1954) (court looked at both direct and grass roots lobbying activities as a whole and found that the activities were insignificant when compared with the overall broad purpose). Christian Echoes, 470 F.2d at 851. Id. at 855. Id. at 858. League of Women Voters v. United States, 180 F. Supp. 379 (Ct. Cl. 1960), cert. denied, 364 U.S. 822 (1960). §501(h); §4911. Churches, church-related entities, and private foundations are not eligible to make the expenditure test election. §501(h)(5); Reg. §1.50(h)-2(b)(3) and (4). Organizations not electing the “lobbying expenditure” test must comply with the “substantial part” test, i.e., no substantial part of the activities of an exempt organization may consist of attempting to influence legislation. Reg. §1.501(h)-4; Reg. §1.501(h)-1(a)(1). See Section 2.4(c)(i)(A). §501(h)(1). §4911(c)(2). The allowable yearly expenditures for general lobbying cannot exceed the lesser of $1,000,000 or the graduated percentage of the organization’s exempt purpose expenditures. §4911(c)(4).
䡲
52
䡲
c02.fm Page 53 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
by looking at the level at which the lobbying occurs. General lobbying is concerned with direct contacts with legislators or their staff.126 Grass roots lobbying refers to activity to influence legislation through molding public opinion.127 Once a charitable organization elects the lobbying provisions, the organization is subject to an excise tax on any amount of lobbying expenditures in excess of either the general or grass roots limitations.128 In the recent announcement, the IRS also included questions about lobbying on the Internet by organizations that have made the lobbying election:129 • To determine whether a charitable organization that has made the §501(h)
election has engaged in grass-roots lobbying on the Internet, what facts and circumstances are relevant regarding whether the organization has made a “call to action”? • Does publication of a Web page by a charitable organization constitute an
appearance in the mass media? Do e-mail or listserv communications by the organization constitute an appearance in mass media if sent to more than 100,000 people and fewer than half of those people are members of the organization? • What facts and circumstances are relevant in determining whether an Inter-
net communication (a limited-access Web site, a listserv, or an e-mail) is a communication directly to or primarily with members of an organization? (C) E XCEPTIONS The following activities are excepted from classification as “influencing legislation”: • Making nonpartisan analysis, study, or research available to the general
public130 • Providing technical advice to a governmental body or committee in
response to a written request131 • Appearing before or communicating with any legislative body in regard
to a possible decision of such body that might affect the existence of the organization, its exempt status, or the deductibility of contributions to the organization132 • Communications between the organization and its bona fide members
regarding legislation of direct interest to the organization133 126 127 128
129 130 131 132 133
§4911(d)(1)(B); §4911(c)(1). §4911(d)(1)(A); §4911(c)(3). The excise tax equals 25 percent of the excess lobbying expenditures taxed on the greater excess (general or grass roots). Furthermore, if the organization’s lobbying expenditures normally exceed 150 percent of either limitation, then the organization may lose its exempt status. Once exempt status is lost, the organization is prohibited from converting to an exempt social welfare organization. However, organizations may reapply for recognition of exemption. Reg. §1.501(h)-3(d). Announcement 2000-84, 2000-42 I.R.B. 385. §4911(d)(2)(A). §4911(d)(2)(B). §4911(d)(2)(C). §4911(d)(2)(D).
䡲
53
䡲
c02.fm Page 54 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
• Communication with a governmental employee other than communica-
tion with a legislative employee or communication that proposes to influence legislation134 (ii) Political Campaigns. Charitable organizations135 must not participate or intervene, directly or indirectly, in any political campaign on behalf of any candidate for public office.136 This prohibition is absolute.137 Corresponding prohibitions were added to the charitable income tax deduction,138 the estate tax deduction,139 and the gift tax deduction140 in 1969.141
134 135
136
137
138 139 140 141
§4911(d)(2)(E). Charitable organizations must be distinguished from political organizations that are exempt under §527. See Chapter 2. §527 generally deals with the tax status of political organizations such as political parties, campaign committees, and PACs. See generally Ann. 73-84, 1973-2 C.B. 461; Rev. Rul. 74-21, 1974-1 C.B. 14; Rev. Rul. 74-475, 1974-2 C.B. 22. §527 political organizations are subject to tax on income other than contributions, dues, and fundraising income used for political campaign purposes. In addition, §501(c) organizations that expend any money for political activity may be subject to tax under §527. Charitable organizations must be distinguished from political organizations that are exempt under §527. §527 generally deals with the tax status of political organizations such as political parties, campaign committees, and PACs. See generally Ann. 73-84, 1973-2 C.B. 461; Rev. Rul. 74-21, 1974-1 C.B. 14; Rev. Rul. 74-475, 1974-2 C.B. 22. §527 political organizations are subject to tax on income other than contributions, dues, and fundraising income used for political campaign purposes. In addition, §501(c) organizations that expend any money for political activity may be subject to tax under §527. United States v. Dykema, 666 F.2d 1096, 1101 (7th Cir. 1981) (“It should be noted that exemption is lost . . . by participation in any political campaign on behalf of any candidate for public office. It need not form a substantial part of the organization’s activities.”); Ass’n of the Bar of the City of New York v. Commissioner, 858 F.2d 876 (2nd Cir. 1988), cert. denied, 490 U.S. 1030 (1989) (the court rejected the contention that the substantiality requirement for lobbying activity limitations be applied to the political campaign activity restriction); United States v. Naftalin, 441 U.S. 768, 773 (1979). See also H.R. No. 91-413, 91st Cong., 1st Sess. 32 (1969); S. Rep. No. 91-552, 91st Cong., 1st Sess. 47 (1969). In a high-profile case, the Christian Coalition withdrew its application for tax-exemption as a §501(c)(4) organization after the IRS determined that its activities were “too campaignrelated.” “Exempt Organizations: Christian Coalition to Restructure After Apparent Denial of 501(c)(4) Status,” Daily Tax Report (June 11, 1999): G-10. As a result, the Christian Coalition announced it would reorganize into two separate organizations, one of which would be forprofit and would endorse and contribute to political candidates. Id. A second case involves the Second Baptist Church in Lake Jackson, Texas. The church sent letters to 7,000 other churches, soliciting their aid in ensuring that pro-choice candidates were defeated on a nationwide basis. The letter stated, “It is our intention that any candidate who endorses abortion will not be elected in November.” The mailing included statements from a doctor and a nurse who had performed a partial birth abortion and a diagram purporting to describe the procedure, which they asked the other churches to distribute to their members. Other distributed material urged voters to defeat President Clinton on the basis of his veto of a bill that would have banned certain abortion procedures, claiming that persons who vote for President Clinton would be “guilty before God.” The Second Baptist Church is currently under investigation by the IRS and faces a loss of its exempt status. “Texas Church in Hot Water over Political Activities,” Tax Notes Today (1996): 200–202. Second Baptist has indicated that it intends to challenge the application of the political campaign prohibition on First Amendment grounds. Note that any amount of activity considered campaign intervention by the IRS can endanger an organization’s exempt status. See “Owens Outlines IRS Exempt Organization Division’s Agenda,” Tax Notes Today (1995): 139– 144; “Commissioner Richardson Warns Against Political Activity by Exempts,” Tax Notes Today (1996): 115–124. §170(c)(2)(D). §170(c)(2)(D). §2522(a)(2). Tax Reform Act of 1969, P.L. 91-172, §201(a)910 and §201(d)(4).
䡲
54
䡲
c02.fm Page 55 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
(A) B ASIC D EFINITIONS IN P OLITICAL C AMPAIGNS A “candidate for public office” is any individual who offers himself or herself, or is proposed by others, as a contestant for an elective public office.142 This office can be national, state, or local.143 Because the candidate must be for an elective public office, IRC §501(c)(3) organizations are prohibited from participating or intervening in election campaigns only. Thus, a §501(c)(3) organization is not prohibited from participating or intervening in the Senate confirmation of an individual nominated by the president to serve as federal judge, because federal judges are not elected.144 A “candidate” also encompasses those individuals who are prospective candidates. Thus, an individual who has not yet announced an intention to seek elective office may nonetheless be considered a candidate.145 A “public office” is defined thus: (1) It is a position that is created by national, state, or local statute, (2) the position is continuing, (3) the position is not occasional or contractual, (4) there is a fixed term of office, and (5) there is a required oath of office.146 Thus, the IRS has determined that under relevant state law, precinct committeeman is an elective public office under IRC §501(c)(3).147 The prohibition against “participation or intervention” includes the publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to a candidate for public office.148 Thus, any endorsement, whether written or oral, is absolutely prohibited.149
142
143 144
145
146
147 148 149
Reg. §1.501(c)(3)-I(c)(3)(iii); Reg. §53.4945-3(a)(2). Although §4945 and the regulations thereunder apply to private foundations, these rules and regulations also provide guidance for public charities because of the corresponding provision in §4955. Reg. §1.501(c)(3)-I(c)(3)(iii); Reg. §53.4945-3(a)(2). IRS Notice 88-76, 1988-2 C.B. 392. However, participating in the Senate confirmation process does constitute lobbying, subject, in the case of a §501(c)(3) organization, to the rules governing lobbying activities. See §2.4(c)(i). Tech. Adv. Mem. 91-30-008 (Apr. 16, 1991). Compare Staff of the Joint Committee on Taxation, 100th Cong., 1st Sess., “Lobbying and Political Activities of Tax-exempt Organizations” ( Joint Comm. print 1987) at 14 (the fact that an individual is a prominent political figure does not make him a candidate, even if there is speculation regarding his possible future candidacy for particular offices). Thus, it appears that some action must be taken before an individual is considered a candidate. Gen. Couns. Mem. 39,811 (June 30, 1989). Compare Reg. §53.4946-1(g)(2)(i) (a limited regulation defines “public office” as an elective or appointive public office in the executive, legislative, or judicial branch of the government of a state, possession of the United States, or political subdivision or other area of any of the foregoing, or the District of Columbia, that pays gross compensation at an annual rate of $15,000 or more). Gen. Couns. Mem. 39,811 (June 30, 1989). Reg. §1.501(c)(3)-1(c)(3)(iii); Reg. §53.4945-3(a)(2). Ass’n of the Bar of the City of New York v. Commissioner, 858 F.2d 876 (2nd Cir. 1988), cert. denied, 490 U.S. 1030 (1989) (the rating of candidates on a nonpartisan basis by a §501(c)(3) organization is considered participation in a political campaign). But see Rev. Rul. 78-248, 1978-1 C.B. 154, which discusses certain “voter education” activities that do not constitute political campaign activity. For example, in Situation 1, an organization that publishes an annual compilation of voting records of all members of Congress on major legislative issues involving a wide range of subjects, was not engaged in political campaign activity. On the other hand, a voter record on land conservation issues, even without editorial comment, is considered participation or intervention in a political campaign, because the voters’ guide concentrates on a narrow range of issues and is distributed among the electorate during an election campaign. Situation 4, Rev. Rul. 78-248. Subsequently, in Rev. Rul. 80-282, 1980-2 C.B. 178, the IRS amplified its ruling in Rev. Rul. 78-248 and held that the publishing of congressional incumbents’ voting records on selected issues in a nonpartisan newsletter did not constitute participation in a political campaign. Crucial to that ruling was the fact that the organization
䡲
55
䡲
c02.fm Page 56 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
In 1998, the IRS revoked the exemption of two nonprofit organizations on the grounds that they engaged in partisan politics.150 The Abraham Lincoln Opportunity Fund (ALOF) was affiliated with former House Speaker Newt Gingrich. The IRS revoked its exempt status retroactive to 1990 on grounds that it used charitable contributions to repay loans it had made to GOPAC, a political action committee associated with the Republican Party. ALOF, which is now defunct, challenged the proposed revocation in the Tax Court, but the case was dismissed for lack of jurisdiction because all relevant statutes of limitations had expired.151 However, on May 16, 2003, the IRS announced that ALOF qualified as a charitable donee under §170(c)(2) in Announcement 2003-30, retroactively for all periods that it was in existence. The IRS made this determination after the Independent Review Process within the Commissioner’s office reviewed all of the factual information in the case. The IRS has also revoked a church’s nonprofit status for allegedly engaging in partisan politics.152 Four days before the 1992 presidential election, an Evangelical church known as the “Church at Pierce Creek” ran advertisements, in two national newspapers, that opposed the election of William Clinton. When the church challenged the revocation, the court granted the IRS’s motion for summary judgment made no attempt to target the publication toward particular areas in which the elections were being held, nor did it time its publication to coincide with the election campaign. See also Tech. Adv. Mem. 91-17-001 (Sept. 5, 1990) (code words such as “liberal,” “conservative,” “pro-life,” or “proabortion,” coupled with a discussion of a candidacy or election is deemed an “intervention” and is thus strictly prohibited). In Priv. Ltr. Rul. 96-09-007 (Dec. 6, 1995), the IRS held that a charity’s fundraising activities—a targeted direct mail campaign—violated the prohibition against campaign intervention. Although the fundraising letters did not specifically endorse or decry particular candidates, the masthead contained the names of the charity’s board of advisors, many of whom were prominent figures in one of the major political parties; the mailings were sent almost exclusively to members of the same political party; the letter strongly implied that a donation to the charity would help greatly in securing the election of that party’s candidate; and the text of the letter strongly implied endorsement or condemnation of particular candidates. For example, one letter read as follows: Try starting off your day with this headline: [Other party candidate] DEFEATED! Some will react with grief, others with joy. There is a good chance you will see such a headline this November. [Other party candidate] won election by only X votes last year and the polls this year are dead even. [We] have already registered 12,000 voters this year and are well on [our] way to [our] goal of 5% of expected turnout. These voters could well hold the balance of power. [Other party candidate] would become [holder of the elected office] . . . and will be heavily targeted by [issue #1] advocates, [and] advocates of cuts in [issue #2] spending. . . . Defending [other party candidate] will be the top priority for those who seek to maintain current levels of [issue #3] spending, restrict [issue #4] and limit [issue #5] regulation. Id. The IRS found this letter to “carry with it the clear implication that [the other party candidate] is the candidate whom [the organization] opposes for reelection. There is not even a mention, much less a balanced attempt to describe” the other candidate. Another fundraising letter mailed to potential supporters of a tax-exempt organization that was signed by a political candidate also impermissibly “intervened in a political campaign,” for similar reasons. It was mailed to 2.7 million people during an election campaign and contained language constituting an “affirmative statement by candidate ‘A’ himself,” because it supported A’s political agenda and criticized his opposing candidate. Tech. Adv. Mem. 20044038. 150 151 152
Fred Stokeld and Jon Almeras, “Gingrich, North Group Challenges Loss of Exemption,” Exempt Organization Tax Review (April 1999). Abraham Lincoln Opportunity Fund v. Commissioner, T.C. Memo 2000-261, 2001 TNT 125-10. Branch Ministries, Inc. v. Commissioner, D.D.C. No. 95-0724 (March 30, 1999) aff’d, 211 F.3d 137 (D.C. Cir. 2000).
䡲
56
䡲
c02.fm Page 57 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
and upheld the IRS’s position.153 The D.C. Circuit Court of Appeals upheld the prohibition on churches intervening in political campaigns. However, it agreed that some alternative avenue of participation is constitutionally required.154 The court proposed that a church establish a §501(c)(4) organization that would in turn create a §527 political organization.155 The church must separately incorporate the §501(c)(4) organization and keep records demonstrating that no tax-deductible contributions to the church have been used to support political activities. The §527 organization would be subject to recently enacted disclosure requirements.156 The IRS approved as a “separate segregated fund under section 527(f)(3)” a political action committee proposed by a §501(c)(6) trade association.157 It was to be funded separately from contributions (except that the trade association would contribute use of its mailing list), and would have an independent financial manager. However, the organizations would have the same chairman of the board, and the board of the political action committee (PAC) would be appointed by the board of the trade association. The IRS also allowed a health plan, recognized as a §501(c)(3) organization, to use its payroll system to collect contributions from employees for a union PAC.158 The Agency reasoned that the health plan carries out purely ministerial duties, that it did not select the PACs and has no influence over them, and that all expenses are reimbursed by the PACs. The funds involved are voluntarily contributed by the employees. The activity is not attributable to the employer because it is not within the scope of their employment, nor ratified by the employer. The Federal Election Commission (FEC) proposed to exempt some Internet political activity from campaign finance rules159 but the proposal may contradict statutory prohibitions for some tax-exempt corporations. The IRS has pointed out that the hyperlinks that the FEC proposes to allow corporations and unions to use to express support for political candidates may constitute prohibited political activity. The IRS included two questions about political activity through the Internet in its call for public comment:160 1. What facts and circumstances are relevant in determining whether information on a charitable organization’s Web site about candidates for public office constitutes intervention in a political campaign or is permissible charitable activity consistent with the principles set forth in Rev. Rul. 78248, 1978-1 C.B. 154, and Rev. Rul. 86-95, 1986-2 C.B. 73? 2. Does providing a hyperlink on a charitable organization’s Web site to another organization that engages in political intervention result in per se prohibited political intervention? What facts and circumstances are relevant in determining whether the hyperlink does constitute political intervention? 153 154 155 156 157 158 159 160
See id. Relying on Regan v. Taxation With Representation, 461 U.S. 540 (1983), and FCC v. League of Women Voters, 468 U.S. 364 (1984). See supra n. 129; §2.4(c)(ii)(C). See Section 2.8. Priv. Ltr. Rul. 200103084. Priv. Ltr. Rul. 200151060. FEC Notice 2001-14. Announcement 2000-84, 2000-42 I.R.B. 385.
䡲
57
䡲
c02.fm Page 58 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
In June 2004, the IRS Tax Exempt and Government Entities Division (TE/GE) established a Political Intervention Project (PIP)charged with fast-tracking the review of allegations that a 501(c)(3) organization violated a prohibition against intervention in political campaigns during the 2004 campaign season. Upon review of the 131 cases referred to the TE/GE, a three-person PIP committee found that 80 of those cases warranted further investigation, with 34 of these groups being religious organizations.161 Although the Treasury Inspector General for Tax Administration (TIGTA) found no indication that the cases reviewed or procedures used in the review were inappropriate, it has not issued comment on whether the IRS has the authority to “fast track” these allegations absent a finding of a flagrant violation of the proscription.162 The IRS maintains its continued handling of controversial investigations of the political activities of tax-exempt charities. These efforts achieved prominence after the Service launched an investigation surrounding remarks made by the president of the National Association for the Advancement of Colored Persons (NAACP) at its 2004 convention. Like all 501(c)(3) organizations, the NAACP is barred from intervening in elections, but may comment on government policies and actions.163 The NAACP questioned the timing of an IRS examination notice dated October 8, 2004, calling the action a politically motivated attempt to silence the organization.164 Although the NAACP refused to respond to an IRS audit summons issued on January 14, 2005, the Service has maintained that the organization’s tax-exempt status is not likely to be at risk.165 An August 9, 2006 letter from Marsha A. Ramirez, director of Exempt Organizations Examinations, to the NAACP said the organization continues to qualify for exemption as an organization described in section 501(c)(3). Ramirez conveyed that the Service had concluded that the organization did not engage in political campaign intervention in violation of §501(c)(3).166 In a statement issued following the letter, the Service stated that political intervention was found in 71 percent of the 87 then-completed audits involving nonprofit organizations. Among the PIP audits garnering significant attention have been inquiries into politics-from-the-pulpit—political activity engaged in by religious leaders in the course of sermons to their congregants. In 2005, the Service announced that the PIP had uncovered several potential instances of political intervention by churches in the 2004 Presidential campaign. In late 2005, the IRS announced that the PIP had uncovered several instances of campaign intervention by churches. Exempt Organizations director Martha Sullivan announced that the IRS had uncovered “blatant” violations of the §501(c)(3) proscription against partisan political activity, as well as several cases that were “close to the line.”167 These violations included churches handing out 161 162 163 164 165 166 167
Kenneth P. Doyle, “Everson Defends IRS Probes of Charities Targeted in Complaints About Campaigning,” BNA Daily Tax Report, April 11, 2005, G-1. Id. OMB Watch: NAACP IRS Audit, at http://www.ombwatch.org/article/articleview/2700/1/ 3?TopicID=2 (last visited March 31, 2005). Id. Stephen Joyce, “IRS Will Refer NAACP’s Refusal to Comply with Exam Summons to Justice Department,” BNA Daily Tax Report, March 21, 2005, G-11. IRS Doc. 2006-18394.] Fred Stokeld, “IRS’s Sullivan Reports on Political Activities by Charities, Churches,” Tax Notes Today, November 21, 2005.
䡲
58
䡲
c02.fm Page 59 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
documents endorsing particular candidates to their congregants and pastors openly endorsing candidates from the pulpit. In addition, Sullivan refuted the notion that the PIP investigations are politically motivated, citing a TIGTA report finding no political motivation in IRS probes.168 Sullivan added that in addition to the existing IRS Publication No. 557, the Service may continue to add more examples specific to church involvement in the political process and may provide more informal advice.169 One of the most noted PIP investigations concerned the All Saints Church in Pasadena, California. On June 9, 2006, the Service notified All Saints that there was a reasonable belief that All Saints may not be tax-exempt as a church under §501(a), or that it may be liable for tax as a result of its alleged involvement in political campaign intervention activities. In its notice, the Service referred to a November 1, 2004 article in the Los Angeles Times and a sermon presented at the All Saints Church discussed in the article. The article, entitled “The Race for the White House: Pulpits Ring with Election Messages,” states that a sermon, given on October 31, 2004 to a congregation of 3,500, delivered a searing indictment of the Bush administration’s policies in Iraq, criticism of the drive to develop more nuclear weapons, and described tax cuts as inimical to the values of Jesus. The sermon was entitled, “If Jesus Debated Senator Kerry and President Bush.” The Service subsequently requested that All Saints comply with a summons. As of this writing, the leadership of All Saints Church has refused to comply with the IRS requests on grounds that the Church should be allowed to criticize any public policies that conflict with its religious tenants, and that the sermon offered on October 31, 2004 was meant as a condemnation of war, poverty, torture, and terrorism as a matter of expressing faith and not, as the Service alleges, an endorsement of a particular candidate. (B) E XPANDING THE P OLITICAL C AMPAIGN P ROHIBITION In 1987, Congress amended several provisions of the Code to clarify the prohibition against political activity by exempt organizations.170 Congress also enacted IRC §4955, which imposes a tax on prohibited political expenditures of §501(c)(3) organizations.171 A political expenditure is generally defined as any amount paid or incurred by an organization in connection with any participation or intervention in any political campaign on behalf of (or in opposition to) any candidate for public office. Intervention in a campaign includes the publication or distribution of
168 169 170
171
Id. Id. §501(c)(3) was amended to clarify that the prohibition on political activity applied to activities in opposition to, as well as on behalf of, any candidate for public office. Furthermore, §505 was amended to provide that a §501(c)(3) organization that lost its exemption because of a violation of the political campaign prohibition could not at any time thereafter be treated as a §501(c)(4) organization. §504; Reg. 1.504- 1(a)(2)(ii). §4955. The tax and correction structure of this provision is identical to that of §4945, which deals with private foundations. To avoid potential duplicative excise taxes on a private foundation, §4955 provides that if taxes are imposed on a private foundation, the expenditure is not treated as a taxable expenditure under the tax in §4945. See §4955(e). Final regulations for §4955 were issued in December 1995.
䡲
59
䡲
c02.fm Page 60 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
statements.172 This tax is imposed regardless of whether the organization’s exempt status is revoked. In other words, the enactment of §4955 does not affect the absolute prohibition against political campaign activities; rather, it is an additional deterrent.173 In limited situations the IRS may impose the excise tax instead of revoking exempt status.174 The IRC §4955 tax is a two-tier tax imposed both on the organization itself and on the management. A first-tier tax, equal to 10 percent of the expenditure amount, is imposed on the organization for each political expenditure of the organization.175 If the political expenditure is not “corrected”176 within the
172
173
174
175 176
§4955(d)(1). The §4955 political expenditures tax has recently been applied in two cases. First, in Priv. Ltr. Rul. 96-35-003 (Apr. 19, 1996) the IRS analyzed a series of political forums sponsored by a §501(c)(3) organization. At each regional forum, three selected issues were discussed among the participants (a cross section of the state’s voting population) and the invited candidates. Rather than inviting all legally eligible candidates, the organization invited six candidates—one from each major party and four selected by vote of the participants—to the regional forums, and only those candidates who had achieved at least 15 percent popular support in a statewide poll to a statewide forum. At the conclusion of the forums, the organization published the results, with the format varying from year to year. The IRS determined that the reports from the first and second years, which contained candidate rankings and editorial comments by the participants, constituted campaign intervention and were subject to the §4955 tax. The third year’s report, which merely recounted the question-and-answer sessions with the candidates, was permissible. This memorandum is important because (1) it is one of the first cases in which the §4955 sanctions have been applied and (2) it provides exempt organizations with a measure of guidance on the extent to which political forums may be conducted. Specifically, the ruling demonstrates that limiting a public forum to less than all possible candidates, if objective criteria exist on which the exclusion is based, does not constitute campaign intervention. Further, the memorandum suggests that the selection of only a few issues to be discussed at the forum will not necessarily disqualify the forum as campaign intervention. Compare Rev. Rul. 86-95, 1986-2 C.B. 73. See also Priv. Ltr. Rul. 96-09-007 (Dec. 6, 1995) for another example of activities triggering the application of §4955. In a recent case, a district court upheld the IRS’s refusal to grant exempt status to a fund established to support Republican Party leaders in preparing a report proposing enactment of a flat tax. The court held that the fund supported a one-sided political agenda and improperly participated in partisan advocacy to obtain its political objective. Fund for the Study of Economic Growth and Tax Reform v. Internal Revenue Service, 997 F. Supp. 15 (D.D.C. 1998). H.R. Rep. No. 100-391. 100th Cong., 1st Sess. 1623-27 (1987). In T.A.M. 200446033, the IRS ruled that a healthcare organization’s supervision of a payroll deduction plan, which allows employees to contribute to a hospital association political action committee, triggers excise tax. The hospital organization discussed in the T.A.M. allowed managerial employees to deduct contributions to a state hospital association’s political action committee. The IRS stated that such contribution deductions “constitute[d] participation or intervention in a political campaign prohibited by section 501(c)(3)” and imposed excise taxes on the hospital organization. The IRS will not necessarily revoke exempt status in situations when revocation seems disproportionate to the political expenditure at issue. Here, the excise tax might suffice. See H.R. Rep. No. 100-391, 100th Cong., 1st Sess. 1623-27 (1987). This safety net of nonrevocation is limited to situations where the political expenditure was unintentional and involved only a small amount and where the organization subsequently adopted procedures to ensure that similar expenditures would not be made in the future. §4955(a)(1). “Correction” is defined in the statute as recovering part or all of the expenditure to the extent recovery is possible, establishment of safeguards to prevent future political expenditures, and where the full recovery is not possible, such additional corrective action as is prescribed by the Secretary by regulations. §4955(e)(3).
䡲
60
䡲
c02.fm Page 61 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
“taxable period,”177 then an additional second-tier tax, equal to 100 percent of the political expenditure, is imposed on the organization.178 Likewise, there is a 2.5 percent first-tier tax on any manager of the organization who willfully and unreasonably agrees to any expenditure by the organization that the manager knows to be a political expenditure.179 In order to enforce IRC §4955 in an effective manner, the IRS was granted authority to immediately determine, compute, and assess the amount of income and excise tax due from the exempt organization for that year and the preceding tax year when a violation occurs.180 In addition, the IRS is granted authority to seek an injunction against any §501(c)(3) organization that flagrantly violates the political campaign prohibition, in order to prevent further political expenditures by the organization.181 (C) P OLITICAL O RGANIZATIONS Section 527 political organizations have proliferated since the mid-1990s. A combination of rulings under the tax code and federal election laws allowed organizations that engaged in activities intended to influence an election, but not directly supporting a particular candidate, to operate under §527 without restrictions or gift tax on contributions and without disclosure of contributors to either the FEC or the IRS.182 Until this time, most §527 organizations had made reports to the FEC. (Tax-exempt status under §527 is accorded to an organization that is organized and operated primarily for the purpose of accepting contributions or making expenditures to influence the selection or election of an individual to political office at any level.) In July 2000, Congress amended the section to require such political organizations to make a number of disclosures to the IRS.183 The IRS issued guidance to help taxpayers comply with the changes, which were effective upon passage.184 The new law requires a §527 organization to identify itself to the IRS within 24 hours of creation, or its exempt-function income will become taxable. It must also make “periodic” reports disclosing the recipients of payments aggregating more than $500 per year, and the names of contributors of more than $200. Annual 177
178 179
180 181
182 183 184
The “taxable period” is defined as the period beginning with the date on which the political expenditure occurs and ending on the earlier of (A) the date of mailing of a notice of deficiency under §6212 with respect to the tax imposed by [§4955], or (B) the date on which the tax imposed by [§4955] is assessed. §4955(e)(4). §4955(b)(1). §4955(a)(2). This tax, paid by the manager, is limited to $5,000 for any “one political expenditure.” §4955(c)(2). If more than one manager is involved in the expenditure, each manager is jointly and severally liable for the tax imposed. §4955(c)(1). If the manager refuses to agree to a “correction” of the expenditure, there is a 50 percent second-tier tax imposed. §4955(b)(2). The second-tier managerial tax, for any expenditure, cannot exceed $10,000. §4955(c)(2). §6852. §7409. See Rev. Rul. 67-71, 1967-1 C.B. 125 (an organization that attempted to improve the public school system by campaigning for its choice of candidates for election to the school board was not exempt under §501(c)(3). But see Rev. Rul. 74-574, 1974-2 C.B. 160 (an organization that operated a broadcasting system that presented religious, educational, and public interest programming, was held not to be participating in political campaigns when it provided reasonable air time equally available to all qualified candidates for election to public office in compliance with federal laws and when it refrained from endorsing any particular candidate or viewpoint). Martin A. Sullivan, “More Disclosure from 501(c)(3)s,” Exempt Organization Tax Review 29 (July 2000): 10. Pub. L. No. 106-230 (July 1, 2000); IRC §527. Rev. Rul. 2000-49, 2000-44 I.R.B. 1.
䡲
61
䡲
c02.fm Page 62 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
returns on both Form 1120-POL and Form 990 are also required. The IRS has become aware of widespread failure by state and local campaign committees to register as required and is concerned about two new reporting deadlines in the spring of 2002, when political organizations are supposed to begin filing Forms 990 and annual tax returns on Form 1120 POL. The Agency is actively working to raise awareness while contemplating enforcement policy.185 Bills have been introduced in both houses of Congress to change the requirements in different ways. The IRS created its first totally Internet-based filing option for the contributions and expenditures report. The form is available at <www.irs.gov/polorgs>. (iii) The Lobbying Disclosure Act of 1995.186 In addition to the general proscription against legislative activity under IRC §501(c)(3) and the absolute prohibition on campaign activity, the Lobbying Disclosure Act of 1995 (LDA or “the Act”) requires additional disclosure and reporting of lobbying activity beyond a threshold level and imposes monetary penalties on those organizations or individuals that fail to meet these requirements. Exempt organizations must familiarize themselves with the Act, because many terms used in the Act, such as covered executive branch official (CEBO), covered legislative branch official (CLBO), and lobbying contact, are defined differently than in other lobbying-related provisions. (A) R EGISTRATION In general, organizations other than churches or certain religious orders187 must register and file semiannual reports detailing their lobbying activity if • They have at least one employee who qualifies as a “lobbyist” under the
Act. • The organization expects to spend $20,000 or more in a six-month period
in furtherance of lobbying activities. A “lobbyist” is any person who during either semiannual period makes more than one “lobbying contact”188 with a “covered government official” and whose lobbying activities consume at least 20 percent of that employee’s time.189 Only organizations that have at least one employee who qualifies as a lobbyist are required to register and report under the Act. PRACTICE TIP Charitable organizations should consider splitting the time spent on lobbying and lobbying-related (supporting) activity among their employees, so that the activity of each will fall below the 20 percent threshold. 185 186
187 188 189
Statement by Judy Kindell, reported in Daily Tax Report (Feb. 25, 2002). U.S.C. §1605. For a more in-depth discussion of the LDA, see Boisture, “What Charities Need to Know to Comply with the Lobbying Disclosure Act of 1995,” Exempt Organization Tax Review 13 (Jan. 1966): 35. [hereinafter Boisture]. Churches and certain religious orders are exempt from the registration requirements of the Act. LDA §8(B)(xviii). LDA §3(10). LDA §3(8)(A).
䡲
62
䡲
c02.fm Page 63 Thursday, March 15, 2007 3:46 PM
2.4 STATUTORY REQUIREMENTS
In order to qualify as a “lobbying contact,” the communication must be made to either a covered executive branch official (CEBO)190 or a covered legislative branch official (CLBO).191 (B) L OBBYING A CTIVITIES AND L OBBYING C ONTACTS The Act defines lobbying activity to mean any “lobbying contact” and any efforts made in support of such a contact.192 A lobbying contact is any oral or written communication to a CEBO or CLBO by an employee who qualifies as a lobbyist, made in reference to the formulation, modification, or adoption of federal legislation or legislative proposals; federal rules or regulations; executive orders or policy positions; the administration, negotiation, or award of a federal program, grant, loan, permit, or license; or the nomination or confirmation of a person subject to confirmation by the Senate.193 (C) L OBBYING A CTIVITY AND I NFLUENCING L EGISLATION—TAX D EFINITION VERSUS A CT D EFINITION In determining whether and to what extent it must report lobbying activity, a charitable organization eligible to make the IRC §501(h) lobbying election may elect to use either the Act definition or the tax definition194 of “lobbying.” Although the tax definition and the Act definition in large part overlap, many activities specifically excluded from the tax definition of lobbying constitute lobbying activity under the Act. For example, reports that constitute nonpartisan analysis195 and are made available to the general public, although excluded from the tax definition of lobbying, are considered to be lobbying activity for purposes of the Act.196 Although the Act definition appears to be generally more inclusive than that provided by the tax law, it is less restrictive in other respects. For example, the 190
191
192
193 194 195 196
CEBOs include the president, vice president, and their staffs; persons serving in Executive Level I through V positions; high-ranking military officers (brigadier general or rear admiral or higher); and federal employees serving in “confidential” or “policy-making or -influencing” positions. LDA §3(3). Note that this definition includes important federal officials, such as the IRS Commissioner and the Assistant Secretary of Treasury for Tax Policy, and lower-level employees in confidential or policy-influencing positions, who are not considered to be CEBOs under other definitions of the term. See §162(e). A general guide to confidential, policymaking, -determining, and -influencing positions is Policy and Supporting Positions (the “Plum Book”), published every four years. LDA Guidance at 5. CLBOs include members of Congress and their staffs; elected officers of either House; employees or representatives of the leadership staff or committees of either House, joint congressional committee or caucus, and certain other congressional staff. LDA §3(4). LDA §3(7). Supporting activities include preparation and planning activities and research and background work that is intended, at the time it is performed, to be used in furtherance of lobbying contacts. LDA §3(8)(A). The Act specifically excludes 19 types of communication from the definition of lobbying contact. See LDA §3(8)(B). §15(a). See §§501(h)(2)(B), 4911(d); see also Section 2.4(c)(i)(B). See Reg. §56.4911-2(c)(1). Compare §4911(d)(2)(A) with LDA §8(6) (list of communications excluded from the definition of lobbying under the Act). Similarly, oral responses (other than testimony) made in response to written requests for technical assistance from a congressional committee, and lobbying on legislative proposals that have not yet matured into “specific legislation,” are also considered to constitute lobbying under the Act, even though they are specifically excluded from the tax definition of lobbying. Compare §4911(d)(2)(B) and §4911(e)(2) with LDA §8(A)(i)-(iii).
䡲
63
䡲
c02.fm Page 64 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
legislative history of the Act strongly suggests that the Act’s definition of lobbying activity excludes “grass roots” lobbying,197 and under the Act efforts made to influence state or local legislative bodies are not considered lobbying activity, including contact with a nonfederal official.198 Accordingly, the choice of which definition to rely on in determining whether registration and reporting are required will turn upon what type of activity makes up the bulk of the organization’s lobbying efforts. If a charity’s lobbying efforts are primarily conducted on the state and local levels, the Act definition will be more attractive. If most of the charity’s lobbying activity is the publication of reports qualifying under IRC §4911 as nonpartisan analysis, reliance on the tax law definition will likely yield a more favorable result. Charitable organizations must realistically examine their anticipated “lobbying” efforts to determine which definition may enable them to avoid triggering the registration and reporting requirement of the Act. CAVEAT Note that because private foundations are not eligible to make an IRC §501(h) lobbying election, they must rely on the Act definition of lobbying. Yet certain activities not considered lobbying under the tax definition will constitute lobbying under the Act and trigger a reporting requirement on the part of the private foundation.* Thus, special care must be taken by private foundations so as not to unknowingly trigger an obligation to register and report under the Act. *
For example, nonpartisan analysis, self-defense, oral responses (other than testimony) made in connection with written requests for technical assistance from a congressional committee, and lobbying on legislative proposals that have not yet matured into “specific legislation” are all excluded from the definition of lobbying or “influencing legislation” for the purposes of the tax laws, but included for purposes of measuring lobbying activity under the Act. Compare §4911(d)(A)-(C),(E) with LDA §5(B)(2) and §3(8)(A)-(B).
(D) P ROCEDURAL R EQUIREMENTS: R EGISTRATION S TATEMENT AND S EMIANNUAL R EPORTS If an organization is required to register, it must file a registration statement with the Secretary of the Senate and the Clerk of the House of Representatives.199 The registration statement must be filed within 45 days after an employee who qualifies as a lobbyist first makes a lobbying contact or agrees to make a lobbying contact—whichever is earlier.200 Organizations that do not exceed or expect to exceed $20,000 in lobbying expenditures (both direct and indirect) in a semiannual period are not required to register.201 Once an organization has triggered 197
198 199 200 201
Boisture at 38. Under §4911, grass roots lobbying does constitute lobbying activity for tax purposes, see §501(h)(1)(B); §501(h)(2)(C)-(D), and special restrictions are imposed on the amounts that may be expended in furtherance of a grass roots activity. See §4911(c). See §3(3)-(4) for the definition of covered officials. Under the tax law any attempt to directly influence state legislation will be considered a lobbying expenditure. See §4911(d)(1)(B). LDA §4(A)(1). LDA §4(A)(1). If an organization is required to register under the Act, it will also be required to file semiannual reports on its lobbying activity. For purposes of determining whether an organization meets the $20,000 threshold, amounts spent on third-party lobbyists are included, although the actual registration of the third-party lobbyist is the responsibility of the outside lobbying firm.
䡲
64
䡲
c02.fm Page 65 Thursday, March 15, 2007 3:46 PM
2.5 GENERAL REQUIREMENTS
the reporting requirements of the Act, semiannual reports must be filed even if the charity ceases to meet the minimum requirements in a subsequent period. The organization must act affirmatively in order to be relieved of its reporting obligations.202 (E) S ANCTIONS Any person who fails to remedy a defective or incomplete filing within 60 days of notice, or knowingly fails to comply with any other provision of the Act, is subject to a fine of up to $50,000. (F) S PECIAL R ULE A PPLICABLE TO IRC §501( C)(4) O RGANIZATIONS: F EDERAL F UNDS B AN The Act also provides that §501(c)(4) social welfare organizations engaging in lobbying activities are prohibited from receiving any federal funds in the form of grants, loans, awards, contracts, or the like.203 There is currently legislation pending that would repeal or modify this ban. (d)
Feeder versus Integral Part
IRC §502 denies exemption to an organization that is engaged in a trade or business for profit even if the organization pays over all profits to an exempt organization. Reg. §1.502-1(b) provides that, despite this general rule of taxation of “feeder” organizations: If a subsidiary organization of a tax-exempt organization would itself be exempt on the ground that its activities are an integral part of the exempt activities of the parent organization, its exemption will not be lost because, as a matter of accounting between the two organizations, the subsidiary derives a profit from its dealing with the parent organization.
In some cases, an organization engaged in a trade or business that would normally fail to qualify for tax exemption may so qualify as an integral part of an exempt organization in the system. This doctrine was invoked, albeit unsuccessfully, by a health maintenance organization (HMO) in the important Geisinger case,204 discussed in detail in §11.3(e)(ii).
2.5
GENERAL REQUIREMENTS
To qualify for exempt status, a charitable organization must benefit a “charitable class,” and it must not be operated contrary to public policy.
202
203 204
The organization must (1) cease all lobbying activity, (2) have no intention of resuming lobbying activity, and (3) notify the Clerk of the House and the Secretary of the Senate of this fact and request that its registration be terminated. LDA §18. Geisinger Health Plan v. Commissioner, 34 F.3d 494 (3rd Cir. 1994), aff’g 100 T.C. 394 (1993). See also Redlands Surgical Services revised denial letter and pending tax court case discussed in Section 11.3.
䡲
65
䡲
c02.fm Page 66 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
(a)
Organization Must Benefit a Charitable Class
A charitable organization or trust must be set up for the benefit of an indefinite class of individuals, not for specific persons.205 Hence, a trust or corporation organized and operated for specific individuals is not charitable.206 For example, a trust to benefit John Jones is not a charitable trust even though the facts and circumstances may show that John Jones is impoverished. However, an organization set up with the general charitable purpose of benefiting needy individuals in a particular community is a charitable organization, and the organization may select John Jones as a beneficiary. Furthermore, a large class does not necessarily make the class a charitable one. 207 Hence, if an organization is established to benefit 110,000 homeowners, those homeowners do not inherently constitute a charitable class.208 Likewise, the Republican Party is not, merely because of its size, a charitable class.209 However, an organization may properly have a purpose to benefit a comparatively small class of beneficiaries, provided the class is open and the identities remain indefinite. Hence, a foundation organized to award scholarships solely to undergraduate members of a designated fraternity could be exempt as a charitable organization.210 (b)
Organization Must Not Operate Contrary to Public Policy
An activity is not charitable if it is contrary to public policy.211 In interpreting IRC §501(c)(3), the IRS concludes that [an] organization is not operated exclusively for charitable purposes if its activities are carried on in a manner that can be reasonably classified as contrary to well-established public policy.212
205
206
207 208 209 210
211
212
American Campaign Academy v. Commissioner, 92 T.C. 1053, 1076 (1989). See also Rev. Proc. 96-32, 1996-20 I.R.B. 14 (low-income individuals are a charitable class); Priv. Ltr. Rul. 93-11-034 (Dec. 21, 1992). Gen. Couns. Mem. 39,876 (July 29, 1992). Compare Aid to Artisans, Inc., 71 T.C. 202 (1978). The Tax Court held that alleviating economic deficiencies in communities of disadvantaged artisans is a valid charitable and educational purpose, and stabilizing the income of the poor is a charitable purpose. Hence, because the disadvantaged artisans are a charitable class, the court held that the organization is serving public, not private, interests and therefore qualifies for exemption under §501(c)(3). Columbia Park and Recreation Ass’n v. Commissioner, 88 T.C. 1 (1988); American Campaign Academy v. Commissioner, 92 T.C. 1053 (1988). Columbia Park and Recreation Ass’n v. Commissioner, 88 T.C. 1, 18-21 (1988). American Campaign Academy v. Commissioner, 92 T.C. 1053, 1076 (1989). Rev. Rul. 55-406, 1955-1 C.B. 73 (an organization formed to benefit the dependent spouses and children of policemen and firemen killed in the line of duty was held to be charitable because it stated a charitable class). But cf. Rev. Rul. 57-449, 1957-2 C.B. 622 (a trust to pay a certain sum to all the individuals enrolled in a certain school on a particular date was held to be a private trust and not charitable). Rev. Rul. 71-447, 1971-2 C.B. 230. Here, the IRS relies primarily on Brown v. Board of Education, 347 U.S. 483 (1954), to support its public decision. See also Rev. Rul. 75-231, 19751 C.B. 158 Bob Jones University v. United States, 461 U.S. 574 (No. 81-23) (1983); American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). Rev. Rul. 71-447, 1971-2 C.B. 230.
䡲
66
䡲
c02.fm Page 67 Thursday, March 15, 2007 3:46 PM
2.5 GENERAL REQUIREMENTS
Thus, private schools that discriminate on the basis of race are not charitable.213 Likewise, organizations that promote racism and discrimination as a means of creating social, economic, and political change are not entitled to tax-exempt status.214 What about schools that discriminate on the basis of gender? The Supreme Court has determined that the Virginia Military Institute (VMI), an all-male military academy supported by the state of Virginia, must either admit women or give up its state financing, converting to private status.215 Although this case does not have a direct impact on the permissibility of privately maintained single-sex educational programs, in that it involves a publicly supported institution, the VMI case (or its progeny) could eventually have the same effect on private singlesex schools as the Bob Jones case had on racially discriminatory private schools.216 Although the majority of the Court in the VMI case stated that the decision will not adversely impact single-sex education in general because the opinion addresses only the “unique” situation existing at VMI,217 the dissent recognized 213
214
215 216 217
Bob Jones University v. United States, 461 U.S. 574 (No. 81-23) (1983); Green v. Connaly, 330 F. Supp. 1150 (1971), aff’d sub nom Coit v. Green, 404 U.S. 997 (1971); Goldsboro Christian Schools, Inc. v. United States, 461 U.S. 574 (1983); Norwood v. Harrison, 413 U.S. 455 (1973). Some limited affiliation with an organization that is discriminatory, however, is apparently not fatal to an organization’s exemption determination. See Bob Jones University Museum & Gallery, Inc. v. Commissioner, T.C. Memo 1996-247 (1996). Bob Jones University operated an art gallery (hereinafter the “gallery” or the “museum”) as part of the University beginning in 1951. Following the Supreme Court’s revocation of the University’s exempt status in 1983, the museum was separately incorporated and applied for an exemption from tax under §501(c)(3) as an educational organization. The IRS denied the exemption, in part on the bases that the museum (1) admitted a substantial nonexempt purpose in its application by providing that one of its purposes was to allow the public to make deductible contributions to the museum, whereas no such deduction would be allowed if the gifts were made directly to the University, and (2) that the actual purpose of the gallery was to serve as a conduit for charitable contributions to the University. Id. at ¶¶ 16-19. The Tax Court overruled the IRS and granted the gallery its exemption, holding that the museum was a bona fide organization that served legitimate educational purposes. The court’s decision was influenced by a number of factors, including a provision in the gallery’s application that contributions would be used only to operate the museum, and the facts that (1) a majority of the museum’s board of directors was made up of persons not affiliated with the University, (2) the lease terms were favorable to the gallery, (3) the museum employees did not provide any services to the University, and (4) the museum was not one of the University’s “essential parts.” Accordingly, provided that there is a distinct separation from the otherwise disqualified organization, mere affiliation with an entity operating contrary to public policy will not serve to automatically disqualify an otherwise charitable organization from exemption. Likewise, illegal activity is considered to be contrary to public policy. Thus, for example, the IRS determined that an organization formed to promote world peace and disarmament could not qualify under 501(c)(3), because its primary activity was sponsoring antiwar protest demonstrations, in which the organization urged participants to commit violations of local ordinances and breaches of public order. Rev. Rul. 75-384, 1975-2 C.B. 204. See generally Nationalist Movement v. Commissioner, 37 F.3d 216 (5th Cir. 1994), cert. denied, 513 U.S. 1192 (1995). (This decision offers valuable insight into many fundamental concepts that are used in determining whether an organization is operated in furtherance of a charitable purpose.) United States v. Virginia, 116 S. Ct. 2264 (1996). See Alexander, “Validity of Tax-Exemption and Deductible Contributions for Private Single Sex Schools,” 13 Exempt Org. Tax Rev. 235 (Feb. 1996) (hereinafter “Alexander”). VMI has been in existence for more than 150 years and was one of the nation’s first military colleges. VMI relies on the “adversative method” of training, which features “physical rigor, mental stress, absolute equality of treatment, absence of privacy, minute regulation of behavior and indoctrination in desirable values.” 116 S. Ct. at 2270. The method serves to “dissect the young students” and to rebuild them into model citizen soldiers. See id. The Court provided that VMI is perhaps the only public institution at which the unique educational benefits of the adversative model can be obtained, and thus it should be open to all qualified individuals, irrespective of gender.
䡲
67
䡲
c02.fm Page 68 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
the widespread ramifications the VMI case might have for the exempt community. “The issue will not be whether government assistance turns private colleges into state actors,” thus subjecting them to the equal protection clause and the VMI ruling, “but whether the government itself would be violating the Constitution by providing state support to single-sex colleges.”218 Such support could, of course, include exemption from tax.219 Accordingly, if single-sex education is determined to be contrary to public policy, private single-sex institutions could face a loss of tax-exempt status.
2.6 (a)
CHARITABLE ORGANIZATIONS Charitable
Charitable is a generic term for any organization exempt from taxation under IRC §501(c)(3).220 However, the intended scope and definition of charitable has received wide attention for decades. Since 1923, the IRS has interpreted this word in its popular and ordinary sense.221 Initially, charitable referred primarily to “relief of the poor.”222 In 1959, regulations were promulgated that defined the term.223 The regulations, which are still in effect, provide the following: The term “charitable” is used in IRC §501(c)(3) in its generally accepted legal sense and is, therefore, not to be construed as limited by the separate enumeration in section §501(c)(3) of the other tax-exempt purposes which may fall within the broad outlines of “charity” as developed by judicial decisions. Such term includes: relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.224 218
219
220
221
222 223 224
United States v. Virginia, 116 S. Ct. at 2307 (Scalia, J., dissenting). See also Norwood v. Harrison, 413 U.S. 455, 465 (1973) (a state was prohibited from providing textbooks to students attending private schools to the extent that the program benefited racially discriminatory schools). In Virginia, the Court held that “it is also axiomatic that a state may not induce, encourage or promote private persons to do what it is constitutionally forbidden to accomplish.” 116 S. Ct. at 2306 (citations omitted) (Scalia, J., dissenting). The Supreme Court has held that tax exemptions are not meaningfully different from grants of aid to the exemption recipients. Alexander at 238 (citing Regan v. Taxation with Representation of Wash., 461 U.S. 540, 544 (1983)). The term charitable refers not only to one of the purposes for which exemption is recognized under §501(c)(3), but is also the generic term for religious, charitable, educational, and scientific purposes under that section. Rev. Rul. 67-325, 1967-2 C.B. 113, discusses the legislative history of §501(c)(3). The IRS provides [t]hat the Congress has legislated in this area with reference to organizations generally recognized as charitable is demonstrated by the legislative history of the Corporation. See I.T. 1800, 11-2 C.B. 152, 153 (1923); see also NLRB v. Boeing Co., 412 U.S. 67, 75 (1973) (the Supreme Court agrees that “a consistent and contemporaneous construction of a statute by the agency charged with its enforcement is entitled to great deference”). Reg. 65, Art. 517 (Revenue Act of 1924, 43 Stat 282). For an application of the charitable purpose of “relief to the poor,” see Section 2.6(a)(1). Reg. 1.501(c)(3)-1(d)(2). See id.
䡲
68
䡲
c02.fm Page 69 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
This regulation expanded the purposes for which a charitable organization may qualify for exempt status beyond “relief of the poor.”225 IRS rulings have continued to expand the definition of charitable over the years, reflecting societal changes.226 A statute provided a temporary expansion of the meaning of “charitable” for victims of the September 11 terrorist attack and the anthrax attack. Organizations dispensing aid to such victims need not make a specific assessment of need before providing aid if: (1) payments are made in good faith using a reasonable and objective formula that is consistently applied, and (2) the charitable class being served is either large or indefinite.227 The IRS has also provided administrative leeway to relief organizations in the wake of September 11. For example, the IRS approved contractual use of a whale-watching boat to provide ferry transportation to commuters in the New York City area coping with damaged public transportation. The IRS ruled that once the environmental education organization amended its Articles of Incorporation to include the provision of public transportation, the activity would be related to its charitable purpose, that it was of limited duration, not entered into with intent to profit, and that facilitating public transportation has been recognized as a charitable purpose since the seventeenth century.228 In addition to statutory requirements, organizations seeking exempt status must meet general historical and legal requirements of charitable organizations.229 For example, the IRS has stated that the provisions in the Code “do not reflect any novel or specialized tax concept of charitable purposes, and that . . . [those provisions] should be interpreted as favoring only those purposes which are recognized as charitable in the generally accepted legal sense.”230 225
226
227 228 229
230
In Rev. Rul. 67-325, 1967-2 C.B. 113, the IRS reiterated that it would treat as tax-exempt only those purposes that are recognized as charitable in the generally accepted legal sense. The ruling provides thus: The favored treatment of charitable organizations for federal tax purposes in the income, estate, and gift tax legislation enacted in the current century has not provided a comprehensive definition of charitable purposes in the various statutory provisions that have been enacted. It is clear for this and other reasons that those statutory provisions do not reflect any novel or specialized tax concept of charitable purposes, and that the income, estate, and gift tax provisions of the Code here in question should be interpreted as favoring only those purposes which are recognized as charitable in the generally accepted legal sense (Rev. Rul. 67-325, 1967-2 C.B. at 116). The legal precedents determining what activities are in furtherance of charitable purposes are not limited to decisions under §501(c)(3). Rev. Rul. 67-325, 1967-2 C.B. 113, indicated that the case law relating to charitable trusts and to the exemption statutes are the primary sources of the legal definition of charity. See generally 4 Scott on Trusts, 368 (3rd ed. 1967). Rev. Rul. 71-580, 1971-2 C.B. 235; Rev. Rul. 80-301, 1980-2 C.B. 180; compare Rev. Rul. 80302, 1980-2 C.B. 182 (organization limited to researching one family’s genealogy is not exempt); see Rev. Rul. 75-74, 1975-1 C.B. 152 (public interest law firms are charitable organizations). Procedures and guidelines for organizations seeking exemption as a public interest law firm are provided at Rev. Proc. 92-59, 1992-29 I.R.B. 11 See Rev. Rul. 72-228, 1972-1 C.B. 148 (organization to investigate employment discrimination is charitable). Victims of Terrorism Tax Relief Act of 2001, Advance Notice of Special IRS Publication, available on the IRS Web site at <www.irs.gov>. Priv. Ltr. Rul. 200204051. H.R. Rep. No. 1860, 75th Cong., 3d Sess. 19 (1938). Congress, in the legislative history, provided an explanation of the theory and purpose behind tax exemption: The exemption from taxation of money or property devoted to charitable and other purposes is based upon the theory that the government is compensated for the loss of revenue by its relief from financial burdens which would otherwise have to be met by appropriations from other public funds, and by the benefits resulting from the promotion of the general welfare. Rev. Rul. 67-325, 1967-2 C.B. 113.
䡲
69
䡲
c02.fm Page 70 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
It is important to understand that it is not the activity per se that must qualify as charitable. Rather, it is the charitable purpose to be attained through that activity that must qualify as charitable.231 The performance of a particular activity that is not inherently charitable may nonetheless further a charitable purpose. The overall result in any given case is dependent on why and how that activity is actually being conducted.232 (i) Relief of the Poor. The relief of the poor and underprivileged is the most basic of the charitable purposes of IRC §501(c)(3) organizations.233 Relief of the poor is most often accomplished through the provision of services to individuals, including employment assistance for the poor234 and elderly235 and providing housing,236 financial advice,237 and legal services.238 (A) L OW-I NCOME H OUSING AS “R ELIEF OF THE P OOR” A charitable purpose may be found in those organizations dedicated to the relief of the poor, distressed, and underprivileged, as well as in those entities organized to lessen neighborhood tensions, to eliminate prejudice and discrimination, to combat community deterioration, and to lessen the burdens of government.239 Through a series of rulings and administrative pronouncements, the IRS has made it clear that providing housing assistance to persons living at or below the poverty level generally is viewed as promoting charity by offering relief to those who could not otherwise afford decent housing.240 Furthermore, homes for the aged241 and the physically disabled242 may qualify for exemption.243 Unlike lowincome housing organizations, however, organizations providing housing for the elderly are not limited by the charitable class’s financial need.244 In 1972, the Service established that the healthcare and housing needs of the elderly transcended their ability to pay and accorded §501(c)(3) status to organizations formed to meet those needs.245 Therefore, the exemption status of organizations providing housing for the elderly is not only dependent upon the elderly charitable class’s income, but also their healthcare and housing needs.246 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246
See, e.g., Rev. Rul. 69-572, 1969-2 C.B. 119; Rev. Rul. 80-279, 1980-2 C.B. 176; Rev. Rul. 80-278, 1980-2 C.B. 175. Rev. Rul. 69-572, 1969-2 C.B. 119. Reg. §1.50(c)(3)-1(d)(2). Rev. Rul. 73-128, 1973-1 C.B. 222; Rev. Rul. 68-167, 1968-1 C.B. 255. Rev. Rul. 66-257, 1966-2 C.B. 212. Rev. Rul. 70-585, 1970-2 C.B. 115; Rev. Rul. 68-17, 1968-1 C.B. 247; Rev. Rul. 67-250, 1967-2 C.B. 182. Rev. Rul. 69-441, 1969-2 C.B. 115. Rev. Rul. 78-428, 1978-2 C.B. 177; Rev. Rul. 69-161, 1969-1 C.B. 149. Reg. §1.501(c)(3)-1(d)(2). See Rev. Proc. 96-32, 1996-1 C.B. 717, for the IRS guidelines on qualifying as an exempt organization that provides low-income housing. Also see Section 4.2(d)(ii)(A) and Chapter 12. Rev. Rul. 72-124, 1972-1 C.B. 145; Rev. Rul. 64-231, 1964-2 C.B. 139; Rev. Rul. 61-72, 1961-1 C.B. 188. Rev. Rul. 79-19, 1979-1 C.B. 195; Rev. Rul. 72-16, 1972-1 C.B. 143 (halfway house for mentally ill individuals is charitable). Reg. §1.501(c)(3)-1(d)(2). For a detailed discussion of joint ventures involving low-income housing, see Chapters 1 and 13. Rev. Rul. 72-124, 1972-1 C.B. 145 (1972). See Elizabeth C. Kastensberg and Joseph Chasin, Elderly Housing, IRS 2004 CPE book, available at http://www.irs.gov/pub/irs-tege/eotopicg04.pdf. See id.
䡲
70
䡲
c02.fm Page 71 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
(B) E CONOMIC D EVELOPMENT O RGANIZATIONS AS “R ELIEF OF THE P OOR” Organizations that aim to assist certain for-profit businesses (or other beneficiaries that do not constitute a charitable class) may qualify for exemption under IRC §501(c)(3), provided that the assistance or other activity furthers charitable purposes.247 For example, assistance to a for-profit business in an economically distressed and disadvantaged neighborhood may “combat community deterioration and juvenile delinquency” and “lessen the burdens of government,” thereby constituting a charitable purpose within the meaning of the regulations.248 Such organizations that provide economic and other assistance to for-profit businesses are commonly referred to as economic development corporations, or EDCs.249 The IRS has recognized EDCs as exempt under IRC §501(c)(3)—despite the fact that assistance is directly provided to for-profit businesses—on the ground that the ultimate good received by the general public outweighs the private benefit accorded to the direct beneficiaries.250 247
248
249
250
The IRS has provided guidance on the requirements for an economic development corporation (EDC) to qualify as a charitable entity. See Department of Treasury, Internal Revenue Service, “Exempt Organizations Continuing Professional Education Technical Instruction Program for Fiscal Year 1992,” at 155. In the IRS Manual the IRS determined factors necessary to conclude that an EDC is primarily accomplishing charitable purposes, despite the element of private benefit being present. The assistance must be targeted (i) to aid an economically depressed or blighted area; (ii) to benefit a disadvantaged group, such as minorities, the unemployed, or underemployed; and (iii) to aid businesses that have actually experienced difficulty in obtaining conventional financing (a) because of the deteriorated nature of the area in which they were or would be located, or (b) because of their minority composition, or to aid businesses that would locate or remain in the economically depressed or blighted area and provide jobs and training to the unemployed or underemployed from such area only if the economic development corporation’s assistance was available. See Rev. Rul. 77-111, 1977-1 C.B. 144. The revenue ruling sets forth two factual scenarios in which organizations attempted to promote business activity in economically deteriorated areas. Reg. §1.501(c)(3)-1(d)(2). See also Rev. Rul. 85-1, 1985-1 C.B. 177; Rev. Rul. 85-2, 1985-1 C.B. 178 (examples of organizations that “lessen the burdens of government”). For specific factors to qualify as an organization that lessens governmental burdens, see Department of the Treasury, Internal Revenue Service, “Exempt Organizations Continuing Professional Education Technical Instruction Program for Fiscal Year 1992,” at 151, 159-60. In Tech. Adv. Mem. 96-29-002 (Apr. 8, 1996), the IRS ruled that an organization formed by a city’s economic development authority to acquire, develop, and operate a correctional facility housing prisoners from within and without the prison’s home state would create local jobs and stimulate the local economy, thus lessening the burdens of government. Some common forms of EDCs include “incubators,” which are generally formed to provide assistance to encourage new businesses to locate in neighborhoods or communities whose economies are depressed and deteriorating, or to provide assistance to existing or emerging businesses to encourage them to remain in such areas. Incubators provide various types of assistance, such as financial assistance in the form of low interest loans and technical and clerical services for emerging or establishing businesses. Other types of EDCs that may qualify for tax exemption under §501(c)(3) include entities formed under the Small Business Investment Act and administered by the Small Business Administration (SBA). Such entities include Small Business Investment Corporations (SBICs) and “Section 301(d) Licenses,” also known as Minority Enterprises Small Business Investment Companies, or MESBICS. MESBICs generally involve tax-exempt organizations serving as catalysts to Drysdale, Ltd., entitled “Tax Exempt Organizations and Economic Development” presented at the ABA Exempt Organizations Committee Meeting (Feb. 7, 1993). See Rev. Rul. 74-587, 1974-2 C.B. 162.
䡲
71
䡲
c02.fm Page 72 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
The IRS ruled that an organization that devoted its resources to programs to stimulate economic development in high-density urban areas inhabited mainly by lowincome minority or other disadvantaged groups, qualified for exemption under IRC §501(c)(3).251 The organization in question made loans to and purchased equity interests in businesses unable to obtain funds from conventional sources, and showed that its investments were not undertaken for profit or gain, but to advance its charitable goals.252 Funds for its program were obtained from foundation grants and public contributions. In granting the exemption, the IRS noted that the organization’s activities: • Lessened prejudice against minorities by demonstrating that such groups
could operate a business with proper guidance • Eliminated poverty and lessened neighborhood tensions by assisting
local businesses, thereby creating job opportunities • Combatted community deterioration by establishing new businesses and
rehabilitating existing ones253 (ii) Promotion of Health. The promotion of health is a “charitable” purpose.254 Hospitals are the most common type of organization operated for the promotion of health.255 Hospitals include any organization that is a hospital, with a principal purpose of providing medical or hospital care, medical education, or medical research.256 To qualify for exempt status, a hospital must demonstrate that it serves a public rather than a private interest.257 The term hospital is not defined in IRC §501(c)(3) or in the regulations thereunder. However, the Supreme Court held that “as the Code does not define the term charitable, the status of each nonprofit hospital is determined on a case-by-case basis by the IRS.”258 Originally, hospitals qualified for exemption only if they provided patient care without charge or below cost to promote relief of the poor.259 Although providing medical care to those unable to pay for such service is still a factor,260 the 251 252 253
254 255 256
257
258 259 260
Rev. Rul. 74-587, 1974-2 C.B. 162. See id. Id. In another instance, the IRS ruled that an organization qualified for exemption under IRC §501(c)(3) when the organization encouraged businesses to locate new facilities in an economically depressed area and provided employment opportunities for low-income residents in the area. Rev. Rul. 76-419, 1976-2 C.B. 146. The IRS found that the organization was formed and operated for the charitable purpose of relieving poverty and lessening neighborhood tensions caused by the lack of jobs in the area, and by combating community deterioration by establishing new business opportunities. Although the promotion of health is not delineated in the regulations, the IRS has recognized it as a charitable purpose. Rev. Rul. 69-545, 1969-2 C.B. 117. See Chapter 11. See generally §170(b)(1)(A)(iii). Reg. §1.170A-9(c)(1). The term hospital also includes a rehabilitation institution, outpatient clinical or community mental health or drug treatment center, so long as the organization’s primary purpose is providing hospital or medical care. Reg. §1.170A-9(c)(1). Reg. §501(c)(3)-1(d)(1)(ii). See generally “Exempt Organizations. Examination Guidelines for Hospitals, Ann.” 92-83, 1992-22 I.R.B. 59 (June 1, 1992); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Simon v. Eastern Kentucky Welfare Rights Organization, 426 U.S. 26, 29 (1976). Rev. Rul. 56-185, 1956-1 C.B. 202. Rev. Rul. 69-545, 1969-2 C.B. 117; “Exempt Organizations. Examination Guidelines for Hospitals, Ann.” 92-83, 1992-22 I.R.B. 59 (June 1, 1992). The operation of an emergency room is one of the primary factors for determining exempt status. However, a hospital would not be precluded from exemption if it did not operate an emergency room when the state health planning agency determined that such facilities are unnecessary or duplicative. Rev. Rul. 83-157, 1983-2 C.B. 94.
䡲
72
䡲
c02.fm Page 73 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
IRS now adheres to the “community benefit” standard.261 Thus, hospitals and other health care organizations are exempt from taxation under IRC §501(a) if they meet the “community benefit” standard set forth in §501(c)(3).262 This standard requires merely that the hospital and its charitable activities be dedicated to the promotion of health of the public in general. (b)
IRS Theory Distinguishing Nonprofits from For-Profits
Under §501(c)(3), an organization must meet three requirements in order to qualify for tax exemption: (1) It must be organized and operated exclusively for “charitable” purposes; (2) no part of the organization’s earnings may inure to the benefit of any shareholder or individual; and (3) the organization must not engage in political campaigns or, to a substantial extent, lobbying activities. The first requirement, the subject of this discussion, requires that in order for an organization to serve a “charitable” purpose, it must serve a public rather than a private interest (Reg. §1.501(c)(3)-1(d)(1)(ii)). This requirement that charities serve a public purpose is not new; in fact, it is a fundamental tenet of the law of charities. For example, in the most frequently cited IRS ruling in the area of publishing, Rev. Rul. 67-4, 1967-1 C.B. 121, the IRS established four criteria that an organization must meet in order for its publishing to be considered “charitable.” One of those criteria, perhaps the most scrutinized by the IRS, is to be able to show that the manner in which distribution of published materials is accomplished is distinguishable from ordinary commercial publishing practices. The means of showing this is by establishing that the publishing activities of the nonprofit, unlike those of its commercial counterpart in the for-profit sector, lack a “profit motive.” For example, the absence of large net receipts, pricing patterns, and noncommercial dissemination of the published materials are all evidence of public purpose. Currently, the requirement of a public purpose is again being used by the IRS in two significant and “profitable” nonprofit sectors—healthcare and housing—to differentiate these nonprofits from their commercial counterparts. In the healthcare area, it has long been recognized that the promotion of health for the benefit of the community is a charitable purpose. However, in defining charitable in this context, the key is the community benefit, not merely the promotion of health. The standard, as set forth in Rev. Rul 69-545, is as follows: The promotion of health, like the relief of poverty and the advancement of education and religion, is one of the purposes in the general law of charity that is deemed beneficial to the community as a whole even though the class of beneficiaries eligible to receive a direct benefit from its activities does not include all members of the community, such as indigent members of the community, provided that the class is not so small that its relief is not of benefit to the community.
A new community benefits plus theory, in the context of nonhospital healthcare entities, has been articulated in a recent appeals court decision upholding the 261 262
Rev. Rul. 69-545, 1969-2 C.B. 117. §501(c)(3); Reg. §1.501(c)(3)-1; Rev. Rul. 69-545, 1969-2 C.B. 117. For a detailed discussion of health care organizations, see Chapter 12.
䡲
73
䡲
c02.fm Page 74 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
IRS’s decision denying nonprofit status to health maintenance organizations (HMOs). The case, IHC Health Plans Inc. v. the Commissioner,263 involves three affiliated HMOs that did not operate primarily for the purpose of benefiting the community they serve, according to the ruling of the U.S. Court of Appeals. Although the HMOs arranged for health services in exchange for a fee, served many individuals eligible for Medicaid, and may have provided coverage to the general community at a discount, those activities were provided only to subscribers, not to the community at large. In addition, while those activities serve the charitable purpose of promoting health for the benefit of the community to a certain degree, the court held that was not their primary purpose. In its ruling, the court endorsed the community benefit standard as the appropriate test for all healthcare organizations, but it also went further in insisting on a “plus” requirement, saying that community-wide healthcare promotion activities must be accompanied by some “additional public benefit” that would “give rise to a strong inference that the public benefit conferred is the primary purpose of the organization.” In the low-income housing area, the IRS appears to be imposing a “plus” standard on §§501(c)(3) and 501(c)(4) low-income housing and community development organizations that serve as general partners in limited partnerships or limited liability companies using the low-income housing tax credit (LIHTC). Specifically, under audit or during the exemption application process, the IRS is requiring these nonprofits to differentiate so-called nonprofit-sponsored limited partnerships and limited liability companies that have §501(c)(3) or §501(c)(4) organizations as general partners, from other partnerships and LLCs in which all parties are for-profit entities. In trying to distinguish nonprofit-sponsored projects from purely for-profit projects, the nonprofit is asked to show that there is something extra in the deal, a “plus,” that differentiates the nonprofit-sponsored project from its for-profit counterpart. For example, nonprofit-sponsored LIHTC projects are often controlled by community-based boards of directors whose goal is to use housing as a means of transforming the lives of residents, not simply providing housing. In addition, and perhaps most importantly from the IRS’s point of view, nonprofitsponsored projects have as a goal maintaining the housing as low income over the life term of the projects and using the right of refusal under §42 as a tool to enable reacquisition of the projects at the end of the LIHTC, thus preserving the projects as affordable housing in the neighborhood for the long term.264 It appears that the IRS is heading in the direction of requiring nonprofits in at least two major sectors of the nonprofit industry, healthcare and housing, to distinguish themselves from their commercial counterparts by demonstrating an overwhelming public purpose, a “community benefits plus,” as it were, in the activities in which they participate.
263
264
325 F.3d 1188, 91 AFTR2d 2003-1767 2003-1 USTC P 50, 368 (10th Cir. 2003), aff’g T.C. Memo 2001-246, T.C. Memo 2001-247, T.C. Memo 2001-248. The court’s opinion in this case creates an expanded community benefits standard. See Chapter 12 for a discussion of arguments setting forth the distinctions between for-profitand nonprofit- sponsored LIHTC projects.
䡲
74
䡲
c02.fm Page 75 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
(c)
Religious Organizations
(i) What is “Religion” Under IRC §501(c)(3)? Section 501(c)(3) provides for the exemption of organizations organized and operated exclusively for “religious” purposes.265 In addition, organizations that are “advancing religion” may also be recognized as exempt under the definition of charitable.266 The term religion is not defined in IRC §501(c)(3). However, the term has been interpreted broadly by the courts, following definitions developed in other areas of the law. Therefore, a clearer understanding of the term can be obtained from an analysis of actual cases. In one early case, interpreting the scope of this exemption, the court stated that “religion is not confined to a sect or a ritual. The symbols of religion to one are anathema to another.”267 Another court, in refusing to delve into the merits of a religion, stated: Neither this Court, nor any branch of this Government, will consider the merits or fallacies of a religion. Nor will the Court compare the beliefs, dogmas, and practices of a newly organized religion with those of an older, more established religion. Nor will the Court praise or condemn a religion, however excellent or fanatical or preposterous it may seem. Were the Court to do so, it would impinge upon the guarantees of the First Amendment.268
In another case, the members of one family stated that they had received supernatural revelations and, on the basis of these revelations, they developed a “religious activity” that ultimately had thousands of adherents throughout the country and abroad. The organization was controlled by the founding family. The organization engaged in the sale of books and other materials that yielded substantial income. On the basis of these facts, the court nevertheless found it unnecessary to inquire into the nature of the beliefs held by his organization. The court held that the organization was operated for religious purposes and, in the absence of private inurement, entitled to exemption under IRC §501(c)(3).269 Furthermore, unorthodox religious beliefs are also included under the definition of religion. For example, the Supreme Court has suggested that serious constitutional difficulties would be presented if this section were interpreted to exclude those beliefs that do not encompass a supreme being in the conventional sense, such as Taoism, Buddhism, and secular humanism.270 For IRC §501(c)(3) purposes, the IRS generally will not question the religious nature of an organization’s beliefs if it determines that (1) the particular beliefs are truly and sincerely held by those professing them, as opposed to constituting 265 266
267 268 269 270
Reg. §1.501(c)(3)-1(d)(1)(I)(a). Reg. §1.501(c)(3)-1(d)(2). Organizations that advance religion are a separate category from “religious” organizations. Their primary purpose is to provide activities and services collateral to religion, such as the construction of a church building, publishing a church newsletter or newspaper (Rev. Rul. 68-306, 1968-1 C.B. 257), providing counseling services (Rev. Rul. 6872, 168-1 C.B. 250), offering Christian retreats in the countryside (Rev. Rul. 77-430, 1977-2 C.B. 194), operating a religious broadcasting center (Rev. Rul. 66-220, 1966-2 C.B. 209; Rev. Rul. 68-563, 1968-2 C.B. 212) or a financial mortgage organization to facilitate the building of churches (Rev. Rul. 75-282, 1975-2 C.B. 201). Unity School of Christianity, 4 B.T.A. 61 (1962), acq. VI-1 C.B. 6 (1927). Universal Life Church v. United States, 372 F. Supp. 770 (E.D. Cal. 1974). Saint Germain Foundation, 26 T.C. 648 (1956), acq., 1956-2 C.B. 8. United States v. Seeger, 380 U.S. 163 (1965).
䡲
75
䡲
c02.fm Page 76 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
a mere sham, and (2) the organization’s practices and rites are associated with the organization’s belief or creed and are not contrary to clearly defined public policy.271 (ii) Definition of Church. In seeking to understand the term religion, it is helpful to look to the definition of the term church.272 The IRS has provided an ad-hoc definition of a church.273 This 14-point definition includes the following: a distinct legal existence, a recognized creed and form of worship, a definite and distinct ecclesiastical government, a formal code of doctrine and discipline, a distinct religious history, a membership not associated with any other church or denomination, an organization of ordained ministers, ordained ministers selected after completing prescribed studies, a literature of its own, established places of worship, regular congregations, regular religious services, Sunday school for religious instruction of the young, and schools for the preparation of its ministers.274 No single factor from the list is controlling, and not all 14 may be relevant to a given determination.275 Based on these factors, a church, at a minimum, includes a body of believers or communicants that regularly assembles for worship.276 Although the IRS will not typically challenge a church’s religious beliefs, it will apply the statutory requirements, such as the prohibition against inurement277 and the restrictions on lobbying and political activities, in determining whether a church’s activities are in compliance with the law.278 271 272
273
274
275
276 277 278
Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook 7(10)69, §321.3(3). It is important to make a distinction between church and religion for tax-exempt purposes. An organization may be exempt as a religious organization or one that advances religion without being classified as a church. However, exempt religious organizations often seek classification as a church to attain additional tax benefits, such as exemption from certain excise taxes and exemption from annual IRS informational filings. For a discussion of the interrelationship of a religious organization and a church or convention or association of churches, see De LaSalle Institute v. United States, 195 F. Supp. 891 (N.D. Cal. 1961). Classification of a religious organization as a church may offer tax and nontax advantages. See IRC §170(b)(1)(A)(I) (providing for fewer restrictions for charitable contributions to churches); §508(c)(1)(A) (granting exemption for churches from tax-exempt notice and filing requirements); §514(b)(3)(E) (providing that churches may acquire debt-financing property or church usage); §6033 (a)(2)(A)(i) (excluding churches from annual informational filings); §§7605(c) and 7611 (placing restrictions on examinations of church records and books). Speech of Jerome Kurtz, IRS Commissioner, PLI Seventh Biennial Conference on Tax Planning (1978), reprinted in Fed. Taxes (P-H) 54,820 (1978). These guidelines were cited with approval in Spiritual Outreach Society v. Commissioner, 927 F.2d 335 (8th Cir. 1991); American Guidance Foundation, Inc. v. United States, 490 F. Supp. 304 (D.D.C. 1980). The “Kurtz test” may be found in the Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook 7(10)69, §321.3(3). Speech of Jerome Kurtz, IRS Commissioner, PLI Seventh Biennial Conference on Tax Planning (1978). See Spiritual Outreach v. Commissioner, 927 F.2d 335 (8th Cir. 1991). Here, the Eighth Circuit upheld the Tax Court and the IRS in concluding that the Spiritual Outreach Society (SOS) did not qualify as a “church”; VIA v. Commissioner, 68 T.C.M. (CCH) 212 (1994) (organization consisted of members who met fairly regularly to discuss and promote “wellness” through education in the latest discoveries of exercise, nutrition, and stress management. The Tax Court held that the organization in question lacked most, if not all, of the criteria to qualify as a church within the meaning of §170(b)(1)(A)(i). American Guidance Foundation, Inc. v. United States, 490 F. Supp. 304 (D.D.C. 1980). The general public must have access to the organization, i.e., a family does not constitute a church. See Founding Church of Scientology, 412 F. 2d 1197 (Ct. Cl. 1969), cert. denied, 397 U.S. 1009 (1970). Christian Echoes Nat’l Ministry, Inc. v. United States, 470 F.2d 849 (10th Cir. 1973), cert. denied, 414 U.S. 864 (1973).
䡲
76
䡲
c02.fm Page 77 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
(d)
Educational Organizations
An organization may be exempt from taxation under IRC §501(c)(3) as an “educational” organization.279 Organizations that are “advancing education” within the meaning of the regulations may also be recognized as charitable organizations.280 The regulations provide an expansive definition of education. Under the regulations, education is both of the following: • The instruction or training of the individual for the purpose of improving
or developing his capabilities • The instruction of the public on subjects useful to the individual and ben-
eficial to the community281 Thus, an organization need not be a school to be exempt as an educational organization.282 The regulations separate educational organizations into three basic categories: 1. Schools 2. Educational organizations 3. Public cultural organizations (i) Schools. A school is an educational organization; this category includes institutions such as colleges and universities.283 The main characteristics of such an organization are that: its primary function is the presentation of formal instructions and it normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.284
Furthermore, the educational activities must be the primary function of the university and any noneducational activities must be incidental. (ii) Other Educational Organizations. Organizations in this category are generally active in presenting public discussion groups, forums, panels, or lectures, either live or on radio or television. Problems often arise when an educational organization advocates a particular viewpoint.285 The question is whether the activity is actually educational or whether it is political propaganda. The regulations deal with this situation by providing that: [a]n organization may be educational even though it advocates a particular position or viewpoint so long as it presents a sufficiently full and fair exposition of the 279 280 281 282
283 284 285
§501(a); §501(c)(3). §501(c)(3); Reg. §1.501(c)(3)-1(d)(2). Reg. §1.501(c)(3)-1(d)(3)(i)(a) and (b). Of note, “education” refers only to the education of persons, so that an organization to train dogs is not “educational” within the meaning of IRS §501(c)(3). Rev. Rul. 71-421, 1971-2 C.B. 229. Reg. §1.701A-9(b)(1). See id. See Rev. Rul. 78-305, 1978-2 C.B. 172 (an organization formed to educate the public about homosexuality qualifies as an “educational” entity).
䡲
77
䡲
c02.fm Page 78 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
pertinent facts as to permit an individual or the public to form an independent opinion or conclusion.
The “full and fair exposition” test has been held to be unconstitutionally vague.286 In Big Mama Rag v. United States, a nonprofit organization was formed to create “a channel of communication for women that would educate and inform them on general issues of concern to them.”287 Its primary activity was the publication of a monthly newsletter, the Big Mama Rag, which printed articles of interest to feminist women. The organization also devoted time to promoting women’s rights through workshops, seminars, lectures, a weekly radio program, and a free library.288 The IRS denied tax-exempt status to the organization, concluding among other things that the content of the Big Mama Rag was not “educational” as that term is defined under the “full and fair exposition” standard.289 The district court granted the IRS’s motion for summary judgment. The D.C. Circuit reversed, holding that the “full and fair exposition” test was unconstitutionally vague. The court found that the test lacked “the requisite clarity, both in explaining which applicant organizations are subject to the standard and in articulating its substantive requirement.”290 The court concluded that this vagueness left the regulation inherently susceptible to discriminatory enforcement by individual IRS officials.291 The court required that “applications for tax exemption must be evaluated, however, on the basis of criteria capable of neutral application.” It went on to state, “the standards may not be so imprecise that they afford latitude to individual IRS officials to pass judgment on the content and quality of an applicant’s views and goals.”292 In an effort to use an objective standard, the IRS offered the “methodology test,” which “test[s] the method by which the advocate proceeds from the premises he furnishes to the conclusion he advocates.”293 The IRS applied the methodology test in denying tax exemption to an organization whose publications asserted the racial superiority of white citizens.294 The methodology test, which is now used by the IRS along with the “full and fair exposition” test, contains the following four criteria: 1. Whether the presentation of viewpoints unsupported by a relevant factual basis constitutes a significant portion of the organization’s communications 2. Whether, to the extent viewpoints purport to be supported by a factual basis, the facts are distorted 286 287 288 289 290 291 292 293 294
Big Mama Rag, Inc. v. United States, 631 F.2d 1030 (D.C. Cir. 1980). Big Mama Rag, 631 F.2d at 1032. See id. Reg. §1.501(c)(3)-1(d)(3). Big Mama Rag, 631 F.2d at 1036. Id. at 1040. See id. National Alliance v. United States, 710 F.2d 868 (D.C. Cir. 1983). Id. The D.C. Circuit did not reach the question of the validity of the regulations that were struck down in Big Mama Rag because it found that National Alliance’s activities were not “educational” within any reasonable interpretation of the term.
䡲
78
䡲
c02.fm Page 79 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
3. Whether the organization makes substantial use of particularly inflammatory and disparaging terms, expressing conclusions based more on strong emotional feelings than objective factual evaluations 4. Whether the approach to a subject matter is aimed at developing an understanding on the part of the addressees, by reflecting consideration of the extent to which they have prior background or training295 Under the methodology test, “the method used by the organization will not be considered educational if it fails to provide a factual foundation for the viewpoint or position being advocated, or if it fails to provide a development from the relevant facts that would materially aid a listener or reader in a learning process.”296 The methodology test is used to “reduce the vagueness found” to be present in the “full and fair exposition” standard.297 Thus, through a combination of the regulations and the methodology test, the IRS can “maintain a position of disinterested neutrality with respect to the beliefs advocated by an organization.”298 The Tax Court addressed the constitutional validity of the methodology test in Nationalist Movement v. Commissioner.299 The court held that Rev. Proc. 86-43, which contains the methodology test, is not unconstitutionally vague or overbroad on its face, nor was it unconstitutional as applied. The court found that the revenue procedure’s provisions are sufficiently understandable, specific, and objective both to preclude chilling of expression protected under the First Amendment and to minimize arbitrary or discriminatory application by the IRS.300 The revenue procedure in question focuses on the method rather than the content of the presentation. In contrast, it was the potential for discriminatory denials of tax exemption based on speech content that caused the Court of Appeals for the District of Columbia Circuit to hold that the vagueness of the “full and fair exposition” standard violates the First Amendment.301 (iii) Public Cultural Organizations. Other organizations may be classified as educational because they provide public cultural activities, such as museums, zoos, symphony orchestras, planetariums, and similar beneficial activities.302 (e)
Scientific Organizations
The term scientific generally refers to the carrying on of scientific research in the public interest. Research, in general, is not scientific per se.303 One court has defined “scientific research” by noting that “while projects may vary in terms of 295 296 297 298 299 300 301 302 303
Id. at 874. Rev. Proc. 86-43, 1986-2 C.B. 729. National Alliance, 710 F.2d at 875. Rev. Proc. 86-43, 1986-2 C.B. 729. 102 T.C. 558 (1994). See id. Id., citing Big Mama Rag, Inc. v. United States, 631 F.2d 1030 (D.C. Cir. 1980), a case discussed in detail earlier in this section. Reg. §1.501(c)(3)-1(d)(3) (example 4). See generally Rev. Rul. 64-175, 1964-1 C.B. 185. Robert W. Hammerstein v. Kelly, 349 F.2d 928 (8th Cir. 1965); Colonial Trust Co. v. Commissioner, 19 B.T.A. 174 (1930); Rev. Rul. 69-632, 1969-2 C.B. 120; Rev. Rul. 71-506, 1971-2 C.B. 185.
䡲
79
䡲
c02.fm Page 80 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
degree of sophistication, if professional skill is involved in the design and supervision of a project intended to solve a problem through a search for a demonstrable truth, the project would appear to be scientific research.”304 Other courts have focused on the scientific method, whereby “science” is “the process by which knowledge is systematized or classified through the use of observation, experimentation, or reasoning.”305 The regulations present four tests that must be met in order to conclude that an organization qualifies as an exempt scientific organization under IRC §501(c)(3).306 The regulations question307 1. Whether the organization conducts “scientific research”308 2. Whether the scientific research is conducted “incident to commercial or industrial operations”309 3. Whether the organization meets the “specific public interest” test310 4. Whether the organization meets the “general public interest” test311 (i) Scientific Research. A discussion of whether an organization conducts scientific research begins with the cryptic guidance in the regulations, which provide that scientific research includes carrying on scientific research in the public interest.312 Without examples, the regulations assert that scientific research is narrower than research, although it can be practical and applied, as well as fundamental or theoretical. The inclusion of applied research within the definition of scientific research has allowed research in the social sciences area to be included along with more traditional forms of scientific research.313 EXAMPLE: X, a university, forms a joint venture to engage in social sciences research. The purpose of the joint venture is to develop and disseminate a body of new knowledge regarding worker productivity, including psychological and sociologic aspects. The joint venture has a professional research staff. A substantial amount of the research is performed under contract with federal government agencies, thereby 304
305 306 307 308 309 310 311 312
313
Midwest Research Institute v. United States, 554 F. Supp. 1379, 1386 (W.D.Mo. 1983), aff’d, 74 F.2d 635 (7th Cir. 1984). See also Dumaine Farms v. Commissioner, 73 T.C. 650 (1980), acq., 1980-2 C.B. 5 (the conduct of farming projects qualified for exemption as scientific research under Midwest standards): Gen. Couns. Mem. 35,536 (Oct. 30, 1973) (operating a prepaid legal services plan on an experimental pilot basis to research the operational feasibility of such plans qualified for exemption as scientific research). ITT Research Institute v. United States, 9 Ct. Cl. 13 (1985). See Chapter 2; Chapter 13. Reg. §1.501(c)(3)-1(d); Gen. Couns. Mem. 39,883 (Oct. 16, 1992). Reg. §1.501(c)(3)-1(d)(5)(i). Reg. §1.501(c)(3)-1(d)(5)(ii). The specific public interest tests are found at Reg. §1.501(c)(3)-1(d)(5)(iii) and (iv). The general public interest test is found at Reg. §1.501(c)(3)-1(d)(1)(ii). Reg. §1.501(c)(3)-1(d)(5)(I). See also Gen. Couns. Mem. 39,883 (Oct. 16, 1992); Priv. Ltr. Rul. 79-02-019 (Sept. 29, 1978); Dumaine Farms v. Commissioner, 73 T.C. 650 (1980), acq. 1980-2 C.B. 5; Midwest Research Institute v. United States, 554 F. Supp. 1374 (W.D.MO. 1983), aff’d per curiam, 774 F.2d 635 (8th Cir. 1984). See Rev. Rul. 65-60, 1965-1 C.B. 231; Gen. Couns. Mem. 32,726 (Nov. 12, 1963) (social research); Rev. Rul. 69-526, 1969-2 C.B. 115; Gen. Couns. Mem. 54,128 (May 22, 1969) (medical research). See also Gen. Couns. Mem. 35,536 (Oct. 30, 1973) (prepaid legal services pilot program was social service); ITT Research Institute v. United States, 9 Ct. Cl. 13 (1985).
䡲
80
䡲
c02.fm Page 81 Thursday, March 15, 2007 3:46 PM
2.6 CHARITABLE ORGANIZATIONS
promoting public interests. The research is published, and the joint venture conducts seminars open to the general public in the area. Under these facts, the social sciences research will meet the scientific research exemption criteria.314 (ii) Commercial or Industrial Operations. Scientific research “does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations, as, for example, the ordinary testing and inspection of materials or products or the designing or construction of equipment.”315 This is a commonsense test that requires evaluation of the facts and circumstances with respect to the particular research activity or joint venture involved in light of industrial and commercial practices in comparable situations.316 Hence, if the activity or operation involved is in direct competition with an activity or operation customarily carried on by taxable business organizations as incidental to their ordinary or commercial operations, it is not basic or fundamental scientific research.317 (iii) Specific Public Interest. The specific public interest test provides that scientific research is carried on in the public interest if: • The results—that is, patents, copyrights, processes, or formulas—are
made available to the general public on a nondiscriminatory basis. • The research is performed for a government entity. • The research is directed toward benefiting the public.318
EXAMPLE: Research in aiding the scientific education of college or university students, obtaining scientific information published in a form available to the interested public, discovering the cure for a disease, and aiding a community by attracting new industry to the community or encouraging the development or the retention of an industry in that location are all examples of research that benefits the public.319 The research will be regarded as benefiting the public even though it is performed under an agreement that allows the sponsors the right to obtain ownership or control of the resulting patents, copyrights, processes, or formulas.320
314
315 316 317
318 319 320
This example is based on the factual situation presented in Rev. Rul. 65-60, 1965-1 C.B. 231, discussed in Gen. Couns. Mem. 32,726 (Nov. 12, 1963). But cf. Gen. Couns. Mem. 39,883 (Oct. 16, 1992) (the organization did not qualify for exemption as a social sciences research organization because it failed the “commercial or industrial operations” test in Reg. §1.501(c)(3)-1(d)(5)(ii) and it was not operated for the public benefit. Reg. §1.501(c)(3)-1(d)(5)(ii). See also Gen. Couns. Mem. 35,804 (May 6, 1974). Gen. Couns. Mem. 35,804 (May 6, 1974). See generally Advance Ann. 93-2, 1993-2 I.R.B. 39, §342.8(10) (Dec. 21, 1992). See also Midwest, 554 F. Supp. at 1386. (The IRS defined the indicia of ordinary and routine testing conducted incident to commercial operations: a standard procedure is utilized; no intellectual questions are posed; the work is routine and repetitive; and the procedure is merely a matter of quality control.) Gen. Couns. Mem. 39,196 (Aug. 31, 1986); Rev. Rul. 68-373, 1968-2 C.B. 206 (testing drugs for commercial pharmaceutical companies in connection with their marketing applications to the FDA is testing ordinarily carried on incident to commercial pharmaceutical operations and not scientific research). Reg. §1.501(c)(3)-1(d)(5)(iii); see also Rev. Rul. 69-632, 1969-2 C.B. 120; Priv. Ltr. Rul. 7902-019 (Sept. 29, 1978); Priv. Ltr. Rul. 79-36-006 (May 23, 1979). Reg. §1.501(c)(3)-1(d)(5)(iii)(c). See id.
䡲
81
䡲
c02.fm Page 82 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
(iv) General Public Interest. The general public interest requirement under IRC §501(c)(3),321 which dictates that the organization be operated exclusively for nonprivate interests, is incorporated by reference within general public interest tests for scientific research.322 Thus, an organization is not organized or operated exclusively for charitable purposes unless it serves a public rather than a private interest.323
2.7
STRUCTURE OF THE IRS
In 1998, Congress passed the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA), which dramatically changed the Service’s structure. The Service had been operating under a complex system of 4 regions, 33 districts, and 10 service centers. Each district office and service center assisted every type of taxpayer. Because of the complexity of IRS operations and the sheer volume of work, the IRS was being criticized for delays and lack of responsiveness. To implement the RRA, the Service discontinued its geographic approach and created a structure of four operating units: Wage and Investment Income, Small Business and Self-Employed, Large and Mid-size Business, and Tax Exempt and Government Entities. The four units were intended to focus on taxpayers with “similar needs.” In December 1999, the Tax Exempt unit became the first of the four units to convert to the new system, and Evelyn Petschek was named commissioner. The acronym for the new unit is TE/GE. It contains subunits concerned with employee plans, exempt organizations, and government entities. The three segments are further divided into four functions: education and communication, rulings and agreements, examinations, and customer account services.324 See Exhibit 2.1 for a detailed description of the new organization. Customer account services serve all three segments in TE/GE. To contact IRS Customer Service operations concerning tax-exempt organizations: Call (877) 829-5500 (toll-free number) from 8:00 A.M. to 9:30 P.M. Eastern time. Write to the Service at the following address: Internal Revenue Service TE/GE Division, Customer Service P.O. Box 2508 Cincinnati, OH 45201 Contact the IRS through the Internet at < www.irs.gov>.
321 322 323 324
Reg. §1.501(c)(3)-1(d)(1)(ii). Reg. §1.501(c)(3)-1(d)(5)(i). Reg. §1.501(c)(3)-1(d)(1)(ii). See generally Section 2.4; Chapter 5. See IRS Organization Blue Print (2000 Phase IIB), Doc. 11052, Rev. 4-2000, available at: <www.irs.gov>.
䡲
82
䡲
c02.fm Page 83 Thursday, March 15, 2007 3:46 PM
E XHIBIT 2.1 • • • • • • • •
Administrative Services Business Systems Planning Senior Technical Advisor EEO Research and Analysis Strategic Planning and Finance Communication and Liason Human Resources
TAX-E XEMPT AND G OVERNMENT E NTITIES D IVISION O RGANIZATION S TRUCTURE
HQ Support Functions
Director Exempt Organizations
Program Management Staff
EP Customer Education and Outreach Staff
Director Government Entities
Program Management Staff
Director- EP Rulings and Agreements
Manager- EP Determinations
Manager- EP Determinations Quality Assurance
Director- EP Examinations
Counsel Information Systems Taxpayer Advocate Appeals Agency Wide Shared Services Criminal Investigation
Internal Partners
Director Employee Plans
Director- EP Customer Education and Outreach
• • • • • •
TE/GE Commissioner & Deputy Commissioner
Director- EO Customer Education and Outreach
Manager- EP Examination EO Customer Education and Outreach Staff Programs and Review
EP Examination Area Managers Six Areas
DirectorFederal,State and Local Governments
Director- EO Rulings and Agreements
Manager- EO Determinations
Manager- EO Examination Programs and Review
Managers- EO Determinations Quality Assurance
EO Examinations Area Managers Six Areas
Manager- EP Technical
Manager- EO Technical
Manager- EP Technical Quality Assurance and Guidance
Manager- EO Technical Quality Assurance and Guidance
Manager- EP Voluntary Compliance
Manager- EO Projects and Voluntary Compliance
䡲
Director- EO Examinations
STRUCTURE OF THE IRS 2.7
Director Indian Tribal Governments
Director Tax Exempt Bonds
Manager- FSL Outreach,Planning and Review
Manager- ITG Outreach,Planning and Review
Manager TEB Outreach,Planning and Review
Federal,State and Local Field Group Managers
IndianTribal Government Field Group Managers
Manager TEB Field Operations
Director Customer Account Services
Director Customer Service
Manager Quality Review
83
䡲
Systems Analysts
Management Analysts
Customer Service Group Managers
Director Service Center Programs
c02.fm Page 84 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
2.8 (a)
APPLICATION FOR EXEMPTION Individual Organizations
An organization seeking tax-exempt status as an entity under IRC §501(c)(3) must file an application with the IRS.325 The organization seeking exemption must submit a completed Form 1023 to the Employee Plans/Exempt Organizations Division of the key district office for the sites of the organization’s principal place of business.326 Churches, other religious organizations, and organizations with receipts under $5,000 do not need to file an application for exemption.327 The Form 1023 application for exemption must be submitted within 15 months from the end of the month in which the entity was organized in order for the exemption to apply retroactively to the date of organization.328 Applications filed after the 15- month period are effective only from the date of filing. However, there is an automatic 12-month extension available for organizations that file the application within 12 months of the end of the 15-month period so that, in effect, an application must be filed within 27 months of formation.329 The IRS also has the power to grant a discretionary extension beyond the 27-month period where certain specified criteria are met.330 PRACTICE TIP When working with a local nonprofit group in connection with the preparation of Form 1023, it is advisable to suggest that the organization draft a business plan to assist it in working through economic and monetary issues such as raising funds and dealing with unanticipated budgetary questions. Drafting a business plan helps to focus the organization on long-range strategy and ensures that the organization has considered relevant financial and operational issues.* *
See Comments of Ellen Lazar at the 4th Annual ABA Conference on Affordable Housing and Community Development Law, reprinted in Exempt Organization Tax Review 12 (Oct. 1955); 739, 744.
As a result of an IRS centralization project, all exemption applications are sent to Covington, Kentucky, rather than to a regional service center. All exempt applications are initially screed in Covington to determine whether they can be closed without further development or correspondence with the organization. Generally, applications that are “merit closed” are fully completed, contain all required forms and supporting documents (such as bylaws, articles of incorporation, and financial information); clearly meet the statutory guidelines of §501(c)(3) organizations; have small operating budgets; and have no “red-flagged areas, including paid employees, political activities or transactions with “insiders”. 325 326 327 328 329 330
See Rev. Proc. 93-23, 1993-19 I.R.B.6. This filing will satisfy the timely notice requirement of §508. See Reg. §1.508-1; Reg. §1.5081(a)(2). Reg. §1.508-1; Reg. §1.508-1(a)(3). Rev. Proc. 84-46, 1984-1 C.B. (superseded by Rev. Proc. 90-27, 1990-18 I.R.B. 17, and Rev. Proc. 84-47, 1984-1 C.B. 545). Reg. §301.9100-2. To obtain this extension, the organization must add the following language at the top of its application: “Filed Pursuant to Section 301.9100-2.” Reg. §§301.9100-1 and 301.9100-3.
䡲
84
䡲
c02.fm Page 85 Thursday, March 15, 2007 3:46 PM
2.8 APPLICATION FOR EXEMPTION
When the IRS feels that additional development is needed, processing is likely to take much longer. In these cases, a Form 1023 inquiry letter is sent to the applicant. The Service allows 21 days for review of the information requests and submission of a response. Occasionally, an applicant will request expedited consideration. Sometimes these requests are precipitated by unusual circumstances, such as the rush to recovery witnessed in the southeastern United States following the Hurricane Katrina response, the IRS will be reluctant to expedite an application. However, if the applicant makes a “Request for Expedited Treatment explicit in its cover letter, and includes letters of support from an unrelated third party (such as potential donors), the Service may hasten its consideration of the application. (b)
Group Exemption
The IRS has a procedure whereby a “central organization,” with one or more “subordinates” under its “general supervision and control,” may file a group exemption application on behalf of its subordinates.331 The group exemption relieves each of the subordinates from filing its own application for recognition of exemption, but generally does not relieve those organizations from filing their own tax returns (Forms 990), unless the central organization voluntarily agrees to file a consolidated return for its subordinates. In any event, the central organization must have its own tax-exempt status, and it must file a Form 990. A subordinate organization may or may not be separately incorporated, although to limit potential liability, it is prudent for each subordinate to be separately incorporated. Each subordinate would have to have its own organizational documents (articles and bylaws) and its own employer identification number. In its group exemption application, the central organization must demonstrate that the subordinates are under its “general supervision and control.” This term is not defined in the Code, but it is generally satisfied if the central organization elects or appoints some or all of the subordinates’ boards of directors, requires annual or more frequent financial reporting by the subordinates, requires subordinates to use model organizational documents, and/or has a group policy that subordinates must adhere to. In addition, all of the subordinates must be exempt under the same section of the Code, although they do not need to have the same tax status as the central organization. Each of the subordinates must be operating on the same accounting period as the central organization if they are going to be included in a consolidated Form 990.332 The group exemption process is begun when the central organization files an application with the IRS. The group may be formed with as few as two subordinates. To maintain the group exemption, the central organization must submit annually, at least 90 days before the close of its accounting period, information regarding any changes in the purposes, character, or method of operation of its subordinates and a list of subordinates that have changed their names or addresses, that should no longer be included in the group, or that should be
331 332
Rev. Proc. 80-27, 1980-1 C.B. 677; Reg. § 601.201(n)(7). Rev. Proc. 96-40, 1996-2 C.B. 301. These annual reports are filed with the Internal Revenue Service Center in Ogden, Utah.
䡲
85
䡲
c02.fm Page 86 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
added to the group. In other words, on an annual basis, the central organization may add new subordinates to the group, and the new subordinates do not need to apply to the IRS for their tax-exempt status. The IRS has indicated that it will closely scrutinize new group exemptions, “passthrough” LLCs, and other multiple vehicles that may enable one §501(c)(3) organization to engage in a number of projects around the country through single-asset entities. To overcome the IRS concern, it is particularly important to demonstrate that the structure is necessary to implement a legitimate charitable purpose, and that the newly formed entity will be accountable to the community as reflected in the composition of the board. EXAMPLE: A community development organization proposes to create single-asset LLCs to own 10 properties nationwide, which the organization plans to renovate using funds raised through §501(c)(3) bonds. The IRS’s position is that it will not issue a group exemption in such a situation, given the control organization’s plan to use §501(c)(3) bond financing. Underlying the IRS’s apparent concern is that, in a group exemption, the Service in effect is being asked to delegate its authority to the parent organization to assess the subordinate organizations’ eligibility for 501(c)(3) status.
2.9
REPORTING REQUIREMENTS
Organizations exempt from taxation under §501(a) of the Internal Revenue Code must, with few exceptions,333 file an annual information return.334 Most exempt organizations are required to file an annual return on Form 990.335 All private foundations, without exception, must file an annual Form 990-PF.336 Form 990 must be filed within four and one-half months after the end of the organization’s fiscal year.337 Forms 990 and 990-PF are designed to obtain basic financial information such as revenues, disbursements, assets, and liabilities in order to evaluate and assess the exempt organization’s activity.338 The forms may also reflect information that 333
334
335 336 337 338
Certain exempt organizations are not required to file a Form 990. The IRS does not require the following organizations to file an informational return: (1) any organizations with gross annual receipts “normally” under $25,000; (2) churches; (3) church affiliates; (4) religious schools; and (5) mission societies. Furthermore, the Secretary has discretion to exempt organizations from filing Form 990 when not efficient for tax administration. §6033(a)(2)(B); Reg. 1.60332(g)(6); §6033(a)(2)(A); Reg. §1.6033-2(g)(5)(g). See also Rev. Proc. 83-23, 1983-1 C.B. 687 (the exception was initially limited to organizations with less than $5,000; however, the exception threshold was raised to $25,000). Rev. Proc. 94-17, 1994-1 C.B. 597 (supplements Rev. Proc. 83-23 by exempting certain foreign organizations (generally those with less than $25,000 in gross annual receipts and no substantial activities within the United States) from filing). §6033(a)(1); Reg. 1.6033-2(a)(1). In most cases, the organization will file a Form 990 or Form 990-PF. Exempt organizations engaged in joint venture arrangements generally must file a Form 1065 annual partnership return for the joint venture, as well. §6031(a); Reg. §1.60311(a)(1). An unincorporated association that elects, under §761(a), to be wholly excluded from Subchapter K, must file a Form 1065 only for the first year of operations. Reg. §1.6031-2. The Form 990 informational return must provide the items of gross income and deductions allocated by the joint venture and the names and share amounts of individuals entitled to a distributive share. §6031(a); Reg. §1.6031-1(a)(1). See generally Chapter 4. Reg. §1.6033-2(a)(2)(ii). See id. Reg. §1.6033-2(e). §6033 (b).
䡲
86
䡲
c02.fm Page 87 Thursday, March 15, 2007 3:46 PM
2.9 REPORTING REQUIREMENTS
is helpful to an IRS revenue agent in detecting compliance failures by the exempt organization. The IRS examined less than 1 percent of the 800,000 returns filed in fiscal year 2000, and only about 1,200 of the returns that reported unrelated business income.339 The IRS has requested public comment to assist with development of an electronic filing system for tax-exempt organizations.340 Any organization, without exception, that is exempt under IRC §501(a) and that has more than $1,000 of gross income from an unrelated trade or business must file a Form 990-T.341 Specifically, an organization described under §511(a)(2) that is subject to the tax imposed by §511(a)(1) on its unrelated business taxable income must make a return on the Form 990-T for each taxable year if it has gross income, included in computing the unrelated business taxable income, of $1,000 or more.342 The filing of the 990-T does not relieve the organization of the duty to file other required returns.343 The Taxpayer Bill of Rights 2 amended IRC §6033 to require §501(c)(3) taxexempt organizations to disclose on each Form 990 for taxable years ending after June 30, 1996344 the amount of taxes imposed on the organization or any of its organization managers during that tax year, along with the amount of any reimbursements that the organization paid during the taxable year in respect to taxes imposed on any such organization manager under IRC §4911 (excess expenditures to influence legislation), IRC §4912 (disqualifying lobbying expenditures), and IRC §4955 (political expenditures). In addition, the Taxpayer Bill of Rights 2 also requires such organizations to disclose on each Form 990 for taxable years after June 30, 1996, the amount of taxes imposed under IRC §4958 (excise taxes imposed under the intermediate sanctions provisions) on the organization, any of its organization managers, or any disqualified person with respect to such organization, along with the amount of any reimbursements that the organization pays with respect to such §4958 taxes.345 The legislation increased the penalties for willful failure to allow public inspection of Forms 990 and exemption application information from $1,000 to $5,000,346 and doubled the daily and maximum penalties for failure to file complete and timely Forms 990 from $10 per day, capped at the lesser of 5 percent of the organization’s gross annual receipts or $5,000, to $20 per day, capped at the lesser of 5 percent of the organization’s gross annual receipts or $10,000.347 339 340 341 342 343 344 345
346 347
IRS Data Book at 20. Announcement 2002-27, IRB 2002-11 (Mar. 18, 2002) Reg. §1.6033-2(g)(6)(h)(3)(I); Reg. §1.6012-2(e). Reg. §1.6012-2(e). Id. See also Chapter 7 on unrelated business income tax. Pub. L. No. 104-162, Taxpayer Bill of Rights 2, §1312(a), as amended by Pub. L. No. 105-34, Taxpayer Relief Act of 1997, §1603. In Notice 96-46, 1996-39 I.R.B. 1, the IRS set forth the reporting requirements for persons subject to the intermediate sanction provisions. Specifically, it provides that, for excess benefit transactions that occurred after Sept. 13, 1995, in a taxable year ending before Dec. 31, 1996, disqualified persons, organization managers, and their 35-percent-controlled entities liable for payment of the IRC §4958 excise taxes must use the 1995 Form 4720 to calculate and report such taxes. The IRS will revise Form 4720 for tax years that end on or after Dec. 31, 1996. Such Forms 4720, prepared for tax years ending after Sept. 13, 1995, and before July 30, 1996, were due on Dec. 15, 1996. Returns for tax years that end after July 30, 1996, are due on the 15th day of the fifth month following the end of that tax year. See §6685. See §6652(c)(1)(C).
䡲
87
䡲
c02.fm Page 88 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
Finally, the legislation established a new, special penalty provision for organizations having more than $1 million in annual gross receipts (in respect to failure to file timely and complete annual returns) that imposes a $100-per-day penalty, capped at a maximum of $50,000. Section 1313 of the Taxpayer Bill of Rights 2 further modified the disclosure provisions of IRC 6104(d)348 so that in addition to making materials “available for inspection,” the organization must provide a copy of the requested materials to a party seeking them as well.349 Further modifications were added by the Tax and Trade Relief Extension Act of 1998,350 which also amended IRC §6104 regarding public disclosure of annual information returns and exemption applications by private foundations (which previously were governed by separate disclosure requirements).351 As a result of this change, the rules of §6104(d) are now applicable to private foundations.352 The final regulations regarding the disclosure provision, which became effective as of June 8, 1999, include several more modifications to the disclosure provision. Under the new rules, if a request for a copy is made in person, a copy must be provided immediately, with the organization charging a reasonable fee for reproduction costs.353 If a request for a copy is in writing, it must be provided within 30 days with a reasonable fee for reproduction costs and mailing.354 However, the final regulations provide that a tax-exempt organization is not required to comply with requests for copies if the organization has made the requested documents widely available, by posting the applicable documents on the organization’s World Wide Web page on the Internet or on another organization’s World Wide Web page as part of a database of similar materials.355 Inspection of annual returns is limited to a three-year statute of limitations, so that an organization need only supply the three most recent returns.356 These rules apply to all exempt organizations, including private foundations,357 although organizations that are not private foundations do not have to disclose their contributor list.358 Further, the disclosure to individuals will not be
348 349 350
351 352 353 354 355 356 357 358
P.L. 104-168, 110 Stat. 1452 (July 30, 1996). §6104(d)(1)(A) and (B). This applies to organizations having one or more regional or district offices with three or more employees at each office. P.L. 105-277, 112 Stat. 2681 (Oct. 21, 1998). These changes apply to requests made after the 60th day after the IRS issues final regulations defining when requested documents are considered widely available or when the request is part of a harassment campaign. H.R. Report No. 105-817. The final regulations were released in April 1999. However, they did not contain provisions relating to private foundations. These provisions will be released separately as an amendment to the final regulations. Thus, the changes made by the Tax and Trade Relief Extension Act of 1998 will not apply to private foundations until an amendment to the final regulations is issued. §6104(d)(1). The final regulations regarding disclosure for private foundations were published at 65 Fed. Reg. 2030, T.D. 8861, and became effective March 13, 2000. §6104(d)(1). §6104(d)(1). Reg. §301.104(d)-4. The documents must be posted in a format that meets the criteria set forth in the final regulations. See Reg. §301.6104(d)-4(b)(2)(B). §6104(d)(2) §6104(d)(1). §6104(d)(3)(A).
䡲
88
䡲
c02.fm Page 89 Thursday, March 15, 2007 3:46 PM
2.10 THE IRS AUDIT
required if, pursuant to regulations promulgated pursuant to revised §6104(c), the request is part of a harassment campaign.359 The growth of the Internet has accelerated and has led to intensive scrutiny by the IRS as well as the public. The scrutiny has revealed that more than half of the Forms 990 contain significant omissions, misrepresentations, or mistakes.360 The IRS published a detailed explanation of the Form 990 as a part of its professional education program to assist exempt organizations in filing more accurate and standardized forms, and to assist the public in understanding the data in the forms. CAVEAT Organizations should carefully review their Forms 990 before submission to the IRS, as wide exposure increases the chances that problem areas will be discovered by the public. In January 2000, the staff of the Joint Committee on Taxation issued a report on confidentiality and disclosure provisions for tax-exempt organizations, as required by the IRS Restructuring and Reform Act of 1998.361 The committee staff recommended that all written determinations, including closing agreements and the results of audits, should be publicly disclosed without redactions. Practitioners criticized the recommendations as detrimental to tax-exempt organizations as well as to the IRS itself.362
2.10
THE IRS AUDIT
The IRS has several functions. It promulgates regulations and issues rulings that provide guidance to aid taxpayers in compliance with the Internal Revenue Code. Another important function is the audit, whereby examiners attempt to confirm taxpayer compliance with tax laws.363 Because an audit can involve any type of organization and any number of issues, the following discussion provides general guidelines to minimize potential audit issues, as well as steps to take once an organization has received an audit notice.364
359 360 361 362 363
364
See Reg. §301.6104(d)-5. Cheryl Chasin, Debra Kawecki, and David Jones, “Form 990.” Exempt Organizations Continuing Professional Education (CPE) Technical Instruction Program for Fiscal Year 2002. Joint Committee on Taxation Staff Report, JCS-1-00 (Jan. 28, 2000). Peter L. Faber, “The Joint Committee Staff Disclosure Recommendations: What They Mean for Exempt Organizations,” Exempt Organization Tax Review 28 (April 2000): 31. On March 16, 2000, the Joint Committee on Taxation reported that, after a three-year investigation, it had not found credible evidence of bias in the way the IRS treated tax-exempt organizations. Among other things, the Joint Committee found no credible evidence that the IRS had delayed or accelerated determination letters based on the nature of an organization’s views, nor any credible evidence that the views of an organization played a part in its selection for examination, nor credible evidence that Clinton administration officials intervened in the selection of organizations for examination. JCS-3-00 (Mar. 2000). The increased scrutiny by state Attorneys General as well as the IRS underscores the need for careful record keeping and compliance with federal and state law. These recommendations are based on outlines by William Driggers, Esq., and Leonard J. Henzke Jr., Esq., Powell Goldstein, Frazer & Murphy, Washington, D.C. (on file with the authors). See Section 4.11 for a detailed discussion.
䡲
89
䡲
c02.fm Page 90 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
(a)
Minimizing Audit Issues—Advance Planning
(i) Conduct In-House Periodic Audits. It is useful to have an independent outside professional regularly review an organization’s records and programs for possible compliance issues. Organizations should: • Arrange for an annual legal audit in which a professional advisor or
counsel (1) reviews the organization’s activities and files, (2) reports on potential legal problems, and (3) provides recommendations for solving or ameliorating those problems. • Implement counsel’s recommendations. Modify activities to avoid revocation
of exempt status or substantial unrelated business income tax (UBIT). Where activities are continued, document exempt reasons for their conduct. For example, if an organization’s activity could be viewed as commercial— e.g., sales of books, handicrafts, paintings, etc.—detail in writing how the sales further exempt purposes. However, sales of some items may have to be reduced or curtailed if sales are substantial and constitute a clearly commercial-type activity. (ii) Have Important Documents Reviewed by Counsel. Draft minutes, contracts, employment agreements, and other important documents should be sent to counsel for review prior to being finalized. (iii) Consistently Document Charitable Nature of Organization’s Activities. It is important that all of an organization’s written materials consistently and accurately describe its exempt purposes. In this regard, the organization should: • Prepare an “annual report” to the board of directors detailing the organi-
zation’s activities in furtherance of its exempt purposes. • Provide detailed descriptions on Form 990, Part III, “Statement of Pro-
gram Service Accomplishments.” • Describe consistently the organization’s exempt purposes and activities in
all pamphlets and brochures that explain the organization’s activities. • Maintain organized records, that is, minutes, written health and welfare,
and other fringe benefit plans where legally required. • Maintain a file of newspaper, magazine, and similar articles and include
references to them in board minutes. (b)
Surviving an Audit
There may come a time when regardless of how carefully an organization complies with IRS rules and regulations, it receives an IRS audit notice. The notice can be triggered by an item on the organization’s Form 990 or by the IRS’s instituting a selective audit of certain designated organizations (e.g., hospitals or universities).365 In this situation, an organization should take the steps outlined in the following guidelines: • Conduct an internal “compliance audit” to assess audit risks and develop
a clear audit strategy before the first meeting with the agent. Knowing 365
See Chapters 12 and 13.
䡲
90
䡲
c02.fm Page 91 Thursday, March 15, 2007 3:46 PM
2.11 CHARITABLE CONTRIBUTIONS
where the risks are helps in determining whether to obtain professional assistance and how best to proceed. • If there is any significant audit exposure, retain professional assistance,
such as a law firm or an accounting firm. The most important criterion is that the professional have a high degree of expertise in federal income tax issues (especially in healthcare or low-income housing tax credit, as the case may be) and significant experience in handling IRS audits. • It may be advisable to hire professional assistance even when an organi-
zation may not have any significant audit exposure. The reason is that revenue agents are trained in auditing and interview techniques and have an incentive to propose adjustments. It can be very helpful to interpose a tax professional between the exempt organization or entity and the agent. • Appoint one employee to coordinate the organization’s communications
with outside counsel and/or the IRS. In this way, the organization can maintain control and have knowledge of the information and documentation that is turned over to the IRS. • To the extent possible, the audit should be conducted at the office of its
representative, with the agent visiting the project only for a site visit or to conduct discreet interviews of personnel (interviews at which the entity’s representative should be present). • Provide the agent with only what is requested. • Review the most recent Exempt Organizations Continuing Professional Edu-
cational Technical Instruction Program (CPE) manuals to determine whether any issues relevant to the organization’s activities are addressed. For example, the 1999 CPE has an entire chapter on whole hospital joint ventures.366 Recently, on-site audit requests by the IRS have been commonplace in situations where there is a significant number of documents to review. In instances in which the requests for documents are voluminous, granting an on-site audit is a practical solution (i.e., an effective cost saving measure) for both the IRS agent and the exempt organization. If an on-site audit takes place, practitioners should take steps to separate the IRS agent from the employees of the organization to the extent possible. It is important to ensure the IRS agent does not have any casual contacts with the employees of the exempt organization.367
2.11
CHARITABLE CONTRIBUTIONS
One of the principal tax benefits of exemption under IRC §501(c)(3) is the deductibility of charitable contributions to the organization by a donor. Generally, a donor is allowed a deduction for contributions of cash or property to a 366 367
1999 CPE Chapter A. Posting of Nancy O. Kuhn, Counsel, Powell Goldstein LLP, to ABA TAXEXEMPT Listserv, (September 28, 2004 13:07 EST) (copy on file with author).
䡲
91
䡲
c02.fm Page 92 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
qualifying charitable organization.368 When a charitable contribution is made in property other than cash, the value of the deduction to the donor is equal to the fair market value of the property as of the date of the contribution.369 Initially, the allowable yearly deduction is limited to a percentage of the donor’s “contribution base” subject to certain limitations.370 Several percentage limitations are applicable, depending on the identity of the donee organization, the type of property donated, and whether the property is donated directly “to” the organization or “for the use of” the organization.371 For a payment to be deductible as a charitable contribution under IRC §170(a), the regulations372 provide that a taxpayer must intend to make a payment to a charitable organization in an amount that exceeds the fair market value of any goods or services received, and must actually make such a payment.373 In short, the taxpayer must have donative intent to be entitled to the deduction. (a)
Contributions of Cash, Ordinary Income Property, and Short-Term Capital Gain Property
Contributions of cash,374 ordinary income property, and short-term capital gain property to churches, qualifying educational organizations, medical research organizations, governmental units, and other publicly supported IRC §501(c)(3) organizations and private operating foundations are generally deductible up to 50 percent of the donor’s contribution base.375 Charitable contributions in excess of this amount may be carried forward by the donor for up to five years and treated as a contribution made by the donor in those carry-forward years.376 The deduction for a contribution of ordinary income and short-term capital gain property to either a public charity or a private foundation must be reduced by the full amount of any gain.377
368 369 370 371
372 373 374
375
376 377
§170(a). See M. Sanders, “Traps for the Unwary Concerning Gifts of Appreciated Property to Charity: New Section 170(e)”, 24 University of So. Calif. Law Center 719 (1972). Reg. §1.170-1(c)(1); see also Rev. Rul. 55-410, 1955-1 C.B. 297; Osborne v. Commissioner, 1994 T.C.M. 360 (1994). “Contribution base” is defined as the donor’s adjusted gross income computed without regard to net operating loss carrybacks. §170(b)(1)(F). In general, contributions of income interests to a charity are contributions “for the use of” the organization; contributions of property or cash directly to a charity, including remainder interests, are “to” the organization. 60 Fed. Reg. 39,896-39,902 (1995) (IA-44-940). Reg. §1.170A-1(h); United States v. American Bar Endowment, 477 U.S. 105 (1986). In Priv. Ltr. Rul. 96-23-065 (Mar. 8, 1996) the IRS ruled that credit card holders were entitled to claim charitable contribution deductions for amounts donated to charities of their choice by the credit card company, where such amounts were based on a percentage of the price of certain items charged to their accounts. Key to the ruling was the fact that cardholders could opt to have the rebates applied to their outstanding account balances rather than having them transferred to a charity. See United States v. American Bar Endowment, 477 U.S. 105 (1986); Reg. §170A-1(h); Section 2.10(d)(iii). In order to claim the deduction, however, the cardholder would have to meet the general substantiation requirements under §170(f)(8). §170(b)(1)(A). Contributions by individuals of cash or ordinary income property to private foundations, on the other hand, generally are deductible up to 30 percent of the donor’s contribution base. §170(d)(1)(A). §170(e)(1)(A) Rev. Proc. 84-46, 1984-1 C.B. 541 (superseded by Rev. Proc. 90-27, 1990-18 I.R.B. 17 and Rev. Proc. 84-47, 1984-1 C.B. 545). See also Sanders, 24 Univ. of So. Calif. Law Center Review 719 (1972).
䡲
92
䡲
c02.fm Page 93 Thursday, March 15, 2007 3:46 PM
2.11 CHARITABLE CONTRIBUTIONS
(b)
Contributions of Capital Gain Property
When a donor contributes long-term capital gain property to a public charity, the donor’s deduction attributable to the value of the property’s appreciation is limited to 30 percent of the donor’s contribution base, instead of the higher 50 percent.378 However, a donor may elect to deduct up to 50 percent of his or her contribution base for purposes of computing the allowed contribution deduction for capital gain property.379 In the case of an election, the donor may deduct only his or her adjusted basis in the property, rather than the fair market value.380 The deduction allowed for any contribution of capital gain property that is not described in IRC §170(b)(1)(A) is limited to 20 percent of the donor’s contribution base.381 Finally, the charitable contribution deduction is subject to further reduction by reason of the overall limitation on itemized deductions for high-income individuals.382 (c)
Contributions of Conservation Easements
Ordinarily, charitable contribution deductions are permissible only if the taxpayer conveys his or her entire interest in the property. However, the Internal Revenue Code provides an exception for qualified conservation contributions.383 This includes conservation easement contributions, granted in perpetuity, of real property with a restriction on its use. To ensure that a taxpayer is not making an improper charitable contribution deduction of conservation easements, the taxpayer must restrict the future land use to the protection of a natural habitat for fish, wildlife, plants, or similar ecosystems, or for the preservation of open space. Further, the open space restriction must be for the scenic enjoyment of the general public or pursuant to a clearly delineated governmental conservation policy, and the public benefit of the open space must be significant, or the deduction will be disallowed.384 378
379 380
381 382 383 384
§170(b)(1)(C)(i); §170(b)(1)(B)(ii). Gifts of capital gain property to private foundations are subject to a limitation of 20 percent of the donor’s contribution base. Ltr. Rul. 95-01-031 (Oct. 6, 1994). However, for donations of appreciated stock to private foundations donors may deduct the full fair market value of such stock if such stock constitutes “qualified appreciated stock.” IRC §170(e)(5). Qualified appreciated stock is corporate stock for which market quotes are readily available on an established securities market on the contribution date, and whose sale on the contribution date at fair market value would have resulted in long-term capital gain. IRC §170(b)(1)(C)(iv). If the amount of the donation of qualified appreciated stock exceeds the donor’s IRC §170(b)(1)(D)(i) percentage limitation, any carryover amounts are deductible to the full extent of their value as measured at the time of the donation. See, e.g., Priv. Ltr. Rul. 95-09-037 (Dec. 5, 1994); Priv. Ltr. Rul. 95-10-050 (Dec. 13, 1994). Testamentary gifts of appreciated assets to private foundations are generally not subject to the foregoing rules, and thus are generally fully deductible without regard to when such gifts occur. §170(b)(1)(c)(iii); Reg. §1.170-8(d)(2). §170(b)(1)(C)(iii). With regard to contributions of tangible personal property, if the use of such property by the charitable organization is unrelated to the purpose for which the charity’s exempt status is granted, then the allowable contribution deduction must be reduced by the amount of gain that would have been long-term capital gain had the property been sold at its fair market value. §1.170A-4(a)(2); §1.170A-4(a)(3). §170(b)(1)(D). §68. Section 170(f )(3)(B)(iii); see Joe Stephens, “Tax Break Turns Into Big Business,” Washington Post, Dec. 13, 2004, at A1, for an excellent example of the fraudulent uses of conservation easements. IRS Notice 2004-41.
䡲
93
䡲
c02.fm Page 94 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
In addition, a taxpayer must substantiate a contribution of $250 or more in order to properly claim the charitable contribution deduction. To substantiate a contribution, the taxpayer must obtain from the charitable organization a statement that includes (1) a description of any return benefit provided by the charitable organization, and (2) a good-faith estimate of the return benefit’s fair market value. A taxpayer will be allowed a charitable deduction for the contribution of a conservation easement if he or she complies with these requirements; however, the deduction may not exceed the fair market value of the property contributed (reduced by the fair market value of consideration received by the taxpayer). Furthermore, no deduction will be allowed if the donor (or related person) can expect to receive financial or economic benefits greater than those that will inure to the general public as a result of the donation of the conservation easement. Finally, no deduction is allowed if the donation of the conservation easement either enhances the value of real property, or has no material effect on the value of the property.385 (i) Notice 2004-41. In Notice 2004-41, the Service warned against inappropriate charitable contribution deductions for transactions involving taxpayers’ purchases of real property. In particular, the Service will be reviewing those situations in which a taxpayer purchases property from an exempt organization, subject to an easement, at a substantially discounted sales price. The Service will be looking for any subsequent payments that are made by the taxpayer to the charity, designated by the taxpayer as a charitable contribution. The Service warns that the substance of these transactions will determine the tax treatment, and alleges in the Notice that the result of this transaction is that the charitable organization is fully reimbursed for the original cost of the property through the aggregate payments made by the taxpayer, and the taxpayer has received an inappropriate charitable contribution deduction. The Service, through Notice 2004-41, advises that it will disallow the charitable deduction and treat the total payments made to the charity by the taxpayer as the purchase price for the property. In order for a taxpayer to properly claim a deduction under §170 of the Code for a charitable donation after purchasing real property from the charity, the taxpayer and the organization must conform to the requirements for a permissible charitable contribution deduction. That is, the taxpayer must purchase the property for its fair market value and then independently donate cash or an easement (subject to the requirements set forth above) to the charitable organization, thereby making the substance of the transaction a legitimate purchase of property and a permissible charitable contribution. In Notice 2004-41, the Service also states that it intends to assess penalties and excise taxes against taxpayers and organization managers who knowingly participate in these impermissible charitable contribution transactions. Furthermore, the Service announced that it may challenge the tax-exempt status of organizations participating in these transactions.
385
Id.
䡲
94
䡲
c02.fm Page 95 Thursday, March 15, 2007 3:46 PM
2.11 CHARITABLE CONTRIBUTIONS
(d)
Charitable Contributions by Joint Venture
Under IRC §702(a) and §703(a), in determining his or her individual taxable income, each partner in a partnership or joint venture can take into account his or her distributive share of all charitable contributions paid by the partnership in a tax year.386 This rule follows the general rule that a partnership or a joint venture is a passthrough entity.387 (e)
Charitable Contribution Substantiation and Disclosure Requirements
(i) Written Substantiation for Gifts of $250 or More. The Revenue Reconciliation Act of 1993 included new charitable contribution substantiation and disclosure requirements for public charities and individuals. Accordingly, IRC §170 was amended to provide that in order to claim a charitable contribution deduction for any contribution of $250 or more,388 a taxpayer must substantiate the contribution by a “contemporaneous written acknowledgment389 from the donee organization. A canceled check is not sufficient proof for the charitable contribution.390 The acknowledgment391 must include the following information: (1) the amount of cash and a description (but not the value) of any property contributed; (2) whether the donee organization provided any goods or services in consideration, in whole or in part, for any property contributed; and (3) a description and “good-faith estimate” of the value of any goods or services provided. However, if the goods or services consist “solely of intangible religious benefits,” a statement to that effect should be provided to the donor but no estimate of value is required. For these purposes, goods or services will consist “solely of intangible religious benefits” if they are provided by an organization organized exclusively for religious purposes and are generally not sold in a commercial transaction outside the donative context (e.g., admission to a religious ceremony). (ii) Disclosure Relating to Quid Pro Quo Contributions. The Revenue Reconciliation Act of 1993 also requires charitable organizations that receive a “quid pro quo contribution”392 in excess of $75, to provide a written statement to donors that (1) informs the donor that the amount of the contribution deductible for federal 386 387 388
389
390
391
392
§702(a); Reg. §1.702-1(a)(4). See generally §703(a); Reg. §1.703-1. §701; Reg. §1.701-1. The Statement of Conference Managers (H. Rept. 103-213) provides that separate payments generally will be treated as separate contributions and will not be aggregated for purposes of the $250 threshold. In cases of contributions paid by withholding from wages, the deduction from each paycheck will be treated as a separate payment. An acknowledgment is “contemporaneous” if the taxpayer obtains the acknowledgment on or before the earlier of (1) the date on which he or she files a tax return for the taxable year in which the contribution was made; or (2) the due date (including extensions) for filing the return. Taxpayers report cash contributions on Form 1040, Schedule A, Line 13. Noncash contributions over $500 for individuals and over $5000 for business entities are reported on Form 8283. The Statement of Conferencing Managers (H. Rept. 103-213) indicates that this provision does not impose an information reporting requirement on charities; rather, it places the burden on taxpayers to obtain substantiation from the charity. The term quid pro quo contribution means a payment made partly as a contribution and partly in consideration for goods or services to the donor by the donee organization. However, a “quid pro quo contribution” does not include any payment made to a religious organization, in return for which the donor receives solely an intangible religious benefit.
䡲
95
䡲
c02.fm Page 96 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
income tax purposes is limited to the excess of the amount of any money (and the value of any property other than money) contributed by the donor over the value of the goods or services provided by the organization and (2) provides the donor with a good-faith estimate of the value of the goods or services furnished by the organization. The disclosure must be made by the charitable organization in connection with either the solicitation or receipt of the contribution. The legislative history provides that the disclosure requirement does not apply if only de minimis, token goods or services are given to the donor.393 Furthermore, the disclosure requirement does not apply to transactions that have no donative element—for example, sales of goods by a museum gift shop that are not in part donations. There is a penalty ($10 per contribution, capped at $5,000 per particular fundraising event or mailing) that will be imposed on organizations that fail to make the required disclosure, unless the failure is due to reasonable cause. The provision is effective for contributions made on or after January 1, 1994. (iii) Regulatory Modifications. The IRS has promulgated regulations that, although tracking the language of IRC §170 closely, clarify four issues and expand on existing guidance. First, the IRS adopted the test for deductibility set down in United States v. American Bar Endowment:394 A payment made in partial consideration of goods and/or services is deductible only if, and to the extent that, the payment exceeds the fair market value of the goods received or services rendered. In addition, to be deductible, the excess payment must be made with the intent to make a charitable contribution.395 Second, if a partnership or S corporation makes a charitable contribution and receives a contemporaneous written acknowledgment (as required by IRC §170), the individual shareholders or partners need not secure separate acknowledgments to deduct their shares of the contribution.396 Third, the regulations clarify what items may be disregarded in determining the value of goods and services received in exchange for the contribution. Whereas only items having an “insubstantial” value are disregarded under current law, the regulations state that other benefits received by the donor may be disregarded if they are provided as part of an annual membership (the fee for which may not exceed $75) and consist of either (1) admission to members-only events, which have a projected per-person cost less than or equal to the standard 393
394 395 396
Small items and token benefits (e.g., key chains and bumper stickers) that have “insubstantial” value are disregarded, and the full amount of the contribution is deductible. Rev. Proc. 90-12, 1990-1 C.B. 471, provides that tokens or benefits given to the donor in connection with a contribution will be considered to have insubstantial value if (1) the payment occurs in the context of a fundraising campaign in which the donor informs patrons how much of their payment is a deductible contribution; and (2) either (a) the fair market value of all the benefits received in connection with the payment is not more than 2 percent of the payment or $50, whichever is less, or (b) the payment made by the patron is $25 or more (adjusted for inflation) and the only benefits received in connection with the payment are token items that bear the organization’s name and logo and which in the aggregate are within the limits for low-cost items under §513(a)(2) (i.e, $5 (adjusted for inflation), currently $6.60). 477 U.S. 105 (1986). Reg. §1.170A-1(h). Reg. §1.170A-13(f)(14)
䡲
96
䡲
c02.fm Page 97 Thursday, March 15, 2007 3:46 PM
2.11 CHARITABLE CONTRIBUTIONS
for low-cost items, or (2) rights and privileges members can exercise frequently during their membership (e.g., free museum admission).397 The current threshold value of low-cost items is $6.60. Fourth, if an individual incurs unreimbursed expenses in the course of rendering services to a donee organization, the regulations allow substantiation of those expenses by reference to the donor’s normal records and an abbreviated written acknowledgment by the donee.398 The IRS included questions about charitable contributions in the November 2000 announcement asking for public comment on a variety of Internet activities.399 It indicated that it was considering clarification on the following questions: • Are solicitations for contributions made on the Internet (either through a
Web site or e-mail) in “written or printed form” for the purposes of §6113? If so, what facts and circumstances are relevant to determining whether a disclosure is in a “conspicuous and easily recognizable format”? • Does an organization meet the requirements of §6115 for “quid pro quo”
contributions with a Web page confirmation that may be printed out by the contributor or by sending a confirmation by e-mail to the donor? • Does a donor satisfy the requirement under §170(f)(8) for a written
acknowledgment of a contribution of $250 or more with a printed Web page confirmation or copy of a confirmation e-mail from the donee organization? The first guidance provided by the IRS on the Internet was contained in a revision of Publication 1771, which now allows electronic documentation to donors to serve as a “written acknowledgement” of a contribution.400 (f)
Registration for Charitable Solicitation
Most states require charitable organizations to register with the state before soliciting contributions from the residents of that state. Complying with many separate registration systems has been onerous. The National Association of State Charities Officials (NASCO) and the National Association of Attorneys General (NAAG) have created a single form to simplify the task of registering in multiple states. Of the 39 jurisdictions that require registration of charitable solicitations, 34 will accept the unified registration statement, although 5 states require a supplemental form in addition. The form, with instructions and advice, may be found at <www.nonprofits.org/library/gov/urs/>.401 NASCO has also developed advice to the states on how to regulate charitable solicitations using the Internet. The result of more than a year of study and discussion is embodied in the “Charleston Principles,” which can be found at <www.nasconet.org>. 397 398 399 400 401
Reg. §1.170A-1(f)(8)(B). Reg. §1.170A-1(f)(10). Announcement 2000-84, 2000-42 I.R.B. 385. Publication 1771, Mar. 13, 2002. For an extensive and practical guide to conducting charitable solicitations, see Bruce Hopkins, Law of Fundraising 3rd ed. (Hoboken NJ: John Wiley & Sons, 2002).
䡲
97
䡲
c02.fm Page 98 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
Clearly, an entity that uses the Internet to conduct charitable solicitations in a state in which it has its principal place of business must register with that state. An entity must register in other states: (1) if its non-Internet activities would be sufficient to require registration; or (2) if the entity solicits contributions through an interactive Web site (or invites offline activity to complete a contribution or establishes other contacts) and either specifically targets persons located in the state or receives contributions from the state on a repeated and ongoing basis or substantial basis. Of course, if a Web site merely provides program services or information but does not contain a solicitation, it need not register, even if it generates unsolicited donations. The Charleston Principles also address the situation of a charity that receives donations through a Web site operated by another organization. If the law of the state does not universally require registration of all charities on whose behalf contributions are solicited or received through a commercial fundraiser, commercial co-venturer, or fundraising counsel, the Principles recommend that states independently apply the preceding criteria to each charity. If the state does universally require registration of all charities under such circumstances, the Principles suggest that “states should consider whether, as a matter of prosecutorial discretion, public policy, and the prioritized use of limited resources, it would take action to enforce registration requirements as to charities who do not independently meet the criteria.” The terms cause marketing or commercial coventuring refer to promises to donate a portion of an ordinary commercial sale of a product or service to a charitable organization. The Charleston Principles recommend that such solicitations be governed by the same standards as those governing charitable solicitations.
2.12
CAR DONATION PROGRAMS
Car donation programs deserve special mention due to the recent attention they have received from the Service and Congress.402 Under the programs, exempt organizations (or their agents) receive donated cars, and in exchange, the donors receive charitable deductions equal to the value of the donated vehicles. Following donations, charities ordinarily sell the cars “resulting in millions in revenue for cashstrapped organizations.”403 However, charities may choose to use the cars in their charitable programs. There are generally four types of car donation programs: 1. The charity uses the donated cars in its charitable program or distributes the cars to needy individuals. 2. The charity sells the donated cars and uses the proceeds to fund its charitable programs. 3. The charity hires an agent to operate the car donation program and remit the contribution to the charity. 402
403
See, e.g., Charity Oversight and Reform, Hearing on Charitable Giving, Before Senate Committee on Finance, 108th Cong. (2004), available at http://finance.senate.gov/sitepages/ hearing062204.htm. Rachel Jacobson, “The Car Donation Program: Regulating Charities and For-Profits,” Exempt Organization Tax Review 213, 214, n. 9 (Aug. 2004).
䡲
98
䡲
c02.fm Page 99 Thursday, March 15, 2007 3:46 PM
2.12 CAR DONATION PROGRAMS
4. A for-profit entity receives donated cars directly and sells them utilizing the charity’s name pursuant to a licensing agreement, and remits the contribution to the charity. In June 2004, Congress held hearings regarding several car donation programs, and expressed concern about perceived irregularities among charities and the operations of these programs. Congress was concerned that donors were claiming charitable deductions based upon unrealistic fair market values found in used-car pricing guides. Additionally, Congress found that in certain situations, the charities were receiving only a small percentage of the gross proceeds from the sales of the donated cars.404 In response to the congressional hearings and testimony discussing charitable car donation programs, Congress passed the American Jobs Creation Act (2004 Jobs Act),405 which was signed by President Bush on October 22, 2004. The 2004 Jobs Act enacted new substantiation requirements that apply to deductions for the charitable contribution of qualified vehicles (used automobiles, boats, or airplanes, other than inventory).406 The new substantiation rules apply to the donation of vehicles with a claimed value that is greater than $500. For donations of such vehicles, no deduction is allowed unless the taxpayer substantiates the contribution by including an acknowledgment from the donee organization with the tax return on which the deduction is claimed. The amount of the deduction may be limited to the gross sales proceeds received from the sale of the vehicle by the donee organization. The new substantiation requirements are effective for contributions of qualified vehicles made after December 31, 2004. (a)
Valuation of Deduction
In general, if the donee organization sells the vehicle without any significant intervening use or material improvement, the donor’s deduction is limited to the gross sale proceeds. Note that prior to the 2004 Jobs Act, a donated vehicle could be valued using an established used car pricing guide. Under the 2004 Jobs Act, the amount of the deduction may be uncertain until the charity sells the vehicle, unless the donation is within one of the exceptions: 1. If the donee organization sells the vehicle after significant intervening use, or materially improves the vehicle prior to sale, the donor’s deduction is not limited to the gross sale proceeds. Instead, the donating taxpayer may value the vehicle using any reasonable method, including use of a car pricing guide. 2. If the donee organization utilizes the vehicle to directly further its charitable purpose, it is possible that the donor may value the vehicle using any reasonable method, including use of a car pricing guide. The IRS has been instructed to prescribe regulations or other guidance that provides an 404
405 406
Albert B. Crenshaw, “Charities’ Tax Breaks Scrutinized,” Washington Post, June 21, 2004, at A01; see also Rachel Jacobson, “The Car Donation Program: Regulating Charities and ForProfits,” Exempt Organization Tax Review 213, 214, n. 9 (Aug. 2004). American Jobs Creation Act of 2004, H.R. 4520, 108th Cong. (2004). IRC §170(f)(12), as amended by the American Jobs Creation Act of 2004, §884(a).
䡲
99
䡲
c02.fm Page 100 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
exemption for sales of vehicles that are in direct furtherance of the donee’s charitable purposes from the requirement that the donor may not deduct an amount in excess of the gross proceeds from the sale. There is some uncertainty as to whether the exception may be claimed in the absence of additional guidance. (b)
Significant Intervening Use and Material Improvements
The method of determining the amount of the deduction claimed for the vehicle and the requirements for substantiation differ depending upon whether the vehicle is within an exception: • A vehicle has been subject to significant intervening use if the donee organiza-
tion actually uses the vehicle to substantially further its regularly conducted activities and the use is significant and intended at the time of contribution. • A vehicle has undergone material improvements if it has undergone
major repairs or has been subject to other improvements that significantly increase its value. (c)
Substantiation Requirements
If a donated vehicle is sold by the donee organization without any significant intervening use or material improvement, the donee organization must provide an acknowledgment to the donating taxpayer within 30 days of the sale of the vehicle. The acknowledgment must include: • The taxpayer’s name and taxpayer identification number • The vehicle identification number or similar number • A certification that the vehicle was sold in an arm’s-length transaction
between unrelated parties • The amount of the gross proceeds from the sale • A statement that the deductible amount may not exceed the amount of
the gross proceeds If a donated vehicle undergoes significant intervening use or material improvement by the donee organization, the donee organization must provide an acknowledgment to the donating taxpayer within 30 days from the contribution of the vehicle. The acknowledgment must include: • The taxpayer’s name and taxpayer identification number • The vehicle identification number or similar number • A certification of the intended use or material improvement of the vehicle
and the intended duration of that use • A certification that the vehicle would not be transferred in exchange for
money, other property, or services before completion of that use or improvement Donee organizations that fail to furnish a required acknowledgment or that furnish fraudulent acknowledgments are subject to penalty equal to the greater 䡲
100
䡲
c02.fm Page 101 Thursday, March 15, 2007 3:46 PM
2.13 SARBANES-OXLEY AND EXEMPT ORGANIZATIONS
of the value of the tax benefit to the donor or the gross proceeds from the sale.407 Information contained in the acknowledgment must also be provided to the IRS by the donee organization.
2.13
SARBANES-OXLEY AND EXEMPT ORGANIZATIONS
The American Competitiveness and Corporate Accountability Act of 2002, or the Sarbanes-Oxley Act408 (the Act), has had a significant impact of the corporate sector. Arising out of the Enron and Arthur Andersen scandals, the Act requires publicly traded companies to adhere to stringent new standards of accountability, including implementing new audit guidelines and requiring executives to certify financial statements. Currently, there is no federal requirement that exempt organizations comply with Sarbanes-Oxley. States, however, are passing legislation similar to Sarbanes-Oxley to ensure the financial integrity of public charities. For instance, in 2004 California passed SB 1262. The statute requires, inter alia, all charitable organizations with annual gross revenues equal to or exceeding $2,000,000 to obtain an independent audit by the board of directors, which must appoint an audit committee that is responsible for retaining and terminating the independent auditor and negotiating the auditor’s compensation. The audit committee must also act as a board representative in conferring with the auditor. Massachusetts and New York have made similar proposals requiring charitable organizations to obtain audits. Although the Act does not apply to tax-exempt organizations on its face, exempt organizations should consider implementation to help ensure that there is no misuse of the organization’s funds. Below is an outline of “best practices” for medium- to large-size tax-exempt organizations. (a)
Independent Auditors
The Act requires that a corporation’s auditors be independent from the company’s operations. In this regard, exempt organizations can adopt certain provisions of the Act to help ensure auditor independence. 1. Exempt organizations should consider prohibiting their external auditors from providing nonaudit services, including bookkeeping, financial system design and implementation, and management functions.409 a.
If nonaudit services are provided by audit firm, the exempt organization’s audit committee should approve the services.410
2. Exempt organizations should evaluate the performance of the audit firm annually and require that the lead partner on the audit engagement rotate every five years.411 407 408 409 410 411
IRC §6720A, as amended. The American Competitiveness and Corporate Accountability Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).
Title 2 §201 of the Act. Title 2 §202 of the Act. Title 2 §§203 and 207 of the Act.
䡲
101
䡲
c02.fm Page 102 Thursday, March 15, 2007 3:46 PM
TAXATION OF CHARITABLE ORGANIZATIONS
3. The exempt organization’s audit committee should be responsible for the external auditor’s appointment and compensation.412 4. The independent auditor should not have been employed by the exempt organization within the year preceding the audit.413 (b)
Senior Management
Senior management of an organization plays a crucial role in ensuring the integrity of the organization and its finances. The Act provides the senior management of exempt organizations with an outline of corporate responsibility. 1. The senior financial managers should adopt a code of ethics and a code for financial accountability. a.
The organization should consider implementing internal controls to ensure compliance with the financial and ethical standards.
b.
The internal controls should be reviewed on a periodic basis.414
2. Senior management should install a confidential complaint program to assist employees with communicating unethical behavior in the organization—for example, an anonymous e-mail or voice-mail, or secure complaint boxes.415 3. The exempt organization should consider disclosure requirements, requiring senior management to attest to the accuracy of the financial statements.416 (c)
Audit Committees
The board of directors of the exempt organization should appoint an audit committee. The Act provides guidelines to assist in ensuring the integrity and independence of the audit committee. 1. Management or employees must not be voting members of the audit committee. 2. The audit committee should be responsible for overseeing the entire external audit, including engaging the auditors, setting the external auditor’s compensation, and overseeing the audit process.417 3. The audit committee should have the power to engage independent counsel or other advisors, as necessary to carry out its duties.418 4. Finally, at least one financial expert should be on the exempt organization’s audit committee. 412 413 414 415 416 417 418
Title 2 §204 of the Act. Title 2 §206 of the Act. Title 4 §404 of the Act. Title 3 §301 of the Act. Title 3 §302 of the Act. Title 3 §301 of the Act. Id.
䡲
102
䡲
c02.fm Page 103 Thursday, March 15, 2007 3:46 PM
2.14 STATE LAWS
2.14 (a)
STATE LAWS California Nonprofit Integrity Act of 2004
In 2004, the California legislature enacted the Nonprofit Integrity Act of 2004419 (the NIA), which became effective on January 1, 2005. The NIA provides for increased registering and reporting requirements for charities over which the attorney general has jurisdiction as well as new requirements with respect to the governance of such charities, such as the imposition of audit committees. Although the NIA does not contain standards to which directors and officers of nonprofit corporations must adhere, it does set forth certain requirements, such as who may vote to approve compensation packages and when compensation is to be reviewed.
419
2004 Cal. Stat. 919.
䡲
103
䡲
c03.fm Page 104 Wednesday, March 7, 2007 6:58 PM
C H A P T E R
T H R E E 3
Taxation of Partnerships and Joint Ventures 3.1
SCOPE OF CHAPTER
Because the joint venture structure is typically used in arrangements between exempt organizations and for-profit partners, it is fundamental in the analysis of joint ventures to examine the rules of partnership taxation under Subchapter K of the Internal Revenue Code (IRC or “the Code”).1 This subject is especially important, as substantial funds are channeled into the charitable stream through public and private syndications, such as low-income housing tax credit syndications. Partnership tax issues also arise under the tax-exempt entity leasing rules2 and the IRC §514(c)(9) exception to the debt financed property rules in the unrelated business income tax (UBIT) context that involve qualified allocations3 and “substantial economic effect” issues under §704(b). The partnership itself is nontaxable under IRC §701;4 the partners, however, are liable for tax in their individual capacities. Each member is taxed individually on his or her distributive share of income, gain, loss, deduction, or credit.5 A partner is entitled to deduct his or her distributive share of partnership losses, if any, to the extent of the tax basis of his or her partnership interest, which may include his or her share of partnership liabilities.6 The amount of partnership losses a partner may deduct may be subject to additional limitations, including the at-risk limitation7 and the passive activity loss limitation.8
1
2 3 4 5 6 7 8
A joint venture is generally treated as a partnership for tax purposes. §7701(a)(2); Reg. §3017701-3(a). Many joint ventures are formed as limited partnerships or limited liability companies. See Section 3.2. For a detailed discussion of exempt organizations investing through limited liability companies, see Chapter 17. See Chapter 10. See Chapter 5. All section references hereinafter are to the Internal Revenue Code of 1986 as amended and the regulations promulgated thereunder, unless otherwise noted. §752(a). in lieu thereof. §752(a). §465. §469.
䡲
104 䡲
c03.fm Page 105 Wednesday, March 7, 2007 6:58 PM
3.2 QUALIFYING AS A PARTNERSHIP
3.2
QUALIFYING AS A PARTNERSHIP
Before addressing the particular tax aspects of partnerships or joint ventures and how they are distinguished from other business entities, it is essential to determine whether the business activity or activities performed in a joint undertaking by two or more parties constitute a partnership for federal tax purposes.9 Some parties may assume incorrectly that a particular joint undertaking, such as an unusual employer-employee arrangement or real estate transaction, qualifies as a partnership for federal tax purposes, when in fact it does not. Moreover, to complicate matters, venturers cannot base their assumption that a partnership exists (for federal tax purposes) on the characterization of the entity as a partnership under state law, or on the name or designation that is assigned to the undertaking.10 Accordingly, to avoid business planning or tax pitfalls that may result from an erroneous assumption of partnership status, the parties must be confident that the business activity of the venture constitutes a partnership for federal tax purposes. (a)
Focus on Parties’ Intent
The courts and the IRS traditionally have looked to the facts as determined by the conduct of the parties in deciding whether a venture constitutes a partnership for federal tax purposes. Of all the indicia of partnership status, the intent of the parties has emerged as the most important factor.11 In Commissioner v. Tower,12 the Supreme Court held that, despite state law to the contrary, a family partnership did not exist for federal tax purposes. In so holding, the Supreme Court set forth the following criteria to determine when a joint venture constitutes a partnership for federal income tax purposes: A partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses. When the existence of an alleged partnership arrangement is challenged by outsiders, the question arises whether the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both. And their intention in this respect is a question of fact, to be determined from testimony disclosed by their agreement, considered as a whole, and by “their conduct and execution of its provisions.”13 9
10
11 12 13
The terms partnership and joint venture, although distinguishable, are intended to be synonymous for purposes of this classification discussion. The courts have recognized that the existence of a joint venture for tax purposes is determined by applying the same tests used in determining the existence of a partnership. See, e.g., Wheeler v. Commissioner, 37 T.C.M. 883 (1978). See Reg. §301.7701-1(ca)(3) (explaining that an entity formed under local law is not always recognized as a separate entity for federal tax purposes); Reg. §301.7701-3(a)(2) (distinguishing a separate entity (which may qualify as a partnership) from expense-sharing arrangements and mere co-ownership of property). The intentions of the partners should be set forth in the partnership agreement or the operating agreement of the limited liability company. Commissioner v. Tower, 327 U.S. 280 (1946). Id. at 286–87 (citing Drennen v. London Assurance Company, 113 U.S. 51, 56 (1885)). See also Commissioner v. Culbertson, 337 U.S. 733, 742 (1949) (finding that partnership exists for federal tax purposes only when “considering all the facts . . . the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise”).
䡲
105
䡲
c03.fm Page 106 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
The Internal Revenue Service (IRS) and courts have looked at a number of factors to determine whether the requisite intent exists. In Rev. Rul. 82-6l,14 the IRS ruled that two domestic utility corporations were co-owners of, rather than partners in, an electricity generating facility. In reaching this conclusion, the IRS made it clear that the critical inquiry is whether the parties intended to join together in order to carry on a business for joint profit or loss. In the ruling, the IRS identified the following factors, none of which is conclusive, as evidence of this intent: • The agreement of the parties and their conduct in executing its terms • The contributions, if any, that each party makes to the venture • Control over the income and capital of the venture and the right to make
withdrawals • Whether the parties are coproprietors who share in net profits and who
have an obligation to share losses • Whether the business was conducted in the joint names of the parties and
was represented to be a partnership Other authorities also have identified these factors as relevant indicia of partnership status: the carrying on of a trade or business, the joint ownership of the capital contributed, the exercise of control of the business, and the existence of separate books of account for the business.15 In sum, although it is difficult to guarantee that an entity will be recognized by the IRS as a partnership for tax purposes, some of the objective factors described here can help determine whether people or entities have combined sufficiently to form a partnership. (b)
Limited Partnerships
A limited partnership is a partnership having at least one general partner and one or more limited partners.16 To qualify as a limited partnership, a certificate of limited partnership must be executed and filed with the state in which the limited partnership is organized.17 Limited partners generally do not participate in the management or control of the partnership’s business; therefore, their liability is only to the partnership itself, and not to the creditors of the partnership.18 Accordingly, the limited partnership has become a popular, and often the preferred, vehicle for investors who wish to obtain the tax advantages of a pass-through entity with limited personal 14 15
16 17 18
Rev. Rul. 82-61, 1982-1 C.B. 13. See Willis, Pennell, and Postlewaite, Partnership Taxation (4th ed., 1989), §3.01; Luna v. Commissioner, 42 T.C. 1067 (1964). See also Rev. Rul. 75-374, 1975-2 C.B. 261; Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521 (1979), aff’d, 633 F.2d 512 (7th Cir. 1980); Bentex Oil Corp. v. Commissioner, 20 T.C. 565 (1953). Uniform Limited Partnership Act (ULPA) §1 (1916). ULPA §2; Revised Uniform Limited Partnership Act 1976, as amended 1985 (RULPA); §201. ULPA, Official Comment—Seventh to §17; RULPA, Prefatory Note art. 3, Comment §303.
䡲
106
䡲
c03.fm Page 107 Wednesday, March 7, 2007 6:58 PM
3.3 CLASSIFICATION AS PARTNERSHIP
liability.19 Limited partnerships permit taxpayers to utilize losses, with some limitations generated by an investment in which the taxpayer is not actively involved. In addition, a limited partner is protected against personal liability for the debts of the partnership in excess of its capital contribution. Losses from the limited partnership’s operations pass directly through to the limited partner, as does any income, usually in the form of capital gains from the later sale of the partnership’s assets. Thus, a limited partner avoids the imposition of the double layer of corporate and individual income tax, while retaining the benefit of limited personal liability afforded a corporate shareholder.
3.3
CLASSIFICATION AS PARTNERSHIP
The first step in the tax analysis of partnerships is determining whether a business enterprise will be classified as a partnership for federal tax purposes. IRC §7701(a)(2) provides that “the term ‘partnership’ includes a syndicate, group, pool, joint venture or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not . . . a trust or estate or a corporation.”20 If a partnership is treated as an association for federal income tax purposes, then the entity will be taxed as a corporation. In such a case, tax benefits, including losses and credits, would not flow through to the partners, and cash distributions to partners would be characterized as corporate distributions, some or all of which might be treated as dividends for federal income tax purposes.21 Moreover, the net income would be subject to federal income tax and, possibly, to state and local taxes. Before January 1, 1997, an unincorporated entity was classified and treated as an association rather than a partnership if “the organization more nearly resembled a corporation than a partnership.”22 That is, an unincorporated association that possessed more than two of the following characteristics would be classified as an association under the four-factor test and taxed accordingly:23 (1) continuity of life, (2) centralization of management, (3) limited liability, and (4) 19 20 21
22
23
See, however, the discussion of limited liability companies in Section 3.4. See also §761(a); §7701(a)(2); Reg. §1.761-1(a) (containing virtually identical definitions of the term partnership.) When an entity is subject to taxation as a corporation under Subchapter C, the entity and its shareholders may incur a “double tax.” First, an income tax is imposed on the entity at the corporate level, and second, the shareholders can be taxed on any dividend-like distributions. However, limited liability companies and corporations meeting certain requirements may be taxed as a pass-through entity, much like a partnership (an S corporation), while retaining nontax corporate characteristics (limited liability, etc.). Because an S corporation is not separately taxable on its income and income is passed through to its shareholders, the income is taxed only once. See generally §§1361–1379. See Former Reg. §301.7701-2(a)(1), which provided that the “major characteristics ordinarily found in a pure corporation” that distinguish it from other types of organizations were (i) associates, (ii) an objective to carry on a business for profit, (iii) continuity of life, (iv) centralization of management, (v) limited liability for corporate debts, and (vi) free transferability of interests. However, Former Reg. §301.7701(a)(2) provided that characteristics (i) and (ii) were common to corporations and partnerships, and therefore, classification issues were to be resolved based on factors (iii)–(vi), inclusive. See also Morrisey v. Commissioner, 296 U.S. 344 (1935). In Rev. Proc. 89-12, 1989-1 C.B. 798, the IRS offered guidance on how it would rule that an entity constituted a partnership under the four-factor test.
䡲
107
䡲
c03.fm Page 108 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
free transferability of interests. These four characteristics were based on an allor-nothing approach, rather than as matters of degree, so that an entity was classified as an association only when it had three of the four relevant corporate characteristics.24 In 1996 this four-factor classification test was replaced by an elective system. Under the “check-the-box” regulations, unincorporated business organizations may generally choose to be classified for federal tax purposes as either partnerships or associations taxable as corporations. The regulations specifically provide that an eligible entity that has been determined to be, or claims to be, exempt from taxation under IRC §501(a) will be treated as having elected to be classified as an association.25 However, this deemed election rule does not prevent a joint venture from qualifying as a partnership merely because the venturers include one or more exempt -organizations.26 The elective classification rules apply to periods beginning on or after January 1, 1997.27 Although the adoption of the elective system has rendered the traditional four characteristics irrelevant for federal classification purposes, the four characteristics remain applicable for all prior periods to which the new rules do not apply.28 For a discussion of the final regulations, see Section 17.5.
3.4 (a)
ALTERNATIVES TO PARTNERSHIPS Limited Liability Companies
Joint venturers increasingly prefer using a limited liability company (LLC) in place of a general or limited partnership.29 An LLC is a relatively recent state law creation that provides limited liability to all owners while, if properly structured, it also establishes a pass-through entity for purposes of federal income taxation. The major advantage of an LLC is that all of its members have limited liability, even those who participate in the management of the entity. Thus, an 24 25 26
27 28
29
See W. Brannan, “Just When You Thought It Was Safe to Go Back into the Water,” Tax Notes Today 66–184 (1993). Reg. §301.7701-3(c)(1)(v)(A). For background on the proposed check-the-box regulations, which were adopted as final regulations without significant structural change, see Grace, “Proposed Check-the-Box Regulations Would Streamline but Not Eliminate Entity Classification Process,” Tax Management Memorandum 37 (Sept. 30, 1996): 295; Grace and Becker, “Check-the-Box Top 40,” Tax Management Memorandum 37 (24)(Nov. 25, 1996): S-348. For additional discussion of the check-the-box rules, see Section 19.5. Reg. §301.7701-3(f)(1). Kenneth Kies, Chief of Staff, Joint Committee on Taxation, was quoted as finding the checkthe-box proposal “a little stunning.” See Daily Tax Report (BNA) 201 (Oct. 17, 1996): G-5. The Joint Committee Staff (JCS) commenced studying the tax rules governing partnerships, corporate spin-offs, and limited liability companies. See Tax Notes Today (1996): 223–227 (text of letter authored by Kenneth Kies inviting particular tax law experts to discuss the check-the-box regulations and associated developments). The JCS study, however, did not delay the promulgation of the final check-the-box regulations. The JCS later released a study that conjectured on whether legal authority adequately supports the Treasury Department’s promulgation of the check-the-box regulations. To resolve any uncertainties concerning this issue, the JCS proposed either legislatively granting the Treasury authority to issue such regulations or legislatively codifying the regulations. See Staff of the Joint Committee on Taxation, Review of Selected Entity Classification and Partnership Tax Issues (JCS-6-97), April 8, 1997, reprinted in “Highlights & Documents,” Tax Analysts (April 9, 1997). For a thorough discussion of limited liability companies, see generally Chapter 19.
䡲
108
䡲
c03.fm Page 109 Wednesday, March 7, 2007 6:58 PM
3.4 ALTERNATIVES TO PARTNERSHIPS
individual who acts as a general partner in a partnership (and would otherwise be personally liable) is protected by limited liability, and such a person may participate in management without losing his or her limited liability protection. The single most attractive feature of an LLC is that it enables closely held businesses to benefit from certain corporate advantages without jeopardizing treatment as a partnership for federal income tax purposes.30 The proliferation of LLCs over the past few years began with the issuance of Revenue Ruling 88-7631 and Private Letter Ruling 8106082,32 wherein the IRS classified a limited liability company as a partnership based on the absence of free transferability of interests and continuity of life.33 LLCs are classified for federal tax purposes under the same principles that apply to entities formed as partnerships. Classification is governed by IRC §7701 and not by local law. Before 1997, an LLC’s tax classification depended on the number of the traditional corporate characteristics the LLC possessed or lacked.34 Under the check-the-box regulations, an LLC, like a partnership, can choose to be classified as either an association taxable as a corporation or a partnership, regardless of how many of the four characteristics the LLC possesses or lacks. If a domestic LLC does not make a classification election, it automatically is classified as a partnership under “default rules” included in the check-the-box regulations.35 An increasing number of state LLC statutes recognize LLCs owned by one person. For federal tax purposes, an LLC having a single owner may choose to be taxable as a corporation or otherwise default to being disregarded as an entity separate from its owner.36 (b)
Title-Holding Companies
IRC §501(c)(2) provides tax-exempt status to certain corporations organized for the exclusive purpose of holding title to property and remitting over any income from the property to one or more related tax-exempt organizations.37 Section 501(c)(25) provides tax-exempt status to certain corporations and trusts that are organized for the exclusive purposes of acquiring and holding title to real property, collecting income from such property, and remitting the income to one or more qualified pension plans or tax-exempt entities, which have no more than 35 shareholders or beneficiaries. Under prior law a title-holding company described in §501(c)(2) or §501(c)(25) could lose its tax-exempt status if it generated any amount of unrelated business income.38 30 31 32 33 34 35 36
37 38
For an example of a hospital reorganization using an LLC, see Priv. Ltr. Rul. 95-17-029 (Jan. 27, 1995). See generally Chapter 11 for a discussion of healthcare entities and joint ventures. Rev. Rul. 88-76, 1988-2 C.B. 360. Priv. Ltr. Rul. 81-06-082 (Nov. 18, 1980). As of Nov. 24, 1996, all 50 states and the District of Columbia had enacted limited liability company legislation. See Section 3.3. Reg. §301.7701-3(b)(1). Reg. §301.7701-3(b)(1)(ii). The issue of whether a single-member LLC formed by a nonprofit must file for exemption is under consideration at the IRS, which will not issue private letter rulings on the question at present. Rev. Proc. 99-4, 1999-1 I.R.B. 115 (Jan. 4, 1999). See Section 17.5(f)(ii). §501(c)(2). Reg. §1.511-2(c)(1).
䡲
109
䡲
c03.fm Page 110 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
The Revenue Reconciliation Act of 1993 permits a title-holding company that is exempt from tax under IRC §501(c)(2) or §501(c)(25) to receive unrelated business income (UBI) (that would otherwise disqualify the organization) up to 10 percent of its gross income for the taxable year, provided that the UBI is “incidentally derived” from the holding of real property.39 For example, income generated from parking or operating vending machines located on real property owned by a title-holding company generally would qualify for the 10 percent de minimis rule, and income derived from an activity that is not incidental to the holding of real property would not so qualify.40 The provision is effective for taxable years beginning on or after January 1, 1994.41 (i) IRC §501(c)(2) Title-Holding Companies. To qualify for tax-exempt status under IRC §501(c)(2), a title-holding corporation is required to: • Be organized for the exclusive purpose of holding title to property and
collecting the income therefrom • Turn over all income, less expenses, to an organization that is exempt
under IRC §501(a) The major problem with using an IRC §501(c)(2) corporation is that the use of multiple shareholders is restricted. When there is more than one shareholder, the IRS generally will grant an exemption under §501(c)(2) only if the shareholders are organizationally or functionally related to each other.42 The utility of a §501(c)(2) corporation as a joint venture vehicle therefore is severely limited. (ii) IRC §501(c)(25) Title-Holding Companies. Another investment option is the use of a title-holding corporation or trust exempt from federal income taxation under IRC §501(c)(25) of the Code. A §501(c)(25) corporation or trust will be exempt if it is organized for the exclusive purpose of acquiring and holding title to real property and remitting the entire amount of the income to its shareholders or beneficiaries. To obtain an exemption under §501(c)(25), the corporation or trust must have no more than 35 shareholders or beneficiaries and only one class of stock or beneficial interest. Unlike an IRC §501(c)(2) corporation, because of this 35-owner limit a §501(c)(25) entity is allowed to be used for joint venture purposes. The owners of a §501(c)(25) entity, however, are limited to qualified pension, profit sharing, or stock bonus plans that meet the requirements of §401(a); a governmental plan under §414(d); governmental units, agencies, or instrumentalities; and §501(c)(3) entities. Thus, a §501(c)(25) entity cannot be used as a joint venture vehicle if any of the investors are taxable entities. In addition, it is important to keep in mind that a §501(c)(25) entity can be used only when a direct investment in real property is desired. Interests in real property as a tenant in common (or similar joint 39 40 41 42
§501(c)(2) as amended by §13146(b) of the 1993 Act; §501(c)(25) as amended by §13146(a) of the 1993 Act. H.R. Rep. to 1993 Act, 103d Cong., 1st Sess. 618 (1993). §13146(c) of the 1993 Act. See Priv. Ltr. Rul. 82-42-065 (July 21, 1982).
䡲
110
䡲
c03.fm Page 111 Wednesday, March 7, 2007 6:58 PM
3.6 ALLOCATION OF PROFITS, LOSSES, AND CREDITS
ownership interest) and any indirect interests in real property, such as ownership through a partnership, are not permitted.43 Accordingly, the utility of using a §501(c)(25) corporation or trust is limited to situations when a real property joint venture with other tax-exempt entities is contemplated.
3.5
PASS-THROUGH REGIME: THE CONDUIT CONCEPT
Partnerships are treated as conduits for federal income tax purposes. Under this “pass-through” or “flow-through” system, partnership income is taxable to the partners but not the partnership. Likewise, partnership losses or credits may flow through to—and be deducted by—the partners. The character of items of income, deduction, gain, loss, and credit to a partner will be the same as if such items bypassed the partnership entirely and was earned or incurred directly by the partner.44 The pass-through regime of taxation enables partnerships to conduct activities without concern for the two-tier system of taxation imposed on corporations and their shareholders. Flow-through taxation also provides businesses with some flexibility to shift economic and tax benefits among the owners.45
3.6
ALLOCATION OF PROFITS, LOSSES, AND CREDITS
Under IRC §704(a), a partner’s distributive share of income, gain, loss, deduction, or credit generally is determined under the partnership agreement. Section 704(b) provides that a partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof) will be determined in accordance with the partner’s interest in the partnership (taking into account all facts and circumstances) if a partnership agreement fails to provide for allocations or if the allocations provided for in the partnership agreement do not have “substantial economic effect.” Thus, an allocation under a partnership agreement must have substantial economic effect to be valid under §704(b), or it is subject to reallocation according to the “partner’s interest in the partnership.” The substantial economic effect test operates as a safe harbor. If allocations satisfy this test, the IRS cannot successfully challenge them on examination. The alternative is the more subjective “partner’s interest in the partnership” test in the regulations.46 Because the application of the partner’s interest in the partnership test is generally viewed as less certain, cautious practitioners go to great lengths to ensure that a partnership agreement meets the substantial economic
43 44 45
46
§501(c)(25). See §§701–704. The 1997 legislation simplifies the reporting rules for “electing large partnerships” (ELPs). An ELP is a partnership having 100 or more partners that affirmatively elects into the simplified reporting rules. For partnership taxable years beginning after Dec. 31, 1997, an ELP will have to report only 10 separate items to each partner. §772(a). The 1997 legislation also requires an ELP to furnish this information to partners on or before March 15 following the close of each taxable year. New procedures for auditing ELPs are patterned after, but not identical to, the previously described partnership unified audit rules. Reg. §1.704-1(b)(3).
䡲
111
䡲
c03.fm Page 112 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
effect test. However, partnership allocations are not necessarily invalid simply because they do not meet the substantial economic effect test. (a)
Substantial Economic Effect Test, in General
The determination of whether an allocation to a partner has substantial economic effect involves a two-part analysis that is made as of the end of the partnership taxable year to which the allocation relates.47 First, the allocation must have “economic effect,”48 and second, the economic effect of the allocation must be “substantial.”49 (i) Economic Effect Test. Allocations under a partnership agreement generally will be considered to have economic effect if the partnership agreement requires (1) capital accounts to be maintained in accordance with the §704(b) regulations, (2) liquidation proceeds to be distributed in accordance with positive capital accounts, and (3) partners to be obligated to repay negative capital accounts upon liquidation of their partnership interests.50 An alternate test for economic effect, however, is provided if the third factor, a full deficit make-up obligation on liquidation, is not present.51 This provision is designed to accommodate limited partnerships that otherwise would not be able to meet the economic effect test while preserving the limited liability of their limited partners. Under the alternate test, an allocation will have economic effect to the extent that it does not create a capital account deficit in excess of any obligation to restore a deficit capital account, if the partnership agreement contains a “qualified income offset.” A qualified income offset requires that in the event of unexpected distributions or certain specified adjustments and allocations, there must be an allocation of income and gain that eliminates a limited partner’s excess capital account deficit as quickly as possible.52 For purposes of the alternate test for economic effect, a partner is deemed to have an obligation to restore capital equal to (1) its allocable share of partnership minimum gain, when partnership minimum gain equals the excess of nonrecourse indebtedness over the adjusted tax basis of the property securing such indebtedness, plus (2) any limited deficit make-up obligation.53 A partner who is not expressly obligated to restore a deficit is treated as obligated to the extent of the amount of any unconditional obligation to make subsequent capital contributions, provided that the obligation is required to be satisfied no later than the end of the taxable year in which the partner’s interest is liquidated.54 47 48 49 50 51 52 53
54
Reg. §1.704-1(b)(2)(i). Reg. §1.704-1(b)(2)(ii). Reg. §1.704-1(b)(2)(iii). Reg. §1.704-1(b)(2)(ii). Reg. §1.704-1(b)(2)(ii)(d). Reg. §1.704-1(b)(2)(d) flush language. Partners’ capital accounts are regulated by an extensive and complex set of rules that are generally based on tax accounting principles. See Marich, “Substantial Economic Effect and the Value Equals Basis Conundrum,” Tax Law Review 42 (1987): 509. See also Rev. Rul. 97-38, 1997-38 I.R.B. 14, regarding the calculation of a partner’s limited deficit restoration obligation. Reg. §1.704-1(b)(2)(ii)(c). See also Rev. Rul. 97-38, 1997-38 I.R.B. 14. For an excellent analysis of the economic effect test, see Lind, Schwartz, Lathrope, and Rosenberg, Fundamentals of Partnership Taxation, 5th ed. New York: Foundation Press, 1998, 126–136.
䡲
112
䡲
c03.fm Page 113 Wednesday, March 7, 2007 6:58 PM
3.6 ALLOCATION OF PROFITS, LOSSES, AND CREDITS
Allocations that fail to have economic effect under either the primary test or the alternate test will be deemed to have economic effect under the economic effect equivalence rules55 if, at the end of any year, a liquidation of the partnership would produce the same economic results to the partners as if the aforementioned requirements for economic effect had been met. (ii) Substantiality Test. An allocation has economic effect that is “substantial” if it meets three tests—an “overall substantiality” test and tests for offsetting allocations that are either “shifting” or “transitory.” An allocation is tested for substantiality, on a present value basis, at the time it becomes part of the partnership agreement. On November 18,2005 the IRS issued proposed amendments to Regulation §1.704-1(b)(2)(iii) that provide rules for applying the substantiality tests when the partnership has a partner that is a look-through entity (i.e. partnership, S corporation, trust) or a member of a consolidated group. In general, the proposed amendments provide that when testing whether an allocation of profits or losses to a partner that is a look-through entity or a member of a consolidated group is substantial, the tax attributes of the owners of the lookthrough entity or the consolidated group must be taken into account. The overall substantiality test will be met if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners independent of tax consequences.56 All allocation will not be substantial if (1) the after-tax economic consequences of at least one partner may be enhanced as compared with the consequences if the allocation were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax consequences of no partner will be substantially diminished as compared with such consequences.57 In determining the after-tax economic benefit or detriment accruing to a partner, the tax consequences resulting from the interaction of the allocation with the partner’s tax attributes that are unrelated to the partnership are taken into account.58 Shifting allocations are those that occur within the same partnership taxable year.59 Transitory allocations are those that will be largely offset by subsequent allocations occurring in a future partnership taxable year.60 There is a rebuttable presumption that the economic effect of shifting and transitory allocations will not be substantial where (1) there is a strong likelihood that the net increases and decreases that will be recorded in the partners’ respective capital accounts will not differ substantially from the net increases and decreases that would be recorded if the allocations had not been made, and (2) the total tax liability of the partners will be less than it would have been had the allocations not been made.61 The presumption that at the time these allocations became part of the partnership agreement there was a strong likelihood such results would occur, can 55 56 57 58 59 60 61
Reg. §1.704-1(b)(2)(ii)(i). Reg. §1.704-1(b)(2)(iii)(a). See id. See id. Reg. §1.704-1(b)(2)(iii)(b). Reg. §1.704-1(b)(2)(iii)(c). Reg. §1.704-1(b)(2)(iii)(b)(2), (c)(2).
䡲
113
䡲
c03.fm Page 114 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
be overcome by a showing of facts and circumstances by the taxpayer proving otherwise.62 In addition, offsetting transitory allocations will not be considered insubstantial if there is a strong likelihood that they will not be made within five years of the original allocations.63 In Rev. Rul. 99-43,64 the IRS tested the substantiality of particular partnership allocations. Under the facts of the ruling, individuals A and B agreed in the partnership agreement to share all partnership items 50–50. Subsequently, the value of the partnership’s property declined by $4,000, causing the partnership to have a “book” loss of $4,000. A lender agreed to reduce the principal of partnership debt by $2,000, causing the partnership to realize $2,000 of cancellation of indebtedness (COD) income. At that time, B was insolvent within the meaning of IRC §108(a). Instead of equally allocating the foregoing items, the partnership specially allocated all $2,000 of the COD income to B and specially allocated $1,000 of the book loss to A and the remaining $3,000 to B. The special allocations affected the partners’ capital accounts no differently than equal allocations would have affected them. However, the special allocations caused the partners in the aggregate to recognize less taxable income compared to equal allocations, because B could exclude from B’s gross income the $2,000 allocation of COD income.65 Consequently, the IRS ruled that the partnership’s special allocations lacked substantiality. (b)
Special Rules for Allocations of Nonrecourse Deductions
A partner’s tax basis in its partnership interest is increased by its share of partnership nonrecourse liabilities. Accordingly, if the partnership incurs indebtedness secured by its properties, such nonrecourse indebtedness will be allocated and added to the partner’s tax basis. Any reduction in such nonrecourse indebtedness is treated as a cash distribution for federal income tax purposes, although no cash is ever distributed. Under the IRC §704(b) regulations, allocations of nonrecourse deductions cannot have economic effect, because the lender bears the ultimate risk of loss.66 Accordingly, nonrecourse deductions must be allocated in accordance with the partners’ interests in the partnership.67 The §704(b) regulations, as amended by Treas. Reg. §1.704-2(e), provide that an allocation of losses attributable to nonrecourse debt will be deemed to be in accordance with the partners’ interests in the partnership if and only if: • The capital account maintenance rules are followed.68 • Liquidating distributions are made in accordance with capital account.69 62 63 64 65 66 67 68 69
See id. Reg. §1.704-1(b)(2)(iii)(c)(2). 1999-2 C.B. 506 (Oct. 18, 1999). IRC §108(a)(1)(B). Reg. §1.704-2(b)(1). See id. Reg. §1.704-2(e)(1); Reg. §1.704-1(b)(2)(ii)(b)(1). Reg. §1.704-2(e)(i); Reg. §1.704-1(b)(2)(ii)(b)(2).
䡲
114
䡲
c03.fm Page 115 Wednesday, March 7, 2007 6:58 PM
3.6 ALLOCATION OF PROFITS, LOSSES, AND CREDITS
• The partners have an unconditional deficit restoration obligation or agree
to a qualified income offset.70 • Allocations of nonrecourse deductions are made in a manner that is “rea-
sonably consistent” with allocations of some other partnership item attributable to the property securing the nonrecourse debt that has substantial economic effect other than “minimum gain.” 71 • All other material allocations are valid.72 • The partnership agreement contains a “minimum gain chargeback.”73
A minimum gain chargeback requires that when a decrease in minimum gain occurs before any other allocation of income, gain, loss, or deduction is made, each partner must be allocated items of income and gain for that year and, if necessary, for subsequent years, in proportion to and to the extent of the portion of such partner’s share of the net decrease in minimum gain.74 (c)
Reallocations in Accordance with the Partners’ Interests in the Partnership
Allocations of either (1) individual items of profit, gain, loss, or deduction or (2) bottom line income or loss that fail to have substantial economic effect under the safe harbor provisions discussed in Section 3.6(a) will be reallocated in accordance with the “partner’s interests in the partnership,“ based on the relevant facts and circumstances, including relative capital contributions, economic profits and losses, rights to capital distributions upon liquidation, and rights to cash flow and other nonliquidating distributions.75 A partner’s interest in the partnership is based on the manner in which the partners have agreed to share the economic benefit or burden with respect to the income, gain, loss, deduction, credit, or item thereof that is allocated.76 The §704(b) regulations do not indicate whether a partner’s interest in the partnership is to be determined solely with respect to the sharing ratio used in a particular taxable year, or whether an economic interest is to be determined over the expected life of the partnership. Under a special rule,77 if an allocation lacks economic effect due solely to the creation of a capital account deficit that the partner is not obligated to restore or resulting from the lack of a qualified income offset, the partner’s interest is determined by examination of how distributions will be made in the year of the allocation, as compared with the previous year, assuming that the partnership is liquidated at book value. In the case of nonrecourse deductions, it appears that any reallocations made under the “partners’ interests
70 71 72 73 74 75 76 77
Reg. §1.704-2(e)(1); Reg. §1.704-1(b)(2)(ii)(b)(3). Reg. §1.704-2(e)(2). Reg. §1.704-2(e)(4). Reg. §1.704-2(e)(3); see also Reg. §1.704-2(f). Reg. §1.704-2(f)(1); see also Reg. §1.704-2(g)(2). Reg. §1.704-1(b)(1)(i); see also Reg. §1.704-1(b)(3). Reg. §1.704-1(b)(3). Reg. §1.704-1(b)(2)(c).
䡲
115
䡲
c03.fm Page 116 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
in the partnership” test would be in accordance with the partners’ overall economic interests in the partnership.78
3.7
FORMATION OF PARTNERSHIP
Tax consequences of partnership formation mirror, to some extent, the nonrecognition treatment granted to shareholders on the formation of a corporation.79 The underlying rationale for this treatment is the belief that tax should not be imposed on mere changes in the form of holding property or doing business. As with its corporate counterpart, the tax treatment of partnership formation begins with a general rule that must be considered in light of several exceptions and special rules relating to it. (a)
Contribution of Property in Exchange for Partnership Interest
Under IRC §721, the contribution of “property” to a partnership in exchange for an interest in the partnership will not cause the contributing partner, or the partnership, to recognize gain or loss.80 This general nonrecognition rule applies equally to newly formed and preexisting partnerships.81 Assuming that the IRC §721 nonrecognition rules apply, a contributing partner’s basis will be a carryover basis (i.e., the precontribution adjusted basis of the property) under §722. If the contribution is made to a partnership in which the partner already has an interest, the partner’s basis is simply increased to reflect the additional contribution. In both cases, under §723, the partnership carries over the partner’s precontribution adjusted basis in the property plus the amount of any gain recognized on the transfer by the contributing partner.82 Several important exceptions to the nonrecognition rules merit attention. First, under §721(b), a contributing partner must recognize gain that is realized on an exchange of appreciated property to a partnership that would qualify as an “investment company” if the partnership were to incorporate.83 As described in detail in the following paragraphs, a partner contributing services to a partnership under some circumstances must recognize gain equal to the value of the partnership interest received for the services. The third exception, designed as an anti-abuse rule, is that a partner’s provision of services or contribution of 78 79 80
81 82 83
Reg. §1.704-1(b)(4)(iv); Reg. §1.704-2(b)(1). See generally §721 (nonrecognition for partnerships); §351 (nonrecognition for corporations). The term property is not defined in the Code for purposes of §721. The courts, however, have interpreted the term broadly. See, e.g., United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984) (contribution of letter of intent to partnership qualifies as property, even though letter of intent was unenforceable under state law). An important exception is that the provision of services alone will not qualify as “property” for purposes. The American Jobs Creation Act of 2004 (the Jobs Act) amended §108(e)(8) to provide that nonrecognition treatment under Section 721 is not necessarily available when a partnership transfers a partnership interest to a creditor in satisfaction of the debt. The partnership will recognize cancellation of indebtedness income to the extent the amount of the indebtedness exceeds the fair market value of the partnership interest transferred to the creditor. of §721. See Section 3.7(b). Reg. §1.721-1(a). Gain may be recognized to the contributing partner if the partnership qualifies as an investment company under §721(b). See Reg. §1.351-1(c)(1). Note that no losses would be recognized.
䡲
116
䡲
c03.fm Page 117 Wednesday, March 7, 2007 6:58 PM
3.7 FORMATION OF PARTNERSHIP
property to a partnership will be treated as a sale for tax purposes when a related distribution is made by the partnership to the partner in question.84 Finally, a partner can recognize gain on the contribution of encumbered property to a partnership. Under §752(b), a partner will be treated as having received a constructive cash distribution when (1) the partner contributes property with liabilities in excess of basis and (2) the partner is relieved of a portion of such liabilities as a result of the contribution. In such a case, the contributing partner’s basis in its partnership interest will be decreased by the portion of indebtedness assumed by the other partners of the partnership. Under §752(a), the other partners must increase their respective bases in the partnership, because their assumption of the contributor’s indebtedness is treated as a contribution of money by them to the partnership. EXAMPLE: TE, a tax-exempt organization, and FP, a for-profit entity, form a partnership (P) to provide food and shelter to the disadvantaged in City X. TE contributes cash in the amount of $1,000, and FP contributes various items of personal property worth $3,000 (with a basis of $1,000). Under the nonrecognition provisions of §721, neither TE nor FP will recognize any gain on the formation of the partnership. P’s basis in the personal property is $1,000. EXAMPLE: TE1 and TE2, two tax-exempt organizations involved in the construction of low-income housing, form a partnership (P) to build a facility consistent with their exempt purposes. TE1 contributes $350,000 in cash for a fifty percent interest in P, while TE2 transfers real property valued at $500,000 (with a basis of $100,000) subject to a mortgage of $150,000 in exchange for the other fifty percent interest. TE1 recognizes no gain or loss, and TE1’s basis in its P interest is $425,000 (cash contribution of $350,000 plus $75,000 of mortgage pursuant to §752(a)). P is treated as having assumed the $150,000 liability, with the result that TE2’s liabilities decrease by $150,000. At the same time, however, TE2’s share of liabilities increases by $75,000. TE2 thus receives a net constructive cash distribution of $75,000, giving it a basis in its interest in P of $25,000 ($100,000 basis in the property contributed minus the $75,000 share of the mortgage allocated to TE1 pursuant to §752(b)).85 P’s basis in the property is $100,000. EXAMPLE: The facts are the same as in the preceding example, except that the real property is subject to a mortgage of $250,000. P is treated as assuming the $250,000 liability, and TE2’s share of P’s liabilities increases by $125,000. TE2 recognizes a $25,000 capital gain from the sale or exchange of a partnership interest ($125,000 net constructive cash distribution minus $100,000 basis in the property contributed). The gain is added to TE2’s basis, with the result that TE2’s basis in its interest in P is $25,000.86 P’s basis in the property is $100,000. Under §704(c), when the basis and fair market value of the contributed property differ, any built-in gain or loss is allocated solely to the contributing partner 84 85 86
§707(a)(2). See Section 3.9(d). See Reg. §§1.722-1; 1.752-1(e), (f), (g). See id.
䡲
117
䡲
c03.fm Page 118 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
upon disposition of such property from the partnership.87 This rule prevents any precontribution gain or loss from being shifted to other partners in the partnership. Accordingly, under the facts presented in the second preceding example, any gain attributable to the $400,000 difference between the basis and value of the real property would be allocated to TE2. Section 707(c)(1)(C), as added by the Jobs Act, provides that built-in loss with respect to property contributed to a partnership by a partner is taken into account only by such contributing partner and no other partner. Thus, items attributable to such built-in loss are allocated only to the contributing partner. The basis to the partnership of the contributed property is treated as equal to its fair market value at the time of contribution in order to determine the amount of items allocated to noncontributing partners. The purpose of this new provision is to prevent built-in losses from being transferred from contributing partners to noncontributing partners. In addition to allocating the built-in gain or loss to the contributing partner upon disposition of the contributed property, Treasury regulations also require the partnership to allocate any cost recovery deductions, or depreciation, with respect to the contributed property, in a manner that reduces the amount of the built-in gain or loss.88 To do this, the partnership first must allocate tax depreciation deductions, with respect to the contributed property, to the noncontributing partners, up to the amount of their share of the book depreciation deductions. The remaining tax depreciation, if any, is then allocated to the contributing partner.89 The regulations permit three primary methods to be used to allocate the built in gain or loss during the period the partnership owns the property: (1) the “traditional” method,90 (2) the traditional method with curative allocations,91 and (3) the “remedial allocation” method.92 Under the traditional method, the partnership is required to allocate depreciation in a manner that reduces the amount of the built-in gain or loss with respect to the contributed property on a yearly basis.93 However, these allocations are subject to a “ceiling rule,” which applies whenever the total amount of tax basis depreciation is less than the amount of book depreciation. As a result of the ceiling rule, the total deductions allocated to the individual partners for tax purposes cannot exceed the aggregate partnership tax deductions.94
87
88 89 90 91 92 93 94
§704(c)(1)(B). Proposed amendments to Reg. §1.704-3(a)(8) provide (i) that an installment obligation received in exchange for Code §704(c) property is also Code §704(c) property and (ii) if a contract contributed to a partnership is Code §704(c) property, and the partnership receives property in accordance with the terms of the contract in a transaction in which less than 100 percent of the gain or loss is recognized, the property received is also Code §704(c) property. Reg. §1.704-3(a). See id. Reg. §1.704-3(b). Reg. §1.704-3(c). Reg. §1.704-3(d). Reg. §1.704-3(b)(1). See id.
䡲
118
䡲
c03.fm Page 119 Wednesday, March 7, 2007 6:58 PM
3.7 FORMATION OF PARTNERSHIP
EXAMPLE: A and B form the AB partnership and agree that each will have a 50 percent share of all partnership items. B contributes $10,000; A contributes property with an adjusted basis of $4,000 and a fair market value of $10,000. The contributed property is depreciated on a straight-line basis over 10 years. A has a built-in gain of $6,000, the excess of the partnership’s book value over A’s adjusted tax basis in the property at the time of contribution. Although each partner is allocated $500 of book depreciation per year, the partnership is allowed a tax depreciation deduction of only $400 per year (10 percent of $4,000). Under the regulations, B must be allocated tax depreciation up to the amount of his book depreciation. Thus, the $400 of tax depreciation is allocated entirely to B.A will not receive an allocation of tax depreciation, because none remains. Assume the proceeds generated by the depreciable property exactly equal AB’s operating expenses for the year. At year end, the adjusted book basis of the property is $9,000 ($10,000 less $1,000 book depreciation) and the adjusted tax basis is $3,600 ($4,000 less $400 tax depreciation). Because of the allocation, A’s built-in gain has decreased to $5,400 ($9,000 book value less $3,600 adjusted tax basis). B’s tax basis in his partnership interest is now $9,600 ($10,000 less $400 tax depreciation), but his capital account balance is $9,500 ($10,000 less $500 book depreciation). If, on day 1 of year 2, the property is sold for its book value, the partnership dissolved, and all cash distributed, A would be allocated the remaining built-in gain of $5,400. B would have a capital loss of $100 ($9,600 adjusted tax basis in his partnership interest less $9,500 cash distributed pursuant to his capital account). A would have a capital gain of $100 ($9,400 adjusted tax basis in her partnership interest less $9,500 cash distributed pursuant to her capital account).95
Under the second method, the partnership may make reasonable “curative allocations” to correct distortions in the timing and character of deductions due to operation of the ceiling rule.96 A curative allocation is an allocation made for tax purposes that differs from the partnership’s allocation of a corresponding book item.97 For example, if a noncontributing partner is allocated less tax than book depreciation because of the limitation of the ceiling rule, the partnership may make a curative allocation to that partner of tax depreciation from other partnership property to make up the difference.98 EXAMPLE: Assume the same facts as in the preceding example. In addition, the partnership purchases a piece of depreciable equipment for $2,000. This new property is depreciated on a straight-line basis over 10 years. To offset the operation of the ceiling rule, the partnership makes a curative allocation to B, for tax purposes, of an additional $100 of depreciation expense on the new asset. Thus, B
95 96 97 98
Reg. §1.704-3(b)(2), ex. 1. Reg. §1.704-3(c)(1). See id. See id.
䡲
119
䡲
c03.fm Page 120 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
would be allocated the entire $200 of depreciation expense on the newly purchased equipment for tax purposes, and A would be allocated nothing.99 At year end, B’s tax basis in his partnership interest would be $9,400 ($10,000 less $600 tax depreciation), and his capital account balance also would be $9,400 ($10,000 less $600 book depreciation). A’s tax basis in her partnership interest would be $4,000 ($4,000 less $0 tax depreciation), and her capital account balance would be $9,400 ($10,000 less $600 book depreciation). The remaining builtin gain of $5,400 is preserved in the contributed asset and would be allocated to A upon sale of the asset or dissolution of the partnership. Under the third method, a partnership may make “remedial allocations”— tax allocations created by the partnership that have no effect on the partnership’s book capital accounts—to eliminate distortions caused by application of the ceiling rule.100 If operation of the ceiling rule results in a book allocation to the noncontributing partner that is different from the corresponding tax allocation, the partnership may make a remedial allocation of income, gain, loss, or deduction to the noncontributing partner equal to that difference, and a simultaneous, offsetting remedial allocation to the contributing partner.101 (b)
Partnership Interest in Exchange for Services
Because IRC §721 applies only when property is contributed to a partnership, a partner who receives a partnership capital interest in exchange for services generally realizes ordinary income under §61.102 Under §83, which broadly applies 99
100 101 102
Reg. §1.704-3(c)(3)(iii). The partnership could achieve a similar result if it allocated an item of gross income to A, away from B, as long as it was of the same character (here, ordinary) as the deduction. For example, if the partnership did not have additional depreciation deductions available, but had rental income of $200 (which would normally be allocated $100 to A and B, respectively, for both book and tax purposes), the partnership could allocate B’s $100 of rental income to A, for tax purposes, achieving the same net tax result as if it had allocated B an additional $100 of depreciation expense. Reg. §1.704-3(d)(1). For an illustration of application of the remedial allocation method, see Reg. §1.704-3(d)(7), examples 1–3. Reg. §1.721-1(b)(1). Some commentators read Reg. §1.721-1(b)(1) and Prop. Reg. §1.7211(b)(1) to apply only to the receipt of an interest in partnership capital, as opposed to an interest in partnership profits. See Manning, “Choosing the Business Entity,” CCH Tax Trans. Lib. ¶ 503. Under this analysis, a service provider could take an interest in partnership profits without immediate (and possibly severe) tax consequences. See Campbell v. Commissioner, 443 F.2d 815 (8th Cir. 1991) (taxpayer not taxable on receipt of his partnership profits interest since interest had only speculative or no determinable value at the time of receipt). Other commentators and courts hold that an interest in future profits is taxable upon receipt. See generally Willis, Pennell, and Postelwaite, Partnership Taxation,Warren, Gorham, and Lamont (4th ed. 1989) §5.1; Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974) (partner’s receipt of interest in future profits as consideration for past services held taxable where value of interest is readily determinable and sold shortly after receipt). The Eighth Circuit’s holding in Campbell, supra, has reignited the debate and has encountered much criticism. See, e.g., Banoff, “Status of Service Partners Remains Unclear Despite Eighth Circuit’s Reversal in Campbell,” 75 J. Tax’n 268 (Nov. 1991). In Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS stated that it would not treat the receipt of a profits interest for the provision of services to a partnership as a taxable event for the partners or the partnership, unless: (i) the interest relates to a substantially certain and predictable stream or income; (ii) the partner disposes of the interest within two years; or (iii) the interest is a limited partnership interest in a “publicly traded” partnership.
䡲
120
䡲
c03.fm Page 121 Wednesday, March 7, 2007 6:58 PM
3.8 TAX BASIS IN PARTNERSHIP INTERESTS
to any person who receives property (i.e., the partnership interest) as compensation for the performance of past, present, or future services, the income will be realized upon its receipt if it is not subject to any restrictions. However, if the compensation is subject to a substantial risk of forfeiture or is nontransferable, the fair market value of the partnership interest will be included in the partner’s gross income only when these restrictions lapse.103 In either case, the partner providing the services will take a tax cost basis in the interest equal to the amount that is included in income. For its part, the partnership must treat the transfer of a partnership interest to a partner as a “guaranteed payment” when the receipt of the interest by the partner is taxable as compensation.104 Guaranteed payments that are ordinary and necessary business expenses may be deducted under IRC §162; those that are not are treated as capital expenditures under §707(c). Finally, if the service partner’s interest is subject to a substantial risk of forfeiture or is nontransferable under §83, the partnership can deduct the value of the interest only at the time the service partner recognizes income.105
3.8 (a)
TAX BASIS IN PARTNERSHIP INTERESTS Loss Limitation
Each partner is required to report on its federal income tax return its allocable share (as determined in accordance with the partnership agreement) of the partnership’s income, gains, losses, deductions, and credits.106 Under IRC §704(d), however, a partner must limit its deductible losses to the extent of the adjusted basis of its interest in the partnership at the end of the partnership year in which such loss occurred.107 This loss limitation rule merely acts to defer deductions; if a partner’s share of partnership loss exceeds that partner’s basis in its partnership interest at the end of any taxable year, such excess may be carried forward indefinitely and deducted prospectively, provided that such partner has additional basis in its interest at the end of any subsequent year. 103
104 105 106 107
§83(a); Prop. Reg. §1.721-1(b)(1)(i). Rev. Proc. 2001-43, clarifying Rev. Proc. 93-27, provides guidance on how to treat the grant of a nonvested profits interest in exchange for services. Whether the interest is a profits interest is to be determined at the time it is granted. If the requirements of Rev. Proc. 93-27 are met, Rev. Proc 2001-43 provides that neither the grant of the interest nor the event causing it to become substantially vested will be treated as a taxable event for the service provider or the partnership. Therefore, the service provider need not make a §83(b) election. Proposed Regulations 1.83-3(e) and (l) and 1.721-1(b) were added on May 25, 2005 to provide, when finalized, that Code §83 applies to all partnership interests granted in exchange for services, whether profits interests or capital interests. The proposed regulations address the taxability of the partnership interest to the recipient—that as a general rule the issuing partnership will not recognize gain or loss on the transfer or vesting of the partnership interest—and special rules dealing with the forfeiture of an unvested partnership interest. Once the proposed regulations are finalized, Rev. Proc. 93-27 and Rev. Proc. 2001-43 will be obsolete. Reg. §1.721-1(b)(2)(i). Guaranteed payments are discussed in greater detail at Section 3.9 (d)(iii). §83(h); Reg. §1.83-6(a)(4). §704(b). This treatment corresponds to and is consistent with the rules that require a partner to reduce its basis in its partnership interest (but not below zero) by its share of partnership losses. §705(a)(2)(A).
䡲
121
䡲
c03.fm Page 122 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
The loss limitation rule forces partners to pay careful attention to the basis of their partnership interests. To some extent, partners can plan to avoid the loss limitation rule by maintaining sufficient basis in their interests. They may do so either by contributing additional property to the partnership or by incurring additional liabilities such as nonrecourse debt.108 EXAMPLE: A and B are equal partners in the AB partnership. A contributes property with a basis of $100,000 and value of $1,000,000 to AB, and B contributes $1,000,000 in cash. A and B each have a share of partnership losses in the amount of $150,000. B can deduct his share of the loss in full. Under §704(d), however, A will be limited to an allowable loss of $100,000, unless A increases his outside basis (by contributing property or cash, etc.). The $50,000 of disallowed loss will be suspended and may be used in later years against any available additional basis. (b)
Basis
The loss limitation rule is one of many tax items that cannot be determined without first calculating a partner’s basis in its partnership interest. Likewise, calculations for many items on a partnership’s IRS Form 1065 depend on a partnership’s basis in its assets. A brief discussion of how a partner and a partnership calculate their respective bases follows. (i) Partner’s Basis in Partnership Interest (Outside Basis). A partner’s basis in its partnership interest (“outside basis”) is generally equal to the amount of money and the adjusted basis of any property contributed by the partner to the partnership.109 This outside basis is increased by such items as the partner’s share of (1) partnership taxable income, (2) partnership nonrecourse liabilities, and (3) partnership recourse liabilities to the extent that the partner bears the “economic risk of loss” of such liability, and is reduced (but not below zero) by the partner’s share of partnership distributions and losses.110 The IRS requires distributions to be taken into account before losses in computing a partner’s adjusted basis for its interest.111 108
109 110
111
Under §752, an increase in a partner’s share of partnership liabilities would be treated as a contribution of money to the partnership. Accordingly, a partner’s basis in his or her partnership interest would be increased. Reg. §1.752-1(e). See discussion of §752 at Section 3.8(c). §722. See §742 to determine the basis of an interest in a partnership acquired other than by contribution. See generally §§705; 733. §705 also requires positive adjustments to outside basis for a partner’s additional contributions to the partnership, as well as the partner’s distributive share of tax-exempt income and deductions for depletion that exceed the basis of the depletable property. Negative adjustments under §705 also include a partner’s share of nondeductible partnership expenditures and the amount of the partner’s deduction for depletion with respect to oil and gas wells. See Rev. Rul. 96-11, 1996-1 C.B. 365 (partnership’s charitable contribution of property decreased each partner’s basis in the partnership interest by the partner’s share of the partnership’s basis in the contributed property); Rev. Rul. 96-10, 1996-1 C.B. 138 (if a loss on the sale of partnership property to a related party is disallowed under §707(b)(1), the basis of each partner’s interest in the partnership is to be decreased by the partner’s share of the loss to preserve the intended detriment of not allowing losses from sales or exchanges between partnerships and related parties to be deducted (i.e., without basis reduction, partners could subsequently recognize loss by disposing of their partnership interests)). Rev. Rul. 66-94, 1966-1 C.B. 166.
䡲
122
䡲
c03.fm Page 123 Wednesday, March 7, 2007 6:58 PM
3.8 TAX BASIS IN PARTNERSHIP INTERESTS
EXAMPLE: Partner X has a $20,000 outside basis in the XYZ partnership. X, a onethird partner, receives $15,000 of cash distributions from XYZ, and X’s distributive share of partnership losses is $7,000. X’s outside basis for the taxable year would be zero ($20,000 less cash received [$15,000] less share of losses [$7,000], but not below zero). If XYZ had borrowed $21,000 from a commercial lender during the year in question, X’s share of the nonrecourse liability would have increased X’s basis by $7,000. Accordingly, X’s adjusted basis for its interest would be $5,000 at year’s end. (ii) Partnership’s Basis in its Assets (Inside Basis). A partnership’s basis in partnership property is referred to as “inside basis.” As a general rule, a partner’s outside basis is intended to be symmetrical with, if not identical to, its proportionate share of all partnership property (inside basis). The Code imposes a series of carryover basis and basis adjustment rules to preserve this symmetry.112 Not unexpectedly, many types of day-to-day partnership transactions upset the symmetry between inside and outside basis. For example, the carryover basis rules under IRC §722 and §723 will not apply when a partner acquires an interest by some method other than contributing property to the partnership. For example, when a partner acquires a partnership interest by purchase or inheritance, the basis in that interest is likely to be different from that of the transferor partner. Under the general provisions of §743(a), the transferee partner does not make an adjustment to the basis of partnership property on account of the transfer of a partnership interest by sale, exchange, or on the death of a partner. An exception to this general rule applies, however, when the partnership makes an election pursuant to §754 of the Code to adjust the basis of its assets under §743(b).113 This optional adjustment to the basis of partnership property under §743(b) applies “with respect to the transferee partner only,” and serves to put the new partner in the same position as if it had bought a proportionate share of partnership assets directly.114 Similarly, a §754 election can trigger a basis adjustment under §734(b) with respect to partnership distributions. The general rule under §734(a) is that a partnership does not adjust the basis of its assets when it distributes property to its partner. Again, however, a §754 election permits a partnership under §734(b) to increase or decrease the basis in its remaining assets upon the distribution of partnership assets that have increased or decreased in value. This inside basis adjustment under §734(b) benefits or harms the remaining partners, as the case may be, and corrects the imbalances to basis that result from distributions of partnership property.
112
113
114
See, e.g., §722; §723 (relating to carryover basis) and §705(a); §733 (relating to basis adjustments). Reg. §1.723-1 notes that because the partnership basis in the property is the same as the basis in the hands of the contributing partner, “the holding period of such property for the partnership includes the period during which it was held by the partner.” A §754 election is filed by a partnership in order to adjust the basis of partnership property under §734; §743. Once made, the §754 election applies to all distributions and transfers during the taxable year “with respect to which such election was filed.” Reg. §1.754-1. As a general rule, the adjustment under §743(b) should be made—pursuant to a sale, exchange, or inheritance of a partnership interest—whenever the outside basis exceeds the inside basis of the partnership. Once made, it can cause downward adjustments.
䡲
123
䡲
c03.fm Page 124 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
The Jobs Act amended §743(b) (subject to certain exceptions) and Section 734(b) to provide a mandatory basis adjustment with respect to the transfer of a partnership interest and distribution of partnership property, respectively, when the partnership has a substantial built-in loss (greater than $250,000). The basis adjustment is required whether a §754 election is in effect at the time of the transfer or distribution or not. Notice 2005-32 provides interim procedures to comply with the mandatory basis adjustment provisions. Partnership losses can similarly create or increase a disparity between inside and outside basis. When a partnership suffers a loss, inside basis and a partner’s capital account will be reduced.115 As discussed in Section 3.8(b)(i), a partner’s outside basis will also be reduced, but not below zero. Consequently, a partnership loss in excess of a partner’s outside basis may reduce that basis only to zero, whereas the inside basis can be reduced by the full amount of the loss. EXAMPLE: A, B, and C are equal partners in the ABC partnership, which is involved in constructing housing for the elderly poor. A has a $10,000 basis in her interest, which is valued at $40,000. ABC has an inside basis of $30,000, but its assets are valued at $120,000. Upon A’s death, her ABC interest is bequeathed to TE, a tax-exempt organization involved in low-income housing work. As a result of the bequest, TE takes a $40,000 stepped-up basis in the ABC interest under §1014 of the Code. Assuming that a §754 election is made (and a concomitant basis adjustment is made under §743(b)), TE’s share of ABC’s inside basis will increase to $40,000 ($10,000 original inside basis attributable to TE plus $30,000 to account for the appreciation in value of A’s interest). However, if A had gifted the partnership interest to TE prior to her death, ABC would not take a stepped-up basis, because the gift of a partnership interest does not qualify as a transfer “by sale or exchange or on the death of a partner” under §743. (iii) Exempt Organization’s Basis. An exempt organization’s basis in a partnership is determined in the same manner as a nonexempt partner’s basis. The exempt organization receives a basis equal to the money contributed by the organization to the partnership, plus the adjusted basis of any property contributed.116 If the property contributed to the partnership by the exempt organization is donated property, the basis must be calculated as required for gifted property. Exempt organizations regularly receive donations to supplement their income and operations. Donations in the form of money and property are designated as charitable gifts from donors. Under IRC §1015, gifts received have a taxable basis equal to the donor’s adjusted basis in the property at the time of the gift, or a “carryover basis.” Therefore, an exempt organization’s basis in donated property is equal to the donor’s adjusted basis in the property. Furthermore, the donor receives a tax deduction under §170, which is generally equal to the fair market value of the donated property.
115 116
See Reg. §1.705-1(a)(1). IRC §722.
䡲
124
䡲
c03.fm Page 125 Wednesday, March 7, 2007 6:58 PM
3.8 TAX BASIS IN PARTNERSHIP INTERESTS
EXAMPLE: N, a nonprofit organization, receives property with a fair market value of $20,000 and an adjusted basis of $15,000. Because N receives a carryover basis in donated property, N’s basis in the property is $15,000. Furthermore, the donor of the property will be entitled to a charitable contribution deduction of $20,000 (fair market value of the property) on her individual income tax return. When an exempt organization subsequently contributes donated property to a partnership, the exempt organization receives a basis in the partnership equal to the adjusted basis of the property contributed.117 Likewise, the partnership receives a carryover basis equal to the exempt organization’s basis in the property.118 EXAMPLE: N forms a partnership with P, a for-profit company. P contributes $20,000 in cash to the partnership in exchange for a 50 percent interest. N contributes the property donated to it in the above example. Consequently, N will receive a partnership interest equal to the adjusted basis of the property contributed. The fair market value of the property is $20,000; therefore N will receive a 50 percent interest in the partnership. The partnership will receive a carryover basis in the property equal to $15,000. (c)
Liabilities and Economic Risk of Loss
The treatment of partnership liabilities for purposes of determining a partner’s basis in its partnership interest is governed by IRC §752 and the regulations thereunder. Under §752, a partner receives basis in partnership recourse liabilities only to the extent that the partner bears the “economic risk of loss” with respect to such debt.119 Stated differently, deductions and basis attributable to a liability will be allocated only to those partners who would bear the economic burden associated with those deductions and basis.120 Accordingly, a liability will be considered nonrecourse only if no partner bears a risk of loss.121 In determining the allocation of nonrecourse liabilities among partners, however, the economic risk of loss concept offers little in the way of guidance. It is the nonrecourse lender, rather than the partners, who bears the economic risk of loss of a decline in the value of a security.122 The regulations under §752 therefore provide a safe harbor under which allocations of nonrecourse deductions are deemed to be in accordance with the partners’ interests in the partnership. 117 118 119
120 121 122
Id IRC §723. Reg. §§1.752-1 and -3. Proposed Regulation §1.752-2(k) was issued August 12, 2004. It provides that in determining the extent to which a partner that is a disregarded entity under Regs. 301.7701-1 through 301.7701-3 bears the economic risk of loss for a partnership liability, such a partner shall have a payment obligation only to the extent of the “net value” of the disregarded entity as of the date its share of partnership liabilities is determined. In addition, final Regs. 1.752-7 were issued on May 26, 2005. They ensure that tax losses cannot be duplicated by transferring contingent obligations to a partnership. Reg. §1.704-2(b)(3). Reg. §1.752-3(a)(1). See generally Reg. §1.704-2(b)(1).
䡲
125
䡲
c03.fm Page 126 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
Accordingly, nonrecourse liabilities are allocated as follows: first, to the extent of each partner’s share of “minimum gain” with respect to the property that secures such nonrecourse debt;123 second, to each partner to the extent of any gain that would be allocated to such partner under the principles of §704(c) were the partnership to dispose of the property that secures nonrecourse debt in a taxable transaction in full satisfaction of the debt but for no other consideration;124 and third, in accordance with the manner in which the partners share profits.125 The partnership agreement may specify the sharing ratio to be used in allocating excess nonrecourse liabilities. However, the allocation must be “reasonably consistent with” the allocation of a significant item of partnership income or gain and must have “substantial economic effect.”126 A partner will bear the “economic risk of loss” with respect to a recourse liability to the extent that the partner would be obliged to make a payment to a creditor or a contribution to the partnership under the circumstances of a hypothetical “constructive liquidation” scenario.”127 In this liquidation scenario (1) the partnership liabilities become due and payable in full, (2) all of the partnership’s assets become worthless, (3) the partnership disposes of its assets in liquidation for no consideration other than relief from nonrecourse liabilities, and (4) the partnership allocates gain or loss in such liquidation in accordance with the partnership agreement and liquidates the interests of the partners. For purposes of these constructive liquidation rules, any liability of a person related to the partner will be
123 124 125 126
127
Reg. §1.752-3(a)(1). Minimum gain exists to the extent that the amount of the liability exceeds the property’s adjusted tax basis. Reg. §1.752-3(a)(2). Reg. §1.752-3(a)(3). Reg. §1.752-3(a)(3). See also the regulations under §704(b). See also Rev. Rul. 95-41, 19951 C.B. 132, explaining the manner in which §704(c) affects the allocation of partnership nonrecourse liabilities among partners. Under Reg. §1.752-3(a)(3), a partnership must allocate its “excess nonrecourse-liabilities” based on the partners’ respective shares of partnership profits. Traditionally, a partnership may determine the partners’ profits interests for this purpose using either of two methods. First, the partnership agreement may specify profits interests that are reasonably consistent with allocations (having substantial economic effect) of some other significant item of partnership income or gain. Second, excess nonrecourse liabilities may be allocated among the partners based on how the parties reasonably expect the partnership to allocate associated deductions. Reg. §1.752-3(a)(3). Reg. §1.752-3(a)(3) was amended to provide a third permissible method for allocating excess nonrecourse liabilities. This method becomes relevant when a partnership’s total built-in gain under IRC §704(c) exceeds the amount of “§704(c) minimum gain” on the basis of which liabilities are allocated under tier 2 (Reg. §1.752-3(a)(2)). Under this new method, a partnership may first allocate an excess nonrecourse liability to a partner in the amount by which the total §704(c) built-in gain allocable to the partner exceeds the §704(c) minimum gain accounted for under tier 2. Any remaining amount of that excess nonrecourse liability must be allocated among the partners using one of the other permissible methods. In general, a partnership may use this new method only for a liability incurred or assumed on or after October 31, 2000. However, a partnership at its option may rely on the new method for any liability it incurred or assumed before October 31, 2000, for taxable years ending on or after that date. Reg. §1.752-5(a). Reg. §1.752-2(b). Proposed Regulations §1.752-2(k) provides that in determining the extent to which a partner bears the economic risk of loss for a partnership liability, obligations of a disregarded entity are taken into account only to the extent of the net value of the disregarded entity. This limitation does not apply to an obligation of a disregarded entity to the extent that the owner of the disregarded entity otherwise is required to make a payment with respect to such obligation of the disregarded entity.
䡲
126
䡲
c03.fm Page 127 Wednesday, March 7, 2007 6:58 PM
3.8 TAX BASIS IN PARTNERSHIP INTERESTS
treated as part of the economic risk of loss borne by such partner.128 Moreover, a partner will not bear an economic risk of loss with respect to any payments to a creditor or contributions to the partnership if the partner would be entitled to reimbursement from another partner, a person related to another partner, or the partnership. Under IRC §752(a), increases in partnership liabilities or assumptions by a partner of the liabilities of a partnership are treated as cash contributions by the partner to the partnership. As a result, the partner receives an increase in the adjusted basis of its interest (and a concomitant increase in its distributive share of any partnership loss under §704(d)). Conversely, under §752(b), any decrease in a partnership’s liabilities or any assumption by the partnership of a partner’s liabilities is treated as a distribution of money.129 The effect of such a distribution is to limit the partner’s distributive share of any partnership losses. EXAMPLE: X and Y are equal partners in the XY partnership. In exchange for its 50 percent interest, X contributes real property that is worth $300,000, has an adjusted basis of $100,000, and is encumbered by a $60,000 mortgage. Y contributes $240,000 in cash. X and Y each are considered to bear $30,000 of the mortgage contributed by X. Accordingly, under IRC §752(b), X is deemed to have $30,000 of debt relief and is treated as receiving a $30,000 distribution of cash from XY. X’s adjusted basis would thus be $70,000 ($100,000 basis less portion of liability treated as cash contribution ($30,000)). Y’s outside basis would be increased under §752(a) to $270,000 ($240,000 basis plus portion of liability treated as cash contribution by Y ($30,000)). The following example illustrates the operation of the economic risk of loss rules under the IRC §752 regulations. EXAMPLE: X and Y, two tax-exempt organizations in the business of developing low-income housing, form partnership XY with equal contributions of $5,000. XY purchases land from a third party for $10,000 in cash and a $90,000 mortgage note. The note is a general obligation of the partnership; that is, no partner has been relieved from personal responsibility. The XY partnership agreement provides for profits and losses to be divided 40 percent to X and 60 percent to Y, and requires X and Y to restore any deficits in their respective capital accounts. On a hypothetical constructive liquidation (as described earlier), X’s capital account would reflect a deficit of $35,000 ($5,000 contribution less $40,000 share of loss) and Y’s capital account would reflect a deficit of $55,000 ($5,000 contribution less $50,000 share of loss). Both X and Y would have to restore their capital accounts. Accordingly, the $90,000 mortgage note is a recourse liability, because X and Y bear the economic risk of loss with respect to the liability. X’s share of the liability is $35,000, and Y’s share is $55,000.130
128 129 130
Reg. §1.752-4(b) defines “related person” for purposes of these partnership liability rules. See, e.g., LTR 96-22-014 (a partner’s share of partnership recourse liabilities decreased as a result of indemnification by an assignee). See Reg. §1.752-2(f), Example 2.
䡲
127
䡲
c03.fm Page 128 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
(d)
Loss Deferral Provision
Under §470 of the American Jobs Creation Act of 2004 (H.R. 4520), a partnership is now prohibited from deducting losses relating to “tax-exempt use of property” in excess of the income or gain from that property.131 Generally, §470(a) provides that a “tax-exempt use loss” for any taxable year will not be allowed.132 Section 470(c)(1) defines “tax-exempt use loss” as the amount by which the aggregate of all deductions (other than interest) directly allocable to “tax-exempt use property” (plus the aggregate deductions for interest properly allocable to such property) exceeds the aggregate income from such property.133 Under §470(b), any “tax-exempt use loss” relating to “tax-exempt use property” that is then disallowable for a taxable year is treated as a deduction with respect to such property in the next taxable year.134 If, and when, the taxpayer disposes of its entire interest in the property, §470(e)(2) provides that rules similar to those of §469(g) will apply.135 Under these provisions (similar to the passive activity loss rules), the taxpayer should generally be able to then deduct any previously disallowed deductions and losses when it completely disposes of its interest in the property.136
3.9 (a)
PARTNERSHIP OPERATIONS Overview
Individuals, businesses, or tax-exempt entities that wish to operate in partnership form must take into consideration two general points. The first of these considerations relates to federal income tax consequences. As indicated throughout this chapter, the Code generally taxes a partnership’s profits and losses to the individual partners, and not to the partnership. Accordingly, potential partners must consider the tax consequences of a partnership operation at the partner level. Second, as a nontax matter, partnerships essentially turn on contractual arrangements. That is, although no particular formalities are required to create a partnership, a written partnership agreement enables partners to govern themselves and arrange all business activities and decisions among themselves.137 In the absence of such an agreement, state adaptations of the Uniform Partnership Act (UPA), the Uniform Limited Partnership Act (ULPA), or the revised Uniform Limited Partnership Act (RULPA) may govern the legal relationships and business dealings among partners, and between partners and third parties dealing with the partnership.
131 132 133 134 135 136 137
American Jobs Creation Act of 2004, H.R. 4520, 111th Cong. §470 (2004). Id. at §470(a). §470(c)(1); see Section 10.6(a) for further discussion of tax exempt use property. 470(b). See §469(g)(providing rules involving a total disposition of interests in a passive activity); §470(e)(2). Id. A written partnership agreement may also enable the partners to establish that the partnership’s allocations satisfy the previously described substantial economic effect test.
䡲
128
䡲
c03.fm Page 129 Wednesday, March 7, 2007 6:58 PM
3.9 PARTNERSHIP OPERATIONS
The brief discussions of organizational expenses and depreciation that follow demonstrate how tax considerations and business planning in the partnership agreement affect the day-to-day operations of a partnership. (b)
Partnership Organizational Expenses
The organization of a partnership may require a variety of costs and expenses. In general, such costs and expenses, as well as expenses incurred in promotion and sale of partnership interests (i.e., syndication expenses), are not deductible.138 Any such amounts must be capitalized and are deductible, if at all, upon the termination of the partnership. Under IRC §709(b), however, a partnership may elect to amortize partnership “organizational expenses” over a 60-month period, commencing with the month in which the partnership begins business.139 Organizational expenses are defined as expenses that are incident to the creation of partnership, are chargeable to its capital account, and are of a character which, if a partnership had an ascertainable life, would be amortized over such life.140 Such expenses include filing fees and legal and accounting fees for services incident to the organization of the partnership, but do not include expenses incurred in connection with the acquisition of assets, the admission or withdrawal of partners, or syndication costs.141 EXAMPLE: Two hospital centers, associated with public universities and exempt from federal income tax, form a partnership to develop and utilize a new radiation technology. The hospitals are interested in additional partners and decide to target other hospitals and medical groups in their area. Accordingly, attorneys for the hospital centers draw up the appropriate syndication documents and provide both the organizing and potential partners with sufficient detail as to securities law and tax law issues in a private placement memorandum. On related facts, the Tax Court has held that legal fees for tax advice—generally deductible under IRC §212(3)— must be capitalized when such advice is “an integral part of the offering prospectus and was . . . included therein to facilitate the sale of partnership interests.”142 (c)
Cost Recovery: Modified Accelerated Cost Recovery System
As a general rule, a partnership will use the same method of depreciation as that used by the contributing partner.143 This rule is consistent with the nonrecognition provisions regarding contributions of property to partnerships, that is, that any deductions for depreciation taken by the partnership would be the same as
138 139
140 141 142 143
§709(a). Note, however, that expenses for advice in connection with the determination, collection, or refund of any tax is generally deductible under §212(3). §709(b)(1). The partnership makes the election by attaching a statement to the partnership’s return of income for the taxable year in which the partnership begins business. Reg. §1.7091(c). See generally Rev. Rul. 87-111, 1987-2 C.B. 160. §709(b)(2). Reg. §1.709-2(a). Diamond v. Commissioner, 92 T.C. 423, 446 (1989) (citing Surloff v. Commissioner, 812 T.C. 210, 245 (1983)). §168(i)(7). However, the partnership, and not any individual partner, makes the election to determine which method is to be used to recover the cost of depreciable assets. §703(b).
䡲
129
䡲
c03.fm Page 130 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
if the contributing partner retained ownership and took the depreciation deductions associated with the property itself. An important limitation on depreciation deductions applies when “taxexempt use property” is either used by or leased to tax-exempt entities or partnerships when such entities are involved.”144 In particular, such property is denied depreciation under the modified accelerated cost recovery systems (MACRS) and is instead subject to depreciation using the straight-line method over a recovery period equal to the greater of the depreciation periods established under an alternative depreciation system in MACRS, or 125 percent of the lease term. When a partnership sells property on which it has taken depreciation deductions, “depreciation recapture” must be treated as ordinary income even if the gain on the sale otherwise would qualify as capital gain.145 The recapture requirement is based on the rationale that the partnership has enjoyed the benefit of taking depreciation deductions against ordinary income. In general, a partnership must allocate depreciation recapture income among its partners in the same percentages in which the associated depreciation deductions have been allocated. Thus, if the partnership specially allocated the depreciation deductions, the partnership must allocate the recapture income in the same percentages.146 (d)
Transactions Between Partner and Partnership
Partners are generally taxed on their “distributive shares” of partnership income and deductions (i.e., such payments represent the partners’ annual return on their interests in the partnership and are generally based on the partners’ contributed capital and any services they may render in their capacities as partners). Partners may also receive taxable payments from their partnerships resulting from services provided to the partnerships in a capacity other than as a partner. Special rules under IRC §707 govern the tax treatment of these payments. The rules are described in the following paragraphs. (i) Payments to partner acting in capacity as nonpartner. Under IRC §707(a), payments from a partnership to a partner in connection with a “transaction” in which the partner is acting other than in its capacity as a partner are treated in all respects as payments between the partnership and a nonpartner.147 Consequently, payments for services or for the use of property or money that qualify as §707(a) payments will always be ordinary income to the recipient partner, and 144 145 146 147
“Tax-exempt use property” is generally defined in §168(h). For a detailed discussion of taxexempt use property and related tax-exempt entity leasing, see Chapter 11. §1245(a)(1), §1250(a)(1). Reg. §§1.1245-1(e)(2), 1.1250-1(f). In codifying §707(a) as part of the 1954 Code, Congress specifically rejected the “aggregate theory” of partnerships, i.e., that a partnership and its partners are one inseparable legal unit, in favor of the “entity theory.” Under the entity approach, transactions involving sales of property or the performance of services between a partner and his or her partnership are treated in the same manner as though the partner were an outsider dealing with the partnership. See H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 67 (1954), U.S. Code Cong., & Admin. News 1954, pp. 4025, 4093. Consequently, a partner may stand in a number of relationships with his or her partnership, including creditor-debtor, employee-employer, and vendor-vendee. Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968).
䡲
130
䡲
c03.fm Page 131 Wednesday, March 7, 2007 6:58 PM
3.9 PARTNERSHIP OPERATIONS
will enable the partnership to deduct such payments as an ordinary business expense in the taxable year for which the partner reports the payments as income. The substance of any particular transaction, rather than its form, will determine whether the transaction is between a partnership and a partner in that partner’s capacity as such.148 Nonpartner status is likely to result when a partner acts in an independent capacity or renders services of a limited technical nature or in connection with a limited transaction. EXAMPLE: Partnership XYZ invests in securities. A, one of the general partners, directed XYZ’s investment choices and was compensated with 10 percent of the partnership’s gross income. On these facts, the IRS has ruled that the compensation to partner A fell within the scope of IRC §707(a). The IRS noted in its ruling that (1) the advisor-partner was in the trade or business of providing investment advice, (2) the general partners as a group supervised the advisor-partner, (3) the general partners could remove partner A from its advisory role, and (4) partner A paid its own expenses and was not liable to the partnership for losses incurred on the investments.149 As part of the Tax Reform Act of 1984, Congress added IRC §707(a)(2), which authorized the Treasury to promulgate regulations that will treat a distribution from a partnership and a related transfer of property or services to the partnership as a single transaction. That is, if (1) a partner provides services for, or transfers property to, a partnership, (2) the partnership makes a related distribution or allocation to such partner, and (3) the services or property and related distribution or allocation “when viewed together, are property characterized as a transaction occurring between the partnership and a [non]partner,” then the transaction will be characterized as such.150 (ii) Sale of Property Between Partnership and Related Party. As discussed earlier, bonafide sales or exchanges of property by a partner to a partnership, and vice versa, are generally treated under IRC §707(a) as transactions between unrelated parties. To ensure that this treatment of a partner as a third party would not be abused, Congress placed limitations on certain sales with respect to controlled partnerships. Under §707(b), losses are disallowed on sales or exchanges of property between partnerships and partners who directly or indirectly own more than a 50 percent interest in partnership capital or profits.151 Section 707(b) also applies to sales or exchanges of property between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the
148 149
150 151
Reg. §1.707-1(a). Rev. Rul. 81-301, 1981-2 C.B. 144. But see Pratt v. Comm’r, 64 T.C. 203 (1975) (partner acts as a partner when he performs services that are ongoing and integral to the business of the partnership), rev’d in part, 550 F.2d 1023 (5th Cir. 1977). §707(a)(2)(A); §707(a)(2)(B) addresses the related issue of disguised sales. The attribution rules of §267(c) are applied to determine indirect ownership of a partnership interest.
䡲
131
䡲
c03.fm Page 132 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
capital or profits interests.152 These disallowance provisions, however, do not apply to the sale of a partnership interest by a partner to its partnership. Once a loss is disallowed under IRC §707(b), any gain realized on a subsequent disposition of the property is recognized only to the extent that it exceeds the loss that was disallowed on the original partner-partnership transaction. EXAMPLE: X, who has a 75 percent capital or profits interest in the XY partnership, sells property with an adjusted basis of $20,000 to the partnership for $16,000. Under IRC §707(b)(1), the $4,000 loss to X is disallowed. If the partnership later sells the property to an unrelated party for $28,000, it has a taxable gain of $12,000 over its initial cost of $16,000. This economic gain belongs to X and Y in accordance with their profit and loss ratios: $9,000 to X and $3,000 to Y. However, because of the limitations on subsequent sales of property in §707(b)(1), only $8,000 of this gain is recognized ($12,000 gain less the $4,000 loss disallowed X). Under IRC §707(b)(2), any gain on the sale or exchange of property (other than a §1221 capital asset) is treated as ordinary income if the transaction is between a partnership and a partner owing more than 50 percent interest in capital or profits, or between two partnerships in which the same persons own more than 50 percent of the capital or profits. EXAMPLE: X, who is a 75 percent partner in the XY partnership, sells a copying machine with a $2,000 tax basis to the partnership for $2,500. Under IRC §707(b)(2)(A), the $500 gain to X will be treated as ordinary income and not as a capital gain. Under IRC §707(a)(2)(B), a contribution of property by a partner to a partnership, followed by a related distribution of money or other consideration by the partnership to the partner, can be recharacterized as a “disguised sale” of the property.153 A disguised sale occurs when the partnership would not have made the distribution to the partner “but for” the partner’s contribution of the property.154 The disguised sale rule is intended to prevent the parties from structuring a sale or exchange of property as a nontaxable contribution (under §721) and distribution (under §731) to avoid tax on the transaction.155 If the contribution and related distribution are recharacterized as a “disguised sale” under §707(a)(2)(B), then the transaction is treated as a sale or exchange between the partnership and a person acting in a capacity other than as a member of the partnership for all purposes of the Code.156 The determination of whether the contribution and distribution could be characterized as a disguised sale is made based on all the facts and circumstances surrounding the transfers.157 In some instances, the assumption of, or taking property subject to, certain liabilities may also be construed as a disguised sale.158 152 153 154 155 156 157 158
§267 of the Code, and not §707(b), applies to losses between partnerships and persons related to partners. Reg. §1.267(b)-1(b). Reg. §1.707-3(a)(3)(B)(1). See id. H.R. Conf. Rep. 861, 98th Cong., 2d Sess. (1984), 1984-3 C.B. 859, 861. PS-163-84, 1991-1 C.B. 951, 953 preamble. Reg. §1.707-3(a)(3)(B)(1). Reg. §1.707-5(a).
䡲
132
䡲
c03.fm Page 133 Wednesday, March 7, 2007 6:58 PM
3.9 PARTNERSHIP OPERATIONS
Transfers between a partner and a partnership within a two-year period (which are not considered a guaranteed payment or a net distribution of a partner’s cash flow from operations under the regulations), are presumed to be a sale, unless the facts and circumstances surrounding the transfers clearly establish otherwise.159 If such transfers occur within the two-year period, the partnership must disclose the facts of the transaction to the IRS through a completed Form 8275, “Disclosure Statement.”160 (iii) Guaranteed Payments. Under IRC §707(c), payments by a partnership to a partner for services or for the use of capital, if determined without regard to the income of the partnership, are considered “guaranteed payments.”161 Partnerships are entitled to deduct guaranteed payments to partners as ordinary and necessary business expenses under §162(a). The partnership, however, must meet the same tests under §162(a) as it would if the payment had been made to a person who is not a member of the partnership, and the rules of §263 (relating to capital expenditures) must be taken into account.162 In addition to being deductible by the partnership, guaranteed payments are taxable to the partner as ordinary income regardless of the amount or character of the partnership’s taxable income.163 Guaranteed payments are similar to payments under IRC §707(a) in that they are fixed payments for services or for the use of property, and they are treated for some tax purposes as made to a person who is not a member of the partnership (i.e., ordinary income treatment for partner and deductibility for partnership). However, there are two important distinctions between payments made under §707(a) and those made under §707(c). First, guaranteed payments resemble distributive shares in that they relate to services or contributed property that is an integral part of the partnership’s activities. That is, the partner must receive the payment in its capacity as a partner. Second, for timing purposes, guaranteed payments resemble distributive shares in that they are included in income for a partner’s taxable year within, or with which ends, the partnership taxable year in which the partnership deducted such payments as paid or accrued under its method of accounting.164 To this extent, a cash basis partner is treated as if it were on the accrual method of accounting. The following examples illustrate the mechanics of structuring guaranteed payments, as well as the problems in categorizing certain payments made at the partnership level as guaranteed payments. EXAMPLE: Under the XYZ partnership agreement, partner A is entitled to a 10 percent interest in XYZ’s profits and losses. In addition, partner A is entitled to a $10,000 payment for ordinary and necessary services rendered to the partnership. Assuming that XYZ has ordinary taxable income for the year of $100,000, the 159 160 161 162 163 164
Reg. §1.707-3(c)(1). Reg. §1.707-8. See Reg. §1.707-1(c). Reg. §1.707-1(e). Reg. §1.707-1(c). Reg. §1.707-1(c).
䡲
133
䡲
c03.fm Page 134 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
effect of the guaranteed payment is to reduce XYZ’s taxable income to $90,000. Accordingly, partner A must include $19,000 as ordinary income for its taxable year within or with which the partnership taxable year ends ($10,000 guaranteed payment plus $9,000 distributive share). EXAMPLE: GP, the general partner of a limited partnership engaged in shopping center development, received a management fee of 5 percent of the gross rentals of the various developments, pursuant to identical limited partnership agreements. On these facts, the Tax Court has held that the management fee was not a guaranteed payment, because the payments to GP were not made “without regard to the income of the partnership” (Pratt v. Commissioner, 64 T. C. 203 (1975), rev’d in part, 550 F. 2d 1023 (5th Cir. 1977). But see Rev. Rul. 81-300, 1981-2 C. B. 143 (payment for services determined by reference to gross income “will be a guaranteed payment if on the basis of all the facts and circumstances, the payment is compensation rather than a share of partnership profits”)). (e)
Disguised Sales of Partnership Interests
As stated above, under IRC §707(a)(2)(B), a contribution of property by a partner to a partnership followed by a related distribution of money or other property by the partnership to a partner can be characterized as a “disguised sale.” Reg. §1.707-7 was reserved to provide rules with respect to disguised sales of partnership interests. On November 26, 2004, proposed regulations §1.707-7 were finally issued. The Proposed Regulations provide that a transfer of money, property, or other consideration (including the assumption of a liability) (“consideration”) by a partner (“purchasing partner”) to a partnership and a transfer of consideration by the partnership to another partner (“selling partner”) are treated as a sale, in whole or in part, of the selling partner’s interest in the partnership to the purchasing partner only if, based on all the facts and circumstances, the transfer of consideration by the partnership to the selling partner would not have been made but for the transfer of consideration to the partnership by the purchasing partner and, in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.
3.10
PARTNERSHIP DISTRIBUTIONS TO PARTNERS
Partnership distributions to partners may be characterized either as current distributions or as liquidating distributions, according to the regulations.165 A current distribution is any distribution that does not completely liquidate a partner’s interest and may include such items as distributions of current and accumulated earnings, distributions in partial liquidation of a partner’s interest, and pro rata distributions of a portion of the partners’ capital investments. A liquidating distribution, on the other hand, is any distribution or series of distributions that terminates a partner’s entire interest in a partnership.166 The tax 165 166
Reg. §1.761-1(d). §761(d); Reg. §1.761-1(d).
䡲
134
䡲
c03.fm Page 135 Wednesday, March 7, 2007 6:58 PM
3.10 PARTNERSHIP DISTRIBUTIONS TO PARTNERS
implications, particularly as they relate to basis determinations, vary, depending on whether a distribution is a current or liquidating distribution. Generally, a partner receiving a current distribution, and the partnership making the current distribution, will recognize neither gain nor loss on the transaction.167 However, to the extent that any cash received by the distributee partner exceeds its predistribution basis in the partnership interest, gain is recognized.168 Moreover, under §752(b), a decrease in a partner’s share of partnership liabilities is considered to be a distribution of money to that partner. As a result, a partner may recognize taxable gain when there is a decrease in the partner’s share of partnership liability and the decrease exceeds the partner’s basis in its partnership interest. For example, assume partnership XY distributes equipment subject to a $200,000 mortgage to Y. If 50 percent partner X’s basis in its partnership interest was $80,000, X has a $20,000 gain on a $100,000 deemed cash distribution. For purposes of determining whether a partner must recognize gain upon receiving a distribution, the term money includes marketable securities, and the securities must be taken into account at their fair market value as of the date of the distribution.169 The term marketable securities for this purpose means financial instruments and foreign currencies that are, as of the date of the distribution, actively traded and various other types of designated financial instruments.170 The rule treating marketable securities as money is subject to three exceptions. First, a distributee generally does not recognize gain if the security was contributed to the partnership by that partner. Second, to the extent provided in regulations, the property was not a marketable security when acquired by the partnership. Third, the partnership is an investment company and the partner is an eligible partner thereof.171 In addition, a distributee in effect must recognize gain only to the extent that the appreciation inherent in the distributed security exceeds the amount of gain the partner would recognize had the partnership sold the security and allocated the gain among the partners.172 With respect to other basis determinations, current distributions of cash reduce the partner’s basis in its partnership interest, but not below zero.173 The partner will also reduce its outside basis on the distribution of non-cash property by the partnership, using the partnership’s predistribution basis.174 However, to the extent that the partner’s basis in the partnership interest is less than the partnership’s basis in the distributed property, the partner is required under §732(a)(2) to substitute the lower basis.
167 168 169 170
171 172 173 174
§731(a) and (b). §731(a)(1). §731(c)(1). See §731(c)(2). See also Priv. Ltr. Rul. 96-20-020 (a liquidated partnership’s mortgage notes receivable were not marketable securities for purposes of §731). Reg. §1.731-2 interprets these exceptions. §731(c)(3)(A). Reg. §1.731-2 interprets these exceptions. §731(c)(3)(B). §733; Reg. §1.733-1. §732(a)(1); §733.
䡲
135
䡲
c03.fm Page 136 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
EXAMPLE: X is a partner in the XYZ partnership. At a time when X’s basis in its partnership interest equals $200, XYZ distributes cash of $100 to X, as well as a capital asset with an adjusted basis (to XYZ) of $150 and a fair market value of $200. X will not recognize gain on the distribution because the amount of cash distributed is less than its outside basis. X’s basis in the property distributed to it equals $100,175 and X’s basis in its partnership interest is reduced to zero. As with current distributions, gain is recognized on liquidation of a partner’s interest in a partnership only to the extent that any cash received exceeds the basis of the partner’s partnership interest. Moreover, loss is generally deferred by carrying over the distributee partner’s outside basis among the distributed assets. However, an exception to the rule is applied when the property distributed consists only of cash, unrealized receivables, and inventory. Under IRC §732(c), the distributee partner receives a substituted basis in the assets equal to the lesser of (1) the partnership’s adjusted basis in the assets prior to distribution or (2) the distributee partner’s outside basis prior to distribution.176 EXAMPLE: X, a one-third general partner in the XYZ partnership, receives a distribution of $20,000 cash and inventory worth $60,000 in complete liquidation of its interest in XYZ. At the time of the distribution, XYZ owned cash of $60,000 and inventory with a fair market value of $180,000 and adjusted basis of $90,000. X’s partnership interest had a fair market value of $80,000, and an adjusted basis of $50,000. On the liquidating distribution, X will realize a gain of $30,000. None of that gain will be recognized, however, because the cash distributed to X is less than its basis in XYZ prior to the distribution (§731(a)(1)). Finally, under §732(c)(1), X’s basis in the inventory will be $30,000. A partnership’s basis in its remaining property is generally not changed by reason of a distribution in liquidation of a partner’s interest. However, if a “§754 election” is in effect, the partnership’s basis in remaining property may be increased or decreased as described in §734(b).177 Special rules relating to disproportionate distributions apply to unrealized receivables and inventory items, otherwise known as “hot assets.” Under §751(b), a distribution is treated as a sale or exchange of property between the distributee and the partnership to the extent that a partner receives in a distribution (1) hot assets in exchange for the partner’s interest in other partnership property (including money) or (2) partnership property (including money) in 175 176 177
§732(a)(1) and (2) (providing that distributed cash is subtracted from a partner’s outside basis before any of his or her basis is allocated to distributed property). §731(a)(2) provides for capital loss treatment at the time of the liquidating distribution for the distributee partner whose outside basis may be lost. The Jobs Act amended §734(b) to provide a mandatory basis adjustment with respect to the distribution of partnership property, respectively, when the partnership has a substantial builtin loss (greater than $250,000). The basis adjustment is required whether a §754 election is in effect at the time of the transfer or distribution or not. Notice 2005-32 provides interim procedures to comply with the mandatory basis adjustment provisions.
䡲
136
䡲
c03.fm Page 137 Wednesday, March 7, 2007 6:58 PM
3.10 PARTNERSHIP DISTRIBUTIONS TO PARTNERS
exchange for the partner’s interest in hot assets. The distributee partner may recognize gain or loss. The character of the gain or loss depends on the character of the partnership property, the interest in which the distributee is treated as selling. For example, if the distributee is treated as selling hot assets in exchange for other partnership property, the distributee’s gain will constitute ordinary income. EXAMPLE: XYZ partnership’s assets consist of $30,000 in cash and inventory of $30,000 with adjusted basis of $12,000. Partner Z wants to liquidate its entire partnership interest. Accordingly, XYZ distributes to Z $20,000 in inventory. Under §751, XYZ will be treated as having sold one-third of the inventory for $10,000 because XYZ’s distribution to Z is not proportionate to Z’s interest in the inventory. (The other $10,000 is Z’s pro rata share of inventory.) XYZ will recognize ordinary income of $6,000 ($10,000 purchase price less $4,000 basis) which will be allocable to X and Y. Z is entitled to step up its basis in half of the inventory to $10,000 as its “cost” basis.178 The rules of §751(b) do not apply to distributions of property contributed by the distributee partner.179 In recent years, Congress has expanded the circumstances under which partners are subject to tax upon receiving partnership distributions. Various special rules attempt to prevent perceived abuses of the general rule under which partnership distributions are not subject to tax. One such rule, previously described, treats marketable securities distributed to a partner as “money.”180 Under the “disguised sale” rules, a distribution of cash or other property to a partner may be recharacterized as consideration for a sale of property between the partner and the partnership.181 Finally, a partner who contributes appreciated property to a partnership may be subject to tax under the “anti-mixing bowl” rules if the partnership later makes certain types of distributions. Under one such rule, if the partnership, within seven years after the appreciated property was contributed, distributes that property to another partner, the contributing partner must recognize the net precontribution gain in the property. The “net precontribution gain” means the amount of gain the contributing partner would recognize if the partnership, instead of distributing the property to another partner, had sold the property.182 Under a similar rule, a contributing partner must recognize gain if
178
179 180 181 182
See Reg. §1.751-1(g), Example 2. Cf. Priv. Ltr. Rul. 96-20-020 (because a partnership distributed its assets in liquidation in proportion to each partner’s ownership interest in the partnership, §751 did not apply to the distribution). §751(b)(2)(A); Reg. §1.751-1(b)(1)(i). §731(c)(1). §707(a)(2)(B); Reg. §§1.707-3 through 1.707-9. Prop. Regs. 1.707-7 were issued dealing with disguised sale of partnership interests. See Section 3.9(e). §704(c)(1)(B). The Taxpayer Relief Act of 1997 generally lengthened the period from five years to seven years for property contributed to a partnership after June 8, 1997.
䡲
137
䡲
c03.fm Page 138 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
within seven years the partnership distributes to the contributing partner other property besides cash.183
3.11 (a)
SALE OR OTHER DISPOSITION OF ASSETS OR INTERESTS Sale or Other Disposition of Assets
The tax consequences of a sale or other disposition of property depend on the time of the sale, the terms and conditions of the purchase agreement, the price paid, and numerous other conditions, including the federal tax laws at the time of sale. However, as long as a partnership operates property as a trade or business and does not hold the property for purposes of sale, any gain or loss from the sale or exchange of such property should generally be treated as capital gain or ordinary loss described in §1231. It has traditionally been advantageous for partnerships, like other taxpayers, to convert ordinary income into capital gains, and capital losses into ordinary losses.184 Congress, however, has sought to prevent taxpayers from altering the gain or loss character resulting from certain sales or dispositions of partnership assets. Under §724, enacted in 1984 as part of the Tax Reform Act, taxpayers are prevented from converting gain or loss through contributions of property to a new or existing partnership. In particular, three categories of contributed property— unrealized receivables, inventory items, and capital loss property—are subject to anticonversion provisions. With respect to unrealized receivables, §724(a) provides that any gain or loss recognized by the partnership on the disposition of unrealized receivables will be ordinary. Inventory items (as broadly defined in §751(d), including property “primarily held for sale”) retain an ordinary income taint for five years after contribution to the partnership.185 After the five-year 183
184
185
§737. The Taxpayer Relief Act of 1997 generally lengthened the period from five years to seven years with respect to property contributed to a partnership after June 8, 1997. A partnership may distribute to a partner, as either a current or liquidating distribution, more than one asset in addition other than cash. Until recently the distributee partner’s basis generally had to be allocated among the distributed assets in proportion to their relative adjusted basis within the partnership. §732(c). The Taxpayer Relief Act of 1997 amended these rules for property distributed after August 5, 1997. The new rules addressed situations in which a distributee partner’s allocable basis (after subtracting any cash distributed) differs from the partnership’s basis in the distributed properties. If the distributee partner’s allocable basis exceeds the partnership’s basis in the distributed properties, the increase must be allocated first among properties having unrealized appreciation in proportion to each asset’s respective amount of unrealized appreciation. Any remaining increase must be allocated among the assets in proportion to their respective values. If, on the other hand, the distributee partner’s allocable basis is less than the partnership’s basis in the distributed assets, the decrease must be allocated first among properties having unrealized depreciation in proportion to each asset’s respective amount of unrealized depreciation. Any remaining decrease must be allocated among the properties in proportion to their respective adjusted bases. §732(c), as amended by the Taxpayer Relief Act of 1997. Individual taxpayers can deduct capital losses only to the extent of capital gains plus a maximum of $3,000 of ordinary income; corporate capital losses can be deducted only to the extent of capital gains. Consequently, even without a rate differential or advantage, ordinary losses are more useful than capital losses because of the taxpayer’s ability to absorb ordinary losses without limitation and capital gains are preferable to ordinary income. See Prop. Reg. §1.732-1(c). §724(b).
䡲
138
䡲
c03.fm Page 139 Wednesday, March 7, 2007 6:58 PM
3.11 SALE OR OTHER DISPOSITION OF ASSETS OR INTERESTS
period, the character of the inventory items is determined at the partnership level. Finally, “capital loss property”—defined to include any capital asset held by the contributing partner that had an adjusted basis in excess of its fair market value immediately prior to contribution to the partnership— is subject to a comparable limitation.186 Section 724(c) requires the built-in loss at the time of the contribution to retain its character as a capital loss for a period of five years from the time of the contribution. Additional loss that accrues while the property is held by the partnership is characterized at the partnership level. Congress has also enacted rules to prevent the conversion of gain or loss upon the distribution of property from a partnership to a partner. Under §735(a), gain or loss on the disposition by a partner of unrealized receivables or inventory items (whether or not substantially appreciated) distributed by the partnership is ordinary in character. With unrealized receivables, the character taint remains with the assets as long as they are held by the distributee partner.187 In the case of inventory items, this rule applies only if the sale takes place within five years of the date of distribution.188 (b)
Sale or Other Disposition of Partnership Interests
Partnership interests are generally recognized as capital assets that may be sold or exchanged with capital gain or loss treatment to the selling partner.189 However, if a transferee partner receives proceeds (or suffers a loss) attributable to unrealized receivables or inventory under §751, then the sale proceeds (or losses) are treated as ordinary income (or loss).190 EXAMPLE: Partnership XY, owned in equal shares by brothers X and Y, was engaged in the management of low-income housing projects. X and Y sold their respective partnership interests in XY to A and B, two distinct and unrelated exempt organizations engaged in low-income housing activity. XY’s assets included an assignable low-income housing management contract with a period remaining of approximately 20 years of the 25 years originally agreed upon. Because payment by A and B for the XY partnership interest included payment for an unrealized receivable (the right to earn and receive future income under the management contract), the proceeds attributable to the contract rights must be treated as ordinary income under §751.191
186 187 188 189
190
191
§724(c). §735(a)(1); Reg. §1.735-1(a)(1). §735(a)(2); Reg. §1.735-1(a)(2). §741; Reg. §1.741-1. Traditionally, a partnership’s taxable year closed with respect to a particular partner only if the partner sold or exchanged his or her entire partnership interest or had his or her interest liquidated. For partnership taxable years beginning after Dec. 31, 1997, a partnership’s taxable year also will close with respect to a partner who dies. §706(c)(2)(A), as amended. §741 and §751 apply regardless of whether the selling partner disposes of its entire interest or only a portion of that interest. For sales of partnership interests occurring after Aug. 5, 1997, the Taxpayer Relief Act of 1997 deleted the limitation requiring the inventory to be “substantially appreciated.” This amendment will expand the circumstances in which partners have to recognize ordinary income upon selling partnership interests. See Prop. Reg. §1.751-1(a). See United States v. Woolsey, 326 F.2d 287 (5th Cir. 1963).
䡲
139
䡲
c03.fm Page 140 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
The selling partner’s gain or loss is computed first by determining what part of the amount realized is attributable to §751 assets (i.e., ordinary income or loss), with the balance attributable to the residual §741 interest (i.e., capital gain or loss).192 (c)
Termination of the Partnership
Regardless of state law determinations to the contrary, partnerships do not terminate for tax purposes unless (1) there is a complete discontinuation of partnership activities (an “actual termination”) or (2) there is a sale or exchange of 50 percent or more of the total interests in the capital and profits of the partnership within any 12-month period (a “technical” termination).193 Examples of terminations for tax purposes include the acquisition by one partner of all partnership interests, or the death of one partner in a two-person partnership (unless the estate or other successor in interest to the decedent continues the partnership business). The “sale or exchange” requirement can present some interesting issues. First, the transfer must take place within a 12-month period (not a calendar year) and does not include multiple sales of the same interests. Next, terminations can have a domino effect if multiple-tiered partnerships are involved (i.e., partnerships as partners owning 50 percent or more in lower-tiered partnerships). Finally, it should be noted that a contribution of property to a partnership is not treated as a “sale or exchange” for partnership termination purposes.194 EXAMPLE: Partnership X is owned in equal 50 percent interests by individual A and partnership B. Partnership B, in turn, is owned in equal 50 percent interests by individuals C and D. D’s sale of her 50 percent interest to E will result in the termination of both partnership B and partnership X. EXAMPLE: Partnership XYZ is a limited partnership involved in multifamily housing development. On June 1, an exempt organization contributes cash in exchange for a 60 percent interest in XYZ. XYZ does not terminate, because the change in ownership of more than 50 percent was not the result of a “sale or exchange” of partnership interests.195 If a sale or exchange of a partnership interest causes the partnership to undergo a technical termination, the terminated partnership is treated as contributing all its assets and liabilities to a successor partnership and then distributing to the purchaser of the partnership interest and the nonselling partners the interests in the successor partnership.196 Previously, if a partnership technically 192
193 194
195
The IRS adopted final regulations providing that a transferor of a partnership interest may recognize collectibles gain and §1250 gain equal to the amount of such gain that would be allocated to such transferring partner if the partnership transferred all of its collectibles and §1250 property for cash equal to the fair market value of such property. Reg. §1.1(h)-1. See also Reg. §1.741-1. §708; Reg. §1-708-1(b)(1)(ii). Reg. §1.708-1(b)(1)(ii). See Section 3.11(c) for discussion of Rev. Rul. 99-6, explaining tax consequences of one person purchasing all of the membership interests in an entity taxed as a partnership. See Rev. Rul. 75-423, 1975-2 C.B. 260.
䡲
140
䡲
c03.fm Page 141 Wednesday, March 7, 2007 6:58 PM
3.11 SALE OR OTHER DISPOSITION OF ASSETS OR INTERESTS
terminated, the terminated partnership was treated as distributing all its properties in liquidation to the purchaser of the partnership interest and the nonselling partners, who were then treated as recontributing those assets to a newly formed partnership.197 The mechanics of a technical termination were altered to prevent various anomalies that could have occurred following such a termination.198 (d)
Liquidating Distributions
Distributions made to a retiring (or deceased) partner in liquidation of the partner’s entire interest in a partnership are classified into two types: IRC §736(a) payments and §736(b) payments. Section 736 does not apply to complete liquidations of the partnership itself, or to transactions solely between partners.199 IRC §736(a) payments consist of any amounts not paid in exchange for the redeemed partner’s interest in partnership assets. Section 736(a) payments to a retiring or deceased partner who was a general partner in a partnership in which capital is not a material income-producing factor also include amounts paid for unrealized receivables and goodwill of the partnership (except to the extent that the partnership agreement provides for a payment with respect to goodwill).200 Because §736(a) distributions are generally either guaranteed payments under §707(c) or payments of a distributive share of partnership income, such payments are usually ordinary income to the distributee partner. Liquidating distributions of a partner’s interest in partnership property (other than those made under IRC §736(a) for unrealized receivables or unstated goodwill) are §736(b) payments. Section 736(b) payments that exceed a partner’s basis in its partnership interest generally will be taxed as capital gain from the sale or exchange of the interest under §731 and §741. Nevertheless, distributions made to a partner under §736(b) may also trigger §751(b) ordinary income treatment. (e)
Consequences of Charitable Contribution: Bargain Sales
Partnerships and partners may transfer properties or partnership interests to charitable organizations. Such transfers may be treated for tax purposes as part gift and part sale, that is, as a “bargain sale.” A partnership would recognize taxable gain on the sale portion and would be entitled to deduct as a charitable contribution the excess of the property’s fair market value over its sale price. Under IRC §1011(b), the partnership’s adjusted basis for determining its gain on the transfer is that portion of the adjusted basis that bears the same ratio as the amount realized by the transferor bears to the property’s fair market value. If the property is transferred to a charity subject to indebtedness, the amount of the indebtedness is treated as an amount realized on the transfer, whether or not the charity agrees to assume or pay the indebtedness.201 Any 196 197 198 199 200 201
See Reg. §1.708-1(b)(1)(iv). Former Reg. §1.708-1(b)(1)(iv). See Michael Grace, “Interaction of the Final Regs. on Partnership Technical Terminations with TRA-97,” Journal of Partnership Taxation 14 (winter 1998): 275. Reg. §1.736-1(a)(1)(i). Reg. §1.736-1(a)(3). Reg. §1.1011-2(a)(3).
䡲
141
䡲
c03.fm Page 142 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
charitable contribution deduction taken by the partnership that flows through to the partners is subject to the limitation on individual or corporate charitable contributions contained in §170.202 EXAMPLE: Partnership XYZ sells a piece of property with a market value of $3,000 to a charitable organization for $1,800. The donated property had a basis of $1,200. The partnership gain on the bargain sale is $1,080, or the $1,800 sales price less adjusted basis of $720 ($1,800/$3,000 of XYZ’s total adjusted basis of $1,200). However, from a planning standpoint, the benefits of nonrecognition under the “like-kind” exchange rules (including deferred exchanges) may be available to minimize the tax on bargain sales while preserving the advantages of the charitable contribution deduction.203 No gain or loss is recognized when property held for productive use in a trade or business, or for investment, is exchanged solely for property of a like kind and is held for similar use. If the taxpayer receives cash or other property (which is not of like kind), at least part of the gain or loss may be recognized. Nonrecognition provisions will not apply to deferred like-kind exchanges unless the exchange meets a 180-day time limit on the completion of the exchange and a 45-day rule for identification of the property to be received in the exchange.204 (f)
Application of Bargain Sale Technique to “Burned-Out” Shelters
In this context, many individual limited partners are unable to take advantage of passive losses because of application of the passive activity loss limitations.205 Indeed, partners may be faced with allocations of phantom income, without distributions of cash flow, from investments in “burned-out” shelters, which often involve subsidized low-income housing. Under these circumstances it may be a good strategy for the individual investor if the partnership were to transfer the property to a charitable organization in consideration for cash, with the charity taking subject to a HUD-insured mortgage. If the property can be appraised at an amount substantially in excess of the purchase price, the individual limited partner may be entitled to a current charitable contribution deduction in a “bargain-sale” transaction.206 The charitable organization would then attempt to resyndicate the property in a joint venture with a new group of investors who can take advantage of the income housing tax credit; the property could be rehabilitated and additional use restrictions could be applied that would preclude the property from being converted from low-income housing use for an extended period of time (see Chapter 13). In 202 203 204 205 206
§170(b)(2). See §1031. See §1031(a)(3). See §469. This transaction also raises the issue of whether the contributor’s suspended passive losses allocable to the contributed property transfer to the charity. If the contribution qualifies as a gift for income tax purposes, then the suspended losses are added to the donee’s basis in the property under §469(j)(6). No known legal authority addresses whether §469(j)(6) applies to this transaction.
䡲
142
䡲
c03.fm Page 143 Wednesday, March 7, 2007 6:58 PM
3.11 SALE OR OTHER DISPOSITION OF ASSETS OR INTERESTS
addition, the selling partnership may be able to minimize the tax consequences through the use of the like-kind exchange technique. EXAMPLE: Assume that partnership AB owns a low-income housing project with a fair market value of $3,700,000 subject to a nonrecourse mortgage debt of $900,000; the adjusted basis is $1,500,000. Assume that EO, an IRC §501(c)(3) organization, agrees to purchase the property for consideration of $1,000,000 (by assuming the mortgage liability and paying $100,000 in cash). The gift will be treated for income tax purposes as though AB’s assets had been sold to EO in consideration of the assumption by EO of the AB mortgage debt and the payment of $100,000. Because EO is a charitable organization and the deemed sales price is less than the fair market value of the contributed property, the bargain sale rules of §1011(b) will apply. 1. Under the bargain sale rules, AB will be deemed to have made a charitable contribution of $2,700,000—that is, $3,700,000 (fair market value) less $1,000,000 (the assumed mortgage liability plus cash). AB’s adjusted basis for determining gain on the sale will be $419,000, equal to $1,500,000 [adjusted basis] × ($1,000,000) [amount realized through assumption of mortgage liability plus cash] divided by $3,700,000 [fair market value]. Because the partnership will recognize gain of $581,000 from the bargain sale ($1,000,000 amount realized less $419,000 adjusted basis), IRC §1250 will apply to recharacterize a portion of the gain as ordinary income. Generally, such recharacterization in the case of residential multifamily housing results in treatment as ordinary income of an amount equal to the depreciation in excess of straight-line on a phased-in basis. Assuming the recapture were approximately 30 percent, the gift would give rise to $406,700 of capital gain and $174,300 of ordinary income. 2. IRC §1250 recharacterization would also result in a reduction in the charitable contribution under §170(e). Under §170(e), 27 percent ($1,000,000 [amount realized through assumption of mortgage liability plus cash] divided by $3,700,000 [fair market value]) of the property is treated as sold, and, thus, 73 percent is treated as contributed. The amount of the charitable contribution will be reduced by the amount of gain recharacterized as ordinary income attributable to the contributed property, or $127,200 ($174,300 × 73%); therefore, the net amount of the charitable contribution deduction will be $2,572,800 ($2,700,000 × $127,200). 3. The charitable contribution deduction available to any partner in the year of the gift will be limited to 30 percent of his adjusted gross income, computed without regard to net operating loss carrybacks.207 Thus, a 5 percent partner in the partnership that has adjusted gross income of $200,000 would be deemed to have made a charitable contribution of approximately $125,000, but would be able to deduct only $60,000 in the year of the gift. The remaining $65,000 will be carried over as a charitable contribution 207
§170(b)(1)(A).
䡲
143
䡲
c03.fm Page 144 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
deduction for the succeeding five years. The ability of the partner to take the full advantage of a carried-over deduction will depend on his adjusted gross income and subsequent charitable contributions. The charitable contribution deduction is subject to further reduction by reason of the overall limitation on itemized deductions.208 4. The partnership may defer the gain attributable to the “sale” aspect of the bargain sale by structuring a like-kind exchange under IRC §1031. To qualify, continuing from the foregoing example, the partnership would need to acquire other real property by investing at least the $100,000 it received in cash proceeds and incurring at least $900,000 in debt; any reduction in debt will be treated as taxable cash “boot.” The partnership’s basis in the replacement property will be carried over from the old property, increased by any gain recognized with respect to this aspect of the transaction.209 5. If the partnership does not acquire the replacement property simultaneously with the bargain sale, it will need to comply with the deferred exchange rules in IRC §1031(a)(3) and the regulations promulgated thereunder. Briefly, it must identify in writing up to three potential replacement properties of comparable value within 45 days of the closing on the bargain sale and acquire one of them within 180 days. The cash proceeds may be held by an escrow agent or trustee satisfying the safe-harbor rules set forth in the regulations. Interest earned on the cash proceeds will be taxable to the partnership as such, but should not be distributed to the partnership until the exchange is complete. The replacement property may be conveyed to the partnership by a third party or a qualified intermediary, and may be either existing property or property constructed for the partnership. (g)
Partnership Mergers and Divisions
Final regulations under IRC §708(b)(2) explain the steps deemed to occur when a partnership merges, consolidates, or divides.210 Under the new regulations, the IRS will respect the form of a merger or division structured to take either the “assets-over form” or the “assets-up form.” If partnerships merge or divide without specifying a form, the IRS will deem it to be using an assets-over form. In the assets-over form, each terminating partnership is deemed to contribute its assets and liabilities to the resulting partnership in exchange for an interest in that partnership and then to distribute that interest to its partners in liquidation. In the assets-up form, each terminating partnership is deemed to distribute its assets and liabilities to its partners, who then contribute assets and liabilities to the resulting partnership. The final regulations clarify that the assets-up form may be applied to assets that the partners could not otherwise hold outside of the partnership, such as goodwill. The IRS will not require actual 208 209 210
§68. §1031(d). 66 Fed. Reg. 715, T.D. 8925, 2001 TNT 3 (Jan. 4, 2001).
䡲
144
䡲
c03.fm Page 145 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
transfer and recording of the assets if the transaction is documented as required by the local jurisdiction. However, the assets-up form must be used for all assets of a merging partnership. The new rules must apply to all partnership mergers and divisions occurring on or after January 4, 2001, but may be applied to mergers and divisions occurring after January 10, 2000. Revenue Ruling 2004-43 provides that Code §704(c)(1)(B) applies to newly created Code §704(c) gain or loss in property contributed by the terminating partnership to the continuing partnership in an assets-over partnership merger, but does not apply to newly created reverse Code §704(c) gain or loss resulting from a revaluation of property in the continuing partnership. In addition, for purposes of Code §737(b), net precontribution gain includes newly created Code §704(c) gain or loss in property contributed by the terminating partnership to the continuing partnership in an assets-over partnership merger, but does not include newly created reverse Code §704(c) gain or loss resulting from a revaluation of property in the continuing partnership.
3.12 (a)
OTHER TAX ISSUES Profit Motive Test
The IRS, courts, and commentators have generally viewed the existence of a profit motive to be an essential characteristic of partnerships for state law and tax purposes.211 The concern is not so much that partnerships should yield financial rewards to its partners, but rather that the partnership structure is not used solely as a vehicle for producing tax deductions or other tax benefits. Section 183 limits the ability of individual investors and S corporations to deduct expenditures attributable to “activities not engaged in for profit.” In general, such taxpayers can deduct expenses incurred in such activities only to the extent of the income generated therefrom. Court cases and rulings have extended the application of §183 to partnerships and have applied the profit motive test at the partnership level.212 A profit motive, however, may not be an absolute requirement or prerequisite for partnership treatment. For example, the IRS has taken the view that the “not-for profit” rules would not apply to deductions attributable to a qualified low-income housing project.213 Similarly, the regulations provide that the “notfor profit” rules of §183 will not apply to disallow credits or deductions to a partnership that are attributable to a qualified low-income housing project.214 On a
211
212
213 214
§6(1) of the Uniform Partnership Act provides that a partnership is an association of two or more persons “to carry on as co-owners a business for profit.” A more extensive discussion of state law regarding partnership is beyond the scope of this chapter and book. See, e.g., Brannen v. Commissioner, 78 T.C. 471 (1982), aff’d, 722 F.2d 695 (11th Cir. 1984); Deegan v. Commissioner, 787 F.2d 825 (2nd Cir. 1986) (noting that when a “general partner bears responsibility for managing the business of a limited partnership, the relevant inquiry is whether the general partner harbored ‘an intent and objective of realizing a profit’ through the investments”). Rev. Rul. 79-300, 1979-2 C.B. 112. Reg. §1.42-4.
䡲
145
䡲
c03.fm Page 146 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
broader scope, the IRS has overlooked the profit motive requirement when an organization is formed for a business purpose not involving profit.215 (b)
Ownership of the Properties
To claim tax benefits (including depreciation and the low-income housing credit), a partnership must be treated as the owner of the properties for federal income tax purposes. The ownership issue may arise if parties other than partners, such as mortgage lenders, have certain interests and other contractual rights in the properties through the loans and other agreements. Accordingly, any advance of funds to a partnership should be carefully structured to reflect the parties’ intention—whether the money constitutes a loan or whether it is for the purchase of equity, that is, for an ownership interest.216 The essential inquiry in characterizing what appears to be a capital contribution is whether the contributer intends the amount to be repayable regardless of the venture’s profitability, or whether the contributor is willing to assume the risk of profit or loss with the funds. Unfortunately, there is little clear-cut guidance to determine whether a purported loan arrangement will be treated as a bona fide debtor-creditor relationship.217 EXAMPLE: X, a taxpayer, agreed to advance funds called a “loan” to an unrelated limited partnership, LP. The nonrecourse loan was secured by LP’s properties, consisting of some unproven leases and some expensive but unsalvageable oil and gas installations. X also had the right, at any time, to convert the loan into a 25 percent interest in LP’s profits. The IRS has ruled, on substantially similar facts, that such a loan is not bona fide debt, but is capital placed at the risk of the LP venture by X. Accordingly, X’s investment represents its equity interest in LP. See Rev. Rul. 72350, 1972-2 C.B. 394. See also Gibson Prod. Co. v. United States, 637 F.2d 10th (5th Cir. 1981) (nonrecourse note did not constitute a true loan because of insufficient assets of the purported borrower to secure the loan and the purported lender’s right to share in investment of “loan” proceeds). (c)
Passive Activity Loss Rules
As part of the Tax Reform Act of 1986, Congress enacted passive loss limitations, contained in §469.218 This section was enacted to restrict taxpayers from using deductions and other losses generated from certain passive investment activities to “shelter” income from other sources.219 The passive loss rules divide all 215
216
217 218 219
See, e.g., Priv. Ltr. Rul. 91-08-025 (Nov. 26, 1990) (IRS rules that a business trust formed to clean up hazardous waste site has an objective to carry on business and divide profits from it, and thus can be classified as a partnership). The consequences of a mischaracterized loan could be significant for a lender and business venture because, under certain circumstances, money distributed to the lender may not be treated as interest payments; i.e., the transaction may be recharacterized as equity. See Section 6.2(c). Although not specifically applicable to partnerships, §385 of the Code provides some guidance in distinguishing debt from equity investments. §469, as added by P.L. 99-5, §501 (hereinafter “1986 TRA”). See generally Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 100th Cong., 1st Sess. 209–254 (1987).
䡲
146
䡲
c03.fm Page 147 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
income and loss into three categories: active, passive, and portfolio. Furthermore, the rules generally bar taxpayers from using losses arising from passive activities in any given year to offset their active income or portfolio income.220 Any losses (or credits) resulting from passive activities for the taxable year that exceed the taxpayer’s passive income may be carried forward and deducted against future net income from passive activities.221 These “suspended” losses (or credits) from a particular passive activity are generally allowed in full when the taxpayer disposes of his entire interest in the activity in a taxable transaction—first against passive income and then, to the extent not absorbed by passive income, against active income and portfolio income. 222 Finally, the passive activity limitation rules apply at the individual partner level with respect to passive income earned or passive deductions incurred at the entity level.223 To determine whether entity level income or loss is passive, §469 is applied on an activity-by-activity basis. In general, a passive activity is any activity (1) that involves the conduct of any trade or business and (2) in which a taxpayer does not “materially participate.”224 A partner “materially participates” in an activity only if it is involved on a regular, continuous, and substantial basis in the operation of the activity.225 EXAMPLE: X, a physician earning $200,000 in medical practice fees, is also a limited partner in a limited partnership involved in real estate development. X has no other sources of current income. X does not “materially participate” in the investment activities of the limited partnership. During calendar year 1992, X is allocated a loss of $15,000 from the limited partnership. Because X does not materially participate in the limited partnership’s activities, his investment is a passive activity. Accordingly, X would be prohibited from deducting the $15,000 loss against his salary income in 1992, because his salary income is active and cannot be offset by a passive loss. A rental activity is generally treated as a passive activity regardless of how much or how little a taxpayer participates in it.226 The term rental activity means any activity wherein payments are principally for the use of tangible property.227 Two special rules mitigate, in certain circumstances, this rule generally treating rental activities as automatically passive activities. First, it does not apply to individuals and closely held C corporations significantly engaged in
220
221
222 223 224 225 226 227
§469(a)(1)(A); §469(d)(1); Reg. §1.469-2T(c)(3). Similarly, tax credits generated by passive activities (such as a rehabilitation tax credit allocated to an individual limited partner) generally may not be used to reduce tax attributable to active income or portfolio income. §469(a)(1)(B) provides similar rules for credits from passive activities. The limitation applies to the extent that credits from passive activities for the year exceed the tax liability for the year attributable to such activities. Credits may also be carried forward. §469(g). §469(a)(2). §469(c)(1); Reg. §1.469-1T(e)(1). §469(c)(2); Temp. Reg. §1.469-1T(e)(1)(ii). See generally Temp. Reg. §1.469-5T and discussion, supra. §469(c)(2). Section 469(j)(8); see also Reg. §1.469-1T(e)(3).
䡲
147
䡲
c03.fm Page 148 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
real property trades or businesses. Section 469 does not limit any losses or credits from rental real estate activities in which these qualifying taxpayers materially participate.228 Second, individuals and certain estates can deduct up to $25,000 of nonpassive income losses from rental real estate activities in which they actively participate.229 The $25,000 offset phases out at the rate of $.50 per $1.00 as a taxpayer’s adjusted gross income (computed with certain modifications) increases from $100,000 to $150,000. As a result, no offset is allowed once modified adjusted gross income equals or exceeds $150,000.230 Historic rehabilitation and lowincome housing tax credits from passive activities may be used to offset tax on up to $25,000 of nonpassive income, whether or not the taxpayer actively participates in the activities.231 For example, a taxpayer paying tax at the 39.6 percent marginal rate may use up to $9,900 of such credits ($25,000 times 39.6%) to offset tax attributable to active or portfolio income. However, the $25,000 offset is applied to losses before credits.232 With respect to the historic rehabilitation tax credit, the $25,000 offset begins phasing out at modified adjusted gross incomes exceeding $200,000, with the result that no offset is allowed once modified adjusted gross income equals or exceeds $250,000.233 The $25,000 offset does not phase out with respect to low-income housing tax credits.234 Over the years, the passive loss limitations have been criticized for their breadth. Besides impeding traditional tax shelters, the rules sometimes cause ordinary business transactions to have aberrant tax consequences. Some courts have demonstrated willingness to bend the draconian statutory rules and regulations enough to treat particular taxpayers fairly. In Hillman v. Commissioner,235 the Tax Court allowed the taxpayer, a real estate developer, to “self-charge” real property management fees. Hillman owned rental real estate through numerous partnerships, as well as stock in an S corporation that managed the partnerships’ properties. He had active income from the management company and passive losses from the partnerships. The income and losses consisted in part of management fees that the partnerships paid the corporation. The court allowed 228
229 230 231 232 233 234 235
§469(c)(2), §469(c)(7); Reg. §1.469-9. An individual qualifies for this special relief by satisfying both of two requirements: (1) more than one-half of the personal services performed in trades or business by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. A closely held C corporation qualifies if more than 50 percent of the corporation’s gross receipts for the taxable year are derived from real property trades or businesses in which the corporation materially participates. All the normal material participation tests apply in determining whether a taxpayer satisfies these tests and, if so, whether the qualifying taxpayer materially participates in particular rental real estate activities. Reg. §1.469-9(b)(5). See Grace, “Final Passive Loss Regulations Explain Treatment of Rental Real Estate Owned Through Partnerships,” Journal of Partnership Taxation 13 (summer 1996): 172; Grace, “Real Estate Professionals May Qualify to Deduct Passive Losses,” Practical Real Estate Lawyer 11 (May 1995): 37. §469(i)(1), (4). The amount of losses or credits allowable under §469(i) is determined after the rules of §469(c)(7) are applied. Reg. §1.469-9(j). §469(i)(3)(A). §469(i)(6)(B). §469(i)(3)(D). §469(i)(3)(B). §469(i)(3)(C). Hillman v. IRS No. 00-1915 (4th Cir., April 17, 2001) reversing 114 T.C. 103 (2000).
䡲
148
䡲
c03.fm Page 149 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
Hillman to self-charge (i.e., offset) his management income with his share of the partnerships’ deductions for the same management fees. Similarly, in Glick v. United States,236 Mr. and Mrs. Glick owned interests in more than 100 rental real estate partnerships and most of the stock of an S corporation that managed the rental properties. Under §469 as generally applied, the Glicks had active income from the management company and passive losses from the partnerships. However, the district court interpreted the regulations defining activity in such a way as to allow the Glicks to combine the corporation’s management activity with the partnerships’ rental activities.237As a result, the Glicks were able to offset all their management income from the corporation with their partnership losses.238 In April 2001, however, the Fourth Circuit overruled the Tax Court’s decision in Hillman. The Fourth Circuit found no exceptions under which the Hillmans could avoid the plain language of IRC §469, which prohibits a taxpayer from deducting passive losses from nonpassive gains.239 (d)
“At-Risk” Limitations
In addition to the passive activity loss rules, a partner may be prevented from using current partnership losses because of the “at-risk” limitations under the Code.240 The at-risk rules limit a taxpayer’s ability to use losses resulting from a broad range of business and investment activities to the amount the taxpayer has at risk with respect to those activities. A taxpayer’s at-risk amount includes (1) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and (2) amounts borrowed for use in the activity for which the taxpayer is personally liable or which are secured by property of the taxpayer to the extent of the fair market value of the encumbered property.241 In the case of partnerships, partners are at risk to the extent of their proportionate share of partnership recourse debt.242 Under proposed regulations, a partner would increase its at-risk amount if it is liable for any obligation of the partnership.243 Likewise, the partner’s amount at risk in an activity is increased by amounts borrowed for use in the activity when the taxpayer is not personally 236 237 238
239 240 241
242 243
96 F. Supp. 2d 850 (C.D. Ind. 2000). See Treas. Reg. §1.469-4(d). The government initially appealed the District Court’s decision in Glick to the United States Circuit Court of Appeals for the Seventh Circuit, but then withdrew the appeal. For details on the Hillman and Glick cases, see Grace, “Self-Charged Management Fees at Last: Tax Court Decides It Won’t Wait Any Longer,” Journal of Passthrough Entities 3 (2000): 26. Grace served as special tax counsel to the Glicks. Hillman v. IRS, 263 F.3d 338 (4th Cir. 2001) §465(a) et seq. §465(b)(3), however, excludes from the at-risk amount certain recourse borrowings if the lender or person related to the lender has an interest in the activity other than as a creditor. In addition, in Hubert Enterprises, lnc. v. Comm'r, 125 T.C. 72 (2005), the Tax Court held that a deficit restoration obligation imposed on members of a limited liability company taxed as a partnership did not increase such members' amounts at-risk for purposes of Code Section 465. Any disallowed deduction resulting from the at-risk rules may be allowed in subsequent years, under §465(a)(2), so long as the taxpayer increases the amount of risk. Prop. Reg. §1.465-24(a)(2). F.S.A. 200025018 provides that a member of a limited liability company, classified as a partnership for federal income tax purposes, who has guaranteed a liability of the limited liability company is at risk with respect to the amount guaranteed, except to the extent such member has a right of reimbursement from the other members.
䡲
149
䡲
c03.fm Page 150 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
liable for repayment of the loan, to the extent that the taxpayer pledges property not used in the activity as security for the loan.244 EXAMPLE: To illustrate the application of the at-risk rules in the partnership context, assume X and Y form partnership XY to engage in an activity described in the at-risk rules under §465(c), such as film distribution. XY borrows $10,000 secured by a purchase money mortgage for which neither X nor Y is personally liable. XY invests the funds to purchase equipment used in its business. Shortly thereafter, with funds earned from the film distribution business, XY repays $7,500 of the loan. Neither the initial borrowing of the funds, nor the repayment of part of the loan, will increase or affect the amount X and Y are at risk in the activity.245 As part of the Tax Reform Act of 1986, Congress extended the at-risk rules to real estate activities. In so doing, however, Congress created an exemption for a partner’s share of qualified nonrecourse financing of real estate, which is treated as an amount at risk.246 Generally, the exception is available for nonrecourse financing obtained from governmental or commercial lenders or “qualified persons,” borrowed by the taxpayer in connection with the activity of holding real property247 and that does not represent convertible debt.248 Qualified persons are any individuals (1) actively engaged in the business of lending money, (2) unrelated to the taxpayer, (3) not the person from whom the taxpayer acquired the property underlying the loan, and (4) not a person who receives a fee in connection with the taxpayer’s investment in the property.249 A related party will be considered qualified, however, if the loan is made on commercially reasonable terms and on substantially the same terms and conditions as loans involving unrelated parties.250 (e)
Tax Shelter Registration and Other Reporting Requirements
The Jobs Creation Act of 2004 (JA) repealed the tax shelter registration rules and amended IRC Section 6111 to require each material advisor with respect to any reportable transaction (including any listed transaction), as defined in IRC Section 6011, to timely file an information return with the IRS identifying and describing the transactions and its expected, potential tax benefits. The return must be filed on such date as specified by the IRS. The information return must include: (1) information identifying and describing the transaction; (2) information describing 244
245 246
247
248 249 250
See Prop. Reg. §1.465-25. The amount at risk is increased for a general or limited partner who lends money to the partnership, but only to the extent the partner’s adjusted basis in the partnership interest is increased. Prop. Regs. §1.465-7(a). See Prop. Reg. §1.465-25(b)(3) (Example 5). §465(b)(6)(A). See also Reg. §1.465-27, which provides a “look-through” for partnerships applied directly, or indirectly (through a chain of partnerships). If a person is personally liable for repayment of a portion of the financing, the portion for which no person is personally liable can qualify as qualified nonrecourse financing. Reg. §1.465-27(b)(3). The activity of holding real property includes the holding of personal property and the rendering of services in connection with making real property available as living accommodations. It does not include the holding of mineral property. See §465(b)(6)(E)(i)–(ii). §§465(b)(6)(A), (B)(ii), (B)(iv). §469(a)(1)(D)(iv); §465(b)(6)(C). §465 (b)(6)(D)(ii).
䡲
150
䡲
c03.fm Page 151 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
any potential tax benefits expected to result from the transaction; and (3) such other information as the IRS may request.251 A “material advisor” means any person: (1)who provides material aid, assistance, or advice with respect to organizing, promoting, selling, implementing, or carrying out any reportable transaction; and (2)who directly or indirectly derives gross income in excess of $250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons) for such advice or assistance.252 In addition, under IRC §6112, as amended by the Jobs Act, a material advisor is required to keep lists of each person with respect to whom the advisor has acted as a material advisor with respect to a reportable transaction, generally for transactions with respect to which material aid, assistance or advice is provided. The Jobs Act repealed the present law penalty for failure to register tax shelters. Instead, amended IRC §6707 imposes a penalty on any material advisor who fails to file an information return, or who files a false or incomplete information return, with respect to a reportable transaction (including a listed transaction). The amount of the penalty is $50,000. If the penalty is with respect to a listed transaction, the amount of the penalty is increased to the greater of: (1) $200,000; or (2) 50 percent of the gross income of such person with respect to aid, assistance, or advice which is provided with respect to the transaction before the date the information return that includes the transaction is filed. Intentional disregard by a material advisor of the requirement to disclose a listed transaction increases the penalty to 75 percent of the gross income.253 (f)
Unified Audits and Adjustments
The IRS has been focusing increased attention on the proper application of the federal tax laws to partnerships, including partnerships investing in real estate. Under the Code, the tax treatment of items of partnership income, loss, deduction, and credit will be determined in a unified audit of the partnership, rather than in separate proceedings with each of the partners.254 In addition, all partners are required, on their individual returns, to treat partnership items in a manner that is consistent with the treatment of such items on the partnership’s return. This unified concept applies as well in judicial and administrative proceedings. Any such proceedings will be managed by a general partner (including an exempt organization) designated as the “tax matters partner.”255 The tax matters partner is required to keep other partners informed of administrative and judicial proceedings and to maintain a list identifying each person who invests in the partnership, in addition to other responsibilities and obligations.256 Any partner has the right to participate in any administrative proceedings relating to the determination of the partnership items at the partnership level. The tax matters partner is authorized to obtain judicial review of any proposed adjustment of partnership items by the IRS, and the outcome of that 251 252 253 254 255 256
IRC Section 6111(a). IRC Section 6111(b)(1)(A). IRC Section 6707(b). §6221; Temp. Reg. §301.6221-1T. §6231(a)(7)(A) and (B); §6223(g); Temp. Reg. §301.6231(a)(7)-1T(b). §§6223(g); 6230(e); Temp. Reg. §§301.6223(g)-1T; 301.6230(e)
䡲
151
䡲
c03.fm Page 152 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
proceeding will bind all partners. If the matters partner fails to seek judicial review of a proposed adjustment of partnership items, other partners may seek such review.257 (g)
Anti-Abuse Regulations
In May 1994, the Treasury Department proposed a broad partnership “antiabuse” rule. The proposed regulation authorized the IRS to disregard the form of a partnership transaction if the transaction involved two elements: first, if the partnership was formed or availed of with a principal purpose of substantially reducing the present value of the partners’ aggregate federal tax liability; second, if that reduction in tax liability was inconsistent with the intent of Subchapter K.258 This anti-abuse rule would have applied for all purposes under the Code (e.g., income, estate, gift, generation skipping, and excise tax).259 The proposed regulations were widely criticized as being unduly broad and vague.260 They contained only four examples, which raised more questions than they answered about the proposed rules’ scope. Many commentators called for their repeal.261 Although more expansive and specific than the proposed rules, the final regulations262 nevertheless potentially affect many partnership transactions.263 They must be carefully considered in structuring joint ventures involving exempt organizations.
257
258
259 260
261 262 263
The IRS may select the tax matters partner if the partnership does not designate one. Reg. §301.6231(a)(7)-1. The Taxpayer Relief Act of 1997 (Pub. L. No. 105-34) amended the partnership unified audit rules in various technical respects. Prop. Reg. §1.701-2(b), Notice of Proposed Rulemaking PS-27-94, 59 Fed. Reg. 25, 581 (May 17, 1994). Prop. Reg. §1.701-2(a) stated that the intent of Subchapter K of the Code was “to permit taxpayers to conduct business for joint economic profit through a flexible arrangement that accurately reflects the partner’s economic arrangement without incurring an entity-level tax.” For background on the proposed regulations, see Grace, “Partnership Anti-abuse Rule Provokes Fury,” Journal of Partnership Taxation 11 (fall 1994): 257. See, e.g., Lipton, “Controversial Partnership Anti-Abuse Prop. Regs. Raise Many Questions,” 81 Journal of Taxation 68 (Aug. 1994); “Subchapter K Anti-abuse Reg. Sparks Heated Reactions,” 63 Tax Notes 933 (May 23, 1994). For contrary views, however, see Sheppard, “Partnerships, Consolidated Returns, and Cognitive Dissonance,” Tax Notes 63 (May 23, 1994): 936; “Not All Plumbers Oppose Anti-abuse Regs,” anonymous letter to the editor, Tax Notes 63 (May 30, 1994): 1209. See, e.g., “Stakeholders Offer Different Approaches to Partnership Anti-Abuse Proposal,” Daily Tax Report (BNA) (July 7, 1994): G-4. Reg. §1.701-2, T.D. 8588, 60 Fed. Reg. 23 (Jan. 3, 1995). Practitioners met the final regulations with a similarly chilly, though somewhat less hostile, reception. See, e.g., Banoff, “Anatomy of an Anti-Abuse Rule: What’s Really Wrong with Section 1.701-2,” Tax Notes Today 95 (Mar. 21, 1995): 56–84; Grace, “Final Anti-abuse Regulation Expanded and Clarified, but Uncertainties Remain,” Journal of Partnership Taxation 12 (summer 1995): 91. But see Hyde, “Anti-abuse Rule Rhetoric Is Full of Holes,” Tax Notes Today 95 (Apr. 11, 1995): 72–49. While some commentators believe that the regulations are still too vague to provide practitioners with requisite predictability, others take the position that the regulations present little more than formalization of already established judicial doctrines, such as the business purpose test, sham transaction doctrine, step transaction doctrine, and substance over form principles. Lind, Schwartz, Lathrope, and Rosenberg, Fundamentals of Partnership Taxation, 4th ed. (Student Update Memorandum, June) (New York: Foundation Press, 1995), 18, 24. The doctrines, however, are not superseded by the regulations and may be separately applied. Reg. §1.701-2(h).
䡲
152
䡲
c03.fm Page 153 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
(i) Changes Made to the Final Regulations. Three primary changes were made to the proposed regulations in arriving at the final regulations. First, the scope of the regulations was clarified by including specific attributes that a partnership, and the transactions in which it engages, must meet in order to avoid being recast by the Commissioner. Second, a separate rule was added to address the abuse of the partnership entity.264 Third, numerous examples based on common partnership transactions describe how to determine whether a principal purpose of a transaction is the substantial reduction of federal tax liability in a manner inconsistent with Subchapter K. However, some of the examples cannot easily (if at all) be reconciled with other examples.265 (ii) Intent of Subchapter K. Many commentators criticized the proposed regulations for presuming the intent of Subchapter K without providing a clear explanation to the practitioner describing that intent. The final regulations provide that although Subchapter K is intended to permit taxpayers to conduct business activities through a flexible economic arrangement without incurring an entity level tax,266 several requirements are “implicit in the interest of Subchapter K”: • The partnership must be bona fide, and each partnership transaction or series
of transactions must be entered into for a substantial business purpose.267 • The form of each partnership transaction must be respected under substance over form principles.268 • The tax consequences under Subchapter K to each partner of partnership operations and the transactions between the partner and the partnership 264
The Commissioner has the power to treat a partnership as an aggregate of its partners (or a collection of individual taxpayers rather than a separate business entity) when the use of the partnership entity frustrates any Code provision or regulation. See Reg. §1.701-2(e)(1). This power will typically be exercised when one or more corporate partners attempt to use the partnership structure to avoid the application of Code provisions that affect only corporations. The intent of the taxpayer in structuring the transaction is irrelevant to the application of this rule. The IRS added this section to the final regulations because of its “belief that significant potential for abuse exists in the inappropriate treatment of a partnership as an entity applying rules outside of Subchapter K to transactions involving partnerships.” Tax Notes Today 95 (June 27, 1995): 124–10, Issue Paper on Subchapter K Anti-Abuse Rule.
EXAMPLE: Corporations X and Y are partners in the PRS partnership. As part of its regularly conducted business activities, PRS purchases 50 shares of Z corporation common stock. Six months later, Z announces an “extraordinary dividend,” which would, absent the partnership structure, force X and Y (as corporations) to reduce their respective bases in the Z stock by the amount of any untaxed portion of the dividend. The provision mandating this treatment, §1059, applies only to corporations—not to partnerships; accordingly, X and Y contend that they need not lower the bases in their partnership interests, and PRS contends that it need not lower its basis in the Z common stock.
265 266 267 268
Because the use of the partnership has the effect of circumventing §1059, the Commissioner may disregard the partnership entity and treat the stock as being owned by an aggregate of its partners, or individually by X and Y. Each partner of PRS would be treated as owning its share of the stock. Thus, PRS must adjust its basis in the Z stock, and X and Y must correspondingly reduce the bases of their partnership interests under §705(a)(2)(B). Reg. §1.701-2(f), ex. 2. See Grace, “Final Anti-abuse Regulation Expanded and Clarified.” Reg. §1.701-2(a). Reg. §1.701-2(a)(1). Reg. §1.701-2(a)(2).
䡲
153
䡲
c03.fm Page 154 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
must accurately reflect the partner’s economic arrangement and clearly reflect the partner’s income.269 CAVEAT If the partnership meets the first two of these requirements, it need not meet the third requirement if a section of Subchapter K and the facts and circumstances clearly contemplate that income need not be accurately reflected.* *
That is, the value equals basis rule of Reg. §1.704-1(b)(2)(iii)(c) (see generally Section 3.6(a)(ii)); an election under §754 to adjust basis (see Section 3.8(b)(ii)); and the carryover basis rules for partnership property distributed to a partner under §732 (see generally Section 3.10).
(iii) Requirement to Accord with Intent of Subchapter K. The provisions of Subchapter K and the regulations thereunder must be applied in a manner consistent with the intent of Subchapter K. If a partnership is formed or availed of in connection with a transaction, a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of Subchapter K, the Commissioner may recast the transaction for federal tax purposes, “as appropriate to achieve tax results that are consistent with the intent of Subchapter K, in light of the applicable statutory and regulatory provisions and the pertinent facts and circumstances.”270 The Commissioner may recast a transaction even if it may fall within the literal words of a particular statutory or regulatory provision.271 The Commissioner may take the following actions, to the extent necessary to achieve tax results consistent with the intent of Subchapter K: • Disregard the purported partnership, in whole or in part, and consider
the partnership’s assets and activities, in whole or in part, owned or conducted by one or more of the purported partners.272 • Treat one or more of the purported partners as not being partners.273 • Adjust the methods of accounting used by the partnership or a partner to
reflect clearly the partnership’s or the partner’s income.274 • Reallocate the partnership’s items of income, gain, loss, deduction, or
credit.275 • Otherwise adjust or modify the intended tax treatment.276
(iv) Facts and Circumstances. The proposed regulations were criticized for not stating factors on the basis of which the Commissioner may determine that a transaction conflicts with the intent of Subchapter K. The final regulations set 269 270 271 272 273 274 275 276
Reg. §1.701-2(a)(3). Reg. §1.701-2(b). See id. Reg. §1.701-2(b)(1). Reg. §1.701-2(b)(2). Reg. §1.701-2(b)(3). Reg. §1.701-2(b)(4). Reg. §1.701-2(b)(5).
䡲
154
䡲
c03.fm Page 155 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
forth, with numerous caveats, are factors to consider in analyzing all the facts and circumstances. These factors “may be indicative, but do not necessarily establish,” that a partnership was used impermissibly. These factors are illustrative only, and therefore may not be the only factors taken into account in making the determination. Moreover, the weight given to any factor (including factors not specified in the regulations) depends on all the facts and circumstances. The presence or absence of any listed factor does not create a presumption that a partnership was (or was not) used impermissibly. Reg. §1.701-2(c) lists the following factors: • The present value of the partners’ aggregate federal tax liability is sub-
stantially less than had the partners owned the assets and conducted the partnership activities directly.277 • The present value of the partners’ aggregate tax liability is substantially
less than would be the case if purportedly separate transactions, designed to achieve a particular end result, were integrated and treated as steps in a single transaction.278 • One or more partners who are necessary to achieve the claimed tax results
either have a nominal interest in the partnership, are substantially protected from any risk of loss from the partnership’s activities (through distribution preferences, indemnity or loss guarantee agreements, or other arrangements), or have little or no participation in the profits from the partnership’s activities other than a preferred return that is in the nature of a payment for the use of capital.279 • Substantially all of the partners (measured by number or interests in the
partnership) are related (directly or indirectly) to one another.280 • Partnership items are allocated in compliance with the literal language of
§§1.704-1 and 1.704-2 but with results that are inconsistent with the purpose of §704(b) and those regulations.281 • The benefits and burdens of ownership of property nominally contrib-
uted to the partnership are in substantial part retained (directly or indirectly) by the contributing partner (or a related party).282 • The benefits and burdens of ownership of partnership property are in
substantial part shifted (directly or indirectly) to the distributee party before or after the property is actually distributed to the distributee party (or a related party).283 277 278 279 280 281
282 283
Reg. §1.701-2(c)(1). Reg. §1.701-2(c)(2). Reg. §1.701-2(c)(3). Reg. §1.701-2(c)(4). Reg. §1.701-2(c)(5). In this regard, particular scrutiny will be paid to partnerships in which income or gain is specially allocated to one or more partners that may be legally or effectively exempt from federal taxation (for example, a foreign person, an exempt organization, an insolvent taxpayer, or a taxpayer with unused federal tax attributes such as net operating losses, capital losses, or foreign tax credits). Reg. §1.701-2(c)(6). Reg. §1.701-2(c)(7).
䡲
155
䡲
c03.fm Page 156 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
(v) Examples. Absent other facts, the IRS does not consider the following partnership transactions inconsistent with the intent of Subchapter K: • The use of a partnership by a business to obtain limited liability for some
of its partners and flow-through tax treatment, thus avoiding an entitylevel tax on any income generated by the business284 • The use of a partnership (or real estate investment trust), rather than a
corporation to avoid recognition of gain under §351(e)285 and §357(c)286 on the contribution of encumbered real estate287 • A special allocation of depreciation deductions or tax credits to taxable or
high-bracket partners away from a tax-exempt or low-bracket partner, as long as the allocation has substantial economic effect288 • Failure to make a §754 election or proper use of the §732 liquidation rules
(both of which can result in disproportionally high bases in distributed property)289 The anti-abuse rules would be violated, however, if a transitory partner were involved in a series of transactions in which the business purpose is insignificant as compared with the conferred tax benefits,290 or when a double loss is created by contribution of loss property to a partnership that fails to make a §754 election.291 The following examples demonstrate transactions that are not consistent with the intent of Subchapter K: EXAMPLE: X, a tax-exempt organization, and Y, a for-profit organization form the PRS partnership. Y is in the 40 percent tax bracket. Y contributes $250,000 in taxexempt bonds and $250,000 in taxable securities as its capital contribution. X contributes a like amount of cash. X and Y agree that any tax-exempt interest will be allocated 90 percent to Y and 10 percent to X, and any taxable interest or dividends will be allocated 90 percent to X and 10 percent to Y. In the absence of such an agreement, the interest and dividends would have been divided equally between X and Y. The partnership earns $25,000 of tax-exempt interest and 284 285 286
287
288 289 290
291
Reg. §1.701-2(d), ex. 1. §351(e) prohibits the diversification of a taxpayer’s investments through a tax-free transfer of the taxpayer’s assets to a corporation. §357(c) provides that a taxpayer must recognize gain to the extent that he or she is relieved of debt in excess of his or her basis in property transferred to a corporation in a tax-free formation or reorganization of the corporation. Reg. §1.701-2(d), ex. 4. This example was included to assuage apprehensions that the Service might invoke Reg. §1.701-2 to invalidate the formation of an umbrella partnership REIT (UPREIT). However, soon after the example was released, the IRS national office informally imposed a moratorium on issuing private letter rulings on UPREITs while it studied the scope of the example and any potential abuses it may have been read to permit. Although the moratorium later was lifted, the National Office cautioned that transactions not identical or substantially similar to the example could be viewed as violating the antiabuse rule. Reg. §1.701-2(d), ex. 5. See infra Chapter 10 (tax-exempt entity leasing rules) and Sections 8.4–8.7 (“fractions rule”). Reg. §1.701-2(d), ex. 9 & 10. Lind, Schwartz, Lathrope, Rosenberg, Fundamentals of Partnership Taxation, 4th ed. (Student Update Memorandum, June) (New York: Foundation Press, NY, 1995), 22; Reg. §1.7012(d), ex. 7. Id., ex. 8.
䡲
156
䡲
c03.fm Page 157 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
$25,000 in taxable dividends. Compare the tax effects of the special allocation versus a 50/50 allocation: 50/50 ALLOCATION X Tax-Exempt Interest Taxable Dividends Pre-Tax Income Tax on Dividends After-Tax Income
12,500 12,500 25,000 —0— 25,000
Y 12,500 12,500 25,000 (5,000) 20,000
SPECIAL ALLOCATIONS X Tax-Exempt Interest Taxable Dividends Pre-Tax Income Tax on Dividends After-Tax Income
2,500 22,500 25,000 —0— 25,000
Y 22,500 2,500 25,000 (1,000) 24,000
Because the special allocations would have resulted in the substantial reduction of the present value of the partners’ aggregate federal tax liability in a manner “inconsistent with the intent of Subchapter K” and do not accurately reflect the partners’ income, the Commissioner may find that this reduction in tax liability was a principal purpose underlying the formation of the partnership. Accordingly, the Commissioner may reallocate the income on a 50/50 basis.292 EXAMPLE: Partnership PRS has for several years engaged in the development and management of commercial real estate projects including Blackacre. X, an unrelated party, wants to purchase Blackacre, an undeveloped parcel of real property with a value of $95 and a basis of $5. X intends to hold Blackacre for some time. Rather than purchase the property outright for $95, X contributes $100 to PRS in exchange for a partnership interest. Soon thereafter, PRS makes a liquidating distribution to X of Blackacre and machinery with a value and basis of $5. Under §732(b) and (c), X’s basis in its partnership interest is allocated between the assets distributed proportionally to their bases—in this case $50 each. X plans to sell the machinery for $5 and recognize a $45 loss. Between the tax benefit of the $45 loss
292
Note that these special allocations will also fail the substantiality test (see Section 3.6(a)(ii)). This illustration is adapted from an example in Lind, Schwartz, Lathrope, and Rosenberg, Fundamentals of Partnership Taxation, 3d ed. (New York: Foundation Press, 1991), 153, and Reg. §1.704-1(b)(5), ex. 5.
䡲
157
䡲
c03.fm Page 158 Wednesday, March 7, 2007 6:58 PM
TAXATION OF PARTNERSHIPS AND JOINT VENTURES
and the $5 received from the sale of the unwanted machinery, X will recover almost immediately a portion of the original Blackacre purchase price. This basis shift provides a federal income tax benefit to X, with no offsetting detriment to any of PRS’s partners. Although the partnership has complied with the letter of Subchapter K, the resulting situation does not properly reflect X’s income. Further, the basis distortion caused by the shifting of a significant portion of X’s basis to an inconsequential asset—the $5 machinery—has served to frustrate the intent of §732, which was intended to simplify tax results for bona fide partnership transactions having a substantial business purpose. Accordingly, the Commissioner may recast the transaction as necessary to ensure proper reflection of income and conformity with the intent of Subchapter K.293 The scope of the final regulations was limited by Announcement 95-8,294 which stated that the regulation would be amended so that it would apply solely to taxes under Subtitle A of the Code (income taxes). The final regulations were then amended.295 Because the regulations would not apply to transfer (estate and gift) taxes, two of the 13 examples, dealing with family partnerships, were eliminated and the remaining examples renumbered.296 (vi) Application by Revenue Agents. The final regulations reduced, but by no means eliminated, concern about how revenue agents examining partnership returns might seek to apply the anti-abuse rule. These apprehensions increased when, at approximately the same time the final regulations were issued, the IRS announced that it was increasing the resources of its Industry Specialization Program (ISP) dedicated to examinations of partnership returns and that a new ISP team would be appointed to coordinate applications of the anti-abuse rule. In an attempt to allay practitioners’ concerns, the IRS issued two announcements. First, in Announcement 94-87,297 the Service announced that revenue agents would be required to coordinate any application of Regulation §1.701-2 with both the ISP specialists and the IRS national office.298 Later, the IRS issued a Notice that expanded on the specific procedures that were to be followed by a revenue agent seeking to apply the anti-abuse rules.299 The Notice stated that if an examiner believes the anti-abuse rule should apply to a case, the examiner must contact one of the Service’s designated partnership issue specialists “as early as possible” during the examination process. The examiner should not raise the issue with the taxpayer until clearance has been obtained from the specialist. The specialist will review the facts of the case and, if the specialist determines that the issue has merit, will bring it before the 293 294 295 296 297 298
299
Reg. §1.701-2(d), ex. 13. Note that this arrangement will not meet the business purpose test and/or the requirements of the sham transaction doctrine. Ann. 95-8, 1995-7 I.R.B. 56. T.D. 8592, 26 C.F.R. pt. 1 (Apr. 12, 1995). See id. Announcement 94-87, 1994-27 I.R.B. 124. A Coordinated Issue Paper was also released to highlight the regulation and the announcement. The paper, however, merely paraphrased the regulations and did not specifically address the procedures to be followed when the regulation is considered on examination. Notice dated Oct. 24, 1995, at 16, reprinted in Standard Federal Tax Reporter (CCH) ¶ 46,038 (1996).
䡲
158
䡲
c03.fm Page 159 Wednesday, March 7, 2007 6:58 PM
3.12 OTHER TAX ISSUES
entire industry team (which includes members from the IRS Office of Chief Counsel). If the team agrees the issue has merit, the specialist will inform the examiner. Only at that time may the examiner raise the partnership anti-abuse rule with the taxpayer. It is estimated that this process will take a maximum of 60 days from the time the specialist first receives the case. Although practitioners welcomed these guidelines, the jury remains out on whether these stated clarifications will prevent “renegade” revenue agents from misapplying the anti-abuse rule or overstepping its bounds. Only time will tell whether the Service will maintain the announced safeguards once the initial concerns over the anti-abuse rule have abated. (h)
Foreign Partnerships300
A number of rules are designed to prevent partnerships from shifting income from U.S. to foreign sources. Section 721(c) allows the Treasury to issue regulations under which gain realized upon transferring property to a partnership (foreign or domestic) must be recognized if the gain will be shifted to a person other than a U.S. person.301 A foreign partnership now must file a partnership return if the partnership has gross income from U.S. sources or gross income effectively connected with the conduct of a trade or business within the United States. Domestic (U.S.) partners of foreign partnerships now must comply with the same information reporting requirements that apply to U.S. shareholders of foreign corporations. Finally, a partner must report a transfer of property to a foreign partnership if the transferring partner holds at least a 10 percent interest immediately after the transfer or the value of the property transferred during the prior 12-month period exceeds $100,000. (i) Investment Companies. In general, a contributing partner does not recognize gain upon contributing property to a partnership.302 An exception is made if the partnership, if incorporated, would be classified as an investment company.303 Before the 1997 Act, a partnership would be treated as an investment company only if (1) the transfer to the partnership resulted in diversification of the transferors’ interests and (2) the transferee was a regulated investment company, a real estate investment trust, or an entity more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations) were held for investment and were readily marketable stocks or securities. The 1997 Act does not alter the “diversification” prong of this test. However, it greatly expands the types of financial instruments that must be taken into account to include items such as options, forward or futures contracts, notional principal contracts, derivatives, and interests in publicly traded partnerships. In addition, all stocks and securities must be taken into account whether or not they are readily marketable. This change will expand the circumstances under which partners must recognize gain in contributing property to a partnership. 300 301 302 303
See Chapter 17, which discusses international joint ventures. New §721(c) replaces the excise tax under §1491 that had been applied when property was transferred to a foreign partnership. §721(a). §721(b), cross-referencing §351(e).
䡲
159
䡲
c04.fm Page 160 Thursday, March 15, 2007 5:17 PM
C H A P T E R
F O U R 4
Overview: Joint Ventures Involving Exempt Organizations 4.1
INTRODUCTION
The participation of tax-exempt organizations in joint ventures with taxable entities is increasing at a rapid pace, particularly in the healthcare and low-income housing fields.1 Current economic and social conditions present exempt organizations that seek to expand and diversify their activities with significant opportunities to further their charitable purposes through participation in joint ventures.2 Exempt organizations are becoming more entrepreneurial, as government funding for the nonprofit sector has decreased and there is increased competition for contributions from the general public.3 Starting in the 1980s, nonprofits faced huge cutbacks in government contracts and grants. The effect of this decrease in available government funding was amplified in the 1990s with a dynamic growth in the number of new nonprofit organizations. Of course, the September 11 tragedy added another dimension, as nonprofit organizations that were not responding to the disaster faced the great challenge of retaining their existing donors while attracting new contributors. The confluence of these factors has caused organization managers to look outside of the traditional sources of fundraising. More often than not, joint ventures with for-profit entities have become an essential norm within the exempt community. Joint ventures give charitable organizations an opportunity to raise capital beyond individual and corporate giving, give third parties a stake in the enterprise, and create economic efficiencies. In addition, a for-profit partner, such as a pre-existing managed care network, may bring its expertise to the venture and thereby enable the exempt organization to continue operations with enhanced capability and operating revenues.
1
2 3
See Sanders, Roady, and Cobb, “Partnerships and Joint Ventures: Alive and Well or Endangered Species,” NYU Eighteenth Conf. on Tax Planning for §501(c)(3) Organizations (1990). Portions of this chapter are based on research from the author’s NYU article. See also Petroff, “Whole Hospital Joint Ventures: The IRS Position on Control,” Exempt Organization Tax Review (July 1998). See id. See id.
160
c04.fm Page 161 Thursday, March 15, 2007 5:17 PM
4.1 INTRODUCTION
There are numerous structural techniques that an exempt organization might utilize in expanding its activities. A partnership, limited liability company, or other joint venture arrangement can be formed with taxable or exempt entities. In some cases, when the project furthers an organization’s exempt purpose, it may serve as a general partner of a partnership or as a managing member4 of a limited liability company, with operational responsibilities for the project.5 Alternatively, because the Internal Revenue Service (IRS) has established strict requirements for charitable organizations that serve as general partners or managing members,6 the organization may choose to form a subsidiary or an affiliate to serve in such capacity.7 In other cases, particularly when a certain transaction does not further the organization’s exempt purposes, the exempt organization may serve as limited partner or otherwise as an investor.8 Alternatively, the exempt organization’s role may be limited to that of a lender or lessor, with or without some participation in the profits of the venture.9 This chapter focuses on the viability of, and consequences to, exempt organizations that participate in joint ventures with taxable and exempt entities. It explains the IRS’s evolving approach, from an initial per se prohibition to the current practice of examining all relevant factors that indicate whether the nonprofit’s charitable assets and purposes are protected and accomplished by the venture. It also examines how participation as a general partner or member of a limited liability company, by itself or through a subsidiary, might affect an organization’s exempt status; the tax treatment of income derived by the exempt organization as venturer or lender; and the effect on the taxable entities of having an exempt organization involved in the joint venture or partnership.
4 5
6
7
8
9
The term for a person or entity that participates in the management of a limited liability company varies from state to state. See generally Chapter 19. See Plumstead Theatre Soc’y, Inc. v. Commissioner, 675 F.2d 244 (9th Cir. 1982) (per curiam) aff’g 74 T.C. 1324 (1980); Rev. Rul. 68-655, 1968-2 C.B. 213 (development of low- and moderate-income housing as a means of lessening neighborhood tensions and combating neighborhood deteriorations is a charitable purpose). See also Gen. Couns. Mem. 39, 005 (Dec. 17, 1982); Priv. Ltr. Rul. 91-48-047 (Sept. 5, 1991). But cf. Gen. Couns. Mem. 36, 293 (May 30, 1975). Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 39,005 (Dec. 17, 1982). This concept is equally applicable to a nonprofit serving as a managing member of a limited liability company (LLC). See Chapter 19. See generally California Thoroughbred Breeders Ass’n v. Commissioner, 57 T.C.M. (CCH) 962 (1989). A tax-exempt organization, pursuant to §501(c)(5), replaced its joint venture horse auction operation with a for-profit subsidiary. The change in structure from a joint venture arrangement to a taxable subsidiary was made because the exempt organization was “at a crossroads” with the joint venturer and the taxable subsidiary was the best alternative available. Previously, the tax-exempt organization, whose exempt purpose was to “encourage, assist, regulate and protect the raising and breeding of thoroughbred horses . . .” had entered into a joint venture with a for-profit auction company. The Tax Court held that the joint venture auction activities were “substantially related” to the tax-exempt purpose. See Priv. Ltr. Rul. 92-07-033 (Nov. 20, 1991). As a limited partner, the exempt organization may be subject to the unrelated business income tax on income from the partnership’s business activity that is unrelated to the exempt organization’s exempt purposes. See generally §§511–513. See Priv. Ltr. Rul. 91-12-013 (Mar. 22, 1991).
161
c04.fm Page 162 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
4.2 (a)
EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE Introduction
As nonprofit organizations have developed new ways of generating funds and fulfilling their exempt purposes, the IRS has responded in what has become an evolving approach. Initially, the IRS’s position was that a nonprofit was per se prohibited from serving as a general partner.10 After this position was defeated in the courts, the IRS adopted a two-prong test to determine the permissibility of the general partner role.11 That two-prong test has now evolved into an examination of the facts and circumstances of each case to determine whether, through analysis of a variety of criteria, the nonprofit has retained sufficient control over the project to ensure that its exempt purposes will be fulfilled.12 The development of each of these stages is discussed in the following paragraphs. (b)
Per Se Prohibition
Prior to Plumstead Theatre Soc’y v. Commissioner,13 an exempt organization automatically ceased to qualify as a tax-exempt organization under Internal Revenue Code (IRC) §501(c)(3) when it served as a general partner in a partnership that included private investors as limited partners14 or if it otherwise shared net profits.15 EXAMPLE: In General Counsel Memorandum 36,293, an exempt organization under IRC §501(c)(3) formed a limited partnership. The exempt organization would serve as the general partner, and private investors, infusing venture capital, would serve as limited partners. The IRS regarded the limited partnership arrangement as a means for sharing the net profits of an income-producing venture with private individuals and, hence, incompatible with being operated exclusively for charitable purposes. By its agreement to serve as the general partner, the IRS held that the exempt organization shouldered an obligation to further the “private financial interests of the limited partners.”16 The IRS found support for this “per se” position in the regulations: An organization is not organized or operated exclusively for one or more of the purposes specified in subdivision (i) of this subparagraph unless it serves a public rather than a private interest. Thus, to meet the requirement of this subdivision, it is necessary for an 10 11 12 13 14
15
16
See Section 4.2(b). See Section 4.2(d). See Section 4.2(f). Plumstead Theatre Soc’y, Inc. v. Commissioner, 675 F.2d 244 (1982) (per curiam), aff’g 74 T.C. 1324 (1980). For an entity to be classified as a limited partnership, the entity must fulfill the criteria set forth in Rev. Proc. 89-12, 1989-1 C.B. 798. See generally Rev. Proc. 72-13, 1972-1 C.B. 735 and Rev. Proc. 74-17, 1974-1 C.B. 438. See Gen. Couns. Mem. 36, 293 (May 30, 1975), which highlights the IRS former position. The IRS reasoned that the partnership structure was incompatible with the charitable purposes of exempt entities because, in a partnership, there must be joint profit motive. Reg. §301.77012(a)(2); Gen. Couns. Mem. 39,546 (Aug. 15, 1986). Gen. Couns. Mem. 36, 293 (May 30, 1975).
162
c04.fm Page 163 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organizations, or persons controlled, directly or indirectly, by such private interests.17
The IRS rationalized that an exempt organization’s participation as a general partner in a limited partnership would substantially promote the private interests of the limited partners.18 This assumption of a duty to promote the limited partners’ interests would “necessarily create a conflict of interest that is legally incompatible with the exempt organization being operated exclusively for charitable purposes.”19 Furthermore, under a limited partnership arrangement, the exempt general partner would assume unlimited liability to creditors and third parties for partnership activities.20 Although this risk may be mitigated by agreement, insurance, indemnification, or contributions from other partners,21 all of the exempt organization’s assets, including those used exclusively for charitable purposes, could be exposed to liability.22 The IRS then began to relax its per se prohibition by adopting a “close scrutiny” facts and circumstances test.23 In General Counsel Memorandum 37,852, an exempt organization planned to enter into a joint venture arrangement with a for-profit pharmaceutical company and the company’s subsidiary.24 Through the joint venture, the corporations planned to construct and operate a jointly owned facility. Assuming arguendo that the joint venture would be a partnership, the IRS stated: [A]ny partnership or other joint venture arrangement between an organization described in IRC §501(c)(3), and one or more for-profit entities obviously requires careful scrutiny due to the strong possibility of conflict between the exempt organization’s duty to operate exclusively for exempt purposes and any duty it may have to advance the private interests involved in the venture. However, such an arrangement does not per se preclude exemption under §501(c)(3); and in some circumstances, there may be no conflict between the charitable and for-profit purposes.25
17 18 19 20
21 22
23
24 25
Reg. §1.501(c)(3)-1(d)(1)(ii); §501(c)(3). See id. See id. However, Reg. §301.7701-2(d)(2), with regard to classification, provides as follows: If the limited partnership agreement provides that a general partner is not personally liable to creditors for the debts of the partnership (other than debts for which another general partner is personally liable), it shall be presumed that personal liability does not exist with respect to that partner unless it is established that the provision is ineffective under local law. Reg. §1.752-2(b)(3) & (5). Gen. Couns. Mem. 36,293 (May 30, 1975); Gen. Couns. Mem 39,546 (Aug. 15, 1986). In Gen. Couns. Mem. 37,259 (Sept. 19, 1977), a tax-exempt organization sought to form a joint venture with a commercial entity to distribute an educational film. The IRS stated that if the arrangement furthered the private interests of the joint venturers, then the per se rule in Gen. Couns. Mem. 36,293, supra, would control. Gen. Couns. Mem. 37,852 (Feb. 15, 1979). See also O.M. 19,225 (Mar. 13, 1980) (the IRS indicated, in this interoffice technical memorandum, that an exempt organization’s participation in a partnership as a general partner should not per se result in a denial of tax-exempt status under §501(c)(3)). Gen. Couns. Mem. 37,852 (Feb. 9, 1979). See id.
163
c04.fm Page 164 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
However, with the advent of the Tax Court’s decision in Plumstead,26 the climate for exempt organizations serving as general partner in limited partnership arrangements dramatically improved. The per se prohibition was abandoned. (c)
Plumstead Theatre Society Doctrine
In Plumstead, a nonprofit, tax-exempt corporation, the Plumstead Theatre Society, was formed to promote and foster the performing arts, including theater.27 The Society engaged in a number of artistic endeavors, including the coproduction and co-financing of a play with the John F. Kennedy Center for the Performing Arts.28 Prior to the opening of the play, the Plumstead Theatre Society encountered financial difficulties in raising its share of costs.29 To assist in its funding, the Plumstead Theatre Society formed a limited partnership30 in which it served as sole general partner, and two individuals and Pantheon Pictures, Inc., a for-profit corporation, served as limited partners.31 Under the partnership agreement, the limited partners were required to contribute $100,000. In return, the limited partners received a 63.5 percent share in any profits or losses resulting from the play.32 Ultimately, the play closed at a loss.33 The IRS denied tax-exempt status to the Plumstead Theatre Society on the ground that it was not operated exclusively for charitable purposes under IRC §501(c)(3). The IRS reasoned that Plumstead had a substantial commercial purpose and was operated for the benefit of private, rather than public, interests.34 However, the Court of Appeals for the Ninth Circuit affirmed the Tax Court’s holding that Plumstead was operated exclusively for “charitable and educational” purposes within the meaning of §501(c)(3)35 and therefore qualified for tax-exempt status.36 The court held that the limited partnership agreement expressly reserved full management control to Plumstead; hence, the arrangement did not impermissibly serve the private interests of the limited partners.37 The Tax Court focused on the limited partnership agreement, which contained several “safeguards” successfully insulating the exempt organization
26 27 28 29 30 31 32 33 34 35 36
37
Plumstead, 74 T.C. at 1324. Plumstead, 675 F.2d at 245. See id. Plumstead, 74 T.C. at 1328. See id See id. See id. See id. See id. §501(c)(3); Reg. §1.501(c)(3)-1. Plumstead, 675 F.2d at 245. The IRS argued on appeal that the Tax Court erred when it found that Plumstead was not operated for the benefit of private individuals in violation of Reg. §501(c)(3)-1(d)(1)(ii). The IRS argument was not found to be persuasive by the Ninth Circuit Court of Appeals. Plumstead, 675 F.2d at 245. The Court analogized to the factual situation in Broadway Theatre League of Lynchburg, Va., Inc. v. United States, 293 F. Supp. 346 (W.D. Va. 1968). In that case, a contract with a booking agent under which the agent was paid a percentage of the membership dues did not impermissibly interfere with the theater’s exempt purposes.
164
c04.fm Page 165 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
from potential conflict with its exempt purpose.38 The safeguards included the following: • The exempt organization’s sale of its interest through an arm’s length
transaction for a reasonable price • The exempt organization’s lack of obligation to return the capital contri-
bution made by the limited partners • The limited partners’ lack of control over the exempt organization’s affairs • The lack of a profit motive by the exempt organization • The fact that none of the limited partners or any officer or director of
those partners was an officer or director of the exempt organization39 As a result of this holding, the IRS abandoned its position that an exempt organization’s participation in a partnership as a general partner necessitated a per se denial of tax-exempt status.40 (d)
The Two-Prong Test: IRS Adopts Plumstead Theatre Doctrine
(i) Adopting Plumstead. After its defeat in Plumstead, the IRS began to use a two-prong test for analyzing whether a tax-exempt organization, by serving as a general partner in a limited partnership, jeopardizes its tax-exempt status. This two-prong analysis of a partnership or other joint venture arrangement between an IRC §501(c)(3) organization and one or more for-profit entities requires “close scrutiny” to determine whether the potential conflict between the exempt organization’s duty to operate exclusively for exempt purposes and any duty it may have to advance private interests, placed the organization’s exempt status in question:41 [I]n all partnership cases, initial focus should be on whether the organization is serving a charitable purpose. Once charitability has been established, the partnership arrangement itself should be examined to see whether the arrangement permits the exempt organization to act exclusively in furtherance of the purposes for which exemption may be granted and not for the benefit of the limited partners.42 38
39 40
41 42
Plumstead, 74 T.C. at 1333. See also Gen. Couns. Mem. 39,546 (Aug. 15, 1986). The memorandum deals with the safeguards necessary for an exempt organization, acting as a sole general partner of a limited partnership, to meet its fiduciary duties to the other partners and at the same time be operated exclusively for charitable purposes. Plumstead, 74 T.C. at 1333. Gen. Couns. Mem. 39,005 (Dec. 17, 1982). See also Gen. Couns. Mem. 39,732 (May 27, 1988). In a case involving an exempt organization that is a private foundation satisfying the excess business holdings rules under §4943, the foundation must still satisfy the double-prong test of the Plumstead doctrine to remain an exempt organization. See Section 10.1. See id. Id. Priv. Ltr. Rul. 93-49-032 (Sept. 17, 1993) (exempt organization participated in a low-income housing joint venture. In addition, the exempt organization performed all management and administrative functions for the venture and earned fees therefrom. The IRS, relying on the Plumstead analysis, held that the exempt organization could participate in the venture through its subsidiary without jeopardizing its exempt status and that the management fee income was not subject to unrelated business income tax (UBIT)); Priv. Ltr. Rul. 93-50-044 (Sept. 24, 1993) (exempt organization entered into a joint venture with a commercial television network to produce educational television programming for children. The IRS utilized the Plumstead doctrine to hold that the exempt organization could participate in this joint venture without
165
c04.fm Page 166 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
In General Counsel Memorandum 39,005, an exempt organization was one of several general partners in a limited partnership created to construct, own, and operate a federally financed apartment project for limited-income, disabled, and elderly persons. The organization retained its exempt status on the basis of two factors: its charitable purpose and its insulating structure. First, the IRS scrutinized the purpose of the limited partnership, to determine whether or not a charitable purpose was being served, and found that providing housing for low-income, elderly, and disabled individuals is a well-recognized charitable purpose:43 [I]n the instant case, the Corporation’s participation in the building and management of a government-financed housing project for the handicapped and elderly serves to further charitable purposes. As a direct result of the Corporation’s participation, 100 percent of the units will be held open to elderly or handicapped individuals with limited incomes (although the government subsidy program requires that only 85 percent of the units be made available to these tenants). Moreover, the Corporation will conduct numerous programs to meet the physical, social and recreational needs of this group. The IRS has held that an organization which undertakes these activities is operating exclusively for charitable purposes.44
In the second prong of its analysis, the IRS examined the transaction to determine whether the nonprofit and its charitable purposes are protected or “insulated” from conflict. This step is triggered because, notwithstanding an established charitable purpose, conflicts with charitable goals can arise in a limited partnership situation. This can occur because the use of the partnership vehicle jeopardizing its exempt status); Priv. Ltr. Rul. 94-38-030 (June 28, 1994) (without expressly citing Plumstead, IRS applied the two-prong test to approve participation of an exempt organization as general partner in low-income housing joint venture, when the venture’s terms and the presence of governmental regulatory controls ensured furtherance of exempt purpose rather than private benefit; development, management, and consulting fees not subject to UBIT); Priv. Ltr. Rul. 96-45-018 (Aug. 9, 1996) (IRS, relying in part on Plumstead, ruled that a §501(c)(3) exempt organization’s participation in the ownership and operation of an existing joint venture LLC, which provided dialysis services on an outpatient basis, including the exempt organization’s proportionate participation in any loans or financing incurred by the LLC, would not jeopardize its §501(c)(3) exempt status); Priv. Ltr. Rul. 97-09-014 (Nov. 26, 1996) (IRS ruled that hospital’s acquisition of general partnership interest in an ambulatory surgical center will not jeopardize its exempt status, stating, among other things, that the hospital’s arrangement with for-profit partners does not per se endanger its exempt status and that the hospital would continue to promote health because of its control over the partnership and the requirements of the certificate of need). See also discussion of Priv. Ltr. Ruls. 97-36-039 (Sept. 15, 1997) and 97-31-038 (May 7, 1997) in Section 4.2(b). 43
44
Charitable is defined in the regulations in its generally accepted legal sense. Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Gen. Couns. Mem. 39,862 (Nov. 21, 1991) (whenever a charitable organization engages in unusual financial transactions with private parties, the arrangements must be evaluated in light of the tax law and other legal standards); §501(c)(3); Reg. §1.501(c)(3)-1(d)(2). For a detailed discussion of tax-exempt purposes under §501(c)(3), see Chapter 2. Gen. Couns. Mem. 39,005 (Dec. 17, 1982). The IRS was careful to distinguish the factual situation in Gen. Couns. Mem. 36,293 (May 30, 1975). There, the organization could not establish a charitable purpose for the project. First, only a portion of the units were for low-income individuals; thus, the project was not seen as relieving the poor or distressed. Second, the project was to be located in an affluent suburb with no indication of decay or community tension. Reg. §1.501(c)(3)-1(d).
166
c04.fm Page 167 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
imposes certain statutory obligations on the general partner or because the partnership agreement can impose obligations or take away rights and powers a partner might otherwise have.45 Those obligations include an assumption of liabilities by the general partner, which exposes the general partner’s personal assets to partnership debts and liabilities, as well as a basic profit orientation in furtherance of the interests of the limited partners.46 However, a partnership agreement may be structured to preclude a conflict of interest between the tax-exempt general partner’s obligations and its charitable purposes.47 For example, the structure of the partnership arrangement in General Counsel Memorandum 39,005 averted significant conflict for the following reasons: • Only the for-profit general partners were obligated to protect the interests
of the limited partners. • Other general partners reduced the exempt organization’s risk of expo-
sure of its charitable assets. • The exempt organization had no liability on the mortgage, which was
non-recourse. • Department of Housing and Urban Development income guidelines
restricted the partnership’s pursuit of private profit.48 These criteria are developed in greater detail below. (ii) Application of the Two-Prong Analysis (A) C HARITABLE P URPOSE As set forth in Plumstead, the activities of a venture must further recognize charitable purposes. The term charitable includes [r]elief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (1) to lessen neighborhood tensions; (2) to eliminate prejudice and discrimination; (3) to defend human and civil rights secured by law; or (4) to combat community deterioration and juvenile delinquency.49
45
46 47
48 49
See Uniform Limited Partnership Act, §9 (approved by the National Conference of Commissioners on Uniform State Laws in 1916); Revised Uniform Limited Partnership Act, §403 (approved by the National Conference of Commissioners in 1976). See generally Mery v. Universal Sav. Ass’n, 737 F. Supp. 1000 (S.D. Tex. 1990) (general partner jointly and severally liable for partnership acts); Betz v. Chena Hot Springs Group, 657 P.2d 831 (Alaska 1982) (general partner personally liable on debts even after retirement from partnership). Gen. Couns. Mem. 39,005 (Dec. 17, 1982). See also Uniform Limited Partnership Act, supra note 46; Revised Uniform Limited Partnership Act, supra note 46. See Reg. §301-7701-2(d)(2) (structuring limited partnership agreement to shield general partner). However, if the general partner is completely shielded from liability, then the entity may be viewed as something other than a partnership. Gen. Couns. Mem. 39,546 (Aug. 15, 1986). Gen. Couns. Mem. 39,005 (Dec. 17, 1982). Reg. §1.501(c)(3)-1(d)(i). See generally Chapter 2.
167
c04.fm Page 168 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
A single substantial noncharitable purpose can destroy the tax-exempt status of an organization, regardless of the presence of charitable purposes.50 Furthermore, if the public benefit derived from the exempt organization’s activity bears only a tenuous relationship to its underlying charitable purpose, then the risk of forfeiture of its exempt status is greatly increased.51 Determining whether a benefit flowing to private individuals evidences a substantial noncharitable purpose frequently requires a balancing of interests.52 Necessarily, an inquiry must be made as to whether the exempt organization serves a public rather than a private interest.53 Successfully traversing the “charitable purpose” prong is not an easy task. However, exempt organizations that further medical and low-income housing goals have been particularly successful. The acquisition of medical equipment,54 the provision of medical services,55 and the construction and operation of a medical building56 or facility57 have each
50
51
52
53
54 55 56
57
Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279 (1945); Universal Life Church, Inc. v. United States, 13 Cl. Ct. 567 (1978), aff’d, 862 F.2d 321 (1988) (court utilized the single noncharitable purpose test to balance the charitable and noncharitable purposes, ultimately denying the tax exemption); Stevens Bros. Found., Inc. v. Commissioner, 324 F.2d 633 (8th Cir. 1963), aff’g 39 T.C. 93 (1962), cert. denied, 376 U.S. 969 (1964), reh’g denied, 377 U.S. 920 (1964); Copyright Clearance Ctr. v. Commissioner, 79 T.C. 793, 804 (1982). Reg. §501(c)(3)-1(e)(1); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The memorandum reviews three letter rulings on the issue of whether an exempt organization jeopardizes its exempt status by forming joint ventures with hospital staff and selling to the joint venture the revenue stream from all or a portion of the hospital. The IRS noted that the exempt status was in jeopardy for three reasons: The organization allows inurement of part of a charitable organization’s net earnings to the benefit of private individuals; more than incidental benefits are conferred on private interests; and federal laws may be violated. See generally Chapter 5 (private inurement). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See Aid to Artisans, Inc. v. Commissioner, 71 T.C. 202 (1978) (public versus private benefits must be determined by examining the charitable purposes for which the organization is operated). §501(c)(3) (no portion of the net earnings may inure to the benefit of private interests); Reg. §1.501 (c)(3)-1(d)(1)(ii). See also Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992) (prohibited private benefits may include an “advantage; profit; fruit; privilege; gain; [or] interest.”); Retired Teachers Legal Fund v. Commissioner, 78 T.C. 280, 286 (1982). Airlie Found. Inc. v. United States, 826 F. Supp. 537 (D.D.C. 1993), aff’d, 55 F.3d 684 (D.C. Cir. 1995) (tax-exempt organization’s exempt status was revoked because a substantial number of its activities served the private interest of its executive director and a part of its earnings inured to the benefit of the director). Priv. Ltr. Rul. 88-33-038 (May 20, 1988) (magnetic resonance imaging equipment); Priv. Ltr. Rul. 83-44-099 (Aug. 5, 1983) (computerized tomography scanner). Rev. Rul. 69-545, 1969-2 C.B. 117; Priv. Ltr. Rul. 93-08-034 (Nov. 30, 1992) (acute care services); Priv. Ltr. Rul. 92-46-004 (July 22, 1992); Priv. Ltr. Rul. 85-34-089 (May 31, 1985). Rev. Rul. 69-545, 1969-2 C.B. 117 (exempt organization owned office building adjacent to its hospital where space was reserved for doctors and staff); Rev. Rul. 69-463, 1969-2 C.B. 131; Rev. Rul. 73-313, 1973-2 C.B. 174; Priv. Ltr. Rul. 85-08-073 (Nov. 28, 1984) (exempt organization, as general partner of a limited partnership, constructed clinical faculty office building and parking garage); Priv. Ltr. Rul. 83-12-129 (Dec. 13, 1982) (exempt organization, as general partner of limited partnership, will construct a medical office building); Priv. Ltr. Rul. 8325-133 (Mar. 22, 1983). Gen. Couns. Mem. 37,852 (Feb. 15, 1979). See also Priv. Ltr. Rul. 88-33-038 (May 20, 1988) (operation of a magnetic resonance imaging facility by a tax-exempt hospital, as general partner in a limited partnership, served a charitable, public benefit rather than a private benefit); Priv. Ltr. Rul. 88-20-093 (Feb. 26, 1988) (exempt organization operation of gastroenterology laboratory and surgical facility furthers exempt purposes). Priv. Ltr. Rul. 94-07-022 (Nov. 22, 1993) (provision of ambulatory surgical center by a hospital/physician joint venture furthers the charitable purposes of the hospital in providing needed care).
168
c04.fm Page 169 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
been ruled to be an activity that can be conducted by an exempt general partner in a partnership arrangement because it furthers charitable purposes.58 EXAMPLE: A, an exempt hospital, recognizes the need for magnetic resonance imaging (MRI) technology within its geographic area. Because of the high costs associated with the construction and maintenance of an MRI facility and the level of technical expertise required for daily operation, the hospital approaches B, a forprofit healthcare provider with MRI experience, to create a joint venture to construct and operate an MRI facility. The partnership, X, will house an MRI scanner, associated equipment and furnishings, patient waiting and dressing rooms, physician consulting rooms, and administrative space. A and B will serve as general partners, with local doctors investing as limited partners. Profits, losses, distributions, and ownership of capital will be allocated to the general partners in equal amounts and then distributed among the limited partners according to the proportion of investment. A has stated that it is entering into the partnership to provide quality medical services economically and efficiently. The provision of medical care is A’s primary, exempt purpose. Because the facility will be operated on a nondiscriminatory basis and the distributions will be made on an equitable basis, A is assured that the partnership will be operated for the benefit of the public rather than for the private benefit of the limited partners. Therefore, because this activity furthers A’s exempt purposes and will not constitute private benefit or inurement, it will not affect A’s exempt status. Moreover, because the activity is in furtherance of A’s exempt purposes, the income A receives will not constitute “unrelated business taxable income”59 to A.60 Accordingly, the first prong of the analysis was satisfied. This may not always be the result, however. Although activities in furtherance of the promotion of health are charitable, not every activity that promotes health qualifies for IRC §501(c)(3) tax exemption. Selling pharmaceutical drugs for a profit, as is done by pharmacies, is not charitable, nor is the provision of medical services for a profit.61
58
59
60 61
§501(c)(3); Reg. §1.501(c)(3)-1(d)(1). See also Rev. Rul. 69-463, 1969-2 C.B. 131 (hospital medical office building leased to medical group furthers exempt, charitable purposes); Rev. Rul. 69-464, 1969-2 C.B. 132 (hospital medical office building leased to staff “primarily” furthers exempt purposes); Rev. Rul. 69-545, 1969-2 C.B. 117. See generally, §511 (imposes tax on unrelated business income (UBI)); §512(a)(1) (defines UBI as income from an unrelated business regularly carried on by exempt organization); §513(a) (UBI is not substantially related to exempt purposes of organization); and Chapter 9. This example is based on the factual situation in Priv. Ltr. Rul. 88-33-038 (May 20, 1988). Rev. Rul. 98-15, 1998-12 I.R.B. 6, citing Federation Pharmacy Servs., Inc. v. Commissioner, 72 T.C. 687 (1979), aff’d, 625 F.2d 804 (8th Cir. 1980), and Sonora Community Hosp. v. Commissioner, 46 T.C. 519 (1966), aff’d, 397 F.2d 814 (9th Cir. 1968). See Chapter 12 for a detailed analysis. See also IHC Health Plans, Inc. v. Commissioner of Internal Revenue, 325 F.3d 1188, 91 AFTR2d 2003-1767 2003-1 USTC P 50, 368 (10th Cir. 2003), aff’g T.C. Memo 2001-246, T.C. Memo 2001-247, T.C. Memo 2001-248. (See Section 2.6 for discussion of the IHC case).
169
c04.fm Page 170 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
CAVEAT Recently, congressional leaders, including the former chairman of the Senate Finance Committee, Charles Grassley (R-Iowa), have expressed their concern that many nonprofit healthcare systems are not providing enough charitable care in order to justify their status as tax-exempt organizations. In addition to congressional inquiry, the IRS has stated that its observations have shown little difference between nonprofit and for-profit healthcare systems “in their operations, their attention to the benefit of the community or their levels of charitable care.”* In addition to the levels of charitable care provided, both Grassley and the IRS have raised concern about these healthcare systems’ practices of compensating executives.†) Although there has been a recent trend of lawsuits filed by low-income groups against private nonprofit hospitals, alleging that the nonprofit hospitals have failed to provide free or reduced-price services to the uninsured, the courts have routinely rejected these arguments. Moreover, the courts have been clear that the process of determining a community benefit standard should be reserved for the legislature. * †
Robert Pear, “Nonprofit Hospitals Face Scrutiny Over Practices,” New York Times (March 19, 2006). Id.
The first prong of the Plumstead analysis is not met if the sole purpose of the venture is to earn income for the charity. EXAMPLE: N, a nonprofit organization, forms an LLC with P, a for-profit company, to purchase commercial annuities and term life insurance policies on selected pools of individuals. N does not invest any equity (except its insurable interest in the individuals in the pool), but receives voting rights and a share of the profits. P will contribute all capital in exchange for a preferred return and a liquidation share. The joint venture does not meet the first prong of the Plumstead analysis since its sole purpose is to earn income for the exempt organization, which, by itself, is not a charitable purpose. Nevertheless, the gross income may not be subject to UBIT, because annuities are excluded under §512(b)(1) and life insurance proceeds are excluded from gross income under §101. NOTE If the organization’s primary activity is its participation in the LLC, which purchases annuities and life insurance policies, its fundamental purpose may not be charitable and its exemption may be jeopardized. (See discussion of commensurate test.*) *
See Section 2.4.
Similarly, the ownership and operation of low-income housing furthers an exempt organization’s charitable purposes.62 However, prior to 1992 there existed 62
Reg. §1.501(c)(3)-1(d)(2) (the term charitable includes relief of the poor and distressed and combating community deterioration); Rev. Rul. 79-19, 1979-1 C.B. 195. See generally Roady, “Low-Income Housing Organizations: Adapting the Rules of the ’70s to the Needs of the ’90s,” Exempt Organizations Committee, ABA Section on Taxation (1993).
170
c04.fm Page 171 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
little precise guidance from the IRS on what constituted “relief of the poor and distressed” in the context of the provision of low-income housing. In 1992, the IRS issued “Safe Harbor Guidelines”63 (Notice 93-1) to facilitate the processing of applications for recognition of exemption (Form 1023) filed by organizations seeking to qualify as charitable on the basis of their low-income housing activities.64 In practice, these guidelines proved too restrictive for many exempt organizations engaged in housing activities. Not only did they contain more stringent requirements than most federal housing programs, but in addition, because they did not permit any units to be leased at market rates, the development of selfsubsidizing or mixed-income projects was essentially precluded.65 As a result of extensive input from a number of commentators, the IRS issued a revised set of guidelines in the form of a proposed revenue procedure (Announcement 95-37), which addressed many of the concerns raised in connection with Notice 93-1.66 However, despite its improvement over Notice 93-1, commentators noted several areas in which Announcement 95-37 needed to be modified. In response, in May 1996, the IRS finalized its low-income housing safe harbor guidelines in Revenue Procedure 96-32.67 Pursuant to Rev. Proc. 96-32, an organization will be considered charitable as described in IRC §501(c)(3) if it satisfies the following requirements:68 • An organization establishes for each project that (a) at least 75 percent of the
units are occupied by residents that qualify as low-income; and (b) either at 63 64
“IRS Safe Harbor Guidelines for Organizations Providing Low-Income Housing Activities,” I.R.M. 76.64.342 (Oct. 16, 1992), as modified by Notice 93-1, 1993-1 C.B. 290. See id. A number of issues and concerns were raised by the private sector during IRS public comment on the guidelines, including 1. whether the requirements that 75 percent of the units in a project be rented to persons with incomes at or below 60 percent of the area median income is too restrictive because 75 percent is unduly burdensome or the 60 percent level of tenant income may be too low; 2. whether the test should be applied on the basis of an organization’s overall activities rather than on a project by project basis, thereby granting the organization the flexibility to vary the income mix among projects as appropriate under the particular circumstances; and 3. whether the guidelines should provide more specific guidance as to the other “facts and circumstances” that will justify charitable exemption for organizations not meeting the safe harbor, including adoption of voluntary rental limits, a showing of lack of affordable housing in the area, and the provision of social services in the area.
65
66 67 68
See Roady, “Low-Income Housing Organizations. See generally Chapter 13. These guidelines proved too restrictive for many exempt organizations engaged in housing activities. Not only did they contain more stringent requirements than most federal housing programs, but also, because they did not permit any units to be leased at market rates, the development of self-subsidizing or mixed-income projects was essentially precluded. See Sanders and Cobb, “IRS Proposes Modified Housing Guidelines Under Tax Code Section 501(c)(3),” Low-Income Housing Tax Credit Advisory (May 1995): 1. Self-subsidizing projects are those in which income from market-rate units offsets some or all of the loss from the low-income units. Id. Mixed-income projects seek to promote social and economic integration by interspersing families of various income levels and backgrounds (including some with incomes beyond that permitted by the original guidelines) within a given project area. Ann. 95-37, 1995-20 I.R.B. 18. Rev. Proc. 96-32, 1996-1 C.B. 717. As this is a general discussion of the criteria intended to provide an overview, Rev. Proc. 9632 should be reviewed in its entirety for planning purposes.
171
c04.fm Page 172 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
least 20 percent of the units are occupied by residents that also meet the very-low-income limit for the area or 40 percent of the units are occupied by residents that also do not exceed 120 percent of the area’s very low-income limit. Up to 25 percent of the units may be provided at market rates to persons who have income in excess of the low-income limit.69 • The project is actually occupied by poor and distressed residents.70 • The housing is affordable to the charitable beneficiaries, which in the case of
rental housing, is satisfied by the adoption of a rental policy that complies with government-imposed rental restrictions or otherwise ensures that the housing is affordable to low-income and very-low-income residents.71 • If a project consists of multiple buildings and each building does not sepa-
rately meet the requirements of IRC §§3.01(1), (2), and (3), then the buildings must share the same grounds, except for organizations that provide individual homes or individual apartment units located at scattered sites in the community exclusively to families with income at or below 80 percent of the area’s median income.72 For the most part, Rev. Proc. 96-32 closely tracks the earlier proposed guidelines, but includes several important changes and a number of clarifications. First, the numerical safe harbor, affordability,73 and “actual occupancy” requirements were retained, but the grace period in which the occupancy thresholds must be met was extended in the case of buildings requiring construction or significant rehabilitation. Second, the full set of “facts and circumstances” tending to demonstrate charitability was also retained, and slightly broadened to more directly address the provision of home ownership opportunities, in addition to rental housing.74 Third, the restrictions placed on scattered site projects were significantly relaxed, provided the scattered units are made available exclusively to 69 70
71 72 73
74
Rev. Proc. 96-32, §3.01(1). The final guidelines provide that a “reasonable” transition period is permitted for projects requiring substantial rehabilitation or construction. For projects not requiring substantial rehabilitation or construction, the occupancy threshold must generally be met within one year. Rev. Proc. 96-32, §3.01(2). Rev. Proc. 96-32, §3.01(3). Rev. Proc. 96-32, §3.01(3). The affordability requirement may be satisfied by the adoption of a rental or mortgage policy that follows government-imposed restrictions or otherwise provides relief to the poor and distressed. In practice, if the unit rent or mortgage payment does not exceed 30 percent of the tenants’ income, the rents will qualify as “affordable.” Some commentators believe this requirement to be too restrictive, noting that it is not uncommon for low-income persons to pay up to 50 percent of their income in rent, although the majority of developers abide by the 30 percent standard. See Pryde, “IRS Safe Harbor Holds Hidden Obstacles, Lawyers Say,” Bond Buyer (Oct. 5, 1995): 21. If the safe harbor test is not satisfied, an organization may demonstrate that it relieves the poor and distressed by reference to all the surrounding facts and circumstances, which include demonstrating that: 1. A substantially greater percentage of residents than required by the safe harbor with incomes up to 120 percent of the area’s very-low-income limit 2. Limited degree of deviation from the safe harbor percentages 3. Limitation of a resident’s portion of rent or mortgage payment to ensure that the housing is affordable to low-income and very-low-income residents 4. Participation in a government housing program designed to provide affordable housing
172
c04.fm Page 173 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
low-income or very-low-income residents.75 Finally, the guidelines include explicit language indicating that they are intended to be prospective in effect and that organizations holding determination letters, that have not significantly altered their operations, may continue to rely on those determinations.76 Despite the retention of the actual occupancy requirement, which continues to concern some practitioners, the final guidelines present a clear and workable safe harbor on which housing organizations may rely in structuring their activities and operations. (B) S PECIAL I SSUES: C HARITABLE P URPOSE AND D OWN P AYMENT A SSISTANCE/ S ECOND M ORTGAGE I NSURANCE P ROGRAMS Many nonprofits, in order to meet their charitable mission, attempt to respond to public’s needs for products or programs that are innovative in structure; in fact, the organization may be unable to demonstrate that the product satisfies either the safe harbor or facts and circumstances tests of Rev. Proc. 96-32. EXAMPLE: First-time home buyers, such as teachers and government employees who have annual incomes above 80 percent Area Medium Income, often need down payment assistance; the nonprofit develops a mortgage product that will provide the homeowner with up to 20 percent of the purchase price. It would be structured as a second mortgage (with an insurance product) as to which the borrower would pay no debt service with the payback of principal and a share of appreciation to the organization at the earlier of its resale, refinancing, or a predetermined date.77 5. Operation through a community-based board of directors, particularly if the selection process demonstrates that community groups have input into the organization’s operations 6. The provision of additional social services affordable to the poor residents 7. Relationship with an existing §501(c)(3) organization active in low-income housing for at least five years if the existing organization demonstrates control 8. Acceptance of residents who, when considered individually, have unusual burdens such as extremely high medical costs that cause them to be in a condition similar to persons within the qualifying income limits in spite of their higher incomes 9. Participation in a homeownership program designed to provide homeownership opportunities for families that cannot otherwise afford to purchase safe and decent housing 10. Existence of affordability covenants or restrictions running with the property Factor 3 was expanded to provide for “limitation of a resident’s portion of rent or mortgage payment” (emphasis added), and factor 9 was expanded to include “participation in a homeownership program.” See Rev. Proc. 96-32; §4.02. 75
76 77
Many commentators expressed concern regarding the provisions in the proposed revenue procedure (Ann. 95-37) requiring that projects made up of multiple buildings occupy the same contiguous parcel of land, noting that it unnecessarily restricted the development of inner-city areas and the use of “scattered-site” projects. Scattered-site housing typically involves the development of housing on vacant lots interspersed throughout an urban area or rehabilitation of existing buildings (not typically situated in one location) for use as low-income housing. Thus, in heavily developed urban areas, the use of a single parcel of land may be impractical. The final revenue procedure (96-32) modified the proposed revenue procedure by requiring that projects made up of multiple buildings must occupy a single contiguous parcel of land unless (1) the buildings can each satisfy the safe harbor requirements on an individual basis or (2) the units of scattered-site buildings are provided exclusively to low- or very-low-income residents. Rev. Proc. 96-32, §3.01(4). Rev. Proc. 96-32, §1.02. The author extends his appreciation to Susan Cobb for her assistance in the preparation of this section.
173
c04.fm Page 174 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
In Rev. Rul. 70-585, 1970-2 C.B. 115, Treasury described four situations in which an exempt organization was providing housing in fulfillment of a charitable purpose. Treasury analyzed each situation regarding whether each organization qualified as charitable within §501(c)(3). As relevant herein, Situation 1 described an organization formed to construct new homes and renovate existing homes for sale to low-income families who could not obtain financing through conventional channels. The organization also provided financial aid to lowincome families eligible for loans under a federal housing program that did not have the necessary down payment. When possible, the organization recovered the cost of the homes through small periodic payments from the homeowners. However, its operating funds were obtained from federal loans and contributions from the general public. The revenue ruling held that the organization relieved the poor and distressed by providing homes for low-income families who otherwise could not afford to buy a home. However, Situation 4 in Rev. Rul. 70-585 described an organization formed to alleviate a shortage of housing for moderate-income families in a community. An organization was formed to build new housing facilities for the purpose of helping families to secure decent, safe, and sanitary housing at affordable prices. Its membership was composed of community organizations that were concerned with the growing housing shortage in the community. The organization planned to erect housing that was to be rented at cost to moderate-income families. The organization was to be financed by mortgage money obtained under federal and state programs and by contributions from the general public. The IRS held that since the organization’s program was not designed to provide relief to the poor or to carry out any other charitable purpose, it was not entitled to exemption from federal income tax under §501(c)(3) of the Code. (C) D OWN P AYMENT A SSISTANCE G UIDANCE Revenue Ruling 2006-27, 2006-21 I.R.B. 915 (May 22, 2006) was recently issued to examine down payment assistance programs for low-income home buyers. CAVEAT Recently there has been a focus on the “circular” down payment assistance programs in which the seller of the home makes a gift to the charity, which then passes along that same money to the home buyer, who then uses the money for the down payment. The assumption is that the seller increases the sales price of the home to include the circular gifts. These programs were determined to be abusive by the IRS.
Rev. Rul. 2006-27 was issued to provide general guidance to charities that provide assistance to prospective homeowners in order to facilitate the down payment on the home; it analyzed three scenarios, and found that two of the scenarios (Situations 1 and 3) encompassed activities that were consistent with the organization’s charitable purpose and thus, not a threat to the organization’s §501(c)(3) status. However, the third scenario (Situation 2) was the circular gift situation outlined above, which was deemed to benefit nonexempt parties more
174
c04.fm Page 175 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
than incidentally, and thus the organization was not recognized as an exempt organization under §501(c)(3). EXAMPLE: In Situation 1, X, the non-profit corporation, helps low-income individuals and families purchase decent, safe, and sanitary homes throughout the metropolitan area where X is located. X conducts a broad-based fundraising program to attract grants from foundations, businesses, and the general public. The down payment assistance program is structured so that X’s staff does not know the identity of the donors, the identity of the sellers of the homes, or the identities of any other parties such as developers or real estate agents who might receive a financial benefit from the sale. X uses standards set by federal housing statutes and administered by the Department of Housing and Urban Development (HUD) to determine who is a low-income individual. The program administered by X provides funds to eligible individuals and families for all, or a part, of the down payment on the purchase of a home. The amount awarded is a gift to the home buyer from X, and is not subject to repayment. Treasury found this situation consistent with X’s charitable purpose of relieving the poor, distressed and underprivileged by enabling low-income individuals and families to obtain decent, safe, and sanitary housing. It is significant that X’s grantmaking procedures ensured that X is not beholden to any particular donors or other supporters whose interest may conflict with that of the low-income buyers X is working to help. Also, X provided educational programs for the home buyers to help prepare potential home buyers for the responsibility of homeownership. Because the down payment assistance payments are made to the home buyers out of a detached and disinterested generosity, the payments qualify for exclusion from the home buyers’ gross income as “gifts” under §102. Also, the amount will be included in the home buyers’ cost basis in the home under §1012. EXAMPLE: In Situation 2, the facts were similar to those in Situation 1, except for several key differences. The tax-exempt organization, Y does not conduct a broadbased fundraising campaign to attract financial support, but rather gets support from home sellers and real estate-related businesses that may benefit from the sale of homes to the buyers who receive assistance from Y. Also, the down payment assistance payments are circular, in that Y receives a payment from the seller, which is then passed along to the purchaser for use as a down payment. There is a direct correlation between the amount of the down payment assistance provided by Y and the amount of the home seller’s payment to Y. Y’s staff also knows the identity of the parties involved in all aspects of the transaction. Treasury found this type of down payment assistance program to be outside of Y’s charitable purpose. Treasury noted that Y is structured and operated to assist private parties who are affiliated with its funders. Although Y also served an exempt purpose, it was not operated exclusively for exempt purposes and so did not qualify as a tax-exempt organization under §501(c)(3). Therefore, the amount of the down payment assistance was not a disinterested gift to the home buyer, but a rebate. Thus, the amount of the down payment assistance grant to the home buyer was not included in the adjusted basis of the home.
175
c04.fm Page 176 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
EXAMPLE: In Situation 3, the charitable organization Z was formed to combat community deterioration in an economically depressed area of its city. Z receives funding from government agencies to build affordable housing, and cooperates with government agencies and community groups to attract new businesses to the area. As a substantial part of its activities, Z makes down payment assistance available to eligible home buyers. Z conducts a broad-based fundraising program to attract gifts, grants, and contributions from foundations, businesses and the general public. Treasury found this program to be consistent with furthering the exempt purpose of Z, and thus found Z to continue to be recognized as a tax-exempt organization under §501(c)(3). Treasury, in analyzing these three situations, relied heavily on several court cases and earlier revenue rulings. The seminal case is Better Business Bureau of Washington v. U.S., 326 U.S. 279, 283 (1945), in which the Supreme Court held that the “presence of a single . . . [nonexempt] purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly . . . [exempt] purposes.” Similarly, in American Campaign Academy v. Commissioner,78 the Tax Court held that an organization that operated a school to train individuals for careers as political campaign professionals for primarily Republican candidates served private interests more than incidentally, was not nonpartisan, and thus did not qualify as a §501(c)(3) organization. The court stated that the conferral of benefits on disinterested persons who are not members of a charitable class may cause an organization to serve a private interest. The court concluded that the organization conducted its educational activities with the objective of benefiting the Republican party’s candidates and entities. In Columbia Park and Recreation Association v. Commissioner,79 the court held that an association formed in a private real estate development to operate recreational facilities did not qualify as a §501(c)(3) organization. Although there was some benefit to the general public since the recreational facilities were available for use by the public, the primary intended beneficiaries were the residents and property owners of the private development. Easter House v. U.S.,80 is another relevant case in which the courts concluded that an organization that provided adoption and related health services to pregnant women who agreed to place their newborns for adoption through the Easter House organization did not qualify for exemption under §501(c)(3). The court ruled that the health services were merely incidental to the organization’s operation of an adoption service, which did not differ markedly from a commercial adoption agency. The organization’s sole source of support was the fees it charged adoptive parents, and the organization advertised and competed directly with commercial adoption agencies. The court found that the organization was not operated exclusively for charitable purposes. See also, Airlie Foundation v. Commissioner.81 78 79 80 81
92 T.C. 1053 (1989). See detailed analysis of American Campaign Academy v. Commissioner in Chapter 5.1(c). 88 T.C. 1 (1987), aff’d without published opinion, 838 F.2d 465 (4th Cir. 1988) 12 Cl. Ct. 476 (1987), aff’d 846 F.2d 78 (Fed. Cir. 1988). 283 F.Supp.2d 58 (D.D.C. 2003).
176
c04.fm Page 177 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
The IRS issued a favorable private letter ruling to a private foundation that was primarily funded by a for-profit corporation, active in the secondary mortgage market. The for-profit purchased loans from mortgage lenders. CAVEAT The foundation provided research on topics of current importance in the area of housing, and also presented forums, lectures, seminars and other educational opportunities on first-time homeownership to prospective homeowners. The forprofit also conducted similar educational programs as a form of advertising, since research indicated that a lack of information is a main barrier to homeownership. The ruling request was for the purpose of verifying that the advertising, the educational activities, and all associated materials, if conducted by the charity, would not endanger the charity’s exempt status. The IRS concluded that the proposed outreach, advertising, counseling and other activities of an educational nature were activities that educate low- and moderateincome families, including families from underserved areas and groups historically underrepresented in homeownership, on how to obtain a home. Therefore, the IRS found these activities to be in furtherance of the charity’s exempt purpose. (D) C HARITABLE C LASS In PLR 200634042 a nonprofit organization was denied §501(c)(3) status principally because it offered the type of circular down payment assistance program held to be abusive in Rev. Rul. 2006-27, 2006 I.R.B. 915 (May 22, 2006). However, the IRS did not limit its denial of exemption to the private benefit issues raised by the circular nature of the down payment assistance program. Instead, the PLR contains an extensive discussion of the class of persons being served by the down payment assistance program, and concludes that the program does not serve exclusively low-income persons, nor does it serve any other exempt purpose such as combating community deterioration or lessening the burdens of government. CAVEAT For example, the program at issue was open to anyone without any income limitations. Moreover, it was not specifically targeted to any one disadvantaged group, nor did it attempt to attract a mixed-income group of homeowners to a defined geographic area that had a history of racial problems. The ruling concluded that arranging the purchase of homes in a broadly defined metropolitan area does not combat community deterioration within the meaning of §501(c)(3). Moreover, despite the fact that there was a clear educational component in the program at issue, it did not ensure that the house would be habitable or that the buyer would be able to afford to maintain the house over time. Instead, the organization relied solely on the mortgage lender, insurance agency, home inspector, or other third party to conduct such review.
177
c04.fm Page 178 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
In sum, this recent private letter ruling provides further insight as to the factors that the IRS will examine in determining whether the homeownership program is a charitable activity. Most obvious would be to limit the program exclusively to low-income persons. However, that is not the only means of demonstrating charitability, which can also be shown by targeting defined geographic areas with a history of racial tensions or community deterioration, and by designing educational programs that assist first-time homebuyers to ensure that the homes they purchase are safe and affordable, and/or educate them on ways to ensure their homeownership experience is successful. (E) A PPLICATION OF R EV. P ROC. 96-32: F ACTS AND C IRCUMSTANCES TEST The facts and circumstances test82 under Rev. Proc. 96-32 specifies multiple factors that may enable the nonprofit to satisfy the charitable standard: • Limitation of a resident’s portion of rent or mortgage payments to ensure
that the housing is affordable to low-income and very-low-income residents • Participation in a government housing program designed to provide
affordable housing • Operation through a community-based board of directors, particularly if
the selection process demonstrates that community groups have input into the organization’s operations • The provision of additional social services affordable to the poor residents • Relationship with an existing §501(c)(3) organization active in low-
income housing for at least five years if the existing organization demonstrates control • Participation in a homeownership program designed to provide home-
ownership opportunities for families that cannot otherwise afford to purchase safe and decent housing • Existence of affordability covenants or restrictions running with the property
CAVEAT Any social services or educational services that could be provided to the prospective home buyers would be viewed favorably by the IRS. Such a program will arguably expand homeownership opportunities to those individuals and families that would otherwise be unable to purchase a home. Additional factors could be incorporated into the program to assist in developing the facts and circumstances to allow first-time home buyers of modest means the opportunity to own their own home. In summary, the nonprofit should plan to provide substantial educational activities that assist and educate first-time homebuyers; and once the home is purchased, teach them how to maintain the home and possibly leverage the investment. Similar to the analysis in the private letter ruling discussed above, the educational process of homeownership is considered charitable, and not advertising. However, the program must be structured carefully in order to avoid private benefit or inurement to those entities involved in financing the sale of the home. 82
See footnote 68.
178
c04.fm Page 179 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
CAVEAT If the conferral of benefits, in the form of a second mortgage or a first mortgage guarantee, is instead benefiting lenders who are not members of a charitable class, then the IRS is likely to conclude that the activity will be serving a private interest, rather than a public interest. The issue will be whether this program serves private interests more than incidentally. As stated above, it is well established that helping low-income persons obtain adequate and affordable housing is “charitable” because it relieves the poor and distressed or underprivileged.* *
See Rev. Rul. 2006-27 quoting Rev. Rul. 67-138, 1967-1 C.B. 129.
CAVEAT In order for the program to be classified as an activity that furthers exempt purposes and thus, does not threaten its §501(c)(3) tax-exempt status, it is necessary to ensure that there are real differences between the program and other commercial second mortgage or insurance programs. The program must primarily benefit the homeowners; the benefit to the banks from whom the second mortgages are purchased, and to the investors, must be minimized so that those benefits can be viewed as incidental. Additionally, the nonprofit will need to be able to demonstrate that the increased transaction fees to the lenders, and the return on investment to the investors, are incidental benefits. Finally, to the extent that the program specifies that upon the homeowner’s resale or refinancing of the property, the lender will receive an appreciation sharing ratio of a percentage of the housing price appreciation, there needs to be a cap placed on the amount of return to the investor. CAVEAT If the nonprofit receives say, 50 percent of the appreciation on the property without a cap, it would be difficult to argue that it does not have a profit motive and thus, a single nonexempt purpose, substantial in nature, and lose its exemption under the authority of Better Business Bureau, supra. However, if the return on the second mortgage is limited by a cap to an amount that would reflect a reasonable interest rate to the homeowner and a reasonable return to the investor, then the nonprofit has a strong position that there is no profit motive, and that the program furthers its charitable purpose.* *
To the extent that any of the benefits from the appreciation sharing ratio ultimately are received by any party other than the nonprofit, it is necessary to analyze whether that party is an insider, (i.e., disqualified person). If so, §4958 needs to be examined in order to establish a rebuttable presumption of reasonableness and to avoid the imposition of excise taxes on any perceived excess benefits. If the party in receipt of benefits is not an insider, as long as the benefits are capped at a reasonable rate as discussed above, inurement or private benefit should not be an issue.
The Internal Revenue Code recognizes that assistance to for-profit housing developers and businesses located in depressed areas may accomplish charitable
179
c04.fm Page 180 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
purposes, such as the relief of community deterioration and relief of the poor through increased employment opportunities, even though the businesses themselves are not charitable. Community development corporations—many of them organized by universities, hospitals, and churches—are now the primary vehicle for such assistance and development in distressed communities.83 The IRS will look favorably upon an entity that: (1) targets assistance to an economically depressed or deteriorated area; (2) assists a disadvantaged group such as minorities, the underemployed, or the unemployed; or (3) aids businesses that have experienced difficulty obtaining conventional financing because of the deteriorated neighborhood in which they are located or because of their minority ownership, and guides businesses that want to locate in an economically depressed area and provide jobs and training to residents of the neighborhood.84 A recent IRS determination letter denying exemption to a low-income housing organization illustrates the importance of the safe harbor provisions of Rev. Proc. 96-32.85 The organization at issue originally applied for exempt status to provide education and assistance to residents of low-income housing in the form of down payment assistance. The organization subsequently abandoned its down payment assistance program and announced plans to utilize down payment assistance programs operated by other nonprofit organizations. Instead, the organization focused 90 percent of its activities on the rehabilitation, development, management, or sale (with low down payment costs) of affordable housing in blighted areas and 10 percent of its activities on low-income homeowner education (by becoming a HUD-certified housing counseling agency). The organization planned to limit its program to persons at or below 75 percent of the local county’s median income. The IRS denial letter did not state a reason for the organization’s abandonment of the down payment assistance program, but often the withdrawal of a particular activity assistance program in the application process may be the result of discussions with the IRS, and indicates the IRS may have had certain concerns with the way the activity was planned. This, we simply do not know. It is also significant to note that the organization at issue had significant negative factors, which influenced the Service’s decision to deny exempt status. Specifically, the officers and directors of the organization were also the owners and employees of a for-profit entity, which operated in substantially the same field as the organization in question. Although the applicant organization was a separate legal entity from the for-profit entity, the Service ruled that the applicant organization was “clearly controlled” by the for-profit entity. Significantly, the applicant organization refused to adopt a bylaws provision that would require a majority of the board members to have no financial interest in the organization’s 83
84
85
Gittell and Wilder, “Community Development Corporations: Critical Factors That Influence Success,” Journal of Urban Affairs 21 (June 1999): 21; Paul S. Grogan and Tony Proscio, Comeback Cities (2000). See generally Loethian and Friedlander, “Economic Development Corporations, Charity Through the Back Door,” IRS Exempt Organizations CPE Technical Instruction Program (1991), 151. See Section 6 for a more comprehensive discussion of ways an exempt organization can participate in activities by lending funds or becoming a ground lessor in a project. 2004 TNT 199-21.
180
c04.fm Page 181 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
affairs. Moreover, the organization failed to specify with whom the organization could contract for services. In addition to these significant private benefit concerns, the Service relied heavily on the safe harbor provision of Rev. Proc. 96-32, and the “facts and circumstances” test that is applied if the safe harbor provision is not satisfied, in denying §501(c)(3) status to the applicant organization. The safe harbor provision requires that a low-income housing organization establish, for each project, that at least 75 percent of its housing units are occupied by residents whose income is 80 percent or below area median income. In addition, the organization must establish either that: (1) at least 20 percent of the units are occupied by residents that also meet the very low-income limit for the area; or (2) 40 percent of the units are occupied by residents that do not exceed 120 percent of the area’s very low-income limit. In the denial letter, the Service ruled that the organization did not meet the safe harbor provision, notwithstanding the fact that the organization planned to provide housing exclusively to persons who are considered “low-income.” The Service also concluded that the organization did not meet the additional facts and circumstances that demonstrate charitability. Perhaps most significantly, the Service found that the organization failed to establish that: [It] will comply with government-imposed rent restrictions or limitations of rent to an affordable level. With regard to sales activities, [the organization] indicated only that [it] will provide for low downpayment costs, and that some of this subsidy will come from other nonprofit downpayment assistance organizations. [The organization] has failed to show how continuing costs will be made affordable. Moreover, [the organization] lacks many favorable factors set forth in the facts-and-circumstances test, such as serving excess very-low-income-persons, limitation of rent or mortgage payments, participation in a government affordable housing program, a community-based board, relationship with an existing 501(c)(3) organization, and affordability covenants that run with the land. (Emphasis added).86
The Service also stated that although “[h]ousing organizations may also be charitable through combating community deterioration . . . the mere redevelopment of blighted areas is not necessarily a charitable purpose, as for-profit organizations often engage in such activity.”87 Consequently, the Service ruled that the organization did not qualify for exemption under §501(c)(3). The IRS denial letter reinforces the IRS’s reliance on Rev. Proc. 96-32, as the most important indicator of charitable status in the low-income housing area. Simply assisting in the redevelopment of blighted areas may not be sufficient to obtain exempt status as a housing organization under §501(c)(3). These factors need to be carefully considered when defining the charitable class that is to benefit from a low-income housing program.
86 87
Id. Id.
181
c04.fm Page 182 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
(F) S TRUCTURE OF THE L IMITED P ARTNERSHIP: I NSULATE E XEMPT O RGANIZATION AND N O P RIVATE B ENEFIT When a housing activity is conducted through a partnership vehicle, the IRS will scrutinize the arrangement to determine whether the partnership is exclusively or substantially operating for charitable purposes.88 When an organization participates in a government-sponsored housing project that is limited to lowincome individuals, the IRS will likely approve the arrangement.89 Furthermore, if the project is located in a depressed inner-city neighborhood, this tends to indicate that the project will relieve the poor and distressed, combat community deterioration, and lessen neighborhood tensions.90 Under these circumstances, the exempt organization has demonstrated its charitable purpose for the joint venture project and the organization can participate as general partner.91 In many situations in which a nonprofit is the general partner of a partnership that owns a low-income housing project, the nonprofit is set up as a social welfare organization under §501(c)(4), rather than a public charity under §501(c)(3).92 The IRS applies the same two-prong Plumstead test for exemption determinations of both types of organizations and also treats them similarly for purposes of lowincome tax credits. Recently, the Service has focused on whether the general partner of the local partnership, or lower tier partnership, is itself an exempt organization. Although that does not yet appear to be a requirement, control of the general partner at the lower tier by the upper tier exempt partner is critical to ensure that the project furthers charitable objectives. However, there are material differences between the two types of organizations, which to date have had no impact on their treatment by the IRS. For example, contributions to a §501(c)(3) are deductible under §170 of the Code,93 but not so for a §501(c)(4) organization. In addition, unlike a §501(c)(4), a §501(c)(3) may pursue a declaratory judgment action against the IRS under §7428 of the Code. Nevertheless, a §501(c)(4) structure may be preferable in some cases because, unlike the §501(c)(3) entity, the §501(c)(4) is not subject to the prohibition against engaging in political activities 88
89
90 91 92 93
Rev. Rul. 79-18, 1979-1 C.B. 194. See Gen. Couns. Mem. 36, 293 (May 30, 1975) (exemption denied because the primary purpose was not to benefit low-income individuals). But cf. Gen. Couns. Mem. 39,005 (Dec. 17, 1982) (exemption allowed because 100 percent of units were reserved for low-income individuals, hence, furthering exempt purpose was exclusive activity of organization). See Rev. Rul. 70-585, 1970-2 C.B. 115. The revenue ruling sets forth the standards for exemption under §501(c)(3) for housing organizations. The IRS has utilized the principles of this revenue ruling in considering applications for exemption for nonprofit housing organizations for more than 20 years. The ruling discusses four situations involving nonprofit organizations that provide low-income housing as their charitable purpose. Under situation 4, if the housing is limited to “moderate-income” families, the organization would not qualify for exempt status. However, an organization providing housing to moderate-income families may qualify as taxexempt if, by providing the moderate-income housing, it lessens the burdens of government. See, e.g., Priv. Ltr. Rul. 94-11-037 (Mar. 18, 1994). See Celia Roady, Comment, at the 4th Annual ABA Conference on Affordable Housing and Community Development Law, reprinted in Exempt Organization Tax Review 12 (Oct. 1995): 739. Rev. Rul. 70-585, 1970-2 C.B. 115. Specifically, in situation 3 of the ruling, rehabilitating a deteriorated housing area would qualify as charitable under §501(c)(3). See Gen. Couns. Mem. 39,005 (Dec. 17, 1982). See Section 12.2(c) for discussion of nonprofit entities as general partners in low-income housing projects. See Chapter 2 for a more detailed discussion.
182
c04.fm Page 183 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
and limitations regarding lobbying activities. Moreover, §501(c)(4) organizations usually do not project taxable income and do not rely on charitable contributions as a source of gross support. Furthermore, unlike a §501(c)(3), which has a limited time period in which to apply retroactively for exemption, a §501(c)(4) social welfare organization has no time limitation for a retroactive exemption application.94 Once charitability has been determined, the second prong of the test requires that the joint venture arrangement be examined for potential conflicts that can arise because of the general partner’s statutory obligations or by virtue of the structure itself.95 The IRS will examine the venture to confirm that the exempt general partner has not placed its charitable assets at risk96 and that the exempt organization is permitted to operate exclusively in furtherance of its charitable purposes with only incidental benefits bestowed upon the for-profit partners.97 In other words, once a charitable purpose is established, the second prong requires a determination of whether these purposes will in fact be met through the joint venture vehicle—that is, whether the nonprofit retains a sufficient amount of control to ensure that its exempt purposes are met. The problematic obligations of a general partner were explained by the IRS as follows: By agreeing to serve as the general partner . . . the Corporation would take on an obligation to further the private financial interests of the limited partners. Since the promotion of those private interests would tend to foster operating and maintenance practices favoring the equity holdings of the limited partners to a greater extent than would otherwise be justifiable on the basis of reasonable financial solvency, the Corporation’s assumption of a duty to promote such interests in its capacity as general partner would necessarily create a conflict of interest that is legally incompatible with its being operated exclusively for charitable purposes.98
The regulations provide that an organization is not organized or operated for charitable purposes unless it serves public rather than private interests.99 94 95 96
97
98 99
See Section 2.7 for discussion of the exemption application rules. See Uniform Limited Partnership Act, supra note 46; Revised Uniform Limited Partnership Act, supra note 46. Gen. Couns. Mem. 39,005 (Dec. 17, 1982). This is necessary because a general partner’s personal assets may be subject to partnership debts. Mery v. Universal Sav. Ass’n, 737 F. Supp. 1000 (S.D. Tex. 1990). This was the original second prong of the double-prong test. §501(c)(3); Reg. §1.501(c)(3)-1(d)(ii). The private benefit aspect is highlighted by the IRS in Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See, e.g., Rev. Rul. 78-86, 1978-1 C.B. 151, considered in Gen. Couns. Mem. 37,166 (June 15, 1977); Rev. Rul. 76-152, 1976-1 C.B. 151, considered in Gen. Couns. Mem. 35,701 (Mar. 4, 1974). Gen. Couns. Mem. 36,293 (May 30, 1975) cited in Gen. Couns. Mem. 39,005 (Dec. 17, 1982). But cf. Gen. Couns. Mem. 37,852 (Feb. 15, 1979). See generally Chapter 5. Reg. §1.501(c)(3)-1(d)(1)(ii). Protecting charitable organizations from private inurement serves important social purposes. A charitable organization is viewed under common law and the Internal Revenue Code as “a trust whose assets must irrevocably be dedicated to achieving charitable purposes.” Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The prohibition against private inurement or benefit serves to prevent anyone in a controlling position in the exempt organization from impermissibly exploiting income or assets for personal use. Reg. §1.501(a)1(c). See also American Campaign Academy v. Commissioner, 92 T.C. 1053, 1066 (1989); Christian Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037 (1978) (prohibited private benefit applies to unrelated third parties).
183
c04.fm Page 184 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
However, an organization that serves a charitable purpose with incidental benefits conferred upon private individuals is permissible.100 This proposition is simply an expression of the basic principle underlying IRC §501(c)(3): Exempt assets must be devoted to purposes that are considered beneficial to the community in general, rather than to particular individuals.101 The benefits conferred upon private interests must be incidental to the charitable public interests in both a quantitative and qualitative sense.102 These two tests have been defined as follows: To be qualitatively incidental,103 a private benefit must occur as a necessary concomitant of the activity that benefits the public at large; in other words, the benefit to the public cannot be achieved without necessarily benefiting private individuals. Such benefits might also be characterized as indirect or unintentional. To be quantitatively incidental,104 a benefit must be insubstantial when viewed in relation to the public benefit conferred by the activity. It bears emphasis that, even though exemption of the entire organization may be at stake, the private benefit conferred by an activity or arrangement is balanced only against the public benefit conferred by that activity or arrangement, not the overall good accomplished by the organization.105
The IRS provided an excellent example of its two-pronged test in General Counsel Memorandum 39,862. In that ruling, the IRS Chief Counsel’s Office concluded that a hospital jeopardized its tax-exempt status by forming a joint venture with members of its medical staff and selling, to the joint venture, the gross or net revenue stream derived from the operation of an existing hospital department or service.106 100
101 102
103
104 105 106
Rev. Rul. 69-545, 1969-2 C.B. 117; Gen. Couns. Mem. 39,762 (Oct. 24, 1988) (private benefit must be incidental in both a qualitative and quantitative sense); Gen. Couns. Mem. 37,789 (Dec. 18, 1978). See, e.g., St. Louis Union Trust Co. v. United States, 374 F.2d 427 (8th Cir. 1967) (when activity serves both exempt and nonexempt purposes, the organization is exempt only if charitable purposes are predominant). By contrast, in Sonora Community Hosp. v. Commissioner, 46 T.C. 519 (1966), aff’d, 397 F.2d 814 (9th Cir. 1968), the benefits bestowed upon two doctors from the activities of the hospital were more than “incidental.” In Sonora, the doctors, who previously owned the hospital, ran a for-profit laboratory and X-ray facility in the now tax-exempt hospital. The Tax Court ruled that serving the private interests of the physicians was inconsistent with the requirement that the hospital exclusively further its exempt purposes. Gen. Couns. Mem. 37,789 (Dec. 18, 1978); IV A. Scott on Trusts, §348 (3rd ed. 1967). Gen. Couns. Mem. 37,789 (Dec. 18, 1978); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). This private benefit must be “incidental” in both a qualitative and quantitative sense. See Rev. Rul. 70-186, 1970-1 C.B. 128 (example of qualitative aspect); Rev. Rul. 76-152, 1976-1 C.B. 151 (example of quantitative aspect). For an example of qualitatively incidental, compare Rev. Rul. 72-559, 1972-2 C.B. 247 (an organization is exempt that provides relief of the poor and distressed by providing training and salaries to recent law graduates who agree to provide legal services to indigent clients) with Rev. Rul. 80-287, 1980-2 C.B. 185 (an organization is not exempt that provides assistance to persons in need of legal services by operating a lawyer referral service). Gen. Couns. Mem. 78,789 (Dec. 18, 1978). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The IRS notes that this type of joint venture arrangement is becoming more common because “many medical and surgical procedures once requiring inpatient care, the exclusive province of hospitals, now are performed on an outpatient basis, where every private physician is a potential competitor.” Gen. Couns. Mem. 39,862 (Nov. 21, 1991). From the IRS perspective, there are multiple reasons for an exempt hospital to engage in joint venture arrangements: the need to raise capital; to give the staff physicians a stake in the success of a new enterprise or service; the hope or expectation of additional admissions or referrals; and the fear that a physician will send patients elsewhere or, worse, establish a new competing provider.
184
c04.fm Page 185 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
The IRS noted that the proper starting point for the “analysis of the net revenue stream arrangements” is to ask what the hospital gets in return for the benefit conferred on the physician-investors. Put another way, it asks whether and how engaging in the transaction furthers the hospital’s exempt purposes.107 The IRS determined that “there appears to be little accomplished that directly furthers the hospital’s charitable purposes of promoting health . . . [hence] we have to look very carefully for any reason why a hospital would want to engage in this sort of arrangement.”108 Instead, this venture arrangement was used as a “means to retain and reward members of their medical staff; to attract their admissions and referrals; and to pre-empt the physicians from investing in or creating a competing provider.”109 The IRS concluded thus: [W]e have moved from joint venture ownership of property and operation of an activity typically viewed as promoting the health of the community to a shell type of arrangement where the hospital continues to own and operate the facilities in question and the joint venture invests only in a profits interest. These arrangements, despite the joint venture cloak, are merely an arrangement between an exempt hospital and its medical staff physicians through which the hospital shares its net profits from designated activities with the physicians . . . [a] hospital’s participation in this type of partnership does not clearly further any exempt purpose.110
Hence, the partnership arrangement confers a private benefit in violation of the inurement provisions in IRC §501(c)(3).111 Regarding the balancing of the private benefits against the public benefits, the IRS found that the private benefits were substantial, and not merely incidental. The “public benefits expected to result from these transactions—enhanced hospital financial health or greater efficiency achieved through improved utilization of their facilities —bears only the most tenuous relationship to the hospitals’ charitable purposes of promoting the health of their communities.”112
107 108 109 110 111
112
See id. See id. See id. See id. It should be noted that the proscription against inurement in §501(c)(3), while stated in the context of the net earnings of an organization, applies to any of an exempt organization’s charitable assets. Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Furthermore, net earnings may inure to the benefit of an individual in ways other than through the distribution of dividends, that is, substantial income to private individuals. Harding Hosp., Inc. v. United States, 505 F.2d 1068, 1072 (6th Cir. 1974); Chattanooga Auto Club v. Commissioner, 182 F.2d 551 (6th Cir. 1950) (perks to members viewed as inurement). The inurement may also be found even though the amounts are small; there is no de minimis exception to inurement. Spokane Motorcycle Club v. United States, 222 F. Supp. 151 (E.D. Wash. 1963). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Compare Maynard Hosp., Inc. v. Commissioner, 52 T.C. 1006 (1969). The substance of the arrangements in the General Counsel Memorandum is similar to the situation in Maynard. There, six physicians took control of the exempt hospital pharmacy. The pharmacy continued to operate under the veil of the hospital. The IRS concluded that the physicians were receiving profits that would have otherwise gone to the hospital. Finding the arrangement analogous to a dividend on stock, the court found inurement.
185
c04.fm Page 186 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
The General Counsel Memorandum, which overruled three earlier letter rulings, concluded that such joint ventures jeopardize a hospital’s exempt status under IRC §501(c)(3) because • The transaction causes the hospital’s net earnings to inure to the benefit of
private individuals. • The private benefit cannot be considered incidental to the public benefits
achieved. • The transaction may violate federal law, specifically the Medicare and
Medicaid Anti-Fraud and Abuse Law.113 The IRS focuses on structural control apparently because it does not believe that assessment of past operations is a reliable indication of whether they will continue to serve charitable purposes in the future. The IRS does not have resources to keep a constant watch on the operations of all the partnerships. In some situations, mechanisms for control by the nonprofit partner should not be necessary to maintain the charitable purposes because other, nontax incentives also support the exempt function. For example, partnerships that build affordable housing for low-income residents are often designed to use the low-income housing tax credits provided in IRC §42.114 These credits align the interests of the for-profit investor and the exempt organization partner. Both parties benefit by the development of the maximum number of affordable units. The tax credit, which is the chief financial reward for the investors who do not typically receive significant cash flow or an appreciation in the value of their investment, is available only for the low-income units. Moreover, the Department of Housing and Urban Development regulates production of affordable housing. Its regulations require that at least 20 percent of the units in a project will be set aside for residents whose income is at or below 50 percent of the area median or 40 percent of the units for residents whose income is at or below 60 percent of the area median. Furthermore, the regulations require the set-aside and rent limitations to be met for 30 years, even though the tax credits are only claimed over 10 years. Other kinds of ventures may have their own nontax incentives protecting the charitable purposes. A university involved in a distance learning venture will likely insist upon control over the educational content at the very least as a way to protect its reputation. The for-profit venturer joins with the university because of its expertise in providing the educational content and ability to manage the substantive content of the venture, as well as the reputation attached to the name of the nonprofit partner. The Tax Court in Plumstead,115 recognized that there are nontax business advantages for a nonprofit theater. The opinion 113
114 115
Gen. Couns. Mem. 39,862 (Nov. 21, 1991). For a limited time period, the IRS was willing to resolve any tax issues arising from gross or net revenue stream joint ventures without loss of tax-exempt status. Ann. 92-70, 1992-19 I.R.B. 89 (Apr. 21, 1992). The offer to enter into a closing agreement terminated on Sept. 1, 1992. In order to qualify for settlement, the hospitals were required to terminate the joint venture arrangements without any further private benefit flowing to the physician-investors. See Sections 13.2 for a more extensive discussion of the low-income housing tax credit. Plumstead Theatre Soc’y. Inc. v. Commissioner, 74 T.C. 1324 (1980); aff’d 675 F.2d 244 (9th Cir. 1982).
186
c04.fm Page 187 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
mentioned the lower pay scale for actors offered by the actor’s union (equity league). Even Henry Fonda agreed to forgo a share of the profits and to accept a lower salary for the play in question. The tax on unrelated business income and the intermediate sanction regulations under IRC §4958, which punish excess benefits, create additional incentives for the charitable member to assure that the venture continues to advance the charitable purposes and does not provide excess benefits to the for-profit partners in the venture. (iii) A Case Study of the Second-Prong Analysis: Housing Pioneers. In Housing Pioneers, Inc. v. Commissioner,116 the complex issues raised by joint ventures providing low-income affordable housing seemed to confuse even the courts.117 Housing Pioneers was a California nonprofit organization, ostensibly organized to provide affordable housing to low-income, disabled, and previously incarcerated individuals. Rather than develop new low-income housing projects, the organization targeted existing limited partnerships that owned low-income housing projects and offered to serve as managing general partner. This arrangement was intended to allow the limited partnerships to qualify for a California state property tax reduction and/or low-income housing tax credits under IRC §42, the benefits of which would be shared by Housing Pioneers.118 To implement its plan, Housing Pioneers entered into management contracts with two limited partnerships, under which it agreed to acquire an interest in the partnerships and be named co-general and managing general partner. Housing Pioneers was, however, a managing partner in name only; most of the management duties fell to the nonexempt general partner. In addition, the organization had strong insider connections with one of the two limited partnerships: The cogeneral partner was a corporation controlled and owned by the founder of Housing Pioneers and his father; the founder served as attorney for Housing Pioneers, as its president, and as a member of its board of directors; and the limited partners of the partnership included the founder and his family.119 The Tax Court agreed with the IRS’s denial of Housing Pioneers’ IRC §501(c)(3) exemption because the organization’s activities (enabling the limited partnerships to benefit from the reduced California property taxes and low-income housing tax credits (LIHTC) under §42) served “the commercial purposes of the for-profit partners.” Accordingly, Housing Pioneers’ primary purpose was not charitable.120 116
117 118
119 120
65 T.C.M. (CCH) 2191 (1993), aff’d, 49 F.3d 1395 (9th Cir. 1995), amended, 58 F.3d 401 (9th Cir. 1995). See generally Sanders and Cobb, “Housing Joint Ventures: A Case of Judicial Misunderstanding,” Low-Income Housing Tax Credit Advisor (May 1995). See id. Housing Pioneers, 65 T.C.M. (CCH) 2191 (1993). Under California Rev. & Tax. Code §214(g), a real property tax reduction is available for property used exclusively for rental housing owned and operated by charitable organizations and limited partnerships in which the managing general partner is a charity. Housing Pioneers, 65 T.C.M. (CCH) 2191 (1993). Sanders and Cobb, “Housing Joint Ventures.” Id. Significantly, the court criticized the LIHTC structure in dictum. The court noted that “the very purpose of §42 (the low-income housing tax credit), compliance with which it is [Housing Pioneers’] duty to ensure, is to provide tax incentives to business entities.” The court added that “it is difficult to see how petitioner can avoid the taint of non-exclusive operation for charitable purposes” inherent in enabling the nonexempt partners to benefit from tax credits or benefits under §42 or the California property tax reduction. This finding, although appropriate under the egregious factual situation presented, ignored the long-standing precedent of Plumstead.
187
c04.fm Page 188 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
Housing Pioneers appealed to the Ninth Circuit, arguing that IRC §42 contemplates the participation of exempt organizations in partnerships acquiring low-income housing credits and that such a partnership would, if successfully operated, generate a benefit for the private investors.121 In affirming the Tax Court’s decision, the Ninth Circuit compounded the lower court’s faulty reasoning. Like the Tax Court, it failed to address the obvious insider private inurement that should have been the reason the organization failed to qualify for charitable status, again equating private inurement with the presence of forprofit limited partners. The Ninth Circuit acknowledged that its holding led to the conclusion that no transaction qualifying for §42 credit could ever be accomplished through a partnership involving an exempt organization, a proposition clearly at odds with Plumstead and the legislative intent underlying §42. The court declined to resolve this inconsistency, however, finding that Housing Pioneers had failed to demonstrate that it was technically qualified to receive tax credits under §42(h) of the Code. In ignoring the substantial body of law that permits an IRC §501(c)(3) organization to serve as a general partner in limited partnerships (i.e., Plumstead),122 the Ninth Circuit unnecessarily cast into doubt the tax-exempt status of organizations that participate as general partners in low-income housing activities. Further, the court failed to properly address the issue of insider private inurement that should have formed the basis for denial of Housing Pioneers’ exemption under either §501(c)(3) or Plumstead. Commentators perceived the Housing Pioneers decision as an aberration, and it was the subject of much criticism.123 Perhaps in response to those concerns, the Ninth Circuit amended its opinion in Housing Pioneers,124 affirming the Tax Court decision on the basis of “a single statute, IRC §501(c)(3).” The court found Plumstead distinguishable, noting that two of the directors of Housing Pioneers (the general partner) held limited partnership interests in the limited partnership, a factor not present in Plumstead. Although the amended opinion does not provide detailed analysis, the case was subsequently cited in Rev. Rul. 98-15, a major ruling in the joint venture area, as an example of a “bad” scenario.125 In its 1998 reference to Housing Pioneers, the IRS cited as negative elements the facts that the organization’s power as a co-general partner was limited, it had no management responsibilities, and its 1 percent general partner interest appeared to serve the sole purpose of sharing tax benefits with the for-profit partners.126
121
122
123
124 125 126
Housing Pioneers v. Commissioner, 49 F.3d 1395 (9th Cir. 1995). See also discussion of Redlands Surgical Services wherein the tax court upheld the IRS’s denial of tax-exempt status, discussed in Section 12.3. Provided that the organization’s exempt purposes are furthered by its participation in the limited partnership and the participation of the exempt organization in the partnership, only incidentally benefits private interests. See, e.g., Sanders and Cobb, “Housing Joint Ventures: A Case of Judicial Misunderstanding,” Low-Income Housing Tax Credit Advisor at 8-9 (May 1995); B. Hopkins, “Partnership Case Won by IRS on Appeal—On Technicality,” 12 Nonprofit Counsel No. 4 at 1-4 (Apr. 1995). 58 F.3d 401 (9th Cir. 1995). See Section 4.2(e) for a discussion of Rev. Rul. 98-15. Rev. Rul. 98-15, 1998-12 I.R.B. 6 (Mar. 23, 1998).
188
c04.fm Page 189 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
(e)
The Second Prong Comes to the Forefront: Revenue Ruling 98-15
Revenue Ruling 98-15 presents two scenarios involving a tax-exempt hospital operator.127 NOTE Although this ruling was long awaited in the healthcare area, the IRS has stated that its guidelines can be applied to joint ventures between nonprofits and forprofit organizations in other areas.* *
“Whole Hospital Joint Ventures,” Exempt Organizations Continuing Professional Educational Technical Instruction Program for FY 1999 (hereinafter 1999 CPE). See also, statement of IRS Exempt Organizations Division Director Marcus Owens, “Exempt Organizations Get Plenty to Chew on in L.A.,” Tax Notes (Nov. 16, 1998): 829.
In each scenario, a nonprofit forms a limited liability company (LLC) with a for-profit entity, which then operates a hospital. The nonprofit in both cases contributes all of its operating assets, including a hospital, to the LLC in exchange for an ownership interest in the LLC. The parties’ ownership interests (in both situations) are proportional to their respective contributions. With regard to any LLC distributions, the nonprofit in each situation intends to use the proceeds to fund grants that will further its charitable purpose in the healthcare facility. Although many facts in the two situations are similar, as discussed in the following paragraphs, there are significant differences in the following areas: (1) control through board composition, (2) overriding fiduciary duty, (3) management contract, (4) related versus independent officers, (5) conflicts of interest, (6) minimum distributions, and (7) reserved powers. In Situation 1, the joint venture’s operating agreement provides that the board consist of three individuals chosen by the nonprofit and two by the forprofit, giving the nonprofit effective control. The nonprofit’s board members are community leaders with no financial interest in the hospital. In addition, its officers, directors, and key employees were not promised employment or other inducement to approve the transaction, and none of them has any interest in the for-profit organization. Any amendment of the LLC’s governing documents can only be accomplished with the approval of both the nonprofit and the for-profit (collectively, “the Members”). Major decisions require the approval of a majority of three board members. In addition, the governing documents explicitly require the joint venture to operate in a manner that furthers the nonprofit’s charitable purposes. The LLC contracts with an unrelated management company to provide day-to-day management services; the management contract is for a limited period, is renewable by mutual consent, and provides for payment of reasonable fees. Finally, the members of the LLC may terminate the agreement for cause.128 In Situation 2, the for-profit company has more control in the LLC. The operating agreement does not obligate the LLC to operate for charitable purposes. 127 128
Rev. Rul. 98-15, 1998-12 I.R.B. 6 (Mar. 23, 1998). See also G. Petroff, “Whole Hospital Joint Ventures: The IRS Position on Control,” Exempt Organization Tax Review (July 1998). Rev. Rul. 98-15, Situation 1.
189
c04.fm Page 190 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
Both members must approve any amendment to the operating agreement, which, in effect, gives the for-profit organization a veto right. In addition, the LLC’s chief executive officer (CEO) and chief financial officer (CFO) are not disinterested but have a prior relationship with the for-profit member. Similarly, the management company is a wholly owned subsidiary of the for-profit and can unilaterally renew its contract, has broad discretion over the joint venture’s activities, and is not required to operate under the board’s supervision at all times. The management company is permitted to enter into all but unusually large contracts without board approval. Based on these facts and circumstances, the IRS determined that the nonprofit in Situation 1 retained its exempt status because it continued to operate exclusively for charitable purposes and only incidentally for the benefit of the for-profit’s private interests. Specifically, the IRS looked to the governing documents of the LLC, which obligate the joint venture to provide healthcare services for the benefit of the community and to give charitable purposes priority over the maximization of profits. In addition, the ruling noted that the structure of the board gives the nonprofit’s appointees voting control, thus ensuring that the assets owned by it and the activities it conducts through the joint venture are used to primarily advance its charitable purposes. Thus, the nonprofit retained sufficient control over the joint venture’s activities to ensure that its charitable purposes would be fulfilled. On the other hand, in Situation 2, there was no binding obligation to serve charitable purposes, so the LLC could deny treatment to the poor. The nonprofit could not initiate new charitable programs without at least one vote from the for-profit member. Moreover, the management company was a subsidiary of the for-profit organization, with broad discretion over the venture’s activities and assets, and the chief executives had a prior relationship with the for-profit. Finally, the management company could unilaterally renew the contract. In this situation, the nonprofit could not establish that the venture would fulfill charitable purposes as opposed to private interests. A private letter ruling129 approved the participation of an exempt organization in an ancillary joint venture with for-profit members. The exempt entity is a conservation organization, which proposed to acquire from individual owners of forestland the right to maintain, selectively cut, manage, and sell trees. By managing the property of many small owners, the organization planned to provide a satisfactory economic return while conserving the forest in a more ecological and sustainable manner than the individual owners had done in the past. The IRS did not refer to Rev. Rul. 98-15 in approving of the arrangement. However, the venture met many of the Service’s concerns. The venture was in the form of an LLC, of which the exempt organization itself was the managing member. The organizing agreement expressly stated that the conservation purposes of the LLC would prevail if there were a conflict with the financial purpose. The conservation organization could be removed as manager only by a two-thirds vote after two consecutive years in which the minimum annual return was not paid to the members. Any manager selected to replace the conservation organization 129
Priv. Ltr. Rul. 200041038 (July 20, 2000).
190
c04.fm Page 191 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
was required by the organizing agreement to be another §501(c)(3) organization dedicated to the conservation of forestland. The conservation entity could not be required to provide additional capital. By both organization and operation, the exempt entity retained control and the exempt purposes were protected. (i) Lessons for Joint Ventures Involving Tax-Exempt Organizations. First, as a preliminary note, because Situation 1 involved a number of facts and circumstances all of which were favorable and Situation 2 involved facts and circumstances all of which were unfavorable, it is difficult to prioritize the importance of any one particular factor or to determine how far an arrangement may differ from the facts as set forth in Situation 1 without jeopardizing the charity’s taxexempt status.130 Moreover, some of the facts and circumstances may not be comparable to those encountered in the “real world.” The first case is too good to be true, which the IRS will acknowledge, and the management contract in Situation 2 allows the management company to continuously renew the contract into perpetuity, whereas in practice, such a provision may be rare. Immediately after the release of Rev. Rul. 98-15, the IRS acknowledged that the lack of any middle ground fact pattern in the Ruling had left many questions as to how it would apply the Ruling in consideration of real life scenarios. Notably, while the IRS identified several open issues that were not addressed in Rev. Rul. 98-15, the Service has suggested that a critical issue in determining exempt status is whether the nonprofit party retains ultimate day-to-day control of the venture In this regard, Rev. Rul. 98-15 suggests that the organizational documents for partnerships involving tax-exempt organizations should contain a structure that provides exempt organizations with control over the venture. The IRS position should give exempt organizations significant “leverage” when negotiating joint venture agreements with for-profits that are not likely to invest substantial monies unless they can negotiate fundamental protection, thus establishing the tension between the parties. Although Rev. Rul. 98-15 is clear that the IRS will favorably view charitable “override” provisions in joint venture operating agreements (i.e., explicitly requiring the joint venture’s managers to operate the venture in a charitable manner in case any conflict arises between the interests of the nonprofit and for-profit directors), this provision is no longer a strict requirement, provided that the exempt organization maintains control of all charitable aspects of the joint venture. As an example, in Rev. Rul. 2004-51, the IRS considered a non-healthcare ancillary joint venture where both parties held a 50 percent share in the venture, but where the exempt entity retained exclusive control only of the charitable 130
The IRS Exempt Organizations Continuing Professional Educational Technical Instruction Program for FY 1999 includes a chapter on whole hospital joint ventures. It lists no less than 24 factors that agents will consider in making determinations on joint ventures. 1999 CPE Chapter A. See also Section 4.2(i). These factors are said to be “not exhaustive.” 1999 CPE Chapter A. They include detailed inquiries into how the exempt purposes of an organization are being served through the joint venture; the composition, selection, and structure of the governing board; the employment of management companies; the fees charged for healthcare; the compensation and selection of executives, physicians, accountants, and attorneys; the returns of capital and distribution of earnings in proportion to capital contributions; conflicts of interest; authority over medical and ethical standards and oversight of the quality of healthcare; and the responsibilities of the exempt organization within the partnership.
191
c04.fm Page 192 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
activities rather than over all of the aspects of the venture. In this case, the IRS determined that a lack of a charitable override provision would not affect the exempt status of a nonprofit organization involved, provided that the exempt entity continued to retain the exclusive control over all charitable aspects of the venture. Rev. Rul. 2004-51 is discussed at length later in this chapter.131) Notwithstanding whether an explicit charitable override provision exists, management agreements should still be drafted to conformity to the “favorable” provisions in Rev. Rul. 98-15. The IRS clearly views an independent management company (not affiliated with the for-profit partner) as a positive factor, with terms in the management agreement that allow the exempt organization a “way out.” In other words, an agreement that unilaterally permits a management company to renew the agreement would appear to be unacceptable. Moreover, exempt organizations must be extremely careful about allowing employees or former employees of for-profit partners to serve in key positions in the joint venture entity. The IRS appears to be primarily concerned that such persons would limit or “package” information flowing to exempt organization partners so that such partners would, as a practical matter, be deprived of some of their control because of the limited information flow. Finally, the ruling indicates that other provisions in the partnership agreement that, as a practical matter, limit the exempt organization’s control, will also be carefully scrutinized. To illustrate, the IRS implied that the provision in example 2 allowing the management company to enter all but unusually large contracts, combined with the limited flow of information likely to result from employing former employees of the for-profit entity, meant that the exempt organization could not effectively establish that the activities of the venture would further its exempt purposes. In sum, exempt organizations participating in ventures with for-profit entities and/or private investors should carefully structure provisions in the agreements to satisfy themselves that do not cede control over the operations of the joint venture to the for-profit parties or otherwise limit their ability to ensure that the venture will be operated for charitable purposes. Accordingly, despite its shortcomings, Rev. Rul. 98-15 provides significant guidance for all partnerships and joint ventures involving tax-exempt organizations. (ii) ABA Health Law Section Proposed Ancillary Joint Venture Fact Patterns Submitted to the IRS. In August, 2002, the American Bar Association’s (ABA’s) Health Law Section (the “Section”) drafted a proposed revenue ruling containing two fact patterns in which a tax-exempt hospital and an unrelated for-profit company form a joint venture to own and operate a freestanding ambulatory surgery center (ASC). The Section was attempting to assist the IRS in developing and providing much-needed guidance in the area of ancillary joint ventures in the healthcare context, which had not been addressed by the IRS in Rev. Rul. 98-15 (and which at the time of submission had not been tested in litigation132). 131 132
See Section 4.4, infra. See Section 4.2(g) for discussion of the John Gabriel Ryan Association case in which the IRS granted exemption to a nonprofit participant in an ancillary joint venture after petitioner had filed a petition in the Tax Court.
192
c04.fm Page 193 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
The Group noted that even though IRS agrees that the rules governing whole hospital joint ventures may be quite different from those governing ancillary joint ventures in which only an insubstantial amount of an exempt entity’s activities are transferred to the joint venture, the IRS has not provided specific guidelines regarding ancillary joint ventures. The Group was hopeful that the proposed revenue ruling will provide such guidance on issues relating to the private benefit test and its applicability in making a determination as to whether an activity is subject to the unrelated business income tax (UBIT), the tax risks involved in ancillary joint ventures, and the type or amount of control that is important in structuring ancillary joint ventures. S ITUATION 1 A tax-exempt hospital (“Hospital”), which was recently determined by the IRS to have continuously satisfied the “community benefits” standard of Rev. Rul. 69-545, entered into a joint venture arrangement with a for-profit entity (“ASC Company”) to own and operate a free-standing ASC. To achieve its primary goals of enhancing the quality and efficiency of its delivery of surgical services and to obtain management expertise without a significant capital commitment, Hospital and ACS Company form a limited liability company (LLC) to own and operate the ASC. Both participants each have a 50 percent interest in capital, profits, losses, and income, which amount is proportional and equal in value to their capital contributions. While the ASC is an important activity for Hospital, it represents an insubstantial part of Hospital’s overall activities. The LLC Operating Agreement, which can be amended only with the consent of both participants, has the following provisions: 1. The LLC is to be managed by a Board of Managers (“Board”) consisting of six individuals, three of whom are selected by ASC Company and the other three by Hospital. Two-thirds Board approval is required for several major decisions relating to the operation of the ASC, such as (i) annual capital and operating budgets; (ii) distribution of the joint venture’s earnings; (iii) appointment of the joint venture’s chief executive officer (CEO); (iv) acquisition or disposition of the assets of the ASC; (v) contracts requiring expenses in excess of $25,000 per year; (vi) any significant changes in the types of services to be provided by the ASC; and (vii) the termination or renewal of any management agreements relating to the operation of the ASC. 2. The ASC is to be operated in a manner that is consistent with the “community benefit” standard of Rev. Rul. 69-545 by adopting Hospital’s charity care policies, which include the treatment of Medicare- and Medicaid-eligible patients without discrimination. 3. ASC’s charitable purposes are expressly given precedence over the objective of maximizing profits. 4. If, based on objectively determinable factors, the LLC is found to have failed to meet the community benefit requirements, notice and opportunity to cure the default will be provided to the LLC. If such failure continues, Hospital may initiate binding arbitration and request that a default
193
c04.fm Page 194 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
provision of the Operating Agreement, which gives Hospital the right to select the fourth member of the Board, be applied. 5. The Board will meet quarterly to discuss issues relating to the operation of ASC and to review reports prepared by the Manager regarding the LLC’s compliance with the community benefit standards. This meeting must be attended by at least two of Hospital’s LLC Board representatives, who will then report all matters discussed to Hospital’s Board of Directors at its next regular or special meeting. The LLC entered into an arm’s-length management contract with a for-profit affiliate of ASC Company (“ASC Manager”). The contract, which contains terms that are reasonable and comparable to those that are similar in the industry, is for 10 years, renewable for three additional three-year terms with the consent of both joint venture participants. ASC Manager is required to conform to the same community benefit requirements set forth in the LLC Operating Agreement and will be paid a fee based on the LLC’s gross income. ASC Manager’s continued failure to satisfy the community benefit standard, after it is provided with notice of default and opportunity to cure within 45 days, is cause for termination of the contract. In a noncompete agreement executed by the two joint venture participants and ASC Manager, the parties agree not to own, operate, or materially participate in the operation of any competitive ASC facility within a 15-mile radius of LLC’s ASC. No reference is made to Hospital’s inpatient or outpatient surgical services in the noncompete agreement. The same surgeons on Hospital’s medical staff are on ASC’s medical staff, and these physicians do not receive any special financial incentives for performing surgical services to ACS. S ITUATION 2 Except for the following differences, Situation 2 is identical in all material respects to Situation 1: The Operating Agreement does not contain a provision requiring the ASC to be operated in a manner consistent with the “community benefit” standard of Rev. Rul. 69-545 and, as such, does not require that the ASC adopt the charity care policies of Hospital by providing medical services to the underprivileged. In addition, while the Operating Agreement provides for quarterly meetings of the Board, it does not state that during such meetings the Board would review the LLC’s compliance with charity care policies or the community benefit standard. Furthermore, ASC Company prepared a business plan, which was approved and adopted by the Board, emphasizing the need to maximize profitable surgical procedures by focusing marketing efforts primarily on private pay and private insurance patients. Finally, the management contract does not impose charity care or community benefits requirements on ASC Manager, so its failure to operate the ASC in a manner that is consistent with the community benefit standard is not cause for termination of the contract. The Section provided a detailed analysis of the requirements of §§501(c)(3), 511(a), 512(c), 513(a) and the regulations thereunder, Rev. Ruls. 69-545 and 98-15 and case law concerning joint ventures. The Section stated that unlike in the St. David’s and Redlands cases and Rev. Rul. 98-15 wherein the organization’s sole
194
c04.fm Page 195 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
activity was participating in the joint venture, in both Situations 1 and 2, Hospital’s participation in the LLC was only an insubstantial part of its activities. Therefore, after the LLC was formed, Hospital continued to engage in the same hospital and healthcare services it previously provided in a manner consistent with the community benefit standard of Rev. Rul. 69-545. Because of Hospital’s continued exempt activities outside its participation in the LLC, Hospital satisfies the operational test under §501(c)(3) and the private benefit test under §1.501(c)(3)1(d)(ii). Based on its analysis, the Section concluded that the issue in both Situations 1 and 2 should not be whether Hospital’s participation in the LLC is inconsistent with its continuing status as an exempt organization, but rather, whether Hospital’s participation in the LLC is an unrelated trade or business. The Section held that in Situation 1, even though Hospital does not have numerical voting control of the LLC, Hospital has enforceable legal rights under the Operating and Management Agreements that allow it to ensure that the venture is operated in a manner that is consistent with Hospital’s exempt purpose. Therefore, Hospital’s participation in the LLC is not only consistent and substantially related to its exempt status and purpose, it also does not result in unrelated business taxable income. With respect to Situation 2, the Section held that, even though Hospital has neither voting control of the LLC nor other assurances present in Situation 1 that the ASC will be operated in a manner that is substantially related to Hospital’s exempt purposes, Hospital’s participation in the LLC, which is an insubstantial portion of Hospital’s overall activities, is treated as an unrelated business and does not jeopardize Hospital’s §501(c)(3) status. In addition to the above, the ABA Committee on Exempt Organizations’ Task Force on Joint Ventures (the “Task Force”) submitted several nonhealthcare joint venture examples of real-world situations, with a short analysis of each example, to the IRS. The primary goals of the Task Force are to provide guidance in the “gray area,” which was not addressed by either the good or the bad examples of Rev. Rul. 98-15, and to address joint venture situations outside the healthcare context in which the nonprofit does not have voting control. According to the Task Force, where a joint venture situation is outside the healthcare context and therefore not held to a community benefit standard, the important question should not be who has voting control, but rather, whether there are other mechanisms in place to ensure that the charitable purposes of the exempt organization are being served. The Task Force’s submission contained fact situations analyzing ancillary joint ventures structured with a separate entity, such as an LLC, and also ancillary joint ventures that are purely contractual in nature and therefore do not utilize a separate entity. The Task Force’s analysis of the five fact situations reached a similar conclusion as the Health Law Section in its analysis of the two healthcare situations discussed above. According to the Task Force, because only an insubstantial amount of the exempt organization’s activities are contributed to the joint venture in an ancillary structure, the exempt status of the exempt participant will not be jeopardized even if it has 50 percent or less control of the joint venture or if the activities of the joint venture are not substantially related to its exempt purposes. The exempt participant may, however, be exposed to the assessment
195
c04.fm Page 196 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
of the UBIT. To date, the IRS has not commented on either submission, although its work plan includes the issuance of guidance in this area. (f)
Redlands Surgical Services v. Commissioner and St. David’s HealthCare System v. U.S.
The IRS’s position that charitable organizations that place their assets at risk in a joint venture with private investors must control the venture, has been tested in a Tax Court case, Redlands Surgical Services v. Commissioner.133 The Tax Court litigation involving Redlands Surgical Services (RSS) provides more specific guidance as to how the operational test of exemption should be applied when an IRC §501(c)(3) organization enters into a joint venture with a for-profit partner. Redlands Surgical Services, Inc. (Redlands), a California nonprofit public benefit corporation, was a wholly owned subsidiary of Redlands Health Systems, Inc. (RHS), a charitable organization under §501(c)(3). RHS was the parent corporation of three other subsidiaries, two of which were also exempt under §501(c)(3).134 One of the two exempt subsidiaries was Redlands Community Hospital (Redlands Hospital), a hospital within the meaning of §170(b)(1)(A)(iii), which provided medical care free of charge or at a discount, and which maintained its own surgery program and emergency room. In March 1990, RHS became a co-general partner with Redlands–SCA Surgery Centers, Inc. (SCA Centers), a for-profit corporation, in a general partnership formed to acquire a 61 percent interest in an existing outpatient surgical center in Redlands, California. RHS contributed cash and SCA Centers contributed cash and stock to the general partnership. In return for its 37 percent investment, RHS received a 46 percent interest in profits, losses, and cash-flow of the general partnership. The general partnership agreement provided that the management and determination of all questions relating to the affairs and policies of the partnership were to be decided by a majority vote of the managing directors. The managing directors consisted of four persons—two of whom were appointed by RHS and two of whom were appointed by SCA Centers. In the event the managing directors were unable to agree, either RHS or SCA Centers could submit the matter to arbitration. The decision of a majority of the arbitrators was to be final and binding. The general partnership became the sole general partner in Inland Surgery Center Limited Partnership (the Operating Partnership), a California limited partnership that owned and operated a freestanding ambulatory surgery center (the Surgery Center) within two blocks of Redlands Hospital. Prior to the Operating 133
134
See Redlands Surgical Servs. v. Commissioner, 113 T.C. 47 (1999). See also T.J. Sullivan, “Whole Hospital Joint Ventures,” Exempt Organization Tax Review (Jan. 1998): 47, for a detailed discussion of the Redlands case. The Stipulated Administrative Record on which this case was decided was filed with the court on Oct. 17, 1997. The key document setting forth the IRS’s analysis of the joint venture at issue is a revised adverse determination letter (i.e., one denying recognition of exemption) dated Apr. 1, 1996. The denial letter sets forth in detail an analysis of charitable organization “real world” control similar to that found in the lowincome housing partnership private letter ruling cited earlier (Priv. Ltr. Rul. 97-36-039 (June 9, 1997)). See also Chapter 13. For assistance in understanding the corporate structure, See Exhibit 12.3.
196
c04.fm Page 197 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
Partnership’s affiliation with the general partnership, the Operating Partnership had been a for-profit venture which served only surgical patients who could pay for its services. The partnership agreement of the Operating Partnership did not contain a statement of charitable purpose or a requirement that it operate for a charitable purpose before its affiliation with RHS and it was not amended to include such a provision after its affiliation with RHS. The Surgery Center offered no free care to indigents and it had no emergency room or certification to treat the emergency patient population. The Operating Partnership entered into a contract with SCA Management Company (SCA Management), a for-profit subsidiary of SCA, whereby SCA Management would provide management and administrative services for the Surgery Center. With the exception of decisions relating to the care and treatment of patients or other medical policy matters, SCA Management had wideranging authority for the management of the Surgery Center. In return for its services, SCA Management was to receive a monthly management fee of 6 percent of gross revenue from the operation of the Surgery Center. The management agreement had a term of 15 years, renewable unilaterally by SCA Management for two, five-year extensions. With the exception of bankruptcy or insolvency, the management contract was terminable by the Operating Partnership only if SCA Management breached the agreement, and then only after a 90-day notice and a 90-day cure period. In April 1990, SCA Management entered into a quality assurance agreement with RHS whereby RHS agreed to perform managerial and supervisory quality assurance duties in connection with the operation of the Surgery Center. RHS was to receive a monthly fee after the first year, and it was to be reimbursed for its direct out-of-pocket expenses. Five months after entering into the general partnership agreement with SCA Centers, RHS incorporated Redlands as a California nonprofit public benefit corporation, and transferred its interest in the General Partnership to Redlands. RHS also transferred its obligations and rights under the quality assurance agreement to Redlands. Redlands’ sole activity (and its sole source of revenue) was to be its participation in the Operating Partnership. The IRS argued that Redlands was not operated exclusively for charitable purposes because it operated for the benefit of private parties and failed to benefit a broad cross-section of the community. In support of its position, the IRS stated that the partnership agreements and related management contract were structured to give for-profit parties control over the Surgery Center. Moreover, the Surgery Center had never operated with a charitable purpose. Redlands, however, argued that it met the operational test of §501(c)(3) because its activities with respect to the Surgery Center furthered its purpose of promoting health for the benefit of the Redlands community, by providing access to an ambulatory surgery center for all members of the community based upon medical need rather than ability to pay, and by integrating the outpatient services of Redlands Hospital and the Surgery Center. Redlands further argued that it engaged in arm’s-length transactions with the for-profit partners, and that its influence over the activities of the Surgery Center has been sufficient to further its charitable goals. Redlands also argued that it performed services that
197
c04.fm Page 198 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
were “integral” to the exempt purposes of RHS, its tax-exempt parent, and Redlands Hospital. By applying a facts and circumstances analysis, the Tax Court upheld the IRS’s denial of Redlands’ tax-exempt status. The court concluded that Redlands had effectively ceded control over the operations of the partnerships and the Surgery Center to private parties, thus conferring impermissible private benefit upon them. In this regard, the court noted that the promotion of health for the benefit of the community is a charitable purpose. However, the community benefit standard also requires that the charity serve a sufficienty large and indefinite class and that private interests not benefit to any substantial degree. In arriving at its decision that private, rather than charitable, interests were being served, the court examined various factors, similar to the factors the IRS enunciated in Revenue Ruling 98-15. The court noted, most significantly, that there was a lack of any express or implied obligation of the for-profit parties to place charitable objectives ahead of for-profit objectives. Moreover, after the general partnership acquired an interest in the Operating Partnership, the Operating Partnership failed to amend its organizing documents to include an overriding charitable purpose. In fact, the Operating Partnership explicitly acknowledged the partnership’s noncharitable objectives, authorizing the General Partnership, for example, to amend the Operating Partnership, but only if the amendments did not alter the economic objectives of the partnership or materially reduce the economic return of the partners. The court emphasized (as did the IRS in Revenue Ruling 98-15) the relevance of control by the tax-exempt entity. Although Redlands had successfully blocked various proposals with respect to expanding the scope of activities performed at the Surgery Center, the court concluded that such veto rights did not establish that Redlands had effective control over the manner in which the Surgery Center performed its operations. Furthermore, there was no indication that Redlands possessed significant “informal” control with respect to influencing Surgery Center’s activities. For example, there was no evidence of Redlands’ role in effecting a change in the criteria for procedures performed at the Surgery Center, there was no increase in charity care, and only negligible coverage for Medi-Cal patients due to Redlands’ involvement in the Operating Partnership. The court seemed particularly concerned that the general partnership agreement restricted RHS’s (Redlands’ parent corporation) ability to provide outpatient services at Redlands Hospital or elsewhere without the approval of its for-profit partner. As a result, from 1990 to 1995, there was actually a decrease in outpatient surgeries performed at Redlands Hospital and an increase at the Surgery Center. The court found it difficult to conceive that such a restriction in services served a charitable purpose. Finally, the court concluded that the management contract between the Operating Partnership and SCA Management conferred too much management authority to the for-profit manager. Moreover, SCA Management’s fee of 6 percent of the gross revenues provided it with an incentive to manage the Surgery Center to maximize profits, while none of the operational documents required SCA Management to conduct its activities with the goal of satisfying a community benefit.
198
c04.fm Page 199 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
In addition, the Operating Partnership was virtually “locked into” the management contract which was renewable after 15 years at SCA Management’s sole discretion. Based on the totality of these factors, the Tax Court concluded that Redlands impermissibly served private interests. Although the court did not specifically refer to Revenue Ruling 98-15, Redlands buttresses the IRS’s authority to enforce Revenue Ruling 98-15 with respect to whole hospital joint ventures and other types of joint ventures involving exempt organizations. Again, the analysis will be based on the totality of all relevant factors, including, but not limited to, the exempt organization’s formal and informal control of the day-to-day activities of the venture, as well as a binding commitment of the parties in the operative documents that charitable purposes, as opposed to for-profit purposes, must prevail. Factors that will mitigate against charitability are long-term management agreements with a for-profit entity which has the unilateral right to renew the contract, arbitration provisions that do not take into account charitability, and the lack of any evidence of actual charitable operations. Just 10 days after oral arguments, the Ninth Circuit issued a per curiam opinion.135 The single paragraph adopted the Tax Court holding that Redlands had “ceded effective control over the operations of the partnerships and the surgery center to private parties, conferring impermissible private benefit.” Because private parties were obtaining substantial benefit, the surgery center was not being operated exclusively for exempt purposes. The Ninth Circuit also affirmed the Tax Court view that private benefit prevented Redlands from claiming exempt status under the integral part doctrine. The Court of Appeals had little choice but to affirm the decisions of the Tax Court and the IRS. The Redlands venture incorporated none of the positive factors and many of the negative factors that the IRS has discussed in Rev. Rul. 98-15 and elsewhere: • No charitable purpose in partnership documents (in fact, profit motive
protected by partnership documents). • No charitable override for deadlocked board or arbitration decisions. • Management company was a subsidiary of the for-profit partner. • Long-term management contract (15 years) renewable in sole discretion
of management company. • Surgery center did not perform free medical care even after it formed the
venture. • An agreement restricted the ability of charitable hospital to expand its
own ambulatory surgery center. • Rate of return on the venture was in excess of 43 percent.
135
Redlands Surgical Servs. v. Commissioner, 242 F.3d 904 (9th Cir. Mar. 15, 2001), 2001 TNT 52-6, petition for reh’g denied, May 30, 2001 (unpublished ruling).
199
c04.fm Page 200 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
The terse opinion disappointed many practitioners who had hoped for a more expansive discussion that would have provided guidance on a broader range of situations. Practitioners believe that Rev. Rul. 98-15 is based on extreme examples that ignore the gray area where most real life ventures are found. A for-profit partner, who typically invests substantial capital in the venture, is usually reluctant to grant control over a venture to the nonprofit. The exempt partner may be more concerned with attracting the financial support of the forprofit, which is critical to implementing its exempt function through the project, than the details of control. Although the IRS is keenly aware of the need for additional guidance, it is a difficult subject to address through advance private letter rulings, because the agency policy requires scrutiny of operations as well as organizational structure. The venture must first operate for a period of time, in order for the IRS to be able to rule on both the organizational and the operational aspects of the venture. Only hindsight allows the IRS to rule on a joint venture.136 On November 7, 2003, the Fifth Circuit Court of Appeals filed its opinion in St. David’s Health Care System v. United States, 349 F.3d 232, 2003 WL 22416061 (5th Cir. 2003). Previously, the District Court granted St. David’s summary judgment motion and ordered the government to refund the taxes paid by St. David’s for the 1996 tax year. The District Court also ordered the government to pay $951,569.83 in attorney’s fees and litigation costs. The Appellate Court vacated that decision, and has remanded the case back to the District Court for further proceedings. The Appellate Court found genuine issues of material fact. St. David’s operated a nonprofit hospital system in the Austin, Texas, area, and was recognized as a charitable organization entitled to tax-exempt status under §501(c)(3). In 1996, St. David’s formed a partnership with Columbia/ HCA Healthcare Corporation (“HCA”), a for-profit company that operates 180 hospitals nationwide. The government contends that in entering into this “wholehospital” joint venture, St. David’s ceded control of the hospital system to HCA. The government relied on Rev. Rul. 98-15, 1998-1 C.B. 718 (1998) and Redlands Surgical Services v. Commissioner, 242 F.3d 904, 904-5 (9th Cir. 2001) aff’g 113 T.C. 47 (1999) in making its arguments regarding the control issue. St. David’s contends that the joint venture continues to operate in a charitable manner and provides extensive benefits to the community, relying on Rev. Rul. 69-545, 1969-2 C.B. 117 (1969) and the community benefit standard as justification for continued exempt status. The Court of Appeals focused on the control of the joint venture, and whether St. David’s ceded control to the for-profit HCA. As authority for this focus, the Appellate Court adopted the government’s arguments and relied on Redlands and Rev. Rul. 98-15. Although St. David’s argued that the community benefit standard and the standards set forth in Rev. Rul. 69-545 applied, the Court found that area of the law was not directly on point (St. David’s, 349 F.3d at 239, fn 9). In fact, the Appellate Court agreed that St. David’s provides extensive charity care to the Austin community. The Court rejected the government’s arguments that charity 136
Presentation of Elizabeth Purcell, Corporate Philanthropic Leadership Summit (Mar. 17, 2001).
200
c04.fm Page 201 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
care does not include bad debts that are ultimately written off by the hospital. Instead, the court cited to Maynard Hosp., Inc. v. Commissioner, 52 T.C. 1006, 1026 (1969), where the Tax Court indicated that “charitable services” may include collection attempts, as long as “[p]atients who were found unable to pay their bills often had them reduced or entirely canceled.” Ultimately, the Appellate Court examined whether St. David’s operated “exclusively in furtherance of exempt purposes.” The Court noted that it “must also ensure that those activities do not substantially further other (noncharitable) purposes.” (St. David’s, 349 F.3d at 237.) The Court stated: “Therefore, even if St. David’s performs important charitable functions, St. David’s cannot qualify for tax-exempt status under §501(c)(3) if its activities via the partnership substantially further the private, profit-seeking interests of HCA” (St. David’s, 349 F.3d at 237). In its analysis of the control issue, the Appellate Court utilized Rev. Rul. 9815 as a starting point. The Court cited three factors from the revenue ruling, and stated that a nonprofit can demonstrate control over the joint venture by showing some or all of the following: 1. That the founding documents of the partnership expressly state that it has a charitable purpose and that the charitable purpose will take priority over all other concerns; 2. That the partnership agreement gives the nonprofit organization a majority vote in the partnership’s board of directors; and 3. That the partnership is managed by an independent company (an organization that is not affiliated with the for-profit entity). (St. David’s, 349 F.3d at 239.) The Appellate Court examined these three factors, and analyzed the control that St. David’s “managed to secure” to protect its charitable mission. CAVEAT The Court noted the unequal bargaining positions of the parties and that St. David’s, by its own admission, entered into the partnership with HCA out of financial necessity, while HCA entered into the partnership for reasons of financial convenience. This issue of relative financial position should be irrelevant as a factor in the court’s determination. Indeed, it could be argued that St. David’s board was fulfilling its fiduciary obligation consistent with the exempt function of the hospital in order to obtain additional revenues to sustain the hospital system. The Court noted the Partnership Agreement states that the manager of the partnership “shall” operate the partnership facilities in a manner that complies with the community benefit standard. The Court further noted that this statement, standing alone, will not ensure that St. David’s has adequate control over the partnership operations, but nonetheless concluded that this “appears to comply with the first factor listed in Revenue Ruling 98-15.” (St. David’s, 349 F.3d at 240, f.n. 11.) Another favorable factor for St. David’s was the membership on the partnership’s Board of Governors. The court noted that St. David’s can exercise a certain degree of control over the partnership through its veto power, however, stated
201
c04.fm Page 202 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
that St. David’s does not control a majority of the Board. St. David’s and HCA each appoint half of the Board. The Court also stated that although St. David’s can veto board actions, it does not appear that it can initiate action without the support of HCA. The Court noted that St. David’s assertion that it can use the threat of dissolution to force the partnership to give priority to charitable concerns is questionable, in that it is difficult to imagine a scenario in which St. David’s would move to dissolve the partnership when that would be disastrous to St. David’s operations. The partnership documents also contain a noncompete clause which provides that, in the event of dissolution, neither partner can compete in the Austin area for two years. Therefore, the Court stated that the possibility of St. David’s forcing dissolution of the partnership appears to be unlikely, since St. David’s would cease to exist if the joint venture were dissolved. Another issue that presented the Court with questions of fact was with regard to the management agreement that St. David’s entered into with Galen, a forprofit subsidiary of HCA. The Court noted that Galen had little incentive to further the exempt purposes of St. David’s, and that it seemed “more likely that Galen would prioritize the (presumably noncharitable) interests of its parent organization, HCA.” The Appellate Court cited to Rev. Rul. 98-15 and Redlands, which both indicate that a charitable hospital is unlikely to be in control of a partnership with a for-profit entity when the partnership manager is a subsidiary of the for-profit entity (St. David’s, 349 F.3d at 242). The Court noted further that part of Galen’s fee is computed as a percentage of the partnership’s net revenues. Even though the percentage is 1 percent, this contingency could give Galen an incentive to maximize revenues and to neglect charitable goals, and the Court suggested that Galen will not be inclined to prioritize charitable goals (St. David’s, 349 F.3d at 242, f.n. 13). However, the Court also stated that this fact, standing alone, does not preclude tax-exempt status for the nonprofit partner, given the conclusion in Rev. Rul. 98-15 that even though a partnership paid its manager a fee based on the partnership’s gross revenues, the nonprofit member of the partnership was entitled to tax-exempt status based on other factors. In sum, the Appellate Court found that the factual issues relating to whether St. David’s ceded control to HCA were in dispute, and therefore present a genuine issue of material fact. Although the Appellate Court clearly set forth the legal standards to apply regarding the appropriate determination as to whether St. David’s is entitled to retain its exempt status, the Court could not conclusively determine that St. David’s retained sufficient control over the joint venture to ensure that the partnership would continue to operate exclusively in furtherance of exempt purposes. CAVEAT Due to the summary judgment nature of the proceeding, St. David’s did not provide all of the factual evidence that is relevant to these tests regarding control. The Court noted that it does not make credibility determinations or weigh the evidence, but rather considers all of the evidence in the record and draws all reasonable inferences in favor of the nonmoving party. As a result, the District Court’s opinion was vacated and the case is remanded back to the District Court for further proceedings.
202
c04.fm Page 203 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
The Appellate Court provided a road map for the District Court and for St. David’s to follow, to resolve the only factual issue remaining which is whether St. David’s ceded control over the partnership to HCA. The jury in the U.S. district court found in favor of the nonprofit, having applied the Fifth Circuit’s reasoning, which expands the control test of Rev. Rul. 98-15 and Redlands. On remand, the District Court, following the Fifth Circuit, instructed the jury to consider the totality of the circumstances in deciding whether the partnership’s operations primarily furthered charitable purposes, including the partnership’s benefit to the community. The circumstances highlighted by the District Court in the jury instructions included the following: To “give up control” of the Partnership . . . means to give up the direct or indirect ability to determine the direction of management and policies through ownership, contract or otherwise. In determining whether St. David’s retained sufficient effective control, you should consider all the facts and circumstances, including, but not limited to, (i) any applicable powers or rights allocated to St. David’s in the Partnership’s governing documents, (ii) evidence of St. David’s ability and willingness, if any, to enforce any such powers, (iii) the structure of the Partnership, (iv) the management of the Partnership, and (v) the actual operation and subsequent activities of the Partnership.137
The court also instructed the jury that even if the community benefit test is met and St. David’s and the partnership provided an extensive amount of charity care, “You must also find that the Partnership’s activities do not substantially further the private benefit of HCA.”138 The jury was also instructed that: In considering whether Partnership operations primarily further charitable purposes, you must determine whether St. David’s, when it entered the Partnership, retained sufficient control over Partnership operations to ensure that Partnership operations primarily further charitable purposes, and that no more than an insubstantial amount of the Partnership’s activities further nonexempt interests. If St. David’s gave up formal or effective control, it is presumed that the Partnership operations further the profit-seeking motivations of HCA and that St. David’s activities via the Partnership are not primarily in furtherance of its charitable purposes.”139
The jury found in favor of St. David’s, and the government’s appeal of the jury verdict was settled out of court by the parties. The jury instructions, derived from the Fifth Circuit opinion, expand the two-prong charitable purpose and control test that is most clearly applicable to whole hospital joint ventures. The test that was utilized in St. David’s encompasses a community benefit standard, unique to the health care area, as an important part of the first prong charitable purpose test. The St. David’s test also utilizes a broader facts and circumstances determination as to whether the exempt partner has retained effective control over the activities carried on by the joint venture. 137
138 139
St. David’s Health Care System v. United States, Civil Action No. A-01-CA-46JN, Jury Instructions filed March 4, 2004, United States District Court, Western District of Texas, Austin Division, para. 15. Id. at para. 10. Id. at para. 13.
203
c04.fm Page 204 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
In January 2003, the IRS released two private letter rulings140 addressing joint ventures between exempt entities in the healthcare area. These private letter rulings, rather than providing the much-awaited additional guidance in this area, reinforced the Service’s position on the requisite issue of control.141 Exempt organization practitioners have described the Service’s position as unreasonable and unattainable in the real world and have renewed their request for additional guidance that will address joint venture situations that neither fall within the “good” nor the “bad” fact situations in Rev. Rul. 98-15. 142 (g)
John Gabriel Ryan Association v. Commissioner of Internal Revenue: The IRS Approves a 50–50 Joint Venture
The issue of control in joint ventures involving tax-exempt entities was raised in another case that was filed in the Tax Court.143 In the JGR case, the petitioner, a nonprofit healthcare entity whose sole activity is participating in five ancillary healthcare and medical office building joint ventures, challenged the IRS’s denial of its application for tax-exempt status as a §501(c)(3) organization, contending that it is operating exclusively for charitable purposes, including the promotion of health for the benefit of the community, and not in a manner that benefits private interests other than incidentally. The IRS initially disagreed with this contention and held that the petitioner did not satisfactorily establish that it is operated exclusively for exempt purposes and that its activities further charitable purposes and only incidentally benefit private interests. In two of the five joint ventures that are the subject of this case, all the participants are tax-exempt entities. In another two of the joint ventures, the petitioner is the sole general partner, owning 99 percent of each joint venture jointly with its sole corporate member, Providence Health System–Washington (“PHS– Washington”), also a §501(c)(3) entity. In the fifth joint venture, the most relevant and problematic in this case, the petitioner is a co–general partner with a forprofit entity, each owning a 50 percent interest in the joint venture, South Sound Regional MRI Center (“South Sound”). However, the joint venture agreement contains provisions intended to further the petitioner’s charitable purposes, promote health, and place charitable activities ahead of profitable goals, such as the following: 140 141
142 143
Priv. Ltr. Rul 200304041 (Jan. 24, 2003); Priv. Ltr. Rul. 200304042 (Jan. 24, 2003). In Priv. Ltr. Rul. 200304041, an exempt organization initially enters into a joint venture with another exempt organization. Immediately after the LLC is formed, one of the exempt participants withdraws and a physician group is admitted as a member of the joint venture. Where the two participants are exempt organizations, the IRS is less concerned with the issue of control. However, the issue of control becomes important if the joint venture arrangement involves exempt and for-profit participants. In this letter ruling, the for-profit physician group holds a 48 percent membership interest in the joint venture while the exempt participant holds a 52 percent interest and also appoints three of the LLC’s five-member board of governors. The IRS held that because it had voting control over major decisions of the board of governors, the exempt participant will exercise effective control over the major decisions of the LLC and over the operations and activities of the facility. See Subsection (e)(ii) above for discussion of ABA submissions to the IRS of proposed joint ventures examples that address the “gray” areas. John Gabriel Ryan Association v. Commissioner of Internal Revenue, Tax Court Docket No. 16811-02X (filed October 25, 2002) (the JGR case).
204
c04.fm Page 205 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
1. South Sound is required to have an “open door” policy and is not to deny services to anyone based on inability to pay. 2. South Sound is required to comply with all policies and procedures of the affiliated local charitable hospitals. 3. South Sound is required to observe the Ethical and Religious Directives for Catholic Health Facilities (ERDs) issued or approved by the National Conference of Catholic Bishops and the U.S. Catholic Conference. 4. The tax-exempt participant has the unilateral right to dissolve the joint venture and the right of first refusal to purchase all or a portion of its assets upon dissolution. (This may be an important factor, analogous to the statutory right of first refusal provided in §42(i)(7), applicable to nonprofits participating in low-income housing joint ventures.) 5. South Sound is managed by a committee that is not related to or affiliated with the for-profit participant or any other for-profit entity. Both joint venture participants are equally represented on the committee, which has full management authority. All decisions are to be made by unanimous consent, except for major decisions needing the approval of the boards of each participant. 6. The joint venture serves Medicare and Medicaid patients, provides charity care and engages in other activities intended to further the petitioner’s charitable purposes. 7. South Sound has a good track record of providing substantial amounts of charity care and community benefits. In June, 2003, the IRS released a determination letter reversing its position in the case and granted 501(c)(3) tax-exempt status to the petitioner, to be effective from December 30, 1998. While not specifying the grounds for reversing its position, the IRS apparently concluded that the various partnership agreements provided enough “other mechanisms” that minimize any potential for impermissible private benefit, despite the lack of majority control by JGR. This IRS position supports the petitioner’s argument that its affiliation with for-profit partners did not per se make it ineligible for exemption. It is not clear what factors were ultimately persuasive to the IRS, except that they wanted to avoid litigation on the structure in the context of Rev. Rul. 98-15. It is also reasonable to assume that because JGR was involved in five ancillary joint ventures, the IRS concluded that overall, JGR qualified for exempt status. The IRS have assessed the UBIT against JGR on any taxable income from its South Sound joint venture, based on its position in previous cases, although this was unlikely. (h)
A Road Map
Based on the body of law as it currently exists, the IRS has identified the factors or categories that will be examined in determining the acceptability of a joint venture arrangement involving a nonprofit.
205
c04.fm Page 206 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
(i) Favorable Factors. Factors in a partnership or LLC arrangement that the IRS considers to be favorable in determining whether the assets of the exempt organization are adequately protected, include the following:144 • Limited contractual liability of the exempt partner145 • Limited rate of return on the invested capital of the limited partners (a
stated ceiling that is reasonable under the circumstances)146 • An exempt organization’s right of first refusal on the sale of partnership
assets147 • The presence of additional general partners obligated to protect the inter-
est of the limited partners148 • Lack of control over the venture or the exempt organization by the for-
profit limited partners (i.e., no limited partner serves as an officer or director of the exempt organization) except during the initial start-up period149 • The absence of any obligation to return the limited partners’ capital from
the exempt organization’s own funds150 • Absence of profit as a primary motivation151 • All transactions with partners are at arm’s length • Management contract (1) terminable for cause by the LLC152 (2) with a
limited term, and (3) renewal subject to approval of the LLC;153 and (4) preferably with an independent entity154 • The nonprofit organization’s having effective control over major deci-
sions as well as day-to-day operations155 and • Written commitment in the joint venture governing document to the ful-
fillment of charitable purposes in the event of a conflict with a duty to maximize profit156
144
145 146 147 148 149 150 151 152 153 154 155 156
These factors were originally enunciated in Plumstead and amplified in Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See also Marcus Owens, Director, IRS Exempt Organizations Technical Division, at the Georgetown University Law Center Tenth Annual Conference, “Representing and Managing Tax-Exempt Organizations” (Apr. 30, 1993) (Owens, in providing an IRS perspective, listed factors utilized in determining whether a joint venture arrangement sufficiently insulates the exempt organization from conflict). Gen. Couns. Mem. 39,005 (Dec. 17, 1982). Plumstead, 74 T.C. at 1334. Gen. Couns. Mem 39,005 (Dec. 17, 1982). See id. Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Plumstead, 74 T.C. at 1334; Rev. Rul. 98-15. Plumstead, 74 T.C. at 1333-34; See Priv. Ltr. Rul. 97-31-038. Gen. Couns. Mem. 39,005 (Dec. 17, 1982). Id. Id. Id. Id. Id.
206
c04.fm Page 207 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
CAVEAT The Service is inclined to look more favorably at partnerships where one of the partners is a large organization with a significant financial base that has a track record of participating in charitable ventures. In these cases, the Service is likely to conclude that the venture implements the organization’s exempt purpose if the tax-exempt partner can show, through experience or an overall explanation of circumstances, that the provisions will not impair the charitable purpose of the joint venture, and will not provide undue private benefit to the for-profit partners.* *
Leonard J. Henzke, Jr., Speech at the Western Conference on Tax Exempt Organizations (Nov. 18, 2004).
(ii) Unfavorable Factors. Factors that may cause the IRS to look unfavorably upon an exempt organization’s participation in a partnership or LLC include the following: • A disproportionate allocation of profits and/or losses in favor of the lim-
ited partners157 • Commercially unreasonable loans by the exempt organization to the
partnership • Inadequate compensation received by the exempt organization for ser-
vices it provides, or excessive compensation paid by the exempt organization in exchange for services it receives158 • Control of the exempt organization by the limited partners or lack of suf-
ficient control by the exempt organization to ensure that it is able to carry out its charitable functions159 157
158 159
Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See, e.g., Priv. Ltr. Rul. 97-39-036 (June 30, 1997); Priv. Ltr. Rul. 97-39-037 (June 30, 1997); Priv. Ltr. Rul. 97-39-038 (June 30, 1997); and Priv. Ltr. Rul. 97-39-039 (June 30, 1997) (IRS ruled that the participation by three §501(c)(3) hospitals and the for-profit subsidiaries of two of such tax-exempt hospitals in a joint venture to operate a diagnostic laboratory, while raising private benefit issues under the joint venture’s operating agreement, did not result in private benefit where the participants’ profits and losses were not allocated based on invested capital, but instead were specially allocated among the participants based on source, differentiating between the patient and nonpatient sources following the principles set forth by the IRS in Rev. Rul. 85-110, 1985-2 C.B. 166, and Rev. Rul. 68376, 1968-2 C.B. 246), which are discussed in greater detail in Section 12.3. Plumstead, 74 T.C. at 1333. Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 39,005 (Dec. 17, 1982). “Control” of the partnership can occur in many ways. For example, if the general partner grants a power of attorney to the limited partner to carry out certain partnership business; if the limited partner has the right to amend the partnership agreement; if “special limited partners” exist that may step into the shoes of the general partner under certain circumstances; or if the limited partner has sole discretion to approve or disapprove of the sale of partnership assets. In each of the foregoing examples, excessive limited partner control may exist. See 1996 CPE at 62-4; see also Gen. Couns. Mem. 39,005 (Nov. 21, 1991); Plumstead, 74 T.C. at 1334. In Priv. Ltr. Rul. 97-36-039 (Sept. 15, 1997), discussed in Section 17.6, the IRS was concerned that a tax-exempt, co-general partner in a limited partnership formed to provide affordable housing could not cause the partnership to carry out its exempt objectives because it lacked control over the partnership’s substantive obligations due to its minority (in fact, de minimis) interest. In response to such IRS concerns, the parties amended the partnership agreement to “redistribute control” among the general partners. Their amendment delegated to the charity substantive authority that was formerly reserved jointly for the general partners. Under the amendment, the charity maintained its authority as managing partner over the partnership’s “day-to-day” operations, which demonstrated to the IRS that the exempt organization could ensure that the joint venture was serving a charitable purpose, whereas lack of control suggested the possibility of private benefit.
207
c04.fm Page 208 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
• Abnormal or insufficient capital contributions by the limited partners • A profit motivation by the exempt partner160 • Guarantee of the limited partner’s projected tax credits or return on
investment to the detriment of the general partner161 The IRS continues to require that an exempt organization control a joint venture that includes for-profit partners. Because healthcare ventures are generally reviewed at their inception, the IRS has focused on “organizational” control as a way to ensure that the venture would continue to promote charitable purposes after the venture is approved.162 In three IRS rulings approving healthcare joint ventures, control over the venture was firmly secured in the exempt organization by multiple means: ownership of a majority of membership shares, voting control over the board of directors, and management by the exempt organization.163 The control had the desired result of giving priority to the charitable purpose of promoting health for the community as a whole and limiting benefit to for-profit partners. In two of the cases, a state certificate of need also regulates the venture, requiring certain levels of charity care, community board members, open staffing, and de-licensing of some of the partner’s competing facilities. The key is the continued control by the charity over the “community benefit.” An extended example in the 2002 CPE section on Health Care164 discusses a variation in which the for-profit (rather than the nonprofit partner) is manager of the venture. However, in the example the nonprofit entity owns 65 percent of the partnership, has voting control of the management committee, the management agreement provides a fixed-fee payment and a five-year term renewable for additional two-year terms, and the partnership agreement gives charitable purposes precedence over profit maximization. Although the for-profit is managing the day-to-day affairs of the venture, the exempt organization has control over the policies and the organization as a whole. None of these scenarios provide guidance on the situation of a joint venture in which ownership is evenly split between exempt and for-profit organizations. The CPE chapter raises the issue, asking in a separate subsection: “Is Control Necessary?”165 It says that, theoretically, the exempt organization (EO) partner is not required to have majority control to meet the requirements of Rev. Rul. 98-15. However, the CPE authors assert that there must be “another mechanism” to ensure that the venture will promote charitable purposes, but acknowledge that to date the Service has not seen any that were worthy of approval. The factors 160 161 162
163 164 165
Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Guarantees are discussed in greater detail in Chapters 13 and 19. However, in one technical advice memorandum, the IRS seems to concede that evidence that the venture actually operates consistently with the community benefit standard is pertinent. “Although in the examination year the partnership agreement did not specifically provide that charitable interests have priority over profit interests, the facts show that [the venture] was operationally consistent with Situation 1 of Rev. Rul. 98-15 during that time.” Tech. Adv. Mem. 200151045, p. 8. Priv. Ltr. Rul. 200118954; Tech. Adv. Mem. 200151045; Priv. Ltr. Rul. 200206058. 2002 CPE, Lawrence M. Brauer, Mary Jo Salins, and Robert Fontenrose, “Update on Health Care,” p. 160. Id. at p. 161.
208
c04.fm Page 209 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
that the IRS lists at the end of the section are those “useful to ensure compliance with Situation 1 of Rev. Rul. 98-15,” rather than factors that would be helpful in the uncharted area between the “good example” and the “bad example.” A question arises as to whether the majority control test would be satisfied if more than one unrelated charity has combined voting rights that exceed 50 percent in a limited liability company or a partnership. Although there is no IRS guidance on the issue, a carefully drafted operating agreement and/or a voting agreement could support an argument that Situation 1 of Rev. Rul. 98-15 is complied with. However, the total arrangement would need to be examined, including the charitable purposes and the relationship among the charities with a review of their missions. In addition, the organizations would need to carefully document participation and the decision-making mechanism. The IRS has been unwilling to issue meaningful guidance for joint ventures not controlled by a charitable organization. In fact, in Rev. Proc. 2007-4 (January, 2007) the IRS announced that it will no longer issue any private letter rulings as to whether a joint venture between a nonprofit and for-profit results in UBIT or revocation. Nevertheless, transactions need not be deferred while waiting for further clarification. A venture that builds on a number of the following suggestions could proceed: • An established charity party should be the party in the transaction, rather
than use of a newly formed subsidiary that would have to apply for exemption in its own right. An alternative is to use a disregarded singlemember LLC. These structures have the additional advantage of not needing a ruling from the IRS in advance. Often the Service is more lenient when it reviews a venture during an audit and has operating history to consider as well. • Another option would be to create a taxable subsidiary through which the
charity could participate in the venture.166 The new subsidiary must be truly independent. The IRS approved such a structure in a private letter ruling to the AARP.167 Most of the 25 favorable factors that the IRS listed describe conventional corporate behavior (e.g., separate boards of directors, separate meetings, detailed minutes, and documenting participation and decisions). • The activities of the joint venture need to advance the charitable purpose
of the nonprofit partner. The IRS has stated that it could approve “other mechanisms” to ensure that a partnership would pursue a charitable purpose, even if the charitable organization did not have voting control. However, it has not given any examples of what these “mechanisms” might be. Below are possibilities that could be combined or used separately: • The presence of the community board is a point in favor of exemption, but is
not an absolute requirement for exemption. The purpose of a community 166 167
Priv. Ltr. Rul. 19938041 (June 28, 1999). Id.
209
c04.fm Page 210 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
board is to ensure that the community’s interest is given precedence over any private interest. • Give the charity veto rights over issues critical to it or a supermajority
vote to approve major financial and organizational decisions, such as: the venture’s annual capital and/or operating budgets; amending the venture’s governing documents; distribution of earnings and available cash; additional capital contribution calls (protect the exempt organization by assigning it either a pro rata amount or increasing its ownership share at the same time); assumption of additional indebtedness; acquisition or disposition of the facilities; approving unusually large contracts involving equipment and other goods and services; hiring key executives (and setting their compensation); and ensuring adequate reserves. • The chairman’s seat should be reserved for a member appointed by the
nonprofit who would have control over the board’s agenda. Also, give the charity the power to unilaterally remove the chief executive officer. Grant a tie-breaking vote to a chairman of the board appointed by the nonprofit. It is not clear whether the IRS would require further structural assurance that the chair would need to exercise this vote consistent with exempt purposes (e.g., in the healthcare context: meeting the community benefit standard.) • Establish ground rules for arbitration containing a presumption in favor
of the tax-exempt that could be overcome only if the for-profit meets a preset burden of proof (e.g., preponderance of the evidence or that the charity’s position is arbitrary, capricious, or unreasonable). For example, if the for-profit partner of a 50/50 shared venture wants to terminate free emergency room service and the tax-exempt vetoes the decision, an arbitrator would have to recognize a presumption in favor of the tax-exempt partner. The for-profit would have the burden of showing that the charitable purpose would not be jeopardized or that the charity’s position was arbitrary and without merit. Such a provision would resolve any ultimate conflict between profit and exempt purposes in favor of the exempt purpose, and should therefore alleviate the concern of the IRS. • In a healthcare venture, a “community benefit committee” might be cre-
ated by the nonprofit partner to monitor compliance with the community benefit standard. The committee could certify annually to the nonprofit’s board that the operations of the partnership satisfy the community benefit standard, which the nonprofit could report on its Form 990. Alternatively, it could hire a manager to conduct an internal audit to verify compliance with the community benefit standard. • With regard to a hospital venture, the partnership agreement should
require that all hospitals owned by the partnership be operated in accordance with the community benefit standard. Should a hospital fail to meet that standard, the charity should have the unilateral right to dissolve the partnership. • The identity of the management company and the details of its contract
are of particular importance to the IRS because they demonstrate who
210
c04.fm Page 211 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
controls the day-to-day management of the venture. It is preferable (although not required) that the management company be controlled by parties unrelated to the for-profit partner. The contract should be for a short term (no more than five years), with board authority to terminate for cause, power in the nonprofit to approve extensions, and acknowledgment by the parties that the charitable purposes are paramount. • Do not hire employees or former employees of the for-profit partners to
serve in key positions in the venture. The IRS appears to be primarily concerned that such persons would not be accountable to the exempt organization so that the charity would be deprived of critical information. • The exempt partner’s board members should take an active role and doc-
ument their participation in written, detailed minutes of the meetings. This shows that they are actively involved in decision making. • Build in a right to unwind in the event that the transaction ultimately fails
to meet the Plumstead dual-prong test. If the parties agree in advance on a fair and orderly way to end the venture if the exempt status of the nonprofit members is threatened, the IRS should not be able to subsequently argue impermissible private benefit at the back end. NOTE The Form 990 (Return of Organization Exempt From Income Tax) includes question 88A in Part V: “At any time during the year, did the organization own a 50% or greater interest in a . . . partnership, or entity disregarded as separate from the organization?.” If so, the information regarding the entity, including its name, address and EIN number, percentage of partnership interest, nature of activity, total income and end of year assets need to be included. The Form 1023 (Application for Recognition of Exemption Under 501(c)(3)) (Rev. June, 2006) in Part VIII, question 8 asks whether the organization plans to enter into joint ventures, including partnerships or limited liability companies treated as partnerships, in which it shares profits and losses with partners other than §501(c)(3) organizations? If so, the organization is asked to describe the activities of these joint ventures. In response to these questions, the IRS will be kept informed about the joint venture activities of nonprofits.
(i)
The Healthcare Arena: Community Benefit and Charitable Care
(i) Whole Hospital Joint Ventures and Ancillary Ventures. A major trend in the late 1990s was the “whole hospital joint venture,” which became increasingly popular through the efforts of large, for-profit healthcare organizations seeking to expand their networks. In a whole hospital joint venture, a for-profit and a nonprofit may each contribute one or more hospitals (and sometimes cash) to a joint venture partnership or limited liability company. These transactions differ from “ancillary” joint ventures in which a nonprofit contributes a portion of its assets, services, or facilities, (e.g., a cardiac care unit), and a for-profit organization contributes funds and/or other assets. Whole hospital joint ventures have attracted the attention of the National Office of the IRS because of the significant concerns they raise under (1) the private inurement doctrine (particularly if “golden parachutes” for a nonprofit’s board members are present), (2) the operational test (including the private benefit
211
c04.fm Page 212 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
limitation) of §501 (c)(3), particularly if the charity conducts no other charitable activity beyond holding an interest in the joint venture, and (3) Plumstead, in that the charity may not maintain a sufficient measure of control over the operations of the joint venture to ensure charitable operation, yet maintains too much involvement to be considered a purely passive investor. Another danger presented by such an arrangement is that the charitable organization, after the merger, may not be able to meet public support requirements and could become subject to the restrictive private foundation rules.168 Whole hospital joint ventures can raise issues similar to those that can arise in ancillary joint ventures. For example, the private inurement issue relating to physician compensation169 can arise in both types of projects. On the other hand, ancillary joint ventures can raise different issues, such as UBIT questions.170 If a nonprofit engages in an ancillary joint venture that does not further charitable interests but is unrelated to the nonprofit’s exempt purposes, income from the venture will be UBIT.171 Moreover, if a nonprofit enters into a whole hospital joint venture that is found to further its exempt purposes, it could maintain its tax exemption but lose its public charity status, as its postmerger income stream172 will be from only one source. CAVEAT In May 2006, the IRS launched a new and extensive hospital information gathering project, sending approximately 600 compliance letters to tax-exempt hospitals. These letters requested information about the organizations’ community benefit activities and their compensation practices. The letters contain over 80 questions and the responses were reportedly “voluntary” and in the form of checking the boxes or responding in narrative form. There were no requests for documents. Although this information gathering initiative occurred at the same time that the Senate Finance Committee called for an extensive audit of whole-hospital joint ventures, the IRS has indicated that it was gathering the information merely to spot trends and industry standards before moving forward with further examination of a smaller number of the organizations. Notably, the information provided by taxexempt healthcare organizations that demonstrate a commitment to charity care and community benefits could assist the IRS and Congress to differentiate the activities of a tax-exempt healthcare organization from a taxable healthcare organization. NOTE The Exempt Organizations Continuing Professional Education Technical Instruction Program for FY 1999* (CPE) discusses whole hospital joint ventures and explains to agents how these arrangements emerged in the healthcare field, their basic structure, and how Rev. Rul. 98-15 applies.†
168 169 170 171 172
See Section 12.4 for a more detailed discussion. But see Rev. Rul. 98-15 for a favorable determination of this issue. See Section 4.2(i)(ii) and Chapter 5. See Section 4.4(b). Id. See Section 12.4 for a more detailed discussion.
212
c04.fm Page 213 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
The CPE text suggests 24 questions agents should ask themselves when determining whether participation in a joint venture furthers an exempt purpose and in gauging whether private benefit to the for-profit managers is more than incidental. Essentially, joint ventures between for-profit and tax-exempt hospitals will be permitted if “charitable purposes supersede profit maximization purposes.” According to the CPE text, in addition to raising other questions, agents are instructed to inquire into the following:
* † ‡
•
Is the partnership required by its governing documents to promote the health of a broad section of the community?
•
Does participation in the joint venture by the exempt organization further its exempt purpose?
•
Is there actual evidence that partnership activities are undertaken chiefly to promote the health of a broad cross section of the community rather than to produce benefits?
•
Is there a management firm? If so, how is it selected, how is it compensated, and what are its duties?
•
How is the governing board of the joint venture selected? Who serves on the governing board? How are issues brought before the board?
•
Do any of the representatives of the exempt organization who serve on the governing board of the joint venture have a conflict of interest with their ability to effectively represent the interests of the community?
•
How is the compensation for physicians and for executives established? Who sets the medical and ethical standards of the venture? Who oversees the quality of the healthcare provided?‡
1999 CPE, Chapter A. Although the CPE text is written for internal training purposes at the IRS, it provides practitioners with valuable clues on how the IRS will approach certain issues. See id. See also “Exempt Organizations Technical Instruction Program for FY 2000” which contains five articles on hospitals (2000 CPE). See id.
(ii) “Insiders” and Inurement. One of the issues in the healthcare area that has attracted much attention is the potential for doctors and other medical staff to obtain “impermissible” benefits. As discussed in Rev. Rul. 98-15, a nonprofit’s activities can only incidentally benefit a private party; the overall purpose of the venture must be charitable. An analysis of this issue historically raised the question of whether a doctor is an “insider” in relation to the nonprofit—that is, is the doctor in such a position that he can cause him- or herself to receive a private benefit? The IRS historically took the position that all hospital staffers were insiders.173 However, Congress has rejected that view as reflected in the legislative history of the Taxpayer Bill of 173
See §501(c)(3); Gen. Couns. Mem. 39,498 (Jan. 28, 1986); Gen. Couns. Mem. 39,670 (June 17, 1987) (indicating that all persons performing services for an organization have a personal and private stake in it and, therefore, possess the requisite relationship on which to base inurement). See also §501(o), which states that an organization can still “be treated as organized and operated exclusively for a charitable purpose” under §501(c)(3) even if a hospital owned and operated by the organization participates in a provider-sponsored organization (PSO) that may or may not be tax exempt. But anyone with a material financial interest in the PSO is a private shareholder or individual with respect to the hospital. A PSO is defined in §1853(e) of the Social Security Act as an organization organized and operated by a healthcare provider(s) and providing a “substantial proportion” of healthcare items or services directly through the provider, the provider sharing in the financial risk of providing
213
c04.fm Page 214 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
Rights 2, which contain the new intermediate sanction provisions.174 The intermediate sanctions focus on a person’s actual ability to exercise substantial control over the entity,175 and, as discussed in the following paragraphs, impose a tax on the person receiving the improper benefit. Prior to the passage of §4958, the IRS’s only compliance tool for a violation of the prohibition on private inurement by an IRC §501(c)(3) organization (other than a private foundation) was revocation of the organization’s tax-exempt status. Because this remedy was so harsh, it was seldom used. In response to the need for a usable enforcement tool, the Clinton Administration proposed a set of rules that would penalize a person who improperly reaped a benefit from an §501(c)(3) or (4) organization by imposition of excise taxes similar to those applicable to private foundations. This proposal became the excise tax provisions that are now codified as §4958 by the Taxpayer Bill of Rights 2. On January 23, 2002, final regulations interpreting IRC 4958 were published in the Federal Register, 67 F.R. 3076.(insert fn: See also 202-7 I.R.B. 500 (2/19/ 02).) The first reported case decided under IRC 4958 was Caracci v. Commissioner, 118 T.C. No. 25 (2002). Caracci is discussed in Chapter 5. The intermediate sanction regulations, which are discussed in depth in Chapter 5, contain two examples that bear on the issue of “insiders.” To summarize, the penalty taxes of §4958 are imposed on disqualified persons who receive an excess benefit, that is, a benefit whose value exceeds the consideration given in return, including the value of services performed.176 Disqualified persons include a person who has “substantial influence over the affairs of” a tax-exempt organization.177 This category includes high-level employees, members of the organization’s governing body, and persons with a material financial interest in the organization.178 NOTE This category of disqualified persons is determined on the basis of the facts and circumstances that indicate the degree of control the individual has in regard to the entity. The principle of control, as discussed in Section 4.2(b), is also the major factor examined in determining whether a nonprofit jeopardizes its status by entering into a particular joint venture. items or services and having at least a majority financial interest in the PSO. 42 U.S.C.S. §1395w-25(d)(1). §501(o) was added by §4041(a) of the Balanced Budget Act of 1997, Pub. Law 105-33. The House Report states that subsection (o) does not change current restrictions on private inurement and private benefit. Instead, §501(o) stipulates that for purposes of applying the inurement prohibition in §501(c)(3), anyone with a material financial interest in the PSO shall be treated as a private shareholder or individual with respect to the hospital. The House Report also states that the “provision is necessary to ensure that certain providers not lose tax-exempt status simply because they join or form a PSO.” 174 175
176 177 178
Pub. L. No. 104-168 (110 Stat. 1452). Committee Report on the Intermediate Sanctions Provisions, H. Rep. No. 506, 104th Cong., 2d Sess., n.12 (1996), which states that the intermediate sanctions provisions intend that only those physicians having “substantial influence” over the affairs of the organizations should be considered disqualified persons subject to the intermediate sanctions. See Sections 5.4 and 4.2(j) for a more detailed discussion. Prop. Reg. §§53.4958-1(a) and 53.4958-(c). Prop. Reg. §53.4958-3(a). Reg. §53.4958-3(c).
214
c04.fm Page 215 Thursday, March 15, 2007 5:17 PM
4.2 EXEMPT ORGANIZATION AS GENERAL PARTNER: A HISTORICAL PERSPECTIVE
EXAMPLE: An exempt acute care hospital (H) employs a radiologist (R) who has no managerial authority over H. R gives instructions to staff that perform the work he conducts, but has no other supervisory functions. R is not on the governing board of H, does not receive compensation based on revenues of H under his control, and has no authority to control a significant portion of H’s budget or employee compensation. Under these facts and circumstances, R is not a disqualified person.179 EXAMPLE: H also employs a cardiologist (C), who is head of its cardiology department, which is a principal source of revenue for H. C has the authority to allocate the department budget, which includes distributing incentive bonuses from a pool funded by H’s revenues from the cardiology department. C is a disqualified person as to H with respect to any transaction on which H provides him with economic benefits because of the importance of the department to H and C’s control over that department.180 These examples demonstrate that, as it did concerning the issue of a nonprofit serving as a general partner in a joint venture, the IRS has moved away from a per se rule that all hospital employees are insiders to a facts and circumstances examination of a person’s actual position and power. The IRS has also published a sample “conflicts of interest” policy that, if adopted and followed by a hospital or other healthcare organization that is involved in business dealings with members of its board, will help to demonstrate the charitability of the hospital’s operations, despite insider involvement.181 Generally, to ensure charitability, practitioners have relied on an informal restriction providing that no more than 20 percent of a hospital’s board should be made up of affiliated physicians.182 The IRS has relaxed the application of the 20 percent test and will allow a substantially greater portion of the board to be made up of affiliated physicians, provided that the organization is governed by an independent, representative, community board and the facts and circumstances otherwise indicate charitability. A major factor in this analysis is the presence and enforcement of a substantial conflicts of interest policy183 requiring disclosure, investigation, and consideration of the financial interest of board members with respect to board actions, the recusal of financially interested parties from debate or vote regarding the proposed action(s) in which they have a financial stake, and the keeping of detailed records evidencing compliance with the policy.184 Even with a conflicts policy, however, extreme caution must be exercised in structuring joint venture arrangements involving an organization and its insiders. 179 180 181
182 183 184
This example is contained in Reg. §53.4958-3(g), Example 10. This example is contained in Reg. §53.4958-3(g), Example 11. 1997 CPE at 17. The IRS issued a revised “Sample Conflicts of Interest Policy” in the 2000 CPE. The major change is a prohibition on a board member from voting on a compensation matter that affects him or her. See, e.g., T. J. Sullivan, “Current Developments in Tax-Exempt Health Care at 21” (on file with author). For a sample conflicts of interest policy, see 1997 CPE at 25. For a more in-depth discussion of the conflicts of interest policy and physician representation on the community board, see Section 12.4.
215
c04.fm Page 216 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
A relatively new issue potentially involving the inurement question in the healthcare field is the concept of gain sharing. The term gain sharing generally refers to any plan to align the economic interests of doctors to those of a hospital with which the doctors are affiliated. Gain sharing can occur in many forms but usually involves payments to doctors based on a percentage of hospital cost reductions or improved margin on hospital services.185 It arises in numerous contexts, such as bonus pools or incentive compensation plans for those in a particular department or practice.186 CAVEAT Use of the term “gain sharing” is a red flag to the IRS’s Exempt Organizations Division.* Moreover, such arrangements may also raise issues under a variety of federal and state antikickback statutes and other laws.† Therefore, they should be undertaken only after consultation with professional advisors. *
Statement of Marcus Owens, Former Director Exempt Organizations Division, at the Healthcare Organizations Program, Arlington, Va. (Nov. 12–13, 1998). See “Physician Compensation”, note 182.
†
(j)
Colleges and Universities: Special Issues
(i) Audit Guidelines. The IRS has issued guidelines for colleges and universities. These guidelines also discuss joint ventures.187 Exempt organizations must be attentive to this increased IRS attention and scrutiny, and joint venture activities must be structured with current IRS guidelines, regulations, and rulings in mind. In general, the guidelines provide as follows in regard to unrelated business income tax (UBIT) issues: Items that are necessary for course instruction or that further the intellectual life of the campus community are substantially related to the institution’s educational purposes. Such items include books, paper, pens, pencils, typewriters, tapes, records, compact discs, computer software and hardware, and athletic wear required for participation in an athletic program or physical education class. All other items not directly related to the institution’s exempt purposes will not be substantially related unless IRC §513(a)(2), which excepts any trade or business carried on for the convenience of students or employees, applies. In general, convenience items include toiletries, wearing or novelty apparel bearing the institution’s logo, candy, cigarettes, newspapers, magazines, greeting cards, film, cameras, radios, televisions, appliances, operation of food and drink vending machines, laundromat facilities, and items that are of low cost and in recurrent demand. However, the convenience exception does not apply to sales made to alumni.188 185
186 187 188
Bonnie S. Brier, Esq., “Physician Compensation: Exempt Organization Creativity Without IRS Problems” (hereinafter “Physician Compensation”) presented at American Health Lawyers Association Tax Issues for Healthcare Organizations Program, Arlington, Va. (Nov. 12– 13, 1998) (hereinafter the “Healthcare Organization Program”). See “Physician Compensation,” note 197. Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” (Aug. 1994). Id.
216
c04.fm Page 217 Thursday, March 15, 2007 5:17 PM
4.3 LIMITED PARTNER OR LLC NON-MANAGING MEMBER
(ii) Corporate Sponsorship. Many colleges and universities receive corporate sponsorship payments in return for some recognition or acknowledgments. The issue of corporate sponsorship became extremely controversial in the early 1990s, beginning with the issuance of Technical Advice Memorandum (TAM) No. 91-47-007. In that ruling, the IRS stated that sponsorship of a football game, the Cotton Bowl, by a for-profit corporation, Mobil Oil, constituted UBI to the Cotton Bowl Athletic Association. The TAM led to a great deal of controversy, which in turn led to the promulgation of proposed regulations in 1993. In 1997, Congress codified the proposed regulations (with some modifications) to provide more definitive guidelines in this increasingly important arena. IRC §513(i) provides that “unrelated trade or business” does not include the solicitation and receipt of “qualified sponsorship payments.”189 The latter term is defined as a payment made by a for-profit entity to a non-profit where there is no expectation that the for-profit entity will receive any substantial benefit other than the use or acknowledgment of its name, logo, or product line.190 The exception does not apply to advertisements of the for-profit’s services or products or any payment whose amount is dependent upon the level of attendance at an event, broadcast ratings, or other indicia of the degree of public exposure to the event.191 Factors that indicate that a message is an advertisement, as opposed to an acknowledgment, are the presence of qualitative or comparative language, price information, an inducement to purchase, an endorsement, or any indication of savings or value.192 The exclusion also is inapplicable to payments for acknowledgments in a nonprofit’s regularly published materials, such as an alumni bulletin; the published materials must be tied to a specific event for the exception to apply.193 EXAMPLE: A university sponsors a track event and solicits and receives an endorsement by a well-known sneaker manufacturer. As long as the university uses the manufacturer’s name and logo only to acknowledge its support in its program materials or on other permissible items, the income for the acknowledgments will not be UBIT. On the other hand, if the university also receives payments for “acknowledgments” in its monthly alumni newsletter, those payments could well be UBIT if other UBIT rules are met, because these “acknowledgments” are not connected with a specific event but appear in a regularly published periodical.194
4.3
EXEMPT ORGANIZATIONS AS LIMITED PARTNER OR LLC NON-MANAGING MEMBER
As noted earlier in Section 4.2, an exempt organization’s involvement as a general partner in a limited partnership or as a managing member of an LLC can jeopardize its exempt status. Generally, however, an exempt organization may 189 190 191 192 193 194
§513(i)(1). See also Section 8.4(h). §513(i)(2)(A). §513(i)(2)(A) and (B)(i). §513(i)(2)(A). §513(i)(B)(ii)(I) and (II). §513(i)(B)(ii)(I) and (II).
217
c04.fm Page 218 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
invest as a limited partner (or non-managing member) in any prudent investment activity. The exempt organization’s role, in this instance, would be as a passive investor.195 EXAMPLE: An exempt educational institution becomes aware of the need for offcampus housing suitable for student living. To facilitate the construction of the housing, the institution forms a limited partnership with a local construction firm. The institution will serve as a limited partner, contributing necessary monetary resources to capitalize the partnership. In return, the institution receives a limited partner profits interest in the partnership. The construction firm serves as general partner with day-to-day responsibility for constructing the housing. Under this arrangement, the educational institution is acting solely as a passive investor in the housing project. As a limited partner or non-managing member, the exempt organization (and its assets) would not be exposed to unlimited liability. Furthermore, the exempt organization would not have a statutory fiduciary obligation to maximize profits for the investors. However, there may be tax consequences for an exempt limited partner or non-managing member, depending on the type of activity, exempt or for-profit, engaged in by the partnership. (a)
Joint Venture That Engages in Exempt Activities
An exempt organization may be a limited partner in a partnership or a nonmanaging member of an LLC that ultimately engages in an activity that furthers the charitable purposes of the exempt organization. In such a case, the income received by the exempt limited partner (or non-managing member) will not constitute UBI.196 EXAMPLE: A limited partnership is comprised of 10 limited partners, all hospitals, which are exempt organizations under IRC §501(c)(3). X is one of the exempt limited partners. The general partner is a for-profit entity. This limited partnership was 195
196
Questions have arisen regarding a charitable entity’s involvement in an LLC as a non-managing member. It is reasonable to characterize the charity’s role in the LLC as “passive” and thus analogous to a limited partnership interest; however, such a characterization may not be respected by the IRS. In an LLC, all members have the right to participate in the management of the entity, but there is no reason that a non-managing member cannot contractually relinquish this right and take a more passive role. Problems can arise, however, when the exempt organization attempts to maintain some operational control, or the appearance of control, over the affairs of the LLC through the use of restrictive operational covenants in the operating agreement. If these controls are present, the IRS may determine that the exempt organization more closely resembles a general partner than a limited partner and should be held to the Plumstead standards. In the case of a non-managing exempt member, the IRS will likely closely scrutinize the arrangement to determine whether the interest is truly in the nature of a passive investment (which, if not in furtherance of the charity’s exempt purposes will generate UBI under §512(c)), if the charity’s involvement furthers charitable purposes, or if its participation in the LLC benefits private interests to a more than incidental degree. For a more in-depth discussion of this issue, see Chapter 19. Priv. Ltr. Rul. 91-09-066 (Mar. 1, 1991) (exempt organizations served as limited partners in limited partnership, and the limited partnership was a general partner in a partnership that engaged in charitable activities; the income was not subject to UBIT); Priv. Ltr. Rul. 92-07-032 (Nov. 20, 1991). See, e.g., Rev. Rul. 85-110, 1985-2 C.B. 166.
218
c04.fm Page 219 Thursday, March 15, 2007 5:17 PM
4.3 LIMITED PARTNER OR LLC NON-MANAGING MEMBER
formed to provide unique mobile medical services to a rural community. Because these medical services are needed, unique, and otherwise unavailable, the partnership is viewed as furthering exempt charitable purposes, the same charitable purposes shared by X and the other limited partners. The participation by X as an exempt limited partner will not jeopardize X’s tax-exempt status. Furthermore, the income received by X, as a limited partner, will not constitute unrelated business income, because the business activity of the limited partnership has a substantial, causal relationship to the exempt purposes of X.197 Pension funds, which are exempt under IRC §401,198 have emerged as major players in joint venture transactions, especially transactions involving the ownership and operation of real estate projects. EXAMPLE: A pension and profit-sharing trust may serve along with other exempt organizations as limited partners in a limited partnership that purchases timber tracts. The limited partnership expects to hold and manage those tracts for investment. When market conditions are favorable, the limited partnership plans to dispose of the timber under timber cutting contracts. Pursuant to these contracts, the limited partnership will retain proceeds from the harvesting of timber tracts based on an agreed-upon volume of timber ultimately harvested. The gain that the pension and profit-sharing limited partner receives will be excluded from unrelated business taxable income pursuant to IRC §512(b)(5).199 (b)
Joint Venture Engaged in an Unrelated Trade or Business
An exempt organization may invest, to an “insubstantial” degree, in real estate and other commercial ventures that have no charitable purpose.200 In that event, the exempt limited partner may be subject to UBIT on income derived from the activity.201 EXAMPLE: If an exempt educational institution serves as a limited partner in a partnership that operates a factory, the exempt organization must include, in computing its unrelated business taxable income, its share of the items of income, deduction, gain, and credit from the operation of the factory.202 This tax is imposed at the applicable corporate or trust rates, depending on whether the exempt organization is classified as a corporation or a trust. 203
197 198 199 200 201 202 203
This example is based on the factual situation presented in Priv. Ltr. Rul. 91-09-066 (Mar. 1, 1991). See generally §513; Reg. §1.513-1(d)(2). §401; Reg. §1.401-1(a). This example is based on the factual situation presented in Priv. Ltr. Rul. 92-07-003 (Nov. 20, 1991). See generally §512(b); Reg. §1.512(b)-1(d)(1). §513(a); Reg. §1.513-1. See Chapter 8. Reg. §1.512(c)-1. §511(a)(1); Reg. §1.511-1. §511(a)(2)(A) (tax imposed on entities under §§401(a) and 501(c); §511(b) (tax imposed on trusts). See Reg. §1.511-2. See also Chapter 8.
219
c04.fm Page 220 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
4.4
JOINT VENTURES WITH OTHER EXEMPT ORGANIZATIONS
Joint ventures composed wholly of exempt organizations must further the exempt purposes of each of the exempt partners in order for the income derived therefrom to be exempt from taxation.204 EXAMPLE: X, an exempt educational institution, has a large, well-respected communications department on its campus. Y is a tax-exempt public broadcasting organization. X and Y seek to co-develop a national communications center to be located on X’s campus. This project will be structured using a joint venture or partnership. The arrangement will entail the construction and sharing of facilities on X’s campus. X will also hold a ground lease on the land on which the new facility is situated. Under these circumstances, because the partnership will further the exempt purposes of both exempt organizations, the income will not constitute unrelated business income to either X or Y.205 However, to the extent that an exempt organization is a partner in a partnership that regularly carries on a trade or business that would constitute an unrelated trade or business if directly carried on by the exempt organization, the organization must include its share of partnership income and deductions in determining its UBIT liability.206 LLCs with multiple exempt owners may now separately qualify for exemption under §501(c)(3). As long as the entity is claiming exemption, the IRS will treat it as an association, consistent with the Service’s long-standing position that a partnership cannot qualify for exemption. The IRS gave informal guidance on the conditions under which multiple-owner LLCs may qualify for exemption: when such status is permitted under state law and when the LLC’s articles of organization and operating agreements comply with 12 other conditions designed to ensure that the organization is both organized and operated exclusively for exempt purposes.207 1. The organizational documents must limit the LLC’s activities to one or more exempt purposes. (Standard purposes-and-activities clauses will suffice.) 2. The organizational documents must specify that the LLC is operated exclusively to further the charitable purpose of its members.
204 205
206 207
See §512(c)(1); Reg. §1.512(c)-1. This discussion applies to joint ventures structured as partnerships, limited liability companies, or other vehicles. The joint venture partnership must further the exempt purposes of both X and Y. If it is not clear that the joint venture arrangement furthers the exempt purposes of both exempt partners, then the partners should consider seeking separate tax-exempt status for the joint venture. Under this scenario, X and Y should seek a ruling from the IRS on the issue of whether the joint venture furthers the exempt purposes of both X and Y. Reg. §1.512(c)-1. See Richard A. McCray and Ward L. Thomas, “Limited Liability Companies as Exempt Organizations—Update,” Exempt Organizations Technical Instruction Program for FY2000, 27 (2000): 29.
220
c04.fm Page 221 Thursday, March 15, 2007 5:17 PM
4.4 JOINT VENTURES WITH OTHER EXEMPT ORGANIZATIONS
3. The organizational language must limit membership in the LLC to §501(c)(3) organizations or governmental units. 4. The organizational language must prohibit direct or indirect transfer of membership interests in the LLC to transferees other than §501(c)(3) organizations or governmental units. (The IRS is concerned that allowing private shareholders or individuals as members could result in inurement problems, because state laws generally provide LLC members with ownership rights in the assets of an LLC.) 5. The organizational language must state that transfers of the LLC, or interests in the LLC (other than membership interests) or its assets, must be made in exchange for fair market value when made to any nonmember other than a §501(c)(3) organization or a governmental unit. (However, this does not prevent grants for exempt purposes.) 6. The organizational language must guarantee that, upon dissolution of the LLC, the assets will continue to be devoted to charitable purposes. (A standard dissolution clause will suffice.) 7. The organizational language must require that any amendments to the LLC’s articles of incorporation and operating agreement be consistent with §501(c)(3). 8. The organizational language must prohibit the LLC from merging with or converting into a for-profit entity. (The IRS does not want to see LLCs flip between exempt and nonexempt status.) 9. The organizational language must forbid the LLC from distributing any assets to members who cease to be recognized under §501(c)(3) or to be governmental units. (Such a distribution would be inurement, unless the member is acting in another capacity, such as creditor.) 10. The organizational language must contain an acceptable contingency plan in the event any members change status. (Forfeiture or a forced sale of the nonexempt member’s interest is acceptable. The plan cannot involve a transfer of assets to the nonexempt member and should ensure that the nonexempt member’s rights are terminated within a reasonable time, such as 90 days.) 11. The organizational language must state that the LLC’s members will expeditiously and vigorously enforce all their rights in the LLC and will pursue all legal and equitable remedies to protect their interests in the LLC. 12. The LLC must represent that all of its organizing document provisions are consistent with state law and enforceable under state law. (In some states it is questionable whether an LLC may be formed as a charitable organization. For the time being, absent state case law to the contrary, the Service is willing to recognize an exemption based on the LLC’s representation that its charitable status is permitted under state law and that the provisions set forth are enforceable.)
221
c04.fm Page 222 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
4.5
NEW SCHEME FOR ANALYZING JOINT VENTURES
At present the IRS ruling position assumes that all joint ventures involving charities should be analyzed in the same way: consistent with Rev. Rul. 98-15. But if the IRS was willing to distinguish among different kinds of ventures, it may allow for a more nuanced approach that could conserve IRS resources (yet deals could proceed on course). Certain categories should require little analysis—certainly not along the lines of Rev. Rul. 98-15—as some ventures do not carry risks that the charitable assets will be used for private benefit. In this context, the following four categories should be considered, segmented according to the proportion of the charity’s assets committed to the venture. Two of the categories should be further subdivided into industry-specific segments.208 (a)
Exempt-Only Ventures
The IRS has acknowledged that ventures composed entirely of exempt organizations do not pose the same impermissible private benefit concerns that exist where a for-profit is involved as a co-venturer.209 Nevertheless, care must be taken to assure that the management of the joint venture is not delegated by the exempt parties to for-profits. In other words, the day-to-day responsibilities, governance, and management decisions need to be retained exclusively by one or more of the exempt co-venturers, in which case there will be no need to examine further the specifics of the arrangement relative to the private benefit issue. In this category, the exempt organizations, especially public charities, should be free to participate in a venture with another charity regardless of the respective ownership interests of the parties; and even if the governance and economic rights are not proportionate with their respective contributions so long as the venture is consistent with the exempt purposes of the organizations.210 Although control of the venture by one or more of the exempt organizations assures the absence of private benefit, the venture must substantially further the exempt purposes of the organization; otherwise the activity could be taxed as unrelated trade or business.211 (b)
Investment-Type Ventures
The second category includes exempt organizations that make passive investments as a limited partner (or as a nonmanaging nonparticipatory member as in 208
209
210 211
While the proposed categories are those of the author, the analysis draws upon the excellent paper written by Ronald J. Schultz, “Joint Ventures Involving Public Charities: The Search for “Situation 3” and the Need for Safe Harbor Guidance” which is on file with the author, as well as Douglas M. Mancino, “Joint Ventures With Non-Exempts Require Special Tax Planning,” 10 J. Tax’n Exempt Orgs. 51 (1998). Two ancillary joint ventures between exempt healthcare organizations were analyzed according to the reasoning of Rev. Re. 98-15 and found to advance the charitable purposes of both participants without risk to private benefit or inurement. Priv. Ltr. Ruls. 200102053, 200211052. Two exempt organizations devoted to improving a deteriorated part of the city would further the charitable purposes of the partners and income received from the partnership would be related to the exempt purpose. Priv. Ltr. Rul. 200211052. See Schultz, p. 54. See Section 8.
222
c04.fm Page 223 Thursday, March 15, 2007 5:17 PM
4.5 NEW SCHEME FOR ANALYZING JOINT VENTURES
the case of an LLC). The control test would not be relevant to this category, although the investment could generate unrelated business income. This passive type of investment would not expose the assets of the exempt organization to the sort of risk that could occur where the charity serves as the general partner or managing member or makes significant guarantees. (c)
Ancillary Joint Ventures
In ancillary joint ventures, the most commonly used type of venture by charities, quantitative standards should also be provided along with a significantly relaxed set of rules. First, the IRS should make it clear that this type of transaction will not impact on the tax-exempt status simply because of certain defects in management control. Indeed, the focus of the IRS would be on the unrelated business income issue as well as perhaps, private inurement or the excess benefit tax. Rev. Rul. 98-15 should not be directly applicable to ancillary ventures. A numerical test to distinguish ancillary ventures could be based on the total assets of the charity (avoiding any need to examine a percentage of revenue), including both exempt functions and other activities. The result would provide a satisfactory bright-line standard without the need to have specific appraisals made for the safe harbor. A standard of 10 percent to 15 percent is reasonable with a provision that would not allow the charity to fragment investments to fit within the safe harbor (i.e., an aggregation rule). The issue of control would not be relevant to the determination of whether there is unrelated business income, provided that the UBIT rules, including specifically the “substantially related” test is satisfied. Particularly in ancillary ventures, an exempt organization may have effective control of a venture even with less than majority ownership or voting rights if participation in the joint venture by the for-profits is widely disbursed.212 The economics of many industries create additional incentives for the joint ventures to further the charitable purpose of the exempt organization, as discussed previously in Section 4.2(d). (d)
Disposition-Type Ventures
In a disposition-type or whole hospital joint venture, the exempt organization transfers “all or substantially all” of its assets to the venture. The IRS could create a safe harbor test that would recognize a series of factors heretofore discussed and allow a relaxation from the 50/50 control test. The guidelines should incorporate a checklist of factors that were included in the 2002 CPE text, along the lines of Rev. Rul. 98-15, with appropriate modifications for activities outside of the healthcare area and in circumstances where management is not delegated on a long-term basis to a third party. This test would apply where all or substantially all of the operating assets are transferred. 212
Schultz, n. 304. See also section 4943(c)(2)(B) relating to when a private foundation and all disqualified persons own less than 35 percent of the voting stock (which is an increase from the 20 percent permitted holdings) because effective control is in one or more persons who are not disqualified with respect to the foundation.
223
c04.fm Page 224 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
4.6
REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
Soon after St. David’s was decided by the jury, the IRS issued Rev. Rul. 2004-51, 2004-22 I.R.B. 974. This ruling analyzes a non-healthcare, ancillary joint venture and is the first published guidance of its kind, involving an ancillary venture between a non-healthcare charitable organization and a for-profit entity, where each party maintains a 50 percent share in the venture. The ruling demonstrates that “control” of the entire venture is not essential; control can be “bifurcated,” as long as the exempt organization controls the substantive, “charitable” aspects. Moreover, given the exempt organization’s exclusive control over the venture’s charitable aspects, the need for an affirmative charitable “override” is no longer required. EXAMPLE: N, a large nonprofit hospital, enters into a joint venture with a group of physicians to operate a trauma care center. N will operate the joint venture, furnish all the equipment and employees, and require the hospital’s standards for charitable care to be applied in the operation and management of the joint venture. The physicians act solely as investors, financing the joint venture. In this venture, the IRS is likely to be less concerned with formal structural control if the hospital has practical control of operations and will maintain the charitable principles applied in the hospital. A similar result would occur if the hospital established a separate controlled nonprofit organization to be the tax-exempt partner in the joint venture. The IRS, however, would need to be satisfied that the subsidiary was bound by the same charitable standards as its tax-exempt parent.213 In the revenue ruling, a §501(c)(3) university expanded the scope of its educational programs by forming a limited liability company (LLC) with a for-profit entity specializing in interactive video training. The activities of this joint venture between the exempt university and the for-profit corporation were an insubstantial part of the university’s overall activities. The Articles of Organization and the Operating Agreement (Agreement) provided that the LLC’s sole purpose was to offer teacher training programs to satellite locations using interactive video technology. The university and the forprofit each owned a 50 percent share in the company, and had equal representation on the Board of Directors. All allocations, returns of capital, and distributions were to be made commensurate with the nonprofit and for-profit members’ respective ownership interests. The LLC was responsible for arranging and conducting all administrative details regarding the video training seminars for teachers. The video seminars covered the same substantive material as the university’s seminars conducted on campus. Additionally, the Agreement gave the university the exclusive right to determine and approve the curriculum, training materials, instructors, and standards of completion for the seminars. It gave the for-profit, on the other hand, the exclusive right to select video training technicians and locations. All other decisions were to be made by mutual consent of both the for-profit and the 213
Leonard J. Henzke, Jr., Speech at the Western Conference on Tax Exempt Organizations (Nov. 18, 2004).
224
c04.fm Page 225 Thursday, March 15, 2007 5:17 PM
4.6 REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
university. Furthermore, in accordance with the Agreement, all transactions entered into by the LLC were presumed to be conducted at arm’s length, with all prices presumed to be at fair market value. The Agreement restricted the LLC’s activities to the administrative tasks connected with the teacher training seminars, and mandated that the LLC not engage in any activities that would jeopardize the university’s 501(c)(3) exempt status. The Service analyzed two issues: (1) whether the university would lose its exempt status due to its participation in this ancillary joint venture; and (2) whether the university would recognize unrelated business taxable income on its distributive share of the net profits. (a)
Issue 1: Exemption Under §501(c)(3) Whether, under the facts described above, an organization continues to qualify for exemption from federal income tax as an organization described in §501(c)(3) of the Internal Revenue Code when it contributes a portion of its assets to and conducts a portion of its activities through a limited liability company (LLC) formed with a for-profit corporation.
The Internal Revenue Service, in the revenue ruling, makes three important assumptions: (1) the joint venture activity is an “insubstantial” part of the university’s total activities; (2) all transactions are conducted at “arm’s length;” and (3) all contract and transaction prices are at “fair market value.” Given these three fundamental assumptions, it is difficult to envision a scenario in which any activity would endanger an organization’s exempt status. Indeed, the revenue ruling provides little analysis regarding this issue, and merely states that based upon all the facts and circumstances, the university’s participation in the joint venture, taken alone, will not affect the university’s continued qualification for exemption as an organization described in §501(c)(3). However, the inquiry does not stop there, because prior to reaching its conclusion about exempt status, the Service sets forth what it views as the relevant legal standards: applicable provisions of the Internal Revenue Code, Treasury Regulations, Rev. Rul. 98-15, Redlands, and St. David’s. It is the Service’s reliance upon Rev. Rul. 98-15, Redlands, and St. David’s, in particular, that gives rise to the significance of this otherwise “plain vanilla” ruling. Implicitly, the ruling suggests, but does not state, that given a different set of facts, the cited legal standards would govern the analysis. In its reliance upon the legal precedent governing joint ventures, the Service reiterates the two-prong test of Rev. Rul. 98-15, that: (1) participation in the joint venture must further a charitable purpose, and (2) the partnership arrangement must permit the exempt organization to act exclusively in furtherance of its exempt purpose and only incidentally for the benefit of the for-profit partners. Redlands is cited for the holding that an exempt organization may form a partnership, so long as it does not thereby impermissibly serve private interests. Ceding “effective control” of partnership activities is highlighted as a factor that impermissibly serves private interests. Finally, St. David’s is cited for the proposition that it is not enough to conclude that the joint venture actually serves charitable interests; rather, the nonprofit partner must have the “capacity to ensure” that the partnership’s operations further charitable purposes, again reemphasizing that if
225
c04.fm Page 226 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
the nonprofit cedes control to the for-profit entity, the nonprofit should lose its tax exempt status. While none of these principles came into play given the favorable facts and circumstances of Rev. Rul. 2004-51, they imply that the analysis in ancillary joint ventures will follow the principles set down in Rev. Rul. 98-15, Redlands, and St. David’s, that control over the joint venture, or at a minimum, “bifurcated” control over the charitable aspects of the venture, is necessary to avoid unrelated business income as well as loss of exemption, at least in the context of a “substantial” activity. Accordingly, this ruling suggests the application of a new test, referred to herein as the “UBIT plus Control” test, which includes a Rev. Rul. 98-15 “control” analysis as an added component to the standard UBIT analysis, converting an otherwise “related” activity to an “unrelated” activity, if the exempt organization cedes control over the substantive aspects of the venture. The “conversion” occurs because the lack of control presumes unwarranted private benefit.214 (b)
Issue 2: Unrelated Business Income Whether, under the same facts, the organization is subject to unrelated business income tax under §511 on its distributive share of the LLC’s income.
The second issue raised by the IRS in Rev. Rul. 2004-51 should require a standard unrelated business income tax analysis under §§511, 512, and 513 of the Internal Revenue Code. Again, however, the Service has set forth a factual scenario that should lead to an obvious conclusion that the educational activities of the joint venture are substantially related to the university’s exempt purpose, which renders the unrelated business analysis superfluous, at best. As stated in this factual scenario, the university has an educational exempt purpose, clearly defined in the Treasury regulations. The ancillary joint venture furthered the pursuit of that purpose by broadening the outreach of the educational activities of the university. Significantly, as to the educational functions of the LLC, the exempt organization had exclusive control. Moreover, the manner in which the for-profit conducted the administrative functions did not affect the educational nature of the venture. Thus, based upon all of the facts and circumstances, the IRS concluded that the activities of the joint venture were related to the clearly defined educational exempt purpose of the university and so the university did not have any unrelated business tax liability attributable to its participation in the joint venture. As mentioned previously, an interesting question in the analysis in Rev. Rul. 2004-51 is whether the Service is now applying a “UBIT plus Control” test, which applies the standard UBIT analysis to ancillary joint ventures involving exempt organizations, and superimposes upon that standard the “control test” of Rev. Rul. 98-15, Redlands, and St. David’s—so that even if the activity of the partnership is “substantially related” to the exempt organization’s purpose, it will be deemed 214
See Bruce R. Hopkins’ “Nonprofit Counsel,” The Law of Tax-Exempt Organizations Monthly, Vol. 21, No. 7 (July 2004) at 3, in which Mr. Hopkins, in discussing Rev. Rul. 2004-51, states: “The IRS is implicitly saying that the business in the joint venture is thereby converted to an unrelated business, even though the business remains inherently related. Presumably, this transformation occurs by application of the private benefit doctrine—a novel theory.”
226
c04.fm Page 227 Thursday, March 15, 2007 5:17 PM
4.6 REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
to be an “unrelated” trade or business if the exempt organization cedes effective control over the substantive aspects of the venture to the for-profit entity. Stated another way, what this ruling implies is that, given other factual patterns or scenarios not presented in the ruling, even a substantially related activity may cause loss of exemption, or generate UBIT to the nonprofit, if the nonprofit cedes control to the for-profit, at least as to the “charitable” or substantive aspects of the venture. In order to illustrate this new standard, we have set forth below eight different “scenarios” or fact patterns, with various combinations of factors, to illustrate the possible implications of Rev. Rul. 2004-51. (c)
Factual Scenarios 1–4: Joint Venture Is a “Substantially Related” Charitable Activity (See Exhibit 4.1) 1. Scenario 1:
Exempt organization does not cede control over joint venture activities to for-profit; and
The joint venture is an insubstantial part of the exempt organization’s total activities.
This is the “plain vanilla” scenario described in Rev. Rul. 2004-51, in which the exempt organization’s status is not jeopardized by its participation in the joint venture, since it retains control over the charitable aspects of the venture and the venture is an insubstantial part of the nonprofit’s total activities. E XHIBIT 4.1 Joint Venture is a “Substantially Related” Charitable Activity (e.g., Educational or LIHTC)
Yes Does §501(c)(3) org. cede control over charitable function to for-profit?
No
Is Joint Venture activity an insubstantial part of EO's activities? No
Yes
Is Joint Venture activity an insubstantial part of EO's total activities?
Yes
No UBIT. Rev. Rul. 2004-51
UBIT plus Control test may create UBIT . No effect on §501(c)(3) exemption. See Rev. Rul. 2004-51
No
Loss of exemption. See Rev. Rul. 98-15
227
No UBIT. No effect on §501(c)(3) exemption.
c04.fm Page 228 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
As in the ruling, the university is not subject to unrelated business income tax liability for the activities of the joint venture. 2. Scenario 2:
Exempt organization does not cede control over joint venture activities to for-profit; and
The joint venture is a substantial (but less than 50 percent) part of the exempt organization’s total activities.
Again, this scenario is similar to the fact pattern in Rev. Rul. 2004-51, in that the activity is “related” to the exempt organization’s charitable purpose, and the exempt organization retains control over the joint venture’s educational activities. Thus, even though the activities are a substantial part of the exempt organization’s total activities, the organization’s exempt status is not jeopardized, and there is no unrelated business income tax liability, pursuant to the analysis contained in Rev. Rul. 200451, Rev. Rul. 98-15, Redlands, and St. David’s. 3. Scenario 3:
Exempt organization cedes control over joint venture activities to forprofit; and
The joint venture activities are an insubstantial part of exempt organization’s total activities.
Under this scenario, the university (using the fact pattern of Rev. Rul. 2004-51) would cede control over the educational aspects of the venture to the for-profit. Since the joint venture is an insubstantial part of the university’s total activities, the exempt status of the university would presumably not be affected. Similarly, since the activities of the joint venture are “related” to the university’s educational purposes, under a traditional UBIT analysis, there should be no unrelated business income tax liability. However, given the new “UBIT plus Control” test, which looks to Rev. Rul. 98-15, Redlands, and St. David’s, certain unanswered questions remain. For example:
Since the activity is “related,” is it relevant that the nonprofit cedes control over the joint venture activities?
Does the fact that the for-profit partner controls the venture’s activities convert clearly “related” activities to unrelated activities, similar to the analysis in Rev. Rul. 98-15?
Is the inquiry no longer a straightforward UBIT analysis for an ancillary joint venture, but rather a determination as to whether the joint venture’s activities will always further the nonprofit’s exempt purpose and never result in private benefit?
Is control over the joint venture’s activities a relevant inquiry for purposes of a UBIT analysis?
228
c04.fm Page 229 Thursday, March 15, 2007 5:17 PM
4.6 REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
Those questions remain unanswered, since Rev. Rul. 2004-51 does not provide clarity on these issues. However, applying the analysis of the “bad” example in Rev. Rul. 98-15 results in the conclusion that “control” over the activities of an ancillary joint venture is an important, if not essential, factor, and conversely, a for-profit’s control over the venture could convert an otherwise “related” activity into an “unrelated” activity. In this factual scenario, since the activities of the venture are “insubstantial” in view of the exempt organization’s overall activities, the exempt status of the organization should not be jeopardized. However, the exempt partner may be liable for unrelated business income tax on the income from the venture. 4. Scenario 4:
Exempt organization cedes control over joint venture activities to forprofit; and
The joint venture is a substantial (but less than 50 percent) part of the exempt organization’s total activities.
This scenario raises similar questions to those raised in Scenario 3 above, and is very close to the “bad” example in Rev. Rul. 98-15. The Service concluded, in Rev. Rul. 98-15, that since the nonprofit ceded control over the healthcare activities to the for-profit partner, the joint venture was not required to serve charitable purposes and the private benefit to the for-profit partner would, therefore, not be incidental. Thus, the exempt status of the nonprofit partner was denied. Essentially, in that ruling, the “related” activity of the provision of healthcare was converted into an “unrelated” activity, due to the nonprofit’s lack of control over the venture and its inability to initiate programs to meet the community benefit standard without the support of the for-profit partner. Again, in that ruling, the presence of substantial private benefit to the for-profit partners was assumed. Presumably, the analysis for an ancillary joint venture with these three criteria would follow the “whole hospital” joint venture analysis in Rev. Rul. 98-15, since a substantial part of the exempt organization’s total activities will be encompassed by the joint venture, even though those activities do not constitute all of the exempt organization’s operations. (d)
Factual Scenarios 5–8: Joint Venture Is an Unrelated Business Activity (see Exhibit 4.2) 1. Scenario 5:
Joint venture is an unrelated trade or business, and the exempt organization cedes control over the joint venture’s activities to for-profit; and
The joint venture is an insubstantial part of the exempt organization’s total activities.
An example of this scenario would be if the university described in Rev. Rul. 2004-51 were to enter into a joint venture with AMC Widgets,
229
c04.fm Page 230 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
E XHIBIT 4.2 Joint Venture is not a “Substantially Related” Charitable Activity (e.g., Widget Manufacturing Business)
Yes Does §501(c)(3) org. cede control over Joint Venture function to for-profit?
No
Is Joint Venture activity an insubstantial part of EO's activities? No
Yes
Is Joint Venture activity an insubstantial part of EO's total activities?
Yes
UBIT. Control is irrelevant.
Loss of §501(c)(3) exemption possible. Control is irrelevant.
UBIT Control is irrelevant
No
Loss of exemption. Rev. Rul. 98-15 §501(c)(3)
Inc., to manufacture widgets for sale to the public. This is clearly an “unrelated” activity, yet only an insubstantial part of the university’s overall activities. It would seem at first blush that Rev. Rul. 2004-51 should have no impact on this scenario: Section 513(c) of the Internal Revenue Code provides that an exempt organization’s share of partnership income from an unrelated trade or business carried on by a partnership of which it is a member, must be included in calculating the organization’s unrelated business taxable income. However, under the “UBIT plus Control” test, since the for-profit has control over the joint venture’s activities in this scenario, there may be a presumption of unwarranted private benefit under the analysis in Rev. Rul. 98-15. In that case, there could, but would not likely, be jeopardy to the exempt organization’s charitable status. 2. Scenario 6:
Joint venture is an unrelated trade or business, and the exempt organization cedes control over the joint venture’s unrelated activities to forprofit; and
The joint venture is a substantial (but less than 50 percent) part of the exempt organization’s total activities.
230
c04.fm Page 231 Thursday, March 15, 2007 5:17 PM
4.6 REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
This factual scenario is closest to Redlands, where the for-profit partner had control over the activities of the joint venture (in that case, the outpatient surgical center), and thus, the healthcare activities of the surgical center were deemed to be “unrelated” to the nonprofit’s exempt purpose. In Redlands, the court held that the nonprofit partner did not qualify to be recognized as a tax-exempt entity, since the unrelated joint venture activities were its sole activities. Accordingly, in this scenario, there is a question as to whether substantial unrelated activities will result in a denial or revocation of exemption. Under a standard UBIT analysis, the answer would be determined by analyzing all of the facts and circumstances. However, assuming a “UBIT plus Control” test, the analysis looks to the fact that the for-profit entity controls the joint venture, and thus, private benefit is assumed. Under that type of analysis, the exempt organization’s status would likely be in jeopardy. Given the fact that Rev. Rul. 2004-51 has cast doubt upon the well-established analysis utilized in unrelated business inquiries when the unrelated business is conducted through an ancillary joint venture, the better option in this case may be to spin the unrelated business activity off into a wholly owned for-profit corporate subsidiary. 3. Scenario 7:
Joint venture is an unrelated trade or business, and the exempt organization does not cede control over joint venture’s activities to for-profit; and
The joint venture is an insubstantial part of the exempt organization’s total activities.
This scenario would require a standard unrelated business taxable income analysis in which control is irrelevant. The activity is insubstantial, and the exempt organization would be liable for the unrelated business income tax, but its exempt status would not be jeopardized. Because the activity is controlled by the exempt organization, private benefits flowing to the for-profit partners would not be assumed, pursuant to the reasoning in Rev. Rul. 2004-51. 4. Scenario 8:
Joint venture is an unrelated trade or business, and the exempt organization does not cede control over joint venture’s activities to for-profit; and
The joint venture is a substantial (but less than 50 percent) part of exempt organization’s total activities.
Although the exempt organization does not cede control, the activity is unrelated and substantial, and even under the conventional unrelated business income tax analysis, this activity could impact the exempt status of the nonprofit organization. The issue of control over the unrelated activity should be irrelevant. However, since the nonprofit retained control, there presumably would not be any presumption of private benefit. In any event, the nonprofit would be subject to the unrelated business income tax under §§511–513.
231
c04.fm Page 232 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
(e)
General Legal Analysis of Rev. Rul. 2004-51
As discussed above, the importance of Rev. Rul. 2004-51 is not in what it says, but in what it implies and leaves unsaid. The addition of the “UBIT plus Control” test to what would otherwise be a straightforward unrelated business income tax analysis raises many questions, as suggested above. The practitioner should be aware of this implication and recognize that the IRS may require that a “UBIT plus Control” test be applied to determine whether an organization’s exempt status will be impacted by an ancillary joint venture’s activities in which the substantive aspect of the venture is controlled by the for-profit entity, whether or not the venture constitutes a “related” activity. Under the theory of Rev. Rul. 98-15, when the for-profit partner controls the activity, a “related” activity may be analyzed as “unrelated” and private benefit may be assumed. Moreover, the entity’s exempt status may be jeopardized if the activity is substantial. As indicated, the variable that is absent in the eight scenarios discussed above is the specific presence or absence of private benefit to the for-profit partners. In Rev. Rul. 2004-51, it is stated that there is no private benefit, although there are, of course, certain benefits flowing from the joint venture partnership to the for-profit partner. It can be argued that when the nonprofit partner controls the joint venture, it is safe to assume there will be no unwarranted private benefit to the for-profit partners, other than the proportional benefits of the partnership interests. If impermissible private benefit develops within a joint venture structure in which the nonprofit maintains control, this premise assumes that the nonprofit will exercise its control to protect its charitable assets. However, if the nonprofit cedes its control to the for-profit, it appears that the IRS will likely assume the presence of impermissible private benefit. (f)
Structural Guidance
Rev. Rul. 2004-51 provides certain lessons to the tax-exempt practitioner. Significantly, the governing documents between the university and the for-profit entity incorporate certain safeguards to prevent the venture from serving private interests. Any exempt entity contemplating such a venture should ensure that its venture documents contain similar provisions. First, the governing documents should require that the terms of all contracts and transactions entered into by the joint venture, both with its venturers and with any other parties, be at arm’s length and for fair market value, based on comparables. Second, the governing documents should restrict activities in which the joint venture may participate to activities that further the exempt purposes of the nonprofit partner. Third, the governing documents should contain a general prohibition against engaging in any activity that might jeopardize the exempt organization’s status. Finally, the facts should demonstrate that the joint venture did, in fact, operate in accordance with the terms of the governing documents. Furthermore, and most important in forming a joint venture or partnership, the governing documents should ensure that the exempt organization has full control over the substantive exempt function activities of the joint venture. For example, in Rev. Rul. 2004-51, the university had control over the educational content, including sole approval of course curricula, training materials, and
232
c04.fm Page 233 Thursday, March 15, 2007 5:17 PM
4.6 REVENUE RULING 2004-51 AND ANCILLARY JOINT VENTURES
instructors, even though the for-profit partner had control over certain administrative matters. This bifurcation of the functions of the joint venture is a significant concession on the part of the IRS, that “control” of the entire venture is not essential, as long as the exempt organization controls the substantive, “charitable” aspects of the venture. Finally, in order to avoid unrelated business income, it is necessary for the joint venture to participate in an activity that is “substantially related” to its exempt purpose. In Rev. Rul. 2004-51, the determination that the activities were related was straightforward, given the regulatory definition of “educational purposes.”215 Therefore, it may be easier to demonstrate “substantially related” in the education and low-income housing216 context, where there is a clear definition of charitable purpose, and particularly in the low-income housing tax credit context, where there is a significant level of governmental oversight and review, than it would be to demonstrate activities that are substantially related to the provision of healthcare and other charitable activities, where there are no clear statutory or regulatory definitions. Recently the IRS has indicated that it may be relaxing the control requirement. In PLR 200528029, which cites to the “substantially related” test in Rev. Rul. 2004-51, the IRS determined that a business league, exempt from federal income tax under Section 501(c)(6) of the Internal Revenue Code, was not subject to UBIT for its indirect investment in a for-profit, ancillary joint venture. Notably, in the private letter ruling, the IRS did not analyze whether the 501(c)(6) organization had sufficient control over the partnership to ensure furtherance of its exempt purposes. Instead, the IRS based its decision on whether the activities of the venture furthered the nonprofit organization’s exempt purpose. The conspicuous absence of any control analysis could be an indication that exempt organizations participating in ancillary joint ventures need only establish that the activities of the joint venture are sufficiently related to its exempt purpose. However, the control issue is still likely to be a necessary element with respect to §501(c)(6) organizations participating in joint ventures, even if not discussed in the ruling. The facts of PLR 200528029—that the organization had a 50 percent interest in the partnership, could appoint half of the governing board of the partnership, and could buy the databases produced by the partnership in certain situations—seem to indicate that the nonprofit organization had some measure of control over the partnership.217 Unfortunately, the IRS was silent as to this issue in its ruling.
215
216
217
Stokeld, Harris, and Thorndike, “EO Reps Focus on Ancillary Joint Ventures, Shelters,” Tax Notes 824 (May 17, 2004). (Catherine E. Livingston, IRS assistant chief counsel, in a recent meeting with the ABA tax section stated that the regulations containing a definition of educational purposes “was an important underpinning to our ability to do the guidance.”) See Rev. Proc. 96-32, 1996-1 C.B. 717 (May 1, 1996), which sets forth safe harbor guidelines that, if satisfied, demonstrate that the organization meets the §501(c)(3) standards of “charitability.” See Section 15.3(a) for further discussion of PLR 200528029 and §501(c)(6) organizations.
233
c04.fm Page 234 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
4.7
UBIT IMPLICATIONS FROM JOINT VENTURE ACTIVITIES
An exempt organization that participates in a partnership or joint venture with taxable or nontaxable entities is subject to taxation on any income from an unrelated business activity.218 (a)
Definition of Unrelated Business Income
Unrelated business income is generally defined as the gross income derived from any unrelated trade or business regularly carried on by the exempt organization,219 less allowable deductions that are directly connected with the carrying on of the trade or business.220 Income is subject to UBIT if • It is income from a “trade or business.”221 • The trade or business is “regularly carried on.”222 • The activity is not “substantially related” to the organization’s perfor-
mance of its exempt function.223 (b)
UBIT Applied to Income from a Partnership
Under general rules of partnership taxation that apply to LLCs as well as partnerships, if an exempt organization is a member of a partnership or LLC that regularly carries on a trade or business that is an unrelated trade or business, the organization must include its share of the entity’s gross income, less applicable deductions, from these activities in calculating its UBIT.224 218
219 220 221 222 223 224
§501(b); §511(a) and (b). The UBIT tax was intended to prevent unfair competition by nonprofit organizations that engage in a commercial activity. Clarence LaBelle Post No. 217 v. United States, 580 F.2d 270 (8th Cir. 1978). See also General Accounting Office, Tax Policy: “Competition Between Taxable Businesses and Tax-Exempt Organizations” (1987); U.S. Small Business Administration, Office of Chief Counsel for Advocacy, “Unfair Competition by Nonprofit Organizations with Small Businesses: An Issue for the 1980s” (1983). §512(a)(1); Reg. §1.512(a)-1(a). §512(b); Reg. §1.512(b)-1(b). §513(a); Reg. §1.513(a)-1(b). §512(a); Reg. §1.512(a)-1(a); Reg. §1.513-1(c)(1). §513(a); Reg. §1.513-1(a); Reg. §1.513-1(d)(1). §512(c)(1); Reg. §1.512(c)-1. Reg. §1.512(c)-1 provides that if an exempt organization is a member of a partnership engaged in a taxable trade or business, then the income received as its share from the partnership is subject to UBIT. Compare Priv. Ltr. Rul. 91-09-066 (Mar. 1, 1991). In this letter ruling, the IRS held that the activities of the partnership allowed each partner to further its exempt purpose of promoting health. Therefore, the income received was not subject to UBIT. For federal income tax purposes, the activities of a partnership are often considered to be the activities of the partners. See Butler v. Commissioner, 36 T.C. 1097 (1961) acq. 1962-2 C.B. 4, cited in Rev. Rul. 98-15. Aggregate treatment is also consistent with the treatment of partnerships for purpose of the unrelated business income tax under §512(c). See H.R. No. 2319, 81st Cong., 2d Sess. 26, 109-110 (1950); §1.512(c)-1. In light of the aggregate principle discussed in Butler and reflected in §512(c), the aggregate approach also applies for purposes of the operational test set forth in Reg. §1.501(c)(3)-1(c). Thus, the activities of an LLC treated as a partnership for federal income tax purposes are considered to be the activities of a nonprofit organization that is an owner of the LLC when evaluating whether the nonprofit organization is operated exclusively for exempt purposes within the meaning of §501(c)(3). See also Chapter 19.
234
c04.fm Page 235 Thursday, March 15, 2007 5:17 PM
4.7 UBIT IMPLICATIONS FROM JOINT VENTURE ACTIVITIES
Under prior law, a tax-exempt organization’s distributive share of gross income from a publicly traded partnership was automatically treated as UBIT.225 The Revenue Reconciliation Act of 1993 repealed the rule that automatically treats income from publicly traded partnerships as UBIT.226 Thus, investments in publicly traded partnerships are treated the same as investments in other partnerships for purposes of the UBIT rules. The provision is effective for partnership years beginning on or after January 1, 1994.227 (c)
General Exclusions from UBIT
IRC §512(b) sets forth exceptions to the definition of UBIT, which include dividends, interest, rents, and noninventory sales.228 However, if any of these items (except dividends) is derived from controlled subsidiaries229 or debt-financed property,230 it may not qualify for the UBIT exceptions. (i) Interest Exclusion. Generally, interest is excluded from the computation of an exempt organization’s UBIT unless it is interest from debt-financed property or from a controlled organization.231 A payment will usually qualify as interest if it is remuneration for the use of, or forbearance of, money.232 However, the question of whether an item is interest is determined by the “facts and circumstances of each case.”233 EXAMPLE: If a payment to an exempt organization from a joint venture is labeled as “interest” but, in reality, is a share of the profits retained by the exempt organization as a joint venturer or partner, then such payment is not within the exception for interest in IRC §512(b).234 Thus, in certain cases, an equity kicker may cause the loan to be viewed in substance as a joint venture, and thereby subject to UBIT.235 (ii) Rent Exclusion. Rent is generally excluded from UBIT.236 However, the IRS has been challenging the classification of certain lease agreements as joint ventures rather than leases.237 For example, the IRS attempted to reclassify a crop-sharing 225 226 227 228 229 230 231 232 233 234
235 236 237
§512(c)(2). §514(c) as amended by §13145(a)(1) of the 1993 Act. §13145(b) of the 1993 Act. §512(b); Reg. §1.512(b)-1. §512(b)(13); Reg. §1.512(b)-1(1)(1). §512(b)(4); Reg. §1.512(b)-1(1)(5)(i). §512(b)(1)(a); Reg. §1.512(b)-1(a). See generally Chapters 8 and 9. Deputy v. DuPont, 308 U.S. 488 (1940). See also Rev. Rul. 69-188, 1969-1 C.B. 54. Reg. §1.512(b)-1; Priv. Ltr. Rul. 89-05-002 (Oct. 10, 1988). Reg. §1.512(b)-1. See generally A. Teitelbaum v. Commissioner, 294 F.2d 541, 546, cert. denied, 368 U.S. 987 (1961) (interest payments supposedly convertible to principal by a sales agreement were properly labeled as interest). See Chapter 6. §512(b)(3); Reg. §1.512(b)-1(c)(2). See generally Chapter 8. Harlan E. Moore Charitable Trust v. United States, 812 F. Supp. 130 (C.D. Ill. 1993); Trust U/W Emily Oblinger v. Commissioner, 100 T.C. No. 9 (1993).
235
c04.fm Page 236 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
lease arrangement as a joint venture taxable as UBIT. However, the district court properly held that the rents from the farm operation were true rents based on a fixed percentage of receipts from the farm production.238 The rent from real property is not excluded from UBIT if the amount of rent depends, in whole or in part, on the income or profits derived by any person from the leased property (excluding amounts based on a fixed percentage of the gross receipts or sales).239 Furthermore, the regulations governing real estate investment trusts,240 which define rents based on income or profits, are incorporated into the UBIT regulations for determining whether the rental exclusion applies.241 Rent that is attributable to services other than those usually or customarily rendered in connection with the rental of rooms or other space solely for occupancy, is not within the UBIT exclusion for rental income.242 Hence, payments for the use of space in parking lots, warehouses, or storage garages are generally treated as payments for services.243 (d)
Calculation of UBIT
The UBI tax is imposed on gross income from any regularly carried on unrelated trade or business, less allowable deductions directly connected with the carrying on of the trade or business.244 If an exempt organization has UBI from a number of unrelated trades or businesses, the tax is imposed on the aggregate of gross income less aggregated deductions from all unrelated trades or businesses.245
4.8
USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
As an alternative to direct participation in a joint venture,246 an exempt organization may form a for-profit subsidiary to join the partnership or LLC.247 238
239 240 241 242 243 244 245 246 247
Harlan E. Moore Charitable Trust. The district court found that this arrangement was a typical crop-sharing arrangement that farmers in the midwest have been utilizing for years; hence, the IRS erred in attempting to reclassify a traditional lease arrangement as a joint venture. Reg. §1.512(b)-1(c)(2)(iii)(b). Real estate investment trusts will hereinafter be referred to as “REITS.” Reg. §1.512(b)-1(c)(2)(iii)(B), which incorporates Reg. §1.856-4(b)(3) and (6)(i). Reg. §1.512(b)-1(c)(5). Rev. Rul. 69-69, 1969-1 C.B. 159. For a comprehensive discussion of the rental exclusion, see Chapter 8. §512(a)(1); Reg. §1.512(a)-1. Reg. §1.512(a)-1(a). See generally Chapter 8. This discussion applies to a subsidiary created as a limited liability company, S corporation, or other entity. Tech. Adv. Mem. 89-38-002 (May 31, 1989). The IRS held that an exempt organization’s status was not jeopardized by its participation, through its for-profit subsidiary which served as general partner, in seven limited partnerships. See Gen. Couns. Mem. 39,598 (Jan. 23, 1987), clarified in Gen. Couns. Mem. 39,646 (June 30, 1987); Gen. Couns. Mem. 39,326 (Jan. 17, 1985); Priv. Ltr. Rul. 91-05-029 (Feb. 1, 1991). See also Priv. Ltr. Rul. 93-08-047 (Dec. 4, 1992); Priv. Ltr. Rul. 93-49-032 (Sept. 17, 1993) (exempt organization participated in low-income housing joint venture through its wholly owned subsidiary. In addition, the exempt organization performed all management and administrative functions for the venture and earned fees therefrom. The IRS, utilizing the Plumstead analysis, held that the exempt organization could participate in the venture through its subsidiary without jeopardizing its exempt status and that the management fee income was not subject to UBIT).
236
c04.fm Page 237 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
EXAMPLE: An exempt organization was formed to provide hospital management and support activities to nonprofit hospitals. However, its business was successful and the exempt organization planned to expand its operations to include governmental agencies, hospital associations, educational agencies, and for-profit entities. Because the expanded activities could be viewed as noncharitable, the exempt organization formed a wholly owned subsidiary to the IRS for-profit entities. Thus, the exempt organization segregated the taxable activities so as not to jeopardize its tax-exempt status.248 Through the use of a subsidiary, an exempt organization can indirectly be involved in a for-profit activity without jeopardizing the parent’s exempt status. Furthermore, because the income of the subsidiary is fully taxable, the parent will not be subject to UBIT on the subsidiary’s income.249 On the other hand, a subsidiary that is an S corporation or LLC “taxable” as a partnership, will not pay tax, but will pass its income and deductions through to the parent.250 (a)
Reasons for Use of a Subsidiary
There are a variety of reasons for using a subsidiary entity to conduct commercial venture activity.251 (i) Protects Parent’s Exempt Status and Insulates Parent’s Assets. The use of a for-profit subsidiary protects the status of the exempt parent and insulates its assets from possible liability.252 If the exempt parent were to undertake these activities, and if involvement in these activities were more than insubstantial, its tax exemption could be jeopardized.253 Furthermore, exempt organizations may choose to place an activity in a separate subsidiary to insulate the parent corporation from legal liability for the activity. A parent corporation is not generally liable for the debts or tortious acts of its subsidiary. 248
249
250
251 252
253
See Gen. Couns. Mem. 39,326 (Jan. 17, 1985) (an exempt organization engaged in taxable activities and lost its exempt status but, by forming a taxable subsidiary, the organization was allowed to regain its exempt status). See also Priv. Ltr. Rul. 84-24-064 (Mar. 14, 1984); Priv. Ltr. Rul. 84-23-083 (Mar. 12, 1984); Priv. Ltr. Rul. 83-52-093 (Sept. 30, 1983). These letter rulings presented situations that are indistinguishable from the example noted above. See Priv. Ltr. Rul. 93-08-047 (Dec. 4, 1992). Here, the IRS ruled that an exempt organization did not jeopardize its exempt status by owning all of the stock of a for-profit subsidiary. Furthermore, sharing office facilities, equipment, and supplies with the taxable subsidiary did not constitute private inurement, provided that the costs are allocated based on actual use and each pays the fair market value for any facilities or services used. Finally, the taxable income of the subsidiary was not UBI to the exempt parent. See Section 19.3(c) for a discussion of pass-through treatment. In view of the recent promulgation of the check-the-box regulations (see Sections 3.3 and 19.5), tax-exempt organizations have been able to generate substantial funds in the secondary market by selling up to 90 percent of the for-profit subsidiaries’ interest as general partner in a partnership or joint venture that utilizes the low-income tax credit (LIHTC). Banks are often encouraged to invest in lowincome housing to meet the CRA requirements. Thus, a secondary market has been created allowing the tax-exempt parent to sell interests in the partnership to raise new equity. For discussion of spinning off an existing growth business activity into a subsidiary for liability reasons, see Section 4.6(d). Orange County Agricultural Soc’y, Inc. v. Commissioner, 893 F.2d 529 (2nd Cir. 1990) (operation of an unrelated business by an exempt organization will cause loss of exempt status if the business becomes a too important part of the activities of the organization); Priv. Ltr. Rul. 93-08-047 (Dec. 4, 1992). Gen. Couns. Mem. 39,326 (Jan. 17, 1985).
237
c04.fm Page 238 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
CAVEAT *
In General Counsel Memorandum 39,598, the IRS, in deciding that a subsidiary of an exempt organization did not qualify for tax-exempt status, noted that if the private benefits that caused the denial of tax-exempt status to the subsidiary could be attributed to the exempt parent, then the exempt parent may also jeopardize its exempt status. The rationale is that the subsidiary could be acting as the “mere instrumentality” of the parent, without any independent business purpose.† The IRS noted two factors in making this determination: (1) whether the subsidiary is organized for a bona fide business purpose and (2) the degree of involvement of the parent in the affairs of the subsidiary.‡ The tests are discussed below. * † ‡
Gen. Couns. Mem. 39,598 (Jan. 23, 1987). See id. See id. See also Gen. Couns. Mem. 39,326 (Jan. 17, 1985).
(ii) Sources of Capital are Expanded. Frequently, investors and creditors will more readily invest or lend capital to for-profit entities than to tax-exempt organizations. One reason is that in the event of insolvency of the exempt organization, an involuntary bankruptcy cannot be filed against it by creditors.254 Furthermore, a forprofit entity has the capacity to raise capital from the general public through a conventional stock issue. With the creation of the minority enterprise small business investment company (MESBIC) and the small business investment company (SBIC), these capital sources are reinforced. For example, the MESBIC program involves tax-exempt organizations providing seed capital for the establishment of organizations to serve as catalysts to obtain loans for minority businesses. In this case, the government has guaranteed these funds, permitting further leveraging through financial institutions.255 (iii) Provides Flexibility in Operations. The independence of operations such as management, administration, and accounting provide two key functions: (1) the subsidiary will be viewed as a distinct entity from the exempt parent, thereby preserving the parent’s exempt status and limiting the liability of the parent, and (2) the use of a subsidiary allows for growth within the subsidiary in its activities, whereas if the parent directly engaged in the activity and the operations were successful, exempt status may be adversely affected.256 254
255 256
See 11 U.S.C. §303(a), which provides that an involuntary case may be commenced only under chapter 7 or 11 of this title, and only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation. The Senate Judiciary Committee specifically stated in a report that “elemosynary institutions, such as churches, schools and charitable organizations and foundations, likewise are exempt from involuntary bankruptcy.” S. Rep. No. 95-989, 95th Cong. (1983). Cerny, “Tax-Exempt Organizations and Economic Development,” Exempt Organization Panel, ABA Section on Taxation (Feb. 7, 1993). 7 Gen. Couns. Mem. 39,326 (Jan. 17, 1985). See also Priv. Ltr. Rul. 93-05-026 (Nov. 2, 1992). In this letter ruling, the for-profit subsidiary had separate and independent management from the exempt parent. The majority of the directors of the subsidiary consisted of individuals unrelated to the exempt parent. The exempt parent was not involved in the day-to-day management of the subsidiary. Finally, all transactions between the parent and the subsidiary were conducted at arm’s length. Under these circumstances, the IRS held that the parent corporation that owns 100 percent of the subsidiary will not jeopardize its exempt status. Thus, the subsidiary’s income and activities will not be attributed to the parent and the dividends paid by the subsidiary to the parent will not jeopardize its exempt status and are not taxable to the parent under §512(b).
238
c04.fm Page 239 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
(b)
Requirement for Subsidiary to Be a Separate Legal Entity
In order to utilize a subsidiary organization, the exempt parent must take care to structure the subsidiary arrangement so that the subsidiary is viewed as a separate legal entity from the parent.257 If the subsidiary is not viewed as a separate legal entity, the activities of the subsidiary could be attributed to the exempt organization, which would then be in jeopardy of losing its tax-exempt status. The IRS has formulated a two-part test to determine whether parent and subsidiary activities are sufficiently segregated.258 (i) Bona Fide Function. The subsidiary must be established with a bona fide intention that it will have a real and substantial function.259 That function need not be an inherently commercial, for-profit activity.260 The IRS noted that [t]he first aspect is the requirement that the subsidiary be organized for some bona fide purpose of its own and not be a mere sham or instrumentality of the parent. We do not believe that this requirement that the subsidiary have a bona fide business purpose should be considered to require that the subsidiary have an inherently commercial or for-profit activity. The term “business,” as used in the context of this text, is not synonymous with “trade or business” in the sense of requiring a profit motive. Instead, we believe the term “business” was simply carried over from Moline and Britt, . . . which involved for-profit corporations, and in which the determination as to the existence of a business purpose of activity was an appropriate test for requiring substance over form given the factual circumstances of the particular case.261
Hence, a parent corporation and its subsidiary are separate taxable entities so long as the subsidiary engages in, or carries on, independent business activities.262 That is, when a corporation is organized with the bona fide intention that it will have some real and substantial business function separate and apart from the parent, its existence generally may not be challenged for tax purposes.263 (ii) Not a Mere “Arm” of Parent. The subsidiary must not, in reality, be a mere arm, agent, instrumentality, or integral part of the parent.264 Ownership of stock and the power to appoint an entire board of directors does not necessarily indicate 257 258 259 260 261
262 263
264
Gen. Couns. Mem. 39,866 (Dec. 30, 1991); Priv. Ltr. Rul. 94-01-034 (Jan. 7, 1994); Priv. Ltr. Rul. 94-02-031 (Oct. 22, 1993); Gen. Couns. Mem. 39,866 (Dec. 30, 1991). Gen. Couns. Mem. 39,326 (Jan. 17, 1985). Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943); Britt v. United States, 431 F.2d 227 (5th Cir. 1970). Gen. Couns. Mem. 39,598 (Jan. 23, 1987); Gen Couns. Mem. 39,776 (Feb. 9, 1989). Gen. Couns. Mem. 39,598 (Jan. 23, 1987). See also Priv. Ltr. Rul. 94-21-006 (May 27, 1994) (wholly owned subsidiary of exempt organization was held to have a bona fide business purpose, even though it operated in a manner that was not inherently commercial or a for-profit activity). Moline Properties, 319 U.S. at 436. See also Gen. Couns. Mem. 39,598 (Jan. 23, 1987). Britt, 421 F.2d at 234; Gen. Couns. Mem. 39,598 (Jan. 23, 1987); Priv. Ltr. Rul. 92-05-026 (Nov. 12, 1992) (exempt parent provided job training services to unemployed and disadvantaged individuals; subsidiary performed complementary yet different function of providing job placement services to individuals trained by parent). Krivo Indus. Supply Co. v. National Distiller & Chem. Corp., 438 F.2d 1098 (5th Cir. 1973). See also Gen. Couns. Mem. 39,326 (Jan. 15, 1985).
239
c04.fm Page 240 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
sufficient control to make the subsidiary a mere arm of the exempt parent. However, factors such as involvement in the day-to-day affairs and arm’s length transactions between the two are critical. The IRS noted that the second aspect of the test is the requirement that the parent not be so involved in, or in control of, the day-to-day operations of the subsidiary that the relationship between parent and subsidiary assumes the characteristics of the relationship of principal and agent, i.e., that the parent not be so in control of the affairs of the subsidiary that it is merely an instrumentality of the parent.265
In examining any control element, the IRS looks at [c]ontrol through ownership of stock, or power to appoint the board of directors, of the subsidiary will not cause the attribution of the subsidiary’s activities to the parent. We do not believe that the GCM should be read to suggest, by negative inference, that when the board of directors of a wholly-owned subsidiary is made up entirely of board members, officers, or employees of the parent there must be attribution of the activities of the subsidiary to the parent.266
The extent to which the parent is involved in the day-to-day management of a subsidiary is the factor that must be considered, along with the bona fide and substantial purpose of the subsidiary, in determining whether the subsidiary entity is so completely an arm, agent, or integral part of the parent that its separate corporate identity should be disregarded. As discussed earlier, the doctrine of corporate identity is well established, and the courts, in considering whether to disregard corporate identity, have articulated a very demanding evidentiary standard requiring clear and convincing evidence of the subsidiary’s lack of independent status. Hence, the activities of the subsidiary should not ordinarily be attributed to its parent organization unless the facts provide clear and convincing evidence that the subsidiary is in reality an arm, agent, or integral part of the exempt parent.267 NOTE BRANDING ISSUES: Many nonprofits have devoted substantial time and expense into the development of “branding” strategies. Such “branding” efforts most commonly involve the merger of a tax-exempt affiliate with one or more for-profit subsidiaries, renaming the group, and creating a new Web site.* The IRS has provided very little substantive guidance regarding the use of the Internet by exempt organizations, except to state that where possible, the existing rules governing the operations of exempt organizations should apply. It is well settled, however, that when a nonprofit
265 266 267
Gen. Couns. Mem. 39,598 (Jan. 23, 1987). Gen. Couns. Mem. 39,598 (Jan. 23, 1987). Gen. Couns. Mem. 39,866 (Dec. 30, 1991); Gen. Couns. Mem. 39,326 (Jan. 17, 1985); Gen. Couns. Mem. 39,598 (Jan. 23, 1987). See also Priv. Ltr. Rul. 92-45-031 (Nov. 6, 1992); Priv. Ltr. Rul. 93-05-026 (Nov. 12, 1992) (majority of subsidiary’s directors not officers or directors of parent); Priv. Ltr. Rul. 93-05-026 (Nov. 12, 1992) (no active participation by parent in business planning or day-to-day operations of subsidiary); Priv. Ltr. Rul. 94-01-034 (Jan. 7, 1994) (all parent-subsidiary transactions conducted at arm’s length); Priv. Ltr. Rul. 94-02-031 (Jan. 14, 1994) (separate books and records).
240
c04.fm Page 241 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
organization forms a for-profit subsidiary, it must do so in a way that the subsidiary cannot be viewed as a mere “arm” of its parent. Otherwise, the activities of the subsidiary may be attributed to the parent. Commingling of the activities and functions of the nonprofit and for-profit on one Web site, without clear indication as to which entity “owns” the particular page being viewed, is likely to raise significant adverse tax consequences. There may be ways, however, to structure the Web site to minimize these consequences. For example, factors that may indicate that a subsidiary is not a mere instrumentality of its parent would include: the maintenance of separate offices, telephone numbers, telephone listings, bank accounts, and stationery. Another factor might be reimbursement by the subsidiary for any shared use of the parent’s resources. Importantly, if a subsidiary is determined to be the mere “arm” or instrumentality of its parent, then its activities may be attributed to the parent organization. Hence, any revenue derived from the subsidiary through a trade or business that is unrelated to the exempt purpose of the exempt parent would potentially be subject to the unrelated business tax. Moreover, if the activities of the subsidiary that are unrelated to the parent organization’s exempt purposes are considered substantial in relation to the parent organization’s total operations, then the parent organization risks losing its tax-exempt status because more than an insubstantial amount of its activities are not in furtherance of an exempt purpose.† * †
See 8.5(g) for an in-depth analysis of branding issues, including unrelated business income tax implications. See Treas. Reg. §1.501(c)(3)-1(c)(1).
(iii) National Geographic Ruling: Use of a For-Profit Subsidiary. In 1995, the IRS released the text of a significant private letter ruling268 involving the use of a for-profit subsidiary by a charitable organization to conduct unrelated business activities. The ruling confirms a number of previous IRS positions and discusses issues of importance to exempt organizations that have, or contemplate the use of, one or more for-profit subsidiaries. In order to meet IRS scrutiny, it is vital that a subsidiary be able to demonstrate a substantial business purpose, as well as a separate corporate existence from its parent. This ruling provides guidance on both of these issues. The facts of the letter ruling indicate that for many years, the Charity269 (either on its own or through the Public Broadcasting Service (PBS)), was able to secure corporate sponsorship to underwrite the production costs of its educational films. For the 1995 calendar year, however, neither PBS nor the Charity was able to secure adequate funding for this purpose. Accordingly, the Charity agreed to produce a five-hour program for a commercial network, for which the network would underwrite the production costs and pay the Charity a fixed fee,
268 269
Priv. Ltr. Rul. 95-42-045 (July 28, 1995). Although the names of the taxpayers are not revealed in published private letter rulings, it is commonly believed that Priv. Ltr. Rul. 95-42-045 was issued to the National Geographic Society (“the Charity”), a publicly supported charitable and educational organization within the meaning of §501(c)(3).
241
c04.fm Page 242 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
in no way based on advertising revenue. Concerned that its broadcast on a commercial network might be viewed by the IRS as an unrelated business activity and that such activity could conceivably jeopardize its tax-exempt status, the Charity proposed an arrangement that would minimize any UBIT risks. The Charity planned to transfer its film library, subscription lists, cash, and certain other property to a newly created for-profit subsidiary (Y), in exchange for all of the stock of the subsidiary. The Charity also planned to license its name and mailing lists to subsidiary Y. In addition, the Charity proposed to create Z, a second for-profit subsidiary, to engage in “strategic planning activities” on behalf of the Charity, and transfer to it its stock in Y, in exchange for stock in Z. In this manner, Y would become a wholly owned subsidiary of Z and a second-tier subsidiary of the Charity.270 For the first six months after its capitalization, officers of the Charity were also to serve as officers of Y and Z. Moreover, after the six-month interim period, some ovelap of officers would continue, but the president/chief executive officers (CEOs) of Y and Z were to be independent of the Charity. Finally, although there would be some boards of directors overlap, a majority of the board of each subsidiary was to be independent of the Charity.271 From the IRS’s perspective, the composition of the officers and board of directors is of vital importance in demonstrating that a subsidiary has a separate legal existence from its parent and will be respected for federal tax purposes. Although it is not unusual for a newly formed for-profit subsidiary to share some officers or directors with its tax-exempt parent until it “gets on its feet,” the length of this start-up period and the extent to which overlap is permissible has been the subject of some debate. In this regard, Priv. Ltr. Rul. 95-42-045 confirms the following: • First, it is important for a for-profit subsidiary to have an independent
board of directors from its tax-exempt parent, even if the directors may be 270
271
In this particular case, the Charity chose to use a two-tiered subsidiary structure, presumably because it allows the Charity to avoid the “control” provisions of §512(b)(13), which provide that otherwise passive income (i.e., rents, royalties, etc.) will be characterized as UBIT if the entity actually making the payments to the exempt organization is a “controlled” subsidiary. §512(b)(13) does not require attribution between entities, and thus payments from a secondtier subsidiary to the parent organization are not implicated by the restriction. See Section 4.6(c). The use of a second-tier subsidiary also provides a means through which a charitable organization can further insulate its assets from liability and minimize any possible UBIT implications where the charity is involved in a number of separate unrelated activities. In the ruling request, the Charity proposed that its president and executive vice president be the “sole members of the [Y and Z] Boards of Directors for an interim period, not to exceed six months.” When replying to the ruling request, however, the IRS stated that “for an interim period of time represented to be no longer than six months . . . the officers of [the Charity] will also serve as officers of [Y and Z]. A majority of the Board of Directors of Y and Z will be independent of [the Charity], i.e. will not be Charity Board members, officers of staff persons” [emphasis added]. Apparently, the IRS misunderstood (or misstated) the facts by assuming that the boards of the subsidiaries would at all times be made up of a majority of individuals who were independent of the Charity. This statement by the IRS suggests the importance the IRS places on the independence of the board of directors. National Geographic expanded the activities of one of its taxable subsidiaries when it acquired a 30 percent stake in a travel Web site that presents information about and facilitates direct purchasing of adventure travel tours. The investment is not merely a passive one. National Geographic will include iExplore’s travel information on its own Web site and promote iExplore in its magazines. iExplore will add the Society’s tour program to its offerings, and include National Geographic content on its Web site. Visitors to its Web site will be able to chat online with National Geographic experts. See also Priv. Ltr. Rul. 02-25-046 (March 28, 2002).
242
c04.fm Page 243 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
elected by the board of the parent organization. This ruling seems to indicate that at least a majority of the board of a for-profit subsidiary should (even during the start-up period) be independent of the tax-exempt parent in order to meet the separate entity test. • Second, although some overlap of officers is permissible, it is important
that the key positions (i.e., president and/or CEO) of the parent and subsidiary be held by different persons. The CEO is the individual who is generally responsible for the day-to-day affairs of the organization and most clearly represents it in the public domain. Accordingly, the potential for confusion is great if one person fills this position for both organizations. • Third, the IRS ruling provides some assurance that during a short interim
period (six months under these facts), it is permissible for an exempt parent and its for-profit subsidiary to have a significant overlap of officers and directors, so long as the long-term goal is to achieve independence in this regard. (c)
Single-Member Nonprofit LLCs
An increasingly popular entity is the limited liability company (LLC), which combines the pass-through attributes of partnerships with the liability protection of corporations.272 Pursuant to the “check-the-box” regulations,273 an exempt entity is deemed to be taxable as a corporation.274 On the other hand, an unincorporated organization with one owner can choose to be taxable as a corporation or disregarded for federal tax purposes—that is, all tax attributes are passed through to the owner/member.275 An exempt organization that is the sole owner of an LLC has two choices, both of which allow the LLC to claim §501(c)(3) exemption. The default position is to treat the wholly owned LLC as a part of its owner; that is, to “disregard” its separation from the owner.276 The IRS will now recognize the exempt status of such a disregarded LLC owned by a sole exempt organization.277 The announcement is consistent with the Service’s general policy of “disregarding” singlemember LLCs for other federal tax purposes. The exempt owner of a disregarded LLC must treat the operations and finances of the LLC as its own for tax and information reporting purposes. The IRS has added a section to Form 990 soliciting information about disregarded entities. Disregarded entities need not independently satisfy the organizational test of §501(c)(3). The IRS has not yet decided whether contributions to a disregarded entity should be deductible or whether disregarded entities should be allowed to choose between regarded and disregarded status for employment tax purposes. 272 273 274 275 276 277
See Chapter 19. See Chapter 19. Reg. §301.7701(b)(2). Reg. §301.7701-(a)(4). Id. Ann. 99-102, 1999-43 I.R.B. 545 (Oct. 25, 1999).
243
c04.fm Page 244 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
CAVEAT For planning purposes, a charity can place activities in a single-member LLC that will be disregarded for tax purposes, but provide limited liability. However, subsequently, it can add another member. If the additional member is also an exempt organization, the entity could itself qualify for exemption.* If the new member is a for-profit, the activities of the LLC would no longer be wholly attributable to the parent.† * †
See Section 4.4. See Richard A. McCray and Ward L. Thomas, “Limited Liability Companies as Exempt Organizations—Update,” Exempt Organizations Technical Instruction Program for FY2001, 27 (2000): 29.
A single-owner LLC may also elect to be treated as a separate entity. There are two ways to do that: by filing for separate-entity treatment on Form 8832, or by claiming exemption as an entity separate from the owner (by filing either a separate Form 1023 or Form 990). One situation in which an owner might prefer to treat its subsidiary as a separate entity is when the subsidiary conducts activities that would jeopardize the exemption of the parent organization if attributed to the parent. The parent would want to maintain formal separation of the organizations. As a separate entity claiming exemption, the LLC will be treated as an association. (d)
UBIT Implications Applicable to the Use of a Subsidiary
(i) General Rule. In general, if a parent and subsidiary maintain separate corporate identities, the subsidiary’s income will be taxable to it at normal corporate tax rates, and distributions from the subsidiary to the parent in the form of dividends, interest, rent, and so forth, will not result in UBIT to the parent.278 (ii) Exception for Controlled Subsidiaries. However, if an exempt parent corporation receives rent, interest, annuities, or royalties from a “controlled” subsidiary, whether taxable or exempt, it must treat the payment as taxable income “to the extent such payment reduces the net unrelated income of the controlled entity.”279 If the controlled entity is taxable, “net unrelated income” means the income that would be UBIT if the entity were exempt and had the same purpose as its controlling organization. The term “reduces” is not defined, but appears to mean: sufficiently related so that the subsidiary is justified in deducting it from the unrelated income as a business expense. In other words, if the subsidiary treats the payment to the parent as a business expense and deducts it, thereby reducing the subsidiary’s taxes, then the parent must include it in unrelated income and pay taxes on it at that level.280 The IRS has referred to the “dual use
278 279 280
§512(b); Reg. §1.512(b)-1. See also Priv. Ltr. Rul. 93-01-023 (Jan. 8, 1993); Priv. Ltr. Rul. 9242-002 (Oct. 16, 1992); Priv. Ltr. Rul. 91-05-029 (Feb. 1, 1991). §512(b)(13)(A). See Tax Management Portfolio 874-2 pp. A-121, A-122 for examples.
244
c04.fm Page 245 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
rule” to “allocate the specific portion . . . of the income or expense items proximately and primarily related to the respective use. . . .”281 Effective August 5, 1997, the Taxpayer Relief Act of 1997 (the Act) modified the test for determining control for IRC §512(b)(13) purposes, so that “control” now means (for a stock corporation) ownership by vote or value of more than 50 percent of the stock.282 For a partnership or other entity, control means ownership of more than 50 percent of the profits, capital, or beneficial interests.283 Moreover, the Act provides that the constructive ownership rules of IRC §318 apply for §512(b)(13) purposes.284 Thus, parent exempt organizations are deemed to control any subsidiary in which they hold more than 50 percent of the voting power or value, directly (for example, a first-tier subsidiary) or indirectly (for example, a second-tier subsidiary). Thus, to illustrate, if an exempt organization owns 100 percent of a first-tier corporation, which in turn owns 50 percent of a second-tier corporation, the exempt parent organization would not be considered to control the second-tier corporation. However, if the first-tier corporation owns 51 percent of the second-tier corporation, it would be considered to control the second-tier corporation. (A) E XEMPT C ONTROLLED S UBSIDIARY For the tax years prior to August 5, 1997, if the controlled organization is exempt from taxation under IRC §501 (a), the amount of interest, annuities, royalties, or rents included by the controlling parent is an amount that bears the same ratio to the interest, annuities, royalties, and rents received by the controlling parent from the controlled subsidiary, as the unrelated business taxable income of the controlled organization bears to the greater of the following: • The taxable income of the controlled subsidiary, computed as though the
controlled subsidiary were not exempt from taxation under §501 (a). • The unrelated business taxable income of the controlled organization.285
EXAMPLE: A, an exempt scientific organization owns all of the stock of B, another exempt scientific organization. During 1992, A rents space for a laboratory to B for $15,000 a year. A’s total deductions for 1992 with respect to the leased property are $3,000: $1,000 for maintenance and $2,000 for depreciation. If B were not an exempt organization, its total taxable income would be $300,000, disregarding rent paid to A. B’s unrelated business taxable income, disregarding rent paid to A, is $100,000. Under these circumstances, $4,000 of the rent paid by B will be included by A as net rental income in determining its UBIT, computed as follows:286
281 282 283 284 285 286
Priv. Ltr. Rul. 199941048; Chapter 8.3(b)(i)(B). §512(b)(13)(D)(i)(I). §512(b)(13)(D)(i)(II)-(III). §512(b)(13)(D)(ii). Reg. §512(b)-1(1)(2)(a) and (b). See generally Priv. Ltr. Rul. 87-29-005 (Apr. 13, 1987). See Reg. §1.512(b)-1(1)(2)(ii) (example 1). See also Priv. Ltr. Rul. 92-42-002 (Oct. 16, 1992).
245
c04.fm Page 246 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
B’s UBIT (disregarding rent to A) B’s taxable income (computed as though B were not exempt and disregarding rent to A) Ratio ($100,000 to $300,000) Total rent Total deductions Rental income treated as gross income from unrelated business (1/3 of $15,000) Less deductions directly connected with income Net rental income included by A in computing its UBIT
$100,000 300,000 1/3 15,000 3,000 5,000 –1,000 = 4,000
Effective August 5, 1997,287 the Act provides that if the controlled subsidiary is exempt under IRC §501(a), the controlling parent must treat any interest, annuity, royalty, or rents that the subsidiary pays to it as UBIT to the extent that such payment reduces the unrelated business taxable income of the controlled subsidiary (or increases any unrelated loss of the controlled subsidiary).288 Under the Pension Protection Act of 2006, the general rule of §512(b)(13), which includes interest, rent, annuity, or royalty payments made by a controlled entity to a controlling tax-exempt entity in the latter organization’s unrelated business income to the extent the payment reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity, applies only to the portion of the payments received or accrued in a taxable year that exceeds the amount of the payment that would have been paid or accrued if such payment had been determined under the principles of IRC §482.(insert fn: IRC §512(b)(13)(E).) thus, if a payment by a controlled subsidiary exceeds fair market value, the excess amount of the payment over fair market value is included in the parent organization’s unrelated business income, to the extent that such excess reduced the net unrelated income (or increased any net unrelated loss) of the controlled entity. This new provision relating to payments to controlling organizations, applies only to payments received or accrued after December 31, 2005 and before January 1, 2008. (B) TAXABLE C ONTROLLED S UBSIDIARY For the tax years prior to August 5, 1997 if the controlled subsidiary is not exempt from taxation under IRC §501(a), the amount of interest, annuities, royalties, or rents included by the controlling parent is an amount that bears the same ratio to the interest, annuities, royalties, and rents received by the controlling parent from the controlled subsidiary, as the “excess taxable income” of the controlled organization bears to the greater of the following: • The taxable income of the controlled subsidiary. • The excess taxable income of the controlled organization.289 287
288 289
The rules under prior law also apply to payments made during the first two tax years beginning on or after Aug. 5, 1997, if the payment is made pursuant to a written binding contract in effect on June 8, 1997, and at all times thereafter before the payment. “Conf. Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong., 1st Sess., pt. 2, at H6530 (1997). §512(b)(13)(A). Reg. §1.512(b)-1(1)(3)(a) and (b).
246
c04.fm Page 247 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
The excess taxable income is the excess of the controlled subsidiary’s taxable income over the amount of such taxable income which, if derived directly by the controlling organization, would not be subject to UBIT.290 EXAMPLE: A, an exempt university described in IRC §501(c)(3), owns all the stock of M, a nonexempt subsidiary. During 1992, M leases a factory and dormitory from A for a total annual rent of $100,000. During the taxable year, M has $500,000 of taxable income, disregarding the rent paid to A: $150,000 from a dormitory for students of A university and $350,000 from the operation of a factory, which is a business unrelated to A’s exempt purpose. A’s deductions for 1992 with respect to the leased property are $4,000 for the dormitory and $16,000 for the factory. Under these circumstances, $56,000 of the rent paid by M will be included by A as net rental income in determining its UBIT, computed as follows:291 M’s taxable income (disregarding rent to A) Less taxable from dormitory Excess taxable income Ratio ($350,000/$500,000) Total rent paid to A Total deductions ($4,000 & $16,000) Rental income treated as gross income from unrelated business (7/10 of $100,000) Less deductions directly connected with income (7/10 of $20,000) Net rental income included by A in computing its UBIT
$500,000 –150,000 = 350,000 7/10 100,000 20,000 70,000 –14,000 = 56,000
These rules are intended to prevent tax avoidance in situations in which a parent could characterize payments by a subsidiary to itself as rent, interest, royalties, or annuities. Those payments are generally deductible by the subsidiary and not taxable to the exempt parent. However, with controlled subsidiaries, IRC §512(b)(3) makes such payments taxable.292 EXAMPLE: A parent organization, exempt pursuant to IRC §501(c)(4), received substantially all of its income from pari-mutuel horse racing activity. The parent made its facilities available for a substantial number of civic and community activities. The parent formed a wholly owned, taxable subsidiary. The subsidiary will engage in a for-profit keno lottery. Under this arrangement, the subsidiary will lease space from the parent organization. Accordingly, the taxable income of the subsidiary will not constitute UBIT to the parent. However, a portion of the rents derived by parent from the subsidiary will be included in the UBIT of the parent, consistent with §512(b)(13).293 290 291 292 293
Reg. §1.512(b)-1(1)(3)(ii). See Reg. §1.512(b)-1(1)(3)(iii). See Priv. Ltr. Rul. 92-45-031 (Nov. 6, 1992). This example is based on the factual situation presented in Priv. Ltr. Rul. 92-45-031 (Nov. 6, 1992).
247
c04.fm Page 248 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
As with noncontrolled subsidiaries, dividends paid by a controlled subsidiary to its exempt parent are not deductible by the subsidiary; thus, the dividend payments to the parent organization would not be subject to UBIT.294 As stated, effective August 5, 1997,295 the Act provides that if the controlled subsidiary is not exempt under IRC §501(a), the controlling parent must treat any interest, annuity, royalty, or rents that the subsidiary pays to it as UBIT to the extent such payment reduces the part of the subsidiary’s taxable income that would constitute unrelated business taxable income if it were tax exempt under §501(a) and had the same exempt purposes as the parent.296 (iii) Use of Holding Company Intermediary. Because, before August 5, 1997, IRC §512(b)(13) did not contain attribution rules, it was possible to utilize a holding company as an intermediary to avoid the application of the controlled subsidiary rules. Under this strategy (which can no longer be used successfully because of the amendments to §512(b)(13) by the Taxpayer Relief Act of 1997) the exempt parent organization could form a wholly owned taxable first-tier subsidiary. The first-tier subsidiary could then create one or more wholly owned second-tier subsidiaries. The second-tier subsidiaries could pay royalties, rents, interest, or other allowable passive income to the exempt parent without violating the (prior) 80-percent-controlled-subsidiary rules. Before the Act, the IRS had approved this approach in a Technical Advice Memorandum297 in which P was a tax-exempt museum that owned all of the stock of a taxable subsidiary corporation R, which in turn owned all of the stock of S, a taxable corporation. S paid rent to P for the use of space in the museum where S operated a store. The issue was whether rental income from S, a secondtier subsidiary, was includable in UBIT of P. The IRS ruled that the income was not taxable to P under IRC §512(b)(13) because P did not directly own at least 80 percent of all classes of stock of S, confirming that no indirect ownership rules applied under §512(b)(13).298 The Act, however, precludes this approach from being used successfully after August 5, 1997. (e)
Spin-Off of Existing Activity or Venture Interest
Exempt organizations (EOs) often find it advantageous to spin off a business or division or to create a new entity to house particular charitable or taxable activities. EXAMPLE: H is a hospital exempt from taxation under IRC §501(c)(3). M is a holding company for H and is recognized as exempt under §501(c)(3) as a healthcare 294
295
296 297 298
§512(b). See Priv. Ltr. Rul. 93-05-026 (Nov. 11, 1992) (dividends from a wholly owned, forprofit subsidiary are not taxable to the exempt parent organization); Priv. Ltr. Rul. 93-03-030 (Oct. 29, 1992); Priv. Ltr. Rul. 93-08-047 (Dec. 4, 1992). The rules under prior law also apply to payments made during the first two tax years beginning on or after Aug. 5, 1997, if the payment is made pursuant to a written binding contract in effect on June 8, 1997, and at all times thereafter before the payment. Conf. Report on H.R. 2014, Taxpayer Relief Act of 1997, 105th Cong., 1st Sess., pt. 2, at H6530 (1997). §512(b)(13)(A). Tech. Adv. Mem. 93-38-003 (June 19, 1993). See also Priv. Ltr. Rul. 90-03-060 (Oct. 30, 1989). But see Priv. Ltr. Rul. 94-02-031 (Jan. 14, 1994) (IRS declined to rule on use of a second-tier subsidiary to avoid §512(b)(13) in a medical reorganization case).
248
c04.fm Page 249 Thursday, March 15, 2007 5:17 PM
4.8 USE OF A SUBSIDIARY AS PARTICIPANT IN A JOINT VENTURE
educational organization. F is an endowment fund recognized as exempt under §501(c)(3). Historically, H has devoted part of its assets and personnel to coordinating and supervising its various departments and affiliates, to managing the investment of its excess funds (including investments in joint ventures), and to raising funds for its operations. H’s governing board decides that H could improve the efficiency and quality of its operations by concentrating more exclusively on the provision of healthcare. To achieve these goals, H will spin off its fund-raising and investment management functions to F and will spin off its overall coordination and supervision functions to M, which will function as the parent of H following this reorganization.299 The spin-off in the example was not tax-motivated. Other nontax reasons for an exempt organization to divest itself of one of its divisions or operations include the more efficient use of resources,300 segregation of fund-raising activities,301 promotion and education of the public on the exempt organization and its activities,302 reorganization or restructuring of its operations,303 and reduction or elimination of potential liability for certain activities.304 EXAMPLE: X is a charitable organization involved in numerous charitable and educational activities. One of X’s operating divisions conducts activities for emotionally disturbed and physically disabled individuals, including a summer day camp and a foster care adoption program. X perceives that it has significant potential liability through the operation of this division. Thus, X creates Y and spins off the liability-generating activities conducted by the division to Y. Because a parent corporation is not generally liable for the activities of its subsidiary, through this structure X can ensure that the day camp and foster care adoption program activities are continued while insulating its other activities from potential liability. Generally, when a spin-off is pursued for such nontax reasons, no special tax issues arise, and the spun-off entity is itself tax exempt. However, spin-offs may be motivated by tax concerns. This typically occurs when a tax-exempt organization experiences significant growth of an unrelated trade or business. Two common tax concerns in this situation are (1) private inurement and private benefit issues305 arising from the desire of key personnel to participate in the expansion through stock ownership, increased compensation, or other investment, and (2) potential jeopardy to the exempt organization’s tax exemption if 299 300 301
302 303 304 305
This example is based on the factual situation presented in Priv. Ltr. Rul. 88-11-015 (Dec. 16, 1987). Priv. Ltr. Rul. 88-11-015 (Dec. 16, 1987). See Priv. Ltr. Rul. 84-41-047 (July 12, 1984) (A, an exempt organization engaged in the treatment of needy and neglected children, creates B, an exempt organization whose directors have significant fund-raising experience, to provide various supporting services to A. A will spin off its own fund-raising functions to B, thus enhancing overall efficiency through consolidation of fund-raising functions). See Priv. Ltr. Rul. 84-08-057 (Nov. 23, 1983) (M, an exempt hospital, spins off certain facilities and programs to newly created X). See, e.g., the previous example in the text, based on the factual situation presented in Priv. Ltr. Rul. 88-11-015 (Dec. 16, 1987). See Priv. Ltr. Rul. 87-44-059 (Aug. 6, 1987). See Section 5.2(a).
249
c04.fm Page 250 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
the sheer size of the unrelated business reaches the point where it becomes, quantitatively, the dominant part of the exempt organization. The organization may seek to insulate itself from these risks by spinning off the profitable activity to a for-profit entity. One well-publicized example of this technique was the spin-off by the Christian Broadcasting Network (CBN) of the Family Channel into a separate taxable entity. CBN is a nonprofit, tax-exempt cable network founded by television evangelist Dr. M.G. Pat Robertson. In 1977, CBN started the Family Channel, the nation’s first satellite-based cable channel, which, unlike the existing religious division of CBN, functioned as a commercial programming company. The Family Channel was so successful that by the late 1980s it brought in $4.50 in advertising and licensing revenues for every dollar of contributions generated by CBN’s religious broadcasting. Robertson became concerned that the Family Channel’s commercial importance could jeopardize CBN’s exempt status. In 1990, CBN undertook a plan to spin off the Family Channel by selling it to a for-profit entity, International Family Entertainment (IFE), which had been newly created by Robertson, his son, and a minority shareholder for the purpose of the spin-off. The sale price was established by the higher of two independent appraisals. The spin-off succeeded in protecting CBN’s tax exemption while permitting key personnel (the Robertsons) to share in the Family Channel’s profits through substantial salaries and stock ownership. Indeed, in the latter respect the transaction may have succeeded too well. IFE went public in 1992, whereupon the Robertsons’ $150,000 investment in IFE became worth $90 million. The lucrativeness and the Wall Street-style, management-led, debt-financed nature of the buyout306 attracted much adverse publicity and even spawned legislative proposals to impose excise taxes on transactions between exempt organizations and related persons.307 Moreover, the IRS conceivably could have viewed the vast difference between what the Robertsons paid in the transaction and the value of what they soon received as jeopardizing CBN’s exempt status through private inurement of CBN’s earnings. However, any IRS attack on this basis would have faced the formidable obstacle of the arm’s length dealings that the Robertsons conducted with CBN by obtaining independent appraisals of the Family Channel assets. CBN stands as a textbook example of how spin-offs motivated by tax concerns may allay those concerns but trigger others, at least when the transaction is structured so that a person related to the exempt organization participates as a kind of joint venturer in the value of the spun-off business. A critical feature of any such transaction is to avert IRS valuation-inurement concerns by negotiating at arm’s length—for example, by using multiple independent appraisals. 306
307
It should be noted that the debt financing used by IFE in the purchase of the Family Channel did not pose any UBIT problem to CBN under §514 (see generally Chapter 8) because the exempt organization, CBN, was selling rather than acquiring the assets to be debt-financed in the transaction. See Isikoff and Hosenball, “With God There’s No Cap,” Newsweek 42 (Oct. 3, 1994); Weiser, “An Empire on Exemptions?,” Washington Post(Feb. 13, 1994): H1, Gaul and Borowski, “The IRS, An Enforcer That Can’t Keep Up,” Philadelphia Inquirer (Apr. 21, 1993): A1. See also the remarks of Congressman Pete Stark on the Exempt Organization Reform Act of 1993, reproduced in Exempt Organization Tax Review 9 (Jan. 1994): 224-225.
250
c04.fm Page 251 Thursday, March 15, 2007 5:17 PM
4.9 USE OF A SUPPORTING ORGANIZATION IN A JOINT VENTURE
Another organization that has created a subsidiary for its UBIT generating programs is the American Association of Retired Persons (AARP), a §501(c)(4) organization. As a result of an IRS audit of AARP which focused on AARP’s income from licensing its name and logo over a four year period, the IRS and the AARP agreed that AARP would create a taxable subsidiary, AARP Services, Inc., which would independently operate certain parts of AARP’s licensing activities.308 The IRS issued a private letter ruling, widely understood to be addressed to the AARP, in June 1999. The Service concluded that the subsidiary would be truly independent, and therefore its income would not be attributed to the parent.309 Finally, it should be noted that exempt organizations occasionally engage in the reverse of a spin-off, which is the liquidation of an existing subsidiary. This procedure could be warranted, for example, when the primary activity of the subsidiary becomes “related” to the parent’s exempt purpose and there no longer exists any administrative reason to house the activity in a separate entity.310 Gains realized by the exempt parent upon such a liquidation are exempt from UBIT under IRC §512(b)(5), which excludes from the computation of UBIT all gains or losses from the sale, exchange, or other disposition of noninventory property.
4.9
USE OF A SUPPORTING ORGANIZATION IN A JOINT VENTURE
A supporting organization to an exempt organization may be proposed as the participant in a joint venture arrangement similarly to the use of a for-profit subsidiary of an exempt organization or a limited liability company.311 A supporting organization must apply for exemption and qualify as an exempt organization under §501(c)(3) in its own right. The supporting organization participant is subject to all of the same rules applicable to exempt organizations involved in joint ventures. The supporting organization is a unique entity because it must qualify for exempt status under §501(c)(3) in addition to qualifying for public charity status under one of several complex tests set forth in §509(a)(3), as explained below. In essence, it must exist and operate in relationship with another charity with which it shares an exempt purpose. An organization may qualify as a supporting organization under §509(a)(3) by demonstrating one of three types of relationships with the public charity it supports (the “supported charity”). By qualifying as a supporting organization, the organization is excluded from the definition of private foundation and is treated as a public charity. Under §509(a)(3), a supporting organization is one 308 309 310
311
“AARP, IRS Reach Agreement,” Tax Notes (July 15, 1999): 36. Priv. Ltr. Rul. 199938041 (June 28, 1999). See, e.g., Priv. Ltr. Rul. 94-38-029 (June 28, 1994) (for-profit subsidiary was originally spun off by hospice agency to house unrelated business; upon change of subsidiary’s activity to a hospice-related activity administered directly by parent, subsidiary was liquidated into parent). But see Section 4.12. See discussion in Section 4.8, regarding single-member limited liability companies, in which the exempt organization is the single member. Also see Section 19.6 for a related discussion. As indicated in these discussions, the advantage of a single-member LLC is protection of the charity from liability.
251
c04.fm Page 252 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
organized and operated exclusively for the benefit of, to perform the functions of, or to carry out the pur-poses of one or more public charities; operated, supervised, and controlled by or in connection with one or more public charities; and is not controlled by a disqualified person.312 The type of supporting organization created is determined by the relationship between the supporting organization and the supported organization. A Type 1 supporting organization has a relationship similar to a “parent–subsidiary” relationship with the supported organization because the supporting organization is operated, supervised, and controlled by the supported organization.313 The relationship between a Type 2 supporting organization and its supported organization is similar to a “brother–sister” relationship, whereby the supporting organization is operated, supervised, or controlled by the supported organization. The Type 3 is simply operated in connection with a public charity. Of the three types, the Type 3 is the most difficult to establish. In fact, with the recent decision of the Tax Court in two separate cases314 in which it was held that the organizations structured as Type 3 supporting organizations failed to qualify as such under §509(a)(3), practitioners have become quite concerned and have expressed the need for additional guidance from the IRS in this area. Practitioners have noted a growing hesitation on the part of the IRS to qualify organizations as Type 3 supporting organizations, regardless of the fact that there is very little difference in the structure and operations of all these entity types. Unlike the other two types of supporting organizations, the Type 3 does not require extensive supervision or control from the supported charity. However, the supporting organization must establish that it is responsive to the needs or demands of the supported organization by allowing the supported organization to have an active voice in its investment policies and grant-making activities (the responsiveness test).315 In addition, the Type 3 supporting organization must maintain a significant involvement in the operations of the supported organization, and the supported organization must be dependent on the supporting organization for the support it provides.316 This second requirement, the integral part test, was the focus of the Tax Court in the two cases in which the organizations were denied qualification as Type 3 supporting organizations. 317 The integral part test can be satisfied by showing either that “but for” the involvement of the supporting organization in activities that perform the functions of the supported organization, such activities would ordinarily be carried out by the supported organization,318 or that the amount of support 312 313 314 315 316 317
318
IRC §509(a)(3)(A), (B), and (C). Treas. Reg. §1.509(a)-4(g)(1). Lapham Foundation, Inc. v. C.I.R., T.C. Memo 2002-293; Cuddeback v. C.I.R., T.C. Memo 2002-300. Treas. Reg. §1.509(a)-4(i)(2)(ii). (This responsiveness test is one of two tests that must be satisfied by the organization seeking to be qualified as a Type 3 supporting organization). Treas. Reg. §1.509(a)-4(i)(3)(i). This is the “integral part test,” the second and more difficult test to be satisfied by the organization seeking to be qualified as a Type 3 supporting organization. In an earlier case, the Tax Court noted that “[w]hile the responsiveness test guarantees that the supported organization will have the ability to influence the supporting organization’s activities, the integral part test insures that the supported organization will have the motivation to do so.” See Nellie Callahan Scholarship Fund v. Commissioner, 73 T.C. 626, 637–638 (1980). Treas. Reg. §1.509(a)-4(i)(3)(ii).
252
c04.fm Page 253 Thursday, March 15, 2007 5:17 PM
4.9 USE OF A SUPPORTING ORGANIZATION IN A JOINT VENTURE
provided by the supporting organization to the supported organization is sufficient to ensure the attentiveness of the supported organization. In order to ensure attentiveness, the IRS requires that the amount of support provided by the supporting organization represent a significant part of the supported organization’s total support.319 Thus, in a growing number of cases, the IRS (supported by the Tax Court) has refused to qualify an organization as a Type 3 supporting organization because it has not established satisfactorily that the amount of support provided to the supported organization would be sufficient to ensure attentiveness. CAVEAT In making this determination, the IRS considers pertinent factors such as (1) the number of charities supported, (2) the history and nature of the relationship between the supporting and supported charity, and (3) the purpose for which the funds are used by the charity.
According to the IRS, imposition of a requirement by the supported organization that the supporting organization furnish annual reports, which will assist the supported charity to ensure that the supporting organization has not engaged in any impermissible activity and has invested its endowment, provides a strong evidence of actual attentiveness.320 Attentiveness is not quantifiable; thus, merely making a large grant and providing annual reports do not ordinarily establish attentiveness. In the Lapham case,321 the Tax Court found that the amount contributed by the supporting organization, when measured against the total amount of contributions received by the supported charity, was not enough to ensure its attentiveness. In addition, the court held that since the support provided by the supporting organization was not earmarked by either of the entities for any particular activity and there was no evidence that the activity for which the support was provided was a substantial activity of the supported organization, the activity would not be interupted if the support was no longer provided, and therefore the organization failed to establish that the support provided ensured the attentiveness of the supported charity. The question of whether interruption of the supported activity requires a discontinuance or merely a curtailment was raised but not answered by the court in the Cuddeback case. 322 The court held, however, that the organization failed to provide any evidence that the supported organization would be sufficiently attentive to the supporting organization’s activities, especially since there was proof of availability of other funding sources for the activity supported.
319 320 321 322
Treas. Reg. §1.509(a)-4(i)(3)(iii)(a). Treas. Reg. §1.509(a)-4(i)(3)(iii)(d) Lapham Foundation, Inc. v. C.I.R., T.C. Memo 2002-293. Cuddeback v. C.I.R., T.C. Memo 2002-300.
253
c04.fm Page 254 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
CAVEAT In a General Counsel Memorandum,* the IRS stated that the “rule of thumb” in testing attentiveness is that the supporting organization must provide at least 10 percent of the total support received by the supported charity and the activity supported must be separately identifiable. The IRS believes that this amount is substantial enough to ensure a meaningful amount of dependency on the support provided, and therefore would ensure attentiveness. *
GCM 36379 (Aug. 15, 1975).
The Internal Revenue Service is now closely scrutinizing supporting organizations, following the changes to the law in the Pension Protection Act of 2006 (Pub. L. No. 109-280). Those provisions impose new requirements on supporting organizations; for example, type III supporting organizations will not be considered to operate “in connection with” a qualified organization. Moreover, an organization will not qualify as a Type I or Tye III supporting organization if it accepts a gift from a donor who controls, either directly of indirectly a supported organization.323 In addition, the IRS is authorized to promulgate regulations regarding annual distribution requirements for Type III supporting organization, similar to the distribution requirements imposed on private foundations324. Moreover, the definitions of “excess benefits,” “excess benefit transation,” and “ disqualified person” are expanded under IRC §4958, specifically as they pertain to supporting organizations. In particular, any payment of a grant, loan, compensation, or “similar payment” by a supporting organization to a substantial contributor, a member of her family, or a 35 percent controlled entity, is automatically treated as an excess benefit with the entire amount of the payment treated as the excess benefit. Loans by any supporting organization to a disqualified person of the supporting organization, are treated as excess benefit transactions with the entire amount of the loan considered to be the excess benefit. Finally, the definition of “qualifying distribution” under IRC §4942 has been modified, payments made by a private foundation to a Type III supporting organization (that is not a “functionally integrated” Type III supporting organization) or any other supporting organization (if a disqualified person with respect to the private foundation controls the supporting or the supported organization) will not constitute qualifying distributions. These provisions became effective in August 17, 2006. CAVEAT These changes have made the exemption application process for supporting organizations much more onerous. Speaking at the January 19, 2007 American Bar Association Tax Section midyear meeting, Catherine Livingston, IRS assistant chief counsel with the tax exempt and government entities division, stated that “the internal revenue service is giving much closer scrutiny to applications for supporting organizations because some of them have been set up to use their supported 323 324
IRC F 509(f)(2)(A). Pension Protection Act of 2006, §1241(d)(1).
254
c04.fm Page 255 Thursday, March 15, 2007 5:17 PM
4.10
THE IRS AUDIT
organizations as a ‘rubber stamp’ for the activities of a donor.” However, Ms. Livingston acknowledged that these changes may have gone “too far the other way in sweeping in the trustworthy supporting organizations with the bad.” In fact, many supporting organizations are seeking a change of status to the stand alone public charities, in order to continue to qualify private foundation grants, and to avoid the automatic excess benefit transactions provisions.
4.10 (a)
THE IRS AUDIT Introduction
As all taxpayers know, the IRS has several functions. It promulgates regulations and issues rulings that provide guidance to aid taxpayers in compliance with the Internal Revenue Code. Another important function is the audit, whereby examiners attempt to confirm taxpayer compliance with tax laws. As described throughout this book, there are many areas of the law regarding exempt organizations that are still developing. Yet the fact that the IRS position on some issues is not finalized does not prevent the audit function from proceeding. Rather, as in the area of whole hospital joint ventures, the audit process can proceed “full steam ahead” even though a particular area presents new factual and legal issues. Thus, although most of this book addresses policy questions with an eye toward planning, the audit process itself merits attention as well. Because an audit can involve any type of organization and any number of issues, the following discussion offers general guidelines to minimize potential audit issues, as well as steps for an organization to take once it has received an audit notice.325 (b)
Minimize Audit Issues—Advance Planning 1. Conduct In-House Periodic Audits.
Arrange for an annual legal audit in which a professional advisor or counsel (1) reviews the organization’s activities and files, (2) reports on potential legal problems, and (3) provides recommendations for solving or ameliorating those problems.
Implement counsel’s recommendations. Modify activities to avoid revocation of exempt status or substantial UBIT. Where activities are continued, document exempt reasons for continuing. For example, if an organization’s activity can be viewed as commercial—for example, sales of books, handicrafts, paintings, and so on—detail in writing how the sales further exempt purposes. On the other hand, sales of some items may have to be reduced or curtailed if sales are substantial and constitute clearly commercial-type activity.
2. Have Important Documents Reviewed by Counsel.
325
Draft minutes, contracts, employment agreements, and other important documents should be sent to counsel for review prior to being finalized.
These recommendations are based on outlines by William Driggers, Esq. and Leonard J. Henzke Jr., Esq., Powell Goldstein, Frazer & Murphy, Washington, D.C. (on file with the authors).
255
c04.fm Page 256 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
3. Consistently Document Charitable Nature of Organization’s Activities.
Prepare an “annual report” to the board of directors, detailing the organization’s activities in furtherance of its exempt purposes.
Provide detailed descriptions on Form 990, Part III.
EXAMPLE: “The organization provided 10,454 hours of instruction in 24 different courses of study, in subjects such as sewing, carpentry, nutrition, and gardening. Approximately 80 percent of the students had incomes below the poverty level. Thirty percent of the courses were provided at or below cost. The courses are estimated to have increased each student’s annual income by $2,000 per year.”
Consistently describe the organization’s exempt purposes and activities in all pamphlets and brochures that explain the organization’s activities.
Maintain organized records—for example, minutes, written cafeteria, health and welfare, and other fringe benefit plans where legally required.
Maintain a file of newspaper, magazine, and similar articles and include references to them in board minutes.
There may come a time when, regardless of how carefully an organization complies with IRS rules and regulations, it receives an audit notice. The notice can be triggered by an item on the organization’s Form 990 or prompted because the IRS has a certain type of organization, (e.g., hospital or university) under review.326 In this situation, an organization should take the steps outlined in section 2.9(b).
4.11
CONVERSIONS FROM EXEMPT TO FOR-PROFIT AND FROM FOR-PROFIT TO EXEMPT ENTITIES
Conversions from for-profit status to exempt status, and vice versa, are becoming increasingly frequent. In the healthcare area in particular, there has been a significant increase in the number of conversions of nonprofit hospitals to forprofit status, driven in part by the consolidation into major for-profit hospital chains.327 However, the number of conversions in the health industry slowed considerably since 1999.328 A great deal of attention has also been given to conversions from for-profit to nonprofit status, with the IRS focusing on preventing such a conversion from being used as a tool to avoid payment of tax on appreciated assets. In response to IRS concerns, Congress acted to close this loophole.
326 327
328
See Chapters 12 and 14. Douglas M. Mancino, Taxation of Hospitals and Health Care Organizations, Ch. 12 (1995– 1997 Supp.). Structuring such a conversion involves guidance on detailed and numerous requirements that should be provided by professionals. Grantmakers in Health, “Philanthropy’s Newest Members: Findings from the 1999 Survey of New Health foundations” (Mar. 2000).
256
c04.fm Page 257 Thursday, March 15, 2007 5:17 PM
4.11 CONVERSIONS FROM EXEMPT TO FOR-PROFIT
In the Tax Reform Act of 1986, Congress repealed the “General Utilities” doctrine so that corporations would have to recognize gain (or loss) when property is distributed or sold pursuant to a complete liquidation.329 The Treasury Department issued final regulations pursuant to these legislative changes, which were effective as of January 28, 1999.330 The issue addressed by the regulations was the conversion of a for-profit to a nonprofit or the distribution of a forprofit’s assets to a nonprofit in the course of a complete liquidation, each of which presents the potential for tax avoidance absent the regulatory changes. According to the new law and the regulations, if a for-profit corporation transfers all or substantially all of its assets to one or more tax-exempt entities, it is required to recognize gain immediately before the transfer as if the assets were sold at fair market value.331 Similarly, if a taxable entity converts to a tax-exempt entity, the foregoing rule will apply (unless the entity had lost and regained exempt status within a delineated time frame).332 Taxation upon conversion or contribution is not triggered if the assets will generate UBIT, but will be triggered at such time as the assets are sold by the nonprofit.333 Conversions of tax-exempt organizations to taxable ones present diverse issues. In this situation, the IRS is concerned with preventing private inurement or private benefit and with ensuring that the assets of the exempt organization continue to serve charitable purposes.334 An independent valuation of the EO’s assets conducted at the time of the conversion is essential to avoiding private inurement335 and to documenting the fairness of the transaction.336 The IRS has provided a rebutable presumption of reasonableness if the following conditions are met: • The board approving the conversion is composed entirely of individuals
who do not have a conflict of interest in the transaction. • The board relies on appropriate comparability data, including indepen-
dent appraisals and evidence of third-party offers. • The board documents its decision concurrently in writing (including data relied
on by members present and voting, and actions of those who had a conflict).337 329 330 331 332 333 334 335
336
337
§337(d), as amended by the Tax Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of 1988. T.D. 8802 (Dec. 29, 1998). Reg. §1.337-4(a)(1). Reg. §1.337-4(a)(3). Reg. §1.337-4(a)(4). This material draws on a presentation by LaVerne Woods, Davis Wright Tremaine LLP, at the Fourth Annual Western Conference on Tax-Exempt Organizations (Oct. 27, 2000). See descriptions of acceptable appraisals in articles by Charles Kaiser and Amy Henchey, “Valuation of Medical Practices,” in 1996 CPE Text at 304–438, and Judith Kendall and T.J. Sullivan, “Health Care Update,” in IRS Continuing Professional Education Exempt Organizations Textbook for FY1995, at 162–181. The first challenge in the Tax Court to an intermediate sanction concerned a conversion of four home healthcare agencies from EOs to S corporations. Caracci v. Commissioner, 118 T.C. No. 25 (2002) reversed 456 F.3d 444 (2006). Family members who controlled the agencies formed corporations that acquired their assets in return for assumption of their liabilities. However, the IRS valued each agency at $5 million, thus making the conversions excess benefit transactions for which it imposed fines in excess of $200 million. The IRS also retroactively revoked the tax exemptions of the agencies on the basis of private inurement. See Section 5.2. Treas. Reg. §53.4958-6. For a more detailed discussion of private inurement and private benefit, see Chapter 5.
257
c04.fm Page 258 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
Most transformations of an EO to a for-profit will result in gain or loss that must be realized. Whether the gain is taxable is a separate analysis. The sale of substantially all an EO’s assets typically will not generate taxable unrelated business income because the sale is not a trade or business “regularly carried on.” However, sale of debt-financed assets may result in UBI.338 Both state and federal law require tax-exempt organizations to ensure that their assets will continue to serve exempt purposes even after the organization dissolves. The proceeds of a converted EO must be received by a preexisting EO or one organized for that purpose. The IRS will scrutinize the “successor charity’s” purpose to make sure that it is not simply a way to transfer assets to the new for-profit and its owners. The composition of the board can help demonstrate the independence of the successor charity. The successor charity should also continue financial support for exempt purposes at levels equivalent to its predecessor. A successor charity may have difficulty maintaining the same public charity status as the prior EO if it no longer actually carries on medical or educational activities, and if the investment income from the proceeds greatly exceeds sources of revenue considered to be public support. See Chapter 10 for further discussion of the implications of private foundation status on the excess business holdings rules.
4.12
EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
An exempt organization may choose to participate in a joint venture by lending funds or becoming a ground lessor to the venture, rather than being a principal.339 The exempt organization must use ordinary business care and prudence in making a loan to a joint venture.340 Hence, the loan must be reasonable, adequately secured, and have a market rate of interest.341 In addition, the loan can be in the nature of a “program-related investment.”342 (a)
Program-Related Investments
A program related investment (PRI) is an investment, the primary purpose of which is to accomplish one or more of the exempt organization’s charitable purposes, and for which there is no significant purpose to produce income or appreciate property.343 338 339 340 341 342
343
See Chapter 8. See Chapter 6. See generally M. Sanders, C. Roady, and S. Cobb, “Partnerships and Joint Ventures.” Reg. §53.4944-1(a)(2). See Priv. Ltr. Rul. 91-12-013 (Mar. 22, 1992). See also Gen. Couns. Mem. 38,841 (Feb. 26, 1982). §4944(a)(1) prohibits a private foundation from making a “jeopardizing” investment. However,” program-related investments” are specifically excluded from definition of a “jeopardizing” investment. Program-related investments will hereinafter be referred to as “PRIs.” A PRI is a special type of social investment that meets the criteria for qualifying distributions for private foundations in §4944(c). These investments satisfy statutory requirements as long as the primary purpose in making the PRI is charitable; the PRI will have a charitable effect that would not have occurred without the PRI; and the charitable effect is commensurate with the investment. Reg. §53.4944-3(a)(2)(i); see also Rev. Rul. 72-559, 1972 C.B. 247. §4944(c).
258
c04.fm Page 259 Thursday, March 15, 2007 5:17 PM
4.12 EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
PRIs344 were made possible by passage of the Tax Reform Act of 1969, in the context of private foundation legislation. Congress established guidelines whereby investments serving valuable societal and charitable purposes could be treated as “qualifying distributions”345 and not run afoul of the jeopardizing investment rules.346 One of the early examples of a foundation using PRIs is that of the Cooperative Assistance Fund, a public charity created to invest portions of private foundation assets in support of minority enterprises, in the form of loans to, or equity investments in, small businesses and inner-city community development organizations.347 Another example is that of the John D. and Catherine T. MacArthur Foundation (“MacArthur Foundation”), which has, over a 10-year period, made more than 100 PRIs, with a total value in excess of $80 million, to organizations whose goals range from biological research to the development of economically depressed areas.348 For an investment to qualify as a PRI, three requirements must be met: 1. The primary purpose of the investment must be to accomplish one or more of the organization’s charitable purposes;349 2. The investment must be of a type that would not have been made but for the relationship between the investment and the accomplishment of the foundation’s exempt activities;350 and 3. The investment must not have, as one of its significant purposes, the production of income or the appreciation of property.351 Typically, PRIs take the form of loans to organizations bearing below-market interest rates, or to borrowers who could not otherwise qualify for such funds from commercial lending institutions.352 344 345 346
347
348
349 350 351
352
See Section 10.4(b). Reg. §53.4942(a)-3(a)(2)(i). M. Cerny, “Program Related Investments Past, Present and Future—Historical Perspective,” Exempt Organizations Committee, ABA Section on Taxation 3 (May 1995). §4944 provides that if a private foundation invests any amount in such a manner as to jeopardize the carrying out of its exempt purposes, certain excise taxes will be imposed on the foundation and its managers. §4944(c) specifically provides that PRIs are not considered jeopardizing investments. Cerny at 4. The IRS has ruled that for the charitable purpose of “encouraging economic development of a disadvantaged group, foundations can make loans or equity investments . . . to organizations that prevent community deterioration or provide employment opportunities.” Id. at 3-4, citing Rev. Rul. 74-587, 1974-2 C.B. 162. Chernoff, Associate General Counsel, MacArthur Foundation, “Some Practical Observations About Making, Documenting and Enclosing PRIs,” Exempt Organizations Committee ABA Section on Taxation (May 1995). See Priv. Ltr. Rul. 88-07-048 (Nov. 23, 1987); Priv. Ltr. Rul. 89-06-062 (Nov. 17, 1988). Reg. §53.4944-3(a)(i); Rev. Rul. 77-111, 1977-1 C.B. 144. Reg. §53.4944-3(a)(2)(i). Reg. §53.4944-3(a)(2)(ii). If a PRI does produce income, the charitable purpose of the investment is not necessarily jeopardized. The regulations also provide that the investment may not have as one of its purposes the furtherance of legislation or political activities. Reg. §53.49443(a)(2)(iii). See Cerny, “Program Related Investments Past, Present and Future—Historical Perspective,” Exempt Organizations Committee, ABA Section on Taxation 4 (May 1995), citing Priv. Ltr. Rul. 87-10-076 (Dec. 10, 1986); Priv. Ltr. Rul. 86-37-120 (June 19, 1986); Gen. Couns. Mem. 33906 (Aug. 7, 1968). See Priv. Ltr. Rul. 90-14-063 (Jan 10, 1990).
259
c04.fm Page 260 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
EXAMPLE: An exempt organization, whose charitable purpose includes “relief of the poor and distressed and combating community deterioration,” proposes to lend money to a for-profit limited partnership. The limited partnership will use the funds to provide affordable housing to low-income individuals in a blighted area. The loan will bear a 9 to 10 percent rate of interest. Payments are “interest only,” with principal payable in full 15 years after construction but no later than 17 years after issuance of the loan. The loan will be secured by a second priority deed of trust on all properties owned by the partnership. Under these circumstances, the loan will not jeopardize the exempt organization’s exempt status. Furthermore, the loan is not a “jeopardizing” investment because it is in furtherance of the exempt organization’s charitable purposes; hence, it is a PRI.353 Equity investments may also meet PRI requirements. This will generally be the case if the investment is “riskier than for-profit investments that ordinarily would not receive commercial funding.”354 Examples include investments in a new venture in an untested market, or investments in a venture with a lower capitalization than a conventional investment.355 EXAMPLE: X is a small limited liability company (LLC) located in a deteriorated urban area and owned by members of an economically disadvantaged minority group. Conventional sources of funds are unwilling to provide funding to X at reasonable interest rates unless it increases the amount of its equity capital. Consequently, Y, a private foundation, acquires a membership interest in X. Y’s primary purpose for making the investment is to encourage the economic development of minority groups. Assuming the investment has no significant purpose involving the production of income, furthers the accomplishment of Y’s exempt activities, and would not have been made but for Y’s exempt purposes, the acquisition of the membership interest in the LLC qualifies as a program-related investment even though Y may realize a profit if its membership interest appreciates in value.356 Moreover, PRIs need not be made only to businesses experiencing financial difficulty or owned by members of a disadvantaged class. In certain cases, the end result of an investment will be the significant factor in qualifying it as a PRI. EXAMPLE: X is a financially secure business enterprise. Its stock is listed and traded on a national exchange. Y, a private foundation, one of whose purpose is to combat community deterioration, makes a loan to X at an interest rate below market to induce X to establish a new plant in a deteriorated urban area, which, because of 353
354 355 356
This example is based on the factual situation presented in Priv. Ltr. Rul. 91-12-013 (Mar. 22, 1991). In one instance, the IRS liberally interpreted the loan requirements. See Priv. Ltr. Rul. 84-29-051 (Apr. 18, 1984). Here, an exempt organization made a nonrecourse loan at belowmarket interest to a limited partnership that constructed low-income housing. Because the area was high risk and, therefore, unable to secure conventional financing, the IRS held that this loan was a PRI. Hence, the loan would not jeopardize the exempt organization’s exempt status. M. Cerny, “Program Related Investments Past, Present and Future—Historical Perspective,” Exempt Organizations Committee, ABA Section on Taxation 4-5 (May 1995). See id. at 5. See Reg. §53.4944-3(b), example 3. Investment in an LLC by a private foundation raises issues regarding control of charitable assets and potential concerns with excess business holdings rules. For a discussion of these issues, see Section 19.7.
260
c04.fm Page 261 Thursday, March 15, 2007 5:17 PM
4.12 EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
the high risks involved, X would be unwilling to establish absent such an inducement. No significant purpose underlying the loan involves the production of income or the appreciation of property. The loan significantly furthers Y’s exempt activities and would not have been made except for the relationship between the purpose of the loan and the furthering of Y’s activities. Accordingly, the investment qualifies as program related even though X is a large and established business entity.357 Since the implementing regulations were written for the PRIs in 1972, both the vision of foundations, and the financial instruments available to them have greatly expanded. Rather than directly lending money, organizations have found that they can leverage a loan by making a guarantee, providing a letter of credit or collateral. Foundations still make equity investments to advance their exempt purposes, but they may now be structured more like joint ventures, using such new structures as LLCs. Foundations are making loans to for-profit businesses or through financial intermediaries to accomplish charitable ends. Many more foundations are now interested in projects in foreign countries such as strengthening the media, protecting the environment, or providing jobs.358 None of these innovative PRIs are referenced in the regulations. EXAMPLE: A museum intends to issue qualified §501(c)(3) bonds to help finance construction of a new building, but will not receive a favorable rating without additional security or credit enhancement. A foundation that supports educational endeavors purchases a “participation interest” in a letter of credit designed to enhance the credit rating. The foundation accepts terms offered to other investors, which some had declined as too risky and having insufficient return. However, the foundation views the investment as a commitment to the city for the unique educational facility, in furtherance of its exempt purpose. The IRS concludes that the investment does further the foundation’s exempt purposes. Given the many uncertainties surrounding the project, including the real possibility that the foundation may not recover the investment, the IRS also concluded that the investment was not made for the production of income.359 EXAMPLE: A foundation previously established to provide long-term foster care to children, formed an LLC with a public charity to operate a family service support center. The IRS ruled that the foundation’s capital contributions to the LLC were program-related investments because they were made to accomplish a charitable purpose, even though made to an organization not itself described in §501(c)(3). Furthermore, the foundation may treat 50 percent of the disbursements of the LLC as qualifying distributions made directly for active conduct of its activities because it maintains a “significant involvement” by direct participation and by monitoring and administrative activities.360 The IRS has relied on private letter rulings addressing one specific case at a time, rather than issuing new regulations or precedential guidance on these 357 358 359 360
Reg. §53.4944-3(b), example 5. See Section 16.7 for examples of PRIs involving foreign countries. Priv. Ltr. Rul. 9033063. Priv. Ltr. Rul. 9834033.
261
c04.fm Page 262 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
newer forms of program-related investments. Practitioners have called for revision of the regulations (and expansion of the examples) to take the new economic and social realities into account, and provide assistance to foundations as they look for innovative ways to pursue their charitable goals in the United States and abroad.361 In four recently released private letter rulings,362 the IRS held that funds provided by a private foundation to §501(c)(3) public charities for purposes of providing loans to developers for construction of housing in a blighted area and the economic development of the area constituted program-related investments under §4944(c). PRIs offer several advantages over conventional investments. For example, PRI funding is typically allotted from a foundation’s grant budget. Grants generally represent one-time transfers and are rarely, if ever, recovered or recycled by the foundation. PRIs, in contrast, often take the form of loans, which are generally recovered and typically earn a modest rate of return.363 Further, under IRC §4942, PRIs constitute qualifying distributions; thus, they count toward the foundation’s annual distribution requirements and lessen the amount of additional qualifying distributions that must be made in a given year. Finally, instead of yielding a 3 to 4 percent rate of return (a typical interest rate on a PRI, if it is in the form of a loan), the private foundation making the PRI will actually realize a higher effective rate of return. This is because PRIs are considered to be “assets used (or held for use) in carrying out the foundation’s exempt purpose”364 (“charitable use assets”) and thus are not taken into consideration in calculating the foundation’s 5 percent required distribution amount.365 To illustrate this point, compare the following two situations: 1. In 1995, F, a private foundation, had $5,000,000 in net investment assets and had made no PRIs. In calculating its required distribution amount, F takes into account the entire $5,000,000. Hence, its minimum distribution amount is $250,000 ($5,000,000 × .05).366 Accordingly, F makes a $250,000 grant to a public charity to meet its annual distribution requirement. As a result, F has $4,750,000 in assets and no expectation of recovering the grant for future use. 2. In 1995, G, a private foundation, had $5,000,000 in total assets. Moreover, G made (in 1995) a PRI of $200,000. Because the $200,000 PRI is considered to be a charitable use asset, it is not taken into account in calculating G’s minimum distribution amount. Thus, the foundation has $4,800,000 of noncharitable use assets, and G’s minimum distribution amount is $240,000 ($4,800,000 × .05). 361
362 363 364 365 366
For example, David Chernoff, “Outdated Regulations Hamper Foundations Making Foreign Program-Related Investments,” 12 Journal of Taxation of Exempt Organizations 249 (May/ June 2001). Priv. Ltr. Ruls. 200331005–008 (May 9, 2003). Chernoff, “Some Practical Observations About Making, Documenting and Enclosing PRIs,” Exempt Organizations Committee, ABA Section on Taxation 2 (May 1995). Reg. §53.4942(a)-2(c)(3)(ii)(d). See §4942(e)(1)(a). Calculation of the minimum distribution amount pursuant to §4942 is a complex endeavor, and many other factors, such as taxes paid on net investment income, enter into the equation. For the purposes of this comparison and the sake of simplicity, it is assumed that these additional factors are not present.
262
c04.fm Page 263 Thursday, March 15, 2007 5:17 PM
4.12 EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
Because the PRI is treated as a qualifying distribution, G will have to distribute only an additional $40,000 ($240,000 – $200,000) to meet its minimum distribution requirement. Accordingly, G makes a $40,000 grant to a public charity. G now has $4,760,000 in noncharitable use assets and, unlike F, reasonably expects to recover the PRI amounts for future use. In addition, unlike F’s grant, G’s PRI (as a loan) should yield a modest rate of return, providing the foundation with additional income. Finally, although PRIs may initially seem risky, steps may be taken to minimize the risks involved, such as close scrutiny of the proposed investments by the board of directors (or a subcommittee thereof) and the methodical structuring and documentation of the transaction.367 According to a recent survey of some 200 institutions making program-related investments over the last 10 years, $718 million had been disbursed or guaranteed, $403 million remains outstanding, and only $9 million—less than 2 percent—is in default.368 In sum, PRIs represent a useful alternate method of maximizing a foundation’s grant monies. Whether in the form of capital financing or bridge loans to low-income housing organizations, revolving educational loan funds, or interim financing to begin or expand urban redevelopment programs, PRIs can serve an important role in furthering the exempt purposes of private foundations. When considering whether to make a loan, an exempt organization must exercise prudent investment policy and make sure that the terms of the loan are structured in such a way so as not to generate UBIT or jeopardize the exempt status of the lender. (b)
Below-Market Loans
The Tax Reform Act of 1984 added to the Internal Revenue Code a provision that deals with loans with below-market rates of interest.369 The Code provision treats certain loans in which the interest rate charged is less than the market rate of interest, as the economical equivalent of loans bearing interest at the applicable federal rate, coupled with an imputed payment by the lender to the borrower sufficient to fund all or part of the payment of interest by the borrower.370 Thus, an interest-free or below-market interest rate loan is recharacterized as an arm’s length transaction in which the lender is deemed to have made • a loan to the borrower at a statutory rate of interest.371 • a payment to the borrower in the amount of the forgone interest.372 367
368 369 370 371 372
The MacArthur Foundation, for example, requires the following documents when making a PRI loan: Initially: Questionnaire, Commitment Letter, Loan Agreement, and a Promissory Note. At closing: Officer’s Certificate, Certificate of Good Standing, Certified Borrowing Resolutions, Certificate of Incumbency, Certified Articles of Incorporation, Certified Bylaws, and two opinion letters (one corporate and one tax). Chernoff, “Some Practical Observations About Making, Documenting and Enclosing PRIs,” Exempt Organizations Committee, ABA Section on Taxation 3-4 (May 1995). “Few Foundations Make Loans for Programs,” Chronicle of Philanthropy (May 4, 1995). §7872; Reg. §1.7872-1(a); Reg. §1.7872-3. Reg. §1.7872-1(a)(1) and (2). Reg. §1.7871-1(a)(1). Reg. §1.7872-1(a)(2).
263
c04.fm Page 264 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
The deemed interest is includable in the lender’s income and may be deductible by the borrower.373 The rules for below-market loans apply to (1) gift loans (those in which the lender’s forgone interest is in the nature of a gift to the borrower); (2) compensation-related loans; (3) corporation-shareholder loans; (4) tax avoidance loans (the principal purpose of the interest arrangement is the avoidance of tax); and (5) any other below-market loan in which the interest arrangement has a significant effect on the federal tax liability of the lender or the borrower.374 However, the IRS may exempt from the below-market loan rules any class of transaction that does not significantly affect the tax liability of the lender or borrower.375 Consistent with the statute, the IRS issued temporary regulations that specifically exempt loans made by an IRC §501(c)(3) organization in furtherance of its charitable purposes from the below-market loan rules.376 (c)
Tax Advantages to Lender or Ground Lessor
An exempt organization often enters into a loan or ground lease as an alternative to making an equity investment. Exempt lenders and ground lessors in such transactions typically require a return beyond a flat rate of interest or rent. The yield may consist of two components: (1) a fixed return in the form of interest or rent, but typically often at a below-market rate, plus (2) additional compensation, whether or not dubbed “interest” or “rent,” for the additional risk assumed by the lender or ground lessor. The second component, commonly referred to as an “equity kicker,” is the major source of tax difficulty, because this form of yield may cause the loan or lease to be viewed in substance as an equity investment and thus subject to UBIT and other tax disadvantages. As discussed in Chapter 6, recharacterization of debt or a ground lease as an equity investment is substantially more likely if the interest or rent is based on net income or profits of the borrower or lessee, and is less likely if the interest or rent is based on gross revenue or receipts. The advantages of a lender-borrower or ground lessee structure are to allow, inter alia, the possible exclusion of interest and rent from UBIT; a preferred return which, under the tax exempt leasing rules, is unavailable to an equity investor without loss of depreciation deductions for the taxable venturer; loss of exemption from the debt-financed income rules; and recognition of partnership tax allocations and tax basis. However, against these advantages must be weighed certain advantages of equity ownership: If a debt or lease structuring were vulnerable to recharacter373
374 375 376
The deemed interest rate that a lender and borrower must use for a below-market rate loan is determined by reference to the term of the loan and the applicable federal rate corresponding to the term: Term of Loan Interest Rate 3 years or less Federal short-term rate More than 3 years but no more than 9 years Federal mid-term rate More than 9 years Federal long-term rate §7872(c). §7872(h)(1)(C); Temp. Reg. §1.7872-5T(a)(1). Temp. Reg. §1.7872-5T(b)(11).
264
c04.fm Page 265 Thursday, March 15, 2007 5:17 PM
4.13 ISSUANCE OF TAX-EXEMPT BONDS
ization as equity, it might be preferable for non-tax reasons to structure the transaction ab initio as an equity investment. On balance, a loan or ground lease arrangement will often be more advantageous than a joint venture. Chapter 6 explores these alternative structurings and discusses certain guaranty devices, which are largely of financial rather than tax import. (d)
Special Rules for Private Foundations as Lenders
There are special rules that apply when the exempt organization is a private foundation. In that case, the lending of money or other extension of credit between a private foundation and a disqualified person constitutes an act of selfdealing.377 Thus, a private foundation may not make a loan to a partnership in which one or more disqualified persons (such as a director of the foundation) owns a profit interest of more than 35 percent. The Code provides rules to determine the profit interests of such disqualified persons. Under the Code, a disqualified person must take into account the profit interests owned by his or her family in determining his or her profit interest in the partnership.378 For purposes of this attribution rule, family members include only the disqualified person’s spouse, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren.379 Furthermore, a sale or exchange of property between a private foundation and disqualified person constitutes an act of self-dealing. For this purpose, a contribution to the foundation of real or personal property by a joint venture that is a disqualified person, is treated as a prohibited sale or exchange if the foundation assumes a mortgage or similar lien that was placed on the property prior to transfer, or takes subject to a mortgage or similar lien that a disqualified person placed on the property within the 10-year period ending on the date of the transfer. The term similar lien includes, but is not limited to, deeds of trust and vendor liens, but does not include any other lien if the lien is insufficient in relation to the fair market value of the property transferred. Finally, the leasing of property by a disqualified person to a private foundation may be an act of self-dealing unless the lease is without charge.380
4.13
ISSUANCE OF TAX-EXEMPT BONDS
A charitable organization may choose to become the beneficiary of a bond offering whereby the interest payments are exempt from federal income taxes. IRC §145 provides that certain types of private activity bonds may be issued on a taxexempt basis to benefit §501(c)(3) organizations.381 However, §§147, 148, and 150 impose requirements for using these bonds.
377 378 379 380 381
§4941(d)(1)(B). §4946(a)(1)(D). §4946(d). Reg. §53.4941(d)-2(a)(2) and (b). §145.
265
c04.fm Page 266 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
To utilize “qualified IRC §501(c)(3) bonds,” all property financed by the qualified issue must be owned by a §501(c)(3) organization or a governmental unit. Furthermore, at least 95 percent of the net proceeds of a bond issue must be used for the organization’s exempt purposes. Hence, no more than 5 percent of the bond proceeds may be used for unrelated or nonexempt purposes. Because the interest on qualified IRC §501(c)(3) bonds is exempted from federal income taxes, bonds often provide a cost-effective form of financing. This financing tool is potentially an attractive vehicle for an exempt organization to raise revenue to further the organization’s exempt purposes.
4.14 (a)
REPORTING REQUIREMENTS Overview
With few exceptions, every organization exempt from taxation under §501(a) of the Internal Revenue Code must file an annual return.382 Exempt organizations engaged in joint venture arrangements will likely file a Form 1065 annual partnership return for the joint venture.383 This informational return must specifically state the items of gross income and deductions allowable by the joint venture and the names and share amounts of individuals entitled to a distributive share.384 In addition, most exempt organizations must file an annual return on a Form 990.385 All private foundations, without exception, must file an annual Form 990-PF.386 The IRS Forms 990 are designed to accomplish several purposes. First, the IRS is seeking basic financial information such as revenues, disbursements, assets, and liabilities in order to evaluate and assess the exempt organization’s activity.387 Second, the IRS is attempting to elicit information that is helpful to an IRS revenue agent in detecting compliance failures by the exempt organization. Form 990 must be filed within four and one-half months after the end of the organization’s fiscal year.388 Third, expanded disclosure of Forms 990, 990PF, and 1023389 will provide an opportunity for nonprofit organizations to explain to the general public about their programs with supplemental discussion about community benefit and justify their expenditures (such as salaries of key employees).390
382 383
384 385 386 387 388 389 390
§6033(a)(1); Reg. §1.6033-2(a)(1). In most cases, this annual return would be on one of the 990 Forms. §6031(a); Reg. §1.6031-1(a)(1). An unincorporated association that elects, under §761(a), to be wholly excluded from Subchapter K, must file a Form 1065 only for the first year of operations. Reg. §1.6031-2. §6031(a): Reg. §1.6031-1(a)(1). Reg. §1.6033-2(a)(2)(ii). Id. §6033(b). Reg. §1.6033-2(a)(4)(e). See Section 2.8. Comments of Marcus Owens, Director, IRS Exempt Organizations Division, as reported in “EO Reps Are All Ears at Georgetown Conference,” Exempt Organizations Tax Review (June 1999): 455.
266
c04.fm Page 267 Thursday, March 15, 2007 5:17 PM
4.14 REPORTING REQUIREMENTS
Certain exempt organizations are not required to file a Form 990. The IRS does not require the following organizations to file an informational return: • Any organizations with gross annual receipts “normally” under $25,000 • Churches • Church affiliates • Religious schools • Mission societies391
Furthermore, the Treasury Secretary has discretion to exempt nonprofit organizations from filing a Form 990 when it is not efficient for tax administration.392 However, organizations that are excepted from the annual filing may nonetheless wish to file a Form 990. The reason for this is that organizations that do not file a Form 990 are removed from IRS Publication 78, the master list of qualifying charitable organizations.393 The IRS maintains that if an organization is not listed in Publication 78, then taxpayers are on sufficient notice that contributions to the organization are no longer deductible, even though no revocation announcement has been published in the Internal Revenue Bulletin.394 Hence, in order to not give contributors the false impression that the organization has lost its exempt status, an exempt organization that is not required to file a Form 990 may decide to do so voluntarily, thus maintaining its listing in Publication 78. (b)
Public Inspection of Returns
Section 1313 of the Taxpayer Bill of Rights 2, enacted in 1996, modified the disclosure provisions of IRC 6104(d)395 by requiring a copy of the requested materials to be provided, in addition to making materials “available for inspection.”396 Further modifications were added by the Tax and Trade Relief Extension Act of 1998,397 which also amended IRC §6104 regarding public disclosure of annual information returns and exemption applications by private foundations (which were previously governed by separate disclosure requirements).398 As a result of this change, the rules of §6104(d) are now applicable to private foundations.399 391
392 393 394 395 396 397
398 399
§6033(a)(2)(A); Reg. §1.6033-2(g)(5)(g). See also Rev. Proc. 83-23, 1983-1 C.B. 687 (the exception was limited to organizations with less than $5,000; however, the exception threshold was raised to $25,000). §6033(a)(2)(B); Reg. 1.6033-2(g)(6). Gen. Couns. Mem. 39,809 (Feb. 12, 1990); Gen. Couns. Mem. 39,389 (Aug. 22, 1984). Estate of Clopton v. Commissioner, 93 T.C. 275 (1989); Gen. Couns. Mem. 39,809 (Feb. 12, 1990). P.L. 104-168, 110 Stat. 1452 (July 30, 1996). §6104(d)(1)(A) and (B). This applies to organizations having one or more regional or district offices with three or more employees at each office. P.L. 105-277, 112 Stat. 2681 (Oct. 21, 1998). These changes apply to requests made after the 60th day after the IRS issues final regulations defining when requested documents are considered widely available or when the request is part of a harassment campaign. H.R. Report No. 105-817. The final regulations were expected to be released in February or March 1999. However, they will not contain provisions relating to private foundations. These provisions will be released separately as an amendment to the final regulations. Thus, the changes made by the Tax and Trade Relief Extension Act of 1998 will not apply to private foundations until an amendment to the final regulations is issued. §6104(d)(1). §6104(d)(1)(A) and (B). The rules for public inspection of the returns of private foundations became final on January 31, 2000 in T.D. 8861, 2000-5 I.R.B. 441. See Section 2.8.
267
c04.fm Page 268 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
Under the new rules, if a request for a copy is made in person, a copy must be provided immediately, with the organization charging a reasonable fee for reproduction costs.400 If a request for a copy is in writing, the copy must be provided within 30 days, with a reasonable fee for reproduction costs and mailing.401 Inspection of annual returns is limited to a three-year statute of limitations, so an organization need only supply the three most recent returns.402 These rules apply to all exempt organizations, including private foundations.403 However, organizations that are not private foundations do not have to disclose their contributor list.404 Further, the disclosure to individuals will not be required if, pursuant to regulations promulgated pursuant to revised §6104(c), the IRS deems the documents to be widely available or if the request is part of a harassment campaign.405 According to an IRS Exempt Organizations representative, “a clear intent of recent changes in disclosure requirements for exempt organizations was to encourage dissemination of exempt organization returns via the Internet.”406 Indeed, the Internet is now a place to find many information returns. Not only do the charitable organizations publish their own returns, but several independent sites also provide access to returns for many organizations. Guidestar, an online database run by Philanthropic Research, Inc., provides the IRS Forms 990 for more than 220,000 public charities, beginning with 1998, and for private foundations beginning with 1999. The Guidestar Web site is <www.guidestar.com>. The Urban Institute’s National Center for Charitable Statistics also provides both forms at its research Web site: <www.nccs.urban.org>. The Foundation Center provides 990-PF forms for private foundations through its site: <www.fdncenter.org>. Unfortunately, a significant number of the Forms 990 contain omissions, misrepresentations, or falsifications.407 The IRS went on to say that the wider dissemination of the Forms 990 could lead to greater scrutiny by the media and other interested parties.408 This, in turn, should lead exempt organizations to complete their returns with greater care.409 (c)
Affiliated Organizations
IRS Form 990 requires specific information about the joint venture activity of an exempt organization. For example, an exempt organization must report the name 400 401 402 403 404 405
406 407
408 409
§6104(d)(1). Final regulations became effective on June 8, 1999. They are published at 21 C.F.R. §301.6104(a), T.D. 8818. §6104(d)(1). §6104(d)(2). §6104(d)(1). §6104(d)(3)(A). §6104(d)(4). The IRS issued proposed regulations in 1997 on this issue (Prop. Reg. §301.6104(e)-2; Reg. §246250-96, Sept. 26, 1997), which are discussed in detail in the 1999 CPE, Chapter L. Tom Gilroy, “Exempt Organizations’ Tax Returns Due for Broad Exposure, IRS Official[s] [sic] Says,” Daily Tax Report (Nov. 6, 1998): G-1. See Harvey Lipman, “Charities’ Zero-Sum: Filing Game” Chronicle of Philanthropy, 12, no. 15 (May 18, 2000) p. 1, and the 2001 CPE, “Section G. Form 990,” by Cheryl Chasin, Debra Kawecki, and David Jones. See id. See id.
268
c04.fm Page 269 Thursday, March 15, 2007 5:17 PM
4.14 REPORTING REQUIREMENTS
of, and certain other information about, any taxable corporation or partnership in which it owned a 50 percent or greater interest at any time during the year. (i) Taxable Subsidiaries. Form 990 requires information on whether the exempt organization, at any time during the year, owned a 50 percent or greater interest in a taxable corporation or partnership. If the answer to this question is yes, the exempt organization must complete Part IX of Form 990. Part IX requires the following information: • The name, address, and employer identification number of the taxable
corporation or partnership • The percentage of ownership interest • The nature of the taxable entity’s business activities • The amount of the taxable entity’s total income • The amount of the entity’s end-of-the-year assets
The use of the Internet has grown even faster than predicted and has led to much greater scrutiny by the public. The IRS produced a detailed explanation of the Form 990 as a part of the 2001 CPE to assist exempt organizations in filing more accurate and standardized forms, and to assist the public in understanding the data in the forms. CAVEAT Organizations should carefully review their Forms 990 before submission to the IRS, as wide exposure increases the chances that problem areas will be investigated by the public. (ii) Exempt Subsidiaries. Form 990, Schedule A, Part VII, requests certain information regarding transfers to, and transactions and relationships with, noncharitable exempt organizations. Generally, only IRC §501(c)(3) organizations (except private foundations) are required to complete Schedule A.410 They must report transactions such as sharing of facilities, sales of purchase of assets, rental of facilities or equipment, and performance of services or fund-raising solicitations with organizations exempt under §501(c)(4) or §501(c)(6). In addition, §501(c)(3) organizations must list the name and type of any affiliated exempt organization and describe the nature of the relationship to that organization.411 An exempt organization that wholly owns an LLC must report and treat the operations and finances of the LLC as its own for tax and information purposes. Part IX of Form 990 solicits information about any disregarded entities the reporting organization might own.
410 411
Organizations exempt under §§501(e), 501(f), 501(k), and §4947(a)(1) are also required to complete Schedule A. Priv. Ltr. Rul. 92-42-002 (Oct. 16, 1992).
269
c04.fm Page 270 Thursday, March 15, 2007 5:17 PM
OVERVIEW: JOINT VENTURES INVOLVING EXEMPT ORGANIZATIONS
(iii) Partnerships of Exempt Organizations. All partnerships, including those composed of several tax-exempt organizations, must file federal information returns on Form 1065.412 (iv) Other Related Organizations. Even if not related through common ownership, exempt organizations related through common membership, governing bodies, officers, etc. (other than by association with a statewide or nationwide organization) must so indicate on Form 990, Part VI, Line 80a. Furthermore, the association must report the name of the affiliated organization and its exempt status on Line 80b. (d)
Mandatory Filing for Exempt Organizations with UBIT
Any organization, without exception, that is exempt under IRC §501(a) and that has more than $1,000 of gross income from an unrelated trade or business must file a Form 990-T.413 Which is now required to be made available for public inspection, unless the disclosure would adversely affect the organization, as in the case of a patent, trade secret, etc.414 Specifically, an organization described under §511(a)(2) that is subject to the tax imposed by §511(a)(1) on its unrelated business taxable income must make a return on Form 990-T for each taxable year if it has gross income, included in computing the unrelated business taxable income, of $1,000 or more.415 The filing of Form 990-T does not relieve the organization of the duty to file other required returns.416
412 413 414 415 416
§6031; Reg. §1.6031-1; Priv. Ltr. Rul. 89-25-092 (Mar. 30, 1989). Reg. §§1.6033-2(g)(6) and (h)(3)(i); Reg. §1.6012-2(e). §6104(d)(1)(A)(ii). Reg. §1.6012-2(e). See id.
270
c04.fm Page 271 Thursday, March 15, 2007 5:17 PM
A P P E N D I X
4 A
Joint Venture Checklist
Set forth below are several factors that can be used as guidance in making a determination as to whether a joint venture arrangement allows a nonprofit to operate exclusively for charitable purposes. These questions were developed based on a review of recent court opinions and IRS administrative materials on joint ventures, including the IRS EO Technical Topics on Whole Hospital Joint Ventures.417 While these factors are not exhaustive, they can serve as a starting point for practitioners structuring joint venture arrangements.418 In General 1. Does the participation of the exempt organization in the joint venture further its exempt purposes? The IRS will deny or revoke exemption of an organization that enters into a joint venture where the primary motive is to make a profit. 2. Are the assets of the exempt partner adequately protected? The exempt organization can avoid a negative conclusion by ensuring that (i) it has taken steps to limit its contractual liability in the joint venture; (ii) the rate of return on the invested capital of the for-profit partner is limited (reasonable under the circumstances, perhaps subject to a reasonable cap); and (iii) there is no obligation on the part of the exempt partner to return the for-profit partner’s capital from the exempt partner’s own funds. 417 418
Mary Jo Salins, Judy Kindell, and Marvin Friedlander, “Exempt Organizations Technical Topics, Part A: Whole Hospital Joint Ventures,” 1999 CPE. In Priv. Ltr. Rul 200304041, an exempt organization initially enters into a joint venture with another exempt organization. Immediately after the limited liability company is formed, one of the exempt participants withdraw and a physican group is admitted as a member of the joint venture. Where the two participants are exempt organizations, the IRS is less concerned with the issue of control. However, the issue of control becomes important if the joint venture arrangement involves exempt and for-profit participants. In this letter ruling, the for-profit physician group holds a 48 percent membership interest in the joint venture while the exempt participant holds a 52 percent interest and also appoints 3 of the LLC’s 5-member board of governors. The IRS held that because it had voting control over major decisions of the board of governors, the exempt participant will exercise effective control over the major decisions of the LLC and over the operations and activities of the facility.
271
c04.fm Page 272 Thursday, March 15, 2007 5:17 PM
JOINT VENTURE CHECKLIST
3. Does the exempt partner have a right of first refusal on the sale of the assets of the joint venture and/or the right dissolve the joint venture if the charitable purposes of the exempt partner are not being fulfilled? 4. Has the tax-exempt partner obtained a written, reasoned, and comprehensive opinion from counsel prior to proceeding with the joint venture transaction? 5. Is the tax-exempt partner the tax matters partner? It is advisable that the exempt partner be the tax matters partner in the joint venture since this will allow it to control all IRS audit and related issues. 6. Has the tax-exempt partner received an ownership interest in the joint venture commensurate with the value of the assets it contributed? 7. Do the joint venture participants receive distributions of earnings in proportion to their capital contributions? 8. Has the exempt partner entered into a noncompete agreement or restrictive covenant that would cause it to yield significant market advantages and competitive benefits to the for-profit partner? 9. Does the joint venture engage the services of independent attorneys and accountants who do not also represent the for-profit partner? 10. Were any financial or other inducements offered to the executives of the nonprofit or members of the governing board for approval of the affiliation? 11. Is the tax-exempt partner providing any guarantees? While not all guarantees are problematic, the IRS views certain guarantees, especially in the low-income housing area, that have the effect of insulating the for-profit partner from potential risk as problematic, since the guarantees increase the potential risk to the nonprofit. (See Section 6.4B for a discussion of low-income housing guarantees.) Board Involvement 12. Does the tax-exempt partner have voting control of the board of the joint venture so that it can exercise effective control over policies, major actions, and decisions that affect its tax-exempt purposes? 13. What criteria are used by the joint venture to select its governing board? 14. What are the qualifications of the members of the governing board of the joint venture, and how much input did the exempt organization have in the selection of these people? 15. Have the board members signed conflict of interest guidelines? 16. Are the members of the board “representative of the community”? 17. Do the governing documents impose on the governing board members a duty to promote the charitable purposes of the nonprofit, which should take precedence over any other fiduciary duty, such as maximizing profits? 18. Does the exempt board have the right to (i) amend or modify the joint venture’s governing documents; (ii) approve the venture’s annual capital
272
c04.fm Page 273 Thursday, March 15, 2007 5:17 PM
JOINT VENTURE CHECKLIST
and operating budgets; (iii) approve distribution of income and additional capital contributions; (iv) approve the venture’s acquisition and disposition of healthcare facilities and equipment; (v) approve large contracts and assumption of indebtedness by the venture; (vi) approve changes in the types of services offered by the venture; (vii) select key executives of the venture and of the healthcare facilities, hire and fire employees, compel an audit, and ensure adequate reserves? 19. Does the operating agreement of the joint venture include a dispute resolution provision that would ensure that, in the event that a disagreement arises between the board and the members over the actions or policies of the joint venture, resolution would favor the exempt partner’s charitable purposes? Healthcare Ventures 20. Do the governing documents of the joint venture require that the services provided by the joint venture promote the health of the community as a whole? 21. Does the joint venture undertake activities for the primary purpose of promoting health rather than to confer private benefits? 22. Does the operating agreement of the point venture include a provision requiring that the venture operate its facilities for charitable purposes and in accordance with the community benefits standard? 23. Does the exempt partner have the responsibility of adopting and setting medical and ethical standards for the joint venture hospitals? 24. Does the exempt partner oversee the quality of healthcare provided? 25. Does the exempt partner determine the prices for the delivery of healthcare or control how the determination is made? 26. Does the joint venture have a substantial charity care program that is consistent with the community benefit requirements? 27. Does the joint venture have an accounting policy that separates bad or uncollectable debts from charity care? Day-to-Day Management 28. Is there a management firm responsible for day-to-day activities? If so, how is it selected? Is there a requirement that the venture engage the services of a management firm that is affiliated with the for-profit partner? 29. What are the terms of the management contract? Is it comparable to similar arrangements in the marketplace? Is the management agreement one that is for a stated and reasonable time period (not to exceed five years)? May it be extended without the consent of the nonprofit? Is the management fee a contingent fee based on revenues generated by the joint venture? The IRS views long-term management contracts and revenue-based management fees unfavorably.
273
c04.fm Page 274 Thursday, March 15, 2007 5:17 PM
JOINT VENTURE CHECKLIST
30. Is the management agreement terminable by the exempt partner if it determines that the management company is not acting in furtherance of its exempt purpose? 31. Is the management company under a binding and enforceable obligation to further the charitable purposes of the nonprofit? 32. Does the management company have the power to restrict the authority of the exempt partner’s board representatives to initiate or react to decisions that would ensure that charitable goals are promoted? 33. Are the duties and responsibilities of the exempt partner within the joint venture meaningful? Management: Healthcare 34. How are executives selected, and who determines their compensation and compensation for the service provider, including the physicians? 35. What are the duties of the management firm? For instance, does the management firm engage in any duties that may conflict with the exempt partner’s purpose to promote the health of a broad section of the community? 36. Do any of the exempt partner’s board member representatives have a financial or other kind of dependency on the hospital, the for-profit entity or the partnership, which would create a conflict of interest with their duty to represent the interests of the community?
274
c05.fm Page 275 Friday, March 9, 2007 12:02 PM
C H A P T E R
F I V E 5
Private Benefit, Private Inurement, and Excess Benefit Transactions 5.1 (a)
WHAT ARE PRIVATE INUREMENT AND PRIVATE BENEFIT? Introduction
The prohibitions against private inurement and private benefit are fundamental to tax-exempt status under §501(c)(3) of the Internal Revenue Code (IRC, “the Code”) and are among the key issues on which the Internal Revenue Service (IRS) focuses in analyzing joint ventures with exempt organizations. This chapter explores the parameters of the doctrines of private inurement and private benefit and examines various types of transactions in which these issues may arise. Some of the most controversial transactions involve nonprofits that offer educational and health services and form joint ventures with commercial entities to provide those services, attempt to attract qualified executive officers by offering competitive compensation packages, and engage in related-party transactions that are not at arm’s length. The critical issue is the primary purpose of the particular transaction and whether public, as opposed to private, interests are being served. In the 1990s several high-profile cases involving financial abuses by public charities received a great deal of publicity. For example, a situation that received continuous first page coverage involved the United Way of America, Inc., and its then-president, William Aramony. Among the controversial issues were a high rate of compensation, luxury travel, and contracts favorable to entities wholly owned by the president and members of his family.1 In a different case, in 1996, a federal grand jury charged the head of the Foundation for New Era Philanthropy, John G. Bennett Jr., with fraud, filing false tax returns, and money laundering in what was called “the largest financial scandal ever to hit a public charity.”2 Bennett was charged with transferring more than $3 million to himself 1
2
Felicity Barringer, “United Way Stops Paying Salary of Ousted Leader,” New York Times (Mar. 18, 1992): B4; Charles E. Shepherd and Bill Miller, “Former United Way Chief Aramony Is Indicted,” Washington Post (Sept. 14, 1994): A1. Sharon Walsh, “Head of Charity Charged with Fraud; New Era Philanthropy Foundation Said to Have Collected $350 Million,” Washington Post (Sept. 28, 1996): C1.
䡲
275 䡲
c05.fm Page 276 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
and accounts he controlled and using funds raised by the Foundation to pay for residences and luxury travel for himself and family members.3 Similarly, in 1996, Frank L. Williams, who had raised millions of dollars for the American Parkinson Disease Association, was sentenced to 15 months in prison for embezzling more than $1 million in contributions to the Association.4 Mr. Williams said that he needed the money because he was living beyond his means and “his $109,000 a year salary was half of what others in his position at comparable charities earned.”5 Since 2000, there have been numerous investigations involving public charities. Most notably, after the September 11 tragedy, spending and management practices at the American Red Cross were examined, culminated in the resignation of the organization’s President.6 More recently, the American Red Cross again came under intense scrutiny for mismanagement of aid funds in the wake of Hurricane Katrina7 These recent examples of financial abuse and mismanagement are not exclusive to disaster relief organizations: In 2006, the Senate Finance Committee concluded an extensive, yearlong investigation of the compensation approved by the Board of American University in Washington, D.C. to its former President.8 These glaring abuses, along with alleged excess compensation in the healthcare area, led to Congressional hearings and the enactment, in 1996, of the “intermediate sanctions” provisions to the Code.9 In 1998, the Treasury Department provided additional guidance by issuing Prop. Treas. Reg. §§53.4958-1-7, which interprets new IRC §4958.10 Until the enactment of intermediate sanctions, the only penalty the IRS could impose on an exempt organization (other than a private foundation) that had engaged in impermissible private benefit or private inurement transactions was revocation of the organization’s exempt status. Although revocation may have been appropriate in the most egregious cases, such instances were rare, and the IRS was left without a fair and effective way to discourage such misconduct. For example, if a low-income housing organization paid excessive compensation to one of its officers, the resulting “inurement” would violate one of the standards for tax exemption, yet revoking the housing organization’s exemption could be an inappropriate response and have an unintended chilling effect on future investments in the low-income housing project. Moreover, prior to the intermediate sanctions rules, even if the exempt organization’s exempt status were revoked, the person who received the excessive compensation would generally 3 4 5 6 7 8 9
10
See id. Lynda Richardson, “Former Charity Head Ordered to Prison,” New York Times (July 31, 1996): B3. See id. Mary Jacoby, “Red Cross President Resigns,” St. Petersburg Times (October 27, 2001). “Red Cross Under Senate Scrutiny,” available at : http://www.cbsnews.com/stories/2005/12/ 29/katrina/main1172203.shtml (Last visited on 9/28/06) Susan Kinzie & Valerie Strauss, “Ladner’s $3.75 Million Deal Severs Ties to American U.,” Washington Post, B01 (October 25, 2005). Pub. L. No. 104-168 (110 Stat. 1452), which added §4958 to the Code. The sanctions apply to §501(c)(3) and §501(c)(4) organizations, but not to trade associations or private foundations (the latter category has its own penalty excise taxes in Chapter 42). Prop. Treas. Reg. §§53.4958-0 through 53.4958-7 (Reg. 246256-96).
䡲
276 䡲
c05.fm Page 277 Friday, March 9, 2007 12:02 PM
5.1 WHAT ARE PRIVATE INUREMENT AND PRIVATE BENEFIT?
be permitted to retain the excessive benefits, hardly a deterrent to accepting an excess benefit. The passage of intermediate sanctions has created a more focused and equitable deterrent to excessive compensation, although numerous questions remain unanswered by the sanctions provisions. Intermediate sanctions are particularly important with respect to joint ventures because of the increased potential for private inurement or private benefit that exists when business is conducted with private parties. For example, the typical joint venture will involve numerous compensation arrangements, service contracts, and, if conducted through a subsidiary established for the purpose of engaging in the joint venture, a separate set of officers and directors who will control the operations of the subsidiary. Each of these elements has potential to raise concerns about private benefit. This chapter describes the concepts of private inurement and benefit as set forth in §501(c)(3) and the law that has developed thereunder. It will also provide a road map for prudent planning in light of the existing body of law regarding private inurement and private benefit, as well as the intermediate sanctions regulations. (b)
Private Inurement and “Insiders”
To qualify for exemption under IRC §501(c)(3), an organization must be organized and operated so that no part of its net earnings “inures to the benefit of any private shareholders or individuals.”11 Unlike the rules that allow an exempt organization to generate an “insubstantial” amount of unrelated business income,12 the law in this case mandates that no portion of the net earnings of the organization may inure to the benefit of a private interest without jeopardizing the organization’s exempt status. Thus, any amount of inurement is impermissible and can also (or in the alternative) trigger imposition of the intermediate sanction rules.13 The Treasury regulations define the words private shareholder or individual as “persons having a personal and private interest in the activities of the organization.” 14 In construing this definition, the IRS and the courts generally have applied the inurement doctrine to transactions between an exempt organization 11
12 13
14
§501(c)(3). See also Reg. §1.501(c)(3)-1(c)(2). See generally Nationalist Movement v. Commissioner, 102 T.C. 588 (1994), aff’d, 37 F.3d 216 (5th Cir. 1994), cert. denied, 513 U.S. 1192 (1995); Retired Teachers Legal Defense Fund v. Commissioner, 78 T.C. 280 (1982); Goldsboro Art League, Inc. v. Commissioner, 75 T.C. 337 (1980), acq., 1986-2 C.B. 1. See Section 2.4(b). See, e.g., Spokane Motorcycle Club v. U.S., 222 F. Supp. 151 (E.D. Wash. 1963). But see Gen. Couns. Mem. 18,924 (Mar. 8, 1978) (IRS applied a de minimis rule to the prohibition against inurement). See also statement of Leslie B. Samuels, Assistant Secretary (Tax Policy), Department of the Treasury, before the Subcommittee on Oversight, Committee on Ways and Means (Mar. 16, 1994) (the IRS and Treasury recognize that in many instances, revocation of exempt status for an inurement violation is an inappropriate and harsh penalty). See Housing Pioneers, Inc. v. Commissioner, 65 T.C.M. (CCH) 2191 (1993), aff’d, 49 F.3d 1395 (9th Cir. 1995), amended 58 F.3d 401 (9th Cir. 1995) (nonprofit organization formed to assist in the provision of affordable housing was denied tax-exemption because the organization violated the inurement proscription). Reg. §1.501(a)-1(c). The proposed intermediate sanction regulations also contain definitions and examples of “insiders.” See Section 5.2(b) and Prop. Reg. §53.4958-3(b)(1).
䡲
277 䡲
c05.fm Page 278 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
and “insiders.”15 An organization’s directors, officers, members, founders, or any other person in a position of control or influence over the exempt organization are usually considered to be insiders.16 In a controversial case, United Cancer Council v. Commissioner,17 the Tax Court held that a third party constituted an insider for private inurement purposes because it had a meaningful opportunity to exercise substantial control over a tax-exempt organization’s activities so as to be able to readily manipulate the exempt organization or its activities to the third party’s benefit, even though that third party lacked any formal voice in the selection of the exempt organization’s directors or officers. In February 1999, the Seventh Circuit reversed and remanded this decision. The appellate court disagreed with the IRS assertion and Tax Court conclusion that the fundraiser could be considered an insider for purposes of inurement. It did, however, remand the case for consideration as to whether the United Cancer Council (UCC) may have allowed impermissible benefit to flow to a private party as a result of possible “imprudence on the part of UCC’s board of directors.”18 In February 2000, the IRS reached a final settlement on all the outstanding tax issues with the United Cancer Council (UCC). The final intermediate sanctions regulations show that the IRS has only partially adopted the position of the Seventh Circuit: an outsider is not converted into a disqualified person by negotiating a contract.19 However, the regulations contain examples that continue to set forth the IRS’s position that once the contract has been entered into, the outsider has been converted into a disqualified person. This position was not upheld by the Seventh Circuit in the UCC case. This is more fully discussed in Section 5.4(b). 15
16
17 18 19
See, e.g., Gen. Couns. Mem. (Oct. 6, 1982). (Investment advisor to title holding corporation had sufficient “private” interest in the activities of the title holding corporation’s parent organization to be subject to the inurement proscription, because the advisor was given broad discretion over the corporation’s real property and was compensated with earnings that otherwise would have been distributed to the owners of the corporation.) See also Gen. Couns. Mem. 39, 498 (Apr. 24, 1986); Gen. Couns. Mem. 39,598 (Dec. 8, 1986); Rev. Rul. 73-313, 1973-2 C.B. 174. The IRS has even gone so far as to conclude that the required insider relationship may exist with employees of an organization who have no other relationship with the organization. See, e.g., Gen. Couns. Mem. 39,498 (Apr. 24, 1986) (physicians newly admitted to the medical staff of an exempt hospital are insiders for purposes of the inurement prohibition even if they were recruited under arms’s length contracts). See Gen. Couns. Mem. 39,670 (Oct. 14, 1987), in which a §501(c)(3) organization established a deferred compensation plan that provided for crediting of amounts plus investment earnings to accounts set up for the benefit of athletic coaches employed by another §501(c)(3) organization. The IRS ruled that the payment of fixed amounts of deferred compensation, together with income earned thereon, as well as additional amounts of current compensation such as life insurance premiums, moving expenses, bonuses, and payment of contract amounts did not result in private benefit or prohibited inurement that would cause the fund to lose its exempt status. The facts indicated that the arrangements were not inconsistent with exempt status, were not the result of other than arm’s length bargaining, and that the compensation packages as a whole did not constitute unreasonable compensation. However, the Tax Court, on at least one occasion, appears to have rejected the IRS position that employees have a close enough relationship to an exempt organization to be insiders for inurement purposes. In Senior Citizens of Missouri, Inc. v. Commissioner, T.C. Memo. 88-493 (1988), the court adopted a private benefit rationale to deny exemption to an organization that paid excessive commissions to employees, but specially rejected an inurement analysis. United Cancer Council, Inc. v. Commissioner, 109 T.C. 17 (Dec. 2, 1997). United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). See discussion of regulations in Section 5.4, as updated.
䡲
278 䡲
c05.fm Page 279 Friday, March 9, 2007 12:02 PM
5.1 WHAT ARE PRIVATE INUREMENT AND PRIVATE BENEFIT?
Although the concept of private inurement lacks precise definition, the essence of private inurement is a prohibition against transactions between a taxexempt organization and insiders who are in a position to exercise control or influence over the organization. 20 According to the IRS, “the prohibition of inurement, in its simplest terms, means that a private shareholder or individual cannot pocket the organization’s funds except as reasonable payment for goods or services.”21, 22 Private inurement is similar to the concept of “self-dealing” by “disqualified persons” in the private foundation context.23 Thus, the self-dealing rules provide guidance as to the types of transactions that may give rise to private inurement. Acts of self-dealing between a disqualified person24 and a private foundation include (1) the sale, exchange, or leasing of property, (2) lending of money or other extension of credit, (3) payment of other than reasonable compensation for services, (4) furnishing of goods, services, or facilities, 25 and (5) transfers of income or assets of the private foundation.26 Unless there are specific exceptions27 in the regulations, self-dealing, in the context of private foundations as to the self-dealer or disqualified person, is a per se test that does not look to the 20 21
22
23
24
25
26 27
As discussed in Section 5.2(b), the concept of control is the fundamental criterion used in the definitions of disqualified persons in the intermediate sanctions provisions. IRS Exempt Organizations Handbook (IRM 7751), §342.1(3); see also Statement of Howard M. Schoenfeld, Special Asst. for Exempt Organization Matters, and Marcus S. Owens, Director, Exempt Organization Technical Division, Internal Revenue Service on IRS Compliance Activities Involving §501(c)(3) Public Charities Before the Subcommittee on Oversight, House Committee on Ways and Means (Aug. 2, 1993). See, e.g., Page v. Commissioner, 66 T.C.M. 571 (1993), aff’d, 58 F.3d 1342 (8th Cir. 1995) (substantial private inurement existed when a vast amount of a church’s expenditures went to the minister and his family’s personal living expenses). In a letter ruling addressing a §501(c)(3) organization’s scholarship program, the Service ruled that scholarships awarded to relatives of community foundation officials, who are responsible for preliminarily selecting candidates, do not constitute private inurement, so long as the organizations involved adhere to strict program guidelines. The Service declined to answer whether such awards constitute an excess benefit transaction. However, in a general information letter, the Service stated that ordinarily an excess benefit transaction would not result if the community foundation official recuses herself from the selection process of the applicant. Priv. Ltr. Rul. 200332018 (Aug. 8, 2003). In the private foundation context, the rules are clear: Certain transactions between disqualified persons and private foundations constitute prohibited acts of self-dealing. §4941(d); See also Priv. Ltr. Rul. 94-08-006 (Feb. 25, 1994) (B and C are directors of a private foundation, A. B used A to promote C’s artwork and advance her career. B prominently displayed C’s work at exhibitions underwritten by A. The facts demonstrate that A’s assets were used to promote C’s artwork and to advance C’s career. The IRS held that each instance in which A made a payment or incurred an expense on C’s behalf was an act of self-dealing. Each payment resulted in a direct economic benefit to C because it relieved C of the economic burden of making the payments. A disqualified person means, with respect to any private foundation, an individual who is a substantial contributor to the foundation; a foundation manager; an owner of more than 20 percent of the voting power of a company or profits interest of a partnership, which entity is a substantial contributor; a family member of one of the aforementioned; a partnership where one of the aforementioned owns more than 35 percent; or a trust or estate. §4946(a)(1). In Priv. Ltr. Rul. 2000-14-040 (April 7, 2000), a donation of real estate from the directors of a private foundation to the private foundation was found not to be self-dealing, because the real estate was not encumbered by a mortgage and the donors received no financial benefit in return for the donation. §4941(d)(1)(A) through (E). See Reg. §53.4941(d)-3; Reg. §53.4941(d)-4. One such exception is provided in the administration of estates. Reg. §53.4941(d)-(1) (b) (8), example 5. See, e.g., Priv. Ltr. Rul. 95-25-056 (Mar. 27, 1995).
䡲
279 䡲
c05.fm Page 280 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
“reasonableness” or arm’s length nature of the transactions. In contrast, private inurement, as applied to all IRC §501(c)(3) organizations, looks to the reasonableness of the benefit or compensation. Therefore, not all acts of self-dealing would be considered acts of private inurement. The intermediate sanctions provisions use a different term, “excess benefit” transactions, to refer to an impermissible situation in which a disqualified person receives a financial benefit greater than the consideration given for the benefit. (c)
Distinction Between Private Benefit and Private Inurement
The private inurement proscription is in addition to the requirement that an organization must be organized and operated exclusively for an exempt purpose.28 Thus, a charitable organization must serve a public rather than a private interest.29 In this regard, the regulations provide that it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.30 There are two primary distinctions between inurement and private benefit. First, the proscription against private benefit has broader application because it applies to activities involving unrelated third parties—it is not limited to activities with insiders. 31 For example, in American Campaign Academy v. Commissioner, 32 one of the issues before the Tax Court was whether the prohibition against private benefit is limited to situations in which the benefits have accrued to an organization’s insiders. The court held that the prohibition against private benefit is not so limited; it embraces benefits to “disinterested persons” as well.33 Thus, there are circumstances in which there can be disqualifying private benefit even when there is no private inurement.
28
29
30
31 32 33
Reg. §1.501(c)(3)-1(d). Although separate, the private benefit and private inurement proscriptions often overlap. However, violation of either doctrine will result in revocation of the organization’s tax-exempt status. See, e.g., Church by Mail, Inc. v. Commissioner, 765 F.2d 1387 (9th Cir. 1985); Orange County Agricultural Soc’y Inc. v. Commissioner, 893 F.2d 529 (2d Cir. 1990). Reg. §1.501(c)(3)-1(d)(1)(ii). See also Variety Club Tent No. 6 Charities, Inc. v. Commissioner, 74 T.C.M. (CCH) 1485; T.C.M. (RIA) ¶ 97,575 (1997); Airlie Foundation, Inc. v. United States, 826 F. Supp. 537 (D.D.C. 1993), aff’d, 55 F.3d 684 (D.C. Cir. 1995); Bob Jones University Museum & Gallery Inc. v. Commissioner, 71 T.C.M. (CCH) 3120 (1996) (museum’s application for exempt status was denied because its operation resulted in substantial private benefit to Bob Jones University, which was itself previously denied exemption owing to its ban on interracial dating and marriage); Kentucky Bar Foundation, Inc. v. Commissioner, 78 T.C. 921 (1982). Reg. §1.501(c)(3)-1(d)(1)(ii). However, substantial domination of an organization by its founder does not necessarily violate the private benefit proscription. Nationalist Movement v. Commissioner, 102 T.C. No. 22 (Apr. 11, 1994); Church of Visible Intelligence That Governs Universe v. United States, 4 Ct. Cl. 55, 62 (1983); Bubbling Well Church v. Commissioner, 74 T.C. 531, 535 (1980), aff’d, 670 F.2d 104 (9th Cir. 1981). See, e.g., Airlie Foundation, Inc. v. United States, 826 F. Supp. 537 (D.D.C. 1993), aff’d, 55 F.3d 684 (D.C. Cir. 1995) (extent of inurement is immaterial). See id. American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). American Campaign Academy, 92 T.C. at 1068–69.
䡲
280 䡲
c05.fm Page 281 Friday, March 9, 2007 12:02 PM
5.1 WHAT ARE PRIVATE INUREMENT AND PRIVATE BENEFIT?
Second, unlike the inurement doctrine, the prohibition against private benefit is not absolute, that is, a certain level of private benefit is permissible. The Treasury regulations provide that: [A]n organization will be regarded as “operated exclusively” for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes. An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose34 (Emphasis added).
In interpreting this regulation, the courts and the IRS have applied different standards for determining permissible levels of private benefit. For example, when an activity has been carried on both for an exempt and a nonexempt purpose, many courts base their decisions (1) on whether the primary purpose of the activity is exempt or nonexempt or (2), alternatively, on whether there is a substantial nonexempt purpose.35 When a particular activity is nonexempt, many courts focus on whether the private benefit resulting from such activity is more than insubstantial.36 In addition, the IRS has adopted an “incidental” test that is used in conjunction with the substantiality test. The courts weigh the substantiality of the private benefit to the individual from an activity against the total public benefit conferred by the activity. Then, under the incidental test, the courts determine whether the private benefit from the particular activity is incidental to the public benefit from the activity, both in a qualitative and quantitative sense.37 “Qualitatively incidental” means that the exempt organization could not avoid conferring the private benefit in achieving its public benefit. “Quantitatively incidental” means that the private benefit is not substantial as compared with the overall public benefit conferred by the activity. EXAMPLE: Physicians on staff at an exempt hospital rented land for 99 years from the hospital for an annual rental of one dollar. The physicians planned to build a medical office building on the land. The IRS concluded that the physicians derived more than an incidental benefit from the lease transaction, in both a qualitative and quantitative sense. The IRS reasoned that “the significant private benefit derived by the doctors (land at essentially no cost) is by no means a necessary concomitant of the hospital’s desired end. The hospital could accomplish the same result by renting the land at whatever its fair market value might be. Viewed in the context of the overall public benefit conferred by having a medical arts building, the benefit bestowed on the physicians was more than incidental.38 34
35 36 37
38
Reg. §1.501(c)(3)-1(c)(1). See also Better Business Bureau v. United States, U.S. 279 (1940) (the Court held that an organization is not operated excusively for charitable purposes if it has a single noncharitable purpose that is substantial in nature). See, e.g., Christian Manner International v. Commissioner, 71 T.C. 661, 667-71 (1979); B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352, 356–57 (1078). See, e.g., Kentucky Bar Foundation v. Commissioner, 78 T.C. 921, 923 (1982); American Campaign Academy, 92 T.C. at 1065–66. See, e.g., Gen. Couns. Mem. 39,598 (Dec. 8, 1986); Gen. Couns. Mem. 39,498 (Apr. 24, 1986). Under this test, the private benefit will be qualitatively incidental if the benefit to the public cannot be achieved without necessarily benefiting certain private individuals. It will be quantitatively incidental if the private benefit is not found to be substantial after considering the overall public benefit resulting from the activity. Gen. Couns. Mem. 37,789 (Dec. 18, 1978).
䡲
281 䡲
c05.fm Page 282 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
The prohibition against private benefit must also be analyzed in terms of the recipient of the benefit. In American Campaign Academy v. Commissioner,39 the Tax Court issued an extraordinary opinion that drew a distinction between “primary” and “secondary” private benefit. The court upheld the IRS position that the Academy, which conferred substantial private benefits on Republican entities and candidates, did not qualify as an exempt educational institution on the grounds that nearly all of the school’s graduates became employees of or consultants to these entities or candidates. Specifically, no known graduate of the Academy had affiliated with any domestic political party other than the Republican Party. The Academy trained individuals for careers as political campaign professionals such as campaign managers and finance directors. The Academy clearly qualified as a school in that it had a regular curriculum, regular faculty, and a full-time student body. 40 The Academy was an outgrowth of the National Republican Congressional Committee (NRCC), an association of Republican members of the House of Representatives. It was agreed by the parties that the Academy did not intervene in political campaigns nor engage in any legislative activities. The IRS further conceded that the Campaign Academy’s net earnings did not inure to the benefit of any private individuals. The court’s decision turned on the presence of impermissible “secondary” private benefit as opposed to “primary” private benefit. The court was not troubled by the beneficiaries of the primary private benefit—in this case, the students; rather, it was the beneficiaries of the secondary private benefit—the employers— that caused the Academy not to qualify for exemption under IRC §501(c)(3). The Academy contended that because all educational programs inherently benefit both the student (by increasing his or her skills and future earnings) and the eventual employer (who profits from the services of trained individuals), the educational benefits it provides should not be construed as prohibited private benefits. The court determined that the Academy’s activities benefited the private interests of Republican entities and candidates more than incidentally and therefore constituted a substantial nonexempt purpose. The court further held that prohibited private interests include those of unrelated third parties. An organization’s conferral of benefits on disinterested persons may cause it to serve “a private interest” within the meaning of the statute.41 The court explained that 39
40
41
American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). But see Rev. Rul. 76456, 1976-2 C.B. 151 (an organization collected, collated, and disseminated information concerning general campaign practices on a nonpartisan basis. The organization also furnished “teaching aids” to political science and civics teachers. Emphasizing the organization’s nonpartisan nature, the IRS determined that the organization exclusively served a public purpose by enouraging citizens to increase their knowledge and understanding of the election process and participate more effectively in their selection of government officials); Rev. Rul. 72-512, 1972-2 C.B. 246 (no inurement was found when a nonpartisan educational purpose was advanced by a university through means of a political science course that required each student to participate for a two-week period in the political campaign of a candidate of his or her choice). See Reg. §1.170A-9(b)(1) (a school’s “primary function is the presentation of formal instructions and [a school] normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils”). Reg. §1.501(c)(3)-1(d)(1)(ii).
䡲
282 䡲
c05.fm Page 283 Friday, March 9, 2007 12:02 PM
5.1 WHAT ARE PRIVATE INUREMENT AND PRIVATE BENEFIT?
the term disinterested is used to distinguish persons who are not private shareholders or individuals having a personal and private interest in the activities of the organization. Thus, non-incidental benefits conferred on disinterested persons may serve private interests. The court found that the Academy conducted its educational activities with the partisan objective of benefiting Republican candidates and entities, namely that (1) the Academy was incorporated by the general counsel of the NRCC, (2) its Application for Recognition of Exemption stated that its training program was an outgrowth of the program run by the NRCC, (3) its activities were exclusively funded by the National Republican Congressional Trust, (4) two of its three initial directors had significant ties to the Republican Party, (5) its bylaws authorized the Republican majority of the board to have general charge of the affairs, property, and assets of the corporation, and (6) the Academy instituted a curriculum that included studies of such topics as “Growth of NRCC” and “Why Are People Republicans?” The Academy unsuccessfully cited as precedent several IRS revenue rulings allowing tax exemption to organizations that provide training to individuals in a particular industry or profession.42 The court accepted the IRS’s characterization of these rulings, which was that “the secondary benefit provided by each ruling was broadly spread among members of an industry as opposed to being earmarked for a particular organization or person.” The court explained that the secondary benefit in those rulings was merely incidental to the organization’s exempt purpose and, therefore, not a substantial nonexempt purpose.43 The court held that when the training of individuals is focused on furthering a particular targeted private interest, the conferred secondary benefit ceases to be incidental to the providing organization’s exempt purposes. However, where secondary benefits are broadly distributed (i.e., to employers of union members within an industry, banks within an urban area, members and designees of a local bar association) as opposed to being earmarked for a particular organization or person, they become incidental to the organization’s exempt purposes. The Academy also argued that the secondary benefit concept was inapplicable to it because the secondary beneficiaries were representatives of a charitable class (i.e., the millions of individuals who constitute the Republican Party). However, the court concluded that size alone does not transform a benefited class into a charitable class. Practitioners are concerned that the IRS could attempt to extend the secondary benefit doctrine to other situations. Many would argue that the court wrongly decided the case under the private benefit analysis, because a school confers private 42
43
See Rev. Rul. 72-101, 1972-1 C.B. 144 (six-week full-time training program created as a result of collective agreements and funded by industry employers to train individuals working or desiring to work in that industry); Rev. Rul. 67-72, 1967-1 C.B. 125 (organization created as a result of collective bargaining and funded jointly by labor and management to conduct an industry-wide apprentice training program for interested individuals seeking to qualify for employment as journeymen anywhere in the industry); Rev. Rul. 68-504, 1968-2 C.B. 211 (organization with a membership open to all bank employees in a particular urban area operated to conduct an educational program and publish a professional magazine); Rev. Rul. 75196, 1975-1 C.B. 155 (organization supported by a local bar association to maintain a law library for the use of bar association members and their designees). American Campaign Academy, 92 T.C. at 1074.
䡲
283 䡲
c05.fm Page 284 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
benefit on its students as well as on those for whom the students work. Query: Should a university lose its tax exemption because its law school confers primary benefits on law students and secondary benefits on the employers of the graduates? The IRS will most likely limit the holding in American Campaign Academy, with regard to its application of the secondary benefit concept, to similar fact patterns.
5.2
TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
Private benefit and inurement can occur in a variety of financial transactions engaged in between exempt and for-profit organizations, including, inter alia, the payment of unreasonable compensation, borrowing transactions that are not at arm’s length, transfers of the organization’s income or assets, and the issuance of IRC §501(c)(3) bonds. Each of these types of financial transaction is discussed in the following sections. The proposed intermediate sanctions regulations specify that the excise taxes of IRC §4958 do not “affect the substantive statutory standards for taxexemption under §§501(c)(3) or (4). Organizations are described in those sections only if no part of their net earnings inure to the benefit of any private shareholder or individual.”44 Thus, the existing body of law is not superseded by the intermediate sanctions law and proposed regulations, although we fully expect the developing guidance under §4958 to have an impact on the principles of inurement and private benefit in the future—and vice versa, as their concepts are interrelated. It is therefore necessary to be acquainted with the private benefit and inurement law as it existed prior to adoption of §4958, both because the concepts of private benefit and inurement are “alive and well” (and impact on exemption itself) and because the body of law thereunder is similar to or parallel to the intermediate sanctions concepts. (a)
Compensation for Services
(i) Introduction. Although many individuals donate their services to exempt organizations as directors or volunteers, many other individuals derive their livelihood as employees or managers of such organizations. The managers of a joint venture with an exempt organization generally expect to be compensated for their services in the same way they would be compensated in purely private sector employment. As one court observed, “the law places no duty on individuals operating charitable organizations to donate their services; they are entitled to reasonable compensation for their efforts.”45 However, as discussed in §§5.1(a) and 5.2, in the 1990s the IRS became increasingly concerned about the compensation paid to the top executives of exempt organizations.46 44 45
46
Prop. Reg. §53.4958-7(a). World Family Corporation v. Commissioner, 81 T.C. 958, 969 (1983). See Founding Church of Scientology v. United States, 412 F.2d 1197 (Ct. Cl. 1969), cert. denied, 397 U.S. 1009 (1970); The Ecclesiastical Order of the ISM of AM, Inc. v. Commissioner, 80 T.C. 833 (1983). In Priv. Ltr. Rul. 2000-14-040 (April 7, 2000), a donation of real estate from the directors of a private foundation to the private foundation was found not to be self-dealing, because the real estate was not encumbered by a mortgage and the donors received no financial benefit in return for the donation.
䡲
284 䡲
c05.fm Page 285 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
Whether or not there are any exempt entities as partners in a joint venture, nonexempt partners face the same issue of reasonable compensation (and the more stringent guideline of the intermediate sanctions proposed regulations) that plagues many commercial entities—deductibility under IRC §162.47 The presence of an exempt organization as a joint venture partner introduces additional key concerns, however. The first concern is whether any of the financial or nonfinancial arrangements contemplated by the joint venture results in the inurement of any portion of the exempt organization’s earnings to an insider— for example, a manager of the joint venture. The second concern is whether the participation of the exempt organization in the joint venture confers a benefit on private individuals that is so substantial as to provide evidence that the exempt organization is operating for private benefit rather than for its exempt purpose.48 The third concern, which can be related to the first two, is whether a transaction constitutes an excess benefit transaction. Compensation is one of the more sensitive and troublesome, yet common, contexts in which these basic proscriptions apply.49 The law of exempt organizations has borrowed the nomenclature from the for-profit sector: Compensation is said to be “reasonable” when the total compensation package is found to be reasonable relative to the services provided to the exempt organization.50 Moreover, the proposed regulations and the legislative history of IRC §4958 states that the body of law under IRC §162 should be applied in intermediate sanctions cases: “Existing tax law standards apply in determining reasonableness of compensation and fair market value.”51 Preliminarily, it is important to understand that compensation includes all forms of payments and benefits provided to or on behalf of those who provide services to the joint venture—for example, salary and wages, pension and profit 47
48 49
50
51
Congress responded to these concerns in the 1993 Act by adding §162(m) to the Code, imposing a $1 million ceiling on deductible compensation paid to executives of publicly traded corporations. See Chapter 12 for a case study concerning hospital physicians and private inurement. For an example of the level of the IRS’s concern with compensation arrangements, see the discussion of the IRS physician recruitment guidelines in Sections 5.2(a)(iii) and 11.4(c). Bonuses given to offset inadequate starting salaries are considered compensation. Such payments for undercompensated past services have been found “reasonable” by the Tax Court. Mad Auto Wrecking, Inc. v. Commissioner, 69 T.C.M. (CCH) 2330 (1995); but see Modernage Developers, Inc. v. Commissioner, 66 T.C.M. 1575, aff’d, 52 F.3d 310 (2d Cir. 1995); Donald Palmer Co. v. Commissioner, 69 T.C.M. 1869 (1995), aff’d, 96-1 U.S. Tax Case. (CCH) ¶ 50, 221 (5th Cir. 1996). See, e.g., Gen. Couns. Mem. 39,498 (Apr. 24, 1986) (with regard to compensation arrangements, a particular arrangement may result in inurement of earnings to private individuals and may indicate that private rather than public interests are being served. In this context, a question arises as to whether persons performing services, as a class, must have a controlling or “insider” relationship with an organization before private benefit or prohibited inurement can occur. Physicians employed by a hospital who were recruited under arm’s length contracts, and who were not directors or officers or otherwise in control of the hospital, were found to have a “close professional working relationship” with the organization, and, therefore, even without any other connection with the organization, those individuals had a personal and private interest, rather than a public interest, in the activities of the organization, and those individuals were therefore subject to the inurement proscription); Alive Fellowship of Harmonious Living v. Commissioner, 47 T.C.M. 1134 (1984); World Family Corporation v. Commissioner, 81 T.C. 958 (1983). Taxpayer Bill of Rights 2, P.L. 104-168 (July 30, 1996) House Explanation and Prop. Reg. §§53.4958-4(b)(3)(i).
䡲
285 䡲
c05.fm Page 286 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
sharing plan contributions, deferred compensation, payment of personal expenses, fringe benefits, rents, royalties and other fees, and personal use of the joint venture’s property or facilities. In addition, compensatory transfers of noncash property are also treated as compensation.52 For instance, in a private letter ruling, the IRS ruled that when equity interests in a joint entity are granted to directors as compensation, the effect of the transfers will depend on whether the value of the equity interests represents reasonable compensation.53 In 2005, the issue of excessive compensation emerged as one of the most scrutinized areas in nonprofit management. In August 2005, the California attorney general’s office opened an inquiry into financial practices at the J. Paul Getty Trust, the world’s richest art institution. At particular issue in the investigation are alleged patterns of excessive spending and, specifically, compensation paid to Barry Munitz, the Trust’s Chief Executive Officer. In 2004, Munitz received over $1.2 million in total compensation (including $72,000 to provide him with a Porsche Cayenne SUV), making Munitz the one of the nation’s highest-paid nonprofit leaders. If state regulators conclude that there has been a misuse of the Trust’s resources, outcomes may include the imposition of penalties, repayment of misspent funds, and the removal of those trustees who approved the abusive transactions.54 Another sign of the growing inquiry into alleged excessive compensation is the vote taken by the Board of Trustees of American University on October 10, 2005, dismissing President Benjamin Ladner and requiring him to reimburse the university $125,000 and add $398,000 to his taxable income for the past three years.55 In an October 27, 2005, letter to the acting board chair of American University, Senate Finance Committee chair Charles Grassley said he was “deeply troubled” by reports of large payments made to Ladner, which “raise significant questions about what other things a charity that has such a cavalier attitude towards the tax laws might be doing.”56 Grassley requested that American University provide the Committee with copies of Ladner ’s employment contract, deferred compensation, severance plans, and any other compensation agreements.57 (ii) Reasonableness Requirement (A) G ENERAL R ULE The compensation paid by a joint venture to individuals who provide services must be reasonable.58 In this regard, compensation is considered reasonable if it 52 53 54 55 56 57 58
See Prop. Reg. §§53.4958-4(b)(2) and (3) and Section 5.2(a) for a discussion of the elements of compensation in the intermediate sanctions proposed regulations. Priv. Ltr. Rul. 92-42-038 (July 22, 1992). Robin Fields and Jason Felch, “State Examines Spending at Getty,” L.A. Times, August 2, 2005 at B1. Valerie Strauss and Susan Kinzie, “Second Trustee Critical of Ladner Departs American University Board,” Washington Post, October 13, 2005 at B2. Fred Stokeld and Christopher Quay, “Grassley Wants Answers from American University,” Tax Analysis Tax Notes Today (October 31, 2005). Id. Mabee Petroleum v. U.S., 203 F.2d 872 (5th Cir. 1953) (individuals who operate charitable organizations are entitled to reasonable compensation for their services).
䡲
286 䡲
c05.fm Page 287 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
is in an amount that would ordinarily be paid for similar services by comparable organizations under like circumstances.59 (B) F ACTORS C ONSIDERED IN D ETERMINING R EASONABLENESS The following is a nonexclusive list package of factors that the IRS and the courts consider in determining whether a compensation of an employee, manager, or third party is reasonable.60 • Arm’s Length Negotiation. Most cases and rulings cite arm’s length negotia-
tions as an important factor in judging reasonableness. However, the lack of arm’s length negotiation does not make the compensation unreasonable as a matter of law.61 • Comparable Services from a Third Party. If the joint venture or partnership
could obtain comparable services from an outside source at a lower cost, this fact would indicate that the compensation is unreasonable.62 • Nature of Duties. The reasonableness of compensation should be based on
an individual’s levels of skill, education, and expertise. For example, a hospital radiologist’s compensation was found to be unreasonable when compared with that of other radiologists with similar responsibilities and volume of patients.63 • Background and Experience. The employee’s education, prior experience,
and expertise are important factors in determining the reasonableness of the compensation paid. For example, a higher salary than normal may be warranted when an employee is particularly well qualified for a position.64 • Salary History. A substantial increase in compensation over the compensa-
tion received in prior positions may be a factor in judging reasonableness.65 • Contribution to the Organization’s Success. In a for-profit company, an
employee’s contribution to a business is typically measured by its financial 59
60
61 62 63
64 65
Cf. Reg. 1.162-7(b)(3) (in any event, the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned). See Mad Auto Wrecking, Inc. v. Commissioner, 69 T.C.M. 2330 (CCH) (1995) (the court applied a fourteen-factor test in concluding that the corporation’s bonuses represented reasonable compensation. Significantly, the court found that seven factors favored the corporation, six factors were neutral, one factor did not apply, and none of the factors favored the IRS). World Family Corporation, 81 T.C. at 969. Church by Mail v. U.S., 48 T.C.M. 471 (1984). See, e.g., B.H.W. Anesthesia Foundation, Inc. v. Commissioner, 72 T.C. 681 (1979). Rev. Rul. 69-383, 1969-2 C.B. 113. See also Rapco, Inc. v. Commissioner, 69 T.C.M. 2238 (CCH) (1995), aff’d, 85 F.3d 950 (2d Cir. 1996)(bonus payments made under a compensation package that did not consider industry norms or performance standards was deemed unreasonable). Home Oil Mill v. Willingham, 68 F. Supp, 525 (D.C. Ala. 1945), aff’d, 181 F.2d 9 (5th Cir. 1950), cert. denied, 340 U.S. 852 (1950). See Northern Illinois College of Optometry v. Commissioner, 2 T.C.M. 664 (1943) (an increase of more than 400 percent in the salaries of the employees’ family-run college of optometry was unreasonable). Lack of a set formula for compensation amounts may also be a factor in determining reasonableness. See, e.g., Dexsil Corp. v. Commissioner, 69 T.C.M. 2267 (CCH) (1995).
䡲
287 䡲
c05.fm Page 288 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
success. In the context of an exempt organization, reasonableness is evaluated based on a determination about the value of the employee’s services to the exempt organization.66 Where the employee’s services do not contribute importantly to furthering the organization’s exempt purposes, the reasonableness of his or her compensation may be called into question. • Time Devoted. The amount of time spent performing services for an orga-
nization is an important factor in judging the reasonableness of the compensation.67 For example, an exempt organization should record the type of service performed, the amount of time devoted by an employee to the task, and the amount of compensation paid to the employee. • Size of the Organization. The size and complexity of an organization is a
factor used to judge the reasonableness of the compensation paid to its employees. A large organization may be able to justify paying a higher salary than a small organization, on the ground that the employee has increased responsibilities and duties.68 (iii) Special Limitations on Incentive Compensation Arrangements (A) I NCENTIVE F ORMULA M UST P ROMOTE E XEMPT G OALS The IRS has emphasized that the level of compensation must be sufficient to allow the organization to attract and retain skilled employees, and must also serve to promote the objectives of the exempt organization. For example, the IRS approved an incentive plan designed “to recognize and reward employee performance, encourage cost containment, motivate and reinforce efficiency and quality of service, and provide compensation competitive with that offered by other employers.”69 However, if the incentive formula is likely to encourage individuals to promote their own financial interests through a course of conduct that would be inconsistent with the objectives of the exempt organization, the IRS is likely to conclude that the plan results in private inurement or private benefit.70 For example, the Tax Court found a private inurement violation in a compensation arrangement under which a tax-exempt clinic paid physicians and dentists, who were also trustees of the exempt clinic, salaries based on the ratio of each physician’s charges to total charges, patient visits to total visits, and new patients to all new patients.71
66 67 68 69
70 71
Gen. Couns. Mem. 39,498 (Apr. 24, 1986). Church by Mail v. Commissioner, 48 T.C.M. 471 (1984) (the court emphasized that two ministries devoted only 60 percent of their time to the organization but were paid $160,000). Home Oil Mill v. Willingham, 68 F. Supp. 525 (D.C. Ala. 1945), aff’d, 181 F.2d 9 (5th Cir. 1950), cert. denied, 340 U.S. 852 (1950). Gen. Couns. Mem. 39,674 (Oct. 23, 1987); see also Gen. Couns. Mem. 35,638 (Jan. 28, 1974) (the IRS approved a hospital’s incentive plan that was designed “to increase individual productivity and to lower unitary costs and charges while nonetheless maintaining the maximum possible quality of care at all times.”) Gen. Couns. Mem. 35,638 (Jan. 28, 1974). Lorain Avenue Clinic v. Commissioner, 31 T.C. 141 (1958). But see the determination letter issued to Marietta Health Care Physicians, Inc. In the ruling, the IRS approved a physician compensation package that included a productivity bonus. The compensation structure, which “was the product of lengthy negotiations between the taxpayer and the IRS,” based the bonus in part on a number of traditional factors—efficiency, quality of care rendered, patient satis
䡲
288 䡲
c05.fm Page 289 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
(B) C OMPENSATION B ASED ON R ECEIPTS OR E ARNINGS Compensation based on gross receipts or income earned by an exempt organization can give rise to unreasonable compensation issues because of the variability in compensation levels under such arrangements. However, tying compensation to receipts or earnings will not automatically result in inurement or private benefit. The key question is whether there are sufficient restrictions to ensure that total compensation will be reasonable—that is, is there a “cap” on total compensation?72 For example, fund-raising commissions that “are directly contingent on [the] success in procuring funds” have been held to be an “incentive well suited to the budget of a fledgling organization.”73 Similarly, the IRS concluded that the establishment of incentive compensation plans for hospital employees, with payments determined as a percentage of the excess of revenues over the budgeted level, does not constitute private inurement when the plans are not devices to distribute profits to principals and are the result of arm’s length negotiations.74 faction, hours worked, and level of experience and expertise required. However, the bonus also relied on nontraditional factors, taking into account the number of Medicare and Medicaid patients treated, the number of charity care patients treated, and the physician’s participation in community education and scientific programs. See also C.G. Wilkinson Physician Network, 14 Exempt Org. Tax. Rev. 307 (1996); Ranier Oncology Professional Services, 15 Exempt Org. Tax Rev. 442 (1996); North Shore Medical Specialists, 16 Exempt Org. Tax Rev. 104 (1997). See also Rev. Rul. 97-21, 1997 I.R.B. 1, in which the IRS issued published guidance concerning the tax consequences of tax-exempt hospital physician recruitment activities. Rev. Rul. 97-21 is discussed in detail in Section 12.3 as are the issues of incentive compensation and gain sharing in the healthcare field. Chapter 12 also contains a discussion of a private letter ruling that was issued by the IRS and released by the attorney for the nonprofit organization which received it. In the ruling, which as of the time of this writing had not been released by the IRS, the IRS determined that the physician recruitment incentive program designed by the nonprofit was permissible because it would result in reasonable compensation being paid. Also see Carolyn Wright, “Unreleased Letter Ruling Clarifies Physician Recruitment Guidance,” Exempt Organization Tax Review 10 (July 1999): 16. 72
73
74
See, e.g., Gen. Couns. Mem. 32,453 (Nov. 11, 1962) (IRS lists factors that it will consider in reviewing incentive compensation arrangements). Also see Jean Wright and Jay H. Rotz, “Reasonable Compensation,” Continuing Professional Education Exempt Organizations Technical Instruction Program for 1993 (hereinafter the “1993 CPE Reasonable Compensation Article”). World Family Corp., 81 T.C. at 970 (1983). The court noted that a contingent fee arrangement made by a tax-exempt entity is not per se unreasonable. Such arrangements are a part of business life and must occasionally be paid by a charity to salesmen, publishers, support groups, and even fund-raisers. The court relied on several factors in determining the reasonableness of the compensation, including (1) whether comparable services would cost as much if obtained from an outside source in an arm’s length transaction; (2) whether the commissions are payable to any individual who procures contributions for petitioner, rather than particular persons; (3) whether commissions are directly contingent on success in procuring funds and as such are tied to services rendered; and (4) whether the commissions are equal to or below the amount of commissions specified by state statute (up to 30 percent in some statutes) to fund-raisers. The court held that these elements distinguished this commission arrangement from other arrangements found by the courts to constitute private inurement. In other cases, some percentage of receipts or salary was routinely designated for one dominant individual, and he was entitled to receive this income whether or not he rendered services to the payor organization. In Gemological Institute of America v. Commissioner, 17 T.C. 1604 (1952), aff’d 212 F.2d 205 (9th Cir. 1954), a percentage of earnings was earmarked for a dominant individual in a manner arguably related to services rendered. This court found private inurement, however, because the percentage was so high—50 percent. Such a percentage, especially when specifically designated for only one individual, is clearly unreasonable. Gen. Couns. Mem. 39,674 (Oct. 23, 1987). In Rev. Rul. 69-383, 1969-2 C.B. 113, the IRS ruled that a hospital’s compensation arrangement with a radiologist did not result in private inurement, in part, because the radiologist did not exercise control over the hospital and the agreement was negotiated at arm’s length.
䡲
289 䡲
c05.fm Page 290 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
On the other hand, the Tax Court has held that compensation based on a percentage of an exempt organization’s gross receipts constituted private inurement when there was no upper limit on the amount of total compensation.75 At this time relatively few of the cases and rulings in the reasonable compensation area involve a joint venture fact pattern. However, contractual arrangements outside the joint venture context are highly relevant even if the relationship between the parties does not rise to the level of a formal joint venture.76 Indeed, if the compensation arrangement involves the sharing of profits, the IRS may treat it as a partnership, regardless of the formal structure or how the parties treat the arrangement.77 For example, the courts and the IRS have held that the presence of a percentage compensation agreement will jeopardize an organization’s exemption under IRC §501 (c)(3) when the arrangement is merely a device for distributing profits to persons in control or when it transforms the arrangement into a joint venture between the exempt organization and private individuals.78 (b)
Loans
A loan made from the assets of a charitable organization will be closely scrutinized by the IRS to verify that the terms and conditions of such loan arrangements are reasonable and that the loan furthers the organization’s exempt purpose. Issues of inurement and private benefit are likely to be raised if the borrower fails to pay market interest to the exempt organization, to provide adequate security, or to repay the loan in a timely manner. For example, in Lowry Hospital 75
76
77 78
See People of God Community v. Commissioner, 75 T.C. 127 (1980), wherein the Tax Court revoked the exemption of a religious organization that paid its ministers a predetermined percentage of the gross tithes and offerings received. Each minister’s percentage was based on what he received in the prior year, adjusted upward to reflect his increased personal expenses such as home improvements and taxes, and downward to the extent that larger gross receipts permitted an increase in the compensation. No upper limit was set for the total amount a minister could receive under the formula. The court reasoned that because all of the organization’s operating revenues were derived from tithes and offerings, the revenues must be considered “earnings” for purposes of §501(c)(3). The court held that whatever the ministers’ services were worth, their worth was not directly related to the organization’s gross receipts. By basing compensation on a percentage of the organization’s gross receipts, subject to no upper limit, a portion of the organization’s “earnings” was being passed on to the ministers. The court held that paying over a portion of gross earnings to those vested with the control of a charitable organization constitutes private inurement. For example, in Priv. Ltr. Rul. 92-42-038 (July 22, 1992), the transaction involved compensatory transfers by an exempt organization of equity interests that were corporate stock (as opposed to profits interests in a partnership) from its wholly owned corporation (as opposed to a partnership). Nevertheless, the ruling is relevant to joint ventures in partnership form. The IRS ruled that the exempt organization could provide reasonable compensation to its directors in the form of common stock of the corporation. The compensation was based on the services rendered by the directors, and the exempt organization used the fair market value of the stock to pay the reasonable compensation. See generally Section 3.2; Section 3.3. See, e.g., Rev. Rul. 69-383, 1969-2 C.B. 113; Birmingham Business College v. Commissioner, 276 F.2d 476 (5th Cir. 1960). See, e.g., Airlie Foundation, Inc. v. United States, 826 F. Supp. 537 (D.D.C. 1993), aff’d, 55 F.3d 684 (D.C. Cir. 1995) (tax-exempt organization violated the private inurement proscription when it forgave accrued interest owed to it by a forprofit entity that was controlled by the executive director of the tax-exempt organization and his family).
䡲
290 䡲
c05.fm Page 291 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
Association v. Commissioner,79 the Tax Court found private inurement in a case in which a tax-exempt hospital made a number of unsecured loans to a nursing home owned by a physician and a trust for the benefit of the physician’s children; the physician was also the founder of the hospital. These loans were unsecured and at below-market interest rates. The Tax Court based its finding of inurement, in part, on the fact that the hospital could have expected higher earnings on these loans in the open market without incurring any greater risk. The IRS concluded that a portion of the hospital’s net earnings inured to the benefit of the founder and his family and, therefore, that the hospital no longer qualified for tax exemption under IRC §501(c)(3). The court concluded that the loans to the nursing home were not in the hospital’s best interest. Although the interest received by the hospital on the unsecured loans was roughly equivalent to the interest rate it was receiving or could have received on passbook deposits from the local bank at the time the loan was made, the nursing home loans represented a substantially greater risk. The court indicated that an equivalent risk, in a true arm’s length transaction, could be expected to produce higher earnings elsewhere. Furthermore, the hospital could have used these funds to improve its service to the community instead of making loans. Moreover, the reason for making the loan must further the organization’s exempt purpose.80 For example, a law school’s tax-exemption was revoked in part because the school made interest-free unsecured loans to two of its officers, which, as the court noted, subjected the school to uncompensated risks that had no business purpose.81 (c)
Joint Ventures with Commercial Entities
As it does with loan arrangements, the IRS closely scrutinizes joint ventures between exempt organizations and taxable individuals or entities to ascertain 79
80
81
Lowry Hosp. Assoc. v. Commissioner, 66 T.C. 850 (1976). See Founding Church of Scientology v. United States, 412 F.2d 1197 (Ct. Cl. 1969), cert. denied, 397 U.S. 1009 (1970). The Court found that inurement resulted from a number of different arrangements between an organization and its founder. Not only did the organization pay its founder 10 percent of its gross revenues, but it also loaned money to him and his family, paid expenses on their behalf, and engaged in property rental at an inflated price. The Court rejected a reasonable compensation defense, stating, “If in fact a loan or other payment in addition to salary is a disguised distribution or benefit from the net earnings, the character of the payment is not changed by the fact that the recipient’s salary, if increased by the amount of the distribution benefit, would still have been reasonable.” Founding Church of Scientology, 412 F.2d at 1202. See generally Chapter 6. Griswold v. Commissioner, 39 T.C. 620 (1962). Here, a foundation’s activity of lending funds to its substantial donors was not considered to constitute operation for a substantial nonexempt purpose. The foundation made at least one student loan, as well as loans to be used in the construction of houses on the properties that secured each respective loan. The foundation never solicited the public as potential borrowers, nor did it ever advertise that it was lending money. The IRS contended that the foundation failed to meet the requirement of being organized and operated exclusively for exempt purposes in that it was primarily a banking device for its founder, his family, and his controlled corporations, and that its principal purpose and activity was the business of making inadequately secured short-term business loans to the interested parties out of funds that would otherwise have had to be paid to the government as income taxes. However, the court held that the foundation demonstrated that it was not being operated as a device for the substantial purpose of rendering financial aid to its founder and related persons. The court reasoned that the foundation’s loans were not so frequent and its charitable expenditures and loans not so minor in relation to its income as to justify the conclusions that a major purpose of its operations was to engage in a trade or business for profit. John Marshall Law School v. United States, 81-2 U.S.T.C. ¶9514 (Ct. Cl. 1981).
䡲
291 䡲
c05.fm Page 292 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
whether there is any unwarranted private benefit or private inurement to the participants. Although the IRS no longer considers such arrangements to result in private inurement per se (as discussed below), it does examine whether the exempt organization’s participation in a joint venture is substantially related to its exempt purposes and whether safeguards are in place so that the arrangement does not yield excessive benefits to private interests.82 The term “joint venture” in this context includes a partnership as well as any other arrangement that accomplishes a comparable sharing or redistribution of benefits and burdens. The mere involvement of an exempt organization in a joint venture does not support a per se conclusion that the exempt organization is operating for the benefit of private interests. For example, in Plumstead Theatre Society Inc. v. Commissioner,83 the exempt organization was a general partner in a limited partnership with for-profit persons as limited partners. The exempt organization sold a portion of its rights in a play to outside investors through the limited partnership. In rejecting the IRS position that the organization was being operated for private interest, the Tax Court found that (1) the sale of the interest in the play was for a reasonable price, (2) the transaction was at arm’s length, (3) the organization was not obligated for the return of any capital contribution made by the limited partners, (4) the limited partners had no control over the organization’s operations, and (5) none of the limited partners nor any officer or director of the for-profit entities was an officer or director of the organization.84 Typically, the private inurement and benefit doctrines are raised when the business relationship is with the persons closely linked to the exempt organization, such as founders or controlling directors, or with for-profit business entities with interlocking directors or officers. The IRS will review the structure and substance of the joint venture to determine whether a for-profit entity has received any private inurement or private 82
83 84
See Rev. Proc. 98-15; also see Section 4.2. and Priv. Ltr. Rul. 97-18-036 (Feb. 7, 1997) (in ruling that a §501(c)(3) organization’s plan to form limited liability companies (LLCs) (whose other LLC members were commercial banks) to make business development loans in an impoverished area would not benefit the non-tax-exempt LLC members more than incidentally, the IRS cited, among other factors, the fact that the nonprofit organization would appoint a majority of the management committee members so as to retain control of the LLC and to deter the LLC from orienting toward a profit direction on behalf of the non-exempt members); Priv. Ltr. Rul. 96-45-018 (Aug. 9, 1996) (in ruling that a hospital’s participation in a dialysis service joint venture LLC would not result in private inurement or private benefit where the hospital and an unrelated IRC §501(c)(3) organization would hold 62.5 percent of the membership interests in the LLC and would elect five of the eight members of the LLC’s board of managers, the IRS noted that IRC §501(c)(3) organizations would control the LLC, thus assuring that it would operate exclusively in furtherance of charitable purposes with only incidental benefits to the physicians who would own the remaining minority interest in the LLC). Two years after the publication of Rev. Rul. 98-15, the Service issued Priv. Ltr. Rul. 200041038. It concerned a §501(c)(3) organization that was involved in a joint venture, in addition to many other activities—a situation often referred to as an “ancillary joint venture.” The IRS ruled that the venture would not threaten the tax-exempt status of the §501(c)(3) participant, because the venture directly implemented the organization’s exempt purpose of conserving forest lands; the organizing documents of the venture gave precedence to the exempt purpose; and the exempt organization itself managed the venture, and could only be replaced by another §501(c)(3) per a supermajority vote. Plumstead Theatre Society, Inc. v. Commissioner, 74 T.C. 1324 (1980), aff’d, 675 F.2d 244 (9th Cir. 1982). Id. Plumstead is discussed in more detail in Section 4.2.
䡲
292 䡲
c05.fm Page 293 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
benefit. Thus, the IRS will look at relative capital contributions and risks of the various joint venturers to determine whether the capital contributions are proportionate to the sharing of profits and losses, among other indicators. The IRS will also examine the terms of all transactions between the exempt organization and other joint venture partners (e.g., loans, leases, etc.). Joint ventures can also take the form of a contractual arrangement for services. In one case, United Cancer Council, Inc. v. Commissioner, 85 the IRS challenged an organization’s tax-exemption based on its contract with a professional fund-raising company, claiming that the terms of the contract resulted in private benefit and inurement to the fund-raising company. In 1984, while on the verge of bankruptcy, United Cancer Council (UCC) entered into a five-year fund-raising contract with the Watson and Hughey Company (W&H), a fund-raising company, under which W&H agreed to be UCC’s exclusive fund-raising consultant and advisor with respect to direct mail fund-raising solicitations. The fund-raising contract provided that all materials developed by W&H remained W&H’s sole property and that any contributor lists W&H developed would be the joint property of UCC and W&H. W&H provided UCC with the initial capital to conduct the fund-raising campaigns and offered to furnish continued operating funds. During the contract period, UCC received $29 million of contributions and incurred $27 million of expenses, yielding a $2 million profit. UCC paid W&H $4 million directly for its services; it also paid an additional $4 million to a division of W&H for the performance of list brokerage services. All amounts received through the fund-raising efforts were deposited with an escrow agent unrelated to W&H or UCC, which paid money out of the account to vendors, W&H, and UCC only in response to check requests submitted by W&H. UCC made several requests to assert more control over the escrow account, but was ultimately unsuccessful. In 1990, the IRS revoked UCC’s tax-exempt status, retroactively to 1984. The IRS argued that because UCC transferred substantial control to W&H, through the fund-raising contract between UCC and W&H and through the related escrow agreement, which W&H used to further its own interests by unduly and directly enriching itself, UCC was operated for a commercial purpose and thus was nonexempt. The Tax Court held that W&H was an insider for private inurement purposes because it had a “meaningful opportunity” to exercise substantial control over a tax-exempt organization’s activities so as to be able to “readily manipulate” UCC or its activities to W&H’s benefit, even though W&H lacked any formal voice in the selection of UCC’s directors or officers. In a strongly worded opinion, the Seventh Circuit Court of Appeals reversed and remanded the Tax Court decision. 86 The Seventh Circuit, in its analysis, traced the legal history of the inurement clause and explained that the term “any private shareholder or individual” means an insider of the charity, or one who 85 86
United Cancer Council v. Commissioner, 109 T.C. 17 (Dec. 2, 1997). United Cancer Council, Inc. v. Commissioner, 7th Cir., No. 98-2181 and 98-2190 (Feb. 10, 1999).
䡲
293 䡲
c05.fm Page 294 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
has control over the organization—a functional test. It noted the IRS position that W&H had effective control over UCC because it was UCC’s only fund-raiser for five years. The Court responded: Singly and together, these points bear no relation that we can see to the inurement provision. The provision is designed to prevent the siphoning of charitable receipts to insiders of the charity, not to empower the IRS to monitor the arm’s length contracts made by charitable organizations with the firms that supply them with essential inputs, whether premises, paper, computers, legal advice or fundraising services.87
The Court went on to reject the IRS argument that W&H had defrayed such a large portion of UCC’s expenses that it was the equivalent of a “founder.”88 It also rejected the contention that because W&H was the exclusive fund-raiser, UCC was at its mercy, on the grounds that had W&H failed to fulfill its contractual obligations, it could have been terminated. 89 Similarly, it dismissed the argument that there was inurement to W&H because the fund-raising costs were so high relative to the net funds received by UCC.90 In some of the opinion’s strongest language, the Court stated that there was nothing in tax or other law that supported the IRS’s allegation that W&H had “control” of UCC, thereby becoming “an insider; triggering the inurement provision and destroying the exemption.”91 The court noted that this position could cripple the charitable sector by enabling the IRS to revoke a charity’s exemption if it entered into an unfavorable contract.92 However, the Court did observe that the ratio of net income to expenses may have reflected imprudence on the part of UCC’s board of directors in approving the contract. The case was remanded for determination as to whether the contract resulted in private benefit to W&H which, the Seventh Circuit Court noted, could have been a valid reason for revocation of UCC’s exempt status. In February 2000, the IRS entered into a comprehensive settlement with UCC, 93 which revoked UCC’s tax exempt status for 1986–1989, applied a reduced amount in settlement of stipulated tax deficiencies, and granted exempt status from 1990 forward for the very limited activities of accepting charitable bequests and transmitting them to local §501(c)(3) cancer councils solely to provide direct care for cancer patients. The IRS agreed not to challenge the deductibility of contributions made to UCC during the period 1986–1989 on the ground that UCC was not a qualified recipient. UCC agreed not to solicit funds from the general public from the date of the settlement. Any assets remaining in UCC’s bankruptcy estate, after paying the IRS and other claims, will also be transferred to tax-exempt local cancer councils to care for cancer patients. 87 88 89 90 91 92 93
Id. Id. Id. Id. Id. Id. “United Cancer Council Closing Agreement,” Doc. 2000-11201, 200 TNT 75-12, Exempt Organization Tax Review 28, no. 2 (May 2000): 250–53.
䡲
294 䡲
c05.fm Page 295 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
(d)
Private Inurement Per Se
Private inurement per se is found when the nature of a transaction is inherently suspect. This concept was invoked by the IRS when it concluded that a hospital jeopardized its tax-exempt status by forming a joint venture with members of its medical staff and selling the gross or net revenue stream derived from the operation of an existing hospital department to the joint venture.94 The IRS investigated the benefit conferred on the physician-investors, and how engaging in the transaction furthered the hospital’s exempt purposes. The IRS concluded that little was accomplished that directly furthered the hospital’s charitable purposes of promoting health. No expansion of healthcare resources resulted, no new provider was created, and no improvement in treatment modalities or reduction in costs was foreseeable. The IRS implied that the reason a hospital would want to engage in this sort of arrangement is suspect. The hospital argued that engaging in the joint venture was necessary if it was to operate efficiently, to compete, or possibly even to survive. The hospital explained that it would have the benefit of receiving the discounted cash value of its expected revenue stream in advance, and would experience greater utilization of ancillary and inpatient services. However, the hospital made no allegation that obtaining the advanced funds was necessary to fund the joint venture or enable the hospital to carry out its exempt purposes, nor did it explore other sources of financing. In fact, the hospital contributed funds to its subsidiary to purchase the joint venture interest and establish a loss reserve. The IRS noted that the hospital’s goal of preserving or expanding its market share did not justify means that violate the Code’s restrictions. The IRS determined that the arrangement was a joint investment and sale of a profits interest, not a compensation arrangement for professional services. The IRS concluded that the joint venture jeopardized the hospital’s exempt status under IRC §501(c)(3) because (1) the transaction caused the hospital’s net earnings to inure to the benefit of private individuals, (2) the private benefit could not be considered incidental to the public benefits achieved, and (3) the transaction could violate federal law, specifically the Medicare and Medicaid Anti-Fraud and Abuse Law.95 The IRS determined that the hospital engaged in this venture largely as a means to retain and reward members of its medical staff, to attract their admissions and referrals, and to preempt the physicians from investing in or creating a competing provider. The IRS held that giving (or selling) staff physicians a proprietary interest in the net profits of a hospital under these circumstances creates a result that is indistinguishable from paying dividends on stock. In substance, profit distributions were made out of the net earnings of the organization to persons having a personal and private interest in the activities of the organization. Thus, the arrangements conferred a benefit that violated the inurement proscription of IRC §501(c)(3).
94 95
Gen. Couns. Mem. 39,862 (Nov. 22, 1991). This Gen. Couns. Mem. is discussed in detail in Chapter 12.
䡲
295 䡲
c05.fm Page 296 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
(e)
Asset Sales to Insiders
Selling the assets of a tax-exempt organization to insiders may raise questions of private inurement and private benefit. The issue of whether a tax-exempt organization pays or receives fair market value plays a key role in determining whether private benefit or private inurement results from transactions involving partnerships and joint ventures that involve tax-exempt organizations.96 For this purpose, fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all relevant facts.97 In many joint ventures and partnerships involving tax-exempt organizations, it may be difficult to determine fair market value because of the complexity of the transaction and the nature of the assets involved. In this regard, the intermediate sanctions proposed regulations recognize the willing buyer and seller standard, but also state that independent appraisals should be obtained to satisfy the rebuttable presumption requirement.98 Generally, when exempt organizations engage in transactions with independent third parties, a purchase or sale price arrived at through arm’s length negotiations is presumed to be at fair market value. Conversely, where the buyer and seller are related or under common control, the price is not presumed to be correct and an independent appraisal is required.99 A case that illustrates the pitfalls of failure to establish and pay fair market value is Anclote Psychiatric Center.100 On July 27, 1998, the Tax Court upheld the IRS revocation of the §501(c)(3) exemption of the Anclote Psychiatric Center (APC). APC was granted exemption in 1958 for its operation of Anclote Manor Hospital (“the hospital”). In 1980, the hospital’s capacity was up to 99 beds, and in 1982 it obtained a certificate of need from the state allowing it to increase its capacity to 130 beds. APC was governed by a board of 12 directors consisting of doctors and local and regional business persons. At about that time, APC’s president and some of its directors decided to convert the hospital into a for-profit entity, while retaining APC’s exempt status through research and education. The board also wanted to continue running the hospital. The board members hired an attorney to advise them on conversion to a for-profit entity, possibly through a sale to an entity consisting of some or all of the board members. The attorney submitted a request to the IRS for a private letter ruling (PLR) on whether APC would retain its charitable status if it sold the hospital at its appraised value to its board of directors (most likely in the form of a limited 96
97 98 99
100
See generally Rochelle Korman and William F. Gaske, “Joint Ventures Between Tax-Exempt and Commercial Health Care Providers,” Tax Notes Today 97 (Mar. 24, 1997) 54–56, and see Rev. Rul. 76-91, 1976-1 C.B. 149. See Rev. Rul. 76-91, 1976-1 C.B. 149. Prop. Reg. §§53.4958-4(b)(2) and 53.4958-6(d)(i). See e.g., Rev. Rul. 76-91, 1976-1 C.B. 149 (where a nonexempt hospital sold its assets to a newly created tax-exempt corporation and more than 50 percent of the nonprofit organization’s directors were share-holders of the for-profit corporation, the parties could not rely on a presumption of fair market value). See generally John A. Bogdanski, Federal Tax Valuation (1996) for a discussion of valuation methodologies that may be used in this context. Anclote Psychiatric Center v. Commissioner, 98 T.C. 374 (1992). T.C. Memo 1998-273 (July 27, 1998). Anclote Psychiatric Center v. Commissioner, T.C. Memo 1998-273, aff’d without published opinion, 190 F.3d 541(11th Cir. 1999).
䡲
296 䡲
c05.fm Page 297 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
partnership). The ruling request stated that the appraiser would be independent and the counsel for APC and the buyer would be separate. The board hired an appraiser who determined the fair market value of the hospital as of September 30, 1981, to be between $3.5 million and $4.3 million. This appraisal did not include two unused parcels of land, together worth approximately $1,046,000. On May 27, 1982, the IRS issued a PLR stating that the proposed transaction seemed to be at arm’s length and the exemption of APC should not be jeopardized by it. The board subsequently formed a for-profit purchasing entity, Anclote Manor Hospital, Inc. (AMH), whose stock was owned by APC’s board members individually. The sale was finalized at a price of $4.5 million plus assumption of liabilities. In 1985, AMH sold the two unused properties for a total of $1,875,000 and also sold the hospital’s operating assets for $29,587,000. The hospital was sold again in 1990 for $4,276,000. The IRS revoked APC’s exemption on December 12, 1991, for years beginning October 1, 1982. The revocation was based on the sale of the hospital’s resulting inurement to the benefit of private individuals and the lack of actual charitable, research, or educational activities. The Tax Court deemed it unnecessary to determine the actual fair market value of the hospital at the time of the sale in order to find prohibited inurement. The Tax Court stated that the issue was whether the sale price was the result of arm’s length negotiations and within a reasonable range of the fair market value. Although the parties seemed to act in good faith when negotiating the sale, the Tax Court stated that they should have considered changes in value from the time of the appraisal to the time of the sale, the value of the two unused parcels of land, certain liabilities, and other issues relating to hospital operations. The Tax Court ultimately found that the actual value of the property sold was at least $1.2 million more than was paid, resulting in inurement to AMH’s owners. The opinion stated that, notwithstanding the private letter ruling, the transaction was closed 18 months after the appraisal and did not take into account subsequent changes that would have adjusted the sale price. According to Judge Wright, the task of determining the reasonable range for fair market value is not unlike determining, for inurement purposes, “whether payments of compensation are excessive or reasonable” (citing Church of Scientology v. Commissioner101 and United Cancer Council, Inc. v. Commissioner102). Sales of assets to noninsiders may also raise private benefit issues because, as Section 5.1(d) discussed, the proscription against private benefit is not limited to activities with insiders. To illustrate, in Priv. Ltr. Rul. 97-22-032 (Feb. 28, 1997),103 the IRS addressed the issue of whether the issuance of stock and stock options to private individuals (the “Management Team”) in connection with the spin-off of a taxable affiliate by an IRC §501(c)(3) tax-exempt organization conferred a substantial private benefit on the Management Team. The IRS concluded that any 101 102 103
823 F.2d 1310, 1317 (9th Cir. 1987). 109 T.C. 326, 396 (1997). See also Priv. Ltr. Rul. 97-20-031 (Feb. 14, 1997).
䡲
297 䡲
c05.fm Page 298 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
such private benefit was incidental to properly staffing the spun-off corporation (the “Affiliate”). The IRS based its conclusion on the following facts: • The Affiliate’s stock would have been unmarketable to third parties with-
out a management team in place that evidenced its commitment to the Affiliate through employment agreements and ownership in the Affiliate, at a minimum. • The Affiliate was advised that to attract outside investors, it was impor-
tant for it to demonstrate that the Management Team had a substantial stake in the Affiliate’s success. • The Management Team refused to enter employment agreements without
the ability to acquire the Affiliate’s stock under the terms negotiated. (f)
Valuation of New-Economy and Internet Companies
As tax-exempt organizations increasingly become involved in commercial ventures, either to exploit technologies developed by the organization or its employees (such as distance learning) or to passively invest in other enterprises, the valuation issues surrounding these ventures take on ever-increasing importance.104 Valuation issues also come into play in the context of management compensation, acquisition of physician practices, and consolidations and acquisitions or spin-offs involving tax-exempt organization assets. Although traditional valuation methods are employed by the IRS to ascertain fair market value (depending on the situation being scrutinized),105 the recent spate of Internet106 and new media mergers, acquisitions, and initial public offerings (IPO), and the dramatic surge in venture capital funding of technology startups107 104
105
106
107
This section is adapted from an unpublished white paper prepared by Wayne M. Zell, Esq., for the National Multi Housing Council, November 2000. Zell is a recognized authority on corporate finance and taxation issues of New-Economy companies, including Internet companies. He is a member in the Reston, Virginia, office of the law firm of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. This section focuses on valuation metrics as applied to New-Economy companies, based on Zell’s analysis. The term New Economy refers to companies that rely heavily on new technologies to generate revenues and profits, such as information technology companies (including Internet infrastructure companies and dot.coms), biotechnology companies, telecommunication companies, and healthcare device and technology companies. Traditional valuation methods, such as the IRS’s well-documented methodology for valuing intangibles under Rev. Rul. 59-60, are discussed elsewhere in this book. Until the year 2000, Internet companies were the hot investment alternative. Publicly traded Internet companies commanded extremely high market values, resulting in inflated pricing for other public and privately held companies in the same sector. Although premiums were paid for Internet companies prior to 2000, the premiums have all but disappeared. More traditional investments, along with exciting new biotechnology opportunities, have replaced Internet companies as the investment of choice in the year 2001. According to the National Venture Capital Association and Venture Economics, venture capital (VC) investments in the United States totaled more than $25.9 billion in the third quarter of 2000, after reaching a second-quarter 2000 investment total of more than $27.8 billion and a first-quarter 2000 total of more than $26.2 billion, for a total of nearly $80 billion through the first three quarters of 2000. This compares to total venture capital investments in U.S. companies in all of 1999 of more than $59.5 billion, which nearly tripled any previous year’s total. Though VC investments will hit record levels in 2000, the rate of investment appears to be slowing dramatically due to recent precipitous declines in the stock market. Of the VC investment totals, Internet-related investments accounted for 81 percent in the first two quarters of 2000 and 90 percent of all investments in 1999.
䡲
298 䡲
c05.fm Page 299 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
mandate consideration of new valuation approaches. New metrics are required to explain the valuation of Internet companies, including those that occupy the “new media” sector. As one group of experts put it, “the problem for new media is that those metrics don’t exist.”108 EXAMPLE: A university creates an LLC to operate a new distance learning program. Although the university is the initial sole owner of the LLC, it anticipates bringing in other entities as joint venturers. Eventually, a successful distance learning company could go public with an IPO. To attract venture partners and eventually to value stock for the IPO, the university must find a way to value its distance learning company. Traditional methods such as discounted cash flow are unlikely to be effective or accurate. (i) Preliminary Considerations in Conducting a Valuation. Before discussing the various methods for valuing any business, several preliminary considerations should be presented. Assuming the goal is to determine fair market value or market value of a particular investment,109 the practitioner generally needs to determine why the valuation is being conducted, which valuation method is appropriate for the situation, and what factors will influence the valuation. The most common reasons cited for performing a valuation include: • Estate planning and transfer tax determination • Company merger or sale • Evaluation of potential acquisition or sale of a business • Bank or investor financing110
In the context of tax-exempt organizations, however, an additional compelling reason for valuation exists: to avoid a private inurement or private benefit taint and the impact of intermediate sanctions. 111 Specifically, the valuation question arises not only in the context of finding whether sales or acquisitions of businesses or assets are fair to an exempt organization, but also in determining whether executives who participate in for-profit ventures in which tax-exempt organizations hold ownership interests receive excessive compensation. An investor in or purchaser of a New-Economy technology company typically would value the business either as a going concern or as a functioning combination of independently valued assets. The stage and size of the business will affect the extent to which a premium is attached for going-concern value (i.e., the net value of assets other than tangible assets, such as workplace in force, installed assets, processes and systems, etc.). The type and quality of core, intangible assets 108 109 110
111
Dixon, Preissler, and Kim, “Valuing New Media,” PaineWebber Industry Outlook, January 13, 2000, at 2. Fair market value is commonly defined as the price at which a willing buyer will purchase, and a willing seller will sell, the asset or assets under consideration. According to a February 1999 article in Inc. magazine, 42.6 percent of outside appraisers were hired for estate planning purposes, 41.3 percent for company merger or sale, 21.9 percent for curiosity about the value of a business, and 15.5 percent for bank or investor financing. Other reasons to hire an appraiser included growth-management strategies, required valuations for ESOPs, anticipation of going public, and divorce. See Section 5.4.
䡲
299 䡲
c05.fm Page 300 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
(e.g., patented or patentable intellectual property, copyrights, trademarks, logos, brand value, trained and contented workers, customer lists, knowhow, etc.) will affect the premiums attached to those assets as well.112 Further, the size of an investment in the stock or membership interests of an Internet corporation or limited liability company will dictate the valuation methodology. If the investor acquires a minority interest in a company, a minority discount typically is subtracted from the value of the investor’s interest. If the investor acquires control (which can fall anywhere across a broad spectrum, depending on the facts), a control premium may attach to the shares or membership interest acquired. CAVEAT The liquidity, or marketability, of the investment affects the valuation significantly. A minority interest in stock of an actively traded, public company (i.e., where the shareholder has the ability to sell shares at the last reported transaction price by a phone call to a broker or in an online trade and to receive cash within five business days of the trade) arguably is worth substantially more than a similar block of shares in a privately held company in the same business with the same financial results and prospects. (ii) Income-Based Approaches—Discounted Cash Flow. Investment bankers and business appraisers traditionally apply discounted cash flow (DCF) analysis and other income-based approaches to value ongoing businesses. Until recently, many investors did not embrace the concept of cash flow in valuing New-Economy companies, primarily because the highest-growth companies were huge loss generators with no immediate prospects for profits or cash flow. These investors relied more on comparable-company and revenue-based analyses, as well as other more exotic tools, to rationalize their investment behavior. Cash flow valuations typically focus on accounting earnings before interest, taxes, depreciation, and amortization (EBITDA). This approach tends to emphasize the operating aspects of the business and not secondary, financing costs or profits, which include interest income, interest expense, and taxes.113 Earnings before interest and taxes (EBIT), which essentially is the pretax operating income a company would have if it had no debt, is further adjusted for one-time charges and benefits (e.g., extraordinary income or loss, gains or losses from discontinued operations, and investment income from nonoperating assets). Depreciation and amortization represent noncash charges that purportedly reflect how fixed and intangible assets become less useful over time. Because the 112
113
By contrast, some investors use liquidation value, the antithesis of going-concern value, to value a business. The method typically is reserved for failing businesses that cannot be safely characterized as going concerns for accounting purposes or for other troubled business situations. Liquidation value refers to the net amount that can be realized if the business is terminated and the assets are sold off piecemeal. In an orderly liquidation, the assets are sold off over a reasonable period of time, whereas in a forced liquidation, the assets are disposed of as quickly as possible, frequently at one time or in an auction. The latter situation invariably results in depressed values for the assets being sold. S. Pratt, Valuing Small Businesses and Professional Practices, 2d ed. (Hoboken, NJ: John Wiley & Sons: 1993), 31. Tax considerations can have a significant impact on earnings from year to year. For example, losses generated in early years may be available to offset profits in later years; however, the ability to use these losses may be severely limited by changes in control or even a public offering of the company’s stock, according to Zell.
䡲
300 䡲
c05.fm Page 301 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
accounting conventions used to estimate these charges are based on rough estimates of how groups of assets decline in value (often with little connection to economic reality), depreciation and amortization usually are ignored in estimating cash flow in an EBITDA-based valuation.114 A variation on the EBITDA theme, net operating profit after taxes (NOPAT), also referred to as net operating profit less adjusted taxes (NOPLAT), is a critical component of McKinsey’s valuation models, as well as of the highly touted economic value added (EVA) model.115 The calculation begins with EBIT and subtracts depreciation, resulting in net operating profit before taxes. Amortization of goodwill and other intangibles usually is not deducted in determining NOPAT. Unlike EBIT, taxes are deducted when calculating NOPAT. The tax calculation basically starts with the company’s income tax provision for financial statement purposes, and adjusts it for items excluded from NOPAT. So, the tax provision would be reduced by tax on any interest income or other nonoperating income and increased by the tax savings attributable to interest expenses and other nonoperating charges or losses. Taxes are calculated by multiplying the income or expense item in question by the company’s marginal combined federal and state income tax rate for the forecasted year. For valuation purposes, income taxes are reflected on a cash basis, although financial accounting rules require that taxes be stated on the accrual basis, subject to various adjustments.116 Free cash flow is a company’s true operating cash flow. It equals a company’s total after-tax cash flow that is also available to all providers of capital to the company, both creditors and shareholders.117
114
115 116
117
Amortization yields particularly anomalous results if the company being evaluated shows goodwill as a significant asset on its balance sheet, which represents premiums paid to acquire other businesses. EVA is a registered trademark of Stern Stewart & Co. See generally FAS 109, Accounting for Income Taxes. McKinsey’s valuation model uses NOPLAT to determine an investor’s return on invested capital. Invested capital represents the amount invested in the operations of the business. It is the sum of: operating working capital (operating current assets, including some cash, all trade receivables, and inventory, minus operating, noninterest-bearing current liabilities); property, plant, and equipment (net of depreciation); and other assets (net of noncurrent, noninterest-bearing liabilities). Excess cash and marketable securities, which generally represent aberrations in a company’s normal operating behavior or extra cash flow temporarily available to the company, are excluded from the calculation of invested capital. Return on invested capital (ROIC), which equals NOPLAT divided by invested capital, is a very useful performance measure because it focuses on the true operating performance of the company, not a combination of operating and nonoperating performance. In technical terms, free cash flow equals NOPAT/NOPLAT minus net investment, where net investment is the change in invested capital. Frequently, appraisers add depreciation (but not amortization, if it was not deducted in determining NOPAT/NOPLAT) back to NOPAT/NOPLAT and net investment to derive gross cash flow numbers used in a DCF-free cash flow analysis. Gross cash flow represents the total cash flow generated by the company and is the amount available for maintenance and growth of the business. Free cash flow is often capitalized into perpetuity in determining terminal value. Many New-Economy companies lack earnings and cash flow to discount. Some experts suggest that, instead of starting with past or current performance, one should attempt to look into the future to a fixed point in time and predict what the company and the industry will look like after they transition from the high growth state they are in to a more moderate growth state, then extrapolate back to the present. For the pure startup, cash flow projections would be based on purely hypothetical scenarios anyway, but still would have to level off at some point to appear more realistic. Because NewEconomy companies are new by definition, more stable economics may not appear until at least 10 to 15 years into the future.
䡲
301 䡲
c05.fm Page 302 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
CAVEAT At the end of the projection period, the appraiser often makes an assumption, known as terminal value, about how the company will grow indefinitely. The initial projection period that uses variable cash flows on more readily available information generally ranges from 5 to 10 years. After 10 years, it probably is not reasonable to assume that the company will continue to grow forever at the breakneck pace it showed in the earlier years. At some point, estimates of growth must level off and reflect more consistent results. Terminal value is supposed to take these factors into account. It often is estimated as a multiple of EBITDA, NOPAT, or free cash flow or by capitalizing a “smoothed” cash flow stream into perpetuity (see the next section for a discussion of cap rates).* *
The terminal value is perhaps the most unpredictable of all variables used in DCF analysis, particularly for Internet companies. It assumes that the company will achieve estimable growth rates into the future for revenues, expenses, and capital expenditures, which are speculative at best. It also may use a capitalization rate based on today’s information or an estimate of what tomorrow will bring. Not even a clairvoyant can conjure accurate estimates of what the future holds.
Another key variable in the DCF analysis is the rate at which earnings can be discounted to the present. A discount rate converts a variety of expected future cash flows to a present value. Instead of discounting various future cash flows, a more convenient, but less accurate, way of determining the present value of a business is to derive its capitalization rate. The capitalization rate converts only a single flow of earnings or cash flow to a present value and implies that a particular investment has perpetual life at a constant growth rate. Appraisers and investment bankers normally use a weighted average cost of capital formula to determine an appropriate discount rate to apply to a cash flow stream available to all invested capital (i.e., interest-bearing debt and equity). The formula weights the costs of debt and equity based on the assumed relative proportions of each in the company’s capital structure. Another important source for estimating the market value of a company’s capital structure is to look at “comparable” companies. This reveals unusual aspects of the target company’s capital structure as compared with others in the public market. Comparable company analysis also is used in determining the value of a nonpublicly traded company, minus a discount for lack of marketability for the private company’s shares. The difficulty comes in identifying truly comparable companies. A further source of valuable information is the investors’ expectations of return on their invested capital. This may be explicit in term sheets or even shareholders’ agreements that set target returns for management to vest in restricted stock or performance options or to cause a change in management control of the company. Next, appraisers determine the cost of debt and equity. Stated very simply, the discount rates for the cost of debt generally are determinable from the marketplace. If a company currently is able to borrow, its actual borrowing cost provides significant current evidence as to its cost of debt. This evidence would have to be adjusted if, for example, any personal guarantees of well-heeled 䡲
302 䡲
c05.fm Page 303 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
investors have been provided to the company’s lender to reduce the overall cost of borrowing for the company. In addition, if the company does not currently borrow but could if it wanted to do so, the cost of borrowing of other similarly situated companies could be utilized to determine the company’s cost of debt.118 CAVEAT Discount rates for equity often cannot be readily observed in the marketplace. Appraisers typically segregate the different types of equity used in today’s NewEconomy companies into convertible securities (including convertible debt and convertible preferred stock); non-callable, nonconvertible preferred stock; and common stock.* If a large number of options and warrants are outstanding, they must be included in the weighted average cost of capital analysis as well. *
Each type of security has different ways of being valued, and a separate cost of capital, which is beyond the scope of this book.
CAVEAT The cost of common equity usually is determined by using the capital asset pricing model (CAPM). To summarize the CAPM for equity, the cost of equity equals the return on risk-free securities,* plus the market risk premium,† multiplied by the company’s systematic risk or “beta.” In one study of Internet companies from 1999, the author used a cost of capital of 17 percent.‡ Another study applied discount rates ranging from 13 percent to 16 percent in valuing the combined company following the merger of AOL-Time Warner.** *
†
‡
**
Three alternatives frequently used for the risk-free rate are: (1) the Treasury bill rate; (2) the rate for 10-year Treasury bonds; and (3) the rate for 30-year Treasury bonds. The middle alternative generally reflects a reasonable middle ground, as most cash flow projections do not exceed 10 years, but are longer than the short-term Treasury bill rate. The market risk premium is the difference between the expected rate of return on the market portfolio and the risk-free rate. Generally, a market risk premium of 5 percent to 6 percent is used for U.S. companies. This is based on the long-term geometric mean rate of return for the S&P 500 versus long-term government bonds from 1926 to 1992. See McKinsey’s Valuation Guide, ch. 8, at 260–61, citing Ibbotson Associates, Stock, Bonds, Bills and Inflation 1993 Yearbook (1993). Variations of this approach would include using arithmetic means (instead of geometric means), which would yield a higher market premium for the same period, and using a shorter measurement period to compare the S&P 500 with long-term government bonds. BIA Financial Network, Valuing Internet Companies: December 1999 Analysis (2000), at 21. Clearly, a case can be made for a higher cost of capital, particularly given the market risk and higher volatility associated with Internet companies. PaineWebber, Valuing New Media, January 13, 2000, 5.
(iii) Other Earnings-Based Valuation Methods. Earnings per share (EPS) simply reflects the earnings of a company reported in its financial statements, divided by the number of shares it currently has outstanding. EPS has its limitations. It is 118
The cost of debt normally is computed on an after-tax basis, as follows: r = k(1 –t), where: r = the after-tax cost of debt; k = the before-tax cost of debt; and t = the company’s effective income tax rate.
䡲
303 䡲
c05.fm Page 304 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
based solely on historical financial accounting data, which does not clearly reflect the company’s growth prospects. In the 1970s, managers relied heavily on EPS as an accurate measure of a company’s performance, which permitted them to emphasize short-run results at the expense of other items that affect value. Another pure accounting approach is the price-earnings or P/E ratio. Based on this approach, the value of a company simply is the earnings times some multiple. Stated another way, the value is the company’s stock price divided by its last four quarters of earnings. In its most extreme form, P/E focuses only on current or next year ’s earnings to predict the company’s value. The P/E ratio is worthless in explaining the value of New-Economy companies in today’s volatile market. Companies that generated losses over the past year, but show promise of producing income in the future, would not even have a P/E ratio. Notably, most publicly traded online media companies are not reporting profits119 and therefore do not show P/E ratios today, but clearly have some intrinsic value, as evidenced by their stock prices. The P/E ratio often is modified to incorporate the quality of a company’s earnings, enabling the potential investor to distinguish among companies with identical earnings performance but different cash flows or risks.120 (iv) Other Nontraditional Valuation Methods and Metrics. Another approach used to explain the value of New-Economy companies is the price/sales ratio or PSR, which compares a public company’s market cap121 to its 12 months’ trailing revenues. By the end of 1999, the entire Internet information industry was trading at a PSR of about 55 times. For some companies, the PSR was well over 200.122 The PSR for most New-Economy companies has declined radically over the last year and a half. One useful method for distinguishing a potentially successful New-Economy company from one that is on the verge of bankruptcy is to ascertain the total number of customers, the churn rate (i.e., how long a customer remains loyal to an Internet site or how many are lost each year), the revenue and contribution margin per customer (before considering the cost of acquiring new 119
120
121
122
Kim, Esposito, and Wang, The Pricing of Online Media, http://www.houlihan.com/articles/ internet_media_pricing/internet_media_pricing.htm (Houlihan Valuation Advisors, January 5, 2000). The formula for this modified P/E ratio is: P/E = [1 – (g – r)] / (k – g), where g = the company’s long-term growth rate in earnings and cash flow, r = the company’s expected rate of return on a new investment, and k = the company’s cost of capital or discount rate. Some analysts use a modified metric known as PEG, which takes the P/E ratio and divides it by the annualized rate of EPS growth out to the furthest estimate. Another twist on the P/E ratio, known as YPEG, is the year-ahead P/E and growth ratio, which uses the same assumptions as the PEG ratio but takes the earnings estimates out five years. Though this approach may be useful in analyzing larger, more established companies, it suffers from the same infirmities as EPS and P/E in any form. Both the PEG and the YPEG operate on the assumption that P/E should reflect EPS growth, which simply is not the case for Internet companies. Market cap refers to market capitalization and is calculated by multiplying a company’s price per share by the number of shares outstanding. A more conservative measure of PSR would add the current portion of long-term debt to the market value of a company’s stock to determine its market cap. This allows for comparisons with companies with varying long-term debt loads. BIA Financial Network, Valuing Internet Companies: December 1999 Analysis, at 20. Prior to its announced merger with Time Warner, AOL was trading in excess of 20 times trailing revenues, as were DoubleClick, Lycos, and CNET.
䡲
304 䡲
c05.fm Page 305 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
customers), and the average cost to acquire a new customer. Other critical components of the valuation equation for online media companies therefore include brand value (discussed later); advertising expenditures (online and offline); marketing expenditures (other than advertising, such as public relations, Web site design and updating, and online marketing events and promotion); total number of unique visitors per month, over the trailing 12 months, and projected 12 months; total number of unique page views per month, over the trailing 12 months, and projected 12 months; market segment (i.e., business-to-business or business-to-consumer); position in the market (is the company first in its market space?); and revenues by source (i.e., advertising, sponsorships, direct marketing, and transactions). CAVEAT In addition to the PSR, analysts use the following tools to value and compare online media companies: price-to-unique visitors, revenue per unique page view or unique visitor. Each time a Web page is delivered to the user’s screen, a “page view” statistic is generated. A “unique page view” represents a single, unique page that is delivered to a user once per month, and technically would not include pages that are viewed more than once by the same unique visitor.* Revenue per unique visitor is commonly used to evaluate portal companies (e.g., AOL, Yahoo!, and Go Network). *
Although analysts rely on the statistics generated by such measurement services, there is a great deal of skepticism in the industry over the accuracy or reliability of these statistics. Sites are often accused of inflating the statistics relating to visitors, page views, and dwell time and, because there are no SEC or financial reporting criteria for gathering and reporting such statistics, there are no checks and balances preventing such overstatements.
(v) Asset-Based Valuation Issues. One of the most important indicators of value in New-Economy companies is the existence of proprietary intellectual property, such as patented business processes,123 genomes or drug formulae, or software, that erect significant barriers to entry in the niche occupied by the company being valued. CAVEAT Unlike many of the online media and information-oriented companies that receive the greatest amount of coverage in the market, the backbone or infrastructure builders of the Web and the new technologies that increase the speed at which content is delivered and transactions are consummated also command extreme market premiums. Cisco is a prime example, Amazon another, and Nortel yet another. On the biotechnology frontier, Celera Genomics, Biogen, Genentech, and Amgen lead the pack in patenting valuable formulae, which represent significant components of these companies’ overall valuations. They each have acquired or developed proprietary technologies or taken stakes in technology companies that dramatically decreased their time to market. 123
Priceline.com has fine-tuned the concept of business process patents, whereas Amazon owns one of the most significant business process patents in the form of its “affiliate” program model.
䡲
305 䡲
c05.fm Page 306 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
Brand value consists of brand awareness, brand loyalty, perceived quality, and an ability to extend the brand through other sites or services.124 (vi) Market Value-Based Approach. As noted earlier, comparable company transactions—whether IPOs or mergers and acquisitions (M&A) transactions— may not yield particularly useful results, given that no two New-Economy companies are alike. For example, although oxygen.com, Women.com, and iVillage (which recently announced that it would acquire Women.com) may appear quite similar (they are vertical portals devoted to women), they have very different internal strategies for growing and capturing different aspects of their respective markets. Nonetheless, analysts and experts depend on statistics of IPOs and M&A activity to define the current market for emerging companies. Certainly, these statistics cannot be ignored. If the statistics are not comparable because of differences in the companies being compared, arbitrary discounts often are applied and the statistics are used anyway. In contrast, a market value approach can be used to test the assumptions and results used in the modified DCF model for New-Economy companies. This method clearly provides further evidence of value, even though it may not be a sound procedure in isolation for valuing startup (or even established) NewEconomy companies. The extreme volatility of specific stocks and the market in general makes comparable company analysis difficult, however. CAVEAT Other external factors that affect the valuation of New-Economy companies may include cyclicality of the industry (e.g., biotech is in favor now, dot.coms were hot last year), unique aspects of the industry segment in which the company operates, the ability of users to access the technology given the growth of the industry and regulatory constraints (e.g., FDA approval, bandwidth limitations, etc.), the market position of the company (i.e., market leader versus follower), and the business model underlying the technology (e.g., for online media companies in particular, advertising growth on the Internet generally and at the company). (vii) Stock Options and Stock Compensation. As noted throughout this text, tax-exempt organizations are spinning off technologies developed by employees and researchers into for-profit subsidiaries and other joint ventures in which the organizations or their subsidiaries participate. To avoid the private benefit taint and the impact of the intermediate sanctions rules, these organizations must 124
For a thoughtful explanation of these concepts and the issue of brand value, see Angberg, “What You Should Know About Branding and Brand Value” <www.houlihan.com/services/ brand_article/brand_article.htm> (Houlihan Valuation Advisors, 2000). Three basic approaches are used in valuing a brand: cost, income, and market. The cost approach (which also applies in valuing other intellectual property) requires the evaluator to analyze the various costs of developing the brand in question. The market approach focuses on scarce transactions in brands. The income approach combines the DCF model with the excess earnings method used in calculating goodwill and other intangible assets. (See FASB No. 123, Accounting for Stock-Based Compensation.) Brand value under the latter approach equals the present value of the stream of income or cash flow generated solely by the brand. Brand value’s importance was overstated during the heat of the Internet craze during the late 1990s, and has declined in light of the recent spate of dot.com failures.
䡲
306 䡲
c05.fm Page 307 Friday, March 9, 2007 12:02 PM
5.2 TRANSACTIONS IN WHICH PRIVATE BENEFIT OR INUREMENT MAY OCCUR
ensure that the overall compensation package paid to the management team is not excessive. Yet, the managers are demanding the right to receive equity in the ventures they run. The valuation of stock options and compensatory share issuances is also important for federal income tax, financial reporting, and securities law purposes.125 The selection of the valuation model is the first step in valuing stock options or stock appreciation rights.126 For financial reporting purposes, three methods are generally acceptable for valuing options of public entities and two are available for private entities.127 Both the IRS and the Financial Accounting Standards Board recognize the use of the Black-Scholes method to value stock options of publicly traded companies.128 In addition to Black-Scholes, the FASB recognizes the use of the binomial formula and the 5 percent and 10 percent annual appreciation models for valuing public companies. Private companies typically use the minimum value method. (g)
IRC §501(c)(3) Bonds
In 1990, the IRS issued new instructions to its examiners to intensify its efforts to detect potentially abusive transactions in which exempt organizations buy or sell facilities with IRC §501(c)(3) bonds.129 Three types of transactions are highlighted as possibly resulting in impermissible private benefit or inurement and the loss of tax-exempt status: 1. The first transaction involves an exempt organization acquiring a nursing home or hospital with proceeds of tax-exempt bonds. Here, a developer acquires a nursing home and resells it at a substantial profit to a new or existing exempt organization over which the developer exercises control or influence. The developer also enters into an agreement with the exempt organization to rehabilitate, manage or operate the nursing home for an excessive fee. 2. A second transaction involves an exempt organization leasing or selling healthcare or similar facilities that it financed with proceeds of taxexempt bonds.130 The facilities are leased or sold to partnerships or other entities in which the physicians or medical staff of the exempt organization have a financial interest. 125 126
127 128 129 130
See FASB No. 123, Accounting for Stock-Based Compensation. Notwithstanding the existence of various valuation methodologies discussed herein, the IRS has successfully argued that for §83 purposes, options to purchase stock in privately held corporations typically do not have a readily ascertainable market value and therefore are incapable of valuation. See, e.g., Pagel v. Commissioner, 905 F.2d 1190 (8th Cir. 1990); Cramer v. Commissioner, 101 T.C. 225 (1993), aff’d, 64 F.3d 1406 (9th Cir. 1995). But see Rev. Proc. 98-34, 1998-18 I.R.B. 15, in which the IRS permitted the use of the Black-Scholes option valuation method for estate and gift tax purposes. See Paragraph (c) of Item 402 of Regulation S-K, 17 C.F.R. §229.402(c). SFAS No. 123, ¶ 19. IRS News Release 90-60 (April 4, 1990). On August 21, 1990, the IRS announced in News Release IR-90-107 the issuance of new determination and examination instructions, Internal Revenue Manual sections 7668.(17) and 7(10)7(11), drafted to assist exempt organizations specialists and agents in detecting potentially abusive transactions in which charitable organizations buy or sell healthcare facilities financed with tax-exempt bonds.
䡲
307 䡲
c05.fm Page 308 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
3. A third transaction involves a private healthcare corporation selling an unprofitable facility to an exempt organization. For example, a private corporation sets up a new exempt organization to issue tax-exempt bonds and uses the proceeds, along with purchase money debt, to purchase the facility from the private corporation at an inflated price.131 In 1993, the IRS adopted revised procedures for processing certain applications for tax exemption in Internal Revenue Manual Supplement 76G-33. The Supplement instructed that organizations applying for exemption be asked to provide information that will enable the determination specialists to better assess the likelihood of impermissible private benefit and identify cases for referral to the National Office.132 The Supplement also announced that if an organization was unable to provide the required information, the key district office could still issue a favorable determination letter if the organization agreed to request a confirmation ruling from the National Office that the organization’s tax-exempt bond financing would not adversely affect the organization’s exempt status. 133 Although the Supplement states that its expiration date is October 21, 1994,134 the IRS continues to process initial applications that indicate tax-exempt financing under the Supplement. However, revised guidance is currently under review by the IRS135 and the IRS is no longer issuing confirmation rulings.136 In conjunction with the issuance of the final Treasury regulations under IRC §148, in June 1993,137 the IRS announced that it was intensifying its tax-exempt bond compliance program. 138 The final regulations assume that tax-exempt bonds will be the subject of an effective compliance program. Accordingly, the IRS has consolidated and coordinated all enforcement activities relating to taxexempt bonds under the jurisdiction of the Assistant Commissioner for Employee Plans and Exempt Organizations (EP/EO). EP/EO has expanded its examination program to encompass all types of tax-exempt bond transactions. The program includes achieving significant levels of audit coverage, increasing the effective use of tax-exempt bond information returns, and responding promptly to abusive transactions. As part of this program the IRS has placed agents who are bond specialists in examining taxexempt bond transactions in each of its seven key district offices. In addition, the IRS plans to develop audit guidelines on tax-exempt bond issues and to revise the tax-exempt bond information return forms to make them more effective compliance tools.139 131 132 133 134 135
136 137 138 139
For a more detailed discussion of bond financing, see Chapter 12. See Internal Revenue Manual Supplement 76G-33. The Supplement was incorporated by reference into IRM 7668.16 (previously numbered IRM 7668.(17)) on August 11, 1994. See id. See id. Clifford J. Gannett and Gerald V. Sack, “Identifying Abusive Transactions Involving Section 501(c)(3) Organizations and Tax-Exempt Bonds,” 1998 (for Fiscal Year 1999) IRS Continuing Professional Education Exempt Organizations Technical Instruction Program (hereinafter “1999 CPE Bond Article”). 1999 CPE Bond Article at ¶ 2; Rev. Proc. 98-8, 1998-1 I.R.B. 225. T.D. 8476, I.R.B. 1993-24 6. Announcement 93-92, I.R.B. 1993-24 66. See id.
䡲
308 䡲
c05.fm Page 309 Friday, March 9, 2007 12:02 PM
5.3 PROFIT-MAKING ACTIVITIES AS INDICIA OF NONEXEMPT PURPOSE
5.3
PROFIT-MAKING ACTIVITIES AS INDICIA OF NONEXEMPT PURPOSE
The IRS, when alleging that an organization is not operated exclusively for an exempt public purpose, frequently bases its reasoning on a finding that the organization’s operation is similar to that of a commercial enterprise operated for profit. Having a substantial nonexempt purpose will jeopardize an organization’s exemption under IRC §501(c)(3). The decisive factor is generally not the profit itself, but the purpose toward which the organization’s activities are directed.140 In addition, when the IRS alleges that an organization is operated for a substantial nonexempt purpose, the outcome may depend on the organization’s charges for services or products in relation to its costs. (a)
Operations for Profit
The mere showing of a profit (excess of revenue over expenses) will not per se bar exemption under IRC §501(c)(3). However, if the profit is derived from what is viewed by the IRS as a business activity, the existence of a profit may be used by the IRS as one of the indicia to demonstrate the commercial nature of the activity.141 For example, in Greater United Navajo Enterprises v. Commissioner,142 the Tax Court denied tax-exempt status under §501(c)(3) to an organization engaged in equipment leasing operations and construction activities, both for profit. The organization contended that it carried on these activities solely for the training and employment of indigent Navajo Indians. Thus, the organization argued, although profit was pursued, it used all profits exclusively for charitable purposes.143 The Tax Court in the Navajo case stated that “if an organization engages in an activity which might be carried on as a trade or business in competition with commercial enterprises, the organization must prove that its primary objective in carrying on the activity is an exempt purpose, and not the production of profits.144 The court defined the general rule as follows: Profits may be realized or other nonexempt purposes may be necessarily advanced incidental to the conduct of the commercial activity, but the existence of such nonexempt purposes does not require denial of exempt status so long as the organization’s dominant purpose for conducting the activity is an exempt purpose, and so long as the nonexempt activity is merely incidental to the exempt purpose.145
In the Navajo case, the court concluded that the leasing activity was the organization’s principal activity (measured by total gross income), and its charitable activities were deemed minimal. Thus, the organization was not primarily engaged in an exempt activity, and its tax-exempt status was denied.
140 141 142 143 144 145
See generally B. Hopkins, The Law of Tax-Exempt Organizations, 8th ed. (Hoboken, NJ: John Wiley & Sons, 2003), 258. Tech. Adv. Mem. 96-36-001 (Jan. 4, 1996). Greater United Navajo Enterprises v. Commissioner, 74 T.C. 69 (1980). Greater Navajo, 74 T.C. at 77. Greater Navajo, 74 T.C. at 79. Greater Navajo, 74 T.C. at 79 (emphasis added).
䡲
309 䡲
c05.fm Page 310 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
Several cases discussing profit-making activities of exempt organizations have arisen in the religious publications area. In one such case,146 an exempt organization that prepared and sold religious literature was denied charitable status because (1) its materials were competitively priced and (2) its sales over a seven-year period yielded substantial accumulated profits that greatly exceeded the amounts expended for activities. In one year, for example, the organization had accumulated capital and surplus of $1,610,817, with only $72,886 in expenditures for charitable activities. In Technical Advice Memorandum 96-36-001 (January 4, 1996), the IRS applied unrelated business income tax (UBIT) principles to an exempt organization (a promoter of Christian textbooks) that realized profits as high as 75 percent of gross receipts. The publishing division of the exempt organization produced more than 1,000 different textbooks, maintained a sales force of 40 people (paid in part on a commission basis), did business in all 50 states and in foreign countries, and accounted for more than one-half of the organization’s receipts. The IRS concluded that the publishing activities furthered the educational purposes of the exempt organization “in some manner.” The IRS characterized the publishing activities as “an exempt program commensurate in scope with [the organization’s] financial resources” and did not revoke the organization’s exemption. Although the activities were related to the organization’s exempt purposes “in some manner,” the IRS determined that they were not “substantially related” enough to avoid application of the UBIT rules. The IRS concluded that the activities were not substantially related to the organization’s exempt purposes because they only furthered the provision of income to support the other activities of the organization. In addition, the large profit margin, coupled with a pricing scheme and other activities similar to those conducted by commercial religious publishers, indicated to the IRS that the activities engaged in constituted a trade or business. Because the publishing activities were clearly conducted on a regular (in fact, ongoing) basis, the publishing income was subject to UBIT. One of the principal cases in the publishing area is Presbyterian and Reformed Publishing Co. v. Commissioner.147 The Tax Court in that case had upheld the IRS’s revocation of exemption of an organization whose sole function was the publication of religious literature. Over the years, the organization had achieved substantial profits. However, the appellate court, in reversing the Tax Court’s decision, held that the relevant inquiry was not “the volume of business” of an exempt organization, but rather “the purpose to which the increased business activity is directed.”148 The court analogized the exempt organization’s accumulation of cash to accumulated earnings in the for-profit area, in which a tax is imposed on businesses that accumulate earnings beyond their reasonable needs. The court noted that “reasonable needs” in this case included reasonably anticipated future needs.149 The publishing house at issue needed to expand its physical capacity and had accumulated profits for this purpose. Such an expansion, 146 147 148 149
Scripture Press Foundation v. United States, 285 F.2d 800, 806 (Ct. Cl. 1961), cert. denied, 368 U.S. 985 (1982). Presbyterian and Reformed Pub. Co. v. Commissioner, 743 F.2d 148 (3rd Cir. 1984). Presbyterian, 743 F.2d at 156. Presbyterian, 743 F.2d at 157.
䡲
310 䡲
c05.fm Page 311 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
the court concluded, was a legitimate reason to accumulate profits, and was not necessarily a strong indication of a nonexempt purpose.150 (b)
Fees for Services
Often, when the IRS is concerned that an organization is operated for a substantial nonexempt purpose, the status of an organization’s exemption depends on the organization’s charges for services or products in relation to its costs. Generally, when fees are set at a level less than costs,151 the courts and the IRS will conclude that the organization is not operated in an ordinary commercial manner.152 On the other hand, if fees are set at comparable commercial rates, courts and the IRS are more likely to characterize the activity as a trade or business.153 For example, when an organization sold its publications at standard commercial rates, the court concluded that “competition with commercial firms is strong evidence of the predominance of nonexempt commercial purposes.”154 Moreover, an organization is not exempt merely because it sets its fees at rates that do not produce a profit. For example, the IRS ruled that an organization formed to provide managerial and consulting services at cost to unrelated exempt organizations did not qualify as charitable within the meaning of IRC §501(c)(3).155 The IRS stated: Providing managerial and consulting services on a regular basis for a fee is a trade or business ordinarily carried on for profit. The fact that the services in this case are provided at cost and solely for exempt organizations is not sufficient to characterize this activity as charitable within the meaning of IRC §501(c)(3). Furnishing the services at cost lacks the donative element necessary to establish this activity as charitable.156
5.4
INTERMEDIATE SANCTIONS
As explained in Section 5.1, the intermediate sanctions rules were enacted in response to perceived financial abuses in the world of nonprofit organizations in general and public charities specifically. 150 151
152 153 154 155 156
Presbyterian, 743 F2d. at 157–58. A 1972 ruling, discussing a home for the aged, illustrates the concern of the IRS regarding exempt organizations funded primarily or exclusively from fees for services rendered. In Rev. Rul. 72-124, 1972-1, C.B. 145, the IRS concluded that in order to qualify under §501(c)(3), a home for the aged, funded primarily from fees charged for residence in the home, must at a minimum (1) maintain in residence any persons who become unable to pay the home’s regular charges, and (2) provide its services at the “lowest feasible cost,” taking into consideration such expenses as “the payment of indebtedness, maintenance of adequate reserves sufficient to insure the life care of each resident, and reserves for physical expansion commensurate with the needs of the community and the existing resources of the organization. The IRS stated that any doubt as to whether an organization is operating at its “lowest feasible cost” may be resolved if the organization makes some part of its facilities available at rates below its customary charges to personss of limited means. Moreover, the IRS emphasized that “the amount of any entrace, life care, founder’s, or monthly fee charged is not, per se, determinative of whether an organization is operating at the lowest feasible cost, but must be considered in relation to all items of expense, including indebtedness and reserves.” Id. Peoples Translation Service? Newsfront International v. Comm’r, 72 T.C. 42 (1979); Rev. Rul. 71-259, 1972-2 C.B. See e.g., Gospel Workers Soc’y v. U.S., 510 F. Supp. 374 (D.C. 1981). Gospel Workers, 510 F. Supp. At 379. Rev. Rul. 72-369, 1972-2 C.B. 245. See id.
䡲
311 䡲
c05.fm Page 312 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
For example, in early 1992 it was reported that the president of United Way of America, Inc., was receiving an annual salary of $390,000, which, when coupled with benefits, totaled a compensation package of $463,000.157 Ultimately, Mr. Aramony was indicted and convicted on charges of diverting funds from United Way “for gambling trips, European vacations” and other improper uses.158 The United Way case and other allegations of excessive compensation packages for executives of public charities and lax supervision of the use of charitable funds led to hearings in 1993 and 1994 by the Oversight Subcommittee of the House Ways and Means Committee.159 This public scrutiny, coupled with IRS concerns that it lacked efficient enforcement tools for dealing with such abuses, led to the adoption of the intermediate sanctions provisions of IRC §4958. Until the adoption of IRC §4958, the IRS’s only enforcement tool was revocation of a public charity’s exempt status, a result considered too severe in most circumstances. In addition to the severity of revocation as a penalty, revocation penalized the nonprofit itself. There was no mechanism to punish the wrongdoer in the context of public charities, as there was for private foundations in the Chapter 42 excise tax provisions. When the Chapter 42 taxes were enacted, there was a widely held belief that the financial transactions of private foundations might not be subject to the same high level of scrutiny as those of public charities, because their governing boards could be comprised mainly of insiders, whereas the governing boards of public charities were likely to be independent and broader based. However, as the incidents of abuse concerning public charities arose, it became apparent the assumption that the boards of public charities would exercise stricter scrutiny may not always be a valid one. As the Seventh Court of Appeals noted in its decision reversing and remanding United Cancer Council, Inc. v. Commissioner:160 Charitable organizations are plagued by incentive problems. Nobody owns the rights to the profits and therefore no one has the spur to efficient performance that the lure of profits creates.161
Congressional adoption of the intermediate sanctions provisions was an acknowledgment of this weakness and an attempt to give the policing agency, the IRS, more effective tools to monitor abuses. In 1998, the Treasury Department issued proposed regulations to provide more detailed guidance on the intermediate sanctions provisions.162 Temporary regulations were issued and re-proposed in January 2001, superseding the 1998 proposed regulations. Final regulations were issued in January 2002. Under these rules, as in the private foundation excise tax rules, the disqualified person who receives an excess benefit is subject to a two-tier penalty tax, as well as the organization managers who participated 157
158 159 160 161 162
“Former United Way Chief Still Drawing $390,000 Pay; Charity: Aramony Stays on Salary After Being Forced to Resign. Angry Local Affiliates Continue to Withhold Dues from the National Office,” Los Angeles Times (Mar. 7, 1992): A2. “Former United Way Chief Aramony is Indicted,” Washington Post (Sept. 14, 1994): A1. Boisture and Cerny, “Second Oversight Subcommittee Hearing Explores Need for Intermediate Sanctions and More Disclosure,” Tax Notes Special Report (Sept. 6, 1993). United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). Id. Prop. Treas. Reg. §§53.4958-0 through 53.4958-7 (Reg. §246256-96).
䡲
312 䡲
c05.fm Page 313 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
knowingly, willfully, and without reasonable cause.163 The organization itself is not subject to penalty tax. Compliance with the guidelines of the intermediate sanctions provisions is particularly important in regard to joint ventures between for-profit and nonprofit organizations. First, such ventures by their nature attract greater scrutiny. Second, engaging in a transaction with one or more for-profit entities inherently raises the potential for impermissible benefit and inurement. Accordingly, this section will explain the significant terms and definitions of the intermediate sanctions rules. Specifically, the final regulations apply to public charities that would be described in §501(c)(3) or §501(c)(4) and exempt form tax under §501(a), as well as any organizations that were exempt from tax under §501(a) and that were described in §501(c)(3) or §501(c)(4) at any time during the five years preceding the date of an excess benefit transaction (the “lookback period”).164 They do not, however, apply to private foundations,165 trade associations, or other types of exempt organizations. Foreign organizations receiving substantially all of their support from sources outside the United States are also not subject to §4958, regardless of §501(c)(3) or §501(c)(4) status.166 The excise taxes apply to transactions occurring on or after September 14, 1995.167 On September 8, 2005, the IRS published proposed regulations detailing situations in which the intermediate sanctions imposed under §4958 may include the revocation of an organization’s exempt status. These proposed regulations state that the IRS will consider all relevant facts and circumstances when deciding if revocation of exempt status is appropriate when §4958 excise taxes apply. This consideration includes: (1) the size and scope of the organization’s regular and ongoing activities that further its exempt purposes before and after the excess benefit transaction took place; (2) the size and scope of the excess benefit transaction in relation to the size and scope of the organization’s regular and ongoing activities that further its exempt purposes; (3) whether the organization has been involved in repeated excess benefit transactions; (4) whether the organization has established safeguards to prevent future violations; and (5) whether the excess benefit transaction has been corrected or the organization has made good-faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transaction. 163 164
165
166 167
See Section 5.4(a)(v). With the exception of churches that, per statute, do not have to file Form 1023, only §501(c)(3) organizations that file Form 1023 are subject to the intermediate sanctions. State and local government organizations that would be described in §501(c)(3) or §501(c)(4) were they not government related are therefore not subject to the intermediate sanction regulations, absent a request for §501(c)(3) status. See Bernadette M. Broccolo et al., “Rules to Life By: IRS Releases Intermediate Sanctions Regulations,” 21 Exempt Organization Tax Review (1998) 287, 291. Because private foundations are subject to §4941 excise taxes, it would not make sense for a §501(c)(3) organization to seek private foundation status in order to avoid the intermediate sanctions. Reg. §53.4958-2(b)(2). The excise taxes do not apply to any benefit arising from a transaction pursuant to a contract that was binding on September 13, 1995, and continuing in force through the time of the transaction without any material modifications. Reg. §53.4958-1(f)(2). For a general discussion of §4958, see Nancy Ortmeyer Kuhn, “Intermediate Sanctions on NPO Executives,” Journal of Accountancy (Nov. 2001).
䡲
313 䡲
c05.fm Page 314 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
(a)
Disqualified Person
(i) Substantial Influence. A disqualified person is anyone in a position to exercise substantial influence over the affairs of the organization at any time during a five-year period beginning after September 13, 1995, and ending on the date of the excess benefit transaction.168 The regulations identify certain persons who are per se disqualified by virtue of having substantial influence over the affairs of an organization.169 These include voting members of the governing body, the president, chief executive officers, chief operating officers, treasurers, chief financial officers and persons with a material financial interest in a provider-sponsored organization.170 CAVEAT Persons who have or share ultimate responsibility for implementing decisions of the governing body or supervising the management, administration, or operation of the organization, are disqualified persons whether or not they have the title of president, chief executive officer, or chief operating officer, as they are considered to have substantial influence.* The same applies to anyone with responsibilities similar to those of a treasurer or chief financial officer.† * †
Reg. §53.4958-3(c)(3). Reg. §53.4958-3(c).
Thus, the regulations employ a practical approach or, as is commonly referred to, a “form over substance” analysis. Consequently, a person is considered to serve as treasurer or chief financial officer (CFO) whether or not he or she holds that title, as long as he or she has or shares ultimate responsibility for managing the nonprofit’s financial assets. (ii) Per se Disqualified. Under IRC §4958, family members of disqualified persons are disqualified, as are corporations, partnerships, and trusts or estates in which 35 percent of the voting power, profit interest, or beneficial interest is owned by disqualified persons.171 For these purposes, a person’s family members include a spouse; brothers and sisters (by whole or half blood) and their spouses; ancestors, children, grandchildren, great-grandchildren, and their spouses.172 EXAMPLE: An exempt organization contracts with a management services company. The son of a member of the board of trustees of the organization owns 35 percent of the service company that performs services for the organization. The son and the service company would both be considered disqualified persons vis-à-vis the nonprofit.173 168 169 170 171
172 173
Reg. §53.4958-3(a). For transactions occurring before September 14, 2000, the lookback period will go back only to September 14, 1995. Reg. §53.4958-3(c). Reg. §§53.4958-3(c)(1) through 53.4958-3(c)(4). Reg. §53.4958-3(b). For purposes of this determination, the constructive ownership rules of §267(c) apply, except that in applying §267(1)(4), a person’s family includes the family members listed in the following sentence. Reg. §53.4958-3(b)(2)(iii). Reg. §53.4958-3(b)(1). Reg. §§53.4958-3(b)(1), 53.4958-3(b)(2).
䡲
314 䡲
c05.fm Page 315 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
(iii) Per se not Disqualified. The regulations identify certain persons who are not considered to have substantial influence over the affairs of an organization. These persons include other IRC §501(c)(3) charitable organizations, certain IRC §501(c)(4) organizations, and employees who are not highly compensated, unless such an employee is statutorily disqualified or otherwise identified as having substantial influence, or is or was a substantial contributor to the organization, within the four preceding taxable years.174 (iv) Facts and Circumstances. In all other situations, whether a person has substantial influence over an organization will be evaluated according to all of the facts and circumstances.175 The regulations identify facts and circumstances that point toward the existence of substantial influence, including the following: that the person founded the organization; that the person is a substantial contributor; that the person’s compensation is based on revenues derived from activities of the organization that the person controls (revenue sharing); that the person has or shares authority to control or determine a significant portion of the organization’s capital expenditures, operating budget, or employee compensation; that the person manages a discrete, but substantial, activity of the organization; that the person owns a controlling interest in an entity that is a disqualified person.176 NOTE In an effort to demonstrate the practical approach intended in this analysis, the regulations state that an individual who has control over a discrete segment of the organization may nonetheless be deemed to have substantial influence over the entire organization and therefore be a disqualified person.* *
Reg. §53.4958-3(e).
The regulations also address certain factors that tend to indicate that a person does not have substantial influence over the affairs of an organization. 177 These factors include, but are not limited to, the following: the person has taken a vow of poverty in connection with a religious organization; the person is an independent contractor, such as an accountant or a lawyer (unless that person is acting in that role with regard to a transaction in which he or she might benefit economically, aside from professional service fees); the person receives a preference that is based on the size of a donation, where that preference is given to all persons making similar contributions.178 The regulations include several examples that illustrate what the IRS considers its practical approach in determining whether an individual has substantial influence. 174 175 176 177 178
Reg. §53.4958-3(d). Reg. §53.4958-3(e)(1). Reg. §53.4958-3(e)(2). Reg. §53.4958-3. Reg. §53.4958-3(e)(3).
䡲
315 䡲
c05.fm Page 316 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
EXAMPLE: O is a tax-exempt organization that hires organization B, a for-profit entity, to conduct weekly bingo games on its premises. O’s only involvement in the games is the use of its facility. B provides all staff and equipment and pays O a percentage of the income from the events, retaining the balance for itself. The income from the bingo games constitutes more than 50 percent of O’s annual income. Because B has full managerial control over O’s major source of income, B is deemed to be in a position to exercise substantial influence over O’s affairs and is a disqualified person in regard to any transaction that provides an economic benefit to B.179 This fact pattern is similar to the facts of United Cancer Council, Inc. v. Commissioner,180 wherein the Seventh Circuit Court of Appeals rejected the IRS argument that a fund-raiser was an “insider” for inurement purposes because it raised and therefore “controlled” the majority of the organization’s funds. This example in the regulations seems to be based on the same IRS theory that an outside fundraiser can become an insider by virtue of raising a majority of an organization’s revenues despite the Seventh Circuit’s rejection of that theory. EXAMPLE: The facts are the same as in the preceding example, with the additional fact that individual M owns 100 percent of the stock of B and is actively involved in managing B. Based on these facts and circumstances, M is deemed to have control over O because he owns a controlling interest in and actively manages B, which, in turn, is deemed a disqualified person because it has full managerial control over O’s income. M is therefore a disqualified person with respect to O.181 The foregoing situation regarding another contractor can be distinguished from that of an employee of an organization who has control over a significant segment of the organization’s budget, although the result is the same. EXAMPLE: D is the dean of L, the law school at U university. L is a major source of revenue for U, including contributions from alumni and foundations. D has a key role in determining L’s budget and in hiring decisions. D’s management of a discrete segment of U that represents a substantial portion of the income of U, places D in a position to exercise substantial influence over U. D is a disqualified person with respect to U.182 This example differs from the preceding two examples because the disqualified person is an employee of an important segment of the nonprofit organization. Thus, the disqualified person in this example exercises influence by virtue of his responsibilities inside the nonprofit organization, as opposed to providing third-party services through a contractual relationship. The regulations do not directly address the issue of joint ventures between for-profit and nonprofit entities. The regulations do state that with regard to multiple organizations affiliated by common control or governing documents, 179 180 181 182
This example is based on Reg. §53.4958-e(g), Example 5. United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). The facts in this example are based on the facts contained in Reg. §53.4958-3(g), Example 6. This fact situation is based on Reg. §53.4958-3(g), Example 8.
䡲
316 䡲
c05.fm Page 317 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
the determination of whether a person does or does not have substantial influence shall be made separately for each applicable tax-exempt organization.183 The regulations also specify that a person may be a disqualified person with respect to transactions with more than one tax-exempt organization.184 There is also the following example: EXAMPLE: H is a tax-exempt organization that owns and operates an acute care hospital. H contributes the hospital to L, a limited liability company that it formed with F, a for-profit corporation that contributes other assets to L. Subsequently, all of H’s assets consist of its interest in L and it continues to operate exclusively for charitable purposes through the activities it conducts through L. L contracts with a management company, M, to provide management services for the hospital. Under the contract, M has broad discretion to manage L’s day-to-day activities. M is deemed to have substantial influence over H’s affairs because of its control over L’s hospital, which is H’s primary asset and which is the basis for its continued exemption. M is therefore a disqualified person with respect to H.185 This analysis also seems to be based on the IRS’s rationale in the United Cancer Council case—that is, that an “outsider” can become a disqualified person by virtue of a contractual relationship with the nonprofit. This example remained in the final regulations despite the appellate court reversal in United Cancer Council. The IRS has adhered to its position, regardless of the litigation loss. (v) Organization Managers. An organization manager (an officer, director, trustee, or person with similar powers regardless of title) is subject to a 10 percent penalty tax if he or she participates, willfully and without reasonable cause, in what he or she knows is an excess benefit transaction.186 As under the private foundation regulations, “knowing and willful participation” will not be found if the organization manager has relied on a written legal opinion of counsel that a transaction is not an excess benefit transaction. 187 However, the opinion must recite the facts and analyze the law; it is not sufficient to recite the facts and state a conclusion.188 CAVEAT Given the material penalties for violation of the intermediate sanctions rules, as well as the potential complexity of many of the issues involved, organizations may want to seek a written legal opinion on significant transactions involving the payment of benefits to disqualified persons. The tax imposed on an organization manager is less than that imposed on disqualified persons, but it is, nevertheless, substantial. This tax is equal to 10 183 184 185 186 187 188
Reg. §53.4958-3(f). Id. Reg. §53.4958-3(g), Example 7. Reg. §§53.4958-1(d)(1), 53.4958-1(d)(2). Reg. §53.4958-1(d)(4)(iii). See id.
䡲
317 䡲
c05.fm Page 318 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
percent of the excess benefit, but cannot exceed $10,000 for any one excess benefit transaction. Organization managers include not only officers, directors, and trustees of applicable tax-exempt organizations (and any individuals with like powers or responsibilities), but also members of a governing body committee who are not officers, directors, or trustees, where the rebuttable presumption in a compensation arrangement is relied upon. However, any person who has authority merely to recommend particular administrative decisions, but not to implement those decisions, is not an officer and presumably not an organization manager.189 However, any person who has authority merely to recommend particular administrative decisions, but not to implement those decisions, is not an officer and presumably not an organization manager. Organization managers are not subject to a heightened penalty for noncorrection, but are jointly and severally liable for the organization manager tax.190 (b)
Excess Benefit Transactions
Excess benefit results when the amount of the economic benefit provided by an applicable organization to a disqualified person exceeds the fair market value of the consideration, including services rendered, provided in return by the disqualified person. The excess benefit is the amount by which the benefit exceeds the value of the consideration.191 CAVEAT It is important to note that an excess benefit may also result when economic benefit is provided to a disqualified person indirectly, through an entity controlled by or affiliated with the applicable exempt organization. For example, an exempt organization may not avoid imposition of intermediate sanctions by using a wholly owned, for-profit subsidiary to provide compensation to the executive director of the exempt parent, where such compensation is excessive.* This caveat would similarly apply to a joint venture—if the joint venture entity paid excessive compensation to a disqualified person, there could be an excess benefit transaction attributable to the nonprofit partner. Thus, even if all formalities regarding a subsidiary or joint venture entity are met so that the IRS cannot successfully “pierce the corporate veil,” an excess benefit transaction can arise under the regulations from an attribution theory. *
Reg. §53.4958-4(a)(2).
(i) Exclusions from Excess Benefits. The regulations disregard certain benefits from the excess benefit transactions category, for purposes of §4958.192 The disregarded, or excluded, benefits include nontaxable fringe benefits and expense reimbursement payments pursuant to accountable plans.193 Also, benefits provided to a 189 190 191 192 193
Reg. §53.4958-1(d)(2). Reg. §53.4958-1(d)(8). Reg. §53.4958-4(a)(1). Reg. §53.4958-4(a). Reg. §53.4958-4(a)(ii).
䡲
318 䡲
c05.fm Page 319 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
disqualified person in his or her capacity as a volunteer or organization member, as long as that same benefit is provided to the public in exchange for annual membership dues or contributions of $75 or less. Thus, if a disqualified person is a member of an organization and receives a member discount at the organization’s gift shop, no excess benefit will occur so long as membership dues do not exceed $75 per year.194 There is also an exclusion for benefits to a member of a charitable 195 and benefits to or for the use of governmental units.196 (ii) Initial Contract Exception.197 The regulations create an exception for fixed payments made pursuant to an initial contract between an exempt organization and a person who was not a disqualified person immediately prior to entering into the contract. These fixed payments are not subject to §4958, although if the contract is renewed or modified with any material change, it is considered to be a new contract and not within this exception. 198 This exception appears to be in response to the Seventh Circuit’s decision in United Cancer Council. 199 However, an example in the regulations regarding the initial contract exception states the following: “Upon entering into this contractual arrangement, Company Y becomes a disqualified person with respect to Hospital C.”200 In this example, the assumption is made that merely by entering into a contract with an organization an unrelated party will, upon the date of execution, become a disqualified person. Based on this example, the government appears to be adhering to the position it unsuccessfully advocated throughout the United Cancer Council litigation. (iii) Excise Penalty Taxes. For each excess benefit transaction, a penalty tax is imposed on the disqualified person who benefits from the transaction. The “first tier” penalty tax is 25 percent of the excess benefit. EXAMPLE: Assume, that a disqualified person enters into an excess benefit transaction with an applicable organization. The disqualified person receives $100 from the organization, and provides $80 worth of services in return. The excess benefit is $20. The first tier tax imposed is 25 percent of the excess benefit, so it is $5. (If the disqualified person does not correct the excess benefit transaction within a certain time period, an additional second tier tax of 200% of the excess benefit is imposed.) Any organization manager that participates in the transaction knowing that it is improper is subject to a penalty tax that is 10 percent201 of the excess benefit, up to $20,000202 per excess benefit transaction. Organization managers include directors, trustees, and officers. 194 195 196 197 198 199 200 201 202
Reg. §53.4958-4(a)(4)(iii). Reg. §53.4958-4(a)(4)(v). Reg. §53.4958-4(a)(4)(vi). Reg. §53.4958-4(a)(3). Reg. §53.4958-4(a)(3)(v). United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). Reg. §53.4958-4(a)(3)(vii), Example 7. Pension Protection Act of 2006, P.L. 109-280) Id.
䡲
319 䡲
c05.fm Page 320 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
(iv) Pension Protection Act of 2006. On August 17, 2006, President George Bush signed the Pension Protection Act (Act) of 2006 into law, expanding the definition of a “disqualified person” and increasing the penalties for excess benefit transactions. Under the Act, the definition of disqualified person was expanded to include certain persons with respect to donor-advised funds and certain persons with respect to supporting organizations. Specifically, disqualified persons with respect to supporting organizations are not automatically considered disqualified with respect to the supported organization. The Act also introduced new automatic excess benefit transactions. These are, generally, any payment from a supporting organization to: a substantial contributor, one of his/her family members, or an entity that is 35 percent controlled by a substantial contributor or his family members. Expense reimbursements may actually be considered to be an automatic excess benefit transaction under the Act. In addition, any loans made by a supporting organization to any disqualified person will be an automatic excess benefit transaction, except loans to public charities that are not supporting organizations. For an automatic excess benefit transaction, the entire amount of the payment is the excess benefit, not just the amount in excess of the consideration provided in return. EXAMPLE: If A is a substantial contributor of a supporting organization, and receives $100 from the organization in return for $80 of work, it’s an automatic excess benefit transaction because it is a payment between a supporting organization and a substantial contributor, and the amount of the excess benefit is the entire $100 payment, not just the $20 difference between what he was paid and the value of the work A performed. (c)
Compensation
Recently, Congress and the Internal Revenue Service have stepped up their efforts to investigate the business practices of tax-exempt organizations in order to curtail perceived abuses in the nonprofit sector. In particular, Congress and the IRS will focus on the executive compensation arrangements of public charities and private foundations.203 On June 22, 2004, the Senate Finance Committee heard testimony on “Charity Oversight: Keeping Bad Things from Happening to Good Charities.” As a result of the hearing, the committee issued a number of proposals for reform on how tax-exempt nonprofits do business, including: • Extending to public charities the rules against self-dealing that currently
apply to private foundations. • Prohibiting or limiting compensation of private foundation trustees. • Requiring justification if a private foundation’s administrative costs exceed
10 percent of its total expenses and limiting the proportion of administrative expenses that can be counted in a foundation’s qualifying distribution.204 203
204
A November 8, 2004 Business Week article highlighted the problems with excessive executive compensation, stating “top execs sport million-dollar pay packages.” Jessi Hempel, “When Charity Begins at Home,” Business Week (Nov. 8, 2004), at 76. Suzzane E. Coffman, Guidestar, Congress Looks at Charity Reform (July 2004), available at http://www.guidestar.org/news/features/040622_hearings.jsp.
䡲
320 䡲
c05.fm Page 321 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
Following the congressional hearings, the Internal Revenue Service announced that it plans to examine nearly 2,000 charities as part of its TaxExempt Compensation Enforcement Project.205 In particular, the IRS will concentrate on compensation packages of officers and other insiders of public charities and private foundations. The IRS will also review various kinds of insider transactions, such as loans and the sale, exchange, or leasing of property. Steven T. Miller, former Commissioner of the IRS’s Tax Exempt/Government Entities division, said the goals of the project are to deter exempt organizations from providing excessive compensation, to gather information about how organizations establish compensation levels, and to address the compensation packages of specific individuals. Because this is an information-gathering project, contact by the IRS is not necessarily an implication of wrongdoing. However, Miller warned that some organizations will be contacted based upon suspicious information contained in their Form 990. He also noted that any finding by the IRS of improper activity may lead to an “imposition of a penalty for filing incorrect information” or the “revocation of exemption.”206 Information gathered through this project will also be utilized to revise the information requested by the IRS on the Form 990, according to Miller.207 Under the regulations, organizations must ensure that their compensation arrangements are “reasonable”—reasonable being that which would be paid for similar services by similar enterprises under similar circumstances. In determining reasonableness, the IRS will consider those circumstances in existence when a contract for services is made, unless reasonableness cannot be determined from such circumstances, such as when an unspecified performance bonus is to be paid at a later date. Under these circumstances, a determination of reasonableness cannot be made as of the date of the contract but, rather, will be based on all the facts and circumstances, up to and including, the date of payment.208 Compensation includes cash and noncash compensation, including the following: • Salary, fees, bonuses, and severance payments that are 209
All forms of deferred compensation that are earned and vested210 • Premiums paid for liability or other insurance, as well as payments or
reimbursement for expenses, fees, or taxes not covered by insurance211 • All other benefits, including dental, disability benefits, and life insurance
plans, as well as taxable and certain nontaxable fringe benefits212
205 206 207 208 209 210 211 212
I.R. 2004-106 (Aug. 10, 2004). “Nearly 2,000 EOs Will Be Contacted Regarding Compensation, IRS Official Says,” by Fred Stokeld, Tax Analysts (Aug. 11, 2004). Id. Reg. §53.4958-4(b)(2). Reg. §53.4958-4(b). Reg. §§53.4958-4(b)(1)(ii), 53.4958-1(e)(2). Reg. §53.4958-4. Reg. §53.4958-4.
䡲
321 䡲
c05.fm Page 322 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
(i) Establishing Intent to Treat Economic Benefit as Payment for Service. I n order to be treated as having provided an economic benefit as a compensation for services, an organization must provide clear and convincing evidence of its intent when the benefit was paid.213 Clear and convincing evidence is established by reporting the benefit paid as compensation on original or amended federal tax returns with respect to the payment (Form W-2 or Form 1099) or, with respect to the organization, on Form 990 prior to the commencement of an audit wherein the benefit is examined.214 The burden of proof is also met where the recipient disqualified person reports the benefit on his or her Form 1040 for the year in which payment is received.215 An organization can establish that failure to report is due to reasonable cause and that it acted in a reasonable manner before and after the failure occurred.216 If the organization fails to provide clear and convincing evidence, services provided by the disqualified person will not be treated as provided in exchange for the economic benefit and therefore may be an excess benefit transaction.217 EXAMPLE: A nonprofit organization hires an LLC to design a computer program. The parties execute a contract specifying that payments to the LLC will be in exchange for computer programming services. The nonprofit places the contract in its files and reports the payment on its Form 990 for the fiscal year in which it was paid. The contract and the Form 990 each constitute clear and convincing evidence that the payment to the LLC was intended as compensation for its services.218 CAVEAT Because these rules apply to direct and indirect payments, the intermediate sanctions rules can be applied to payments made by a joint venture entity. By way of illustration, in Example 7 of Reg. §53.4958-3(g),* a nonprofit contributes a hospital to an LLC that it formed with a for-profit. After the contribution, the nonprofit’s sole assets consist of its interests in the LLC, and it continues to operate exclusively for charitable purposes involving the activities it conducts through the LLC. The LLC contracts with a management company to provide services for the hospital. In this example, the management company is a disqualified person to the nonprofit because it has substantial influence over the LLC’s and, therefore, the nonprofit’s affairs. Consequently, nonprofits engaged in joint ventures entailing a similar fact pattern must ensure that the joint venture documents clearly indicate when third-party companies are paid for services and the terms thereof. All such documents must reflect the basis for determining that the compensation is reasonable and should be retained in the organization’s files.† * †
See Section 5.4(a)(iii). Presumably, the joint venture entity will be a disqualified person vis-§a-vis the nonprofit by virtue of being a 35 percent controlled entity, as would be any management entity 35 percent owned or controlled by the for-profit partner. See Reg. §53.4958-3. 213 214 215 216 217 218
Reg. §53.4958-4(c). Reg. §53.4958-4(c)(3). See id. Reg. §53.4958-4(c)(3). See also Reg. §§301.6724-1(b), 301.6724-1(c), 301.6724-1(d). Reg. §53.4958-4(c)(3). This example is based on the facts set forth in Reg. §53.4958-4(c)(4), Examples 1 and 2. Reg. §53.4958-4(c)(4), Example 1 clearly demonstrates that a contract can constitute “clear and convincing” evidence that a payment is intended to be compensation for services.
䡲
322 䡲
c05.fm Page 323 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
(ii) Rebuttable Presumption of Reasonableness. Payment or a transfer of property by a nonprofit to a disqualified person will be presumed reasonable if the following three conditions are satisfied: • The arrangements are approved by the organization’s governing body or
a committee thereof comprised entirely of persons who have no conflict with regard to the transaction. • The governing body (or committee thereof) obtained and relied on appro-
priate information as to comparability. • The governing body (or committee) concurrently documented the basis
for its decision.219 Each of these elements is discussed in further detail below. CAVEAT Even if an organization satisfies these three requirements for a rebuttable presumption, the IRS may rebut that evidence with additional information showing that the compensation was not reasonable or the transfer was not at fair market value.* On the other hand, the fact that a transaction does not meet the rebuttable presumption requirements does not create any inference that the transaction constitutes an excess benefit transaction.† * †
Reg. §53.4958-6(b). Reg. §53.4958-6(e).
(A) D ECISION M AKING D ONE BY D ISINTERESTED G OVERNING B ODY The governing body of an organization is its board of directors or trustees or the equivalent thereof; if permissible under state law, the governing body may designate other persons to act on its behalf by meeting guidelines established to satisfy the three criteria. Any transaction approved by the governing board’s designees in accordance with the guidelines will satisfy the rebuttable presumption requirements.220 A member is considered to be free of conflict where he or she: • Is not the disqualified person, not related to the disqualified person, and
is not benefiting economically from the financial arrangement in issue221 • Is not in an employment relationship subject to the direction or control of
the disqualified person222 219 220
221 222
Reg. §53.4958-6(a). Reg. §53.4958-6(c). However, if the rebuttable presumption is triggered by action of a committee, any members of the committee who are not board members will be considered organization managers for purposes of Reg. §53.4958-1(d), which governs imposition of the intermediate sanctions taxes on organization managers. Reg. §53.4958-6(c)(1)(iii)(A). Reg. §53.4958-6(c)(1)(iii)(B).
䡲
323 䡲
c05.fm Page 324 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
• Is not receiving compensation or other financial benefit subject to the dis-
qualified person’s approval223 • Has no material financial interest affected by the transaction in issue224
(B) A PPROPRIATE D ATA AS TO C OMPARABILITY The regulations state that a governing body (or committee thereof) has appropriate data as to comparability if, given the knowledge and expertise of its members, “it has information sufficient to determine that compensation is reasonable or that a transaction will be fair market value.”225 Relevant information includes, but is not limited to, compensation paid by similar organizations for similar positions, availability of similar services in the nonprofit’s geographic area, compensation surveys produced by independent organizations, written offers to the individual by other firms, and independent appraisals of the value of the property.226 NOTE The regulations specifically state that data on compensation levels paid by similarly situated organizations can include nonprofit and for-profit organizations.* *
Reg. §53.4958-6(c)(2).
The following are publications that, as of the date of this edition, may be useful in obtaining comparable data on compensation paid by nonprofit and forprofit organizations: Council on Foundations 1828 L Street, N.W., Suite 300 Washington, DC 20036-5168 Phone: 202-466-6512 Fax: 301-843-0159 Web site: <www.cof.org> Publication: Foundation Management Report. This report is published in even years and includes information on salary, type of foundation, position held, and bonuses. In odd years, a report updating salary only is published. National Charities Information Bureau 19 Union Square West New York, NY 10003 Phone: 212-929-6300 Web site: <www.give.org> Publication: Model Board Governance Policies re: Compensation and Other Issues 223 224 225 226
Reg. §§53.4958-6(c)(1)(iii)(C), 53.4958-6(c)(1)(iii)(E). Reg. §53.4958-6(c)(1)(iii)(D). Reg. §53.4958-6(c)(2). See id.
䡲
324 䡲
c05.fm Page 325 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
Abbott, Langer & Associates 548 First Street Crete, IL 60417 Phone: 708-672-4200 Fax: 708-672-4674 Web site: <www.abbott-langer.com> Publication: Compensation in Non-Profit Organizations. This is a two-volume salary report analyzing salaries by type of organization, number of employees, total annual budget, geographic scope, region, state, and metropolitan area. The publication is updated annually and was last published in October 2001. General Sources Re: For-Profit Salaries Internal Revenue Service Contact: Taxpayer Assistance Technical Department Phone: 800-829-1040 Publication 1053: Corporation Source Book of Statistics of Income American Society of Association Executives 1575 I Street, N.W. Washington, DC 20005-1168 Phone: 202-626-2723 Web site: <www.asaenet.org> Publication: Association Executives’ Compensation and Benefits Study. This study is generally issued in December of even-numbered years. Additional Publication: Blue Chip Association Executives’ Compensation and Benefits Study. This study is released every October and is limited to organizations that compensate their chief executive officers (CEOs) with a minimum of $125,000 of total compensation, including base salary and other cash compensation. Towers, Perrin 1001 19th Street North, Suite 1500 Arlington, VA 22209 Phone: 703-351-4749 Publication: Management Compensation Report for Not-for-Profit Organizations In regard to the healthcare field, the following sources are suggested: • Regional compensation studies in urban areas227 • The American Hospital Association’s Annual survey of average physi-
cians’ compensation for given specialties228
227
228
Charles F. Kaiser, Phyllis D. Haney, and T.J. Sullivan, “Integrated Delivery Systems and Joint Venture Dissolution Update, IRS Exempt Organizations Continuing Professional Education Technical Instruction Program Textbook (hereinafter “1995 CPE Article”). See id.
䡲
325 䡲
c05.fm Page 326 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
• Data from state and local medical societies and national physician trade
associations (AMA)229 • Studies produced by accounting firms, healthcare consulting firms, and
physician recruiting firms.230 There are special rules for organizations whose annual gross receipts are less than $1 million. The governing body will be considered to have obtained appropriate data if it obtains data on three “comparable organizations in the same or similar communities for similar services.” 231 For purposes of the preceding determination, a “rolling average” based on three prior taxable years may be used to calculate gross receipts.232 In addition, in calculating gross receipts, the gross receipts of any organization affiliated with the nonprofit by common control or governing documents must be included.233 In regard to purchasers or sellers of property between a nonprofit and a disqualified person, independent appraisals of the property would be relevant information as to the value.234 The fair market value of a property is the price at which the property would “change hands between a willing buyer and a willing seller.”235 (C) D OCUMENTATION In order to satisfy the documentation requirements, the written or electronic records of the governing body or committee must demonstrate: • The terms of the transaction and the date of approval • The names of the persons who were present during the debate and the
names of those who voted • The comparability data that was relied on and how it was obtained • The action taken with regard to any persons who had a conflict regarding
that transaction236 CAVEAT If the governing body or committee finds that reasonable compensation or fair market value is higher or lower than shown by the comparable data, the reasons for the difference must be specifically recorded. Thus, going above a range is not per se prohibited. An organization must, however, substantiate its reasons for doing so.* *
Reg. §53.4958-6(c)(3)(ii). 229 230
231 232 233 234 235 236
See id. Bonnie S. Brier, Esq., “Physician Compensation: Exempt Organization Creativity Without IRS Problems,” American Health Lawyers Association, Tax Issues for Healthcare Organizations Conference (Nov. 12–13, 1998), Arlington, VA (hereinafter “Brier Article”). Reg. §53.4958-6(c)(2)(ii). Reg. §53.4958-6(c)(2)(iii). See id. Reg. §53.4958-6(c)(2). Reg. §53.4958-6(c)(3). Reg. §53.4958-6(c)(3)(i).
䡲
326 䡲
c05.fm Page 327 Friday, March 9, 2007 12:02 PM
5.4 INTERMEDIATE SANCTIONS
For a decision to be deemed timely documented, records reflecting the decision-making process must be prepared before the later of the next meeting of the governing body or 60 days after the decision and must be reviewed and approved as reasonable, accurate, and complete within a reasonable time thereafter.237 (D) R EVENUE S HARING The regulations do not directly address the issue of revenue-based compensation. The regulations withdrew the section on revenue sharing that had appeared in the proposed rules and “reserved” that section.238 The preamble makes clear that revenue-sharing transactions will be analyzed under the general rules and a facts-and-circumstances determination as to whether the economic benefits were excessive. One factor that will help the IRS distinguish reasonable compensation arrangements is the existence of a cap. If the cap is objectively determined and a reasonable amount, the compensation package will be deemed to be reasonable at the time the compensation arrangement is entered into. In that situation, the individual will have the benefit of the rebuttable presumption if the documentation requirements have been met from that earlier date. If, however, the cap is subjective in nature, the reasonableness determination will be made at the time compensation is determined and the rebuttable presumption will attach at that later date, assuming all other criteria are met.239 Particularly in a joint venture, an individual may perform services for several entities but not receive compensation from the specific entity for which services are performed. The final regulations confirm that the reasonableness of the compensation is determined by a review of 100 percent of the services performed and 100 percent of compensation received on an aggregate basis.240 For example, if a disqualified person performed services for two or more entities within a joint venture but was paid by only one of those entities, the reasonableness determination is not based on a pro rata approach, but on an aggregate approach. As long as the total compensation is reasonable for the services performed for all entities, the disqualified person will not be in receipt of an excess benefit and will not be subject to the excise tax.241 Of course, the private benefit or inurement provisions will very likely apply regarding the benefit received by the entity not paying the compensation. Additionally, depending on the organizational structure, the entity receiving the services might be a disqualified person itself and subject to the §4958 excise taxes. (E) I NITIAL C ONTRACT E XCEPTION The regulations include a broad exception for initial contracts entered into between the organization and an unrelated person.242 Essentially, any new contract between 237 238 239 240 241 242
See id. Reg. §53.4958-5 (reserved). Reg. §53.4958-6. Reg. §53.4958-4. Based on Reg. §53.4958-4(a)(3)(vii), Example 1. Also, written contracts that were binding on September 13, 1995, are excepted from these rules. State law will determine what constitutes a binding, written contract. A combination of several writings is often needed to establish the intent of the parties and create a binding contract. Reg. §53.4958-3(a)(2).
䡲
327 䡲
c05.fm Page 328 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
a previously unrelated person and an exempt organization is not subject to the excise tax. Any amount, even an amount that is outrageously excessive, will not be subject to the excise tax under §4958. However, the well-established inurement and private benefit rules are still in place, allowing the IRS to revoke the organization’s exempt status if a transaction is egregious. Several examples illustrate the application of the initial contract exception to revenue-sharing arrangements. If the initial contract sets forth compensation as an objective formula applied to gross receipts or some other well-defined term, the compensation will be excepted from these rules. However, if the revenuesharing arrangement is subjectively determined, the contract will not be within the initial contract exception, and the facts and circumstances of the compensation ultimately paid will determine whether an excess benefit was received by the insider. Two specific examples illustrate these concepts. EXAMPLE: J is a performing arts organization and an applicable tax-exempt organization for purposes of §4958. J hires W to become the CEO of J. W was not a disqualified person, within the meaning of the statute, immediately prior to entering into the employment contract with J. W’s duties and responsibilities under the employment contract convert W into a disqualified person with respect to J. Under the contract, J will pay W $x (a specified amount) plus a bonus equal to 2 percent of the total season subscription sales that exceed $z. The $x base salary is a fixed payment. The bonus payment is also a fixed payment pursuant to an initial contract, because no person exercises discretion when calculating the amount of the bonus payment or deciding whether the bonus will be paid. Therefore, §4958 does not apply to any of J’s payments to W pursuant to the employment contract, because of the initial contract exception.243 EXAMPLE: Hospital C is an applicable tax-exempt organization for purposes of §4958. Hospital C enters into a contract with an unrelated entity, Company Y, under which Company Y will provide a wide range of hospital management services to Hospital C. Because of this contract, Company Y becomes a disqualified person with respect to Hospital C. The contract provides that Hospital C will pay Company Y a management fee of x percent of adjusted gross revenue (i.e., gross revenue increased by the cost of charity care provided to indigents) annually for a five-year period. The management services contract specifies the cost accounting system and the standards to be used in calculating the cost of charity care. The cost accounting system objectively defines the direct and indirect costs of all healthcare goods and services provided as charity care. Because Company Y was not a disqualified person with respect to Hospital C immediately before entering into the management services contract, that contract is an initial contract within the regulatory exception. The annual management fee paid to Company Y is determined by an objective fixed formula specified in the contract, and is therefore a fixed payment. Accordingly, §4958 does not apply to the annual management fee, because of the initial contract exception.244
243 244
Based on Reg. §53.4958-4(a)(3)(vii), Example 5. Based on Reg. §53.4958-4(a)(3)(vii), Example 7.
䡲
328 䡲
c05.fm Page 329 Friday, March 9, 2007 12:02 PM
5.5 CASE LAW
(d)
Reporting Requirements
In Notice 96-46,245 the IRS set forth the reporting requirements for persons subject to the intermediate sanction provisions.246 IRC §501(c)(3) and §501(c)(4) organizations must report the amount of §4958 taxes paid with respect to excess benefit transactions involving the organization for tax years beginning after July 30, 1996. Also, §501(c)(3) organizations must report any taxes imposed under §4958 on any organization manager or any disqualified person, as well as any reimbursements of §4958 excise tax liability paid by the organization to such organization managers or disqualified persons.247 (e)
Indemnification Agreements
Some practitioners have recommended that their clients use indemnification agreements to require organizations to indemnify disqualified persons for intermediate sanctions excise tax liabilities. Use of an indemnification agreement raises a crucial issue. Specifically, the intermediate sanctions regulations provide that if an organization reimburses intermediate sanctions liabilities of disqualified persons, such reimbursements must be treated as an excess benefit, subject to the intermediate sanctions excise tax liabilities, unless they were included in the disqualified persons’ compensation during the year in which the organization makes the reimbursement. 248 Moreover, the total compensation package, including the amount of any reimbursement, will constitute an excess benefit to the extent that such compensation exceeds a reasonable level.249 Therefore, indemnification payments may, themselves, constitute excess benefit payments subject to the intermediate sanctions excise tax.
5.5
CASE LAW
In Sta-Home Health Agency, the first publicized enforcement of §4958 sanctions, the IRS imposed intermediate sanctions of more than $40 million on the conversion of nonprofit home healthcare agencies to for-profit concerns, with the Tax Court upholding the imposition of a lesser amount of §4958 excise taxes.250 In the late 1970s, a husband and wife formed three nonprofit corporations to provide home healthcare services, all of which were subsequently recognized as tax-exempt under IRC §501(c)(3). Later, other family members entered the 245 246
247 248 249 250
1996-39 I.R.B.1. Notice 94-46 provides that for excess benefit transactions that occurred after September 13, 1995, in a taxable year ending before December 31, 1996, disqualified persons, organization managers, and their 35 percent controlled entities liable for payment of the IRC §4958 excise taxes must use the 1995 Form 4720 to calculate the report such taxes. The IRS revised Form 4720 for tax years that end on or after December 31, 1996. (Such Forms 4720, prepared for tax years ending after September 13, 1995, and before July 30, 1996, were due on December 15, 1996.) Returns for tax years that end after July 30, 1996, are due on the 15th day of the fifth month following the end of that tax year. IRC §6033(b)(11), as amended by the Taxpayer Relief Act of 1997. Reg. §53.4958(b)(1)(ii)(B). See id. Caracci v. Comm’r, 118 T.C. No. 25 (May 22, 2002).
䡲
329 䡲
c05.fm Page 330 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
business. In October 1995, the board of directors for each of the organizations transferred the assets of the nonprofits to three for-profit subchapter S corporations. The S corporations would continue the healthcare business and the family would own all of the voting stock. No consideration was provided to the exempt organizations for the asset transfer other than the assumption of liabilities by the S corporations. The family’s CPA firm reported that the organization’s liabilities exceeded the fair market value of its assets. However, when the IRS evaluated the transactions, it calculated a substantially higher value for each organization’s assets. For example, petitioners asserted that assets transferred from one nonprofit to the S corporation represented a deficit of $602,800 due to the liabilities assumed, whereas the IRS valued those same assets at $7.8 million.251 The IRS also found that each of the family members was a disqualified person as defined in §4958(f). The IRS claimed that the S corporations and their shareholders had received an excess benefit within the meaning of §4958(c)(1). As a result, the IRS assessed the 25 percent first-tier excise tax. Each of the family members, as disqualified persons, and each of the S corporations were jointly and severally liable for the first-tier excise tax. Because none of the excess benefit transactions had been corrected by the time the statutory notices were sent out, the IRS applied the 200 percent secondtier excise tax to each transaction. The family members and each of the S corporations were held jointly and severally liable for this excise tax as well. Several of the family members were also determined to be organization managers. The IRS believed that each knew this was an excess benefit transaction and that their participation in the transactions was willful. Thus, an additional 10 percent excise tax applied, under §4958(a)(2), up to the maximum amount of $10,000. Furthermore, the IRS retroactively revoked the §501(c)(3) exempt status of the three original organizations, because transferring assets to the S corporations was a substantial activity not in furtherance of an exempt purpose, which conferred private inurement and private benefit on each of the family members. Also, the organizations “no longer promoted health in a charitable manner.”252 The Sta-Home Health Agency and various family members subsequently filed petitions in the U.S. Tax Court to protest the intermediate sanctions excise tax and the revocation of the exempt status of the original organizations. On May 22, 2002, the United States Tax Court issued its opinion in Caracci v. Commissioner, 118 T.C. No. 25 (5/22/02) upholding the §4958 excise taxes against the family members who controlled three home healthcare entities: the Sta-Home Health Agencies. The dispute was whether the “sale” of the three tax-exempt healthcare entities to three newly formed for-profit S corporations of similar names was at fair value, or whether the family members and the S corporations received an excess benefit upon the sale/conversion from nonprofit to for-profit 251
252
Alison Bennett and Barbara Yuill, “Exempt Organizations First Challenges to Intermediate Sanctions Highlight IRS Focus on EO Asset Transfers,” BNA, Daily Tax Report (Dec. 8, 1999); G-3. Lawrence M. Brauer and Roderick H. Darling, “Update on Health Care,” Exempt Organizations Technical Instruction Program for FY2001: 67.
䡲
330 䡲
c05.fm Page 331 Friday, March 9, 2007 12:02 PM
5.6 PLANNING
status. The Internal Revenue Service alleged that the excess benefit was $20 million. The taxpayers alleged that the entities were transferred subject to extensive liabilities and there was no excess benefit. The Tax Court, as is customary in valuation cases, concluded that the excess benefit was somewhere in the middle, and evaluated the excess as $5,164,000. The Tax Court upheld the imposition of §4958 excise taxes against the family members and the three for-profit S corporations, finding all were disqualified persons. The Tax Court also upheld the income tax liabilities of a similar amount against the S corporations. The Tax Court, however, declined to revoke the exempt status of the three nonprofit entities. The Tax Court instructed the taxpayers to return the assets to the tax exempt entities during the “correction” period, which expires 90 days after the court’s opinion becomes final. If the taxpayers are able to “correct” the excess benefit, the court indicated that abatement of the §4958 excise taxes, both the 1st Tier 25 percent excise tax and the 2d Tier 200 percent excise tax would be considered. The Tax Court noted that the years at issue in this case predated the effective date of the §4958 regulations. Therefore, it was decided without the benefit of the rebuttable presumption safe harbor. However, the court’s interpretation of §4958 was generally consistent with the guidance provided in the §4958 regulations. On July 11, 2006, the United States Court of Appeals for the Fifth Circuit253 reversed the Tax Court’s holding in Caracci, concluding that a “cascade of errors” initially made by the IRS, including the use of an intermediate economic study (instead of a final study) to value the determined liability prevented the Caracci family from being allowed to correct the transactions, and thereby reduce the resulting intermediate sanctions. Significantly, the Fifth Circuit held that the Tax Court applied, incorrectly, its own valuation method to calculate the excess benefit for exempt entities using comparables from public, profit-generating companies. Although the Fifth Circuit’s holding in Caracci reversed the IRS’ first major challenge under section 4958, the opinion was grounded on the inadequacies and incongruities with the IRS’ valuation methods, and not with the statute itself. The notable caveat, however, from Caracci is the importance in documenting fair market values of assets in transactions with insiders, and diligence on the part of exempt entities to ensure that excess benefits do not result.
5.6
PLANNING
Exempt organizations subject to the intermediate sanctions provisions should consider the following guidelines:254 • Adopt a comprehensive conflict of interest policy containing clear proce-
dures for officers and directors to disclose transactions in which they may have a financial or other conflict of interest.
253 254
456 F.3d 444 (2006). These recommendations, originally published by Susan A. Cobb in “Intermediate Sanctions: Planning to Avoid the New Penalties,” Association Law and Policy (Apr. 1, 1997), continue to be sound planning advice.
䡲
331 䡲
c05.fm Page 332 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
• Compile a list of all persons believed to be disqualified persons, as well as
a list of all entities in which the organization and/or disqualified persons own more than a 35 percent interest. Justify the position that others are excluded from the list. • In determining compensation arrangements, the board or committee
should rely on appropriate comparability data and promptly document the basis for the determination. A board or committee member with a conflict of interest must recuse himself or herself from the determination. • The record of the decision-making process must be timely prepared
before the next meeting of the committee or board and must be approved within a reasonable time thereafter. • Report all compensation, including fringe benefits, insurance premiums,
and indemnification payments, on Form W-2, 1099, or 990, and make sure the payee understands his or her obligation to report. If compensation is mistakenly omitted, promptly file an amended form with the correction. • Include caps and guidelines for awarding incentive bonuses in all com-
pensation contracts. • In revenue-sharing transactions, ensure, to the extent possible, that the
disqualified person, which may be a third-party service provider, has no incentive to act contrary to the organization’s exempt purposes. Ideally, a disqualified person should not have significant control over the activities on which his or her compensation is based. • If the disqualified person in a revenue-sharing arrangement does have
control over the revenue-generating activity on which his or her compensation is based, ensure that proportional benefit is available to the organization whenever the disqualified person increases his or her economic benefit. For example, a third-party provider whose fee is based solely on a fixed percentage of the exempt organization’s gross income ordinarily should be able to increase its economic benefit only in proportion to that of the exempt organization. • Where there is a question as to whether a transaction may constitute an
excess benefit transaction, obtain a written legal opinion that addresses the facts of the specific situation and the applicable law. It is insufficient if the opinion states only the facts and a legal conclusion. Obtaining such an opinion will preclude a finding that a foundation’s manager (officers, directors, trustees) acted knowingly or willfully, but rather that the manager acted with reasonable cause even if the transaction is found to constitute an excess benefit. • If an organization believes that it has entered into an excess benefit trans-
action, it should promptly correct the situation by “undoing” the excess benefit to the extent possible and taking any additional measures needed to put the exempt organization in no worse financial position than if it had not occurred, which essentially requires payment of interest from the date of the transaction until the date the transaction is corrected. 䡲
332 䡲
c05.fm Page 333 Friday, March 9, 2007 12:02 PM
5.7 STATE ACTIVITY WITH RESPECT TO INSIDER TRANSACTIONS
• Report any excess benefit transaction to the IRS as soon as possible so as
to avoid additional taxes. To summarize, nonprofit organizations have to focus on establishing policies and procedures, obtaining and retaining comparable data, recording and ratifying its decision-making process, reporting appropriate information, and, where necessary, obtaining opinions of counsel. Undoubtedly, these steps will create additional administrative burdens and will draw funds away from charitable purposes. Moreover, it will become more difficult to attract board members who, in addition to the common law and statutory fiduciary standard of care, now face the potential imposition of penalty taxes for participation in a board decision where compensation of any type is awarded. The development of the law and the impact on the nonprofit world will be the subject of nearly as much interest as the financial scandals that precipitated the changes themselves.
5.7 (a)
STATE ACTIVITY WITH RESPECT TO INSIDER TRANSACTIONS State Activity
Although the enactment of intermediate sanctions represents a significant change in the exempt landscape on the federal level, individual states have also taken steps to stem the rising number of prohibited or suspect transactions between local charities and insiders. For example, New Hampshire enacted strict rules barring all transactions between insiders and charitable organizations unless a transaction is in the charity’s best interest and stringent rules are met.255 Under this law, all charities are required to adopt a conflict-of-interest policy. No charity may lend money to directors, officers, or trustees; and no charity may buy, sell, or lease for more than five years any real property to or from insiders without the prior approval of the probate court.256 Further, charity boards must be made up of at least five members not related by blood or marriage, charity employees may not serve as the chairperson of the board, and all transactions involving benefits in excess of $500 to insiders must be approved by two-thirds of the board, following a full discussion of the issue.257 Another example of state action can be found with respect to whole hospital joint ventures. The IRS anticipates that the expanded availability of Forms 990 of tax-exempt organizations,258 which have been revised to include excess benefit transactions, could lead to increased scrutiny by state attorneys general. Specifically, the Pension 255 256 257
258
New Hampshire Code, ch. 302. “New Hampshire Adopts Conflict-of-Interest Rules of Charities,” Highlights & Documents (Oct. 23, 1996): 753. The person(s) who are to receive the benefit may not be present during the vote or discussion, and a written record of the proceedings must be maintained. If the amount of pecuniary benefit is in excess of $5,000, the charity must publish a notice describing the proposed transaction (including the name of the charity, the monetary amount involved, and the identity of the participants) in a general circulation newspaper, and notify the state director of charitable trust of the proposed transaction. Id. §6104(d).
䡲
333 䡲
c05.fm Page 334 Friday, March 9, 2007 12:02 PM
PRIVATE BENEFIT, PRIVATE INUREMENT, AND EXCESS BENEFIT TRANSACTIONS
Protection Act of 2006 provides that, effective August 26, 2006, information relating to proposed IRS actions regarding organizations described in IRC § 501(c)(3), or organizations that have applied for recognition under § 501(c)(3), may be disclosed to state officials upon written request. Moreover, whether states will impose their own penalties for excess benefit transactions, resulting in possible double taxation, remains to be seen. Perhaps a credit system, will ultimately be worked out between the IRS and the state enforcement agencies,259 but the outcome at this time is uncertain (b)
Conclusion
Recent years have seen considerable state action to prevent the misuse of charitable assets, and practitioners can anticipate continued growth in this area. For example, culminating a year-long investigation, the Attorney General of California, Bill Lockyer, in October 2006, issued a report that concluded, among other things, that the Trustees of the J. Paul Getty Trust improperly used charitable assets for the private use of the Trust’s former president, his spouse and certain retiring trustees. The report details the Attorney General’s extensive findings and appoints an independent monitor to ensure that the Trust’s trustees and employees will comply with mandated policy and procedural reforms.260 Accordingly, careful attention must now be paid not only to IRS and federal restrictions, but also to state and local laws, to ensure that the activities of charitable organizations in the joint venture context meet all applicable operative requirements.
259 260
§6104(d) See, Report on the Office of the Attorney General’s Investigation of the J. Paul Getty Trust, State of California, Office of the Attorney General, October 2, 2006.
䡲
334 䡲
c06.fm Page 335 Thursday, March 15, 2007 10:15 AM
C H A P T E R
S I X 6
The Exempt Organization as Lender or Ground Lessor 6.1
OVERVIEW
This book deals largely with the participation of an exempt organization in a “joint venture” in the legal sense of an equity investment in a partnership or limited liability company.1 Nevertheless, well-advised exempt organizations may prefer to participate in activities by lending funds or becoming a ground lessor rather than taking an equity ownership position in a venture.2 This is true because, among other advantages, tax-exempt organizations may generally receive rental and interest income from real estate leases and loans that is excluded from unrelated business income tax (UBIT).3 This chapter deals with alternative lender and lessor arrangements, which often so replicate the economic functions and goals of partnerships that they are frequently referred to colloquially as “joint ventures” even though it is generally disadvantageous for them to be so treated for federal income tax purposes. This chapter explores alternatives to a joint venture structure. Precisely because exempt organizations often enter into loans and ground leases as alternatives to equity investments, lenders and ground lessors in such transactions often require a return beyond a flat rate of interest or rent. The yield may instead consist of two components: (1) a fixed return in the form of interest or rent, but typically at a below-market rate; plus (2) additional compensation, whether or not dubbed “interest” or “rent,” for the additional risk assumed by the lender or ground lessor. The latter is commonly referred to as an “equity kicker.”
1 2 3
See, e.g., §7701(a)(2). But see Section 4.9 for a discussion of the rules governing loans including transactions between a disqualified person and a private foundation See generally Chapter 8. See also §512(b)(1,3); Reg.§1.512(b)-1(c)(2); Priv. Ltr. Rul. 78-52001 (Mar. 15, 1978); Priv. Ltr. Rul. 96-05-001 (Oct. 9, 1995).
䡲
335 䡲
c06.fm Page 336 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
Some nonprofit organizations lease land or lend money as a means of accomplishing their charitable purposes, particularly in the fields of affordable housing and community development. Two of the most renowned are the Enterprise Community Partners, Inc. and the Local Initiatives Support Corporation. Since the early 1980s they have supported local community development corporations and their projects with billions of dollars of loans, grants, and investments.4 Their involvement has made it possible to attract capital from the private sector as well and has resulted in hundreds of thousands of units of new and renovated housing. There are also advantages to the developer in leasing rather than purchasing land for a low-income housing project. The developer of low-income housing is not permitted to include the cost of land in the eligible basis for determining the amount of the low-income housing tax credit (LIHTC) that may be claimed. If a developer does not have to purchase the land (because, for example, a nonprofit organization owns it and leases it to the developer), a significant amount of equity may be available for other charitable purposes. The developer can use the available equity to build additional amenities, provide additional services, or give deeper subsidies.5 EXAMPLE: A church owns a vacant lot, which it leases to a tax-credit partnership to build an apartment building for low-income tenants. To establish tax ownership in the partnership, the term of the ground lease must exceed the economic life of the building. Frequently, when the investors sell such a building, at the end of the compliance period, the nonprofit ground lessor will hold a right of first refusal to acquire the property.
6.2 (a)
A PARTICIPATION AS A LENDER OR GROUND LESSOR Advantages of Lender/Lessor Arrangement
The tax advantages of a lender-borrower or ground lessor–lessee relationship can be a potent incentive to avoid the equity alternative in structuring investments
4
5
The role of these “intermediary” organizations in funding, training, and guiding local community development corporations is detailed in Grogan and Proscio, Comeback Cities (Westview Press, 2000). However, it can be difficult to spend the 10 percent of project costs necessary to be eligible for a carryover allocation if land is not included. Because upfront costs such as architectural and engineering studies may not total 10 percent, the developer may have to begin construction to meet the carryover requirement. Interview with Jerome Breed, partner, Powell Goldstein, LLP, Feb. 2001.
䡲
336
䡲
c06.fm Page 337 Thursday, March 15, 2007 10:15 AM
6.2 A PARTICIPATION AS A LENDER OR GROUND LESSOR
by exempt organizations. The advantages of a lender-borrower or ground lessorlessee relationship include the following: • The return on a loan6 or a ground lease7 comes in the form of interest or
rent, both of which are generally excluded from UBIT under IRC §512(b)(1) and (3).8 • In the case of pension funds, an investment in a form other than an equity
interest may avoid the “plan asset” rules governing fiduciary liability.9 • A debt structuring permits all depreciation and other deductions and
losses to be retained by the taxable owner of the property, whereas any such deductions would be “wasted” in the hands of an exempt organization to which such items were allocated through an equity interest. • A loan transaction or ground lease may secure for the exempt organiza-
tion the kind of preferred return which, under the tax-exempt leasing rules, is unavailable to an equity investor without loss of depreciation deductions for the taxable venturer and loss of exemption from the debtfinanced income rules.10 • A true lending transaction or ground lease cannot properly be termed a
“joint venture” and thus would not be subject to the IRS position that the tax exemption of the participating exempt organization is jeopardized unless the joint venture itself pursues a “related activity.”11
6
7 8
9 10 11
It may nonetheless be considered an “investment” for some purposes. For example, §4944(a)(1) prohibits a private foundation from making a “jeopardizing investment.” Although these rules do not strictly apply to public charities, they offer guidance to charities when determining what joint ventures they should fund. One investment that is specifically excluded from the definition of a “jeopardizing investment” is a “program-related investment,” defined as an investment whose primary purpose is to accomplish one or more charitable purposes and no significant purpose of which is the production of income or appreciation of property. §4944(c). Examples of program-related investments include (1) high-risk loans to nonprofit low-income housing projects; (2) low-interest loans to small businesses owned by members of economically disadvantaged groups, when commercial funds at reasonable interest rates are not readily available; and (3) low-interest loans to businesses in deteriorating urban areas under a plan to improve the economy of the area and offer jobs to the unemployed. See Reg.§53.4944-3(b), Examples 1-6. For a detailed discussion of PRIs, see Section 4.9(a). See Priv. Ltr. Rul. 84-29-051 (Apr. 18, 1984). See Priv. Ltr. Rul. 90-12-058 (Mar. 23, 1990); Priv. Ltr. Rul. 81-33-051 (May 19, 1981). See, e.g., Priv. Ltr. Rul. 93-19-044 (Feb. 18, 1993) (exempt university loaned construction funds to a joint venture. The joint venture involved the building of an educational/medical facility. In return, the university received interest income and rental income from the joint venture, which were not subject to UBIT) See §512(b)(3); Reg. §1.512(b)-1(c)(2). See Chapter 8. See generally Rev. Rul. 79-349, 1979-2 C.B. 233. See Chapter 4. However, echoes of that doctrine arguably reverberate in Priv. Ltr. Rul. 84-29051 (Apr. 18, 1984), which considered the status of an exempt organization that made a nonrecourse loan at below-market interest to a limited partnership that was to construct and develop a marketplace in a depressed urban area where conventional financing sources were unavailable. The IRS held that the transaction would not affect its exemption because the activity would further traditionally charitable purposes. However, this holding seemed directed less at the lending transaction itself than at the payment of a percentage of partnership profits to forprofit affiliates for services as managing general partner and project manager.
䡲
337
䡲
c06.fm Page 338 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
(b)
Advantages of Equity Ownership
There are, however, advantages of equity ownership that must be carefully weighed against the benefits of a lender or lessor arrangement before an informed structuring decision can be made: • If the exempt organization has unrelated business taxable income derived
from business activities, services, or debt-financed income, the depreciation deductions available to a property owner can be a valuable offset. • If the exempt organization invests in a venture through a corporate subsid-
iary that is partially capitalized with debt or otherwise lends money directly or indirectly to a C corporation, the exempt organization must run the gamut of the “earnings stripping” rules of IRC §163(j), resulting in possible loss of deductibility of the interest paid by the borrower corporation.12 • If a debt or lease structuring were vulnerable to recharacterization as
equity for the reasons discussed later in this chapter, it may be preferable for non-tax reasons to structure the transaction ab initio as an equity investment; if loan or lease documentation is in place but there is then a recharacterization to equity, the exempt organization could lose the security position it holds as lender through possessory rights of foreclosure or eviction, while having forgone the protections it would have enjoyed as a party to a partnership agreement. (c)
Tax Consequences of Reclassification of Loan or Lease as Joint Venture
The author has found that in most cases, after balancing the foregoing respective advantages of a joint venture and the alternatives thereto, a loan or ground lease is the preferred structuring alternative. Suppose such a transaction is consummated in the expectation that equity consequences will be avoided, but the IRS then seeks to reclassify the loan or ground lease arrangement as a joint venture for any of the reasons to be discussed in this chapter. What are the tax consequences if the IRS’s position prevails? First, all of the enumerated advantages of nonequity investments would be lost; for example, in addition to UBIT exposure, some of the depreciation and other expenses would be reallocated to the exempt organization, which would now be treated as a partner of the taxable joint venturer. Second, the “interest” or “rent” payments would be subjected to the rules of Subchapter K, the code provision governing taxation of partnerships. The fixed component of those payments would likely be treated as IRC §707(c) guaranteed payments to the lender or lessor partner for the use of its capital, deductible by the joint venture in determining the amount of profits allocable among the partners. Any contingent equity kicker component could be treated either as a guaranteed payment or a distributive share of partnership income. Third, the tax basis of property held by the partnership may be affected. Where the exempt organization has historically owned the property in question, a purchase—money lending transaction would 12
§163(j).
䡲
338
䡲
c06.fm Page 339 Thursday, March 15, 2007 10:15 AM
6.3 TYPES OF REAL ESTATE LOANS
probably be recharacterized as contribution of the property to a partnership, resulting in a carryover of the basis of the contributing partner to the partnership;13 typically, this basis would be significantly lower than the fair-marketvalue sale price for the property, resulting in reduced depreciation deductions and greater capital gain on ultimate disposition. As will be seen in this chapter, and as reflected in the term equity kicker, it is the contingent component of ground rent or interest that tends to cause the IRS to view the loan or lease as being tantamount to an equity investment in substance, suitable for recharacterization.14
6.3 (a)
TYPES OF REAL ESTATE LOANS Construction Loans
When an entity owns or purchases undeveloped land, or owns property with a depreciated building on it, the organization may desire to improve the property.15 The value of the undeveloped land is likely to be considerably less than the value of the land with improvements. Thus, the property owner that requires funds to develop the property must convince the lender that the owner will be able to pay back the loan from the projected net operating income from the completed project and/or from the proceeds upon sale of the property.16 The construction loan is typically the riskiest of all real estate loans. The lender usually lends money to cover all of the hard and soft construction costs of the project.17 The loan is typically structured as a term loan and funds are advanced in stages, as construction progresses. Usually, the stages correspond to completion phases of the project. For example, if property is raw land, there is a development stage when the property must be subdivided, infrastructure must be constructed, roads must be dedicated and built, and utilities must be installed. The construction stage is broken down in accordance with a construction schedule, budget, and agreement. The construction loan term is usually short: approximately two to three years. On the maturity date, the project is expected to be substantially completed. At that time, the construction lender is typically “taken out” of the transaction through the substitution of a permanent lender, when the proceeds of a permanent loan are used to pay off the construction loan.
13 14
15 16 17
§723. As will also be seen, such recharacterization is substantially more likely to occur if certain factors are present, e.g., the interest or rent is based on net income or profits of the borrower or lessee, and is less likely if, e.g., the interest or rent is based on gross revenue or receipts. See generally Sections 6.3(b) and 6.4(b). Selling the property after subdividing it, instead, may maximize the entity’s total yield. For a detailed discussion of the options available to an entity holding raw land, see Section 6.8. Priv. Ltr. Rul. 84-29-051 (Apr. 18, 1984) (exempt organization participation in construction loan to further charitable purposes). Priv. Ltr. Rul. 93-19-044 (Feb. 18, 1993) (an exempt university participated in a joint venture, which constructed an educational/medical facility on land owned by the university. The university loaned a portion of the construction funds to the joint venture).
䡲
339
䡲
c06.fm Page 340 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
(b)
Bridge Loans
To bridge the gap between a construction loan and a permanent loan, or to finance the acquisition of a project prior to obtaining a permanent loan, a lender may finance a portion or all of the costs for a short term. This is commonly referred to as a bridge loan. A bridge loan affords the borrower time to arrange for a permanent loan or to structure an alternative source of financing. (c)
Wraparound or Second Mortgage Loans
When the property is acquired or the construction is to begin, if a low-interest loan is in place, a wraparound or second mortgage loan may be structured to finance the balance of the acquisition cost or the construction cost of the project. For example, a purchaser of real property may acquire property subject to an assumable mortgage. The terms of the existing loan may be more attractive than a market-rate loan. In addition, by allowing the existing mortgage to stay in place, the purchaser or borrower can often save recording expenses, transfer taxes, and certain financing fees. In most situations, though, the existing loan has been paid down and the borrower needs additional financing to acquire and fund the project. If the borrower obtains financing from a different lender, the new loan may “wrap around” the old loan, and the original lender’s security interest will not be impaired. The borrower may also obtain financing from another source at market rates. The new loan from an independent source may be secured by the remaining equity in the project, and the security interest therein would typically be subordinate to the existing loan. The new lender is often referred to as a second lienholder. (d)
Permanent Loans
The more conventional loan is a first mortgage for a term of approximately 7 to 10 years. Typically, a permanent loan finances improved property; a lender may issue a forward commitment. This means that a lender agrees in advance to make a permanent loan once improvements to the real property are substantially complete.18 A permanent loan may also be funded in stages, similar to a construction loan. After the initial advance, subsequent advances may be conditioned on the property satisfying certain operating requirements. Alternatively, a portion of the loan proceeds may be held in reserve, to be advanced when certain leasing requirements are met. Part of the proceeds may be earmarked to cover the loan’s debt service. (e)
Bond Financing
Lenders may provide credit enhancement to assist borrowers in obtaining alternative financing, such as bond financing.19 If a borrower desires to obtain bond financing from a municipality, often the municipality requires additional credit 18 19
See Priv. Ltr. Rul. 78-46-033 (Aug. 16, 1978); Priv. Ltr. Rul. 78-46-034 (Aug. 16, 1978). See Chapter 16.
䡲
340
䡲
c06.fm Page 341 Thursday, March 15, 2007 10:15 AM
6.4 PARTICIPATING LOANS
to secure its loan. The lender may agree to add its credit in the form of a direct repayment obligation to a third-party lender to obtain the bond financing. The lender may guaranty the loan and secure its guaranty with a letter of credit. In exchange, the lender could receive an equity interest or “kicker” in the project for providing the letter of credit. When charging a fee for the use of its funds, the exempt organization should carefully distinguish the purpose of the fees, to be assured that they will be characterized as interest. The fee should be required by the lender as a condition of obtaining the loan, should be refundable if the loan is not consummated, and should not be based on the length of the commitment (because the fee then has the appearance of being associated with a period other than the loan term) or related to the services of processing the loan.
6.4 (a)
PARTICIPATING LOANS Overview
When considering whether to lend funds, the exempt organization lender should evaluate the intended use of the loan proceeds, the security for the loan, the borrower’s financial capabilities, the term of the loan, and the yield on the lender’s investment.20 The yield may be in the form of a simple fixed interest rate or may, in addition, include a percentage of the net proceeds received from the property as a result of the refinancing of a mortgage on the property or the sale of all or a portion of the property. Alternatively, or in addition to residual participation, a lender may share in the cash flow of the project. Interest rates for real property loans vary, depending on the purpose and risk of the loan, the type of property that will secure repayment of the loan, and the term of the loan. For example, a lender may be willing to commit to a long-term loan and may initially charge a lower interest rate. However, the lender may increase the interest rate during the term of the loan, based on assumptions as to when the property will produce net operating income, so that the cash flow can meet the increased debt service and give the lender a satisfactory yield commensurate with the risk. The increase in the interest rate is considered the lender’s participation in the loan. In a participating loan, the primary question is whether the proposed increase will be treated as debt for federal income tax purposes.21 For the exempt organization lender, receipt of interest income will not be subject to UBIT, as would income from a joint venture interest if either the joint venture property is debt financed or the joint venture has certain types of active business income.22 20
21 22
Under the Pension Protection Act of 2006, P.L. 109–280, which was signed into law on August 17, 2006, loans between certain exempt organizations and certain disqualified persons are considered automatic excess benefit transactions. See Section 5.4 for a discussion of intermediate sanctions and automatic excess benefit transactions. See generally, Buchholz, Cassanas, and Massman, “The Road from Debt to Equity,” ABA Section of Taxation (May 1993). §§514(c)(9) and 512(b)(8)(B). See generally Bussing v. Commissioner, 88 T.C. 449 (1987) (purported sale-leaseback arrangement reclassified as a joint venture). Priv. Ltr. Rul. 93-19044 (Feb. 18, 1993) (exempt university participated in joint venture involving the construction of an educational/medical facility. Because the medical/educational facility was substantially related to the university’s exempt function, the property was not considered debt-financed). For a thorough discussion of the debt-financed property rules, see Chapter 8.
䡲
341
䡲
c06.fm Page 342 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
To illustrate, a lender may agree to make a nonrecourse loan, accruing interest at the rate of 12 percent per annum, with fixed monthly payments based on a 7 percent pay rate. Payments can be applied first against the current pay rate, then against accrued interest (at the 5 percent rate), and then against principal. In addition, the borrower can agree to pay a percentage of the project’s cash flow over and above the debt service to bring the unpaid principal balance in line with that required by an amortized schedule based on 12 percent interest. The entire unpaid balance of the loan, including unpaid accrued interest, would be paid at maturity of the loan. If the property does not generate enough cash flow to meet the debt service on the loan, the lender can allow interest to accrue and remain unpaid until maturity. When deferred interest is added to the principal loan balance, this is commonly referred to as negative amortization. In addition to charging simple interest on a loan, the lender may negotiate an equity interest in the project. The ownership interest is commonly referred to as a “kicker,” whereby the lender shares the benefits of ownership with the borrower. In addition to paying the lender interest, the borrower may agree to (1) provide the lender with a percentage of cash flow, (2) pay a percentage of refinancing or sale proceeds, and/or (3) share certain tax benefits to the extent the lender subsequently acquires an equity interest in the property.23 An equity kicker may take the form of a conversion feature in the loan documents. In other words, instead of receiving a percentage of the income from the property, the lender may have the option to convert the loan, or a portion of the loan, into a partnership or other equity interest in the borrower.24 The amount of “participation” that the lender receives may depend on whether the lender is financing a first or second loan, the term of the loan, and the risks associated with the project. EXAMPLE: If the level of financing is 90 to 95 percent of the cost of the project, the lender may receive as much as a 50 percent participation in both the property’s cash flow and its appreciation. Alternatively, if the lender is providing secondary financing, it may receive only a 10 to 15 percent participation in the project. As can be seen from the foregoing discussion, there are numerous types of financing alternatives available to a tax-exempt organization. The type and form of the structure of the loan may have a significant impact on the tax consequences to a tax-exempt organization as a lender, as well as to the taxable borrower. Substance over form must be considered in evaluating each transaction.
23 24
See Priv. Ltr. Rul 90-12-058 (Mar. 23, 1990). See Gen. Couns. Mem. 36,702 (Apr. 12, 1976) (a “loan” was evidenced by a 40-year note, with interest payable monthly and secured by a second mortgage. The interest was adjustable and escalated based on a percentage of the borrower’s gross profits above a certain threshold. The borrower did not have the right to prepay the note, and the lender could convert the note into an equity position in the property. The IRS recharacterized the “loan” arrangement as a partnership). But see Priv. Ltr. Rul. 81-20-107 (Feb. 20, 1981) (a long-term ground lease provided for a fixed rent with periodic escalations. The real estate investment trust (REIT) lessor had the option to convert its creditor position to that of a partner if the cash flow or gross income from the lessee’s operations exceeded a minimum agreed-upon threshold. The IRS determined that payments made by the lessee constituted rent, despite the conversion option).
䡲
342
䡲
c06.fm Page 343 Thursday, March 15, 2007 10:15 AM
6.4 PARTICIPATING LOANS
(b)
Debt-Equity Classification
Whether a debt obligation is to be treated as debt or equity is generally a question of fact, determined by evaluating various factors. Especially with participating loans, the determination of whether the loan will be treated as debt for tax purposes will likely be based on an examination of the “equity type” features of the loan. As discussed above, the participating loan may provide more than one component of interest: (1) interest payable to a lender as fixed or simple interest income and (2) interest payable as a percentage of the borrower’s receipts or profits from the project. Whether the interest income is recharacterized as equity could affect both the exempt organization and the taxable investors in the joint venture.25 Generally “passive” interest is excluded from UBIT. However, contingent interest based on the borrower’s net receipts or income may be characterized as participation in the borrower’s business, and therefore, would not be “passive.”26 The loan (or a portion thereof) may be reclassified as an equity interest in the borrower and would fall outside the UBIT exclusion for interest. (i) The Farley Case. One of the leading cases in determining whether a payment to a lender is to be characterized as an interest payment on a debt or the payment of a dividend on an equity interest is Farley Realty Corporation v. Commissioner.27 The Second Circuit held that despite the clear intent of the parties to establish a debtor-creditor relationship, the lender held two positions, both as a creditor and as a stockholder, because it had the right to share in the appreciation of the property similar to an owner of the property. In reaching its conclusion, the court first noted that the lender had initially demanded a higher interest rate, but agreed to a lower rate in exchange for a “less certain but potentially more lucrative right to share in the fortunes”28 of the venture. If the venture was successful, the lender would have benefited; if it was not, the lender would have suffered the loss measured by the difference in the 25
26
27 28
Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960). An individual agreed to lend money to a corporation for the purchase of real property. The loan earned interest at a below-market fixed interest rate, and gave the lender the right to receive 50 percent of the appreciated value in the real property. The lender also had a right of first refusal upon the sale of the property and the right to receive an ownership interest in the property in lieu of repayment of the outstanding principal on the maturity date. See Rev. Rul. 69-188, 1969-1 C.B. 54 (classification of debt-equity). For UBIT purposes, the regulations provide that rent may be based on gross receipts but not net profits. Reg. §1.512(b)-1(c)(2)(iii)(b). There is no equivalent express rule for interest, but §856(f)(1)(A) would probably apply by analogy. That provision states, for purposes of defining interest as a permitted type of passive income of a real estate investment trust (REIT), that contingent interest may be based on gross receipts but not on net profits. See Rev. Rul. 76-413, 1976-2 C.B. 213, which concludes that the REIT restriction on contingent interest income is designed to ensure that no profit-sharing arrangement exists to make the lender an active participant in the property. Because this policy applies equally to UBIT, and because the UBIT rent regulation cited earlier cross-references to the corresponding REIT standard for rent, the REIT rules would likely be applied to interest as well as to rent for UBIT purposes. Many of the citations in this chapter are to the REIT regulations or rulings thereunder, as those rules have been the subject of far more published authority than have the UBIT rules themselves. See generally H.R. Rep. No. 2020, 86th Cong., 2d Sess. 3 (1960) (legislative history of REITs). 279 F.2d 701 (2d Cir. 1960). See Reg. §1.512(b)-1(a)(1). Farley, 279 F.2d at 704.
䡲
343
䡲
c06.fm Page 344 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
interest rate he originally sought and the rate eventually accepted.29 Thus, he shared in the risk of the venture as an equity owner does. Second, the amount of the appreciation was indefinite, whereas interest was a fixed amount. Third, there was no fixed maturity date for termination of the parties’ relationship. However, the court failed to indicate whether equity characterization could have resulted from fewer than all of these factors taken in the aggregate, and if so, which ones would have sufficed.30 Indeed, other cases have been decided differently from Farley. Several courts have broadly defined interest as compensation for the use of, or forbearance of, money and therefore have allowed interest deductions even when interest is paid in the form of property. Based on this broad definition, any amount paid in excess of the original principal amount lent may be characterized as interest. In one situation,31 a lender agreed to accept stock in addition to a lump sum payment of the principal amount owed for the use of its money. The amount paid in excess of the principal balance was characterized as interest, because the excess was paid for the use of the borrowed money. Even when stock is transferred in lieu of a fixed amount of cash, a court may characterize the stock as an interest payment if it concludes that the stock is compensation for the loan. (ii) Contingent Interest. When contingent interest payments are provided for in a loan, the payments will qualify as interest only if the IRS finds that the payments are for the use of money,32 not payments for specific services that the lender performs.33 (iii) Option to Purchase: Sale-Leaseback. The IRS will scrutinize transactions in which an exempt organization lender is given an option to purchase the underlying land in consideration for repayment of the loan, especially when the borrower can lease back the property and pay rent equal to interest under the loan.34 Alternatively, the exempt organization, in lieu of making an acquisition and construction loan, may purchase land from a partnership and lease it back to the entity. The exempt organization may also make a construction loan with participation features.35
29 30
31 32 33 34
35
See id. The court did state, however, that “the absence of a fixed maturity date is a critical factor weighing against a corporate taxpayer’s claim that a debtor-creditor relationship existed between it and its payee.” Farley, 279 F.2d at 705. It is not clear whether this factor would have been, in and of itself, enough to bring about equity characterization. Gardner v. Commissioner, 613 F.2d 160 (6th Cir. 1980). See Deputy v. DuPont, 308 U.S. 488 (1940); Old Colony R.R. Co. v. Commissioner, 284 U.S. 552 (1932); Rev. Rul. 83-51, 1983-1 C.B. 48. See Rev. Rul. 79-349, 1979-2 C.B. 233 (income attributable to services performed by lender is not excludable from UBIT). See Priv. Ltr. Rul. 78-46-034 (Aug. 16, 1978), in which the IRS considered such a factual situation and concluded that the exempt organization/lender should be treated as the owner of the land throughout the transaction, and therefore, all payments would be treated as UBIT and would not qualify as interest payments. For a general discussion of the sale-leaseback and its relationship to joint ventures, see Bussing v. Commissioner, 88 T.C. 449 (1987). See also Robinson, Federal Income Taxation of Real Estate ¶8.03[1], 6th ed. (1996).
䡲
344
䡲
c06.fm Page 345 Thursday, March 15, 2007 10:15 AM
6.4 PARTICIPATING LOANS
EXAMPLE: A ground lease provides for fixed rent based on a coupon of 8 percent per annum, plus additional rent equal to a percentage of net cash flow from the project. The borrowing partnership can require the exempt organization lender to participate in a sale of the project upon maturity of the loan. In that case, the lender, as owner of the ground, would receive a share of the aggregate sales proceeds. Having no “cap” on the lender’s rate of return may give the appearance of an equity interest. CAVEAT Caution is also required when an exempt organization initially owns real property, sells it to an entity, and lends purchase money to the purchasing entity. If the loan documents give the lending exempt organization an open-ended option to purchase the property back and allow the lender to participate in the day-to-day management decisions to protect its interest in the property, the IRS may take the position that the lending exempt organization retains an ownership interest in the property. The IRS has recharacterized certain loan transactions in which an exempt organization provided permanent financing for an office building.36 The exempt organization made two loans to a joint venture, and the exempt organization was given the right to purchase the property during certain periods. One promissory note had a fixed rate of interest and matured in 36 years, unless prepaid by the owner or accelerated by the exempt organization. The other note matured in 65 years, unless the exempt organization exercised its right to purchase the property. The 65-year note had a fixed interest rate plus additional interest equal to 46 percent of the gross income of the building over a base amount. Interest payments made on the 36-year note qualified as interest. However, the IRS would not automatically characterize the additional interest payable under the 65-year note as interest, rather than an equity interest taxable to the exempt organization as unrelated business income.37 The facts that the exempt organization had a right to purchase the property and that the borrower would not benefit from the appreciation of the property were important in the determination of ownership for federal income tax purposes. The foregoing discussion demonstrates the importance for an exempt organization to carefully structure its financing of a real estate project. Although interest income is generally not subject to UBIT, and nothing in the UBIT provisions specifically provides for recharacterization of debt as equity, the wellknown potential for such recharacterization in the tax laws mandates that the 36
37
See Priv. Ltr. Rul. 78-46-033 (Aug. 16, 1978), in which the IRS ruled that a loan with fixed interest is not subject to UBIT. However, the IRS would not issue an advance ruling that a loan that gives the lender the option to purchase the secured property and to participate in the appreciation of the property qualifies as a debt. In other words, the IRS will scrutinize all of the facts of such a participating loan transaction before it concludes that the investment should be characterized as a loan. See Dorzback v. Collison, 93 F. Supp. 935 (1950), aff’d, 195 F.2d 69 (1952), in which the court held that the lender’s right to purchase the property and share in the appreciation of the property disqualified the payments as interest.
䡲
345
䡲
c06.fm Page 346 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
compensation paid to the exempt organization/lender should not be based on net income or profits.38 If the structure of the transaction between the borrower and the exempt organization/lender bears resemblance to an equity investment, as opposed to a debtor/creditor relationship, the IRS may recharacterize the payment made to the lender as equity instead of debt, with the attendant adverse tax consequences. (c)
Guidelines in Structuring Contingent Interest Debt
The following is a review of certain common features of a participating loan that will support treatment of the transaction as debt rather than equity.39 A lender’s right to contingent interest, an interest kicker, and certain management rights will be considered in light of the entire loan transaction. (i) Definite Maturity Date and Cap on Interest Participation. A participating loan should have a definite maturity date that is well within the typical duration for a conventional real estate loan. A short term is an important indication of debt status.40 A lending exempt organization should have a right to receive a return on its money measured by reference to both a fixed interest rate and a percentage of income from the borrower’s project, which percentage should be set forth in a formula. The Internal Revenue Service (IRS) has held that the method of computation does not control a payment’s characterization as interest, as long as the amount in question is an ascertainable sum contracted for the use of borrowed money.41 The inclusion of substantial fixed interest, payable in all events on fixed dates, supports a creditor’s relationship with the borrower. The lending exempt organization’s right to receive contingent interest should be limited to rebut the presumption that participating debt is disguised equity. A ceiling on the amount or rate of interest that the lender may receive is considered a “cap” on the interest. A loan that provides additional interest based on the appreciated value of real property should provide a formula for determining the property’s fair market value and a cap on the rate of interest. For example, if the lender is given an option in the future to purchase the property, the loan documents should provide a date certain to exercise the option (e.g., the earlier of the maturity date or the date the property is sold). In addition, the documents should provide that in no event may the purchase price of the property exceed the principal loan balance plus interest based on the prevailing market rate for fixed interest rate loans determined on the date the option is exercised. Arguably, the contingent interest is to be used to protect against inflation and 38
39
40 41
See generally §385 and §856(f)(1)(A). It may be argued that the real economic function of contingent interest is not to participate in the borrower’s business but to protect the value of the loan against the unpredictable ravages of inflation. However, for planning purposes it would not be prudent to assume the IRS would accept this argument. See Kaster and Ross, 591 T.M., “Real Estate Transactions by Exempt Entities,” at §IIE-4. Lew Kaster is widely regarded as a leading authority in this area and his treatise is an excellent and thorough resource. In Monon R.R. v. Commissioner, 55 T.C. 345 (1970) (acq.), the court respected a 50-year participating loan as debt. See Rev. Rul. 69-188, 1969-1 C.B. 54; Kena, Inc. v. Commissioner, 44 B.T.A. 217 (1941).
䡲
346
䡲
c06.fm Page 347 Thursday, March 15, 2007 10:15 AM
6.4 PARTICIPATING LOANS
can be ascertained. The agreement to cap the lender’s participation in a meaningful way is inconsistent with an intention to share profits.42 In certain situations, contingent payment formulas that represent either a substantial portion of the borrower’s net profits or a substantial percentage of the principal of the loan have been allowed as interest payments.43 However, as the IRS and the courts gain sophistication in understanding these transactions, such holdings will likely become rare. Reclassification of a loan as an equity investment should be expected where the transaction as a whole “smells” like a priority partnership distribution—as it may, for example, where the kicker combined with the regular interest accounts for the bulk of the projected profits and the lender organization reserves certain management rights (see discussion in Section iii). The most reliable way to enhance the probability that a significant kicker will be upheld as interest is to place a meaningful cap on the potential amount of the participation. (ii) Convertibility. The right to convert the loan (or a portion of the loan) into an ownership interest in the borrower may be recharacterized as an equity interest in a joint venture, especially if the economic return both before and after the conversion is inextricably tied to the net income of the borrower. A conversion feature may pass IRS scrutiny if participation after conversion is equal to the ratio of the outstanding debt balance to the fair market value of the property on the date of conversion.44 EXAMPLE: If (1) the lender has a right to convert the principal balance of the loan into a partnership interest in the borrower at any time, and (2) the interest rate of the loan is continually adjusted based on (a) the borrower’s gross income and (b) the payment of the borrower’s debts, then, arguably, the economic return before conversion and the return after conversion are identical. The interest looks more like a return on equity than interest on indebtedness.45 Alternatively, if (1) the lender is given an option to purchase an equity interest in the borrower on a specified future date, and (2) the outstanding debt is reduced to an amount equal to the ratio of the outstanding debt balance to the fair market value of the property being purchased on the date of the conversion, and (3) there is a cap on the interest participation, then the transaction should continue to be characterized as a loan.
42 43
44 45
See Commissioner v. John Kelly Co., 1 T.C. 457 (1943), rev’d 146 F.2d 466 (7th Cir. 1944), rev’d 326 U.S. 521 (1946); Monon R.R. v. Commissioner 55 T.C. 345 (1970). Kena, Inv. v. Commissioner, 44 B.T.A. 217 (1941) (uncapped contingent interest equal to 80 percent of net operating profits); Dorzback v. Collison, 195 F.2d 69 (3d Cir. 1952) (uncapped contingent interest equal to 25 percent of net operating profits, which typically equaled or exceeded the entire principal advanced on an annual basis); Rev. Rul. 83-51, 1983-1 C.B. 48 (uncapped kicker interest equal to 40 percent of appreciation on sale). See Kaster and Ross, note 31, at §IIE4b. See Gen. Couns. Mem. 36,702 (Apr. 12, 1978).
䡲
347
䡲
c06.fm Page 348 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
PLANNING POINT Check whether applicable state law would preclude enforceability of a conversion option. A prohibition against the mortgagee’s “clogging the equity of redemption” would render it counterproductive to use a conversion option with its attendant tax risk. In other words, the borrower must have a vehicle to redeem its interest in property after the borrower has defaulted under loan documents and forfeits its property interest. If the conversion option stands in the way of the borrower’s right to redeem, the conversion option would be unenforceable. CAVEAT Convertible debt does not constitute “qualified nonrecourse financing” under IRC §465(b)(6)(B)(iv), and thus will not be an amount “at risk” that would provide additional basis to support the owner’s deductions.* *
§465(b)(6)(B)(iv).
(iii) Management Rights. Although the exempt organization lender may have some management rights to protect its right to receive interest in a participating loan or affect the security interest in the loan, these management rights should be limited. The loan may permit the lender to approve major decisions, but should not give the exempt organization/lender a voice in day-to-day management. If the lender participates in day-to-day management, its interest may be recharacterized as an equity interest in a joint venture. The lending exempt organization’s role should be limited to monitoring operations through reports rather than being directly involved with the day-to-day operations, so that the lender’s management role will not have a substantial impact on the overall analysis of the transaction. The following is a list of approval rights that a lender commonly requires in a loan transaction to protect its investment. Because these are standard lending requirements, they are less likely to be characterized as day-to-day management rights: • Approval of lease form • Approval of leasing guidelines • Approval of each lease • Approval of standards of maintenance • Approval of management contract and any change of management com-
pany • Approval of property leasing agreement and leasing company • Approval of sale of property • Approval of capital improvements • Approval of annual budgets • Approval of settlement of litigation involving the project46 46
See Buchholz, Cassanas, and Massman, note 13, at 4.
䡲
348
䡲
c06.fm Page 349 Thursday, March 15, 2007 10:15 AM
6.4 PARTICIPATING LOANS
(iv) Interest Based on Gross Receipts. Contingent interest may be computed by reference either to the borrower’s gross income (or receipts or cash flow from the property) above a floor, or the borrower’s net profits. A sharing of net profits is more typical of an equity joint venture, whereas a right to share in gross income is more common in a loan transaction. Interest should be based on gross receipts rather than net income, with specified modifications to account for the costs associated with running the property.47 (v) Adequate Capitalization. If the borrower makes a substantial equity investment in the project, this would be a strong indication of debt status, because the investment lends economic reality to the lender’s forbearance of its use of its funds and supports the lender’s security interest in the property. “Substantial” equity would be determined based on the industry standards. Typically, a prudent lender would make a loan in an amount not to exceed 80 percent of the fair market value of the property.48 (vi) Prepayment Penalty or “Premium”. A prepayment penalty or premium is typically treated as interest.49 If the lender wants to preserve its interest yield, the lender can limit the borrower’s right to prepay the loan to the back end, such as the last two years of the loan. If the borrower were to prepay the loan prior to the last two years of the loan, the lender could impose a prepayment penalty based on a lost yield analysis. Thus, the exempt organization would receive a yield equivalent to that which would have been realized had the loan continued to maturity. The following is an example of a prepayment penalty provision that may be included in a promissory note: This Note may be prepaid upon ten (10) days prior written notice in whole or in part on any regularly scheduled interest due date hereof, by paying all interest accrued on this Note to date of such prepayment (together with accrued and unpaid late charges, if any), plus a prepayment premium equal to—percent of the amount of the prepayment if such prepayment is made during the—through—months after the date of this Note and equal to—percent of the amount of the prepayment if such prepayment is made at any time thereafter to and including the—month, and without prepayment premium thereafter.
(vii) Other Controls. There are other functional responsibilities associated with an exempt organization’s role as a lender in a joint venture. It is important that the lender negotiate adequate controls, operating parameters, and borrower obligations, which should be sufficiently documented to protect the exempt organization’s financial investment in the participating loan. The joint venture should provide the exempt organization with projections to support the borrower’s ability to repay principal and to service, at a minimum, the fixed interest 47
48 49
Rev. Rul. 76-413, 1976-2 C.B. 213; Priv. Ltr. Rul. 83-13-037 (Dec. 27, 1982) (payments based on the excess of adjusted gross income over a basic amount that excluded various costs connected with the property, such as utilities, taxes, insurance, and common area maintenance, held to be interest on indebtedness). Ruspyn Corp. v. Commissioner, 18 T.C. 769 (1952) (acq.). S. Rex Lewis v. Commissioner, 65 T.C. 625 (1975).
䡲
349
䡲
c06.fm Page 350 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
payments of the loan. The absence of cash flow coverage may be evidence that the exempt organization did not expect timely repayment, and therefore did not intend to create a debtor-creditor relationship. The exempt organization lender should require standard quarterly and annual financial statements, as well as reports as to leasing status, rental rates, operating expenses, cash flow, capital expenditures, and reserves. The loan documents should provide the right to perform regular inspections and audits. In connection with an office building or shopping center, leasing parameters should be established at the outset. The joint venture/borrower and the exempt organization/lender must keep each other informed of market conditions affecting the property. The joint venture and the exempt organization may have different perspectives and sources of information, which should be exchanged to permit a better understanding of the demographic trends and leasing opportunities that affect the property’s value. The joint venture may subsequently sell the property to a third party. In this regard, a “due on sale” clause should be included in the deed of trust or mortgage, which would require the loan to be paid in full upon the sale of the property. Alternatively, the property may be sold with the loan remaining in place, but the exempt organization should reserve the right to approve the new owner. If the loan is to remain in place, the lender’s equity participation earned to date should be paid at the time the property is sold, and the sale price will then create a new base for further equity participation by the exempt organization/lender. (d)
Service and Commitment Fees
The fees received by the lender associated with processing the loan are likely to be considered subject to UBIT. Origination fees and service fees commonly charged in connection with a loan transaction would not be considered “interest income” because this form of compensation is often paid to the exempt organization lender for services rendered in obtaining a loan and not for the use of money. Loan commitment fees, however, are specifically excluded from UBIT.50 Unrelated business income (UBI) is generally defined as gross income derived from any unrelated trade or business regularly carried on by the exempt organization, less allowable deductions that are directly connected with carrying on the trade or business.51 Three conditions must be met for income to be UBI to the exempt organization: 1. The income must be from a “trade or business.” 2. The trade or business must be “regularly carried on.” 50
51
§512(b) as amended by §13148(a) of the 1993 Act. If a loan fee is not customary as a prerequisite to a commercial loan origination, however, it may not fit within the boundaries of the specific exception. If there is a question as to whether the fee is customarily required, precautions should be taken to ensure that fee will be, in the alternative, characterized as interest— also excluded from UBIT. To maximize the likelihood of interest treatment, the fee should be required by the lender as a condition of obtaining the loan, should be refundable if the loan is not consummated, and should not be based on the length of the commitment. See Kaster and Ross, note 31 at IIE6d. See Chapter 8 on UBIT.
䡲
350
䡲
c06.fm Page 351 Thursday, March 15, 2007 10:15 AM
6.4 PARTICIPATING LOANS
3. The activity must not be “substantially related” to the organization’s performance of its exempt function.52 Unless an exempt organization is engaged in a regular volume of loan activity, the “regularly carried on” element would not be present. Thus, it appears that fees generated from an isolated lending transaction should be outside the UBIT rules even if they do not qualify as interest. On the other hand, for exempt organizations that engage in such investments with some regularity, great care must be observed so that the “regularly carried on” threshold is not crossed or, alternatively, that such fees constitute excludable interest. Whether a payment qualifies as interest depends on the facts and circumstances of the particular case.53 Neither the label that the parties attach to a payment nor the method of computation determines its treatment.54 EXAMPLE: A loan fee charged to obtain a construction loan has been treated as “interest” within the meaning of IRC §163(a).55 Similarly, points paid to obtain a low interest rate, or to obtain a construction loan, are considered fees paid for the use or forbearance of money. The IRS considers the facts carefully to determine whether any portion of a loan fee is attributable to services rendered in connection with processing the loan. A lender is entitled to charge a fee to create a cushion for a low interest rate.56 However, a brokerage fee or a loan commitment fee generally is not interest.57 Similarly, service fees paid for legal, closing, accounting, and appraisal costs related to a loan are not interest.58 A prepayment penalty is treated as interest.59 A guaranteed payment made to a partner for the use of capital is generally not interest.60 When charging a fee for the use of its funds, the exempt organization should carefully distinguish the purpose of the fees, to be assured that the fees will be characterized as interest. The fee should be required by the lender as a condition of obtaining the loan, should be refundable if the loan is not consummated, and should not be based on the length of the commitment (because the fee then has the appearance of being associated with a period other than the loan term) or related to the services of processing the loan.
52 53 54 55 56 57 58 59 60
§512(a)(1). Reg. §1.512(b)-1. Reg. §1.512(b)-1. See Alan A. Rubnitz v. Commissioner, 67 T.C. 621 (1977). See Donald W. Wilkenson v. Commissioner, 70 T.C. 240 (1978). See Lay v. Commissioner, 69 T.C. 421 (1977); H.K. Francis, 36 T.C.M. (CCH) 704, 707-08 (1977). Rev. Rul. 79-349, 1979-2 C.B. 233. S. Rex Lewis v. Commissioner, 65 T.C. 625 (1975). Although earlier authority held that such a payment was treated as interest (see Gen. Couns. Mem. 36,702 (Apr. 12, 1976) and Gen. Couns. Mem. 38,133 (Oct. 10, 1979)) modern rulings decline to do so. See, e.g., Priv. Ltr. Rul. 86-39-035 (June 27, 1986), as modified by Priv. Ltr. Rul. 87-13-031 (Dec. 24, 1986). See Kaster and Ross, note 31 at IIE6g.
䡲
351
䡲
c06.fm Page 352 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
6.5 (a)
GROUND LEASE WITH LEASEHOLD MORTGAGE Overview
An exempt organization may purchase or own property on which a project is to be built. It may choose to be in a lending role rather than take the risks attributable to the owner-developer.61 A hybrid structure may be created in which the exempt organization could own the underlying ground, and a developer would improve and operate the property. The exempt organization could ground lease the property for a long term (such as 75 years) to a developer/borrowing entity in exchange for a fixed rental plus contingent rent based on the project’s revenues or its income.62 In addition, the exempt organization may make a fixed-rate permanent or construction loan to finance the project. Typically, the ground lease is for a term of 35 to 99 years, and at the expiration of the lease term, the improved property reverts to the ground owner. The rental payments under the ground lease may include fixed minimum rent, plus a kicker based on a percentage participation in the project. The ground lease structure enables the ground lessee to own and operate improvements for an extended period of time without having to incur the costs of acquiring a fee interest in the real property.63 The ground lease structure allows the landowner to own improved property without being directly obligated for construction costs and financing costs. In the event of a default by the ground lessee under the ground lease, or at the maturity of the ground lease term, the landowner can terminate the ground lease and therefore own the property. Great care should be taken in structuring a rental formula; otherwise, the IRS may recharacterize the ground lease as a joint venture and treat rental payments as UBI.64 The form of a ground lease will be respected if the structure has true business and economic substance.65 The IRS, in evaluating a lease structure, will consider the customary elements of a ground lease transaction; an exempt organization that owns the land would be expected to enter into a ground lease as an investment as opposed to
61
62 63 64
65
Priv. Ltr. Rul. 90-12-058 (Mar. 23, 1990); Priv. Ltr. Rul. 82-44-016 (no date given). In some jurisdictions, the lessee may not be required to pay transfer and recordation taxes, whereas other jurisdictions may impose such taxes in these circumstances. Local law must be consulted. See generally Priv. Ltr. Rul. 89-32-085 (May 19, 1985). Priv. Ltr. Rul. 83-13-037 (Dec. 27, 1982); Priv. Ltr. Rul. 82-44-016 (no date given). See Harlan E. Moore Charitable Trust v. United States, 812 F. Supp. 130 (1993) (IRS attempts to reclassify a lease as a joint venture), aff’d, 9 F.3d 623 (7th Cir. 1993), acq. in action on decision 95-3953 (Apr. 14, 1995) (Issues 1 & 2); Trust U/W Oblinger v. Commissioner, 100 T.C. No. 9 (1993); Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960). In Priv. Ltr. Rul. 81-20-107 (Feb. 20, 1981), an REIT entered into a ground lease on property to be developed into multiple residences for a term of 65 years. The ground lease provided for a fixed rent plus escalations. In addition, the REIT had the option to purchase a partnership interest in the ground lessee once the income from the property reached a certain level. The IRS held that the payments under the ground lease qualified as rent because the rents were a fixed amount and the escalations were based on gross receipts. See also Priv. Ltr. Rul. 81-33-051 (May 19, 1981) (ground lease respected as lease even though lessor retains extensive controls over refinancing); Priv. Ltr. Rul. 82-44-016 (no date given) (no joint venture found upon ground lessor’s subordination of its fee interest to leasehold financing). Frank Lyon Co. v. United States, 435 U.S. 561 (1978). See generally Section 6.2(c).
䡲
352
䡲
c06.fm Page 353 Thursday, March 15, 2007 10:15 AM
6.5 GROUND LEASE WITH LEASEHOLD MORTGAGE
the carrying on of a trade or business.66 The IRS has recognized a rental formula under a ground lease composed of • a fixed rental amount • a percentage of gross rental from the occupancy tenants, net of property
taxes • extraordinary rent equal to a specified fixed percentage of net sale pro-
ceeds of the leased property67 Even management approval rights held by the exempt organization/ground lessor are acceptable and appropriate in the eyes of the IRS, because they “ensure that the improvements made under the lease will lead to a profitable investment and not a waste of the demised premises.”68 Although the ground lessor’s participation in occupancy and construction details may be considered prudent management of its investment rather than the operating of a business venture or partnership, the involvement should nevertheless be limited.69 Because of the hybrid nature of a ground lease transaction, the structure is subject to being recharacterized by the IRS or the courts as an equity participation arrangement or joint venture, which would affect the tax treatment of the ground lessor’s interest in the rental income. To determine whether an investment, or a portion thereof, should be classified as equity, the courts look to the intent of the parties as objectively manifested by their acts. If the exempt organization is found to be actively engaged in a trade or business, the business activity may generate substantial unrelated business income and the corresponding income tax liability for the organization.70 (b)
Will Rental Income be Treated as UBIT?
(i) Rental Income Based on Net Income or Profits. Rental income from real property under a lease between an exempt organization and an unrelated party is generally excluded from UBI.71 However, rental income will be treated as UBIT to an exempt organization if the amount of rent depends, in whole or in part, on the net income or profits derived by any person from the leased property (other than an amount based on a fixed percentage or percentages of gross receipts or sales).72 66 67
68 69 70 71
72
See Priv. Ltr. Rul. 78-36-030 (June 8, 1978); Priv. Ltr. Rul. 81-33-051 (May 19, 1981). See Priv. Ltr. Rul. 90-12-058 (Mar. 23, 1990); Priv. Ltr. Rul. 89-32-085 (May 19, 1989). In both letter rulings, rentals were due under a long-term ground lease consisting of minimum rent, escalation rent, and rent equal to a portion of the proceeds received by the lessee upon the sale of its leasehold. These rentals constituted “rents” for purposes of §512(b)(3). Priv. Ltr. Rul. 90-12-058 (Mar. 23, 1990); Priv. Ltr. Rul. 89-32-085 (May 19, 1989). Priv. Ltr. Rul. 90-12-058 (Mar. 23, 1990). See generally Priv. Ltr. Rul. 89-01-065 (Oct. 17, 1988). §512(b)(3); Priv. Ltr. Rul. 78-52-001 (Mar. 15, 1978). See also Tech. Adv. Mem. 89-64-002 (Oct. 24, 1988); Priv. Ltr. Rul. 89-01-065 (Oct. 17, 1988). If the property from which the income is derived is debt-financed, however, the income will likely not be excluded from UBIT, even if in the form of rent or interest. §512(b)(4); §514(a)(1); see Section 8.2. §512(b)(3)(B)(ii); Priv. Ltr. Rul. 90-12-058 (Mar. 23, 1990); Madden v. Commissioner, 74 T.C.M. (CCH) 440 (1997) (proceeds from leasing amphitheater included in UBIT because portion of rental income was based on percentage of profits on a sublease).
䡲
353
䡲
c06.fm Page 354 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
Typically, in a ground lease structure an exempt organization leases real property to an unaffiliated third party (the “prime tenant”), which may enter into subleases with subtenants (the “occupancy tenants”). With particular regard to retail leases, the subleases may provide fixed minimum rent plus additional percentage rent based on a percentage of the tenant’s sales and other receipts in excess of the fixed rent, plus a charge for escalated costs in common area maintenance (CAM), real estate taxes, and property insurance. Rent under the prime tenant’s lease may be fixed or may be based on a percentage of the prime tenant’s receipts from the occupancy tenants. The exempt organization is primarily concerned with whether rental income will be treated by the IRS as based on net income or profits, and therefore taxed as UBIT.73 Generally, if rent under the prime lease is based on the prime tenant’s receipts from subleases and if rent under even one of such subleases is based on the net income or profits of an occupancy tenant, the tainted character of the sublease income will disqualify all rental income received by the exempt organization from exclusion from UBIT.74 However, if the rent collected from the prime tenant by the exempt organization is not based on amounts paid to the prime tenant by the occupancy tenants, the payments made to the exempt organization should qualify as rent from real property and therefore not be subject to UBIT. Accordingly, when an exempt organization leases property to a prime tenant with contingent rentals, to prevent rental income from being treated as UBIT, the prime lease should prohibit subleasing on a net income or net receipts basis.75 The following are examples of the types of rental formulas that may be excluded from UBIT: • Fixed percentages of gross receipts if such percentages are set in advance
of the rental period and are not renegotiated during the term of the lease or any renewal period. The formula used should conform with normal business practices76 • Sliding percentages applied to the gross sales of the preceding year • Annual fixed rental payable in equal monthly installments plus percent-
age rents computed quarterly based on tenant’s gross sales for each lease-quarter-year77 • A combination of (1) a fixed minimum rent, (2) a percentage rent above a
fixed base, (3) additional rent such as from the sharing of sale or refinancing
73
74 75
76 77
The regulations governing real estate investment trusts (REITs) are applicable in determining whether rents are based on net income or profits. Reg. §1.512(b)-1(c)(2)(iii)(b). Reg. §1.8564(b)(3) and (6) describe those rents that are disqualified from treatment as “rents,” and the effect of a subtenant’s rental obligation being based on its profits. See Madden v. Commissioner, 74 T.C.M. (CCH) 440 (1997). See Kaster and Ross, note 31, at §IID4b(2)(b). See also Rev. Rul. 66-379, 1966-2 C.B. 279; Reg. §1.856-4(b)(1) and §1.856-4(b)(3), in which rents are not disqualified when the amount received in a taxable year depended only on a fixed rental. Reg. §§1.856-4(b)(1) and 1.856-4(b)(3); Priv. Ltr. Rul. 78-36-030 (June 8, 1978), as amended by Priv. Ltr. Rul. 78-42-041 (July 20, 1978). Rev. Rul. 74-198, 1974-1 C.B. 171.
䡲
354
䡲
c06.fm Page 355 Thursday, March 15, 2007 10:15 AM
6.5 GROUND LEASE WITH LEASEHOLD MORTGAGE
proceeds,78 and (4) reimbursement for all or part of increases in CAM, real estate taxes, and property insurance79 • A rental formula that provides for inflation increases 80
In practice, the IRS appears to respect percentage formulas as being based on gross receipts rather than net income, as long as not all expenses are deducted. The IRS has permitted a wide variety of items to be excluded from gross income,81 including returned merchandise,82 sales taxes,83 intercompany transactions of the tenant,84 reimbursements of “tenant finish work,”85 rent escalations,86 and even operating costs.87 The chances of passing tax muster with any rental formula will improve to the extent that the type of formula conforms to customary business practice in the geographical location of the property.88 Tenants are normally reluctant to assume the economic risk inherent in having their rent obligations based on gross receipts rather than net income. Thus, there is a natural tension between tax planning for the exempt organization and the economics of the transaction. A compromise, not devoid of tax risk, may be a gross receipts formula capped by “stop loss” provisions to protect the tenant from worst-case profitability scenarios. (ii) Income Attributable to Rental of Real Estate Versus Provision of Services. Rent is taxable as unrelated business income if it is attributable to services that are (1) unrelated to the purpose of the exempt organization and (2) not usually or customarily rendered in connection with the rental of real property to an 78 79 80
81 82 83 84 85 86 87
88
See Priv. Ltr. Rul. 81-33-051 (May 19, 1981). Reg. §856-4(b)(3). Rev. Rul. 69-107, 1969-1 C.B. 189 provides that rent fixed for 25 years and adjusted after each 10 years based on a percentage of the appraised value of the property is considered rent from real property for purpose of §856(d). See also Priv. Ltr. Rul. 79-38-074 (June 2, 1979), in which additional rent, based on cost of living increases, appraised value of the real property, or increases in gross income received by the tenant, is not considered UBI. See generally Priv. Ltr. Rul. 78-36-030 (June 8, 1978); Priv. Ltr. Rul 78-42-041 (July 20, 1978). Reg. §1.856-4(b)(3). See id. Rev. Rul. 74-134, 1974-1 C.B. 170. Tech. Adv. Mem. 78-52-001 (Mar. 15, 1978). Reg. §1.856-5(b)(3). This exclusion may include actual prior escalations that have been built into the base rent. See Priv. Ltr. Rul. 81-28-058 (Apr. 16, 1981). Priv. Ltr. Rul. 82-04-193 (Oct. 30, 1981). The facts underlying (but not reported in) this ruling indicate that operating costs did not include commissions, executive salaries, or depreciation, thus distinguishing the formula from pure net income. Compare Priv. Ltr. Rul. 80-08-116 (Nov. 29, 1979) (IRS approved a formula based on “net cash flow” in which virtually all expenses other than depreciation reduced gross receipts). See Reg. §§1.856-1(b)(1) and 1.856-1(b)(3). See, e.g., Priv. Ltr. Rul. 79-05-010 (no date given), in which the IRS approved an agreement under which the lessor bank and the tenant shared the cost of producing crops (50/50) and received a share (50 percent) of the crops upon harvest. The IRS found this formula to be a “standard cropshare arrangement”; accordingly, the income from the crop profit was treated as rent. See also United States v. Myra Found., 382 F.2d 107 (8th Cir. 1967). Compare State Nat’l Bank v. United States, CIV No. E.P. 71 CA-224 (W.D. Tex. 1975), in which the lessor bank supplied most of the financial resources required for the operation of a farm, participated materially in management of the farm, and received more than 90 percent of the crops upon harvest. In this case, the crop profit was found not to constitute rental income.
䡲
355
䡲
c06.fm Page 356 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
occupancy tenant.89 For example, services such as heat, electricity, and cleaning of common areas are customarily provided to an occupancy tenant, and payment for such services will be considered rent. Provision of cable television service has been found to be similar to providing heat and electricity. In Priv. Ltr. Rul. 98-35-013,90 the IRS ruled that the provision of cable or satellite television is “similar to services provided by public utilities and [has] become, in part, an important means of providing information relating to health, safety and security.”91 However, if the exempt organization provides services in connection with the operation of hotels and boarding houses that are primarily for the convenience of the occupants (e.g., maid services or cafeteria services), such services may be so extensive that the additional rent to cover such services would not qualify as being exempt from UBIT.92 Whether services are usually or customarily rendered has become the subject of numerous private rulings, particularly in the areas of parking income and storage facilities.93 The first criterion examined in addressing whether a service is customary is consideration of whether it is usually rendered in that “market area.”94 The issue of parking rental income is addressed in Reg. §1.512(b)-1(c)(5), which states that payments for the use of space where services are also rendered, such as hotel rooms or parking lot spaces, are not rent for real property and therefore constitute UBIT. Accordingly, in Gen. Couns. Mem. 39,825,95 the IRS took the position that revenue from the direct operation of parking facilities by an exempt organization generally does not produce exempt rent. In Tech. Adv. Mem. 89-04-002,96 the IRS determined that income from a parking lot operated by an exempt organization was not excludable as rent, despite the fact that the only “service” provided by the organization was the provision of an attendant to collect fees from nonmonthly customers. On the other hand, in Priv. Ltr. Rul. 87-20-005,97 income from rental of a parking deck was excludable from income as rent because no services whatsoever were provided by the lessor—lot attendants, trash removal, snow removal, and security services were 89 90 91 92
93 94 95 96 97
Reg. §1.512(b)-1(c)(5). (Aug. 28, 1998). Priv. Ltr. Rul. 98-35-013. See also Kaster and Ross, supra, note 31 at II 4b2(c)(x). In Rev. Rul. 80-298, 1980-2 C.B. 197, an exempt university leased a stadium to a professional football team for several months each year. The university, under the lease, provided utilities, grounds maintenance, dressing rooms, security, and linen services. The IRS determined that the income was subject to UBIT and, based on the grounds maintenance and linen service, held that the university was providing “substantial services for the convenience of the lessee that go beyond those usually rendered in connection with the rental of space for occupancy.” Accordingly, the income received did not fall under the rental income exception. See also Priv. Ltr. Rul. 87-34-007 (May 8, 1987), which provided that an organization that rents out space in a performing arts complex for catered parties and wedding receptions could not exclude income attributable to those events as rent, because it provided bartending and other personal services to the lessors, and Tech. Adv. Mem. 1999-01-002 (Jan. 8, 1999), where an exempt organization’s income from the leasing of its buildings for temporary storage of cars, boats, and motor homes was held to generate UBIT. Kaster, “When Is a Lease Not a Lease,” Real Estate Review, 18 (No. 1) (spring 1988). See id. (Aug. 27, 1990). (Oct. 24, 1988). (Feb. 20, 1987).
䡲
356
䡲
c06.fm Page 357 Thursday, March 15, 2007 10:15 AM
6.5 GROUND LEASE WITH LEASEHOLD MORTGAGE
the responsibility of the lessee. Similarly, in Priv. Ltr. Rul. 84-45-005,98 income from a daily and monthly self-parking facility was considered rent when no services were provided for convenience of the customer. As an option to avoid UBIT, in addition to transferring responsibility for the performance of service to the tenant, the exempt organization can contract with a third party to perform services related to parking lots.99 (c)
Non-Tax Considerations
An exempt organization that owns property may choose to ground lease the property for a long term, rather than to sell the property to a developer and provide financing, for many nontax and business reasons.100 If the exempt organization has favorable financing on the property and the lender will not provide financing to a new owner on the same attractive terms, the exempt organization may choose to lease the property and keep the loan in place. This structure would prevent the triggering of a due-on-sale provision in a deed of trust loan. The lease should be triple net to cover all expenses of the landowner, including the financing costs. By selecting a lease arrangement rather than conveying fee simple title to real property, the parties may be able to avoid the need to subdivide the property, which would be required in order to convey a portion of the property. For example, if a party is interested in purchasing a portion of a large lot that is not subdivided, local zoning laws may require subdivision of the property before conveyance. If the parties do not want to subdivide the property because of excessive costs and time constraints, a leasehold may be appropriate. Another advantage of a lease is that it may avoid the transfer and recordation taxes imposed when property is sold or encumbered with a deed of trust or mortgage. However, certain jurisdictions, including the District of Columbia, treat a long-term ground lease as a transfer of a fee interest and therefore as a taxable event. In addition to the IRS’s recharacterizing a landlord-tenant relationship as a joint venture, courts may recharacterize a lease transaction if the documentation is not consistent with the intent of the parties, the economics of the business deal, and the allocation of burdens and benefits.101 The courts will look at substance over form, and therefore the enforcement rights of a landlord or tenant are unpredictable in certain situations. As one bankruptcy court held: The use of terms such as “lease” or “landlord” and “tenant” does not automatically transform an agreement into a bona fide lease for the purposes of this section of the 98 99
100
101
(June 11, 1984). See Priv. Ltr. Rul. 98-25-033 (June 19, 1998) and Priv. Ltr. Ruling 97-51-036 (Dec. 19, 1997). In these rulings, the garage staff were employees of the independent contractor. Also see Kaster, p. 45, IID4b3. Kaster, “When Is a Lease Not a Lease.” By entering into a long-term ground lease, in some jurisdictions the parties can avoid transfer and recordation taxes imposed when property is sold and encumbered with a deed of trust or mortgage. However, in certain jurisdictions, such as the District of Columbia, a long-term ground lease is treated as a transfer of a fee interest and is a taxable event. See id.
䡲
357
䡲
c06.fm Page 358 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
Code; rather, a court must look into the economic substance of the transaction and not its form.102
For example, if a tenant declares bankruptcy, it has to affirm or reject its lease within a statutory period. If the bankrupt tenant had chosen to lease the property to avoid transfer and recordation taxes or had other motives, and it fails to reject its lease during the statutory period, the landlord may believe it has an enforceable lease and is entitled to rents. However, if a court considers all of the facts and concludes that the parties did not intend to enter into a lease, the court may refuse to enforce the landlord’s right to rent because it is not a true lease subject to the bankruptcy 60-day rejection rule.103 Bankruptcy courts are concerned that a “sale of property” disguised as a lease would unjustifiably benefit the lessor/creditor because of the preferential treatment accorded leases under the Bankruptcy Code.104 The court will consider whether the lessor is acting as a true landlord or as an investor or mortgagee. If the ground lessee is responsible for obligations and costs that are regularly the responsibility of the landowner, or if the ground lease is a “non-recourse” ground lease and any claims of the lessor against the lessee may be satisfied solely from the property and not the lessee’s other assets, the lease would confer the same rights as a deed of trust or mortgage. If the lessee is free to encumber the property without the permission of the lessor, the objective intention of the ground lessor and ground lessee may not be to create a true or bona fide lease. The economic substance105 of such a transaction is almost identical to a sale of property with the owner maintaining a security interest in the property. Furthermore, if the “rent” under the ground lease is calculated to provide the ground lessor with a guaranteed return on the investment, rather than to relate to the value of the possessory right, the court may find that the parties did not intend a true landlord-tenant relationship.106 In a sale-leaseback transaction where income tax issues are fundamental to the structure, the courts have recharacterized the transaction as a financing arrangement, especially if the documentation does not reflect the intent of the parties.107 An exempt organization may choose to purchase real property and lease it back to the seller instead of electing to make a loan to the property owner to avoid the need to enforce its rights through foreclosure proceedings. The exempt organization would obtain title to the property upon payment of the purchase price to the landowner. A court will weigh the equities to determine whether to enforce the sale leaseback or to recharacterize the transaction as a financing 102 103 104 105
106 107
International Trade Admin. v. Rensselaer Polytechnic Inst., 936 F.2d 744, 748 (2d Cir. 1991), citing In re PCH Associates, 804 F.2d 193, 200 (2d Cir. 1986). In re PCH Associates, 804 F.2d 193 (2d Cir. 1986). International Trade Admin. v. Rensselaer Polytechnic Inst., 936 F.2d 744, 750 (2d Cir. 1991). See Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (the government should respect the transaction entered into between the parties so long as there is economic substance that is compelled or encouraged by business or regulatory reality); Sanderson v. Commissioner, 50 TCM (CCH) 1033 (1985) (taxpayers are free to structure transactions as they see fit, even if motivated by tax avoidance, provided a nontax or business purpose is also present, i.e., economic substance). In re Moreggia & Sons, Inc., 852 F.2d 1179, 1182 (9th Cir. 1988). Burke Investors v. Nite Lite Inns, Bankr. 1388 (S.D. Cal. 1981) (No. 79-03-350-K).
䡲
358
䡲
c06.fm Page 359 Thursday, March 15, 2007 10:15 AM
6.6 SALE OF UNDEVELOPED LAND
arrangement.108 In Kassuba, the landlord purchased property from the tenant and leased it back to the tenant so that the tenant could build apartment complexes on the land. The purchase price for the land included the residual value of the apartment complex at the end of the lease term. The tenant had an option to purchase back the property in the fourth year of the lease. If the tenant did not exercise its option to purchase back the property, the residual interest in the apartment complex would revert to the landlord at the end of the lease term. The tenant wanted the court to recharacterize the lease as a loan transaction and give the tenant the right of an equity of redemption. However, the court looked to the intent of the parties and noted that the arrangement was specifically structured as a purchase and leaseback by sophisticated parties to avoid foreclosure proceedings in the event of the lessee’s default. Thus, the court would not recharacterize the sale-leaseback as a mortgage. When an exempt organization structures a transaction, it should be certain that the documents reflect the intent of both parties. In addition, the organization should be familiar with local case law to determine the standards used by courts to sustain lease characteristics. Finally, an exempt organization should be aware that the recent tendency of bankruptcy courts is to use the substanceover-form analysis to favor the debtor’s position. This means that the structure should be consistent with the economic substance of the business deal and the standard documentation for such arrangements, and, most important, the paper trail must establish an intent consistent with the structure of the deal.109
6.6
SALE OF UNDEVELOPED LAND
Charitable organizations that hold valuable tracts of undeveloped land (which may have been given or bequeathed to them) often can maximize the value of that land by development, subdivision, and subsequent sale of the parcels. (a)
Unrelated Business Income
A threshold issue for any charitable organization seeking to dispose of a large tract of land is whether that disposition will be considered (1) the sale of a capital asset, the gain from which is exempt from UBIT, or (2) a sale of property in the ordinary course of business, the gain from which is subject to UBIT.110 IRC §512(b) states that in computing UBIT, there shall be excluded “all gains or losses from the sale, exchange or other disposition of property . . . other than property held primarily for sale to customers in the ordinary course of the trade or business [emphasis added].” Case law and IRS rulings look to the income tax rules governing capital gain versus ordinary income (dealer) treatment to determine
108 109 110
Kassuba v. Realty Income Trust, 562 F.2d 511 (7th Cir. 1977); Chicoine v. OMNE Partners II, 67 Bankr. 793 (D.N.H. 1986). Rev. Rul. 69-69, 1969-1 C.B. 159. See also Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Sanderson v. Commissioner, 50, TCM (CCH) 1033 (1985). See Chapter 8.
䡲
359
䡲
c06.fm Page 360 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
whether a sale is in the ordinary course of business.111 The analysis is based on facts and circumstances; no single factor is controlling. Factors that have been considered relevant in making this determination are discussed briefly in the following subsections. (i) The Purpose for Which the Property was Acquired. This first factor examines the intent of the exempt organization in acquiring the land that it proposes to sell. It is a favorable factor when the land was purchased for use in a specific project related to the organization’s charitable activities.112 It is also favorable when the property was received as a gift or bequest, because under these circumstances the organization plays little or no role in acquiring the property, and thus has no business purpose for the acquisition.113 By contrast, the purchase of land with no corresponding plan for use in an exempt activity is an example of an unfavorable factor supporting the conclusion that a sale of such property generates UBIT. (ii) The Frequency, Continuity, and Size of Sales. If sales are infrequent, not continuous, and small, the organization will likely not be viewed as in the trade or business of selling real estate.114 Conversely, as sales become more frequent, more continuous, and larger, they are more likely to be considered a trade or business that is regularly carried on, comparable to the commercial activity of a dealer in the trade or business of selling real estate. If, however, an organization owns significant amounts of land of a total value precluding sale of the entire holdings to a single purchaser, it is more likely that the organization will be able to sell the land in more than one transaction and still qualify for the exclusion from UBIT.115 (iii) The Extent of Improvements to the Property. The smaller the extent of improvements to the property, the more likely the sale will come under the exclusion from UBIT. In private rulings, for example, the fact that the land remains undeveloped has been significant in determining that gains from the proposed sale would not constitute UBIT.116
111 112
113 114
115 116
See, e.g., Malat v. Riddell, 383 U.S. 569 (1966). For example, in Priv. Ltr. Rul. 88-22-057 (Mar. 4, 1988), land was originally purchased by a church to build a larger sanctuary and parking lot. In Tech. Adv. Mem. 87-34-005 (April 27, 1987), an exempt organization acquired property for use in operating an orphanage. See, e.g., Priv. Ltr. Rul. 93-16-032 (Jan. 25, 1993); Priv. Ltr. Rul. 93-08-040 (Dec. 2, 1992) (organizations selling property received by gift). See Priv. Ltr. Rul. 91-32-061 (May 15, 1991), in which the sale of land was a one-time transaction, and Priv. Ltr. Rul. 81-52-157 (Oct. 5, 1981), where the organization disposed of property in one transaction. See, e.g., Priv. Ltr. Rul. 92-47-038 (Aug. 27, 1992), selling land in 15 sales over a 5–10-year period was not UBIT, due to value of land and particular market conditions. See, e.g., Priv. Ltr. Rul. 80-43-052 (July 30, 1980).
䡲
360
䡲
c06.fm Page 361 Thursday, March 15, 2007 10:15 AM
6.6 SALE OF UNDEVELOPED LAND
(iv) The Activities of the Owner in Improving and Disposing of the Property. The more minimal the activities of the owner in improving and disposing of the property, the more likely its sale will be considered to qualify for the exclusion from UBIT.117 (v) The Purposes for Which the Property is Held. Examination of the purposes for which the property is held differs from the first factor (the purpose for which the property is acquired) in that the relevant inquiry is the actual use of the property, rather than the intentions of the purchaser at the time of acquisition. If the land is used in furtherance of an organization’s exempt purposes, this fact will weigh in favor of exclusion of the sale from UBIT.118 (vi) The Proximity of Purchase and Sale. Generally, the longer the period between purchase and sale, the more likely it is that the sale will be excluded from UBIT.119 Other factors to consider in determining whether the sale of land will generate UBIT include the existence of local ordinances that necessitate a sale, the impact of land use laws, relevant market factors, and master land use plans. (b)
Discussion of IRS Rulings
A number of IRS private letter rulings discuss the application of the foregoing factors in the context of a proposed sale of land. Several of these rulings are described in this section. A private letter ruling issued in 2001 discusses most of the factors in the course of deciding that while some of the organization’s sales were substantially related, other sales and loans to developers were regularly carried on businesses that were unrelated and therefore resulted in UBIT.120
117
118
119
120
See, e.g., Priv. Ltr. Rul. 92-47-038 (Aug. 27, 1992) (organization made limited improvements to enhance sale of property; other improvements were constructed by various buyers of property at their expense); Priv. Ltr. Rul. 91-28-030 (Apr. 15, 1991) (owner retained oversight over development of property, but developer paid all development costs and did actual work); Priv. Ltr. Rul. 85-22-042 (Mar. 5, 1985) (all improvements were constructed by unrelated third parties); Priv. Ltr. Rul. 84-03-053 (Oct. 19, 1983) (organization did not participate in construction of condominiums on the property it owned). See, e.g., Priv. Ltr. Rul. 88-22-057 (Mar. 4, 1988). But see Deer Park Country Club v. Commissioner, 70 T.C.M. (CCH) 1445 (1995) (a country club’s subdividing and selling land was treated as UBIT because the land was never actually and directly used in performing the club’s exempt function). See also Tech Adv. Mem. 96-30-001 (Apr. 4, 1996) (same result on similar facts); Priv. Ltr. Rul. 93-07-004 (Oct. 22, 1992) (social club’s sales of homesite lots to raise money for new facilities was subject to taxation as UBIT, because club failed to show that any exempt function occurred on the subdivided parcel). More recently, TAM 200047049 made a similar finding that sale of single family lots at the historic campus of an organization providing comprehensive summer education and recreation activities did not substantially support its exempt purpose. See, e.g., Priv. Ltr. Rul. 90-17-058 (Jan. 31, 1990) and Tech. Adv. Mem. 87-34-005 (Apr. 27, 1987), in which the land was held for more than 80 years prior to disposition. See Adam v. Commissioner, 60 T.C. 996 (1973); Priv. Ltr. Rul. 89-01-064 (Oct. 13, 1988). See also Priv. Ltr. Rul. 95-51-021 (Sept. 21, 1995) (land held more than 38 years). Priv. Ltr. Rul. 200119061.
䡲
361
䡲
c06.fm Page 362 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
(i) Installment Sale to Developer. A charitable organization proposed to sell property received by bequest and held for a significant period of time.121 Because of recently enacted legislation which affected the exempt organization’s ability to sell its property at fair market value in the future, the exempt organization decided to sell a portion of its property. To do so, it entered into an agreement with a developer with whom it had dealt in the past. The development agreement provided that the developer would, at its own risk and expense, subdivide and improve the property and construct an infrastructure in accordance with a master plan approved by the exempt organization. Each phase of the master development plan had to be approved by the exempt organization. The property was sold to the developer as an installment sale. The deed to the property was transferred to the developer only as the developer fulfilled its legal and contractual requirements under the development agreement. The IRS held that a sale purpose was not predominant in that arrangement, because: • The property was received by bequest and held for a significant period of
time. • The exempt organization was compelled by law to liquidate its holdings
to get a fair market value rather than the proceeds of a condemnation sale; therefore, the sale was not wholly voluntary. • The property was not advertised to the public but sold to a known and
trusted developer; thus, it was considered a one-time sale. • The property was sold subject to significant conditions that allowed the
exempt organization to exercise a substantial degree of control over the property’s future development. (ii) Developer Engaged to Subdivide and Sell Property. Similarly, an exempt §501(c)(3) organization retained a developer to develop and sell land that it owned.122 The developer was to subdivide the land into 14 separate three-acre parcels; the site plan reflected a sensitivity to the natural beauty of the surroundings. The development agreement provided that: • The developer would subdivide the land in a manner approved by the
exempt organization. • The exempt organization would retain oversight on all phases of develop-
ment. • The exempt organization reserved the right to approve all development
costs (the developer would absorb all development costs, recovering its costs from buyers as the land was sold). • The developer had the exclusive right to build on the land and to market
the lots. The exempt organization was not to advertise, market, or attempt 121 122
Priv. Ltr. Rul. 89-01-064 (Oct. 13, 1988). Priv. Ltr. Rul. 91-28-030 (Apr. 15, 1991).
䡲
362
䡲
c06.fm Page 363 Thursday, March 15, 2007 10:15 AM
6.6 SALE OF UNDEVELOPED LAND
to sell the lots itself. When the developer found a prospective buyer, the exempt organization would deed the lot over to the buyer. The exempt organization retained a fee simple interest in the property until it was actually sold. The IRS held that a sale purpose was not predominant in this case, and thus the income from the sales would not generate UBI, for the following reasons: • The choice of the developer was dictated not only by the high yield of the
sale, but also with equal concern for the special features of the property that the developer promised to maintain. • The exempt organization had substantial control over the development,
so that it was able to achieve its goal of creating a community in keeping with the environment. • The exempt organization required a provision in the sales agreements
that lots could not be resold for a period of one year. This avoided land speculation and was in keeping with the exempt organization’s concern that the land be maintained in a way that furthered its unique purposes. (iii) Four Alternative Uses of Property. A charitable foundation had as its single largest asset a parcel of unimproved real property comprising some 260 acres.123 The property was leased at an annual rental of $100,000, which was the minimum amount available as rental for undeveloped property. In conjunction with professional consultants, the foundation arrived at four alternative uses of the property: • Alternative 1 would continue unchanged the present leasing arrangement
with annual rental income to the foundation of approximately $100,000. • Alternative 2 would sell the property, as is, for an estimated cash value of
$4 million. • Alternative 3 would be to complete some preliminary development work
(e.g., obtain various permits and approvals) and sell the property in large blocks to a few developers prior to the construction of any improvements. The exempt organization’s anticipated net income from this third alternative was $6 million. • Alternative 4 would require the exempt organization to assume all risks
of development and manage the development and marketing process from start to finish. This would include design and construction of streets, curbs, gutters, sidewalks, lighting, and utilities. The exempt organization would then subdivide the property and sell individual lots to the general public. The exempt organization anticipated that this alternative would provide a much greater return on its investment than any of the other alternatives.
123
Priv. Ltr. Rul. 89-50-072 (Sept. 21, 1989).
䡲
363
䡲
c06.fm Page 364 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
The IRS concluded that the first three alternatives would not subject the organization to UBIT; however, the fourth alternative involved the exempt organization in extensive development and marketing activities. Thus, this was trade or business which would result in UBI. (iv) Eight Sales Over Five Years did not Constitute UBI. An IRC §501(c)(3) organization’s activities included the operation of an orphanage located on a 60-acre tract of land.124 When the orphanage changed from institutional facilities located on the tract of land to a family-oriented setting in which children were placed in cottages located in the communities, the organization decided to sell the 60 acres of land, after holding the property for more than 80 years. The organization attempted to have the property rezoned to allow commercial development, but was not successful. Then it attempted to sell the entire parcel to one buyer. Again, the organization was not successful, so it hired an engineer to subdivide the property into 36 lots. As the subdivider, the organization was also required by city ordinance to construct a street, curbs, gutters, sidewalk drainage, and water supply improvements. The lots were purchased in large blocks by five different parties. Eight sales occurred over the course of five years, with net receipts from the sales totaling almost $7 million. In concluding that this was not a sale in the ordinary course of business, the IRS found that it was significant that the organization had held the property for more than 80 years for the purposes of operating its orphanage. Moreover, when the organization could not sell the property in one block, it subdivided the land and made only the minimum improvements required by city ordinances. The organization hired a real estate developer to market the property rather than marketing the property itself. Finally, the IRS concluded that the eight sales over a five-year period were due to difficult market conditions rather than a continuous marketing activity. Thus, although there was significant development of the land, other factors were found to be persuasive and the gain from the sale did not constitute UBI. (v) Subdivision and Sale of 31 Lots not Substantially Related. A §501(c)(3) organization that conducts summer courses, recreation, religious exercises and performances in the arts in a town that is designated an historic district, acquired and subdivided 7.5 acres for 31 additional single-family homes and some open space. The organization agreed that the development and sale of the lots to third parties constituted a trade or business, but argued that it was substantially related to its exempt purpose, by bringing people into its grounds. The service disagreed as the lots were sold to the highest bidders in a blind process, without any reference to the involvement of the new owners in the activities of the organization, and terms of the sale specified that the residents would have to purchase regular admission tickets.125
124 125
Tech. Adv. Mem. 87-34-005 (Apr. 27, 1987). Tech. Adv. Mem. 200047049.
䡲
364
䡲
c06.fm Page 365 Thursday, March 15, 2007 10:15 AM
6.6 SALE OF UNDEVELOPED LAND
PRACTICE TIP Often exempt organizations request a ruling before proceeding with the sale of land that is not related to their exempt purposes. Indeed, organizations typically withdraw ruling requests when the IRS proposes a negative ruling, so there is scant record of adverse private letter rulings to serve as reference as to a proposed development that would not pass muster.* *
See Richardson and Barrett, “UBIT: Sale of Land,” IRS Technical Review Institute Training Manual (1997).
(c)
Excess Business Holding Rules
A critical issue for any private foundation that holds an ownership interest in a business activity is whether it violates the excess business holdings rules.126 Those rules generally limit to 20 percent the permitted ownership in a “business enterprise” that may be held by a private foundation and all “disqualified persons” combined (i.e., substantial contributors, foundation managers, certain 20 percent owners and members of the family of any of the foregoing). Moreover, a private foundation may have no permitted holdings in a sole proprietorship.127 A business enterprise includes the active conduct of a trade or business that is regularly carried on for the production of income and which constitutes an unrelated trade or business under §513. The term business enterprise does not include a trade or business at least 95 percent of the gross income of which is derived from passive sources. Gross income from passive sources includes the income items excluded by IRC §512(b)(1) (relating to dividends, interest, and annuities), §512(b)(2) (relating to royalties), §512(b)(3) (relating to rents), and §512(b)(5) (relating to gains or losses from the disposition of property).128 Thus, to the extent a private foundation receives rental income from the lease of real property, or income in the form of capital gains from the disposition of property, it does not have an IRC §4943 excess business holdings problem. Although the interaction between the UBIT and excess business holdings rules is not crystal clear, it would appear that if a private foundation holds property for sale in the ordinary course of business, it is holding an interest in a business enterprise, the income from which would not be income from passive sources. Thus, the foundation would have excess business holdings and it would have to divest itself of those holdings.129 126 127 128 129
See Chapter 10. Reg. §53.4943–3(c)(3). §4943(d)(3). Reg. §53.4943–10(d)(2) provides that when an interest not originally deemed an interest in a business enterprise subsequently becomes one, it will be treated as having been acquired by purchase by a disqualified person at the time of change. The effect of this rule is to require the interest in question to be treated as an excess business holding immediately. Thus, an initial tax of 10 percent of the value of the foundation’s excess business holdings would be imposed (Reg. §53.4943–2(a)), with an additional tax of 200 percent of the value of the excess business holdings if the holdings are not divested to unrelated parties within the taxable period (i.e., not later than the earlier of the date of mailing of the notice of deficiency, the elimination of the excess, or assessment of the tax. See §4943(d)(2)). With regard to correction procedure, see §§4961 and 4963(d).
䡲
365
䡲
c06.fm Page 366 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
(d)
Participating Ground Lease
As an alternative to development and sale, the exempt organization could enter into a ground lease arrangement with a developer. Under a ground lease, the developer-lessee would pay periodic rent to the exempt organization for the right to be the prime tenant of the land. The term of this lease could be, for example, 99 years, making it economically worthwhile for the lessee to undertake residential development of the property even though ownership of the improvements would pass to the exempt lessor when it regains possession of the land at the end of the term. The developer could construct improvements on the property, which would be leased to occupancy tenants together with a sublease of the underlying ground. The rent to be paid by the developer could consist of both a fixed minimum amount and a contingent component (a so-called kicker) based on a certain percentage of participation in the income of the project.130 (e)
Use of Taxable Subsidiary
Another alternative would be for an exempt organization to create a taxable subsidiary the purpose of which would be to develop, market, and sell the land. If tax-exempt parent were a private foundation, it could own 20 percent of the voting stock of the subsidiary (perhaps 35 percent if it did not have “effective control”) and an unrelated developer could own the remaining 80 percent of the voting stock.131 As long as the subsidiary maintains an identity separate from the nonprofit, the activities of the subsidiary would not be attributable to the exempt parent.132 The tax-exempt organization could sell the land to the subsidiary in return for an installment note, payable with interest. The land would have a steppedup basis in the hands of the subsidiary. The organization (through its 20 percent ownership of the taxable subsidiary) could then receive a share of the proceeds of the subsequent sales of the land in the form of dividends excluded from UBIT.133
6.7 (a)
GUARANTEES Overview
The exempt organization lender must be conservative when considering whether to make a real estate loan, because it cannot afford to make speculative investments.134 When evaluating whether to make a loan, the exempt organization/ lender may conclude that it needs additional security from the borrower to protect its investment. Lenders may require letters of credit, pledges of marketable
130 131 132 133 134
For a detailed discussion of the advantages and disadvantages of the participating ground lease structure as an alternative to the equity joint venture, see Section 6.5. As long as all disqualified persons together did not own more than 20 percent of the subsidiary’s voting stock, nonvoting stock would be permitted holdings. See Section 4.6 for a discussion of the taxable subsidiary structure. §512(b)(1). However, the taxable subsidiary would pay federal taxes on the income. See, e.g., §4944.
䡲
366
䡲
c06.fm Page 367 Thursday, March 15, 2007 10:15 AM
6.7 GUARANTEES
securities, and partnership pledges as additional security. Most often, lenders require recourse liability, usually in the form of a guaranty. Loan guarantees are usually a requirement of construction financing rather than permanent financing.135 When making a permanent loan, a lender will often rely solely on the value of its security interest in the developed property in the event of a default by the borrower, because a completed project is typically projected to generate net operating income and, theoretically, should be able to (1) generate sufficient funds to repay the loan or (2) create sufficient value to refinance the loan without the developer having to invest additional funds in the project. Neither the borrower nor any other person or entity on behalf of the borrower is personally liable to repay the loan. This is commonly referred to as a nonrecourse loan.136 In the case of a construction loan, however, a lender’s security, if limited to the land and improvements (i.e., nonrecourse), is encumbering only an incomplete project that would not generate net operating income. Such a loan carries a more substantial risk of nonpayment. In response to that risk, a construction lender usually will require that the borrower and/or a guarantor of the borrower’s financial obligations be obligated for the repayment of some portion or all of the loan. Such a loan, therefore, is referred to as a recourse loan, which means that in the event of a borrower’s default, the lender cannot only foreclose against the real property and acquire the property, but, in addition, seek a deficiency judgment from the borrower/guarantor to recover the balance of the unpaid loan based on the borrower’s or guarantor’s personal liability. Alternatively, the lender may sue the borrower and/or guarantor for the full amount of the loan and not seek recovery from the security. (b)
Third-Party Guaranty
An exempt organization lender may require a third party to guarantee the loan (whether a construction or permanent loan) as an alternative (or in addition) to the personal liability of the borrower. A third-party guaranty is typically obtained when the borrower has limited assets (and therefore, liability is limited) or is a single-asset entity (that is, it only owns the land and improvements granted as security for the loan). With a corporate borrower, the lender would likely require a guaranty from the majority stockholder, a subsidiary, or a sister corporation. With a partnership, the lender may require a guaranty from the individual general partners. The managing member and/or developer may be required to guarantee the obligations of a limited liability company. The developer in a real estate joint venture is typically required to be personally liable for completion of the project, the costs and expenses of the project, and the promised rate of return to the lender. The developer is asked to assume the risk because the developer is in control of the project. However, the developer may attempt to limit its liability, and in exchange therefore the lender may demand a higher interest rate or an increased equity interest in the project to compensate it for the increased risk. Typically, the guaranty is absolute and unconditional. 135 136
Douglas and Koppel, Real Estate Financing Forms Manual §1.07 (1985). See Priv. Ltr. Rul. 84-29-051 (Apr. 18, 1984).
䡲
367
䡲
c06.fm Page 368 Thursday, March 15, 2007 10:15 AM
THE EXEMPT ORGANIZATION AS LENDER OR GROUND LESSOR
The lending exempt organization should consider whether to require the guarantor to secure the guaranty with collateral sufficient to provide the exempt organization with adequate security for the guarantor’s obligation to repay if the borrowing entity cannot satisfy its loan obligation. Additional collateral may include certificates of deposit, marketable securities, a pledge of partnership interests, letters of credit, and interests in other real estate. (c)
Limited Individual Recourse Guaranty
In the last few years, primarily since the advent of securitization of pooled commercial mortgages, lenders have been making loans that are nonrecourse for tax basis purposes but that provide for limited personal recourse under certain circumstances. Specifically, many commercial lenders now require that a borrowerprincipal or other individual be liable for either the mortgage debt or loss suffered by the lender arising out of, among other things, (1) fraud by willful misconduct of, or misappropriation of the project funds by the borrower, (2) the initiation of a voluntary bankruptcy of the borrower, (3) a material breach of a representation or warranty, or (4) failure of the borrower to pay taxes or insurance. Circumstances peculiar to the borrower or loan transaction are often added to the litany of acts giving rise to borrower-principal liability. (d)
Master Lease
An alternate type of guaranty is a master lease or a convenience lease. A master lease is generally a lease executed by the borrower or a principal of the borrower (as with a third-party guaranty) and may be entered into without any intention that the master-tenant will actually occupy the leased premises. Instead, the purpose of the lease is to guarantee that the lender will receive an adequate income stream in the event of a default under the loan. The master lease may be partially or totally terminated by the tenant before the end of the lease term on the occurrence of any of the following events: 1. The loan balance is reduced to a stated amount. 2. A certain percentage of space has been occupied by tenants. As a variation, the obligation under the master lease may be partially released (pro rata) as parts of the leased premises are leased to occupancy tenants. 3. Rental income reaches a specified level and/or is maintained at a specified level over a specified period of time. EXAMPLE: An exempt organization enters into a long-term ground lease of its property to a developer, the developer improves the property by constructing an office building. In addition, the exempt organization may lend the developer the funds to construct the building. Ultimately, the exempt organization will depend on the rents from the occupancy tenants to pay the rental under the ground lease and to pay the debt service on the construction loan. To guarantee payment before the building is fully or substantially leased, the exempt organization may require the ground lessee/developer to enter into a master lease agreement. Pursuant to the 䡲
368
䡲
c06.fm Page 369 Thursday, March 15, 2007 10:15 AM
6.8 CONCLUSION
master lease agreement, the ground lessee/developer guarantees to the exempt organization that it will pay a fixed amount of rental on the master leased premises (which covers the unleased space), which rental is payable even if the developer has not fully leased all of the space to occupancy tenants. Once the master leased premises are substantially leased to occupancy tenants, the master lease agreement may be terminated subject to reinstatement in the event that occupancy declines below the termination level within a specified period of time. (e)
Limitations of the Guaranty
The lender must use caution in deciding which remedy to pursue following a loan default. If the lender decides to sue on the personal guarantee first, under some state laws, the lender may, under the theory of election of remedies, be deemed to lose any right to subsequently reach the real estate through foreclosure.137 Alternatively, if the lender forecloses on the property first and then seeks a deficiency judgment against the borrower, other problems may be encountered. In some states, if a lender elects to foreclose on the property first, it may be precluded from seeking a deficiency judgment.138 In other jurisdictions, a lender that seeks a deficiency judgment must pursue judicial foreclosure rather than nonjudicial foreclosure procedures (the latter usually being less costly and less time consuming).139 In many states, the amount of a deficiency judgment is not necessarily the difference between the highest bid at foreclosure and the outstanding indebtedness; rather, the amount of the deficiency judgment may be the difference between the “fair value” of the security, as determined by an independent appraisal, and the amount of the unpaid debt.140 If an appraiser determines that the value of the property is equal to the unpaid debt, there can be no deficiency judgment.
6.8
CONCLUSION
The participation of an exempt organization in a joint venture as a lender or ground lessor, rather than an equity holder, may be an advantageous investment alternative. When formulating an investment strategy for an exempt organization, the lender-lessor avenue should always be considered based on the factual circumstances, the exempt purposes of the organization, and the organization’s financial goals.
137
138
139 140
Durrett v. Washington National Insurance Co., 621 F.2d 201 (5th Cir. 1980). Here the court held that a foreclosure sale could be set aside in bankruptcy if the sale price was not sufficiently high. Farm Credit Bank v. Faught, 492 N.W.2d 422 (Iowa 1992), related proceeding, 540 N.W.2d 33 (Iowa 1995); Marshall v. Middleton, 100 Or. 247, 191 P. 886 (1921); Anderson v. Pilgram, 30 S.C. 499, 9 S.E. 587 (1889). Union Bank v. Gradsky, 265 Cal. App. 2d 40, 71 Cal. Rptr. 64 (1968), citing §580d of the Code of Civil Procedure. See Kaster, Real Estate Transactions by Tax Exempt Entities: Techniques and Taxability (1995).
䡲
369
䡲
c07.fm Page 370 Friday, March 9, 2007 4:32 PM
C H A P T E R
S E V E N 7
Exempt Organizations as Accommodating Parties in Tax Shelter Transactions
7.1
INTRODUCTION
With the complexity of today’s tax laws, practitioners and their clients are continuously seeking and developing new ways to structure transactions to lessen the clients’ tax burdens. According to the IRS’s Advisory Committee on Tax Exempt and Government Entities, there are three general types of tax avoidance transactions.1 The first category consists of “legitimate tax shelters.”2 Legitimate tax shelters take advantage of laws Congress specifically enacted to provide tax incentives in order to promote social objectives. Tax-qualified retirement plans and tax-exempt organizations are examples of legitimate tax shelters. The second category of tax avoidance transactions consists of “abusive tax shelters.” These tax shelters involve transactions or products that have no reasonable basis under the Code for the tax advantages purportedly received by the taxpayer. Finally, there are the “disputed tax shelters.”3 Disputed tax shelters “consist of transactions that may comply with the literal language of a specific tax provision yet yield tax results that may be unwarranted, unintended, or inconsistent with the underlying policy of the provision.”4 There are numerous instances of exempt organizations taking part in questionable or outright abusive tax transactions, “instances where charitable organizations . . . have overvalued property contributed to charitable organizations and been subjected to the tax shelter and aiding and abetting penalties.”5 Therefore, it is incumbent upon exempt organizations and practitioners to familiarize themselves with the general laws regulating tax transactions.6 1
2 3 4 5 6
Advisory Committee on Tax Exempt and Government Entities (ACT), IRS, “TE/GE Abusive Tax Shelters Involving Tax-Exempt and Government Entities,” available at http://www.irs .gov/pub/irs-tege/act_rpt2_part2.pdf (May 20, 2003). Id. Id. Id. Advisory Committee on Tax Exempt and Government Entities, IRS, “TE/GE Abusive Tax Shelters Involving Tax-Exempt and Government Entities Project 1” (May 20, 2003). Id. n. 231.
䡲
370 䡲
c07.fm Page 371 Friday, March 9, 2007 4:32 PM
7.2 PREVENTION OF ABUSIVE TAX SHELTERS
7.2
PREVENTION OF ABUSIVE TAX SHELTERS
In 2005, the IRS announced an initiative focused on abusive tax avoidance transactions.7 The IRS has identified abuses involving charities as falling into several categories: • Commercial enterprises setting themselves up as charities (e.g., credit
counseling organizations, down-payment-assistance organizations) • Pure tax avoidance by using organizations that are shams (mail-order
churches, a variety of trusts, donor-directed funds, and offshore entities) • Overly aggressive claims of qualification for exempt status for privately
controlled entities in order to shelter income or claim improper deductions (involving abuse of §509(a)(3) supporting organizations) • People siphoning money from good or bad charities for various purposes,
ranging from simply lining their pockets to funding terrorism • Otherwise compliant tax-exempt organizations knowingly or unknow-
ingly facilitating tax abuses by other people (i.e., functioning as accommodating parties) • Using insurance products to achieve tax benefits in transactions that would
otherwise produce negative cash flow and earnings (COLI and BOLI); for example, abuses involving tax-exempt parties and abusive transactions involving insurance (a)
Judicial Doctrines
Courts have developed several doctrines to combat abusive tax avoidance transactions. Five doctrines represent the courts’ prohibition on abusive tax shelters: (1) the Sham Transaction Doctrine; (2) the Economic Substance Doctrine; (3) the Business Purpose Doctrine; (4) the Substance-Over-Form Doctrine; and (5) the Step-Transaction Doctrine. (i) Sham Transaction Doctrine. A sham transaction is a transaction that is on its face completely void of economic substance.8 The Supreme Court analyzes sham transactions objectively, without looking into the motivations of the taxpayer.9 Therefore, sham transactions are mostly fictitious transactions designed to obtain tax benefits without any economic activity. Courts have recognized two basic types of sham transactions: Shams in fact are transactions that never occur. In such shams, taxpayers claim deductions for transactions that have been created on paper but which never took place.
7 8
9
IRS, “Fiscal Year 2006 Exempt Organizations Implementing Guidelines,” available at http:// www.irs.gov/pub/irs-tege/fy_2006_implementing_guidelines.pdf. IRS, “The Tax Exempt and Government Entities Division Strategy for Abusive Tax Avoidance Transactions Needs Further Development,” published in the Eighth Annual Western Conference on Tax Exempt Organizations 1 (Sept. 2004). Dow Chemical Co. & Subs v. Lawson, 250 F. Supp. 2d 748, 789 (E.D. Mich. 2003).
䡲
371 䡲
c07.fm Page 372 Friday, March 9, 2007 4:32 PM
EXEMPT ORGANIZATIONS IN TAX SHELTER TRANSACTIONS
Shams in substance are transactions that actually occurred but which lack the substance their form represents.10
(ii) Economic Substance Doctrine. The economic substance doctrine provides that a transaction ceases to warrant tax benefits when it has no economic effect other than the creation of tax benefits.11 Moreover, even if the transaction has economic effect, it still must be disregarded if the motive behind the transaction is tax avoidance.12 Therefore, the economic substance doctrine can be distinguished from the sham transaction doctrine because it adds a subjective analysis to the transaction. In other words, the economic substance doctrine looks at the motive of the taxpayer instead of a superficial analysis of the transaction. (iii) Business Purpose Doctrine. The business purpose doctrine is often considered together with (if not the same as) the sham transaction and economic substance doctrines. Simply put, any transaction entered into by the taxpayer must have a business purpose, and must not be “a mere device which put[s] on . . . a disguise for concealing its real character.”13 It follows that a transaction will be considered legitimate for tax purposes only if it has “economic substance that is compelled or encouraged by business or regulatory realities, is imbued with taxindependent considerations, and is not shaped solely by tax-avoidance features to which meaningless labels are attached.”14 (iv) Substance Over-Form Doctrine. The substance-over-form doctrine is essentially a doctrine of equity. It stands for the principle that two transactions that achieve the same substantive result should be taxed similarly. In other words, a transaction should not be taxed differently from a similar transaction by virtue of the formal steps by which the arrangement was undertaken. For that reason, the IRS and the courts have the ability to recharacterize a transaction according to its underlying substance. (v) Step-Transaction Doctrine. The step-transaction doctrine is essentially an extension of the substance-over-form doctrine.15 The step-transaction doctrine “treats a series of formally separate ‘steps’ as a single transaction if such steps are in substance integrated, interdependent, and focused toward a particular result.”16
10 11 12 13 14
15 16
Id. at 789 (citing Gregory v. Helvering, 293 U.S. 465 (1935)). United Parcel Service of America, Inc. v. Commissioner, 78 T.C.M. (CCH) 262 at n. 29 (1999), rev’d, 254 F.3d 1014 (11th Cir. 2001) (emphasis added). Kirchman v. Comm’r, 862 F.2d 1486 (11th Cir. 1989). Id. Gregory v. Helvering, 293 U.S. 465, 724 (1935); ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189, 2215 (1997), aff’d, 157 F.3d 231 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999). Frank Lyon Co. v. Commissioner, 435 U.S. 561 (1978). IRS, “Report Outlining TE/GE Accomplishments for FY 2004, Implementing Guidelines for FY 2005,”available at http://www.irs.gov/pub/irs-tege/implementing_guidelines_1104.pdf (Nov. 4, 2004).
䡲
372 䡲
c07.fm Page 373 Friday, March 9, 2007 4:32 PM
7.2 PREVENTION OF ABUSIVE TAX SHELTERS
(b)
Reportable Transactions
Another method for the IRS to oversee tax avoidance transactions is by classifying the transactions as reportable. A federal income tax regulation issued February 28, 2003 mandates that every taxpayer who files a federal income tax return (including a 990T) make certain disclosures if the taxpayer participated in a “reportable transaction.”17 Reportable transactions are a group of six transactions that the IRS has identified as potentially abusive tax shelters. While these six transactions receive increased scrutiny, the fact that the transactions are reportable does “not affect the legal determination of whether the taxpayer’s treatment of the transaction is proper.”18 (i) Listed Transactions. A listed transaction is any transaction that has been identified by the IRS (either in a notice, regulation, or other form of published guidance) as a tax avoidance transaction.19 The Service published a comprehensive updated list of tax avoidance transactions in Notice 2003-76. Any taxpayer whose tax return reflects the benefits of one of the transactions listed in IRS Notices must disclose its participation in the listed transaction. In Notice 2004-30, the IRS first exercised its authority under the tax shelter regulations to specifically designate a tax exempt partner as a participant in a tax avoidance transaction. The Notice involved an S corporation that issued, pro rata to each of its shareholders (the original shareholders), nonvoting stock and warrants exercisable into nonvoting stock. The fair market value of the nonvoting stock was then substantially reduced because of the existence of the warrants. The transaction presented as follows: Shortly after the issuance of the nonvoting stock and the warrants, the original shareholders donate the nonvoting stock to the exempt party. The parties to the transaction claim that, after the donation of the nonvoting stock, the exempt party owns [X] percent of the stock of the S corporation. The parties further claim that any taxable income allocated on the nonvoting stock to the exempt party is not subject to tax on unrelated business income (UBIT) under §§511 through 514 (or the exempt party has offsetting UBIT net operating losses). The original shareholders might also claim a charitable contribution deduction under §170 for the donation of the nonvoting stock to the exempt party. In some variations of this transaction, the S corporation may issue nonvoting stock directly to the exempt party. Pursuant to one or more agreements (typically redemption agreements, rights of first refusal, put agreements, or pledge agreements) entered into as part of the transaction, the exempt party can require the S corporation or the original shareholders to purchase the exempt party’s nonvoting stock for an amount equal to the fair market value of the stock as of the date the shares are presented for repurchase. In some cases, the S corporation or the original shareholders guarantee that the exempt party will receive the fair market value of
17 18 19
Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987). Reg. §1.6011. The disclosures must be made on a Form 8886T. Reg. §1.6011-4(c)(3)(i)(A).
䡲
373 䡲
c07.fm Page 374 Friday, March 9, 2007 4:32 PM
EXEMPT ORGANIZATIONS IN TAX SHELTER TRANSACTIONS
the nonvoting stock as of the date the stock was given to the exempt party if that amount is greater than the fair market value on the repurchase date. Because they own 100 percent of the voting stock of the S corporation, the original shareholders have the power to determine the amount and timing of any distributions made with respect to the voting and nonvoting stock. The original shareholders exercise that power to cause the S corporation to limit or suspend distributions to its shareholders while the exempt party purportedly owns the nonvoting stock. For tax purposes, however, during that period, X percent of the S corporation’s income is allocated to the exempt party and Y percent [(the remaining value of the nonvoting stock not owned by the exempt organization)] of the S corporation’s income is allocated to the original shareholders. The transaction is structured for the original shareholders to exercise the warrants and dilute the shares of nonvoting stock held by the exempt party, or for the S corporation or the original shareholders to purchase the nonvoting stock from the exempt party at a value that is substantially reduced by reason of the existence of the warrants. In either event, the exempt party will receive a share of the total economic benefit of stock ownership that is substantially lower than the share of the S corporation income allocated to the exempt party[; the economic benefits of owning the stock will be enjoyed at a later date by the original shareholders.]20
Under the authority of Reg. §1.6011-4(C)(3)(i)(A), the exempt party in the listed transaction described in Notice 2004-30 would also be treated as a participant in the transaction (whether or not otherwise a participant). The exempt party would be treated as participating in the transaction for the taxable year of the purported donation, the taxable year of the reacquisition, and all intervening taxable years. (ii) Confidential Transactions. Any transaction offered to a taxpayer under conditions of confidentiality and for a minimum fee is a reportable transaction.21 Conditions of confidentiality are present any time the taxpayer’s disclosure of tax treatment is limited in any manner by an express or implied understanding or agreement with or for the benefit of any person who makes or provides a statement, oral or written, to the taxpayer (or for whose benefit a statement is made or provided to the taxpayer) as to the potential tax consequences that may result from the transaction, whether or not such understanding or agreement is legally binding.22 Essentially, confidential transactions are those transactions that promoters have developed as proprietary products and require potential beneficiaries to sign a nondisclosure agreement. Tax-exempt organizations should carefully scrutinize all tax-oriented products for conditions of confidentiality to ensure the organization is complying with the reportable transaction laws.23
20 21 22 23
Reg. §1.6011-4(b)(2). Notice 2003-76. Reg. §1.6011-4(b)(3). Reg. §1.6011-4(b)(3)(i).
䡲
374 䡲
c07.fm Page 375 Friday, March 9, 2007 4:32 PM
7.2 PREVENTION OF ABUSIVE TAX SHELTERS
(iii) Transactions with Contractual Protections. Any tax transaction for which the taxpayer or a related party has the right to a full or partial refund of fees if the tax consequences expected from the transaction are not sustained is a reportable transaction.24 Moreover, the transaction is reportable if the fees are contingent upon the receipt of a tax advantage.25 (iv) Loss Transactions. Many tax shelters are designed to create a loss deduction “without a corresponding economic loss.”26 Consequently, the IRS has classified certain §165 losses as reportable transactions. (v) Transactions with a Significant Book-Tax Difference. A tax transaction that leads to a significant difference between taxable and book income is a reportable transaction. Generally, a significant difference between tax and book income is a transaction where the taxpayer’s reportable income, gain, expense, or loss from the transaction differs by more than $10 million on a gross basis from the amount of the corresponding item or items on the taxpayer’s financial books.27 (vi) Transactions Involving a Brief Asset Holding Period. Tax shelters that involve the acquisition and sale of assets within a short period are reportable as transactions involving a brief asset holding period. The transaction is reportable if the taxpayer is claiming a tax credit exceeding $250,000 and the taxpayer has held the asset for less than 45 days.28 (vii) Nature and Timing of disclosure. If a taxpayer is uncertain whether a transaction is a reportable transaction or substantially similar to one, the taxpayer may request a ruling from the Service. Alternatively, if the taxpayer is uncertain as to whether a transaction must be disclosed, the taxpayer may disclose the transaction with its return and indicate on the disclosure statement that the taxpayer is uncertain whether the transaction is required to be disclosed and that the disclosure is being filed on a protective basis. The taxpayer must attach the disclosure Form 8886 to the tax return that corresponds with the year in which the tax benefit is received.29 Furthermore, if the taxpayer files an amended return that reflects a tax benefit received from a reportable transaction, the taxpayer must attach the disclosure form to the amended return.30 Additionally, Form 8886 must be filed by participants in a reportable transaction, including tax-exempt entities that are tax-indifferent accommodating parties.31
24 25 26 27 28 29 30 31
Frances Hill and Douglas Mancino, “Taxation of Exempt Organizations,” para. 33.11[1][b] (19). Reg. §1.6011-4(b)(4). Id. Frances Hill and Douglas Mancino, “Taxation of Exempt Organizations,” para. 33.11[1][b] (19). Reg. §1.6011-4(b)(6). Reg. §1.6011-4(b)(7). Reg. §1.6011-4(e). Id.
䡲
375 䡲
c07.fm Page 376 Friday, March 9, 2007 4:32 PM
EXEMPT ORGANIZATIONS IN TAX SHELTER TRANSACTIONS
7.3
EXCISE TAXES AND PENALTIES
The Tax Increase Prevention and Reconciliation Act of 2005 enacted new Code Section 4965, which provides for an excise tax on certain tax exempt organizations (those described in §501(c) or (d)) that participate as accommodating parties in certain types of tax shelter transactions. The entity tax is imposed at the highest corporate income tax rate unless the exempt organization that participated in the transaction knew, or had reason to know, that it was a prohibited tax shelter at the time it became a party to the transaction. If the organization knew or had reason to know that the transaction was a prohibited tax shelter, then the entity excise tax is imposed at a rate of 100 percent. In addition to the entity tax, §4965 also provides for a separate excise tax on managers of exempt organizations who knew or had reason to know that the transactions engaged in by their respective entities were prohibited, and where the manager approved of or caused the entity’s participation in the prohibited transaction. This “entity manager” tax is a flat amount of $20,000 per manager, irrespective of the amount involved in the transaction. (a)
Applicable Transactions
Section 4965 applies to four categories of prohibited tax shelter transactions: (1) those that were listed transactions when the entity became a party to the transaction; (2) those that were confidential reportable transactions when the entity became a party to the transaction; (3) those that were contractual protection transactions when the entity became a party to the transaction; and (4) those that were not listed, confidential, or contractual when the entity became a party to the transaction but were then subsequently identified by the IRS as a listed transaction. Loss transactions and transactions involving brief asset-holding periods are not subject to §4965. For purposes of the manager excise tax, §4965 applies to: (1) transactions that were listed transactions at the time the manager approved the entity as a party; (2) transactions that were confidential reportable transactions at the time the manager approved the entity as a party or caused the entity to become a party; and (3) transactions that were contractual protection reportable transactions at the time the manager approved the entity as a party or caused the entity to become a party. In contrast to the entity tax, a transaction entered into by a manager that is then subsequently identified as a listed transaction will not impart the manager excise tax if the transaction did not subject the manager to the tax based on his or her initial approval. (b)
Tax Imposed
The amount of the entity tax will generally (see above) equal 35 percent of the greater of: (1) the entity’s net income from the transaction for the applicable taxable year, or (2) 75 percent of the proceeds received by the entity from the transaction for the applicable taxable year. The entity tax will be applied to the taxable year in which the entity became a party to the prohibited transaction, as well as for any subsequent year in which 䡲
376 䡲
c07.fm Page 377 Friday, March 9, 2007 4:32 PM
7.4 SETTLEMENT INITIATIVES
the entity derived income from the transaction. The amount of the tax will be based upon the entity’s net income as derived from the transaction in that year. The tax rate will also depend upon whether the entity knew or had reason to know that the transaction was a prohibited tax shelter at the time that it became a party, and whether the transaction entered into was prohibited at that time, or was subsequently identified by the IRS as a listed transaction. An entity manager excise tax of $20,000 will be applied if an entity manager approved or otherwise causes the entity to become a party to a prohibited tax shelter transaction at any time during the entity’s taxable year, and where the entity manager knew or had reason to know that the transaction was a prohibited tax shelter. The trigger event for determining the entity manager tax will be either the date of the manager ’s action, approval or an inaction causing the entity’s participation in the prohibited scheme as compared to the date that the entity actually entered into the transaction. The excise tax of $20,000 per approval or act causing participation in a prohibited transaction will be in addition to any another applicable excise taxes. For example, an entity manager subject to the entity manager excise tax may still be subject to §4958 intermediate sanctions with respect to the prohibited tax shelter transaction. (c)
Disclosure Requirements
Under §6033(a)(2), any exempt organization that is a party to a prohibited tax shelter transaction under §4965 must disclose its involvement in the transaction, as well as the identities of any other parties involved and known to the entity. Section 6652(c)(e) provides that any failure to disclose this information will subject the entity to a penalty of $100 for each day of nondisclosure, up to a maximum penalty of $50,000. (d)
Date Effective
Section 4965 will apply to taxable years ending after May 17, 2006; however, no entity excise tax will be imposed with respect to income received that is allocable to any period ending on or before August 15, 2006. Accordingly, a transaction completed before May 17, 2006 or within the period ending on August 15, 2006 will not result in an excise tax.
7.4
SETTLEMENT INITIATIVES
Announcement 2005-80, released by the IRS on October 27, 2005, unveiled the most sweeping tax shelter settlement initiative in the Service’s history, providing taxpayers (including promoters, persons related to promoters, and TEFRA partners of promoters) with an opportunity to settle on 21 “eligible” transactions covering a wide array of abusive schemes.32 Sixteen of the 21 dealings eligible under the initiative involve “listed” transactions, those already identified by the Service as abusive. The remaining five, while not “listed,” pose concern as potential 32
Alison Bennett, “IRS Unveils Sweeping Shelter Settlement Covering 21 Abusive Deals, 4,000 Taxpayers,”BNA Daily Tax Report, October 28. 2005 at GG-1.
䡲
377 䡲
c07.fm Page 378 Friday, March 9, 2007 4:32 PM
EXEMPT ORGANIZATIONS IN TAX SHELTER TRANSACTIONS
shelters of tax abuse. Of specific concern with respect to joint ventures is the possibility that the exempt partner is viewed as an accommodating party. In Notice 2004-30, the IRS exercised its authority under the tax shelter regulations to specifically designate a tax-exempt partner as a participant in a tax avoidance transaction. Specifically highlighted in the Announcement as “eligible dealings” are two abusive charitable contributions: contributions of conservation easements and contributions of patents and other intellectual property. Contributions of easements involve deductions improperly claimed under §170 as a result of: (a) open space easements with the easement having no, or de minimis, value; (b) historic land or façade easements that have no, or de minimis, value; and (c) so-called conservation buyer transactions where the charitable organization purchases property, places an easement on it, and then “sells” the property with the easement to a buyer at a price substantially less than that paid for it, and the buyer also makes a charitable contribution that approximates the price differential.33 Contributions of patents and other intellectual property entail transfers to charitable organizations where the property has no, or de minimis, value.34 Although taxpayers will still be required to remit the full amount of taxes and penalties owed, as part of the initiative, taxpayers may receive penalty relief for transactions previously disclosed to the Service, as well as cases where the taxpayer sought and received independent opinions on the transactions. The Announcement further provides taxpayers with the ability to deduct costs associated with these transactions, including professional and promoter fees, and will allow taxpayers to take their cases to Appeals. Taxpayers have until January 23, 2006, to notify the Service of their intent to participate in the initiative.
7.5
ABUSIVE SHELTERS AND TAX CREDIT PROGRAMS
Recently, the IRS issued Notice 2006-65, which provided guidance with respect to the application of §4965 to certain credit programs, such as the LIHTC and NMTC. This Notice raises the possibility that many tax-exempt entities that participate in partnerships associated with the aforesaid credits (and are otherwise encouraged to do so) would become subject to the application to the penalties provided thereunder. The implications of this Notice are discussed at length in Chapter 13.
33 34
IRS Announcement 2005-80 §2-19 (November 14, 2005). Id. at §2-20.
䡲
378 䡲
c08.fm Page 379 Thursday, March 15, 2007 10:18 AM
C H A P T E R
E I G H T 8
The Unrelated Business Income Tax 8.1 (a)
INTRODUCTION The Rising Tide of Commercialism
As nonprofit organizations continue to face competition for donors and muchneeded funds, many tax-exempt entities have turned their focus to business endeavors more traditionally held captive by taxable entities. Exempt organizations can be found operating diverse enterprises such as organizing travel tours; publishing magazines; selling medical equipment, artwork, T-shirts, jewelry, life and health insurance; developing retirement communities; facilitating selfinsurance; conducting business and estate planning seminars; marketing video productions; operating pharmacies; and managing investment firms.1 Most notably, the Internet has evolved as a leading source for unrelated business income (UBI), with some exempt organizations receiving payments for advertising in online publications,2 and selling merchandise on Web sites in a manner similar to catalog sales.3 Competition for funds has led even storied nonprofit organizations to dramatically alter the manner in which they conduct their commercial activities. In 2004, for example, the Smithsonian Institution, established more than 150 years ago, announced that it was dismantling its publishing division. The division published mainly academic material and distributed the books free to libraries and educational institutions. Officials said that the closing was a result of a $2 million net loss over the last decade. In its place, the Smithsonian has entered into a joint venture designed to earn profits by selling books that are more commercial in nature.4 The pressure on nonprofits to act like and attract commerce
1 2
3 4
See Gaul and Borowski, “Nonprofits: America’s Growth Industry,” Phila. Inquirer (Apr. 18, 1993). Fred Stokeld, “Owens Briefs Association Reps on Internet Tax Issues,” Exempt Organization Tax Review 22, no. 2 (Nov. 1998), citing statements of Celia A. Roady, Esq., Morgan, Lewis, & Bockius, LLP, Washington, D.C., pp. 252–253. See id. Jacqueline Trescott, “Smithsonian to Overhaul its Unprofitable Book Division,” Washington Post (Oct. 16, 2004), at C01.
䡲
379 䡲
c08.fm Page 380 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
as if they were for-profit entities has never been greater, and will continue to increase so long as there is pressure to attract needed funds. (b)
Impact of UBIT and Reporting Trends
According to the most recent and comprehensive 20-year study (1975–1995) of nonprofits by the Internal Revenue Service, exempt organizations had an estimated $900 billion in gross total revenues in 1995.5 Moreover, assets held by exempt organizations in that year had more than tripled since 1975, to $1.9 trillion. By 1995, exempt organizations represented approximately 12.4 percent of the nation’s total economic output, which was more than double the percentage in 1975. Total UBI reported by all exempt organizations that filed Form 990-T (on which UBI is reported) for 1995 was $6.3 billion. Of the 36,400 exempt organizations that filed Form 990-T for 1995, only 18,200 organizations reported positive (net after allowable deductions) UBI of $893 million, with a total tax liability of $277.5 million. The sources of this income can be grouped mainly in two general areas: (1) major industrial categories and (2) finance, insurance, and real estate.6 Although IRC §501(c)(3) organizations represented the largest portion of exempt organizations filing Form 990-T for 1995, and therefore filed the largest proportion of Forms 990-T among all exempt organizations, only 4 percent of all §501(c)(3) organizations actually filed Form 990-T.7 At the same time, Form 990-T was filed by 24 percent of §501(c)(6) organizations (business leagues, Chambers of Commerce), 41 percent of §501(c)(7) social and recreational clubs, and 28 percent of §501(c)(19) war veterans organizations.
8.2
HISTORICAL AND LEGISLATIVE BACKGROUND OF UBIT
Since their inception, the federal income tax laws have provided an exemption from taxation for organizations operating “exclusively for religious, charitable, scientific . . . literary, or educational purposes.”8 Some organizations benefiting from the exemption, however, sought to obtain profits through means having little or nothing to do with the purposes for which their exemptions were granted. Although this unrelated business activity traditionally followed more indirect pursuits, such as the ownership of stock in a commercial corporation,9 in the absence of appropriate restrictions some exempt organizations developed a penchant for direct ownership of unrelated commercial businesses and the profits reaped therefrom.10
5
6 7 8 9 10
Alicia Meckstroth and Paul Arnsberger, “A 20-year Review of the Nonprofit Sector, 1975– 1995,” vol. 18, no. 2, Internal Revenue Service Statistics of Income Bulletin (fall 1998) (hereinafter referred to as “Fall 1998 SOI Bulletin”). See id. See id. §501(c)(3); See generally Chapter 2; see also Moore, “Current Problems of Exempt Organizations,” New York University Law Review, 24 (1969): 469, 470 (citing §501(c)(3)). Kaplan, “Intercollegiate Athletics and the Unrelated Business Income Tax,” Columbia Law Review 90 (1980): 1431, 1432. See S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950); H.R. Rep. No. 2319, 81st Cong., 2d Sess. 36 (1950). See also Portland Golf Club v. Commissioner, 497 U.S. 154 (1990).
䡲
380
䡲
c08.fm Page 381 Thursday, March 15, 2007 10:18 AM
8.2 HISTORICAL AND LEGISLATIVE BACKGROUND OF UBIT
(a)
The “Destination of Income” Test
Despite being in competition with regularly taxed organizations engaged in the same or similar commercial activities, profitable exempt organizations and their “feeders”—organizations created to engage in commercial and investment activities for the sole benefit of their exempt parents—were given an inadvertent boost by the United States Supreme Court in Trinidad v. Sagrada Orden de Predicadores.11 In Trinidad, the Court stated in dicta that the provision whereby an organization may seek to obtain exempt status “says nothing about the sources of the income, but makes the destination the ultimate test of exemption.”12 The Supreme Court, through this statement, adopted what became known as the “destination of income” test. Under this test, organizations otherwise qualifying for tax-exempt status were permitted to receive tax-free earnings as long as such earnings were used for, or “destined” to carry out, the organization’s exempt purpose. Exempt organizations were thus free to engage, untaxed, in virtually all types of commercial activity, no matter how far removed from their stated purposes, provided that all of the income from such activities went toward the furtherance of the organizations’ exempt purposes.13 This naturally imbued exempt organizations with an unfair advantage over their commercial counterparts,14 thus denying taxable entities the ability to compete effectively in the marketplace.15 Faced with a declining tax base because of the ability of exempt organizations to take control over, or force out of business, taxable enterprises, it was perhaps inevitable that Congress would step in. However, it was not until 1947, when the C. F. Mueller Company, 16 the country’s largest manufacturer of noodles at the time, achieved tax-exempt status by directing all profits to its 11 12 13
14
15
16
See Trinidad v. Sagrada Orden de Predicadores, 263 U.S. 578 (1924). See Trinidad, 263 U.S. at 581. Weithorn and Liles, “Unrelated Business Income Tax: Changes Affecting Journal Advertising Revenues,” Taxes 45 (1967): 791, 793 (citing Hearings on Revenue Revisions before House Committee on Ways and Means, 77th Cong., 2d Sess. 89 (1942)). President Truman’s tax message to Congress echoed the sentiment, “An exemption intended to protect educational activities has been misused in a few instances to gain competitive advantage over private enterprise through the conduct of business and industrial operations entirely unrelated to educational activities.” Hearings on Revenue Revision before House Committee on Ways and Means, 81st Cong., 2d Sess. 4, 5 (1950). “The specific business advantage possessed by an exempt business is a higher rate of return on capital.” Note, “The Macaroni Monopoly: The Developing Content of Unrelated Business Income of Exempt Organizations,” Harvard Law Review 8 (1968): 1280, 1281. Exempt organizations were not reticent to acquire profitable commercial enterprises having no relation to their exempt purpose. Examples of such acquisitions include: cotton gins, oil wells, automobile parts, theaters, food products, a radio station, a hydroelectric plant, a street railway, and an airport. Kaplan, “Intercollegiate Athletics and the Unrelated Business Income Tax” (citing Revenue Revision of 1950; Hearings Before the House Committee on Ways and Means, 81st Cong., 2d Sess. 19 (1950) (statement of Secretary of Treasury); Mezerik, “The Foundation Racket,” The New Republic (Jan. 30, 1950): 11, 13 (cattle ranches, haberdasheries, and citrus groves); 96 Cong. Rec. 9274 (1950) (remarks of Rep. Sabath). See C.F. Mueller Co. v. Commissioner, 190 F.2d 120 (3d Cir. 1951). In Mueller, a group of donors to New York University (NYU) School of Law created a corporation under the control of NYU. The corporation borrowed $3 million and purchased all of the outstanding stock of Mueller Company. The organization’s charter provided that the corporation was organized and operated exclusively to benefit NYU Law School and no income could inure to the benefit of any private individual. However, because of the outstanding debt incurred to purchase Mueller, not all of the income was available for NYU; a portion was used to finance the debt.
䡲
381
䡲
c08.fm Page 382 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
tax-exempt parent, the New York University School of Law,17 that congressional leaders and business interests alike proclaimed the need to redefine the parameters governing an exempt organization’s participation in commercial unrelated business activities.18 At the urging of Treasury that a tax be imposed on such activities,19 Congress enacted the unrelated business income tax as part of the Revenue Act of 1950.20 (b)
The Revenue Act of 1950
The Revenue Act of 1950 overturned the destination of income test by denying tax-exempt status to feeder organizations, making such organizations fully taxable,21 and establishing the unrelated business income tax.22 The purpose of the tax, however, was not to prevent an exempt organization from engaging in a commercial activity. Rather, it was designed to strike a balance between exempt and nonexempt organizations by imposing on the former the same tax that nonexempt organizations, engaged in the same commercial activity, were required to pay.23 The legislative history of the Revenue Act of 1950 expressly indicates that the motivation behind UBIT was a concern over unfair competition. The Senate Report provides the following justification for UBIT: The problem at which the tax on unrelated business income is directed is primarily that of unfair competition. The tax-free status of [§501(c)(3)] organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with profits remaining after taxes. Also, a 17
18
19 20
21 22 23
The Third Circuit upheld Mueller’s tax-exempt status on the premise that the benefit to the general public welfare from the encouragement of charity outweighed the benefit of the revenue received. Mueller, 190 F.2d at 122. “The Mueller macaroni situation aroused strong public interest in the expanding business activities of exempt organizations. Private industry became increasingly fearful of competition from tax-exempt organizations, and Congress worried that a growing number of commercial businesses would come under the control of exempt organizations, with a consequent lessening of the tax base.” Moore, “Current Problems of Exempt Organizations,” N.Y.U. Law Rev. 469, 470–71 (1969). Representative Dingell, in an obvious and somewhat apocalyptic reference to the Mueller acquisition, stated that “all the noodles produced in this country will [eventually] be produced by corporations held or created by universities . . . and there will be no revenue to the federal treasury from this industry.” Revenue Revision of 1950, Hearings Before the House Committee on Ways and Means, 81st Cong., 2d Sess. 580 (1950) (remarks of Rep. Dingell). Weithorn and Liles, note 21 (citing Hearings on Revenue Revisions before House Committee on Ways and Means, 77th Cong., 2d Sess. 89 (1942)). In fact, some commentators believe that the enactment of the unrelated business income tax was a direct result of the Mueller decision. See, e.g., “The Macaroni Monopoly: The Developing Concept of Unrelated Business Income of Exempt Organizations,” Harvard Law Rev. 81 (1968): 1280; Moore, “Current Problems of Exempt Organizations,” N.Y.U. Law Rev. 469, 471. This is not without support. The legislative history of the 1950 Act provides that “the problem at which the tax on unrelated business income is directed is primarily that of unfair competition. The tax-free status of §101 (now §501) organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes.” H.R. Rep. No. 2319, 81st Cong., 2d Sess. 36 (1950); S.Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950). §502(a). Revenue Act of 1950, ch. 994, 64 Stat. 906; §§511-14. H.R. Rep. No. 2319, 81st Cong., 2d Sess. 36 (1950); S. Rep. No. 2375, 81st Cong. 2d Sess. 28 (1950). See Portland Golf Club v. Commissioner, 497 U.S. 154 (1990).
䡲
382
䡲
c08.fm Page 383 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
number of examples have arisen where these organizations have, in effect, used their tax exemptions to buy an ordinary business. That is, they have acquired the business with little or no investment on their own part and paid for it in installments out of subsequent earnings—a procedure which could not be followed if the business were taxable. [T]his provision [does not] deny the exemption where the organizations are carrying on unrelated active business enterprises, nor require that they dispose of such businesses. [It] merely imposes the same tax on income derived from an related trade or business as is borne by their competitors. In fact it is not intended that the tax imposed on unrelated business income will have any effect on the tax-exempt status of any organization. An organization which is exempt prior to the enactment of this bill, if continuing the same activities, would still be exempt after this bill becomes law. In a similar manner any reasons for denying exemption prior to enactment of this bill would continue to justify denial of exemption after the bill’s passage.24
The statutory elements to the enactment of UBIT legislation are contained in §511 through §514 of the Internal Revenue Code (IRC).
8.3 (a)
GENERAL RULE Organizations Subject to UBIT25
“Virtually all tax-exempt business organizations are required to pay federal income tax on their ‘unrelated business taxable income.’”26 UBIT applies to all organizations described under IRC §501(c)(3)27 other than federal instrumentalities created pursuant to an act of Congress.28 Furthermore, although not enumerated in IRC §501(c), governmentally controlled educational institutions are also subject to UBIT,29 including any college or university owned or operated by a
24
25
26 27 28 29
S. Rep. No. 2375, 81st Cong., 2d Sess. 28-9 (1950), reprinted in 1950-2 C.B. 483, 504-05. See also Revenue Revision of 1950: Hearings Before the House Committee on Ways and Means, 81st Cong., 2d Sess. 579-80 (1950) (Statement of Representative Dingell). Under the Revenue Act of 1950, the UBIT applied only to select exempt organizations, including charitable, educational, and religious organizations (other than churches); labor, agricultural, and horticultural organizations; and business leagues. Churches, social clubs, and fraternal benefit societies were not subject to UBIT. However, the Tax Reform Act of 1969 extended the UBIT to practically all exempt organizations, including churches. In expanding the UBIT, Congress stated: In recent years, many of the exempt organizations not subject to the unrelated business income tax—such as churches, social clubs, fraternal benefit societies, etc.—began to engage in substantial commercial activity. For example, numerous business activities of churches were brought to the attention of Congress. Some churches are engaged in operating publishing houses, hotels, factories, radio and TV stations, parking lots, newspapers, bakeries, restaurants, etc. Furthermore, it is difficult to justify taxing a university or hospital which runs a public restaurant or hotel or other business and not tax a country club or lodge engaged in similar activity. Joint Committee on Taxation, 91st Cong., 2d Sess. 66-7 (1970). Portland Golf Club v. Commissioner, 497 U.S. 154, 110 S. Ct. at 2785 (1990). §501(c)(3); Reg. §1.501(c)(3)-1. See generally Chapter 2. §511(a)(2)(A); Reg. §1.511-1. §511(a)(2)(B); Reg. §1.511-2(a)(2). The tax applies to any corporation wholly owned by such college or university.
䡲
383
䡲
c08.fm Page 384 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
government or political subdivision thereof.30 Pension, profit sharing, and stock bonus plans described in §401(a)31 and exempt under §501(a)32 and individual retirement accounts described in §40833 are likewise subject to UBIT. Only a few exempt organizations escape the UBIT provisions.34 (b)
The Definition of “Unrelated Trade or Business”
UBIT is generally defined as the gross income derived from any unrelated trade or business regularly carried on by an exempt organization,35 less allowable deductions that are directly connected with the carrying on of the trade or business.36 An “unrelated trade or business” is defined as any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under §501.37
Hence, income is subject to UBIT if • It is from a “trade or business” within the meaning of §162. 38 • The trade or business is “regularly carried on.”39 • The activity is not “substantially related” to the organization’s perfor-
mance of its exempt function.40 (i) Trade or Business. In defining “trade or business,” the regulations reiterate the congressional motivation in adopting the UBIT: to eliminate unfair competition by placing an exempt organization that conducts business activities unrelated to its exempt purposes on equal footing with commercial, taxable
30
31 32 33 34
35 36 37 38 39 40
The term “government” includes any foreign government (to the extent not contrary to a treaty) and all domestic governments (the United States and any of its possessions, any state, and the District of Columbia). Reg. §1.511-2(a)(2). For purposes of UBIT, an Indian tribal government shall be treated as a state. §7871(a)(5). However, an elementary or secondary school is not subject to UBIT if it is operated by the government. Reg. §1.511-2(a)(2). §401(a). §501(a). §408(e)(1). These include title holding companies, which are subject to special rules (see §511(c) and §501(c)(2)) and feeder organizations (see §502). Feeder organizations are excluded from UBIT because they are already taxed under §502(a). §512(a)(1); Reg. §1.512(a)-1(a). See generally Chapter 4. §512(b); Reg. §1.512(b)-1(b). §513(a); Reg. §1.513(a)-1. §513(a); Reg. §1.513(a)-1(b). §512(a); Reg. §1.512(a)-1(a); Reg. §1.513-1(c)(1). §513(a); Reg. §1.513-1; Reg. §1.513-1(d). See Texas Apartment Ass’n v. United States, 869 F.2d 884 (5th Cir. 1989); see also California Farm Bureau Fed’n v. United States, 769 F. Supp. 332, 334 (E.D. Cal. 1991).
䡲
384
䡲
c08.fm Page 385 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
businesses.41 The regulations also provide that if an activity of an exempt organization is not comparable to the activity of a commercial enterprise, then the activity does not pose a sufficient threat necessary to impose the UBIT provisions.42 Hence, if an exempt organization sends out a low-cost article incidental to the solicitation of a charitable contribution, the UBIT does not apply because the organization is not in competition with commercial, taxable organizations.43 EXAMPLE: A school sent packages of greeting cards along with a solicitation for donations. The recipients of the greeting cards are under no obligation to make a contribution. Furthermore, the recipients are free to keep the greeting cards at no cost. Because the greeting cards are low-cost articles incidental to the solicitation of a charitable contribution and because the school’s solicitation campaign does not unfairly compete with commercial, taxable businesses, the activity is not a trade or a business.44 The term trade or business includes any “activity carried on for the production of income from the sale of goods or performance of services.”45 However, profit motivation is a key factor in determining whether any activity constitutes a trade or business.46 A profit motive can be inferred from the objective facts.47 EXAMPLE: A trade association, exempt from taxation under §501(c)(6), actively promotes and endorses an insurance program. As a consequence of its promotion, the exempt organization receives dividends from the insurance company. Because 41
42 43 44
45
46
47
Reg. §1.513-1(b). The regulations provide: “The primary objective of adoption of the unrelated business income tax was to eliminate a source of unfair competition by placing the unrelated business activities of certain exempt organizations upon the same tax basis as the nonexempt business endeavors with which they compete.” “Draft Report Describing Recommendations on the Unrelated Business Tax,” oversight Subcommittee of the House Ways and Means Committee (June 1989) (hereinafter referred to as “Draft Report”). See F.O.P., Ill. State Troopers, Lodge 41 v. Commissioner, 833 F.2d 717 (7th Cir. 1987) (the court notes that the primary factors in determining whether a trade or business exists are unfair competition and a profit motive). Reg. §1.513-1(b). See id. This example is based on the factual situation presented in Hope Sch. v. United States, 612 F.2d 298 (7th Cir. 1980). But see Disabled Am. Veterans v. United States, 650 F.2d 1178 (Fed. Cir. 1981), aff’d, 704 F.2d 1570 (Fed. Cir. 1983) (the organization was engaged in a trade or business when a solicitation letter merely described the gifts that prospective donors would receive after make a contribution). Reg. §1.513-1(b); see §162. See also United States v. American Bar Endowment, 477 U.S. 105, 110 n.1 (1986) (quoting Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir. 1984); See also State Troopers, note 49. See Professional Ins. Agents v. Commissioner, 78 T.C. 246 (1982), aff’d, 726 F.2d 1097 (6th Cir. 1984) (the intent to earn a profit is the determinative factor in ascertaining whether a trade or business exists); Louisiana Credit Union League v. United States, 693 F.2d 525, 532-33 (5th Cir. 1982) (existence of a profit motive is the most important factor as to whether an activity is a trade or business); Rev. Rul. 81-69, 1981-1 C.B. 351 (“An activity lacking a profit motivation, whether conducted by an exempt organization or a profit-making concern, does not constitute a trade or business”). Tech. Adv. Mem. 2000-47-049 (Aug. 2, 2000) (organization that provided municipal-type services to private residences in its planned community did not have profit motive and so not subject to unrelated business tax). See National Water Well Ass’n v. Commissioner, 92 T.C. 75 (1989). The Tax Court stated that “profit motive can be inferred in this case from the objective facts that petitioner was extensively involved in endorsing and administering a program that proved to be highly profitable.” (citing Louisiana Credit, 693 F.2d 525 (5th Cir. 1982).
䡲
385
䡲
c08.fm Page 386 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
the exempt organization performs administrative services for the insurance program, endorses and promotes the program to its members, and receives dividends, the activities of the exempt organization will likely constitute a trade or business.48 In searching for a profit motive, the starting point is a review of the end results achieved by the activity.49 The Fourth Circuit Court of Appeals has stated that “there is no better objective measure of an organization’s motive for conducting an activity than the ends it achieves.”50 Furthermore, courts will likely look through the transaction to determine whether a trade or business exists. The D.C. Circuit Court of Appeals, in examining a transaction and discounting the exempt organization’s explanation of the activity, stated, “Apparently we are invited to believe that the profit received was, as has been said of the British Empire, merely picked up in moments of absentmindedness.”51 Thus, courts will look through the facts and circumstances of an activity to find any profit motive indicative of a trade or business.52 Furthermore, “where an activity carried on for the production of income constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in a profit.”53 Profit motivation can be determined through a number of factors, including the accounting method used by the taxpayer;54 the manner in which the taxpayer carries on the activity; the expertise of the taxpayer or its advisors; the time and effort expended by the taxpayer in carrying on the activity; the expectation that assets used in the activity may appreciate in value; the success of the taxpayer in carrying on other similar or dissimilar activities; the taxpayer’s history of income or losses with respect to the activity; the amount of occasional profits, if any, that are earned; the financial status of the taxpayer; and the elements of personal pleasure or recreation.55 (A) S EGREGATING A B USINESS FROM WITHIN AN E XEMPT A CTIVITY In 1967, the Treasury issued a proposed regulation interpreting the unrelated income provision of the 1950 Act.56 Prior to the issuance of the 1967 regulation, a 48 49
50 51
52 53 54 55
56
This example is based on the factual situation presented in National Water Well Ass’n v. Commissioner, 92 T.C. 75 (1989); see also Tech. Adv. Mem. 92-23-002 (Feb. 13, 1992). See Carolina Farm and Power Equip. Dealers Ass’n v. United States, 699 F.2d 167 (4th Cir. 1983). See also American Postal Workers Union v. United States, 925 F.2d 480, 484-85 (D.C. Cir. 1991). Carolina Farm, 699 F.2d at 170. American Postal Workers Union v. United States, 925 F.2d 480, 484-85 (D.C. Cir. 1991). The Circuit Court went on to state that “given the traditional view that parties intend the obvious consequences of their acts, we join the other courts that have highly discounted such selfserving testimony.” Id. at 485. See State Troopers, 833 F.2d at 722. Reg. §1.513-1(b). See also Iowa State Univ. v. United States, 500 F.2d 508 (Cl. Ct. 1974); Cleveland Athletic Club v. United States, 779 F.2d 1160 (6th Cir. 1985). See Portland Golf Club v. Commissioner, 497 U.S. 154 (1990). See Portland Golf Club v. Commissioner, 497 U.S. 154 (1990) (Kennedy, J., O’Connor, J., and Scalia, J., concurring) (citing Reg. §1.183-2(b)(1)-(9)). See, e.g., Teitelbaum v. Commissioner, 294 F.2d 541, 545 (7th Cir. 1961); Patterson v. United States, 459 F.2d 487, 493-94, 198 (Cl. Ct. 543 (1972). The 1967 Treasury regulations, published in final form at 32 Fed. Reg. 17657 (1967), have not been amended in pertinent part since their promulgation, and references herein to those regulations are to the current version.
䡲
386
䡲
c08.fm Page 387 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
“trade or business” was regarded as a single economic unit to be considered as a whole and taxed in its entirety. The new, subsequently approved, regulation dramatically altered the scope of conduct falling within the term trade or business by instructing that the term be “fragmented”57 into its several independent activities so that each activity within the total “trade or business” is considered and tested as a separate taxable entity.58 For example, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy does not lose identity as a trade or business merely because the pharmacy also furnishes supplies to the hospital and patients of the hospital in accordance with its exempt purposes. 59 Similarly, activities of soliciting, selling, and publishing commercial advertising do not lose identity as a trade or business even though the advertising is published in an exempt organization periodical that contains editorial matter related to the exempt purposes of the organization.60 However, the IRS found that limited sales to people who are neither inpatients nor patients of physicians on the staff of a rural hospital could be considered “casual sales” under the reasoning of Rev. Rul. 68-374, and thus not subject to UBIT.61 The existence of a profit motive and the source of funding being primarily activity-generated are highly important factors in determining whether a particular activity may be properly fragmented from its larger, and perhaps exempt, enterprise.62 IRC §513(c) states, with regard to advertising activities, that “the term ‘trade or business’ includes any activity carried on for the production of income from the sale of goods or the performance of services.”63 In this section of the Code, Congress hoped to clarify the tax treatment of revenues generated by the advertising activities of professional journals, although it was not written in such confining terms.64 The solicitation, sale, and publishing of commercial advertising is explicitly identified as being within the category of “activities” 57
58 59
60 61 62
63 64
Reg. §1.513-1(b). The regulation provides: Activities of producing or distributing goods or performing services from which a particular amount of gross income is derived do not lose identity as trade or business merely because they are carried on within a larger aggregate or similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization. See Rev. Rul. 82-139, 1982-2 C.B. 108 (the IRS segregated commercial advertisements within a bar association journal, taxable as UBI, from editorial material that furthers the exempt purpose of the exempt organization). In computing UBIT, an exempt organization must allocate expenses such as depreciation between the exempt function activity and the unrelated business activity. Generally, for purposes of UBIT, the exempt organization cannot allocate expenses attributable to the conduct of the exempt activities to the unrelated business activity. However, there is an exception in the case of “exploitation.” Reg. §1.512(a)-1(d)(1). For UBIT computations including the allocation and exploitation rules, see Section 8.7. Reg. §1.513-1(b); see also Tech. Adv. Mem. 92-23-002 (Feb. 13, 1992). Reg. §1.513-1(b); see also Rev. Rul. 78-145,1978-1 C.B. 169 (IRS segregated activities when an exempt blood bank utilized red blood and then sold the plasma to commercial laboratories; the plasma sales were an unrelated trade or business). Reg. §1. 513-1 (b); See also Rev. Rul. 82-139, 1982-2 C. B. 108. Priv. Ltr. Rul. 200203070. Kaplan, “Intercollegiate Athletics and the Unrelated Business Income Tax,” 80 Colum. L. Rev. 1431, 1438- 39 (citing Iowa State Univ. of Science & Tech. v. United States, 500 F.2d 508 (Cl. Ct. 1974) (“a profit motive is intrinsic to the concept of a business”). See also Adirondack League Club v. Commissioner, 55 T.C. 796 (1971), aff’d per curiam, 458 F.2d 506 (2d Cir. 1972). §513(c). Kaplan, “Intercollegiate Athletics and the Unrelated Business Income Tax,” 80 Colum. L. Rev. 1430, 1438 n.41 (citing S. Rep. No. 552, 91st Cong., 1st Sess. 75-76 (1969)).
䡲
387
䡲
c08.fm Page 388 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
capable of being fragmented from a “trade or business.”65 Furthermore, the performance of these activities within the larger context of publishing an exempt organization’s journal or periodical does not prevent their being identified as distinct trades or businesses, even though the journal or periodical contains editorial material in common with the exempt purpose of the organization.66 CAVEAT The IRS is currently considering guidance requests from hospitals regarding the unrelated business income ramifications arising from physician use of electronic patient record systems and specifically, whether use of the record system for a physician’s private care patients would be unrelated trade or business income.* *
Fred Stokeld, “IRS Will Review Exempt Hospitals’ Compliance with Community Benefit Standard,” Tax Analysts’ Tax Notes Today, 2005 TNT 205-9 (October 25, 2005).
(B) D UAL-U SE F ACILITIES An asset or facility that is necessary to the conduct of the exempt functions of an organization may also be employed in a commercial endeavor. When a facility is used for both exempt and nonexempt functions, the IRS will likely find a trade or business that is unrelated to the exempt purposes of the exempt organization.67 The test is whether the activities producing the income in question contribute importantly to the accomplishment of the exempt purposes. EXAMPLE: An exempt educational institution operates a ski facility that is used by the students as part of their educational curriculum. Any income derived from the students’ recreation and the physical education program is not taxable as UBI because it is related to the exempt purposes of the school. However, the school also derives income from the use of the ski facility by the general public. The public pays ski lift fees that are comparable to those of commercial ski facilities. Because the public use of the ski facility does not contribute importantly to the exempt purpose of the school, the income derived from the public use is income from an unrelated trade or business.68 The regulations provide the example of a museum that operates a theater to show educational films during museum hours, but then shows commercial movies to the general public in the evenings for a fee similar to that charged by commercial businesses. The operation of the theater in the evening hours is an unrelated trade or business.69
65 66
67 68 69
Reg. §1.513-1(b). See id. See also United States v. American College of Physicians, 475 U.S. 834, 839 (1986) (“The new regulation segregated the “trade or business” of selling advertising space from the “trade or business” of publishing a journal, an approach commonly referred to as “fragmenting” the enterprise of publishing into its component parts”). See generally Section 15.4. Reg. §1.513-1(d)(4)(iii). In computing UBIT, see Reg. §1.512(a)-1(c) on dual use facility allocation and exploitation rules. See also Section 8.7 on computing UBIT. This example is based on the factual situation presented in Rev. Rul. 78-98, 1978-1 C.B. 167. Reg. §1.513-1(d)(4)(iii).
䡲
388
䡲
c08.fm Page 389 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
Similarly, John W. Madden, Jr., v. Commissioner70 involved a museum “without walls” whose purpose was to expose the public to all forms of art, including music. The museum had an amphitheater that seated 18,000 persons; it used the amphitheater for about five performing arts events per year. The museum leased its space to members of the community for isolated social functions during the year; income from this leasing activity was minimal, and often was less than related expenses. The museum also leased its 18,000-seat amphitheater to MCA Concerts, Inc. (MCA), a commercial entity that sponsored performances by popular performers at high-priced-ticket events. The initial MCA lease term was six years. The Tax Court held that the museum’s occasional leasing of its facilities to members of the public did not constitute a trade or business, as the public was exposed to the museum’s artworks at these events and they generated minimal income, if any, for the museum. On the other hand, the Tax Court ruled that the MCA lease arrangement constituted a regularly carried on trade or business—the lease was long-term, and the museum had made improvements to the amphitheater that appeared to have been done only to accommodate MCA and not to further the museum’s exempt purposes.71 Moreover, the MCA concerts had a commercial flavor in that they charged premium prices and featured popular entertainers.72 (ii) “Regularly Carried On” (A) T HE R EGULATIONS The regulations provide that even if a taxpayer is viewed as satisfying the trade or business requirement (i.e., the taxpayer is operating a trade or business), the taxpayer can still avoid UBIT classification if the activity is not “regularly carried on.”73 Consistent with the desire to eliminate, as much as possible, the unfair advantage of exempt organizations, the regulations require that the frequency and continuity with which an exempt organization engages in a specific business activity be compared with the same or similar business activity of nonexempt organizations.74 • Normal Time Span of Activities. In addition to the frequency requirement, the
regulations also require that the manner in which an activity is engaged in by an exempt organization be compared to the manner in which the same business activity is pursued by the nonexempt entity.75 Activities exhibiting “a frequency and continuity, and . . . pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations,” will be deemed to have been “regularly carried on.”76 For example, if the income producing activities are of a kind normally carried on by a taxable commercial enterprise on a year-round basis, the conduct of the same activities by an exempt organization over a period of only a few weeks 70 71 72
73 74 75 76
John W. Madden, Jr. v. Commissioner, 74 T.C. M. (CCH) 440 (1997). Tech. Adv. Mem. 97-01-003 (Aug. 28, 1996). The UBIT exception for rents, as described in Section 8.5(b) of this chapter, was deemed unavailable by the court, as rental payments were found to be based, in part, on net profits, which disqualifies rent from coming within the UBIT exception of §512(b)(3). §512(a); Reg. §1.512(a)-1(a); Reg. §1.513-1(c)(1). Reg. §1.513-1(c)(1). See id. See id.
䡲
389
䡲
c08.fm Page 390 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
does not constitute the “regular carrying on” requirement.77 The regulations draw a distinction between intermittent, seasonal, and year-round activities. For example, a sandwich stand operated for two weeks of the year by a hospital auxiliary is not a regularly carried on activity.78 The same activity is, however, regularly carried on if it is undertaken one day each week.79 Moreover, seasonal activities, such as the operation of a horse racing track for several weeks of the year, are regularly carried on because “it is usual to carry on such trade or business only during a particular season.”80 • Intermittent Activities. In determining whether intermittent activities are
regularly carried on, the regulations once again require a comparison of the manner in which the activity is performed by the exempt organization with the performance of the same activity by a nonexempt organization.81 Activities of an exempt organization that are “discontinuous” or “periodical” will not ordinarily be deemed to be regularly carried on if performed “without the competitive and promotional efforts typical of commercial endeavors.”82 The regulations give the following example of intermittent activity: [W]here an organization sells certain types of goods or services to a particular class of persons in pursuance of its exempt functions or “primarily for the convenience” of such persons within the meaning of §513(a)(2) (as, for example, the sale of books by a college bookstore to students or the sale of pharmaceutical supplies by a hospital pharmacy to patients of the hospital), casual sales in the course of such activity which do not qualify as related to the exempt function involved will not be regular (presumably, the casual sale of a textbook to a nonstudent by a college bookstore would not be considered “regular”).83 • Infrequent Conduct. Finally, the regulations imply that the foregoing analy-
sis may be entirely preempted if an initial determination can be made that the relevant activities occurred “so infrequently that neither their recurrence nor the manner of their conduct will cause them to be regarded as trade or business.”84 The example given involves fundraising activities
77 78
79 80 81 82 83 84
Reg. §1.513-1(c)(2)(i). Reg. §1.513-1(c)(2)(i). See S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1988); see also National Collegiate Athletic Ass’n v. Commissioner, 914 F.2d 1417 (10th Cir. 1990), rev’g 92 T.C. 456 (1989) (a three-week activity was not viewed as regularly carried on) (hereinafter referred to as “NCAA”). Reg. §1.513-1(c)(2)(i). See S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950). See id. Reg. §1.513-1(c)(2)(ii). Id. See also Priv. Ltr. Rul. 88-40-056 (1988) (a one-time sale of music by an exempt organization to a taxable corporation is not regularly carried on). Reg. §1.513-1(c)(2)(ii). Reg. §1.513-1(c)(2)(iii). See Priv. Ltr. Rul. 96-29-030 (Apr. 24, 1996) (organization that disposed of real property via sale three times since 1925 does not recognize UBIT on the sale of four properties it received by gift or bequest, because such sale was not “regularly carried on”); Priv. Ltr. Rul. 96-31-025 (May 7, 1996) (exempt private school’s sale of its interest in land underlying a condominium development, which was held for a “significant period of time,” received as a donation and under threat of condemnation by the state did not generate UBIT). See Section 6.4 A for a complete discussion of the topic.
䡲
390
䡲
c08.fm Page 391 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
occurring for a brief period of time. The regulations state that these shorttime-period activities will not ordinarily be treated as regularly carried on. Furthermore, activities recurring on a yearly basis, such as an annual dance, will likely not be regarded as having been regularly carried on.85 (B) C ASE L AW The landmark case that defined whether a trade or business is regularly carried on is National Collegiate Athletic Association v. Commissioner,86 a Tenth Circuit Court of Appeals case. The facts of this case date back to 1981, when the National Collegiate Athletic Association (NCAA) contracted with a for-profit firm to produce the program for its annual “Final Four” basketball tournament. The NCAA received approximately $56,000 from the for-profit firm to publish the program, which contained many pages of advertising. The IRS claimed that such revenue was advertising income subject to UBIT. The Tax Court determined that the revenue derived from the program was not related to the NCAA’s exempt purposes and was therefore subject to UBIT. On appeal, the only question remaining was whether the trade or business was “regularly carried on” by the NCAA. The Tenth Circuit, properly relying on the regulations for the definition of “trade or business,” determined that the regulations required a two-step analysis. The court first considered the “frequency and continuity” of the activity, giving due consideration to the activity’s normal time span in order to determine whether the time actually spent in performing the activity itself suggested whether it was “regularly” or “intermittently” carried on. The second step of the analysis was an evaluation of the manner in which the activity had been pursued.87 Substantial reliance was placed on the examples of competing activities set forth in the regulations.88 The Tax Court viewed the relevant time period for determining whether the NCAA’s advertising activity was “regularly carried on” as the time spent to solicit advertisements and prepare them for publication. In this regard, the Tax Court attributed all of the time spent by the for-profit publisher to the NCAA, based on their principal–agent relationship. The Tenth Circuit disagreed, stating that preparatory time should not be considered; instead, the court concluded that the three-week tournament was the relevant time.89 The Tenth Circuit reasoned that the relevant time span should be judged in relation to the period in which a commercial entity would normally conduct a 85
86 87 88
89
Id. The example in the regulations was taken from the Senate Report to the Revenue Act of 1950, ch. 994, 64 Stat. 906, which provides: “If a charitable organization, exempt under [§501(c)(3)], gives an occasional dance to which the public is admitted for a charge, hiring an orchestra and entertainers for the purpose, this would not be a trade or business regularly carried on.” S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950). NCAA v. Commissioner, 914 F.2d 1417 (10th Cir. 1990), rev’g 92 T.C. 456 (1989). See id. See id. The example of a hospital auxiliary’s operation of a sandwich stand two weeks out of a year is offered to describe an intermittent activity, while the example of a commercial parking lot operated every Saturday is cited as an activity that is “regularly carried on.” Finally, the operation of a horse racing track several weeks a year illustrates a seasonal, and hence, “regularly carried on” activity. NCAA, 914 F.2d at 1421-22 (citing Reg. §1.513-1(c)(2)(i)). NCAA, 914 F.2d at 1421. But cf. Rev. Rul. 80-298, 1980-2 C.B. 197 (the use of a football stadium for several months out of a year constitutes a regularly carried on activity).
䡲
391
䡲
c08.fm Page 392 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
comparable activity. The court stated, for example, that if an activity is normally carried on by a for-profit organization on a year-round basis, the conduct of that activity by an exempt organization for a few weeks each year would not constitute the regular carrying on of a trade or business.90 By contrast, if the activity is normally a seasonal one, its conduct by an exempt organization on a seasonal basis would be a regularly carried on activity. The Tenth Circuit explained that the activity from which the NCAA derived income was the publication of program advertising, which occurred only during the three-week tournament. Accordingly, the court held that three weeks was not a sufficiently long time to constitute a regularly carried on business.91 The court then considered whether the NCAA’s advertising activities were conducted in a sufficiently commercial manner so as to be regularly carried on. According to the regulations, intermittent activities of an exempt organization may nevertheless be considered regularly carried on if they are conducted with the competitive and promotional efforts of comparable for-profit firms. The IRS argued that the advertisements in the program were indistinguishable from those that might appear in magazines such as Sports Illustrated and were, therefore, unrelated business activity. The Tenth Circuit refused to consider whether the advertising was too commercial in nature, but focused instead on the fact that the activity was so infrequent that neither its recurrence nor the manner of its conduct should cause it to be regarded as a trade or business “regularly carried on.”92 Similarly, prior to NCAA, the Tax Court ruled that a vaudeville show, produced by an organization exempt under §501(c)(4), that ran for two nights each year for four consecutive years was not a regularly carried on activity.93 The exempt organization received income from the show and from advertising in the accompanying programs and, under a joint venture arrangement with a commercial program promoter, received a percentage of the advertising proceeds. The commercial promoter solicited the advertising for the vaudeville show for two to four months a year. In this situation, the Tax Court did not look to the activities of the promoter, but rather held that the vaudeville shows and the programs were intermittent activities that “did not constitute an unrelated business which was regularly carried on.”94 On the other hand, in State Police Ass’n of Mass. v. Commissioner,95 the First Circuit upheld a Tax Court ruling classifying income from an annual yearbook as UBIT. In State Police, a 501(c)(5) association operated on behalf of the state 90 91 92 93 94
95
Reg. §1.513-1(c)(2)(i). Accord Veterans of Foreign Wars v. Commissioner, 89 T.C. 2 (1987) (mailing solicitations with accompanying Christmas cards four times a year is regularly carried on). The IRS has announced that it will not follow the NCAA case outside the Tenth Circuit, and that it will look for another case to challenge the decision. See Suffolk County Patrolmen’s Ass’n v. Commissioner, 77 T.C. 1314 (1981). See Suffolk County, 77 T.C. at 1325. See also Rev. Rul. 75-201, 1975-1 C.B. 164. The Tax Court in Suffolk County found this ruling to be similar to the facts in the case at bar. The ruling presents the situation of an exempt organization (a symphony orchestra) raising funds by selling advertising in an annual concert book. Here, the IRS held that the activity was not subject to UBIT. State Police Ass’n of Mass. v. Commissioner, 125 F.3d 1 (1st Cir. 1997), cert. denied, 118 S. Ct. 1036 (1998).
䡲
392
䡲
c08.fm Page 393 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
troopers who constituted its membership. The association published an annual yearbook that included photos, articles, display advertisements, and a business directory; five regional editions with common articles were produced. The yearbook was published by two outside firms that hired telemarketers to solicit advertisements; the larger the ad, the higher the fee. The association’s contracts with both of the firms gave it significant control over the publishing activities, including sales of advertising, handling of the raised funds, and the publication of the yearbook. Under both contracts, the telemarketers were considered employees of both the association and the outside firms; troopers monitored all solicitations; the association selected the geographic areas for solicitation; and, finally, the association retained the right to inspect, without notice, the field offices used by the telemarketers. Advertising fees were paid directly to the association, which paid a stipulated percentage amount to the outside firms and the telemarketers, keeping any excess, after expenses, for itself. The First Circuit rejected the association’s contention that income from the yearbook was not UBIT. It agreed that the IRS’s characterization of the advertisements as such was accurate; in fact, the association referred to them as advertisements for several years and only belatedly started referring to them as “acknowledgements,” trying, unsuccessfully, to come within a new statutory exception to UBIT in IRC §513(i).96 The court found that the IRS’s reliance on Fraternal Order of Police v. Commissioner97 was well founded in that both cases involved publications with display ads and a directory, coupled with a message asking readers to patronize the listed merchants. In addition, in both cases, the advertising charges were directly related to the size of the ad. Finally, the court rejected the association’s reliance on NCAA on the ground that the latter case involved a publication tied to a particular event, whereas in this case, the association engaged in the activities related to the yearbook for about 46 weeks of the year, which the court characterized as “sufficient regularity by any standard.”98 Moreover, the association had substantial involvement and control over the activities. In the most recent controversy over revenue from advertisements, the parties stipulated that publication of the official magazine of the Arkansas State Police Association was not substantially related to the Association’s exempt purpose, but disagreed as to whether payments from advertisements in the magazine were royalty payments excluded from UBIT.99 The association had licensed its name and logo to the publishing company for use in the publication of its magazine. The Tax Court cited Fraternal Order of Police100 for the proposition that advertising proceeds will not qualify as royalties when an organization takes an active role in the publication activity. It cited State Police Ass’n of Massachusetts101 for the proposition that if an organization closely supervises and is involved in the content of the magazine and sale of advertising, the publishing 96 97 98 99 100 101
See Section 8.4. Fraternal Order of Police v. Commissioner, 87 T.C. 742 (1986), aff’d, 853 F.2d 717 (7th Cir. 1987). 123 F.3d at 8. Arkansas State Police Ass’n, Inc. v. Commissioner, T.C. Memo. 2001-38. 87 T.C. 742 (1986), aff’d 853 F.2d 717 (7th Cir. 1987). 125 F.3d (1st Cir. 1997).
䡲
393
䡲
c08.fm Page 394 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
company is acting as its agent, and payments will be subject to UBIT. The association in this case did maintain control over most aspects of the magazine, actively reviewing articles, photographs, and publicity for each edition. The Tax Court distinguished the affinity card cases because the exempt organizations in the latter cases were passive, and had very minimal involvement in the fee generating activity. Therefore, the Tax Court held that the association’s share of advertising proceeds was not royalty income, but unrelated business income. The Eighth Circuit Court of Appeals affirmed the decision of the Tax Court in the Arkansas Police Association case on March 6, 2002. It held that the payments should not be considered royalties, even if the association spent little time working on the magazine because the agreement created an agency relationship. In the court’s view, the publisher acted on the association’s behalf to promote the association. In contrast, the affinity card cases present a true royalty in which the credit card companies used an EO’s name to promote the credit cards. A Technical Advice Memorandum102 considered the nature of a commission from advertising fees received by a trade association from ads placed in the free newspapers circulated by its members. It concluded that although the trade association had initiated the placement of the ads by contracting with a forprofit entity, it did not exercise any control over them, and neither the members nor the for-profit were acting as agents of the association. Therefore, the amounts received would be regarded as additional dues payments from the members of the association rather than taxable income. Proceeds from a gambling game run by local taverns was not income to the volunteer fire department to which they were donated.103 The fire department’s very limited role in the games was insufficient to constitute participation in a trade or business. In another gambling case, the Tax Court agreed with the IRS that an educational athletic association that derived all of its funding from sale of pickle cards to liquor establishments in Nebraska owed UBIT on the proceeds because they were not substantially related to the association’s exempt purpose. Furthermore, because all of the financial support for the association came from the sale of pickle cards, the association was deemed a private foundation rather than a public charity.104 (iii) “Substantially Related” (A) T HE R EGULATIONS If an exempt organization is viewed as meeting the first two requirements (i.e., the organization derives income from a regularly carried on trade or business), the organization may still escape UBIT classification if the trade or business is substantially related to the organization’s exempt purposes.105 In determining whether an activity is substantially related to the exempt purpose of an organization, there must be an “examination of the relationship between the business 102 103 104 105
Tech. Adv. Mem. 200102051 (Sept. 5, 2000). Vigilant Hose Co. of Emmitsburg v. United States (U.S. D. Ct. Md., May 18, 2001), 2001 WL71063. T.C. Memo. 1999-75. Reg. §1.513-1(d)(1).
䡲
394
䡲
c08.fm Page 395 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
activities which generate the income in question . . . and the accomplishment of the organization’s exempt purpose.”106 This examination requires, with regard to each activity in question, a facts and circumstances review of the relationship between the activity and the organization’s exempt purpose.107 The IRS has issued a number of Private Letter Rulings to hospitals proposing to operate healthclubs. The government’s response is generally favorable when the facilities are integrated into the treatment offered to patients (e.g., for rehabilitation after surgery), when the hospital ensures that membership will be available to a broad section of the community through proper pricing, discounts, and scholarships, and when the facilities are used for community education programs.108 A trade or business is “related” to an organization’s exempt purposes if the activity bears a “causal relationship” to the achievement of the exempt purpose.109 Furthermore, an activity is considered to be “substantially related” to the organization’s exempt purpose if the performance of the activity that results in the production of gross income “contributes importantly” to the exempt purpose, such that it is a substantial cause in bringing about the organization’s achievement of that purpose.110 For an activity to contribute importantly to the organization’s exempt purpose, the size and extent of the related activities must be compared with the nature and extent of the organization’s exempt functions.111 EXAMPLE: M, an organization described in §501(c)(3), operates a school for training children in the performing arts, such as acting, singing, and dancing. It presents performances by its students and derives gross income from admission charges for the performances. The students’ participation in performances before audiences is an essential part of their training. Because the income realized from the performances is derived from activities that contribute importantly to the 106 107
108 109
110 111
See id. See also Gen. Couns. Mem. 39,752 (Sept 6, 1988). Reg. §1.513-1(d)(2). See also United States v. American College of Physicians, 475 U.S. 874 (1986) (the Court utilized a “facts and circumstances” approach and found that advertising revenue in a periodical did not contribute importantly to the exempt educational purpose of the organization). For a recent example see Priv. Ltr. Rul. 200101036. Reg. §1.513-1(d)(2). See Priv. Ltr. Rul. 94-20-042 (May 20, 1994) (a blood bank operated a computer database that is utilized by other nonprofit blood banks. The IRS held that the shared use of the computer system ensured the safety of the blood supply nationwide, and that the safeguarding of the blood supply bore a “causal relationship” to the organization’s exempt purpose). Reg. §1.513-1(d)(2); Gen. Couns. Mem. 39,752 (Sept. 6, 1988). Rev. Rul. 81-61, 1981 C.B. 355 (exempt organization that operates an elderly facility also runs a beauty salon and barber shop; the IRS ruled that these contribute importantly to the exempt purpose of caring for the elderly); Rev. Rul. 81-19, 1981-1 C.B. 351 (university’s operation of vending and laundry facilities contributes importantly to the exempt purpose of student education). For example, in Letter Ruling 200411044, the Service ruled that a joint venture’s income derived from developing an urban area for the purpose of attracting qualified workers was not UBIT. In that ruling, four exempt organizations specializing in the medical field formed an LLC to combat urban deterioration and attract qualified businesses and workers by developing their urban surroundings. The LLC was responsible for purchasing, developing, and leasing or selling land in the surrounding area. The purchasers and lessees included entrepreneurs in the technology field, and the member organizations. Income from the sale and/or lease of the land was to be distributed to the member organizations. The Service ruled that the income from the development and sale of land was not subject to UBIT, because the income was substantially related to the exempt organization’s exempt activities. The IRS reasoned that development of an urban community furthered the organizations’ charitable, scientific, and educational purposes to retain professionals or attract them to the area.
䡲
395
䡲
c08.fm Page 396 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
accomplishment of M’s exempt purposes, it does not constitute gross income from unrelated trade or business.112 Thus, the size and extent of the business activity must be proportional to the activity’s contribution to the exempt purposes.113 Hence, when the scope of all activity conducted by an exempt organization exceeds that which is reasonably necessary to satisfy the exempt purpose, UBIT will be imposed on that portion of income exceeding the amount required to achieve the intended result.114 CAVEAT In Rev. Rul. 2004-51, the Service suggested that in addition to the “substantially related” requirement, it may apply a “UBIT plus Control” test to ancillary joint ventures. The “UBIT plus Control” test superimposes the “control test” of Rev. Rul. 98-15, Redlands, and St. David’s upon the standard UBIT analysis—so that even if the activity of the partnership is “substantially related” to the exempt organization’s purpose, it will be deemed to be an “unrelated” trade or business if the exempt organization cedes effective control over the substantive aspects of the venture to the for-profit entity.* *
Rev. Rul. 2004-51. See Section 4.4 for a more detailed discussion of Rev. Rul. 2004-51.
(B) C ASE L AW In Louisiana Credit Union League v. United States,115 the Fifth Circuit Court of Appeals examined the “substantial relationship” requirement. The court, in examining the activities of a business league to determine whether the activity
112
113
114
115
Reg. §1.513-1(d)(4)(i) (example 1). See also Gen. Couns. Mem. 39,752 (Sept. 6, 1988) (exempt school’s manufacturing facility is not substantially related to exempt educational function). But see Priv. Ltr. Rul. 96-41- 011 (June 28, 1996) (organization’s retail sales operation, under which it collects, sorts, repairs, and resells surplus and used goods donated by the public, is substantially related to the organization’s charitable purposes of providing retail training and job placement for economically or socially disadvantaged or disabled individuals). Rev. Rul. 73-128, 1973-1 C.B. 222 (the IRS ruled that “there is likewise no evidence that the scale of the endeavor is such as to suggest that it is being conducted on a larger scale than is reasonably necessary to accomplish the organization’s charitable purpose”). See also Rev. Rul. 73-386, 1973-2 C.B. 191 (the IRS ruled that an exempt business league’s activities went “well beyond” those necessarily contributing to the exempt purpose—the business league’s activity was more like a commercial enterprise). Reg. §1.513-1(d)(3). See Tech. Adv. Mem. 96-36-001 (Jan. 4, 1996), in which the IRS ruled that income from an exempt religious and educational organization’s substantial publishing activities (some 30,000 textbooks per day) was subject to UBIT because the activity “far exceed[ed] that which [was] necessary to educate the organization’s students.” The regulations also deal with the dual use of assets or facilities, providing that taxable and nontaxable income are capable of being produced by the same assets. Reg. §1.513l(d)(4)(iii) (museum theater shows educational films all day but features commercial films in the evening; the income generated during the day would likely be exempt from UBIT, but the income generated in the evenings would be UBIT). This is a substantial departure from the old regulations, which appeared to follow an “all or nothing” approach to the question of whether the income was subject to tax, i.e., if any part of the income was subject to UBIT, all of that activity’s income would be similarly tainted. Reg. §1.513-1(a)(4) (1958). Louisiana Credit Union League v. United States, 693 F.2d 525 (5th Cir. 1982).
䡲
396
䡲
c08.fm Page 397 Thursday, March 15, 2007 10:18 AM
8.3 GENERAL RULE
was substantially related to the exempt purposes of the organization, made factual inquiries into the following: • The unique nature of the activities vis-à-vis the organizational function or
purpose116 • The capacity in which benefits are received by the organization’s members117
The court held that the promotional and administrative actions of the exempt organization were not the sort of unique activity that satisfied the “substantially related” test.118 In United States v. American College of Physicians,119 the Supreme Court directly addressed the “substantially related” requirement. The issue was whether the American College of Physicians is subject to UBIT on income it earns by selling commercial space in its journal, the Annals of Internal Medicine.120 If the advertising activity is not substantially related to the exempt purposes of the organization, then the exempt organization must pay UBIT on the income. The United States Claims Court (the trial court) concluded that the advertisements in Annals were not substantially related to the exempt purposes.121 Rather, in focusing on the nature of the College’s advertising business, the Claims Court held that any correlation between the advertisements and the College’s educational purpose was incidental and, therefore, taxable as UBIT.122
116
117
118 119 120 121 122
See id. at 535. In this regard, the court stated, “In order for the activities of a business league to be substantially related to its exempt function, those activities must be unique to the organization’s tax-exempt purpose. It is the distinctiveness of the activity that cements the substantial relationship between the two. Such services as educational and training programs, legislative lobbying, and institutional advertising clearly satisfy this uniqueness test, because they advance the purposes of the business league as an entity in itself. It is the institutional ends that must be served if the activity is to be deemed substantially related. Educational, legislative, and advertising services are peculiarly suitable activities for a business league because they further the common business interest that unites the association’s members.” See id. at 535. See also Treas. Reg. §1.501(c)(6)-l. See Louisiana Credit, 693 F.2d at 536. Here, the Louisiana Credit court stated that “the capacity in which benefits are received by the organization’s members is as important as the unique character of the organization’s activities. For a substantial relationship to exist, any direct benefits flowing from a business league’s activities must inure to its members in their capacities as members of the organization. Thus, when a business league’s uniquely relevant activities produce inherently group benefits that accrue to its members qua members, a substantial relationship exists within the meaning of §513. This distinction between inherently group benefits and individual benefits is analogous to the aggregate/entity concept familiar in partnership taxation. Just as a member of a partnership may enjoy benefits in his separate capacities as partner and non-partner, so may a member of the LCUL enjoy benefits both as a League member and as an individual credit union. Only those activities that benefit the credit unions in their capacities as League members can be considered substantially related to the League’s exempt function. This group benefit standard also accords with the requirement that a business league seek to improve the conditions of an entire line of business rather than perform discrete services for individuals. See id. at 536. See also Treas. Reg. §1.501(c)(6)- 1;” California Thoroughbred Breeders v. Commissioner, 57 TCM (CCH) 962 (1989). See also Section 8.4 for a discussion of the related issue of associate member dues. Louisiana Credit, 693 F.2d at 536. See generally National Association of Postal Supervisors v. United States, 944 F.2d 859 (D.C. Cir. 1991). See United States v. American College of Physicians, 475 U.S. 834 (1986). See American College of Physicians, 475 U.S. at 835. See American College of Physicians, 3 Cl. Ct. at 531. See id.
䡲
397
䡲
c08.fm Page 398 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
The Court of Appeals for the Federal Circuit reversed the decision of the trial court, holding that the College had established the requisite substantial relationship to its exempt purpose.123 The Supreme Court, however, reversed the decision of the Federal Circuit. The Supreme Court found that the Claims Court’s analysis was proper: The evidence is clear that plaintiff did not use the advertising to provide its readers a comprehensive or systematic presentation of any aspect of the goods or services publicized. Those companies willing to pay for advertising space got it; others did not. Moreover, some of the advertising was for established drugs or devices and was repeated from one month to another, undermining the suggestion that the advertising was principally designed to alert readers of recent developments (citing, as examples, ads for Valium, insulin, and Maalox). Some ads even concerned matters that had no conceivable relationship to the College’s tax exempt purposes.124
Thus, the Supreme Court held that the advertising in Annals was not substantially related to the College’s exempt purposes.125 The Supreme Court upheld the Claims Court in examining the conduct and intent of the organization rather than the educational impact of the advertisements on the organization’s members.126 The Supreme Court, however, rejected the IRS’s argument that advertising income is per se taxable as UBIT. Furthermore, the Supreme Court noted that the College could control the advertising in the future to reflect an intention to contribute importantly to its educational purposes by coordinating the content of the advertisements with the editorial content, or by publishing only advertisements highlighting new developments in the market.127
8.4
STATUTORY EXCEPTIONS TO UBIT
The Internal Revenue Code provides nine specific activity exclusions from the term “unrelated trade or business.”128 The exclusions are set forth in the following sections. (a)
Volunteer Activities
The Code excludes from the definition of UBIT any trade or business in which substantially all the work is performed by volunteers.129 The regulations provide an example of an exempt orphanage operating a retail store that sells goods to the general public. If all of the work is performed by uncompensated volunteers,130
123 124 125 126 127 128 129 130
See American College of Physicians, 743 F.2d at 1570. See American College of Physicians, 475 U.S. at 849 (quoting 3 Cl. Ct. at 534). See id. See, e.g., California Thoroughbred Breeders v. Commissioner, 57 TCM (CCH) 962 (1989); see also National Waterwell, 92 T.C. at 75. See American College of Physicians, 475 U.S. at 849. See also St. Joseph Farms of Indiana v. Commissioner, 85 T.C. 9 (1985). §513. §513(a)(1); Reg. §1.513-1(e)(1). See also Rev. Rul. 78-144, 1978-1 C.B. 168. Reg. §1.513-1(e).
䡲
398
䡲
c08.fm Page 399 Thursday, March 15, 2007 10:18 AM
8.4 STATUTORY EXCEPTIONS TO UBIT
then the operation of the retail store is not considered to be a trade or business subject to UBIT.131 The IRS has taken the position that this volunteer exception must be strictly construed so that virtually any compensation, however small, will take the activity outside the exception.132 In one case, the IRS argued that providing free drinks (adding up to $2.22 per worker per night) was compensation, thereby taking the organization’s bingo games out of the volunteer exception from UBIT.133 The Tax Court agreed with the IRS in holding that any nonmonetary compensation was the equivalent of compensation for purposes of the volunteer exception.134 However, the Fifth Circuit disagreed on this point and noted that the question of compensation depends on the facts of each particular case.135 The court stated that it cannot “seriously be argued that the workers were induced to work for this ‘compensation.’ We do not believe that the definition of compensation in the Code was meant to include such a trifling inducement.”136 (b)
Activities for the Convenience of Members
The Code excludes from the definition of UBIT any trade or business of a §501(c)(3) organization or a governmental college or university that is carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees.137 The regulations offer the example of a laundry operated by a college for the purpose of laundering dormitory linens and the clothing of students.138 The IRS has approved many situations similar to the college laundry facility139 as long as the activity is operated primarily for the convenience of the members.140 Other examples include bookstores,141 vending machines,142 and restaurants.143 (c)
Donated Merchandise
Exempt organizations often raise needed capital by selling contributed personalty. The Code excludes from UBIT any trade or business consisting of sales or merchandise, substantially all of which has been received by the organizations as gifts or contributions.144 This “thrift shop” exception applies when an exempt organization 131 132 133 134
135 136 137 138 139 140 141 142 143 144
S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950). See Waco Lodge No. 166 v. Commissioner, 42 TCM (CCH) 1202, aff’d, 696 F.2d 372 (5th Cir. 1983). See Waco Lodge, 42 TCM (CCH) at 1202. See Waco Lodge, 42 TCM (CCH) at 1205. See also Shiloh Youth Revival Ctrs. v. Commissioner, 88 T.C. 565 (1987) (organization did not qualify for exclusion because workers received “compensation” in the form of free room and board). See Waco Lodge, 696 F.2d at 376. Waco Lodge, 696 F.2d at 395. §513(e)(2). §1.513-1(e)(2). See S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950). Rev. Rul. 69-269, 1969-1 C.B. 353. Rev. Rul. 69-267, 1969-1 C.B. 160 (hospital gift shop); Rev. Rul. 69-268, 1969-1 C.B. 160 (hospital cafeteria); Rev. Rul. 69-269, 1969-1 C.B. 160 (hospital parking lot). Rev. Rul. 58-194, 1958-1 C.B. 240; Rev. Rul. 69-538, 1969-2 C.B. 116. Rev. Rul. 81-19, 1981-3 I.R.B. 10, 1981-1 C.B. 353. Rev. Rul. 58-194, 1958-1 C.B. 240. §513(a)(3); Reg. §1.513-1(e)(3).
䡲
399
䡲
c08.fm Page 400 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
receives old clothing, books, furniture, or other contributed goods for resale to the general public and the proceeds benefit the exempt organization.145 (d)
Qualified Public Entertainment Activity
The Code specifically excludes the conduct of a qualified public entertainment activity from the definition of unrelated trade or business.146 A public entertainment activity is any entertainment or recreational activity, traditionally held at fairs or expositions promoting agriculture or education, for the purpose of attracting the general public, promoting animal husbandry, or developing new products or equipment. To be considered a “qualified public entertainment activity” excluded from UBIT, an exempt organization must conduct the activity • In conjunction with an international, national, state, regional, or local fair
or exposition147 • In accordance with state law permitting the activity and limiting the con-
duct of the activity to the exempt organization or an instrumentality of the government148 • Under a provision of state law that permits the exempt organization to be
granted a license to conduct the activity for not more than 20 days at a lesser fee than normally charged to nonqualifying organizations149 A qualifying organization is one described in IRC §501(c)(3), (4), or (5) that regularly conducts, as one of its substantial exempt purposes, an agricultural and educational fair or exposition.150 (e)
Qualified Trade Show and Convention Activities
The Code excludes certain trade show and convention activity from the definition of unrelated trade or business.151 Qualified exempt organizations are described in §501(c)(5) or (6) if one of their substantial exempt purposes is carrying on a qualified convention or trade show.152 To meet this exclusion from UBIT, the following conditions must be complied with: • The activity must be conducted by a qualifying organization.153 • At least one of the purposes of the sponsoring organization must be edu-
cation of its members or promoting an interest in and demand for the products or services of the industry.154 145 146 147 148 149 150 151 152 153 154
Reg. §1.513-1(e)(3). §513(d)(2)(A). §513(d)(2)(B)(i). §513(d)(2)(B)(ii). §513(d)(2)(B)(iii). §513(d)(2)(C). §513(d)(3); Reg. §1.513-3. §513(d)(3)(C); Reg. §513-3(c). Reg. §1.513-3(c)(2)(i). Reg. §1.513-3(c)(2)(ii).
䡲
400
䡲
c08.fm Page 401 Thursday, March 15, 2007 10:18 AM
8.4 STATUTORY EXCEPTIONS TO UBIT
• The trade show or convention must be designed to achieve the organiza-
tion’s exempt purposes through the type of material displayed at a significant number of exhibits or the substantive content of the conferences or seminars held.155 If an organization meets these requirements for the exclusion, then income from renting exhibition space will be excluded from UBIT even though the exhibitors sell or solicit orders.156 (f)
Certain Hospital Services
The Code excludes from UBIT any income that an exempt hospital derives from providing certain services to other exempt hospitals.157 The exclusion applies if • The services are furnished solely to hospitals that have more than 100
patients on an inpatient basis.158 • The services, if performed by the recipient hospital on its own behalf,
would constitute furthering its exempt purpose.159 • The services are provided at actual cost.160
(g)
Certain Bingo Games
The Code also excludes from UBIT all income from certain bingo games.161 A bingo game is defined as a game of chance played with cards that are generally printed with five rows of five squares each.162 A bingo game means any game in which wagers are placed, winners are determined, and prizes are distributed in the presence of all persons participating in the game.163 Furthermore, to qualify for the bingo exclusion, the game must not be carried out by, or in competition with, any commercial enterprise164 and the bingo must not violate any state or local law in the jurisdiction.165 However, “instant 155 156
157 158 159 160 161
162 163 164 165
Reg. §1.513-3(c)(2)(iii). Reg. §1.513-3(d)(1). CAVEAT: Certain convention or trade show activity may endanger the UBIT exemption by application of the exploitation rules (Reg. §1.512(a)-1(d)). Recently, an exempt business league sponsored a convention for its members. In connection with the event, the business league published a convention newsletter for distribution to the attendees. Although the IRS conceded that the newspaper was a “qualified trade show activity,” it determined that the advertising contained within the newsletter constituted an exploitation of an exempt activity (the publication of the newsletter) under §§1.513-1(b) and 1.513-1(d)(4)(iv). Accordingly, the income derived from the advertising sales was subject to UBIT. See Tech. Adv. Mem. 9509-002 (Sept. 30, 1994). §513(e); Reg. §1.513-6. §513(e)(1). §513(e)(2). §513(e)(3). §513(f); Reg. §1.513-5. An organization does not have to utilize this exception if substantially all of the work is performed by volunteers without compensation. §513(a)(1); Reg. §1.5135(b). Reg. §1.513-5(d). §513(f)(2)(A)(i)-(iii); Reg. §1.513-5(d). §513(f)(2)(B); Reg. §1.513-5(c)(2). This means that the exclusion does not apply if bingo is regularly carried out in the jurisdiction by commercial enterprises for a profit. §513(f)(2)(C); Reg. §1.513-5(c)(1).
䡲
401
䡲
c08.fm Page 402 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
bingo,” a variation on traditional bingo that has (along with other “pull-tab” games) been growing in popularity among charitable organizations as a revenue-raising device, does not qualify for the §513(f) exception. In Julius M. Israel Lodge of B’nai B’rith v. Commissioner,166 the court confirmed that “instant bingo” games—in which players purchase preprinted cards with the numbers covered by pull tabs, pull back the sealed tabs to reveal a pattern, and compare the pattern with a set of winning patterns printed on the back of the cards to determine whether they have won a prize—do not qualify as bingo under the Code. The court held that because (1) the bingo operator is not required to determine the winner in the presence of all persons placing wagers and (2) the method by which the game is played does not fall within the traditional definition of bingo contained within the regulations, the §513(f) exception was not available, and proceeds from instant bingo were considered UBIT. In general, charitable gaming (particularly bingo) has come under increased scrutiny by the Internal Revenue Service (IRS), not only in terms of its UBIT treatment, but also because of the significant potential for fraud and other wrongdoing associated with the operation of the games.167 Accordingly, beginning in 1999 the IRS Exempt Organizations Division continued to focus on gaming and gambling activities, defined as bingo and casino nights.168 (h)
Corporate Sponsorship
The issue of corporate sponsorship became extremely controversial in the early 1990s beginning with the issuance of a Technical Advice Memorandum (TAM)169 in 1991, leading to proposed regulations in 1993, and a new statutory UBIT exception under the Taxpayer Relief Act of 1997.170 In TAM No. 91-47-007, the IRS stated that sponsorship of a football game, the Cotton Bowl, by a for-profit corporation, Mobil Oil, constituted UBIT to the Cotton Bowl Athletic Association. The TAM led to a great deal of controversy, which in turn led to the promulgation of proposed regulations in 1993. In 1997, Congress stepped into the debate with §513(i), which, with some modifications, codified the proposed regulations to provide more definitive guidelines in this increasingly important arena. IRC §513(i) provides that “unrelated trade or business” does not include the solicitation and receipt of “qualified sponsorship payments.”171 The latter term is defined as a payment made by a for-profit entity to a nonprofit where there is no expectation that the for-profit entity will receive any substantial benefit other than the use or acknowledgment of its name, logo, or product line.172 166 167
168 169 170 171 172
70 T.C.M. (CCH) 673, aff’d, 98 F.3d 190 (5th Cir. 1996). See, e.g., Executive Network Club v. Commissioner, 69 T.C.M. (CCH) 1680 (1995) (holding that income generated by a casino operation conducted by an exempt organization at a volunteer fire department was subject to UBIT); see also “Detecting Fraud in Charity Gaming,” Exempt Organizations 1996 CPE, Topic D; “Gambling: Pull Tabs Bingo v. Instant Bingo,” Exempt Organizations 1999 CPE, Topic 9A. Daily Tax Report, No. 215, G-1, G-2 (Nov. 6, 1998) (citing statement of Marcus Owens, National Director, IRS Exempt Organizations Division). TAM No. 91-47-007. Taxpayer Relief Act of 1997, adding §513(i); see also Section 14.4. §513(i)(1). §513(i)(2)(A).
䡲
402
䡲
c08.fm Page 403 Thursday, March 15, 2007 10:18 AM
8.4 STATUTORY EXCEPTIONS TO UBIT
The exception does not apply to advertisements of the for-profit’s services or products or any payment whose amount is dependent on the level of attendance at an event, broadcast ratings, or other indicia of the degree of public exposure to the event.173 Factors that indicate that a message is an advertisement, as opposed to an acknowledgment, are the presence of qualitative or comparative language, price information, an inducement to purchase, an endorsement, or any indication of savings or value.174 The exclusion also is inapplicable to payments for acknowledgments of the for-profit’s name, logo, or products in a nonprofit’s regularly published materials such as a monthly newsletter; the published materials must be tied to a specific event for the exception to apply.175 An improvement of the statutory UBIT exception over the proposed regulations is the allocation provision of §513(i).176 That section states that, to the extent a portion of a payment would be a “qualified sponsorship payment” and therefore not UBIT, it will not be “tainted” by a portion that would be UBIT.177 In other words, payments can be separated into UBIT and non-UBIT portions. These provisions apply to “qualified sponsorship payments” solicited or received after December 31, 1998. EXAMPLE: A university sponsors a track event and solicits and receives an endorsement by a well-known sneaker manufacturer. As long as the university uses the manufacturer’s name and logo only to acknowledge its support in its program materials or on other permissible items, the income for the acknowledgments will not be UBIT. On the other hand, if the university also receives payments for “acknowledgments” in its monthly alumni newsletter, those payments could well be UBIT if other UBIT rules are met, because these “acknowledgments” are not connected with a specific event but appear in a regularly published periodical.178 Subsequent to the promulgation of §513(i), the IRS issued TAM 98-05-001,179 which offers further guidance on determining the difference between an acknowledgment and an advertisement. The TAM involved a §501(c)(4) entity organized to increase public interest in certain breeds of animals that are pets. In furtherance of its purposes the organization holds an annual animal show, which is its principal activity. The organization sells commercial television broadcast rights to the show. The television show generates most of the organization’s income and is watched by approximately 14 million people. The organization had an arrangement with a pet food company whereby the company made an annual payment to the nonprofit in return for numerous rights, including two free two-page advertisements in the show catalog, the right to advertise its support of the show, a discount on booth space at the show, and its product names and/or logo appearing on the judging program envelope as well as on exhibitor arm bands. 173 174 175 176 177 178 179
§513(i)(2)(A) and (B)(i). §513(i)(2)(A). §513(i)(B)(ii)(I) and (II). §513(i)(3). See id. §513(i)(B)(ii)(I) and (II). Oct. 7, 1997.
䡲
403
䡲
c08.fm Page 404 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
The IRS determined that the sale of broadcast rights did not generate UBIT, as it furthered the association’s purposes by exposing a larger audience to the show. The full-page ads examined by the IRS did not appear to go beyond permissible “acknowledgments,” as they did not contain comparative product information or quality claims. Significantly, the IRS also stated that the pet food company’s logos on arm bands and other materials were permissible acknowledgments and not advertising. This TAM provides useful guidelines for a nonprofit considering entering into a sponsorship arrangement with a for-profit entity. (i)
Corporate Sponsorship Regulations
In April 2002, the IRS finalized regulations to implement the changes of the 1997 Taxpayer Relief Act, to respond to comments on the 1993 and 2000 proposed regulations, and to address new areas.180 The regulations are very similar to the 2000 proposed regulations and eliminate the “tainting rule,” address exclusivity arrangements, and finalize a number of changes in response to comments on the 1993 and 2000 proposed regulations. The regulations distinguish between contributions to an exempt organization that are given without expectation of anything in return and those given with such an expectation. A substantial return benefit is anything more than an acknowledgment of the payor by using the name or logo, or by providing goods or services of insubstantial value.181 Permissible acknowledgments may include the name and logo, location, telephone number, street and Internet addresses, value-neutral descriptions of the payor’s product or services, and slogans that do not contain qualitative or comparative descriptions. Display or distribution of the sponsor’s products or services to the public at the sponsored event are not considered an inducement to purchase, and therefore will not be a substantial return benefit that disqualifies the payment.182 If a contributor does not receive a substantial return benefit, then the contribution is considered a qualified sponsorship payment (QSP) that will not be taxed as UBI to the exempt organization. If the contributor does receive a substantial benefit in return, the portion of the contribution that exceeds the fair market value of the benefit will be treated as a QSP.183 The balance of the contribution must be evaluated according to other rules to determine whether it is subject to UBIT. This allocation provision follows the 1997 legislation, which overturned the original regulations. EXAMPLE: S, a symphony orchestra, performs a series of concerts. A program guide that contains notes on guest conductors and other information concerning the evening’s concert is distributed by S at each concert. The Music Shop makes a payment to S in support of the concert series. As a supporter of the event, the Music Shop is recognized in the program guide and on a poster in the lobby of the 180 181 182 183
Reg. §1.513-4. Permissible goods and services are those that have an aggregate fair market value of not more than 2 percent of the amount of the payment. Reg. §1.513- 4(c)(2). Reg. §1.513-4(c)(2)(iii). Reg. §1.513-4(c)(2).
䡲
404
䡲
c08.fm Page 405 Thursday, March 15, 2007 10:18 AM
8.4 STATUTORY EXCEPTIONS TO UBIT
concert hall. The Music Shop receives complimentary tickets to the concert series. The fair market value of the tickets exceeds the amount specified in paragraph (c)(2)(ii) of the proposed regulations. The lobby poster states that “the S concert is sponsored by the Music Shop, located at 123 Main Street, telephone number 5551234.” The program guide contains the same information and also states, “Visit today for the finest selection of music CDs and cassette tapes.” S’s use of the Music Shop’s name and address in the lobby poster constitutes acknowledgment of the sponsorship. However, the promotion in the program guide and the complimentary tickets are a substantial return benefit. S may treat as a qualified sponsorship payment only that portion of the payment, if any, that exceeds the fair market value of the promotion in the program guide and the tickets.184 The regulations clarify the position of the IRS that a qualified payment may sponsor an activity that is unrelated to the recipient’s exempt purpose; the activity may be a single event, a series of events, or continuing support of an extended activity or of the exempt organization itself.185 A QSP may be made pursuant to a written agreement. The payment may be contingent on the sponsored event or activity taking place, but may not be contingent on level of attendance, broadcast ratings, or other measures of public exposure to the sponsored activity.186 An arrangement that acknowledges the payor as the exclusive sponsor of an activity, or the exclusive sponsor representing a particular industry or trade, may be a qualified sponsorship. An arrangement that limits the distribution, sale, or use of competing products or services generally results in a substantial return benefit.187 Nearly all of the speakers at the public hearing on the 2000 proposed regulations argued that limiting competing goods and services should not be considered a per se substantial return benefit.188 The service has since issued a memorandum explaining that exclusive provider arrangements would not be assumed to be outside the scope of §513(i) and therefore subject to UBIT. The memo contained two examples of contracts between a university and a softdrink company. Where the university has no role in providing the drinks, there is no return benefit to the company to trigger UBIT for the university. Where the university joins the company to develop marketing plans and makes university personnel (such as coaches) available for promotional appearances, the activities may be regarded as regularly carried on and the attendant fees become subject to UBIT.189 An exempt organization has an additional reason to want a payment to be classified as a QSP. QSPs, in the form of cash or property (but not services), will count as public support for the purpose of determining whether an organization is a public charity. However, the fact that payment is treated as a contribution to
184 185 186 187 188 189
Reg. §1.513-4(f), Example 8. Reg. §1.513-4(c). Reg. §1.513-4(e)(2). Reg. §1.513-4(c)(2)(vi)(A) and (B). Faisal Sheikh, “Witnesses at Corporate Sponsorship Hearing Focus on Exclusivity Agreements,” Exempt Organization Tax Review 29, no. 12 (July 2000): 14. Thomas J. Miller, IRS Memorandum (Aug. 14, 2001).
䡲
405
䡲
c08.fm Page 406 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
the exempt organization does not determine whether the payor may deduct it under §162 as a business expense or under §170 as a charitable contribution.190 If a payment does not qualify as a sponsorship payment, it is not automatically treated as UBI. The payment must be subjected to the usual analyses to determine whether it may be excluded from UBIT (because it is rent or royalty, because the activity is not a trade or business regularly carried on, or because it is carried on primarily by volunteers, for example). The regulations do not apply to payments made in connection with qualified conventions and trade shows that are governed by Treas. Reg. §1.513-3. Nor do the regulations apply to income from the sale of advertising or acknowledgments in exempt organization periodicals. For these purposes, such periodicals are defined as “regularly scheduled and printed material published by or on behalf of the exempt organization that is not related to and primarily distributed in connection with a specific event.”191 (j)
Associate Member Dues
Associate member dues is another area receiving attention, both in Congress and at the IRS. For example, in National League of Postmasters,192 the National League of Postmasters (NLP), a §501(c)(6) organization formed to assist and advance the interests and skills of postmasters, created a separate class of members—limited (or league) benefit members (LBMs)—and excluded their dues from UBIT as “substantially related” to its exempt function. The IRS challenged the characterization, alleging that because the LBMs were not entitled to similar rights and privileges as the full members (LBMs had minimal representation on the board; limited voting rights; limited access to the healthcare plan, legal services, and other league benefits; and were not required to be postmasters or even work in a postal position), servicing the LBMs did not further the exempt purposes of the NLP. The Tax Court agreed, holding that the LBM activity was conducted not primarily in furtherance of the interests of postmasters, but rather in a manner suggesting that the actual purpose of the activity was to generate income. In June 1996, the court of appeals affirmed the Tax Court, finding that the LBM activity was not “substantially related” to the NLP’s exempt purposes and was thus subject to UBIT. The NLP litigation and the general concern regarding §501(c)(5) and §501(c)(6) dues payments and UBIT did not go unnoticed by Congress. The Small Business Job Protection Act of 1996 provided that with respect to §501(c)(5) organizations, annual dues not exceeding $100 will be exempted from UBIT, whether paid by full or limited members.193 The IRS has now extended the nonrecognition treatment of §512(d) to §501(c)(6) organizations such as boards of trade, chambers of commerce, and 190 191 192 193
Reg. §1.513-4(e)(3). The regulations also amend §1.170A-9 and §1.509(a)-3 to clarify this point. Reg. §1.513-4(b). National League of Postmasters v. Commissioner, 69 T.C.M. (CCH) 2569 (1995), aff’d, 86 F.3d 59 (4th Cir. 1996). §512(d). This amount was indexed to $109.00 by Rev. Proc. 97-57, 1997-52 I.R.B. 20.
䡲
406
䡲
c08.fm Page 407 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
business leagues.194 Beyond the exempt amount, creation of an associate member class that actually has involvement in an association’s exempt function activities will not be considered to have been done merely to generate income, and therefore dues above the exemption amount will not be considered UBIT.195 In this regard, it is important that any promotional or marketing literature in connection with associate membership categories carefully describe the purposes behind the creation of the new class so that these materials will support the position that they were not established for the sole purpose of raising revenue.196 If the promotional materials are not properly drafted, the IRS could use them to bolster its contention that the class was created solely to raise revenue.
8.5
MODIFICATIONS TO UBIT
In addition to the exclusions from UBIT, IRC §512(b) sets forth certain modifications to the definition of UBIT, which include dividends, interest, rents, and noninventory sales.197 This section briefly highlights these modifications. The determination of “whether a particular item of income falls within any of the modifications provided in §512(b) shall be determined by all the facts and circumstances of each case.”198 However, if any of these items are derived from debt-financed property, they may constitute UBIT.199 Some of the modifications were enacted because they exclude “passive” investment income, which is not likely to result in competition for commercial businesses.200 The legislative history in the Senate Finance Committee Report on UBIT states that [d]ividends, interest, royalties, most rents, capital gains and losses and similar items are excluded from the base of the tax on unrelated income because your committee believes that they are “passive” in character and are not likely to result in serious competition for taxable businesses having similar income. Moreover, investment-producing incomes of these types have long been recognized as a proper source of revenue for educational and charitable organizations and trusts.201
194 195
196 197
198 199 200 201
Rev. Proc. 97-12, 1997-1 C.B. 631. See TAM 97-51-001 (Apr. 25, 1997) for an analysis of the application of Rev. Proc. 97-12 to a §501(c)(5) labor union; see also TAM 97-42-001 (June 26, 1997) for an analysis of this issue in regard to a §501(c)(6) organization. Exempt Organization Tax Review 22, no. 2 (Nov. 1998): 251. §512(b); Reg. §512(b)-1; see also H.R. Rep. No. 2319, 81st Cong., 2d Sess. 36 (1950); S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950). Gains or losses from the sale or exchange of property held primarily for sale to customers in the ordinary course of business are not excluded from UBIT. §512(b)(5)(B). However, the Revenue Reconciliation Act of 1993 provides an exception to that general rule by excluding gains and losses from the sale, exchange, or other disposition of certain real property and mortgages acquired from financial institutions that are in conservatorship or receivership. Only real property and mortgages owned by a financial institution (or that were security for a loan held by the financial institution) at the time that the institution entered conservatorship or receivership are eligible for the exception. The provision is effective for property acquired on or after January 1, 1994. See §512(b)(16)(A), as amended by §13147(a) of the 1993 Act. Reg. §1.512(b)-1. §512(b)(4). See generally Chapter 9 on debt-financed income. Reg. §1.512(b)-1(a). Of course, the purpose of UBIT is to prevent unfair competition by exempt organizations. S. Rep. No. 2375, 81st Cong., 2d Sess. 30-1(1950).
䡲
407
䡲
c08.fm Page 408 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
For a long time the law was unclear on whether premiums from unexercised options on real estate and loan commitment fees were subject to UBIT.202 However, the Omnibus Budget Reconciliation Act of 1993 expanded the exception for gains on the lapse or termination of options on securities to include gains or losses from such options (without regard to whether they are written by the organization), from options on real property, and from the forfeiture of goodfaith deposits (that are consistent with established business practices) for the purchase, sale, or lease of real property.203 In addition, the Act provided that loan commitment fees are excluded from UBIT.204 For these purposes, loan commitment fees are nonrefundable charges made by a lender to reserve a sum of money with fixed terms for a specified period of time. These charges are to compensate the lender for the risk inherent in committing to make the loan. The exclusion is effective for premiums or loan commitment fees received on or after January 1, 1994. (a)
Exclusion of Interest
Interest is excluded from UBIT unless it is interest from debt-financed property205 or from a controlled entity,206 in which cases it may be included in computing UBIT.207 A payment will generally qualify as interest if it is compensation for the use of or the forbearance of money.208 However, payments for services rendered in connection with obtaining or making a loan will not qualify as interest. Moreover, whether a payment actually constitutes “interest” depends on the facts and circumstances of the particular case.209 Neither the label that the parties attach to a payment nor the method of computing the payment is determinative of its treatment. For example, exempt organizations may structure loans so that, in addition to a fixed amount of interest, they get an “equity kicker;” that is, they share in the proceeds from the operation of the property or from its sale or refinancing. In addition, the exempt
202 203 204 205
206 207
208 209
H.R. Rep to H.R. 2264, 103d Cong., 1st Sess. 620 (1993). §512(b)(1) as amended by §13148(a) of the 1993Act. §512(b)(5) as amended by §13148(b) of the 1993 Act. Rev. Rul. 95-8, 1995-1 C.B. 107, provides that income from the short sale of stock will not be considered income attributable to debt-financed property for purposes of the UBIT calculation. See Section 8.5(a). See Section 4.6(d) and Tech. Adv. Mem. 200208027 for discussions of what constitutes a controlled entity and how income from exempt and nonexempt controlled entities is treated. §512(b)(4); Reg. §1.1512(b)-1(a). See Southwest Tex. Elec. Coop. v. Commissioner, 68 T.C.M. (CCH) 285 (1994), aff’d, 67 F.3d 87 (5th Cir. 1995). (Tax Court sustained the IRS’s determination that interest earned by a tax-exempt organization on debt-financed Treasury notes was unrelated business taxable income. The cooperative borrowed construction funds from the USDA’s Rural Electrification Administration to upgrade its facilities and invested the unused portion of the loan in Treasury notes. The court held that the notes were purchased with borrowed funds and, thus, constituted debt-financed property. The petitioner’s application of the interest earned on the Treasury notes to its exempted activities did not make the incomeproducing property “substantially related” to its exempted purpose. The court stated that the linchpin of the provision is that the Treasury notes themselves must be used by the petitioner in the exercise or performance of its exempt activities). See Deputy v. Dupont, 308 U.S. 488 (1940); Rev. Rul 69-188, 1969-1 C.B. 154. Reg. §1.512-1(b) (guidelines for structuring contingent interest).
䡲
408
䡲
c08.fm Page 409 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
organization may have an option to convert its debt interest to an equity interest. In these situations, the IRS may attempt to treat the entire loan as equity, or at least, to treat the “contingent” portion as equity.210
If the IRS is successful in reclassifying a loan as equity (for example, by reclassifying a loan as a joint venture or partnership interest), the income would be recharacterized in accordance with the underlying business of the joint venture or partnership. Moreover, if all or a portion of a loan is reclassified as equity, the borrowing entity may be denied its interest deduction, with the interest payments being deemed to be nondeductible distributions to the “lender.” Furthermore, the reclassification may cause tax items to be reallocated among the “partners.”211 (b)
Exclusion of Rents
Rent is also generally excluded from UBIT.212 This includes rental income from real property as well as personal property leased with the real property.213 The determination of whether an item is rent is based on the “facts and circumstances of each case.”214 For example, the IRS attempted to reclassify rental income from a crop-sharing lease arrangement as income from an unrelated joint venture and, hence, taxable as UBIT. However, the district court properly held that the rents from the farm operation were true rents based on a fixed percentage of receipts from the farm production.215 The Seventh Circuit Court of Appeals, in Harlan E. Moore Charitable Trust v. United States,216 affirmed the decision of the district court by rejecting the IRS’s position that an assumption of a portion of the cost of production by the owner transformed the lease into a partnership for tax purposes. The court conceded that if the Trust had agreed to pay half of the operational costs in exchange for half of the profits, the situation would give rise to unrelated business income even if the parties called it rent. However, the court refused to accept the IRS’s position that the owner’s agreement to share in a portion of the costs transformed the lease into a partnership for tax purposes. The fact that the parties’ agreement diverged from a pure cash lease did not convert the lease into a partnership.217
210 211 212 213
214 215
216 217
See generally Section 6.3. See Section 6.2(c) (tax consequences of reclassification). §512(b)(3); Reg. §1.512(b)-1(c)(2). Reg. §1.512(b)-1(c)(2)(ii)(a) and (b). The rental income from the personalty must be incidental to the real property rents. “Incidental” is defined as 10 percent or less of the total rental income. Reg. §1.512(b)-1(c)(2)(ii)(b). Reg. §1.512(b)-1; Priv. Ltr. Rul. 89-05-002 (Oct. 10, 1988). Harlan E. Moore Charitable Trust v. United States., 812 F. Supp 130 (C.D. Ill. 1993), aff’d, 9 F.3d 623 (7th Cir. 1993), acq. in action on decision 95-3953 (Apr. 14, 1995) (Issues 1 and 2). The District Court found that this arrangement was a typical crop-sharing arrangement that farmers in the Midwest have been utilizing for years. Hence, the IRS erred in attempting to reclassify a traditional lease arrangement as a joint venture. Harlan E. Moore Charitable Trust v. United States, 9 F.3d 623 (7th Cir. 1993), acq. in action on decision 95-3953 (Apr. 14, 1995) (Issues 1 and 2). See id.
䡲
409
䡲
c08.fm Page 410 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
However, the rent from real property is not excluded from UBIT if the amount of the rent depends, in whole or in part, on the income or profits derived by any person from the leased property (other than amounts based on a fixed percentage or percentages of the gross receipts or sales).218 Rents received from a controlled entity (defined in §512(b)(13))219 are also subject to UBIT. An entity is controlled if the exempt organization owns over 50 percent of its stock; profits interest or capital interest; or beneficial interests. Previously, interest, annuities, royalties, or rents (but not dividends) received by an exempt organization from a controlled entity were taxable as unrelated business taxable income (“UBTI”) to the extent such payments either reduced the controlled entity’s net unrelated income or increased its net unrelated loss. Under the Pension Protection Act of 2006, such payments received by an exempt organization during 2006, 2007, or 2008 from a controlled entity will only be included in the calculation of the exempt organization’s UBTI to the extent that the payments exceed a comparable fair market value payment, as determined using the principles of IRC §482. Certain regulations governing real estate investment trusts (REITS) that define rents based on income or profits are incorporated into the UBIT regulations for determining when this exclusion applies.220 The following general rules are set forth in these regulations: • Rental income determined by a percentage of receipts or sales in excess of
determinable dollar amounts will be excluded from UBIT only if two conditions exist: first, the determinable amounts must not depend, in whole or in part, on the income or profits of the lessee; and second, the percentages and determinable amounts must be fixed at the time the lease is entered into, and the percentages and determinable amounts must not be changed in a manner that, in effect, would cause the rent to be based on income or profits. • Rental income based on differing percentages of receipts or sales from
various departments or from separate floors of a retail space will not be UBIT, as long as each percentage is fixed at the beginning of the lease term and not later changed in a manner that would have the effect of basing the rental income on the income or profits of the tenant.221 • Rental income based on a fixed percentage or percentages of the lessee’s
receipts or sales reduced by escalation receipts (which are defined to include amounts received by reason of increases in real estate taxes, property insurance, operating costs, and similar items included in lease escalation clauses) will not be UBIT.222 • Whether rental income qualifies for exclusion from UBIT is determined
on an annual basis. Thus, rental income that is taxable in one year does 218 219 220 221 222
§512(b)(3)(B)(ii); Reg. §1.512(b)-1(c)(iii)(b). See, e.g., Priv. Ltr. Ruls. 199941048, 199938041; and Section 4.6(d). Reg. §1.512(b)-1(c)(2)(iii)(b), which incorporates Reg. §§1.856-4(b)(3) and (6)(i). Reg. §§1.856-4(b)(1) and 1.856-4(b)(3); see Priv. Ltr. Rul. 78-36-030 (Jan. 8, 1978), as amended by Priv. Ltr. Rul. 78-42-041 (Jul. 20, 1978). Reg. §1.856-4(b)(3).
䡲
410
䡲
c08.fm Page 411 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
not preclude the receipt of rental income that is excluded from UBIT in another year. • Rental income will not qualify as “rents from real property” if, consider-
ing the lease and the surrounding circumstances, the arrangement does not conform with normal business practice but is in reality simply a means of basing the rent on income or profits.223 • If an exempt entity leases real property to a tenant under terms other than
a fixed rent (for example, a percentage of the tenant’s gross receipts) and the tenant subleases all or part of the property under leases to subtenants based, all or in part, on the income or profits of the subtenants, the entire amount of the rent received by the exempt organization will not qualify as “rents from real property.”224 This result should be contrasted with the regulations applicable to REITs, which provide that in this situation only the portion of the rents received by the REIT that relates to the subtenant’s income or profits will constitute disqualified rental income to the REIT.225 Finally, the IRS found that a lease participation based on net proceeds of a sale or refinancing is permissible. The rationale is basically that net proceeds from a sale or refinancing of the property are not “based in whole or in part on the income or profits derived by any person from the leased property.”226 In addition, rent that is attributed to a payment for services, other than those usually or customarily rendered in connection with the rental of rooms or other space solely for occupancy, is not within the exclusion for rents.227 The regulations provide that the furnishing of heat and light and cleaning of public areas are customary services.228 However, the usual services in connection with hotel rooms and boarding houses are so extensive that the “rental” payments do not qualify as exempt rental income; the same is true of apartment buildings furnishing hotel services. Payments for the use of space in parking lots, warehouses, or storage garages are treated as payments for services.229 The Service reversed an earlier ruling and held that rental payments from lease of space on antenna towers and a related transmission facility do constitute unrelated business income from tangible personal property.230 Section 512(b)(3)(A) provides that property described in §1245(a)(3)(B), including other tangible property used as an integral part of furnishing communication services, is personal property. Unlike rent from real property, rent from personal property is not excluded from UBIT. 223 224 225 226 227
228 229 230
Reg. §§1.856-1(b)(1) and 1.856-1(b)(3). See, e.g., Priv. Ltr. Rul. 78-36-030 (June 8, 1978), as amended by Priv. Ltr. Rul.78-42-041 (July 20, 1978). John W. Madden, Jr. v. Commissioner, note 77. Reg. §1.856-4(b)(6)(ii). Priv. Ltr. Rul. 81-33-051 (May 19, 1981). Reg. §1.512(b)-1(c)(5). In Private Letter Ruling 200410010, which involved the provision of construction services to tenants by a REIT, the Service ruled that the rent received by the REIT would qualify as rent from real property and not from the provision of services. This conclusion was based, in part, on a finding that the supervisory services were for the benefit of the REIT, not the tenants. Id. Reg. §1.512(b)-1(c)(5). See also Rev. Rul. 69-69, 1969-1 C.B. 158. Priv. Ltr. Rul. 200104031.
䡲
411
䡲
c08.fm Page 412 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
(c)
Royalties
Income classified as a royalty is also exempt from UBIT.231 Whether an item of income constitutes a royalty is determined from the facts and circumstances, as the term is not defined in the statute or regulations.232 The courts and the IRS have defined a “royalty” to include a payment for the use of a valuable right such as a trademark, trade name, service mark, or copyright.233 However, income derived from services provided by an exempt organization in connection with rental of a property right such as a mailing list is subject to UBIT, even if the income is characterized as a royalty in the governing documents.234 Consequently, the courts and the IRS have consistently held that UBIT applies to royalties “earned” from substantial services performed by an exempt organization under the terms of a licensing agreement.235 As discussed in the following sections, the royalty issue arises in a variety of circumstances as exempt organizations endeavor to find new sources of income, and the IRS continues its scrutiny of nonprofit activities. (i) Insurance. In a landmark case, United States v. American Bar Endowment,236 the Supreme Court considered various aspects of a life insurance arrangement offered by the American Bar Endowment (ABE) to its members.237 ABE’s participation in the insurance program included compiling lists of its members, soliciting its members, answering members’ questions, and maintaining a file on each policyholder. In reversing the lower courts, the Supreme Court held that the
231 232 233
234 235
236 237
§512(b)(2); Reg. §1.512(b)-1(b). Reg. §1.512(b)-1. See generally Sierra Club, Inc. v. Commissioner, 65 T.C.M. (CCH) 2582 (May 10, 1993); NationalWater Well Ass’n v. Commissioner, 92 T.C. 75 (1989). See, e.g., Commissioner v. Wodehouse, 337 U.S. 369 (1949), reh’g denied, 338 U.S. 840 (1949); see also Rohmer v. Commissioner, 153 F.2d 61 (2d Cir.), cert. denied, 328 U.S. 862 (1946); see also Fraternal Order of Police v. Commissioner, 833 F.2d 717, 733 (7th Cir. 1987). See, e.g., Fraternal Order of Police, 833 F.2d 717 (7th Cir. 1987). Rev. Rul 81-178, 1981-2 C.B. 135. In Priv. Ltr. Rul. 94-50-028 (Dec. 17, 1994), for example, a §501(c)(3) organization that operated a museum entered into an agreement with a longdistance telephone rebilling company, under which it agreed to endorse and promote the company’s services exclusively to its members. The endorsement would be via newsletters and word of mouth, but no active solicitation would be required. In addition, the logo of the organization and the museum appeared in the upper right-hand corner of the long-distance subscription form, which was included in each copy of the newsletter. The IRS found that the funds received by the museum were not royalty income, but rather were subject to UBIT, because the cooperation and endorsement given by the exempt organization constituted a “valuable service . . . vital to the success of the plan.” See Section 7.5(c). In Priv. Ltr. Rul. 95-52-019 (Sept. 27, 1995), a §501(c)(3) organization entered into an agreement under which it licensed land surrounding a lake with the purpose of selling fishing passes to the general public and distributing the “royalty” profits therefrom to its social welfare and client services branches. The charitable organization policed and supervised the area and provided trash removal services and utilities for the site. The IRS determined that the passes were sold on a “fee-for-service” basis and the organization provided substantial services in connection with the passes. Accordingly, the fees generated were held to be subject to UBIT, rather than exempt royalties. United States v. American Bar Endowment, 477 U.S. 105 (1986). The American Bar Endowment (ABE) is a §501(c)(3) charitable affiliate of the American Bar Association.
䡲
412
䡲
c08.fm Page 413 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
insurance activity was the type of activity Congress had intended to subject to UBIT.238 In another Tax Court case, National Water Well Association,239 the court discussed the type of involvement by an exempt organization in an insurance program that will give rise to UBIT. National Water Well involved a tax-exempt association that was established to promote the interests of the water well industry. The association had entered into an agreement with an insurer to provide group casualty insurance benefits to its members. Pursuant to its agreement, the association was to assist in the promotion of the program, cooperate in its presentation to the membership, make the program known to the membership, have an exclusive arrangement with the insurer, pledge to cooperate in the collection of premiums, and obtain the approval of the insurer concerning any promotional literature. For its services, the association received approximately $117,000 during the year in question.240 The IRS position was that the monies received by the association constituted UBIT. The association argued that the monies were, in fact, royalties and thus were excluded from UBIT. The Tax Court agreed with the IRS and concluded that the income was in the nature of payments for services rendered and, therefore, was not royalty income.241 The National Water Well Association had agreed with the insurer not to sponsor or endorse any other property or casualty insurance company. In this regard, the court stated: If petitioner had intended to support the mutual interests and welfare of the water well industry, petitioner would have conducted its activities in such a way to reflect this. Petitioner would not have selected only one insurance company to promote and advertise at its conventions and in its journals. If petitioner had intended to educate and advise its members of the need for casualty industry insurance, petitioner might have advised its members of various types of insurance from which its members could select. . . . Petitioner did not educate the water well industry, serve the public interest, or advise industry members of the need for such insurance by endorsing and sponsoring only insurance from Maryland Casualty.242
The IRS examined the relationship between a §501(c)(3) organization and an insurance company that provided insurance to the exempt organization’s members.243 The IRS stated that it would look beyond the mere form of the arrangement (structured as a licensing agreement) and would examine a number of factors in evaluating the tax treatment of the payments. Those factors included the following: • Whether services such as endorsements, promotions, and marketing were
performed for the licensee
238 239 240 241 242 243
We note that an otherwise qualifying §501(c)(3) organization will be denied tax exemption if a substantial portion of its activities consist of providing commercial-type insurance. §501(m). National Water Well Ass’n v. Commissioner, 92 T.C. 75 (1989). National Water Well, 92 T.C. at 82. National Water Well, 92 T.C. at 101. See also State Troopers, 833 F.2d at 723-24. National Water Well, 92 T.C. at 97-8. The IRS has also reviewed a number of cases in which an insurance company provides insurance to an exempt organization’s members. See Priv. Ltr. Rul. 90-29-047 (Apr. 1990).
䡲
413
䡲
c08.fm Page 414 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
• Whether payments for the use of the exempt organization’s name and
logo were contingent on, and inseparable from, payments for the use of its membership list • Whether an intermediary organization was performing services in such a
way that it created an agency relationship with the exempt organization Two factors indicated to the IRS that the transaction was not a licensing arrangement: The exempt organization agreed to publish advertisements for the insurance program in its magazine and promote the insurance plan among its members; and the president of the organization circulated a letter to the members, endorsing the plan and urging them to enroll. Moreover, the arrangement dealt exclusively with one insurance carrier, and the exempt organization had the right to approve the selection of the carrier. It also had the right to determine the types and amounts of insurance to be offered, set all terms and conditions of the group insurance plans, and approve modifications to the plan. The IRS concluded that the payments for the use of the exempt organization’s name and logo were in fact payments for services rendered. Moreover, the mailing list income was contingent upon, and inseparable from, the use of the organization’s name and logo. Thus, all of the income was subject to UBIT. In another ruling,244 the IRS ruled that insurance premium rebates received by a trade association were subject to UBIT. The association had compiled a list of new members, submitted the list to the insurance company, and agreed to advise new members on the availability of the program in an initial membership package sent to all new members. All other matters concerning the insurance were handled by the insurance company. The IRS held that the insurance premium rebates in excess of profits were subject to UBIT, on the ground that compiling a list of new members for the insurance company was a service provided by the association.245 Finally, in revoking another private letter ruling, the IRS concluded that the income received by an exempt organization from an insurance company pursuant to a license agreement was subject to UBIT.246 The exempt organization had endorsed the insurance program, published advertisements about the services of the insurance company in its magazine, granted the insurance company access to its mailing list, and permitted representatives of the insurance company to attend its board meetings and meet informally with its members. Based on these facts, the IRS concluded that the exempt organization was “directly and extensively involved” in the insurance program, and all income derived from the insurance company was subjected to UBIT. This is not to say, however, that there are not circumstances under which an insurance endorsement arrangement will not generate UBIT. In American Academy of Family Physicians v. United States,247 the Eighth Circuit Court of Appeals determined that a §501(c)(6) organization’s income from the sponsorship of several group insurance plans was not subject to UBIT. The 244 245 246 247
Tech. Adv. Mem. 92-23-002 (Feb. 13, 1992). See id. See Priv. Ltr. Rul. 93-06-030 (Nov. 18, 1992). American Academy of Family Physicians v. United States, 95-1 U.S.T.C. (CCH) 50, 240 (W.D. Mo. 1995), aff’d, 91 F.3d 1155 (8th Cir. 1996).
䡲
414
䡲
c08.fm Page 415 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
court determined that the exempt’s involvement in the insurance programs was not extensive, despite the presence of factors that were present in cases that have triggered UBIT liability.248 For example, in American Academy, the exempt organization purchased group insurance plans from the providers, offered coverage under those plans to its members, sold its mailing list to a for-profit organization formed to administer the group plans,249 loaned the insurance company and the foundation its endorsement of the programs, and monitored the policies to ensure that their provisions would adequately serve the needs of its members.250 American Academy is, however, an unusual case; as a general rule, it is difficult to take any substantial role in an insurance or affinity card program without triggering at least some amount of UBIT liability.251 (ii) Payments for Mailing Lists, Affinity Cards, Names, and Logos. Exempt organizations frequently exchange mailing lists with other organizations to increase their donor or membership bases. They also sell their lists to raise revenue. The management, use, and rental of specialized lists is complex and typically includes managers, computer servicing firms, brokers, and mailers in addition to the owners of the list. After nearly two decades of litigation, the issue of whether income from use of mailing lists and affinity cards is a royalty, and thus excluded from UBIT, has been settled. The IRS has accepted the prevailing view of numerous courts that such royalties, if they are essentially passive, are not subject to UBIT.252 Exempt organizations may take some action to protect and exploit an intangible asset (such as a logo or list of names and addresses) without affecting the characterization of the income as passive royalty. Courts have carefully analyzed each of the activities that make up the transactions and concluded that limited actions by the owners or attributable to the owners (under an agency theory) undertaken to protect or exploit the value of the asset, do not change the characterization of income derived. Two cases consolidated for trial purposes were decided in June 1999. The Tax Court in Planned Parenthood Federation253 and Common Cause254 rejected the arguments
248
249 250 251
252
253 254
In analyzing the insurance endorsement program, the court relied heavily on the trade or business test set forth by the Supreme Court in American Bar Endowment v. United States, 477 U.S. 105 (1986), discussed in Section 7.5(c). See 91 F.3d at 1159. The UBIT implications of mailing list rentals and exchanges are addressed in Section 8.4(c)(i) and (ii). See 91 F.3d at 1159. One commentator has noted that involvement of the exempt entity in the “marketing and administering [of the plan] cause[s] the circuit courts to balk” at affinity or insurance endorsement arrangements. Carson, “EO’s Insurance Endorsement Program Survives Appellate Court Scrutiny,” Tax Notes Today 96: 176-6. The court stated that “the Academy had no administrative or underwriting responsibilities unlike [the American Bar Endowment] and the taxpayers in all the other cases the IRS cites on appeal.” 91 F.3d at 1159 (citing Texas Farm Bureau v. United States, 53 F.3d 120, 124-25 (5th Cir. 1995), rev’g in part, 822 F. Supp. 371 (W.D. Tex. 1993)); see also Illinois Ass’n of Professional Insurance Agents v. Commissioner, 801 F.2d 987, 989-90 (7th Cir. 1986); see also Professional Insurance Agents of Mich. v. Commissioner, 726 F.2d 1097, 1099-1100, 1102 (6th Cir. 1984). “IRS Memorandum to Area Managers on Affinity Card Cases,” The Exempt Organization Tax Review (Apr. 2000): 141; 2001 CPE, Sean Barnett, Shed Jessup, and Charles Barrett, “UBIT— Current Developments.” T.C. Memo. 1999-206. 112 T.C. 332 (1999).
䡲
415
䡲
c08.fm Page 416 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
of the IRS. The Court also found persuasive legislative history to show that the explicit mention of exchanges between exempt organizations carried no inference that revenues from other kinds of mailing list transactions were intended to be considered unrelated business income.255 These decisions, together with those in the Oregon State University affinity card cases,256 precipitated a change in IRS policy. In December 1999, the IRS instructed area managers not to pursue further litigation in cases involving affinity credit cards or mailing lists with facts similar to those decided in favor of the taxpayer, and to resolve future cases in a manner consistent with precedent. However, the memo noted that the managers should consider requesting technical advice in cases in which extensive services had been provided along with lists or logos, or where payments might reasonably be allocated between services and protection of the intangible asset. (A) DAV I AND DAV II The seeds of this dispute in regard to mailing lists can be found in Disabled American Veterans v. United States,257 (DAV I). In DAV I, the organization maintained an extensive mailing list of its donees and members, which it rented out on a frequent, and somewhat indiscriminate, basis to both private and charitable entities. DAV hired several full-time employees to maintain and market the list, and it was commonly known in the direct mail industry that DAV’s list could be acquired, in whole or in selected part, for a fee. Alleging that §512(b)(2) of the Code was meant to apply only to “passive” royalties, and not those activities in which the exempt organization rendered substantial services or otherwise took an active role, the IRS challenged the characterization of income attributable to DAV’s rental of its mailing list. The court agreed with the IRS and held that DAV’s mailing list rentals constituted an unrelated, regularly carried on trade or business. More important, the court held that the income from this rental was not within the royalty exception to UBIT, because it was the “product of extensive business activities” on the part of DAV, and did not “fit within the types of ‘passive’ income set forth in section 512(b).”258 In response to DAV I, Congress enacted §513(h)(1)(B), which provides that with respect to organizations qualified as charitable under §501, and to which contributions are deductible under §170(c)(2) or (3), the term unrelated trade or business does not include “any trade or business which consists of exchanging . . . or renting” donor lists to similarly qualified organizations.259 Although this provision had the effect of overruling DAV I with respect to the income attributable to rentals made to other charitable organizations, the legislation was silent with respect to rentals to commercial entities. However, the legislative history clearly states that enactment of this provision was not intended to affect the outcome in other situations. Nearly a decade after DAV I, DAV again filed suit in the Tax Court, alleging that amounts received from the rental of its mailing lists (for different years) 255 256 257 258 259
Id. at 349. Oregon State Univ. Alumni Ass’n. v. Commissioner, 193 F.3d 1098 (9th Cir. Oct. 4, 1999); see Section 8.5(c)(ii)(C). Disabled American Veterans v. United States, 650 F.2d 1178 (Cl. Ct. 1981). Id. §513(h)(1)(b).
䡲
416
䡲
c08.fm Page 417 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
were excludable from UBIT under §512(b)(2).260 Although the IRS argued that the case was barred by collateral estoppel, the Tax Court disagreed and seized the opportunity to address the meaning of the term royalty and the scope of §512(b)(2). The court determined that, contrary to the IRS’s position that only passive income was excluded from UBIT by §512(b)(2), the IRS had acknowledged in Rev. Rul. 81-178 that the term royalty had a broader meaning when it “appl[ied] the general rule that a royalty is a payment for the right to use an intangible asset . . . [in] conclud[ing] that the payments under the licensing agreements” in that case were excludable royalties.261 On appeal, however, the Sixth Circuit reversed the Tax Court’s decision on the basis of the IRS’s collateral estoppel argument. The court seemed to indicate in dicta, however, that it was inclined to agree with the reasoning of the Court of Claims in the original DAV case, and would likely have accepted the IRS’s “passive” royalties position had it not been estopped from doing so.262 (B) S IERRA I 263 The issue was raised again in Sierra Club v. Commissioner, in which the court addressed the appropriate treatment of income received from mailing list rentals and affinity cards. In Sierra I, as it did in DAV I and DAV II, the IRS asserted that the Sierra Club should have recognized UBI from the rental of its mailing lists; fees paid to a §501(c)(3) organization, in this case to Sierra Club, based on its endorsement of an “affinity” credit card; and commissions resulting from use of the cards. The Sierra Club moved for summary judgment, alleging that amounts received for rental of its mailing list and endorsement of the affinity cards were royalty income and thus not subject to UBIT. The court granted the Sierra Club partial summary judgment, finding that mailing lists are intangible property and, accordingly, all consideration received for use of the lists constitutes royalties exempt from UBIT.264 The court denied motions for summary judgment on the issues of whether the Sierra Club rendered substantial services in connection with the rental of the lists and whether the affinity card payments were subject to UBIT,265 although these issues were addressed at length in Sierra II,266 discussed in the following paragraphs.267 260 261 262 263 264 265 266 267
See Disabled American Veterans v. Commissioner, 94 T.C. 60 (1990), rev’d, 942 F.2d 309 (6th Cir. 1991). 94 T.C. at 70 (citing Rev. Rul. 81-178, 1981-2 C.B. 135, at 136). Becker, “Hurricane ‘UBIT’?—The Development of the Royalty Exception to the Unrelated Business Income Tax” (on file with author). Sierra Club v. Commissioner, 65 T.C.M. (CCH) 2582 (1993) (Sierra Club I). See Sierra Club v. Commissioner, 65 T.C.M. (CCH) at 2592; See also Disabled American Veterans v. Commissioner, 94 T.C. at 70. See Sierra Club, 65 T.C.M. at 2591-92. 103 T.C. 307 (1994). See Section 7.5(c). Nevertheless, the IRS continued to assert its “passive” royalties interpretation. In Tech. Adv. Mem. 95-09-002, for example, the IRS again addressed the mailing list/affinity card issue. A business league entered into an agreement with an independent for-profit organization under which it agreed to provide tailored mailing lists to the outside agency (up to three times per year) and to support and promote the outside organization’s affinity card program among its members. In return, the business league was promised royalties based on the number and type of accounts opened or renewed by its members. The business league took the position that it was entitled to the royalty exception because it was only “passively involved” with the program and all “activity [was] provided by the independent party contacting [the league].” The IRS, noting that the agreement provided for the business league to “promote” the cards, and relying on its “passive royalties” position, found that the income generated from the program was subject to UBIT and not excludable under §512(b)(2).
䡲
417
䡲
c08.fm Page 418 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
(C) S IERRA II 268 The treatment of affinity card arrangements was the subject of Sierra Club v. Commissioner (Sierra II), in which the Tax Court rejected the IRS’s position that income received by the Sierra Club from its bank card arrangement was subject to UBIT. The IRS argued that the Sierra Club was in the trade or business of promoting the acquisition and use of the Sierra Club credit card. The IRS alleged that the Sierra Club was either a participant in a joint venture with American Bank Services, Inc. (ABS) and Chase Lincoln Bank, or a sole proprietor in the business of providing its services in marketing and endorsing the Sierra Club credit card through ABS as its agent. The Tax Court concluded that a joint venture did not exist between the parties by examining the substantive provisions of the parties’ agreements in light of the Supreme Court’s holding in Commissioner v. Culbertson269 and the Tax Court’s previous holding in Luna v. Commissioner.270 These decisions state the elements of a joint venture as a coproprietary interest in profits, a sharing of losses, the maintenance of separate books of account for the venture, and joint participation in management.271 The Tax Court indicated that the most important factors in establishing the presence of a joint venture are a proprietary interest in the net profits of the enterprise, coupled with an obligation to share in the losses.272 The court held that the Sierra Club did not have the required mutual proprietary interest in net profits, because the Sierra Club’s royalty fee was based on gross credit card sales and the Sierra Club had no responsibility for the expenses incurred in operating the affinity card program. Moreover, the agreement guaranteed the Sierra Club a minimum royalty of .25 percent of gross sales, regardless of the program’s costs.273 In addition, although ABS maintained certain separate books and accounts, the separate books were kept solely for computing and substantiating the royalty fee and were not of a type that could be used to calculate net profit. Therefore, the separate books were inconsistent with a finding of a joint venture for tax purposes.274 Finally, the court concluded that the cooperation between the parties required by their agreement, which limited the Sierra Club’s control and responsibility primarily to encouraging its members’ participation in the program and to quality control activities, was insufficient to establish the mutual control and responsibility indicative of a partnership/joint venture for tax purposes. Using a similar analysis, the court also rejected the IRS’s position that the Sierra Club operated as a sole proprietor in the business of providing its services in marketing and endorsing the Sierra Club credit card through ABS as its agent. 268 269 270 271 272 273 274
See Sierra Club v. Commissioner, 103 T.C. No. 13 (CCH) 5050, 5058 (1994), as corrected, 103 T.C. No. 17 (1994). See Commissioner v. Culbertson, 337 U.S. 733 (1949). See Luna v. Commissioner, 42 T.C. 1067 (1964). See id. at 1077-78. See Sierra Club v. Commissioner, 103 T.C. No. 13 (CCH) 5050, 5058 (1994). See id. at 5060. See id.
䡲
418
䡲
c08.fm Page 419 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
The court explained that, unlike a business, the Sierra Club had no interest in net profits or losses and did not share in “the risks and rewards of marketing” the credit cards.275 Moreover, the Sierra Club had insufficient control over ABS to create an agency relationship. Indeed, pursuant to the contract, ABS controlled the development and operation of marketing programs, with the Sierra Club obligated merely to “cooperate” with ABS’s promotional efforts.276 The IRS appealed Sierra II, and the Ninth Circuit partially affirmed and partially reversed the Tax Court.277 The court held that the meaning of the term royalty, not otherwise defined in the Code or regulations, must be determined according to its dictionary definition: “a payment made to the owner of property for permitting another to use the property.”278 The court rejected Sierra’s argument and held that “a royalty is by definition ‘passive’ and thus cannot include compensation for services rendered by the owner of the property.”279 The court then applied the general dictionary definition to the two types of income at issue in Sierra, mailing list rental income and income from the affinity card program. With respect to the mailing lists, the court squarely rejected the IRS’s position that income from mailing list rentals may never (except between two charities) constitute royalties.280 It held, however, that any activities carried on by Sierra that constituted services rendered in connection with the mailing list rental could jeopardize the characterization of the payments.281 Fortunately for Sierra, all “service-type” activity, with respect to the mailing lists, was carried on by outside organizations, retained to maintain and market the lists.282 In reference to the affinity card program, the court concluded that a facts and circumstances analysis was needed to determine whether services provided by an exempt organization in connection with the use of its name and logo would disqualify the payment from royalty characterization. The Ninth Circuit court further concluded that the Tax Court erred in granting summary judgment on this issue because it resolved issues of disputed facts in favor of the Sierra Club, rather
275 276
277 278 279
280 281
282
Id. at 5058. See id. at 5064; see generally Henzke and Robinson, “Tax Court Holds That Affinity Card Payments Constitute Nontaxable Royalties,” Journal of Taxation of Exempt Organizations (1994). See Sierra Club v. Commissioner, 86 F.3d 1526 (9th Cir. 1996). Id. at 1531. Id. This definition is an interesting one, in that it allows the exempt organization to engage in certain activities traditionally considered by the IRS to be “active” participation, such as providing a rate sheet listing the fees charged for list rental and retaining the right to approve the manner in which the intangible property is used and marketed, while disallowing royalty characterization for income received from more “service-type” activities (marketing or administrative services) performed in connection with the licensing of the intangible property right. See Sierra Club v. Commissioner, 86 F.3d at 1536. Id. One commentator has interpreted the Ninth Circuit opinion to mean that “[s]ervices benefiting the list user [such as] segregating lists by zip code or providing information on adhesive labels, must be performed by the list broker or third party company;” whereas the Tax Court opinions indicated that “some or all of these functions [could be] performed by the nonprofit.” Cerny and Lauber “Ninth Circuit Rules on Sierra Club Mailing List and Affinity Card Income,” Exempt Organization Tax Review 14 (Aug. 1996): 255. See Sierra Club v. Commissioner, 86 F.3d at 1535-36.
䡲
419
䡲
c08.fm Page 420 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
than in the light most favorable to the IRS. Accordingly, the court remanded this issue for trial before the Tax Court.283 On remand, the Tax Court analyzed the IRS’s arguments that the Sierra Club had received income for services rendered as opposed to tax-exempt royalty income under IRC §512(b) and rejected all of the IRS’s theories, concluding that the income was royalty income and therefore not UBIT.284 The IRS’s first contention was that the Sierra Club controlled the marketing of the credit card and was therefore paid for these services. After examining the various agreements among the parties, the Tax Court concluded that ABS was delegated control of the marketing, with Sierra Club having veto power where appropriate to protect its property rights. The court said that the Sierra Club’s exercise of its obligations and powers was not in the nature of services but was done to protect the valuable intangible property rights it had licensed to ABS. In this regard, the court quoted the agreement that gave marketing responsibility to ABS, and also noted that the agreement specified that it did not create an agent/principal relationship, which itself indicated a lack of control by Sierra Club. The court further commented that the record reflected that the Sierra Club did not intend to be involved in the marketing process and that only a small portion of one employee’s time was devoted to the program. The Tax Court also rejected IRS’s argument that the affinity credit card was a “member service” offered by Sierra Club. Testimony by Sierra Club employees indicated that Sierra Club’s membership services department did not provide any significant services to its members or answer inquiries with respect to the
283
284
See id. at 1537. Pending the Sierra II appeal, the IRS continued to assert, and the Tax Court continued to reject, the “passive royalties” argument. See Mississippi State University Alumni Ass’n v. Commissioner, 74 T.C.M. (CCH) 458 (1997), wherein the Tax Court held that a university alumni association’s income from an affinity card program was excluded from unrelated business taxable income under IRC §512(b)(2) as royalties, reasoning that the fees the association received were for the use of intangible personal property rather than services. The IRS did not appeal this case; see also Michigan Alumni Ass’n v. Commissioner T.C. Dkt. No. 5106-95 (which the IRS settled); Exempt Organization Tax Review 21, no. 2 (Aug. 1998). In two factually similar cases, Alumni Association of the University of Oregon v. Commissioner and Oregon State University Alumni Association v. Commissioner, the university entered into an agreement with the United States National Bank of Oregon (USNB) to establish an affinity card program. Alumni Ass’n of the Univ. of Or. v. Commissioner, 71 T.C.M. (CCH) 2093 (1996). Its purposes in doing so were to keep alumni aware of their ties to the university, provide a low-cost credit card to the alumni, and provide revenue for the alumni association while placing minimal demands on its staff. Under the agreement, the university was to give USNB the names, addresses, and graduation dates of its members, license the use of its name, logo, and seal to the bank, and inform its members of the affinity card program at least once a year. The bank was obligated to prepare and provide all promotional materials, design the credit cards, and perform the bulk of the marketing. In return, the university received a flat fee per card and per renewal (varying by the type of account opened), as well as a percentage of total charges. The IRS asserted that the income received by the university did not constitute royalty income, because substantial services were rendered in connection with the rentals, and again advanced the “negative inference” argument. The Tax Court found that the services rendered in connection with the affinity card program closely resembled those rendered in Sierra Club and were de minimis in nature. Moreover, the court held that no negative inference regarding the use of mailing lists by noncharitable organizations could be drawn from §513(h), a position upon which the IRS has long relied. Accordingly, the court found the payments to be royalty income, excludable from UBIT under §512(b)(2). See Becker, note 248. Both cases are on appeal and have been consolidated by the Ninth Circuit. 9th Cir. Nos. 96-70593 and 96-70565. Sierra Club, Inc. v. Commissioner, T.C. Memo 1999-86 (March 23, 1999).
䡲
420
䡲
c08.fm Page 421 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
credit card program. Rather, the court noted, credit was extended by Chase Lincoln and marketing was handled by ABS. Another issue raised by the IRS was in regard to advertising because ABS advertised in national and local Sierra Club publications for which ABS was charged regular billing rates (although it failed to pay one bill). The court ruled that the agreement between ABS and the Sierra Club was not a contract for advertising and that the advertising was in conjunction with the affinity card program. Consequently, the court ruled that none of the Sierra Club’s receipts should be characterized as advertising income, which would be UBIT under Treas. Reg. §1.512(a)–1(f)(2). The court also rejected the IRS position that Sierra Club’s duty “to cooperate” obligated it to perform services in regard to promoting and endorsing the credit card program. Rather, the court stated that Sierra Club’s agreement to cooperate did not impose a duty to do anything further than the endorsement that flows from the license of its name and logo. In summary, the Tax Court concluded that none of the income Sierra Club received was for services, but rather constituted royalties within the meaning of IRC §512(b)(2). (D) T HE S IERRA R OAD M AP The IRS decided not to appeal the Sierra Club decision, perhaps because there were two factually stronger cases for the IRS on appeal to the Ninth Circuit285 (the two cases involving Oregon State Alumni Association286). The Ninth Circuit consolidated the Oregon cases and issued the first appellate court ruling on the merits of an affinity card case.287 The court rejected the IRS’s “all-or-nothing proposition” that even minimal services (i.e., 50 hours of service over 2 years) provided by the schools would taint all of the royalties.288 The Ninth Circuit held that the de minimis services provided by the alumni associations did not alter the fact that the payments by the banks were for royalties, not for services. While the IRS has acquiesced in allowing a limited amount of services in return for royalty payments, it will still regard active involvement or substantial services as transforming royalties into Unrelated Business Income. Therefore, exempt organizations should carefully document their transactions and involvement. The advice in the list of factors below is based on court decisions and IRS rulings and continues to be sound guidance. • The nonprofit should engage in limited rentals. First, a nonprofit should rent
its mailing list on a limited basis, as in Sierra, to obtain favorable treatment. Consistent rentals is a negative factor as it was in DAV I, where the organization had rented out its list on a frequent, nondiscriminate basis. • Documentation of royalty arrangements must be precise. Agreements reflect-
ing mailing list rentals or affinity card agreements should be labeled 285 286 287 288
“IRS Waves White Flag in Sierra Club v. Commissioner,” 1999 TNT 130-2 (July 8, 1999). See note 235. Carolyn D. Wright and Fred Stokeld, “Ninth Circuit Rejects IRS’s UBTI Argument in Oregon Cases,” Exempt Organization Tax Review 26, no. 2 (Nov. 1999): 173. Oregon State Univ. Alumni Ass’n v. Commissioner, 193 F.3d 1098 (9th Cir. Oct. 4, 1999).
䡲
421
䡲
c08.fm Page 422 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
“license agreements” and income paid to the nonprofit should be called “royalties.” The agreements should specify the rights and obligations of each party so that it is clear that the nonprofit’s role is exercise of quality control (see following bullet point). Even though labels are not dispositive of an issue, courts do look at how the parties to an agreement regard their relationship, as the Tax Court did in the remand of Sierra II. • The nonprofit should limit its activities. Exempt organizations that offer to
rent mailing lists or engage in licensing arrangements with commercial entities should contract only to perform “quality control” activities and such other minimal functions as setting mailing list rental rates and sending out rate cards. The nonprofit should not control the marketing, participate in the creation of marketing materials, or perform other controlling functions. All other activities in connection with mailing list or affinity card arrangements—particularly those that are for the benefit of the list user, such as solicitations and designing of promotional materials— should be subcontracted to a third party or performed by the licensee. For example, in Oregon State, the nonprofit was required to inform its members about the affinity card program annually, but it did not participate in the creation or mailing of the materials to its members. It had the right to review the solicitation materials, but it did not have final decision-making power. Similarly, in Sierra Club II, the nonprofit had veto power over marketing materials and plans for quality control purposes. It is crucial to remember that while all documentation of a transaction should reflect the nonprofit’s limited role, it is just as important that the nonprofit actually exercise only those powers necessary for quality control. In other words, both form and substance are important. • Execute a separate contract in the case of additional involvement by the non-
profit. If the exempt organization intends to provide additional services itself, it should enter into a separate contractual arrangement with its licensee or it should create a separate entity, which could be for-profit, to execute a contract with the licensee.289 Although an IRS representative has indicated that this segregation may be observed by the IRS, there is, of
289
The IRS has approved creation of a subsidiary to conduct activities that generate UBIT in a private letter ruling issued to the American Association of Retired Persons (P.L.R. 199938041 (June 1999)). The ruling is significant as it represents the IRS’s formal approval of the use of a subsidiary by a nonprofit to conduct activities that could be troublesome if done by the nonprofit parent. “AARP, IRS Reach Agreement,” Tax Notes (July 15, 1999): 36. The ruling establishes guidelines for ensuring that the nonprofit’s licensing of intangibles (such as endorsements or trademarks) is treated as completely passive by the IRS so that payments for such intangibles are tax-free royalties under §512(b)(1). All of the activities the IRS deems to be services can be placed in a wholly-owned taxable subsidiary. Only payments for such “services” will be made to the subsidiary by the licensee. The subsidiary will be able to offset its expenses against its income and therefore pay little or no taxes. Creation of a subsidiary is important when an organization’s UBI is so high that its tax-exempt status could be jeopardized by additional UBI activities. In order for a subsidiary to be respected by the IRS, it must be formed for a valid business purpose, have a separate board of directors and day-to-day management team (some overlap is permissible), and conduct any business with the nonprofit in an arms-length manner. See generally Section 4.6 and P.L.R. 199938041 for a list of what the IRS considers to be key elements of separation.
䡲
422
䡲
c08.fm Page 423 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
course, no guarantee that this will be the case.290 If a separate contract is executed, income attributable to the specific activities of the nonprofit should be allocated to that contract. • Royalties should be based on gross profits. Payments to a nonprofit for the use
of a logo or mailing list should be based on the commercial entity’s gross, as opposed to net, profits. Sharing in the profits of an activity is indicative of a partnership or joint venture, wherein both parties assume the risk of loss. This is a characterization the nonprofit wants to avoid. Rather, the nonprofit should receive a share of the gross receipts that entitles it to income regardless of whether the commercial entity earns a profit. This is consistent with the position that the nonprofit is being paid a royalty for the use of its intangible property. • Specify that the relationship is not an agency or partnership. It is common for
parties to an agreement to include a paragraph delineating what their relationship is not, in order to avoid misinterpretation, future conflicts between themselves, or recharacterization by a court. Licensing agreements should specify that the parties do not intend to create an agency arrangement, and the commercial entity (or third party) is not an agent of the nonprofit, or vice versa. The parties to the agreement are not partners in a partnership or parties to a joint venture. • Royalty income should be reported on Form 990. The nonprofit should consis-
tently report income from the licensing arrangement as royalty income on Form 990. Thus, the IRS is on notice as to the issue, and the statute of limitations will commence as to this item of income. • Restrict use of postal permit. Do not allow the nonprofit’s special postage
permit to be used by the licensee291 and do not mix credit card solicitations with general mailings of the nonprofit. (d)
Travel Tours
Another area involving joint ventures between nonprofit and for-profit organizations that has been receiving increasing scrutiny is travel tours. Both for-profit organizations and Congress had been pressuring the IRS for more guidelines on when travel tours conducted by nonprofits are considered substantially related to the organizations’ exempt purposes and therefore not generating UBIT, or are not related and generating taxable income.292 In response, the IRS issued proposed Treas. Reg. §1.513-7,293 “Travel and Tour Activities of Exempt Organizations.”
290
291 292 293
See note 278. See also “IRS Unlikely to Take Sierra Club Case to High Court, Owens Says,” Tax Notes Today 96 at 202-4. Exempt Organization Tax Review 14 (Aug. 1996): 229. For a thoughtful article on the Sierra “road map” see Cerny and Lauber, “Ninth Circuit Rules on Sierra Club Mailing List and Affinity Card Income.” In the remand of Sierra II, the IRS argued that the ABS’s use of Sierra Club’s nonprofit postal permit for a mailing showed that Sierra Club offered a service. Highlights & Documents, “IRS Issues Proposed Regulations on EO Sponsored Travel Tours,” IRS News(Apr. 21, 1998). Reg. 121268-97; IRS Doc. 98-12792.
䡲
423
䡲
c08.fm Page 424 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
Hearings on the proposed regulations were held in February 1999.294 In February 2000, the IRS released the final regulations (Treas. Reg. §1.513-7). The final regulations state that whether tour activities are substantially related to an organization’s exempt purposes will be decided on the basis of all the facts and circumstances, including, but not limited to, how a travel tour is developed, promoted, and operated.295 The regulation’s guidance is contained in seven examples, discussed in the following paragraphs. The final regulations added three additional examples to those included in the proposed regulations. (i) Tours with no Educational Purpose. Example 1 relates to O, a §501(c)(3) university alumni association. O operates a travel tour program that is open to all current members and their guests. Through the program, which O creates with various travel agencies, O offers about 10 tours each year to different global destinations. The participants pay the travel agencies for the tours, and the agencies remit a fee to O for each participant. O’s advertising literature encourages members to continue their education by participating in the tours, each of which is accompanied by a faculty member. However, because there is no scheduled instruction or curriculum on the tour, the IRS concludes that the tour program is an unrelated trade or business whose purpose is to generate income for O and not to further its educational purposes.296 (ii) Tours with an Educational Purpose. Example 2 is at the opposite end of the spectrum. It involves N, a §501(c)(3) educational and cultural organization formed to educate individuals about U.S. culture and geography. N offers courses, publishes books and periodicals, and also conducts study tours led by teachers and other professionals. During the tour, five to six hours each day are devoted to study, report preparation, lectures, and other instruction; a library of relevant materials is brought along on each tour. At the end of each tour, exams are given and the board of education in N’s state awards credit for tour participation. Because of the high level of study and instruction, the examination and credit given, the IRS concludes that this tour program furthers N’s educational purposes and is not an unrelated trade or business.297 (iii) Tours that Further Social Welfare Purposes. Example 3 concerns R, a §501(c)(4) social welfare organization whose purpose is advocacy on a particular issue. Each year, R organizes several travel tours for its members to visit Washington, D.C. During their visits, R’s members spend most of their time visiting legislators and government officials and receiving lectures on recent developments related to R’s advocacy issue. The tours are designed to generate a profit for R. Nonetheless, the IRS concludes that the tours are in furtherance of R’s social welfare purpose and are not an unrelated trade or business.298 294 295 296 297 298
“IRS Schedules February Hearings on Travel and Tour Activity Regulations,” Daily Tax Report (Nov. 20, 1998), G-3. Prop. Treas. Reg. §1.513-7(a). Prop. Treas. Reg. §1.513-7(b), Example 1. Prop. Treas. Reg. §1.513-7(b), Example 2. Prop. Treas. Reg. §1.513-7(b), Example 3.
䡲
424
䡲
c08.fm Page 425 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
(iv) Instructional Tours that Further Exempt Purposes Versus Recreational Tours Offered by the Same Organization. Example 4 relates to an organization that sponsors two tour programs, both of which are designed to generate a profit. However, one category of tours is not deemed to further the nonprofit’s exempt purposes, whereas the other is. S is a §501(c)(3) educational and cultural organization formed to foster cultural unity and to educate Americans about X, its members’ country of origin. The first category of tours is designed so that participants spend virtually all of their time in X, receiving instruction in its language, history, and culture. Destinations are chosen for their cultural or historical significance or their instructional resources. The IRS concludes that tours in this category are substantially related to S’s exempt purposes and therefore do not generate UBIT. However, the second category of tours, which also go to X, is deemed unrelated to S’s exempt purposes. This category offers participants optional guided tours, but no other instruction. A participant who goes on all of the tours would have a significant amount of free time. Moreover, the sites visited on these tours are of more recreational interest than cultural or historical. Consequently, the conduct of the second category of tours is not considered to contribute importantly to S’s exempt purposes, is designed to generate a profit, and is therefore deemed to constitute an unrelated trade or business.299 It is clear from these examples that designing a travel program to produce a profit is not fatal so long as the program is otherwise designed to further the nonprofit’s exempt purposes. It is also important to note that subsequent to the publication of Prop. Treas. Reg. §1.513-7, IRS officials have instructed exempt organizations to keep thorough records from the initial planning stages so that the “fragmentation rule” can be applied in appropriate circumstances.300 (v) Scientific Research Trips Offered to Nonscientists. Example 5 describes a scientific organization, T, that performs environmental research. The organization offers one-week trips for nonscientists to T’s bases, where the nonscientists assist T’s biologists in data collection. The promotional materials for the research trips emphasize the work schedule and the contribution that participants offer T. T’s sponsorship of the trips to T’s bases is substantially related to the exempt purpose of the organization and does not constitute unrelated trade or business income.301 (vi) Archaeological Trips. Example 6 relates to an educational organization, V, that studies ancient history and cultures and conducts archaeological expeditions. V created a travel tour program to educate the public about current archaeological field research. V’s tour program included two archaeologists 299 300
301
Prop. Treas. Reg. §1.513(7)(b), Example 4. See Section 7.3(b)(i)(A); see also IRS Document 98-12792. The fragmentation rule allows the exempt organization to separate income earned from tours that are exempt from income earned from tours that do not have an exempt purpose. Additional recordkeeping requirements were not imposed in the final regulations because the IRS believes those in IRC §§6001 and 6033 are sufficient. Sean Barnett, Shed Jessup & Charles Barrett, 2002 CPE, “UBIT: Current Developments.” Reg. §1.513-7(b), Example 5.
䡲
425
䡲
c08.fm Page 426 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
accompanying and leading participants on guided tours of the site, as well as detailed educational materials that highlighted the research methods for exploring the sites and the historical significance of discoveries made at the site. V’s tour program does not constitute an unrelated trade or business because the scheduled activities, including the tours and educational component, are directly related to V’s exempt purpose.302 (vii) Performing Arts Travel Tour. Example 7 concerns an educational organization, W, devoted to the study of the performing arts, which presents public musical and theater performances. W offers its members opportunities to travel to major United States cities to attend various theater or concert events. W also arranges for sightseeing tours of the cities. The tours offer no scheduled instruction and no educational materials are provided. The staff of W offers no special expertise in performing arts and performs no educational role. Because the sightseeing and viewing the various performances are not part of an educational program, W’s tour program is an unrelated trade or business.303 (e)
Application of the UBIT
Technical Advice Memoranda 95-50-003 provides an informative example as to the application of UBIT to the sale of various items by a museum. The ruling addressed a “living museum” engaged in both on-site and off-site sales of merchandise. The ruling analyzed whether, and to what extent, the sales generated unrelated business income. The analysis focused on the museum’s primary purpose for selling the items, examining the nature, scope, and motivation for the particular sales activity, and whether the sales furthered the museum’s exempt purposes.304 In assessing the UBIT implications of the various items, the IRS provided an excellent review of the UBIT as applied to sales of merchandise by exempt organizations. (i) Reproductions or Adaptations. Sales of reproductions, which are copies of original works,305 or adaptations, which are copies incorporating minor changes, will generally be considered exempt activities if the items are imprinted with, or accompanied by, descriptive literature linking the item to the organization’s educational purposes.306 302 303 304
305
306
Reg. §1.513-7(b), Example 6. Reg. §1.513-7(b), Example 7. Among the items sold by the museum were reproductions and adaptations of pieces in the museum’s collection; various utilitarian items adorned with designs or pictures of items in the museum’s collection; educational and interpretive toys and games; books, videos, and CDs; film, batteries, umbrellas, and other “convenience items;” prepackaged and nonprepackaged foods; and newspapers, magazines, and cigarettes. Generally, the sale of original works of art or craft will be subject to UBIT. These sales are not considered to be substantially related, because there is no connection between the items and the organization’s exempt purpose to educate the general public; See Priv. Ltr. Rul. 88-14-002 (Oct. 29, 1987); but see Goldsboro Art League, Inc. v. Commissioner, 75 T.C. 337 (1980), acq., 1986-2 C.B. 1. Reproductions and adaptations approved by the IRS in the ruling included prints, slides, posters, postcards and greeting cards depicting paintings, and objects in the organization’s collection or miniature replicas of those items.
䡲
426
䡲
c08.fm Page 427 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
Utilitarian items—those with an everyday practical use, such as furniture, jewelry, ties, and decorative items—will generally be substantially related when the sale is accompanied by descriptive literature. For example, when a museum, organized to educate the public on works of art, sells a small replica statue of an Egyptian cat (either decorated or designed in the Egyptian style or replicated from an actual museum piece) and accompanies this sale with descriptive literature, such sale aids the museum in carrying out its educational purposes.307 Items that have present-day utilitarian functions that display artistic designs from the organization’s collection or exhibition may be substantially related when accompanied by descriptive literature. For example, Christmas cards, calendars, and stationery may be substantially related if they bear detailed and accurate portrayals of original artifacts or items and if the exempt organization exercises “particular care” in reproducing the works of art displayed on their covers and/or pages.308 However, “interpretations” of original items or designs taken from historical subjects are generally not substantially related. Items such as furniture, silverware, coasters, and so forth, which have, as their only connection to the organization’s exempt purpose, a display of an interpretive design taken from the organization’s collection, will generally be considered too tangentially related to warrant exclusion from UBIT. (ii) Educational and Interpretive Toys and Games, Books, Videos, and CDs. Educational toys and interpretative games sold by the museum are considered substantially related because they concern topics and themes related to the historical periods focused on by the museum. The IRS concluded that such items “contribute importantly to [the charity’s] educational purposes in a manner comparable to instructive literature.”309 This interpretation would allow, for example, an organization formed to educate children about third-world cultures to exclude from UBIT income realized from the sale of a craft kit teaching children how to make artwork in a particular cultural style.310 (iii) Souvenirs or Items Displaying Logo of Exempt Organization. As stated in the ruling, the museum also sold souvenirs (key chains, mugs, T-shirts, soap, shot glasses, and so forth) bearing the logo of the organization. These items are generally not related to the organization’s exempt purposes because utilitarian aspects dominate the items and the historical, educational, or cultural theme appears incidental. In addressing the proper treatment of income from the sales of these items, the IRS stated that “merely imprinting an object with the museum’s
307
308 309 310
See Cobb, “UBIT Traps in Alternative Revenue Sources,” at 275. If the item is designed to be used only for a brief time, such as a chocolate art replica (meant to be eaten), the item does not have sufficient permanence to serve the educational purposes of the exempt organization and will likely be subject to UBIT. Id. See also Priv. Ltr. Rul. 83-26-003 (1983). See Rev. Rul 73-104, 1973-1 C.B. 263. Tech. Adv. Mem. 95-50-003 (Sept. 8, 1995) (citing Rev. Rul. 73-105, 1973-1 C.B. 264). Books, tapes, records, videos, and compact discs containing music, depictions, descriptive accounts, or historical discussions of the time, culture, geography, peoples, or way of life of the group or era depicted by the exempt organization are also considered educational and thus substantially related.
䡲
427
䡲
c08.fm Page 428 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
name does not establish a substantial causal relationship under Section 513(a) of the Code.”311 (iv) Convenience Items. The museum addressed in the ruling provided a wide array of “convenience items” to aid in the public’s enjoyment of its facility.312 The IRS held that, in general, these items are not substantially related because they primarily contribute to the production of income rather than to the organization’s exempt purpose. Under certain circumstances, however, items such as batteries, flashbulbs, and umbrellas may be substantially related because they “enable visitors to devote more of their time to viewing the museum.”313 Food items may be substantially related or unrelated, depending on the packaging. In the ruling, certain prepared food products that were sold on-site and stored and sold in the same manner as during the relevant historical period were held to be substantially related to a “living museum.” However, prepackaged foods sold by the same living museum were determined to be unrelated because they had no nexus to the organization’s exempt purpose and were otherwise undistinguishable from those sold at typical retail establishments.314 Recently, a great deal of attention has been given to TAM 97-20-002,315 wherein the IRS signaled a narrower focus in examining museum activities that could lead to more findings of sales characterized as UBIT. This TAM addressed the issues of the operation of a restaurant and the sale of items in the children’s section of a museum shop and noted that its conclusions differed from those in TAM 83-26-003,316 which concerned the same art museum. In TAM 97-20-002 the IRS stated: Where the primary purpose behind the production and sale of an item is utilitarian, ornamental, a souvenir in nature, or only generally educational in nature, it should not be considered substantially related within the meaning of Section 513(a) of the Code. However, where the primary purpose behind the production and sale of the item is to further the organization’s exempt purpose, the sale is related, and income earned from that sale is exempt, even though the item has utilitarian function or value. Thus, the primary purpose test examines the nature, scope and motivation for the particular sales activities.
The IRS concluded that articles that increase knowledge in general, but not in the area of art, would not be related to the museum’s exempt purposes. Similarly, items that generally develop a child’s motor skills, but do not develop art skills, appreciation, or awareness, do not further the museum’s purpose. Nonetheless, the IRS pointedly states that sales of such materials could substantially relate to the exempt purposes of other nonprofits. Thus, paint sets, art pads, a 311 312 313 314 315 316
Tech. Adv. Mem. 95-50-003. Among these items were film, newspapers, magazines, cigarettes, candy, aspirin, and other “contemporary products.” Tech. Adv. Mem. 95-50-003 (Sept. 8, 1995) citing Rev. Rul. 74-399, 1974-2 C.B. 172. Tech. Adv. Mem. 95-50-003 (Sept. 8, 1995). Tech. Adv. Mem. 97-20-002 (Nov. 26, 1996). The Exempt Organization, Continuing Professional Education Technical Instruction Program makes note of this ruling. See Section 7, “Museum Gift Shop Sales and Use of Museum Facilities.”
䡲
428
䡲
c08.fm Page 429 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
magnetic wood block set, and a kaleidoscope furthered the museum’s purposes, whereas tot blocks and a baby play gym did not. In regard to items that were not reproductions or adaptations of items displayed in the museum, the ruling held that such items were sufficiently related if their primary purpose was to encourage personal learning about the museum’s collection and if they were accompanied by descriptive literature. Reproductions or adaptations of items in the collection that carefully reflect the proportions of the original and identify the artist, the date of the work, and the museum’s name will be substantially related, even if they have an incidental utilitarian value, if their primary purpose is to increase the public’s awareness, interest, and knowledge of art. The IRS stated, “If the dominant impression one gains from viewing or using the article relates to the subject matter of the original article . . . substantial relatedness would be established. If the noncharitable use or function predominates, the sale would be unrelated.” In regard to the restaurant operated by the museum, the IRS found that it was larger than necessary to accommodate museum staff, members, and visitors who pay the entrance fee. The museum advertises the restaurant to the public and serves patrons who do not pay the museum entrance fee. As a result, the fragmentation rule applies so that income from members of the public who patronize the restaurant but do not visit the museum will be taxed as UBIT, whereas income from museum visitors and staff will not. (f)
Income from Internet Activities
As the audience and use of the Internet continued to expand,317 it was a logical progression that nonprofits would “get online,” offer new services and publications, generate new sources of income, and therefore have new UBIT issues. Nonprofits are using the Internet for diverse educational activities. In partnerships with for-profit organizations, universities and museums conduct “distance learning” courses that allow students in rural Alaska or in Bombay, India, to study via the Internet on their own schedules. National Geographic has entered a partnership (through a for-profit subsidiary) that organizes and sells travel tours through the Internet. WETA, a public broadcasting station in Washington, D.C., has created a huge Internet resource about the nation’s capital aimed at tourists, residents, and students. It includes text, hundreds of pictures, audio and video files, and lesson plans for teachers. Nonprofits also use the Internet to match volunteers to opportunities, to educate would-be contributors and direct their contributions, and to guide those seeking grants through the application process. For example, as nonprofits accept advertising on their Web sites, the IRS will be exploring how to calculate UBIT generated by that advertising.318 Presumably, if a nonprofit receives income for advertising on its Web site on a regular 317
318
According to preliminary reports, 1998 year-end sales by Internet retailers totaled $5 billion, twice what was predicted and four times the sales last year between Thanksgiving and Christmas. Denise Caruso, “Digital Commerce,” New York Times (Dec. 28, 1998), C3. “Exempt Organizations Get Plenty to Chew on in L.A.,” Tax Notes (Nov. 16, 1998).
䡲
429
䡲
c08.fm Page 430 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
basis, that income will be deemed UBIT.319 On the other hand, a public service announcement on a nonprofit’s Web site that contains an acknowledgement that it was sponsored by a certain for-profit entity should be treated in the same way as similar announcements on a public broadcasting station.320 If an organization has an online publication, current rules regarding periodical advertising should be useful as guidelines in determining the UBIT generated therefrom.321 On the other hand, if there is a “members only” Web page, payment for participation on that site may not be treated as UBIT, as it could relate to an exempt purpose of providing a means for members to exchange information. In contrast, advertising on that site could generate UBIT, as it benefits the members who are advertising, as opposed to benefiting the entire industry or membership.322 The IRS’s Continuing Professional Educational manual for FY 2000 (the “2000 CPE”) contains an article on the use of the Internet by nonprofits.323 In that article, the IRS says that the use of the Internet for a particular activity, such as advertising, does not change how the tax laws apply because advertising on the Web is still advertising. On the other hand, the article acknowledges that the Internet does change how advertising is done, and that the IRS “has yet to consider many of the questions raised by Web advertising, merchandising, and publishing.”324 The article continues by saying that it is “reasonable to assume” that the IRS’s treatment of these activities online will be similar to its treatment of these activities off-line.325 One specific issue discussed in the article is whether an exchange of links or banner exchanges among nonprofits will generate UBIT or be treated similar to a mailing list exchange; the article states that no decision has been made yet. In regard to the distinction between corporate sponsorship versus advertising by a for-profit on a nonprofit’s Web site, the IRS states a link may be deemed sponsorship while a moving banner is more likely to be characterized as advertising.326 On the issue of merchandise sales, the IRS is presently inclined to use an analysis similar to that applied to merchandising in stores, catalogues, and so on.327 To summarize, while the IRS’s position on some issues relating to the Internet can be predicted, it is an area in which the applications and IRS reaction to those applications will be subject to continuous change and development. 319 320 321 322 323
324 325 326 327
“Exempt Organizations Get Plenty to Chew on in L.A.,” Tax Notes, (Nov. 16, 1998), (statement of Celia Roady, Esq., Morgan, Lewis and Bockius, LLP, Washington, D.C.). See id. For additional guidance, see Section 8.4(h) which discusses new §513(i), the corporate sponsorship provision. See id. See id. C. Chasin, S. Ruth, and R. Harper, “Tax Exempt Organizations and the World Wide Web Fundraising and Advertising on the Internet,” 2000 CPE, Part 3I (hereinafter referred to as the “Internet Article”). Internet Article at Part 2, Section 1A. Id. Internet Article, Part 2, Section 2C. See Section 7.5(e). Attention should also be paid to potential state sales tax issues arising in connection with interstate sales of goods, although there is a three-year moratorium on the collection of sales and use taxes on any Internet sales as a result of the “Internet Tax Freedom Act,” passed in October, 1998, as part of the Omnibus Appropriations Bill, PL 105-277.
䡲
430
䡲
c08.fm Page 431 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
The IRS has moved cautiously in considering how to apply the tax laws to activities conducted on the Internet. It issued two requests for public comment: one specifically addressing application of rules on trade shows, periodicals, and advertising to activities conducted on the Internet;328 and the second requesting comment on a full spectrum of Internet issues to assist in developing guidance.329 The general questions include: • Does a Web site constitute a single publication or communication? If not,
how should it be separated? • What methodology is appropriate in allocating expenses for a Web site?
Should allocations be based on Web pages? • To what extent are business activities conducted on the Internet “regu-
larly carried on” under §512? What facts and circumstances are relevant in the determination? • Are there any circumstances under which payment of a percentage of
sales from customers referred by the exempt organization to another Web site would be substantially related under §513? • Are there any circumstances under which a “virtual trade show” qualifies
as an activity of a kind “traditionally conducted” at trade shows under §513(d)? To assist exempt organizations while formal guidance is being developed, the IRS revealed its current thinking and gave informal guidance in the Technical Instruction Program for FY2000.330 The IRS has indicated both in its training materials and in Announcement 2000-84 that similar rules will govern Internet activities and the more traditional business activities. Three fundamental questions remain: (1) Is the activity related to the organization’s exempt purpose; (2) is the activity regularly carried on; and (3) is the activity a trade or business? If income is derived from a trade or business that is regularly carried on and not substantially related to the exempt purpose, it is taxable. The content, purpose, and techniques used in generating income on the Internet must all be analyzed to decide whether the resulting income is UBI. For example, a tax-exempt organization may provide a link to another site at which the viewer can learn more about the EO’s exempt purpose. If this is part of an exchange with another exempt organization with related concerns, the IRS may well treat the exchange as it treats mail list exchanges—not subject to UBIT. However, the IRS has indicated that the treatment may be different if the exchange is facilitated by an Internet service provider that also requires the organizations to carry other advertising along with the links. 328 329 330
65 Fed. Reg. 11012-11019; Doc. 2000-6180 TNT 41-16. Announcement 2000-84, 2000-42 I.R.B. 385 (Oct. 16, 2000). See Chasin, Ruth, and Harper, “Tax Exempt Organizations and World Wide Web Fundraising and Advertising on the Internet,” E.O. Technical Instruction Program for FY2000 (1999), topic I, p.119. In July 2003, the IRS and the Treasury released their Priority Guidance Plan for 2003-2004, which included 268 projects to be completed by July 2004. Included is guidance concerning an exempt organization’s use of the Internet and the application of the UBIT rules to Internet activities.
䡲
431
䡲
c08.fm Page 432 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
The IRS will accept the identification of a corporation on an exempt organization’s Web site as an acknowledgment of corporate sponsorship. The identification may even include a logo or slogan that is an established part of the sponsor’s identity. An address or telephone number has traditionally been accepted, and the IRS appears to regard a hyperlink as equivalent because a viewer must still take an affirmative action to reach the sponsor’s Web site. The IRS has questions about treating a Web site as a publication. Is it a single publication? If not, how should it be separated into distinct publications or communications? What methods are appropriate to allocate expenses for a Web site when determining what expenses may be charged against UBI? A “virtual trade show” will have to be substantially similar to a traditional one to take advantage of the exclusion from UBIT. The IRS has mentioned the duration and timing of the virtual trade show as a factor. A virtual trade show that coincides with an actual one might be considered just an extension of the original production. A virtual show that continues all year long would probably not be accorded exclusion from UBIT. The IRS suggests that exempt organizations wishing to sell merchandise from a Web site use the same analysis for sales made through stores or catalogues. Each item must be individually assessed to determine whether the sale furthers the accomplishment of exempt purposes (see also Section 8.5(e)). Online auctions allow exempt organizations to sell donated items to a broader audience than the traditional thrift shop would attract. However, using an outside auction service may create legal complications. If the event is not segregated from other auction activities run by the provider, and if the exempt organization does not take primary responsibility for publicity and marketing, the IRS will likely view the activity as classified advertising and the income as subject to UBIT. (In addition, the exempt organization must closely monitor the relationship with the service provider, which is probably working in multiple states and may be regarded as a professional fundraiser subject to numerous federal and state regulations and inurement and private benefit principles.) One popular Internet venture is an arrangement between an exempt organization and an online merchant (often a bookseller) to remit a percentage of sales to the tax-exempt organization. An organization may make recommendations of books related to its mission, or provide on its Web site a logo or hypertext link to the bookseller. Although the IRS has not specifically considered the tax treatment of income received from such arrangements, it has indicated that it views them as analogous to the affinity card cases. (For new developments, see also Section 8.5(c)(ii).) The IRS has now acquiesced in court holdings that a de minimis amount of services may accompany use of a logo, mailing list, or name without changing the character of the income derived from the intangible asset as nontaxable.331 In online “charity malls,” a “mall operator” organizes vendors to remit some percentage of sales to a designated charity through the operator. In charity malls already in operation, the amount of rebate to the charity varies, as does the amount of the fee claimed by the operator, the type and extent of advertising 331
See Section 8.5(c).
䡲
432
䡲
c08.fm Page 433 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
involved, and other terms. At least one charity mall has proposed a procedure that the IRS has approved. The taxpayer purchases merchandise through a Web site from a vendor. The Web site receives a “rebate” from the vendor that the taxpayer may choose to receive in cash or to donate to charity. The control by the taxpayer distinguishes this situation, and makes it a voluntary payment properly characterized as a donation.332 (g)
Branding Issues
Many nonprofits have devoted a substantial time and expense into a renewed “branding” strategy. The common approach results in merging tax-exempt affiliates as well as for-profit subsidiaries, renaming the group, and creating a new Web site. The site would list services provided by the various entities. Clicking a hyperlink associated with a service would bring the user to a Web page containing information about that service and how the user’s needs can be met. (The consultants often suggest that no mention would be made as to which entity [a for-profit or nonprofit] would be performing these services.) It is typically proposed that all employees would share one e-mail domain; that is, each e-mail address issued by an entity to an employee, whether that individual is affiliated with a for-profit subsidiary or nonprofit, will be composed in the following manner: “
[email protected],” where “xxx” is the individual’s user name, and “nonprofit.org” is the domain name. The IRS has provided very little substantive guidance regarding the use of the Internet by exempt organizations, except to state that, where possible, the existing rules governing the operations of exempt organizations should apply. It is well settled, however, that when a nonprofit organization forms a for-profit subsidiary, it must do so in a way that the subsidiary cannot be viewed as a “mere instrumentality” of its parent. Otherwise, the activities of the subsidiary may be attributed to the parent. Commingling of the activities and functions of the nonprofit and for-profit on one Web site, without clear indication as to which entity “owns” the particular page being viewed, is likely to raise significant adverse tax consequences. There are ways, however, to structure the Web site to minimize these consequences, and a discussion of possible options is set forth below. (i) Applicable Law (A) C ORPORATE S EPARATION It is settled law that an exempt organization may create a for-profit subsidiary that will be considered a separate taxable entity, so long as the purposes for which the subsidiary is incorporated are the equivalent of business activities.333 However, if the parent corporation so controls the affairs of the subsidiary that it is merely an instrumentality of the parent, the corporate entity of the subsidiary may be disregarded.334 332 333 334
Priv. Ltr. Rul. 200142019. Moline Properties, Inc. v. Comm’r, 319 U.S. 436, 438 (1943). Krivo Industrial Supply Co. v. National Distillers and Chemical Corp., 483 F.2d 1098, 1106 (5th Cir. 1973).
䡲
433
䡲
c08.fm Page 434 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
One of the factors indicating that a subsidiary is not a mere instrumentality of its parent is the maintenance of separate offices, telephone numbers, telephone listings, bank accounts, and stationery.335 Another is reimbursement by the subsidiary for any shared use of the parent’s resources.336 If a subsidiary is considered to be an instrumentality of its parent, then its activities may be attributed to its parent organization. Any income derived by the subsidiary through a trade or business unrelated to the parent organization’s exempt purposes would then be subject to unrelated business income tax (UBIT).337 Moreover, if the activities of the subsidiary that are unrelated to the parent organization’s exempt purposes are considered substantial in relation to the parent organization’s total operations, then the parent organization risks losing its tax-exempt status because more than an insubstantial amount of its activities are not in furtherance of an exempt purpose.338 (B) U SE OF THE I NTERNET 1. IRS Announcement 2000-42. Because the Internet is a relatively new invention that has gained widespread use only in the recent past, the IRS has issued very little guidance on its use by exempt organizations. Most notably, in 2000, the IRS issued Announcement 2000-84, which requested public comments concerning the application of the provisions of the IRC to the use of the Internet by exempt organizations.339 Among other questions, the IRS asked for comments with respect to the following: “Does a Web site constitute a single publication or communication? If not, how should it be separated into distinct publications or communications?”340 This question is directly relevant to the issue at hand; that is, can affiliated organizations, with different tax statuses, share a common Web site, and if so, what can be done to minimize any adverse consequences to the nonprofit? Although the deadline for submission of comments was February, 2001, the IRS has not yet released any kind of “global” ruling or precedential guidance that addresses all the issues raised in the Announcement. Rather, a limited number of rulings have been released that concern specific topics relating to Internet usage, such as advertising, sponsorship, and trade shows with corresponding Web sites. For example, in PLR 200447048, the IRS declined to grant exempt status to an organization formed to facilitate economic development in a distressed community by operating a Web site that contained links to the Web sites of merchants from the community. The IRS determined that the links were designed to market and increase the patronage of participating merchants and were thus considered a form of advertising. In PLR 200303062, an agricultural organization exempt under IRC §501(c)(5) provided links from its Web site to the Web sites of providers of benefits to its members. The IRS found that this activity was not advertising where the service providers were not charged a fee for the links, 335 336 337 338 339 340
See PLR 199938041. See id. See IRC §§511, 512, and 513. See Treas. Reg. §1.501(c)(3)-1(c)(1). 2000-42 I.R.B. Id.
䡲
434
䡲
c08.fm Page 435 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
because a link to a sponsor’s Web site, without more, constitutes an acknowledgment rather than advertising. Finally, in Revenue Ruling 2004-112, the IRS ruled that fees derived from Internet postings do not generate unrelated business taxable income if the postings are ancillary to an existing convention or trade show held by a trade association and educate the association’s members or stimulate interest or demand for products relating to the association’s industry. Additionally, Treasury Regulation §1.513-4, concerning qualified sponsorship payments, used two Web site examples to illustrate the difference between acknowledgments and endorsements or advertising. An exempt organization may link the Web sites of sponsors to its Web site, which would constitute acknowledgment of sponsorship. However, a link to a sponsor’s Web site that contains an endorsement of the sponsor’s products by the exempt organization is considered advertising.341 In the only ruling342 that appears to be applicable to the facts at hand, a §501(c)(3) organization formed a for-profit subsidiary for the purposes of creating and maintaining its Web site. The for-profit corporation was established to prevent the Web site activities from jeopardizing the parent organization’s tax-exempt status and to prevent the Web site activities from generating unrelated business taxable income for the parent organization. The parent organization requested a ruling from the IRS that its for-profit subsidiary would be considered a separate taxable entity such that its activities would not be attributed to the nonprofit parent. The resulting private letter ruling therefore focused on the many arm’s-length agreements between the entities, including licensing agreements, reimbursements for shared resources, and advertising agreements. The Web site itself was described only briefly in the ruling. In addition to a section devoted to the parent organization and services and products provided by the parent organization, the Web site provided links to merchant affiliates, online recruiting and career resources, industry directories, and advertising. Moreover, the Web site was named “X.com,” where “X” was the name of the for-profit subsidiary, presumably to alleviate any concerns that the noncharitable activities or income could be attributable to the nonprofit parent. However, the ruling does not discuss the appearance of the Web site, and it is therefore unclear what measures were used to indicate that the Web site was not a single publication attributable to the parent organization. The IRS ultimately determined that the activities of the subsidiary organization should not be attributed to the parent because, based on all facts and circumstances, the parent did not control the affairs of the subordinate. In the absence of guidance from the IRS on the issue of providing cues indicating a separation between nonprofit and for-profit activities on a shared Web site, the suggestions presented by the Independent Sector, discussed below, may be used as best practices for determining how to structure shared Web sites.
341
342
We note that the examples in the sponsorship regulations deal with links between distinct Web sites, clearly attributable to specific entities, and the tax treatment of the payments between those entities. The primary concern is the blurring of the distinction between the nonprofit and for-profit affiliates and the potential tax issues this raises. PLR 200225046.
䡲
435
䡲
c08.fm Page 436 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
2. The independent Sector Comments in Response to Announcement 2000-84. The Independent Sector is a coalition of more than 700 national organizations and companies representing the nonprofit sector, and has convened a Panel on the Nonprofit Sector, at the encouragement of the U.S. Senate Finance Committee, which develops recommendations to improve the governance, ethical conduct, and oversight of nonprofit organizations. The Independent Sector submitted comments (IS Comments) in response to IRS Announcement 2000 -84, which addressed the questions put forth in the Announcement.343 While the suggestions presented in the IS Comments are not binding on the IRS, they may be used as a guide when determining the limits of permissible Internet usage by nonprofit organizations. In response to the IRS question, “Does a Web site constitute a single publication? If not, how should it be separated into distinct publications or communications?” the IS Comments suggest that a Web site should be considered a single publication or communication only if all the facts and circumstances support such a characterization.344 An organization can indicate that discrete portions of its Web site should be viewed as separate communications.345 As stated, the purpose of allowing a Web site to be considered to be several publications is to address the issue of when a charity and a noncharity share a single Web site. If the Web site were considered to be a single publication, then the Internet activities conducted by the noncharitable organization could be attributed to the charitable organization.346 The IS Comments suggest ways in which charitable organizations sharing Web sites with noncharitable organizations could indicate the separation between the materials attributable to the charity and those attributable to the for-profit or noncharitable affiliate, such as including screens that advise users that they are leaving one area of the site and going to another, changing the “look” and “feel” of the different pages such that it is clear which ones belong to the charity and which do not, creating the Web site such that users cannot link directly from pages devoted to the charity to pages devoted to the for-profit organization, and ensuring that Web pages that are attributable to the charity contain only information relating to the charity and its activities.347 The National Geographic Society (the Society), a public charity described under §501(c)(3), appears to have implemented several of these suggestions in its Web site.348 Despite the fact that the Society is a public charity, its Web site is labeled at the top with the banner: “NationalGeographic.com, the Website of the National Geographic Society,” perhaps to acknowledge that the site includes noncharitable material. The home page provides a site index as well as a series of links to the different products and activities provided by the Society and its affiliates. Under “TV & Film,” and the subheader “National Geographic Channel,” the site lists television features being shown on the National Geographic 343 344 345 346 347 348
Available at http://www.independentsector.org/programs/gr/IRS_Comments.PDF. INDEPENDENT SECTOR, Comments in Response to Announcement 2000-84, 7. Id. See INDEPENDENT SECTOR, Comments in Response to Announcement 2000-84, 7. See INDEPENDENT SECTOR, Comments in Response to Announcement 2000-84, 8. This Web site may be found at www.nationalgeographic.com or www.nationalgeographic.org.
䡲
436
䡲
c08.fm Page 437 Thursday, March 15, 2007 10:18 AM
8.5 MODIFICATIONS TO UBIT
Channel (a for-profit subsidiary of the Society). Clicking the link to one of the television shows brings the user to a page with the logo “NationalGeographic.com” at the top, with another banner underneath that contains the logo “National Geographic Channel.” All links to the “National Geographic Channel” reveal Web pages that have the same color scheme and text font, which are dramatically different from the color scheme and text font on the Society’s home page. While all pages that are linked from the Society’s home page have the “NationalGeographic.com” logo at the top of the page, each page also has a banner identifying the specific National Geographic entity with which it is affiliated, and each entity’s Web pages all have a specific identifying color scheme and text font. Therefore, while all the entity Web pages that are navigable through the Society’s homepage are similar, it is clear to users when they are perusing materials that are provided by the Society and when the materials are provided by one of the Society’s subsidiary entities. CAVEAT There needs to be a clear indication on the Web site to inform users which services and/or activities are offered by the nonprofit and which are offered by its for-profit subsidiary. Without such an indication, it is likely the IRS would attribute the entirety of the Web site to the nonprofit.* Moreover, the use of a single domain name for all e-mail addresses issued by the nonprofit entity may be further evidence that there is no clear delineation between the nonprofit and its for-profit subsidiary. *
We note that the revised IRS Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, published in June 2006, requires applicant organizations to submit the organization’s Web site address. Furthermore, the IRS identified Internet activities related to UBIT as one of the most important issues in need of guidance in 2005. IRS, Fiscal Year 20055 Exempt Organization Implementing Guidelines, 18 (Nov. 4, 2004).
(C) C ORPORATE S EPARATION Specifically, a Web site that commingles the services and functions of the nonprofit and for-profit subsidiaries could be viewed by the IRS as one indication that a for-profit is not a separate legal entity; otherwise the group would essentially be holding itself out to the Internet-using public as one entity. Additionally, use of one domain name for all entity e-mail addresses may further obfuscate the corporate separation. Furthermore, use of the domain suffix (sometimes referred to as the “top-level Internet domain name”) “.org” generally signifies that the organization to which the e-mail user belongs is a nonprofit.349 While there is no authority that requires that only nonprofit entities may register domain names with the suffix “.org,” different registries have different rules as to which types of entities may register domain names with certain
349
See, e.g., Kaitlin Duck Sherwood, A Beginner’s Guide to Effective Email: Domain Names (2001), available at: http://www.webfoot.com/advice/email.domain.html.
䡲
437
䡲
c08.fm Page 438 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
suffixes. The Public Interest Registry, an organization that manages the “.org” domain suffix and maintains the database of all “.org” Internet addresses, states: Other top-level domains [TLDs] such as .COM or .NET are associated with commercial business, but .ORG means "noncommercial" to the vast majority of Internet users. Therefore, any organization whose primary focus is noncommercial, such as philanthropic and cultural institutions; foundations; health services; religious, civic, arts, social and fraternal organizations; social and legal services; and clubs and community volunteer groups, should have a .ORG Web site.350
Therefore, use of the domain name “nonprofit.org” for every employee of the entity, including those of its for-profits, could mislead the public into believing that all employees are affiliated with the nonprofit parent. While this factor alone may not cause the IRS to determine that the subsidiary is controlled by the charity to the extent that it is a mere instrumentality, it could, if combined with other unfavorable factors, cause the IRS to disregard the for-profit as a separate legal entity. If this occurs, all of its activities may be attributable to the charity. Moreover, income derived from activities conducted by the for-profit that are not substantially related to the nonprofit’s exempt purposes would be subject to UBIT. Additionally, if the nonprofit’s nonexempt activities become substantial in relation to its exempt activities, then the charity’s exempt status could be in jeopardy.351 (D) A DVERTISING Moreover, if the entirety of the new Web site were to be attributed to the nonprofit parent, then any services offered by a for-profit that are on the Web site could be considered advertising. While providing information about for-profit providers of services and links to their Web sites is not considered to be advertising,352 any message that is otherwise broadcast or transmitted, published, displayed, or distributed that promotes or markets any service, facility, or product of such for-profit entity is considered an advertisement.353 Because the Web site would be promoting the services of the for-profit to the public, the IRS would likely consider it to be advertising. If the charity is paid fair market value for this advertising benefit, then the payment would be subject to UBIT.354 However, if the charity receives insufficient or no remuneration for this advertising service, then it is likely that the
350 351
352 353 354
The Public Interest Registry, Why .Org? (2005), available at: http://www.pir.org/AboutOrg/ Why.aspx. Note as well that Section 501(c)(3) organizations are prohibited from participating in any political campaign activity, and they are limited as to the amount of lobbying that they may conduct. Treas. Reg. §1.501(c)(3)-1. If the for-profit posts any political material on the Web site that is attributed to the non-profit, the non-profit’s tax-exempt status may be jeopardized. See PLR 200302062. Treas. Reg. §1.513-4(c)(2)(v). See Treas. Reg. §1.513-4(b).
䡲
438
䡲
c08.fm Page 439 Thursday, March 15, 2007 10:18 AM
8.6 INCOME FROM PARTNERSHIPS
activity would be considered to confer an impermissible private benefit to the subsidiary.355 CAVEAT One solution may be to have a single Web site that lists the services provided on the home page but uses a clear visual separation between the services and activities offered by the charities on one hand and the for-profit subsidiaries on the other hand. For example, perhaps the Web page could be divided into two columns. Over the left column would be a logo for the charity, and the column would list its services and activities. Over the right column would be the logo for the for-profits, and the column would list services. When a user clicks on a service provided by the charity, it would link to a page that has its logo across the top and gives information concerning that service. Likewise, clicking on a service provided by the for-profits would link to a page that has its logo across the top and gives information concerning that service. CAVEAT For example, a logo across the top of the Web page would be a good indication as to which organization the Web page is attributable. The indication showing which organization provides the services should not be in small type or hidden within the text of the Web page, as that would not likely be convincing evidence that the Web page is attributable to one organization rather than both. The charity may wish to make its Web site similar to the National Geographic Web site, which makes use of two banners of equal size—the top banner stating “NationalGeographic.com” and the second banner stating the entity providing the service. Likewise, the Web site could further differentiate the Web pages provided by the different entities by having a different color scheme for each entity.
8.6
INCOME FROM PARTNERSHIPS
A tax-exempt organization’s distributive share of income from a partnership (whether publicly traded or not)356 is subject to UBIT only if the income would be subject to UBIT if it were derived by the organization directly in a trade or business.357 Where the partnership’s business is related to the exempt purpose of the organization, the organization’s distributable share of partnership profits will not be subject to income tax. (Although an exempt organization may passively invest 355
356
357
An organization exempt under IRD §501(c)(3) must be organized and operated exclusively for exempt purposes. Treas. Reg. §1.501(c)(3)-1(a). An organization does not operate exclusively for exempt purposes if it is operated for the benefit of private interests. Treas. Reg. §1.501(c)(3)-1(d)(1)(ii). Private benefits may be conferred on individuals or corporations who are “insiders,” such as the founder of the charity or shareholders, or “outsiders,” who are unrelated to the charity. See Treas. Reg. §1.501(c)(3)-1(d)(1)(ii), American Campaign Academy v. Comm’r, 92 TC 1053, 1069 (1989). Before the Revenue Reconciliation Act of 1993 repealed the rule, the income from publicly traded partnerships was automatically treated as UBIT. For partnership years beginning on or after January 1, 1994, income from both publicly traded partnerships and privately held partnerships is subject to the same analysis to determine whether it is taxable. §512(c)(2).
䡲
439
䡲
c08.fm Page 440 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
in for-profit partnerships, if the exempt organization is actively involved in a partnership that does not further its exempt purpose, it may threaten the exempt status as well as generate UBIT.) In response to a complaint filed in U.S. District Court, Western District of Texas, by St. David’s Health Care System against the United States,358 the government alleged that all of the income from a partnership (whole hospital venture) will be subject to UBIT pursuant to calculations under IRC §512(c), even if the participation in the partnership is found not to affect its exempt status. This position leads to the incongruous result that if a tax-exempt organization is a partner in a partnership that includes for-profit partners, all partnership distributions may be subject to the UBIT regardless of the activities of the partnership. This position is inconsistent with statutory, regulatory, and agency precedent as discussed at length in Chapters 4, 11, and elsewhere in this book. In 1950, Congress enacted the UBIT in an attempt to eliminate unfair competition between tax-exempt organizations competing for the same consumers as taxable organizations. Congress recognized, pursuant to §512(c), that an organization could be a member of a partnership. If the partnership was conducting an unrelated trade or business, the partnership rules of taxation under Subchapter K would apply and the organization’s share of partnership profits would be subject to tax. The converse is also true. If the partnership is conducting a trade or business related to the exempt purpose of the organization, the trade or business would be related to the exempt purpose of the charity, and its distributable share of partnership profits would not be subject to tax. Congress has emphasized that income from related activities (or exempt function income as it was known in 1969) of a §501(c)(3) organization is an indication of the public, charitable nature of the organization. Under §509(a)(2), “gross receipts from admissions (or) sales of merchandise” in a related business activity represents a basis to relieve a public charity from the excise taxes imposed by Chapter 42 of the IRC.359 Rev. Rul. 98-15, 1998-1 C.B. 718, states that if the activities of the partnership are primarily to further exempt purposes so that the charity’s exempt status is not threatened, then the benefit to the for-profit partner and other private parties will be incidental to the accomplishment of charitable purposes. Rev. Rul. 98-15, in part, affirms a 1997 private letter ruling issued by the IRS, in which the government issued technical advice to a partnership finding no unrelated business taxable income to its exempt limited partners. The limited partnership consisted of one corporate general partner and 39 unrelated exempt healthcare providers, primarily hospitals. The partnership performed group 358 359
St. David’s Health Care Sys. Inc. v. United States, No. A01CA046, (W.D. Tex. Jan. 12, 2001) (Remanded on Appeal on other issues, 349 F.3d 232 (5th Cir. 2003)). S. Rep. 91-552, 91st Cong., 1st Sess. (Nov. 21, 1969), C.B. 1969-3 423 at 442–446, 453–457, 461. The Chapter 42 excise taxes are “penal” in nature and are sanctions for misbehavior. In re Kline, 429 F. Supp. 1025 (D.C. Md. 1977). The exclusion of a charitable organization from the application of such sanctions by reason of the extent of their related business receipts shows not only that such income was appropriate for income tax exemption, but it represented a source of public interest and support enhancing an organization’s right to be free from federal oversight. By providing the §509(a)(2) exception, Congress encouraged §501(c)(3) organizations to seek out and sell their programs to the public in order to make them more responsive to the public’s needs and thereby reflect the public’s interests in the programs.
䡲
440
䡲
c08.fm Page 441 Thursday, March 15, 2007 10:18 AM
8.7 CALCULATION OF UBIT
contracting services for its partners, obtaining group discounts for purchases actually made by each partner on its own behalf. The goods and services purchased consisted primarily of drugs, surgical supplies, and other hospital supplies and services. The partnership generated income by way of fees paid by vendors as well as investment income from invested funds. The IRS found the partnership to be engaged in a trade or business regularly carried on, but concluded that the investment income was protected by §512(b). The IRS also concluded that the fee income was substantially related to the exempt purposes of all 39 limited partners because each limited partner’s share of partnership income was no greater than its share of the purchases generating those fees. Since the purchases were for supplies and services utilized to carry out the partners’ exempt purposes of providing healthcare, the partnership income was related and not subject to tax.360 After the determination is made that a partnership activity furthers the exempt organization’s purpose and therefore does not threaten the charity’s exempt status, it would seem to follow that the activity should also be related to the exempt organization’s purpose and would not constitute unrelated business income. Any activity that furthers an exempt purpose will also be related to that exempt purpose. By definition, furthering an exempt purpose is a more difficult standard to meet than merely being related to that exempt purpose. As previously noted, the IRS had taken a contrary position in the complaint filed in the St. David’s Health Care System case by asserting that all of the distributable share of partnership income is subject to the UBIT even if the participation in the partnership is found not to affect its exempt status.361
8.7 (a)
CALCULATION OF UBIT General Rules
UBIT is imposed on gross income from any unrelated trade or business, less allowable business deductions directly connected with the carrying on of the trade or business.362 This tax is imposed at the applicable corporate or trust rates, depending on whether the exempt organization is classified as a corporation or a trust for tax purposes.363 In the case of a corporation, the amount of the tax is the sum of the following: • 15 percent of taxable income up to $50,000 • 25 percent of taxable income exceeding $50,000 but not exceeding $75,000 • 34 percent of taxable income exceeding $75,000 but not exceeding
$10,000,000 • 35 percent of taxable income exceeding $10,000,000 364 360 361 362 363
364
See Private Ltr. Rul. 9739001. One exception to the analysis above is the fragmentation rul discussed in Section 7.3(b)(A). §512(a)(1); Reg. §1.1512(a)(1). §511(a)(2)(A) (tax imposed on entities under §§401(a) and 501(c); and §511(b)) (tax imposed on trusts). See Reg. §1.511-2; organizations with gross income of less than $1,000 from unrelated business activities are not required to file Form 990-T. §11(b)(1) as amended by §13221(a)(2) of the 1993 Act.
䡲
441
䡲
c08.fm Page 442 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
In the case of a corporation that has taxable income exceeding $100,000 for any taxable year, the amount of tax determined under the preceding rule is increased by the lesser of (1) 5 percent of the excess or (2) $11,750.365 If an exempt organization has UBIT from a number of unrelated trades or businesses, the tax is imposed on the aggregate of gross income less aggregated deductions from all unrelated trades or businesses.366 Thus, excess expenses from one unrelated activity may be used to offset excess income from another. If an exempt organization conducts an unrelated trade or business as a component of an exempt activity, the income and other tax items must be allocated between the unrelated business and the exempt activity.367 (b)
Expenses
(i) General Rule. The general rule concerning expenses in computing UBIT is that exempt organizations may deduct expenses “directly connected with” the carrying on of an unrelated trade or business.368 The regulations define “directly connected with” to mean that an item of deduction must have a “proximate and primary relationship” to the carrying on of the unrelated business in order to be deductible.369 Expenses attributable solely to unrelated business activities, such as salaries of personnel working full-time in carrying on the unrelated business activities, are “proximately and primarily” related to the unrelated business and, hence, are fully deductible.370 However, the treatment of mixed-purpose expenses (attributable to both a related exempt purpose activity and to an unrelated business activity) is more complex.371 When facilities or personnel are used to carry on both exempt function activities and unrelated business activities, the expenses must be allocated between the two uses on a “reasonable basis.”372 EXAMPLE: An exempt organization pays its president a salary of $20,000 per year. Because the president devotes 10 percent of this time during the year to an unrelated business activity, the organization may, in computing its UBIT, deduct $2,000 (10 percent of $20,000).373 This allocation must be reasonable under the facts and circumstances presented.374 365 366 367 368 369 370 371 372
373 374
§11(b). Reg. §1.512(a)-1(a). See Section 7.7(b)(i). §512(a)(1); Reg. §1.512(a)-1. Reg. §1.512(a)-1. Reg. §1.512(a)-1(b). Tech. Adv. Mem. 93-24-002 (Feb. 11, 1993). See, e.g., Rensselaer Polytechnic Institute v. Commissioner, 732 F.2d 1058 (2d Cir. 1984), aff’g 79 T.C. 967 (1982) (reasonable method was based on the percentage of actual use, although the IRS argued for percentage of available use); see also Tech. Adv. Mem. 93-24-002 (Feb. 11, 1993) (IRS utilizes allocation method citing Rensselaer). Reg. §1.512(a)-1(c). Tech. Adv. Mem. 9324002 (Feb. 11, 1993); see Rensselaer, 732 F.2d at 1058 (whether an allocation is reasonable is a factual determination); see also CORE Special Purpose Fund v. Commissioner, T.C. Memo 1985-48 (Jan. 30, 1985) (organization must show that expenses are deductible under §162 or are directly connected with activity to be considered reasonable); see also Inter-Com. Club Inc. v. United States, 721 F. Supp. 1112 (D. Neb. 1989).
䡲
442
䡲
c08.fm Page 443 Thursday, March 15, 2007 10:18 AM
8.7 CALCULATION OF UBIT
In Rensselaer Polytechnic Institute v. Commissioner,375 the Tax Court and the Second Circuit considered a case involving the proper allocation of fixed expenses attributable to the operation of a university field house. The field house was used for both related and unrelated purposes. The university argued that the allocation of expenses should be based on percentages of actual use; the IRS urged that the allocation should be based on percentages of available use. The differences between the two methods are substantial. Assume that a field house is available for use 365 days but is actually used on 200 days, of which 150 days are related and 50 days are unrelated. According to the university’s position, it would be able to deduct 25 percent of the costs of the field house in computing UBIT; under the IRS position, the university would be able to deduct only about 14 percent of the costs. In Rensselaer, the court upheld the university’s position.376 The IRS does not agree with the Rensselaer decision and will likely seek an appropriate case to challenge the holding of the Second Circuit.377 (ii) Exploited Activity Rule. Generally, gross income derived from an unrelated business activity that exploits an exempt function may not be offset by the expenses, depreciation, and similar deductions attributable to the conduct of the exempt activity. The reasoning is that the exempt function expenses are not considered to be directly connected with the unrelated business activity.378 An example of an exploited activity cited in the regulations is the sale of advertising in a periodical of an exempt organization that contains editorial material related to the organization’s exempt purpose. The regulations provide a special rule for certain “exploited” activities.379 Certain expenses attributable to the exploited exempt activity are allowable as deductions against the unrelated business activity income. Where an unrelated 375 376 377 378
379
Rensselaer, 732 F.2d at 1058. See generally Portland Golf Club v. Commissioner, 497 U.S. 154 (1990) (allocation of unrelated losses against investment income). See Tech. Adv. Mem. 93-24-002 (Feb. 11, 1993) (in the meantime, the IRS utilizes allocation method citing Rennselaer). Reg. §1.512(a)-1(d). See also Reg. §1.513-1(d)(4)(iv). Although, on its face, Reg. §512(a)-1 applies to all exempt organizations, in Chicago Metropolitan Ski Council v. Commissioner, 104 T.C. No. 15 (1995), the IRS attempted to restrict the applicability of an exception to the exploitation rule that allows certain exempt organizations publishing a periodical to deduct all readership and circulation expenses from gross advertising revenue (§1.512(a)-1(f)). Absent this exception, these expenses cannot be used to offset advertising proceeds because they are not “directly related” to the sale of advertising. The IRS took the position that the exception to the exploitation rule applied only to organizations that compute their UBI under §512(a)(1), which does not include, for example, social clubs, exempt under §501(c)(7) and required to calculate UBIT under §512(a)(3)(A). In Ski Council, the exempt §501(c)(7) social club published a skiers’ magazine in which it sold advertising space. The IRS contended that only direct advertising expenses could be offset against the advertising income, whereas the social club took the position that the magazine’s entire readership and circulation expenses were deductible under Reg. §1.512(a)-1(f), as noted earlier. The court, relying on the legislative history and plain language of the provision, determined that application of §1.512(a)-1(f) was not limited to those organizations calculating UBIT under §512(a)(1), but instead encompassed all exempt organizations. Accordingly, the social club was allowed to deduct all expenses related to the publication of its magazine. Reg. §1.512(a)-1(d). Because such items and expenses are incident to an activity that is carried on in furtherance of the exempt purpose of the organization, they do not possess the requisite “proximate and primary” relationship to the unrelated trade or business activity and are therefore not directly connected with the unrelated business.
䡲
443
䡲
c08.fm Page 444 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
trade or business activity is of a kind carried on for profit by taxable organizations and where the exempt activity exploited by the business is of a type normally conducted by taxable organizations in pursuance of such business, then the exempt function expenses (e.g., expenses, depreciation, and similar items) may be used to offset the gross income from the unrelated business activity. However, the exempt function expenses can offset the gross income from the unrelated activity only to the extent that the exempt function expenses exceed exempt function income.380 Moreover, the exempt function expenses may not be taken into account in computing UBIT attribution to any unrelated business activity not exploiting the same activity.
8.8
GOVERNMENTAL SCRUTINY AND LEGISLATIVE INITIATIVES
Faced with pressures to raise funds and an influential tide of commercial-like activity, exempt organizations are encountering increasing scrutiny of their unrelated business venture activity. As a result, the law is steadily changing, not only through court cases and Treasury Department rulings and releases, but through congressional action as well. For example, the Taxpayer Relief Act of 1997 added §513(i) to the IRC, exempting certain corporate sponsorship payments from unrelated business income tax (UBIT).381 In the Taxpayer Relief Act of 1997, Congress tightened the rules relating to subsidiaries owned by nonprofits, making it more difficult to avoid paying tax on UBI in controlled taxable entities.382 In addition, the Small Business Job Protection Act of 1996 added a safe harbor from UBIT for de minimis associate member dues paid to §501(c)(5) agricultural and horticultural organizations.383 New Form 990-T reporting requirements have resulted in information about many more charities. It documents the continuing trend of increasing amounts of unrelated income, much of it exempt from tax. A study by the IRS showed that by 1997, charities had doubled the amount of outside business income they
380
381 382 383
Reg. §1.512(a)-1(d)(2)(i). The exploited activity rule was applied by the IRS in Tech. Adv. Mem. 95-09-002 (Sept. 30, 1995) to override the convention and trade show activity exception to UBIT. In this memorandum, a §501(c)(6) business league published and distributed a convention newsletter. An unrelated organization contracted to help the league publish the newsletter in exchange for the exclusive right to sell advertising in the paper for the year. The organization agreed to pay the league a “royalty” based on a fixed amount plus a percentage of advertising revenues collected over a minimum threshold. Although the newsletter was found to constitute a “qualified trade show activity,” the advertisement sales were characterized as an exploitation of the convention activity under §1.513-1(b). Accordingly, the income generated was subject to UBIT. Tech. Adv. Mem. 95-09-002 (Sept. 30, 1995); see §§1.5131(b); 1.513-1(d)(4)(iv); 1.512(a)-1(d)(2); 1-512(a)-1(f). One commentator noted that Tech. Adv. Mem. 95-09-002 “represents one of the rare instances where the ‘exploitation’ rules in the UBIT regulations have been applied by the IRS to override the convention and trade show activity exception to UBIT;” see Tesdahl, “Letter Ruling Alert I,” Exempt Organization Tax Review 11 (Apr. 1995): 789. See Section 8.4(h). §512(b)(13). See discussion in Section 4.6(c). Small Business Job Protection Act of 1996, Pub. L. No. 104-188, amending §512 by adding new §512(d). See discussion in Section 8.3(b)(iii).
䡲
444
䡲
c08.fm Page 445 Thursday, March 15, 2007 10:18 AM
8.8 GOVERNMENTAL SCRUTINY AND LEGISLATIVE INITIATIVES
received in 1990.384 A study by The Chronicle of Philanthropy385 of the tax returns of the 14,000 largest charities in 1998, found at least $61 billion in unrelated income “shielded from federal taxes” in one way or another. The most widely used exemption was for passive investments, which accounted for 75 percent of the revenue that was excluded in 1998. Data from the IRS shows nearly 40,000 organizations filed returns in 1997 reporting some unrelated business income.386 The total gross unrelated income was nearly $71 billion, but the net income was $1.3 billion on which $418 million of unrelated business income tax (UBIT) was paid. The Congress has been acutely aware of the issues posed by outside business income received by nonprofit organizations. The House Ways and Means Committee, for example, held six hearings on unrelated business income between 2004 and 2006, which examined the tax-exempt status of organizations receiving high amounts of unrelated income such as credit unions, hospitals, and college athletic activities.387 Among the committee’s most directed queries was whether some of the funds generated by activates such as college sports programs and the National Collegiate Athletic Association should be subject to the unrelated business income tax.388 With no resolution of these issues in sight, governmental scrutiny over the unrelated business income will surely continue as an issue for these organizations. (a)
Recent Developments
(i) Payments to Controlling Exempt Organizations. H.R. 4, the Pension Protection Act of 2006, signed into law by President Bush on August 17, 2006, amended §513(b)(13) to alter the tax treatment of certain payments received by nonprofit organizations from controlled entities. An entity is controlled if the exempt organization owns more than 50 percent of its stock, profits interest or capital interest, or beneficial interest. Previously, interest, annuities, royalties, and rents (but no dividends) received by an exempt organization from a controlled entity were taxable as UBI to the extent such payments either reduced the controlled entity’s net UBI or increased its net unrelated loss. Under the Act, such payments received by an exempt organization during 2006, 2007, or 2008 from a controlled entity will be included in the calculation of the exempt organization’s UBI only to the extent that the payments exceed a comparable fair market value payment as determined using the principles of section 482. (ii) Public Disclosure of Unrelated Business Income Tax Returns. Also under the Pension Protection Act of 2006, §501(c)(3) organizations must make available for public inspection information found on their Form 990-T, unless the disclosure would adversely affect the organization, such as a trade secret, patent, and so on. 384 385 386 387 388
Harvy Lipman and Elizabeth Schwinn, “The Business of Charity,” The Chronicle of Philanthropy (Oct. 18, 2001): 25. Id. IRS, Statistics of Income Bulletin, Summer 2001, Publication 1136 (Revised Aug. 2001). Elizabeth Schwinn, “Key Lawmaker’s Departure Weighed by Nonprofit World,” The Chronicle of Philanthropy (March 23, 2006). Id.
䡲
445
䡲
c08.fm Page 446 Thursday, March 15, 2007 10:18 AM
THE UNRELATED BUSINESS INCOME TAX
(iii) UBIT-Related Certification—A Sign of Things to Come? In 2006, the Senate passed a legislative provision that would have required §501(c)(3) organizations with either $10 million in gross receipts or gross assets, which were subject to tax under §511, to hire an independent audit firm or tax counsel to certify the accuracy and completeness of their federal tax returns, including the Form 990-T.389 The certification provisions would have required the independent auditor to certify: that the organization’s trades and business, sources of investment income, and sources of program service revenue were complete and accurate; that the auditor reasonably believed that the organization’s expense allocations complies with the requirements of §512; and that the auditor had not reviewed or provided a tax opinion regarding the organization’s treatment of income or an activity under the unrelated business income tax rules.390 Notably, these provisions, not present in the House version, spawned six months of conference negotiations and intense opposition voiced by nonprofit organizations. Chief among the concerns voiced by nonprofit organizations were the added costs, resources, and time that compliance with the proposed provisions would place on the exempt community. Organizations also raised issue with the penalties structure that the provisions would impart. Under the proposed provisions, noncompliant organizations would be subject to a penalty equal to .5 percent of the organization’s total gross revenue for any amount of unreported UBIT. While the final version of the legislation (H.R. 4297) sent to the president did not contain the UBIT-certification requirements, the provisions illustrate the continuing trend of scrutiny aimed at the profit-making activities of nonprofit organizations. Although the UBIT-certification provisions contained in H.R. 4297 ultimately failed due to strong lobbying from the exempt community, the Senate Finance Committee will likely continue their critical examination of the amount and source of profits acquired by exempt organizations.
389 390
Kathleen M. Niles, “UBIT-Related Certification of Charitable Organizations’ Tax Returns,” Tax Notes Today (April 5, 2006). Id.
䡲
446
䡲
c09.fm Page 447 Saturday, March 10, 2007 3:30 PM
C H A P T E R
N I N E 9
Debt-Financed Income
9.1
INTRODUCTION
Exempt organization participants in joint venture arrangements must be aware of the debt-financed property rules if the venture plans to purchase property with borrowed funds.1 Income from debt-financed property may be included in the exempt organization’s unrelated business income.2 However, the inclusionary provisions in IRC §514 may be avoided if, inter alia, the joint venture activity is “substantially related” to the exempt purposes of the exempt participant.3 EXAMPLE: Z, an exempt acute care hospital forms a joint venture to develop a new medical facility. The joint venture will finance the cost of construction of the facility. Thus, the property is debt-financed property as defined by IRC §514(b). Z will receive an allocation of income and management fees from the joint venture. The joint venture furthers Z’s charitable purposes of promoting health in the community. Thus, although the joint venture property is debt financed, the income that Z derives from the joint venture is not included in unrelated business income (UBIT) under the debt-financed property rules because the property is substantially related to the exempt purposes of Z.4 Although the debt-financed property provisions may be successfully traversed, close attention must be given to the complex technical rules.5 1 2 3
4 5
See §514; S. Rep. No. 91-552, 1969-3 C.B. 423, 426 (Tax Reform Act of 1969); Conf. Rep. No. 91-782, 1969-3 C.B. 644, 651; Priv. Ltr. Rul. 91-47-058 (Aug. 29, 1991). §514(a); Reg. §1.514(a)-1(a)(1)(i). §514(b)(1)(A)(i); Priv. Ltr. Rul. 91-47-058 (Aug. 29, 1991). The inclusionary rules may also be averted under §514(c)(9) for certain exempt organizations, including educational organizations under §170(b)(1)(a)(ii), §401 qualified trusts, and §501(c)(25) organizations. See §514(c)(9); Prop. Reg. §1.514(c)-2. See generally Section 9.2. This example is based on the factual situation presented in Priv. Ltr. Rul. 91-47-058 (Aug. 29, 1991). See Priv. Ltr. Rul. 93-19-044 (Feb. 19, 1993); Priv. Ltr. Rul. 86-28-049 (Apr. 15, 1986). For a comprehensive discussion of the history and development of the debt-financed income rules, see Weigel, “Unrelated Debt-Financed Income: a Retrospective (and a Modest Proposal),” Tax Law 50 (1997): 625. Suzanne Ross McDowell argues for repeal of the debt financed property rules as overly broad and no longer necessary to prevent abuses in “Taxation of Unrelated Debt-Financed Income,” The Exempt Organization Tax Review (Nov. 2001): 197. Two other comprehensive articles on this topic are Holloway, “Structuring Real Estate Investment Partnerships with Tax-Exempt Partners,” Tax Notes (June 12, 2000): 1517; and Friz, “Making Real Estate Investment Funds Attractive to Tax-Exempt Investors,” 26 Journal of Real Estate Taxation No. 2 (1999): 130.
䡲
447 䡲
c09.fm Page 448 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
9.2 (a)
DEBT-FINANCED PROPERTY Overview
The UBIT exclusions for interest, rents from real property, and so forth, do not apply to the extent that income is derived from debt-financed property.6 The term debt-financed property is defined in IRC §514(b)(1) as “any property which is held to produce income and with respect to which there is an acquisition indebtedness . . . at any time during the taxable year.”7 Under the regulations, debtfinanced property includes property that was disposed of during the taxable year that had “acquisition indebtedness” outstanding with respect to such property at any time during the 12-month period preceding the disposition. This inclusionary provision is applicable even if such 12-month period covers more than one taxable year.8 EXAMPLE: X, a tax-exempt organization, acquires real property with borrowed funds on January 1, 1985. On January 1, 1992, X repays the entire mortgage and the property thereafter is owned free and clear of any encumbrance. If the real property is sold on December 1, 1992, it will be treated as debt-financed property at the time of sale. However, if the property is sold on January 1, 1993, it will not be treated as debt-financed property because a period of 12 months has elapsed since the mortgage was retired.9 Property is not debt-financed property if substantially all its use is related to the exercise or performance of the organization’s exempt purpose.10 In making the decision as to whether property is substantially related to the organization’s exempt purpose, the regulations under IRC §513 are 6
7
8 9 10
§512(b)(4); §514. See also Rev. Rul. 74-197, 1974-1 C.B. 143 (exempt trust that entered into joint venture to purchase securities with borrowed funds is subject to the debt-financed income rules). Bartels Trust v. United States, 209 F.3d 147 (2d Cir. 2000) (securities purchased on margin by §501(c)(3) trust were debt-financed property and the income derived from them was subject to UBIT). §514(b)(1)(A)(i); see Priv. Ltr. Rul. 91-47-058 (Aug. 29, 1991); Priv. Ltr. Rul. 93-27-090 (Apr. 15, 1993); Priv. Ltr. Rul 98-45-020 (Nov. 7, 1998). (Rents received by exempt organization/ lessor under ground lease not debt-financed. Lessee’s indebtedness not attributed to lessor where lessor was not obligated in any manner on the debt.) Congress, in enacting the debtfinanced income provisions of the Code, sought to prevent tax-exempt organizations from using borrowed funds to acquire additional property rather than finding a means of investing its own funds at an adequate rate of return. See S. Rep. No. 91-552, 1969-3 C.B. 423; Tech. Adv. Mem. 81-46-009 (1980). Priv. Ltr. Rul. 1999-52-089 (Oct. 4, 1999) (guarantee of debt of wholly owned subsidiary did not transform ownership interest in subsidiary into debt-financed property). §514(b)(1); Reg. §1.514(b)-1(a). See generally Reg. §1.514(b)-1(a); Tech. Adv. Mem. 81-46-009 (no date given). §514(b)(1)(A)(i); Reg. §1.514(b)-1(b)(1)(i); Reg. §1.513-1(d)(2). A hospital may convert two medical office buildings to condominiums to avoid local property taxes without incurring UBIT because the tenants will continue to be substantially related to the hospital’s purposes. Priv. Ltr. Rul. 200214036. A partnership formed to combat community deterioration by rehabilitating housing and developing new housing and commercial development may purchase, develop, and sell real estate; the property will not be considered debt-financed because the activity is substantially related to the charitable purposes of the two §501(c)(3) partners. Priv. Ltr. Rul. 200211052. Bartels Trust v. United States, 209 F.2d 147 (2d Cir. 2000) (purchase of securities on margin is not essential to fulfill exempt purpose of trust to support educational programs of University of New Haven; many alternative investments are available to generate income).
䡲
448 䡲
c09.fm Page 449 Saturday, March 10, 2007 3:30 PM
9.2 DEBT-FINANCED PROPERTY
applicable. 11 The regulations provide that an organization’s activities are substantially related when the conduct of the trade or business “contributes importantly” to accomplishing the exempt purposes of the organization.12 EXAMPLE: M, an exempt healthcare organization, forms a joint venture with N, a for-profit enterprise, to operate an acute care rehabilitation center. The venture property will be encumbered by acquisition indebtedness. In furtherance of M’s exempt purposes, the joint venture will generate rental income from leasing space in its property to a specialized rehabilitation unit. Generally, because there is acquisition indebtedness on the joint venture property, the property would be treated as debtfinanced property and, hence, the rental income would not be excluded from UBIT. However, because the joint venture leasing activity is substantially related to M’s exempt purpose of providing healthcare, the property falls outside the definition of debt-financed property and the rental income is, therefore, excluded from UBIT.13 Exceptions to the definition of debt-financed property are also provided for any property to the extent that the income from such property is taken into account in computing the gross income of any unrelated trade or business; 14 any research property to the extent that the income from such property is excluded from UBIT;15 and any property to the extent that it is used in a business commonly associated with exempt organizations, such as a thrift shop or school cafeteria,16 or as otherwise provided for in IRC §514(c).17
11
12
13 14 15 16 17
Reg. §1.514(b)-1(b)(1)(i). See §513(a); Reg. §1.513-1(d)(2); see also Southwest Tex. Elec. Coop. v. Commissioner, 68 T.C.M. (CCH) 285 (Aug. 1, 1994) (borrowed funds used to purchase Treasury notes not “substantially related” to exempt purpose of electric cooperative, even if interest earned on notes used for exempt purposes). Rev. Rul. 69-464, 1969-2 C.B. 132 (office space leased by exempt organization to its physicians was “substantially related” to exempt purpose because it facilitated or furthered the exempt purpose); Rev. Rul. 69-269, 1969-1 C.B. 160 (hospital parking lot was likewise “substantially related”); Priv. Ltr. Rul. 85-34-101 (May 31, 1985). Priv. Ltr. Rul. 2000-32-050 (May 16, 2000) (lease of facility to provide counseling, job training, and day care services to unemployed was “substantially related” to lessor’s exempt purpose of fostering employment and alleviating poverty); Priv. Ltr. Rul. 2000-30-027 (Apr. 26, 2000) (operation of adjacent guest house was substantially related to conference center’s exempt purpose). Reg. §1.513-1(d)(2); Priv. Ltr. Rul. 86-28-049 (Apr. 15, 1986). See generally Chapter 7; see also Priv. Ltr. Rul. 97-36-039 (June 9, 1997) (debt-financed low-income housing owned by partnership was “substantially related” to exempt purpose of managing general partner). This example is based on the factual situation presented in Priv. Ltr. Rul. 90-35-072 (June 7, 1990); see also Priv. Ltr. Rul. 91-47-058 (Aug. 29, 1991). §514(b)(1)(B). §514(b)(1)(C); §512(b)(7)-(9). §514(b)(1)(D); §513(a)(1)-(3). §514(c) defines “acquisition indebtedness,” and in so doing, specifically excepts several categories of property: §514(c)(2)(B) (property that is acquired through bequest, devise, or certain gifts, and is subject to a mortgage, for a 10-year period following the bequest, devise, or gift); §514(c)(4) (indebtedness incurred in performing an organization’s exempt purpose, if the incurrence of the indebtedness is inherent in carrying out the purpose constituting the basis of the organization’s exemption (e.g., the indebtedness incurred by a §513(a)(14) credit union in accepting deposits from its members)); §514(c)(5) (certain annuities); §514(c)(6) (certain federal financing insured by the FHA); §514(c)(9) (real property acquired by certain qualified organizations). See, e.g., Priv. Ltr. Rul. 98-31-026 (July 31, 1998) (§541(c)(2)(B) exception applied); Priv. Ltr. Rul. 97-43-054 (Oct. 24, 1998) (§514(c)(5) annuity exception satisfied); Priv. Ltr. Rul. 95-27-033 (Apr. 10, 1995) (income earned on deferred tuition plan of exempt educational organization not debt-financed because §514(c) exception applied).
䡲
449 䡲
c09.fm Page 450 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
Income from debt-financed property will be subject to UBIT even if that income is derived from an activity that is not a trade or business regularly carried on. In other words, the “trade or business” and “regularly carried on” UBIT tests are not relevant when debt-financed property is involved. (b)
Calculation of Debt-Financed Income
IRC §§512(b)(4) and 514(a)(1) require that a portion of the income derived from or on account of each debt-financed property must be included as an item of gross income from an unrelated trade or business. Specifically, with respect to each debt-financed property, §514(a)(1) of the Code requires that there be included as an item of gross income derived from an unrelated trade or business, an amount that is the same percentage (but not in excess of 100 percent) of the total gross income derived during the taxable year from or on account of such property as • The average acquisition indebtedness for the taxable year with respect to
the property • The average amount of the adjusted basis of such property during the
period it is held by such organization during such taxable year18 For purposes of calculating debt-financed income, this percentage is known as the “debt/basis percentage.”19 The calculation of the debt/basis percentage is demonstrated by the following example from the regulations. EXAMPLE: X, an exempt trade organization, owns an office building that in 1992 produced $10,000 of gross rental income. The average adjusted basis of the building for 1992 was $100,000, and the average acquisition indebtedness was $50,000. The debt/basis percentage for 1992 is 50 percent (the ratio of $50,000 to $100,000). Therefore, the unrelated debt-financed income with respect to the building for 1992 is $5,000 (50 percent of $10,000).20 When debt-financed property is sold or otherwise disposed of, there must be included in computing UBIT an amount with respect to such gain (or loss) that is the same percentage (but not in excess of 100 percent) of the total gain (or loss) derived from such sale or other disposition, as 1. The highest acquisition indebtedness with respect to such property during the 12-month period preceding the date of disposition. 2. The average adjusted basis of such property21 The “average adjusted basis” is defined in the regulations as the average amount of the adjusted basis of the debt-financed property during the portion of the taxable year that it is held by the tax-exempt organization. This amount is 18 19
20 21
§514(a); Reg. §514(a)-1(a)(1)(ii)(a) and (b). See also Tech. Adv. Mem. 81-46-009 (no date given); Priv. Ltr. Rul. 93-16-052 (Jan. 29, 1993). Reg. §1.514(a)-1(a)(1)(iii); see Tech. Adv. Mem. 97-17-004 (Dec. 13, 1996) (same debt/basis percentage used for computing debt-financed income must be used for computing interest expense deductions). Reg. §1.514(a)-1(a)(1)(iv). Reg. §1.514(a)-1(a)(1)(v).
䡲
450 䡲
c09.fm Page 451 Saturday, March 10, 2007 3:30 PM
9.2 DEBT-FINANCED PROPERTY
the average of (1) the adjusted basis of such property as of the first day during the taxable year that such organization holds the property and (2) the adjusted basis of such property as of the last day during the taxable year that such organization holds the property.22 EXAMPLE: On July 10, 1992, X, an exempt educational organization, purchased an office building for $510,000 using $300,000 of borrowed funds. During 1992 the only adjustment to basis was $20,000 for depreciation. On December 31, 1992, the adjusted basis of the building was $490,000 and the indebtedness remained $300,000. Under these facts, the average adjusted basis for 1992 is $500,000 ($510,000 + $490,000 = $1,000,000 ÷ 2 = $500,000).23 The debt/basis percentage is 60 percent (the average acquisition indebtedness of $300,000 over the average adjusted basis of $500,000). “Average acquisition indebtedness” with respect to debt-financed property is defined in the regulations as the average amount of the outstanding principal indebtedness during that portion of the taxable year in which the property is held by the organization.24 This figure is computed by determining the amount of the outstanding principal indebtedness on the first day in each calendar month during the taxable year that the organization holds the property, adding these amounts together, and dividing the sum by the total months during the taxable year that the organization held the property.25 EXAMPLE:
MONTH July August September October November December
INDEBTEDNESS ON THE FIRST DAY IN EACH CALENDAR MONTH THAT THE PROPERTY IS HELD $ 300,000 $ 280,000 $ 260,000 $ 240,000 $ 220,000 $ 200,000 $1,500,000
Average Acquisition Indebtedness: $1,500,000/6 months = $250,000 Assuming an average adjusted basis of $500,000, the debt/basis percentage is 50 percent (average acquisition indebtedness of $250,000 over average adjusted basis of $500,000).26 Deductions are allowed with respect to debt-financed property in an amount determined by applying the debt/basis percentage. The allowable 22 23 24 25 26
Reg. §1.514(a)-1(a)(2)(i)(a) and (b). Reg. §1.514(a)-1(a)(2)(iv). Reg. §1.514(a)-1(a)(3)(i). Reg. §1.514(a)-1(a)(3)(ii) (a fractional part of a month is treated as a whole month under this regulation). Reg. §1.514(a)-1(a)(3)(iii), Example 1.
䡲
451 䡲
c09.fm Page 452 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
deductions are those that are directly connected with the debt-financed property or the income therefrom. The allowance for depreciation may be taken only by using the straight-line method.27 For a deduction to be “directly connected with” debt-financed property or the income therefrom, the item must have a proximate and primary relationship to such income.28 (c)
Acquisition Indebtedness
“Acquisition indebtedness” is defined in IRC §514(c)(1) as • Indebtedness incurred in acquiring or improving any property29 • Indebtedness incurred before the acquisition or improvement of such
property if such indebtedness would not have been incurred but for such acquisition or improvement30 • Indebtedness incurred after the acquisition or improvement of such prop-
erty if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement31 Whether the incurrence of indebtedness is reasonably foreseeable depends on the facts and circumstances of a given case.32 According to the Treasury Regulations, the fact that an organization did not foresee the need for the indebtedness prior to the acquisition or improvement of a property does not 27 28 29
30 31 32
Reg. §1.514(a)-1(b)(2)(ii). Reg. §1.514(a)-1(b)(3)(i). §514(c)(1)(A); Reg. §1.514(c)-1(a)(1)(i). However, acquisition by an exempt organization of a security interest in debt-financed property owned by a borrower does not, of itself, constitute acquisition of debt-financed property. This is because the exempt organization does not have full use or control of the property and its income. Priv. Ltr. Rul. 85-49-061 (Sept. 13, 1985). See Rev. Rul. 95-8, 1995-1 C.B. 108 (short sale of publicly traded stock sold through broker does not create acquisition indebtedness. Following the rule of Deputy v. du Pont, 308 U.S. 488, 497-98 (1940), the IRS found that, for the purposes of §514, a short sale creates an obligation, but not indebtedness within the meaning of that section). See also Priv. Ltr. Rul. 9814-048 (Apr. 3, 1998) (indebtedness incurred by tax-exempt hospital cooperative service organization not attributed to exempt member hospital. Member thus did not have acquisition indebtedness, because it joined cooperative after debt was incurred, had no liability for repayment, and did not receive loan proceeds); Priv. Ltr. Rul. 96-37-053 (June 21, 1996) (gain from short sale transactions realized by an exempt retirement plan excluded from UBIT where stock was borrowed through and sold by plan’s broker and the proceeds from the sale, income on the proceeds, and margin deposit (made up of the organization’s own funds, stock, or government securities) were retained by the broker as collateral for the short sale transaction); Priv. Ltr. Rul. 96-19-077 (Feb. 15, 1996) (loan from tax-exempt lodge to related §501(c)(2) title holding company to finance repairs and improvements to ameliorate earthquake damage does not constitute acquisition indebtedness within the meaning of §514(c)). Priv. Ltr. Rul. 200041-038 (July 20, 2000) (LLC membership interests that provided “annual minimum return” were determined to be an equity interest in LLC and did not create acquisition indebtedness when issued by LLC in exchange for property); Priv. Ltr. Rul. 2000-10-061 (Dec. 17, 1999) (short-term borrowing by tax-exempt trust, when funds were used to make distributions to beneficiaries, did not give rise to acquisition indebtedness; borrowed funds were not used to make or carry any investments). §514(c)(1)(B); Reg. §1.514(c)-1(a)(1)(ii). §514(c)(1)(C); Reg. §1.514(c)-1(a)(1)(iii). Reg. §1.514(c)-1(a)(1).
䡲
452 䡲
c09.fm Page 453 Saturday, March 10, 2007 3:30 PM
9.2 DEBT-FINANCED PROPERTY
necessarily mean that the subsequent incurrence of indebtedness was not reasonably foreseeable.33 EXAMPLE: X, an exempt organization, pledges investment securities for a loan and uses the proceeds of the loan to purchase an office building that it leases to the public, a function that is not related to its exempt purpose. The outstanding principal indebtedness constitutes acquisition indebtedness incurred prior to the acquisition that would not have been incurred but for such acquisition.34 If a tax-exempt organization uses debt-financed property in a manner consistent with its exempt purpose, the indebtedness with respect to such property is not acquisition indebtedness.35 Nonetheless, if that property is later converted to a use that is not consistent with that organization’s exempt purpose, the indebtedness will be treated as acquisition indebtedness at the time the use is converted.36 EXAMPLE : In 1989 a university borrows funds to acquire an apartment building for married student housing. By 1993 student housing for this purpose is no longer needed. The university decides to rent the apartments to the general public. The amount of the outstanding indebtedness becomes acquisition indebtedness when the building is first rented to the public.37 Acquisition indebtedness includes indebtedness secured by a mortgage or similar lien, whether or not the exempt organization assumes the obligation or takes title to the property subject to the indebtedness.38 For this purpose, a lien is similar to a mortgage if title to the property is encumbered for the benefit of a creditor. These rules apply whether the property is acquired by purchase, gift, devise, bequest, or by other means. EXAMPLE: An exempt organization pays $50,000 for property valued at $150,000, subject to a $100,000 mortgage. The $100,000 of outstanding indebtedness is acquisition indebtedness in the same manner as if the organization had borrowed $100,000 to buy the property.39 An extension, renewal, or refinancing of an existing indebtedness is considered to be a continuation of the old indebtedness to the extent that the outstanding 33 34 35
36 37 38 39
Id. Reg. §1.514(c)-1(a)(2), Example 1. §514(c)(4); Reg. §1.514(c)-1(a)(3). See also Rev. Rul. 74-197, 1974-1 C.B. 143; S. Rep. No. 91-552, 91st Cong., 1st Sess. (1969); Southwest Tex. Elec. Coop. v. Commissioner, 68 T.C.M. (CCH) 285 (1994) (borrowed funds used to purchase Treasury notes not “substantially related” to exempt purpose of electric cooperative, even if interest earned on notes used for exempt purposes). aff’d, 67 F.3d 87 (5th Cir. 1995); Priv. Ltr. Rul. 2000-32-050 (May 16, 2000) (lease of facility to provide counseling, job training, and day care services to unemployed was “substantially related” to lessor’s exempt purpose of fostering employment and alleviating poverty); Priv. Ltr. Rul. 2000-30-027 (April 26, 2000) (operation of adjacent guest house was “substantially related to conference center’s exempt purpose); Reg. §1.514(c)-1(a)(3); §514(c)(4). Reg. §1.514(c)-1(a)(3). §514(c)(2)(A); Reg. §1.514(c)-1(b)(1). See also Priv. Ltr. Rul. 85-49-061 (Sept. 13, 1985). Reg. §1.514(c)-1(b)(1).
䡲
453 䡲
c09.fm Page 454 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
principal amount of the existing indebtedness is not increased.40 However, if the principal amount of the modified obligation exceeds the outstanding principal amount of the existing indebtedness the excess is treated as a separate indebtedness for purposes of IRC §514.41 If treated as separate indebtedness, the tests for acquisition indebtedness are applied de novo to that amount. Thus, a separate indebtedness will be treated as acquisition indebtedness only if it can be classified as such under §514(c)(1) of the Code.
9.3
THE §514(C)(9) EXCEPTION
An exception to acquisition indebtedness is provided in IRC §514(c)(9) for indebtedness incurred by a qualified organization in acquiring or improving real property.42 A qualified organization is defined in §514(c)(9)(C) as • An educational organization defined in IRC §170(b)(1)(A)(ii) and its affili-
ated support organizations43 • A qualified pension trust under IRC §401 • A title-holding company defined in IRC §501(c)(25)44
The exception provided in IRC §514(c)(9) is not available to a qualified organization if any of the following conditions exist: • The price for the acquisition or improvement is not a fixed amount deter-
mined as of the date of the acquisition or completion of the improvement (i.e., the purchase price cannot be dependent on revenue generated by the property)45 • The amount of any indebtedness or any other amount payable with
respect to the indebtedness, or the time for making any payment of any such amount, is dependent, in whole or in part, on the revenue, income, or profits derived from the real property (i.e., no contingent interest loans)46 • The real property, at any time after the acquisition, is leased by the quali-
fied organization to the seller or any person related to the seller as defined in IRC §267(b) or §707(b)47 • The real property is acquired by a qualified organization from a party
related to the qualified organization or is leased to a party related to the qualified organization 40 41 42 43
44
45 46 47
Reg. §1.514(c)-1(c)(1). Id. See generally Reg. §1.514(c)-2. A supporting organization that has close ties to a university, funds studies there, supports a specialized library, publishes a journal and supports other activities to promote study of certain foreign countries is a “qualified organization” under §514(c)(9)(C). Priv. Ltr. Rul. 200137061. However, a §501(c)(25) title-holding corporation is not eligible for the §514(c)(9)(E) exception for debt-financed property held by partnerships, discussed later, because a §501(c)(25) title-holding corporation may not hold indirect interests in real property. §514(c)(9)(B)(i). §514(c)(9)(B)(ii). §514(c)(9)(B)(iii).
䡲
454 䡲
c09.fm Page 455 Saturday, March 10, 2007 3:30 PM
9.4 PARTNERSHIP RULES
• The seller of the property, any person related to the seller, or any person
related to the qualified organization provides the qualified organization with any financing in connection with the acquisition or improvement (i.e., no seller financing).48 The Revenue Reconciliation Act of 1993 liberalized these rules significantly. The Revenue Act includes a provision allowing a qualified organization to lease back to the seller up to 25 percent of a debt-financed property, provided that the lease is on commercially reasonable terms and independent of the sale and other transactions between the parties.49 In addition, the Revenue Act of 1993 does not apply the fixed price requirement or the prohibition against participating loans50 to property acquired from a financial institution that had acquired the property by foreclosure51 or through a conservatorship or receivership,52 provided that any gain recognized by the selling financial institution is ordinary income.53 The amount of any participation, however, may not exceed 30 percent of the value of the property.54 The 1993 Act also permits seller financing, if the terms are commercially reasonable and independent of the sale and other transactions between the parties.55 With respect to seller financing, the existing fixed price and participating loan restrictions would continue to apply.
9.4
PARTNERSHIP RULES
Additional limitations are imposed on qualified organizations that invest in real property through partnerships that have as partners both qualified organizations and parties other than qualified organizations. These limitations apply to partnerships and to any other “pass-through” entities, including tiered partnerships. When a qualified organization is a partner in a partnership that holds real property subject to acquisition indebtedness, the debt-financed portion of the qualified organization’s income from the partnership will be subject to UBIT unless the partnership meets the exception provided in IRC §514(c)(9)(vi). This exception requires the partnership to meet one of three tests: 1. All partners must be qualified organizations. 2. Each allocation to a qualified organization must be a qualified allocation under IRC §168(h)(6)—that is, allocations that never vary (“Qualified Allocations Rule”). 3. The partnership meets the requirements of IRC §514(c)(9)(E) (the “Fractions Rule”).56 48 49 50 51 52 53 54 55 56
§514(c)(9)(B)(v). §514(c)(9)(G)(i) as amended by §13144(c)(2) of the 1993 Act. §514(c)(9)(H)(i) as amended by §13144(a) of the 1993 Act. §514(c)(9)(H)(iii). §514(c)(9)(H)(iii)(I) and (II). §514(c)(9)(H)(ii)(I). §514(c)(9)(H)(ii)(II) and (III). §514(c)(9)(G)(ii). See Reg. §1.514(c)-2(b).
䡲
455 䡲
c09.fm Page 456 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
These three tests operate to prevent the transfer of tax benefits from a qualified organization to a taxable partner. When all partners are qualified organizations, there is no potential for a transfer to taxable partners. Because allocations never vary under the Qualified Allocations Rule, taxable partners are prevented from receiving any tax benefits in greater proportion than their underlying interest in partnership capital.57 Under the Fractions Rule, discussed in detail below, allocations may vary but only within certain prescribed limits.
9.5
THE FRACTIONS RULE
The Fractions Rule of IRC §514(c)(9)(E) requires: • Allocations of items to any partner that is a qualified organization cannot
result in the qualified organization having a share of overall partnership income for any year greater than the qualified organization’s share of overall partnership loss for the year when the qualified organization’s loss year will be the smallest; that is, a qualified organization can never have income greater than its smallest share of loss.58 • All partnership allocations must have substantial economic effect under
IRC §704(b)(2).59 The function of the Fractions Rule is to prevent disproportionate income allocations to qualified organizations and disproportionate loss allocations to taxable partners. Qualified organizations generally do not mind receiving disproportionate income allocations if such income is not subject to UBIT, because income allocations increase their capital accounts, giving them a greater interest in liquidation proceeds. For purposes of the Fractions Rule, IRC §514(c)(9)(E) disregards contributed property allocations required by §704(c) of the Code, permits chargebacks for disproportionate losses previously allocated to qualified organizations and disproportionate income previously allocated to nonqualified organizations, and provides for reasonable preferred returns and guaranteed payments. IRC §514(c)(9)(E)(iii) authorized regulations to be prescribed to carry out the purposes of §514(c)(9)(E) of the Code, including provisions for the exclusion and segregation of items.
9.6 (a)
THE FINAL REGULATION Introduction
On June 25, 1990, the IRS issued Notice 90-41, 1990-1 C.B. 350 (“the Notice”), to provide interim guidance regarding the application of IRC §514(c)(9)(E), pending 57 58 59
See Priv. Ltr. Rul. 97-04-010 (Oct. 24, 1996) for an example of a partnership that satisfied the Qualified Allocations Rule. Reg. §1.514(c)-2(b)(1)(i). Reg. §1.514(c)-2(b)(1)(ii); §704; Reg. §1.704-1; Reg. §1.704-2. See generally “NYSBA Submits Report on Taxation of Pension Funds,” Tax Notes Today 97 (Feb. 20, 1997): 34–39, which discusses IRC §514(c)(9)(E) and the regulations thereunder.
䡲
456 䡲
c09.fm Page 457 Saturday, March 10, 2007 3:30 PM
9.6 THE FINAL REGULATION
the release of regulations. The Notice provided the relevant guidance in this area until the IRS issued Proposed Regulations on December 29, 1992 (the “Proposed Regulations”). Comments from various practitioners were considered, and the IRS issued Reg. §1.514(c)-2 (the “Final Regulations”) on May 13, 1994. The Final Regulations, like the Proposed Regulations, give certain general guidance about application of the Fractions Rule, reasonable preferred returns and guaranteed payments, and the exclusion of certain items from the Fractions Rule. The Final Regulations replace the guidance provided by the Notice and the Proposed Regulations and resolves some of the issues pertaining to proper application of the Fractions Rule. A partnership must satisfy the Fractions Rule both on a prospective basis and on an actual basis, commencing in the first taxable year of the partnership in which the partnership holds debt-financed real property and has a qualified organization as a partner.60 If a partnership agreement is subsequently changed in a manner that causes the partnership to violate the Fractions Rule, the partnership will have UBIT only for the taxable year of the change and subsequent years, but not for prior taxable years.61 (b)
Overall Partnership Income and Loss
Overall partnership income and loss is defined as [T]he amount by which the aggregate items of partnership income and gain for the taxable year exceed the aggregate items of partnership loss and deduction for the year. Overall partnership loss is the amount by which the aggregate items of partnership loss and deduction for the taxable year exceed the aggregate items of partnership income and gain for the year.62
(c)
Exceptions to the Fractions Rule for Preferred Returns and Guaranteed Payments
Certain income or loss allocations are excluded for purposes of the Fractions Rule. In this regard, allocations for reasonable preferred returns and guaranteed payments are excluded from the Fractions Rule if certain requirements are satisfied.63 To qualify for the exception, however, a preferred return or guaranteed payment must be set forth in a binding, written partnership agreement.64 (i) Preferred Returns. Items of income (including gross income) that may be allocated to a partner with respect to a current or cumulative reasonable preferred return for capital (including allocations of minimum gain attributable to nonrecourse or partner nonrecourse liability proceeds distributed to the partner as a reasonable preferred return) are disregarded in computing overall partnership income or loss for purposes of the Fractions Rule.65 The exception 60 61 62 63 64 65
Reg. §1.514(c)-2(b)(2)(i). Reg. §1.514(c)-2(b)(2)(ii). Reg. §1.514(c)-2(c)(1). Reg. §1.514(c)-2(d)(1) and (2). Reg. §1.514(c)-2(d)(1). Reg. §1.514(c)-2(d)(2).
䡲
457 䡲
c09.fm Page 458 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
for reasonable preferred returns also applies to allocations “of what would otherwise be overall partnership income.”66 The Final Regulation added this language because the exclusion of an item of income for purposes of the Fractions Rule means that the item will not be available to be included as overall partnership income.67 (ii) Guaranteed Payments. A current or cumulative reasonable guaranteed payment to a partner for capital or services is treated as an item of deduction in computing overall partnership income or loss, and the income that the partner may receive or accrue from the current or cumulative reasonable guaranteed payment is not treated as an allocable share of overall partnership income or loss.68 The treatment of a guaranteed payment as reasonable for purposes of IRC §514(c)(9)(E) does not affect its possible characterization as UBIT under other provisions.69 (iii) “Reasonable” Amount Safe Harbor. In general, a guaranteed payment for services is “reasonable” only to the extent that the amount of the payment is reasonable under Reg. §1.162-7 (relating to the deduction for payments for personal services).70 A preferred return or guaranteed payment for capital is reasonable only to the extent that it is computed, with respect to unreturned capital, at a rate that is commercially reasonable based on the relevant facts and circumstances.71 Under a safe harbor provision, however, a rate will be deemed to be commercially reasonable if it is no more than four percentage points above, or if it is no greater than 150 percent of, the highest long-term applicable federal rate (AFR) under IRC §1274(d) for the month the partner’s right to a preferred return or guaranteed payment is first established, or for any month in the partnership taxable year for which the return or payment on capital is computed.72 In addition, a greater rate may be commercially reasonable if the relevant facts and circumstances so indicate.73 (iv) Unreturned Capital. All relevant circumstances are taken into account in determining whether a distribution constitutes a return of capital.74 Moreover, because capital may be returned from a number of sources, a designation of distributions in a written partnership agreement generally will be respected in determining a partner’s unreturned capital, so long as the designation is economically reasonable.75
66 67 68 69 70 71 72 73 74 75
Id. See Introduction to Treasury Decision 8539 (May 13, 1994), §III.C (hereinafter referred to as “Intro to TD 8539”). Reg. §1.514(c)-2(d)(3). Id; see generally Section 8.3 with regard to application of the unrelated business income tax. Reg. §1.514(c)-2(d)(4)(i). Id. Reg. §1.514(c)-2(d)(4)(ii). Id. Reg. §1.514(c)-2(d)(5)(ii). Id.
䡲
458 䡲
c09.fm Page 459 Saturday, March 10, 2007 3:30 PM
9.6 THE FINAL REGULATION
(v) Timing Rules. To be excluded from the Fractions Rule, certain rules regarding the timing of payment of preferred returns and guaranteed payments must be satisfied. (A) P REFERRED R ETURNS With regard to preferred returns, the Final Regulation follows the Proposed Regulation by applying a “cash before accrual” procedure, which, in general, requires that when a current cash distribution is made in a year in which there is not sufficient income to make a corresponding allocation, an allocation of income may be made in a subsequent year to match the earlier distribution without violating the Fractions Rule.76 Items of income or gain (or part of what would otherwise be overall partnership income) that are allocated to a partner for a taxable year with respect to a reasonable preferred return are disregarded for purposes of the Fractions Rule only to the extent that the amount does not exceed • The aggregate amount that has been distributed to such partner as a rea-
sonable preferred return for the taxable year of the allocation and all prior taxable years on or before the due date (not including extensions) for filing the partnership’s return for the taxable year of the allocation, minus • The aggregate amount of corresponding income and gain (and what
would otherwise be overall partnership income) allocated to such partner in all prior years77 The problem with this approach is that it does not permit the partnership to adopt an “accrual before cash” method. A partnership is prohibited from allocating income in a year before cash distributions are expected unless the cash will be paid on or before the due date (not including extensions) for filing the partnership’s return for the taxable year of the allocation. This situation can cause problems when a partnership has income, but no current cash flow—that is, from original issue discount or cancellation of indebtedness.78 This limitation could also be relevant when a partnership has income but wishes to use its cash for capital improvements or to establish reserves.79 In such a situation, a partnership could be forced to borrow funds to make a current cash distribution in compliance with the Fractions Rule.80 The cash payment requirement has been criticized as a significant limitation on the exception for preferred returns and guaranteed payments.81 Some observers believe that this mandate may prevent partners from achieving their economic deal—that is, a partnership may not have sufficient cash in its early years to make a preferred return. Nevertheless, the IRS refused to back away from this 76
77 78 79 80 81
See Hirschfeld, “Pension Fund Investors in Real Estate Partnerships: Recent IRS Relief from Possible Taxation,” Real Estate Tax Digest (Mar. 1993): 53, 57 (author provides several insightful comments and criticisms with respect to the Proposed Regulation). (hereinafter “Hirschfeld”). Reg. §1.514(c)-2(d)(6)(i). See Hirschfeld at 57. Id. Id. See Introduction to TD 8539, §III.C.
䡲
459 䡲
c09.fm Page 460 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
requirement because it believed that if it did not exist, partnerships could attempt to maximize their overall economics by allocating significant amounts of partnership income to qualified organizations in the form of preferred returns and guaranteed payments.82 EXAMPLE: Qualified organization (QO), and taxable corporation (TP) form a partnership. QO contributes $9,000, and TP contributes $1,000. The partnership borrows $55,000 from a third-party lender. At all relevant times the safe harbor rate is 10 percent.83 The partnership agreement provides that in each taxable year the partnership’s “distributable cash” is first to be distributed to QO as a 10 percent preferred return on its unreturned capital. To the extent the partnership has insufficient cash to pay QO its preferred return in any taxable year, the preferred return is compounded (at 10 percent) and is to be paid in future years to the extent the partnership has distributable cash. The partnership agreement first allocates gross income and gain 100 percent to QO, to the extent that cash has been distributed to QO as a preferred return. All remaining profit or loss is allocated 50 percent to QO and 50 percent to TP. The partnership satisfies the Fractions Rule. Items of income and gain that may be allocated to QO with respect to its preferred return are disregarded in computing overall partnership income or loss for purposes of the Fractions Rule, because the rate of the preferred return is within the safe harbor and the other requirements of Reg. §1.514(c)-2(d).84 After those allocations are disregarded, QO’s Fractions Rule percentage is 50 percent, and under the partnership agreement QO may not be allocated more than 50 percent of overall partnership income in any taxable year. (B) G UARANTEED P AYMENTS To be excluded from the Fractions Rule, the partnership must deduct a reasonable guaranteed payment to a partner no earlier than the taxable year in which it is paid.85 In this respect, the normal rules of accrual accounting do not apply. The deduction for a reasonable guaranteed payment is delayed until the partnership taxable year in which the payment is made in cash. For this purpose, however, a guaranteed payment that is paid in cash on or before the due date (not including extensions) for filing the partnership’s return for a taxable year may be treated as paid in that prior taxable year.86 If a deduction for a reasonable guaranteed payment is delayed until the year in which the payment is made in cash, the payment is not included in the receiving partner’s income until the later year of payment. The existing rule under Reg. §1.707(c), that a guaranteed payment is included in income in the same taxable year in which it is deducted by the partnership that makes the payment, continues to apply in all circumstances.87 82 83 84 85 86 87
Id. For purposes of this example, assume that all allocations in the partnership agreement satisfy the requirements of §514(c)(9)(E)(i)(II) of the Code. See Reg. §1.514(c)-2(d)(7), Example 1. Reg. §1.514(c)-2(d)(6)(ii). Id. See Introduction to TD 8539, §III.C.
䡲
460 䡲
c09.fm Page 461 Saturday, March 10, 2007 3:30 PM
9.6 THE FINAL REGULATION
EXAMPLE: The partnership agreement allocates all bottom-line partnership income and loss 50 percent to QO and 50 percent to TP throughout the life of the partnership. The partnership agreement further provides that QO is entitled each year to a 10 percent guaranteed payment on unreturned capital. To the extent the partnership is unable to make a guaranteed payment in any taxable year, the unpaid amount will be compounded at 10 percent and paid in future years. Assuming that the guaranteed payment is deducted no earlier than the taxable year in which it is paid to QO in cash (or paid in cash on or before the due date (not including extensions) for filing the partnership’s return for that year), the partnership satisfies the Fractions Rule. The guaranteed payment is disregarded for purposes of the Fractions Rule because it is computed with respect to unreturned capital at the safe harbor rate. Accordingly, the guaranteed payment is treated as an item of deduction in computing overall partnership income and loss, and the corresponding income that QO may receive or accrue with respect to the guaranteed payment is not treated as an allocable share of overall partnership income or loss. QO’s Fractions Rule percentage, therefore, is 50 percent, and under the partnership agreement QO may not be allocated more than 50 percent of overall partnership income in any taxable year.88 (d)
Chargebacks and Offsets
Exceptions are provided for four types of chargebacks and offsets: 1. Allocations of overall partnership income that may be made to charge back prior disproportionately large allocations of overall partnership loss to a qualified organization and allocations of overall partnership loss that may be made to charge back prior disproportionately small allocations of overall partnership income to a qualified organization89 2. Allocations of income and gain that may be made to a partner pursuant to a minimum gain chargeback attributable to prior allocations of nonrecourse deductions to such partner90 3. Allocations of income and gain that may be made to a partner pursuant to a minimum gain chargeback attributable to prior allocations of partner nonrecourse deductions to such partner and allocations of income and gain that may be made to other partners to charge back compensating allocations of other losses, deductions, and IRC §705(a)(2)(B) expenditures91 4. Allocations of items of income or gain that may be made to a partner pursuant to a qualified income offset within the meaning of Reg. §1.704(b)(2)(ii)(d)92 (i) Disproportionate Allocations. Prior disproportionate allocations are to be reversed in full or in part, and in any order, but they must be reversed in the 88 89 90 91 92
See Reg. §1.514(c)-2(d)(7), Example 2. Reg. §1.514(c)-2(e)(1)(i). Reg. §1.514(c)-2(e)(1)(ii). Reg. §1.514(c)-2(e)(1)(iii). Reg. §1.514(c)-2(e)(1)(iv).
䡲
461 䡲
c09.fm Page 462 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
same ratio as originally made.93 For example, a partnership may charge back income to a qualified organization at a rate greater than its Fractions Rule percentage if prior losses had been allocated to that qualified organization at a rate greater than its Fractions Rule percentage, but income can be charged back at a rate no greater than the rate at which those prior losses were allocated. A prior allocation is deemed to be disproportionately large if the qualified organization’s percentage share of that allocation exceeds its Fractions Rule percentage.94 A prior allocation, however, will not be considered disproportionate unless the balance of the overall partnership income or loss for the taxable year of the allocation is allocated in a manner that would independently satisfy the Fractions Rule.95 In other words, the portion of overall partnership income or loss for a taxable year that is not allocated as part of the disproportionate allocation must be allocated in compliance with the Fractions Rule.96 (ii) Minimum Gain Chargebacks Attributable to Nonrecourse Deductions. To qualify for the exception from the Fractions Rule, a minimum gain chargeback (or a partner nonrecourse debt minimum gain chargeback) to a partner must be attributable to nonrecourse deductions (or separately, on a debt-by-debt basis, to partner nonrecourse deductions) in the same proportion that the partner’s percentage share of the partnership minimum gain (or separately, on a debt-by-debt basis, the partner nonrecourse debt minimum gain) at the end of the immediately preceding taxable year is attributable to nonrecourse deductions (or partner nonrecourse debt minimum gain).97 The partnership is required to determine the extent to which a partner’s percentage share of the partnership minimum gain (or partner nonrecourse debt minimum gain) is attributable to deductions in a reasonable or consistent manner.98 For example, a partner’s percentage share of the partnership minimum gain is generally attributable to nonrecourse deductions in the same ratio that (1) the aggregate amount of the nonrecourse deductions previously allocated but not charged back to the partner in prior taxable years bears to (2) the amount described in clause (1), plus the aggregate amount of the distributions previously made to the partner of proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain but not charged back in prior taxable years.99 (iii) Chargebacks Attributable to the Distribution of Nonrecourse Liability Proceeds. Allocations of items of income and gain that may be made pursuant to a partnership agreement provision that charges back minimum gain attributable 93 94 95 96
97 98 99
Reg. §1.514(c)-2(e)(2). Id. Id. When preparing the Final Regulations, the IRS considered a proposal to permit all chargebacks without regard to whether the initial allocation was “disproportionate.” This position was rejected because it was not compatible with the mechanical approach of the Proposed Regulations which, the IRS believes, is relatively simple for taxpayers to apply and for the IRS to administer and enforce. See Intro to TD 8539, §III.D. Reg. §1.514(c)-2(e)(3). Id. Id. This example applies in those situations where none of the exceptions contained in Reg. §1.704-2(f)(2)-(5) are relevant.
䡲
462 䡲
c09.fm Page 463 Saturday, March 10, 2007 3:30 PM
9.6 THE FINAL REGULATION
to the distribution of nonrecourse (or partner nonrecourse) liability proceeds are excepted from the Fractions Rule to the extent that an allocation is made.100 In addition, the Final Regulation adds a limited new chargeback for items of income or gain that may be made to a partner pursuant to a minimum gain chargeback attributable to the distribution of a nonrecourse liability.101 Such a chargeback is disregarded in computing overall income or loss for purposes of the Fractions Rule only to the extent that prior disproportionately large allocations of overall partnership loss made to a qualified organization are charged back at the same time.102 This new exception applies only to the extent that the disproportionately large allocation consisted of depreciation from real property (other than items of nonrecourse deduction or partner nonrecourse deduction) that was subsequently used to secure the nonrecourse liability providing the distributed proceeds, and only if those proceeds were distributed as a return of capital and in the same proportion as the disproportionately large allocation.103 The new chargeback applies only if the partners that are qualified organizations initially contributed capital that was used to purchase depreciable real property and are allocated the resulting depreciation deductions.104 If the partnership later borrows money on a nonrecourse basis (using that depreciable real property as security) and distributes the proceeds to the qualified organization partners as a return of capital, the resulting minimum gain chargeback is permanently disregarded in computing overall partnership income or loss for purposes of the Fractions Rule. In the absence of this special rule, the distribution of nonrecourse proceeds and the resulting minimum gain chargeback may cause a violation of the Fractions Rule in the year the minimum gain is triggered. 105 This exception allows the partnership to apply the general chargeback rule for nonrecourse deductions (rather than the general chargeback rule for nonrecourse distributions) even though the initial depreciation deductions allocated to the qualified organization partners were not nonrecourse.106 (e)
Partner-Specific Items of Deduction
A partnership may make a special allocation of some expenditures that are attributable to some but not all partners. This permits an allocation to those partners who bear the economic effect of the allocation without violating the Fractions Rule. In this regard, the following are excluded: • Expenditures for additional record keeping and accounting incurred in
connection with the transfer of a partnership interest107 • Additional administrative costs that result from having a foreign partner 100 101 102 103 104 105 106 107
Reg. §1.514(c)-2(e)(4)(i). Reg. §1.514(c)-2(e)(4)(ii). The chargeback of items of income or gain to a partner must be made in accordance with Reg. §1.704-2(f)(1). Reg. §1.514(c)-2(e)(4)(ii). Id. See Introduction to TD 8539, §III.D. Id. Id. Expenditures incurred in computing basis adjustments under §743(b) of the Code also are included here. See Reg. §1.514(c)-2(f).
䡲
463 䡲
c09.fm Page 464 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
• State or local taxes or expenditures relating to those taxes • Expenditures designated by the IRS by revenue ruling, revenue proce-
dure, or, on a case-by-case basis, by letter ruling108 To be excluded, the deductions generated by these expenditures must be allocated to the partners to whom they are attributable.109 (f)
Unlikely Losses and Deductions
It should be noted that the Treasury Regulations under IRC §704(b) do not override the Fractions Rule. The Fractions Rule stands alone and is a higher standard that must be met by partnerships that have partners who are qualified organizations. The exclusion for “unlikely” losses allows a partnership to comply with the regulations under §704(b) in situations when large unforeseen losses arise from circumstances such as tort claims or property damage in excess of insurance. The Notice indicated that the Proposed Regulations would provide that an allocation could be excluded from the Fractions Rule when an unlikely event occurs. The Final Regulations also exclude from the determination of whether the Fractions Rule is satisfied, any allocation for a partnership tax year of items of loss or deduction (other than nonrecourse deductions) that may be made to partners other than qualified organization partners if the loss or deduction is unlikely and the principal purpose of the allocation is not tax avoidance.110 A loss or a deduction is unlikely only if it has a low likelihood of occurring, after all relevant facts, circumstances, and information available to the partners are taken into account.111 Examples of situations that may give rise to unlikely losses or deductions, depending on the particular facts and circumstances, are unanticipated labor strikes, abnormal weather conditions (considering the season and the job site), significant delays in leasing property because of an unanticipated severe economic downturn in the geographic area, and unanticipated cost overruns.112 In response to a comment, the discovery of environmental conditions that require remediation was added to the Final Regulations as an example of an unlikely event.113 It should be emphasized that these events are not per se unlikely. Their inclusion is meant to illustrate possible situations in which the exception for unlikely losses and deductions may apply.114 No inference is to be drawn as to whether a loss or deduction is unlikely from the fact that the partnership agreement contains a provision allocating that loss or deduction.115
108 109 110 111 112 113 114 115
Reg. §1.514(c)-2(f). Id. Reg. §1.514(c)-2(g). Id. Id. See Introduction to TD 8539, §III.F. Id. Id.
䡲
464 䡲
c09.fm Page 465 Saturday, March 10, 2007 3:30 PM
9.6 THE FINAL REGULATION
CAVEAT Practitioners familiar with partnership arrangements predict difficulties in the application of the “unlikely” allocation standard, as it is hard to know at the outset whether it is unlikely that a loss will occur or a deduction will be made. This may raise problems in structuring deals. (g)
De Minimis Rules
(i) De Minimis Interests. An exception is provided for de minimis partnership interests, pursuant to which IRC §514(c)(9)(B)(vi) does not apply to a partnership otherwise subject to that section if • Qualified organizations do not hold in the aggregate interests of greater
than 5 percent in the capital or profits of the partnership, and • Taxable partners own substantial interests in the partnership through
which they participate in the partnership on substantially the same terms as the qualified organization partners.116 The Final Regulation added the following example to demonstrate the exception for de minimis interests: Partnership PRS has two types of limited partnership interests that participate in partnership profits and losses on different terms. Qualified organizations (QOs) only own one type of limited partnership interest and own no general partnership interests. In the aggregate, the QOs own less than five percent of the capital and profits of PRS. Taxable partners also own the same type of limited partnership interest that the QOs own. These limited partnership interests owned by the taxable partners are thirty percent of the capital and profits of PRS. Thirty percent is a substantial interest in the partnership. Therefore, PRS satisfies the de minimis exception117 and IRC §514(c)(9)(B)(vi) does not apply.118
(ii) De Minimis Allocations. In addition to the de minimis exception for partnerships, an exception for de minimis allocations is provided, pursuant to which a qualified organization’s Fractions Rule percentage of items of loss and deduction that are allocated to other partners in any taxable year will be treated as having been allocated to the qualified organization for purposes of the Fractions Rule if • The allocation was neither planned nor motivated by tax avoidance, and • The total amount of the items of partnership loss or deduction is less than
both (a) 1 percent of the partnership’s aggregate items of gross loss and deduction for the taxable year and (b) $50,000.119
116 117 118 119
Reg. §1.514(c)-2(k)(2)(i)(A). Reg. §1.514(c)-2(k)(2)(i)(B). Reg. §1.514(c)-2(k)(2)(ii). Reg. §1.514(c)-2(k)(3). The Final Regulation uses the “total amount” allocated to test the limit for de minimis allocations. Under the Proposed Regulation, the amount allocated to qualified organization partners had been the standard.
䡲
465 䡲
c09.fm Page 466 Saturday, March 10, 2007 3:30 PM
DEBT-FINANCED INCOME
The exception for de minimis allocations is intended to provide relief from what would otherwise be minor inadvertent violations of the Fractions Rule120— such as, for example, when a plumber’s bill is paid directly by a taxable partner, or is paid by the partnership but is overlooked until after the partnership’s allocations have been computed and then is allocated entirely to the taxable partner.121 It is the IRS’s view that this exception was not intended to be used routinely by partnerships to allocate some of the partnership’s losses and deductions to taxable partners.122 This is why the total amount to which the exception applies is limited to an amount that is less than both $50,000 and 1 percent of the partnership’s total losses and deductions. (h)
Anti-Abuse Rule
The Anti-Abuse Rule was clarified in the Final Regulations. The revised rule states that the Fractions Rule is designed to prevent tax avoidance by limiting the permanent or temporary transfer of tax benefits from tax-exempt partners to taxable partners, whether by directing income or gain to tax-exempt partners; by deducting losses, deductions, or credits to taxable partners; or by some other similar means.123 (i)
Tiered Partnerships
If a qualified organization holds an indirect interest in real property through one or more tiers of partnerships, the Fractions Rule will be satisfied only if • The avoidance of tax is not a principal purpose for investing in the tiered-
ownership structure124 • The relevant partnerships can demonstrate that the Fractions Rule is satis-
fied under any reasonable method125 (j)
Effective Date
The Final Regulations are generally effective with respect to partnership agreements entered into after December 30, 1992, property acquired by partnerships after December 30, 1992, and partnership interests acquired by qualified organizations after December 30, 1992.126 This effective date is the same as that contained in the Proposed Regulations. 120 121 122 123 124
125 126
See Introduction to TD 8539, §III.H. Id. Id. Reg. §1.514(c)-2(k)(4). For this purpose, investing in separate real properties through separate partnerships or chains of partnerships, so that Code §514(c)(9)(E) is applied on a property-by-property basis, is not in and of itself a tax avoidance purpose. Reg. §1.514(c)-2(m)(1). Reg. §1.514(c)-2(m)(1). Reg. §1.514(c)-2(n)(2). For periods after June 24, 1990, and prior to December 30, 1992, the Final Regulation must be satisfied as of the first day that §514(c)(9)(E) applies with respect to the partnership, property, or the acquired interest. Reg. §1.514(c)-2(n)(3). For periods after October 13, 1987, and prior to June 24, 1990, the IRS will not challenge an interpretation of §514(c)(9)(E) that is reasonable in light of the underlying purpose of the section (as reflected in legislative history) and is consistently applied with respect to the partnership, property, or acquired interest. Reg. §1.514(c)-2(n)(4).
䡲
466 䡲
c09.fm Page 467 Saturday, March 10, 2007 3:30 PM
9.7 THE FRACTIONS RULE: A TRAP FOR THE UNWARY
9.7
THE FRACTIONS RULE: A TRAP FOR THE UNWARY
IRC §514(c)(9)(E) is a very complex provision. It is a classic “trap for the unwary.” An innocent mistake in drafting allocation provisions of a partnership agreement may create an unexpected UBIT liability for a qualified organization. However, the Final Regulations are helpful in many respects and clarify some of the issues that have been around since §514(c)(9)(E) was enacted, such as the proper treatment of chargebacks, preferred returns, and guaranteed payments.127 Nevertheless, the exceptions to the Fractions Rule do nothing to facilitate investment in real estate. Qualified organizations are an important source of real estate financing, especially with the instability of the financed marketplace. Accordingly, technical barriers to a qualified organization’s investment in real estate should be diminished, not increased. With this in mind, it is necessary to question whether the restrictions of IRC §514(c)(9)(vi) are needed any longer. Because of amendments to the Code over the past decade, the opportunity to transfer tax benefits from tax-exempt to taxable partners is not as great as it once was. The period for depreciating real estate has been lengthened, the at-risk rules have been extended to real estate, and the alternative minimum tax has been strengthened. The substantial economic effect requirements under the §704(b) regulations also frustrate the transfer of tax benefits to taxable partners.
127
The Section of Taxation of the American Bar Association has recommended the repeal of §514(c)(9)(E). Among the reasons stated for this position is that “[t]he provision has become a trap for the unwary as well as a tremendous source of planning complexity even for those familiar with it. Anecdotal evidence suggests that few practitioners understand the provision completely, and almost no IRS agents or auditors raise it as an issue on audits.” Tax Notes 88 (Sept. 18, 2000): 1531, 1536 (statement of Pamela F. Olson before the House Small Business Committee’s Tax, Finance and Exports Subcommittee on September 7, 2000).
䡲
467 䡲
c10.fm Page 468 Saturday, March 10, 2007 3:32 PM
C H A P T E R
T E N 10
Limitation on Excess Business Holdings 10.1
INTRODUCTION
All charitable organizations are divided into two general categories: public charities (such as hospitals, churches, nonprofit schools, and publicly supported organizations) and private foundations.1 Private foundations are charities that receive their primary financial support from a few individuals or corporations or from income earned by their own large endowments. Public charities and private foundations, including those entities participating in joint ventures, are subject to the same general tax law requirements: They must be operated primarily for public as opposed to private purposes, their earnings and assets cannot be used to benefit private persons, and they cannot engage in any political activity. Public charities, however, may conduct an insubstantial amount of lobbying activity.2 Stringent though these general rules may appear, private foundations are subject to additional onerous standards: Private foundations must pay a tax on their net investment income, they cannot engage in any lobbying, they cannot undertake the simplest of commercial transactions with certain disqualified persons, they must distribute specified amounts for charity each year, their investments must meet strict standards of prudence, their grant-making procedures must be fair to all prospective candidates, and they must not own more than a minority interest in any business. Infractions of these rules are punished by the imposition of stiff excise taxes on the foundation and, in some cases, on the managers of the foundation. This chapter discusses a foundation’s permissible ownership interest in a joint venture and the consequences of excess business holdings.
1 2
§509(a); Reg. §1.509(a)-1. See Chapter 2. See also §501(c)(3); Reg. §1.503(c)(3)-1.
䡲
468 䡲
c10.fm Page 469 Saturday, March 10, 2007 3:32 PM
10.2 EXCESS BUSINESS HOLDINGS: GENERAL RULES
CAVEAT Even though a private foundation may satisfy the excess business holdings requirements, it is cautioned that the foundation must still satisfy the doubleprong test of the Plumstead doctrine and Rev. Rul. 98-15 in order to remain an exempt organization.* *
See Section 4.2(c).
EXAMPLE: An individual who is a general partner in a number of rental real estate projects passes away. The decedent has bequeathed his general partnership interests to a family private foundation created under his will. The foundation is not subject to the excess business holdings rules under IRC§4943, because the partnership investment is not in a “business enterprise” (which does not include a trade or business, at least 95.
10.2
EXCESS BUSINESS HOLDINGS: GENERAL RULES
Generally, a private foundation is penalized through the imposition of an excise tax if the foundation has excess business holdings in a business enterprise.3 A private foundation is defined as an IRC §501(c)(3) charitable organization other than the following four types of organizations: 1. An organization that is a church, a hospital, a broadly supported public entity, a government-supported organization, or an educational organization; 2. An organization that normally receives more than one-third of its annual support from gifts, grants, contributions, membership fees, and receipts from admissions and sales of merchandise from persons other than disqualified persons, and normally does not receive more than one-third of its support from gross investment income in each taxable year. 3. An organization that is operated, supervised, or controlled by an exempt organization; and 4. An organization that is organized and operated exclusively for testing for public safety.4 Excess business holdings are generally determined with reference to the foundation’s own holdings and the holdings of all “disqualified persons.” On August 3, 2006, Congress passed the Pension Protection Act of 2006.5 Title XII of the Act contains 24 provisions affecting tax-exempt organizations, including significant sections on new excise taxes on certain types of charitable organizations such as donor advised funds. Section 1233 of the Act defines 3 4 5
§4943(a)(1); Reg. §53.4943-1. §509(a); Reg. §1.509(a)-1. Pub. Law 109–280, August 17. 2006.
䡲
469 䡲
c10.fm Page 470 Saturday, March 10, 2007 3:32 PM
LIMITATION ON EXCESS BUSINESS HOLDINGS
“donor-advised fund”6 and “supporting organization” in a very broad manner, including where a donor “could reasonably expect to” have his advice considered by an organization sponsoring a fund on a decision about where to re-grant the donor’s funds. Notably, §1233 applies the §4943 excess business holdings limitations, the §4958 intermediate sanctions excess benefit transaction tax, and other rules on donor-advised funds, supporting organizations, their donors, and their managers.7 The combined holdings of a private foundation and all disqualified persons in any joint venture, partnership, or corporation, which are not substantially related (aside from the need of the foundation for income or funds or the use it makes of the profits derived) to the exempt purposes of the foundation, are limited to 20 percent of the voting stock or profits interest.8 A 10 percent initial tax will be imposed, and an additional tax of 200 percent of the value of such excess holdings will be imposed, if the excess business holdings are not disposed of within a “correctional period.”9 Excess business holdings are the holdings of a private foundation in any business enterprise10 that exceed the amount of permitted holdings.11 Permitted holdings in a joint venture or other entity are limited to 20 percent of the profits interest in the case of a joint venture, or 20 percent of all voting stock in a corporation.12 However, the 20 percent requirement is reduced by the percentage of voting stock owned by disqualified persons.13 EXAMPLE: If a disqualified person owns 15 percent of voting stock, the foundation may not own voting stock in the same enterprise in excess of 5 percent. Likewise, any amount of nonvoting stock is a permitted holding of a private foundation if disqualified persons do not hold more than 20 percent of the voting stock, actually or constructively.14
6
7 8 9 10
11 12
13 14
Donor-advised funds are charitable organizations that operate by collecting donations from supporters who then advise the charity as to who should receive aid. Donor-advised funds have garnered a great deal of scrutiny in the aftermath of widespread reports of abuses of these organizations. For example, in some notable cases, supporters of donor-advised funds have claimed charitable deductions for contributions to donor-advised funds, and then directed the funds to their own use, as in fulfilling existing charitable gift pledges to organizations. See IRC §4943(e). Reg. §53.4943-1. Section 1212(c) of the Pension Protection Act of 200 increased the initial tax imposed under IRC §4943 from 5 percent to 10 percent. A business enterprise does not include a functionally related business defined in §4942(j)(4), or any trade or business of which at least 95 percent of the gross income is derived from passive sources. §4943(d)(3). See generally Priv. Ltr. Rul. 93-25-046 (Mar. 29, 1993). §4943(c); Reg. §53.4943-3(a)(1). See also Priv. Ltr. Rul. 93-20-052 (Feb. 25, 1993); Priv. Ltr. Rul. 93-25-046 (Mar. 29, 1993); Priv. Ltr. Rul. 93-06-035 (Nov. 20, 1992). §4943(c)(1); Priv. Ltr. Rul. 93-20-052 (Feb. 25, 1993). The Code provision is stated in terms relating to a corporation. However, permitted holdings apply to other unincorporated businesses, but the term “profits interest” is substituted for “voting stock” in the case of a partnership or joint venture, and “beneficial interest” for trusts and all other cases. §4943(c)(3); Reg. §53.4943-3(b)(4); Gen. Couns. Mem. 39,195 (Mar. 15, 1984). §4943(c)(1). Priv. Ltr. Rul. 93-20-052 (Feb. 25, 1993); §4943(c)(2)(A). See Gen. Couns. Mem. 39,195 (Mar. 15, 1984).
䡲
470 䡲
c10.fm Page 471 Saturday, March 10, 2007 3:32 PM
10.2 EXCESS BUSINESS HOLDINGS: GENERAL RULES
A 35 percent test is substituted for 20 percent if the foundation and all disqualified persons own no more than 35 percent of voting stock (or other interest) and the nondisqualified persons are in “effective control”15 of the enterprise.16 Effective control by one or more unrelated third parties must be affirmatively established by the foundation. A foundation cannot satisfy the effective control standard merely by showing that its disqualified persons do not exercise control over the business enterprise.17 Excess business holdings rules have had previously unforeseen application in the area of whole hospital joint ventures.18 For example, assume that a charitable institution whose only activity is ownership and operation of a hospital enters into a joint venture with a for-profit healthcare organization, in which both would contribute a hospital to the joint venture, share in the profits, and so forth. Assuming that the organization can maintain its exempt status, it may have significant difficulty in meeting its public support requirements. Should the public support tests not be met, the charity would become a private foundation, and thus subject to the excess business holdings limitations (20 or 35 percent interest). As a 50 percent partner, the organization could arguably be required to immediately divest at least 15 percent of its joint venture interest.19 However, in Rev. Rul. 98-15, the IRS looked at the classification of a hospital that transferred all of its assets to a limited liability company (LLC). Prior to the transfer the hospital had, as its principal purpose or function, the provision of medical or hospital care. After contributing all of its operating assets to the LLC, the exempt organization had at least two potential sources of revenue. One was its allocable distribution of earnings from the LLC. The other was the earnings from the investment of any funds received from the distributions of the LLC. The IRS concluded that by participating in the creation of the LLC and contributing all of 15
16 17
18 19
“Effective control” is defined as the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise. Reg. §53.4943-3(b)(3)(ii). See Chapter 12 for a more in-depth discussion of whole hospital joint ventures and their impact on the status of participating organizations. §4943(c)(2)(B). See also Rev. Rul. 81-111, 1981-1 C. B. 509; Priv. Ltr. Rul. 84-07-095 (Nov. 17, 1983). See Rev. Rul. 81-111, 1981-1 C.B. 509. The IRS ruled that a private foundation had excess business holdings in a corporation because the foundation could not affirmatively establish “effective control” by one or more third parties. The foundation and its disqualified persons held an aggregate minority interest of 35 percent of the corporation’s voting stock. The remaining 65 percent of the corporation’s voting stock was held by a large group of individuals, none of whom was a disqualified person with respect to the foundation. The large group of individuals did not have a voting trust, contractual agreement, or other similar agreement among them relating to their stock voting rights. None of the individuals alone had sufficient stock holdings to direct the management and policies of the corporation, nor had one of these individuals historically elected the majority of the corporation’s board of directors. However, because the foundation could not show that the corporation was effectively controlled by one or more third parties, such as this large group of individuals, the foundation’s permissible interest in the corporation was limited to 20 percent. See also Priv. Ltr. Rul. 84-07-095 (Nov. 17, 1983) (the IRS looked to state law and determined that the foundation, which was a limited partner, did not have “effective control” of the general partner of the limited partnership. Under state law, limited partners could not exercise control over the partnership, and, therefore, the general partner was responsible for the operation of the limited partnership); Priv. Ltr. Rul. 92-50-039 (Sept. 16, 1992). See Section 12.3. Rev. Rul. 98-15, 1998-12 I.R.B.6 (Mar. 23, 1998).
䡲
471 䡲
c10.fm Page 472 Saturday, March 10, 2007 3:32 PM
LIMITATION ON EXCESS BUSINESS HOLDINGS
its operating assets to the LLC, the exempt organization’s activities would consist of the healthcare services it provides through the LLC and the grant-making activities it conducts using income distributed by the LLC. Thus, the IRS concluded that as long as the exempt organization’s principal activity continued to be the provision of healthcare, it would not be classified as a private foundation but would be recognized as a public charity within the meaning of IRC §170(b)(1)(A)(iii). Accordingly, the excess business holdings rules would not apply. The issue that remains open is whether another type of exempt organization, such as a low-income organization that derives its public support status from the numerical one-third support test, would be reclassified as a private foundation if it contributed all of its operating assets to an LLC. EXAMPLE: M is a private foundation exempt under IRC §501(c)(3) and classified as a foundation under §509(a). M is a limited partner in N joint venture. M owns a 35 percent profits interest in the N joint venture. The joint venture owns working interests in oil-producing wells. X is the only disqualified person, and X owns 4 percent of N. Because the unrelated general partners are in “effective control” of the N joint venture, M is permitted to own 35 percent of the business holdings of N. Therefore, because M has 4 percent of excess business holdings, M must divest itself of the 4 percent of N to fit within the 35 percent permissible holdings; after divestiture, M will own 31 percent and X will own 4 percent, totaling 35 percent.20 The regulations provide that the “reality of control” is determinative, not the form or means by which it is exercised.21 A de minimis rule permits a foundation to own up to 2 percent of voting stock and 2 percent in value of all outstanding stock, without regard to holdings of disqualified persons.22 A disqualified person is defined, with respect to a private foundation, as any person who is any one of the following: • A substantial contributor to the foundation23 • A foundation manager24
20 21 22
23 24
This example is based on the factual situation presented in Priv. Ltr. Rul. 84-07-095 (Nov. 17, 1983). See also Rev. Rul. 81-111, 1981-1 C. B. 509. Reg. §53.4943-3(b)(3). §4943(c)(2)(C); Reg. §53.4943-3(b)(4). See generally Priv. Ltr. Rul. 93-08-046 (Dec. 4, 1993). In Priv. Ltr. Rul. 96-16-017 (Jan. 16, 1996) a private foundation owned stock that fell within the de minimis exception to §4943. By virtue of holding the stock for a certain period of time, the foundation became entitled to more than one vote per share, which would have caused the foundation to exceed the 2 percent voting stock de minimis threshold. The Service ruled that an agreement under which the foundation would irrevocably relinquish the additional voting rights to which it had become entitled would not be treated as an attempt to convert voting stock into nonvoting stock, and would allow the stock holdings to continue to be disregarded under the de minimis exception. §4946(a)(1)(A); Reg. §53.4946-1(a)(1)(i); §507(d)(2). See generally Priv. Ltr. Rul. 93-15-033 (Jan. 22, 1993). 4946(a)(1)(B); Reg. §53.4946-1(a)(1)(ii). A foundation manager is defined as an officer, director, or trustee of a foundation or any individual having the powers and responsibilities similar to those held by an officer, director, or trustee of a foundation. §4946(b); Reg. §53.4946-1(f).
䡲
472 䡲
c10.fm Page 473 Saturday, March 10, 2007 3:32 PM
10.2 EXCESS BUSINESS HOLDINGS: GENERAL RULES
• An owner of more than 20 percent of the total voting power, more than 20
percent of total profits interest of a joint venture or partnership, or more than 20 percent of total beneficial interest of a trust;25 • A member of the family of any of the persons described in the preceding
three items;26 • A corporation, trust, or partnership composed of persons described in the
preceding four items who own more than 35 percent of the total voting power;27 or • Another private foundation that is effectively controlled by the same per-
sons who control the instant private foundation, or substantially all (85 percent) of whose contributions were made by persons described in any of the preceding items.28 Any excess holdings amount must be disposed of, either by the disqualified person or by the foundation, to any person who is not disqualified. If the foundation receives the excess holdings by purchase, the foundation has 90 days to dispose of the excess interest.29 If the foundation were to receive the excess holdings by gift or bequests, it would have five years to dispose of the excess holdings.30 However, IRC §4943(c)(7) allows the IRS to extend this five-year period for five additional years for unusually large gifts or bequests of diverse business holdings or holdings with complex corporate structures under certain circumstances.31 A private foundation is not permitted to have holdings in a proprietorship.32 The IRS has recently held (in an unreleased private letter ruling) that when an organization ceases to be a public charity by virtue of a hospital reorganization, its investments would be treated as if they were received by gift, under IRC §4943(c)(7), so that it would have 60 months to reduce its holdings in corporate and partnership interests to achieve a permitted level of holdings, which is typically 20 percent. The IRS applies similar rules for purposes of the jeopardy investments proscription under IRC §4944 and to treat any built-in gain or loss at the time of the transaction as excluded from the calculation of tax on investment income under IRC §4940.
25 26
27 28 29 30 31
32
§4946(a)(1)(C); Reg. §53.4946-1(a)(1)(iii). §4946(a)(1)(D); Reg. §53.4946-1(a)(1)(iv). Members of the family include only the person’s spouse, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren. §4946(d). §4946(a)(1)(E); Reg. §53.4946-1(a)(1)(v), (vi), and (vii). Reg. §53.4946-1(b)(1). See also Priv. Ltr. Rul. 93-20-052 (Feb. 25, 1993); Priv. Ltr. Rul. 9308-046 (Dec. 4, 1992). Reg. §53.4943-2(a)(1)(ii). §4943(c)(6). §4943(c)(7). See, e.g., Priv. Ltr. Rul. 97-09-005 (Nov. 21, 1996) (IRS granted nonprofit corporation a five-year extension to dispose of excess business holdings consisting of 53 percent partnership interest where, at various times, corporation was told that the Securities and Exchange Act of 1934 limited the units it could sell within any three-month period, the market for such units was limited, and the partnership was undergoing merger discussions causing the corporation to be reluctant to sell in order to avoid being accused of insider trading). §4943(c)(3)(B).
䡲
473 䡲
c10.fm Page 474 Saturday, March 10, 2007 3:32 PM
LIMITATION ON EXCESS BUSINESS HOLDINGS
10.3
TAX IMPOSED
A 10 percent initial tax is imposed on the value of a private foundation’s excess business holdings in each of its business enterprises.33 The tax is imposed on the last day of the foundation’s taxable year that ends during the taxable period, but it is calculated for each business enterprise using the day during the year when the excess holdings were largest.34 The 10 percent tax does not apply if the foundation disposes of the excess holdings acquired by means other than purchase within 90 days after it knew or should have known that it had excess holdings.35 Furthermore, the 90-day period for disposition is available even if at the time the excess holdings were purchased the foundation did not know, nor have reason to know, that there were prior acquisitions by disqualified persons that caused the holdings to exceed the 20 percent limitation, but only if the foundation’s purchase would not have created excess business holdings but for the prior acquisitions by disqualified persons. The 90-day period may be extended to include the period in which the foundation is precluded from disposing of excess business holdings by federal or state securities laws. The taxable period of a private foundation begins on the first day on which there are excess business holdings and ends on the date a deficiency notice is mailed or the date the tax is assessed, whichever is earlier.36 Furthermore, the taxable period may be suspended for 90 days starting with the date the foundation knows or has reason to know that it has acquired excess business holdings, provided that at the end of the 90-day period the foundation has disposed of the excess business holdings. In any case when the initial tax is imposed, there is an additional tax of 200 percent imposed on the value of the excess holdings if such holdings are not disposed of at the close of the taxable period.37 However, this second-level tax is not assessed, abated, or refunded if there is a reduction of excess holdings to zero during the correctional period that ends 90 days after a deficiency notice is mailed. This correctional period may be extended if the IRS determines that an extension is reasonable, or if a petition is filed in the Tax Court.
10.4
EXCLUSIONS
The excess business holding rules do not apply to any entity that is not a business enterprise.38 The term “business enterprise” does not include a functionally
33 34 35
36 37 38
See Priv. Ltr. Rul. 93-13-032 (Dec. 29, 1992). §4943(a)(2); §53.4943-2(a)(2). See also Priv. Ltr. Rul. 93-20-052 (Feb. 25, 1993). Reg. §53.4943-2(a)(1)(ii). In the case of excess business holdings acquired from a trust or will, such holdings must be disposed of within a five-year period. §4943(c)(6). If a bequest or gift is unusually large, the IRS may extend such period for another five years. §4943(c)(7). See Reg. §53.4943-6(a)(1). §4943(d)(2). §4943(b); Reg. §53.4943-2(b). §4943; Reg. §53.4943-3(a)(1); Reg. §53.4943-10(a)(1).
䡲
474 䡲
c10.fm Page 475 Saturday, March 10, 2007 3:32 PM
10.4 EXCLUSIONS
related business,39 income from passive sources,40 and certain “program-related investments.”41 (a)
Functionally Related Business
As mentioned earlier, the term “business enterprise” does not include a functionally related business.42 A functionally related business is a trade or business that is not an unrelated trade or business under the unrelated business income tax (UBIT) rules of IRC §513. The term functionally related business includes activity that is carried on within a larger aggregate of other endeavors that are related to the exempt purposes of the organization.43 EXAMPLE: A, B, and C are exempt organizations under IRC §501(c)(3) and classified as private foundations under §509(a). These organizations were formed to perpetuate the literary and musical works of worthy composers. Upon the death of a philanthropic individual, A, B, and C acquired the stock of Y, a Subchapter S corporation. Y’s sole business purpose is to promote American music. However, Y is empowered to enter into joint ventures and to earn a profit, which will be distributed to Y’s shareholders. Because Y’s purpose is similar to the exempt educational and literary purposes of A, B, and C, Y is a “functionally related business” within the meaning of §4942(j). Therefore, the ownership of Y by A, B, and C will not result in the imposition of the excess business holdings tax under §4943.44 (b)
Program-Related Investment
A program-related investment (PRI)45 is an investment, the primary purpose of which is to accomplish one or more of the exempt organization’s charitable purposes.46 There must not be significant purpose to produce income or the appreciation of property.47 A PRI is a special type of social investment that meets the criteria for qualifying distributions for private foundations.48 These
39 40 41
42 43 44 45
46 47 48
§4393(d)(3)(A); Reg. §53.4943-10(b). A functionally related business is defined in §4942(j)(4). See Priv. Ltr. Rul. 93-08-045 (Dec. 3, 1992). §4943(d)(3)(B); Reg. §53.4943-10(c)(1). See Priv. Ltr. Rul. 92-50-039 (Sept. 16, 1992). Reg. §53.4943-10(b). Program-related investments are investments that further the exempt purpose of an organization, specifically defined in §4944(c). See Priv. Ltr. Rul. 92-26-073 (Apr. 21, 1992); Priv. Ltr. Rul. 91-12-013 (Mar. 22, 1991). §4942(j)(4); Reg. §53.4943-10(b). See Priv. Ltr. Rul. 93-08-045 (Dec. 3, 1992). §4942(j)(4). See Reg. §53.4943-10(b). This example is based on the factual situation presented in Priv. Ltr. Rul. 93-08-045 (Dec. 3, 1992). §4944(a)(1) prohibits a private foundation from making a “jeopardizing” investment; however, “program-related investments” are specifically excluded from the definition of a “jeopardizing” investment. See generally Priv. Ltr. Rul. 93-08-045 (Dec. 3, 1992); Priv. Ltr. Rul. 93-06-035 (Nov. 20, 1992). See Priv. Ltr. Rul. 93-15-033 (Jan. 22, 1993). For a more thorough discussion of PRIs, see Section 4.9. §4944(c). Id.
䡲
475 䡲
c10.fm Page 476 Saturday, March 10, 2007 3:32 PM
LIMITATION ON EXCESS BUSINESS HOLDINGS
investments satisfy statutory requirements as long as (1) the primary purpose in making the PRI is charitable,49 (2) the PRI will have a charitable effect that would not have occurred without the PRI, and (3) the charitable effect is commensurate with the investment.50 EXAMPLE: X, a private foundation, invests $100,000 in the common stock of corporation M. The dividends received from such investment are later applied by X in furtherance of its exempt purposes. Although there is a relationship between the return on the investment and the accomplishment of X’s exempt activities, there is no relationship between the investment per se and such accomplishment. Therefore, the investment cannot be considered as made primarily to accomplish one or more of the purposes described in IRC §170(c)(2)(B) and cannot qualify as program related.51 EXAMPLE: A is a socially and economically disadvantaged individual. B, a private foundation whose purposes include providing educational assistance to disadvantaged college students, makes an interest-free loan to A for the primary purpose of enabling A to attend college. The loan has no significant purpose involving the production of income or the appreciation of property. The loan significantly furthers the accomplishment of B’s exempt purposes and would not have been made but for such relationship between the loan and B’s exempt activities. Accordingly, the loan is a program-related investment.52 (c)
Income from Passive Sources
The term business enterprise does not include a trade or business in which at least 95 percent of the gross income is derived from passive53 sources.54 EXAMPLE: M, a private foundation pursuant to IRC §509(a), holds an interest in oil and gas wells. M derives royalty income from the oil and gas wells. Under the regulations, royalty income is deemed passive income for purposes of §4943(d)(3).55 Because under §4943(d)(3)(B), the term “business enterprise” does not include a trade or business where at least 95 percent of the gross income is derived from passive sources, M would not have any adverse consequences pursuant to the excess business holdings provisions.56 49
50 51
52 53 54 55 56
An investment shall be considered as made primarily in furtherance of a charitable purpose if it significantly furthers the accomplishment of the private foundation’s exempt activities and if the investment would not have been made but for such relationship between the investment and the accomplishment of the foundation’s exempt activities. Priv. Ltr. Rul. 92-26-073 (Apr. 21, 1992). Reg. §53.4944-3(a)(i); see also Rev. Rul. 72-559, 1972 C. B. 247. See generally Chapter 3. Reg. §53.4944-3(b), Example 7. See Priv. Ltr. Rul. 91-12-013 (Mar. 22, 1991) (a loan was a PRI because it furthered the charitable purpose of the foundation: to provide low-income housing); Priv. Ltr. Rul. 84-29-051 (Apr. 18, 1984) (an exempt organization made a nonrecourse loan at below-market interest to a limited partnership that constructed low-income housing. Because the area was high-risk and, therefore, unable to secure conventional financing, the IRS held that this loan was a PRI. Hence, the loan would not jeopardize the organization’s exempt status). Reg. §53.4944-3(b), Example 9. Passive income includes income from items excluded by §512(b)(2), (2), (3), and (5). Priv. Ltr. Rul. 90 32 052 (Feb. 25, 1993); Priv. Ltr. Rul. 92-50-039 (Sept. 16, 1992). §4943(d)(3)(B); Reg. §53.4943-10(c)(2). Reg. §53.4943-10(c)(2). See Priv. Ltr. Rul. 93-20-052 (Feb. 25, 1993).
䡲
476 䡲
c11.fm Page 477 Saturday, March 10, 2007 3:26 PM
C H A P T E R
E L E V E N 11
Impact on Taxable Joint Ventures: Tax-Exempt Entity Leasing Rules 11.1
INTRODUCTION
Increased tax incentives that became available for the for-profit sector in the early 1980s created new opportunities for nonprofit organizations to raise funds by, in effect, “selling” otherwise wasted tax benefits to for-profit organizations.1 However, the Deficit Reduction Act of 1984 (“the 1984 Act”) contained rules, referred to as the tax-exempt entity leasing rules, that significantly restrict the tax benefits of leasing property to tax-exempt organizations. The 1984 Act also limited the tax benefits available to partnerships composed of taxable and taxexempt entities. In addition, the Tax Reform Act of 1986 (“the 1986 Act”) contained many provisions that had a discernable impact on all types of leasing transactions, including those involving tax-exempt entities. These provisions include technical corrections to the 1984 Act, which clarify the rules regarding the use of subsidiaries, as well as passive loss limitations and other provisions that reduced tax benefits for leasing transactions.2
11.2
TYPES OF TRANSACTIONS COVERED BY 1984 ACT RULES
The tax-exempt entity leasing rules do not apply to any property predominantly used by a tax-exempt organization if the income derived from that property by the tax-exempt organization is subject to tax as unrelated business income (UBI) under the Internal Revenue Code (IRC). If this exception does not apply, the 1984 Act will be applicable to two basic types of transactions.
1 2
Tax incentives included accelerated depreciation and the investment tax credit. See M. Sanders, C. Roady, and S. Cobb, “Partnerships and Joint Ventures: Alive and Well or Endangered Species?” NYU Eighteenth Conference on Tax Planning for 501(c)(3) Organizations (1990). Portions of this chapter are based on research from the author’s NYU article.
䡲
477 䡲
c11.fm Page 478 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
CAVEAT This analysis assumes that the transaction in question furthers the organization’s exempt purposes or involves a partnership that has both taxable and tax-exempt entities as partners in an activity that is not an unrelated trade or business, provided any partnership allocation to the tax-exempt entity is disproportionate during its life.* *
§512(b)(4); §514. But see §514(c)(9). See generally Chapter 9.
The first category involves direct leases of property by taxable organizations to tax-exempt organizations. The second category primarily involves partnerships with taxable and tax-exempt entities as partners when partnership items of income, gain, loss, deductions, credit, and basis are not allocated to the taxexempt entity in the same percentage share during the entire period that the taxexempt entity is a partner. For example, a partnership agreement may allocate only 1 percent of profits, losses, and net cash flow to a tax-exempt partner but allocate 50 percent of sale and refinancing proceeds to that tax-exempt entity. Special rules apply to such partnerships. In either case—the direct lease to a tax-exempt organization or a partnership composed of taxable and tax-exempt entities—IRC §168(h) severely restricts depreciation deductions for many of these transactions that have an impact on the taxable joint venturer. The effect is best illustrated in the context of residential real estate, in which case the depreciation deduction based on a 40-year useful life3 would be approximately one-third less than under the Modified Accelerated Cost Recovery System (MACRS) with a useful life of 27.5 years.4 Prior to the repeal of the investment tax credit in the 1986 Act, the tax-exempt leasing rules also denied use of the investment credit in these situations. These rules were designed to address the perceived abuses of prior law, namely, that (1) for-profit or taxable lessors indirectly made investment tax incentives available to tax-exempt entities through reduced rents; (2) the Code encouraged taxexempt entities to enter into sale/leaseback transactions with taxable entities, which resulted in substantial revenue losses; and (3) partnerships that included tax-exempt and taxable entities could allocate all or substantially all of the tax losses to the taxable entities, although the tax-exempt entities could share in profits and cash distributions on a more favorable basis.
3 4
See §168(g)(2) (the alternative depreciation system for tax-exempt-use property prescribes a 40-year recovery period for residential rental property). See §168(c)(1). However, the rules would have negligible effect if commercial property were involved, because the use file is increased to 39 years under the Revenue Reconciliation Act of 1993. §168(c)(1) as amended by §13151(a) of the 1993 Act.
䡲
478 䡲
c11.fm Page 479 Saturday, March 10, 2007 3:26 PM
11.3 INTERNAL REVENUE CODE §168(H)
CAVEAT The 1986 Act, by enacting longer depreciation periods, introducing the passive loss rules, and repealing the investment tax credit, reduced the available tax benefits to individuals and thus reduced the impact of the tax-exempt entity leasing rules. As a result, because the individual taxpayer is essentially out of the market, more joint venture opportunities have become available to tax-exempt entities, especially those with corporate investors that are not subject to the passive loss limitations.* *
See Chapter 13 on low-income housing tax credit.
11.3 (a)
INTERNAL REVENUE CODE §168(H) Definition of Tax-Exempt Entity
Tax-exempt entities are broadly defined in the Code. Under that definition, the tax-exempt leasing rules apply to the following entities: • Government agencies or instrumentalities.5 • Organizations exempt from federal income tax (other than a cooperative
described in IRC §521), including a tax-exempt trust under §401.6 • Any foreign person or entity.7
(b)
Five-Year Lookback Rule
An organization is treated as a “tax-exempt entity” with respect to property if the organization was exempt from tax at any time during the five-year period ending on the date the property was first leased to the organization.8 (i) Successor Organizations. The five-year lookback rule also applies to a successor organization engaged in substantially similar activities as those engaged in by a predecessor organization.9 (ii) Definition of “First Used.” Under this rule, property is “first used” by a previously tax-exempt entity (1) when the property is first placed in service under a lease to such organization;10 or (2), in the case of property leased to (or held by) a partnership (or other pass-through entity) in which the organization 5 6 7 8 9
10
§168(h)(2)(A)(i). §168(h)(2)(A)(ii). §168(h)(2)(A)(iii). §168(h)(2)(E)(i). §168(h)(2)(E)(iii); see PLR 200451020 (August 31, 2004), look-back rule not applicable to property actually “held” by former tax-exempt organization. In PLR 200451020, the IRS determined that a 501(c)(7) social club, which (prior to an arrangement with a tax-credit partnership) converted into a taxable C corporation for federal purposes, would not be treated as tax-exempt entity when the corporation expected to retain ownership throughout a 29-year lease to the partnership. §168(h)(2)(E)(iv)(I).
䡲
479 䡲
c11.fm Page 480 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
is a member, when such property is first used by such partnership or passthrough entity or when such organization is first a member of such partnership or pass-through entity, whichever is later.11 (c)
Subsidiaries of Tax-Exempt Organizations
Certain taxable subsidiaries of tax-exempt entities are subject to the tax-exempt leasing rules. The affected type of subsidiary—a “tax-exempt controlled entity”— is defined as a corporation (which is not otherwise a tax-exempt entity, i.e., a forprofit subsidiary) 50 percent or more (by value) of whose stock is held by one or more tax-exempt entities. The 1986 Act added a provision whereby subsidiaries of tax-exempt entities may avoid application of the tax-exempt entity leasing rules. Under this election, gain recognized by a tax-exempt entity on disposition of an interest in a tax-exempt controlled entity and any dividend (to the extent that it consists of income not taxed to the controlled entity) or interest received or accrued by the tax-exempt entity from the tax-exempt controlled entity is treated as unrelated business income for purposes of the unrelated business income tax (UBIT).12 Most low-income housing partnerships use for-profit subsidiaries of tax-exempt entities to serve as general partners to avoid classification of the partnership property as tax-exempt use property.13
11.4
TAX-EXEMPT USE PROPERTY
The tax-exempt leasing rules (e.g., the restrictions on depreciation and the denial of investment tax credits) apply to “tax-exempt use property.”14 (a)
Real Property
Real property is tax-exempt use property to the extent that more than 35 percent of the net rentable floor space of the property (not including common areas) is leased to a tax-exempt entity in a disqualified lease.15 (b)
Disqualified Lease
A “disqualified lease” is the lease of property to a tax-exempt entity in which any one of the following four circumstances is present. 11 12
13 14 15
§168(h)(2)(E)(iv)(II). §168(h)(2)(F)(ii). Ordinarily, §168(h)(6)(F)(ii) elections are to be filed by the due date of the tax return for the first taxable year for which the election is to be effective. Under Reg. §§301.9100–1(c) and 301.9100–3(a), the IRS has the discretion to grant a reasonable extension of time to make the election so long as taxpayer acted reasonably and in good faith and granting relief will not prejudice the interests of the government. See Priv. Ltr. Rul. 200411041 (March 12, 2004), and Priv. Ltr. Rul. 200315024 (April 11, 2003) (extensions to file elections were granted where previous accountant, or controller, had failed to timely file the election). See also Priv. Ltr. Rul. 200406022 (Feb. 6, 2004) (extension to file election was granted where taxpayer inadvertently failed to attach election to extended return). See generally Chapter 13. §168(h)(1)(A). §168(h)(1)(B)(i); see PLR 200448015 (July 19, 2004) for analysis of multifaceted transactions, including rehabilitation of a historic building held not to be tax-exempt use property.
䡲
480 䡲
c11.fm Page 481 Saturday, March 10, 2007 3:26 PM
11.5 RESTRICTIONS ON TAX-EXEMPT USE PROPERTY
(i) Tax-Exempt Financing. Part or all of the property was financed directly or indirectly through an exempt obligation in which the tax-exempt (or a related) entity participated.16 (ii) Purchase/Sale Option. There is a fixed or determinable purchase price or sale option or the equivalent of such an option. Any provision that allows the lessor to shift to the lessee any risk of the property’s decline in value will be categorized as a fixed or determinable sale option.17 (iii) Twenty-Year Lease. The lease term exceeds 20 years. The lease term includes all periods in which the lessee (or related entity) has an option to renew or the lessor has a right to require renewal, whether or not the lease is in fact renewed.18 (iv) Sale/Leaseback. The lease occurs after a sale or lease of the property from the tax-exempt entity, and the property has been used by the tax-exempt entity before the sale or lease.19 There is an exception, however, for property that is leased within three months after the date the property was first used by the taxexempt entity.20 (c)
Personal Property
Tax-exempt use personal property includes that portion of any tangible personal property leased to a tax-exempt entity.21 (d)
Short-Term Leases Not Covered
Leases for (1) less than three years (including any options) and (2) less than the greater of one year or 30 percent of the property’s present class life are not covered by the tax-exempt leasing rules.22
11.5 (a)
RESTRICTIONS ON TAX-EXEMPT USE PROPERTY Depreciation of Personal Property
Tax-exempt use personal property must be depreciated on a straight-line basis using the half-year convention.23 In this calculation, salvage value is disregarded.24 16 17 18
19 20 21 22 23 24
§168(h)(1)(B)(ii)(I). §168(h)(1)(B)(ii)(II). §168(h)(1)(B)(ii)(III). Reg. §1.168(i)–2 provides additional rules that clarify the duration of the lease term under certain circumstances. Under the regulations, the lease term includes any period beyond that stated in the original lease for which the original tax-exempt lessee (or a related person) retains financial responsibility for the lease. The regulations apply to leases entered into on or after April 20, 1995. §168(h)(1)(B)(ii)(IV). §168(h)(1)(B)(v). §168(h)(1)(A). §168(h)(1)(C); see note 18. §168(g)(1)(B). §168(g)(1)(A).
䡲
481 䡲
c11.fm Page 482 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
The recovery period is the longer of (1) present ADR class life25 (or 12 years if there is no class life), (2) the property’s recovery period,26 or (3) 125 percent of the lease term, including renewals. (b)
Depreciation of Real Property
Tax-exempt use real property must be depreciated by the straight-line method with a mid-month convention.27 The recovery period is the longer of (1) 40 years, (2) 125 percent of the lease term,28 or (3) the property’s recovery period under IRC §168(g).29 (c)
Tax Credits
Rehabilitation expenditures allocable to that portion of a building that is (or may reasonably be expected to be) tax-exempt use property are not eligible for the rehabilitation tax credit. However, the low-income housing credit under IRC §42 would be available even if the property is tax-exempt use property. (d)
Transfer Restrictions
The final regulations contain provisions to ensure that application of the alternative depreciation system30 (ADS) cannot be avoided through exploitation of the like-kind exchange rules pursuant to IRC §1031. Heretofore, a purchaser of taxexempt property with a high basis could engage in a tax-free exchange with a related party for low-basis property and depreciate the newly acquired property under the general depreciation system rather than the ADS. For instance, prior to the proposed regulations, the following situation could occur: EXAMPLE: Taxpayer X purchases tax-exempt use property Blackacre (subject to the ADS) for $1,000 and immediately transfers the property to a related party, Y, in exchange for Whiteacre, “like-kind” taxable property worth $1,000 but having a zero basis (subject to the general depreciation system, but fully depreciated). After the exchange, Y still holds property with a value of $1,000 and a basis of zero (subject to the ADS, but because the property is fully depreciated, this is of little consequence), and X can depreciate its newly acquired property under the general depreciation system rather than the ADS. Essentially, X and Y have entirely avoided application of the ADS.
25 26 27 28 29
30
Rev. Proc. 87-56, 1987-2 C.B. 674. §168(g)(2)(C)(ii). §168(g)(2) (salvage value is not taken into account under the alternative depreciation system). §168(g)(3)(A). §168(g)(2)(C)(iii). In Field Service Advice 200244010 (November 1, 2002), Chief Counsel noted that there is no authority that precludes the IRS from using the business purpose, step transaction, or substance over form doctrines to disallow a transaction designed to avoid the requirement of a longer depreciation period under §168. (The FSA analyzes a depreciation deduction provided by IRC §167(a), which is determined under IRC §168.) See Section 11.5(b) for a discussion of the alternative depreciation system.
䡲
482 䡲
c11.fm Page 483 Saturday, March 10, 2007 3:26 PM
11.5 RESTRICTIONS ON TAX-EXEMPT USE PROPERTY
Under the proposed regulations, however, property the taxpayer receives from a related person31 in connection with an IRC §1031 like-kind exchange, in which the related party receives tax-exempt use property (“related tax-exempt use property”32), will generally be treated in the same manner as the transferred tax-exempt use property would have been, for the purposes of determining allowable depreciation.33 In other words, property received in the exchange by the party transferring the tax-exempt use property must be depreciated using the same method and convention (the alternative depreciation system) as was applicable to the tax-exempt use property prior to transfer. Thus, under the proposed regulations, in the preceding example X would have to depreciate Whiteacre using the same method and convention as would have been applicable to Blackacre prior to the transfer (the ADS). This rule applies only to the extent that the taxpayer’s basis in the property received does not exceed its pretransfer basis in the transferred tax-exempt use property. Any excess basis is treated as property to which the rule does not apply. Further, the rule will apply only if the property is exchanged under an IRC §1031 (or §1031-related) transaction and if a principal purpose of the transfer is not to avoid or limit application of the alternative depreciation system.34 EXAMPLE: X owns all of the stock of two subsidiaries, B and Z. X, B, and Z do not file consolidated returns. B and Z each own buildings. B’s building is leased to a tax-exempt hospital and has a fair market value (FMV) of $1 million and an adjusted basis of $500,000. Z’s building is leased to a non-exempt U.S. taxpayer as office space and has an FMV of $1 million and an adjusted basis of $100,000. In an attempt to avoid application of the alternative depreciation system to the hospital building, on May 1, 1995, X causes B and Z to exchange buildings, subject to the existing leases. B realizes gain of $500,000 and Z realizes gain of $900,000, but neither recognizes gain because of the operation of the like-kind exchange rules (IRC §1031(a)). B takes a substituted basis under the like-kind exchange rules (IRC §1031(d)) of $500,000 in the non-tax-exempt use property (the office building). Under the regulations, B must depreciate the office building using the remaining recovery period of the hospital building and the same depreciation method and convention as was used on the hospital building prior to the transfer (the alternative depreciation system). Z holds tax-exempt use property (the hospital building) with a substituted basis of $100,000. Because the hospital building is tax-exempt use property, it must be depreciated under the alternative depreciation system as well.35 31 32
33
34 35
As defined in §267(b) or §707(b). “Related tax-exempt use property” is property that is tax-exempt use property at the time of the transfer, or property that does not become tax-exempt use property until after the transfer if, at the time of the transfer, it was intended that the property be put to a tax-exempt use, and thus become tax-exempt use property. Reg. §1.168(h)-1(c). Reg. §1.168(h)-1(b). Congress subjected tax-exempt use property to a restricted depreciation system (see Section 11.5 (a) and (b)) to prevent tax-exempt entities from receiving the benefits of the general depreciation system through reduced rentals. Reg. §1.168(h)-1(a)(1)(i) & (ii). This illustration is based on Example 2 of the regulations. See Reg. §1.168(h)-1(d), Example 2.
䡲
483 䡲
c11.fm Page 484 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
11.6 (a)
PARTNERSHIP RULES Property Treated as Tax-Exempt Use Property
Any property held by a partnership that has both a tax-exempt entity and a forprofit entity as partners will be treated as tax-exempt use property to the extent of the tax-exempt entity’s proportionate share of the property, if any allocation to the tax-exempt entity of partnership items is not a “qualified allocation.”36 CAVEAT If property is owned by a partnership having both taxable and tax-exempt entities as partners, and any allocation to a tax-exempt entity partner is not a “qualified allocation” under IRC §168(h)(6)(B), then such entity’s proportionate share of the property is to be treated as tax-exempt use property for all purposes. However, the property will not be tax-exempt use property if it is predominantly used by the partnership in an activity that, with respect to the tax-exempt entity, is an unrelated trade or business. An activity is an unrelated trade or business with respect to a tax-exempt entity if such entity’s distributive share of the partnership’s gross income from the activity is includible in computing its unrelated business taxable income under §512(c) (determined without regard to the debtfinanced income rules of §514).* *
See Temp. Reg. §1.168(j)-1T, Q & A21. See also Priv. Ltr. Rul. 200318076 (February 7, 2003) for a discussion of the exclusion of acquisition indebtedness under IRC §514(c)(9)(A) for real property held by a partnership.
EXAMPLE: EO, a qualified exempt organization, and P, a taxable entity, form a partnership to develop a commercial office building. Because the receipt of rent would be excluded from UBIT pursuant to IRC §512(b)(3) and the agreement contemplates disproportionate allocations among the partners, EO’s proportionate share of the property would be treated as tax-exempt use property. The result would be the same even when the debt-financed income rules of §514 apply, because the determination of UBIT with respect to the tax-exempt entity leasing rules is made without regard to the application of §514. Therefore, in the latter case, the transaction would be subject to UBIT as well as the tax-exempt entity leasing rules. (b)
Qualified Allocation
A “qualified allocation” means any allocation to a tax-exempt entity (except certain allocations regarding property contributed by the partners to the partnership) that results in the tax-exempt entity’s being allocated the same percentage share of each partnership item of income, gain, loss, deduction, credit, and basis during the entire period the entity is a partner in the partnership.37
36 37
§168(h)(6)(A). §168(h)(6)(B).
䡲
484 䡲
c11.fm Page 485 Saturday, March 10, 2007 3:26 PM
11.6 PARTNERSHIP RULES
(c)
Compliance with General Partnership Rules
A qualified allocation must also meet the “substantial economic effect” requirements under the general partnership provisions.38 The determination of whether a qualified allocation has substantial economic effect requires a two-part analysis.39 First, the allocation must have economic effect,40 and second, the economic effect must be substantial.41 In order for an allocation to have economic effect, the partnership agreement must require (1) capital accounts to be maintained in accordance with the regulations under IRC §704(b), (2) liquidation proceeds to be distributed in accordance with positive capital accounts, and (3) partners to be obligated to repay negative capital accounts upon the dissolution of the partnership.42 The economic effect of a qualified allocation is substantial if the allocation (1) does not shift tax consequences among partners within a single year, (2) is not transitory over time, and (3) passes an “overall substantiality” test.43 (d)
Proportionate Share Owned by Tax-Exempt Entity
The “proportionate share” is determined by looking at the tax-exempt entity’s share of distributions of partnership items of income or gain, whichever results in the greatest share; if the tax-exempt entity’s share varies over time, then the highest share the tax-exempt entity may receive is used.44 CAVEAT A tax-exempt entity partner’s proportionate share of property of a partnership equals such partner’s share of that item of the partnership’s income or gain (excluding income or gain allocated under IRC §704(c)) in which the tax-exempt entity has the highest share. If the tax-exempt entity partner’s share of any item of income or gain (excluding income or gain allocated under §704(c)) may vary during the period it is a partner, the previous rule shall be applied with reference to the highest share of any such item that it may receive at any time during such period.* The application of these rules is illustrated by the following example: *
See Temp. Reg. §1.168(j)-1T, Q & A21.
EXAMPLE: A, B, and EO are members of a partnership that forms on July 1, 1984. On that date the partnership places in service a building and §1245 class property. A and B are taxable entities; EO is a tax-exempt entity. The partnership agreement provides that during the first five years of the partnership, A and B are each allocated 38 39 40 41 42 43 44
§704(b)(2) (an allocation of income, gain, loss, etc. must have “substantial economic” effect); Reg. §1.704-1(b)(2)(i) (two-part analysis for substantial economic effect). See Section 3.6. See Reg. §1.704-1(b)(2)(i). Reg. §1.704-1(b)(2)(ii). Reg. §1.704-1(b)(2)(iii) See Section 3.6(a). Reg. §1.704-1(b)(2)(ii). Reg. §1.704-1(b)(2)(iii). Reg. §168(f)(6)(C).
䡲
485 䡲
c11.fm Page 486 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
40 percent of each item of income, gain, loss, deduction, credit, and basis; EO is allocated 20 percent. Thereafter, A, B, and EO are each allocated 33 1/3 percent of each item of income, gain, loss, deduction, credit, and basis. Assume that these allocations meet the substantial economic effect test of IRC §704(b)(2) and EO’s distributive share of the partnership’s income is not unrelated trade or business income subject to tax under §511. The allocations to EO are not qualified allocations, because EO’s distributive share of the partnership items does not remain the same during the entire period that EO is a partner in the partnership. Thus, 33 1/3 percent of the building and 33 1/3 percent of the §1245 class property are tax-exempt use property from the time each is placed in service by the partnership. (e)
Change as a Result of Sale or Redemption
A change in a tax-exempt entity’s distributive share of income, gain, loss, deduction, credit, or basis that occurs as a result of a sale or redemption of a partnership interest (or portion thereof) or a contribution of cash or property to the partnership will be disregarded in determining whether the partnership allocations are qualified, provided that such transaction is based on fair market value at the time of the transaction and that the allocations are qualified after the change. For this purpose, the consideration determined by the parties dealing at arm’s length and with adverse interests will normally be deemed to satisfy the fair market value requirement. In addition, a change in a tax-exempt entity’s distributive share that occurs as a result of a partner’s default (other than a prearranged default) under the terms of the partnership agreement will be disregarded, provided that the allocations are qualified after the change and that the change does not have the effect of avoiding the restrictions of IRC §168(h). Any of the previously described transactions between existing partners (and parties related to them) will be closely scrutinized.45 EXAMPLE: A, a taxable entity, and B, a tax-exempt entity, form a partnership in 1985. A contributes $800,000 to the partnership; B contributes $200,000. The partnership agreement allocates 95 percent of each item of income, gain, loss, deduction, credit, and basis to A; B’s share of each of these items is 5 percent. Liquidation proceeds are, throughout the term of the partnership, to be distributed in accordance with the partners’ capital account balances, and any partner with a deficit in its capital account following the distribution of liquidation proceeds is required to restore the amount of such deficit to the partnership. Assuming that these allocations have substantial economic effect, within the meaning of IRC §704(b)(2), they are qualified, because B’s distributive share of each item of income, gain, loss, deduction, credit, and basis will remain the same during the entire period that B is a partner. The fact that the liquidation proceeds may be distributed in a ratio other than 95/5 does not cause the allocations not to be qualified.
45
See Temp. Reg. §1.168(j)-1T, Q & A22.
䡲
486 䡲
c11.fm Page 487 Saturday, March 10, 2007 3:26 PM
11.6 PARTNERSHIP RULES
(f)
Impact of Rules on Partnerships in Low-Income Housing Endeavors
Low-income housing projects provide particularly dramatic examples of the impact of a property’s characterization as tax-exempt use property. EXAMPLE: A partnership owning a low-income housing project has a tax-exempt municipal housing authority as the general partner and taxable persons as the limited partners. If the general partner has a 1 percent interest in the income and losses of the partnership and a 10 percent interest in the residual proceeds upon sale or refinancing of the housing project, the allocation will not be a “qualified allocation,” because the municipal housing authority is not receiving the same percentage share of income and losses during the entire period it is a partner. The municipal housing authority will therefore be determined to have a 10 percent proportionate share of the partnership property, because 10 percent is its greatest share of partnership items of income or gain at any time. As a result, the housing project is deemed to be 10 percent tax-exempt use property and only 90 percent of the property will be eligible for normal depreciation. Ten percent of the housing project is tax-exempt use property, which will have to be depreciated over 40 years using the straight-line method. Note: The low-income housing credit as well as the losses from the partnership property, including both the 90 percent normal depreciation property and the 10 percent tax-exempt use property, can still be allocated 99 percent to the taxable partners and 1 percent to the tax-exempt entity as before; it is only the amount of the losses that is reduced. EXAMPLE: If the aforementioned partnership were to make a 10 percent qualified allocation to the tax-exempt entity, such that the tax-exempt entity would receive 10 percent of all income and losses during the time it was a partner, then none of the property would be tax-exempt use property. Consequently, all of the property would be eligible for MACRS and partnership taxable losses would increase. However, the tax-exempt entity’s 10 percent share of these losses and the low-income housing credit would produce no benefit. In addition, because the taxable partners would receive only 90 percent of losses and other tax benefits in this case, the result would be less favorable to these investor/limited partners than in the previous example, in which they were able to take advantage of 99 percent of the depreciation deductions from the tax-exempt use property, albeit on a 40-year straight-line basis. Using the qualified allocation to avoid characterization as taxexempt use property is not an effective strategy. CAVEAT The partnership in the preceding two examples can avoid classification of its property as tax-exempt use property if a wholly owned for-profit subsidiary of the tax-exempt organization is the general partner (rather than the tax-exempt organization itself) and the subsidiary makes the requisite election under IRC §168(h)(6)(F)(ii). Under these circumstances, the general partner may be allocated an increased interest in the project’s sale or refinancing proceeds without the partnership property’s being considered tax-exempt use property. Of course, the trade-off for making the election is that the general partner’s share of the gain on sale of the property becomes taxable. 䡲
487 䡲
c11.fm Page 488 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
CAVEAT The Internal Revenue Service (IRS) will accept requests for rulings on whether an allocation is a qualified allocation for purposes of IRC §168(h)(6). One requirement of a qualified allocation is that such allocation must have substantial economic effect under §704(b)(2). Currently, the IRS will not rule on whether an allocation has substantial economic effect under §704(b)(2). Therefore, unless and until this policy is changed, a ruling request regarding a qualified allocation must contain a representation that the subject allocation has substantial economic effect.* *
See Temp. Reg. §1.168(j)-1T, Q & A24.
(g)
Circumventing the Qualified Allocation Rules
The IRS will examine fees for services and other arrangements to see whether these are attempts to circumvent the qualified allocation rules. However, priority cash distributions, that are guaranteed payments46 and that represent a reasonable return on capital, are permitted. CAVEAT Priority cash distributions to partners that constitute guaranteed payments will not disqualify an otherwise qualified allocation if the priority cash distributions are reasonable in amount (e.g., equal to the federal short-term rate described in IRC §1274(d)) and if they are made in equal priorities to all partners in proportion to their capital in the partnership. Other guaranteed payments will be closely scrutinized and, in appropriate cases, can disqualify otherwise qualified allocations.* *
See Temp. Reg. §1.168(j)-1T, Q & A25.
EXAMPLE: A and B form Partnership AB to operate a manufacturing business. A is a tax-exempt entity, and B is a taxable person. A contributes $500,000 to the partnership, and B contributes $100,000. The partnership agreement provides that A and B are each entitled to cash distributions each year, in equal priority, in an amount equal to 8 percent of their capital contribution. Assume that these payments are reasonable in amount and constitute guaranteed payments under IRC §707(c). Without taking into consideration the guaranteed payments, all allocations constitute qualified allocations. These guaranteed payments will not disqualify such allocations.47 (h)
Partnership and Tax-Exempt Leasing Rules Interplay
The special rules defining tax-exempt use property for partnerships apply separately from the general tax-exempt entity leasing rules. Different portions of
46 47
See §707(c). See Temp. Reg. §1.168(j)-1T, example under Q & A25.
䡲
488 䡲
c11.fm Page 489 Saturday, March 10, 2007 3:26 PM
11.6 PARTNERSHIP RULES
property owned by a partnership can be tax-exempt use property under both sets of provisions. EXAMPLE: Assume that a partnership that owns an office building has a tax-exempt partner with a 1 percent interest in operating profits and losses and a 10 percent interest in residual proceeds (from sale or refinancing of the property). The rest of the partnership interests are held by taxable partners. Assume also that 50 percent of the building is leased to a tax-exempt entity in a “disqualified lease.” Under the taxexempt entity leasing rules, 60 percent of the property must be depreciated over 40 years: 10 percent as a result of the tax-exempt partner’s interest in the partnership and 50 percent as a result of the partnership’s lease to a tax-exempt entity. (i)
Service Contracts
Under prior law, IRC §48(a)(4) and (5) disallowed the investment tax credit for property leased to tax-exempt entities, but could be avoided by the structuring of a transaction as a service contract instead of as a lease. Favorable case law and IRS rulings afforded taxpayers considerable flexibility in arranging transactions to qualify for the investment tax credit.48 Congress responded to this circumvention of IRC §48 by enacting §7701(e) as part of the 1984 Act. This provision offers guidelines for determining whether a contract is a service contract or a lease. If a contract that purports to be a service contract is treated as a lease for that purpose, it is treated as a lease for all purposes of Chapter 1 of the Code, including the tax-exempt entity leasing rules.49 Under IRC §7701(e), a transaction structured as a service contract may be recharacterized as a lease if, taking into account all relevant factors, it is “more properly” a lease.50 The relevant factors include whether: • The service recipient is in physical possession of the property;51 • The service recipient controls the property;52 • The service recipient has a significant economic or possessory interest in
the property;53 • The service provider does not bear any economic risk if there is nonper-
formance under the contract;54 • The service provider does not use the property to provide significant ser-
vices to unrelated entities;55 and • The total contract price does not substantially exceed the rental value of
the property for the contract period.56 48 49 50 51 52 53 54 55 56
See Xerox Corp. v. United States, 656 F.2d 659 (Ct. Cl. 1981). See Temp. Reg. §1.168(j)-1T, Q & A18. §7701(e). See also §168(j)(6)(A) (the term “lease” includes any grant of a right to use property). §7701(e)(1)(A). §7701(e)(1)(B). §7701(e)(1)(C). §7701(e)(1)(D). §7701(e)(1)(E). §7701(e)(1)(F).
䡲
489 䡲
c11.fm Page 490 Saturday, March 10, 2007 3:26 PM
IMPACT ON TAXABLE JOINT VENTURES: TAX-EXEMPT ENTITY LEASING RULES
There are special rules as to when these factors may be applied to service contracts involving certain solid waste disposal, energy, and clean water facilities. In addition, the guidelines do not apply to low-income housing operated by or for organizations that are tax-exempt under IRC §501(c)(3) or (4) if at least 80 percent of the units in such property are leased to low-income tenants.57 (j)
Loss Deferral Rules
Under §470 of the American Jobs Creation Act of 2004 (H.R. 4520), a partnership may no longer deduct losses relating to “tax-exempt use of property” in excess of the income or gain received from that property.58 Generally, §470(a) provides that a “tax-exempt use loss” for any taxable year will not be allowed.59 Although §470 applies broadly to all partnership “tax-exempt use property,” the effective date of the provision (leases entered into after March 12, 2004) and the legislative history suggest that the section is geared primarily toward leasing transactions. Section 470(c)(1) defines “tax-exempt use loss” as the amount by which the aggregate of all deductions (other than interest) directly allocable to “tax-exempt use property” (plus the aggregate deductions for interest properly allocable to such property) exceeds the aggregate income from such property.60 Under §470(b), any “tax-exempt use loss” relating to “tax-exempt use property” that is then disallowable for a taxable year is treated as a deduction with respect to such property in the next taxable year.61 If, and when, the taxpayer disposes of its entire interest in the property, §470(e)(2) provides that rules similar to those of §469(g) will apply.62 Under these provisions (similar to the passive activity loss rules), the taxpayer should generally be able to deduct any previously disallowed deductions and losses when it completely disposes of its interest in the property.63 Notably, “tax-exempt use property” includes property leased to a tax-exempt entity and may include any property (leased or not) owned by a partnership that: (1) has as partners both taxable person and tax-exempt entity and (2) makes allocations to the tax-exempt entity partners that are not “qualified allocations.”
57 58 59 60 61 62 63
§7701(e)(5)(A) and (B). American Jobs Creation Act of 2004, H.R. 4520, 111th Cong. §470 (2004). Id. at §470(a). §470(c)(1). §470(b). See §469(g) (providing rules when there is a total disposition of interest in passive activity); §470(e)(2). Id.
䡲
490 䡲
c12.fm Page 491 Thursday, March 15, 2007 7:59 PM
C H A P T E R
T W E L V E 12
Healthcare Entities in Joint Ventures 12.1
OVERVIEW OF ECONOMICS
With the explosive growth of managed healthcare over the past several years, hospitals and healthcare organizations have been forced to turn to joint ventures, mergers, and other structural reformations in increasing numbers. Where once the purpose underlying such transactions was the enhancement of an individual area of practice, solidifying a local patient base, or bonding with the hospital’s physicians, more urgent factors appear to motivate today’s consolidation transactions.1 Whether reacting to the rapid acquisition of nonprofit hospitals by Columbia HCA,2 OrNda, Tenet,3 and other sprawling healthcare entities, or merely spurred on by the need to streamline operations, reduce capacity, and lower operating expenses in order to survive in the world of managed healthcare,4 1
2
3 4
For two excellent works addressing tax-exempt organizations and the healthcare industry, see Mancino, Hospitals and Health Care Organizations: (Warren, Gorham, Lamont, 1995), and Hyatt and Hopkins, The Law of Tax-Exempt Healthcare Organizations (New York: John Wiley & Sons, 1995). One of the biggest players in the consolidation arena is Columbia HCA (“Columbia”). Once a modest 12-hospital system, Columbia has grown to be the nation’s largest for-profit healthcare company. See “Year in Review 1998,” Modern Healthcare (Dec. 21, 1998). Tenet became the second-largest network in the United States (trailing only Columbia HCA) when it acquired OrNda. Between the significant cuts to Medicare and Medicaid resulting from the Balanced Budget Act of 1997 (BBA) and the practice of health maintenance organizations (HMOs) forcing lower rates and shorter hospital stays on healthcare providers, hospitals are facing ominous prospects with respect to the ability to render adequate amounts of charity care and operate “in the black.” See Preston, “Hospitals Look on Charity as Unaffordable Option of the Past,” New York Times (Apr. 14, 1996), 1,36. In the past, much of the cost of indigent services was passed on to insured or paying customers through increased costs, or defrayed by the receipt of state funds earmarked for charity care purposes. Dwindling state allotments, increasing costs, and decreasing revenues (as a result of the hard-line HMOs) have significantly impaired the financial viability of individual hospitals, or even small hospital systems—particularly in the case of exempt hospitals, which traditionally offer a much broader charity care program than profit institutions. Id. Likewise, HMOs have begun to feel the financial pressure of Medicare and Medicaid cuts. Forty-five HMOs withdrew from the Medicare program, and another 54 reduced their Medicare services for 1999. “Forty-five HMOs Leave Medicare; 54 Reduce Service for 1999, HCFA Reports,” Bureau of National Affairs Health Law Reporter (Dec. 10, 1998). Karen Ignani, CEO of the American Association of Health Plans, a trade association for HMOs, cited Medicare reimbursement rates as one reason for plans’ withdrawal from the program. See “HCFA Turns Down HMOs’ Request to Reopen Premium and Benefit Proposals,” Bureau of National Affairs Health Law Reporter (Oct. 8, 1998).
䡲
491 䡲
c12.fm Page 492 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
many hospitals and clinics have pursued alliances with national or local partners.5 The growth of managed healthcare has spurred an evolution in joint venture form and scale. Where once hospitals concentrated primarily on ancillary or physician-hospital joint ventures, many now engage in “whole hospital” transactions in which all, or almost all, of a hospital’s assets are contributed to an operating partnership, and millions of dollars may change hands.6 Alternatively, nonprofit institutions that are unwilling to relinquish day-to-day control of their hospital, or unable to attract a for-profit “suitor,” choose to enter into “virtual mergers” with other charitable institutions through the use of a joint operating agreement—a contractual affiliation rather than an asset disposition. Some observers believe it is inevitable that virtually all healthcare organizations—hospitals, clinics, and the like—will be forced to affiliate with a larger healthcare system in order to survive.7 Although this prediction may be unduly pessimistic, it is clear that the healthcare industry is undergoing a period of rapid and dramatic change, to which participants and practitioners must quickly adapt. The reason for this situation is not only the 1983 shift in Medicare reimbursements from a cost-based to a fixed-fee-per-case system, a shift subsequently followed by many private insurance companies.8 These Medicare changes radically altered the financial incentives of hospitals, so that higher reimbursement revenues are no longer linked to extended hospital stays but to increased numbers of patient admissions and outpatient services.9 Because such admissions and utilization of facilities are largely controlled by physicians, hospitals have increasingly sought to link themselves financially with referring physicians.10 Joint ventures between hospital and physician are a potent means of forging such a link. EXAMPLE: X, a nonprofit hospital, recognizes that operating its outpatient surgery department is costly and financially risky because of competitive market pressures. A, a for-profit organization, has established a surgery center a few miles away and has offered interests in the businesses to X’s staff physicians. X’s board determines 5
6
7 8 9 10
Mergers, consolidations, and joint ventures proceeded at a pace of almost 2.5 per day during the first half of 1996. Scott, “Will We Like Tomorrow’s Giants?” Modern Health Care (Aug. 5, 1996), (hereinafter “Scott”). Moreover, 20 percent of all community hospitals changed ownership over a three-year period ending in 1996. Id. Although many of these consolidations involve solely for-profit institutions, an increasing number of transactions have included charitable or nonprofit entities. Because a majority of the nation’s hospitals are tax-exempt institutions, it was inevitable that the consolidation boom would eventually reach that community. Whole hospital joint ventures are also referred to as “disposition type” ventures. Mary Jo Salins, Judy Kindell, and Marvin Freidlander, “Whole Hospital Joint Ventures,” Exempt Organizations Continuing Professional Education Technical Instruction Program Textbook for FY 1999 (hereinafter referred to as “1999 CPE Hospital Joint Venture Article”). See, e.g., Pallarito, “Hospital Conversions Raise Thorny Issues,” Modern Health Care (June 17, 1996): 104 (citing comments of California Assemblyman Philip Isenberg). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Medicare policies can greatly influence the behavior of a hospital, because the program accounts for 40 percent of average hospital revenues. Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The IRS noted this change. “Once hospital and physician economic incentives diverged, hospitals began seeking ways to stimulate loyalty among members of their medical staffs and to encourage or reward physician behaviors deemed desirable.” Gen. Couns. Mem. 39,862 (Nov. 21, 1991).
䡲
492
䡲
c12.fm Page 493 Thursday, March 15, 2007 7:59 PM
12.2 CLASSIFICATIONS OF JOINT VENTURES
that if it is unable to maintain physician support and referrals to its own outpatient surgical unit, it will lose substantial revenue. Therefore, X plans to form a joint venture limited partnership to own and operate X’s surgical unit. X will serve as a 1 percent general partner. X’s physicians will serve as 99 percent limited partners. This joint venture arrangement will allow X to provide secure, efficient, and improved surgical services to the public in furtherance of its charitable purposes and will secure physician loyalty and referral support.11 The impact of the federal income tax rules and the determinations of the Internal Revenue Service (IRS) on these transactions cannot be overstated, as demonstrated by the January 1999 decision to abandon a hospital merger because of failure to obtain IRS approval.12 In 1996, Arlington Health Foundation, a nonprofit hospital located in Virginia, had formed a partnership with Columbia/HCA Healthcare Corporation. At the time, Arlington stated that it had to form a partnership with Columbia, the nation’s largest for-profit healthcare company, in order to survive. However, the partnership was dissolved in 1999 “because after more than two years the IRS still had not told the foundation whether it could keep its charitable status while owning half of for-profit Columbia Arlington Healthcare Systems LLC [limited liability company], the foundation said.”13 This chapter describes the types of joint ventures prevalent in the healthcare field and discusses the federal income tax and other issues that arise incident to these ventures.
12.2
CLASSIFICATIONS OF JOINT VENTURES
Joint ventures are often organized as limited partnerships, but, as more states began to recognize limited liability companies, most are now formed as limited liability companies with hospitals serving as the general partner or managing member.14 The major categories of joint ventures in the healthcare field are ancillary joint ventures, whole hospital joint ventures, and joint operating agreements. Each is described in the following paragraphs. As healthcare systems face growing operational costs and falling revenues, these entities continue to look to ancillary joint ventures as particularly effective means that will increase profits while, if designed correctly, preserve their taxexempt status. The continued popularity of ancillary joint ventures can be explained by the benefits that both parties receive when an exempt healthcare system can “contribute” its most profitable assets, such as CT imagery, diagnostic services, and ambulatory surgery into a joint venture arrangement. Ancillary joint ventures have essentially evolved into key financial drivers for hospitals 11
12 13 14
This example is based on the factual situation presented in Priv. Ltr. Rul. 92-33-037 (Aug. 14, 1992). See also Gen. Couns. Mem. 39,732 (May 27, 1988); Rev. Rul. 69-464, 1969-2 C. B. 132. David S. Hilzenrath and Michael D. Shear, “Hospital Alliance in N. Va. to End,” Washington Post (Jan. 29, 1999), E1. Id. 1999 CPE Hospital Joint Venture Article, Section 4.
䡲
493
䡲
c12.fm Page 494 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
struggling to keep up with increasing pressures to keep top-rated physicians on their staffs, while faced with depleted revenues from lowered Medicare reimbursements and tighter insurance industry regulations. These popular ancillary joint ventures typically involve an exempt hospital that joins with a for-profit entity to provide a particular medical service such as home healthcare, magnetic resonance imaging (MRI), or an outpatient surgery center.15 In this arrangement, the exempt hospital contributes only a portion of its assets to the joint venture, and thus continues its independent healthcare activities. Most ancillary joint ventures between hospitals and physicians involve the construction, operation, or acquisition of a new medical facility 16 or the purchase or rental of medical equipment.17 A typical ancillary joint venture structure is diagrammed in Exhibit 12.1.18 According to the Exempt Organizations Continuing Professional Educational Technical Instruction Program for FY 1999 (1999 CPE) Hospital Joint Venture Article, whole hospital joint ventures became more frequent as exempt hospitals sought new ways to remain competitive, in light of the advent of managed care and physician organization contracts, as well as to increase their patient base and control their revenues.19 A typical whole hospital joint venture structure is illustrated in Exhibit 12.2.20
15 16
17
18 19 20
1999 CPE Hospital Joint Venture Article, Section 4D. See, e.g., Priv. Ltr. Rul. 95-18-014 (Feb. 1, 1995) (elder care facility); Priv. Ltr. Rul. 95-18104 (elder care facility); Priv. Ltr. Rul. 94-07-022 (Nov. 22, 1993) (construction of ambulatory surgical center); Priv. Ltr. Rul. 93-23-030 (Mar. 16, 1993) (construction of rehabilitation hospital); Priv. Ltr. Rul. 93-18-033 (Feb. 8, 1993) (inpatient and outpatient orthopedic services); Priv. Ltr. Rul. 93-45-057 (Aug. 20, 1993) (acquisition of ambulatory surgical facility); Priv. Ltr. Rul. 93-19-044 (Feb. 18, 1993) (construction of a university hospital). See Priv. Ltr. Rul. 88-33-038 (May 20, 1988) (joint venture to operate magnetic resonance imaging equipment); Priv. Ltr. Rul. 83-44-099 (Aug. 5, 1983) (joint venture to operate a computerized tomography scanner); Priv. Ltr. Rul. 88-20-093 (Feb. 26, 1988) (exempt organization operation of gastroenterology laboratory and surgical facility furthers exempt purposes); Priv. Ltr. Rul. 85-08-073 (Nov. 28, 1984) (exempt organization, as general partner of a limited partnership, constructed clinical faculty office building and parking garage); Priv. Ltr. Rul. 83-12129 (Dec. 23, 1982) (exempt organization, as general partner of limited partnership, will construct a medical office building); Priv. Ltr. Rul. 83-25-133 (Mar. 22, 1983). Hospital-physician joint ventures are declining in popularity, and many have been forced to “unwind” because of the Stark II antireferral prohibitions. Stark II prohibits Medicare or Medicaid payments for certain enumerated services if an insider referral has been made. See Robert Louthian, “Health Law Update: Discussion of Reasonable Compensation, Physician Practice Acquisitions and Other Valuable Issues: ABA Exempt Organizations Committee Meeting, January 23, 1998,” Exempt Organization Tax Review 20 (May 1998): 273 (hereinafter “Louthian Article”). See also Section 11.3(b). In unwinding these relationships, the participants must take care not to raise additional inurement issues through the disposition of all tangible assets to the physicianpartners (leaving the tax-exempt hospital with below fair market value and only goodwill in an asset that no longer exists) or the payment of greater than fair market value to the limited partners in exchange for their interests. See id.; Section 11.3(b). Id. 1999 CPE Hospital Joint Venture Article, Section 3. 1999 CPE Hospital Joint Venture Article, Section 4B.
䡲
494
䡲
c12.fm Page 495 Thursday, March 15, 2007 7:59 PM
12.2 CLASSIFICATIONS OF JOINT VENTURES
E XHIBIT 12.1 Ancillary Joint Venture Structure
Continues to operate hospital and other exempt activities
For-Profit Health Management Services Corporation
Exempt Hospital
$ Cash
50% interest 50% interest
Facility assets 3 board reps.
3 board reps.
LLC
Ambulatory Surgery Center
E XHIBIT 12.2 Whole Hospital Joint Venture Structure
Exempt Hospital
For-Profit Hospital Management Corporation Hospital Assets
50% interest $ Cash 3 board reps.
3 board reps.
For-Profit Management Subsidiary
50% interest
Management Agreement LLC Hospital
䡲
495
䡲
c12.fm Page 496 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
EXAMPLE: X, a hospital exempt from taxation under IRC §501(c)(3), forms three joint ventures: a free-standing physical therapy center, a free-standing ambulatory surgery center, and a magnetic resonance imaging facility. In each venture, X will serve as the general partner and staff physicians will serve as the limited partners. X has stated that physician participation is critical to the success of the ventures because their participation ensures patient referrals. X’s reason for entering into the joint ventures is to provide improved healthcare services to the public in an area where such services are not generally available. Because each venture creates a new healthcare resource for the area and because physician participation is necessary to the success of the ventures, the joint venture arrangements allow X to act in furtherance of its exempt purposes without improperly benefiting the physicians.21 Another form of joint venture is the “virtual merger” or joint operating agreement (JOA). Typically, a JOA involves two or more exempt healthcare organizations that elect to operate jointly without a merger or asset transfer.22 The operating agreement delineates how the venture will proceed. As of the date of this publication, the IRS had issued rulings only regarding JOAs between exempt organizations; it had not issued any private letter rulings regarding JOAs between nonprofits and for-profit entities, and Rev. Rul. 98-1523 does not address the issue either.
12.3 (a)
TAX ANALYSIS Overview of Tax Restrictions
The federal tax restrictions on hospital and other healthcare transactions are, in broad outline, no different from those discussed earlier in this book as generally applicable to joint ventures involving exempt organizations.24 The overriding planning concern is potential loss of the healthcare organization’s exempt status as a result of the IRS requirement that the joint venture itself pursue an exempt purpose or because of violations of the proscription against private inurement and the public benefit requirement.25 In addition, careful planning is necessary to avoid imposition of the intermediate sanctions excise tax penalty provisions that were added to the Internal Revenue Code (IRC) so that the IRS would have an enforcement tool in addition to revocation of exempt status.26 Finally, there is the possibility that the IRS may assert that although a nonprofit should not lose its exemption as a result of participating in a joint venture, the revenue generated therefrom is unrelated business income (UBI) to the nonprofit.27 21 22 23
24 25 26 27
This example is based on the factual situations presented in Gen. Couns. Mem. 39,732 (May 19, 1988). See also Gen. Couns. Mem. 39,862 (Nov. 21, 1991). 1999 CPE Hospital Joint Venture Article, Section 4(A). 1999 CPE Hospital Joint Venture Article, Section 4(A). Rev. Rul. 98-15, 1998-12 I.R.B.6 The Exempt Organization’s Technical Instruction Program for FY 2000 (hereinafter “2000CPE”) also contains an article on healthcare joint venture arrangements (hereinafter “2000 CPE Joint Venture Article”) which discusses a private letter ruling involving two nonprofits in an ancillary joint venture. See Section 11.3 and footnote 202 therein. See generally Chapters 4 and 7. Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Gen Couns. Mem. 39,862 (Nov. 21, 1991). IRC §4958; Prop. Treas. Reg. §§53.4958-0 through 53.4958-7. Rev. Rul. 98-15; 1999 CPE Hospital Joint Venture Article, Section 1. Also see Section 4.2(i).
䡲
496
䡲
c12.fm Page 497 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
In the 1999 CPE Hospital Joint Venture Article, the IRS states: [T]he activities of the joint venture are considered to be the activities of the exempt organization that is participating as an owner or general partner of the joint venture. Therefore, when evaluating whether an organization that either is under examination or that has applied for exempt status is operated exclusively for exempt purposes within the meaning of IRC §501(c)(3), look to the activities of the joint venture.28
What is different in the healthcare area is the prodigious volume of detailed industry-specific guidance that the IRS has issued in response to perceived abuses.29 (b)
The IRS’s Historical Position
Prior to the Ninth Circuit Court of Appeals decision in Plumstead Theatre Society,30 an exempt organization ceased to qualify for tax exemption when it served as a general partner in a joint venture with for-profit partners.31 Following the Plumstead decision, however, the position of the IRS is that participation of an exempt healthcare organization in a joint venture will not per se jeopardize its exempt status.32 However, the IRS will closely examine all of the facts and circumstances of each case.33 28 29
30 31 32 33
1999 CPE Hospital Joint Venture Article, Section 6. See, e.g., Gen. Couns. Mem. 39,862 (Nov. 21, 1991); see General Accounting Office, “NonProfit Hospitals: For-Profit Ventures Pose Access and Capacity Problems,” Report to Congressional Requesters (July 1993) (hereinafter “GAO Report”) (GAO reiterated motivations for healthcare organizations and physicians entering into joint ventures). Ann. 92-83, 1992-22 I.R.B. 59. See also Priv. Ltr. Rul. 93-08-034 (Nov. 30, 1992); Priv. Ltr. Rul. 92-21-052 (May 22, 1992); Priv. Ltr. Rul. 92-33-037 (Aug. 14, 1992). Plumstead Theatre Society, Inc. v. Commissioner, 675 F.2d 244 (9th Cir. 1982) (per curiam) aff’g 74 T.C. 1324 (1980). See Gen. Couns. Mem. 39,392 (May 30, 1975). See Priv. Ltr. Rul. 94-07-022 (Nov. 22, 1993); Priv. Ltr. Rul. 93-45-057 (Aug. 20, 1993); Priv. Ltr. Rul. 93-18-033 (Feb. 8, 1993). See Gen. Couns. Mem. 37, 852 (Feb. 9, 1979); Gen. Couns. Mem. 39, 732 (May 19, 1988). See also Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991); Priv. Ltr. Rul. 86-38-131 (June 27, 1986). The IRS has held that participation by a §501(c)(3) organization, as a general partner, in a limited partnership does not per se endanger the organization’s exempt status. However, it is necessary to ensure that the obligations of the exempt organization as general partner do not conflict with the organization’s ability to pursue exclusively charitable goals. Thus, in all partnership cases, the initial focus should be on whether the exempt organization is serving a charitable purpose. Once a charitable purpose has been established, the partnership agreement itself should be examined to see whether the arrangement permits the exempt organization to act exclusively in furtherance of the purposes for which exemption was granted and not for the benefit of the limited partners. Priv. Ltr. Rul 91-47-058. In Priv. Ltr. Rul. 94-07-022 (Nov. 22, 1993), the IRS followed the Plumstead analysis in approving a joint venture arrangement between a hospital and a partnership composed of doctors and dentists with staff privileges at the hospital. The joint venture would own and operate an ambulatory surgical center. As may be expected after Gen. Couns. Mem. 39,862 (discussed later in text), the ruling was premised on the condition that the joint venture arrangement not violate the Medicare and Medicaid Antikickback Statute. See also Priv. Ltr. Rul. 97-09-014 (Nov. 26, 1996) (IRS ruled that hospital’s acquisition of a 40 percent general partnership interest in an ambulatory surgical center, whose other limited partnership interests were owned by an affiliated for-profit corporation and private physicians, will not jeopardize its exempt status, and income from partnership will not constitute unrelated business taxable income. Among other things, the IRS said that the hospital’s arrangement with for-profit partners does not “per se” endanger its exempt status and that the hospital would continue to promote health owing to its control over the partnership and the requirements of the certificate of need).
䡲
497
䡲
c12.fm Page 498 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
(i) Charitable Purpose. A threshold inquiry is whether the activity of the joint venture is related to the hospital’s exempt purpose.34 EXAMPLE: A, an exempt hospital, enters into a joint venture to operate a physical therapy center. Under the joint venture arrangement, A will serve as one of two general partners and physicians will serve as the limited partners. A’s charitable purpose is to promote health in the community. A has stated that the joint venture will further its charitable purpose by providing better medical services to the public and promoting improved community health. The IRS has held that this arrangement will further A’s exempt charitable purpose.35
34
35
“Exempt Organizations: Examination Guidelines for Hospitals,” Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992); Gen Couns. Mem. 39,862 (Nov. 21, 1991). See also Gen. Couns. Mem. 39,732 (May 27, 1988); Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991); Priv. Ltr. Rul. 87-09-051 (Dec. 3, 1986); Priv. Ltr. Rul. 87-05-089 (Nov. 7, 1986). See also Priv. Ltr. Rul. 97-34-026 (May 21, 1997) (formation of for-profit corporation by six §501(c)(3) taxexempt healthcare organizations (to provide various services including marketing and sales, product development, network development, contract negotiations, and centralized information to such organizations) through which such organizations could address their community’s healthcare needs satisfied the charitable purpose requirement); Carolyn D. Wright, “IRS Rules Corporate Practice of Medicine Exempt in Ohio,” Tax Notes Today 97 (Aug. 12, 1997): 155-2 (IRS granted §501(c)(3) status to a professional stock corporation that was incorporated to provide clinical medical care in conjunction with an exempt hospital because the corporation’s “structural and financial components are, in fact, controlled by the Hospital, a section §501(c)(3) organization with a community Board of Directors” and the corporation serves a charitable purpose by directly providing medical services to the community regardless of individuals’ ability to pay); “IRS Exemption Ruling Finding Organization That Negotiates Health Care Service Contracts Is Exempt,” Tax Notes Today 97 (July 8, 1997): 131-15 (IRS reversed prior decision rejecting exempt status and ruled that organization that negotiates and obtains service agreements with employers, insurance companies, health benefit trusts, and other similar entities, for the provision of healthcare services to their employees, insureds, beneficiaries, or other eligible individuals on behalf of a tax-exempt member organization was itself tax-exempt. Among other things, the organization amended its articles of incorporation to remove a nonexempt member organization as a member in order to satisfy IRS). In Carolyn D. Wright, “Exemption Ruling Illustrates Distinction Between Integral Part and Feeder Organization,” Tax Notes Today 97 (July 8, 1997): 130-7, T. J. Sullivan stated that having a “nonexempt member tended to suggest (the subject organization) wasn’t operated exclusively for exempt purposes” and although the subject organization might still be contracting with the nonexempt organization, removing it as a member allowed the subject organization to qualify for exemption as an organization providing essential services as an integral part of an exempt organization). Also see Priv. Ltr. Rul. 97-25-035 (Mar. 24, 1997) (the expansion of the purpose of a §501(c)(3) tax-exempt healthcare organization, which was originally created by a county hospital authority to provide funding for healthcare services to the indigent, to include providing funding and assistance for governmental agencies servicing community healthcare needs, will not jeopardize its tax-exempt status). See discussion of integral part test in Section 11.7(b). This example is based on the factual situation presented in Gen. Couns. Mem. 39,732 (May 27, 1988).
䡲
498
䡲
c12.fm Page 499 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
CAVEAT The joint venture arrangement described in the preceding example must further A’s charitable purposes and must not, more than incidentally, benefit the private interests of the staff physicians.* Otherwise, the IRS is likely to conclude that this is a profit-sharing venture; the increased physician loyalty and improved access to the therapy unit bear only a tenuous relationship to A’s charitable purposes. In addition, if the IRS characterizes the venture as a profit-sharing vehicle, the IRS would likely find that the joint venture is operating primarily for the private benefit of the staff physicians.† Therefore, not only would this structure result in private benefit, and perhaps private inurement and be considered an excess benefit transaction, but the joint venture may jeopardize A’s tax-exempt status.‡ * †
‡
See generally Chapter 4. Priv Ltr. Rul. 92-33-037 (Aug. 14, 1992). See also Gen. Couns. Mem 39,862 (Nov. 21, 1991) (the IRS held that the sale of the “net revenue stream” to a staff physician joint venture impermissibly benefits the private interests of the physicians). Priv. Ltr. Rul. 92-33-037 (Aug. 14, 1992); Priv. Ltr. Rul. 92-31-047 (July 31, 1992). See Sections 5.4 and 12.3(c).
Originally, exempt status was conferred to hospitals on the theory that hospitals served the public by furthering charitable goals and providing health services to persons unable to pay.36 In 1969, after the enactment of the Medicare and Medicaid programs and following the release of Revenue Ruling 69-545, the IRS adopted the “community benefit” standard.37 In defining this standard, the IRS stated that the promotion of health, like the relief of poverty and the advancement of education and religion, is one of the purposes in the general law of charity that is deemed beneficial to the community as a whole even though the class of beneficiaries eligible to receive a direct benefit from its activities does not include all members of the community, such as indigent members of the community, provided that the class is not so small that its relief is not of benefit to the community.38
Under this standard, hospitals and other healthcare organizations are exempt from taxation under IRC §501(a) if they can prove that they meet the “community benefit” standard set forth in §501(c)(3).39 Thus, the organization must further exclusively public charitable purposes rather than benefit private interests.40 The
36
37 38 39 40
Rev. Rul. 56-185, 1956-1 C. B. 202. This was the first IRS ruling on the point; the “charity care” standard was espoused by the IRS. The IRS required hospitals to provide charity care to needy persons to the extent that the hospital was financially able, and not merely to provide care to persons who are able and expected to pay. Rev. Rul. 69-545, 1969-2 C.B. 117. Rev. Rul. 69-545, 1969-2 C. B. 117, 118. §501(c)(3); Reg. §1.501(c)(3)-1; Rev. Rul. 69-545, 1969-C.B. 117. Reg. §1.501(c)(3)-1(d)(1)(ii).
䡲
499
䡲
c12.fm Page 500 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
IRS has provided factors useful in determining whether a hospital or other healthcare organization meets the community benefit standard:41 • Does the hospital have a governing board composed of prominent civic
leaders rather than hospital administrators and physicians?42 • If the organization is part of a multi-entity hospital system, do the corpo-
rate documents reflect corporate separateness and do the board members understand the purposes and activities of the hospital?43 • Is admission to the medical staff open to all qualified physicians in the
area, consistent with the size and nature of the hospital facilities?44 • Does Philly the hospital operate a full-time emergency room that is open
to the general public without regard to patients’ ability to pay?45 • Does the hospital provide non-emergency-room care to everyone in the
community who is able to pay, either privately or through third parties, including Medicare and Medicaid?46 In order to satisfy the “community benefit” standard by which hospitals maintain tax-exempt status,47 hospitals offer various charitable purposes for their joint venture activity.48 The primary charitable purpose is the promotion of healthcare to persons in the hospital’s service area.49 In a preeminent Revenue Ruling in this area, the IRS stated that a “nonprofit organization whose purpose and activity [is] providing hospital care is promoting health . . . [and] . . . may, 41 42
43 44 45
46 47 48
49
Rev. Rul. 69-545, 1969-2 C.B. 117; “Exempt Organizations: Examination Guidelines for Hospitals,” Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992). The IRS will scrutinize the Form 990 and the corporate minutes to determine the activity level of the individual board members. Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992). Prior to 1997, the composition of community boards was governed by Rev. Proc. 93-19, 1993-1 C.B. 526, which stated that persons who are insiders—financially related, directly or indirectly, to any shareholder or employee of the medical group or physician providing services in conjunction with the hospital or healthcare group—should not hold more than 20 percent of the available positions on the governing body. However, the IRS has indicated that a board composed of up to 49 percent interested persons is permissible if the hospital has adopted a substantial “conflicts of interest policy,” conducts a periodic review of its activities (and the activities of the system in which it is involved) to ensure that it is operating in accordance with charitable purposes, and ensures that the conflicts policy is being properly and effectively applied. See 1996 (for Fiscal Year 1997) Exempt Organizations CPE Technical Instruction Program Textbook at 17 (hereinafter “1997 CPE Article”). The 2000 CPE contains a revised sample Conflicts of Interest Policy 2000 CPE Part IE. Rev. Rul. 69-545, 1969-2 C.B. 117. Id. Id. The operation of an emergency room is one of the primary factors for determining exempt status. However, a hospital would not be precluded from exemption if it did not operate an emergency room where the state health planning agency determined that such facilities are unnecessary or duplicative. Rev. Rul. 83-157, 1983-2 C.B. 94. Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992). §501(c)(3); Reg. §1.501(c)(3)-1; Rev. Rul. 69-545, 1969-2 C.B. 117. Because the proposed health reform would provide universal health insurance instituting coverage for the poor, non-profit hospitals would naturally provide less “charity care.” Thus, to maintain tax-exempt status, hospitals will have an increased burden of proving their community benefit. See American Health Security Act of 1993, note 2. Reg. §1.501(c)(3)-1(d)(2). The regulation provides that the term “charitable” includes the promotion of health. See also Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991) (hospital promoted health by providing ambulatory and outpatient services to the community); Restatement (Second) of Trusts, §§368; 372.
䡲
500
䡲
c12.fm Page 501 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
therefore, qualify as organized and operated in furtherance of a charitable purpose if it meets the other requirements of IRC §501(c)(3).”50 The IRS detailed the charity care requirement of the community benefit standard in a field service advice memorandum (FSA) dated March 12, 2001. It contained 14 specific factors for IRS auditors to use when examining hospitals to decide whether they provide sufficient services to the indigent. A stated policy will not meet the operational standard without evidence that the policy is actually implemented. The FSA asks, for example, What documents must indigent patients sign before receiving care? What does the hospital tell ambulance services about bringing poor patients to its emergency room? and Does the hospital maintain a separate record of the costs of free or reduced-cost care?51 The evolving IRS position is laid out more comprehensively in the Exempt Organizations Continuing Professional Education (CPE) Instruction Program for Fiscal Year 2002. The “Update on Health Care” article in the CPE points out that while every healthcare facility is not expected to operate an emergency room, lack of an emergency room makes other factors more important to demonstrate community benefit. (For example, a community board, open staff, treatment of Medicare and Medicaid patients, using surplus to improve facilities and equipment, contributing to medical training, education and research, and adoption and implementation of charity care policies.) The two examples given describe mobile vans providing free medical services to indigent inner city residents. Neither is expected to provide emergency room services.52 Other governmental agencies, however, are concerned that many hospital joint ventures have abandoned charitable activities that benefit the public, such as providing care to the poor. In fact, in a study of joint ventures the government found that the ventures offered “significantly less care to Medicaid and charity patients. . . . 13 of 23 served no Medicaid patients and 6 reported providing no uncompensated care.”53 EXAMPLE: A joint venture owned and operated a magnetic resonance imaging (MRI) facility. The venture reported no revenue from Medicaid in 1991, whereas its parent hospital reported 12.3 percent of revenue from Medicaid. An administrator of the joint venture indicated that the venture did not serve Medicaid patients because of low reimbursement rates and slow payments.54 It is this type of “profit-motivated” activity that the IRS and other governmental agencies are likely to scrutinize.
50 51 52
53
54
Rev. Rul. 69-545, 1969-2 C.B. 117; Priv. Ltr. Rul. 93-01-023 (Jan. 8, 1993). F.S.A. 200110030. Lawrence M. Brauer, Mary Jo Salins, and Robert Fontenrose, “Update on Health Care,” Exempt Organizations Continuing Professional Education (CPE) Instruction Program for Fiscal Year 2002, pp. 171– 174. GAO Report at 3. This trend is disturbing because hospitals originally obtained tax-exempt status based on their willingness to provide care to those unable to pay. Rev. Rul. 56-185, 1956-1 C. B. 202. GAO Report at 6. See also “Joint Ventures Among Health Care Providers in Florida,” State of Florida Health Care Cost Containment Board (Sept. 1991).
䡲
501
䡲
c12.fm Page 502 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
It is evident that many healthcare organizations are attempting to expand the outer limits of the “community benefit” standard by entering into complex joint venture arrangements.55 The IRS has recognized this phenomenon: [T]he joint venture arrangements . . . are just one variety of an increasingly common type of competitive behavior engaged in by hospitals in response to significant changes in their operating environment. . . . [T]he marked shift in governmental policy from regulatory cost controls to competition has fundamentally changed the way all hospitals, for-profit and not, do business.56
With the stretching of the joint venture envelope by healthcare organizations, the IRS and other federal agencies are now “carefully examin[ing]” healthcare entities and their joint venture arrangements to assess the validity of their charitable goals.57 Faced with declining net revenues from changes in state and federal healthcare regulations and reimbursement strategies, many hospital systems have implemented ventures with the for-profit sector that provide an allied, medically integrated wellness facility as part of its campus. The Service has determined that these wellness centers may be exempt under §501(c)(3) where the center is operated as part of a larger tax-exempt system, such as a §501(c)(3) hospital, or where the operation of the center is the §501(c)(3) organization’s primary activity.58 A hospital wellness center dedicated to the general public in the community, and charitable in that it serves a generally recognized public purpose (which tends to lessen the burdens of government), is generally considered an exempt activity under §501(c)(3).59 Under the community benefit rule, hospital wellness centers may also be classified as charitable if they are open to the general public, including a wide segment of the community.60 Historically, the IRS has taken the position that physicians performing services for a hospital, in the aggregate, are subject to IRS scrutiny with regard to private inurement, even if the physicians do not have a controlling or “insider” relationship.61 The IRS based its stance on the “close professional working 55 56
57
58 59 60 61
Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992). See also Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The analysis in this memorandum provides guidance for hospitals that wish to engage in joint ventures with a partnership utilized as the vehicle. See also Priv. Ltr. Rul. 93-08-034 (Nov. 30, 1992) (in a joint venture to operate an acute care hospital, the exempt organization did not jeopardize its exempt status by entering into a joint venture with a for-profit organization). Ann. 92-83, 1992-22 1. R.B. 59 (June 1, 1992); GAO Report at 4. This increased governmental scrutiny has had an effect on hospital joint venture activity. Nonprofit hospitals participated in 462 joint ventures in 1989. By 1991, participation had declined to 391 hospital joint ventures. Id. Of these nonprofit hospitals engaged in a joint venture activity, the average rate of participation was 1.4 joint ventures per hospital. Id. at 5. I.R.S. INFO 2005-002 (March 31, 2005). Rev. Rul. 59-310, 1959-2 C.B. 146. Rev. Rul. 67-325, 1967-2 C.B. 113. For further discussion of the community benefit standard, see Rev. Rul. 69-545. Gen. Couns. Mem. 39,670 (Oct. 14, 1986); Gen. Couns. Mem. 39,498 (Apr. 24, 1986). But see Committee Report to the Intermediate Sanctions provisions (§4955) n.12, H. Rep. 506, 104th Cong., 2d Sess. (1996), which provides that for the purposes of intermediate sanctions penalties, physicians will be considered disqualified persons only if they are in a position to exercise substantial control over the affairs of the organization. This statement demonstrates legislative disagreement with the Treasury’s position that automatically classifies doctors as “insiders” with respect to their affiliated institutions. See the discussion of the intermediate sanctions proposed regulations in Sections 5.4 and 12.3(c).
䡲
502
䡲
c12.fm Page 503 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
relationship” the physicians maintain with the hospital.62 Informally, the IRS has suggested that the treatment of physicians as insiders is a rebuttable presumption and, further, that new physicians will be subject to the private benefit analysis as opposed to the private inurement analysis.63 In Revenue Procedure 97-13,64 the IRS set a “safe harbor” limitation on the number of physicians who could sit on the board of directors of independent delivery systems (IDS), specifically tax-exempt hospitals and their affiliates. The revenue procedure provided that no more than 20 percent of the board may be made up of individuals financially related, directly or indirectly, to any medical group or physician providing service in conjunction with the IDS.65 The position of the IRS was a rigid one: Unless a would-be exempt healthcare organization’s governing documents specifically provided that no more than 20 percent of the voting power of the board would be held by physicians having a financial interest in the organization, the IRS would not issue a favorable determination letter. Further, the 20 percent limitation was pervasive in its application. It covered both physicians directly related to the hospital and those performing services for an ancillary medical group that the hospital may have acquired through a joint venture or purchase, and the rule applied to each organization in the structural chain.66 The 20 percent limitation would apply to an organization even if its taxexempt parent was controlled by a community board that retained extensive powers over the operations of the subsidiary.67 As a whole, the 20 percent limitation was “an impediment to [many] nonprofit integrated delivery systems,” particularly when physicians became aggressive in seeking greater control over the system’s operations.68 In 1996, however, the IRS eased its hard-line stance on physician representation,69 expanding the safe harbor percentage in an article contained in the 1997 CPE.70 The article stated that failure to meet the 20 percent test “does not 62 63
64 65
66
67 68 69
70
Gen. Couns. Mem. 39,498 (Apr. 24, 1986). Remarks of T.J. Sullivan, while serving as Technical Assistant, IRS Office of Associate Chief Counsel (Employee Benefits and Exempt Organizations), reported in Exempt Organization Tax Review 8 (Aug. 1993): 256. See Audit Guidelines, IRM7(10)69-38 (Mar. 27, 1992),¶ 333.2(1); Ann. 92-83, 1922-22 I.R.B. 59; see also Section 12.4(c), for a discussion of physician recruitment and intermediate sanctions. The 2000 CPE contains an article on physician incentives and states that the IRS no longer classifies physicians as insiders. 2000 CPE, Part IC. Rev. Proc. 97-13, 1997-5 I.R.B.1. 1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook at 228; 1995 (for Fiscal Year 1996) Exempt Organizations CPE Technical Instruction Program Textbook at 384. See Mills, “IRS Prepares a New Position on Governance for Exempt Health Care Organizations,” Journal of Tax Exempt Organizations 8 (Nov./Dec. 1996): 124 (hereinafter “Mills”). No physician representation was permitted on the compensation committee. The 2000 CPE contains a revised sample Conflicts of Interest Policy which again provides that physicians who receive compensation cannot serve on any compensation committee. 2000 CPE, Part IE. Id. Remarks of T. J. Sullivan, reported in Carson, “Service Eases Stance on Physician Board Representation,” Tax Notes Today 96: 132-1 (hereinafter “Carson”). T. J. Sullivan, former special assistant for healthcare in the IRS office of the assistant commissioner (EP/EO), characterized the change as a “surprising and welcome development . . . [that] reflects the IRS’s increasing comfort level with integrated delivery system arrangements and a new willingness to allow some benefits to flow to physicians, so long as the organization is truly governed by a community based board of directors.” Id. 1996 (for Fiscal Year 1997) Exempt Organizations Continuing Professional Education Technical Instructions Program Textbook Section C (hereafter “1997 CPE Conflicts Article”).
䡲
503
䡲
c12.fm Page 504 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
preclude exemption.”71 The IRS would examine other facts and circumstances, such as whether the board represents a cross section of the community, whether a majority of board members are independent, whether the board has adopted a conflict-of-interest policy, and whether there are periodic reviews to confirm that the organization is operating in a charitable manner.72 To take advantage of this significantly liberalized safe harbor, however, a number of conditions must be fulfilled. In addition to the “community board” requirement,73 as a general rule healthcare organizations seeking exemption rulings will be required to adopt a substantive conflict-of-interest policy.74 All exempt members of the system have to adopt the policy,75 and the policy should include the following provisions in order to be acceptable to the IRS. The policy should • Apply to all transactions with “interested persons.”76 • Require disclosure by interested persons of any financial interests and the
facts surrounding those interests. • Include procedures for determining whether the financial interests of any
parties give rise to a conflict of interest. • Include procedures for addressing conflicts of interests, if any exist.77 • Provide for adequate record keeping of meetings, including the applica-
tion of the conflicts policy, the recording of any conflicts or financial interests that are disclosed by members, the resolutions of any potential conflicts, and the persons that voted on, and were present during the discussions and vote surrounding, any conflict resolution.78 71 72 73
74
75 76
77
78
Id. Id. The 1997 CPE Conflicts Article states “A majority of the voting members of the board of trustees of a hospital should be comprised of independent community members.” This means practicing physicians affiliated with the hospital, as well as officers, department heads, and other employees of the hospital, cannot constitute a majority of the board. In a multientity hospital system, the question of whether the board of a subsidiary nonprofit healthcare organization is considered to be composed of independent community members is determined by the composition of the parent’s board of directors. 1997 CPE Conflicts Article. The IRS has indicated that the presence of such a policy is a “significant” factor in demonstrating that a healthcare organization operates for public rather than private benefit. Id. at 21. 2000 CPE, Part IE. A revised sample conflict of interest policy from the Exempt Organization Continuing Professional Education Instruction Program for FY2000 is included in Appendix 12A of this chapter. Id. Interested persons include individuals who (1) are trustees, directors, principal officers, and members of committees to which the board has delegated certain of its powers and (2) have a direct or indirect “financial interest” in the organization. Id. at 21. Persons have a financial interest if they have, through business, investment, or family (1) an ownership interest in any entity with which the exempt has a financial relationship; (2) a compensation arrangement with the exempt entity, or with any entity described in section (1); or (3) a potential ownership interest in, or compensation arrangement with, any entity or individual with which the exempt entity is negotiating a transaction or arrangement. Id. at 24. Note that section (3) bars a member of the board from voting on his or her own compensation package. These procedures include (1) requiring the interested person to leave the meeting during discussion; (2) investigating, through an independent person or subcommittee, the conflict and proposed alternatives to the contemplated transaction giving rise to the conflict; and (3) allowing for a majority vote of disinterested trustees to approve the transaction despite the conflict if, after a due diligence inquiry, they determine that the arrangement is in the best interests of the organization and a better result cannot be achieved through reasonable efforts. Id. at 21–22. Id. at 22.
䡲
504
䡲
c12.fm Page 505 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
• Include procedures ensuring that all trustees receive, read, understand,
and agree to comply with the policy.79 • Bar physicians with a financial interest in the affairs of the organization
from sitting on the compensation committee.80 • Provide for disciplinary and corrective action against an interested person
who fails to comply with the conflicts policy.81 • Provide for annual compliance audits with additional review of interme-
diate sanction applicability. The IRS has provided that another “significant” factor demonstrating operation for community rather than private interest is that members of the board of trustees require a periodic and systemic review of their activities to ensure (1) compliance with the conflicts policy, (2) that all affiliated organizations are operating in a manner consistent with charitable purposes,82 and (3) no private inurement or private benefit has resulted from their activities.83 With respect to existing organizations, those that have received determination letters based on representations that their boards will be composed of no more than 20 percent physicians, are technically bound by such statements. Should such an organization seek to increase the number of physicians on its board, it must apply for a private letter ruling that the increase will not adversely affect its tax-exempt status.84 (ii) Charitable Assets Must Further Exempt Purposes. Another basic inquiry is whether the partnership arrangement permits the hospital to operate exclusively in furtherance of its exempt purposes. The IRS has noted that the entire body of law and regulations under which hospitals enjoy exemption from federal income taxes is designed in large part to ensure that charitable assets are dedicated exclusively to furthering public purposes. . . . [because a] charitable organization is viewed under the common law and the Internal Revenue Code as a trust whose assets must irrevocably be dedicated to achieving charitable purposes. [Hence], the inurement prohibition serves to prevent anyone in a position to do so from siphoning off any of a charity’s income or assets for personal use.85 79 80 81
82
83
84 85
Id. at 22–23. The policy suggests that each interested person sign an annual statement to this effect. Id. Id. at 23. The 2000 CPE contains a revised Conflicts of Interest Sample Policy which contains a similar provision. 2000 CPE, Part IE. Id. at 22. The conflicts policy and §4955 intermediate sanctions provisions should work well in tandem. By interweaving the requirements of both policies, application and self-enforcement of these rules should enable many exempt organizations to eliminate many instances of inadvertent prohibited inurement or private benefit. See Mills at 126; Carson, note 66. Areas targeted for review include the reasonableness of compensation, acquisitions of physician practice groups, joint ventures, management service organizations (MSOs), physicianhospital organizations (PHOs), and joint operating agreements. Mills at 125. If impermissible private benefit or inurement is found to have occurred, the situation should, of course, be remedied at the first opportunity. Application of the intermediate sanctions could provide for undoing of the transactions involved and the imposition of excise taxes, and the original conflicts policy should be modified to prevent a recurrence of the inurement event. Mills at 126. The organization would likely be required to adopt the conflict-of-interest and periodic review policies as a precursor to a favorable ruling. Id. Gen. Couns. Mem. 39,862 (Nov. 21, 1991).
䡲
505
䡲
c12.fm Page 506 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
If a nonprofit hospital is a general partner, a conflict may arise between its charitable functions and its fiduciary obligations under state law to benefit the financial interests of all partners.86 The IRS explains its position as follows: [B]y agreeing to serve as the general partner of the [joint venture], the [exempt] corporation would take on an obligation to further the private financial interests of the limited partners. . . . [T]he promotion of those private interests would tend to foster operating and maintenance practices favoring the equity holdings of the limited partners to a greater extent than would otherwise be justifiable on the basis of reasonable financial solvency.87
However, the IRS has sanctioned a joint venture arrangement generally where the terms of the partnership agreement insulate the exempt general partner from the potentially offending partnership decision-making power.88 EXAMPLE: Referring to the facts of the first example in Section 12.3(b)(i), the joint venture arrangement provides that A is one of two general partners. The other general partner, Z, a for-profit entity, will act as the managing partner. As such, Z is responsible for the day-to-day management and operation of the physical therapy center. Furthermore, all profits, losses, gain, and deductions will be allocated among the general and limited partners according to their respective partnership interests. There will be no special allocations. Under these facts, the IRS held that there is no conflict presented by A’s serving as a general partner. The presence of a second general partner, who is responsible for the management and operation of the facility, provides insulation for A against potential statutory conflict.89 (iii) Private Benefit and Inurement. A third key factor is whether the terms of the joint venture agreement and any ancillary agreements adequately protect the nonprofit hospital’s financial interests and prevent excessive financial benefits from flowing to the nonexempt partners.90 Although the requirements for finding inurement and private benefit are similar, inurement and private benefit differ in two respects. First, a minimal amount of inurement results in disqualification from exempt status,91 whereas private benefit must be more than quantitatively 86
87 88
89 90
91
Uniform Limited Partnership Act, §9 (1916); Revised Uniform Limited Partnership Act, §403 (1976). See also Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992); Gen. Couns. Mem. 36,293 (May 30, 1975). See generally Chapter 4. Gen. Couns. Mem. 36,293 (May 30, 1975), quoted in Gen. Couns. Mem. 37,852 (Feb. 15, 1979). Gen. Couns. Mem. 39,546 (Aug. 15, 1986); Gen. Couns. Mem. 39,444 (July 18, 1985); Gen. Couns. Mem. 37,852 (Feb. 15, 1979). See also Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991); Priv. Ltr. Rul. 86-31-094 (May 7, 1986); Priv. Ltr. Rul. 86-21-059 (Feb. 25, 1986). Gen. Couns. Mem. 39,732 (May 27, 1988); Gen. Couns. Mem. 39,546 (Aug. 15, 1985). Private inurement was a key topic of concern at Congressional hearings held to discuss §501(c)(3) organizations. See Boisture and Cerny, “Second Oversight Subcommittee Hearing Explores Need for Intermediate Sanctions and More Disclosure,” Tax Notes (Sept. 6, 1993). The Subcommittee also discussed public disclosure, intermediate sanctions, and revisions to the Form 990. Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279 (1945); Universal Life Church, Inc. v United States, 13 Ct. Cl. 567 (1987), affd, 862 F.2d 321 (1988) (court utilized the single noncharitable purpose test to balance the charitable and noncharitable purposes, ultimately denying the tax exemption); Stevens Bros. Foundation, Inc., v. Commissioner, 324 F.2d 633 (8th Cir. 1963), aff’g 39 T.C. 93 (1962), cert. denied, 376 U.S. 969 (1964), reh’g denied, 377 U.S. 920 (1964); Copyright Clearance Center v. Commissioner, 79 T.C. 793, 804 (1982).
䡲
506
䡲
c12.fm Page 507 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
or qualitatively incidental in order to jeopardize tax-exempt status.92 Second, inurement applies only to “insiders,”93 whereas private benefit may be applicable to anyone.94 Thus, the regulations under IRC §501(a) make it clear that the words “private shareholder” refer to persons having a personal and private interest in the organization (inurement), as opposed to members of the general public or the organization’s intended beneficiaries (private benefit).95 Prior to enactment of the intermediate sanction provisions, the IRS ruled that all physicians on the medical staff of a hospital have a personal and private interest in the activities of the hospital, that is, they are insiders.96 Furthermore, a single purpose to benefit the physicians will jeopardize the organization’s exempt status.97 Specifically, the IRS focused on private inurement issues that may arise in a joint venture between a hospital and its physicians.98 Inurement may occur in many different contexts in a joint venture situation, including the following: • Payment of excessive compensation to the nonexempt partner99 • A disproportionate allocation of profits and losses to the nonexempt
partner100 • Payment of inadequate rent by a physician101
92
93
94 95
96
97 98 99
100 101
Rev. Rul. 69-545, 1969-2 C.B. 117; Gen. Couns. Mem. 39,762 (Oct. 24, 1988) (private benefit must be incidental in both a qualitative and a quantitative sense); Gen. Couns. Mem. 37,789 (Dec. 18, 1978). See, e.g., St. Louis Union Trust Co. v. United States, 374 F.2d 427 (8th Cir. 1967) (when activity serves both exempt and nonexempt purposes, the organization is exempt only if exempt purposes are predominant). This private benefit must be “incidental” in both a qualitative and a quantitative sense. See Rev. Rul 70-186, 1970-1 C. B. 128 (example of qualitative aspect); Rev. Rul 76-152, 1976-1 C. B. 151 (example of quantitative aspect). An insider is any individual whose relationship to an organization offers him or her an opportunity to make use of the organization’s income or assets for personal gain. American Campaign Academy v. Commissioner, 92 T.C. 1053, 1066 (1989). The proscription against inurement generally applies to a distinct class of private interests—typically individuals who, because of their relationship with the organization, have an opportunity to control or influence its activities. Ann. 92-83, 1992-22 I.R.B. 59, §333.3 (June 1, 1992). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Reg. §1.501(a)-1(c). See Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Ann. 92-83, 1992-22 I.R.B. 59, §333.2 (June 1, 1992); see also Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991). See generally Chapter 4. Gen. Couns. Mem. 39,498 (Jan. 29, 1986); Gen. Couns. Mem. 39,670 (June 17, 1987); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The legislative history of the intermediate sanctions provisions (§4958) states, however, that “physicians will be considered disqualified persons” for the purposes of the intermediate sanctions” only if they are in a position to exercise substantial influence over the affairs of the organization.” H. Rep. No. 506, 104th Cong., 2d Sess. n.12 (1996). See Section 5.4. Gen. Couns. Mem. 37,789 (Dec. 18, 1978); American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). Gen. Couns. Mem. 37,789 (Dec. 18, 1978); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Ann. 92-83, 1992-22 I.R.B. 59, §333.2 (June 1, 1992). Of note, the payment of personal expenses of a physician, which the exempt organization did not characterize as compensation, may constitute inurement when, if added to compensation, the total amount of compensation is unreasonable. Founding Church of Scientology v. United States, 412 F.2d 1197 (Ct. Cl. 1969), cert. denied, 397 U.S. 1009 (1976); John Marshall Univ. v. United States, 81-2 USTC 9514 (Ct. Cl. 1981). Ann. 92-83, 1992-22 I.R.B. 59, §333.4 (June 1, 1992) (this would also include payment of excessive rent to a physician). Texas Trade School v. Commissioner, 30 T.C. 6,42 (1958), aff’d, 272 F.2d 168 (5th Cir. 1959).
䡲
507
䡲
c12.fm Page 508 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
• Receipt by the hospital of less than fair market value in sales or exchanges
of property with the venture102 • Inadequately secured loans or other questionable loan transactions103 • Unreasonable payments for physician services104 • Any other arrangements that amount to a “dividend-like” distribution105
This does not mean, however, that there can be no economic dealings between a hospital and its physicians.106 For example, the inurement proscription does not hinder the payment of reasonable compensation for goods or services.107 Rather, “it is aimed at preventing dividend-like distributions of charitable assets or expenditures to benefit private interests.”108 Hence, hospitals and physicians can jointly undertake an activity that furthers the hospital’s exempt purpose as long as the joint venture arrangement is structured to prevent private inurement and private benefit.109 The IRS has also ruled, in four identical private letter rulings,110 that the participation by three IRC §501(c)(3) hospitals and the for-profit subsidiaries of two of such tax-exempt hospitals in a joint venture to operate a diagnostic laboratory did not result in private benefit, although the IRS said that their arrangement did raise private benefit issues under the joint venture’s operating agreement. These issues arose because the participants’ profits and losses were not allocated based on invested capital. Instead, profits and losses were specially allocated among the participants based on source, differentiating between patient and nonpatient sources following the principles set forth by the IRS in 102
103 104
105 106 107
108
109 110
Sonora Community Hospital v. Commissioner, 46 T.C. 519 (1966). See also Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See also LAC Facilities, Inc. v. United States, No. 94-604T (Fed. Cl. 1994) (Florida hospital challenged IRS’s revocation of exemption based in part on purchase of medical practices at inflated prices and resale to insiders at below-market prices). See also discussion of Anclote Psychiatric, Section 12.6(b). Lowery Hospital Assn. v. Commissioner, 66 T.C. 850 (1976); Founding Church of Scientology v. United States, 412 F.2d 1197 (Ct. Cl. 1969), cert. denied, 397 U.S. 1009 (1976). Rev. Rul. 69-383, 1969-2 C.B. 113. See generally Mabee Petroleum Corp. v. United States, 203 F.2d 872 (5th Cir. 1953); Birmingham Business College, Inc. v. Commissioner, 276 F.2d 476 (5th Cir. 1960). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Note that these factors track closely the list of favorable and unfavorable factors under the Plumstead test, discussed in Section 4.2(d). Id. Rev. Rul. 69-383, 1969-2 C.B. 113 (IRS approved a payment to a radiologist, an independent contractor based in the hospital, of a percentage of adjusted gross revenues of radiology in exchange for management and professional services). See also Mabee Petroleum Corp. v. United States, 203 F.2d 872 (5th Cir. 1953) (reasonable compensation allowed; however, excessive compensation is treated as a distribution of net earnings or inurement); Birmingham Business College, Inc. v. Commissioner, 276 F.2d 476 (5th Cir. 1960). Old Dominion Box Co., Inc., v. United States, 477 F.2d 340 (4th Cir. 1973), cert. denied, 413 U.S. 910 (1973) (operating for the benefit of private parties who are not members of a charitable class constitutes a substantial nonexempt purpose); Gen. Couns. Mem. 38,459 (July 31, 1980). See generally Chapter 5. With respect to healthcare organizations, the IRS has recently revised its ruling policy to include the adoption of a conflict-of-interest policy as a “significant factor” in demonstrating operation for community rather than private benefit. This policy (discussed in Section 12.3(d)(i)), when combined with the newly enacted §4958 intermediate sanctions provisions, should have the effect of curtailing many improper insider transactions. Gen. Couns. Mem. 38,459 (July 31, 1930); Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992). See Section 12.3(d)(viii). See Priv. Ltr. Rul. 97-39-036 (June 30, 1997); Priv. Ltr. Rul. 97-39-037 (June 30, 1997); Priv. Ltr. Rul. 97-39-038 (June 30, 1997); and Priv. Ltr. Rul. 97-39-039 (June 30, 1997).
䡲
508
䡲
c12.fm Page 509 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
Rev. Rul. 85-110111 and Rev. Rul. 68-376.112 It noted that to the extent that the individuals whose specimens would be tested were patients of one of the three hospitals, the income from that source would be retained by each of the three hospitals and would not inure to any other person. To the extent that these individuals were not patients of any of the three hospitals, the members had agreed to allocate income therefrom to the for-profit subsidiaries, as taxable income, and to the one tax-exempt hospital without a participating subsidiary as unrelated business taxable income. The IRS concluded that the allocation of income by source would not have the effect of utilizing charitable assets or income to benefit private interests. It reasoned that the members of the joint venture limited liability company would receive credit in their capital accounts for assets contributed to the joint venture, and members would receive income allocations consistent with their patient referrals or with the general public usage. It concluded that this formula was consistent with a transaction that does not distort tax consequences to benefit private interests. Therefore, the IRS concluded, the tax-exempt hospitals’ participation in the proposed transaction would not alter their principal purpose, which was to provide healthcare to the community. 113 EXAMPLE: In PLR 200606042, the Service determined that a healthcare system’s investments in a for-profit corporation as a part of a plan to provide professional and general liability insurance to hospitals and physicians would not jeopardize the healthcare entity’s §501(c)(3) status. In the ruling, the Service permitted the hospital’s board to purchase Class A shares in the for-profit corporation so that hospital physicians might purchase their professional liability insurance from the for-profit subsidiary’s wholly-owned subsidiary. Because this paradigm allowed the hospital’s medical staff to retain their positions at the exempt hospital, the hospital asserted (and the Service concurred) that it furthered the organization’s charitable purpose. Further, because none of the hospital physicians at issue were trustees or officers of the hospital, the nonprofit entity’s purchase of stock would not result in the inurement of net earnings in violation of §1.501(c)(3)–1(c)(2). (iv) Redlands Surgical Services. In a significant case in the healthcare area, the Tax Court upheld the denial of IRC §501(c)(3) status to Redlands Surgical Services, 111 112 113
1985-2 C.B. 166. 1968-2 C.B. 246. See also Priv. Ltr. Rul. 97-22-032 (Feb. 28, 1997) (spin-off by a §501(c)(3) tax-exempt medical research organization (“O”) of a for-profit affiliate (“the Affiliate”) to commercialize pharmaceutical products, including a transfer of technology and employees to the Affiliate in exchange for preferred stock, will not result in private benefit to the management team of the spun-off Affiliate, which included (1) a consultant to O who directed the research activities of a division of O (“the Division”), (2) another consultant to O and the Division, (3) a former employee and officer of O, and (4) a former employee of O (collectively “the Management Team”) where the Management Team was considered crucial to the Affiliate’s success, the Affiliate’s stock would be unmarketable without a management team in place that evidenced its commitment to the Affiliate through employment agreements and ownership in the Affiliate, and O provided data supporting its assertion that the stock issued to the Management Team was at fair market value).
䡲
509
䡲
c12.fm Page 510 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
Inc. (Redlands).114 Redlands, a California nonprofit public benefit corporation, was a wholly-owned subsidiary of Redlands Health Systems, Inc. (RHS), a charitable organization under §501(c)(3). RHS was the parent corporation of three other subsidiaries, two of which were also exempt under §501(c)(3). One of the two exempt subsidiaries was Redlands Community Hospital (Redlands Hospital), a hospital within the meaning of §170(b)(1)(A)(iii), which provided medical care free of charge or at a discount, and which maintained its own surgery program and emergency room. In March 1990, RHS became a co-general partner with Redlands-SCA Surgery Centers, Inc. (SCA Centers), a for-profit corporation, in a general partnership formed to acquire a 61 percent interest in an existing outpatient surgical center in Redlands, California. RHS contributed cash and SCA Centers contributed cash and stock to the general partnership. In return for its 37 percent investment, RHS received a 46 percent interest in profits, losses, and cash flow of the general partnership. The general partnership agreement provided that the management and determination of all questions relating to the affairs and policies of the partnership were to be decided by a majority vote of the managing directors. The managing directors consisted of four persons—two of whom were appointed by RHS and two of whom were appointed by SCA Centers. In the event the managing directors were unable to agree, either RHS or SCA Centers could submit the matter to arbitration. The decision of a majority of the arbitrators was to be final and binding. The general partnership became the sole general partner in Inland Surgery Center Limited Partnership (the Operating Partnership), a California limited partnership that owned and operated a freestanding ambulatory surgery center (the Surgery Center) within two blocks of Redlands Hospital. The structure is illustrated in Exhibit 12.3. Prior to the Operating Partnership’s affiliation with the general partnership, the Operating Partnership had been a for-profit venture which served only surgical patients who could pay for its services. The partnership agreement of the Operating Partnership did not contain a statement of charitable purpose or a requirement that it operate for a charitable purpose before its affiliation with RHS and it was not amended to include such a provision after its affiliation with RHS. The Surgery Center offered no free care to indigents and it had no emergency room or certification to treat the emergency patient population. The Operating Partnership entered into a contract with SCA Management Co. (SCA Management), a for-profit subsidiary of SCA, whereby SCA Management would provide management and administrative services for the Surgery Center. With the exception of decisions relating to the care and treatment of patients or other medical policy matters, SCA Management had wide-ranging authority for the management of the Surgery Center.
114
Redlands Surgical Services, Inc. v. Commissioner, 113 T.C. No. 3 (1999).
䡲
510
䡲
c12.fm Page 511 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
E XHIBIT 12.3 Redlands Surgical Services Structure Redlands Health Systems, Inc. (RHS) [(§501(c)(3)]
Redlands Community Hospital [(§501(c)(3)]
Surgical Care Affiliates, Inc. (SCA) [For-Profit]
Petitioner; Redlands Surgical Services, Inc.
Redlands-SCA Surgery Centers (SCA Centers) [For-Profit] 2 Directors
SCA Manangement Co. [For-Profit] 2 Directors
Management Contract (at least 15 years renewable at SCA Management's option)
Redlands-ASC GP* (The General Partnership)
RHS entered into the General Partnership agreement on March 1, 1990. Petitioner succeeded to RHS's partnership interest on September 30, 1990
General Partner 59%
Inland Surgical Center, L.P. (The Operating Partnership)
Limited Partners 41%
Physicians & Beaver Medical Clinic, Inc.
In return for its services, SCA Management was to receive a monthly management fee of 6 percent of gross revenue from the operation of the Surgery Center. The management agreement had a term of 15 years, renewable unilaterally by SCA Management for two, 5-year extensions. With the exception of bankruptcy or insolvency, the management contract was terminable by the Operating Partnership only if SCA Management breached the agreement, and then only after a 90-day notice and a 90-day cure period. In April 1990, SCA Management entered into a quality assurance agreement with RHS whereby RHS agreed to perform managerial and supervisory quality assurance duties in connection with the operation of the Surgery Center. RHS was to receive a monthly fee after the first year, and it was to be reimbursed for its direct out-of-pocket expenses. Five months after entering into the general partnership agreement with SCA Centers, RHS incorporated RSS as a California nonprofit public benefit corporation, and transferred its interest in the General Partnership to RSS. RHS also transferred its obligations and rights under the quality assurance agreement to RSS. RSS’s sole activity (and its sole source of revenue) was to be its participation in the Operating Partnership. The IRS argued that RSS was not operated exclusively for charitable purposes because it operated for the benefit of private parties and failed to benefit a broad cross-section of the community. In support of its position, the IRS stated that the 䡲
511
䡲
c12.fm Page 512 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
partnership agreements and related management contract were structured to give for-profit parties control over the Surgery Center. Moreover, the Surgery Center had never operated with a charitable purpose. RSS, on the other hand, argued that it met the operational test of §501(c)(3) because its activities with respect to the Surgery Center further its purpose of promoting health for the benefit of the RSS community, by providing access to an ambulatory surgery center for all members of the community based on medical need rather than ability to pay, and by integrating the outpatient services of Redlands Hospital and the Surgery Center. RSS further argued that it engaged in arm’s-length transactions with the for-profit partners, and that its influence over the activities of the Surgery Center has been sufficient to further its charitable goals. RSS also argued that it performed services that were “integral” to the exempt purposes of RHS, its tax-exempt parent, and Redlands Hospital. By applying a facts and circumstances analysis, the Tax Court upheld the IRS’s denial of RSS’s tax-exempt status. The court concluded that RSS had effectively ceded control over the operations of the partnerships and the Surgery Center to private parties, thus conferring impermissible private benefit upon them. In this regard, the court noted that the promotion of health for the benefit of the community is a charitable purpose. However, the community benefit standard also requires that the charity serve a sufficiently large and indefinite class and that private interests not benefit to any substantial degree. In arriving at its decision that private, rather than charitable, interests were being served, the court examined various factors, similar to the factors the IRS enunciated in Rev. Rul. 98-15 (although it did not reference Rev. Rul. 98-15 and the court did look at more factors than those enunciated in Rev. Rul. 98-15). The court noted, most significantly, that there was a lack of any express or implied obligation of the for-profit parties to place charitable objectives ahead of for-profit objectives. Moreover, after the general partnership acquired an interest in the Operating Partnership, the Operating Partnership failed to amend its organizing documents to include an overriding charitable purpose.115 In fact, the Operating Partnership explicitly acknowledged the partnership’s noncharitable objectives, authorizing the General Partnership, for example, to amend the Operating Partnership, but only if the amendments did not alter the economic objectives of the partnership or materially reduce the economic return of the partners. The court emphasized (as did the IRS in Rev. Rul. 98-15) the relevance of control by the tax-exempt entity. Although RSS had successfully blocked various proposals with respect to expanding the scope of activities performed at the Surgery Center, the court concluded that such veto rights did not establish that RSS had effective control over the manner in which the Surgery Center performed its operations. Douglas Mancino, attorney for RSS, disputes the Tax Court’s reliance on a covenant not to compete contained in the general partnership agreement.116 115
116
Douglas Mancino, an attorney for Redlands, disputed the court’s reliance on this point, noting that in an earlier ruling, the IRS had said that the past activities of a hospital which had been sold by a for-profit entity to a nonprofit had no effect on whether the acquiring nonprofit could obtain exemption. C. Wright, IRS Wins First Round in Redlands: “Exemption Properly Denied,” Exempt Organization Tax Review (Aug. 1999): 189. Id.
䡲
512
䡲
c12.fm Page 513 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
Under the covenant, RHS had agreed not to re-assess and service community needs until the year 2020. The Tax Court stated that it was hard to understand how this type of restriction could further charitable purposes.117 (Douglas Mancino, an attorney for Redlands, commented that such a clause was typical in the healthcare field.)118 Similarly, the court seemed particularly concerned that the general partnership agreement restricted RHS’s (RSS’s parent corporation) ability to provide outpatient services at Redlands Hospital or elsewhere without the approval of its for-profit partner. As a result, from 1990 to 1995, there was actually a decrease in outpatient surgeries performed at Redlands Hospital and an increase at the Surgery Center. Again, the court did not believe that such a restriction in services served a charitable purpose. Furthermore, there was no indication that RSS possessed significant “informal” control with respect to influencing Surgery Center’s activities. For example, there was no evidence of Redlands’ role in effecting a change in the criteria for procedures performed at the Surgery Center, there was no increase in charity care, and only negligible coverage for Medi-Cal patients due to RSS’s involvement in the Operating Partnership. Finally, the court concluded that the management contract between the Operating Partnership and SCA Management conferred too much management authority to the for-profit manager. Moreover, SCA Management’s fee of 6 percent of the gross revenues provided it with an incentive to manage the Surgery Center to maximize profits, while none of the operational documents required SCA Management to conduct its activities with the goal of satisfying a community benefit. In addition, the Operating Partnership was virtually “locked into” the management contract which was renewable after 15 years at SCA Management’s sole discretion. Based on the totality of these factors, the Tax Court concluded that RSS impermissibly served private interests. Although the court did not specifically refer to Rev. Rul. 98-15, Redlands buttresses the IRS’s authority to enforce Rev. Rul. 98-15 with respect to whole hospital joint ventures and other types of joint ventures involving exempt organizations. Again, the analysis will be based on the totality of all relevant factors, including, but not limited to, the exempt organization’s formal and informal control of the day-to-day activities of the venture, as well as a binding commitment of the parties in the operative documents that charitable purposes, as opposed to for profit purposes, must prevail. Factors that will mitigate against charitability are longterm management agreements with a for-profit entity which has the unilateral right to renew the contract, arbitration provisions that do not take into account charitability, and the lack of any evidence of actual charitable operations. It should be noted that RSS’s sole activity was participation in the joint venture. If RSS’s parent corporation, RHS, had entered into the joint venture instead, there may have been a different outcome because RHS also operated a hospital inter alia. In such a case, where a nonprofit conducts extensive charitable activities 117 118
Id. Id.
䡲
513
䡲
c12.fm Page 514 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
and also engages in a joint venture with a for-profit entity, the IRS would likely apply a similar analysis to determine if the venture itself were operated for charitable purposes. If the nonprofit did not have sufficient control of the venture, for reasons such as in Redlands, but did conduct independent charitable activities, the nonprofit’s tax-exempt status may not be jeopardized if the joint venture did not constitute a major part of its activities. In such a case, the income received by the nonprofit from the venture may be taxable as unrelated business income (UBIT). As discussed in Chapter 4, we are witnessing the development of IRS’s position on these issues as reflected in litigated cases and the progression of the IRS’s position after the promulgation of Rev. Rul. 98-15.119 It is interesting to note, however, that while it is often recommended that a nonprofit create a subsidiary to conduct activities that could be subject to challenge either because they could generate UBIT or threaten the tax exemption of the parent,120 it may not always be advisable to do so. For example, as discussed above, if in Redlands the parent had continued to operate a charitable hospital and had itself participated in the joint venture instead of creating a subsidiary, it may have been found to have received UBIT from the venture but not lost its tax-exempt status. On the other hand, it is sometimes advisable to create a subsidiary, in which case the parent must observe the required formalities and operational proscriptions described in Sections 4.6 and 12.3(d)(x). In summary, the subsidiary must be independent from the parent (after a reasonable transition period) and the parent must not be involved in the subsidiary’s day-to-day activities or decision-making processes. NOTE Another long-term effect of Redlands will be in the intermediate sanctions area. As explained in Sections 5.4 and 12.3(c), reliance on the opinion of counsel will relieve organization managers of liability in excess benefit transactions. The holding in Redlands will make it more difficult for practitioners to issue such opinion letters.* *
See Sections 5.4 and 12.3(c).
In a very brief per curiam opinion, the Ninth Circuit adopted the Tax Court holding.121 The next case litigating the amount of control an exempt healthcare organization must retain in a whole hospital joint venture is St. David’s Health Care Systems, Inc. v. U.S.122 (v) St. David’s Health Care System. In November, 2003, the Fifth Circuit Court of Appeals filed its opinion in St. David’s Health Care System v. United States, 349 119 120 121 122
See Sections 4.2 and 12.3(d). See Section 4.6. 242 F.3d 904 (9th Cir. 2001), unpublished order of May 30, 2001 motion for reh’g denied; see Section 4.2(B). 2002 U.S. Dist. Lexis 70453 (6-7-02).
䡲
514
䡲
c12.fm Page 515 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
F3d 232, 2003 WL 22416061 (5th Cir. 2003). Previously, the Texas District Court granted St. David’s summary judgment motion and ordered the government to refund the taxes paid by St. David’s for the 1996 tax year. The District Court also ordered the government to pay $951,569.83 in attorney’s fees and litigation costs. The Appellate Court vacated that decision, and has remanded the case back to the District Court for further proceedings. The Appellate Court found genuine issues of material fact. St. David’s operated a nonprofit hospital system in the Austin, Texas, area, and was recognized as a charitable organization entitled to tax-exempt status under §501 (c)(3). In 1996, St. David’s formed a partnership with Columbia/ HCA Healthcare Corporation (“HCA”), a for-profit company that operates 180 hospitals nationwide. The government contends that in entering into this “whole-hospital” joint venture, St. David’s ceded control of the hospital system to HCA. The government relied on Rev. Rul. 98-15, 1998-1 C.B. 718 (1998) and Redlands Surgical Services v. Commissioner, 242 F.3d 904, 904-5 (9th Cir. 2001) aff’g 113 T.C. 47 (1999) in making its arguments regarding the control issue. St. David’s contends that the joint venture continues to operate in a charitable manner and provides extensive benefits to the community, relying on Rev. Rul. 69545, 1969-2 C.B. 117 (1969) and the community benefit standard as justification for continued exempt status. The Court of Appeals focused on the control of the joint venture, and whether St. David’s ceded control to the for-profit HCA. As authority for this focus, the Appellate Court adopted the government’s arguments and relied on Redlands and Rev. Rul. 98-15. Although St. David’s argued that the community benefit standard and the standards set forth in Rev. Rul. 69-545 applied, the Court found that area of the law was not directly on point (St. David’s, slip op. at fn 9). In fact, the Appellate Court agreed that St. David’s provides extensive charity care to the Austin community. The Court rejected the government’s arguments that charity care does not include bad debts that are ultimately written off by the hospital. Instead, the court cited to Maynard Hosp., Inc. v. Commissioner, 52 T.C. 1006, 1026 (1969), where the Tax Court indicated that “charitable services” may include collection attempts, as long as “[p]atients who were found unable to pay their bills often had them reduced or entirely canceled.” Ultimately, the Appellate Court focused on whether St. David’s operated “exclusively in furtherance of exempt purposes.” The Court noted that it “must also ensure that those activities do not substantially further other (noncharitable) purposes” (St. David’s, 349 F.3d at 237, emphasis in original). The Court stated: “Therefore, even if St. David’s performs important charitable functions, St. David’s cannot qualify for tax-exempt status under §501 (c)(3) if its activities via the partnership substantially further the private, profit-seeking interests of HCA” (St. David’s, 349 F.3d at 237). Specifically, the Appellate Court narrowed the case to one remaining factual issue: Whether St. David’s engages primarily in activities which accomplish its exempt purpose, in order to satisfy the operational test under Treas. Reg. §1.501 (c)(3)-1(a). The Court decided several settled factual issues. First, the IRS and St. David’s agreed, since it is a whole hospital joint venture, that the Court must look to the activities of the partnership to determine if St. David’s satisfies the 䡲
515
䡲
c12.fm Page 516 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
operational test. Second, the Appellate Court found that St. David’s did provide charity care, and did satisfy the community benefit standard set forth in Rev. Rul. 69-545. However, the Court found this is not the relevant test to determine whether St. David’s is operated exclusively in furtherance of exempt purposes. Third, the Court held that Rev. Rul. 98-15 and the control test is the relevant standard to apply. The Court stated the test as follows: “When the nonprofit organization cedes control over the partnership to the for-profit entity, we assume that the partnership’s activities substantially further the for-profit’s interests. As a result, we conclude that the nonprofit’s activities via the partnership are not exclusively or primarily in furtherance of its charitable purposes” (Slip op. at p. 10). In order to determine whether control has been ceded over to the for-profit entity, the Appellate Court considered the following factors (St. David’s, 349 F.3d at 239): 1. That the founding documents of the partnership expressly state that it has a charitable purpose and that the charitable purpose will take priority over all other concerns; 2. That the partnership agreement gives the nonprofit organization a majority vote in the partnership’s board of directors; and 3. That the partnership is managed by an independent company (an organization that is not affiliated with the for-profit entity). The Court analyzed these three factors relating to control, as follows: (1) The founding documents of the partnership expressly state that it has a charitable purpose and that the charitable purpose will take priority over all other concerns. The Partnership Agreement expressly states that the manager of the partnership “shall” operate the partnership facilities in a manner that complies with the community benefit standard. The Court found that this language was sufficient to satisfy the first factor, however noted, that the language, standing alone, cannot ensure that St. David’s has an adequate amount of control over partnership operations. There must also be language in the partnership documents providing St. David’s with an effective means of enforcing the manager’s obligation to abide by the community benefit standard. The Court noted that it had reasons to doubt that the partnership documents alone provided St. David’s with sufficient control due to the fact that the only apparent method of enforcing the agreement is to take legal action. The Court doubted that St. David’s would resort to litigation every time the manager made a decision that conflicted with the community benefit standard, due to the time and expense of judicial proceedings. The Partnership Agreement gives St. David’s the power to request dissolution of the partnership in the event that its participation in the partnership hinders its taxexempt status. The Court questioned whether the threat of dissolution would ever be carried out by St. David’s, given the strong incentive to St. David’s not to dissolve the partnership. Due to a noncompete clause, St. David’s would be prohibited 䡲
516
䡲
c12.fm Page 517 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
from providing health care in the Austin area for two years. The Court stated that since dissolution would be disastrous to St. David’s in that St. David’s would cease to exist, it was unlikely that St. David’s would exercise its option to dissolve the partnership even if the partnership strayed from St. David’s charitable mission. The Court, however, did not focus on the leverage St. David’s had over HCA, since HCA would lose its foothold in the Austin market in the event of dissolution due to the mutual noncompete agreement. (2) The partnership agreement gives the nonprofit organization a majority vote in the partnership’s board of directors. St. David’s and HCA each appoint half of the Board. “St. David’s can exercise a certain degree of control over the partnership via its membership on the partnership’s Board of Governors.” This is because no measure can pass the Board without the support of a majority of the representatives of both St. David’s and HCA. Thus, St. David’s effectively has veto power over any proposed action of the Board. The Court noted as a negative factor, however, that St. David’s could not initiate actions to further its charitable purpose, but only veto proposed actions. Additionally, the Board is also only empowered to deal with major decisions, not the day-to-day operations of the partnership hospitals. The Court noted that St. David’s or HCA can unilaterally remove the CEO. Also, St. David’s appointed the initial CEO, with the approval of the HCA members of the Board. The Court questioned St. David’s control over the CEO, due to the CEO’s past failure to comply with the Partnership Agreement. The CEO failed to file annual reports with the Board of Governors regarding the amount of charity care provided by the Partnership. The Court noted that St. David’s did not take any punitive action against the CEO for failure to file the reports. St. David’s will have the opportunity to refute these concerns through additional factual evidence to be presented at trial. (3) The partnership is managed by an independent company (an organization that is not affiliated with the for-profit entity). The partnership is managed by a for-profit subsidiary of HCA. However, the Management Services Agreement provides authorization for St. David’s to unilaterally terminate the contract with Galen, the for-profit management company, if Galen takes any action with a “material probability of adversely affecting” St. David’s tax-exempt status. The Court found this to provide a “degree of control over partnership operations.” The Court speculated regarding whether St. David’s would be willing to exercise its termination option of the contract with Galen without the consent of HCA, and also whether St. David’s could ensure a replacement manager that would prioritize charitable purposes. St. David’s will have the opportunity to present additional factual evidence regarding the Galen termination option at trial. Additionally, the Court noted that part of Galen’s fee is computed as a percentage of the partnership’s net revenues, thereby giving Galen an incentive to 䡲
517
䡲
c12.fm Page 518 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
maximize revenues and to neglect charitable goals. The Court noted further, however, that Rev. Rul. 98-15 recognized that a contingency fee for the management company based on net revenues would not automatically preclude tax-exempt status for the nonprofit partner. The Court also stated that its concerns about Galen’s affiliation with HCA were magnified by the fact that the partnership’s contract with Galen appoints the manager “for an extraordinarily long term,” that is, until 2050. However, it is important to note that the length of the contract did not cause the Court to reach a legal determination on this issue against St. David’s. This gives St. David’s an opportunity to further develop the factual record at trial regarding the advantages of a 1 percent management contract. In sum, the Appellate Court found that there remain genuine issues of material fact regarding whether St. David’s ceded control to HCA. Therefore, the district court’s grant of summary judgment in favor of St. David’s is vacated and the case is remanded back to the District Court for further proceedings. Due to the summary judgment nature of the proceeding, St. David’s did not provide all of the factual evidence that is relevant to these tests regarding control. The Court noted that it does not make credibility determinations or weigh the evidence, but rather considers all of the evidence in the record and draws all reasonable inferences in favor of the nonmoving party. As a result, the Appellate Court’s opinion provide a road map for the District Court, and for St. David’s, to follow to resolve the only factual issue remaining, which is whether St. David’s ceded control over the partnership to HCA. The jury in the District court found in favor of St. David and the government’s appeal of the verdict was settled out of court by the parties. (vi) IRS Revocation of Exempt Status of BHS. In 1997, Baptist Health System of Birmingham, Alabama (BHS) announced that it received a 30-day letter from the IRS proposing to revoke its tax-exempt status.123 The basis of the IRS’s proposed revocation was its assertion that BHS paid more than fair market value for physician practice plans, thereby misusing charitable funds. Its alternative position was that if BHS’s tax-exempt status was not revoked, BHS would be liable for $491,258 of unrelated business income tax (UBIT), apparently for such activities as operating parking decks. BHS, which has more than 10,000 employees and 13 hospitals, is the largest healthcare provider in Alabama. Moreover, it has tax-exempt bonds worth more than $270 million outstanding, which would have been affected by the proposed revocation of its tax-exempt status. In August, 1999 BHS reported that it had settled the case by paying a fine and UBIT, while retaining its tax-exempt status.124 BHS maintained that it had done nothing improper but had settled with the IRS so that it could resume its primary focus of the provision of healthcare and because of the large amount of tax-exempt bonds at issue.125
123 124 125
Carolyn D. Wright and Fred Stokeld, “Revocation Threat Against Hope System Chastens Exempts,” Tax Notes Today (Dec. 19, 1997):224. Fred Stokeld, “Nonprofit Hospital System Pays Fine to IRS, Remains Exempt” Exempt Organization Tax Review (Aug. 1999): 194. Id.
䡲
518
䡲
c12.fm Page 519 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
NOTE This case involves the type of situation to which the IRS would likely apply intermediate sanctions. However, the transactions in question predate the effective date for the intermediate sanctions provisions (that is, intermediate sanctions apply to excess benefit transactions that occur on or after September 3, 1995, and at all times thereafter). (c)
Intermediate Sanctions
As explained in Section 5.1, the intermediate sanctions rules were enacted in response to perceived financial abuses in the world of nonprofit organizations in general and public charities specifically. Until the adoption of IRC §4958, the IRS’s only enforcement tool in the case of private benefit or inurement was revocation of a public charity’s exempt status, a result considered too severe in most circumstances. In addition to the severity of revocation as a penalty, revocation penalized the nonprofit itself; there was no mechanism to punish the wrongdoer in the context of public charities, as there was for private foundations in the Chapter 42 excise tax provisions. Compliance with the guidelines of the intermediate sanctions provisions is particularly important in regard to joint ventures between for-profit and nonprofit organizations. First, ventures in the healthcare industry are the subject of intense scrutiny. Second, wherever nonprofits engage in a transaction with one or more for-profit entities, the potential for impermissible benefit and inurement issues is inherent. Third, there are several compensation issues in the healthcare field (e.g., incentive compensation, sharing of revenue streams, and physician recruitment) that, by their nature, invite IRS suspicion. The regulations apply to public charities that would be described in §501(c)(3) or (4) and that were exempt from tax under §501(a), as well as any organizations that were exempt from tax under §501(a) and that were described in §501(c)(3) or (4) at any time during the five years preceding the date of an excess benefit transaction (the “lookback period”)126 The excise taxes apply to transactions occurring on or after September 14, 1995.127 Although these rules are explained in detail in Chapter 5, this section provides a summary because they are critical to the healthcare field; in fact, the regulations contain examples that relate specifically to healthcare providers. To summarize, a penalty can be imposed on a disqualified person who receives an economic benefit from a nonprofit (directly or indirectly) and on the organization manager who approved the 126
127
With the exception of churches that, per statute, do not have to file Form 1023, only §501(c)(3) organizations that file Form 1023 are subject to the intermediate sanctions. State and local government organizations that would be described in §501(c)(3) or §501(c)(4) were they not government-related are therefore not subject to the intermediate sanctions regulations, absent a request for §501(c)(3) status. The lookback period is shorter for any transaction occurring before September 14,2000. In that case, the lookback period begins on September 14, 1995, and ends on the transaction date. In addition, organizations holding themselves out as exempt under §501(c)(4) and those filing information returns as a §501(c)(4) organization are subject to the regulations. They do not apply to any benefit arising from a transaction pursuant to a contract that was binding on September 13, 1995, and continuing in force through the time of the transaction. Reg. §53.4958(f)(2).
䡲
519
䡲
c12.fm Page 520 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
transaction without sufficient safeguards, where the benefit exceeds the fair market value of what the nonprofit receives in exchange. (i) Disqualified Person. The excise taxes can be imposed on disqualified persons who engage in “excess benefit transactions.” There are several categories of disqualified persons, as discussed in the following paragraphs. Under IRC §4958, family members of disqualified persons are per se disqualified, as are corporations, partnerships, and trusts or estates in which 35 percent of the voting power, profit interest, or beneficial interest is owned by disqualified persons.128 For these purposes, a person’s family members include a spouse, brothers and sisters (by whole or half-blood) and their spouses; ancestors, children, grandchildren, great-grandchildren, and their spouses.129 EXAMPLE: An exempt hospital forms an LLC with a for-profit hospital. Each LLC member owns 50 percent of the LLC, as in the example of a whole hospital joint venture in Section 12.2. The LLC is per se a disqualified person in regard to the nonprofit.130 (A) S UBSTANTIAL I NFLUENCE A disqualified person is also anyone in a position to exercise substantial influence over the affairs of the organization at any time during a five-year period beginning after September 13, 1995, and ending on the date of the excess benefit transaction.131 The regulations identify certain persons who are per se disqualified by virtue of having substantial influence over the affairs of an organization.132 These include voting members of the governing body, the president, chief executive officers, chief operating officers, treasurers, and chief financial officers.133 In addition, a person is deemed to have substantial influence if, pursuant to IRC §501(o), that person has a “material financial interest” in a provider-sponsored organization (PSO) (as defined in §1855(e) of the Social Security Act),134 if a hospital that participates in the PSO is a §501(c)(3) or (c)(4) organization exempt from tax under §501(a).135
128
129 130 131
132 133 134 135
Reg. §53.4958-3(b)(2). For purposes of this determination, the constructive ownership rules of §267(c) apply, except that in applying §267(1)(4), a person’s family includes the family members listed in Reg. §53.4958-3(b)(1). Reg. §53.4958-3(b)(1). Reg. §53.4958-3(b)(2). Reg. §53.4958-3(a). If the five-year period were to begin on or before September 13, 1995, the lookback period begins September 14, 1995, and ends on the date of the transaction. Id. In other words, for transactions occurring before September 14, 2000, the lookback period will go back only to September 14, 1995. Reg. §53.4958-3(c). Reg. §53.4958-3(c)(1) and (2). 42 U.S.C. 1395W-25. Reg. §53.4958-3(c)(4).
䡲
520
䡲
c12.fm Page 521 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
CAVEAT Persons who have or share responsibility for implementing decisions of the governing body or supervising the management, administration, or operation of the organization, are disqualified persons whether or not they have the title of president, chief executive officer, or chief operating officer, as they are considered to have substantial influence.* The same applies to anyone with responsibilities similar to those of a treasurer or chief financial officer (CFO).† * †
Reg. §53.4958-3(c)(2). Reg. §53.4958-3(c).
Consequently, a person is considered to serve as treasurer or CFO whether or not that person holds that title, as long as he or she has or shares responsibility for managing the nonprofit’s financial assets or has authority to sign or authorize the signing of checks or electronic funds transfers.136 The regulations also identify certain persons who are not considered to have substantial influence over the affairs of an organization. These include other IRC §501(c)(3) charitable organizations that are subject to intermediate sanctions, and any employee who is not highly compensated (making less than $80,000 per year),137 unless the employee is statutorily disqualified or otherwise identified as having substantial influence, or is or was a substantial contributor to the organization.138 In all other situations, the determination of whether a person has substantial influence over an organization will be based on all of the facts and circumstances.139 The regulations identify facts and circumstances that point toward the existence of substantial influence, including the following: that the person founded the organization; that the person is a substantial contributor; that the person’s compensation is based on revenues derived from activities of the organization that the person controls (revenue-sharing); that the person has authority to control or determine a significant portion of the organization’s capital expenditures, operating budget, or employee compensation; that the person has managerial authority or advises a person with managerial authority; or that the person owns a controlling interest in an entity that is a disqualified person.140 The regulations also address certain factors that tend to indicate that a person does not have substantial influence over the affairs of the organization.141 These factors include, but are not limited to, the fact that the person is an independent contractor (e.g., an accountant or a lawyer), unless that person is acting in that role with regard to a transaction in which he or she might benefit economically, aside from professional service fees.142
136 137 138 139 140 141 142
See id. Reg. §53.4958-3(d)(3)(i); §414(q)(1)(B)(i). Reg. §53.4958-3(d). Reg. §53.4958-3(e)(1). Reg. §53.4958-3(e)(2). Reg. §53.4958-3(e)(3). Reg. §53.4958-3(e)(3)(ii).
䡲
521
䡲
c12.fm Page 522 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
As previously stated, the regulations contain several examples involving the healthcare field: EXAMPLE: R is a radiologist who works for A, a tax-exempt acute care hospital. R is not related to a disqualified person as to A, is not on A’s board of directors or an officer of A. Nor is R a founder or substantial contributor of A (R makes a small annual contribution). Although R gives instructions to staff members about radiology work, R is not a supervisor in regard to other employees and has no managerial authority over any of A’s operations. R does not receive any compensation based on activities of A that R controls. Under these circumstances, R is not deemed to have substantial influence over A’s affairs and, therefore, R is not a disqualified person with respect to any transaction in which R receives any direct or indirect economic benefit from A.143 EXAMPLE: C is the head of the cardiology department in the hospital in the preceding example. C also is not a board member or officer of A, but C has authority to allocate the budget for the cardiology department, which is a principal source of A’s patients and a major source of its revenue. C’s authority includes the power to establish criteria for incentive bonuses for employees of his department and to distribute the bonuses according to such criteria. The bonuses are funded by a portion of A’s revenues derived from the cardiology department. C is deemed to be a disqualified person as to any transaction in which A provides C economic benefits, because C is in a position to exercise substantial influence over A’s affairs, resulting from his managerial control over an important segment of A.144 Thus, under the regulations, in any transaction in which C receives an economic benefit from A, C will be a disqualified person so that the excise tax penalties of IRC §4958 could be imposed on C or any organization manager (defined in the following section) who approves an “excess benefit transaction.” The regulations also address the issue of joint ventures between for-profit and nonprofit entities in the healthcare area, although the determination will depend on a facts-and-circumstances analysis. The regulations state that in the case of organizations affiliated by common control or governing documents, the question of whether a person has substantial influence is to be determined separately for each organization.145 EXAMPLE: H is a tax-exempt organization that owns and operates a hospital. H contributes the hospital to L, a limited liability company that it formed with F, a forprofit corporation that contributes cash and other assets to L. Subsequently, all of H’s assets consist of its interest in L and it continues to operate exclusively for charitable purposes through L’s activities. L contracts with a management company, M, to provide management services for the hospital. Under the contract, M has broad discretion to manage L’s day-to-day activities. M is deemed to have substantial influence over H’s affairs because of its control over L’s 143 144 145
This example is based on Reg. §53.4958-3(g), Example 10. This example is based on Reg. §53.4958-3(g), Example 11. Reg. §53.4958-3(f).
䡲
522
䡲
c12.fm Page 523 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
hospital, which is H’s primary asset and which is the basis for its continued exemption. M is therefore a disqualified person regarding any transaction with H that provides an economic benefit to M, including any transaction H conducts through L.146 (B) O RGANIZATION M ANAGERS An organization manager (an officer, director, trustee, or person with similar powers regardless of title) is subject to a 10 percent penalty tax if that person participates, willfully and without reasonable cause, in what he or she knows is an excess benefit transaction.147 As under the private foundation regulations, “knowing and willful participation” will not be found if the organization manager has relied on a written opinion of a qualified professional that a transaction is not an excess benefit transaction.148 However, the opinion must recite the facts and analyze the law; it is not sufficient for it to recite the facts and state a conclusion.149 CAVEAT Given the material penalties for violation of the intermediate sanctions rules, as well as the potential complexity of many of the issues involved, organizations may want to seek a written opinion on significant transactions involving the payment of benefits to disqualified persons. The tax imposed on an organization manager is less than that imposed on disqualified persons, but it is, nevertheless, substantial. However, the tax cannot exceed $10,000 for any one excess benefit transaction. Organization managers include not only officers, directors, and trustees of applicable tax-exempt organizations, but any individuals with similar powers to make administrative or policy decisions on behalf of the organization and who have the power to carry out such decisions without the approval of a superior.150 Organization managers are not subject to a heightened penalty for noncorrection, and the organization itself is not directly taxed.151 (ii) Excess Benefit Transactions. Excess benefit results when the amount of the economic benefit provided by an applicable organization to a disqualified person exceeds the fair market value of the consideration, including services rendered, provided in return by the disqualified person.152 The excess benefit is the amount by which the benefit exceeds the value of the consideration.153
146
147 148 149 150 151 152 153
Reg. §53.4958-3(g), Example 7. This analysis also seems to be based on the IRS’ rationale in United Cancer Council, Inc. v. Comm’r. 165 F.3d 1173 (7th Cir. 1999), i.e., that an “outsider” can become a disqualified person by virtue of a contractual relationship with the nonprofit. This example was not modified despite the appellate court reversal in United Cancer Council. Reg. §53.4958-1(d)(1) and (2). Reg. §53.4958-1(d)(4). Reg. §53.4958-1(d)(4). Reg. §53.4958-1(d)(2). Reg. §53.4958-1(d)(8). Reg. §53.4958-4(a)(1). Reg. §53.4958-4(a) and (b)(1).
䡲
523
䡲
c12.fm Page 524 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
CAVEAT An excess benefit may occur when economic benefit is provided to a disqualified person indirectly, through an entity controlled by or affiliated with the applicable exempt organization. For example, an exempt organization may not avoid imposition of intermediate sanctions by using a subsidiary to provide compensation to the executive director of the exempt parent, where such compensation is excessive.* This caveat similarly applies to a joint venture—if a joint venture entity pays excessive compensation to a disqualified person, there can be an excess benefit transaction attributable to the nonprofit partner. Thus, an excess benefit transaction can arise as a result of attribution. *
Reg. §53.4958-4(a)(2).
The regulations disregard certain benefits from the excess benefit transactions category. For example, there is an exclusion for nontaxable fringe benefits, including the payment of insurance premiums for liability insurance or indemnification for intermediate sanctions taxes as long as any such payments are included in the disqualified person’s compensation when paid and the total compensation is reasonable.154 Under the regulations, a disqualified person participating in an excess benefit transaction must “correct” the transaction and pay, as a penalty tax, 25 percent of the excess benefit that he or she has received.155 The disqualified person is liable for a second-level penalty tax (200 percent of the excess benefit) if the transaction is not corrected.156 Correction means undoing the excess benefit to the extent possible and taking any additional measures to put the exempt organization in no worse financial position than that in which it would be had the disqualified person been dealing under the highest fiduciary standards.157 In effect, the nonprofit is to be paid “interest” from the date of the transaction through the date of correction. It is important to note that an organization need not terminate the employment of a disqualified person, or the retention of a disqualified person as an independent contractor, in order to correct. However, the organization must alter any terms of an ongoing contract that may lead to excess benefit in the future. (A) C OMPENSATION Under the regulations, organizations must ensure that their compensation arrangements are reasonable—“reasonable” being that which would be paid for similar services by similar enterprises under similar circumstances. In determining reasonableness, the IRS will consider those circumstances in existence when a contract for services is made, unless reasonableness cannot be determined from such circumstances, such as when an unspecified performance bonus is to be paid at a later date. Under these circumstances, a determination of reasonableness 154 155 156 157
Reg. §53.4958-4(a)(4). Reg. §53.4958-1(a) and 53.4958-1(c). Id. Reg. §53.4958-1(c)(2)(ii).
䡲
524
䡲
c12.fm Page 525 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
cannot be made as of the date of the contract but, rather, will be based on all the facts and circumstances, up to and including the date of payment.158 • Salary, fees, bonuses, and severance payments that are paid159 • All forms of deferred compensation that are earned and vested160 • Premiums paid for liability or other insurance as well as payments or
reimbursement for expenses, fees, or taxes not covered by insurance161 • All other benefits, including dental, disability benefits, and life insurance
plans, as wells as taxable and nontaxable fringe benefits162 • Any other economic benefit provided directly or indirectly (including
through joint venture arrangements)163 Payment or a transfer of property by a nonprofit to a disqualified person will be presumed reasonable if the following three conditions are satisfied: 1. The arrangements are approved by the organization’s governing body or a committee thereof comprised entirely of persons who have no conflict with regard to the transaction. 2. The governing body (or committee thereof) has obtained and relied on appropriate information as to comparability. 3. The governing body (or committee) has concurrently documented the basis for its decision.164 In order to satisfy the documentation requirements, the written or electronic records of the governing body or committee must demonstrate essential information about the process.165 For a decision to be deemed timely documented, records reflecting the decision-making process must be prepared by the next meeting and must be reviewed and approved as reasonable, accurate, and complete within a reasonable time thereafter.166 The regulations create an exception for fixed payments made pursuant to an initial contract between an exempt organization and a person who was not a disqualified person immediately prior to entering into the contract.167 These fixed payments are not subject to §4958, although if the contract is renewed or modified with any material change, it is considered to be a new contract and not within this exception.168 This exception appears to be in response to the Seventh Circuit’s
158 159 160 161 162 163 164 165 166 167 168
Reg. §53.4958-4(b)(2). Reg. §53.4958-4(b). Reg. §53.4958-4(b); Reg. §53.4958-1(e)(2). Reg. §53.4958-(b)(1)(ii). Id. Reg. §53.4958-4(b). See Section 5.4 for a discussion of how a nonprofit indicates its intent to pay compensation. Reg. §53.4958-6(a). Reg. §53.4958-6(c)(3). See id. Reg. §53.4958-4(a)(3). Reg. §53.4958-4(a)(3)(v).
䡲
525
䡲
c12.fm Page 526 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
decision in United Cancer Council.169 However, an example in the regulations regarding the initial contract exception states the following: “Upon entering into this contractual arrangement, Company Y becomes a disqualified person with respect to Hospital C.”170 In this example, the assumption is made that merely by entering into a contract with an organization an unrelated party will, upon the date of execution, become a disqualified person. Based on this example, the government appears to be adhering to the position it unsuccessfully advocated throughout the United Cancer Council litigation. (B) R EVENUE S HARING The issue of revenue sharing is especially relevant to joint ventures in the healthcare area. Section 4958(c)(2) specifies that excess benefit transactions may include revenue sharing compensation arrangements, “to the extent provided in regulations prescribed by the Secretary.” However, the IRS and Treasury declined to provide guidance in this area in the final regulations, and reserved for future guidance transactions in which the amount of the economic benefit is determined in whole or in part by the revenues of one or more activities of the organization.171 As noted in the preamble to the final regulations, “The final regulations continue to reserve the separate section governing revenue-sharing transactions. The IRS and the Treasury Department will continue to monitor these types of transactions, and if appropriate, will consider issuing specific rules to regulate them.”172 The preamble does specify that: “The final regulations provide that the general rules of 53.4958-4 apply to all transactions with disqualified persons, regardless of whether the amount of the benefit provided is determined, in whole or in part, by the revenues of one or more activities of the organization.”173 The IRS issued final regulations implementing IRC §4958 in January 2002.174 The regulations clarify that a person will be considered “disqualified” based on his or her powers and responsibilities, not by title alone. The regulations contain guidance on what facts and circumstances show that a person has substantial influence over an organization and would therefore be “disqualified.” Among those of particular interest to organizations involved in joint ventures: • The person’s compensation is primarily based on revenues derived from
activities that the person controls. • The person has or shares authority to control a substantial portion of the
capital expenditures, operating budget, or expenses of the organization. • The person manages a segment or activity that represents a substantial
portion of the assets, income, or expenses of the organization.
169 170 171 172 173 174
United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999). Reg. §53.4958-4(a)(3)(vii), Example 7. Reg. §53.4958-5 [Reserved]. Preamble, Reg. §53.4958, para. 52. Id. at para. 53. T.D. 8978, 26 CFR Part 53.4958-0 through 53.4958-8. See Section 5.4 for a more complete discussion.
䡲
526
䡲
c12.fm Page 527 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
Conversely, facts tending to show that a person does not have substantial influence include: • The person is an independent contractor whose sole relationship to the
organization is providing professional advice for which the person receives only customary fees. • The direct supervisor of the person is not a disqualified person. • The person does not participate in decisions affecting the management of
the organization as a whole or a discrete segment of it. The regulations provide an “initial contract exception.” That appears to be in response to the ruling of the Seventh Circuit in the United Cancer Council case. However, an example given to illustrate the initial contract exception seems to maintain the position that the IRS unsuccessfully advocated through the litigation, that merely by entering into a contract, the previously unrelated person becomes disqualified. Of special interest to joint ventures, the regulations clarify that an organization is prohibited from providing an excess benefit indirectly to a disqualified person through a controlled organization or through an intermediary. The new provisions generally parallel the self-dealing regulations for private foundations. The regulations contain a “rebuttable presumption” that gives organizations the assurance that they have not entered into excess benefit transactions as long as they follow designated procedures. These procedures are designed to produce objective and well-documented decisions by unbiased decision makers. Another provision protects an organization manager from penalty if the manager had relied on written legal opinion that both states the facts and analyzes the law. The section on revenue sharing that was in the proposed regulations has been withdrawn. The IRS will issue new rules for revenue sharing, in proposed form, to provide additional opportunity for comment. In the interim, revenue-sharing arrangements will not automatically be considered excess benefit transactions, according to Susan Brown of the Treasury Department. They will be evaluated under the general rules that provide that an excess benefit is a payment by a tax-exempt organization to a disqualified person which exceeds the consideration for the benefit. All consideration (including services) and all benefits (made directly and indirectly) will be taken into account. The standards used for valuation are fair market value for property and reasonable compensation (an amount that would ordinarily be paid for like services, by like organizations, under like circumstances). A cap imposed on a revenue-sharing arrangement is considered a “relevant factor in determining the reasonableness of compensation.” Two of the examples provided examine revenue-sharing arrangements, and indicate that when revenue sharing is implemented in the form of fixed-formula contracts, such contracts will qualify for the initial-contract exception. (iii) Enforcement. The IRS brought the first enforcement actions under IRC §4958 against a cluster of home healthcare agencies, which it alleges conveyed 䡲
527
䡲
c12.fm Page 528 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
considerable excess benefits to the owners when they converted the agencies from exempt organizations to for-profit corporations.175 In 2006, the United States Court of Appeals for the Fifth Circuit reversed an earlier decision of the Tax Court sustaining the Commissioner’s application of intermediate sanctions pursuant to §4958 against Sta-Home. Whereas the Fifth Circuit did not challenge the validity of §4958 per se, its decision is most notable for its discussion of the valuation methods employed by the parties. For further discussion, please refer to Sections 4.8, 5.4 and 12.6. (d)
Revenue Ruling 98-15
(i) Overview. In 1998, the IRS issued a long-awaited ruling in the area of hospital joint ventures.176 Although the ruling concerns whole hospital joint ventures, IRS officials have stated that its guidelines can be used in joint ventures between a nonprofit and a for-profit in other areas.177 Although the ruling has been criticized for being simplistic (i.e., suggesting that there is a “good” fact pattern and a “bad” fact pattern), it does provide useful direction for structuring joint ventures. (ii) The Ruling. Revenue Ruling 98-15 presents two situations involving an IRC §501(c)(3) nonprofit hospital operator.178 In each case, a nonprofit forms a limited liability company with a for-profit entity, which then operates a hospital. The LLC is treated as a partnership for federal tax purposes. In both scenarios, the nonprofit contributes all of its operating assets, including an acute care hospital, to the LLC in exchange for an ownership interest in the LLC. The for-profit corporation also contributes assets to the LLC in exchange for an ownership interest. Each party’s ownership interest (in both situations) is “proportional and equal in value to [its] respective contributions.”179 With regard to any LLC distributions, the nonprofit in each situation intends to use the proceeds to fund grants that will further its charitable purposes. Although many facts in the two situations are similar, there are significant differences in the following areas: (1) control of the LLC through board composition, (2) overriding fiduciary duty of the LLC to operate for charitable purposes, (3) terms of the management contract, (4) related officers and directors versus independent parties, (5) conflicts of interest, (6) minimum distributions, and (7) reserved powers. In Situation 1, the joint venture’s operating agreement provides that the board is to consist of three individuals chosen by the nonprofit and two by the for-profit member. The nonprofit’s board members are community leaders with
175 176 177
178
179
See Section 5.4 for detailed discussion of Carracci v. Commissioner. Rev. Rul. 98-15, 1998-12 IRB 6 (Mar. 23, 1998). “Whole Hospital Joint Ventures,” Exempt Organizations Continuing Professional Educational Technical Instruction Program for FY 1999 (hereinafter 1999 CPE). See also statement of IRS Exempt Organizations Division Director Marcus Owens, “Exempt Organizations Get Plenty to Chew on in L.A.,” Tax Notes (Nov. 16, 1998) at 829. Rev. Rul. 98-15, 1998-12 IRB 6 (Mar. 23, 1998), reprinted in Exempt Organization Tax Review (Apr. 1998): 142. See also G. Petroff, “Whole Hospital Joint Ventures: The IRS Position on Control,” Exempt Organization Tax Review (July 1998). Rev. Rule 98-15.
䡲
528
䡲
c12.fm Page 529 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
no financial interests in the hospital. In addition, the nonprofit’s officers, directors, and key employees were not promised employment or other inducement to approve the transaction, and none of them has any interest in the for-profit. Any amendment of the governing documents can be accomplished only with the approval of both members, but major decisions, such as those relating to capital and operating budgets, contracts above a set dollar amount, distribution of LLC earnings, changes to the types of services offered by the hospital, selection of key executives, and the renewal or termination of management agreements, require the approval of a majority of three board members, which, in effect, gives the nonprofit control, as it chooses three members. A crucial factor is that the governing documents explicitly require the joint venture to operate in a manner that furthers the nonprofit’s charitable purposes. Toward this end, the community benefit standard effectively overrides any duty to operate the joint venture in a manner that maximizes profitability. The joint venture contracts with an unrelated management company to provide day-to-day management services under an agreement that is for a limited period, is renewable by mutual consent, and provides for payment of fees that are reasonable and comparable to those received by other management firms. The LLC may terminate the agreement for cause.180 In Situation 2, the nonprofit does not have control of the LLC. First, each member chooses two board members. Second, the operating agreement does not obligate the joint venture to operate for charitable purposes and may be amended only with the approval of both members. Because of the 50/50 sharing of control, the nonprofit is unable to initiate programs that serve community health needs without first obtaining the consent of at least one of the for-profit’s governing board members. Third, the joint venture’s CEO and CFO have a prior relationship with the for-profit member. Fourth, the management company is a wholly owned subsidiary of the for-profit, although it receives reasonable compensation comparable to that of other management firms. However, the management firm can unilaterally renew its contract. The IRS determined that the nonprofit in Situation 1 retained its exempt status because it continued to operate exclusively for charitable purposes and only incidentally for the benefit of the for-profit’s private interests. Factors that were particularly important in this analysis were that the governing documents of the LLC obligated the joint venture to provide healthcare services for the benefit of the community and to give charitable purposes priority over the maximization of profits, and that the structure of the board gives the nonprofit’s appointees voting control, thus ensuring that the assets owned by the nonprofit and the activities it conducts through the joint venture are used to primarily advance its charitable purposes.181 Because the nonprofit was considered to be continuing to provide hospital care as its principal activity through the activities of the LLC, it was not reclassified as a private foundation, but continued its status as a public charity.
180 181
Rev. Rul. 98-15, Situation 1. Because the nonprofit’s principal activity will continue to be the provision of hospital care through the joint venture, it will not be reclassified as a private foundation but will retain its status as a public charity. Rev. Rul. 98-15.
䡲
529
䡲
c12.fm Page 530 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
On the other hand, the structure of the LLC in Situation 2 was found to lack many elements of control necessary to ensure that the nonprofit’s charitable activities would be pursued by the venture. First, the governing documents did not require the LLC to pursue charitable purposes or to serve the community as a whole, which would permit the LLC to refuse to provide healthcare services to the indigent. Second, because the two LLC members had equal voting rights, the nonprofit can not initiate new programs to serve the community without the vote of at least one of the for-profit’s governing board appointees. Third, the primary source of information for the nonprofit’s board appointees were persons who had a prior relationship with the management company and the for-profit member. Fourth, the management company had broad discretion over the LLC’s activities and assets and could enter into all but “unusually large” contracts without board approval and could unilaterally renew its five-year management contract. Ultimately, because of its inability to control the programs, activities, and assets of the LLC, the nonprofit was found to have failed the operational test by forming the LLC and contributing all of its assets to it. CAVEAT Ever concerned that tax-exempt hospitals have become more interested in increased revenue than in charity care, the IRS has expanded its audit activity in the healthcare area, focusing on whole hospital joint ventures between taxexempt hospitals and for-profits.The audits are being conducted jointly by the exempt organization and the examinations functions of the IRS and will look at both the exempt and taxable partners “to analyze [the joint ventures] fully, to determine how the money flows, who is deriving a benefit, and whether tax matters have been accounted for and recorded appropriately on both sides of the transaction.” Results are not likely to be available for at least a year or more.* Furthermore, the IRS has not issued any private letter rulings on the subject since Rev. Rul. 98-15 was promulgated, so there is no further written guidance as of this date.† However, the unraveling of the Columbia/HCA Healthcare Corporation joint venture with nonprofit Arlington Health Foundation‡ is expected to be only the first such transaction to be dissolved because of failure to meet the standards of Rev. Rul. 98-15.** *
†
‡ **
“IRS Conducting Audits of Whole Hospital Joint Ventures, Owens Says,” EOTR Weekly (July 27, 1998). On July 16, 1998, Owens spoke in Washington at a program on Rev. Rul. 98-15 that was sponsored by the D.C. Bar Health Law and Taxation Section. “Unwind of Columbia Joint Venture in Virginia a First But Likely Not the Last, Experts Say,” Tax Management Weekly Report (Feb. 22, 1999): 328 (hereinafter “Unwind Article”). The potential negative impact of Rev. Rul. 98-15 is so strong that two national consumer groups have asked the IRS to examine whether the failure to comply with Rev. Rul. 98-15 will result in the unwinding of many joint ventures, with a corresponding detrimental impact on the respective communities in which they operate. The organizations, Consumers Union and Community Catalyst, are also concerned about consequences to nonprofits if joint ventures between nonprofits and for-profits are unwound. The groups asked the IRS to investigate all joint ventures between nonprofits and for-profit entities regardless of whether the parties themselves have requested a ruling. Barbara Yuill, “Groups Post Host of Questions to IRS About Unwinds of Hospital Joint Ventures,” Daily Tax Report (March 31, 1999). See Section 12.1. See Unwind Article at 329.
䡲
530
䡲
c12.fm Page 531 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
(iii) Pre/Post–Joint-Venture Control. In the typical joint venture transaction, an IRC §501(c)(3) organization and a for-profit company create a new entity to which the nonprofit transfers ownership of one or more hospitals (generally, its only operating assets), with the joint venture then contracting with the for-profit for management services.182 In some cases the for-profit also transfers one or more hospitals or other operating assets to the joint venture. The IRS’s position has been strengthened by its victory in Redlands,183 and the Fifth Circuit’s holding St. David’s and the proposed intermediate sanctions regulations regarding revenue sharing reinforce the IRS’s view that “control” over the exempt organization’s activities is extremely important. (iv) Financial Control—Private Benefit. An exempt organization must be organized and operated exclusively for an exempt purpose. This means, in practice, that the charity must serve public rather than private interests.184 An organization is regarded as “operated exclusively” for exempt purposes if it engages primarily in activities that accomplish such purposes.185 Private benefit, if any, must be incidental in both a qualitative and quantitative sense: qualitatively because the private benefit must be a necessary result of an activity that benefits the general public, and quantitatively because the private benefit must not be substantial in comparison with the public benefit.186 The for-profit venturer can legally engage in certain activities and take certain positions relating to the joint venture. When a joint venture is substantially related to the exempt purpose of the tax-exempt venturer, impermissible private benefit does not occur merely because the for-profit venturer, for a fee or price set at fair market value, engages in any of the following activities: • Manages the day-to-day operations of the joint venture187 • Provides management services to the joint venture (such as personnel
management, marketing, public relations, management information systems, accounting and tax, program development, quality management, and billing and collection188 182
183 184 185 186
187 188
See Rochelle Korman and William F. Gaske, “Joint Ventures Between Tax-Exempt and Commercial Health Care Providers,” Exempt Organization Tax Review (May 1997): 783 ff., for a detailed discussion of the form and structure of joint ventures. See also Ross E. Stromberg and Carol R. Boman, Joint Ventures for Hospitals and Physicians (American Hospital Publishing, 1986). In two private letter rulings, the IRS ruled that a joint venture between two nonprofits did not jeopardize their exempt status. In the venture, the two entities formed a limited liability company to construct and operate a new medical campus. The venture was found to further each member’s charitable purposes and was distinguishable from Rev. Rul. 98-15 because both members of the limited liability company were nonprofits. See P.L.R. 1999-13-035 and P.L.R. 1999-13-051; Daily Tax Report (April 7, 1999). See Redlands, and St. David’s Section 12.3(b)(iv), (v). Reg. §1.501(c)(3)-1(d)(1). Reg. §1.501(c)(3)-1(c)(1). See Chapter 5; See also Reg. §1.501(c)(3)-1(c)(1) and American Campaign Academy v. Commissioner, 92 T.C. 1053, 1066, 89 TNT 105-20 (1989); GCM 37789 (Dec. 18, 1978). §501(c)(3) also requires that no part of the net earnings of an exempt organization inure to the benefit of any private shareholder or individual. This total prohibition against private inurement is limited to activities involving insiders. The term “insiders” has been defined as “individuals whose relationship with an organization offers them an opportunity to make use of the organization’s income or assets for personal gain” and generally includes directors, officers, and key staff members. Priv. Ltr. Rul. 95-18-014. Priv. Ltr. Rul. 93-52-030.
䡲
531
䡲
c12.fm Page 532 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
• Provides medical and medical-related services to the joint venture189 • Has an option to buy out the joint venture interest of the exempt organi-
zation190 • Sells a facility to the joint venture191 • Sells or leases equipment to the joint venture192 • Constructs or develops the facility that the joint venture will operate193 • Licenses to the joint venture the right to use the for-profit’s trademark194
Prohibited private benefit will occur, however, when a charity allows a private party to gain control over the venture and to derive significant benefits from the use of core charitable assets, particularly if the assets are not employed to directly advance charitable purposes.195 Prohibited private benefit also occurs if the charity sells property for less than fair market value or buys goods or services for more than fair market value.196 In the IRS’s view, one problem with whole hospital joint venture transactions is that for an investment of as little as 50 percent of the fair market value of the charity’s hospital assets, there is a risk of relinquishing core charitable assets to private parties, who are then potentially able to exploit those assets for private ends.197 The for-profit’s manager in such ventures gains effective control over these assets and is in a position to fully integrate them into its profit-oriented network.198 This may allow the for-profit to increase its market share, realize economies of scale, consolidate and achieve operating synergies, exercise increased bargaining power over vendors, attract physicians and their patients into the network, and compete more effectively for managed care contracts.199 Because it is much more expensive to build hospitals than to buy them, acquiring operating control over nonprofit hospitals is crucial to the for-profit hospital chain’s growth and market domination strategies.200 The paramount problem with this arrangement, however, is that the delegation of control over charitable assets significantly enhances the chances of impermissible private benefit, which would jeopardize the charity’s continued exempt status. (v) 1999 CPE—Comments on Rev. Rul. 98-15. The 1999 CPE Hospital Joint Venture Article discusses whole hospital joint ventures and explains to agents how these arrangements emerged in healthcare, what their basic structure looks like, and how Rev. Rul. 98-15 applies.201 189 190 191 192 193 194 195 196 197 198 199 200 201
Priv. Ltr. Rul. 93-23-030. Priv. Ltr. Rul. 95-18-014. Priv. Ltr. Rul. 93-08-034. Priv. Ltr. Rul. 93-23-030. Id. Priv. Ltr. Rul. 95-18-014. Korman and Gaske, “Joint Ventures Between Tax-Exempt and Commercial Health Care Providers,” 773, 775. Id., 776. See Caplin, note 226, at 650, 651. Id. Id. Id. See 1999 CPE Hospital Joint Venture Article.
䡲
532
䡲
c12.fm Page 533 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
The CPE text suggests 24 questions agents should ask when determining whether participation in a joint venture furthers an exempt purpose and in gauging whether private benefit to the for-profit managers is more than incidental. Essentially, joint ventures between for-profit and tax-exempt hospitals will be permitted if “charitable purposes supersede profit maximization purposes.” According to the CPE text, in addition to addressing other questions, agents are instructed to inquire into the following: • Is the partnership required by its governing documents to promote the
health of a broad section of the community? • Does participation in the joint venture by the exempt organization further
its exempt purpose? • Is there actual evidence that partnership activities are undertaken chiefly
to promote the health of a broad cross section of the community rather than to produce benefits? • Is there a management firm? If so, how is it selected, how is it compen-
sated, and what are its duties? • How is the governing board of the joint venture selected? Who serves on
the governing board? How are issues brought before the board? • Do any of the representatives of the exempt organization who serve on
the governing board of the joint venture have a conflict of interest with their ability to effectively represent the interests of the community? • How is the compensation for physicians and for executives established?
Who sets the medical and ethical standards of the venture? Who oversees the quality of the healthcare provided?202 (vi) Whole Hospital Joint Ventures: Inherent Tax Issues. In the 1990s there were two basic models of the whole hospital joint venture: the “foundation model”203 and the “San Antonio model.” In the foundation model, an exempt organization contributes substantially all of its assets to an operating partner202 203
See 1999 CPE Hospital Joint Venture Article. The foundation model can be illustrated through the following example: Example: Metropolis is the capital of Big State. National HCA, a for-profit hospital, wants to set up a healthcare network in the Metropolis area. It has acquired Metropolis Community Hospital, which serves a large section of suburban Metropolis and is valued at $25 million. It plans to enter into a joint venture with Big State University Hospital, a large charitable facility owned and operated by Big State University. Big State University Hospital is, however, worth considerably more than Metropolis Community and provides significantly expanded services. It also has higher operational costs as a result of its academic and scientific activities. The value of the Big State University Hospital is approximately $75 million. In order to form the joint venture, Big State University and National HCA will each contribute their respective hospitals to a partnership or limited liability company (LLC). Because the Big State University Hospital is valued at $50 million more than Metropolis Community, National HCA will also contribute $25 million in cash, which will be distributed to Big State University, so that a 50/50 joint venture can be established. National HCA requires that it be the managing general partner (or the managing member) of the joint venture and that it control a majority of seats on the board (or half of the seats with the tie-breaking vote). The university, seeking to meet the requirements of the IRS’s twoprong test, conditions the transaction on the newly organized hospital’s being operated in a manner consistent with the requirements of §501(c)(3) (it is required to conduct a minimum
䡲
533
䡲
c12.fm Page 534 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
ship or limited liability company and the for-profit entity contributes cash, its own medical facilities, or a combination of the two. In return, the exempt organization receives a substantial portion of the cash as a distribution from the operating entity (originally contributed by the for-profit participant) and a partnership or membership interest. With the money it receives, the exempt organization often establishes an endowment fund or foundation that can conduct new charitable activities or may be used to fund charitable activities that were conducted by the organization prior to the whole hospital joint venture. This will serve as a basis for the entity’s continuing exemption.204 Generally, in the foundation model, the exempt organization cedes control of the joint venture to the for-profit member.205 Although some exempt organizations attempt to maintain a measure of control over the operational aspects of the joint
amount of charity care, maintain its 24-hour emergency room, which will treat patients irrespective of ability to pay, maintain certain educational programs affiliated with the university medical school, and reserve three of the seven seats on the board for community or university officials), but will otherwise relinquish much of the control that it would otherwise have. This construct raises issues with respect to the charitable status of the university: (1) Does the joint venture improperly benefit a private party—National HCA? (2) Does the exempt partner conduct other charitable activities on which it may base its exemption if the hospital is no longer considered to be operated in furtherance of charitable purposes? (3) What will be the effect on the charity’s public support? (4) How can the charity reconcile the business arrangement with the requirements of the Plumstead doctrine? (5) To what extent does the exempt organization need to be involved in the operation and management of the hospital? (6) To what extent may the exempt organization be involved with the operation of the hospital? (7) How will the income generated by the venture be treated? Given the lack of available guidance, notwithstanding the publication of Rev. Rul. 98-15, determinative conclusions are difficult to reach at this time.
204
205
In the case of a community organization or a small charity, whose only activity prior to whole hospital joint venture was the ownership and operation of the hospital, the purposes to which the fund or foundation are put are critical to its continued exemption. Comments of Laura McNulty-Mack, reported in F. Stokeld, “ABA Tax Section: EO Input on Intermediate Sanctions Wanted, Treasury Official Says,” Tax Notes 72 (Aug. 12, 1996): 809, 811 (hereinafter “McNulty-Mack”). Because the holding of a limited partnership or LLC interest in and of itself does not justify charitable exemption, it is vital that the exempt organization use this money to establish programs—such as medical research and indigent care—that further recognized charitable purposes. It is also important that these activities generate public support, either in the form of donations or receipts from substantially related activities. If the organization does not receive public support from sources other than the hospital (which has been contributed to the operating entity), as is typically the case with a small charity or community hospital, the exempt organization risks reclassification as a private foundation. If this were to happen, not only would the exempt organization be bound by the restrictive private foundation operating rules, but it may be forced to divest itself of a substantial part of the joint venture interest under the excess business holdings rules of §4943. But see Rev. Rul. 98-15 in which the IRS held in the “good” example that the nonprofit’s principal activity would continue to be the provision of hospital care through the joint venture, as its grant-making activities were dependent on receipt of revenue from the venture. One commentator has suggested that the retention of ancillary medical services, a clinic, or some other small medical provider could strengthen the argument in favor of continued exemption, because at no point during the joint venture process would the organization completely lack a charitable purpose. See “Sullivan Discusses Joint Ventures Involving Tax-Exempt Organizations,” reported by Paul Streckfus, Exempt Organizations Tax Journal, 1, no. 6: 25. Columbia HCA generally insists that it be the managing general partner. Stephen Braun, Columbia HCA’s senior vice president, cited by T.J. Sullivan, Exempt Organizations Tax Journal 1, no. 6: 26; but see discussion of San Antonio model below.
䡲
534
䡲
c12.fm Page 535 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
venture through the use of reserved powers, veto rights, or contractual provisions built into the joint venture agreement, the ability of these joint ventures to meet the control requirements of the Plumstead test and Rev. Rul. 98-15 is problematic.206 An inherent conflict arises if (as is typically the case) the for-profit company insists on managerial control of the venture. Control by the for-profit is in direct opposition to the second prong of the Plumstead test and Rev. Rul. 98-15.207 To meet IRS requirements, a joint venture agreement must provide that the exempt organization has ultimate control over the use of the charitable assets, to ensure that they are used in a manner consistent with its exempt purposes.208 As the managing general partner, or managing member, the exempt organization will generally satisfy this requirement. However, when the for-profit holds the primary position, the IRS will be skeptical of the ability of the joint venture to meet the Plumstead requirements. Some exempt organizations satisfy the threshold through the use of contractual restrictions or the retention of veto rights over higher-level functions (budgets, CEO and board composition, resource allocation, acquisition of debt, and so forth),209 but the IRS generally views these provisions as “window dressing.”210 However, there are whole hospital joint ventures in which the exempt organization does not retain majority control over all aspects of the joint venture, yet has actual or practical control of sufficient aspects of the operations so that it has the power to ensure that charitable purposes are the primary purpose of the joint venture.211 EXAMPLE: N, a nonprofit hospital, is in charge of all operations of the hospital in a whole hospital joint venture. P, the for-profit partner, is an investment banker providing financing for the project. The joint venture agreement contains provisions sufficient to ensure that the hospital’s charitable purpose is the primary purpose of the joint venture. Even if the hospital did not have control over all aspects 206
207
208 209 210
211
See Rev. Rul. 98-15 1998-23 I.R.B. (March 23, 1998). See also Robert A. Boisture, “Caplin and Drysdale Addresses Exempt Status of Hospital Joint Ventures,” Tax Notes Today 101–13 (May 29, 1997). See also R. Boisture & A. Lauber, “Caplin & Drysdale Comments on Whole Hospital Joint Ventures,” Exempt Organization Tax Review (Apr. 1997): 650, 655 (hereinafter “Caplin”). The Plumstead test requires that the joint venture (1) serve a charitable purpose and (2) be structured in such a way as to ensure that the exempt partner has not put its charitable assets at unnecessary risk and that the exempt organization is permitted to operate exclusively in furtherance of its exempt purposes with only incidental benefits flowing to the for-profit partners. See Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Section 4.2. The most frequent and direct manner in which exempt organizations can meet the Plumstead requirements is through control of the affairs of the venture by virtue of being the general partner or managing member. In the typical whole hospital case, it may be difficult for the exempt organization to negotiate the appropriate safeguards. See Rev. Rul. 98-15; see also Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Section 4.2. McNulty-Mack, at 812. See Section 12.5 for a discussion of whether it is sufficient for an exempt organization to retain a set of veto rights under Rev. Rul. 98-15. Also see 2000 CPE, Part ID, “Update or Healthcare Joint Venture Arrangements.” Leonard J. Henzke, Jr., Speech at the Western Conference on Tax Exempt Organizations (Nov. 18, 2004).
䡲
535
䡲
c12.fm Page 536 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
of the joint venture, the venture may satisfy the control tests of Rev. Rul. 98-15, to allow the hospital to maintain its tax exemption. This situation would be similar to the hospital receiving a large loan from a conventional bank, provided that the limitations do not interfere with the primary charitable purpose of the hospital, even if the bank insists on considerable controls over various aspects of the hospital’s financing and operations.212 If the exempt organization is unable to meet Plumstead requirements, it may attempt to structure the investment as a limited partnership interest (or the equivalent of a limited partnership interest, that is, a purely passive investment). A difficulty that arises in such cases, however, is that the whole hospital joint venture typically involves substantially all of a charity’s assets, which may preclude the charity from fulfilling its exempt function. Further, the income attributable to the limited partnership interest may be subject to UBIT;213 a significant amount of UBIT could be indicative of a failure to operate for charitable purposes and, by itself, jeopardize the organization’s exemption.214 A problem faced by small and large charities alike is the possibility of impermissible private benefit,215 that is, a substantial nonexempt purpose. The courts and the IRS have consistently held that a single, nonexempt purpose is grounds for denial or revocation of exempt status.216 Accordingly, the IRS may argue that a “successful” whole hospital joint venture provides a significant private benefit
212 213
214
215
216
Example taken from Leonard J. Henzke, Jr., Speech at the Western Conference on Tax Exempt Organizations (Nov. 18, 2004). If the operation of the partnership ultimately furthers the charitable purposes of the exempt organization, however, income received by the charity will be excluded from UBIT as “substantially related.” See Priv. Ltr. Rul. 91-09-006 (Nov. 21, 1990); Rev. Rul. 85-110, 1985-1 C.B. 180; Section 4.3. See discussion of the commensurate test in Section 2.4. Many of these concerns apply to a lesser degree when the exempt organization involved in the venture is a university or other large charitable organization. For example, a university would not likely encounter any difficulty with continued exemption, given its extensive educational, scientific, research, and training activities. Similarly, because a university receives a broad base of public support, it faces little realistic risk of reclassification as a private foundation as a result of its participation in a whole hospital joint venture. Moreover, a university generally has significant exempt function activities, which should enable it to meet the “commensurate test” despite the UBI it may realize from the whole hospital joint venture. In analyzing this issue, three distinct factors must be considered: the benefit to the exempt organization, the benefit to the private investor, and, most important, the benefit to the community at large. It is undeniable that community benefit is realized when a fiscally troubled hospital or charitable organization receives an influx of capital or relief from its debt by virtue of entering into an arrangement with a for-profit organization. Not only is the community hospital able to maintain its charitable functions, but it may be able to expand those functions through streamlining its operations and investment of the cash distribution it may receive. In many cases, faced with competition from other more efficient networks and systems in the area, a community hospital may be forced to close its doors absent the joint venture option. (This argument, however, resembles closely the “survival” argument rejected by the IRS in Gen. Couns. Mem. 39,862 (Nov. 21, 1991)). Similarly, the exempt organization may benefit through the receipt of a valuable partnership or LLC interest and the influx of operating capital through which it may fund other charitable activities. The critical question, therefore, is whether these benefits are sufficient to outweigh the clear monetary and less apparent intangible benefits to the private participant. See Better Business Bureau v. United States, 326 U.S. 279 (1945); Universal Life Church v. United States, 13 Ct. Cl. 567 (1978), aff”d, 862 F.2d 321 (1988).
䡲
536
䡲
c12.fm Page 537 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
to the for-profit participant,217 and because this benefit is made possible only through the involvement of the charity, the charity is furthering a substantial nonexempt purpose. In a transaction structured according to IRS guidelines, the for-profit venturer benefits financially, but the exempt organization is able to ensure that charitable goals are being furthered through its exercise of control over the venture’s day-to-day operations.218 In the whole hospital joint venture, on the other hand, the charity is often unable to ensure that the charitable benefit-private benefit balance is maintained if it has ceded the requisite control to the for-profit entity. Thus, unless the charity retains substantial and enforceable controls, participation in a whole hospital joint venture may present significant jeopardy to a charity’s exempt status. The second model, so far utilized in only one instance,219 more closely resembles the standard Plumstead approved joint venture. In the so-called San Antonio model, Columbia HCA sought to merge its four San Antonio hospitals with South-west Texas Methodist Hospital (“Methodist”), the area’s largest tax-exempt hospital. Because Methodist was a well-respected and highly profitable institution, it was in a better bargaining position than most of Columbia’s acquisition targets. Thus, Methodist was able to negotiate the retention of significant managerial control over the operating entity. Not only is Methodist Healthcare Ministries (the exempt parent of Methodist Hospital) the manager of the hospitals, thus exercising day-to-day control over the medical assets and able to ensure continuing community benefit, but it has also retained equal representation on the governing board.220
217
218 219
220
In addition to the obvious monetary benefits that may be realized by the private investors in a whole hospital joint venture, the for-profit organization also may receive less apparent, indirect economic benefits. The for-profit participant can secure control over a larger group of healthcare providers than it may otherwise be able to achieve relative to the amount of equity that it invests; essentially, the for-profit may receive more than its money’s worth. “Sullivan Discusses Joint Ventures Involving Tax-Exempt Organizations,” 1 Exempt Org. Tax J., No. 6, at 26. Further, the for-profit organization’s financial statements may be significantly improved as a result of the venture, thus making the for-profit’s stock entity more attractive to private investors. See id. See generally Plumstead, Gen. Couns. Mems. 39,005 (June 28, 1983), 39,862 (Nov. 22, 1991); Chapter 4. Although the San Antonio model has been used only once thus far, more than 25 not-for-profit hospitals considering mergers or joint ventures with Columbia HCA have examined the San Antonio system to learn more about the structure of the deal. Comments of John Hornbeak, CEO of Southwest Texas Methodist Hospital, the charitable partner in the “San Antonio” venture, reported in Japsen, “Columbia Finds Success in 50-50 Formula,” Modern Health Care (Sept. 2, 1996): 84. In addition to its interest in the operating partnership holding the five San Antonio hospitals, Methodist Healthcare Ministries received $44 million with which to establish a charitable foundation, which has continued to finance a series of healthcare programs in the San Antonio metropolitan area. Moreover, it has expanded and continued many of the exempt medical functions that it originally conducted prior to its involvement in the joint venture. Methodist Healthcare Ministries significantly expanded the budget (from $260,000/year to $2 million/ year), hours (from 5 to 8 hours per week to 50 to 60 hours per week), and capacity (from 80 patients/day to 800 patients/day) of its primary care facility, Wesley Community Center and Health Care Clinic. Id. Further, the Ministries has established several new indigent care clinics throughout San Antonio and plans to contract with four other area nonprofit community healthcare centers to expand their facilities in a similar manner. See id.
䡲
537
䡲
c12.fm Page 538 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
Although 50/50 ventures are not atypical for Columbia HCA, the board structure in the San Antonio model varies significantly from the usual model. As a rule, Columbia HCA insists on holding the tie-breaking vote on key decisions.221 In the San Antonio merger, however, each party holds certain veto rights over deadlocks, depending on the decision at hand.222 In addition, because the charity holds the management contracts and controls the hospitals’ and clinics’ day-to-day activities, the venture should be able to meet the necessary charitable–private benefit balance that the IRS requires in the Plumstead analysis.223 As a practical matter, most for-profit entities will seek control over the venture, which will raise UBIT and (perhaps irreconcilable) exemption concerns for the exempt participant.224 Although the demise of whole hospital joint ventures (and the corresponding increase in buyouts) would likely raise fewer issues under federal tax laws with respect to charitable exemptions, it would also tend to diminish the amount of charitable healthcare available to the public. Further, such a position may have the effect of constructively eliminating the financial viability of smaller exempt healthcare organizations.225 Because this area is changing so rapidly, new structures and trends are likely to develop in the future. (vii) Pre/Post–Joint-Venture Management Issues. By its very form, the whole hospital joint venture generates concern over control. As stated previously, the essence of the joint venture transaction is that an IRC §501(c)(3) organization and a for-profit corporation create a new entity, to which the nonprofit transfers ownership of one or more hospitals (generally, its only operating assets), with the joint venture then contracting with the for-profit (or its affiliate) for management services.226 In some, cases, the for-profit also transfers one or more hospitals or other operating assets to the joint venture.227 It is through this arrangement that the charity’s participation in, and control of, the joint venture is called into question.
221 222
223
224
225
226 227
Id. The San Antonio board is made up of ten members—five appointed by each entity. Each fiveperson group possesses one vote. In the case of deadlock, tie-breaking votes lie with the charity on certain matters (presumably those issues typically important to the government and the Plumstead analysis). See id. Methodist Health Care Ministries has submitted a private letter ruling request, which has not yet been ruled on by the IRS. Id. Discussion with representative of Methodist Healthcare Ministries on Dec. 10, 1996. This is not to say the San Antonio model could not eventually become more popular. “In terms of the number of organizations interested [in joining with Columbia], the San Antonio project has garnered more attention than any of our others in the country. . . . [I]t has been mind-boggling.” Comments of James Shelton, Id. However, given the recent developments in joint operating agreements, a more stringent set of rules beyond Rev. Rul. 98-15 governing the establishment of whole hospital joint ventures could encourage charities to enter into networks made up solely of charitable organizations (through joint operating agreements), rather than pursuing joint venture opportunities with private institutions. See Ross E. Stromberg and Carol R. Boman, Joint Ventures for Hospitals and Physicians (American Hospital Publishing, Inc. 1986). See Caplin, note 226, at p. 652.
䡲
538
䡲
c12.fm Page 539 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
When it comes to control, the pre– and post–joint-venture entities are two very different species. Before transfer, the pre–joint-venture hospital is generally owned and operated by a nonprofit corporation that is required, both by its corporate charter and as a condition of its federal tax exemption, to be organized and operated exclusively for charitable purposes.228 The pre–joint-venture nonprofit corporation is governed by a board that is generally composed principally, if not exclusively, of prominent citizens with enduring roots in the community.229 By virtue of the corporation’s nonprofit form, the directors cannot have an ownership interest in the hospital that could divert them from a singleminded pursuit of the hospital’s community service mission. In this pursuit, the pre–joint-venture board has the sole authority to define the hospital’s mission, values, and community service priorities. The board also has exclusive power to hire and fire the hospital CEO, and, through the CEO, to control the entire hospital staff. Post–joint-venture management is quite different.230 Once the joint venture has been formed, the nonprofit typically does not have unilateral authority to terminate the management firm, to replace the CEO, or to direct specific changes in hospital operations. Joint venture agreements generally provide for the establishment of a joint venture board, with equal representation by the nonprofit and the for-profit partners.231 Most everyday decisions are within the discretion of the for-profit without review by the nonprofit entity. The for-profit also generally controls the hospital staff.232 In addition, before the joint venture is formed, the entire hospital staff is directly accountable to the nonprofit board and is committed to assisting it in implementing the community service mission. After the joint venture is formed, the staff, under the direction of the for-profit corporation, arguably has an incentive to maximize shareholder return. In fact, the staff may be motivated to control the presentation and flow of information to the joint venture board in a manner that advances the business interests of the for-profit partner. If the forprofit partner has ultimate authority over staff working conditions, compensation, and status, the fundamental loyalty of the hospital staff may likely shift from the nonprofit board and its community service mission to the for-profit joint venture and its goal of profit maximization. This potential realignment in staff loyalty significantly diminishes the nonprofit board’s ability to monitor and control hospital operations and is an important factor in preventing the charity’s representatives on the joint venture board from implementing a community service mission. As reflected by its limited powers over hospital operations and intermittent contact with hospital personnel, it appears that the role of the nonprofit board’s in 228 229 230 231
232
Id. at 655. Id. Id. See Cain Brothers, “Focus on Joint Venture Arrangements,” Strategies in Capital Finance 12 (Spring 1995) (hereafter, “Cain Report”), at 2; Cain Brothers, “Columbia/HCA Healthcare Corporation: Understanding Its Strategies and Tactics” (June 1995), at 15. See also Mills, “Whole Hospital Joint Ventures Raise Questions About Exemption,” Taxation of Exempt Organizations, 204 (Mar./Apr. 1996): 204–205. See Caplin” note 226, at 655–656.
䡲
539
䡲
c12.fm Page 540 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
relation to the joint venture is one that is highly passive. As a result, when the nonprofit is serving as a general partner, such an arrangement appears to fly in the face of Rev. Rul. 98-15, Priv. Ltr. Rul. 97-36-039, Redlands Surgical, and St. David’s which hold that it is critical that the exempt organization remain in control of the partnership or joint venture to ensure that its activities further charitable purposes. In this regard, when it can be demonstrated that the venture is effectively “controlled” by the tax-exempt entity, a finding of charitability will be easier to substantiate. Otherwise, tax-exempt status may be jeopardized. “Control” is clearly a “hot” issue within the IRS. Hence, practitioners must be mindful that whole hospital joint ventures, as currently organized, will fail to pass muster unless they are retooled and structured in such a way as to ensure that the requisite control is placed in the hands of the nonprofit entity. (viii) Drafting the Partnership and LLC Operating Agreements (A) O VERVIEW Partnership and LLC operating agreements in whole hospital joint venture transactions are not typically a matter of public record. However, careful analysis of media reports, statements by the parties, disclosures to state regulators, and commentary by legal and business consultants involved yield a relatively clear picture of these agreements. In general, the partnership or LLC operating agreement is the operative document for the joint venture and contains a description of the specific purpose for which the venture is formed.233 It presents the terms and conditions of the transaction, including the rights and obligations of each venturer with respect to the transaction, the allocation of control over management, and the financial aspects of the venture. Although the details of individual whole hospital transactions vary, it is commonly required that, subject to certain reserved powers, the joint venture agreement give the for-profit entity extensive control over the joint venture’s day-today operations.234 The for-profit is generally empowered to cause the venture to contract with it (or its affiliates) for a range of services that will yield it substantial fees.235 In addition, under applicable financial reporting standards, even if the forprofit owns as little as 50 percent of the joint venture’s equity, operating control may still permit it to report 100 percent of the venture’s assets on its balance sheet, thereby enhancing its attractiveness to investors and its stock price.236 The paramount problem with this sort of arrangement is that the nonprofit entity’s control of the joint venture and rights over decision making may be subordinated. Private Letter Ruling 97-36-039 and Redlands Surgical specifically prohibit such subordination, holding that a charity is not carrying out its exempt purpose “unless [the charity] is in control . . . real control.”237 For example, when the IRS reviewed the initial partnership agreement in Priv. Ltr. Rul. 97-36-039, it 233 234 235 236 237
See R. Stromberg and C. Boman, “Joint Ventures for Hospitals and Physicians,” 30. See Caplin, note 226, at 650. See Mills, “Whole Hospital Joint Ventures Raise Questions About Exemption,” 204–205. See Lutz, “Control Becomes Issue in 50/50 Deal,” Modern Healthcare (Feb. 12, 1996): 56. See Priv. Ltr. Rul.97-36-039; Redlands Surgical, Inc. v. Commissioner; Section 4.2.
䡲
540
䡲
c12.fm Page 541 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
was troubled by the appearance that the for-profit partner controlled operations. It was not until after the joint venture addressed the IRS’s concerns by amending the partnership agreement that approval of the joint venture arrangement was granted. Specifically, the amended agreement redistributed and delegated control over partnership operations to the charity. There was a clear change in the reserved powers and a vesting of control over the day-to day operations in the nonprofit entity. By revamping the partnership agreement, substantive powers that used to be reserved to the for-profit partners were given to the charity.238 By placing control in the hands of the nonprofit, the IRS found that the charitable purpose would be safeguarded. Similarly, in Situation 2 of Revenue Ruling 98-15, the manner in which the partnership agreement was drafted was also an issue. There, the IRS denied tax exempt status because the nonprofit partner failed to establish that it would be operated for exclusively exempt purposes. An important factor considered by the IRS was the absence of a binding obligation in the LLC’s governing document for the joint venture to serve charitable purposes, or to provide services to the community as a whole. Instead, the governing document merely provided that the joint venture’s purpose was to “construct, develop, own, manage, operate and take other action in connection with operating the healthcare facilities it owns and engage in other healthcare related activities.”239 On its face, such language appears to be profit motivated and scarcely related to the advancement of the charitable purpose. As such, the IRS found that the joint venture would be able to deny care to segments of the community, and thus tax exempt status was denied.240 Although the for-profit entity or management company is usually deemed to possess the greater expertise and know-how to efficiently manage and operate the joint venture, the seemingly unbridled control that generally accompanies this arrangement is hard to reconcile with the positions advanced by the IRS in the aforementioned rulings. Accordingly, it is extremely important to structure partnership and management agreements to conform to the IRS’s mandates. Careful drafting of these agreements can ensure that the charity’s influence over hospital operations is not too attenuated to guarantee that the joint venture advances exclusively charitable purposes. (B) D RAFTING R ECOMMENDATIONS Practitioners should consider implementing provisions in the joint venture agreement that address the issues raised in private letter rulings and Rev. Rul. 98-15: • The partnership or LLC agreement should expressly commit the joint
venture to provide healthcare services for the benefit of the community as a whole, and to give charitable purposes priority over maximizing profits. • The nonprofit should choose a majority of the governing board members. • If the joint venture uses the services of a management company, the joint
venture agreement should vest the nonprofit entity with the power to replace the management personnel or terminate the management agreement. 238 239 240
Priv. Ltr. Rul. 97-36-039. Rev. Rul. 98-15, Situation 2. Id.
䡲
541
䡲
c12.fm Page 542 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
• The exempt organization should retain the right to approve the annual
operating plan, budget, and other major decisions.241 • Contributions to the joint venture and allocations of profits and losses
should be proportionate to the interests of the parties.242 • Where the exempt organization is the general partner or managing mem-
ber, the joint venture agreement should empower the governing board to take actions that, in its sole discretion, are consistent with its tax-exempt purposes even if those actions conflict with the profitability of the entity or the objectives of the limited partners.243 • The joint venture agreement should provide the exempt organization
with the ability to unwind the joint venture if its tax-exempt status is jeopardized.244 On this same note, the governing document should specify that a supermajority be required for any decisions potentially affecting the joint venture’s exempt purposes.245 • The joint venture agreement should provide that neither the exempt organiza-
tion nor the joint venture entity will confer any benefits on the for-profit or its affiliates for less than adequate consideration in money or money’s worth.246 • The joint venture agreement should provide for the maintenance of ade-
quate levels of insurance to protect the assets of the exempt organization from claims arising from the joint venture’s business.247 • The exempt organization should not guarantee any material debt of the
joint venture.248 • There should be a ceiling on losses allocable to the nonprofit equal to its
share of total capital249 and no obligation on the part of the nonprofit to repay amounts invested by the other partners.250 • There should be a limit on the hospital’s exposure to liabilities of the joint
venture, and corresponding indemnification.251 241 242 243 244 245 246 247 248 249 250
251
Priv. Ltr. Rul. 93-52-030. Priv. Ltr. Rul. 93-45-057. Id. Priv. Ltr. Rul. 93-52-030. See Jeremy Holmes, “IRS Issues Guidelines for Whole Hospital Joint Ventures: Concern Among Practitioners,” Daily Tax Report (Mar. 5, 1998): GG-2. Id. Priv. Ltr. Rul. 93-45-057. Priv. Ltr. Rul. 96-16-005. Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Gen. Couns. Mem. 39,546 (Aug. 15, 1985). However, the partnership must be careful not to absolve the general partner of all liability, because then the corporate characteristic of limited liability would exist. In that case, the classification of the entity as a partnership could come into question. See generally Reg. §301.7701-2(a)(2); Reg. §301.7701-2(d)(2). Gen. Couns. Mem. 37,852 (Feb. 15, 1979); Gen. Couns. Mem. 39,546 (Aug. 15, 1986). The IRS held that the exposure to the [exempt] general partner may be limited through insurance, indemnity agreements, or limiting the nature of the activities carried on by the partnership. . . .[F]or example, a general partner may refuse to obligate itself to make operating loans to the partnership, or provide that any loans that it does make, will be fully secured. Gen. Couns. Mem. 39,546. See also Gen. Couns. Mem. 39,005 (Dec. 17, 1982) (limited exposure to liability because the loans were federally guaranteed).
䡲
542
䡲
c12.fm Page 543 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
• There should be a prohibition against loans by the nonprofit to the ven-
ture to finance operations, at least without full security, or to the taxable partners to finance contributions.252 • Options (puts, calls, or rights of first refusal) should be granted to the
nonprofit upon disposition of the partnership property or interests.253 No such options should be given to taxable partners unless the hospital is to receive at least fair market value. • There should be a requirement of income distributions to the nonprofit at
least in proportion to its capital contribution.254 • The joint venture agreement should require that all financial arrange-
ments be negotiated at arm’s length and based on payment of fair market value for property and services.255 • The exempt organization should have authority to veto expenses over a
specified material dollar amount, as well as any debt incurred by the joint venture.256 • The management company should be independent of the for-profit part-
ner, and the management agreement should be short-term, that is, not to exceed three to five years, and not unilaterally renewable by the management company. • Officers and directors of the joint venture, for example, the CEO and CFO,
should not have had a prior relationship with the for-profit partner, other than for a brief, initial transition period, after which time employees of the for-profit partner should withdraw from the joint venture entity. Inclusion of a majority of the criteria in the joint venture structure and agreements does not ensure IRS approval, but does increase the likelihood that the joint venture will withstand an IRS challenge on the basis of control. Rev. Proc. 2007-4 (January, 2007) section 6.12, states that the IRS will not issue any PLRs as to whether a joint venture between a nonprofit and a for-profit will result in UBIT or revocation of exemption. However, if that issue is present in an initial application, the IRS will rule on that issue as part of the application approval. The IRS appears to be unwilling to issue meaningful guidance for joint ventures not controlled by a charitable organization following the final determination, in the St. David’s case. Nevertheless, transactions need not be deferred
252
253 254 255
256
Gen. Couns. Mem. 39,546 (Aug. 15, 1985); Priv. Ltr. Rul. 87-05-089 (Nov. 7, 1986). See also Agro Science Co. v. Commissioners, 927 F.2d 213 (5th Cir. 1991) (debt in joint venture partnership must not be illusory debt). Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 39,005 (Dec. 17, 1982). Gen. Couns. Mem. 39,732 (May 27, 1988); Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991); Priv. Ltr. Rul. 87-05-089 (Nov. 7, 1986). Priv. Ltr. Rul. 93-23-030. The transactions can include property transfers, services, and loans between the joint venture and interested persons or “insiders.” Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Gen. Couns. Mem. 37,852 (Feb. 15, 1979); Gen. Couns. Mem. 37,789 (Dec. 18, 1978); Priv. Ltr. Rul. 91-47-058 (Nov. 22, 1991). But see Anclote Psychiatric, Section 12.6, wherein private inurement was found notwithstanding an independent appraisal, separate counsel, and so forth. See also Birmingham Baptist, §11.3(b)(v). Priv. Ltr. Rul. 96-16-005.
䡲
543
䡲
c12.fm Page 544 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
while waiting for further clarification. The following suggestions for structuring a deal are discussed in more detail in Section 4.2(h): • Either have the established charity party directly participate in the transac-
tion or use a disregarded single-member limited liability company (LLC). • Another option would be to create a truly independent taxable subsidiary
through which the charity could participate in the venture.257 • The activities of the joint venture must advance the charitable purpose of
the nonprofit partner. • Give the charity veto rights over issues critical to it or a supermajority
vote to approve major financial and organizational decisions. • The presence of the community board is a point in favor of exemption,
but is not an absolute requirement for exemption. • Grant a tie-breaking vote to a Chairman of the Board appointed by the
nonprofit. Also, should allow the charity the power to unilaterally remove the chief executive officer. • Establish ground rules for arbitration containing a presumption in favor
of the tax-exempt that could be overcome only if the for-profit meets a preset burden of proof. Such a provision would resolve any ultimate conflict between profit and exempt purposes in favor of the exempt purpose, and should therefore alleviate the concern of the IRS. • With regard to a hospital venture, the partnership agreement should require
that all hospitals owned by the partnership be operated in accordance with the community benefit standard. Should a hospital fail to meet that standard, the charity should have the unilateral right to dissolve the partnership. • In a healthcare venture, a community benefit committee might be created
by the nonprofit partner to monitor compliance with the community benefit standard and report to the nonprofit’s board. Alternatively, hire a manager to conduct an internal audit to verify compliance with the community benefit standard. • It is preferable (although not required) that the management company be
controlled by parties unrelated to the for-profit partner. The contract should be for a short term (no more than five years), with board authority to terminate for cause, power in the nonprofit to approve extensions, and acknowledgment by the parties that the charitable purposes are paramount. • Do not hire employees or former employees of the for-profit partners to
serve in key positions in the venture. • The exempt partner’s board members should take an active role and doc-
ument their participation in written, detailed minutes of the meetings. • Build in a right to unwind in the event that the transaction ultimately fails
to meet the Plumstead dual-prong test. The parties should agree in advance on a fair and orderly way to end the venture if the exempt status of the nonprofit members is threatened. 257
Priv. Ltr. Rul. 99-38-041 (June 28, 1999).
䡲
544
䡲
c12.fm Page 545 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
(ix) Application of Rev. Rul. 98-15 to Ancillary Joint Ventures: Rev. Rul. 2004-51. It is now clear that the IRS will apply the reasoning of Rev. Rul. 98-15 to ancillary joint ventures. In the healthcare arena, most joint ventures are “ancillary”. For example, clinical ventures include ambulatory surgical centers, imaging facilities while non-clinical ventures include a medical office building. The IRS published Rev. Rul. 2004-51, which examines a non-healthcare venture but is nevertheless relevant in that the IRS recognizes that control of the entire venture is not essential and may be “bifurcated”. See Section 4.6 for a detailed analysis of Rev. Rul. 2004-51. In addition, six private letter rulings have approved ancillary joint ventures between healthcare organizations citing Rev. Rule. 98-15. Three of these were ventures between two exempt organizations,258 and three involved both exempt and for-profit partners.259 In all cases, the venture was closely related to the purpose of the exempt partner or partners. Two of the cases are discussed in more detail in this section. An ancillary joint venture between two exempt healthcare organizations will not jeopardize their exempt status. A private letter ruling 260 approved formation of an LLC to combine the rehabilitation programs of the two organizations and operate them jointly, expanding some and contracting or re-forming others. The IRS agreed that this would expand the services available to the communities and provide hospital care consistent with the community benefit factors described in Rev. Rul. 69-545. The board would consist entirely of equal representatives from the two members, and the operating agreement required the LLC to operate in a manner consistent with the charitable purposes of the two members. The letter ruling analyzes the proposal under the reasoning of Rev. Rul. 9815. The letter ruling characterizes Situation 1 of Rev. Rul. 98-15 as approving the participation of an exempt hospital in an LLC. Situation 1 also shows that when the tax-exempt hospital retains control over the LLC and the LLC provides hospital care, the hospital’s principal activity continues to be the provision of charitable purposes. This illustrates the aggregation principle that, for federal tax purposes, the activities of the partnership are considered to be the activities of the partners. The aggregate treatment is also consistent with treatment of partnerships for the purposes of unrelated business income tax (UBIT). The private letter ruling distinguished Rev. Rul. 98-15 because both members of the LLC are exempt entities. The control of the LLC only benefits exempt entities. Any income of the LLC is to be distributed to the exempt owners in accord with the operating agreement and will not result in private inurement or private benefit. Because the participation of the exempt owners enables them to provide expanded and improved healthcare, distributions from the LLC will not be considered unrelated business income subject to tax. Another private letter ruling involved an ancillary joint venture, which operated an ambulatory surgery center, and included both for-profit and exempt members.261 The Service emphasized the similarity of the venture with the 258 259 260 261
Priv. Ltr. Ruls. 199913035, 200102052, 200117043. Priv. Ltr. Ruls. 200118054, 200206058; Tech. Adv. Mem. 200151045. Priv. Ltr. Rul. 200102052. Priv. Ltr. Rul. 200118054.
䡲
545
䡲
c12.fm Page 546 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
“good example” in Rev. Rul. 98-14. The tax-exempt healthcare system that had previously owned and operated the surgery center contributed 70 percent of the capital and individual physicians, 30 percent. The healthcare system could continue to sell memberships, but would always retain at least 51 percent of ownership. Profits and losses will be allocated in proportion to membership interests. The operating agreement clearly provided that the purpose was to operate the center in furtherance of tax-exempt purposes by promoting health for a broad cross-section of the community (including Medicare, Medicaid, and indigent patients), and that this duty of the board of directors overrides any duty to operate for the financial benefit of the members. The operating agreement commits the surgery center to continue to provide charity care, and to use binding arbitration (though there is no mention in the private letter ruling of what standard to use in the arbitration). The tax-exempt healthcare system and the directors it appoints to the joint venture have control of both major decisions and day-to-day management through majority representation of the membership and the board of directors. The Service found that this level of control assures that the surgery center will be operated in a manner that furthers charitable purposes and protects the assets of the tax-exempt member. The letter ruling also concluded that because the healthcare system’s involvement with the surgery center is substantially related to its exempt purpose, that it will not result in unrelated business income. CAVEAT Notwithstanding the IRS position on control (Rev. Rul. 98-15), it is understood that an exempt academic medical center with a teaching hospital would not be subject to UBIT on income generated from an ancillary joint venture with a forprofit even if the charity retained significantly less than 50 percent of the board control. (See Section 14.3 for discussion of Special Statutory UBIT Rule.) The most obvious distinction between whole hospital joint ventures and ancillary service joint ventures is that in the former, no exempt hospital remains that can independently satisfy the community benefit standard set forth in Plumstead. By contrast, with ancillary service joint ventures, the profit-conflict standard is far less likely to be implicated because, for instance, the hospital would likely continue to meet the community benefit standard through one or more of its retained functions or departments—for example an emergency room that is open to the public. In a case involving an ancillary joint venture arrangement, John Gabriel Ryan Association (“JGR”) v. Commissioner, the IRS, before the court issued its opinion, granted exemption to a nonprofit participant that had an equal 50 percent interest in the joint venture with the for-profit participants. According to the IRS, since there were other mechanisms in place to ensure that the exempt or charitable purposes of the nonprofit participant were furthered, the fact that it had equal control of the joint venture with the for-profit partner should not result in denial of exemption. Thus, while the IRS has issued neither any formal guidance on ancillary joint ventures nor any statement regarding whether the analysis in 䡲
546
䡲
c12.fm Page 547 Thursday, March 15, 2007 7:59 PM
12.3 TAX ANALYSIS
Rev. Rul. 98-15 applies to such ventures, the IRS’s position in the JGR case is significant because it provides interim guidance on the types of mechanisms (in lieu of greater than a 50 percent ownership interest by the exempt partner) that may be acceptable to the IRS.262 Until there is further clarification of the effect of Rev. Rul. 98-15 on ancillary joint ventures, the following may be prudent steps for hospitals participating in such ventures:263 • Enter into ancillary ventures that clearly further the hospital’s exempt
purposes. Cash contributions may be less risky than asset contributions. • Have the hospital make a capital contribution proportionate and equal to
its percentage interest in the ancillary venture. • The hospital should have more than minimal equity ownership even if it
otherwise controls the ancillary venture. • Add an express requirement to the operative documents of the ancillary
venture that in case of any conflict between the hospital’s obligation to satisfy the community benefit standard and furtherance of profit-making goals, the former will prevail.264 • Limit the hospital’s obligation to fund future capital contributions to the
ancillary venture, and strive to minimize the hospital’s exposure to unlimited liability as a general partner. It has also been suggested that Rev. Rul. 98-15 raises the issue, albeit implicitly, of whether income received through a joint venture is unrelated business income (UBI) if the venture is not consistent with the nonprofit’s exempt purposes.265 The criteria could be particularly relevant in the ancillary joint venture area (where only a portion of a nonprofit’s assets are contributed to a joint venture).266 It should be noted that while discussing ancillary joint ventures, the authors of the 1999 CPE Hospital Joint Venture Article state that the chapter addresses the ancillary joint venture topic “only for completeness.”267 Since the publication of Rev. Rul. 98-15, commentators questioned whether ancillary joint ventures, in which substantially less than all of a hospital’s assets are transferred, are covered by the whole hospital ruling. The 1999 CPE Hospital Joint Venture Article avoided the issue by commenting that the “scope of this article is limited to a discussion of whole hospital joint ventures and the application of
262 263 264 265
266 267
See Section 4.2(g) of this supplement for a discussion of the JGR case. For a more complete discussion of the factors, see Edward J. Buchholz, “The IRS’s Whole Hospital Joint Venture Ruling: Guidance or Confusion?” Taxes (June 1998): 20. See Petroff, “Whole Hospital Joint Ventures: The IRS Position on Control, “30, Exempt Organization Tax Review (July 1998), discussing the resolution of disputes through arbitration. T. J. Sullivan, “Unrelated Business Income: Recent Developments Planning Strategies for Multi-Corporate Entities, and Selected Health Care Issues,” Exempt Organization Tax Review 22, no. 3 (Dec. 1998). See Chapter 8. See 1999 CPE Hospital Joint Venture Article.
䡲
547
䡲
c12.fm Page 548 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
Rev. Rul. 98-15 to such transactions, and does not attempt to analyze the hospital ancillary joint venture.”268 The 2000 CPE raised the issue by discussing a private letter ruling involving two exempt organizations which form an ancillary joint venture to build a new hospital and ambulatory surgery center to serve the poor in their community.269 The private letter ruling distinguishes this situation from Rev. Rul. 98-15 on grounds that both members of this LLC were nonprofits and therefore nonprofits were exclusively in control of the venture which only served charitable purposes. It appears that the facts and circumstances analysis of Rev. Rul. 98-15 could also be readily applicable to an ancillary joint venture between a nonprofit and a for-profit—that is, does the nonprofit have control of the venture and does the venture have a primary charitable purpose? The IRS has since recognized “bifurcated” control in ancillary venture context in Rev. Rule. 2004-51.270 In Redlands Surgical Services, Inc. v. Commissioner,271 the Tax Court used an analysis similar to the IRS’s in Rev. Rul. 98-15. However, it is the author’s opinion that where a nonprofit is a passive investor in an activity, the control issues of Rev. Rul. 98-15 and Redlands should not be relevant. (x) Use of a Subsidiary to Protect the Exempt Parent. If the nature of the activity is such that direct participation by the hospital may jeopardize its exempt status, it may be possible to restructure the transaction by participating through a for-profit taxable subsidiary or affiliate.272 However, for such an alternative structure to succeed, it is preferable for the affiliate’s participation to be funded through a source other than the hospital, because the IRS may analyze such transactions as if the hospital itself were participating directly in the venture to the extent of any funding traceable to it.273 Even with separate funding, the taxable affiliate must be a bona fide entity separate from the hospital.274 Furthermore, the subsidiary must not be a mere arm of the exempt parent.275 The subsidiary’s independent status is established by the following: • Refraining from active involvement of the hospital in the day-to-day busi-
ness affairs of the taxable affiliate 276 268 269 270 271 272
273
274 275
276
Id. P.L.R. 199913035 (Dec. 22, 1998). See Section 4.6 and 12.3(x) Tax Court Docket No. 11025-97(x). See Section 113(b)(iv). Gen. Couns. Mem. 39,866 (Dec. 16, 1991); Gen. Couns. Mem. 39,598 (Jan. 23, 1987). See also Priv. Ltr. Rul. 93-08-047 (Dec. 4, 1992); Priv. Ltr. Rul. 93-05-026 (Nov. 12, 1992); Priv. Ltr. Rul. 93-03-030 (Oct. 29, 1992). See generally Section 4.6. See Gen. Couns. Mem. 39,646 (June 30, 1987); Gen. Couns. Mem. 39,598 (Jan. 23, 1987). See also Priv. Ltr. Rul. 93-03-030 (Oct. 29, 1992); Priv. Ltr. Rul. 86-21-059 (Feb. 25, 1986); Priv. Ltr. Rul. 86-04-006 (Aug. 30, 1985). The IRS has held that attribution of the activities of a subsidiary to the parent should arise only where the evidence clearly shows that the subsidiary is merely a guise . . . or where it can be proven that the subsidiary is an arm, agent, or integral part of the parent. Gen. Couns. Mem. 33,912 (Aug. 15, 1968), quoted in Gen. Couns. Mem. 39,598 (Jan. 23, 1987). Moline Properties Inc. v. Commissioner, 319 U.S. 436 (1943); Britt v. United States, 431 F.2d 227, 234 (5th Cir. 1970); Gen. Couns. Mem. 39,326 (Jan. 17, 1985). See Section 4.6. Krivo Ind. Supply Co. v. Nat’l Distillers and Chemical Corp., 438 F.2d 1098, 1101 (5th Cir. 1973); Gen. Couns. Mem. 39,776 (Feb. 6, 1989); Gen. Couns. Mem. 39,598 (Jan. 23, 1987); Gen. Couns. Mem. 33,912 (Aug. 15, 1968). Gen. Couns. Mem. 39,326 (Jan. 17, 1985).
䡲
548
䡲
c12.fm Page 549 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
• Forming the affiliate for a real business purpose and not as a mere instru-
mentality of the hospital277 • Ensuring that the terms of all transactions between the taxable affiliate
and the hospital organization are at arm’s length278 • Allocating the cost of any shared assets, services, or facilities according to
use279 • Maintaining separate minutes and other formal documentation for the
affiliate280
12.4
OTHER HEALTHCARE INDUSTRY ISSUES
Despite the relatively large number of private letter rulings and general counsel memoranda in the healthcare area, prior to the last few years it had been difficult to sharply define the parameters of acceptability of these joint ventures under present law. There are at least two reasons for this lack of “bright line” rules. First, most of the guidance has been in the form of private letter rulings, which tend overwhelmingly to present favorable holdings. These rulings are mostly favorable because of the element of self-selection in requests for rulings: If the taxpayer’s position is weak, the taxpayer will have the benefit of negative preliminary feedback from the IRS National Office and will likely withdraw the ruling request.281 Second, many of the activities pursued by healthcare joint ventures involve the expansion of healthcare facilities in a tangible way that makes it relatively easy for the IRS to find an activity that furthers an organization’s exempt purpose.282 The IRS is not the only federal agency that scrutinizes joint ventures in the healthcare field, as there are other federal statutes that also trigger scrutiny. First, there is the Medicare/Medicaid Antikickback Statute (the “Antikickback Statute”),283 which prohibits any kind of payment for the referral of a patient for a medical service that is covered by Medicaid or Medicare. Second, the “Stark” Law284 forbids physicians from referring patients to an entity for health services where the physician has a financial interest in the entity. The Office of Inspector General (OIG) of the Department of Health and Human Services oversees compliance with the Antikickback Statute. Both statutes trigger issues concerning physician compensation and asset sales among medical groups and 277 278 279 280 281
282 283 284
Gen. Couns. Mem. 39,598 (Jan. 23, 1987). Gen. Couns. Mem. 39,776 (Feb. 6, 1989); Gen. Couns. Mem. 39,326 (Jan. 17, 1985); Gen. Couns. Mem. 39,598 (Jan. 23, 1987); Priv. Ltr. Rul. 93-08-047 (Dec. 4, 1992). Gen. Couns. Mem. 39,598 (Jan. 23, 1987). Gen. Couns. Mem. 39,325 (July 31, 1984); Priv. Ltr. Rul. 93-05-026 (Nov. 12, 1992); Priv. Ltr. Rul. 88-10-082 (Dec. 17, 1987); Priv. Ltr. Rul. 88-05-059 (Nov. 13, 1987). See Gen. Couns. Mem. 39,646 (June 30, 1987) (the IRS warns that it will issue unfavorable rulings when the joint venture is not operated exclusively for charitable purposes or when private inurement exists). See generally Priv. Ltr. Rul. 93-08-034 (Nov. 30, 1992); Priv. Ltr. Rul. 93-01-023 (Jan. 8, 1993); Priv. Ltr. Rul. 92-42-002 (Oct. 16, 1992); Priv. Ltr. Rul. 83-44-099 (Aug. 5, 1983). 42 U.S.C. §1320a-7(b)(b). 42 U.S.C. §1395nn. For a discussion of the Antikickback Statute and the Stark Law, see the Louthian Article, footnote 17. Also see Section 12.4(d).
䡲
549
䡲
c12.fm Page 550 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
hospitals, as well as real property leases between medical groups and hospitals.285 Thus, the IRS’s increased scrutiny of nonprofit healthcare organizations and any associated joint venture arrangements is consistent with that of other executive branch agencies (Department of Justice, HHS).286 Similarly, the areas of concern to the IRS are also compensation structures, asset valuations, inurement issues, and percentage bonuses or salaries. Because joint ventures between exempt organizations and physicians are a potent means of compensating or retaining a physician and his or her loyalty, the IRS will continue to scrutinize those ventures.287 (a)
Revenue Stream Sharing 288
(i) General Counsel Memorandum 39,862289. In 1991, the IRS issued a general counsel memorandum, in which the IRS disapproved arrangements whereby joint ventures were formed with physicians in order to purchase the net revenue stream from existing hospital facilities.290 Because the purchase price of the net revenue stream from, for example, a hospital surgical facility, was the discounted present value of the existing profit stream, the transaction would become profitable for the venturers only if referrals to the facility increased.291 The physician-venturers thus had an incentive to increase referrals to the hospital. The Memorandum held that the mere enhancement of the hospital’s financial health through increased utilization of its facilities alone did not bear a direct relationship to the hospital’s exempt purpose.292
285 286 287
288
289 290
291 292
See Louthian Article, footnote 17. See generally Statement of Marcus Owens, Former, Director, Exempt Organizations Technical Division, IRS, at the ABA Tax Section Program on Health Care (Aug. 24, 1993). See Statement of Howard Schoenfeld and Marcus Owens, “IRS Compliance Activities Involving Action 501(c)(3) Public Charities, Before the Subcommittee on Oversight of the House Ways and Means Committee (Aug. 2, 1993) (health-care joint ventures are analyzed); statement of Marcus Owens, Former, Director Exempt Organizations Technical Division, IRS, at the ABA Tax Section Program on Healthcare (Aug. 24, 1993). See, e.g., Carolyn D. Wright, “Student FICA Guidance Out Soon; IRS to Focus on For-Profit Deals with Exempts, Says Owens,” Tax Notes Today 97 (Nov. 6, 1997): 215–6 (Marcus Owens “cautioned audience members that healthcare entities and colleges and universities account for more than half of the audits open under the IRS’s Coordinated Examination Program.” Owens also stated that, with regard to joint ventures between nonprofit and for-profit entities in the healthcare area, Treasury and the IRS have “extraordinarily large concerns over these transactions and who might be the ultimate beneficiaries of them”); “IRS EO Division Summarizes Workplan for Fiscal 1998,” Tax Notes Today (Oct. 17, 1997): 201–13 (“Coordinated Examination Program . . . will continue to focus on large, complex exempt organizations, particularly hospitals. . . . For FY 98, the program included a specific focus on joint ventures and similar transactions/arrangements between tax exempt organizations and proprietary healthcare organizations.”); Fred Stokeld, “Health Care Mergers to Get More Attention from IRS, Owens Says,” Tax Notes Today 97 (Oct. 10, 1997): 197–5. Gen. Couns. Mem. 39,862 (Nov. 21, 1991). The memorandum is 82 pages in length. Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See also Priv. Ltr. Rul. 92-33-037 (Aug. 14, 1992) (recent ruling confirmed the IRS holding in General Counsel Memorandum 39,862); Priv. Ltr. Rul. 92-31-047 (July 31, 1992). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See also Ann. 92-83, 1992-22 I.R.B. 59 (June 1, 1992). Few, if any, joint ventures involving the sale of future revenues continue to operate. IRS Exempt Organizations Technical Division reports that 21 joint ventures approached the IRS with this arrangement, and now all 21 are reportedly dissolved. GAO Report at 9, 116.
䡲
550
䡲
c12.fm Page 551 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
These situations can be contrasted with those in which new facilities were created that were beneficial and necessary to the community,293 or in which a lease to staff physicians of office space adjacent to a hospital was held to advance the hospital’s charitable purpose because it resulted in greater patient convenience and greater accessibility of physicians.294 The IRS, in General Counsel Memorandum 39,862, instead found the arrangement similar to that disapproved by the Tax Court in Sonora Community Hospital v. Commissioner,295 in which the public benefit was outweighed by the private benefits to two doctors who had previously owned the hospital and continued to share in hospital revenues.296 Therefore, the joint venture in the General Counsel Memorandum violated the requirement that any private benefit be incidental to public benefit.297 Furthermore, the joint venture was found to result in the inurement of part of the net earnings of the hospital to the benefit of “insider” individuals. Hence, this situation is distinguishable from the situation approved in a Revenue Ruling involving a hospital that paid a percentage of revenues from its radiology department to the radiologist.298 In that case the hospital in effect was acting as the collection agent for the fees for the radiologist’s personal services, and it appears that the amounts remitted to the radiologist were not attributable to the use of the hospital’s facilities.299 The IRS also took the position in General Counsel Memorandum 39,862 that the hospital’s exemption would be jeopardized in the event that the arrangement violated the Antikickback Statute.300 The IRS has applied this caveat in favorable letter rulings issued to hospital/physician joint ventures since the Memorandum.301 The Memorandum is particularly significant because it overruled prior favorable private letter rulings on such transactions; after the Memorandum, the IRS was careful to reconsider and formally revoke those rulings.302 As discussed in Section 12.3(c), the intermediate sanctions proposed regulations applied to and specifically addressed the revenue sharing issue; however, the final regulations did not provide specific guidance as to this issue. While the proposed regulations indicate that a determination will be based on all of the facts and circumstances, they also state that it is key that the nonprofit’s income increase proportionally to that of the disqualified person so as to avoid an excess benefit transaction.303 On the other hand, where a disqualified person controls 293 294 295 296 297 298 299
300 301 302
303
Gen. Couns. Mem. 39,732 (May 27, 1988). Rev. Rul. 69-464, 1969-2 C.B. 132. Sonora Community Hospital v. Commissioner, 46 T.C. 519 (1966), aff’d, 397 F.2d 814 (9th Cir. 1968) (per curiam). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See generally Chapter 5. Rev. Rul. 69-383, 1969-2 C.B. 113. Id. Here, the IRS endorsed rough justice in ruling for the taxpayer. Although the IRS questioned the arrangement, the percentage of revenues remitted to the radiologist, in large part, reflected the personal services performed by the physician. See generally Rev. Rul. 54-68, 1954-1 C.B. 151 (pooling of physician fees in a hospital is a joint venture). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See, e.g., Priv. Ltr. Rul. 94-07-022 (Nov. 22, 1993) (approval of ambulatory surgical center joint venture conditioned on compliance with Antikickback Statute). See Priv. Ltr. Rul. 92-33-037 (May 20, 1992), revoking Priv. Ltr. Rul. 88-20-093 (Feb. 26, 1988), and Priv. Ltr. Rul. 92-31-047 (July 31, 1992), revoking Priv. Ltr. Rul. 89-42-099 (July 29, 1989). Prop. Reg. §53.4958-5(d), Example 1.
䡲
551
䡲
c12.fm Page 552 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
the revenue in circumstances where there is no incentive to maximize the nonprofit’s income as well as its own (as in Prop. Reg. §53.4958-5(d), Example 2), inurement and an excess benefit may exist. (b)
Audit Guidelines for Hospitals
A comprehensive source of current IRS thinking in the healthcare area is contained in the revised “Audit Guidelines for Hospitals.”304 Amid discussion of many kinds of hospital activities, there is a section dealing with joint ventures.305 Specifically targeted as presenting private inurement issues are disproportionate allocations of profits and losses to the physician partners, below-market or undersecured loans by the hospital to the joint venture, provision by the hospital of property or services to the joint venture at less than fair market value, and unreasonable compensation or consideration to physician partners from the joint venture. The guidelines also incorporate by reference General Counsel Memorandum 39,862, discussed earlier, and refer in some detail to the Antikickback Statute.306 Because hospitals constitute 21 percent of the exempt organization community with total assets of $331 million and revenues of $268 million, they attract much of the effort of the examination program at the IRS.307 One third of IRS examinations concern large organizations under the Coordinated Examination Program, and half of those audits involve healthcare organizations. Voluntary compliance is the primary goal. The IRS is working on new voluntary compliance initiatives, including seminars for large exempt organizations on such issues as joint ventures, compensation issues, and political activity. In 2006, the Service sent a questionnaire to approximately 600 nonprofit hospitals, asking detailed questions about their operational practices and the amount and types of community benefits provided. The questionnaire also asked for detailed responses with respect to compensation of officers, directors, trustees, and key employees and the amounts of salary and compensation paid to those persons. Also in 2006, Senator Charles Grassley (R-IA) requested comments from the Service regarding abuse within the nonprofit sector generally and urged the Service to use its authority “more frequently and expeditiously” to prevent abuse among nonprofit hospitals and healthcare systems. Areas highlighted in the request include: the definition of charity care, the requisite level of charity care to be provided, the definition and level of community benefit, the definition of joint ventures, joint ventures involving nonprofit hospitals, the payment of excessive compensation, and the use of tax-exempt bond proceeds. The Senator also requested specific information regarding IRS statistics on audits engaged upon tax-exempt hospitals and the statistics on the numbers of exempt status revocations. Senator Grassley sent a questionnaire to the Catholic Health Association (CHA) and the American Hospital Association requesting information on 304 305 306 307
“Audit Guidelines for Hospitals” was released as Manual Transmittal 7(10)69-38, dated Mar. 27, 1992, also published as Announcement 92-83, 1992-22 I.R.B. 59. Ann. 92-83, 1992-22 I.R.B. 59 §333.4 (June 1, 1992). Id. Speech by Thomas Miller, Manager of Exempt Organizations Technical, BNA Daily Tax. (Feb. 7, 2002).
䡲
552
䡲
c12.fm Page 553 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
the amount of charitable care provided to low-income and indigent patients. In April 2006, the Catholic Hospital Association replied to Sen. Grassley’s request in a response the Senator called “thoughtful and informative.” In its response, Catholic Hospital Association provided in-depth answers to the SFC including information regarding its operational structure, systemwide compliance with the charitable care standards, and its joint ventures. In describing the joint ventures entered into by CHA and its member entities, the organization provided details on the charity care policy it adopted and required as a part of any joint venture arrangements with the health system. In May 2006, Dick Davidson, president of the American Hospital Association (AHA) responded to Grassley’s request. While AHA registered its support for the general notion of transparency and accountability over nonprofit healthcare organizations, it nonetheless expresses concern over the Nonprofit Panel’s recommendation that would require Type III supporting organizations to distribute a specified percentage of their income or assets each year and limit the number of organizations that could be supported. AHA maintained that these Type III supporting organization directives present a particular difficulty for hospitals to concurrently improve their efficiency and organize purchases. (c)
Physician Recruitment Guidelines
Hospital joint ventures often use incentive arrangements to recruit or retain physicians. Such arrangements by their nature are rife with possibilities for private inurement and excessive benefit. The IRS’s increasing scrutiny of transactions that may violate those prohibitions was clearly seen in the October 1994 release of detailed “Hospital Physician Recruitment Guidelines” as part of a binding settlement agreement, or “closing agreement,” between the IRS and the Hermann Hospital in Houston.308 Subsequently, the IRS issued Revenue Ruling 9721,309 which provides precedential physician recruitment guidance.
308 309
The Hermann Hospital closing agreement, including the recruitment guidelines, was published in Exempt Organization Tax Review 10 (Nov. 1994): 1035–41. Rev. Rul. 90-21, 1997-18 I.R.B.1. Technically, these guidelines were directed at only a specific hospital that had acknowledged improper transactions and agreed to pay the IRS more than $1 million to be able to retain its tax exemption; however, even after the issuance of Rev. Rul. 97-21, the guidelines are the most comprehensive IRS pronouncement to date on the scope of permissible physician recruitment and are being looked to widely as a kind of safe harbor for the healthcare industry. The fact that the IRS required the Hermann Hospital to release the guidelines publicly as part of the closing agreement underscores their potential importance. The IRS’s use of the closing agreement process to publicize such guidelines represents a creative method of enforcing compliance with IRC §501(c)(3) without revoking an organization’s tax-exempt status. Key features of the guidelines include the following: • Recruitment incentives are entirely prohibited with respect to physicians who are already practicing in the community; this includes retention incentives provided to physicians already having medical staff privileges at the hospital. • Certain recruitment incentives are expressly permitted to bring physicians into the community: • Income guarantees for two years or less as part of a reasonable compensation package. This includes net income guarantees subject to a ceiling on allowable expenses.
䡲
553
䡲
c12.fm Page 554 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
(i) Revenue Ruling 97-21, Final Physician Recruitment Guidelines310. In April 1997, the IRS released final published guidance concerning the consequences of tax-exempt hospital physician recruitment activities by issuing Revenue Ruling
• Secured loans and lines of credit bearing interest at certain minimum rates. Any loan forgiveness component must be conditioned upon the continued presence of the new physician in the community for at least four years. • Reasonable subsidies of medical office space, equipment, or private practice start-up costs, if not combined with an income guarantee. • Interview travel, moving, and relocation expenses, subject to a reasonable fixed ceiling amount. • Payment to an outside search consultant of up to 50 percent of recruiting fees or costs associated with bringing a new physician into an existing physician’s established practice. • Certain types of incentives are expressly prohibited: • Bonuses of any kind. In the case of “signing” bonuses, IRS officials have expressed the rationale behind this prohibition as being the concern that such bonuses “can very easily become the floor above which the next incentive takes off.” • Subsidized malpractice insurance, parking, telephone allowances, car allowances, health insurance, medical society dues, licensing fees, and travel and continuing education expenses with respect to the physician’s private practice (but permitted with respect to bona fide duties as the hospital’s medical director). The IRS is particularly concerned with malpractice premium payments because they tend to permit the hospital to direct that the insurance be written in a way that creates a “lock-in” for all of the physician’s referrals to that hospital. • Subsidized salary and benefit costs for support personnel in the private practice of a nonemployee physician (but these and other costs may be taken into account indirectly through a net income guarantee). • Conveyance or promise of future conveyance of a hospital outpatient department to a physician. • An otherwise permitted recruitment incentive will not be considered permissible unless there is a demonstrable community need for the physician. A mere need for the physician by the particular hospital will not satisfy this test. • The specific financial package to be provided to each recruited physician must be approved by the hospital board and reviewed by the hospital’s legal counsel or other tax advisor prior to execution. • All incentive arrangements must be memorialized in writing, with clauses requiring the physician to render periodic accountings to the hospital and allowing the hospital to terminate the agreement and recover from the physician any payment determined by a court or government agency to be illegal or inconsistent with the hospital’s tax-exempt status. Practitioners and the hospital community had legitimate concerns about these guidelines. First, their release through the vehicle of a closing agreement precluded the public comment that would have preceded the promulgation of proposed regulations—the format in which issuance of recruitment guidelines had long been expected. Second, a significant set of restrictions such as the guidelines were likely to affect adversely the ability of tax-exempt hospitals to compete with for-profit hospitals in recruitment of the best physicians available. Third, it is problematic whether IRS personnel are qualified to make judgments relative to medical staffing needs and appropriate incentives at a community hospital; a strong case can be made that such determinations should reside with the independent hospital’s board of directors. 310
See generally Michael W. Peregrine and T. J. Sullivan, “IRS Issues Final Physician Recruitment Revenue Ruling: Focus on Process and Community Benefit Continues,” Organization Tax Review 16 (June 1997):1031; Gerald M. Griffith, “IRS Issues Physician Recruitment Revenue Ruling,” Exempt Organization Tax Review 17 (July 1997): 103. See also Carolyn D. Wright, “IRS Shifts How It Evaluates Physician Recruitment Methods, Owens Says,” Tax Notes Today 97 (Oct. 14, 1997) 198–2 (Marcus Owens stated that the IRS has made “a shift over time in the direction of looking at process and safeguards, rather than trying to establish some kind of a per se standard or bright line” for evaluating physician recruitment and compensation).
䡲
554
䡲
c12.fm Page 555 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
97-21.311 Revenue Ruling 97-21 uses a facts-and-circumstances test to determine whether recruitment incentives given to physicians are provided in a manner that causes the providing hospital to violate the operational test.312 Revenue Ruling 97-21 bifurcates this analysis, so that one test applies to physicians that an IRC §501(c)(3) hospital recruits for its medical staff, and another test applies for physicians that such a hospital recruits to provide services to members of the surrounding community but not necessarily for or on the hospital’s behalf. In the first case, when a §501(c)(3) hospital recruits a physician for its medical staff, the hospital satisfies the operational test by showing that, considering all of the benefits that the hospital provides to the physician, the hospital is paying reasonable compensation for the services that the physician will provide in return. In the second case, when a §501(c)(3) hospital recruits a physician for its medical staff to provide services to members of the surrounding community but not necessarily for or on the hospital’s behalf, a violation results from a failure to comply with any of the following four requirements: 1. The organization must not engage in substantial activities that do not further its exempt purposes or that do not bear a reasonable relationship to their accomplishment.313 2. The organization must not engage in activities that result in inurement of the hospital’s net earnings to a private shareholder or individual, including any activity structured as a device to distribute the hospital’s net earnings.314 3. The organization may not engage in substantial activities that cause the hospital to be operated for the benefit of a private interest rather than public interest so that it has a substantial non-exempt purpose.315 4. The organization may not engage in substantial unlawful activities.316 EXAMPLE317: Hospital A, which is located in a rural area that has been designated as a Health Professional Shortage Area for primary medical care professionals, is the only hospital within a 100-mile radius. Dr. M, who resides in Hospital A’s county, recently completed an ob / gyn (obstetrics gynecology) residency and is not on Hospital A’s medical staff. Hospital A recruits Dr. M to establish and maintain a full-time private ob / gyn practice in its service area and become a member of its medical staff. It gives him a recruitment incentive package, pursuant to which it pays him a signing bonus, pays his professional liability insurance premium for a limited period, provides office space for a limited number of years 311 312 313 314 315 316
317
1997-18 I.R.B. 1, initially issued in proposed form as Ann. 95-25. Reg. §1.501(c)(3)(1). Rev. Rul. 97-21 cites to Rev. Rul. 80-278, 1980-2 C.B. 175, and Rev. Rul. 80-279, 1980-2 C.B. 176. Rev. Rul. 97-21 cites to Lorain Avenue Clinic v. Commissioner, 31 T.C. 141 (1958); Birmingham Business College, Inc. v. Commissioner, 276 F.2d 476 (5th Cir. 1960). Rev. Rul. 97-21 cites to Reg. §1.501(c)(3) 1(d)(1)(ii). Rev. Rul. 97-21 cites to Rev. Rul. 75-384, 1975-2 C.B. 204; Rev. Rul. 80-278, 1980-2 C.B. 175; and Rev. Rul. 80-279, 1980-2 C.B. 176, with respect to the conduct of unlawful activity that is inconsistent with charitable purposes. Example 1 is based on Rev. Rul. 97-21, 1997-18 I.R.B. 1, Situation 1.
䡲
555
䡲
c12.fm Page 556 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
at a below-market rent, guarantees Dr. M’s mortgage on a residence in Hospital A’s county, and lends Dr. M’s practice start-up financial assistance. Here, Hospital A does not violate the IRC §501(c)(3) exemption requirements, because it has objective evidence demonstrating a need for ob / gyns in its service area and its physician recruitment activity bears a reasonable relationship to promoting and protecting the community’s health. EXAMPLE318: Hospital B is located in an economically depressed inner-city area. A community-needs assessment, which Hospital B conducts, indicates both a pediatrician shortage in Hospital B’s service area and the difficulties that Medicaid patients in the area have in obtaining pediatric services. Dr. N is a pediatrician currently practicing outside Hospital B’s service area and is not on its medical staff. Hospital B recruits Dr. N to relocate to City W, establish and maintain a full-time pediatric practice in its service area, become a member of its medical staff, and treat a reasonable number of Medicaid patients. It offers Dr. N a recruitment incentive package, pursuant to which it reimburses him for IRC §217(b) moving expenses, reimburses him for professional liability “tail” coverage for his former practice, and guarantees his private practice income for a limited number of years. The amount guaranteed falls within the range reflected in regional or national surveys regarding income earned by physicians in the same specialty. Here, it does not violate the §501(c)(3) exemption requirements, because Hospital B has objective evidence demonstrating a need for pediatricians in its service area and its physician recruitment activity bears a reasonable relationship to promoting and protecting the community’s health. EXAMPLE319: Hospital C, which is located in an economically depressed innercity area, has conducted a community needs assessment indicating that indigent patients have difficulty getting access to care because of a shortage of obstetricians in its service area willing to treat Medicaid and charity care patients. Hospital C recruits Dr. O, an obstetrician and a member of Hospital C’s medical staff, to provide these services. It agrees to reimburse Dr. O for the cost of one year’s professional liability insurance in return for her agreement to treat a reasonable number of Medicaid and charity care patients for that year. Here, Hospital C does not violate the IRC §501(c)(3) exemption requirements because the payment of Dr. O’s professional liability insurance premiums in return for Dr. O’s agreement to treat a reasonable number of Medicaid and charity care patients is reasonably related to the accomplishment of Hospital C’s exempt purposes. EXAMPLE320: Hospital D is located in City 1, which is a medium- to large-sized metropolitan area. It requires at least four diagnostic radiologists to ensure adequate coverage and a high quality of care for its radiology department. Two of its current four diagnostic radiologists are relocating to other areas. Hospital D initiates a search for diagnostic radiologists and determines that one of the two most qualified candidates is Dr. P. Dr. P currently practices in City 1 as a member of the medical 318 319 320
Example 2 is based on Rev. Rul. 97-21, 1997-18 I.R.B. 1, Situation 2. Example 3 is based on Rev. Rul. 97-21, 1997-18 I.R.B. 1, Situation 3. Example 4 is based on Rev. Rul. 97-21, 1997-18 I.R.B. 1, Situation 4.
䡲
556
䡲
c12.fm Page 557 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
staff of Hospital E (which is also located in City 1), but does not refer patients to Hospital E or any other hospital in City 1. Hospital D recruits Dr. P to join its medical staff and to provide coverage for its radiology department. It offers him a recruitment incentive package, pursuant to which it guarantees his private practice income, in an amount that falls within the range reflected in regional or national surveys regarding income earned by physicians in the same specialty, for the first few years that he is a member of its medical staff and provides coverage for its radiology department. Here, Hospital D does not violate the IRC §501(c)(3) exemption requirements, because it has objective evidence demonstrating a need for diagnostic radiologists to provide coverage for its radiology department so that it can promote the community’s health. A significant factor in determining that the community benefit provided by the activity outweighs the private benefit provided to Dr. P is the determination by Hospital D’s Board of Directors that it needs additional diagnostic radiologists to provide adequate coverage and to ensure a high quality of medical care. EXAMPLE321: Hospital F is located in City 2, a medium- to large-sized metropolitan area. Because of its physician recruitment practices, Hospital F has been found guilty in a court of law of knowingly and willfully violating the Medicare and Medicaid Antikickback Statute, 42 U.S.C. §1320a-7b (b), for providing recruitment incentives that constituted payments for referrals. Here, Hospital F does not qualify as an IRC §501(c)(3) tax-exempt organization, because its unlawful physician recruitment activities are inconsistent with charitable purposes. This results because an organization that engages in substantial unlawful activities, including activities involving the use of the organization’s property for an objective that violates criminal law, does not qualify as a §501(c)(3) organization. In June 1999, a nonprofit hospital released an unpublished IRS private letter ruling it had received in July 1998, regarding physician recruitment incentives. In the ruling, the IRS approved certain physician incentive compensation arrangements which it deemed to be reasonable.322 The ruling created a stir in the nonprofit community because it appeared to be the first ruling in which the guidelines of Rev. Rul. 97-21 had been applied and because it sanctioned incentives paid to physicians relocating to the area of the hospital as well as to physicians who were already in the area.323 The hospital stated that it would not pay incentives to physicians already in the geographic area until it obtained the approval of the Office of Inspector General of the Department of Health and Human Services (OIG) because such incentives are subject to particular scrutiny for their potential for changing physician referral patterns, a troublesome issue under the rules enforced by the OIG.324
321 322 323 324
Example 5 is based on Rev. Rul. 97-21, 1997-18 I.R.B. 1, Situation 5. Carolyn Wright, “Unreleased Letter Ruling Clarifies Physician Recruitment Guidance,” Exempt Organization Tax Review (July 1999): 16. R. T. Greenwalt and T. Devetski, “IRS Rules on Cross-Town Recruiting of Physicians,” Exempt Organization Tax Review (July 1999): 31. See Greenwalt and Devetski at 35.
䡲
557
䡲
c12.fm Page 558 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
The hospital in the ruling wanted to create an integrated delivery system through a series of community urban and suburban health centers. After conducting a study, the hospital determined that it would need to add about 200 doctors to its staff. The hospital board established a recruitment incentive plan which included relocation guarantees, a three year income guarantee, as well as signing bonuses. The plan specifically stated that the compensation be reasonable, not constitute private inurement, or render more than an incidental private benefit. The plan applied to both doctors who were not located in the hospital’s geographic region, and to doctors who had been in the area for less than four years but who did not have a major client base. In the ruling, the IRS stated that the plan met the criteria of Rev. Rul. 73-313 and Rev. Rul. 97-21, discussed above, because it required that all compensation be reasonable. The ruling specified that the recruitment of local doctors was similar to that in the fourth example of Rev. Rul. 97-21 because the hospital was not regarding them as a source of future referrals. Income guarantees were approved as part of a wider effort to recruit physicians to a rural area and to improve the health services available to the residents of the area.325 In structuring any types of physician incentive and recruitment compensation, the guidelines of Rev. Rul. 97-21 and the intermediate sanctions proposed regulations should be followed. In addition, the recommendations offered in Section 12.9 should be reviewed and included, as appropriate to the transaction. The following is a summary of the crucial points to be taken into consideration in planning incentive compensation arrangements: • Only the board or a board-authorized committee, the members of which
have no conflict and are disinterested parties, should be involved in the decision-making process. • The board should gather appropriate data (such as compensation sur-
veys) to support (1) the reasonableness of the compensation package and (2) appropriate reasons for the incentives—i.e., to benefit the community as opposed to providing a vehicle for private benefit or inurement. • In all possible cases the board should satisfy the rebuttable presumption
standards of the intermediate sanctions proposed regulations, which would include the preceding points 1 and 2, as well as having a written record of the decision-making process reflecting the arm’s-length nature of negotiations and a copy of the written agreement. • In the case of contingent, incentive, or recruitment compensation paid to a
healthcare provider such as a physician, a leading commentator suggests that the organization consider the following language for inclusion in the employment agreement: Employee acknowledges that employer is a nonprofit corporation that is described in §501(c)(3) of the Internal Revenue Code and as such is prohibited from paying total compensation (including benefits) to any person 325
Priv. Ltr. Rul 200203070
䡲
558
䡲
c12.fm Page 559 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
in excess of that considered reasonable under Section 162 of the Code or that is of a type that may not be paid by such an organization. While the parties believe that the compensation and benefits provided pursuant to this Agreement are well within the range of reasonable and are otherwise allowed to be paid by an organization described in §501(c)(3) of the Code, employee agrees that in no event will employer be required to pay employee total compensation in excess of that considered reasonable under Section 162 of the Code or compensation of a type that may not be paid by an organization described in §501(c)(3) of the Code.326 • The agreement should include a limitation on the number of years in
which the incentive compensation will be paid.327 • The organization should negotiate caps on incentive compensation where
possible. Another relatively new issue potentially involving the inurement question in the healthcare field is the concept of “gainsharing.” The term “gainsharing” generally refers to plans whereby doctors who participate in an effort to control medical costs share the economic benefit to the hospital or other healthcare facility. Gain sharing can occur in many forms but usually involves payments to doctors based on a percentage of hospital cost reductions or improved margin on hospital services.328 It arises in numerous contexts such as bonus pools or incentive compensation plans for those in a particular department or practice.329 The use of the term “gainsharing” is a red flag to the IRS’s Exempt Organizations Division,330 and such arrangements may also raise issues under a variety of federal and state antikickback statutes and other laws.331 Notwithstanding the foregoing caveat, in February, 1999, a Chicago law firm announced that the IRS had issued two unreleased private letter rulings to its client, a nonprofit hospital, stating that two gainsharing plans would not jeopardize the exempt status of the hospital.332 The rulings were apparently based on several factors, including the following: (1) the participating physicians would have to comply with certain program integrity requirements333 to ensure that their participation would not have a negative impact on patient care, (2) the doctors would be providing valuable services to the hospital on a cost-savings basis, and (3) there would be a “fair market value cap” to be determined by an “independent 326
327 328 329 330 331 332 333
This suggested language is included in an excellent outline prepared by Bonnie S. Brier, Esq., “Physician Compensation: Exempt Organization Creativity Without IRS Problems” (hereinafter “Physician Compensation”) presented at American Health Lawyers Association Tax Issues for Healthcare Organizations Program, Arlington, Va. (Nov. 12–13, 1998). This outline presents an overview of compensation issues. See “Physician Compensation” for a complete discussion of these topics. See “Physician Compensation,” 25. See “Physician Compensation,” 25–26. Statement of Marcus Owens, Director, Exempt Organizations Division, at the Healthcare Organizations Program, Arlington. Va. See “Physician Compensation,” 25–26. Barbara Yuill, “IRS Approves Gain Sharing Programs in Two Unreleased Private Letter Rulings,” Daily Tax Report (Feb. 19, 1999). See note 335.
䡲
559
䡲
c12.fm Page 560 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
third-party appraiser.”334 However, the law firm explained that it had not yet received an advisory opinion from the Office of Inspector General of the Department of Health and Human Services as to whether the plan would not be deemed to violate the Antikickback Statute.335 In addition, there was a question as to whether the arrangement would be permissible under the intermediate sanctions proposed regulations requirement that additional compensation paid to a disqualified person must provide proportional benefits to the nonprofit.336 Of course, the intermediate sanction provisions would apply only if the physicians were disqualified persons. The enthusiasm about these rulings was dampened, however, when, on July 8, 1999, the OIG released a Special Advisory Bulletin stating that gainsharing violated federal law. Subsequently, on August 4, 1999, the IRS announced that it would be “reluctant” to issue additional favorable rulings on the gainsharing issue because the OIG had found such arrangements to be prohibited.337 After the OIG announced that these arrangements were illegal, the IRS explained that it would consult with the OIG as to future ruling requests, and would not likely approve a transaction that would run afoul of OIG rules.338 The reaction to the OIG’s action was shock.339 The OIG release was based on an interpretation of §1128A(b)(1) of the Social Security Act, which was added in 1986 as part of the Omnibus Budget Reconciliation Act of 1986.340 There is disagreement as to the long-term impact of the OIG ruling because some commentators believe it to be ambiguous. However, believe that the gainsharing issue is effectively dead, absent a legislative change,341 which would also mean the end of IRS approval of such arrangements. CAVEAT Because of the rapid change in developments in the gainsharing area, it is crucial that organizations consult their tax practitioners as to the soundness of existing or planned gainsharing arrangements. In conclusion, the legal tratment of gainsharing arrangements is evolving, and practitioners must closely monitor new developments both at the IRS and at the Department of Health and Human Services. In the latest twist in gainsharing policy, the Centers for Medicare and Medicaid Services (CMS) has reopened a demonstration project to improve coordination and quality of services, as well as efficiency, by giving doctors and hospitals 334 335 336 337 338 339 340 341
See note 335. See Section 12.4(d). See Section 12.3(c)(ii)(B). B. Yuill, “Government Officials Discuss Gainsharing: IRS ‘Reluctant’ to Issue Favorable Rulings,” Daily Tax Report (Aug. 4, 1999). Id. C. Wright, “OIG Rules Gain Sharing Illegal; Recent IRS Ruling Effectively Moot,” Exempt Organization Tax Review (Aug. 1999): 192. Id. Id. at 193.
䡲
560
䡲
c12.fm Page 561 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
financial incentives to work together. Guidelines for incentive payments under the program include: • Incentive payments may not be more than 25 percent more or less than pay-
ment that would have been made under the traditional Medicare program. • Incentive payments must be based on aggregate costs of all similarly cov-
ered beneficiaries and include not fewer than 10 discharges. • Incentive payments must be based on meeting specific quality standards
and not solely on lowering the volume and cost of services. • Salaried hospital staff and independent physicians who are fully creden-
tialed at the hospital may participate. In this context, the IRS issued an information letter analyzing an incentive compensation program for physicians in a demonstration hospital.342 The letter concludes that nonprofit healthcare organizations may use incentive payments so long as they do not confer impermissible private benefit or private inurement. Specific criteria that the IRS will use to evaluate such incentive payments include: • Was the compensation arrangement established by an independent board
of directors or an independent compensation committee? • Is the resulting total compensation reasonable? • Is there an arm’s-length relationship between the healthcare organization
and the physician? • Does the arrangement have the potential for reducing the charitable ser-
vices or benefits that the organization would otherwise provide? • Does the compensation arrangement transform the principal activity of
the organization into a joint venture with the physicians? (d)
Federal Healthcare Fraud and Abuse Statutes
The structure of joint ventures in the healthcare arena are both shaped and circumscribed particularly by two federal statutes designed to protect federal healthcare programs from fraudulent and abusive practices. The first, the Antikickback Statute, prohibits paying or receiving, directly or indirectly, remuneration for referral of patients for treatment covered by a federal healthcare program.343 Sanctions available under this statute include imprisonment for terms up to five years, civil monetary penalties, and exclusion from federal healthcare programs.344 In 2004, the federal government won or negotiated $605 million in judgments, settlements, and administrative impositions in healthcare fraud cases and proceedings. During the previous year, negotiated settlements and judgments topped $1.8 billion, which constituted the largest return of funds to the government since the inception of the federal healthcare programs. The 342 343 344
Internal Revenue Service General Information Letter Info. 2002-0021 (Jan. 9, 2002). See 42 U. S. C. §1320a-7b(b) and -7(b)(7) (West Supp. 1990). See also H. R. Rep. No. 231, 92nd Cong., 1st Sess. 107 (1972); H.R. Rep. No. 393, 95th Cong., 1st Sess. 48 (1977). 42 U.S.C. §§1320a-7, 1320a-7a and 1320a-7b.
䡲
561
䡲
c12.fm Page 562 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
Department of Health and Human Services and the Department of Justice jointly reported in 2004 that the Healthcare Fraud and Abuse Control Program has returned over $7.3 billion to the Medicare Trust Fund since the inception of the program in 1997.345 The Antikickback Statute is broad, and courts have been reluctant to narrow its scope. For instance, in United States v. Greber,346 the court concluded that if the payments “were intended to induce the physician to use [the diagnostic company’s services], the statute was violated, even if the payments were also intended to compensate for professional services.”347 The court held that “if one purpose of the payment was to induce future referrals, the . . . statute has been violated.”348 The Greber analysis has been endorsed by two other federal courts of appeals. In United States v. Kats,349 the court upheld “the admonition that the jury could convict unless it found the payment ‘wholly and not incidentally attributable to the delivery of goods or services.’ ”350 In United States v. Bay State Ambulance and Hospital Rental Service, Inc.,351 the court endorsed the Greber “one purpose” test and noted that Greber “implies that the issue of the sole versus primary reason for payments is irrelevant since any amount of inducement is illegal.”352 In United States v. Anderson,353 the government tried two physicians, two hospital executives, and the lawyers for the physicians and the hospital for violations of the Antikickback Statute and conspiracy to defraud the federal government. The district court dismissed the lawyers, but the jury handed down convictions against the two doctors and two hospital executives involved, based primarily on the Greber “one purpose” test which was given as the jury instruction. The Antikickback Statute contains a “knowingly and willfully” standard that requires evidence that the parties knowingly and willfully engaged in the conduct prohibited by the Antikickback Statute. The courts have addressed this standard and have ruled that the government need not prove that the defendants knew they were specifically violating the Antikickback Statute, but rather that the defendants knew they were acting unlawfully.354 The breadth and imprecision of the federal Antikickback Statute’s language has been a persistent problem for health providers and enforcement agencies. As written, the Antikickback Statute could be interpreted to prohibit legitimate relationships that pose no threat of harm to the programs. Consequently, the Office of the Inspector General (OIG) of the Department of Health and Human Services (HHS) sought and received legislative authority to promulgate regulations to 345
346 347 348 349 350 351 352 353 354
The department of Health and Human Services and the Department of Justice Health Care Fraud and Abuse Control Program Annual Report for FY 2004 at www.usdoj.gov/dag/pubdoc/hcreport2005.htm (September 2005). 760 F.2d 68 (3d Cir.), cert denied, 474 U.S. 988 (1985). Id. at 72. Id. at 69. 871 F.2d 105 (9th Cir. 1989). Id. at 108. 874 F.2d 20 (1st Cir. 1989). Id. at 30. 85 F. Supp. 2d 1047(D. Kan. 1999), aff’d United States v. McClatchey, 217 F.3d 823 (10th Cir. 2000). United States v. Starks, 157 F.3d 833 (11th Cir. 1998).
䡲
562
䡲
c12.fm Page 563 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
identify practices that would not be prosecuted as violations of the Antikickback Statute, in addition to the statutory exceptions contained in the Antikickback Statute itself. According to the OIG: The Safe Harbor Regulations immunize 22 categories of business relationships from criminal prosecution or administrative sanction.355 According to the OIG: The failure to comply with a safe harbor can mean one of three things. First, . . . it may mean that the arrangement does not fall within the ambit of the [Antikickback Statute]. In other words, the arrangement is not intended to induce the referral of business reimbursable under Medicare or Medicaid, so there is no reason to comply with the safe harbor standards, and no risk of prosecution. Second, at the other end of the spectrum, the arrangement could be a clear statutory violation and also not qualify for safe harbor protection. In that case, assuming the arrangement is obviously abusive, prosecution would be very likely. Third, the arrangement may violate the statute in a less serious manner, although not be in compliance with a safe harbor provision. Here there is no way to predict the degree of risk.356
A recent case, U.S. v. Carroll,357 although not involving joint ventures, provides insight into the use of the safe harbor provisions. In this case defendants allegedly created false, fraudulent, and misleading documents that concealed inducements, bribes, and kickbacks offered to customers during the sale and marketing of enteral feeding products for ultimate use by Medicare beneficiaries. The defendants could not be sheltered by the discount safe harbor because they could not fulfill the requirement by showing a discount and a full and accurate report of the transaction. The court also found that attempting to fit a lease and a discounted sale into a single safe harbor just because they were transferred on the same invoice was inconsistent with the structure of the safe harbor provisions. The defendants’ motions to dismiss their indictments were denied. Many healthcare providers are concerned that if they cannot structure an arrangement to qualify for safe harbor protection, then they are, by definition, in violation of the Antikickback Statute. However, as the preceding language from the OIG indicates, failure to qualify for a safe harbor means only that the arrangement could be subject to subsequent review. The OIG has released Special Fraud Alert—Joint Venture Arrangements,358 setting forth the following list of questionable features that, separately or in the aggregate, could indicate that a joint venture is suspect under the Antikickback Statute: • Investors are chosen because they are in a position to make referrals. 355
356 357 358
42 C.F.R. §1001.952 (a)-(v) (2005). The safe harbors most relevant in a hospital-physician joint venture context are the investment interest safe harbor (42 C.F.R. §1001.952(a)) and ambulatory surgery center safe harbor (42 C.F.R. §1001.952(r)). The investment interest safe harbor is divided into two sections, one dealing with publicly traded securities and the other dealing with investment interest in small entities, causing some commentators to recognize 23 safe harbors. 56 Fed. Reg. at 35, 954. U.S. v. Carroll, 320 F. Supp. 2d 748 (S.D. Ill. 2004). This publication was released in April 1989.
䡲
563
䡲
c12.fm Page 564 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
• Physicians who are expected to make a large number of referrals are
offered a greater investment opportunity in the joint venture than those anticipated to make fewer referrals. • Physician-investors are actively encouraged to make referrals to the joint
venture or are encouraged to divest their ownership interest if they fail to sustain an “acceptable” level of referrals. • The joint venture tracks its sources of referrals and distributes this infor-
mation to the investors. • Investors are required to divest their ownership interest if they cease to
practice in the service area for such reasons as relocation, disability, or retirement. • Investment interests are nontransferable. • The amount of capital invested by the physician is disproportionately
small and the returns on investment are disproportionately large, as compared with a typical investment in a new business enterprise. • Physician-investors invest only a nominal amount, such as $500 to $1,500. • Physician-investors are permitted to “borrow” the amount of the “invest-
ment” from the entity and pay it back through deductions from profit distributions, thus eliminating the need to contribute cash to the partnership. • Investors are paid extraordinary returns on the investment in comparison
with the risk involved, often well over 50 to 100 percent per year. • The joint venture serves merely as a “shell,” allowing referring physicians
to share in income from their referrals to an existing facility. In April 2003, the OIG issued a Special Advisory Bulletin on Contractual Joint Ventures.359 According to the OIG, this Special Advisory Bulletin was issued in response to the proliferation of arrangements between those in a position to refer business, such as physicians, and those who provide items or services in these arrangements, including clinical diagnostic laboratory services, durable medical equipment, and other services.360 The Special Advisory Bulletin lists several examples of inappropriate contractual arrangements and describes the common elements of these problematic arrangements. Safe harbors have been established by the OIG in the form of regulations.361 However, few joint ventures will escape kickback characterization by coming within these narrow safe harbors. For example, a venture would have to be no more than 40 percent owned by physicians in a position to make referrals, and no more than 40 percent of the joint venture’s revenue could come from patients referred by physician-investors. The OIG publishes Advisory Opinions in response to written requests from entities attempting to structure arrangements that may not fit squarely into a safe harbor. However, from the entities’ perspective, their proposed arrangements, 359 360 361
68 Fed. Reg. 23,148 (April 30, 2003). Id. See 42 C.F.R. §1001.952 (1991).
䡲
564
䡲
c12.fm Page 565 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
though not within a safe harbor, will not violate the Antikickback Statute. The Advisory Opinion process allows entities to determine whether their proposed arrangements will be subject to sanctions or whether the OIG is also convinced that the arrangements will not result in illegal kickbacks.362 The agency has published eight Advisory opinions regarding joint ventures since 1997. Five of those opinions were published since February 2003, showing the OIG has received more requests for advice regarding joint venture arrangements in recent years. As 362
Department of Health and Human Services Office of the Inspector General Advisory Opinions at http://www.oig.hhs.gov/fraud/advisoryopinions/opinions.html. The Advisory Opinions dealing with joint ventures include the following: Advisory Opinion No. 97-5 (October 6, 1997): The OIG determined that the proposed joint venture between a hospital system and a radiology group would not violate the Anti-kickback Statute even though it did not fall within any of the safe harbors. The OIG reasoned the joint venture did not violate the Anti-kickback Statute because the hospital system had taken precautions that would prevent any remuneration for referrals and the profit distribution will be proportional to the investments not the volume of referrals. Advisory Opinion No. 98-12 (September 23, 1998): The OIG determined that the proposed joint venture among several orthopedic surgeons and anesthesiologists to establish an ambulatory surgical center could potentially generate prohibited remuneration under the Anti-kickback Statute if the requisite intent to produce referrals was present. However, the OIG determined that it would not impose sanctions. The OIG decided the proposed arrangement was acceptable because: each physician investor would make a substantial financial investment; each physician investor has certified that he currently derives and anticipates continuing to derive at least 40 percent of his aggregate medical practice income from ambulatory service center procedures; the revenue from procedures performed on Medicare beneficiaries is estimated at only 5 percent of the total ambulatory service center income and therefore referral income would be insubstantial; investment returns would be proportional to the physicians’ capital investments; and the physician investors will provide their patients with a written disclosure of their ownership in the ambulatory service center. Advisory Opinion No. 01-17 (October 17, 2001): The OIG determined that although the proposed arrangement in which an existing ambulatory surgical center joint venture between a hospital-affiliated entity and an entity owned indirectly by five ophthalmologists may pose some risk of unlawful remuneration, the safeguards put in place make that risk sufficiently low and therefore the arrangement would not be subject to sanctions. The safeguards taken were: the hospital will refrain from taking action to require or encourage the hospital-affiliated physicians to refer patients to the eye surgery center; the physicians employed by the hospital will not make referrals directly to the eye surgery center; the hospital will not track referrals made by hospital-affiliated physicians to the eye surgery center, the investing ophthalmologists, or their group practices; and compensation paid to the hospital-affiliated physicians will not be related to the volume or value of referrals or other business generated by such physicians to or for the eye surgery center, the investing ophthalmologists, or their group practices. Advisory Opinion No. 03-5 (February 6, 2003): The OIG determined that there was a substantial likelihood of cross-specialty referrals for services performed in an ambulatory surgical center LLC formed by an acute care hospital and a multispecialty clinic (which was owned by physician shareholders). The OIG reasoned that few of the physician shareholders would use the ambulatory surgical center on a regular basis as part of their medical practice and therefore would profit from referring their patients to the center for services. Advisory Opinion No. 03-12 (May 22, 2003): A medical center and a radiology group submitted a request for an advisory opinion to determine whether they could jointly own and operate an outpatient open magnetic resonance imaging facility. The radiology group is the exclusive provider for professional radiological services for the medical center. The compensation the radiology group receives from the medical center for its services represents fair market value in an arm’s length transaction. The OIG determined that it would not impose sanctions because potential for fraud and abuse was minimized by the following safeguards included in the arrangement: the physician investors are not referral sources for the medical center of the MRI facility; only a small percentage of the MRI facility’s referrals will come from the medical center (less than 10%); the medical center certified that it would take steps to limit its ability to direct or influence referrals; any return on investments will be proportional to the investors’ capital investment and will not be based on the previous or expected volume of referrals, services furnished, or the amount of business that may be generated; and the ancillary agreements do not increase the risk of fraud and abuse appreciably.
䡲
565
䡲
c12.fm Page 566 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
with all Advisory Opinions, the requester of the opinion is the only entity that can rely upon the Advisory Opinion drafted in response to the request. However, Advisory Opinions offer valuable guidance and may be analogized by other entities attempting to structure their own arrangements. In comparison with the vague contours of the Antikickback Statute, the federal physician self-referral statute (also known as “Stark II”)363 is relatively precise. This statute provides that if a physician (or family member) has a financial relationship with an entity (and no exception to the statute applies), then that physician
Advisory Opinion No. 03-13: An advisory opinion was requested to determine whether a joint venture ownership of a freestanding magnetic resonance imaging center located on the campus of a rural community hospital and owned by three entities (physician investors with the ability to influence or generate referrals, the rural community hospital, and community members or physicians that do not have the ability to influence or generate referrals) was appropriate. The OIG determined that although the arrangement posed some risk, the safeguards taken would prevent possible fraud and abuse. Those safeguards are: all potential physician and nonphysician investors were offered the opportunity to purchase investment interests and the returns on the investments are proportional to their capital contributions; the arrangement had none of the suspect characteristics identified in the OIG’s 1989 Special Fraud Alert on Joint Ventures; the arrangement was developed as a community-oriented effort to provide access to MRI services in the rural three-county area and had provided substantial community benefit; and the management and space lease agreements comply with the applicable safe harbors. Advisory Opinion No. 04-17 (December 10, 2004): The OIG determined that the proposed joint venture between a physician group practice and a pathology laboratory could potentially generate prohibited remuneration under the Anti-kickback Statute and that administrative sanctions could be imposed. This proposed joint venture has many elements that are highlighted in the Special Advisory Opinion and considered high risk by the OIG, including: The pathology laboratory is an established provider of the same services the joint venture would provide and is in a position to directly provide the pathology services in its own right, bill insurers and patients in its own name, and retain all available reimbursements; the aggregate payment to the laboratory under the proposed arrangement would vary with referrals from the physician group to its pathology lab, as would the physician group’s payments; and the laboratory and the physician group would share in the economic benefit of the physician group’s pathology lab. Advisory Opinion No. 05-12 (November 7, 2005): The OIG determined that a proposal to enter into a joint venture to establish a day treatment facility to provide psychiatric services to pediatric patients could potentially generate prohibited remuneration under the Antikickback Statute, but that the OIG would not impose administrative sanctions. The OIG concluded that although the arrangement posed a high risk of running afoul of the federal healthcare program fraud and abuse laws because 100 percent of the psychiatric day treatment will be owned by potential referral sources, several factors, taken together, adequately mitigate such risk. First, Medicaid HMO patients constitute less than 5 percent of the facility’s patients and they generate less than 2 percent of the facility’s revenue. Providers who are not owners of the facility will refer the vast majority of these patients to the facility and the remaining patients referred by a psychiatrist owner will undergo an independent evaluation. No compensation to the psychiatrist owners or other referring clinicians will be tied in any way to the volume or value of patient referrals. Second, each psychiatrist has an independent private practice, and is a competitor of the others, with a corresponding incentive to retain patients rather than refer them to a co-investor. Finally, the only federal healthcare program beneficiaries who will be treated at the facility will be clinically eligible children enrolled in a Medicaid HMO, which reduces the risk that the facility would serve as a vehicle for inflating charges or for channeling payments for referrals of federal healthcare program beneficiaries to an affiliated entity.
363
42 U.S.C. 1395nn.
䡲
566
䡲
c12.fm Page 567 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
may not refer patients to the entity for a list of designated health services364 and the entity may not bill Medicare or Medicaid for such services. The definition of a financial relationship encompasses ownership, equity, and compensation relationships between the parties, and there are limited exceptions available that would encompass ownership or equity-type joint ventures between physicians and other healthcare providers.365 Although the Stark II statute would not necessarily make such joint ventures illegal, it would deprive the parties of Medicare and Medicaid revenues. Further, if Medicare and Medicaid are billed for services in violation of the physician self-referral prohibition, the parties may be subject to significant criminal and civil liability under the statute itself and under the federal false claims act.366 The Health Care Financing Administration has issued final regulations interpreting the Stark I statute (which applies only to clinical laboratory services)367 and proposed regulations interpreting Stark II.368 Providers and practitioners should monitor carefully developments under the proposed Stark II regulations, as it is likely that when finalized, these regulations will create new possibilities in certain areas and restrict other activities. Providers and practitioners seeking further clarification regarding the permissibility of a proposed or existing arrangement under the antikickback and Stark II statutes may request advisory opinions under procedures defined by regulation. Requests regarding the Stark statutes must be directed to the Health Care Financing Administration,369 and requests regarding the antikickback statutes must be made to the Office of the Inspector General.370 The Centers for Medicare and Medicaid Services (a division of the Department of Health and Human Services) is required to issue written advisory opinions on issues related to the Stark law when requested by an individual or entity. The advisory opinion is dependent on the facts of the particular situation and therefore, cannot be construed as legal advice for anyone other than the requestor. While the opinions are binding only on the requestor, they can be helpful to other parties in clarifying how the Stark laws are applied. CMS issued relatively few advisory opinions under Stark II until March, 2004, when it announced that it would use its advisory opinion procedures to issue determinations regarding whether a hospital ought to be subject to an 18month moratorium on physician ownership and investment interests in “specialty hospitals.” The moratorium was established under §507 of the Medicare
364
365 366 367 368 369 370
The list of designated health services includes the following: (a) clinical laboratory services; (b) physical therapy services; (c) occupational therapy services; (d) radiology services, including magnetic resonance imaging, computerized axial tomography scans, and ultrasound services; (e) radiation therapy services and supplies; (f) durable medical equipment and supplies; (g) parenteral and enteral nutrients, equipment, and supplies; (h) prosthetics, orthotics, and prosthetic devices and supplies; (i) home health services; (j) outpatient prescription drugs; and (k) inpatient and outpatient hospital services. Exceptions are available for physician services, certain publicly traded securities, hospitals in Puerto Rico, certain rural providers and hospital ownership. 42 U.S.C. §1395nn. 42 C.F.R. §411.351 et seq. 63 F.R. 1659 (Jan. 9, 1998). 42 C.F.R. §411.370 et seq. 42 C.F.R. §1008.1 et seq.
䡲
567
䡲
c12.fm Page 568 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
Prescription Drug, Improvement, and Modernization Act of 2003, and was in effect from December 2003 and through June 2005. When the moratorium ended, CMS instituted a temporary suspension on the processing of specialty hospital applications for participation in the Medicare program. In 2006, Congress extended that suspension until the Secretary submitted the final report on physician investment in specialty hospitals, which occurred in August 2006. The moratorium and the subsequent extensions likely precluded certain specialty hospital joint ventures, but its recent expiration could stimulate a revival of these types of ventures. Persons contemplating structuring such ventures, however, need to be aware of the new investment and compensation disclosure requirements enumerated in the CMS report, as well as CMS’s announcement that nonproportional returns on investments in specialty hospitals could violate the physician self-referral and antikickback statutes.371 Finally, it should be noted that many states have enacted their own antikickback statutes, which are, in many instances, more restrictive than their federal counterparts. For instance, one frequently finds that such statutes extend to all payers, not just to Medicare and Medicaid programs, or that exceptions that exist under federal law have no counterparts under a state statute. (e)
IRS Policy and the HHS Office of Inspector General
In its Hospital Audit Guidelines as well as in General Counsel Memorandum 39,862, the IRS specifically tied potential antikickback violations to possible revocation of the federal tax exemption of hospitals. Thus, when the OIG finds a violation, the IRS may revoke exempt status on the ground that tax exemption is inconsistent with activities that are illegal or contrary to public policy. Even when there has been no OIG action, the IRS may be expected to analyze joint ventures, in part under OIG standards, and to equate a likely violation of such standards with a violation of the private inurement and public benefit requirements under the tax law. The relationship between IRS policymaking and that of HHS made headlines in the nonprofit world on July 8, 1999 when the OIG announced that gainsharing arrangements violated the Social Security Act.372 Apparently, the announcement was a surprise to IRS officials who stated that the IRS would have to re-examine its position in light of the OIG announcement.373 The IRS had earlier in 1999 issued two favorable rulings on gainsharing arrangements which it deemed to be reasonable. The likelihood of any future such rulings is now doubtful.374 Because of this “triple jeopardy”—criminal Medicare penalties, civil Medicare exclusion, and loss of tax exemption—there is a huge premium on thorough advance analysis and planning by hospitals considering joint ventures with physicians.
371 372 373 374
See www.cms.hhs.gov/PhysicianSelfReferral/06a_DRA_Reports.asp C. Wright, “OIG Rules Gainsharing Illegal; Recent IRS Ruling Effectively Moot,” Exempt Organization Tax Review (Aug. 1999): 192. B. Yuill, “Government Officials Discuss Gainsharing: IRS ‘Reluctant’ to Issue Favorable Rulings,” Daily Tax Report (Aug. 4, 1999). See Section 12.3(d).
䡲
568
䡲
c12.fm Page 569 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
(f)
Department of Justice/Federal Trade Commission
In a joint Department of Justice/Federal Trade Commission Policy Statement, the two agencies provided antitrust guidance to healthcare organizations and joint ventures.375 According to an “Antitrust Safety Zone,” the agencies will not challenge under the antitrust laws any joint venture among hospitals to purchase, operate, or market the services of high-technology or other expensive equipment if the joint venture includes only the number of hospitals whose participation is necessary to support the equipment, absent extraordinary circumstances.376 If a joint venture falls outside the Antitrust Safety Zone, then the venture will be scrutinized to determine whether competition is substantially reduced in the market-place as a result of the venture. If competition is substantially impaired, the venture is subjected to another test; the joint venture will not be in violation if the venture is likely to produce procompetition efficiencies that outweigh its anticompetitive potential.377 Additional antitrust guidance is provided for physician network joint ventures, hospital joint purchasing agreements, price and information exchange agreements, and healthcare mergers and acquisitions.378 (g)
Integrated Delivery Systems, PHOs, MSOs, and HMOs
As the provision of healthcare becomes more varied and complex, we have seen the proliferation of certain kinds of entities that are different from the traditional hospital and that pose unique tax exemption issues. Although such arrangements are not typically structured as joint ventures, they do involve multiple related entities and, in fact, are often formed when a joint venture “unwinds” to avert running afoul of recently tightened tax and Medicare rules (see previous sections). An integrated delivery system (IDS) combines the healthcare functions traditionally performed separately by hospitals and physicians. An IDS integrates the various components for healthcare services into one full-service healthcare delivery system. The IDS network provides both inpatient medical services of hospitals and outpatient medical services by physicians. The concept of an IDS as an IRC §501(c)(3) organization is evolving. The IRS has issued favorable determination letters to several IDSs379 and has analyzed the exemption issues 375
376 377 378
379
See Department of Justice and Federal Trade Commission Antitrust Enforcement Policy Statement in the Health Care Area (Sept. 15, 1993) published in BNA Antitrust & Trade Regulation Report, Special Supplement (Sept. 16, 1993) (hereinafter “DOJ Report”). H.R. 3080, 103d Cong., 1st Sess. §2501–2 (Sept. 15, 1993) (the congressional healthcare reform bill echoes the DOJ Report on antitrust matters involving joint venture activity). DOJ Report at 5-5. Id. The DOJ Report provides that new services and high-technology joint ventures are examples of arrangements that do not violate the DOJ/FTC Policy. Id. See generally Hospital Bldg. Co. v. Trustees of Rex Hospital, 511 F.2d 678 (4th Cir. 1975) rev’d 425 U.S. 738 (1976) appeal after remand 691 F.2d 678 (4th Cir. 1982) (antitrust issues discussed in context of tax-exempt hospital). Friendly Hills Healthcare Network (Jan. 29, 1993); Facey Medical Foundation (Mar. 3, 1993); Billings Clinic (Dec. 21, 1993); Harriman Jones Medical Foundation (Feb. 3, 1994). But see LAC Facilities, Inc. v. United States, No. 94-604T (Fed. Cl. 1994) (Florida hospital challenged IRS’s revocation of exemption based in part on purchase of medical practices at inflated prices and resale to insiders at below-market prices).
䡲
569
䡲
c12.fm Page 570 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
affecting such systems in its official internal instructional materials.380 Any IDS network seeking tax-exempt status should consult the IRS’s instructional materials before applying for exemption. The IRS will review the IDS application for exemption and evaluate the balance of community benefit and private benefit, the existence of arm’s-length relationships with the physicians, and whether the IDS is sufficiently insulated from undue physician influence. Generally, • The IDS must purchase its tangible and any intangible (e.g., goodwill)
assets at fair market value, established by independent negotiations with the seller and supported by certified appraisals. • The financial condition of the seller must be analyzed to demonstrate that
the primary purpose of the acquisition is not to bail out a financially distressed medical practice. • Any related noncompetition covenants must not be broader than necessary to
protect the IDS from being harmed by competition by a departing physician. • Any compensation paid by the IDS to a medical group must be reason-
able and comparable to payment arrangements adopted by other medical groups of similar size and composition in the same service area. • The integration of all medical functions and records of IDS patients
should provide demonstrable benefits to the community through the elimination of duplicate tests and procedures. • The IDS must demonstrate by its nondiscrimination policies and good
faith Medicare/Medicaid contracting practices that the IDS increases accessibility for Medicare/Medicaid and charity care patients to a greater degree than would be required under the usual community benefit standard governing hospitals. • All hospitals affiliated with the IDS must maintain an open medical staff. • Each IDS-affiliated hospital must operate an emergency room open to all
patients regardless of ability to pay. • The IDS must be governed by an independent community board, which
will be deemed as a “safe harbor” if no more than 20 percent of board members are physicians or other interested parties. Restrictions are also placed on the composition of committees that establish fees and compensation. Issues emerging from IDS practices include (1) physician recruitment incentives, (2) physician compensation, and (3) valuation of medical practices. The IRS closely scrutinizes incentives offered to a physician, by evaluating the terms and conditions of hire, to determine whether the incentives are justified in terms of the community benefit derived from the physician’s association with the IDS. The IRS reviews the compensation arrangement and professional service agreement. Compensation arrangements in IDS organizations include
380
See 1993 (for Fiscal Year 1994) Exempt Organizations CPE Technical Instruction Program Textbook, 212–43. See also 1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook, 153–90.
䡲
570
䡲
c12.fm Page 571 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
base salaries, fringe benefits, deferred payments, income guarantees, contingencies to compensation, and incentive bonuses.381 Whether the recruiting incentives are reasonable depends on the physician’s total compensation package.382 Physician compensation should be (1) comparable to payment arrangements adopted by similar-sized medical groups in similar geographic locales, (2) determined by an independent board of directors with no or few financially interested members participating in the decision, and (3) supported by evidence of written arm’s-length negotiations. All favorable determination letters under IRC §501(c)(3) contain a statement that the applicant organization has relied on fair market valuations that are the result of independent appraisals. Most fair market valuations rely on the business enterprise value (BEV) of the assets of the medical practice.383 The business enterprise value is defined as the “total value of the assembled assets that comprise the entity as a going concern.”384 However, all IDS applications for taxexempt status should include the recognized approaches to valuation, including the income, market, and cost approaches.385 The IRS places heavy reliance on the income approach, which focuses on the present value of the future cash flows of a business medical group.386 The market approach looks to valuations of comparable entities. The cost approach relies on the replacement cost of the assets.387 The IRS has stated that it will infer that payments in excess of the fair market value of the physician practice are intended as a payment for the referral of program-related business.388 Because federal and state antikickback laws prohibit referrals for Medicaid patients, valuation appraisals of medical practices must exclude the value of a referral stream to hospitals.389 The IRS will examine certain factors that may indicate that payment was made to acquire the referral stream when there is a continuing relationship between seller and buyer, and the buyer relies on referrals from the seller, such as: • Goodwill • Value of ongoing business unit • Covenants not to compete • Exclusive dealing agreements 381 382 383 384
385 386 387 388
389
Kaiser and Sullivan, “Integrated Delivery Systems and Health Care Update,” 1995 (for Fiscal Year 1996) Exempt Organizations CPE Technical Instruction Program Textbook, 391. The IRS uses a facts-and-circumstances test to determine whether compensation constitutes private inurement. See Rev. Rul. 69-383, 1969-2 C.B. 113 and Section 5.2(a). Once derived, BEV is allocated among the assets of the business enterprise. Kaiser, Haney, and Sullivan, “Integrated Delivery Systems and Joint Venture Dissolutions Update,” 1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook, 163. The formulas used in the income, market, and cost approaches are beyond the scope of this chapter. Kaiser, Haney, and Sullivan, “Integrated Delivery Systems and Joint Venture Dissolutions Update,” 164. Id. at 166. See letter from D. McCarthy Thornton, Associate General Counsel, Inspector General Division, to T. J. Sullivan, Technical Assistant (Health Care Industries), IRS, dated Dec. 22, 1992, reprinted in 1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook, 187–88, in which Mr. Thornton listed the six items that would indicate that payment was made. See also discussion of Anclote Psychiatric, Section 12.6. See Section 12.3(b).
䡲
571
䡲
c12.fm Page 572 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
• Patient lists • Patient records390
If a buyer pays more than fair market value for the assets, private benefit and possibly private inurement may prohibit the organization from qualifying for exemption.391 The IRS has also scrutinized joint venture arrangements between hospitals and individual physicians and medical groups, such as physician-hospital organizations (PHOs) or management service organizations (MSOs). The IRS uses a facts-and-circumstances test, based on Rev. Rul. 69-545, and the community benefit standard to measure the community benefit of a healthcare provider organized as an IDS.392 The private benefit prohibition applies to physicians who sell assets to a tax-exempt organization and physicians who subsequently perform services for the new tax-exempt IDS organization. All such benefits to the physicians must be weighed against the benefits to the community from this arrangement. Because of the close relationship between physicians and the hospitals where they hold privileges, the IRS is concerned about physicians’ influence as a group. Consequently, physicians are classified as insiders by the IRS with respect to determining the existence of private inurement to physician sellers.393 (i) Physician Hospital Organizations. Generally, a PHO facilitates joint marketing between a hospital and physicians. The PHO is typically a nonprofit member corporation, capitalized and controlled equally by the member physicians and hospital member. The PHO expenses are shared proportionately by the hospital participant and physicians in accordance with the benefit derived from the arrangement.394 The PHO coordinates the resources of the healthcare delivery system through planning, implementing, and marketing the delivery of healthcare services in an efficient and cost-effective manner. It is important to distinguish the functions of a PHO from those of a healthcare provider; the PHO does not practice medicine or operate a hospital, but rather negotiates managed care contracts for the hospital and physician members. A typical PHO consists of an independent practice association (IPA) and a hospital member. An IPA is generally not tax-exempt395 under IRC §501(c)(3) because 390 391 392 393
394 395
1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook at 189. See Anclote Psychiatric, Section 12.6(b). Rev. Rul. 69-545, 1969-2 C.B. 117. See “Tax Management Estates Gifts and Trust Portfolio on Nonprofit Health Care Organizations: Federal Income Tax Issues” (BNA) (1995) at A-69, citing Gen. Couns. Mem. 39,498 (Apr. 24, 1986) and Gen. Couns. Mem. 39,670 (Oct. 14, 1986). This example of a joint marketing arrangement is adapted from one presented by Kaiser, Haney, and Sullivan in “Integrated Delivery Systems and Joint Venture Dissolution Update,” 156. The IRS has granted tax-exempt status to one unique PHO, formed by the University of Kansas Hospital and numerous tax-exempt faculty group practice associations as the members. The PHO is controlled by the tax-exempt practice associations and the hospital, as opposed to the physicians. The PHO was formed to manage the delivery of healthcare, but, more important, to ensure access to a diverse group of patients for the teaching hospital in order to carry out its exempt function of educating medical students. The IRS differentiated this arrangement from the typical PHO because this PHO provides essential services to a group of tax-exempt organizations, as opposed to the physicians. Document 95-2398 (exemption ruling), released on Feb. 17, 1995, reprinted in Tax Notes Today 95. (Mar. 3, 1995): 43–74. Kaiser and Sullivan, “Integrated Delivery Systems and Health Care Update,” 402.
䡲
572
䡲
c12.fm Page 573 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
its primary beneficiaries are private individuals—specifically, its member-physicians—as opposed to the community at large.396 Because a PHO serves the private interests of its member physicians, it violates the proscription against private benefit and therefore precludes exemption under §501(c)(3). A subsidiary of an exempt hospital operating as a PHO would not qualify for exemption either, because it would fail the “integral part test” by not providing essential services to the hospital as its primary activity. The IRS has provided factors to determine whether a hospital’s participation in a PHO will negatively affect its exempt status, which include the following: • Is there a disproportionate allocation of profit or loss in favor of the for• • • • • • •
profit partner? Is there a nominal or insufficient capital contribution by the for-profit partner? Are new equipment or services brought into the partnership, or are the services or equipment already available in the area? Are existing hospital equipment or facilities sold or leased to the partnership? Is any service being provided by the hospital at less than fair market value? Does a for-profit limited partner have significant influence and control over operations? Does the exempt organization bear all risk or liability for the partnership losses? Are commercially unreasonable loans made to the partnership (low interest or inadequate security)?
The joint marketing arrangement between the hospital and the PHO would adversely affect the hospital’s exempt status if the PHO merely serves the purpose of enabling the hospital member to share its net income with the physician members. The hospital must maintain control and a share of the profits in relation to its capital contribution to prevent the physician members from deriving benefit in excess of their economic risk. Moreover, PHO expenses should be shared proportionately between the hospital and the aggregate member physicians, in accordance with the benefit each derives, to ensure that no more than incidental private benefit is conferred on the physicians. Hospitals must take precautions to preserve their tax-exempt status, because the arrangement between the hospital member and member physicians is perceived by the IRS as an attempt to create a more powerful bargaining unit in negotiating managed care contracts. In summary, the PHO does not provide healthcare services, yet it is typically able to demand a higher price per capitation than an individual practice or a non-member stand-alone hospital. However, the hospital and physician members are subject to challenge on the grounds of public benefit and private inurement. The PHO, in essence, is a joint venture between the hospital member and physician members; therefore, if the hospital is not receiving its proportionate 396
See Rev. Rul. 86–98, 1986-2 C.B. 74.
䡲
573
䡲
c12.fm Page 574 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
share of income or deductions, inurement may be present and the hospital could lose its exempt status.397 (ii) Managed Service Organizations. Another form of integrated delivery system is a management service organization (MSO), which generally involves the outright purchase of tangible medical practice assets from physician participants. The MSO provides the assets and administrative and managerial services to private medical practices in exchange for a portion of the practice revenues as a management fee. An MSO is a taxable entity because it lacks a charitable purpose and serves the participants’ private interests more than incidentally.398 The issues relevant to MSOs are analogous to those of PHOs with regard to private benefit and inurement. The purchase of the physician assets from related parties or insiders for greater than fair market value poses an additional risk. An MSO is a less restrictive structure used to achieve integration, because physicians may exercise more control over the MSO than over a tax-exempt organization, while freeing themselves from time-consuming administrative matters. An MSO may operate in different forms: • A tax-exempt hospital may operate as an MSO to provide billing, collec-
tion, and management services for private practitioners.399 • An independent or unrelated MSO may be incorporated to provide ser-
vices to the hospital and physicians. • An affiliate of the hospital may provide MSO services.
As with a PHO, the hospital’s investment in an MSO must be reasonable. The hospital must maintain control and share in profits in proportion to its capital contribution; it must also share MSO expenses in proportion to the benefit derived so as not to confer more than incidental benefit to the physician members. Finally, the income derived by a hospital participant in a PHO or MSO will generally be subject to the unrelated business income tax (UBIT).400 (iii) Health Maintenance Organizations. A health maintenance organization (HMO) is a managed care organization that brings together primary and secondary healthcare providers for the purpose of managing costs. HMOs are regulated by federal and state statute. Most HMOs are not eligible for IRC §501(c)(3) status because they primarily serve their members, who constitute a limited class of the community.401 Apparently the only model402 to achieve exempt status is the staff model HMO 397 398 399
400 401 402
See Gen. Couns. Mem. 39,732 (May 19, 1988). 1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook at 158. The IRS has indicated that it will accept ruling requests from exempt hospitals that plan to participate in an MSO as an initial step toward integration with other physicians and medical groups regarding the effect of MSO participation on their tax-exempt status. Kaiser, Haney, and Sullivan, “Integrated Delivery Systems and Joint Venture Dissolutions Update,” 158. See Section 12.8. Gen. Couns. Mem. 32,453 (Nov. 30, 1962). There are four basic organizational models of HMOs: staff model, group model, IPA model, and direct contract HMOs.
䡲
574
䡲
c12.fm Page 575 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
discussed in Sound Health Association v. Commissioner.403 A staff model HMO directly employs a large number of physicians, especially primary care physicians. Staff model HMOs usually own the office and clinic facilities used by the physicians. The IRS has made clear that it intends to rely on the factors enumerated in the Sound Health case in determining whether an HMO qualifies for exemption under §501(c)(3).404 Within the CPE text, the IRS discusses the exemption standard under IRC §501(c)(3) for Medicaid HMOs and Medicaid service organizations that exclusively serve Medicaid recipients. More specifically, the article addresses “whether charitable purposes are accomplished where an HMO benefits its enrollees, who, as Medicaid recipients are part of a class of persons identified by the government as having special healthcare needs.” The text also discusses whether charitable purposes are accomplished by a service organization that operates to assist in the provisions of healthcare benefits to Medicaid recipients. The CPE text contains three hypothetical examples, which are followed by an analysis of the factors the IRS will weigh in analyzing exempt status. For example, the text examines whether the three nonprofit corporations discussed in the hypotheticals “promote health” in a manner that results in tax exemption. Two of the corporations enable Medicaid benefits “to make efficient use of a managed care health system,” thereby ensuring “that the beneficiaries’ healthcare needs are met.” The text goes on to state that “promoting the health of Medicaid beneficiaries and low-income individuals who have special healthcare needs promotes the health of the community, as defined under IRS revenue rulings, and satisfied the flexible community benefit standards of Geisinger II.” The text also analyzed whether the three hypothetical corporations provide “relief to the poor and distressed” sufficient to qualify for the exemption. Two of the corporations do qualify on that basis, because they are “organized and operated exclusively for the charitable purpose of providing relief to the poor and distressed.” According to the text, the tax status of Medicaid HMOs “has been much debated, because an HMO merges two functions: providing healthcare, which is a traditional charitable activity, and providing insurance, which has traditionally been considered a noncharitable function.” Citing the 1993 Third Circuit decision in Geisinger Health Plan v. Commissioner, the text notes that an HMO’s activities must benefit not just its enrollees but the overall community. The Geisinger ruling was subsequently affirmed by the Tax Court, which also established that “the HMO’s enrollees and the patients of the related exempt hospitals must be essentially identical.”405 Following this rationale, in December 1998, it was reported that the IRS had revoked the tax-exemption of a West Coast HMO in an unreleased technical 403 404
405
71 T.C. 158 (1978), acq., 1981-2 C.B. 2. See Gen. Couns. Mem. 39,828 (Aug. 30, 1990); Gen. Couns. Mem. 39,829 (Aug. 30, 1990); Gen. Couns. Mem. 39,830 (Aug. 30, 1990) (considering the exemption of Geisinger Health Plan, an HMO organized by the Geisinger Foundation). Id. See also Geisinger Health Plan v. Commissioner, 985 F.2d 1210 (3d Cir, 1993).
䡲
575
䡲
c12.fm Page 576 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
advice memorandum (TAM).406 According to the attorney for the HMO, the TAM “is making it very difficult for HMOs to qualify for exemption under §501(c)(3), except for rare or unusual circumstances.”407 The HMO in question was a member of a nonprofit multicorporate healthcare system. The HMO provided services only through accepted employer groups. The HMO paid physicians on a “fee-for-services” basis. About 90 percent of its hospital services were provided by the parent organization’s hospitals; physician care was provided by doctors who were employed by the parent or who had independent practices. The compensation paid to the doctors represented slightly more than half of the HMO’s total medical expenses. The IRS revoked its exemption because the HMO: • Did not provide medical services by its employees at its own facilities • Did not operate an emergency room open to the public • Did not offer healthcare to the indigent • Provided healthcare primarily to persons who could afford to pay premiums • Did not subsidize premiums for those unable to pay408
The TAM was not anticipated by practitioners, because the HMO was affiliated with an exempt healthcare system. The HMO is attempting to settle the case with the IRS whereby the HMO would be reclassified as a §501(c)(4) organization.409 Three HMOs that are part of the Intermountain Health System appealed the IRS’s revocation of their exempt status, retroactive to January 1, 1987. The IRS had concluded that the HMOs were not operated exclusively for the charitable purpose of promoting health, and were not integral parts of §501(c)(3) healthcare organizations. Furthermore, because of the way the physicians were compensated, the HMOs retained a substantial portion of the risk of loss, and thus provided commercial-type health insurance. The Tax Court affirmed the revocation on the grounds that the HMOs “did not provide a meaningful community benefit” and that their operations, which did not provide low-cost health services and relied heavily on physicians outside the InterMountain system were not integral to the system.410 The Tax Court did not consider either the “boost” test from Geisinger or the argument that the compensation arrangements amounted to insurance.411 The Tax Court concluded that the HMO did not fulfill its burden to prove a community benefit. While the HMO did offer plans to a broad cross-section of the community, and evidently did not reject potential enrollees, it did not have any program to permit individuals to pay reduced premiums, did not provide 406
407 408 409 410 411
“HMO Does Not Qualify for Tax Exemption, Unreleased IRS Technical Advice Memo Says,” Daily Tax Report (Dec. 17, 1998), GG-1. Although a technical advice memorandum can not be relied upon by anyone other than the taxpayer to whom it was issued, it is indicative of the IRS’s position on an issue. Id., GG-1. Id. Id. T.C. Memo. 2001-246 (Sept. 19, 2001), 2001 WL 1103284 (U.S. Tax Ct.) Id. at n. 12.
䡲
576
䡲
c12.fm Page 577 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
free or low cost healthcare to the needy, and there was no record of support for medical research or training. The Intermountain HMOs differed from those operated by Sound Health and Geisinger in not owning or operating their own medical facilities and not employing most of their own physicians. The Tax Court also mentioned a failure to explain why the petitioner applied an adjusted community rating methodology for individual and small employer groups, while basing premiums for large employer groups on past claim experience. The Court also noted that the board lacked representation of the community, and is committed by the by-laws to have a plurality from the “buyer-employer community.” In analyzing whether the activities of the HMO were “substantially related” to the exempt parent and siblings, it looked at the way the HMO arranged for hospital and physician care. While some HMO members were cared for in nonsystem hospitals, the Court was satisfied with the explanation that most needed specialized services (burn treatment and pediatric psychiatric care) that were unavailable within the system. However, the Court found that 80 percent of physician services for the HMO’s members were received from physicians with no “direct link to one of petitioner’s tax-exempt affiliates.” This was a crucial distinction from Geisinger. The Intermountain HMO could not be viewed as a conduit to deliver patients to the system doctors. It was delivering them elsewhere. Because the HMO neither supported the charitable purpose nor the business needs of the exempt affiliates, the Court held that it did not satisfy the integral part test. In the 2002 CPE chapter on Health Care, written before the InterMountain decision, the IRS offered a compromise on the way that physician compensation contributes to a decision that the HMO offers commercial insurance. The issue is whether the HMO has shifted a significant portion of its risk of loss to the primary care providers or its gatekeepers, by using capitated fees, for example. The Service recognizes that many HMOs do not currently comply, but says: “. . . the Service would give favorable consideration under the guidelines if an HMO demonstrates that its projected operations will likely satisfy the guidelines, even if its current operations do not.”412 (iv) Point of Service HMOs. One expert has described point of service HMOs (POSHMO) as a “combin[ation of] the elements of an HMO, a PPO and an indemnity insurer.”413 Under a POSHMO, subscribers are free to go to any physician they wish for treatment—an attractive feature to many would-be subscribers. If the selected physician or facility is within the HMO network, the subscriber pays only a minimal charge. If, however, the subscriber utilizes a nonplan provider, the visit will be paid for on an indemnity basis—as though the
412
413
Lawrence M. Brauer, Mary Jo Salins, and Robert Fontenrose, “Update on Health Care,” Exempt Organizations Continuing Professional Education (CPE) Instruction Program for Fiscal year 2002, p. 156. The IRS announced that it would no longer use the economic family theory set forth in Rev. Rul. 77-316 (Revenue Ruling 2001-26). Sullivan, “Current Developments in Tax-Exempt Health Care,” at 18 (on file with author). See also Sullivan, “The Tax Status of Nonprofit HMOs After §501(m),” Tax Notes 50 (Jan. 7, 1991): 75.
䡲
577
䡲
c12.fm Page 578 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
HMO were the insurer of the subscriber. Accordingly, treatment from outside providers entails the satisfaction of significantly greater deductibles and copayments than does treatment by a network provider.414 Although it is a highly attractive feature to potential subscribers, the presence of a point of service program in an HMO makes that organization ineligible for exempt status. IRC §501(m) provides that “an organization described in [§501(c)(3) or (c)(4)] shall be exempt from tax . . . only if no substantial part of its activities consists of providing commercial-type insurance,”415 unless the insurance is “incidental health insurance provided by an [HMO] of a kind customarily provided by such organizations.”416 Despite the fact that more than 60 percent of modern HMOs offer point of service plans, the IRS has determined that such programs are not of a type “customarily provided by” HMOs and, accordingly, do not fall under the IRC §501(m)(3)(B) exception.417 (v) Exemption of Individual Components of Healthcare Systems. Each separate entity in a healthcare system may, of course, qualify for tax exemption on its own merits. However, even if it does not so qualify as a free-standing entity, it may be able to qualify for exemption as an integral part of an exempt entity in the system. This doctrine was recently invoked, albeit unsuccessfully, by an HMO in the important Geisinger case.418 The HMO, Geisinger Health Plan, was part of the Geisinger System, a network whose fundamental purpose was to provide healthcare services to 2.1 million residents of Pennsylvania. All of the nine organizations in the system were exempt under IRC §501(c)(3); the HMO and seven other organizations were commonly controlled by the Geisinger Foundation. Structuring the HMO as a separate entity within the system, rather than as part of another entity, resulted from management and regulatory concerns. The HMO, viewed in isolation, did not qualify for exemption on its own merits because (1) it did not itself provide healthcare services directly, but merely contracted with other entities to provide services to its subscribers, (2) it did not primarily benefit the community, but benefited only subscribers plus a few nonsubscribers whose dues were subsidized, and (3) it did not demonstrate other indicia of community benefit such as educational programs or free emergency care to indigents.419 Thus, the HMO’s exemption depended on the applicability of
414 415 416 417
418 419
Id. §501(m)(1). §501(m)(3)(B). Several other exceptions not applicable to HMOs also exist. See §501(m)(1)– (2), (4)–(5). Id. See Gen. Couns. Mem. 39,829 (Aug. 30, 1990). If an HMO carries on only insubstantial point of service activity, and otherwise qualifies for exempt status, the proceeds of the program will be subject to the UBIT. §501(m)(2). Geisinger Health Plan v. Commissioner, 30 F.3d 494 (3d Cir. 1994), aff’g 100 T.C. 394 (1993). This was the holding of the court in an earlier phase of the case. Geisinger Health Plan v. Commissioner, 985 F.2d 1210 (3d Cir. 1993).
䡲
578
䡲
c12.fm Page 579 Thursday, March 15, 2007 7:59 PM
12.4 OTHER HEALTHCARE INDUSTRY ISSUES
the “integral part” doctrine, which derives from the Regulations under IRC §502420 but was formulated by the court as follows: [A] subsidiary which is not entitled to exempt status on its own may only receive such status as an integral part of its IRC §501(c)(3) qualified parent if: (1) it is not carrying on a trade or business which would be an unrelated trade or business (that is, unrelated to exempt activities) if regularly carried on by the parent; and (2) its relationship to its parent somehow enhances the subsidiary’s own exempt character to the point that, when the boost provided by the parent is added to the contribution made by the subsidiary itself, the subsidiary would be entitled to IRC §501(c)(3) status.
The court did not analyze the first of these elements because it found lacking the second element, the “boost” theory: Here, we do not think that [the HMO] receives any “boost” from its association with the Geisinger System. . . . [T]he contribution that [the HMO] makes to community health is not increased at all by the fact that [it] is a subsidiary of the System rather than being an independent organization which sends its subscribers to a variety of hospitals and clinics. . . . [I]ts association with [the system] does nothing to increase the portion of the community for which [the HMO] promotes health—it serves no more people as a part of the System than it would serve otherwise. . . . [The HMO] merely seeks to “piggyback” off of the other entities in the System, taking on their charitable characteristics in an effort to gain exemption without demonstrating that it is rendered “more charitable” by virtue of its association with them.
The Geisinger litigation has left practitioners without substantive guidance as to how an organization’s affiliation with a healthcare system could generate the requisite boost to its charitable status. Most existing precedents recognizing the integral part test have enjoyed university settings, where the educational boost to an otherwise noncharitable activity is relatively clear. 421 420
421
§502 denies exemption to an organization engaged in a trade or business for profit even if the organization pays over all profits to an exempt organization. Reg. §1.502-1(b) provides that, despite this general rule of taxation of “feeder organizations”: If a subsidiary organization of a tax-exempt organization would itself be exempt on the ground that its activities are an integral part of the exempt activities of the parent organization, its exemption will not be lost because, as a matter of accounting between the two organizations, the subsidiary derives a profit from its dealing with the parent organization. See Squire v. Students Book Corp., 191 F.2d 1018 (9th Cir. 1951) (corporation operating a bookstore and restaurant that sold college texts was exempt where it was wholly owned by a college, used college space free of charge, served mostly faculty and students, and devoted its earnings to educational purposes; it “obviously bears a close and intimate relationship to the functioning of the [c]ollege itself”); Rev. Rul. 63-235, 1963-2 C.B. 210 (law journal corporation was exempt as “adjunct to” exempt law school); Rev. Rul. 58-194, 1958-1 C.B. 240 (bookstore was exempt as integral part of exempt university). See also Rev. Rul. 78-41, 19781 C.B. 148 (trust existing solely as a repository of funds set aside by nonprofit hospital for the payment of malpractice claims against the hospital, and as the payor of those claims, was exempt as an integral part of the hospital); University of Maryland Physicians v. Commissioner, 41 T.C.M. (CCH) 732 (1981); University of Massachusetts Medical School Group Practice v. Commissioner, 74 T.C. 1299 (1980), acq. 1980-2 C.B. 2; B.H.W. Anesthesia Foundation, Inc. v. Commissioner, 72 T.C. 681 (1979).
䡲
579
䡲
c12.fm Page 580 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
The scope of the tax exemption of such nonhospital healthcare entities remains an area very much in evolution. 422 The IRS announced in May 2003 that it will provide guidance, through regulations, on the definition of commercial-type insurance under §501(m) and how this section applies to §501(c)(3) and §501(c)(4) organizations, including health maintenance organizations (HMOs).423 In light of this regulations project, the IRS has withdrawn several sections of the Internal Revenue Manual addressing §501(m) and HMOs. §501(m) provides that a §501(c)(3) or §501(c)(4) organization can be exempt only if no substantial part of its activities consists of providing commercial-type insurance. While §501(m) states what is not included in commercial-type insurance, there is no definition of commercial-type insurance in §501(m) and there are no regulations or other forms of published guidance under §501(m). The IRS noted that the U.S. Supreme Court attempted to explain what factors should be considered in determining whether an arrangement constitutes insurance for purposes of federal income tax.424 Essentially, the Supreme Court held that for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present.425 Congress, in enacting §501(m), did not specifically define commercial-type insurance, but used the Supreme Court’s reasoning in enumerating the types of arrangements not included in commercial-type insurance. The Tax Court, in several cases, has attempted to explain what constitutes commercial-type insurance426 under § 501(m). As a result of this uncertainty, many taxpayers have requested guidance regarding the definition of commercial-type insurance under §501(m) and how the section applies to §501(c)(3) and §501(c)(4) organizations, including HMOs. Treasury and the Service have decided to propose regulations, which will apply prospectively, effective as of the date that the final regulations are published in the Federal Register.
12.5 (a)
PRESERVING THE 50/50 JOINT VENTURE Overview
The situations described in Revenue Ruling 98-15 present two distinct structures of governance. In Situation 1, the joint venture board is composed of five individuals, three of whom are appointed by the nonprofit partner and two of 422
423 424 425 426
At least one IRS official has suggested that any confusion regarding the boost requirement is “semantic” and that what is really required is that the subsidiary further the parent’s exempt purpose through “the served charitable population of the parent.” Remarks of T. J. Sullivan, Special Assistant, Health Care, Office of Assistant Commissioner, reported in Exempt Organization Tax Review 10 (Oct. 1994): 799. See Notice 2003-31, 2003-21 I.R.B. 948. See Helvering v. LeGierse, 312 U.S. 531 (1941). Id. at 539. See Paratransit Insurance Corporation v. Commissioner, 103 T.C. 745, 754 (1994) (wherein the court stated that “ ‘Commercial-type insurance’ as used in §501(m), encompasses every type of insurance that can be purchased in the commercial market.”); See also Florida Hospital Trust Fund v. Commissioner, 103 T.C. 140, 158 (wherein the court stated that under §501(m), “commercial-type insurance” means any type of insurance “normally offered by commercial insurers”).
䡲
580
䡲
c12.fm Page 581 Thursday, March 15, 2007 7:59 PM
12.5 PRESERVING THE 50/50 JOINT VENTURE
whom are appointed by the for-profit. In Situation 2, the governing board is equally controlled by three nonprofit and three for-profit appointees (a 50/50 joint venture). What is significant about the disparity in these two arrangements is that the charity’s majority representation on the governing board in Situation 1 enables it to independently initiate actions on behalf of the joint venture. By contrast, in Situation 2 the nonprofit is merely permitted to block actions proposed by the for-profit partner and is unable to initiate new programs. In part, it is because of the heightened level of control in Situation 1 that the IRS ruled in favor of that joint venture arrangement. In Situation 2, however, because the nonprofit lacks control, the IRS seems to suggest in the unfavorable case that the power of the nonprofit merely to block an action is insufficient to demonstrate adequate safeguarding of the exempt purpose. The governing arrangement in Situation 1 clearly vests control in the hands of the nonprofit entity. In the grand scheme of things however, it is questionable whether such an arrangement harmonizes with common business sense. More specifically, in the typical whole hospital joint venture, the for-profit entity makes considerable cash investment, and thus, it is unlikely to agree to vest the nonprofit entity with such “up-front” control. Therefore, as in Situation 2, the for-profit entity would more realistically negotiate equal representation on the governing board. (b)
Expanding Nonprofit Veto Authority in the 50/50 Joint Venture
After a 50/50 joint venture has been formed, the nonprofit board’s members generally possess veto authority only over major operational decisions and have little or no ability to influence staff working conditions, compensation, or status.427 Although the nonprofit’s representatives in a 50/50 joint venture can block (at least temporarily) actions proposed by the for-profit, they are essentially powerless to force the joint venture to take affirmative actions that they consider essential to meet community healthcare needs.428 For example, the nonprofit board can block termination of existing services, but cannot compel the hospital to undertake new services in response to emerging problems.429 The nonprofit may be able to block the appointment of a joint venture CEO that it thinks may be insensitive to community needs, but cannot compel the appointment of a CEO it affirmatively supports.430 In Situation 2 of Revenue Ruling 98-15, it is apparent that the IRS believes that the power to block an action is, in itself, insufficient to demonstrate and promote the exempt purpose.431 However, in commenting on Rev. Rul. 98-15, the IRS, observed that there is no bright line rule [precluding the nonprofit veto] but that the requisite control will be determined based on the overall facts and 427 428 429 430 431
Robert A. Boisture and Albert G. Lauber Jr., “Caplin & Drysdale Comments on Whole Hospital Joint Ventures,” Exempt Organization Tax Review (Apr. 1997): 650, 655. Id. Id. Id. See Rev. Rul. 98415, Situation 2.
䡲
581
䡲
c12.fm Page 582 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
circumstances:432 “[Practitioners should] not assume that the IRS will limit itself to reviewing [joint venture] relationships to the discrete factors mentioned in the ruling. The IRS’s message is that it will look beyond the window dressing, beyond the labels, to see what is happening with assets, with the flow of money. The IRS will look to control and the various ways that can be defined.”433 On the other hand, the 2000 CPE article on healthcare joint ventures434 emphasizes that “effective control” by the nonprofit partner of the entire decision making process is essential. When answering the question of whether Situation 2 could be reformed so that participation in the venture would not jeopardize the nonprofit partner’s exemption, the IRS states that changing one factor alone, such as requiring the LLC to act for the benefit of the community, or to require a set term for renewal of the management contract, would not be sufficient. Thus, use of a veto as a viable device for preserving exempt organization control in the 50/50 joint venture is suspect, even when coupled with other safeguards as it does not give the nonprofit effective control. (c)
Resolving Disputes Through Arbitration
When seemingly irreconcilable deadlock occurs, joint venture agreements generally seek resolution through the use of arbitration. The problem with arbitration, however, is that it generally does not preserve the nonprofit organization’s control over the joint venture. Rather, it simply transfers control to an arbitrator who must afford equal respect to the for-profit and the charity’s interests. It is also possible that compulsory arbitration may actually reduce the charity’s power by diminishing the force of its veto threat. The problems with arbitration have been summarized as follows: Arbitration does not empower the nonprofit representatives; rather, it delegates final authority to an arbitrator who must give equal weight to the for-profit’s point of view. Provision for arbitration may actually weaken the charity’s position by diminishing its veto threat. Arbitration seems ill-suited to resolving the conflicts over values that joint ventures are likely to encounter.435 [As a result], arbitration cannot provide the nonprofit with any real assurance that community benefit concerns will govern joint venture operations. Indeed, the obvious inefficacy of arbitration in this setting suggests that the parties do not intend to place heavy reliance upon it. The more plausible expectation is that the nonprofit members of the joint venture board will quickly adopt a relatively passive role, avoiding conflict and allowing the for-profit to dominate the decision-making process.436
As a general rule, arbitration appears to be ill-equipped for resolving conflicts over values; it cannot provide the nonprofit with any real assurance that community benefit will dictate joint venture operations. However, as with any general rule, there are exceptions. 432 433 434 435 436
See Carolyn D. Wright, “Owens Discusses Newly Released Joint Venture Revenue Ruling,” Tax Notes Today (Mar. 9, 1998). Id. M.J. Salins and M. Friedlander, “Update on Health Care Joint Venture Arrangements,” 2000 CPE, Section ID. See Caplin, note 423, at 650–651. Id. at 656.
䡲
582
䡲
c12.fm Page 583 Thursday, March 15, 2007 7:59 PM
12.5 PRESERVING THE 50/50 JOINT VENTURE
Should deadlock ultimately lead to arbitration, the partnership agreement should establish the ground rules for the arbitration process. Arbitration is an extremely flexible device, which can be driven by a set of preestablished rules. Such rules should seek to preserve the charity’s ability to ensure a strong community focus in joint venture operations. For example, with regard to arbitrating value-driven disputes, the partnership agreement can set forth a presumption in favor of the nonprofit entity that can be overcome only if the for-profit meets a preset burden of proof (e.g., preponderance of the evidence or that the charity’s position is arbitrary, capricious, or unreasonable). It is only after such a showing has been made that an unbiased and impartial arbitrator may rule in favor of the for-profit. Otherwise, it is the charity’s position that will control. Putting this concept into practice, assume, for example, that the for-profit partner of a 50/50 shared governance joint venture wants to terminate the free emergency room service that the joint venture currently provides. The nonprofit partner, fearing that its charitable purpose will be jeopardized, vetoes the decision. Deadlock results, and the matter proceeds to arbitration. Because a valuedriven principle is at issue here, according to the partnership agreement, the arbitrator must recognize a presumption in favor of the nonprofit partner. The for-profit would bear the burden of showing that the charitable purpose would not be jeopardized or that the charity’s position is arbitrary and without merit. To do so, the for-profit must present evidence that the community purpose is being advanced (such as, for example, that the joint venture conducts extensive research, that it operates a free clinic, or that a free emergency room would be unnecessary and duplicative pursuant to Rev. Rul. 83-157).437 If, after such a presentation, the preservation of tax-exempt status still remains uncertain, the forprofit partner may also be required to request a private letter ruling from the IRS. If favorable, such a ruling would clearly rebut any presumption in favor of the nonprofit entity. Arbitration, if used in this manner, will help enhance nonprofit control and preserve the community purpose.438 The exact wording of arbitration provisions goes beyond the scope of this book. However, practitioners should be mindful that a well-drafted arbitration provision may serve to rebut an IRS challenge on joint venture control, should one arise. (d)
Comparison of For-Profit and Tax-Exempt Joint Venture Structures
Rev. Rul. 98-15 and the St. David’s case offer three exemplars for joint venture structures in the healthcare milieu. Rev. Rul. 98-15 provides two examples; the first, describes the Service’s idyllic scenario wherein there is little question that given all factors (i.e., board governance; the venture’s purpose and mission; and the governing documents), the exempt partner retains control over the venture including, notably, a charitable override of any decision that may be made by forprofit directors. The second example details the Service’s less-favored scenario, 437
438
Rev. Rul. 83-157, 1983 C.B. 94 provides that a hospital may qualify for exemption under §501(c)(3) even if it does not operate an emergency room in situations where such a facility would be unnecessary and duplicative. This revenue ruling amplifies Rev. Rul. 69-545, which sets forth several indicia of community benefit. Petroff, “Whole Hospital Joint Ventures,” note 278, 30.
䡲
583
䡲
c12.fm Page 584 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
where the same factors were presented in such a way that control by the exempt partner is not clear. In the St. David’s case, the facts of the venture considered by the jury fell in the middle of the two Rev. Rul. 98-15 scenarios. For example, in St. David’s, although the governing board, as in the second Rev. Rul. 98-15 scenario, was a 50/50 board, the governing documents, as in the first Rev. Rul. 98-15 scenario, required that the venture operate in conformity with a charitable purpose. Accordingly, the facts and subsequent outcomes of these three distinct “templates” have left those charged with designing these deals unclear. To illustrate, Exhibit 12.4439 compares the three fact patterns, as well as a “typical” structure proposal: As the chart illustrates, following Rev. Rul. 98-15 and the St. David’s case, it remains unclear if one factor, such as voting control or presence of a charitable override, will be dispositive in the Service’s determination of the nonprofit’s exempt status, if that status were to be challenged. (e)
Preserving “Control” in the 50/50 Venture
Following St. David’s, there is uncertainty as to what factors, if any, will be ultimately persuasive if the Service were to challenge and examine the nonprofit partner’s exempt status. Arguably, among these factors, the issue of what “mechanisms,” if any, should be instituted or preserved by the nonprofit partner remains unclear. Nonetheless, nonprofits should be mindful of several “control”-related issues: 1. Management Issues. If a management company is employed to run day-today operations, it may be an independent for-profit company but disclosure should be made if a member of the management group is on the board. In addition, any management agreement should be for no more than five years, and the Service may have concerns about any fees charged by the management company that are based upon revenues, whether gross or not. 2. Excessive Compensation. Deals should be explicit about the amount of compensation paid to “insiders,” and especially, any physician partners. Nonprofits should be particularly mindful of the new excess benefit compensation penalties imposed by §4958 (where the penalty has now been doubled). In addition, physician-partners should be required to invest real money and only receive returns commensurate with their cash investment. They should not have a special or preferred membership and the hospital should not be lending cash to the physicians to make the investment.
439
Chart prepared by Todd Greenwalt, Esq. of Vinton & Elkins, LLP. The author gratefully acknowledges the excellent analysis of the complex joint venture structures.
䡲
584
䡲
c12.fm Page 585 Thursday, March 15, 2007 7:59 PM
E XHIBIT 12.4 Comparison of For Profit/Tax-Exempt Joint Venture Structures 98-15 Situation 1
98-15 Situation 2
St. David's
Typical Proposal
Retain Exemption
Yes
No
Yes
?
Governance
5 member board 3 members appointed by taxexempt partner2 by for profit partner
6 member board 3 appointed by each partner
10 member board 5 elected by St. David’s 5 elected by HCA affiliate
Governing board - equal number elected by Nonprofit (NP) and For profit (FP)
Majority required for major decisions Governing documents
3 members
4 members
Affirmative majority vote of each class
Affirmative majority vote of each class
Requires LLC to operate in a manner that furthers charitable purposes as manifested in the community benefit test Provides that governing board’s duty to operate LLC in a charitable manner overrides any duty to operate for the financial benefit of owners
LLC’s purpose is to construct, develop, own, manage and operate health care facilities No charitable override
Requires partnership to operate in conformance with charitable purposes as manifested in community benefit test No charitable override
Requires venture to operate in conformance with charitable purposes as manifested in community benefit test No charitable override Manager performs annual review of charitable activities and makes recommendations to board regarding future activity
䡲
PRESERVING THE 50/50 JOINT VENTURE 12.5
585
䡲
c12.fm Page 586 Thursday, March 15, 2007 7:59 PM
䡲
586
CH. 12 HEALTHCARE ENTITIES IN JOINT VENTURES
䡲
E XHIBIT 12.4 Comparison of For Profit/Tax-Exempt Joint Venture Structures (continued) 98-15 Situation 1
98-15 Situation 2
St. David's
Typical Proposal
Management of LLC
Management agreement with company unrelated to either party Arm’s length fee based on LLC's gross revenue 5 year term, renewable for additional 5 year terms by mutual consent
Management agreement with subsidiary of for profit partner Arm’s length fee based on LLC's gross revenue 5 year term, renewable for additional 5 year terms at option of management company
Officers, directors, key employees
None of those involved in forming LLC were promised employment or offered any inducement by LLC or for profit partner upon approval of joint venture
Tax-exempt partner agreed to approve selection of CEO and CFO who previously worked for for profit partner
Management agreement with HCA affiliate Arm's length fee based on partnership gross revenue Term coterminous with partnership agreement, but management services agreement defines default to include taking any action that has a material probability of causing St. David's to lose exemption St. David’s selects initial CEO Officers not required to be HCA alumni No inducement offered to St. David's personnel to approve transaction
Management agreement with FP affiliate Arm's length fee based on venture’s gross revenue 10 year term, renewable with mutual consent All employees employed by FP affiliate NP can terminate management agreement for failure to meet community benefit standard NP may terminate CEO, CFO or Chief Compliance Officer for failure to satisfy community benefit test Officers not required to be FP alumni No inducement offered to NP personnel to approve transaction
c12.fm Page 587 Thursday, March 15, 2007 7:59 PM
E XHIBIT 12.4 Comparison of For Profit/Tax-Exempt Joint Venture Structures (continued)
Major decisions requiring board approval
98-15 Situation 1
98-15 Situation 2
St. David's
Typical Proposal
Annual operating and capital budgets Selection of key executives Distributions of earnings Contracts in excess of $x per year Acquisition/disposition of health care facilities Changes in types of services offered by hospital Renewal/termination of management agreement
Annual operating and capital budgets Selection of key executives Distributions of earnings in excess of $x Unusually large contracts
Annual operating and capital budgets CEO Distributions of excess cash Sale of all or substantially all assets, merger, dissolution or consolidation Debt in excess of 10% of assets Admission of new partners
Annual operating and capital budgets Selection of CEO, CFO, Compliance Officer Distributions differing from ownership percentages Contracts involving payments exceeding $250,000 annually Transfer of more than 10% of assets Material addition or reduction of clinical services at NP contributed facilities Termination of management services agreement, other than for failure to meet community benefit standard Debt in excess of 10% of assets Admission of new partners
䡲
PRESERVING THE 50/50 JOINT VENTURE 12.5
587
䡲
c12.fm Page 588 Thursday, March 15, 2007 7:59 PM
䡲
588
CH. 12 HEALTHCARE ENTITIES IN JOINT VENTURES
䡲
E XHIBIT 12.4 Comparison of For Profit/Tax-Exempt Joint Venture Structures (continued) 98-15 Situation 1
98-15 Situation 2
St. David's
Typical Proposal
Agreements with affiliates of either partner Additional capital contributions General and professional liability insurance policies Discontinue/resume audit of partnership activities Partner engaging in competing business Accountants
Agreements with affiliates of either member Additional capital contributions Non-budgeted capital items exceeding $300,000 Filing of litigation not in the ordinary course of business
c12.fm Page 589 Thursday, March 15, 2007 7:59 PM
12.6 VALUATION
3. Control Generally. Although Rev. Rul. 98-15 and the St. David’s case do not provide clear or definite paradigms on how, if at all, “control” should be “guaranteed”, it is important to examine the transaction to determine whether the nonprofit has ceded “control” in the transaction. In this respect, it is important to look not only at formal control but at actual control. What is the solution to this “control” conundrum? Structure the partnership either 51/49 or 50/50 with some type of charitable majority in management representation or “other mechanism.” Notably, however, there is no standard operating procedure in the healthcare area, so it’s questionable if bifurcation can work. 4. Conflicts of Interest. Keep in mind the potential conflict. If the nonprofit is deciding admissions and rates, yet the for-profit is concerned about fees, there is concern that the for-profit may slash away at the loss leaders. Restrictive covenants not to compete need to be reviewed. While the hospital system may prefer such a provision, there is a real issue remaining about how you “ask the other side for it” without giving it up on “your” side. Notably, The Cleveland Clinic in Cleveland, Ohio has gained national attention as one of the major nonprofit hospital systems grappling with the growing challenge of managing the potential conflicts of interest that arise when physicians working closely with drug and medical device manufacturers receive compensation and/or royalty payments as a result of these relationships. More often than not, the doctors spearheading the drug or device studies may use or recommend use of these products to their patients. These relationships may raise issues of impermissible benefit, inurement, and unrelated business income tax. 5. Other Issues. If there is a change in the stated charitable purpose of the new venture/use of the nonprofit entity, it could affect any existing tax-exempt bonds held by the nonprofit. Also, those designing these transactions should be mindful of the infamous revenue stream joint venture rulings.440
12.6 (a)
VALUATION Overview
The present valuation procedures clearly run the risk of allowing mergers with not-for-profit hospitals to occur at prices that substantially undervalue their worth. There have been a surprising number of transactions in which it appears that nonprofit hospitals have delivered to the joint venture more assets than may have been required to justify the value received.441 Thus, as the merger results in inurement to the for-profit partner, the nonprofit entity and the community in general are being short-changed. Whole hospital joint ventures, as they are generally structured, normally involve the transfer of control over key charitable assets to private, profitmaximizing hospital chains. The crucial consideration is whether the control and 440 441
See Section 12.4, supra. See S. R. Hollis, “Strategic and Economic Factors in the Hospital Conversion Process,” Health Affairs (Mar./Apr. 1997): 131–143.
䡲
589
䡲
c12.fm Page 590 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
benefit derived by these private parties is “incidental” to the public benefit. As such, it is of paramount importance that the nonprofit receives at least fair market value for the hospital assets that it sells to the joint venture. Although joint venture agreements generally contain boilerplate statements to the effect that charitable assets cannot be transferred for less than fair market value, there is the potential that such a requirement cannot be adequately policed within the structure typical of these arrangements.442 Consequently, additional safeguards must be implemented. Generally, when an organization purchases assets from an independent third party, there is a presumption that a purchase price arrived at through negotiations represents fair market value.443 Where there is common control by, or a relationship between, the buyer and the seller, however, the presumption of fair market value cannot be made because the elements of an arm’s-length transaction are not present. Similarly, the process of defining the value of a not-forprofit hospital’s assets can be a complicated one, which, as noted previously, is compounded by the secrecy that typically accompanies the negotiation process. “Getting a fair deal” for the nonprofit entity should mean getting full and fair value for its hospital in a transaction that will best serve its original charitable purposes. The process of valuing the nonprofit hospital requires an understanding of both how the value is to be determined and how the transaction is to be structured. To ensure that fair market value is obtained, state attorneys general have often recognized the need for outside expertise and have retained technical assistance in the form of outside consultants who are skilled in financial valuations and in analyzing the terms of the proposed transactions.444 Consequently, to confront this problem and prevent the possibility of prohibited private benefit, the negotiation contract should provide for an independent appraisal of the value of the assets.445 The “big four” accounting firms are generally equipped to provide such a service. As an additional safeguard, the independent appraisal should be buttressed by a fairness opinion, usually rendered by an investment banking firm or other knowledgeable reviewer who lacks a financial interest in the transaction.446 The fairness opinion is a documented analysis and confirmation by an objective and knowledgeable reviewer that the valuation process has resulted in a fair deal from a financial point of view.447 The cost of obtaining this opinion should be borne by the for-profit entity in order to protect the charity’s assets from being used to further a noncharitable purpose.448 Although the aforementioned safeguards are vitally important, practitioners should be mindful that the fairness opinion is merely a starting point, as it 442 443 444
445 446 447 448
Id. See Korman and Gaske, “Joint Ventures Between Tax-Exempt and Commercial Health Care Providers,” 773, 776. See Linda B. Miller, When Your Community Hospital Goes Up for Sale: A Guide to Understanding the Sale and Conversion of Not-for-Profit Hospitals to For-Profit Corporations and What You Can Do About It (Washington: Volunteer Trustees Foundation for Research and Education, 1996), 6. Id. Id. Id. Id.
䡲
590
䡲
c12.fm Page 591 Thursday, March 15, 2007 7:59 PM
12.6 VALUATION
covers only the financial terms of the transaction, not the community interests affected by the proposed sale.449 The fairness opinion does not, in and of itself, answer the question of whether the proposed joint venture will preserve the community’s interest and fulfill the nonprofit hospital’s charitable purpose. It merely seeks to eliminate prohibited private benefit by ensuring that fair market value is obtained. As discussed previously, a carefully structured partnership agreement can pick up where the fairness opinion leaves off and help preserve the charitable purpose.450 (b)
Anclote Psychiatric
The Tax Court addressed the valuation issue in the Anclote Psychiatric decision and held that the hospital’s IRC §501(c)(3) status should be revoked because the organization allowed its assets to inure to the benefit of its board members.451 Anclote Psychiatric Center (APC) was formed in 1951 as a for-profit entity but obtained tax-exempt status in 1958. By 1981 the hospital was operating at full capacity and was governed by a 12-person board consisting of doctors and business people from the local community and surrounding areas.452 In addition to the hospital building, APC owned other, nonadjacent unimproved pieces of land which were appraised by a realty company in 1981 to be worth approximately $1.11 million. Looking for ways to generate funds to expand APC and support the facility’s research and educational work, APC’s chief executive officer engaged a tax attorney to advise the board on the possibilities of converting to for-profit status or selling the hospital to an entity formed by the board. According to the Tax Court’s opinion, because the board did not want to relinquish control of APC, selling to an unrelated third party was not an option. The tax attorney submitted a private letter ruling request to the IRS on APC’s behalf. In summary, the request described a situation in which APC would sell the hospital’s assets to the APC board members. The ruling request asked whether APC would retain its IRC §501(c)(3) status or incur any unrelated business income tax liability and whether the proposed transaction would be otherwise prohibited. The request stated, “APC has decided to sell the hospital at its appraised value to the board of directors, or the entity they propose to form.” In addition, the request stated that an appraisal would be performed “by a qualified competent appraiser” and that all of the documents necessary for the sale would be prepared by separate counsel representing APC and the board. In May 1982, based on the belief that the arm’s-length standard would “prevail during the negotiations and sale . . . attesting to the fact that the price was set at fair market value and that no . . . special concessions [would] be afforded to the present directors,” the IRS issued APC a favorable letter ruling. Subsequently, in 1982, an appraiser hired by the board determined the fair market value of the hospital to be between $3.5 and $4.3 million, not including 449 450 451 452
Id. For an additional discussion of valuations, see Petroff, “Whole Hospital Joint Ventures,” 32– 33. See Anclote Psychiatric Center, Inc. v. Commissioner, 76 T.C.M. 175 (1998). aff’d without published opinion, 190 F.3d 541 (11th Cir. 1999) Id.
䡲
591
䡲
c12.fm Page 592 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
the separate pieces of land. In 1983, Anclote Manor Hospital, Inc. (AMH), a forprofit corporation, was formed to purchase APC’s assets. APC’s board members owned all of AMH’s stock individually. In addition, APC hired another attorney, Rosenkranz, to negotiate the sale of the hospital and represent APC as the seller. The tax attorney represented AMH as the buyer. The Tax Court opinion noted that “both lawyers knew the sale had to be for fair market value” and relied in part on the appraiser’s figures in setting the purchase price. The judge also pointed out that both lawyers knew that the appraisal did not include the nonadjacent land. Rosenkranz reportedly “insisted that AMH assume APC’s liabilities, including the liability for contributions to the pension plans” and that a bank “hold the paper and foreclose on the mortgage if the payments were not made.” The sale of the hospital property and assets for a purchase price of $4.5 million was approved by the board. In addition to the purchase price, AMH assumed APC’s liabilities and an amount to be contributed to APC’s pension plan. The liabilities amounted to approximately $1.7 million. The nonadjacent property was sold in early 1985 for approximately $1.875 million. By the middle of that year, AMH had received several offers to buy the hospital for between $12 million and $26 million. In late 1985, AMH sold the hospital’s operating assets for nearly $30 million. Using the accrual method of accounting, APC timely filed Forms 990 for 1982 through 1988. In its Form 990 for fiscal 1983, APC reported a $1.4 million net operating loss from the sale of the hospital. The IRS issued a notice of deficiency and a final adverse determination in 1991, revoking APC’s exempt status from fiscal 1983 forward, asserting that the IRC §501(c)(3) entity had allowed its assets to inure to benefit of insiders. APC petitioned the Tax Court in 1993 for a declaratory judgment confirming APC’s exempt status. In 1995, Judge Wright denied APC summary judgment regarding its entitlement to deduct certain business expenses and net operating loss carryforwards. In rendering the opinion in this case, Judge Wright rejected the IRS’s contention that fair market value (FMV) was the determinative factor. Judge Wright noted that, unlike the situation in estate and gift tax cases, in this instance the court did not have “to determine a precise amount representing a fair market value of the property transferred.” Rather, the court was looking for “whether the sale price was within a reasonable range of what could be considered fair market value.”453 Judge Wright rejected APC’s urging to minimize “the influence of the fair market value element in determining whether the sale price should be treated as the product of arm’s-length negotiations, with the absence of inurement the result.” The court also noted that the burden of proof regarding the exemption question fell to the IRS because the agency had failed to make a determination concerning APC’s section IRC §501(c)(3) status when APC had asked for such a determination. 453
The court noted that the task of determining whether the compensation payments in Anclote were excessive or reasonable was similar to that in Church of Scientology v. Commissioner, 823 F.2d 1310, 87 TNT 149-15 (9th Cir. 1987), aff’g 83 T.C. 381 (1984) and in United Cancer Council Inc. v. Commissioner, 109 T.C. 326, Doc. 97-32596, 97 TNT 232-8 (1997).
䡲
592
䡲
c12.fm Page 593 Thursday, March 15, 2007 7:59 PM
12.6 VALUATION
Although the court found that the attorneys representing APC and the board had “acted independently and in good faith,” Judge Wright raised “serious questions” as to the extent to which the negotiations adequately took into account certain financial aspects of the transaction which [could] cause the negotiations and the resulting sale price to be categorized as not being arm’s length and therefore giving rise to inurement. As to the valuation reports that each side offered as evidence, the court ruled that the IRS appraiser’s report should not be admitted as evidence. The court noted that the IRS valuation expert’s report was “more characteristic of the work of a revenue agent than an impartial, disinterested appraiser.” Judge Wright further commented that even if the court had allowed the IRS appraiser’s report into evidence, “[W]e would have given it minimal weight because of [the appraiser’s] inexperience at the time of his appraisal, the defects in the report . . . the failure to take into account the impact of income taxes on his projected income stream . . . and the seemingly excessive value for good will.” Nevertheless, based on the entire record, the court concluded that the IRS had borne its burden of showing that APC was not entitled to exemption. Ultimately, although it was worth $7.8 million, the court found that the board of directors had effectively purchased APC for only $6.6 million. The $1.2 million gap was sufficient to find inurement. The Anclote opinion, although heavy on valuation details, provides very important clues as to how the IRS will view compensation and valuation issues in the future. Rather than having to determine and support hard figures showing that an exempt organization paid more than the going rate in executive compensation or received less than FMV in a sale of assets to insiders, the Tax Court has enabled the IRS to show simply that the exempt organization’s financial transactions were not within a reasonable range. Anclote illustrates the importance of having good appraisals properly prepared. Specifically, the sale to the board in this case was not considered to be arm’s length because the attorneys lacked reliable valuation information. Despite having its evaluation rejected by the court, however, the IRS still managed to meet its burden and win the case. APC’s expert had not properly valued the sale, and the board ultimately paid much less than FMV for the assets it bought. The Anclote opinion clearly underscores the importance of obtaining a properly perpared valuation by a reputable, independent expert as part of every transaction with for-profit interests. The Sta-Home Health Agency case appeal454 involved valuation of exemptorganization assets acquired by disqualified persons. Organizations originally recognized as tax-exempt were converted to S corporations. The same family members owned the organizations both before and after conversion. The appraiser for the family determined that the liabilities of the organizations exceeded the fair market value of their assets. The IRS, however, calculated that 454
Caracci v. Commissioner, 118 T.C. 379 (2002), subnom, Sta-Home Health Agency of Carthage Inc., et al v. Commissioner, 5th Circuit DKT. No 02-60912 (Jan. 21, 2003). See Sections 4.8 and 5.4 for discussion of the Tax Court Case.
䡲
593
䡲
c12.fm Page 594 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
the fair market value of each organization’s assets substantially exceeded the liabilities. The IRS imposed first-tier, second-tier, and organization manager excise taxes under §4958. In addition, the IRS revoked the exemption of the organizations because the transfers of net assets for less than adequate consideration was a substantial activity not in furtherance of the exempt purpose, conferred private inurement, and benefited private interests.455 As discussed in Section 5.4, the Tax Court found a value somewhere in the middle, and reinstated the exempt status of the organizations. On July 11, 2006, the United States Court of Appeals for the Fifth Circuit reversed the earlier decision of the Tax Court in Michael T. Caracci et al. v. Commissioner of Internal Revenue. The Fifth Circuit’s opinion focused on the valuation methods the IRS used to determine that the petitioners’ received an excess benefit when the Sta-Home exempt entities transferred their existing assets to the forprofit S corporations. Notably, the Fifth Circuit held the valuation expert hired by the Commissioner was not as versed with the ramifications of the transactions as the same expert hired by the taxpayers. It noted that the petitioners’ valuation expert had spent almost eight weeks in Mississippi studying the intricacies of the deal, whereas the IRS’s expert had spent only one day in Mississippi studying the transaction. Moreover, the Fifth Circuit noted that the valuation expert hired by petitioners was far more knowledgeable as to the home healthcare industry than the IRS expert. The Court ultimately held that neither the Commissioner nor the expert valuation witness proffered by the IRS did the requisite investigative work or had the expertise necessary within the healthcare field to conduct a reliable asset-valuation of the Sta-Home transaction. The Fifth Circuit also faulted the Tax Court for devising its own valuation method based largely on that of the Commissioner’s expert. Notably, while the Tax Court method compared the Sta-Home entities with profitable, publicly traded corporations, Sta-Home neither had equity nor was profitable at the time of the transactions. Significant to the issue of valuation, the Fifth Circuit concluded that in selection of a valuation method, any reference comparables must be substantially similar to the entity or asset that is at issue. When assessing the value of healthcare assets contributed to a joint venture, the fair market value should include the going-concern value. Thus, the amount of income it generates and the extent to which it is reduced by changes in Medicare and Medicaid rates and other normal appraisal factors should be applied.456 (c)
Valuation Guidance from General Accounting Office
For additional guidance on the issue of valuation, the United States General Accounting Office (GAO), in a report to Congress, has published an article wherein it discusses the standard methods that are generally used to value a hospital’s assets.457 In this report, the IRS notes that consultants generally use 455 456 457
See Section 5.4 for a more detailed discussion. 2002 CPE article, p. 161; speech by Marvin Friedlander, Chief of Technical Branch 1, 2001 TNT 124-6 (June 27, 2001). See United States General Accounting Office Report to Congress, Not-for-Profit Hospitals— Conversion Issues Prompt Increased State Oversight, GAO/HEHS 98-24, (Dec. 16, 1997).
䡲
594
䡲
c12.fm Page 595 Thursday, March 15, 2007 7:59 PM
12.6 VALUATION
one of three valuation approaches: the income, market, or cost approach.458 However, a key component considered in estimating the value of the hospitals reviewed by the GAO in the report was their most recent earnings. The GAO suggested that hospitals solicit competing bids through a request for proposals in order to increase the likelihood that a fair market value is realized.459 Although few hospitals in the IRS’s report followed such a formal competitive bidding process, officials at most hospitals were noted as saying that they received multiple bids and accepted the highest bid offered. Once a bid is accepted, the terms of the purchase or partnership agreement are negotiated and formally agreed to by both parties. Participants in the conversion transactions reviewed by the GAO stated that the items negotiated included the final purchase price and continued charity care and hospital services. (d)
1999 CPE Hospital Joint Venture Article
According to the 1999 CPE Hospital Joint Venture Article, a starting point in evaluating the sale, purchase, or sharing of healthcare assets, such as a hospital, is to establish a time line that places information concerning the transaction in perspective.460 The purpose of this time line is to provide a basic guideline for identifying, quantifying, and resolving valuation issues. Information prepared prior to the transaction date is important for explaining and justifying the transaction’s value or price. On the other hand, evidence prepared at the transaction date, including bids, sideline transactions, sales contracts, and employment agreements, may or may not corroborate important factors considered in arriving at a transaction price. The CPE text further notes that the valuation analysis should be tailored to the specific facts of the particular transaction. It is important that this analysis concern not only the exempt hospital’s assets that were contributed to the joint venture, but also the valuation of any of the assets contributed to the joint venture by the for-profit partner as well.461 (e)
Intermediate Sanctions Regulations
Under the intermediate sanctions provisions, an excess benefit transaction can occur if an IRC §501(c)(3) or (4) entity sells property to a disqualified person for less than fair market value or buys property for more than fair market value. The regulations do not offer more than the traditional concept of fair market value as guidance: [T]he fair market value of property . . . is the price at which property or the right to use property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy, sell or transfer property or the right to use property, and both having reasonable knowledge of relevant facts.462
458 459 460 461 462
See GAO/HEHS 98-24 for a detailed discussion of the various valuation methods. Id. See 1999 CPE Hospital Joint Venture Article. Id. See Section 5.4. Reg. §53-4958-4(6)(1)(I).
䡲
595
䡲
c12.fm Page 596 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
CAVEAT Although the intermediate sanctions regulations are not particularly illuminating, the Anclote, Redlands Surgical Services, and Baptist Health Systems cases illustrate the importance of obtaining contemporaneous reliable valuation data as of the date of the transaction to avoid revocation of exempt status and/or imposition of intermediate sanctions penalties.
12.7 (a)
JOINT OPERATING AGREEMENTS Background
As discussed in Section 12.2, exempt healthcare organizations often structure transactions as a joint operating agreement (JOA). Essentially, the JOA is a contractual relationship through which two or more exempt organizations cede significant operational, financial, and managerial power to a newly created governing body (sometimes called a joint operating company) and thus achieve significant integration without relinquishing full control of their assets or activities. This structure allows the participants to take advantage of the efficiency and cost-savings benefits realized by a whole hospital joint venture or actual merger, while retaining ownership of their charitable assets, their individual identities, and control over certain issues of fundamental importance to the individual organization.463 JOAs differ from whole hospital joint ventures in two significant respects. First, whereas whole hospital joint ventures typically involve at least one forprofit entity, JOAs are structured almost exclusively between tax-exempt entities. Second, whole hospital joint ventures are “disposition” transactions—the exempt organization actually transfers ownership of its assets (and control over those assets) to another entity. In a JOA, each entity maintains ownership and some degree of control over its own assets. The interrelationship, however, raises certain exemption and unrelated business income tax (UBIT) issues. As an initial matter, an exempt hospital that provides services for a fee to an unrelated entity (other than the direct provision of healthcare to patients)—even if that entity is tax-exempt—will likely be subject to
463
Wright, “Growth in Hospital Joint Ventures Ups Need for IRS Guidance,” Tax Notes Today 96 (1996): 117-5; 1996 (for Fiscal Year 1997) Exempt Organizations CPE Technical Instruction Program Textbook at 132. This limited degree of control is particularly important to, for example, religious hospitals, which must consider religious principles in reaching medical or other operational decisions, and universities, which may be legally bound to maintain actual title to charitable assets. See id.; see also “JOA, Exemption Rulings Provide Needed Guidance for Healthcare Arrangements,” Tax Notes Today 96 (1996): 218-4.
䡲
596
䡲
c12.fm Page 597 Thursday, March 15, 2007 7:59 PM
12.7 JOINT OPERATING AGREEMENTS
UBIT on those proceeds.464 Accordingly, if the provision of such services is the primary activity of the organization, it may not be entitled to continued exemption under IRC §501(c)(3), based on the presence of a substantial nonexempt purpose.465 Both of these problems may be averted, however, if the mutual governing body and the participating exempt organizations can meet the “integral part” test.466 Essentially, this test requires a showing that the participating organizations have a close and integrated working relationship, involving significant financial and operational overlap. The surest way to make such a showing is to establish a parent-subsidiary relationship or one that is substantially equivalent.467 Because joint operating agreements do not generally provide for the clear-cut parent-subsidiary relationship that is present in the typical “integral part” case (in that each organization elects its own board of directors and retains some degree of autonomy), the IRS “will look for other explicit manifestations of control” or the existence of a “super-parent” whereby to justify “integral part” characterization.468 The IRS has not commented publicly on whether a JOA between a taxexempt entity and a for-profit healthcare organization would be permissible. However, it is anticipated that the IRS will rely on the rules set forth in Rev. Rul. 98-15, Plumstead Theatre Society, Inc. v. Commissioner, and its progeny.469 These cases, along with the various general counsel memos (GCMs) and other IRS 464
465
466 467
468
469
Except for cooperative hospital services under §501(e), which are excluded from UBIT under §513(e), the rendering of ancillary or support services to another, unrelated exempt entity is not an exempt purpose. See Priv. Ltr. Rul. 96-51-047 (Sept. 24, 1996) (citing B.S.W. Group v. Commissioner, 70 T.C. 352) (“JOA Ruling”); Priv. Ltr. Rul. 97-38-038 (June 26, 1997) (affiliation of three tax-exempt hospitals and their affiliates through a joint operating agreement will not affect their tax-exempt status and will not cause unrelated business taxable income (UBTI)); Priv. Ltr. Rul. 97-14-011 (Dec. 24, 1997) (affiliation of two tax-exempt hospitals through a joint operating agreement will not affect their tax-exempt status and will not cause unrelated business taxable income (UBTI); Priv. Ltr. Rul. 97-22-042 (Mar. 7, 1997) (a joint operating agreement between two §501(c)(3) tax-exempt organizations to run their acute care facilities as a single entity, where the agreement constituted a joint venture for operational but not ownership purposes, will not affect either hospital’s tax-exempt status and will not cause unrelated business taxable income); Priv. Ltr. Rul. 97-21-031 (Feb. 26, 1997) (a joint operating agreement between two §501(c)(3) tax-exempt hospitals to run their healthcare facilities as a single regional integrated network, where the agreement constituted a joint venture for operational but not ownership purposes, will not cause unrelated business taxable income); 1996 (for Fiscal Year 1997) Exempt Organizations CPE Technical Instruction Program Textbook at 133. Id. With regard to UBIT in the JOA context, in several private letter rulings involving joint ventures, the IRS concluded that income was not UBTI. These activities include (1) MRI joint venture between nonprofit hospital and for-profit physician service group, (2) operation of an ambulatory surgery center, and (3) inpatient and outpatient surgical orthopedic services. Once again, control of the entity is vital. Even if the purpose of the JOA begins to stray from a “substantially related” position, as defined in Plumstead, the ability of the tax-exempt organization to direct the activities of the JOA will likely provide a safety feature. The tax-exempt entity should always maintain the ability to amend or change the purpose of the JOA or even terminate the agreement. See Geisinger Health Plan v. Commissioner, 30 F.3d 494 (3d Cir. 1994). See JOA Ruling, note 470. This relationship often proved difficult for many organizations to establish, particularly if they were unwilling or unable to cede complete board control to another entity. 1996 (for Fiscal Year 1997) Exempt Organizations CPE Technical Instruction Program Textbook at 134. See also Rev. Rul. 77-72, 1977-1 C.B 157 (indebtedness incurred between a parent and subsidiary was not “acquisition indebtedness” under §514, because the existence of a parent-subsidiary relationship causes dealings between the organizations to be “merely a matter of accounting”). See generally Section 4.2 for a discussion of Rev. Rul. 98-15 and Plumstead.
䡲
597
䡲
c12.fm Page 598 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
pronouncements all focus on the concept of control. Who “drives” the business? Who can make the decisions? What is the makeup of the board? How can the arrangement be terminated? These are all pivotal questions that need to be addressed in JOAs as well as in joint ventures. Control has emerged as a major factor in creating a joint venture between a tax-exempt entity and a for-profit entity, as evidenced by the decision in Rev. Rul. 98-15 and its litigating position in Redlands.470 As it did in its ruling, the IRS will most likely scrutinize the governing documents of the JOA to determine whether the tax-exempt entity will not be in jeopardy of losing its tax-exempt status. Much of the concern regarding JOAs between tax-exempts and for-profits involves the ultimate flow of revenue to the for-profit entity. Although JOAs are extremely flexible arrangements, private benefit—even if not intentional—may still occur. Nonetheless, in examining Rev. Rul. 98-15 it appears that as long as there is some way for the nonprofit entity to maintain control of the JOA, many of the private inurement concerns may be mitigated. (b)
The IRS JOA Checklist—A Relaxation of the Integral Part Test
In July 1996, the IRS issued a checklist of factors that would tend to demonstrate the existence of a parent-subsidiary relationship with respect to joint operating agreements.471 The checklist sets forth a flexible “facts and circumstances” test472 by which it will determine whether “significant control over management and financial decisions have been ceded by participating entities to a mutual governing body” under the JOA.473 The first, and perhaps most important, set of factors involves the delegation of significant management authority to the governing body. The factors include whether the parent is responsible for establishing budgets for the system as a whole and for the individual components of the system. The budgetary powers should include the authority to approve major expenditures, the incurrence of debt, managed care arrangements, management or service contracts, and other proposed capital expenditures.474 It is important that the governing body of the parent meet on a regular basis (not once a year) and actually exercise decisionmaking authority over the subsidiary budgets, rather than simply ratifying the actions of the component boards.475 Along with these powers should be the ability of the governing body to audit the participating entities in order to ensure compliance with the decisions of the body.476 470 471
472 473 474 475 476
See Redlands, Section 12.3(iv). “Full Text: IRS Checklist for Hospital Joint Operating Agreement Applicants,” Tax Notes Today 96 (1996): 149-22 (hereinafter “Checklist”). The checklist is sent to persons seeking a JOA ruling and sets forth a facts and circumstances test under which the IRS will analyze the JOA to determine whether it meets “integral part” requirements. The issuance of the list, although not precedential, represents a significant liberalization of the IRS’s practice of requiring strict structural and financial integration in order to secure a favorable JOA ruling. See “Joint Operating Agreement ‘Checklist’ Indicates a More Liberal Approach, Sullivan Says,” Tax Notes Today 96 (1996): 149-6. Under this test, no factor is determinative, but some factors carry more significant weight than others. Checklist at [2]. Id. Id. at [4](1). Id. at [4]. Id. at [4](2). This is a significant factor.
䡲
598
䡲
c12.fm Page 599 Thursday, March 15, 2007 7:59 PM
12.7 JOINT OPERATING AGREEMENTS
Another, perhaps critical, factor is the ability of the governing body to direct the provision of medical services by participating organizations.477 For example, the governing body should be able to prohibit an entity from establishing a nephrology clinic or rendering orthopedic services, or require that an entity develop its perinatological practice.478 Other factors that tend to demonstrate the grant of significant managerial authority to the governing body include the authority to enter into binding agreements on behalf of the participating entities (that is, managed care agreements), hire and fire personnel,479 grant hospital privileges,480 set and approve fee schedules, buy and sell assets of the participating entities,481 and reallocate income and expenses among the participating entities in order to ensure “financial integration and to achieve mutual objectives.”482 The checklist also indicates that it is important to the IRS that there is evidence demonstrating the permanence of the arrangement. This includes dispute resolution mechanisms, such as binding arbitration, under which disagreements among the parties may be resolved,483 and the presence of “significant hindrances . . . penalties . . . [and] disincentive[s]” to termination of the agreement or the withdrawal of individual members from the participating group. These factors help ensure that the individual entities actually operate in an interdependent and “group based” manner.484 Finally, the checklist addresses the presence of veto powers and discusses the extent to which powers or rights may be reserved by the participating entities. Although the checklist does not specifically enumerate the powers or veto rights that are generally permissible,485 as these will vary greatly based on the needs of the particular organizations involved, it provides generally that if nearly all actions of the governing body are subject to veto or approval of the participating organizations, the requirements of the integral part test “would not be satisfied.” Essentially, the IRS has left organizations a great deal of flexibility with respect to retained powers if they do not materially affect the operations of the affiliated group.486 477 478
479
480
481
482 483 484 485
486
Id. at [4](3). The IRS has designated this as another significant factor. Checklist at [4](3). Note that individual participants can contractually bargain to retain autonomy over certain areas. For example, in the JOA Ruling discussed in note 470, two of the participating hospitals retained specific rights to conduct certain services. One entity reserved the power to approve any decision by the governing board that would eliminate its ability to provide primary and secondary acute healthcare services. Another retained the authority to approve decisions that would eliminate its tertiary care, oncology, or cardiology services. These reservations were found not to preclude the finding of a parent-subsidiary relationship. Id. Similarly, a religious hospital could likely retain the right to temper the directives of the governing board with its secular requirements. See id. at [7]. It is, of course, permissible for the participating entities to have input into the composition of their boards, particularly if the organization is bound by its articles, bylaws, state laws, or charter to maintain a particular board composition or membership. See JOA Ruling, note 470. In the JOA Ruling, the participating entities retained the right to grant additional physicians staff privileges in order to continue to meet accreditation and licensing requirements. This retained right was found, under the circumstances, not to adversely affect the ruling. It would likely be permissible for a university, otherwise required to maintain title to certain charitable assets, to specifically except those assets from the dispository powers of the governing body. See Checklist at [7]. Id. at [4](4)-(9). Id. at [6]. See id. at [5]. The checklist did concede, however, that “powers over ethical or moral issues based on religious principles may be reserved . . . without resulting in a finding that sufficient control has not been ceded to the governing body.” Id. at [7]. See id.
䡲
599
䡲
c12.fm Page 600 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
PRACTICE TIP The key to establishing a joint operating agreement under which the participating entities may retain their exempt status and whose receipts will not be subject to UBIT, appears to be the vesting of almost exclusive managerial control in the governing body. The parties entering into such an arrangement should view themselves as, in effect, having merged with the other entities and, thereby, being operated as a single integrated hospital system, despite the fact that the participants retain title to their charitable assets. The closer the JOA structure resembles an actual merger, in terms of power centralization and economic interdependency, the more likely the JOA is to meet IRS requirements. The provisions allowing for the retention of limited autonomy should be viewed as a recognition by the IRS that exempt organizations have “special needs” that must be considered to enable them to viably compete with growing for-profit systems and thus continue to provide community-based charitable medical services. (c)
Application of the IRS “Flexible” Ruling Guidelines
An example of the application of these rules can be found in Priv. Ltr. Rul. 9651047.487 In the ruling, the IRS determined that a JOA among five exempt healthcare organizations would not adversely affect the exempt status of any of the participants nor result in unrelated business income. In the ruling, the governing body488 actively managed the operations of the participating entities, meeting on an almost monthly basis to address budgetary and operational matters,489 and was involved in the day-to-day operation of all of the institutions through its chief executive officer (CEO), who also served as the president and CEO of each of the five exempt participants.490 In addition, the managerial powers vested in the governing body were substantial.491 487
488
489 490 491
Cited originally in n.129.84, and referred to throughout this section as the “JOA Ruling.” See also Priv. Ltr. Rul. 97-38-038 (June 26, 1997) (affiliation of three tax-exempt hospitals and their affiliates through a joint operating agreement will not affect their tax-exempt status and will not cause unrelated business taxable income); Priv. Ltr. Rul. 97-14-011 (Dec. 24, 1997) (affiliation of two tax-exempt hospitals through a joint operating agreement will not affect their tax-exempt status and will not cause unrelated business taxable income); Priv. Ltr. Rul. 97-22-042 (Mar. 7, 1997) (joint operating agreement between two §501(c)(3) tax-exempt organizations to run their acute care facilities as a single entity, where the agreement constituted a joint venture for operational but not ownership purposes, will not affect either hospital’s tax-exempt status and will not cause unrelated business taxable income); Priv. Ltr. Rul. 97-21-031 (Feb. 26, 1997) (joint operating agreement between two §501(c)(3) tax-exempt hospitals to run their healthcare facilities as a single regional integrated network, where the agreement constituted a joint venture for operational but not ownership purposes, will not cause unrelated business taxable income). The governing body was (and typically is) an organization formed for the sole purpose of administering the JOA. It generally applies for tax-exempt status based on the activities of the system and the integrated nature of the JOA. Checklist at [3]. Id. at [4]. The governing body had the power to (1) hire and fire any persons it deemed necessary to carry out its functions, including the CEO of each participating entity (provided it consulted with that entity in reaching its decision); (2) direct the efforts of all system employees (although it did not do so on a micromanagerial level); (3) grant or revoke staff privileges; (4) set fees and prices for the system; (5) reallocate profits and expenses; (6) control the types of medical services offered by each participating entity; (7) relocate, sell, or buy assets of or for the system; (8) enter into contracts on behalf of the system; and (9) establish budgets, approve the incurrence of debt by, and capital and other major expenditures of, the participating organizations. The governing body also agreed to assume all present and future debt of the participating entities. Id. at [6]–[16].
䡲
600
䡲
c12.fm Page 601 Thursday, March 15, 2007 7:59 PM
12.7 JOINT OPERATING AGREEMENTS
With respect to the individual participants, none reserved powers that addressed day-to-day managerial, operational, or financial control. Rather, the reserved powers addressed the right to approve amendments to the JOA or other governing instruments, matters involving the failure of an organization to comply with the terms of the JOA, and two limited exceptions to the global authority of the governing body to direct the provision (or nonprovision) of healthcare services.492 The agreement also provided significant default provisions, including a notice and cure period, but did not provide a method under which entities could, without action on the part of the other entities, withdraw from the system.493 Relying on Geisinger, Rev. Rul. 77-72, and an evaluation of the facts and circumstances (which resembled closely the checklist described previously),494 the IRS concluded that the JOA served to “bind the [participating entities] under the common control of the [governing body]” in such a way as to demonstrate a relationship “analogous to that of a parent and subsidiary.”495 To qualify for exemption under the “integral part” doctrine, the courts have required a parent and subsidiary relationship, and provision of services that are related to the exempt purpose. In a recent private letter ruling, the IRS concluded that a joint operating agreement that was implemented through an LLC effectively binds the members in a relationship “analogous to that of a parent and subsidiary.” Therefore, the services provided between the previously unrelated organizations would not be subject to UBIT. Among the facts that the IRS deemed important to the conclusion are the amount of authority the participating entities ceded to the LLC to establish budgets; to make major expenditures, contracts, and managed care agreements; to direct the provision of neonatal intensive care services; to provide for dispute resolution; and to monitor compliance with its directives. The governing body meets regularly to exercise responsibility for day-to-day and long-range management decisions.496 (d)
Intermediate Sanctions
Revenue Ruling 98-15 did not specifically address the issue of intermediate sanctions. Although intermediate sanctions are of less concern in JOAs than in joint
492
493 494
495
496
Id. at [17]. One hospital retained the right to approve any plan that would eliminate its ability to provide primary and secondary acute care to its surrounding community from its existing facility. A second hospital reserved the right to approve any plan that would have the effect of eliminating its tertiary care cardiology or oncology programs at a single facility. Id. See id. at [19]–[21]. In this ruling the JOA included all of the factors on the checklist; however, in a case in which the “significant” factors are present, and the facts and circumstances otherwise demonstrate substantial financial, operational, and managerial integration, a JOA could likely provide for more reserved powers (or somewhat less centralization of control over operational issues) and still obtain a favorable ruling. Checklist at [39]. The most important factors were the vesting of total financial and budgetary authority in the governing body, the ability of the parent to direct the participating entity’s healthcare services and to monitor and audit the subsidiaries’ compliance with its directives, and the regularity and extent to which the governing body participated in the active management of the system’s affairs. Id. Priv. Ltr. Rul. 200044040 (Aug. 3, 2000), 2000 WL 33122062.
䡲
601
䡲
c12.fm Page 602 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
ventures because there is no mixing of assets, where overvaluation of a practice acquisition occurs, the IRS may apply the intermediate sanction provisions. (e)
Conclusion
Joint operating agreements, if properly structured, can provide a means through which exempt healthcare organizations can adequately respond to the pressures generated by the new managed care environment. Although a JOA will not typically provide immediate financial benefits as compared with a whole hospital joint venture, the JOA raises far fewer exemption and public support issues, yet results in many of the financial and practical advantages of an actual merger with a forprofit entity, including economies of scale and the streamlining of operations through the elimination of excess capacity and duplicative services. Furthermore, the use of JOAs encourages the continued provision of charity care and the operation of institutions that are responsive to the needs of their individual communities.
12.8
UBIT IMPLICATIONS OF HOSPITAL JOINT VENTURES
This chapter has focused on healthcare joint venture arrangements and the potential for loss of the hospital’s exempt status. A secondary issue is whether income derived from such joint ventures is unrelated business income.497 The UBIT issues confronting healthcare joint ventures are generally no different than those encountered by any joint venture that has an exempt organization participant.498 Typically, when the IRS rules that participation in a joint venture does not jeopardize exempt status, there is an additional separate inquiry as to whether the income from the venture will not be subject to UBIT.499 In view of the IRS position that relatedness of the venture’s activity to the hospital’s exempt function is a basic requirement of the hospital’s continued exemption, it appears unlikely for UBIT and continued tax exemption to coexist in the healthcare joint venture context. However, it has been suggested that Rev. Rul. 98-15 raises the issue of whether income from a venture that fails to satisfy its requirements will be deemed UBIT.500 One type of joint venture subject to close scrutiny is a venture between a hospital and a commercial entity involving the performance of management and 497 498 499
500
See §§511–513. See generally Section 4.5. For a detailed discussion of UBIT implications arising from exempt organizations participating in ventures, see Chapter 8. See Gen. Couns. Mem. 39,732 (May 19, 1988) (ambulatory surgical center); Priv. Ltr. Rul. 8817-039 (Jan. 29, 1988) (same); Priv. Ltr. Rul. 88-33-038 (May 20, 1988) (magnetic resonance image facility); Priv. Ltr. Rul. 82-06-093 (Nov. 10, 1981). The IRS found that distributions from an LLC operating joint rehabilitation facilities for two exempt organizations were income from activities related to the organizations’ charitable purposes and would not generate unrelated business income. Priv. Ltr. Rul. 200102053. A charitable pediatric hospital may convert to condominiums two office towers used primarily by its own physicians without UBIT consequences. The hospital had leased approximately 15 percent of the space to independent pediatric physicians and learned that such leasing might cause all of the space in the office towers to become subject to local property taxes. To minimize the property tax burden, the hospital will contribute the leased offices to a new title holding company. Priv. Ltr. Ruls. 200214035-200214036. See Section 4.2(e)(1).
䡲
602
䡲
c12.fm Page 603 Thursday, March 15, 2007 7:59 PM
12.8 UBIT IMPLICATIONS OF HOSPITAL JOINT VENTURES
other administrative services. In modern healthcare administration, a vast number of hospitals utilize outside ventures or assistance in performing administrative functions such as computerized record keeping databases, record keeping services, billing programs or agencies, and collection services. If the IRS were to argue that such management services are not substantially related to the organization’s exempt purpose, not only could the organization’s tax exemption be jeopardized, but also the income from such a venture could be subject to UBIT.501 It should be noted that under IRC §514(b),502 relatedness to the organization’s exempt purposes would protect rental income from a debt-financed facility or tangible personal property from being subject to UBIT.503 Hence, if substantially all—defined as 85 percent—of the use of any property is related to the exercise or performance of an organization’s exempt purposes, the property will not be treated by the IRS as “debt-financed property.”504 EXAMPLE: Q, an exempt healthcare organization, owns a computer with respect to which there is an outstanding principal indebtedness and which is used by Q in the performance of its exempt purposes. Q sells time for the use of the computer system to Z corporation on occasions when the computer is not in full-time use by Q. Q uses the computer in furtherance of its exempt purposes more than 85 percent of the time it is in use, and Z uses the computer less than 15 percent of the total operating time the computer is in use. Under these circumstances, substantially all the use of the computer is related to the performance of Q’s exempt purposes. Therefore, no portion of the computer is treated as debt-financed property.505 Furthermore, there is a special rule favoring medical offices.506 Property is not debt-financed property if it is real property subject to a lease to a medical clinic and the lease is entered into primarily to further the lessor’s exempt purposes.507 EXAMPLE: EO, an exempt hospital, leases all of its clinic space to an unincorporated association of physicians and surgeons who, by the provisions of the lease, agree to provide all of the hospital’s outpatient medical and surgical services and to train all of the hospital’s residents and interns. Because the lease of the medical 501
502 503
504 505 506 507
See, e.g., Priv. Ltr. Rul. 93-19-044 (May 14, 1993) (administrative joint venture activity is related); Priv. Ltr. Rul. 92-04-048 (Jan. 24, 1992); Priv. Ltr. Rul. 89-01-065 (Oct. 17, 1985) (IRS allows joint venture to provide “management support services” because it “facilitates operations” and improves the system, thereby furthering exempt healthcare purposes); Tech. Adv. Mem. 97-39-001 (June 1, 1996) (exempt hospital’s share of ordinary income from its limited partnership interest in a partnership that engaged in joint purchasing for partners was not unrelated business taxable income because it did not exceed the portion of partnership income attributable to that partner’s own purchases). §514(b)(1)(A)(1). §514(b)(1)(A); Reg. §1.514(b)-l(b)(1)(i). See, e.g., Priv. Ltr. Rul. 97-39-041 (June 30, 1997) and Priv. Ltr. Rul. 97-39-042 (June 30, 1997) (ground lease rents that §501(c)(3) tax-exempt hospital (“H”) receives from §509(a)(3) supporting organization (“O”), and lease rents that O receives from commercial unit tenants will not result in UBTI where, although the property is debt-financed, at least 85 percent of the building will be (1) used by staff physicians and (2) devoted to purposes that are substantially related to H’s purposes). Reg. §1.514(b)-l(b)(1)(ii). This example is based on the factual situation presented in Reg. §1.514(b)-l(b)(1), Example 1. Reg. §1.514(b)-l(c)(1). Id.
䡲
603
䡲
c12.fm Page 604 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
office space furthers EO’s charitable purposes, the rental income received by EO is not treated as unrelated debt-financed income.508 There is also an exception to UBIT for cooperative hospital service organizations that furnish the following specified centralized patient services for the hospital: • Data processing • Purchasing (including the purchasing of insurance on a group basis) • Warehousing • Billing and collection • Food • Clinical services • Industrial engineering • Laboratory • Printing • Communications • Record center • Personnel (including selection, testing, training, and education of person-
nel) services509 Moreover, for UBIT purposes, it is important to distinguish who is and who is not a “patient” of a hospital.510 For example, income from services performed by a PHO511 for the benefit of the hospital participant and its patients is generally considered to be related and not subject to UBIT.512 However, income generated from services provided by the PHO to patients of its physician members does not serve the hospital’s exempt purpose and therefore would be subject to UBIT.513
12.9 (a)
GOVERNMENT SCRUTINY Recent IRS Initiatives
In May 2006, the IRS initiated a “compliance check” concerning charity care, community benefit activities, and compensation provided by tax-exempt hospitals.
508 509 510 511 512 513
This example is based upon the factual situation presented in Reg. §1.514(b)-1(c)(1). §501(e)(1)(A). See Kindell and Sullivan, “Health Care Update,” 1994 (for Fiscal Year 1995) Exempt Organizations CPE Technical Instruction Program Textbook, at 139–41. Rev. Rul. 68-376, 1968-2 C.B. 246 (provides six situations in which individual recipients of services were deemed to be patients). See Section 12.4. See Reg. §1.513-1(b) (pharmaceutical sales to hospital patients not subject to UBIT). See Rev. Ruls. 68-374, -375 and -376, 1968-2 C.B. 242, 245, and 246 (the relationship principle is illustrated with respect to hospital pharmacy sales to patients); Rev. Rul. 78-145, 19781 C.B. 169 (sale of plasma by an exempt blood bank).
䡲
604
䡲
c12.fm Page 605 Thursday, March 15, 2007 7:59 PM
12.9 GOVERNMENT SCRUTINY
The purpose of this initial IRS inquiry project was to spot trends and industry standards before moving forward with further examination of a smaller number of the nonprofit healthcare systems. The Service sent Form 13790 (in questionnaire format) to approximately 600 hospitals, which included questions regarding excessive compensation practices, disqualified persons, governing board composition and expertise and medical research activities, among others. Specifically, Form 13790 contained over 80 substantive questions, with responses to the Form reportedly being voluntary, and in the form of checking the boxes or responding in narrative form. There were no requests for documents. Form 13790 was organized in three main sections: (1) a request for basic information about the organization; (2) 72 questions designed to elicit information about institutional governance and the entity’s community benefit activities; and (3) 9 questions concerning the entity’s compensation policies and practices. The questions regarding community benefit took an expansive view of the definition of community benefit contained in Revenue Ruling 69-545, and covered all of the following areas: • Patients: Demographics and Insurance Coverage • Emergency Room • Board of Directors: Composition and Expertise • Medical Staff Privileges • Medical Research: Funding and Public Access to Results • Professional Medical Education and Training • Uncompensated Care: Treatment of Bad Debts and Treatment of Uncom-
pensated Care • Billing Practices • Community Programs: Immunization, Educational, Medical Screening
The questions regarding compensation practices requested the names and titles of officers, directors, trustees and key employees and their salary and “other compensation” information. In addition, the questions asked about the procedures used by the organization to determine compensation levels for all disqualified persons. These questions built upon information collected by the IRS in a previous compliance initiative relating to executive compensation.514 (b)
Government Scrutiny
In 2006, Senate Finance Committee Chairman Charles Grassley (R-Iowa) urged nonprofit hospitals to increase the level of charity care they provide to the poor and uninsured, noting that in exchange for tax breaks, “[t]he public has a right to expect significant, measurable benefits in return.”515 Although Senator Grassley said he was not anticipating legislation relating to the level of charity care provided by nonprofit hospitals, he did not rule out such legislation.516 Coupled 514 515 516
See Section 12.9(b)(ii) Grassley 9/12/06 SFC Hearing statement. Id.
䡲
605
䡲
c12.fm Page 606 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
with increasing IRS attention to nonprofit hospitals, Senator Grassley has called for standardization in the reporting of charity care, noting that for-profit hospitals are providing the same level of charity care as nonprofits, if not more. (i) Reporting Requirements. The Senate Finance Committee has also focused on the lack of standardization in the reporting on Form 990 of charity care by nonprofit hospitals. Highlighting the differences in how various nonprofits report their charity care, Senator Grassley has stated,” The different yardsticks used makes weighing and considering the charity care and community benefit of different nonprofit hospitals less like comparing apples to oranges as comparing apples to farm tractors.” Notably, both Senators Grassley and Max Baucus (D-Mont) have expressed their support for the guidance for measuring charity care offered by the Catholic Health Association (CHA) in its 2006 Guide for Planning and Reporting Community Benefits. In its guide, CHA charged its members with building a better community benefit infrastructure, using standardized accounting for charity care, and establishing guidelines for what constitutes charity care.517 (ii) Executive Compensation. In addition to urging the nonprofit hospital sector to adopt best practices in delivering and reporting charity care to the needy, the Senate Finance Committee has addressed executive compensation at nonprofit hospitals and the “perks” enjoyed by top-level executives. Executive compensation levels at nonprofit hospitals drew Senator Grassley’s ire: “I’m afraid that if nonprofit hospital boards are focusing so little attention on what they’re paying executives, they’re giving even less attention to how the hospitals are helping the community and the poor. I intend to look at legislative reforms that will make sure the boards are more focused on ensuring fair, just executive compensation at all nonprofits, including hospitals.”518 (c)
Forecast
Following the recent inquiries at the IRS and Congress, a number of changes likely to affect nonprofit hospitals are gaining momentum. Currently, the Internal Revenue Service is crafting a supplement to its IRS Form 990 for the reporting of charity care and community benefits by nonprofit hospitals. Further, Senator Grassley has stated that while he does not currently anticipate the need for federal legislation dealing with charity care requirements for nonprofit hospitals, he would not rule it out in the future. Senator Grassley has also stated that the Committee would develop, as its next task, a white paper on nonprofit hospital charity care. Accordingly, it is unlikely that the Senate Finance Committee will give up on Form 990T certification, given these noted disparities between charitable care provided at charitable versus for-profit healthcare systems. One of the most significant issues is how charitable care standards will be measured when evaluating healthcare joint ventures. Senator Grassley has 517 518
CHA Web site; TNT. SFC Hearing.
䡲
606
䡲
c12.fm Page 607 Thursday, March 15, 2007 7:59 PM
12.10 PRECAUTIONARY STEPS: A ROAD MAP
expressed concern over a trend of healthcare joint ventures that are increasingly limited to “profitable” situations where interested parties view the venture as a means to increase profits without regard to providing indigent care. A related concern is how physicians are being compensated in these “choice” joint ventures and specifically, if the joint venture form easily permits excess benefits to flow to physician partners, and if physicians are more easily poised to take control of the boards of these new partnerships. In the aftermath of these initiatives, the nonprofit hospital sector will likely continue to operate under heightened scrutiny. With revisions likely to IRS Form 990, coupled with the best practices and guidance suggested by Catholic Health Association, which has been praised by Senator Grassley, pressure will only increase on the industry to self-regulate in order to avoid legislative intervention. Although it is not currently expected that the nonprofit status of community hospitals will be jeopardized because of this current focus on community benefit and charity care, it is certain that increased scrutiny will dictate heightened efforts to provide and publicize charitable benefit programs at nonprofit hospitals throughout the country.
12.10
PRECAUTIONARY STEPS: A ROAD MAP
The addition of §4958 to the Code increased the burdens of §501(c)(3) officers, board members, and other foundation managers. To protect against liability for the §4958 penalty taxes, it is crucial that the necessary record keeping requirements be met. This administrative burden is also necessitated by the Antikickback and Stark Statutes,519 as well as cases such as Anclote Psychiatric,520 which demonstrate the exigency of establishing fair market value for a sale or purchase of property. The following is a list521 of policies and procedures that should be followed to minimize the emergence of audit issues: • Organizations should adopt a comprehensive conflict-of-interest policy
containing clear procedures for officers and directors to employ to disclose transactions in which they may have a financial or other conflict of interest. • Organizations should compile a list of all persons who they believe may
be disqualified persons, as well as a list of all entities in which the organization and/or disqualified persons own more than a 35 percent interest. • The governing body should adopt a policy requiring that it review all finan-
cial transactions over a certain amount (e.g. $80,000 in the case of compensation) and a threshold amount for sale, exchange, or lease transactions. • In determining compensation arrangements, the board or committee
should rely on appropriate comparability data and promptly document the basis for the determination. A board or committee member with a conflict of interest must recuse him- or herself from the determination. 519 520 521
See Section 12.4(d). See Section 12.6(b). This list expands upon the list contained in Section 5.5.
䡲
607
䡲
c12.fm Page 608 Thursday, March 15, 2007 7:59 PM
HEALTHCARE ENTITIES IN JOINT VENTURES
• For all compensation arrangements entered into after December 31, 1996,
the board, or a committee of board members, should document the basis for all compensation items. Comparable information according to the guidelines described in Section 5.4(c) should be obtained and retained. • In the event of a sale or exchange of assets of any kind (in excess of the
predetermined dollar amount), the organization should obtain at least one appraisal from an independent qualified professional. • The board must prepare a record of any decision-making process before
the next meeting of the committee or board, which must be approved within a reasonable time thereafter. • The organization must report all compensation, including fringe benefits,
insurance premiums, and indemnification payments, on Form W-2, 1099, or 990 and make sure that the payee understands his or her obligation to report. If compensation is mistakenly omitted, an amended form with the correction must be filed promptly. • The organization should consider including “caps” and guidelines for
awarding incentive bonuses in all compensation contracts. • In revenue-sharing transactions, the organization should ensure to the
extent possible that the disqualified person, which may be a third-party service provider, has no incentive to act contrary to the organization’s exempt purposes. Ideally, a disqualified person should not have significant control over the activities on which his or her compensation is based. • If the disqualified person in a revenue-sharing arrangement does have
control over the revenue-generating activity on which his or her compensation is based, the organization should ensure that proportional benefit is available to the organization whenever the disqualified person increases his or her economic benefit. For example, a third-party provider whose fee is based solely on a fixed percentage of the exempt organization’s gross income ordinarily should be able to increase its economic benefit only in proportion to that of the exempt organization. • The board should not enter into management contracts for longer than
three to five years, should not give the management company the unilateral ability to renew, and should retain the right to terminate the management contract for cause. • Where there is a question as to whether a transaction may constitute an
excess benefit transaction, the board should obtain a written legal opinion that address the facts of the specific situation and the applicable law—it is insufficient if the opinion states only the facts and a legal conclusion. Obtaining such an opinion will preclude a finding that a foundation’s manager (officers, directors, trustees) acted knowingly or willfully, but rather that it is due to reasonable cause even if the transaction is found to constitute an excess benefit. • If an organization believes that it has entered into an excess benefit trans-
action, it should promptly correct the situation by “undoing” the excess 䡲
608
䡲
c12.fm Page 609 Thursday, March 15, 2007 7:59 PM
12.11 CONCLUSION
benefit to the extent possible and taking any additional measures to put the exempt organization in no worse financial position than if the transaction had not occurred, which essentially requires payment of interest beginning with the date of the transaction and ending on the date the transaction is corrected. • The board should report any excess benefit transaction to the IRS as soon
as possible so as to avoid additional taxes. To summarize, nonprofit organizations must focus on establishing adequate policies and procedures, obtaining and retaining comparable data, recording and ratifying the decision-making process, reporting appropriate information, and, where necessary, obtaining opinions of counsel.
12.11
CONCLUSION
For taxpayers and the IRS, the healthcare arena continues to represent the “cutting edge” of exempt organization participation in joint ventures. Not only are these transactions subject to the scrutiny of the IRS and other federal departments and agencies, they are attracting the attention of state officials as well. In fact, the National Association of Attorney Generals issued draft model legislation that would require state attorneys’ general approval of conversions of nonprofit healthcare entities.522 Pursuant to the model statute, which is flexible enough to allow each state to mold it to its legal requirements, entities in a nonprofit conversion would have to give notice and seek approval of the proposed transaction. Issues523 to be examined by the Attorneys General include whether the nonprofit received fair market value, whether the transaction will result in inurement, and whether the proceeds will be used for charitable purposes. In this environment, there is a high premium on obtaining expert advice in planning such transactions.
522 523
“NAAG Issues Model Conversion Guidelines Requiring Notification, Approval of State AG’s,” BNA Health Law Reporter (April 9, 1998). See id.
䡲
609
䡲
c12.fm Page 610 Thursday, March 15, 2007 7:59 PM
A P P E N D I X
1 2 A
Sample Conflicts of Interest Policy* (Revised 1999) A RTICLE I P URPOSE The purpose of the conflicts of interest policy is to protect the Corporation’s interest when it is contemplating entering into a transaction or arrangement that might benefit the private interest of an officer or director of the Corporation. This policy is intended to supplement but not replace any applicable state laws governing conflicts of interest applicable to nonprofit and charitable corporations. A RTICLE II D EFINITIONS 1. Interested Person Any director, principal officer, or member of a committee with boarddelegated powers who has a direct or indirect financial interest, as defined below, is an interested person. If a person is an interested person with respect to any entity in the healthcare system of which the Corporation is a part, he or she is an interested person with respect to all entities in the healthcare system. 2. Financial Interest A person has a financial interest if the person has, directly or indirectly, through business, investment, or family—
*
a.
an ownership or investment interest in any entity with which the Corporation has a transaction or arrangement, or
b.
a compensation arrangement with the Corporation or with any entity or individual with which the Corporation has a transaction or arrangement, or
From Exempt Organizations Continuing Professional Education Instruction Program for FY2000 (1999), Training 4277-051 pp. 48-53 (Rev. 7-1999).
610
c12.fm Page 611 Thursday, March 15, 2007 7:59 PM
SAMPLE CONFLICTS OF INTEREST POLICY
c.
a potential ownership or investment interest in, or compensation arrangement with, any entity or individual with which the Corporation is negotiating a transaction or arrangement.
Compensation includes direct and indirect remuneration as well as gifts or favors that are substantial in nature. A financial interest is not necessarily a conflict of interest. Under Article III, Section 2, a person who has a financial interest may have a conflict of interest only if the appropriate board or committee decides that conflict of interest exists. A RTICLE III P ROCEDURES 1. Duty to Disclose In connection with any actual or possible conflicts of interest, an interested person must disclose the existence of his or her financial interest and must be given the opportunity to disclose all material facts to the directors and members of committees with board-delegated powers considering the proposed transaction or arrangement. 2. Determining Whether a Conflict of Interest Exists After disclosure of the financial interest and all material facts, and after any discussion with the interested person, he/she shall leave the board or committee meeting while the determination of a conflict of interest is discussed and voted on. The remaining board or committee members shall decide if a conflict of interest exists. 3. Procedures for Addressing the Conflict of Interest a.
An interested person may make a presentation at a board or committee meeting, but after such presentation, he/she shall leave the meeting during the discussion of, and the vote on, the transaction or arrangement that results in the conflict of interest.
b.
The chairperson of the board or committee shall, if appropriate, appoint a disinterested person or committee to investigate alternatives to the proposed transaction or arrangement. After exercising due diligence, the board or committee shall determine whether the Corporation can obtain a more advantageous transaction or arrangement with reasonable efforts from a person or entity that would not give rise to a conflict of interest.
c.
d.
If a more advantageous transaction or arrangement is not reasonably attainable under circumstances that would not give rise to a conflict of interest, the board or committee shall determine by a majority vote of the disinterested directors whether the transaction or arrangement is in the Corporation’s best interest and for its own benefit and whether the transaction is fair and reasonable to the Corporation and shall make its decision as to whether to enter into the transaction or arrangement in conformity with such determination. 䡲
611
䡲
c12.fm Page 612 Thursday, March 15, 2007 7:59 PM
SAMPLE CONFLICTS OF INTEREST POLICY
4. Violations of the Conflicts of Interest Policy a.
If the board or committee has reasonable cause to believe that a member has failed to disclose actual or possible conflicts of interest, it shall inform the member of the basis for such belief and afford the member an opportunity to explain the alleged failure to disclose.
b.
If, after hearing the response of the member and making such further investigation as may be warranted in the circumstances, the board or committee determines that the member has in fact failed to disclose an actual or possible conflict of interest, it shall take appropriate disciplinary and corrective action.
A RTICLE IV R ECORDS OF P ROCEEDINGS The minutes of the board and all committees with board-delegated powers shall contain— 1. The names of the persons who disclosed or otherwise were found to have a financial interest in connection with an actual or possible conflict of interest, the nature of the financial interest, any action taken to determine whether a conflict of interest was present, and the board’s or committee’s decision as to whether a conflict of interest in fact existed. 2. The names of the persons who were present for discussions and votes relating to the transaction or arrangement, the content of the discussion, including any alternatives to the proposed transaction or arrangement, and a record of any votes taken in connection therewith. A RTICLE V C OMPENSATION 1. A voting member of the board of directors who receives compensation, directly or indirectly, from the Corporation for services is precluded from voting on matters pertaining to that member’s compensation. 2. A physician who is a voting member of the board of directors and receives compensation, directly or indirectly, from the Corporation for services is precluded from discussing and voting on matters pertaining to that member’s and other physicians’ compensation. No physician or physician director, either individually or collectively, is prohibited from providing information to the board of directors regarding physician compensation. 3. A voting member of any committee whose jurisdiction includes compensation matters and who receives compensation, directly or indirectly, from the Corporation for services is precluded from voting on matters pertaining to that member’s compensation. 4. Physicians who receive compensation, directly or indirectly, from the Corporation, whether as employees or independent contractors, are precluded from 䡲
612
䡲
c12.fm Page 613 Thursday, March 15, 2007 7:59 PM
SAMPLE CONFLICTS OF INTEREST POLICY
membership on any committee whose jurisdiction includes compensation matters. No physician, either individually or collectively, is prohibited from providing information to any committee regarding physician compensation. A RTICLE VI A NNUAL S TATEMENTS Each director, principal officer, and member of a committee with board-delegated powers shall annually sign a statement which affirms that such person— a.
has received a copy of the conflicts of interest policy,
b. c.
has read and understands the policy, has agreed to comply with the policy, and
d.
understands that the Corporation is a charitable organization and that in order to maintain its federal tax exemption it must engage primarily in activities which accomplish one or more of its taxexempt purposes.
A RTICLE VII P ERIODIC R EVIEWS To ensure that the Corporation operates in a manner consistent with its charitable purposes and that it does not engage in activities that could jeopardize its status as an organization exempt from federal income tax, periodic reviews shall be conducted. The periodic reviews shall, at a minimum, include the following subjects: a.
Whether compensation arrangements and benefits are reasonable and are the result of arm’s-length bargaining.
b.
Whether acquisitions of physician practices and other provider services result in inurement or impermissible private benefit. Whether partnership and joint venture arrangements and arrangements with management service organizations and physician hospital organizations conform to written policies, are properly recorded, reflect reasonable payments for goods and services, further the Corporation’s charitable purposes, and do not result in inurement or impermissible private benefit.
c.
d.
Whether agreements to provide health care and agreements with other healthcare providers, employees, and third-party payors further the corporation’s charitable purposes and do not result in inurement or impermissible private benefit.
A RTICLE VIII U SE OF O UTSIDE E XPERTS In conducting the periodic reviews provided for in Article VII, the Corporation may, but need not, use outside advisors. If outside experts are used their use shall not relieve the board of its responsibility for ensuring that periodic reviews are conducted.
䡲
613
䡲
c13.fm Page 614 Thursday, March 15, 2007 10:44 AM
C H A P T E R
T H I R T E E N 13
Low-Income Housing New Markets, Rehabilitation, and Other Tax Credits Programs 13.1
(a)
RELATIONSHIPS BETWEEN NONPROFITS AND FOR-PROFITS IN AFFORDABLE HOUSING - A BASIC BUSINESS TYPOLOGY 1 Business Relationships
Business relationship between tax-exempt organizations and or-profits in affordable housing can be as diverse as those between for-profit businesses, subject to a variety of IRS limitations on partnerships and management contracts. Moreover, the motivations of the parties may vary dramatically from deal to deal. CAVEAT Smaller nonprofits may not have the skill set or balance sheet to develop or operate a property and provide investor guarantees. Even sophisticated nonprofits, like their for-profit counterparts, may lack expertise, staffing, or critical mass in particular geographic area or property types and may want to enter into a relationship with a for-profit for an interim period or over the long term. For-profits may need or seek nonprofit involvement in properties they are developing in order to have access to political support, low income tax credit allocation set-asides, property tax exemptions or abatements, or other special benefits accorded to nonprofits. Listed below are a few of the ways these deals are commonly structured:
1
The materials discussed in this subsection were developed by William C. Kelly, Jr., a noted authority in the LIHTC field, who is presently at Stewards of Affordable Housing for the Future (SAHF).
䡲
614 䡲
c13.fm Page 615 Thursday, March 15, 2007 10:44 AM
13.1 RELATIONSHIPS BETWEEN NONPROFITS AND FOR-PROFITS IN AFFORDABLE
(b)
Joint Nonprofit/For-Profit Ownership Formats FIRST FORMAT
A nonprofit may control a development or acquisition opportunity and serve as the sole general partner.* This is the conventional tax structure as discussed in this chapter. *
For simplicity, this typology will use partnership terminology, but applies equally to limited liability companies.
SECOND FORMAT As a variation on the first format, a for-profit may control the opportunity and attract out a nonprofit to serve as a sole general partner to gain access to nonprofit benefits. In this second format, a nonprofit may control a development or acquisition opportunity and seek out a for-profit to participate in the ownership structure, often to gain access to the for-profits’ skills and balance sheet. The for-profit and the nonprofit may each be general partners or managing members, and the respective rights and duties are assigned in the governing documents, again subject to IRS limitation. One or more passive investor for-profits are typically limited partners. As a variation on this second format, and perhaps more commonly, a for-profit may control the opportunity and seek out a nonprofit to serve as a co-general partner and gain access to nonprofit benefits or otherwise. (c)
Principal Forms of Contractual Arrangements
A partnership with a sole nonprofit general partner may control a development or acquisition/rehabilitation opportunity and retain a for-profit developer to handle the new construction or rehabilitation or to serve as a co-developer. As an alternative, the nonprofit may admit for-profit general partners and jointly control a development or acquisition/rehabilitation opportunity. The entity may then retain a for-profit developer to handle the rehabilitation or the nonprofit and the for-profit may serve as co-developers. CAVEAT A partnership with a sole nonprofit general partner may retain a for-profit property manager to manage it while the nonprofit builds expertise and expands its charitable activities. Finally, a nonprofit may own a property outright and retain a for-profit developer or property manager to handle rehabilitation and/or property management. There are many additional variations on these formats, and often, there may be multiple combinations with for-profit participation, as in co-general partner, contract developer, and property manager roles. 䡲
615
䡲
c13.fm Page 616 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
CAVEAT To avoid or minimize the constraint imposed on deal structuring by IRS limitations (the primary subject of this chapter), and where the involvement of an exempt organization confers no special benefits, an exempt organization may form: (1) a wholly controlled state law nonprofit that does not obtain a federal tax exemption and is thus subject to tax or, (2) a for-profit subsidiary. The resulting controlled, special-purpose entity can then enter into some or all of the business relationships with the for-profit(s). This chapter analyzes the provision of the low-income housing tax credit, with special emphasis on how the credit is utilized by tax-exempt organizations. The chapter also reviews the provisions of the historic investment tax credit and new markets tax credit. Finally, this chapter considers the use of the empowerment zone tax incentives and their application joint ventures involving tax-exempt organizations.
13.2 (a)
LOW-INCOME HOUSING TAX CREDIT Overview
Prior to the Tax Reform Act of 1986 (TRA 1986), the primary tax incentives for low-income housing were tax-exempt bond financing, accelerated depreciation, five-year amortization of rehabilitation expenditures under Internal Revenue Code (IRC) §167, and special deductions for construction period interest and taxes.2 TRA 1986 repealed or reduced these incentives and replaced them with the low-income housing tax credit, an incentive that Congress believed would provide a more efficient and better-coordinated program for encouraging the production of low-income housing.3 Congress initially enacted the low-income housing tax credit on a temporary basis through 1989. However, after several temporary extensions, Congress permanently extended the credit as part of the Revenue Reconciliation Act of 1993.4 The omnibus spending bill that President Clinton signed on December 21, 2000, contained a number of provisions amending and expanding the use of tax credits for housing and community revitalization; these provisions are collectively referred to as the Community Renewal Tax Relief Act of 2000 (CRTR 2000).5 The CRTR 2000 authorized $25 billion in various tax incentives to encourage new construction and renovation of residential and commercial real estate in economically distressed areas. Among other provisions, it increased the per
2 3 4
5
General Explanation of the Tax Reform Act of 1986, 152 (hereinafter referred to as the “Blue Book”). See id. See §13142 of the 1993 Act. Congress believes that the low-income housing tax credit is a useful incentive for increasing the stock of affordable housing available to low-income individuals. Reg. §§1.42-6 and 1.42-8 through 1.42-12 became effective on May 2, 1994. These regulations made obsolete prior IRS guidance provided in Notice 89-1, 1989-1 C.B. 620 and Notice 89-6, 1989-1 C.B. 625. See Notice 94-60, 1994-1 C.B. 371. Pub. L. No. 106–554. See also the summary of provisions prepared by the staff of the Joint Committee on Taxation, JCX-112-00 (Dec. 15, 2000).
䡲
616
䡲
c13.fm Page 617 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
capita allocation of low-income housing credits, established a minimum allocation for small states, increased the number of empowerment zones and the incentives available to businesses in them, established a new category of “renewal communities” that are eligible for various kinds of tax relief, and created a “new markets tax credit” to encourage investment of venture capital in small businesses located in low- and moderate-income communities. The Treasury Department has issued final regulations regarding the new markets tax credit program.6 (b)
Introduction to the Low-Income Housing Tax Credit
The provisions of the (LIHTC) are contained in IRC §42. The LIHTC may be claimed by owners of residential buildings used for low-income housing. The credit may be claimed annually for a period of 10 years, known as the “credit period,” which commences with the first year in which the property is placed in service or, at the owner’s election, in the succeeding year.7 The amount of the credit is based on the amount of qualified construction or rehabilitation expenditures for the project and the portion of the project occupied by low-income tenants. (c)
Utilization of the LIHTC by Tax-Exempt Organizations
Most of the low-income housing developed by tax-exempt organizations is financed in part with the LIHTC.8 Because nonprofit organizations are tax-exempt and do not usually owe tax, the LIHTC is of little use to them. However, a nonprofit can “sell” the credits to a for-profit investor, who can use the credits to offset his or her tax liability. This is done by syndicating the project—that is, by selling an ownership interest in the project to the investor.
6 7
8
Reg. §1.45D-1. §42(f)(1). CAVEAT: The Internal Revenue Service has issued Final Regulations (TD9228) that require an owner of a qualified low-income housing building to file Form 8609, Low Income Housing Credit Allocation Certification, only once, rather than annually over each of the 15 taxable years of the compliance period. The state or local housing agency grants a credit allocation, and Form 8609 is filed with the IRS to attest to the allocation. Charitable organizations that are interested in developing low-income housing should familiarize themselves with Rev. Proc. 96-32, 1996-1 C.B. 717, which sets forth a safe harbor under which organizations that provide low-income housing will be considered charitable under §501(c)(3) because they relieve the poor and distressed as described in Reg. §501(c)(3)1(d)(2). Revenue Procedure 96-32 also sets forth a facts and circumstances test that applies to determine whether organizations that fall outside the safe harbor sufficiently relieve the poor and distressed so that they will be considered §501(c)(3) charitable organizations. The Revenue Procedure also clarifies that housing organizations may rely on other charitable purposes to qualify as §501(c)(3) exempt organizations. Charitable organizations should also familiarize themselves with the IRS’s 1995 Safe Harbor Guidelines set forth in Announcement 95-37, 1995-20 I.R.B. 18, which provide guidance to IRS agents in determining whether an organization’s low-income housing activities serve a charitable purpose. See Section 15.6 for a discussion of these guidelines. See also Housing Pioneers, Inc. v. Commissioner, discussed in detail in Section 4.2(d).
䡲
617
䡲
c13.fm Page 618 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
CAVEAT Because of the IRS restrictions on nonprofits making guarantees to investors, an exempt organization may choose to develop the project (without an investor acquiring LIHTC) solely with financing from the bank. This structure would allow the exempt organization to make conventional guarantees directly to the lender that otherwise would be problematic to the IRS. Likewise, the exempt organization may be able to “bifurcate” and restructure an equity arrangement with the for-profit investor, so that the investor lends a portion of the funds to the exempt organization with guarantees that would otherwise be prohibited. The balance would be treated as equity in consideration for the LIHTC. Both individuals and corporations can use the tax credits to offset their tax liabilities. However, the passive loss rules severely restrict both individuals and closely held C corporations9 from using losses and tax credits generated by passive activities. 10 Taxpayers subject to the passive loss rules are permitted to deduct passive losses only against passive income and to claim passive credits only against tax liabilities allocable to passive activities. The passive loss rules require a person to be a “material participant” in a business, as opposed to a passive investor, in order to use losses and credits from that business to offset income from other non passive activities. Generally, a material participant is one who is involved in the business on a regular, continuous, and substantial basis.11 Rental activity is considered to be passive regardless of whether a person is a material participant.12 In addition, a limited partner in a partnership is almost always deemed to be a passive investor.13 An exception to the passive loss rules allows a limited amount of passive losses from rental real estate activities to offset nonpassive income. An individual is permitted to use passive losses from rental real estate activities in which he or she actively participates, to offset up to $25,000 of nonpassive income.14 As a general rule, an individual taxpayer’s ability to use such passive losses to offset nonpassive income is phased out as the taxpayer ’s income increases from $100,000 to $150,000. For a complete discussion of guidance recently released by the IRS regarding exempt organizations’ participation in LIHTC transactions, see Section 13.7 With respect to tax credits, the $25,000 ceiling is applied in a deduction equivalent sense. The maximum amount of allowable credits is determined by 9 10
11 12 13 14
A closely held C corporation is a corporation in which 50 percent of the value of the corporation’s outstanding stock is owned by five or fewer individuals. §469(j)(1)(A). The 1993 Act added an exception to the passive loss rules applicable to individuals and closely held C corporations that are engaged in a real property trade or business. Thus, for an individual taxpayer, if he or she expends one-half of all personal services during the year in a real property trade or business in which he or she materially participates and spends more than 750 hours of personal services in such trade or business, then the rental activity is not deemed passive. §469(c)(7)(B) as amended by §13143(a) of the 1993 Act. For closely held C corporations, the rental activity is not passive if more than 50 percent of gross receipts are derived from a real property trade or business in which the corporation materially participates. §469(c)(7)(D) as amended by §13143(a) of the 1993 Act. §469(h)(1). §469(c)(2). §469(h)(2). §469(i).
䡲
618
䡲
c13.fm Page 619 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
computing the amount of credits needed to provide the same tax benefit as the maximum amount of allowable deductions. Therefore, in the case of a person whose marginal tax rate is 36 percent, the limitation on credits (before any phaseout) is $9,000 (.36 × $25,000). Active participation is not required with respect to the low-income housing and historic rehabilitation tax credits.15 In addition, the phaseout does not apply to the LIHTC,16 §469(i)(3)(D), and applies to the historic rehabilitation tax credit only if the individual’s adjusted gross income is more than $200,000.17 In addition to the limitations imposed by the passive loss rules, the use of the LIHTC by individuals and closely held C corporations is further restricted by the atrisk rules. These rules are discussed in detail in Section 12.2(k). Because widely held C corporations are not subject to the passive loss or atrisk rules, these corporations are the most likely investors in tax credit projects. Corporations may invest in tax credit projects either through a direct investment in a project or through syndicated equity funds. These funds, some of which are sponsored by national tax-exempt organizations such as the Enterprise Foundation and Local Initiatives Support Corporation, have been organized to assist corporations to invest in projects that qualify for the LIHTC. Examples of such funds include the Housing Outreach Fund, Corporate Housing Initiatives, and the California Equity Fund. Corporate equity funds are structured as limited partnerships in which the sponsor or its affiliate is the general partner and the corporate investors are limited partners. The funds invest in limited partnerships that own projects eligible for the LIHTC. These local partnerships acquire, construct, own, and manage the low-income housing projects and are commonly referred to as operating or project partnerships. Operating partnerships that involve tax-exempt organizations generally consist of a local tax-exempt organization or its wholly owned for-profit subsidiary, which serves as general partner, and an equity fund (or a single corporate investor), which is admitted as a limited partner. The equity fund or other investor generally receives a 99 percent interest in partnership profits, losses, deductions, and credits (including the LIHTC) in return for a capital contribution to the partnership. The tax-exempt or wholly owned for-profit subsidiary typically retains a 1 percent general partnership interest.18 15 16 17 18
§469(i)(6)(B). §469(i)(3)(C). §469(i)(3)(B). Subsequent to the enactment of the check-the-box regulations (see Chapter 3 and Section 19.5), the limited partner’s interest in the partnership may be as high as 99.99 percent and the general partner’s interest may be as low as .01 percent. As a result, tax-exempt organizations were able to generate substantial funds in the secondary market by selling as much as 90 percent of their interest (or their for-profit subsidiaries’ interest) as general partner in a partnership or joint venture that utilizes the low-income tax credit (LIHTC). Given the substantial transactional expenses incurred in secondary market transactions, a tax-exempt entity must hold a substantial number of general partner interests to make the secondary market sale feasible. Banks were encouraged to invest in low-income housing to meet federal banking requirements. Thus, a secondary market had been created, allowing the tax-exempt parent to sell interests in the partnership to raise new equity. The reduction in the size of the general partner’s interest because of the check-the-box rules reduces the possibility of selling a tax-exempt entity’s general partner interests on the secondary market in the future.
䡲
619
䡲
c13.fm Page 620 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
The equity investor typically contributes its capital to the operating partnership in several installments, subject to certain conditions. Depending on the relative amount of each installment and the number of installments, the operating partnership may have to obtain a “bridge loan” to finance the costs of construction or rehabilitation of the project pending receipt of the investor’s equity contributions. Often, such a bridge loan is repaid with the investor’s subsequent equity contributions. Provided that the guarantees given by the tax-exempt entity do not raise an impermissible private benefit issue,19 an organization will not adversely affect its exempt status by acquiring a general partnership interest in a partnership that will develop and own an LIHTC project. Moreover, income derived from participation in the partnership and the development and operation of the project will not constitute unrelated trade or business income.20 In certain cases, the operating partnership may grant the tax-exempt organization or an affiliate a right of first refusal to buy the property, following a 15year period known as the compliance period. 21 IRC §42(i)(7) provides that a qualified low-income building will remain eligible for the LIHTC if the owner of the building grants the tenants, a nonprofit organization, a tenant cooperative, or a resident nonprofit corporation a right of first refusal to purchase the project after the end of the compliance period for a price not less than the minimum purchase price set forth in §42(i)(7)(B). The minimum purchase price is equal to the lesser of fair market value or the sum of the outstanding indebtedness on the project plus any taxes attributable to the sale. In some cases investors may demand a higher price that includes the amount of anticipated tax benefits that the investor did not receive during the compliance period. In any event, if the fair market value of the project exceeds the sales price to the nonprofit, the investor may be entitled to a charitable contribution deduction.22 Notwithstanding the ability to grant a right of first refusal, the LIHTC LPs and LLCs must also comply with the rules governing the tax treatment of such entities generally. Specifically, tax laws prevent 501(c)(3) general partners from including a provision in the partnership agreement “requiring” investors to donate their partnership interests at the end of the 15-year compliance period.23 19 20 21 22
23
See April 2006 IRS Guidance re LIHTC Partnerships Section 13.6 Priv. Ltr. Rul. 97-36-039 (Sept. 5, 1997). See Section 12.2(e) for a discussion of the requirements that a project must satisfy during the compliance period. See Sections 3.11(e) and (f) for a more detailed discussion of the “bargain-sale” rules that would apply to the charitable disposition of a low-income housing project. A bargain sale of property is treated, in part, as a charitable contribution and, in part, as a sale or exchange of property. The taxpayer generally receives a charitable contribution deduction in an amount equal to the excess of the fair market value of the property over the purchase price (i.e., the assumed mortgage plus any cash received); the gain or loss from the sale is equal to the purchase price less an allocable portion of the adjusted basis of the property. This allocable portion is equal to the portion of the adjusted basis that bears the same ratio to the adjusted basis of the property as the purchase price bears to the fair market value of the property. The balance of the adjusted basis is allocated to the gift part of the transaction. §1011(b); Reg. §1.1011-2(b). A taxpayer generally recognizes no gain or loss on a gift of appreciated property. Thus, the taxpayer in a bargain sale ordinarily recognizes no gain or loss on the charitable contribution, regardless of the fact that the fair market value of the gift is greater or less than the portion of the property’s adjusted basis allocable to the gift. See Rul. 60-370, 1960-2 C.B. 203. Celia Roady and Michael I. Sanders, Letter to Mr. Joseph Chasin, Branch Chief, Office of TE/ GE, Internal Revenue Service, dated July 7, 2004 (on file with the author).
䡲
620
䡲
c13.fm Page 621 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
This restriction on partnership interest donations is a construct of traditional partnership law, which provides that the tax benefits, such as credits (including the LIHTC) and deductions, associated with an asset owned by an LP or LLC are limited to the true “owner” of the property.24 The true “owner” is determined by an analysis of the facts and circumstances surrounding the assumption of benefits and burdens of ownership.25 There are several factors to consider in this determination. These factors include: • Whether legal title passes; • The manner in which the parties treat the transaction; • Whether the purchaser acquired equity in the property; • Whether the purchaser bears the risk of loss or damage to the property;
and • Whether the purchaser will receive any benefit from the operation or dis-
position of the property.26 If the for-profit partner was required, as a condition of the investment, to donate his share in the housing to the exempt partner at the end of the 15-year compliance period, he may not be considered the true “owner” of the property. Consequently, he would jeopardize his right to receive the LIHTC because he would have little risk of loss or damage to the property, he could not receive any benefit from the disposition of the property, and he would have no equity in the property. Similarly, granting a below-market purchase option to a tax-exempt partner would impede the for-profit partner from assuming the benefits and burdens of ownership and would risk the availability of the LIHTC. (i) Other Sources of Financing Used With the LIHTC. An investor’s equity, by itself, does not provide sufficient funds for a tax-exempt organization to acquire, construct, and develop a low-income housing project. Other sources of financing must be obtained. In most cases the additional financing will consist of a first mortgage loan and one or more “soft” mortgage loans that are subordinate to the first mortgage loan. The first mortgage loan is generally provided by a commercial lender or a state or local agency and in some cases is financed with the proceeds of tax-exempt bonds. This loan generally carries a market rate of interest and is repayable monthly out of the rental income of the project. The term of the first mortgage loan typically varies from 15 to 30 years. Soft mortgage loans generally bear a below-market rate of interest that is repayable only to the extent of available cash flow. The principal amount of these loans, together with any accrued and unpaid interest, is not due for at least 15 years. The soft mortgage loans are provided by state or local agencies or by one of the federal housing programs. Such federal housing programs include the Department of Housing and Urban Development’s (HUD) Community 24 25 26
Id. See Reg. §1.704-1(b)(2)(ii)(a). Celia Roady and Michael I. Sanders, Letter to Mr. Joseph Chasin, Branch Chief, Office of TE/ GE, Internal Revenue Service, dated July 7, 2004 (on file with the author).
䡲
621
䡲
c13.fm Page 622 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
Development Block Grant Program, HOME Investment Partnerships Program, HOPE VI Public Housing Revitalization Program, and the Federal Home Loan Bank’s Affordable Housing Program. The Community Development Block Grant (CDBG) Program provides communities with a source of financing for housing rehabilitation, economic development, and large-scale physical development projects. The program’s funds may be used for acquisition; rehabilitation; related relocation, clearance, and site improvements; and debt service reserves. 27 To qualify under the CDBG Program, a project must principally benefit low-income and moderate-income persons or meet other urgent community development needs.28 The HOME Investment Partnerships Program was enacted in 1990 to provide grants to states and localities for housing assistance programs, which include new construction, rehabilitation, and rental assistance.29 At least 15 percent of a jurisdiction’s funds must be set aside for housing sponsored by “community housing development organizations” (CHDOs). CHDOs are tax-exempt organizations formed for the purpose of providing decent housing to lowincome and moderate-income families. A CHDO may not be affiliated with a for-profit entity and must set aside one-third of its board seats for low-income residents of the community or representatives of low-income neighborhood organizations. In addition, in 1992, Congress established an appropriation of grants to local public housing authorities to “carry out an urban revitalization demonstration program involving major reconstruction of severely distressed or obsolete public housing projects.”30 Popularly known as “HOPE VI,” the program has been amended, with modifications, through successive annual appropriations through fiscal 1999 and by authorization legislation enacted in 1998 that provides for continuing appropriations through fiscal 2002.31 Following the issuance of a legal opinion of the HUD General Counsel in 1994, which confirmed that ownership of “public housing” assisted under the United States Housing Act of 1937 could be held by entities other than public housing authorities, HUD encouraged HOPE VI grantees to “develop solutions which ‘leverage’ HOPE VI funds and use other private or governmental funds in order to create additional affordable and/or market rate housing in which the HOPE VI units may be blended.”32 The concept of privately owned mixed-income residential developments that include units receiving capital and operating assistance through public housing program funds
27 28 29
30 31
32
24 C. F. R. §570.201. 24 C. F. R. §570.200. 42 U.S.C. §12701 et. seq. The discussion in this section of the HOME and AHP programs is based in part on “Low-Income Housing Organizations: Adapting the Rules of the ’70s to the Needs of the ’90s,” by Celia Roady, Esq., Morgan, Lewis & Bockius LLP, Washington, D.C., on file with the author. Departments of Veterans Affairs and Housing and Urban Development, and Independent Agencies Appropriations Act, 1993, Pub. L. 102-389, 106 Stat. 1571, 1579. §24 of United States Housing Act of 1937, 42 U.S.C. 1437v, as amended by §535 of Quality Housing and Work Responsibility Act of 1998, Pub. L. 105–276, 112 Stat. 2461, 2581. In 2003, President Bush signed a bill extending the HOPE VI program for severely distressed public housing through fiscal year 2006. S.811, Pub. L. No. 108–186. Letter to HOPE VI Grantees dated January 9, 1995, from Deputy Assistant Secretary, Office of Distressed and Troubled Housing Recovery.
䡲
622
䡲
c13.fm Page 623 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
was further defined by HUDs publication of an interim rule providing for a “mixed-finance” method of public housing development in May 1996.33 The HOPE VI funds are awarded annually on a competitive basis to local housing authorities, which are encouraged to assemble a team to design, develop, finance, construct, and operate the development34. HUD has favored revitalization proposals that include demolition of existing housing and replacement by lower-density housing of the “New Urbanism” design, a mixture of rental and home ownership opportunities, a broad range of family incomes, and self-sufficiency opportunities for lower-income residents. For the tax-exempt community, HOPE VI opens up additional opportunities in the context of the low-income housing tax credit.35 The Federal Home Loan Bank’s Affordable Housing Program (AHP Program) requires each Federal Home Loan Bank to establish an affordable housing program to subsidize interest rates on loans to eligible borrowers. Eligible borrowers include those who provide affordable rental housing. Tax-exempt borrowers engaged in the purchase or rehabilitation of rental housing are given priority status under the AHP Program. (ii) Construction, Development, and Management of the Project. When a taxexempt organization serves as the sole general partner of the operating partnership, it will maintain control of the project. As general partner, the tax-exempt organization will be responsible for managing the day-to-day operations of the partnership and the project, including developing and managing the project. As developer, the tax-exempt entity will be responsible for hiring the contractor and overseeing the construction or rehabilitation of the project. The exempt organization typically will be required to guarantee the completion of the construction or rehabilitation of the project and to indemnify the investor for any losses incurred for violations of the environmental laws. Tax-exempt entities should structure any guarantee of the amount of LIHTC or other tax benefits to be received by investors carefully, as such a guarantee may inure to the benefit of a private entity. In the event that a tax-exempt entity is a co-general partner with a for-profit entity, the nonprofit entity must ensure that the operation of the partnership will be consistent with its charitable purposes. If the tax-exempt entity does not control the management of the partnership, it may be difficult to guarantee that the tax-exempt entity’s charitable purposes will be met.36 The IRS is concerned that tax credit adjustors, management and construction guarantees, and removal powers in the limited partners are evidence of unequal bargaining power.37 Furthermore, such provisions may take advantage of weak or inexperienced exempt organizations.38 33 34 35 36 37 38
24 CFR Part 941, Subpart F. See, e.g., Super Notice of Funding Availability (SuperNOFA) for Housing and Community Development Programs, 63 Fed. Reg. 15490, 15577 (Mar. 31, 1998). See also Sections 13.2(g) and 13.2(i). See Section 4.2(g); see also Section 12.6(f) for a discussion of terms required to provide a taxexempt general partner or with sufficient control of the management of an operating partnership. Leonard J. Henzke, Jr., Speech at the Western Conference on Tax Exempt Organizations (Nov. 18, 2004). Id.
䡲
623
䡲
c13.fm Page 624 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
CAVEAT The Service is inclined to look more favorably at low-income housing partnerships where one of the partners is a large organization with good finances that has a track record of participating in low-income housing ventures. In these cases, the Service may consider the venture consistent with the organization’s exempt purpose if the tax-exempt partner can show, through experience or an overall explanation of circumstances, that the provisions will not impair the charitable purpose of the joint venture, and will not provide undue private benefit to the for-profit partners, even if the ambiguities in partnership documents evidence the provision of excess benefits to the for-profit partner.* *
Leonard J. Henzke, Jr., Speech at the Western Conference on Tax-Exempt Organizations (Nov. 18, 2004).
In its capacity as developer of the project, the exempt organization acts on behalf of the partnership with respect to various other matters in connection with the development of the project, including obtaining zoning and occupancy permits, appraisals required by lenders and investors, environmental reports, and market studies. In return for these development activities, the tax-exempt entity is typically paid a development fee from the investor’s equity contribution or other project financing.39 The amount of the development fee is usually 10 to 15 percent of the total development cost of the project. In many transactions, some portion of the development fee is deferred and paid to the developer in annual installments from net cash flow of the operating partnership available for distribution. In its capacity as developer of the project, the tax-exempt organization is also responsible for engaging a property manager for the project. In some cases the tax-exempt entity itself acts as property manager if it has the experience and personnel to manage a low-income housing project. Otherwise, a professional management company with experience in managing low-income buildings should be selected. The partnership pays the property manager a fee (typically 5 percent or more of project rents) to manage the project. Therefore, it is beneficial for the tax-exempt organization to develop the expertise necessary to manage the project. (iii) Partnership Allocations and the Impact of the Tax-Exempt Leasing Rules. The partnership agreement between the tax-exempt organization or its wholly owned for-profit subsidiary and the equity investor typically provides that all items of income, gain, loss, deduction, and credit are allocated 99 percent to the investor and 1 percent to the tax-exempt organization.40 In many tax credit partnerships, upon a sale or refinancing of the project, the general partner will be entitled to a 50 percent or more distribution of the sale or refinancing proceeds after certain priority distributions are made. If a tax-exempt organization is the 39 40
The development fee is includable in a project’s eligible basis. See Section 13.2(i) and Section 13.2(m). Subject to the check-the-box regulations, these percentages may be changed to 99.99 and 0.10 percent.
䡲
624
䡲
c13.fm Page 625 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
general partner, a detailed set of rules, known as the tax-exempt leasing rules, will apply to the project. The tax-exempt leasing rules were enacted by Congress as part of the Tax Reform Act of 1984. These rules extend the cost recovery period of property leased to tax-exempt entities and, in certain cases, of property owned by partnerships that have tax-exempt partners. If a partnership has a tax-exempt partner and such partner is allocated partnership items in a “nonqualified allocation,” a portion of the partnership’s property is considered “tax-exempt use property.”41 Property classified as tax-exempt use property must be depreciated under the alternative depreciation system. Under this system, residential real property of the partnership is depreciated using the straight-line method over a 40-year recovery period, as opposed to 27.5 years.42 If depreciable property is owned by a partnership having both a tax-exempt organization and a for-profit entity as partners, an amount equal to the taxexempt partner’s proportionate share of the property is treated as tax-exempt use property unless all allocations of partnership items to the exempt partner are “qualified allocations,” or the exempt organization’s allocable share of property is used predominantly in an unrelated trade or business whose income is subject to tax under IRC §511.43 A qualified allocation of partnership items is any allocation in which a tax-exempt partner is allocated the same distributive share of each item of partnership income, gain, loss, deduction, credit, and basis, and such share remains the same during the entire period the exempt organization is a partner,44 and the allocation has substantial economic effect within the meaning of §704(b)(2).45 If the tax-exempt partner does not receive a qualified allocation, the partnership property will be treated as tax-exempt use property to the extent of the taxexempt partner’s proportionate share of profits and losses.46 A tax-exempt partner’s proportionate share of any depreciable property is determined on the basis of the exempt partner’s share of partnership income or gain, whichever results in the larger share.47 If a tax exempt partner’s share of income and gain varies during the term of the partnership, such partner ’s proportionate share is the highest share of income or gain that it receives. For example, assume a tax-exempt general partner of a low-income housing partnership is entitled to 1 percent of all partnership items of income, gain, loss, deduction, and credit over the life of the partnership, except that the tax-exempt partner is entitled to a 50 percent share of the gain on the sale or refinancing of a project. Under the tax-exempt leasing rules, 50 percent of the project will be considered tax-exempt use property. Therefore, 50 percent of the construction or rehabilitation costs of the project must be depreciated over 40 rather than 27.5 years.
41 42 43 44 45 46 47
§168(h). §168(g)(2). See Chapter 11 for a further discussion of the tax-exempt leasing rules. §168(h)(6)(A). §168(h)(6)(B). See Chapter 3 for a discussion of substantial economic effect. §168(h)(5)(A). §168(h)(6)(C).
䡲
625
䡲
c13.fm Page 626 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
Partnership property is also treated as tax-exempt use property when one of the partners in the partnership is a tax-exempt controlled entity. A tax-exempt controlled entity is a corporation in which 50 percent or more of the stock is held by one or more tax-exempt organizations.48 For purposes of the tax-exempt leasing rules, a tax-exempt controlled entity is treated as a tax-exempt entity. A for-profit subsidiary of a tax-exempt organization can avoid classification as a tax-exempt controlled entity (and thus not be subject to the rules governing tax-exempt use property) if the subsidiary makes an election pursuant to IRC §168(h)(6)(F)(ii). If an election is made, the tax-exempt parent must treat any gain recognized on the disposition of an interest in the for-profit subsidiary (and any interest income received from the subsidiary) as unrelated business taxable income (UBIT) pursuant to IRC §511. Similarly, the tax-exempt parent must treat any dividends received from the for-profit subsidiary as UBIT, but only if such dividends are attributable to income of the for-profit subsidiary that was not subject to tax. Such an election is irrevocable, and the election binds any other tax-exempt entities holding interests in the tax-exempt controlled entity. When forming an operating partnership, a tax-exempt organization must be aware of the impact of the tax-exempt leasing rules. If a portion of the partnership property is classified as tax-exempt use property, the partnership will be required to depreciate the property over an extended period of time, causing a reduction in depreciation deductions during the 15-year compliance period and a corresponding reduction in losses flowing through to the equity investor. For this reason, the equity investor may be unwilling to grant a tax-exempt general partner an increased interest in the project’s sale or refinancing proceeds, because such an increase will not be a qualified allocation and will cause the property to be considered tax-exempt use property. To alleviate this problem, the tax-exempt organization should consider forming a wholly owned for-profit subsidiary to serve as the general partner and making the requisite election under IRC §168(h)(6)(F)(ii). Under this scenario, the general partner may be allocated an increased interest in the project’s sale or refinancing proceeds without the partnership property’s being considered taxexempt use property; however, pursuant to the election, the tax-exempt parent will be required to treat any gain recognized on the disposition of an interest in the general partner (and any interest income or dividend received from the general partner) as UBIT. The nonprofit organization may take roles other than general or managing partner. For example, a community development corporation (CDC) may not have the technical expertise or the staff to manage development of a large-scale low-income housing project, although it has other strengths to bring to a venture.49 Often, the CDC does the preliminary work on a deal and may control or own the site. The CDC understands the neighborhood it serves and the revitalization plan and can shape a deal to make it consistent. It is likely to be familiar with the market for housing, commercial, and retail space, and day care or 48 49
§168(h)(6)(F)(iii). In testing for the ownership of the corporation, a modified version of the attribution rules of §318 apply. Discussion of complementary roles based in part on a November 14, 2000, Memorandum by Greg Maher, Vice President and Deputy General Counsel of LISC.
䡲
626
䡲
c13.fm Page 627 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
healthcare needs. The better the project responds to community needs, the easier it will be to gain community support. In addition, the CDC’s political standing and contacts can help facilitate government approvals and public subsidies. A CDC also may have access to the LIHTCs and can bring public funding from federal, state, and local sources to help subsidize a project, as well as low-interest loans from a source such as LISC. On the other side of the table, a for-profit often has financial strength that can attract conventional financing. The experience of the for-profit in successfully completing projects on time and within budget is another factor that helps to attract conventional financing. The for-profit partner can also provide technical knowledge. Its experience as developer not only benefits the specific project, but may also train the staff of the CDC. Notwithstanding the business reasons for a joint venture, it may be difficult to structure it to meet the strict guidelines of Rev. Rul. 98-15, which mandate that the nonprofit exercise control over the daily operations of the joint venture.50 The for-profit developer may be better equipped to hire and oversee a contractor and conduct the daily business of the venture, for example. However, the venture can and should be structured to meet the spirit of Rev. Rul. 98-15, so that the charitable purpose of the venture will not be subverted, private parties will not receive excessive economic benefits, and assets of the charitable entity will not be exposed to unnecessary risks. Unlike health care, in the low-income housing field significant economic incentives help to maintain the charitable purpose of the venture. If the project shifted to market-rate housing, it could lose the tax credits that make the project worthwhile to investors. It could also mean loss of public subsidies and taxexempt financing. In fact, profit incentives may well be aligned with the charitable purpose of the venture. The for-profit members should be willing to make certain concessions in the structure consistent with the income, affordability, and occupancy restrictions to prove that the charitable purpose is paramount in the operating agreement. The nonprofit should have a right to intervene if the partnership or for-profit general partner does violate one of the fundamental charitable restrictions. The nonprofit must nevertheless guard against impermissible private benefit and inurement. In this regard, “supermajority” or veto power may be sufficient. 51 Close adherence to the process outlined in the final intermediate sanctions regulations will also prevent excess benefit transactions. For example, the contractor should be unrelated to the parties, and the contract negotiated at arm’s length.52 Finally, the nonprofit must protect its assets. It must ensure that developer fees are not paid to the for-profit before they are earned, and should maintain an adequate reserve to fund cost overruns. If capital contributions are needed, they should be assessed against all the parties commensurate with ownership. The nonprofit should carefully structure any guarantees to the for-profit partners 50 51 52
Greg Maher (in conversation Feb. 15, 2001) and the author agree that there are good arguments to apply Rev. Rul. 98-15 differently to ventures in the low-income housing field. See Section 4.2. See Section 5.4.
䡲
627
䡲
c13.fm Page 628 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
relative to the projected LIHTC completion, or environmental indemnification, to insulate its assets.53 (d)
Allocation of Credits
For a building to be eligible for the LIHTC, it must receive an allocation of credits from the credit agency of the state in which the project is located. The aggregate amount of credits that may be allocated by each state is limited by the state’s annual low-income credit authority.54 A state’s credit authority was initially $1.25 per resident. It was raised to $1.50 per capita for the calendar year 2001, to $1.75 per capita for the calendar year 2002, and is adjusted annually for inflation thereafter. The CRTR 2000 also enacted a minimum allocation that guaranteed small states at least $2 million per year, regardless of the population. This minimum was also adjusted for inflation each year, beginning in 2003. Credit allocations are counted against a state’s annual credit authority limitation for the calendar year in which the credits are allocated. Each state must set aside at least 10 percent of its credit authority for projects developed and operated by qualified nonprofit organizations.55 The 10 percent set-aside is only a minimum amount; a state may reserve more than 10 percent of its credit authority for nonprofit projects.56 To qualify for a nonprofit set-aside allocation, an organization must be a §501(c)(3) or §501(c)(4) organization and one of its exempt purposes must be the fostering of low-income housing. The state credit agency must determine that the organization is not affiliated with, or controlled by, a for-profit organization.57 In addition, the nonprofit organization must own an interest in the project and “materially participate” in its development and operation.58 A tax-exempt organization will generally be considered to materially participate if it serves as general partner of a partnership that owns the project and it meets the general tests for material participation set forth in Reg. §1.469-5T.59 If it creates a subsidiary to act as general partner, the nonprofit will be treated as satisfying the ownership and material participation tests if the nonprofit, by itself or together with another qualified nonprofit, owns 100 percent of the stock of the subsidiary. Congress originally intended for credits to be allocated only during the calendar year in which the building was placed in service, except in the case of credits claimed on additions to qualified basis60 and credits allocated in a later 53 54
55 56 57 58 59 60
See Section 6.4B. The requirement to obtain an allocation of LIHTC from the state tax credit agency does not apply to the portion of LIHTC attributable to eligible basis of a building financed with the proceeds of “tax-exempt bonds” (i.e., bonds that pay interest that is exempt from federal income tax under §103 and that are taken into account under the volume cap established by §146). If more than 50% of the eligible basis of a building is financed with the proceeds of such taxexempt bonds, no allocation from the state tax credit agency is required for any portion of the LIHTC. See infra subsection 13.2(d). §42(h)(5)(A). Blue Book, note 1, at 167-68. §42(h)(5)(C)(ii). §42(h)(5)(B). Except as otherwise provided in the regulations, a limited partner is not treated as a material participant. §469(h). See Section 13.2(g).
䡲
628
䡲
c13.fm Page 629 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
year pursuant to an earlier binding commitment made no later than the year in which the building is placed in service.61 However, in 1988, Congress enacted the carryover allocation provisions, which permit credit allocations to be made in one year with respect to buildings placed in service in later years. Under the carryover allocation provisions, an allocation made prior to the year in which a building is placed in service will be valid if (1) the owner’s actual basis in the building at the end of the year in which the credit is allocated (the “carryoverallocation basis”) equals more than 10 percent of the owner ’s reasonably expected basis in the building two years later and (2) the building is placed in service by the end of the second calendar year following the year of the allocation.62 Regulations issued with respect to carryover allocations permit the person or entity that received the carryover allocation to satisfy the 10 percent test without ownership of the land or depreciable real property that is expected to be part of the project. However, there must be evidence of control of the land, such as an option to buy or a contract of sale.63 An owner’s carryover-allocation basis in a project is the owner’s adjusted basis in land or depreciable property that is expected to be part of the project, whether or not these amounts are includable in a project’s eligible basis.64 In general, both direct and indirect costs of acquiring, constructing, and rehabilitating property may be included in an owner’s carryover-allocation basis, including certain costs incurred in acquiring a leasehold interest in property.65 An owner’s carryover-allocation basis is not required to be more than 10 percent of the reasonably expected basis in the project as of the date of the allocation; rather, the owner must meet this test by the later of the close of the calendar year of the allocation or six months after the date of the allocation. Many state allocation agencies require that a project meet the 10 percent test as of the date set forth in the state’s qualified allocation plan, whereas the federal rule requires the 10 percent test to be applied as of the later of December 31 of year in which the allocation is made or six months after the date of the allocation. State allocation agencies are permitted to establish more rigorous standards. EXAMPLE: A tax-exempt organization receives a reservation of credit from the state credit agency in May 2005. As of that date, the organization has not begun construction of the low-income project it plans to build. However, it has owned the land on which it plans to build the project since 1985. Its basis in the land is $100,000. It reasonably expects that by the end of 2007, its basis in the project will be $2,000,000. Prior to November 1, 1993, the tax-exempt organization incurs $150,000 of costs for architect’s fees and site preparation. Its carryover-allocation basis as of November 1, 2005, is $250,000, which exceeds 10 percent of its reasonably expected basis of $2,000,000 in the project. Therefore, the organization 61 62 63
64 65
Blue Book, note 1, at 167. §42(h)(1)(E). Tax-exempt bond-financed projects that qualify for LIHTC without an allocation of LIHTC pursuant to IRC §42(h)(4)(B) are exempt from the 10 percent test. The CRTR 2000 liberalized the 10 percent rule. If an entity receives its credit share in the second half of the year, it now has six months from the date of the allocation in which to incur 10 percent of the cost of the project. Reg. §1.42-6(b)(1). Reg. §1.42-6(b)(1), (2)(i).
䡲
629
䡲
c13.fm Page 630 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
satisfies the 10 percent test for a valid carryover allocation and the state credit agency will issue a carryover allocation at that time; the federal 10 percent test will also be met. A state credit agency may correct an “administrative error or omission” with respect to allocations and record keeping within a reasonable time after the agency discovers the error.66 An “administrative error or omission” is defined in the Treasury Regulations as a mistake that results in a document that inaccurately reflects the intent of the agency at the time the document is originally completed or, if the mistake affects an owner, a document that inaccurately reflects the intent of the agency and the owner at the time the document is originally completed. An administrative error or omission does not include a misinterpretation of the applicable rules and regulations under §42. The prior approval of the IRS is required if the correction is not made before the end of the calendar year of the error or omission and the correction (1) is a numerical change to the credit amount allocated to a building, (2) affects the determination of any component of the state’s housing credit ceiling, or (3) affects the state’s unused housing credit carryover.67 (e)
Tax-Exempt Bond-Financed Project
Projects as to which more than 50 percent of the aggregate basis of the buildings and land are financed with tax-exempt bonds issued under the volume cap of IRC §146 may claim LIHTC without an allocation of credit. Because these projects use federally subsidized financing, the LIHTC is calculated at the 4 percent, as opposed to the 9 percent rate. As competition for allocations of 9 percent LIHTC has increased, more and more projects are qualifying for LIHTC pursuant to IRC §42(h)(4)(B). Projects are required to satisfy the requirement that at least 50 percent of the aggregate basis of buildings and land are financed with the proceeds of tax-exempt bands (the 50% test) both at the time the bonds are issued and at the end of the first year of the credit period, when eligible basis is determined.68 The IRS has taken a very expansive view of the costs that are included in the calculation of a project’s basis for purposes of the 50% test. In Priv. Ltr. Rul. 200035016 (May 30, 2000), the IRS included the cost of personal property and land improvement as part of the “aggregate basis of building and land.” In Priv. Ltr. Rul. 199917046 (April 30, 1999), the IRS concluded that the reduction of basis attributable to historic credits would not reduce the aggregate basis of buildings and land for this purpose. The 50% test does not apply separately on a building-by-building basis and likewise is not separately applied to acquisition versus rehabilitation costs.69 Where a government program requires the redemption of tax-exempt bonds upon placement in service, or where the redemption of tax-exempt construction bonds is economically compelled, the tax-exempt construction bonds may be redeemed at construction completion. 66 67 68 69
Reg. §1.42-13(b). Reg. §1.42-13(b)(3)(iii). Priv. Ltr. Rul. 199912023 (March 26, 1999). Priv. Ltr. Rul. 200035016 (Sept. 1, 2000).
䡲
630
䡲
c13.fm Page 631 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
Otherwise, the bonds should be redeemed after the end of the first year of the credit period.70 Only the portion of the bond proceeds actually expended on buildings and land counts for purposes of the 50 percent. Accordingly, if bond proceeds are spent on bond issuance costs or reserves, neither of which are includable in basis, the portion of the bonds included in the 50 percent test is reduced by the amount so expended. CAVEAT To maximize the amount of bond proceeds considered in the 50 percent test, the bond documents should require that bond proceeds be spent solely on buildings and land, and have noneligible costs funded from other sources. In addition, the owner of LIHTC projects should ensure that the bond proceeds are actually expended in the manner provided in the documents. Regulation §1.42-1T(f)(ii) states that bond proceeds will be allocated to the various costs of a project in accordance with the terms of the bond financing documents. Private Letter Ruling 200022042 (June 2, 2000) treats the earnings on tax-exempt bonds as additional proceeds. (f)
Qualified Low-Income Housing Project
To be eligible for an LIHTC, a building must be part of a qualified low-income housing project. A qualified low-income housing project is residential rental property71 that is rent-restricted and meets a minimum set-aside requirement.72 These requirements must be satisfied throughout a 15-year period, known as the compliance period.73 In addition, the project must be subject to a minimum long-term commitment to low-income housing for an additional 15 years beyond the compliance period (the “extended use period”).74 The project owner must enter into an extended low-income housing agreement with the state credit agency that (1) requires the owner to maintain a minimum number 70 71
72
73 74
Priv. Ltr. Ruls. 200147008 through 200147011 (November 23, 2001) and 200109011 through 200109014. (March 2, 2001). The Code does not define “residential rental property.” For purposes of the LIHTC, residential rental property has the same meaning as used in the Regulations under §103. The furnishing to tenants of services other than housing (whether or not the services are significant) does not prevent the building from qualifying as residential rental property eligible for the LIHTC. Reg. §1.42-11(a). In Rev. Rul. 98-49 (1998-40 I.R.B. 4), the IRS reconciled inconsistent private letter rulings and ruled that the same standards apply in determining whether a project is a residential rental property or a nursing home. Rev. Rul. 98-49 set forth three examples. The determining factor was whether medically certified personnel were available 24 hours per day. If so, the project did not constitute residential rental housing. Further guidance was provided in Priv. Ltr. Rul. 199949044 (Dec. 10, 1999), which permitted regularly scheduled visits by certified medical personnel. Tax payers are urged to consult their tax advisors as to the permitted scope of services that may be provided to tenants. §42(g)(1). To qualify as residential rental property, the units in the project must be suitable for occupancy, used on a nontransient basis, and available to the general public. §42(i)(3)(B); Reg. §1.42-9. Residential rental units that are part of a hospital, nursing home, sanitarium, life care facility, trailer park, or intermediate care facility for the mentally and physically handicapped are not considered for use by the general public and are not eligible for the LIHTC. Reg. §1.42-9. §42(c)(2), §42(i)(1). §42(h)(6).
䡲
631
䡲
c13.fm Page 632 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
of units as low-income housing for the extended use period, (2) allows tenants to enforce the minimum low-income requirement, (3) is binding on all successors of the owner, and (4) is recorded as a restrictive covenant against the property.75 (i) Minimum Set-Aside Requirement. To satisfy the minimum set-aside requirement, a residential rental project must meet one of the following two tests: (1) At least 20 percent of the residential units must be occupied by families having incomes that are 50 percent or less of area median income, or (2) at least 40 percent of the residential units must be occupied by families that have incomes that are 60 percent or less of area median income. The owner must irrevocably elect to meet one of these tests at the time the building is placed in service and comply with this requirement throughout the extended use period.76 The election of either the 20-50 test or the 40-60 test is made on IRS Form 8609, “Low-Income Housing Credit Allocation Certification.” In general, the minimum set-aside requirement must be met by the close of the first year of the credit period.77 Accordingly, if an owner elects the 40-60 test, the building must have at least 40 percent of the units rented to tenants whose income is 60 percent or less of the area median income prior to the end of the taxable year in which the building is placed in service. However, if the owner elects to begin the credit period in the year after the building is placed in service, the building does not have to meet the 40-60 test until the end of that year. Once the minimum set-aside requirement is met, all units occupied by tenants with qualifying income levels count as low-income units for purposes of the credit. The eligible basis attributable to any units that initially qualify as low-income units after the close of the first year of the credit period will be subject to a reduced credit percentage.78 If a tenant’s income increases above the qualifying income level, the unit will continue to be treated as a low-income unit if the tenant’s income level initially qualified and the unit continues to be rent-restricted. 79 If the tenant’s income increases to more than 140 percent of the maximum qualifying income level, the unit will continue to be considered a low-income unit only as long as the next available residential unit of comparable or smaller size is rented to a
75
76 77 78 79
§42(h)(6)(B). An extended low-income housing agreement satisfies the requirements of §42(h)(6) of the Code even if its provisions may be suspended or terminated after the compliance period when a tenant exercises his or her right of first refusal to purchase a low-income building pursuant to §42(i)(7) of the Code. Rev. Rul. 95-49, 1995-2 C.B. 7. See Section 13.2(c) for a discussion of the rules applicable to granting a tenant a right of first refusal. Blue Book, note 1, at 161. §42(g)(3). §42(f)(3)(A); see Section 13.2(h). §42(g)(2)(D)(i). Similarly, a decrease in area median gross income that occurs subsequent to a tenant’s initial occupancy will not cause that tenant to cease to be a low-income tenant. Rev. Rul. 94-57, 1994-2 C.B. 5.
䡲
632
䡲
c13.fm Page 633 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
tenant who satisfies the applicable income requirement.80 Vacant units formerly occupied by low-income tenants will continue to be treated as occupied by qualified low-income tenants, provided that reasonable attempts are made to rent the units and no other comparable units or units smaller in size are rented to nonqualifying individuals.81
80
81
§42(g)(2)(D)(ii). A decrease in area median gross income reduces the income limitation used to calculate whether the next available unit of comparable or smaller size must be rented to a new low-income tenant under §42(g)(2)(D)(ii). This rule is referred to as the “available unit rule.” Effective September 26, 1997, final regulations clarify the treatment of a low-income unit in which the aggregate income of the occupants increases above the 140 percent income limitation, or above the 170 percent income limitation for deep rent skewed projects described in §142(d)(4)(B) (“over-income units”). Generally, an over-income unit will be considered a low-income unit for §42(g)(1) minimum set-aside requirement purposes if the building owner rents all comparable units in the building that are available or that subsequently become available in the same building (not just the next available comparable unit) to qualified (low-income) residents. Once the percentage of low-income units in a building (excluding overincome units) equals the percentage of low-income units on which the credit is based, failure to maintain the over-income units as low-income units has no immediate significance. §42(g)(2)(D)(i); Reg. §1.42-15(b)-(c). If the available unit rule is violated, however, and a comparable available unit is rented to a nonqualified (market rate) resident, all over-income units will cease to qualify as low-income units in meeting the minimum set-aside test. Reg. §1.42-15(c), (f). If several over-income units exist, the violation may cause the qualified basis of the building to be reduced, triggering a credit recapture. The regulations do provide, however, that over-income residents may move to new units within the same building without violating the available unit rule (the newly occupied unit will adopt the status of the newly vacated unit), and that the rules governing the minimum set-aside requirement are to be applied on a building-by-building basis. Reg. §1.42-15(d)-(e). Example: On January 1, a qualified low-income housing project, consisting of one building with 10 identical units, received a credit allocation from the state housing credit agency based upon the utilization of 50 percent of the units as low-income units. Accordingly, to avoid recapture of §42 credits, the owner must maintain at least five low-income units. Units 1–5 are occupied by low-income tenants, units 6–9 are occupied by market rate tenants, and unit 10 is vacant. In November, the tenants in units 1–3 experienced an increase in income that elevated them above the 140 percent limitation, causing their units to become “over-income,” but still considered “low-income” for purposes of meeting the set-aside requirements, provided the available unit rules were met. Later that same month, units 8 and 9 became vacant. In December, the owner rented units 8 and 9 to qualified (low-income) residents, and then rented unit 10 to a market rate resident. Because unit 10 was not leased to a qualified (low-income) resident, units 1–3 ceased to be treated as low-income units for set-aside purposes. Accordingly, the only low-income units for purposes of the §42 minimum set-aside requirement are 4,5,8, and 9, and because the building fails to meet the five low-income unit minimum, the qualified basis in the building is reduced and credit must be recaptured. If the owner had rented unit 10 to a qualified (low-income) resident, eight of the units (1–5 and 8–10) would have counted as “lowincome” for set-aside purposes, and the over-income units could have been rented to market rate tenants without triggering a basis reduction or recapture. Reg. §1.42-15(h), Example 1. Example: A low-income project consists of a six-floor building. The residential units are identical. The building contains two over-income units on the sixth floor and two vacant units on the first floor. The project owner, desiring to maintain the over-income units as low-income units, wants to rent the available units to qualified (low-income) residents. J, a resident of one of the over-income units, wishes to occupy a unit on the first floor. J’s income has recently increased above the applicable income limitation. The project owner permits J to move into one of the units on the first floor. Despite J’s income exceeding the applicable income limitation, J is a qualified resident under the available unit rule because J is a current resident of the building. The unit newly occupied by J becomes an over-income unit under the available unit rule. The unit vacated by J assumes the status the newly occupied unit had immediately before J occupied the unit. The over-income units in the building continue to be treated as low-income units. Reg. §1.42-15(h), Example 2. Blue Book, note 1, at 162.
䡲
633
䡲
c13.fm Page 634 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
EXAMPLE: If the qualifying income level is 50 percent of the area median income, a tenant’s income can rise to as much as 70 percent of the area median income (140% × 50% = 70%) and the unit will still be considered a low-income unit even if the owner rents the next available unit of comparable or smaller size to a tenant who exceeds the qualifying income level. If the tenant’s income rises higher than 70 percent of the area median income, the unit will remain lowincome only if the owner rents the next available unit of comparable or smaller size to a tenant who meets the qualifying income level. (ii) Rent Restriction Requirement. For a housing unit to qualify for the credit, the gross rent paid by the tenant for the housing unit may not exceed 30 percent of the tenant’s qualifying income level described earlier.82 Unlike the qualifying income level that is adjusted for actual family size, the gross rent limitation is based on an imputed family size determined by the number of bedrooms in the unit. A unit that does not have a separate bedroom—a studio apartment—is deemed to house 1 person. A unit that has one or more bedrooms is deemed to house 1.5 individuals per bedroom. EXAMPLE: A unit that contains three bedrooms is deemed to house 4.5 persons. Suppose the owner elects the 20-50 test and that 50 percent of the area median income for a family of 4 is $19,000, and for a family of 5 it is $21,000. Thus, for a deemed family of 4.5, 50 percent of the area median income is $20,000 [($19,000 + $21,000)/2]. The gross rent limitation for this three-bedroom unit is $500 (30% of $20,000) per month, reduced by the applicable utility allowance. Gross rent includes all utilities other than telephone. If any utilities are paid directly by the tenant, the maximum rent that may be paid by the tenant is reduced by a utility allowance calculated as set forth in Treasury Regulation §1.42-10. Amounts that are paid for mandatory services are included in gross rent for purposes of determining the maximum amount of rent that can be charged with respect to a unit. The gross rent limitation applies only to payments made directly by the tenant. Any rental assistance payments made on behalf of the tenant, such as through §8 of the United States Housing Act of 1937 or any comparable federal, state, or local rental assistance payments, are not included in gross rent. As a result, the sum of the rent paid by the tenant plus the rental assistance payments made with respect to the tenant may exceed the maximum §42 rent. EXAMPLE: Assume that the tenant renting the three-bedroom unit in the preceding example receives monthly rental assistance in the form of HUD §8 vouchers in the amount of $1,200 per year. The owner can receive the rental assistance payments and still charge the tenant rent of $6,000 per year for the unit. Any charges to tenants for services other than housing that are not optional generally must be included in the calculation of gross rent. 83 A service is 82 83
§42(g)(2). Reg. §1.42-11(a).
䡲
634
䡲
c13.fm Page 635 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
optional if payment for the service is not required as a condition of occupancy and a practical alternative exists for tenants to obtain the services elsewhere.84 EXAMPLE: Assume that the tenant renting the three-bedroom unit in the preceding example earns $10,000 per year and thus pays rent of $3,000, or $250 per month, and the voucher payment standard is $600 per month. The rental assistance payment would be $350 per month, and the total rent received by the owner would be $7,200 minus the applicable utility allowance. The excess payments do not disqualify the unit. Gross rent does not include fees paid for supportive services to the owner of low-income units by a governmental assistance program or a qualified nonprofit organization if the program includes rental assistance and such rental assistance is not separable from any supportive service assistance.85 “Supportive services” are defined as a planned program of services intended to enable tenants to live independently and avoid placement in a medical care facility.86 (g)
Applicable Credit Percentage
The LIHTC is available during each year of the credit period and is computed by multiplying the “qualified basis” of each qualified low-income building by the “applicable percentage.”87 The applicable percentage depends on the interaction of several factors, which include the following: when a building is placed in service; whether the credit is attributable to acquisition, construction, or rehabilitation expenditures; and the extent of any federal subsidies. The applicable percentages for lowincome housing placed in service after 1987 are prescribed monthly by the Treasury Department in the Internal Revenue Bulletin. The available LIHTC percentages are those in effect for the month in which the building is placed in service or, at the election of the owner, the month in which the owner and the state credit agency enter into a binding commitment with respect to such building as to the credit amount to be allocated to the building.88 EXAMPLE: An owner of a project is issued a carryover allocation of credit in November 1998, binding the state credit agency to reserve tax credits for the project in the annual amount of $100,000. At this time the owner may elect to use the credit percentage in effect in November 1998 by filing the proper form with the state credit agency, which election form must also be executed by the agency. The election is irrevocable. If the owner does not elect to lock into the November 1998 rate, the credit percentage will be determined as of the month the project is placed in service. 84
85 86 87 88
Reg. §1.42-11(b). If continual or frequent nursing, medical, or psychiatric services are provided, the services will not be considered optional and the building will be ineligible for the LIHTC, as is the case with a hospital, nursing home, sanitarium, life care facility, or intermediate care facility for the mentally and physically handicapped. See Reg. §1.42-9(b). §42(g)(2)(B)(iii). See Priv. Ltr. Rul. 95-26-009 (Mar. 27, 1995). Reg. §1.42-11(b)(3)(ii). §42(a). §42(b)(2)(A); Reg. §1.42-8 specifies the time and manner for making a valid election to fix the LIHTC percentage, including elements that must be included in an agreement between an owner and state credit agency for it to be binding.
䡲
635
䡲
c13.fm Page 636 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
For projects placed in service after 1987, the credit percentages are adjusted monthly so that the present value of the credits taken over 10 years will equal 70 percent (the “9 percent credit”) and 30 percent (the “4 percent credit”) of the qualified basis of a project.89 In general, the credit percentages are 9 percent for new construction and substantial rehabilitation expenditures that are not federally subsidized, and 4 percent for acquisition expenditures and construction and substantial rehabilitation expenditures that are federally subsidized.90 The 9 percent credit is available for substantial rehabilitation costs if the expenditures are allocable to one or more low-income units and if the amount of such expenditures incurred within a defined 24-month period prior to the date the building is placed in service equals the greater of (1) 10 percent of the adjusted basis of the building (determined as of the first day of the 24-month period) or (2) the qualified basis attributable to such expenditures, when divided by the number of low-income units in the building, is $3,000 or more.91 Rehabilitation expenditures include those amounts chargeable to a capital account and incurred with respect to depreciable property or improvements in connection with the rehabilitation of a building.92 The 4 percent credit is available for new construction and rehabilitation expenses that are federally subsidized, as well as for the acquisition costs of existing buildings. The 4 percent credit is available for acquisition costs (the “acquisition credit”) only if the property has been acquired by “purchase,” as that term is defined in IRC §179(d)(2). A property will be considered to have been acquired by “purchase” if the seller (1) is not related to the buyer (within the meaning of IRC §267 or §707(b)), (2) the seller and the buyer do not represent component members of a controlled group, and (3) the basis of the acquired property is not a carryover basis. For purposes of the §707(b) related party test, a buyer will be treated as related to a seller if the seller owns, directly or indirectly, more than 10 percent of the capital or profits interest in a partnership.93 EXAMPLE: EO, a tax-exempt organization, acquires a building from an unrelated party. EO later decides to develop the building into a low-income housing project and sells the property to a partnership in which EO is the sole general partner and Investor is the limited partner. If EO’s capital and profits interest in the partnership is 10 percent or less, EO will not be considered a related party for purposes of the “purchase test.” In addition to the “purchase” requirement, in order to be eligible for the 4 percent acquisition credit, at least 10 years must have elapsed from the date the building was last placed in service or the date of the most recent nonqualified substantial improvement to the building, and the building must not have previously been placed in service by the taxpayer or a person related to the taxpayer 89 90 91 92 93
§42(b)(2)(B). For a discussion of what constitutes a federally subsidized project, see Section 13.2(g). §42(e)(3)(A). §42(e)(2)(A). §42(d)(2)(D)(iii)(I); §707(b).
䡲
636
䡲
c13.fm Page 637 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
as of the time previously placed in service.94 For purposes of determining when a building was last placed in service, any placement in service by a qualified nonprofit organization is not taken into account if the 10 year rule is satisfied with respect to the nonprofit organization’s acquisition of the property and all the income from such property is exempt from federal income taxation.95 EXAMPLE: A residential rental housing property was constructed in 1979 by A, an individual. In 1998, the property was purchased by EO, a qualified nonprofit organization, which continued to operate the property as residential rental property. In 2005, Partnership X purchased the property from EO. X would meet the 10-year test because EO met the 10-year test and the placement in service by EO would be disregarded under IRC §42(d)(2)(D)(ii). In addition, property transfers pursuant to a court-ordered restructuring of administrative control of a housing program do not result in a new “placement in service” for 10-year holding period requirement purposes.96 (i) Impact of Check-the-Box Regulations on Credit. Recent changes in the check-the-box regulations have redefined the tenets that characterize or classify a partnership.97 Previously, the IRS required that a general partner of a partnership own at least 1 percent of the partnership in order for it to be classified as a partnership.98 The new check-the-box regulations have eliminated the minimum ownership percentage. Accordingly, it may be advantageous for tax-exempt organizations (or their for-profit subsidiaries) to reduce their partnership interest in certain low-income tax credit partnerships by selling as much as 90 percent of their current holdings, based on current market pricing of their interest, in order to raise funds to be used for charitable purposes. This may, of course, trigger a small amount of recapture for tax credits previously taken by for-profit affiliates, which will have to be reexamined. 94
95 96
97 98
§42(d)(2)(B)(ii). The 10-year requirement of §42(d)(2)(B)(ii) may be waived by the Secretary of the Treasury if such a waiver is necessary to avert risk to federal mortgage funds used to finance the project, such as those provided under §515 of the Housing Act of 1949 or by HUD. §42(d)(6)(A)(i). See Priv. Ltr. Rul. 96-11-012 (Dec. 12, 1995) (10-year requirement waived where a project was federally assisted with a §515 loan, was determined to be a “troubled” project, the §515 loan funds were “at risk,” and a partner sought to acquire and rehabilitate the project to provide low-income housing for the community); Priv. Ltr. Rul. 96-09-014 (Nov. 22, 1995). §42(d)(2)(D)(ii). See Priv. Ltr. Rul. 9735007 (May 27, 1997). A sale or exchange of more than 50 percent of the capital or profits interest in a partnership within a 12-month period will terminate the partnership. In 1997, Treasury revised the regulations under partnership terminations to provide that adjustments to the basis of assets due to purchase and termination of a partnership would be made prior to the deemed contribution of assets to the “new” partnership. Accordingly, the assets transferred to the “new” partnership from the “terminated” partnership would have a carry over basis. The IRS has privately ruled that the change in the §708 regulations will be respected for the purpose of the low-income housing tax credit. In Priv. Ltr. Rul. 200502019 (January 14, 2005), a transfer of a 99 percent interest in a partnership that terminated the partnership for federal income tax purposes after the effective date of the §708 Regulations did not preclude the availability of an acquisition credit. Treas. Reg. §1.708-1(b)(4) provides that the basis of the assets in the hands of the “new partnership” carries over from the basis of the “old” partnership. Accordingly, the transaction qualifies for the exception to the 10-year placed-in-service rule contained in §42(d)(2)(D)(ii)(I). See Sections 3.3 and 19.5 for a complete discussion of the check-the-box regulations. See Rev. Proc. 89-12.
䡲
637
䡲
c13.fm Page 638 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
(h)
Federal Subsidies
A building is federally subsidized for any taxable year if, at any time during the year or earlier taxable year, there is or was outstanding any tax-exempt obligation under IRC §103, or any below-market federal loan, the proceeds of which are or were used directly or indirectly for the building or its operation.99 A below-market federal loan is any loan funded in whole or in part with federal funds if the interest rate payable on the loan is less than the applicable federal rate under IRC §1274(d)(1) as of the date the loan was funded.100 EXAMPLE: A partnership plans to construct a low-income housing project financed in part by a loan from a public housing authority (HA). The HA loan will be funded with the proceeds of a HUD HOPE VI grant to the HA. If HA advances the funds to the partnership at an interest rate below the applicable federal rate, the loan will be treated as a below-market federal loan and the project will be considered to be federally subsidized for purposes of the LIHTC. However, if the HA lends the funds to the partnership at or above the applicable federal rate, the loan will not be treated as a below-market federal loan and the project will not be considered to be federally subsidized. A building will not be considered federally subsidized because of any loan or tax-exempt obligation used to provide construction financing if (1) when made, the loan or obligation identified the building for which the proceeds would be used and (2) the obligation is redeemed or the loan is repaid before the building is placed in service.101 In addition, below-market loans received under the CDBG Program or from the Federal Home Loan Bank’s Affordable Housing Program are not treated as a federal subsidy for purposes of the credit.102 Under the Revenue Reconciliation Act of 1993, buildings funded with below-market loans received under the National Affordable Housing Act of 1990 (HOME funds) are not treated as federally subsidized if 40 percent of such a building’s rental units are occupied by individuals with incomes of 50 percent or less of area median income.103 These buildings, however, are not eligible for an increase in eligible basis that is available for buildings in qualified census tracts and difficult development areas.104 99
100
101 102 103 104
§42(i)(2)(A). The General Explanation of the Tax Reform Act of 1986 provides that the determination of whether rehabilitation expenditures are federally subsidized is made without regard to the source of financing for acquisition of the building for which the rehabilitation expenditures are made. Blue Book, note 1, at 160. However, if a building is collateralized by other federally subsidized property, the rehabilitation expenditures on the building will be deemed to be federally subsidized. Tech. Adv. Mem. 9528002 (Mar. 20, 1995). §42(i)(2)(D). A taxpayer may assume federally subsidized financing that was placed on a project prior to acquisition, so long as it was not part of an integrated financing plan. When tax-exempt bonds are used to acquire a project and taxable bonds are used to finance rehabilitation, as part of an integrated financing plan, the rehabilitation will be treated as federally subsidized. Priv. Ltr. Rul. 200035016 (May 30, 2000). §42(i)(2)(C). §42(i)(2)(D); Reg. §1.42-3. §42(i)(2)(E). See Section 13.2(i). However, projects financed with loans that bear interest at or above the applicable federal rate may be eligible for the 30% increase in eligible basis for buildings located in qualified census tracts or difficult to develop areas, regardless of whether such loans are funded with HOME funds. In such a case, compliance with the “HOME Set-Aside Test” contained in Section 42(i)(2)(E)(i) is not required.
䡲
638
䡲
c13.fm Page 639 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
EXAMPLE: A partnership plans to rehabilitate a low-income housing project financed in part by a CDBG loan from the city. As long as the loan from the city to the partnership is otherwise treated as a loan for federal income tax purposes, the city may lend the funds to the partnership at a below-market interest rate without causing the project to be considered federally subsidized. Funds received under the CDBG program are not treated as a federal subsidy for purposes of the LIHTC. If an owner elects to exclude the principal amount of a below-market federal loan or the proceeds of a tax-exempt obligation from the eligible basis of a building, the loan or obligation is not taken into account in determining whether a building is federally subsidized.105 If an owner makes this election, the owner gives up basis on which the credit is computed in order to avoid the determination that the building is federally subsidized and, therefore, is eligible only for the 4 percent credit. The owner should compute the credit under both circumstances in order to decide whether to make this election. EXAMPLE: A partnership plans to rehabilitate a low-income housing project financed in part by a HOPE VI loan in the amount of $250,000 from the public housing authority (HA).106 The funds will be lent to the partnership at a below-market interest rate, causing the project to be considered federally subsidized for purposes of the LIHTC. The eligible basis of the project, including the expenditures funded with proceeds of the HA loan, is $1,000,000. The partnership expects that 100 percent of the units will be occupied by qualifying low-income tenants. If the partnership does not elect to exclude the expenditures funded by the HA loan from eligible basis, the partnership will be entitled to claim an annual credit of $40,000 ($1,000,000 × 4%). However, if the partnership elects to exclude the expenditures funded by the HA loan from eligible basis, the partnership will be entitled to claim an annual credit of $67,500 ($750,000 × 9%). (i)
Qualified Basis
As discussed in Section 13.2(f), the amount of the LIHTC for each year is equal to the qualified basis of a building multiplied by the applicable credit percentage.107 The qualified basis of a building is the fraction of the building’s eligible basis that is attributable to low-income units.108 A low-income unit is any unit in the building that is both rent-restricted and occupied by individuals meeting the qualified income level under the minimum set-aside requirement.109 In addition, to qualify as a low-income unit, the unit must be suitable for occupancy and used other than on a transient basis (i.e., the initial lease term must be at least six months).110
105 106 107 108 109 110
§42(i)(2)(B). See Section 13.2(c)(i). §42(a). §42(c)(1)(A). §42(i)(3)(A). §42(i)(3)(B). A single-room occupancy (SRO) unit will not be treated as used on a transient basis merely because it is rented on a month-by-month basis. §42(i)(3)(B)(iv).
䡲
639
䡲
c13.fm Page 640 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
The qualified basis of the low-income units is based on the smaller of the “unit fraction” or the “floor space fraction.” With the unit fraction method, the number of low-income units physically occupied in the building is divided by the total number of residential rental units, whether or not occupied.111 In the floor space fraction method, the total floor space of the low-income units physically occupied is divided by the total floor space of the residential rental units, whether or not occupied.112 EXAMPLE: The eligible basis of a building is $1,000,000; 75 percent of the units are occupied by low-income tenants, and the floor space of these low-income units is 70 percent of the total floor space for all units. The qualified basis is $700,000 (the smaller of 75 percent or 70 percent times the eligible basis). Qualified basis is initially determined based on the number of low-income units occupied on the last day of the taxable year in which the building was placed in service or, at the owner’s election, the last day of the following taxable year.113 The initial qualified basis must be maintained throughout the compliance period. A decrease below this amount can result in recapture of the credits.114 After the initial determination, the qualified basis of a building may be increased by an expansion in the number or floor space of occupied low-income units.115 If, after the close of any taxable year in the compliance period (after the first year of the credit period), the qualified basis of a building is more than the qualified basis of the building as of the close of the first year of the credit period, credit may be claimed on such additional qualified basis using a credit percentage equal to two-thirds of the otherwise applicable credit percentage allowable for the initial qualified basis.116 Credits claimed on additions to qualified basis are allowable annually for the rest of the compliance period, regardless of the year of the increase in such basis.117 This is unlike the treatment of credits claimed on the initial qualified basis, which are claimed over the 10-year credit period. EXAMPLE: The eligible basis of a building is $1,000,000. The building is placed in service in January 1993, when the applicable credit percentage is 8.60 percent. On December 31, 1993, 70 percent of the units are occupied by low-income tenants, and the floor space of these low-income units is 75 percent of the total floor space for all units. The qualified basis of the building at the end of the first year of the credit period is $700,000 (the smaller of 70 percent or 75 percent times the eligible basis). The amount of credit that may be claimed in each year after 1993 is $60,200 ($700,000 × 8.60%), plus any increase in qualified basis.118 During 1994 111 112 113 114 115 116 117 118
§42(c)(1)(C). §42(c)(1)(D) §42(c)(1)(A)(i); §42(f)(1). In the initial year of the credit period for a building, qualified basis is calculated separately for each month in the year. §42(j)(1); see Section 13.2(j). Blue Book, note 1, at 156. §42(f)(3)(A). Blue Book, note 1, at 157. In 1993 the amount of credit allowed is the sum of the credit allowable for each month.
䡲
640
䡲
c13.fm Page 641 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
the owner rents the remaining 30 percent of the units to low-income tenants. On December 31, 1994, 100 percent of the units are occupied by low-income tenants, and the floor space of these units is 100 percent of the total floor space for all units. The qualified basis of the building has increased by $300,000 to $1,000,000 (100 percent of the eligible basis). Beginning in 1994 and continuing for the next 14 years of the compliance period, the amount of credit that may be claimed on the increase in qualified basis is 5.73 percent (2/3 × 8.60%) of $300,000, or $17,190. Therefore, the aggregate amount of credit that can be claimed in 1994 is $77,390 ($60,200 17,190). EXAMPLE: Assume the same facts as in the preceding example, except that the owner elects to begin the credit period in 1994, the year after the building is placed in service. In this case, the initial qualified basis is determined as of December 31, 1994, when 100 percent of the units are occupied by low-income tenants. The amount of credit that may be claimed in 1993 is zero (because the credit period has not yet commenced) and in 1994 is $86,000 ($1,000,000 × 8.60%). (j)
Eligible Basis
The eligible basis of a new building is determined at the close of the first taxable year of the credit period.119 The same rate is applicable to the rehabilitation portion of a rehabilitated building. For purposes of the 4 percent acquisition credit, the eligible basis is the portion of the purchase price that is attributable to the building. Eligible basis includes the costs of architectural and general contractor work, environmental studies, construction period interest and taxes, appraisals, surveys, development fees, and certain legal and accounting costs.120 Eligible basis also includes the costs of such amenities as stoves, refrigerators, and air conditioners and the cost of tenant facilities, such as swimming pools and parking, if there is no fee for their use and the facilities are available to all tenants.121 The IRS released five technical advice memoranda (TAMs) (Tech. Adv. Mem. 200043015–200043017 (Oct. 27, 2000); and 200044004–200044005 (Nov. 3, 2000)) that cover the allocation of costs between buildings and land. The TAMs conclude that grading and landscaping costs may be included in the eligible basis only when they are intentionally associated with the building and would have to be redone if the building were rebuilt. The TAMs address the capitalization of construction loan costs and conclude that impact fees and tax fees are not includable in eligible basis. However, a new revenue ruling reverses IRS policy from the TAMs of 2000 and states that impact fees assessed against a developer by a local government are indirect costs that should be capitalized and added to the eligible basis of the building.122 The IRS has informally indicated that the rationale of the ruling applies to all local government fees such as sewer tax and 119 120 121 122
§42(d)(1). IRS Notice 88-116, 1988-2 C. B. 449. Blue Book, note 1, at 157. Rev. Rul. 2002-9, 2002-10 I.R.B. 614.
䡲
641
䡲
c13.fm Page 642 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
zoning fees. Eligible basis does not include the costs of land, permanent loan fees, syndication fees, or legal and accounting fees related to syndication. The CRTR 2000 added a provision to allow, in the adjusted basis, a portion of a lowincome building used to provide a “community service facility,” even if it serves non-residents. This portion may not exceed 10 percent of the eligible basis of the building. The space could be used for such purposes as child care, senior programs, and job training. (i) Exclusion of Federal Grants from Eligible Basis. Subject to limited exceptions, the eligible basis of a building may not include the amount of any federal grant made with respect to the building or the operation thereto during any taxable year of the compliance period, regardless of whether such grant is included in gross income.123 Grants received by a project that are funded indirectly from federal sources are excluded from eligible basis. For example, if a local government uses federal funds to make a grant to a project, the grant is still considered a federal grant for purposes of the LIHTC. Federal grants include Community Development Block Grants and Hope VI Public Housing Revitalization Grants.124 CAVEAT If a project is to receive a federal grant, the grant should be structured so as not to be made directly to the project. If possible, the funds should be granted to a local government entity or the nonprofit sponsor, which can use the grant to make a loan to the project. Then the rules for federal loans, not federal grants, will apply.* If a local government entity or nonprofit lends the funds to the project, the eligible basis of the project does not have to be reduced. Furthermore, if the funds are lent at an interest rate that equals or exceeds the applicable federal rate, the project will not be considered federally subsidized and will qualify for the 9 percent, rather than the 4 percent, credit. However, if the project is already considered federally subsidized by virtue of first mortgage financing funded by tax-exempt bonds, the project will not qualify for the 9 percent credit in any event, so there is no penalty for lending the HOPE VI funds at a rate lower than the applicable federal rate. If the source of the funds is the CDBG program, the loan can be made below the applicable federal rate without the project’s being treated as federally subsidized, because CDBG funds are not treated as a federal subsidy for purposes of the LIHTC.† * †
Priv. Ltr. Rul. 88-13-024 (Dec. 30, 1987). See Section 13.2(g).
123
124
§42(d)(5)(A). Note that the use of Federal Emergency Management Agency (FEMA) grant funds will not serve to reduce the existing eligible basis of a property for purposes of the credit. See Priv. Ltr. Rul. 96-11-010 (Dec. 12, 1995) (use of FEMA grant funds to repair flood-damaged units in a project with carryover low-income housing tax credits does not result in a reduction in existing eligible basis under §42(d)(5). Blue Book, note 1, at 159–160. Reg. §1.42-16 provides that grants made under §8 or §9 of the United States Housing Act of 1937 will not reduce eligible basis. Grants made under the Shelter Plus Care Program (42 U.S.C. 11301, 11403-11407b) and the Assistance for Single-Room Occupancy Dwelling Program (42 U.S.C. 11301, 11401-11402) do not reduce eligible basis. Reg. §1.42-16 provides that the service will specifically identify other programs that will not be treated as a grant for purposes of §42. In Priv. Ltr. Rul. 200519028 (May 13, 2005), the provision of a federal guaranty under the Rural Housing Service §538 loan program did not constitute a federal subsidy.
䡲
642
䡲
c13.fm Page 643 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
A building planned to be rehabilitated that qualifies as a new building will not be treated as federally subsidized merely because a taxpayer assumes an existing project debt that was originally sourced in tax-exempt bond proceeds.125 Moreover, grants or below-market loans that the Federal Emergency Management Agency (FEMA) provides to owners of properties that are damaged by disasters will not reduce such properties’ eligible bases or cause them to be recharacterized as federally subsidized.126 (ii) Increase in Eligible Basis for High-Cost Areas. The eligible basis of a new building or a substantially rehabilitated existing building located in a “qualified census tract” or a “difficult development area” is considered to be 130 percent of the basis in the building.127 A qualified census tract is a census tract designated by the Secretary of Housing and Urban Development (HUD) in which, according to the most recent year’s available census data, 50 percent or more of the households have an income less than 60 percent of the area median gross income for that year.128 A difficult to develop area is a locality designated by the Secretary of HUD that has high construction, land, or utility costs relative to area median gross income. (k)
Recapture of the Credit
Although the LIHTC is claimed over a 10-year period, the owner must comply with the LIHTC requirements for the 15-year compliance period. If any building fails to remain part of a qualified low-income project because of noncompliance 125 126
127
128
Priv. Ltr. Rul. 96-01-005 (Jan. 5, 1996). Rev. Rul. 96-35, 1996-31 I.R.B. 4. Under temporary regulations, which the IRS issued on January 27, 1997, federal rental assistance payments made to a building owner on a tenant’s behalf do not constitute grants made with respect to the building or its operation if such payments are made pursuant to (1) §8 of the United States Housing Act of 1937, (2) a “qualifying rental assistance program administered under §9 of the United States Housing Act of 1937,” or (3) a program or method of rental assistance as the IRS may designate. Reg. §1.42-16(b). The reference to a program “administered under §9 of the United States Housing Act of 1937” refers to payments made by a public housing authority to a project owner that are derived from public housing operating subsidies paid by HUD to the public housing authority. Payments will be considered to be made pursuant to a “qualifying rental assistance program administered under §9 of the United States Housing Act of 1937” to the extent that they (1) are made to a building owner pursuant to a contract with a public housing authority with respect to units the owner has agreed to maintain as public housing units (PH-units), (2) are made with respect to units occupied by public housing tenants, provided that, for this purpose, units may be considered occupied during periods of short-term vacancy (not to exceed 60 days), and (3) do not exceed the difference between the rents received from a building’s PH-unit tenants and a pro rata portion of the building’s actual operating costs that are reasonably allocable to the PH-units (based on square footage, number of bedrooms, or similar objective criteria), and provided that, for this purpose, operating costs do not include any development costs of a building (including developer’s fees) or the principal or interest of any debt incurred with respect to any part of the building. Id. §1.42–14(c) §42(d)(5)(C). Buildings funded with below-market loans received under the National Affordable Housing Act of 1993 (HOME funds) are not eligible for the 130 percent increase in basis. §42(i)(2)(E). Id. The CRTR 2000 extended the increased credit for high-cost areas to those census tracts in which the Secretary of HUD finds a poverty rate of at least 25 percent. This change will allow about twice as many rural census tracts to qualify as “hard to serve” and thus become eligible for larger credits and the allocation preference, according the Local Initiatives Support Corporation analysis.
䡲
643
䡲
c13.fm Page 644 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
with the minimum set-aside requirement, the gross rent requirement, or other requirement of a qualified low-income project, the penalty is recapture of the “accelerated portion” of the credit, with interest, for all prior years.129 No credit may be claimed by the owner of a project with respect to a unit that is not in compliance in any building in the year of a recapture event. The accelerated portion of the credit is the aggregate amount of credits allowed for the previous years, less the amount that would have been allowable for such years if the credits were claimed ratably over the 15-year compliance period, rather than the 10-year credit period.130 EXAMPLE: Assume a project is expected to generate $200,000 in credits over a 10year period, or $20,000 per year. After year 5, the owner has claimed $100,000 of credits. In year 6, the project fails to meet the minimum set-aside requirement. The owner is subject to recapture of $33,333 of credits ($100,000 less [$200,000 ÷ 15] × 5) (plus interest), the difference between the amount of credit claimed and the amount of credit that would have been claimed over the 15-year compliance period. The accelerated portion of the LIHTC is also required to be recaptured if, at the close of any taxable year in the compliance period, the qualified basis is less than the amount of qualified basis on which the credit was originally claimed at the end of the first year of the credit period. No credit recapture arises from decrease in qualified basis on which the credit was claimed at the reduced two-thirds rate.131 This is because the credits claimed on increases in qualified basis are claimed over the 15-year compliance period and are not considered to be claimed at an accelerated rate. 132 EXAMPLE: A building, placed in service in 1992, has an initial qualified basis of $700,000 on December 31, 1992. The credit is computed based on an applicable percentage of 9 percent. In 1993 the building’s qualified basis increases to $800,000. As of the end of 1998, the building’s qualified basis has decreased to $600,000. The only credit that is subject to recapture is the amount that was claimed on the $100,000 ($700,000 less $600,000) decrease relative to the initial qualified basis. The accelerated portion is the difference between $54,000—the total credit allowed on $100,000 from 1992 through 1997 ($100,000 × 9% × 6 years)—and $36,000, the amount of credit that would have been allowable if the credit were claimed over the 15-year compliance period ([$100,000 × 9% × 10 years] divided by 15 years × 6 years). Therefore, the amount of recapture is $18,000 ($54,000 less $36,000). Any change of ownership of a building, including the transfer of partnership interests, during the compliance period may also result in recapture of the credit, unless the original owner posts a bond that meets certain requirements133 129 130 131 132 133
§42(i)(1) and (2). §42(j)(3). §42(j)(4)(C). See Section 13.2(h). See Rev. Rul. 90-60, 1990-2 C.B. 3. Rev. Proc. 99-11, Jan. 11, 1999; 1999-1 C.B. 275.
䡲
644
䡲
c13.fm Page 645 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
and it is reasonably anticipated that the building will continue to be operated as a qualified low-income building for the rest of the compliance period.134 However, a parent corporation’s assignment of its interest in a partnership that owns buildings qualifying for the LIHTC to a subsidiary will not be considered a disposition, and thus will not trigger the credit’s recapture, and the parent corporation will not be required to post a bond to avoid recapture.135 Transfer of bare legal title to a project will not result in recapture of federal credits, where benefits and burdens of ownership remain with transferring property owner, and the transaction was not designed to avoid federal income tax.136 Credits may be recaptured if the taxpayer’s interest in the property is significantly reduced. Assuming that the taxpayer is a limited partner in a partnership with fewer than 35 partners that owns a LIHTC project, if the taxpayer disposes of more than one third of its interest in the project, and does not post a bond, the taxpayer will be required to recapture the credit.137 The same result would occur if the partnership reduced the percentage of credits to be allocated to the taxpayer by more than one third. Such an allocation shift would occur if losses were reallocated to the general partner or other limited partners pursuant to IRC §704(b)(2), as would happen in the event that the limited partner ’s capital account were reduced below zero, the limited partner did not agree to repay any portion of its negative capital account, and the partnership did not have sufficient minimum gain to permit continued allocation of losses to the limited partner.138 A partnership may avoid this situation if it elects to calculate depreciation deductions pursuant to IRC §168(g), which extends the depreciable life of residential rental property to 40 years.139 This election may be made on a buildingby-building basis. Alternatively, the partnership may try to convert debt as to which a partner directly or indirectly bears the risk of loss into unrelated nonrecourse financing.140 In a Chief Counsel Advisory (CCA) released in 2001,141 the IRS discussed the treatment of casualty losses under §42(j)(4)(E) of the Internal Revenue Code. The CCA stated that while the Code allows the owner of the project a reasonable period to restore a loss resulting from a casualty and thereby avoid recapture, the IRS has not issued any formal guidance defining “a reasonable period.” However, the CCA stated that a period of up to two years following the end of the tax year in which the casualty occurred would be acceptable since this is consistent with general principles of replacement for casualties. In addition, the CCA held that, contrary to previous IRS informal advice to housing credit agencies that 134 135 136 137 138 139 140 141
§42(j)(6). Priv. Ltr. Rul. 9737006 (Sept. 12, 1997), Priv. Ltr. Ruls. 199924064 (June 18, 1999) and 200033030 (Aug. 18, 2000). Priv. Ltr. Ruls. 200029044 (July 21, 2000), 200206037 (February 8, 2002), 200209011 (March 1, 2002). See Rev. Rul. 90-60, 1990-2 C.B. 3. Regulations codifying this de minimis rule are expected. See Section 3.6. See Section 10.2, n.4. Treas. Reg. §1.752-1(a)(2). CCA 200134006 (August 24, 2001).
䡲
645
䡲
c13.fm Page 646 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
noncompliance should be reported only when an owner who has suffered a casualty loss has not restored the property within the two-year period, housing credit agencies are required under the Regulations142 to report any casualty loss that takes a low-income property, wholly or partially, out of service and results in a reduction in basis. Furthermore, the IRS concluded in the CCA that property owners would not be allowed to continue to claim LIHTC on units that are not in service due to a casualty loss. According to the IRS, the Code allows only avoidance of recapture while the property is being restored during the two-year period, but does not indicate that the owner should be allowed to continue to claim the credits during this period. However, pursuant to §7.02 of Rev. Proc. 9528, the IRS noted that properties located in areas that have been designated as a major disaster by the president of the United States may continue to claim the credits during the replacement period, since such an event creates a situation that is quite different from the general casualty event faced by property owners. (l)
Application of the At-Risk Rules
Property with respect to which the LIHTC is claimed is subject to an at-risk limitation similar to that specified by the investment tax credit at-risk rules. These rules generally provide that if property is used in an activity with respect to which any loss is subject to the at-risk limitations of IRC §465, the owner must be at risk with respect to the property in order to claim the credit. In the context of the LIHTC, the at-risk rules apply only when either an individual or a closely held C corporation (a corporation in which 50 percent or more of the total value of the stock is owned by five or fewer individuals) owns all or a portion of a low-income building, either directly or through an equity investment in a partnership or an entity treated as a flow-through entity for federal income tax purposes.143 If an investor is subject to the at-risk rules, the investor’s share of the project’s eligible basis is reduced by its share of “nonqualified nonrecourse financing.”144 Nonqualified nonrecourse financing is any nonrecourse financing that is not “qualified commercial financing.”145 For purposes of the LIHTC, qualified commercial financing is any financing with respect to property if (1) the property is acquired by the owner from an unrelated person, (2) the amount of the financing does not exceed 80% of the credit base of the property, and (3) the financing is borrowed from a qualified person or a federal, state, or local government entity guaranteed by a federal, state, or local government.146 In general, a “qualified person” is any person actively and regularly engaged in the business of lending money and who does not receive a fee with respect to the owner’s investment in the project.147 In addition, loans from certain nonprofit organizations are treated as qualified commercial financing even if the nonprofit is not regularly engaged
142 143 144 145 146 147
See Treas. Reg. §1.42-5(e)(4). §49(a)(1)(B)(i); §465(a)(1). §49(a)(1)(A). §49(a)(1)(D)(i). §§42(k)(1); 49(a)(1)(D). §§42(k)(1), 49(a)(1)(D)(iv).
䡲
646
䡲
c13.fm Page 647 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
in the lending business and/or is the seller of the property.148 To qualify under this exception, the following requirements must be met: • The lender must be a qualified nonprofit organization exempt from tax
under IRC §501(c)(3) or (4), and one of its exempt purposes must be the fostering of low-income housing. • The loan must be used for and secured by a qualified low-income build-
ing. • The amount of the outstanding loan balance may not exceed 60 percent of
the eligible basis of the building as of the end of any taxable year in the compliance period. • If the interest rate on the financing is more than 1 percent below the appli-
cable federal rate when the loan is made, the qualified basis to which the financing relates is reduced to reflect the present value of the principal and interest payments payable over the course of the loan, using the applicable federal rate as the discount rate.149 • The loan must be fully repaid by the earliest of the following: 䡩
The date on which the loan matures:
䡩
Ninety days after the end of the compliance period or, if the property is not acquired from a qualified nonprofit that is providing the financing, 90 days after the earlier of the date the building ceases to be a qualified lowincome building or 15 years after the close of the compliance period; and
䡩
The date the building is sold or the loan is refinanced.150
If the loan is not fully repaid as required, a portion of the credit is recaptured with interest.151 (m) Disposition of the Partnership’s or Investor’s Interest Following the Compliance Period Following the end of the 15-year compliance period, the partnership will typically grant the tax-exempt general partner or other tax-exempt entity a right of first refusal to buy the project or an option to buy the investor’s interest in the partnership. IRC §42(i)(7) provides that a qualified low-income building will remain eligible for the LIHTC if the owner of the building grants (1) the tenants (whether in cooperative form or otherwise), (2) a resident management corporation, (3) a qualified nonprofit corporation, or (4) an agency, a right of first refusal to purchase the project after the compliance period for a price not less than the minimum purchase designated in §42(i)(7)(B). The minimum purchase price established by §42(i)(7) is the sum of the principal amount of outstanding 148 149
150 151
§42(k)(2)(A). If government interest subsidies are used to make interest payments to the nonprofit lender, these subsidies are not counted as interest paid for purposes of determining whether the loan is below market as well as the present value of the loan. §42(k)(3). §42(k)(4) §42(k)(2)(D).
䡲
647
䡲
c13.fm Page 648 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
indebtedness secured by the property, plus all federal, state, and local taxes attributable to such sale. In some cases the purchase price may be increased to include an amount to provide the investor with its anticipated rate of return if the tax benefits generated by the project have been lower than expected.152 An “exit tax” may be due at the time the investor exits the partnership if its cumulative tax losses claimed exceed the amount of capital invested, resulting in a taxable gain. Such taxes can be minimized by monitoring losses and projected exit taxes before the end of the compliance period while there is time to reallocate or limit the losses. The partnership may also transfer the project to the tax-exempt general partner or other charitable organization in the form of a charitable contribution, after the end of the compliance period. Such a transfer would be treated for tax purposes as part sale and part gift.153 The partnership would recognize taxable gain on the sale portion and would be entitled to deduct as a charitable contribution the excess of the project’s fair market value over its sale price. Under IRC §1011(b), the partnership’s adjusted basis for determining its gain on the transfer is that portion of the adjusted basis that bears the same ratio as the amount realized by the transferor bears to the project’s fair market value. The amount realized by the partnership includes the outstanding indebtedness secured by the project, whether or not the charity agrees to assume or pay the indebtedness. In most cases, because the project is subject to the minimum long-term commitment to low-income housing for an additional 15 years beyond the compliance period (the “extended use period”) 154 or a longer restriction period imposed by a state or local agency, the project’s fair market value will be substantially limited to reflect these restrictions, thereby minimizing the partnership’s charitable deduction under the part sale and part gift rules. (n)
LIHTC 15-Year Issues
With the enactment of the Revenue Reconciliation Act of 1989, which added the “extended use” period requirements to §42(h)(6) of the Code, project owners are required to maintain projects under the LIHTC program for an additional 15 years beyond the 15-year compliance period. (A state or local agency may impose a period longer than 15 years as the extended use period.) Congress provided an escape valve to this 15-year extended use restriction by creating the “qualified contract exception.” Pursuant to §42(h)(6)(E)(i)(II), an owner of an LIHTC project may avoid the extended use period by offering to sell the project to the allocating agency pursuant to a “qualified contract” at any time after the expiration of the 14th year of the compliance period. The price under which the project would be offered to the allocating agency under a “qualified contract” is established pursuant to a formula described in §42(h)(6)(F). While at first glance the “qualified contract” process appears straightforward, many issues and questions must be resolved before the process can be implemented 152 153 154
If the purchase price is less than the project’s fair market value, the investor may be entitled to a charitable deduction under the “bargain-sale” rules described in note 18. See Sections 3.11(e) and (f) for a discussion of the “bargain-sale” rules. See Section 13.2(e) for a discussion of the extended use period.
䡲
648
䡲
c13.fm Page 649 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
and before a developer can make a rational decision whether to make a “qualified contract” offer to sell the project. In addition to substantive questions regarding the calculation of the qualified contract price (such as whether fees to be paid from cash flow should be characterized as “cash” available for distribution and whether operating deficit loans funded by the general partner should be treated differently from operating deficit capital contributions funded by the general partner), there are a number of procedural questions. To calculate the qualified contract price, an allocating agency will need to review 15 years of federal income tax returns, and possibly additional material. If project owners cannot provide sufficient documentation to make the required calculation, the allocating agency may determine that the project owner has not made a valid request and the project owner may not be able to exit the program if the allocating agency does not present a qualified contract offer.155 The “qualified contract” process may provide additional opportunities for non-profits to participate in the LIHTC program. First, a nonprofit interested in preserving LIHTC properties as affordable housing may enter into an assignment contract with the allocating agency, whereby the allocating agency assigns its right to purchase the project to the nonprofit. The nonprofit may then choose which projects it will purchase from developers whose projects are subject to the “qualified contract” process. Second, nonprofit organizations may seek to acquire projects that can be rehabilitated through a second round of LIHTC allocations and may wish to lobby allocating agencies to include a second round of allocation preferences in their “qualified allocation plans.” Finally, nonprofit organizations may be able to provide financing to the allocating agencies for the purchase of the projects through the issuance of §501(c)(3) tax-exempt bonds and ensure that the properties continue to be maintained as affordable housing. (o)
IRS Audits
The IRS has published an audit guideline manual to assist agents in the conduct of an audit of LIHTC projects.156 Developers, general partners, and investors in LIHTC projects should study the audit guidelines to become familiar with the issues that the IRS has identified as likely adjustments. Particular care should be taken in the drafting of development agreements to limit the services of such agreements to those that are includable in the basis of a building. The IRS has concurrently initiated a program to audit LIHTC programs and has trained agents to specialize in the conduct of such audits. The IRS’s efforts in compliance activity were initiated after criticism of their efforts in both the GAO report on the LIHTC program and in congressional hearings in 1997. 157
155 156 157
Jerome A. Breed, “How Will Qualified Contracts Work” Affordable Housing Finance, July 2004, at 34. IRS Low Income Housing Tax Credit Audit Technique Guide (1999). Tax Credit: Opportunities to Improve Oversight of the Low-Income Housing Program, Government Accounting Office (GAO) Report, 1997.
䡲
649
䡲
c13.fm Page 650 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
One of the key issues in the audit guide is the treatment of development fees. Tax practitioners generally recommend the following in response to the current IRS position on including development fees in the eligible and depreciable basis: • Separate entities to act as developer and general partner • Exclude from the development agreement services that the IRS does not
include in “eligible and depreciable basis,” such as organizing the limited partnership, obtaining permanent financing, and syndicating the LIHTC • Make earned development fees payable in all events • Actually pay deferred development fees from cash flow within 10 years
The IRS position on development fees has been criticized by practitioners, and there is some legal authority for the taxpayer’s position. However, the issuance of the TAMs provide additional grounds for the IRS to allocate a portion of the development fee to noneligible basis services.158 (p)
State LIHTC
Thirty-eight states have enacted income tax credits to encourage investments in affordable housing. Most of these state programs are patterned after the federal LIHTC enacted in 1987. Until recently, affordable rental housing has not been a high priority for many of the state governments that now are considering the enactment of state affordable housing tax credit programs. While a number of states have devoted a significant portion of their state tax-exempt bond allocation authority to multifamily rental housing, other states have utilized their bond authority for competing uses, such as programs to increase single-family home ownership or to control pollution. The short history of state support for rental housing programs (other than the multi-family tax-exempt bond programs administered by some state agencies) underlies the concern of many affordable housing advocates that funding for housing could be reduced when budget cycles swing from surplus to deficit. When funding for housing is provided through tax expenditures (tax breaks, like the state affordable housing tax credit, which reduce an investor’s income taxes), the reluctance of politicians to raise taxes serves to protect the level of committed expenditures. Loan programs do not enjoy similar protection. Accordingly, many housing advocates believe that the enactment of a state affordable housing tax credit offers the most certain long-term subsidy source.159 The level of subsidy provided by the LIHTC is typically too shallow to permit the program to be effective in areas with very low median incomes, or to provide housing to the extremely poor. To address these needs, additional subsidies or gap financing must be made available. The recognition of the need to fill this gap has led to the enactment of state tax credits. 158 159
See Section 13.2(i). See Jerome Breed, “State Tax Credits,” Urban Land Institute (June 2002). For an excellent discussion of this subject.
䡲
650
䡲
c13.fm Page 651 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
EXAMPLE: In rural areas with very low median income limits, properties that receive an allocation of LIHTC that generate equity equal to 55 percent of the cost of construction cannot produce sufficient rental income to make the debt service payments on a mortgage covering the remaining 45 percent of the cost of construction. (Seventy-eight cents paid per dollar of LIHTC with 83 percent of the cost of the project includable in eligible basis, and an LIHTC applicable percentage of 8.5 percent, will generate LIHTC equity approximately equal to 55 percent of the cost of construction.) To produce rental housing under these circumstances, an additional subsidy is needed to reduce the interest rate or the principal amount of the mortgage. State affordable housing credit programs can piggyback on the administration of the federal LIHTC program. EXAMPLE: Projects that are allocated LIHTC also may receive an automatic allocation of state credits. Compliance monitoring and recapture also can follow the federal requirements. In addition, the characteristics that have made the LIHTC successful carry through to piggybacking state tax credit programs. The balance of state identification of housing needs, private sector development, and operation under third-party oversight remains in place. State affordable housing tax credit programs also have the political advantages of being permanent, off-budget, and not subject to the annual appropriations process. CAVEAT Because state tax payments are deductible from federal gross income, the reduction of state tax liability through utilization of a credit increases federal income tax liability. For example, with a federal income tax rate of 35 percent, each $1 of state credit claimed increases federal income tax liability by $0.35, producing a net benefit of only $0.65. For a state credit investor to make a profit on its investment without regard to any economic return, the price paid for $1 of state credit therefore must be less than $0.65. CAVEAT The existence of state affordable housing tax credits shifts the competitive balance between national syndication of LIHTCs and state and local syndication. The investors in state and local LIHTC funds typically are local corporations with an appetite for state affordable housing tax credits. Investors acquiring interests in nationally syndicated LIHTC funds may not have a state income tax liability in the state in which a specific project is located. The efficiency of state credit programs may be improved by bifurcating the state credit from the federal LIHTC and allocating the state credits to an investor who does not have any other interest in the transaction. In this manner, a pool of 䡲
651
䡲
c13.fm Page 652 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
state credit investors that invest in projects acquired by both national and local syndicators could be cultivated. LIHTC investors who are exempt from state tax or who do not conduct business operations in the project state would not be excluded from the market for LIHTC projects in that state. In addition, the ability to allocate state credit to an investor who does not possess a significant economic interest in the ownership of the project means that the state investor would have little at stake in the documentation of the transaction. As a result, transaction costs and negotiation time could be minimized. However, there are some structural impediments. Some state credits may be separated from the federal LIHTC and allocated to state investors without regard to the federal substantial economic effect regulations, but others may not be separated.160 Also, if state credits are sold to an investor who is not a partner in the partnership, the partnership will recognize gain on the sale. Generally, to claim state credits, an investor must be admitted as a partner in the partnership and the state investors will make a nontaxable capital contribution to the partnership in exchange for the state credits. (q)
Compliance and Revenue Ruling 2004-82
The Internal Revenue Service recently released Revenue Ruling 2004-82, which resolved certain questions regarding §42 of the Internal Revenue Code.161 The revenue ruling was in a question-and-answer format addressing 12 points significant to §42. Ten of the 12 questions and answers were compliance related and answered several questions regarding eligible basis and qualified basis, firstyear low-income units, extended low-income housing commitments, HOME loans, the vacant unit rule, recordkeeping and record retention, and tenant income documentation.162 However, state housing agency officials and LIHTC investors were concerned with one point—the IRS position on the requirements of extended use agreements. (i) Extended Use Commitments. The IRS has published Revenue Ruling 2004-82 as a clarification of its position on the requirements of extended use agreements for LIHTC properties. It contradicts the universally understood requirements that have long been used by state housing financing agencies and LIHTC professionals.
160
161
162
For example, the Georgia and Missouri LIHTC statutes (Ga. H.B. 272 and Mo. Rev. Stat. §135.352) allow bifurcation, but the North Carolina statute (N.C. Gen. Stat. §105.129.16B), now revised, did not. The state low-income credit statutes are rapidly changing. North Carolina has effectively replaced its state tax credit with a program to permit owners to elect to receive either a credit or a 30-year interest-free loan. Since the value of a 30-year interest free loan exceeds the value of a state credit, it is anticipated that most, if not all, project owners will elect to receive the loan. For an excellent discussion of Revenue Ruling 2004-82, see Alex Ruiz, Novogradac & Company LLP, “IRS Ruling Changes Generally Understood Requirements for Extended Use Agreements,” LIHTC Monthly Report, Sept. 2004, at 1. Rev. Rul. 2004-82 (2004).
䡲
652
䡲
c13.fm Page 653 Thursday, March 15, 2007 10:44 AM
13.2 LOW-INCOME HOUSING TAX CREDIT
At the end of the tax credit period, LIHTC property owners are given two options by the IRS: to enter into an extended use agreement that prolongs the period of low-income use to as much as 30 or 50 years, or to opt out of the program. In the latter case, §42(h)(6)(E)(ii) describes a three-year period during which two actions are expressly prohibited: the eviction or termination of tenancy (other than for good cause) of an existing tenant of any low-income housing unit; or any increase in the gross rent with respect to a low-income unit not otherwise permitted under IRC §42. This rule is known as the three-year vacancy decontrol period. The professionals have understood this to mean that the limits are applicable only to the three-year vacancy decontrol period. In Rev. Rul. 2004-82, the IRS said an extended low-income housing commitment must prohibit evictions, failure to renew leases, and increases in gross rent to amounts in excess of §42 rent throughout the initial compliance period and the entire extended use period—not just for the three-year period described in §42(h)(6)(E)(ii) as previously it was common practice by LIHTC professionals. This change raised a red flag for state housing agency officials and LIHTC. If it is determined that a taxpayer’s extended low-income housing commitment for a building does not meet the requirements for an extended low-income housing commitment under §42(h)(6)(E) (for example, does not provide nocause eviction protection for the tenants of low-income units throughout the CAVEAT In the ruling the IRS orders state housing finance agencies to review by December 31, 2004 their extended low-income housing commitments for compliance with this interpretation of IRC §42(h)(6)(E)(i). If during the review period the housing credit agency determines that an extended low-income housing commitment is not in compliance with the interpretation as provided in the ruling, the state agency has one year from the date of that determination to amend the agreement to bring it into compliance. This obviously puts a great deal of pressure on the state agency; general partners need to inquire and make sure that this is on the agency’s radar screen. If the agreement has to be changed it will generally require lender approval; it may be that the lender will not sign off. The result could be that the investor will lose 100 percent of the tax credit for all open years.* Rev. Proc. 2005-37 creates a safe harbor for extended use agreements executed before January 1, 2006, that do not explicitly prohibit the eviction of qualified tenants provided that: (1) the extended use agreement mandates that the project comply with the requirements of §42, and the agency notifies the building owner that eviction of qualified low-income tenants is forbidden in the absence of good cause; and (2) the allocating agency notifies the building owner that the rent charged to a qualified tenant cannot be increased to an amount in excess of the maximum §42 rent at any time during the extended use period. *
Investors have the most at risk since they are not a direct party to the extended use agreements and cannot amend them. Correcting thousands of extended use agreements will waste a huge amount of time and effort, and likely cost each LIHTC project thousands of dollars in legal fees, since lenders will charge their costs to the project owner.
䡲
653
䡲
c13.fm Page 654 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
extended use period), the low-income housing credit is not allowable with respect to the building for the taxable year or any prior taxable year.163 The Tax Bar believes that the ruling is not only contrary to the wording of the law and the legislative history (which was intended to provide a three-year transition to protect the tenants), it is contrary to the LIHTC program’s entire procedural history. It is expected that any remedy, rollback or otherwise will need to be coordinated with the IRS through the National Council of State Housing Agencies. (ii) HOME Rent. In the ruling, the IRS explained that a qualified 9 percent lowincome project that received a HOME loan at less than the applicable federal rate (AFR), and had more than one building and a 40–60 set-aside, must satisfy the special set-aside (40 percent or more of the residential units in each building must be occupied by individuals whose income is 50 percent or less of area medium gross income on a building-by-building basis). The rent for the lowincome units may not exceed 30 percent of the imputed income limitation applicable to the unit (the rent restriction is based on 60 percent of area median gross income, but the units must be occupied by individuals whose income is 50 percent or less of area median gross income).164 In general, the Code provides that in the case of any building located in a designated qualified census tract or difficult development area, the eligible basis of a new building will be 130 percent of the otherwise eligible basis and the rehabilitation expenditures will be 130 percent of said expenditures. The Code says that assistance provided under the HOME Act with respect to any building will not be treated as a below market Federal loan if 40 percent or more of the residential units in the building are occupied by individuals whose income is 50 percent or less of AMGI (special set-aside).165 However, the 130 percent eligible basis increase does not apply to any building to which the preceding sentence applies. CAVEAT The questions and answers in Revenue Ruling 2004-82 outline different scenarios related to a property located in a qualified census tract or difficult development area and detail the eligibility of the high-cost-area 130 percent increase in eligible basis for properties with HOME loans. It also confirms that the properties will qualify for the 130 percent boost if there is already a 4 percent credit because of federal subsidy (e.g., tax-exempt bond financing), or if the taxpayer excludes the HOME loan from eligible basis, or if the HOME loan is not “subsidized,” that is, the interest rate exceeds the applicable federal rates.* *
Rev. Rul. 2004-82 (2004).
163
164 165
However, if the failure to have a valid extended low-income housing commitment in effect is corrected within one year of the date of determination, then the determination will not apply to the current credit year of the credit period or any prior year. Rev. Rul. 2004-82 (2004). Rev. Rul. 2004-82 (2004). IRC §42(i)(2)(E).
䡲
654
䡲
c13.fm Page 655 Thursday, March 15, 2007 10:44 AM
13.3 HISTORIC INVESTMENT TAX CREDIT
(iii) Vacant Unit Rule and Move in Last Day of the Month. Under §1.425(c)(1)(ix) (otherwise known as the “vacant unit rule”), an owner of a low-income housing project must certify (annually) that it made “reasonable” attempts to ensure that its vacant low-income units are “not available.” A low-income unit is “not available” for purposes of the “vacant unit rule” when the unit is no longer available for rent due to contractual arrangements that are binding under local law. Furthermore, that unit is included as a low-income unit in the applicable fraction if the building has been in service for the full month and an income-qualified tenant moved into a unit up to the last day of the month during the building’s initial tax credit year.
13.3 (a)
HISTORIC INVESTMENT TAX CREDIT Overview
Prior to the Tax Reform Act of 1976 (TRA 1976), federal tax law provided no incentives for preserving or rehabilitating old buildings. TRA 1976 added several such incentives, including 60-month amortization of certain rehabilitation costs incurred in connection with property listed in the National Register of Historic Places or located in a historic district. TRA 1976 also provided an alternative of accelerated depreciation for both undepreciated basis in used depreciable property costs associated with the rehabilitation of a property. The Revenue Act of 1978 added an alternative tax incentive to these amortization and depreciation deductions in the form of an investment tax credit equal to 10 percent of the qualified expenditures related to the rehabilitation of properties at least 20 years old. As part of the Economic Recovery Act of 1981, Congress repealed the amortization and accelerated depreciation provisions and restructured and increased the tax credit for rehabilitation expenditures. TRA 1986 made further revisions to the rehabilitation tax credit, focusing the credit on historic and certain other older buildings to ensure that the credits accomplish their intended objectives of preserving historic and older buildings.166 Investor interest in historic investment tax credit deals has increased considerably in the past few years, as the return on low-income housing tax credit deals has decreased (because the market has become more competitive) and as more for-profit institutions enter the marketplace. Many of the historic structures being renovated are owned by governments or by tax-exempt organizations: YMCAs, Masonic temples, and schools. In addition, many of the completed projects have nonprofit tenants. In both situations, the configuration of the transaction is complicated by the tax-exempt entity leasing rules.167 (b)
Introduction to the Historic Investment Tax Credit
IRC §47 provides tax credits for qualified rehabilitation expenditures incurred in connection with a certified historic structure and certain other buildings originally placed in service prior to 1936. The amount of the historic investment tax 166 167
Blue Book, note 1, at 149. See Section 13.2(c)(iii) and Chapter 10.
䡲
655
䡲
c13.fm Page 656 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
credit is equal to 20 percent of rehabilitation expenditures incurred on certified historic structures, and 10 percent of the rehabilitation expenditures incurred on certain buildings placed in service prior to 1936. The following discussion focuses on the 20 percent credit for certified historic structures, because these are the only buildings that may be used for lodging and still qualify for the historic tax credit.168 (c)
Certified Historic Structures
A certified historic structure is any building that is listed in the National Register of Historic Places, or located in a registered historic district and certified by the Secretary of the Interior as being of historic significance to the district.169 For buildings that are not listed in the National Register, Part I of the Historic Preservation Certification Application must be completed and submitted to the appropriate state official or National Park Service (if there is no approved state program) to request certification of a building located in a registered historic district. The major factors for evaluating structures within historic districts are (1) whether the structure’s location, design, setting, materials, workmanship, feeling, and association add to a district’s sense of time and place and historical development; (2) whether the structure’s original design or individual architectural features or spaces have been maintained; and (3) the age of the structure.170 (d)
Qualified Rehabilitation Expenditures
To be eligible for the historic investment tax credit, expenditures incurred in connection with the rehabilitation of a certified historic structure must be qualified rehabilitation expenditures. Qualified rehabilitation expenditures are costs related to a “certified rehabilitation” and include any amount incurred for property that is depreciable under IRC §168 and that is (1) nonresidential real property, (2) residential rental property, (3) real property that has a class life of more than 12.5 years, or (4) an addition or improvement to property housing described in (1), (2), or (3).171 A “certified rehabilitation” is defined as any rehabilitation of a certified historic structure that the Secretary of the Interior has certified as being consistent with the historic character of the property or the district in which the property is located.172 Owners seeking this certification are required to complete Part II of the Historic Preservation Certification Application and submit it to the appropriate state official or regional National Park Service. Following completion of the rehabilitation work, an owner must receive final certification from the Secretary of the Interior that the rehabilitation was completed in accordance with the Phase II approval to claim the historic tax credit.
168 169 170 171 172
§50(b)(2)(C). §47(c)(3)(A). 36 C.F.R. §67.5. §47(c)(2)(A). §47(c)(2)(C).
䡲
656
䡲
c13.fm Page 657 Thursday, March 15, 2007 10:44 AM
13.3 HISTORIC INVESTMENT TAX CREDIT
(e)
Claiming the Historic Tax Credit
The historic investment tax credit is claimed by an owner only in the taxable year in which a project is placed in service.173 If the property is owned by a partnership, the credit may be claimed only by partners who were admitted to the partnership on the date the project was placed in service. Regulation §1.46-3(f) provides generally that each partner’s share of the basis of any property on which the historic credit is claimed is determined in accordance with the ratio by which the partners divide the taxable income of the partnership on the date such property is placed in service. Unlike the low-income housing tax credit, the historic investment tax credit reduces the depreciable basis of the property by the full amount of the credit. In addition, if a project qualifies for both the lowincome housing tax credit and the historic investment tax credit, the adjusted basis of the building for purposes of the low-income credit must be reduced by any historic investment tax credits allowed with respect to the project. Unused historic credits may be carried back 3 years and forward for 15 years. EXAMPLE: A partnership pays $1,000,000 for a certified historic structure that qualifies for the 20 percent historic investment tax credit; $100,000 of the purchase price is allocable to land. The partnership invests $2,000,000 in qualified rehabilitation expenditures for the building and rents 100 percent of the building to low-income tenants who qualify under IRC §42. The partnership is eligible to claim a one-time historic tax credit in the amount of $400,000 ($2,000,000 × 20%). In addition, the partnership may claim low-income housing tax credits in the annual amount of $144,000 ([$2,000,000 $400,000] × 9%). The partnership’s depreciable basis in the project is $2,500,000 ($900,000 $2,000,000 $400,000). In addition, the partnership may be entitled to an LIHTC acquisition credit of $36,000 ($900,000 × 4%) if the acquisition qualifies under IRC §42(d)(2). (f)
Profit Motive Requirement
Unlike those claiming the LIHTC, investors in historic rehabilitation credit must have an intent to make an economic profit without regard to tax benefits.174 Accordingly, under a reasonable projection of the economic returns, the investor must be able to make a cash on cash return. As part of the economic analysis, a number of tax advisors structure transactions to generate at least a 3 percent cash return on investment. (g)
Recapture Provisions
Although the historic credit is claimed in the year a building is placed in service, if, within five years after the placed-in-service date, the partnership or joint venture disposes of a building on which the historic investment tax credit was claimed, the partners will be required to recapture a portion of the historic investment tax credit previously claimed. The recapture percentage equals 100 173 174
Note that the historic rehabilitation tax credit is subject to the application of the at-risk and passive activity loss rules. See §§49, 469(d), 469(i)(b)(iii). See Reg. §1.42-4.
䡲
657
䡲
c13.fm Page 658 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
percent of the historic investment tax credit claimed if the disposition occurs in the first year and decreases by 20 percent each succeeding year, to zero in the sixth year. Recapture also occurs if a partner’s interest in the general profits of the partnership is reduced below 66 2/3 percent of such partner’s interest in the taxable income of the partnership in the year the certified historic structure was placed in service.
13.4 (a)
EMPOWERMENT ZONE TAX INCENTIVES Overview
Congress generally has not targeted specific geographic areas for special federal income tax benefits.175 Within the Internal Revenue Code, however, there are some exceptions that target areas for limited purposes (for example, the lowincome housing credit).176 In the Revenue Reconciliation Act of 1993 (RRA),177 Congress provided special tax incentives for areas designated as “empowerment zones” and “enterprise communities.” Taxpayers located in empowerment zones and enterprise communities are now permitted to issue tax-exempt empowerment zone facility bonds. Furthermore, certain taxpayers located in empowerment zones are eligible for additional incentives, including the empowerment zone employment credit and an increased §179 expensing election for certain property. The CRTR 2000 extended the designation of empowerment zones through the end of 2009, and increased the wage credit, §179 expensing, enhanced taxexempt bond financing, and tax incentives to invest in small empowermentzone businesses. It also authorized designation of nine additional empowerment zones by January 1, 2002, to be eligible for the same enhanced tax incentives. (b)
Definition of Empowerment Zones and Enterprise Communities
The Code authorizes the designation178 of certain distressed urban and rural areas as empowerment zones and enterprise communities.179 To achieve such a designation, the area must be nominated by one or more local governments and 175 176 177 178
179
H.R. Rep. No. 103-213, at 702 (1993) reprinted in 1993 U.S.C.C.A.N. 378, 1391. Id. Pub. L. 103-66, 107 Stat. 416 (codified at 26 U.S.C. §§1391-1397D). These designations are made by the Secretary of Housing and Urban Development for nominated urban communities and by the Secretary of Agriculture for nominated rural communities. §1393(a)(1). §1391(a). Initially, a maximum of 9 areas could be designated as empowerment zones and 95 areas could be designated as enterprise communities, §§1391(b), 1593(b). Of the 9 empowerment zones, no more than 6 could be designated in urban areas and no more than 3 could be designated in rural areas. §1391(b)(2). Of the 95 enterprise communities, no more than 65 may be located in urban areas and no more than 30 may be designated in rural areas. §1391(b)(1). The Code defines rural areas as areas outside a metropolitan statisical area or areas that the Secretary of Agriculture, after consulation with the Secretary of Commerce, determines to be rural areas. §1393(a)(3). The Taxpayer Relief Act of 1997 amended these provisions to raise the maximum number of areas that may be designated as empowerment zones from 9 to 11, 8 of which may be designated in urban areas. These amendments also provided additional authority for the Secretaries to designate another 20 areas as empowerment zones. Not more than 15 of the additional empowerment zones may be designated in urban areas and not more than 5 may be designated in rural areas. Id. §1391(g)(1).
䡲
658
䡲
c13.fm Page 659 Thursday, March 15, 2007 10:44 AM
13.4 EMPOWERMENT ZONE TAX INCENTIVES
the state or states in which the area is located, and must also meet several other criteria.180 Once they are nominated, the federal government chooses the areas to be designated based on certain criteria.181 To qualify for designation as an empowerment zone or enterprise community, an area must be “one of pervasive poverty, unemployment, and general distress” 182 and meet maximum area and population restrictions. 183 In defining whether an area is one of general distress, various factors are to be considered, such as “high crime rates, high vacancy rates, and designation as a disaster area or high-intensity drug trafficking area under the Anti-Drug Abuse Act of 1988; job loss,” and economic distress as a result of closures of military bases or restrictions on timber harvesting.184 In choosing a designated area, the following factors must be considered: the effectiveness of the strategic plan,185 assurances made by the nominating governments,186 and other specified criteria.187 An area cannot be designated as either an empowerment zone or an enterprise community unless it meets statutory requirements, including the population, distress, size, and poverty restrictions outlined in §1392. Once an area is designated as an empowerment zone or enterprise community, it is eligible for special tax incentives. Both empowerment zones and enterprise communities are eligible to use tax-exempt enterprise zone facility bonds. Only empowerment zones are eligible for the empowerment zone employment credit and the increased §179 expensing. (i) Tax-Exempt Enterprise Zone Facility Bonds. Under the RRA, Congress created a new category of tax-exempt financing called “tax-exempt enterprise zone facility bonds,”188 which are similar in many respects to private activity bonds.189 Congress created the bonds to encourage businesses to develop new facilities or renew or expand existing facilities within empowerment zones and enterprise communities. 180
181
182 183 184 185
186 187 188
189
The state and local governments must assure, in writing, that the strategic plan will be implemented and that they have the authority to nominate the area and provide such assurance, and must certify that no portion of the nominated area is included in an existing or currently nominated empowerment zone or enterprise community. In addition, all information must be determined to be reasonably accurate. §1391(e). §1391(a). In the first round of designations the federal government created 7 urban empowerment zones: Atlanta, Baltimore, Chicago, Cleveland, Detroit, New York, and PhiladelphiaCamden. It also designated 3 rural empowerment zones and 95 enterprise communities. In subsequent rounds, another 20 areas have been designated urban empowerment zones. Since the enactment of RRA, 10 areas have been designated as rural empowerment zones. §1392(a). §§1392(a)(1), (a)(3). H.R. Rep. No. 103-213 at 712, reprinted in 1993 U.S.C.C.A.N. at 1401. The strategic plan must, among other factors, identify the state, local, and private resources that will be available in the area, the development plan for the area, and the process for implementing the plan. §1391(f)(2). §1391(e)(3). §1392(c). Final regulations governing the use of enterprise zone facility bonds (EZFBs), have been issued. See Reg. §1.1394-1. Those considering the use of EZFBs should familiarize themselves with the testing, use, and compliance requirements of the regulations. See T.D. 8673, 26 C.F.R. pt. 1 (1996). §145.
䡲
659
䡲
c13.fm Page 660 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
To qualify for tax-exempt status, at least 95 percent of the net proceeds from the bond issue must be used by an enterprise zone business190 to finance an enterprise zone facility.191 An enterprise zone facility consists of “qualified zone property” and “any land functionally related and subordinate to such property.”192 Qualified zone property generally includes depreciable property that meets either the “original use” test or the “substantial renovation” test. The original use test requires that the taxpayer purchase the property after the zone designation, be the original user of the property, and use the property in the active conduct of a qualified business within the zone.193 The substantial renovation test requires that during the two-year period after the designation date, the taxpayer spend on the renovation of the property the larger of an amount equal to or greater than the tax basis of the property, or $5,000.194 Furthermore, the property must be used substantially in the active conduct of an enterprise zone business.195 Generally, bonds may be used in a wide range of commercial settings. Businesses may finance commercial rental real estate with the bonds if at least 50 percent of the gross rental income generated by the property is from enterprise zone businesses.196 Likewise, the bonds may be used to finance rental of personal property if substantially all of the rental income is derived from enterprise zone businesses or residents of an empowerment zone or enterprise community.197 Unlike private activity bonds, enterprise zone facility bonds may be used to purchase land and existing property, including buildings, equipment, machinery, and other depreciable property.198 The bonds may not, however, be used to finance or refinance residential real estate.199 A business may issue up to $3 million of enterprise zone facility bonds in any one empowerment zone or enterprise community,200 but may not, in any case, issue more than $20 million in bonds in all empowerment zones and enterprise communities combined. 201 These limits apply only to the aggregate 190
191 192 193 194 195 196 197 198 199 200 201
An enterprise zone business is any trade or business conducted by a corporation, partnership, or sole proprietorship, except certain statutorily excluded businesses (i.e., golf courses, country clubs, suntan facilities, hot tub facilities, massage parlors, racetracks, gambling facilities, liquor stores, large farm businesses). See §1397B(b), (c). Moreover, to be considered an enterprise zone business (1) at least 80 percent of the gross income must be derived from the active conduct of business within the zone, (2) substantially all of the tangible and intangible property must be located within the zone, (3) substantially all of the services performed by the employees must be performed in the zone, (4) at least 35 percent of the business’s employees must live in the zone, and (5) less than 5 percent of the unadjusted basis of property owned by the business may be attributable to collectibles (art, antiques, metals, gems, stamps, or coins) held primarily for sale to customers or nonqualified financial property (debt, stock, partnership interests, options, futures contracts). §1397B(b), (c). §1394(a). §1394(b)(1). §1397C(a)(1). §1397C(a)(2). Id. §1397B(d)(2). §1397B(d)(33). §1394(d). §1397B(d)(2). §1394(c)(1)(A). §1394(c)(1)(B).
䡲
660
䡲
c13.fm Page 661 Thursday, March 15, 2007 10:44 AM
13.4 EMPOWERMENT ZONE TAX INCENTIVES
amount of outstanding enterprise zone facility bonds and do not include other bond programs.202 Like private activity bonds, enterprise zone facility bonds are subject to a number of restrictions. For instance, the bonds are subject to the state volume ceiling on private activity bonds. 203 In addition, the average maturity of the bonds cannot exceed 120 percent of the average economic life of the financed facilities or property. 204 Moreover, interest earned on enterprise zone facility bonds is a preference item that must be considered under the individual and corporate alternative minimum tax.205 The RRA, however, permits the pooling of loans. (ii) Empowerment Zone Employment Credit. In the RRA, Congress created additional incentives available only in empowerment zones. One of these incentives is the empowerment zone employment credit. The credit is available for certain wages paid by an employer to qualified zone employees to work in the zone. With the empowerment zone employment credit, zone employers receive tax credits equal to 20 percent206 of the first $15,000 of qualified zone wages207 paid to each qualified zone employee.208 Any unused credits may be carried back 3 years and forward 15 years.209 Furthermore, the credit may be used to offset up to 25 percent of the employer’s alternative minimum tax liability.210 A qualified zone employee is an individual who has his or her “principal place of abode“ in an empowerment zone and performs substantially all employment services within the empowerment zone.211 The employee can be either full-time or part-time,212 but must have been employed for at least 90 days.213 Moreover, the employee must not be related to the employer214 or own more than 5 percent of the employer’s business.215 The employer, however, need not be physically located within the zone. Although tax-exempt organizations are not allowed to claim the empowerment zone employment credit,216 they may form joint ventures with for-profit 202 203 204 205 206 207 208 209 210 211 212 213 214
215 216
§1394(c)(2). §146. §147(b)(1). §57(a)(5)(a). §1396(b). “Qualified zone wages” are wages “paid or incurred by an employer for services provided” by a qualified zone employee. §1396(c)(1). §1396(c)(2). This amount must be decreased by any amount taken into account for the targeted jobs credit under §51. §1396(c)(3). §1396(a) (referring to §39(a) and (d)(4)). §1396(a) (referring to §38(c)(2)). §1396(d)(1). H.R. Rep. No. 213 at 705, reprinted in 1993 U.S.C.C.A.N. at 1394. §1396(d)(2)(C). §1396(d)(2)(A). For purposes of the credit, an individual is considered “related” if he or she is the child, stepchild, sibling, parent, stepparent, aunt, uncle, dependent, or in-law of the employer; a grantor, beneficiary, or fiduciary of an estate or trust of the taxpayer; bears any of the previous relationships to a grantor, beneficiary, or fiduciary of a taxpayer estate or trust; or owns more than 50 percent of the stock interest of a taxpayer corporation or entity. Id. §1396(d)(2)(B). §1397(c).
䡲
661
䡲
c13.fm Page 662 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
investors to utilize the credit. This may be done in a manner similar to syndication of the low-income housing tax credit. EXAMPLE: X, an exempt organization, operates a free medical clinic for citizens of a low-income neighborhood located within an empowerment zone. X employs 20 qualified zone employees and pays each employee $30,000 per year. X approaches Z, a for-profit healthcare provider, for the purpose of entering a joint venture to construct and operate a new medical clinic in the area. Z will serve as the general partner and X as the limited partner. Because X is tax-exempt, it cannot take advantage of the empowerment zone credit; however, Z, as a taxable organization, can benefit from the credit. Z will be allocated $60,000 ($15,000 salary cap × 20 employees × .20 allowable percentage) in tax credits each year that the empowerment zone designation remains in effect.217 (iii) Increased IRC §179 Expensing. Congress enacted one other incentive available only to employers in empowerment zones: the increased expensing of capital costs under §179. In general, certain taxpayers can elect, under §179, to deduct up to $17,500 of the cost of qualified property.218 For qualified zone property purchased after December 21, 1994 (that is used and located within in an empowerment zone), up to $37,500 may be written off as a first-year expense under §179.219 Qualified zone property includes all depreciable tangible property, including buildings, used in zone businesses. The taxpayer must purchase the property after the zone designation, be the original user of the property, and use substantially all of the property within the zone and in the active conduct of an enterprise zone business.220 The special first-year allowance may be reduced for taxpayers who purchase, during the year, more than $400,000 in qualified zone property. 221 Note that the increased §179 allowance is not treated as an adjustment for purposes of the alternative minimum tax, and that tax-exempt organizations are not specifically excluded from claiming this deduction.
13.5 (a)
NEW MARKETS TAX CREDITS General Overview
The Community Renewal Tax Relief Act of 2000222 established a program that will provide an incentive to investors in the form of a 39 percent tax credit over a 217 218
219 220
221 222
See Section 3.6, regarding partnership allocations and the substantial economic effect test. §179(b)(1). “Qualifying property” is any property that is, or has been, subject to the §167 depreciation allowance and is (1) personal property, (2) real property, (3) an agricultural or horticultural structure, (4) a petroleum storage facility, (5) a railroad grading, or (6) other tangible property under §1245. Note that §179 property does not include buildings. §1397A(a)(1). The §179 dollar limitation is increased by the lesser of $20,000 or the cost of the property placed in service during the taxable year. §1397C(a)(1). Previously used property can qualify for the increased expensing if it (1) has been substantially renovated by the taxpayer and (2) substantially all of the property is used within the zone and in the active conduct of an enterprise zone business. §1397A(b). Community Renewal Tax Relief Act of 2000 tit. I, subtit. C, §121(a), as enacted by Consolidated Appropriations Act of 2001 §1(a)(7). Pub. L. 106-554 (Dec. 21, 2000), added a new §45D to the Internal Revenue Code of 1986.
䡲
662
䡲
c13.fm Page 663 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
seven-year period, which is expected to stimulate investment in new private capital, that in turn will facilitate economic and community development in distressed communities. A bank may identify and implement strategies to lend (through community development entities (CDEs)) both first mortgage and mezzanine debt to a variety of third-party or affiliate-sponsored real estate development located in emerging or otherwise underserved communities or serving low- and moderate-income populations. These public purpose projects may be part of a larger redevelopment effort in these neighborhoods seeking to maximize impact in the community. The projects will include the rehabilitation or new construction of retail, commercial, and mixed-use developments. A taxpayer may claim a new markets tax credit (NMTC) on a “credit allowance date” in an amount equal to the “applicable percentage” of the taxpayer’s qualified equity investment in a qualified CDE.223 (See Exhibit 13.1.) The NMTC functions more like an interest subsidiary than a capital grant. The ultimate investment in the qualified low-income community must generate significant cash flow and/or return of capital and appreciation to supplement the relatively shallow credit. In contrast to the LIHTC which provides a significant return to the investors based solely on the value of the tax credit, the NMTC cannot stand on its own without significant economic benefits in addition to the credit. The NMTC is based on the amount of cash invested in the CDE; since it E XHIBIT 13.1 Application of the New Markets Tax Credit
LLC or PARTNERSHIP (INVESTORS)
NMTC
Cash Return on Qualified Equity Investment
Capital Contribution
CDE (NMTC Credit Allocation from CDFI)
LOAN (First Mortgage or Mezzanine Debt)
EQUITY
QALICB (e.g., Day Care Center)
223
QALICB (Commercial Shopping Center in Low-Income Community)
See §45D(a).
䡲
663
䡲
LOAN (Construction)
QALICB (Sale of Residential Housing in Low-Income Community)
c13.fm Page 664 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
will return only 39 percent of the investment, an investor needs to be assured of a market rate return and will require additional cash flow or otherwise will need to leverage its investment through personal borrowing. The economic issues become critical especially since the equity investment in the CDE must remain outstanding for a seven-year period. Moreover, in circumstances where the underlying investment in the community is structured as a first mortgage and/ or mezzanine debt, that totals more than 85 percent of the initial value of the property (with limited amortization) an issue may arise as to whether the CDE will be able to refinance the debt under market conditions after the seven-year period in order to pay back the investor its capital account. An NMTC syndicator needs to model the NMTC investment so that the investors receive a return of their initial capital along with targeted cash flow throughout the seven-year period. In addition, the investor will expect to be redeemed in year 8 and receive a return of his capital. A technical question has arisen regarding how to close out different investors (where there are the “staggered investments”) including those that have joined the fund in subsequent years; how do you trace their investment and meet the target yield? How do you blend the portfolio and how is the NMTC to be allocated in the first and last years of the investment? In this regard, it is critical that the investor’s funds remain outstanding for the “full” seven-year period; otherwise, a recapture event may occur. A loan may be structured with an increased interest rate after the seven-year period (when the NMTC ends); assuming the market conditions will support such a structure, the fund may be able to defer the payoff for a few years and compensate the investor accordingly. The credit allowance date for any qualified equity investment is the date on which the investment is initially made in the CDE and each of the six anniversary dates thereafter.224 The applicable percentage is 5 percent for the first three credit allowance dates and 6 percent for the remaining credit allowance dates, for a total credit of 39 percent over seven years.225 The net present value of the NMTC is 30 percent. The taxpayer’s basis in the qualified equity investment is reduced by the amount of any NMTC with respect to the investment on each credit allowance date.226 CAVEAT Community banks are likely to take advantage of the NMTC because it should allow them an attractive tax benefit with regard to its funding of targeted economic development, which will either increase their return or lower their interest rates while fulfilling the Community Reinvestment Act responsibilities. The NMTC can be claimed for projects that also receive tax benefits from empowerment zones and enterprise communities or other federal subsidies such as the historic rehabilitation tax credits.
224 225 226
See §45D(a). See §45D(a)(3). See §45D(h).
䡲
664
䡲
c13.fm Page 665 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
(b)
Allocation of the Credit
The NMTC program is administered by the U.S. Department of the Treasury through its Community Development Financial Institutions Fund (CDFI Fund). The CDFI Fund allocates the NMTC among qualified CDEs selected by the CDFI Fund. There is an annual national designated investment limitation on the total NMTC.227 The limitation for 2001 was $1 billion, $1.5 billion for 2002 and 2003, $2 billion for 2004 and 2005, and $3.5 billion for 2006 and 2007. In its 2003 allocation, the CDFI Fund modified the limitations by combining the 2001 and 2002 limitations for a total allocation amount of $2.5 billion. The 2004 allocation, combining 2003 and 2004 limitations, was greater than the first round, allocating a total of $3.5 billion to 63 organizations. Unlike the first two allocations, the third round of allocations encompasses only one year’s (2005) limitation, amounting to $2 billion. The fourth round (2006) allocated $4.1 billion which includes $600 million designated for the GO Zone. For example, the IRC228 directs the CDFI to allocate NMTC among qualified CDEs selected by the CDFI, giving priority to any entity (1) with a record of having successfully provided capital or technical assistance to disadvantaged businesses or communities, or (2) which intends to make qualified low-income community investments in businesses in which persons unrelated to such entity hold the majority equity interest. The fifth round NMTC allocation application includes a standard list of economic distress criteria including USDA Champion Communities Rural Economic Area Partnership (REAP) Zones. It also includes questions related to the initial GO Zone allocation. The application contains several other additions; for example, it lists Hospitality as a subcategory of Real Estate Financing. It requires a commitment to a range of below market rate and term; it lists Targeted Population as an indicator of higher distress along with REAP Zones and Champion Communities. It now contains questions asking about providing housing to affordable persons below 80 percent of area medium income. Further it asks a question as to whether the applicant or any of its affiliates: (1) made a QEI into a CDE for prior new market allocation or (2) gained control of a CDE that received a prior new market allocation. The Notice of Allocation Availability The NOAA provides specific guidance on how a CDE may apply to receive an allocation of NMTCs, the competitive procedure through which such allocation will be made, and the actions that will be taken to ensure that proper allocations are made to appropriate entities. For purposes of the NOAA, an application for an allocation of NMTCs will not be considered unless: (a) an applicant is certified as a CDE at the time the CDFI Fund receives its NMTC allocation application; or (b) the CDFI Fund receives from an applicant an application for certification as a CDE no later than January 12, 2007 for the fifth round NMTC allocation.
227 228
See §45D(f). See §45D(f)(2).
䡲
665
䡲
c13.fm Page 666 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
The CDFI Fund will not award allocations of NMTCs to applicants that are not certified as CDEs. The CDFI Fund will conduct the substantive review of each application in accordance with the criteria and procedures described in this NOAA and the Allocation Application. In that regard, the NOAA and the Allocation Application identify the following scoring criteria: Business Strategy (25 points), Capitalization Strategy (25 points), Management Capacity (25 points), and Community Impact (25 points). In addition, five priority points may be awarded for prior experience in providing capital or technical assistance to disadvantaged business communities and five priority points may be awarded for investing in businesses the owners of which are unrelated to the applicant. Where an applicant is controlled by an entity with prior experience in relevant areas, that experience may be included in the application. No indication is given as to the number of points that will be awarded for any specific answer to the questions on the application and scant guidance is given as to how the reviewers will judge the relative quality of answers. As a result, only generalized predictions of success can be made with respect to applications. In assessing the impact on communities which will result from an applicant’s proposed investments, the CDFI Fund will consider the level of involvement of community representatives and residents in the design, implementation, and monitoring of the proposed business plan and strategy. It appears that more points will be awarded to investments made (a) in more economically distressed markets, and (b) neighborhoods that receive assistance from other government programs, such as HOPE VI, Empowerment Zones, or Enterprise Renewal Communities, or communities that are the target of federal, state, or local community economic development plans. The economic impact of the proposed investment on job creation, wage enhancement, wealth creation of the community residents, local ownership and minority ownership of the business receiving the investment will be an important part of the scoring system. The community impact criteria is an area in which relatively inexperienced CDEs can score well. In summary, a close review of the NOAA and the application does not reveal bias toward particular types of investment, bias toward urban, suburban, or rural investments, or geographical bias. Investment in more distressed and underserved communities will score well. Prior experience, specifically identified investors, and specifically identified investments will be extremely important factors in the allocation process. Community involvement and a thorough analysis of the economic and personal impact of the investments will also be critical. CAVEAT It is unclear how the Treasury will compare different types of investments, such as a community day care center with a high-tech incubator or a light manufacturing plant.
CAVEAT It may be advantageous for regional or national applicants to set up umbrellatype CDEs and peel-off allocations to subsidiaries as opportunities develop. 䡲
666
䡲
c13.fm Page 667 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
First Round Allocation of NMTC In 2003, the CDFI Fund received a total of 345 applications for the NMTC requesting the authority to issue a total of $25.8 billion in equity. However, only 66 of the 345 applicant CDEs received allocations of the credits in the total amount of $2.5 billion, a combination of the 2001 and 2002 NMTC. In reviewing the allocation applications and selecting the 66 winners, the CDFI Fund engaged in a four-step review process that spanned about six months. Step 1 involved the review of the applications by CDFI Fund staff and other federal agency staff by rating and scoring them from weak to excellent based on the four scoring criteria identified in the NOAA, and recommending an allocation amount based on information provided in the application. Applications that passed step 1 were then forwarded to the step 2 review process. The step 2 review was conducted by an allocation recommendation panel, which reviewed the comments, scores, and recommendations made by the step 1 reviewers. The step 2 reviewers also reviewed compliance, due diligence, eligibility, and regulatory issues. Step 3 involved a review of the applications and the recommended allocation amounts by the program manager, who would either accept or reject the recommendations of the step 2 reviewers. For the final step, the selected applicants were checked out to confirm their eligibility to participate in federal government programs. The average allocation amount is approximately $38 million per allocatee, and the median allocation award is $18 million. Thirty-nine allocatees received an allocation of less than or equal to $25 million, while seven allocatees received allocations in excess of $100 million. The allocation was made to CDEs covering 40 states and the District of Columbia, thus representing a broad geographical mix. Second Round Allocation of NMTC The second round of NMTC allocations, combining 2003 and 2004 allotments, had 250 applications containing $30 billion in requests.229 In 2004, the CDFI Fund allocated a total of $3.5 billion to 63 out of the 250 applicants, about 80 percent of which are located in urban and suburban areas.230 CDEs affiliated with public bodies and mission-driven CDEs (i.e., nonprofits, governmentally controlled organizations, or CDFIs) received $1.7 billion dollars in allocations,231 while CDEs affiliated with for-profits received a share totaling $1.8 billion.232 The second round of allocations was greater than the first round. That is— one billion dollars more in NMTCs than the first, with an average allocation of $56.45 million, compared to the $38 million of the first allocation. The median allocation rose from $21 million to $50 million and the number of CDEs affiliated with for-profit organizations receiving allocations grew.233 However, the second
229 230 231 232 233
Robert A. Rapoza Associates, “NMTC Allocation General Statistics Round II,” available at http://www.rapoza.org/NMTC/round2rar.pdf. CDI Fund, “New Market Tax Credit Fund,” http://www.cdfifund.gov/programs/programs.asp?programID5. Robert A. Rapoza Associates, “NMTC Allocation General Statistics Round II,” available at http://www.rapoza.org/NMTC/round2rar.pdf. Id. Id.
䡲
667
䡲
c13.fm Page 668 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
round of allocations reflected a decrease in the number of mission-driven organizations receiving allocations.234 Third Round Allocation of NMTC In August, 2004, the U.S. Department of the Treasury announced the third round of competition for the allocation of $2 billion in NMTC.235 Unlike the first two rounds, the third round represents only one year of allocations, for calendar year 2005. Consequently, the amount of the third round allocations ($2 billion) will be less than each of the allocations in the first two rounds. However, because each of the first two rounds of allocations covered two years (i.e., $2.5 billion covering years 2001 and 2002, and $3.5 billion covering years 2003 and 2004), the third round will be much larger proportionately. In May, 2005, the Community Development Financial Institutions Fund (Fund) announced that 41 CDEs had been selected to receive allocations of NMTCs under the 2005 round of the NMTC Program. These 41 CDEs are authorized to issue to their investors a combined total of $2 billion in equity for which NMTCs can be claimed. In three rounds to date, the Fund has made 170 awards totaling $8 billion in tax credit authority. Highlights include: • 208 CDEs applied for allocations, requesting a total of $22.9 billion in allo-
cations. • 41 CDEs (or 20 percent of the total applicant pool) received $2 billion of
allocation authority. • The average allocation award is approximately $48,780,000 per allocatee. • Allocation awards range in size from $5 million to $100 million. The
median allocation award amount is $50 million.236 Based on information reported by the allocatees, it is anticipated that approximately $1.18 billion (or 59 percent) will be invested in major urban areas; approximately $494 million (or 25 percent) will be invested in minor urban areas; and approximately $326 million (or 16 percent) will be invested in rural areas. Fourth Round Allocation of NMTC The fourth round (2006) allocated $4.1 billion which included $600 million designated for the Gulf Zone. 234 235
236
Id. U.S. Department of Treasury, “Treasury Announces Opening of Third Round of Competition for New Markets Tax Credit Program,” available at http://www.novoco.com/NMTC/ News_Archive04.shtml (Aug. 5, 2004). Seventeen of the allocates (or 41 percent) are nonprofit organizations or subsidiaries of nonprofit organizations. They received allocations totaling $891 million. Eleven of the allocates (or 27 percent) are certified CDFIs or subsidiaries of certified CDFIs. They received allocations totaling $494 million. Seven of the allocates (or 17 percent) are non-CDFI banks or bank holding companies, publicly traded institutions, or subsidiaries of such entities. They received allocations totaling $381 million. Four of the allocates (or 10 percent) are governmentally controlled entities. They received allocations totaling $160 million. In all, 22 of the allocates (or 54 percent) are CDFIs, nonprofit organizations, governmentally controlled entities, or subsidiaries of such organizations. They received allocations totaling $1.04 billion.
䡲
668
䡲
c13.fm Page 669 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
Through the fourth NOAA, the Fund announced that it would continue to give greater weight to the Business Strategy and Community Impact sections of the Allocation Application. The Fund also modified certain eligibility requirements relating to prior allocatees. These modifications generally require that allocatees demonstrate an increasing percentage of Qualified Equity Investment issuances and/or commitments based on the allocation round in which allocatees received their prior allocation(s). The Fund also clarified that allocatees (or their subsidiary allocatees) are prohibited from forming common enterprises with other allocatees (or their subsidiary allocatees) in the same allocation round after the submission of an allocation application to the Fund. Further, the Fund reserved the right to take prior NMTC Allocation performance into consideration in the case of Allocation Applications submitted by entities that have, or whose affiliates have, received allocations of NMTCs in prior allocation rounds. The Fund also reserved the right to reject an application if it is incorrect in any material respect. To date the fund has made 233 awards totaling $12.1 billion. Fifth Round of Allocation of NMTC Information with regard to the fifth round the NOAA was published on December 1,2006 with an application deadline, February 28, 2007; the awards being announced in the fall of 2007. In March, 2006, Treasury announced that it will allocate an additional $600 million in NMTC authority to help rebuild low income communities devastated by Hurricane Katrina among qualifying pending applicants serving the Gulf Opportunity Zone area that requested authority in fiscal year 2006. The additional investment was authorized by the GO Zone Act which the President signed into law in December, 2005. The CDFI Fund used the authority granted in the prograin to combine 2005 and 2006 amounts and thus, made an additional $600 million of new market tax credit allocation authority for specific use in the GO Zone in 2006. The remaining $400 million of special GO Zone allocation authority will be made available in 2007 NMTC allocation round. (c)
Qualified CDE
A qualified CDE is any domestic corporation or partnership if (1) the primary mission of the entity is serving or providing investment capital in the form of equity or loans for low-income communities or low-income persons; (2) the entity maintains accountability to residents of low-income communities through their representation on any governing board of the entity or on any advisory board to the entity; and (3) the entity is certified by the CDFI Fund.237 The CDFI Fund has issued a CDE Certification Application Form (Form CDFI-0019) and guidelines for certification as a CDE.238 The CDFI Fund will evaluate CDE Certification Applications on an ongoing basis, and certify those applicants that meet the eligibility requirements as CDEs. A CDE certification will continue until it is revoked or terminated by the CDFI Fund. The CDE must attest annually that the CDE continues to meet the eligibility requirements. 237 238
See §45D(c). See §45D(c).
䡲
669
䡲
c13.fm Page 670 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
(d)
Qualified Equity Investments
The NMTC may be claimed only for a qualified equity investment (QEI) in a CDE. A QEI is any equity investment in a qualified CDE if (1) such investment is acquired by the taxpayer at its original issue solely in exchange for cash; (2) substantially all of such cash is used by the qualified CDE to make qualified lowincome community investments; and (3) such investment is designated by the CDE as a QEI.239 An equity investment may include any stock240 or any capital interest in an entity that is a partnership or limited liability company (LLC). CAVEAT In the case where investments are made in CDE over multiple years, in is advisable that they be structured as separate QEIs which will provide some protection in the event of a subsequent recapture event. (See discussion of recapture in Section 13.5(i).)" CAVEAT There is a safe harbor for the “substantially all” requirement if (1) at least 85 percent of the taxpayer’s investment is directly traceable to qualified low-income community investments or (2) at least 85 percent of the aggregate gross assets of the qualified CDE are invested in qualified low-income community investments.* *
See §45D(b)(3).
The “substantially all” test must be met for each annual period during the 7year period.241,242 The test must be performed semi-annually with the average of the calculations meeting the 85 percent rule. Presumably, the remaining 15 percent may be applied to fund cash reserves, pay brokers and underwriters fees and administrative expenses. Treasury needs to provide guidance to syndicated partnerships as to the allowable method by which NMTC is to be allocated among the partners of a partnership. Where multiple investors make multiple investments in a fund, a 239 240 241
242
See §45D(b)(1). Other than nonqualified preferred stock, as defined in §351(g)(2). See Temp. Treas. Reg. §1.45D-1T(c)(5)(i)(2001). The Final Regulations (December 22, 2004) clarified that a CDE may choose the same two testing dates for all qualified equity investments regardless of the date each qualified equity investment was initially made. To conform the annual testing requirement with the 12-month time limit for making qualified low-income community investments, the Final Regulations provide that for the first annual period, the “substantially all” calculation may be performed on a single testing date. The Final Regulations provide that the 12-month period begins on the same date as the beginning of the first annual period of the 7-year credit period. The Final Regulations further provide that reserves under Section 1.45D-1T(d)(3) include fees paid to third parties to protect against loss of all or a portion of the principal of, or interest on, a loan that is a qualified low-income community investment. Section 1.45D-1T(d)(3) provides that reserves (not in excess of 5 percent of the taxpayer’s cash investment under §1.45D-1T(b)(4) maintained by the CDE for loan losses or for additional investments in existing qualified low-income community investments are treated as invested in a qualified low-income community investment.
䡲
670
䡲
c13.fm Page 671 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
question arises whether the investments are fungible? What happens to investments made in different years? Are investments traced to particular deals? How do you account for money that is invested in year 1, year 3, year 5? What about reinvestment of principal repayment? What about subsequent investments made to salvage troubled deals? The accountant’s role becomes critical to the structure. QUERY Will the allocation of the NMTC need to follow net operating income? Will allocations of distributable cash from operations need to match net operating income? Will it be possible, as some have advocated, to “specially allocate” the NMTC to specific partners who do not share the economic return from the investments made by the CDE? (e)
Qualified Low-Income Community Investments
The NMTC is available only if the qualified CDE uses substantially all of the cash to make qualified low-income community investments (QLICI). A QLICI may be (1) any capital or equity investment in, or loan to, any qualified active lowincome community business as defined below; (2) the purchase from another qualified CDE of any loan made by such CDE which is a QLICI; (3) any equity investment in, or loan to, any qualified CDE; and (4) financial counseling or other services to businesses located in, or residents of, low-income communities.243 The NMTC could be implemented with construction loans as well as predevelopment loans and could enable the lender to provide an indirect subsidy to the developer or homebuyer through a below-market interest rate. Moreover, CDEs may be able to buy loan pools. Thus, community banks may be able to sell their current target area loans to a pool created by another CDE. Amounts received by a CDE in payment of, or for, capital, equity, or principal with respect to a QLICI must be reinvested by the CDE in a QLICI no later than 12 months from the date of receipt to be treated as continuously invested in a QLICI. Since CDE investments must be made in active businesses, in the case of a construction loan, the construction of the real estate should be treated as an active business, even before the real estate is complete. This is especially important where the construction period exceeds the 12-month window for the CDE to invest in an active business. The regulations provide that an entity will be treated as engaged in the active conduct of a trade or business if, at the time the CDE makes a capital or equity investment in, or loan to, the entity, the CDE reasonably expects that the entity will generate revenues (or, in the case of a nonprofit corporation, receive donations) within three years after the date the loan is made or date of investment.244 The funds need to be reinvested or “churned” within the targeted low-income community, which requires the availability of new projects to come “on-line” where construction, development, or mini-perm loans are repaid during the 7year credit period. Amounts received by a CDE in payment or, or for, capital, 243 244
See §45D(d)(1). The Final Regulations amended Section 1.45D-1T(d)(4)(iv) by providing that the nonprofit corporation must be engaged in an activity that furthers its purpose as a nonprofit corporation within the three-year period.
䡲
671
䡲
c13.fm Page 672 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
equity, or principal with respect to a QLICI during the seventh year of the sevenyear credit period do not have to be reinvested. (f)
Use of Other Federal Subsidies
The Treasury is required to prescribe regulations that limit the credit for investments that are directly or indirectly subsidized by other Federal tax benefits (including the credit under §42 of the IRC and the exclusion from gross income under §103).245 There currently is no guidance as to the definition of “other Federal tax benefits.” This provision may mean that the NMTC cannot be used in combination with the Historic Credit under §47, that depreciation benefits cannot be used with respect to NMTC projects, or that small businesses may not be able to claim a jobs credit if the business has an NMTC investment. (g)
Qualified Active Low-Income Community Business
In general, a qualified active low-income community business (QALICB)246 includes any corporation (including a nonprofit corporation), partnership, or LLC if with respect to any taxable year (1) at least 50 percent of the total gross income of such entity is derived from the active conduct of a qualified business within any low-income community; (2) a substantial portion (defined as at least 40 percent) of the use of the tangible property of such entity (whether owned or leased) is within any low-income community; (3) a substantial portion (defined as at least 40 percent) of the services performed for such entity by its employees are performed in any low-income community; (4) less than 5 percent of the average of the aggregate unadjusted bases of the property of such entity is attributable to collectibles247 other than collectibles held primarily for sale to customers in the ordinary course of business; and (5) less than 5 percent of the average of the aggregate unadjusted basis of the property of such entity is attributable to nonqualified financial property.248 CAVEAT Portion of a Business. The Final Regulations provide that a CDE may treat any trade or business (or portion thereof) as a qualified active low-income community business if the trade or business (or portion thereof) would meet the requirements of a QALICB provided that if the trade or business (or portion thereof) were separately incorporated and a complete and separate set of books and records is maintained for that trade or business (or portion thereof).
245 246 247 248
See §45D(i). See §45D(d)(2). As defined in §408(m)(2). As defined in §1397C(e). Section 1397C(e)(1) contains an exception to the definition of nonqualified financial property for reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less. The regulations provide that for purposes of §1.45D-1T(d)(4)(i)(E), the proceeds of a capital or equity investment or loan by a CDE that will be expended on construction of real property within 12 months after the date the investment or loan is made qualify as a reasonable amount of working capital.
䡲
672
䡲
c13.fm Page 673 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
A qualified business means any trade or business with certain exclusions.249 The term “qualified business” does not include any trade or business consisting of the operation of any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. It does not include farming, if the assets are greater than $500,000. Finally, the rental to others of real property located in any low-income community is a qualified business if, and only if, the property is not residential rental property250 and there are substantial improvements located on the property. (h)
Rental of Real Property: Substantial Improvement Definition
The Final Regulations (issued on December 22, 2004) expanded the “substantial improvements” rule.251 As originally drafted, this rule would have precluded an allocatee from making permanent loans that close after the completion of construction. The rule required that “substantial improvements”—that is, capital costs incurred with respect to buildings on the site in an amount equal to or exceeding 50 percent of the cost of the land—be incurred after the QLICI is made.252 A loan that closed at a point in time after construction completion would not qualify as a rental real estate loan. CAVEAT There was no indication in the statute or its legislative history that permanent loans should not qualify as a QLICI. Indeed, many allocatees included permanent financing as part of the business plan described in their application to CDFI Fund for an allocation of New Markets Tax Credits and the CDFI Fund rewarded those business plans with an allocation. If the goal was to avoid recycled funds, it would be possible to prohibit refinancing of a permanent loan. The existence of “take out” permanent financing, on the other hand, is a necessary part of the construction process. Construction lenders will not lend without a commitment for permanent financing that will provide the funds required to repay or “take out” the construction loan. As a result, permanent financing is essential to the creation of new assets. However, under the regulations, it is permissible to refinance a permanent loan in a (non–real estate) business, since such refinancings were not subject to the substantial improvement rule.253 The substantial improvement rule would also make it difficult to close historic rehabilitation investments. In those transactions, equity investments are frequently made in three installments: at closing, at construction completion, and at stabilization of the project, generally measured by satisfaction of a debt service coverage ratio. 249 250 251 252 253
See §45D(d)(3). As defined in §168(e)(2)(A). See Treas. Reg. §1.45D-1T(d)(5(ii). Applicable to QALICIs made on or after June 22, 2005. Ibid. See Treas. Reg. §1.45(D)-1T(d)(5).
䡲
673
䡲
c13.fm Page 674 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
The completion installment and the stabilization installment would not constitute QLICIs under the initially proposed §45(D)(d)(5)(ii) of the regulations. Requiring an equity investor to place all of its investment at risk prior to completion of construction substantially changes the relative economic and risk profile of an investment. CAVEAT The Final Regulations were amended (January 28, 2005) to delete the “definition” of substantial improvements so there is no requirement relative to the timing (construction vs. permanent loans) or a 50 percent threshold. However, CDFI revised its draft of the 2005 Allocation Agreement (which is to be executed by the CDE allocatee) and limits the use of financing (or refinancing in a real estate project) creating a risk of noncompliance. The Final Regulations254 initially had the effect of disqualifying the “residential” portion of a mixed-use building from qualification as a QLICI. The disqualification stems from the provision that loans to a real property rental business do not count as a QLICI to the extent that a lessee of the real property is not a qualified business under paragraph §45D(d)(5). Since a tenant who occupied a unit as a principal residence did not use the unit in a qualified business, the loan would not have been treated as a QLICI. The exclusion was inconsistent with the first sentence of (d)(5)(ii), which would permit loans to buildings that were depreciable as a commercial building even though such buildings contain a substantial residential component.255 Accordingly, the Final Regulations were amended (January 28, 2005) to limit the disqualifying “commercial” uses (the so-called sin uses) only to those referenced in §45D(d)(3) (e.g., golf course, country club, or massage parlor) in the “commercial” context but not units occupied as a principal residence. Residential rental property means a building if 80 percent or more of the gross income is rental income form dwelling units. Thus, if more than 20 percent of the income is derived from commercial or retail use, the building would qualify for the NMTC. The residential rental property test is applied each and every year over the seven-year compliance period based on gross rents on a “buildingby-building” analysis, which requires testing of each building in a multiple building project. It could result in a possible recapture event if commercial tenant terminates lease. CAVEAT Use of a master lease for commercial space may be the solution to the potential recapture issue.
254
255
See Section 1.45D-1(d)(5)(ii). The Internal Revenue Service published final regulations relating to NMTCs on December 28, 2004 which were subsequently amended in part on January 28, 2005. See Section 168(e)(2) (i.e., more than 20 percent commercial).
䡲
674
䡲
c13.fm Page 675 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
A residential development or management company qualifies as a business distinguished from residential rental property for these purposes. Assisted living facilities which resemble an operating business should also be eligible for the NMTC. In any event, the NMTC is available for commercial rental properties and sale of residential housing in low-income communities. QUERY Frequently the neighborhood in which services are to be performed won’t match exactly the qualified census tracts that identify the NMTC target area. The source of the revenue for the performance of services needs to be clarified by the Treasury. An entity is treated as a QALICB for the duration of the CDE’s investment in the entity if the CDE reasonably expects, at the time the CDE makes the capital or equity investment in, or loan to, the entity, that the entity will satisfy the requirements to be a QALICB throughout the entire period of the investment or loan.256 QUERY A question arises as to whether a national chain can invest in an affiliated CDE: For example can Wal-Mart invest in a CDE that makes loans to projects in which Wal-Mart is a tenant and claim NMTC for the investment that funds the loan? (i)
Timing of the NMTC Investment
As to the relevance of the various “timing” rules for NMTC investment purposes: Step 1.
256 257
1.
Initially, a NMTC may be claimed by an investor only for a QEI in a CDE. In a leveraged structure, the anticipated investor will invest in an “investment fund” (which will borrow substantial funds from a leveraged lender.
2.
Amounts received by a CDE in payment of (or for) capital, equity, or principal must be reinvested by the CDE in a qualified lowincome community investment (“QLICI”) no later than 12 months from the date of its receipt to be treated as continuously invested in a QLICI.; i.e. The reinvestment must occur within 12 months from the date of receipt-of the QEI. 257 As a result of this rule, the investment fund will often make investments at different times, that is, defer the actual cash transaction in view of the 12 month rule. This approach must be coordinated with the typical construction lender practice of advancing the loan over time as construction progresses.
See Temp. Treas. Reg. §1.45D-1T(d)(6) (2001). The initial QEI is to be invested within 12 months. In addition, principal payments from QALICB must also be reinvested within 12 months.
䡲
675
䡲
c13.fm Page 676 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
For example, the investor can be expected to engage in extensive due diligence of the proposed development, including review of architectural plans, sources of funds, budget, zoning, permitting, condominium documentation and approvals and Board approval, all during the negotiation of documents The investor could well advance the QEI proceeds in stages to coincide with the acquisition of the building and at benchmarks pertaining to the subsequent approvals for and construction of the improvements. Generally, the CDE and QALICB do not draw down money until it is needed. Otherwise, there could be negative arbitrage on the leverage loan (e.g., borrowing money at 6.5% interest but earning interest on money on deposit at 3%). The investor may be unwilling to invest significant equity unless, and until, it is satisfied that the funds are ready to be deployed for project purposes following its due diligence. Step 2. The CDE must make investments in a QALICB. The CDE may advance the loan proceeds to the QALCB, some or all of which may be retained in an account in the name of the QALICB but "controlled" by the CDE. This step will address the 12 month restriction at the CDE level but triggers other requirements at the QALICB level. Among other requirements, no more than 5% of the average of the aggregate unadjusted bases of the property of the QALICB may be attributable to “nonqualified financial property.” Cash on deposit could present a problem. However, there is an exception to the definition of nonqualified financial property for reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less. The final regulations provide that for these purposes, the proceeds of a capital or equity investment or loan by a CDE that will be expended on construction of real property within 12 months after the date of the investment or loan is made, qualify as “reasonable” amounts of working capital (so that the QALICB may hold in a reserve, liquid assets that will be expended on construction of the improvements within a year of its receipt).258 Step 3. A QALICB must be “active”; i.e., generate project and related revenue within three years. In the real estate context, the lease from the QALICB to the tenant must comply with this requirement by becoming enforceable and requiring lease payments within this timeframe. Step 4. The other basic timeframe involved in NMTC transactions is the seven year prepayment lock-out relevant to the leveraged lender which is consistent with the NMTC Compliance Period. See Section 12.5(a).
258
Theoretically, cash could be retained in a CDE for 12 months and then, in a QALICB for another 12 months; in essence 24 months of pre-funding. However, as previously discussed, it is not likely that the investor or CDE would undertake to do so.
䡲
676
䡲
c13.fm Page 677 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
(j)
Look-Through Rule: Trade of Business Involving “Intangibles”
The Final Regulations initially adopted a tenant “look-through” rule to prohibit rentals to tenants whose predominate business was the development, sale or licensing of intangibles. CAVEAT It is difficult to determine exactly what kind of business is conducted by a prospective office tenant. The application to a start-up biotech or computer software business may be clear, but the application of the rule to many other circumstances is extremely confusing. EXAMPLE: The offices of a restaurant franchise business would likely not qualify to the extent that the company did not own and operate a significant number of its own restaurants. If the predominant source of the company’s revenue was collection of franchise fees, it would not qualify. EXAMPLE: A subsidiary of a financial services firm that conducts a commodities business, buying and selling currency futures contracts or any swaps, caps, collars, or notional principal contracts, would be treated as a business predominately selling intangibles. A music production company may likewise generate the predominant share of its revenue from the licensing or sale of intangibles. The office of a university that licenses patents received by its professors would not be a qualified tenant under this definition. Accordingly, the Final Regulations were amended (January 28, 2005) to limit the cross-reference only to disqualifying commercial “sin” uses (e.g., golf courses, country clubs, massage parlors) but not the developing or holding of intangibles for sale or license. The CDE may control the business in which it invests, but such control subjects the transaction to more stringent qualifying requirements.259 Where the CDE controls the business, the business will only be treated as a QALICB for the duration of the CDE’s investment if it actually satisfies the requirements to be a QALICB for the entire term of the CDE’s investment; the test in this case is not merely based on the CDE’s reasonable expectation at the time the investment or loan is made. The failure of the business to qualify as a QALICB will give rise to a NMTC recapture event as discussed in subsection (i). “Control means, with respect to an entity, direct or indirect ownership (based on value) or control (based on voting or management rights) of more than 50 percent of the entity.”260 Recent amended regulations have raised the threshold of control from 33 percent to the current level of 50 percent to allow for more significant investments by CDEs.
259 260
See Temp. Treas. Reg. §1.45D-1T(d)(6) (2001). Temp. Reg. §1.45(D)-1T(d)(6)(ii)(B).
䡲
677
䡲
c13.fm Page 678 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
(k)
Low-Income Community
A low-income community means any population census tract if (1) the poverty rate of such tract is at least 20 percent or (2) (i) in the case of a tract not located within a metropolitan area, the median family income for such tract does not exceed 80 percent of the statewide median family income or (ii) in the case of a tract located within a metropolitan area, the median family income for such tract does not exceed 80 percent of the greater of statewide median family income or the metropolitan area median family income.261 Additional targeted area may be designated by the IRS as low-income communities if certain conditions are satisfied,262 including areas that have a continuous boundary and would otherwise meet the low-income definition assuming there is inadequate access to investment capital in the area. Information with regard to census tracts which qualify are provided on the CDFI Web site: www.cdfifundhelp.gov. The definition of a low-income community may be complicated by the sourcing of income: what happens where services are performed off the premises? For example, in the plumbing and heating business, the service area may not match the census tract. These types of issues will not arise in a true real estate investment. What kind of documentation do you need to satisfy a reasonable expectation that the service area will be a qualified low-income community (in which at least 40 percent of the services performed by the employees are within the community) where in effect the business is serving customers outside the area? This is not a problem is the customer comes to the business, but how is this handled where the employees need to go to the customer’s premises? In June, 2006 the IRS published a notice which announced that it will amend section 1.45D-1 of the Income Tax Regulations to grant flexibility to permit CDEs to invest in certain businesses located outside of low-income coinmunities, provided the businesses serve designated targeted populations. CDEs that receive NMTC allocations will be permitted to invest in certain businesses located in moderate-income census tracts, provided that the businesses are owned by low-income persons, hire significant numbers of low-income persons, or predominantly serve low-income persons. These businesses may be located in a census tract with a median family income at or below 120% of the area median family income. GO Zone. For the purposes of NMTC allocations made pursuant to the Gulf Opportunity Zone Act of 2005, the notice also designates certain individuals displaced from their principal residences and/or who lost their principal sources of employment as a result of Hurricane Katrina as a targeted population.263
261 262 263
See §45D(e)(1). See §45D(e)(2). CDEs will be permitted to invest in certain businesses located in census tracts in the GO Zone with income higher than those traditionally served by the program, provided that those businesses: (a) are located in census tracts that have been identified by FEMA as having experienced flooding and/lor sustained extensive or catastrophic damage in the wake of Hurricane Katrina and (b) are owned by, will hire, or will otherwise predominantly serve individuals displaced from their principal residences and/or who lost their principal sources of employment as a result of Hurricane Katrina and (c) are located in a census tract with a median family income that is at or below 200% of the area median family income.
䡲
678
䡲
c13.fm Page 679 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
(l)
Recapture
If at any time during the seven-year period beginning on the date of the original issue of the QEI in a qualified CDE, there is a recapture event with respect to such investment, the taxpayer’s income tax liability is increased by the credit recapture amount.264 The credit recapture amount equals the sum of the aggregate decrease in the general business credits allowed to the taxpayer for all prior taxable years which would have resulted if no NMTC had been allowed with respect to the investment, plus interest on that amount at the IRC §6621 underpayment rate. There is a recapture event with respect to a QEI in a qualified CDE if (1) the CDE ceases to be a qualified CDE; (2) the proceeds of the investment cease to be used as required; or (3) the investment is redeemed by the CDE. The bankruptcy of a CDE is not a recapture event; however, it is unclear whether the NMTC would continue for the balance of the seven-year term or terminate on the date of the event. An issue may arise if the CDE decides to make a capital call in order to “work out” of a financial difficulty or fund operating deficits, as the case may be. In such a case, would a new seven-year period begin to run from the date of the additional investment (assuming a NMTC is claimed)? The investors may be reluctant to fund in circumstances where a new credit period would created. There may be a disincentive to keep the project alive; and perhaps a willingness to let the project be foreclosed upon if the fresh cash could not be repaid for a new seven-year period. A recapture event may also occur if the CDE fails to satisfy the “substantially all” requirement of the Code.265 Under this test, the CDE is required to use substantially all of the cash received from investors, which is described in §45D(b)(3) of the Code as at least 85 percent of its aggregate gross assets, to make qualifying low-income community investments. This requirement must be satisfied for each of the seven years during the credit period.266 The substantially all test has to be satisfied by the CDE, even though it is the taxpayer investor that receives the NMTC and files the Form 8874. The Final Regulations provide a safe harbor under which cash distributions by a partnership will not be treated as a redemption. Under the safe harbor, a pro rata cash distribution by the CDE to its partners based on each partner’s capital interest in the CDE during the taxable year will not be treated as a redemption if the distribution does not exceed the CDE’s operating income (as defined in the Final Regulations) for the taxable year. In addition, a non–pro rata de minimis cash distribution by a CDE to a partner or partners during the taxable year will be not treated as a redemption. A non–pro rata de minimis cash distribution may not exceed the lesser of 5 percent of the CDE’s operating income for that taxable year or 10 percent of the partner’s capital interest in the CDE. The Final Regulations provide that, if a qualified equity investment fails the substantially-all requirement, the failure is not a recapture event if the CDE corrects the failure within 6 months after the date the CDE becomes aware (or reasonably 264 265 266
See §45D(g). See §45D(b)(1)(B). The 85 percent is reduced to 75 percent for the seventh year of the credit period. See Treas. Reg. §1.45D-IT(c)(5)(v).
䡲
679
䡲
c13.fm Page 680 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
should have become aware) of the failure. Only one correct is permitted for each qualified equity investment during the seven-year credit period. The Final Regulations further provide that if a CDE makes a capital or equity investment or loan with respect to a qualified low-income building under §42,267 the investment or loan is not a qualified low-income community investment to the extent that the building’s eligible basis under §42(d) is financed by the proceeds of the investment or loan. (m) Allocation of New Markets Tax Credit NMTC allocations are awarded to CDEs annually on a competitive basis, pursuant to a Notice of Allocation Availability (NOAA) published in the Federal Register.268 The first NOAA has recently been published. Each applicant that is selected to receive a NMTC allocation must enter into an allocation agreement with the CDFI Fund prior to receiving an allocation.269 The agreement specifies the terms and conditions of the NMTC allocation and will generally include the amount of the allocation, the approved uses of the allocation, the area(s) in which the equity investment proceeds may be used, the CDE’s schedule for obtaining equity investments and compliance/reporting requirements for the CDE. The CDE has five years from the date on which it enters into an allocation agreement with the CDFI Fund to enter into qualified equity investments with investors and 12 months from the date it enters into the qualified equity investment to make qualifying low-income community investments.270 The CDFI Fund will collect information on an annual basis to monitor CDEs compliance with the requirements of the allocation agreement.271 (n)
Compliance Monitoring
The CDFI Fund will collect information on an annual basis, which will be forwarded to the IRS, to monitor CDE’s compliance with the provisions of the Internal Revenue Code, the Treasury Regulations, and the requirements of the allocation agreement.272 This would be achieved by requiring the allocatees to provide QEI data within 60 days of its issuance and transactional data annually to the CDFI Fund. Such data will not only be used to monitor compliance, but also to evaluate the administration of the program. The CDFI Fund has established a Web-based reporting tool (the Allocation Tracking System [ATS]), which will enable it to obtain information regarding the issuance of QEIs to investors 267
268 269 270 271 272
Section 45D(i)(1) authorizes the Secretary to prescribe regulations as may be appropriate to carry out Section 45D, including regulations that limit the NMTCs for investments that are directly or indirectly subsidized by their federal tax benefits (including the low-income housing credit under Section 42 and the exclusion from gross income under Section 103). The final regulations do not prohibit a CDE from purchasing tax-exempt bonds because tax-exempt financing provides a subsidy to borrowers, not to bond-holders. See Guidance for Certification of Community Development Entities, New Markets Tax Credit Program, 66 Fed. Reg. 65,806 (Dec. 20, 2001). See Guidance, New Markets Tax Credits Program, 66 Fed. Reg. 21,846, 21,848 (May 1, 2001). Treas. Reg. §1.45D-1 T(c)(4)(i)(A). See Guidance, New Markets Tax Credits Program, 66 Fed. Reg. 21,846, 21,849 (May 1, 2001). Id.
䡲
680
䡲
c13.fm Page 681 Thursday, March 15, 2007 10:44 AM
13.5 NEW MARKETS TAX CREDITS
by the CDEs, such as the date the QEI was issued, how it was issued, and information concerning the investor.273 (o)
Leveraged Structure
The IRS confirmed in Rev. Rul. 2003-20274 that the tax credit investor in an NMTC transaction may fund its equity investment in a CDE by contributing cash and borrowing substantial funds from an unrelated third-party lender on a nonrecourse basis, in effect, application of a leveraged structure. The nonrecourse loan may not be secured by the assets of the “qualified low-income community investments” (QLICIs). Typically, in such a structure, the investor uses the borrowed cash from the lender, along with its own capital, to invest in the CDE, which then makes an equity investment or loan in a QLICI. The return to the CDE on its investment is used by the investor to pay back the loan from the lender, which in many cases leaves the investor with little cash return on its investment in addition to the NMTC it receives from the CDE. See Exhibit 13.2 for an example of a leveraged structure. The use of the leveraged structure would increase the amount of equity investments that would qualify for NMTC, especially for larger investment pools. The IRS, however, did not address the issue as to whether the leveraged E XHIBIT 13.2 The NMTC Leveraged Structure
273 274
The CDFI Fund published a request for comments regarding this Web-based proposed Allocation Tracking System (ATS). See 68 Fed. Reg. 32580 (May 30, 2003). Reg. Rul. 2003-20, 2003-7 I.R.B. 465.
䡲
681
䡲
c13.fm Page 682 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
structure may create a problem under §183 of the Code, such that the tax credit investor ’s investment would be deemed to lack economic substance because there is no indication that the activity was engaged in by the investor for the purpose of making a profit. The investor’s sole benefit in the transaction is the NMTC, since substantially all the cash it receives from the CDE in return for its equity in the CDE may be used to repay the loan from the lender. (Depending on the relationship of the interest charged on the nonrecourse loan and return generated on the QLICI over a seven-year period.) Thus, the investor may be deemed to have entered into the transaction solely for the tax benefits and without any expectation of making a profit. As a result, the IRS may challenge the transaction as one without economic substance and disallow the tax benefits projected to be available to the investor. NOTE In addition to the $480,000 received to service the fund level debt, the project pays $40,000 per year to provide a 2 percent return on the $2 million equity investment as well as an additional $100,000 per year to return over the 10 year, the $1 million of principal that otherwise would not be returned by the project. In the tenth year, at maturity of the project partnership loan, a principal payment of $9 million will be made, from which $8 million fund level loan will be repaid leaving $1 million for the equity investor. When combined with the $1 million additional interest and the $40,000 annual additional interest, the “economic substance” test will be met. As a result, the total annual interest payment from the project will be $480,000 plus $40,000 plus $100,000 or an annual amount of $620,000. (p)
New Market Tax Credit Guarantees.
In many cases a tax exempt organization either as general partner or managing member (or parent of a wholly-owned for-profit subsidiary) is asked to issue a guarantee or tax credit adjuster relative to the new market tax credit that's projected on the transaction. In accordance with a recent IRS guidance the guarantee must be limited to an amount that does not exceed the aggregate amount of developer and other fees (both payable and deferred) that the nonprofit or any affiliate is entitled to receive in connection with the project.275
13.6 (a)
RECENT IRS GUIDANCE REGARDING GUARANTEES AND INDEMNIFICATIONS Overview
After years of discussion between representatives of IRS and a coalition composed of nonprofit organizations involved in LIHTC projects, the IRS recently released guidance that contains a “safe harbor” for newly formed organizations intending to
275
See Section 13.b(g)(2).
䡲
682
䡲
c13.fm Page 683 Thursday, March 15, 2007 10:44 AM
13.6 RECENT IRS GUIDANCE REGARDING GUARANTEES AND INDEMNIFICATIONS
participate in the venture. Nonprofit organizations that comply with the provisions of the safe harbor should receive favorable determination of tax-exempt status.276 CAVEAT While the guidance specifically applies to newly formed nonprofits seeking exemption from federal income tax, its scope impacts on all LIHTC transactions by establishing standards applicable to LIHTC joint ventures involving nonprofit organizations and for profit investors and/ or developers. Accordingly, for-profit investors and developers must be aware of, and sensitive to, the safe harbor provisions, as they will be critical to the newlyformed nonprofit that intends to participate in the LIHTC joint venture, and they will govern many of the terms of such venture. Moreover, some safe harbor provisions also may be applicable, by analogy, to transactions involving new markets tax credits. (b)
Background
While the IRS has recognized the provision of housing for low-income persons as a charitable activity, nonprofits planning to conduct this activity through LIHTC joint ventures with for-profit investors have historically been subject to extraordinary scrutiny. As with any joint venture involving nonprofit organizations and for-profit entities, the IRS’s primary concern is that the joint venture permit the nonprofit organization to act exclusively in furtherance of its exempt purposes, and not primarily for the benefit of the for-profit parties. Specifically, when §§501(c)(3) and 501(c)(4) organizations serve as general partners in LIHTC limited partnerships, or managing members in LIHTC limited liability companies, the IRS has been concerned about: 1. The limited ability of the tax-exempt organization to control the LIHTC entity (which could restrict the ability of the nonprofit organization to act exclusively in furtherance of its exempt purposes) 2. Certain “industry-standard” guarantees made by these organizations to investors (which have been viewed by the IRS as raising potential private benefit concerns) In the Exempt Organizations Technical Instructions Program for 2003 on Housing Partnership Agreements, the IRS stated its position on exempt organization participation in partnerships with for-profit entities in the low-income housing area. The IRS was concerned about guarantees and indemnifications, and said it may not approve exemption for nonprofit organizations participating in such ventures. In the 2003 Continuing Professional Education Manual, the IRS provided a two-step analysis in making a determination as to whether an exempt entity’s participation as a general partner in a partnership with for-profit investors would have a negative effect on exemption. The first step, which is relatively 276
See M. Sanders and J. Breed, “IRS Issues Guidance for Nonprofit Organizations Involved in Low Income Housing,” Real Estate Finance, August 2006.
䡲
683
䡲
c13.fm Page 684 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
easy to satisfy because of the application of the set-aside requirements of IRC §§42 and 142, requires that the exempt organization’s participation in the partnership further its exempt purpose. The exempt organization is required to show that the activities of the partnership further the nonprofit partner’s exempt purposes, which typically is the relief of the poor and distressed or the underprivileged. The exempt organization can achieve this either by proving that the partnership’s housing project meets the safe-harbor provisions of §3 of Rev. Proc. 96-32, or by relying on the list of facts and circumstances also provided in §3 of Rev. Proc. 96-32 that the housing project is operated for the charitable purpose of assisting the poor and distressed. The second prong of the test requires evidence that the partnership structure permits the exempt organization to act exclusively in furtherance of its exempt purposes rather than for the benefit of its for-profit partners. The IRS was concerned with the possibility of “impermissible private benefit.” To satisfy this test, the IRS states that the partnership documents must ensure that conflicts between charitable goals and private interests do not result in impermissible benefits to the for-profit investors. Most partnership agreements contain a provision giving the limited partner the right to approve amendments to the partnership agreement or to approve dissolution of the partnership. The IRS believed that such provisions may protect the limited partner’s investment by restricting the right of the general partner to change the partnership arrangement after the investment is made. The IRS’s concern is that this right held by the limited partner raised the question as to who is in control of the partnership. Furthermore, the IRS also focused on whether the exempt general partner is obligated to provide environmental indemnifications, completion or performance guarantees, loss reserves, and return of capital indemnification, because such guarantees could place the exempt entity’s assets at risk while providing more than incidental benefits to the for-profit limited partners. CAVEAT However, many joint venture agreements limit guarantees to the assets the exempt organization has invested in the joint venture, usually to the development fee. The limitation would shield the remaining assets of an established exempt organization, or parent, and shift some of the risk back to the limited partner. Additionally, oversight by a state government, through the terms of a grant or loan, might help assure that the partnership fulfilled its exempt purpose, and limit the amount of benefit flowing to the for-profit. Second, the IRS was concerned that the agreement precluded the charitable general partner from amending its articles or by-laws without the reasonable consent of the for-profit limited partner. The IRS wanted the charity to be in control of the partnership to ensure that its operation is conducted in furtherance of the charitable purposes. The IRS believed that this right in the limited partner raised the question as to who is in control of the partnership. Third, the Service was concerned if the general partner was obligated to fund and guarantee construction completion because it may place the charity’s assets at risk. 䡲
684
䡲
c13.fm Page 685 Thursday, March 15, 2007 10:44 AM
13.6 RECENT IRS GUIDANCE REGARDING GUARANTEES AND INDEMNIFICATIONS
Finally, there was concern that the charity may be obligated to purchase the investor’s interest if the partnership became ineligible to receive 50 percent or more of the credits projected to be available in the financial projections. The Service viewed such an obligation as one to return capital to the investor from the charity’s own funds, which they believe is directly contrary to the holding in Plumstead. According to the IRS, all investments carry a degree of risk. Thus, a partnership arrangement that requires the general partner to guarantee the tax credits due to the limited partners or cover partnership tax liabilities that are not attributable to the general partner’s misconduct may go beyond the fiduciary responsibility of the general partner and provides impermissible private benefits to the limited partners. A provision that only obligates the general partner to make all reasonable efforts to ensure that the partnership is operated so as to qualify for tax credits would be acceptable to the Service. In fact, in order to attract funds for a project in the inner city, the deal often needed to include certain standard industry provisions that are comparable to many that are typically contained in loan agreements. In order to raise funds from experienced for-profit institutional investors, nonprofits were typically required to provide indemnifications and guarantees to the investors to minimize certain investment risks. Practitioners argued that the IRS misread the application of the Plumstead case. In the typical case, the investor limited partner is not a shareholder, director, or officer of the charity and has no controlling interest in its activities. The charity generally has exclusive management of and control over the charitable business. The investor’s only significant economic benefit in the partnership arrangement is the availability of the tax credits. These tax credits are congressionally mandated. Indeed, Congress has attracted charitable organizations as sponsors of low-income housing projects financed with the low-income housing tax credits by providing a set-aside equal to 10 percent of all the tax credits for such organizations. See IRC §42(h)5. CAVEAT It is important to note that the terms of the typical limited partnership agreement specify that the conditions for receipt of limited partner equity funds for the development of the housing project are similar to the terms of a lender’s loan agreement for debt financing. For example, loan agreements will usually contain affirmative and negative covenants that restrict to a certain extent the freedom of the borrower. It is important to keep in mind that even if the charity is removed as a general partner, the project will continue to be subject to income and rent restrictions for the remaining term of the tax credit regulatory agreement. These IRS concerns, nevertheless, resulted in substantial delays in processing the applications of nonprofit organizations that were seeking tax-exempt status. Contributing to the lag in processing time was the fact that the IRS generally requested that an applicant organization produce final documents governing its limited partnerships or LLCs before processing the application. 䡲
685
䡲
c13.fm Page 686 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
CAVEAT Because final documents are typically the result of the negotiating process, with agreements being reached within days of closing, the requirement that the final governing documents be reviewed by the IRS inevitably resulted in delayed closings. In some circumstances, when the approval of tax-exempt status was a precondition to closing, the mandatory IRS review of final documents created substantial hardships for pending LIHTC transactions. The new guidance, issued by the acting director of the IRS Exempt rulings and Agreements Division, sets forth criteria regarding LIHTC transactions which, if met, will allow participating §§501(c)(3) and 501(c)(4) organizations to receive favorable determination of tax-exempt status before final governing documents are executed. CAVEAT Failure to satisfy the safe harbor requirements does not necessarily mean that the IRS will issue an adverse determination of tax-exempt status; a favorable determination may still be forthcoming if the applicant organization can otherwise address any IRS concerns. (c)
Requirements For Applicant Organizations
The safe harbor criteria set forth in the new guidance may be divided into two general categories: 1. Information must be submitted that describes the nexus between the applicant organization’s proposed activities, and its charitable purposes. 2. In the absence of submission of final governing documents for an LIHTC limited partnership or LLC, written representations need to be made describing certain provisions that will be in the final governing documents with respect to the charitable purposes of the LIHTC limited partnership or LLC as to the management of the LIHTC entity, and that limit the applicant organization’s financial exposure in case the housing project does not proceed as planned, including representations regarding the specific terms and conditions in the final governing documents and representations regarding actions to be performed by the applicant organization. CAVEAT Although the written representations described in Section 13.6(e) subsequently may be submitted to the IRS in lieu of final documents, when those documents are eventually executed, they must be sent to the IRS. Presumably, if the representations made in the exemption application regarding the final documents were not accurate, the IRS could withdraw a favorable determination letter that it had previously issued to the organization. 䡲
686
䡲
c13.fm Page 687 Thursday, March 15, 2007 10:44 AM
13.6 RECENT IRS GUIDANCE REGARDING GUARANTEES AND INDEMNIFICATIONS
(d)
Description of Organization And activities
An applicant nonprofit must describe to the IRS, in its exemption application, its proposed activities, including identification of a specific housing project, and how participation in the project will accomplish the organization’s charitable purposes, consistent with Revenue Procedure 96-32. Newly formed organizations that plan to participate in LIHTC transactions, but have not yet identified a specific project for participation, will not satisfy the safe harbor, and may be denied exemption altogether pursuant to rules requiring that applicant organizations describe their proposed activities with sufficient detail to permit a conclusion that the organization qualifies for exemption. An applicant organization also must submit a conflicts of interest policy that it has adopted, which protects the organization’s interest when it is contemplating entering into a transaction or arrangement that might result in an excess benefit transaction, or might benefit the private interests of the applicant organization’s officers, directors, trustees, or partners. CAVEAT The IRS safe harbor is silent as to whether newly formed nonprofits planning to participate in an LIHTC joint venture indirectly whether through a single member LLC or a for-profit subsidiary, must make the representations discussed herein. We assume that when a disregarded LLC is used, representations would be required, but when a for-profit is used (assuming corporate formalities are observed), they would not. (e)
Written Representations Regarding Charitable Purpose
The following written representations, which must be submitted by an applicant organization in lieu of final governing documents in order to be within the safe harbor, are intended to eliminate concerns regarding the ability of the nonprofit organization to control the LIHTC entity. 1. Statement of Charitable Purpose. The governing documents of the LIHTC limited partnership or LLC must state that it will operate housing that it owns in a manner that furthers charitable purposes by providing decent, safe, sanitary, and affordable housing for low-income persons and families (including elderly or physically handicapped individuals, when appropriate). 2. Charitable Purposes Must Prevail. The governing documents also must include a provision that states that, in the event of a conflict between the obligations of the applicant organization to operate the LIHTC limited partership or LLC in a manner consistent with charitable purposes and any duty to maximize profits for the for-profit investors, the charitable purposes contained in the governing documents will prevail. Some commentators have noted that the so-called charitable override provision is problematic, as it appears to give the nonprofit organization unlimited power with respect to using the LIHTC property to further charitable purposes 䡲
687
䡲
c13.fm Page 688 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
at the expense of the investors. The argument is that the nonprofit general partner (or managing member) could take certain actions, such as transferring the property to a charitable affiliate for no consideration, because such an action would further a charitable purpose. However, this concern appears to be misplaced; the IRS has historically given close scrutiny to joint ventures between nonprofit organizations and forprofit entities to determine whether conflicts between charitable purposes and profit motive are likely to arise. Moreover, the IRS has, in the past, held that the two factors that indicate that a nonprofit organization participating in a joint venture qualifies for tax-exempt status are: (1) the inclusion in the joint venture governing documents of provisions stating that the joint venture was created for charitable purposes; and (2) that charitable purposes will be given priority over profit motives. Thus, these provisions are not radical departures from existing standards regarding nonprofit participation in LIHTC entities; instead, they represent criteria that have been consistently used by the IRS in considering whether such nonprofits qualify for tax-exempt status. It is, therefore, unlikely that mandating the inclusion of these provisions in the safe harbor will signal any change in the way that nonprofit organizations fulfill their responsibilities as general partners and managing members of LIHTC entities. (f)
Written Representations Regarding Management
The written representations regarding management of the LIHTC entity are intended to give the participating nonprofit organization sufficient control over the LIHTC entity to ensure that the LIHTC entity will accomplish its charitable purposes. 1. Consent May Not Be Unreasonably Withheld. If the applicant organization is required to obtain the consent of limited partners or investor members regarding certain matters not involving day-to-day operations, such consent may not be unreasonably withheld. A number of permissible consent rights are identified within the guidance, including the sale or refinancing of the LIHTC project and the acquisition of additional property, but additional, non-enumerated consent rights may also be included. However, if those additional non-enumerated consent rights become too extensive, the IRS may object to their inclusion. 2. Removal Only for Cause. Documents governing limited partnerships or LLCs must provide that rights of limited partners or other members to remove the applicant organization as general partner may only be for “cause,” and notice must be provided to the applicant organization that states the cause for the action and allows the organization a reasonable period to cure any deficiencies. The definition of “cause” may be tailored to the specific facts of the transaction. (g)
Written Representations Regarding Guarantees
LIHTC transactions are typically structured so that the nonprofit organization, acting as general partner or managing member, is obligated to provide 䡲
688
䡲
c13.fm Page 689 Thursday, March 15, 2007 10:44 AM
13.6 RECENT IRS GUIDANCE REGARDING GUARANTEES AND INDEMNIFICATIONS
guarantees to the investors to protect their investments. In such a case, the IRS has included certain guidelines within the safe harbor, which are designed to minimize the potential exposure of charitable assets for private use. 1. Construction Contracts. LIHTC limited partnerships and LLCs must enter into a fixed-price construction contract with a bonded contractor or a contractor that provides a performance letter of credit or adequate personal guarantee. If an operating deficit guarantee is required of the applicant organization, its liability must be limited to a period not more than five years from the date the project achieves break-even operations, or limited to an amount equal to no more than six months of operating expenses. 2. Tax Credit Guarantees. Any tax credit guarantee made by the nonprofit organization to investors must be limited. The limitation may be adopted through either of the following approaches: A.
If the governing document of the limited partnership or LLC includes separate tax credit adjuster provisions, the guarantee must be limited .under each separate adjustable provision to an amount that does not exceed the aggregate amount of developer and other fees (both payable and deferred) that the applicant organization, or any affiliate, is entitled to receive in connection with the project. This tax credit adjuster provision is also applicable, by analogy, to new markets tax credit transactions.
B.
(b) Any payments by the applicant nonprofit organization must be treated as capital contributions or loans to the limited partnership or LLC, and their repayment must take priority over any other distribution of residual assets to partners upon sale or refinancing of the property. Payments under this approach may be unlimited in amount. CAVEAT
Tax credit adjuster provisions that combine these two approaches would be permissible. 3. Right of First Refusal. The new safe harbor requires applicant organizations to secure a right of first refusal to acquire the project at the end of the LIHTC compliance period under §42(i)(7) of the Internal Revenue Code. However, the organization’s board of directors must review any purpose of the project to ensure that the purchase price is, in fact, “reasonable and consistent with the organization’s charitable status” and the price cannot exceed fair market value of the property.
䡲
689
䡲
c13.fm Page 690 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
CAVEAT Requiring the nonprofit organization to secure a right of first refusal for the lower of fair market value or the §42(i)(7) formula price does not take the right of first refusal out of the §42(i)(7) safe harbor. Under general tax principles, the owner of property may grant a right to another party to purchase the property for fair market value without jeopardizing ownership of the property. Although commentators have suggested that the “reasonable” standard of this provision is open to interpretation (and could thereby invite costly litigation between the nonprofit general partner or managing member and the for-profit investors), given the current pricing for LIHTC, in many transactions the investor ’s capital account remains positive at the end of the 15-year compliance period. When the investor’s capital account is positive, the §42(i)(7) formula price equals the amount of indebtedness secured by the property and no valuation questions will arise. If the debt exceeds the fair market value of the property, either the right of first refusal will not be exercised, or the lender must agree to restructure the debt and the investor’s equity has already evaporated. In cases in which the fair market value substantially exceeds the debt, the formula price will control. As a result, litigation or even extended negotiation to determine the fair market value of a project will be limited to circumstances in which the fair market value of a project exceeds the debt by an amount less than the exit tax, a relatively narrow universe of projects. 4. Repurchase Guarantee. If the applicant organization must guarantee to repurchase the investors’ interest in the limited partnership or LLC in case of a failure to meet certain fundamental requirements relating to the viability of the project, the repurchase price may not exceed the amount of capital contributions. Under this representation, “mark up” of the repurchase amount to cover syndication costs is not permitted, regardless of whether the syndicator is a for-profit or a tax-exempt entity. 5. Environmental Report. An applicant organization is required to protect itself from environmental liability by reviewing an independent Phase I environmental report on the proposed project. (h)
Conclusion
The recent issuance of guidance by the IRS in the form of a safe harbor is a positive development for nonprofit organizations planning to participate in LIHTC projects as general partners or managing members. While the provisions required by the safe harbor are more restrictive than those currently included in the governing documents of many LIHTC entities, investors may adequately protect their interests under the new standards. Representatives of the IRS have cautioned that when the executed documents do not comply with the guidelines set forth in the new guidance, tax-exempt organizations should identify the alternative provisions in the documents that provide equivalent protection for the nonprofit, and identify reasons why the guidelines were not followed. At this time, it is not recommended that tax-exempt organizations apply these standards retroactively, or attempt to 䡲
690
䡲
c13.fm Page 691 Thursday, March 15, 2007 10:44 AM
13.7 REPORTABLE LIHTC/NMTC TRANSACTIONS
renegotiate specific provisions in previously executed documents, but documents entered into after the issuance of the guidelines should comply with the requirements of the safe harbor.
13.7
REPORTABLE LIHTC/NMTC TRANSACTIONS
The Tax Increase Prevention and Reconciliation Act of 2005 added new §4965, which provides for an excise tax on exempt organizations and organization managers that participate in certain types of reportable transactions. Notably, section 4965 holds particular significance to low-income housing development and new markets tax credit joint ventures that often contain contractual protection such as “credit adjustor” provisions. Transactions with contractual protection are generally treated as “reportable transactions” under section 6011. Joint ventures in the low-income housing or commercial arena are typically structured as limited partnerships with the exempt entity serving as general partner with one or more for-profit limited partners. The for-profit partners generally provide equity and, in return, are allocated all or substantially all of the tax credits generated by the project. The exempt organization, in addition to serving as general partner, will often assume the role of sponsor. As sponsor, the exempt organization undertakes and oversees the development and construction of the project and, in return, receives a developer fee for this work. The exempt sponsor may oversee the day-to-day operations of the project and importantly, ensure that the project remains in compliance with the requirements of §§42 and 45D, respectively. Additionally, for purposes of §4965, the exempt party as sponsor may be obligated to return to the for-profit investors some or all of their equity in the project if the project fails at any time to fully qualify for the LIHTC or NMTC under the Code. To this end, the exempt organization enters into a joint venture whereby it may be paid developer fees and management fees and may make payments to its for-profit partners if less than all of the projected credit is generated; this provision could cause the entire venture to be deemed a transaction with “contractual protection” under Treas. Reg. §1.60114(b)(4) and therefore, treated as a reportable transaction. In addition to the low-income housing structure discussed earlier, some ventures involve a for-profit investor who provides additional credit for the development. In these arrangements, the investor will provide a guarantee to the project receiving the LIHTC or NMTC as an incentive to attract new equity partners. While this structure may generate additional project capital and/or decrease debt, it nonetheless involves exempt partners in a contractual guarantee transaction if the guarantee on investment is extended to partners. Treas. Reg. §1.60 11-4(b)(4)(ii) encompasses deals where a refundable fee is paid to a partner who makes a statement concerning the potential tax benefits and consequences that may result from the venture as a contractual protection transaction. For low-income joint ventures, this regulation could have been interpreted to apply if an exempt organization merely advised a potential investor that it intends to build a LIHTC or NMTC project with the potential tax benefits that result. 䡲
691
䡲
c13.fm Page 692 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
LIHTC transactions must already be disclosed by parties on Form 8609. Nonetheless, §4965 arguably makes any involvement by exempt organizations in the low-income housing or new markets ventures described earlier subject to the excise tax. Since the policy behind the new excise tax was more a disclosure of involvement in prohibited shelter transactions and not, the outright ban on exempt organization’s involvement in these deals, the Service has announced that it will exempt new §4965 from nonprofit organizations and their managers who participate in such ventures. CAVEAT In January, 2007 the IRS announced that a wide range of transaction with contractual protection do not have to be reported under Treas. Reg. §1.6011-4(b)(4) including those in which the refundable or contingent fee is related to the low income housing credit, the new markets tax credit, and the empowerment zone employment credit. The guidance also applies for the purposes of §4965 relative to federal income taxes.* *
Rev. Proc. 2007-20 which modifies and supersedes Rev. Proc. 2004-65.
13.8
GULF ZONE OPPORTUNITY ACT OF 2005
In December, 2005, President Bush signed the Gulf Zone Opportunity Act of 2005 (GO Zone Act) into law.277 The GO Zone Act created tax incentives totaling about $8.6 billion targeting rebuilding of the Gulf Coast in the wake of Hurricanes Katrina, Rita, and Wilma. The Act creates a GO Zone comprised of the counties and parishes in Louisiana, Mississippi, and Alabama that were designated as warranting individual and public assistance as a result of Hurricane Katrina. The GO Zone Act provides an emergency allocation of LIHTC in 2006, 2007, and 2008 in the amount of $18 times each State’s population in the GO Zone, more than 9 times larger than the customary allocation of about $1.90 per capita. The emergency allocation must be used to build low-income housing in the GO Zone and may not be carried forward from year to year. In addition, Florida and Texas were each allocated an additional $3.5 million of 2006 LIHTC. The GO Zone, as well as the Rita Zone and the Wilma Zone created by the Act, were designated “difficult development areas” for 2006, 2007, and 2008, making LIHTC projects developed in such zones eligible for the 130 percent basis increase under §42(d)(5)(C)(i). The GO Zone further provides that operators of LIHTC properties may rely on the representations of prospective tenants displaced by reason of Hurricane Katrina for purposes of determining whether such individuals satisfy LIHTC income limitations. With respect to the Historic Rehabilitation Tax Credit, the GO Zone Act increases the credit for historic projects within the GO Zone from 10 percent of qualified rehabilitation expenditures (QREs) to 13 percent for qualified rehabilitated buildings and from 20 percent of QREs to 26 percent for certified historic structures. 277
Pub L. No. 109-135, 119 Stat. 2577.
䡲
692
䡲
c13.fm Page 693 Thursday, March 15, 2007 10:44 AM
13.8 GULF ZONE OPPORTUNITY ACT OF 2005
The GO Zone Act also provides $1 billion from 2005 through 2007 in New Markets Tax Credit authority for investments in CDEs with recovery and redevelopment in the GO Zone as a significant mission. Other tax incentives created by the GO Zone Act include: • Authority for Louisiana, Mississippi, and Alabama to issue a special class
of private activity bonds (GO Zone Bonds) outside the state volume cap to finance the acquisition, construction, and renovation of nonresidential real property, qualified low-income residential rental housing, and public utility property. The amounts authorized are $7.9 billion for Louisiana, $4.8 billion for Mississippi, and $2.1 billion for Alabama. Authority to issue GO Zone Bonds expires on December 31, 2010. Interest on GO Zone Bonds will not be subject to the AMT. • Authority for states and municipalities in the GO Zone for additional
advance refunding before January 1, 2011, which permits issuers to restructure eligible debt by refinancing at a lower rate. The amounts authorized are $4.5 billion for Louisiana, $2.25 billion for Mississippi, and $1.125 billion for Alabama. Some §501(c)(3) bonds may also be eligible for advance refunding. • Authority for GO Zone States to issue debt service tax credit bonds to
help devastated communities meet debt service obligations incurred as a result of the hurricanes. Bonds must mature within two years and must be issued before January 1,2007. The amounts authorized are $200 million for Louisiana, $100 million for Mississippi, and $50 million for Alabama. • For a six-month period, a 30 percent tax credit for employers for the cost
of employer-provided housing (up to $600 per month) for employees located in the GO Zone. In addition, up to $600/month of such costs may be excluded from the employee’s income. • For state and local governments issuing mortgage revenue bonds, a
waiver through 2010 of the first-time homebuyer requirement so that existing homeowners whose homes were rendered uninhabitable by hurricane, Katrina, Rita, or Wilma may refinance or obtain low-interest rate mortgages financed by such bonds. • Authority to allow up to $150,000 of a mortgage financed with mortgage
revenue bonds be used to repair a damaged home (rather than for the purchase of a new home). • Businesses may claim an additional first-year depreciation deduction
equal to 50 percent of the cost of new property investment in the GO Zone. • An increase of the amount that may be expensed under §179 by small
businesses from $100,000 to $200,000 for qualifying investments made in the GO Zone. The Act also increases the phase-out floor for defining small businesses from $400,000 in annual investments to $1 million. • An extension of the carryback period for net operating losses from two
years to five years for losses attributable to: (a) new investment and 䡲
693
䡲
c13.fm Page 694 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
repairing existing investment in areas damaged by Hurricane Katrina, (b) business casualty losses caused by Hurricane Katrina, and (c) moving expenses and temporary housing expenses for employees working in areas damaged by Hurricane Katrina. • Businesses may expense 50 percent of cleanup and demolition costs in the
GO Zone that are incurred before December 31, 2007.
䡲
694
䡲
c13.fm Page 695 Thursday, March 15, 2007 10:44 AM
A P P E N D I X
1 3 A
New Markets Tax Credits Project Compliance/Qualification Checklist* 1. Qualified Census Tract—[AU: CONFIRM NUMBER] 2. Debarment Certificate 3. NMTC Compliance Certificate—368656 (Reasonable Expectation Throughout Compliance Period; “Substantially All” Test) 4. NMTC Representations, Warranties, and Covenants A.
Single-Asset, Special-Purpose Entity with Separateness Covenants— Suggested Language in Document #368445
B.
Gross Income Test (50 percent of the total gross income of borrower derived from a qualified census tract)
C.
Service Test (40 percent of services performed by borrower by its employees must be within a qualified census tract)
D.
Tangible Property Test (40 percent of the use of the QALICB’s tangible property must be within a qualified census tract; 85 percent if no employees)
E.
Nonqualified Financial Property Restriction
F.
Active-Generate Revenue within Three Years
G.
QALICB Bears All CDFI-Related Fees—Annual Fee, Audit Fees, Tax Preparation Fees
H.
See Suggested Language—Documents #360217 and #347723
5. Loan Concepts
*
A.
Restricted Use of Funds
B.
Draw-down Funds within One Year from QEI
C.
Interest-Only Payments
D.
Prepayment Lockout
The material in Appendix 13.A is provided by Colin Uckert.
695
c13.fm Page 696 Thursday, March 15, 2007 10:44 AM
LOW-INCOME HOUSING NEW MARKETS, REHABILITATION, AND OTHER TAX
E.
Reserves Limited
F.
Signage/Publicity
6. Business and Property Use Restrictions (see Documents #360217 and #347723) A.
At least 20 percent of project must be commercial
B.
Less than 5 percent collectibles
C.
Less than 5 percent nonqualified financial property
D.
Not a bank, credit union, or other financial institution
E.
Not developing or holding intangibles for sale or license
F.
No benefit from LIHTCs
G.
No “sin” uses (QALICB or tenants)
7. Reporting Requirements A.
Project and QALICB/Guarantor Financials
B.
Economic impact
C.
Periodic recertification of compliance with NMTC provisions
D.
Site visits; right to review books and records
E.
Permission to disclose
8. Reimbursement and Indemnification Agreement (tax credit recapture guaranty)—in Favor of CDE (Not Investor) 9. Exit Strategy 10. Other Issues A.
Refinance of existing “real estate” debt prior to maturity/no loan purchase
B.
Related parties rule
䡲
696
䡲
c14.fm Page 697 Thursday, March 15, 2007 10:45 AM
C H A P T E R
F O U R T E E N 14
Joint Ventures with Universities
14.1
INTRODUCTION
As increased competition, the emergence of limited service providers, and decreased insurance reimbursement revenues have propelled non-profit healthcare entities into joint ventures, educational institutions (namely, universities) have likewise turned to joint ventures as an alternative solution to the increasing competition for full-paying students, rising capital costs, and decreased investment returns. Joint ventures with universities typically involve an association between the institution and a corporation, government agency, other colleges and/or universities1, and/or individuals (including members of a university’s own faculty.) The popularity of these partnerships can be easily understood by the “win/win” scenarios created for the parties involved; the educational institutions gain a new means to expand enrollment, create revenue, and gain visibility and prestige, while the nonexempt partners, in turn, receive unparalleled access to an institution’s vast resources, “brainpower,” and reputation. Recent examples of these often unique partnerships, and the symbiosis they present between the worlds of academia, government, and business abound: • The Rice Project: A joint enterprise between Missouri State University and
Ventria Bioscience, Inc. to develop a genetically engineered “super rice” aimed at reducing a decades-long depression in state farm revenues.2 • A joint venture between Howard University and the Washington, D.C.
City Council to construct and operate The National Capital Medical Center, a $400 million, 250-bed facility promised to offer hundreds of new jobs in Washington, DC.3
1
2 3
Although the IRS has not explicitly endorsed joint ventures between exempt organizations, it is the author’s opinion that these arrangements should pose no concern so long as the partners exercise care to ensure that the joint venture furthers the specific charitable exempt purposes of both exempt organizations. Alexei Barrionuevo, “Can Gene Altered Rice Help Rescue the Farm Belt?,” New York Times (August 16, 2005). “Certificate of Need? Yes!,” Washington Post (January 10, 2006).
䡲
697 䡲
c14.fm Page 698 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
• The Center for Advanced Study of Language: A joint venture between the
University of Maryland and the National Security Agency to provide advanced instruction and anti-terrorism seminars in Arabic for college students and recent college graduates.4 • A $25 million joint undertaking between The University of California at
Berkeley and the Search for Extraterrestrial Intelligence (SETI) Institute, Inc. to develop high-powered telescopes and satellite dishes to search for signs of intelligent life in the universe.5 • A joint venture between The University of Washington and Apex Learn-
ing, Inc., to offer 11 distance learning degrees, 27 online certificate programs and more than 300 distance courses with nearly 10,000 in yearly enrollments.6 Notably, while these examples illustrate a growing, and diverse trend of joint ventures involving universities, they are not without controversy; political pressures, conflicting societal influences, concerns about international investments and links to terrorism, and ethical concerns about biotechnology and genetic research pervade. In addition, and critical to this discussion, universities that choose to participate in this new era of joint ventures face a significant tax issue; namely, whether participation in a joint venture might (at best) require the institutions to remit income tax on their unrelated business income (UBIT) or, (at worst) jeopardize the institution’s federal tax-exempt status under §501(c)(3) of the Internal Revenue Code and Treas. Reg. §1.501(c)(3)1(c)(1). (a)
IRS Position on University Joint Ventures
The main tax difficulty confronting joint ventures with universities is the Internal Revenue Service (IRS) position (originally developed in the hospital context) that an educational institution acting as a general partner in a joint venture could jeopardize its basic Internal Revenue Code (IRC) §501(c)(3) exemption if the venture is not properly structured.7 In considering the merits of a joint 4 5 6 7
Amy Argetsinger, “Arabic Language A Tough Assignment,” Washington Post (July 3, 2004). Leigh Strope, “No Life of Leisure for Older Americans,” Washington Post (August 19, 2001). Information available at: http://www.apexlearning.com/about/about partners.asp (Last viewed on: February 26, 2006). See generally Chapter 3. A university may be exempt from taxation pursuant to §§501(a), 501(c)(3) of the Internal Revenue Code which provide an exemption for corporations organized and operated exclusively for charitable purposes. A university is described in the Regulations within the definition of educational organizations, which includes institutions such as universities. Reg. §1.170A-9(b)(1). The main characteristic of a university is that its primary function is the presentation of formal instruction, and that it maintains a regular faculty and curriculum, and has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Reg. §1.170A-9(b)(1); §170(b)(1)(A)(ii). Furthermore, the educational activities must be the primary activity of the university and any non-educational activities must be incidental. Id. A university may also be exempt from taxation pursuant to §§501(a), 501(c)(3), which provide an exemption for a corporation organized and operated exclusively for scientific purposes. See also Reg. §1.501(c)(3)-1(d).
䡲
698
䡲
c14.fm Page 699 Thursday, March 15, 2007 10:45 AM
14.1 INTRODUCTION
venture8, the IRS will look through the structure of a joint venture, and attribute the activities of the enterprise back to the exempt partner.9 If the venture is unrelated to the exempt organization’s purposes, but does not constitute a substantial part of the exempt partner’s activities, the income from the venture might be unrelated business income subject to the unrelated business income tax (UBIT), absent exclusion.10 If the activity does not further an exempt purpose, and constitutes all or a substantial portion of the nonprofit’s activities, it could jeopardize the nonprofit’s tax-exempt status.11 However, in the university context, loss of taxexempt status under §501(c)(3) would rarely be an issue because virtually no project, however major, would be so materially relative as to a involve all of an institution’s resources. To illustrate, it is unlikely that a singular research project (such as the development of bioengineered rice) would be so large as to threaten the organization’s exempt status.12 Additionally, the Treasury Regulations specify that a university may engage in research that does not further its exempt purpose without jeopardizing its exemption provided that the university meets the organizational test13, and that the unrelated research is not its primary activity.14 Moreover, while in the non-educational context, the income from such research could constitute UBTI, in the educational context, research can either be classified as scientific or educational and therefore, related to the organization’s exempt purposes. In such cases, the income generated by the research would not subject to UBIT.15 (i) Rev. Rul. 2004-51: An Overview. Since the Internal Revenue Service (IRS) issued Revenue Ruling 98-15, where it emphasized “control” of the joint venture 8
9 10
11 12 13 14 15
Notably, in Rev. Proc. 2006-4, the IRS announced that it would not respond to requests for rulings on whether an exempt entity’s involvement in a proposed joint venture would jeopardize its tax exempt status. Rev. Proc. 2006-4, 2006-1 I.R.B. 132 (January 3, 2006). Accordingly, the practitioner must rely upon prior guidance and specifically, in the context of educational joint ventures, Rev. Rul. 2004-51. See Section 4.2. The author wishes to thank J. Patrick Whaley of Musick, Peeler & Garrett LLP, Los Angeles, California, for his insightful assistance with this chapter. §512(c). Unrelated business income tax (UBIT) issues frequently arise in the university context. In fact, the UBIT was enacted in response to the practice of some exempt charitable and educational organizations engaging in “a wide variety of business undertakings . . . clearly unrelated to their primary functions.” Hearings Before the Committee of Ways and Means, 81st Cong., 2d Sess. 19 (1950). The most infamous example of this practice was the operation of a spaghetti factory by New York University. Clarence Labell Post. No. 217, Veterans of Foreign Wars of the United States v. United States, 580 F.2d 270, 272 (8th Cir. 1978), cert. dismissed, 439 U.S. 1040 (1978); 96 Cong. Rec. 9366 (1950) (remarks of Rep. Lynch). See C.F. Mueller Co. v. Commissioner, 190 F.2d 120 (3d Cir. 1951). See generally Priv. Ltr. Rul. 78-52-001 (Mar. 15, 1978). Redlands Surgical Services, Inc. v. Commissioner, 113 T.C. No. 3 (July 13, 1999). For a detailed discussion of Redlands, see Section 4.2 (f). J. Gilbert, “Research, Technology Transfers and the Unrelated Business Income Tax,” Exempt Organization Tax Review 9 (June 1994):1277. See Chapter 2. Reg. §1.501(c)(3)-1(d)(5)(v). See §512(c); §512(b)(8); Technical Advice Memorandum 8445007 (July 24, 1984) (research activities deemed scientific and educational). On the other hand, not all activities by a university will be deemed educational. See, e.g., Iowa State University of Science and Technology v. The United States, 500 F. 2d 508 (Ct.Cl. 1974) (university owned television station deemed unrelated because commercial nature of its activities were far beyond any educational benefit provided). Also see J. Gilbert, “Research, Technology Transfers and the Unrelated Business Income Tax,” Exempt Organization Tax Review 9 (June 1994): 1277.
䡲
699
䡲
c14.fm Page 700 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
by the exempt organization as the crucial factor in determining whether an exempt entity entering into a whole joint venture with a for-profit entity would continue to maintain its tax-exempt status, it has been unclear as to whether or not the IRS would require that “control” by the exempt organization also be met in an ancillary joint venture. This uncertainty became more definite following the United States Tax Court decision in Redlands Surgical Services v. Commissioner16 (Redlands), and the Fifth circuit’s decision in St. David’s Health Care System v. United States17 (St. David’s). A response on this issue of “control” in an ancillary joint venture came on May 6, 2004, when the Service issued Rev. Rul. 2004-51. In Rev. Rul. 2004-51, 2004-22 I.R.B. 974,18 the IRS analyzed an ancillary joint venture between an educational charitable organization and a for-profit entity. In the Ruling, a university, exempt from federal taxes under §501(c)(3), sought to expand its educational offerings by forming a limited liability company (LLC) with a for-profit entity specializing in interactive video training. The Articles of Organization and the Operating Agreement provided that the LLC’s sole purpose was to offer teacher training programs to satellite locations using interactive video technology. The university and the for-profit each maintained a fiftypercent share in the company, and had equal representation on the Board of Directors. All allocations, returns of capital, and distributions were to be made commensurate with the nonprofit and for-profit members’ respective ownership interests. The LLC was responsible for arranging and conducting all administrative details regarding the video training seminars. The video seminars covered the same substantive material as the seminars conducted on the university’s campus. Additionally, the Agreement gave the university the exclusive right to determine and approve the curriculum, training materials, instructors, and standards of completion for the seminars. The for-profit entity retained the exclusive tight to select video training techniques and locations. All further decisions were to be made by mutual consent of both parties. All transactions were presumed at arm’s length, with all prices presumed at fair market value. The Agreement restricted the LLC’s activities to the administrative tasks connected with the teacher training seminars, and mandated that the LLC not engage in any activities that would jeopardize the university’s §501(c)(3) status. Presented with the facts of Rev. Rul. 2004-51, the Service analyzed two issues: (1) whether the university would lose its exempt status due to its participation in the ancillary joint venture described; and (2) whether the university would recognize unrelated business income tax on its distributive share of net profits. In answering the first question, but without offering any significant explanation, the Service determined that the activities of the joint venture were insubstantial as compared to those of the university and accordingly, loss of exempt-status was deemed a non-issue. With respect to the issue of whether or 16 17 18
Redlands Surgical Services, Inc. v. Commissioner, 113 T.C. No. 3 (July 13, 1999). St. David’s Health Care System v. United States, 349 F. 3d 232 (2003). Rev. Rul. 2004-51, 2004-22 I.R.B. 974 (May 6, 2004).
䡲
700
䡲
c14.fm Page 701 Thursday, March 15, 2007 10:45 AM
14.1 INTRODUCTION
not any UBTI was incurred, the Service cited both the important contributions to the university’s exempt purpose made by the seminars, and that because the seminars were substantially related to the university’s exempt function, income received by the university should not be considered UBTI. In addressing the issue of “control” in Rev. Rul. 2004-51, the Service determined that “control” of an entire venture is not essential; control may be “bifurcated” as long as the exempt organization controls the substantive, “charitable” aspects of the deal. Moreover, if the exempt organization maintains exclusive control over the venture’s charitable aspects, an affirmative charitable “override” is no longer required. Nevertheless, Rev. Rul. 2004-51 presents a number of significant issues specific to ancillary joint ventures. For example, it may suggest that the IRS will now apply a “UBIT-plus-control” test; a test which applies the standard UBIT analysis to ancillary joint ventures involving exempt organizations, and superimposes upon that standard the “control test” of Rev. Rul. 98-15, Redlands and St. David’s.19 (ii) Implications of Rev. Rul. 2004-51: Examples20 and Explanations. As illustrated in the preceding discussion of Rev. Rul. 2004-51, in order for a university that enters into a joint venture with a for-profit entity to retain its tax-exempt status: (1) the university’s participation in the joint venture must further its exempt purpose, and (2) the joint venture must only allow the exempt partner to operate exclusively in furtherance of its exempt purpose, and only incidentally for the benefit of the for-profit partner21. Moreover, if a university, as part of a joint venture deal, enters into a contract with a for-profit entity which gives the for-profit the authority to conduct activities of the joint venture and use the assets of the university, the university must retain ultimate control and authority over the use of the assets and activities in order to preserve its tax-exempt status. To illustrate: EXAMPLE 1: University A has a very strong history program. Several members of its faculty are concerned about the public’s lack of knowledge about history and the misinformation from various media sources. They have met with B, a well-known commercial publisher, to discuss the possibility of publishing a monthly magazine devoted to history. The magazine would be written to appeal to a broad segment of the public and each issue would include some articles with a strong human interest. The magazine would be supported by advertising and subscription revenues, and would be available on-line and in-hand copy. There is no similar product on the market. A and B agree to enter into C, a joint venture to publish a magazine. A will contribute its name, logo, and some start up funding. Members of A’s faculty will provide content for the magazine, for which they will receive compensation, as valued by comparison. B will provide most of the start-up funding, including funds for C to hire writers and editors to take the content provided by A’s faculty and put it into a magazine format. To take advantage of efficiencies of scale, C will contract 19 20 21
See Chapter 4 for further discussion of Rev. Rul. 2004-51. The author wishes to thank Celia A. Roady, Esq. of Morgan, Lewis & Brokius, LLP, Washington, D.C. for her contribution of Examples 1 and 2. Rev. Rul. 2004-51 at 6-7.
䡲
701
䡲
c14.fm Page 702 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
with B for publishing and advertising service. C will select magazine content, but since the publication will bear the name of the university, the head of the history department (or her designee) will have final editorial approval over all articles in the magazine. A and B will have equal control over all aspects of the joint venture except where control is specifically allocated to one party as described above. The joint venture detailed in Example 1 would likely fit within the paradigm of a “good” university joint venture under Rev. Rul. 2004-51; the purpose of the joint venture—to advance the public’s understanding of history—is aligned with the educational, exempt function of the University (A). Although the University (A) contracts with a for-profit (B) to provide essential services for a magazine (C), the University (A) retains the ultimate authority and control over C’s content and editorial direction. Additional factors which liken Example. 1 to Rev. Rul. 2004-51 are: that the venture is initiated by the University, that the services provided by the for-profit are restricted to those of infrastructure and support, that the transactions between the parties are conducted at arms-length, that the profits are shared equally, and that the University retains exclusive control over all of the exempt components of the venture. In contrast: EXAMPLE 2: University D has a very strong history program. Commercial publisher E has explored the possibility of producing a monthly magazine devoted to history and would like to have D’s name and logo on the magazine, as well as to have professors from D serve on the magazine’s editorial board, for which they would be paid. E proposes the following: In return for the use of D’s name and logo, it will give D a 10% interest in a new joint venture established to publish the magazine. Since the publication would bear the name of the university, the head of the history department (or her designee) would have final editorial approval over any articles in the magazine. E will have control over all other aspects of the joint venture. The facts presented in Example 2 present significant distinctions from those in Rev. Rul. 2004-51; while this deal would likely not jeopardize the institution’s tax-exempt status, these differences illustrate how a joint venture might incur taxable unrelated business income to the University partner (D). Although it might be inconsequential that the venture is initially proposed by the for-profit entity (E), it could be argued that, because the for-profit partner in Example 2 has complete control over the writing and editorial processes, and the exempt partner receives only a 10% interest in the profits, it would likely confer more than an incidental benefit to (E), the for-profit entity. The fact that final editorial approval rests with the head of the university’s history department (or, his or her designee, who could be a person outside of the university), while not insignificant, is likely not enough to outweigh the advantage the deal confers upon the commercial partner. (iii) Rev. Rul. 2004-51: Practice Pointers and Recommendations. Rev. Rul. 2004-51 provides certain lessons to the tax-exempt practitioner, especially in the area of university joint ventures. Significantly, in Rev. Rul. 2004-51, the governing documents 䡲
702
䡲
c14.fm Page 703 Thursday, March 15, 2007 10:45 AM
14.1 INTRODUCTION
between the university and the for-profit entity incorporated safeguards to prevent the venture from serving private interests. An exempt entity contemplating such a venture should ensure that its venture documents contain similar provisions: • First, the governing documents should require that the terms of all con-
tracts and transactions entered into by the joint venture, both with its venturers and with any other parties, be at arm’s length and for fair market value, based on comparables; • Second, the governing documents should restrict activities in which the
joint venture may participate to activities that further the exempt purposes of the nonprofit partner; • Third, the governing documents should contain a general prohibition
against engaging in any activity that might jeopardize the exempt organization’s status. The facts should demonstrate that the joint venture did, in fact, operate in accordance with the terms of the governing documents; • Finally, and perhaps most importantly, the governing documents should
ensure that the exempt organization has full control over the substantive exempt functions of the joint venture. For example, in Rev. Rul. 2004-51, the university had complete control over the educational content, including sole approval of course curriculum, training materials, and instructors, while the for-profit partner merely had control over administrative matters. This bifurcation of functions is a significant concession on the part of the IRS; again, “control” of the entire venture is not essential if the exempt organization controls the substantive, “charitable” aspects of the venture. In order to avoid taxable, unrelated business income, it is necessary for the joint venture to participate in an activity that is “substantially related” to its exempt purpose. In Rev. Rul. 2004-51, the determination that the activities were related was straightforward, given the regulatory definition of “educational purposes.”22 Notably, it may be easier to demonstrate “substantially related” in the education and low-income housing23 context, where there is a clear definition of charitable purpose, and particularly in the low-income housing tax credit context, where there is a significant level of governmental oversight and review, than it would be to demonstrate activities that are substantially related to the provision of healthcare and other charitable activities, where there are no clear statutory or regulatory definitions.
22
23
Stokeld, Harris, and Thorndike, “EO Reps Focus on Ancillary Joint Ventures, Shelters,” Tax Notes 824 (May 17, 2004). (Catherine E. Livingston, IRS assistant chief counsel, in a 2004 recent meeting of the ABA Section on Taxation, stated that the regulation containing a definition of educational purposes “was an important underpinning to our ability to do the guidance.”) See Rev. Proc. 96-32, 1996-1 CB 717 (May 1, 1996), which sets forth safe harbor guidelines that, if satisfied, demonstrate that the organization meets the §501(c)(3) standards of “charitability.”
䡲
703
䡲
c14.fm Page 704 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
14.2 (a)
IRS FOCUS ON UNIVERSITIES Examination Guidelines
In its special examination guidelines for colleges and universities24, the IRS focuses on university joint ventures and related issues at several points. Under the guidelines, examiners are instructed to: • Identify income from joint ventures as distinct from regular operating
departments of the institution25 • Identify large cash investments in joint ventures26 • Scrutinize financial terms of all research arrangements to detect private
benefit and unrelated trade or business issues27 • Determine whether purported research is actually the conduct of an activ-
ity incident to a commercial enterprise (e.g., testing, sampling, or certifying of items to a known standard)28 • Obtain a list of all publications that discuss the institution’s research
activities, and determine where and how results of closed research projects were published29 • Determine whether arrangements with research sponsors involve private
use of university employees, facilities, equipment, or intellectual property rights30 • Examine capital structure, service agreements, patent licenses, financial
statements, and flow of royalties and profits of all joint ventures31 With the advent of these audit guidelines, joint ventures in the university area will likely receive more emphasis by the IRS. Here, as in the health care area, the subtleties of interpretation in determining the relatedness of a joint venture to an exempt purpose often make it advisable to pursue an advance private ruling from the IRS before undertaking such a joint venture.32 (b)
The Coordinated Examination Program (CEP Audits)
In 1995, the IRS began a systematic audit of educational institutions, utilizing the finalized college and university audit guidelines. The program has revealed 24 25 26 27 28 29 30 31 32
Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” (Aug. 1994). Id. at §342.41(4) and (5). Id. at §342.44. Id. at §342.(10)(1). Id. at §342(10)(3). Id. at §§342(10)(8), 342(10)(10)(d)3. Id. at §342(10)(6). Id. at §342(10)(7). Id. at §342(10). See generally Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” (Aug. 1994).
䡲
704
䡲
c14.fm Page 705 Thursday, March 15, 2007 10:45 AM
14.2 IRS FOCUS ON UNIVERSITIES
compliance problems in a variety of areas and has shown that the IRS intends to take an aggressive stance on many issues of importance to universities. Campus bookstores, frequently a source of controversy between universities and the IRS, continue to prove troublesome. Although the “convenience exception” applies for sales of items to students and faculty, the IRS currently looks for documentation of the percentage of sales to the public versus sales to the campus community.33 Further, sales made during the summer or winter breaks, or via Internet sites and/or mail order catalogs, are particularly vulnerable to assertions that they do not fit within the convenience exception. When campus bookstores or food service operations are spun off to commercial organizations or subsidiaries, tax-exempt bond problems (such as impermissible private business use) may arise.34 In addition, travel tours (programs commonly offered as “study abroad” opportunities for students and/or alumni) continue to come under IRS scrutiny. The IRS will consider how the tours are structured to determine whether they achieve an educational purpose. Schools should have written tour policies emphasizing the educational nature of the tours and mandatory class attendance. In general, the more a travel tour resembles a college course, the less likely it is to raise UBIT concerns.35 Although unreasonable compensation issues have also been a focus of IRS review, problems have arisen most often when compensation is provided outside the context of a written agreement or in such a way as to be not subject to institutional review, such as participation in the profits of a joint venture, or the use of credit cards.36 Specific attention is being paid to university proceeds stemming from investment partnership income.37 If a “substantial amount of money is flowing through the partnership to the university,” the institution should expect agents to scrutinize the arrangement.38 In at least one CEP audit, a partnership industry specialist was called in to assist with the examination.39 The IRS has stated that it has yet to audit an IRC §403(b) employee annuity plan that meets IRS requirements.40 Advertising revenues and multiple-use facilities are also of great concern to the IRS. In light of the finalization of the examination guidelines and the aggressive stance the IRS is adopting, colleges and universities must be particularly careful to document and structure joint 33 34
35 36
37
38 39 40
“Big Ticket Items May Be ‘Agent Bait’ in IRS Audit, Practitioner Warns,” Tax Notes Today 95 (May 24, 1995): 101-6, citing Robert Louthian III. Comments of Marcus Owens, then-director of IRS Exempt Organizations Division, at the College and University Personnel Association Seminar (Feb. 21, 1995), reported in Tax Notes Today 95 (Feb. 22, 1995): 35-8. Larger institutions had to be careful not to exceed the $150 million cap on bond issuances in the case of IRC §501(c)(3) bonds issued before August 6, 1997. Id. For a thorough discussion of travel tours, see Section 14.6(b)(iv) and Chapter 8. Comments of Marcus Owens, then-director of IRS Exempt Organizations Division, at the College and University Personnel Association Seminar (Feb. 21, 1995), reported in Tax Notes Today 95 (Feb. 22, 1995): 35-8. Comments of Marcus Owens, then-director of IRS Exempt Organizations Division, at the ABA Section on Taxation, Exempt Organizations Committee Meeting (Aug. 4, 1995), as reported in Tax Notes Today 95 (Aug. 7, 1995): 153-6. See id. Id. See Cohen, “Attenders Cautioned of Increased IRS Scrutiny of Pension Plans,” Exempt Organization Tax Review 11 (June 1995): 1192.
䡲
705
䡲
c14.fm Page 706 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
ventures and other business arrangements so as to comply with IRS regulations and established legal doctrines.
14.3
SPECIAL STATUTORY UBIT RULE
The Code, through a special statutory rule applicable to universities and hospitals, contains an exclusion from UBIT for “all income derived from research.”41 Upon close examination, this special rule in IRC §512(b)(8) is not particularly useful in the joint venture area. First, §512 does not eliminate the requirement that a nonprofit have a charitable purpose.42 Second, where a nonprofit participates in a joint venture, the IRS will “look through” the joint venture by virtue of IRC §512(c), which states that a nonprofit partner must include as UBIT its share of income from a partnership which is derived from an unrelated trade or business. Consequently, the next step is to examine whether the income generated by the venture is unrelated or not; because of §512(b), all income derived from research by a university is excludable from UBIT. Further, once a project constitutes “research,” it will likely constitute “scientific research,” thereby falling outside the UBIT provisions because scientific research is not “unrelated” activity.43 Moreover, the statute can be read to require the research to be conducted directly by the university itself, and the statute has in fact been so construed by the IRS in disqualifying a university’s controlled affiliate from the exclusion.44 Thus, if research were performed by a joint venture, the university would have to argue that the exclusion is available by the operation of IRC §512(c), which provides that in computing an exempt partner’s distributive share of UBIT, the exceptions and limitations of §512(b) are to apply. 45 This would allow the university to use the special statutory exclusion from UBIT provided in §512(b)(8) for all income derived from research.
41 42 43
44
45
§512(b)(8); Reg. §1.512(b)-1(f)(1)-(4). See Chapter 2. The IRS has never drawn a distinction in its rulings, although Reg. §1.501(c)(3)-1(d)(5)(i) suggests that there could be “nonscientific research.” Further contributing to the elusiveness of the distinction is the fact that the regulations under the UBIT research exclusion adopt the identical limitation of “incident to commercial operations” used in the definition of scientific research. See Reg. §1.512(b)-1(f)(4). Gen. Couns. Mem. 39,196 (Mar. 20, 1984). However, the income from research conducted by a subsidiary could still be excluded from UBIT under §512(b)(9), which provides: In the case of an organization operated primarily for purposes of carrying on fundamental research the results of which are freely available to the general public, there shall be excluded all income derived from research performed for any person, and all deductions directly connected with such income. See Reg. §1.512(b)-1(f)(3). Additional requirements of the provision dictate that this research be “freely available to the general public,” usually through publication. See also Rev. Rul. 76-297, 1976-2 C.B. 178 (exempt subsidiary of a university was entitled to exclude income from research inventions as royalty income exempt from UBIT). The unavailability of §512(b)(8) and the potential availability of §512(b)(9) are expressly noted in the IRS audit guidelines, which direct examiners to determine whether research is conducted by the university directly or by a separate entity. See Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” §342(10)(2) (Aug. 1994). §512(c); Reg. §1.512(c)-1. This interpretation appears to be accepted by the IRS. See Internal Revenue Manual 7751 H.B. (37)91.
䡲
706
䡲
c14.fm Page 707 Thursday, March 15, 2007 10:45 AM
14.4 RESEARCH JOINT VENTURES GENERALLY
14.4
RESEARCH JOINT VENTURES GENERALLY
Almost all large colleges and universities conduct supported or sponsored research, funded by private firms or the federal government.46 Often these research activities are structured as a joint venture between the university and the sponsor.47 However, relatedness of research to the taxpayer’s scientific or educational purposes is a common theme whether or not the taxpayer is a university, whether or not the relationship is structured as a partnership, and whether the issue involves the basic exemption or UBIT. Therefore, regulations, cases, and rulings on the exempt status of research organizations, and UBIT for universities, are relevant. The IRS concerns are, in theory, similar to those regarding any other joint venture arrangement involving an exempt organization. The venture must be related to the university’s charitable purpose, whether scientific or educational; the venture must allow the university to further exclusively its charitable purposes; the venture arrangement must provide adequate protection for the university’s exempt assets; and private inurement must be strictly avoided.48 However, the definition of “scientific” is so comprehensive that it tends to subsume the other issues in the university research setting. (a)
Scientific Research Organizations: Four-Part Analysis of the Regulations
The regulations present four tests that must be met in order to conclude that an organization qualifies as an exempt scientific organization under IRC §501(c)(3). The regulations49 question: 1. Whether the organization conducts “scientific research”50 2. Whether the scientific research is conducted “incident to commercial or industrial operations”51 3. Whether the organization meets the “specific public interest” test52 4. Whether the organization meets the “general public interest” test53 By extension, these tests also apply in determining whether a university’s joint venture activity allows it to act in furtherance of a scientific purpose. Presumably, the venture itself must meet these regulatory criteria to allow the joint
46 47 48
49 50 51 52 53
See Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” §342(10) (Aug. 1994). See Gen. Couns. Mem. 39,196 (Mar. 20, 1984). See Gen. Couns. Mem. 39,005 (Dec. 17, 1982); Gen. Couns. Mem. 39,862 (Nov. 21, 1991); Statement of Howard Schoenfeld and Marcus Owens, “IRS Compliance Activities Involving §501(c)(3) Public Charities,” before the Subcommittee on Oversight of the House Ways and Means Committee (Aug. 2, 1993) (college inurement and compensation issues are addressed). See generally Chapters 4 and 5. Reg. §1.5019c)(3)-1(d); Gen. Couns. Mem. 39,883 (Oct. 16, 1992). Reg. §1.501(c)(3)-1(d)(5)(i). Reg. §1.501(c)(3)-1(d)(5)(ii). The specific public interest tests are found at Reg. §1.501(c)(3)-1(d)(5)(iii) and (iv). The general public interest test is found at Reg. §1.501(c)(3)-1(d)(1)(ii).
䡲
707
䡲
c14.fm Page 708 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
venture to be viewed as operating exclusively in furtherance of the university’s exempt purposes.54 (i) Scientific Research. A discussion of whether an organization conducts scientific research begins with the cryptic guidance in the regulations, which provide that the term scientific includes carrying on scientific research in the public interest.55 Without examples, the regulations assert that scientific research is narrower than research, although it can be practical or applied, as well as fundamental or theoretical.56 The inclusion of applied research within the definition of scientific research has allowed research in the social sciences area to be included along with more traditional forms of scientific research.57 EXAMPLE: X, a university, forms a joint venture to engage in social sciences research. The purpose of the joint venture is to develop and disseminate a body of new knowledge regarding worker productivity, including the psychological and sociological aspects thereof. The joint venture has a professional research staff. A substantial amount of the research is performed under contract with federal government agencies, thereby promoting public interests. The research is published, and the joint venture conducts seminars open to the general public in the area. Under these facts, the social sciences research will meet the scientific research exemption criteria.58 The nature of scientific research has been specifically addressed by the courts. As a further example, Midwest Research Institute (MRI)59 a nonprofit scientific research organization, was designed and operated to develop agriculture, business, commerce, industry, and natural resources in the Midwest. The Institute conducted research projects for independent sponsors on a contract basis.60 Approximately 75 percent of the projects were commissioned by various governmental entities.61 The IRS argued that the income MRI received from its research was subject to UBIT.62
54 55 56 57
58
59 60 61 62
See generally Chapters 4 and 10. Reg. §1.501(c)(3)-1(d)(5)(i). See also Gen. Couns. Mem. 39,883 (Oct. 16, 1992). Reg. §1.501(c)(3)-1(d)(5). See Rev. Rul. 65-60, 1965-1 C.B. 231; Gen. Couns. Mem. 32,726 (Nov. 12, 1963) (social science research); Rev. Rul. 69-526, 1969-2 C.B. 115; Gen. Couns. Mem. 54,128 (May 22, 1969) (medical research). See also Gen. Couns. Mem. 35,536 (Oct. 30, 1973) (prepaid legal services pilot program was social services). This example is based on the factual situation presented in Rev. Rul. 65-60, 1965-1 C.B. 231, discussed in Gen. Couns. Mem. 32,726 (Nov. 12, 1963). But cf. Gen. Couns. Mem. 39,883 (Oct. 16, 1992) (the organization did not qualify for exemption as a social sciences research organization because it failed the “commercial or industrial operations” test in Reg. §1.501(c)(3)-1(d)(5)(ii) and it was not operated for the public benefit. With respect to taxable venturers, it should be noted that social sciences research is specifically excluded from “qualified research expenditures” in §41 (the research tax credit) and will, therefore, not qualify for the tax credit. §41(d)(4)(G). Midwest Research Inst. v. United States, 554 F. Supp. 1379 (W.D. Mo. 1983), aff’d, 744 F.2d 635 (8th Cir. 1984) (hereinafter referred to as “Midwest”). Midwest, 554 F. Supp. at 1381. See id. Midwest, 744 F.2d at 636. The lawsuit concerned whether 1,218 projects performed by MRI were subject to UBIT. Midwest, 554 F. Supp. at 1381.
䡲
708
䡲
c14.fm Page 709 Thursday, March 15, 2007 10:45 AM
14.4 RESEARCH JOINT VENTURES GENERALLY
In making a determination on the UBIT issues, the district court had to decide whether the independent, private research was substantially related to the organization’s exempt scientific purposes.63 This analysis required that the court define “scientific research” activity. Here, the court stated that a project constituted scientific research “if professional skill [was] involved in the design and supervision of a project intended to solve a problem through a search for a demonstrable truth.”64 The court set forth a definition of scientific research comprised of three parts: 1. There must be project supervision and design by professionals. 2. Researchers must design the project to solve a problem through a search for demonstrable truth suggesting the use of scientific method. 3. The research goal must be discovering a demonstrable truth, thereby emphasizing the novelty and importance of a particular scientific goal.65 Using this analysis, the district court held that all of the research projects were entitled to classification as scientific research and, hence, were substantially related to MRI’s exempt purposes.66 A few unrelated projects, such as computer use rental, lubricating services, and acting as a straw purchaser, were not scientific in nature nor research, and therefore the income from those activities was subject to UBIT.67 The Midwest standard has been applied by the Tax Court in Dumaine v. Commissioner68 and by the IRS.69 The IRS, in Rev. Rul. 76–296, confirmed that if the research is scientific research, the fact that it is undertaken pursuant to contracts with private industry will not cause the IRS to treat it as unrelated.70 As is true with social science research,71 medical research can qualify as scientific research.72 For example, AIDS (acquired immunodeficiency syndrome) research could easily fit within the definition of scientific research because it would seek to discover a unique, demonstrable truth including a cure for a new disease.73 By contrast, mundane 63 64 65 66 67
68 69
70 71 72 73
Reg. §1.513-1(d)(1). Midwest, 554 F. Supp. at 1386. See also Gen. Couns. Mem. 39,883 (Oct. 16, 1992); IIT Research Inst. v. United States, 9 Ct. Cl. 13 (1985). Midwest, 554 F. Supp. at 1391. Midwest, 554 F. Supp. at 1387–88. The IRS argued that many of the research projects were “ordinary testing,” which is taxable under the regulations. The district court was not persuaded by this argument. Id. at 1388–89. Dumaine Farms v. Commissioner, 73 T.C. 650 (1980), acq., 1980–2 C.B. 5 (the conduct of farming projects qualified for exemption as scientific research under Midwest standards). Gen. Couns. Mem. 35,536 (Oct. 30, 1973) (operating a prepaid legal services plan on an experimental pilot basis to research the operation feasibility of such plans qualified for exemption as scientific research). Rev. Rul. 76-296, 1976-2 C.B. 141. See also Midwest Research Inst. v. United States, 554 F. Supp. 1379 (W.D. Mo. 1983), aff’d, 744 F.2d 635 (8th Cir. 1984). Rev. Rul. 65-60, 1965-1 C.B. 231; Gen. Couns. Mem. 32,726 (Nov. 12, 1963). See Rev. Rul. 69-526, 1969-2 C.B. 115; Gen. Couns. Mem. 34–128 (May 22, 1969); cf. Ann. 92–83, 1992-22 I.R.B. 59, §333.8(6). See, e.g., Priv. Ltr. Rul. 97-39-043 (June 30, 1997) (IRS ruled that income from a research facility within a university-based dental school setting did not constitute UBIT where the research provided a unique type of diagnostic dental service, which no commercial laboratories could provide; because the facility educated dental students and practicing dentists in providing new directions for patient care, the IRS concluded that the income from the laboratory was substantially related to the promotion of health, which was one of the exempt organization’s purposes).
䡲
709
䡲
c14.fm Page 710 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
experiments, such as the repetitive testing of cargo shipping containers, are too closely allied with commercial operations to be considered scientific research.74 (ii) Commercial or Industrial Operations. Scientific research “does not include activities of a type ordinarily carried on as incident to commercial or industrial operations, as, for example, the ordinary testing and inspection of materials or products or the designing or construction of equipment.”75 This is a commonsense test that requires evaluation of the facts and circumstances with respect to the particular research activity or joint venture involved, in light of industrial and commercial practices in comparable situations.76 Hence, in the IRS’s view if the activity or operation involved is in direct competition with an activity or operation customarily carried on by taxable business organizations as incidental to their ordinary or commercial operations, it is not basic or fundamental scientific research.77 The distinction between “incident to commercial operations” and “scientific research” can be made by viewing the types of testing involved under both regulational requirements. The court in Midwest stated that “testing” incident to commercial operations is “ordinary and routine testing” that is “generally repetitive work done by scientifically unsophisticated employees for the purpose of determining whether the item tested met certain specifications.”78 This can readily be distinguished from testing done to validate a scientific hypothesis.79 EXAMPLE: The clinical testing of drugs for commercial pharmaceutical companies in connection with their applications for Food and Drug Administration (FDA) approval does not qualify even when the findings are published in scientific journals, because the activity is incidental to commercial operations and principally serves private commercial interests. The IRS reaches a similar result with testing products for commercial interests80 and with testing products for commercial entities for pre-market clearance and environmental law compliance.81 However, drug testing has been found to be related to the exempt purpose of a university hospital when the testing was done on patients who actually had the disease for which the drug company was developing the drug.82
74 75 76 77 78
79
80 81 82
Rev. Rul. 78-426, 1978-2 C.B. 175. Reg. §1.501(c)(3)-1(d)(5)(ii). See also Gen. Couns. Mem. 35,804 (May 6, 1974). Gen. Couns. Mem. 35,804 (May 6, 1974). See generally Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” §342.(10)(3) (Aug. 1994). Midwest, 554 F. Supp. at 1386. The IRS defined the indicia of ordinary and routine testing conducted incident to commercial operations: a standard procedure is utilized; no intellectual questions are posed; the work is routine and repetitive; and the procedure is merely a matter of quality control. Gen. Couns. Mem. 39,196 (Aug. 31, 1986). Midwest, 554 F. Supp. at 1386. See also Rev. Rul. 68–373, 1968–2 C.B. 206 (testing drugs for commercial pharmaceutical companies in connection with their marketing applications to the Food and Drug Administration (FDA) is testing ordinarily carried on incident to commercial pharmaceutical operations and not scientific research); Gen. Couns. Mem. 39,196 (Aug. 31, 1986) (testing necessary to market entry and environmental law compliance was testing incident to commercial operations and not scientific research). Rev. Rul. 68-373, 1968-2 C.B. 206. Gen. Couns. Mem. 39,196 (Mar. 20, 1984). Tech. Adv. Mem. 82-30-002 (no date given).
䡲
710
䡲
c14.fm Page 711 Thursday, March 15, 2007 10:45 AM
14.4 RESEARCH JOINT VENTURES GENERALLY
To avoid the “incident to commercial operations” characterization of the Regulations, research must stop short of any commercial phase of product development or marketing. Thus, research in the field of heating, ventilation, and air conditioning has been approved when the organization did not perform commercial tests or prepare commercial product reports.83 Similarly, when a university’s policy and practice was to terminate a research project once it had constructed a conceptual model that did not represent a prototype of a product to be commercially reproduced, the research was viewed as scientific.84 By contrast, an organization that participated in the commercial exploitation of newly developed agricultural machinery by licensing a manufacturer to build and sell the machinery was held to be involved in research incident to a commercial operation.85 (iii) Specific Public Interest. The specific public interest test provides that scientific research is carried on in the public interest if: • The results—that is, patents, copyrights, processes, or formulas—are
made available to the general public on a nondiscriminatory basis. • The research is performed for a government entity. • The research is directed toward benefiting the public.86
EXAMPLE: Research in aiding the scientific education of college or university students, obtaining scientific information published in a form available to the interested public, discovering the cure for a disease, and aiding a community by attracting new industry to the community or encouraging the development or the retention of an industry in that location—all are examples of research that benefits the public.87 Research that satisfies one or more of the foregoing criteria will be regarded as benefiting the public even though it is performed under an agreement that allows the sponsors the right to obtain ownership or control of the resulting patents, copyrights, processes, or formulas.88 EXAMPLE: A consortium of universities creates a foundation to manage joint research aimed at finding a cure for a serious and widespread disease. Additional funding is provided by private corporations that purchase licenses to develop and exploit discoveries by the foundation’s researchers. A primary concern of the IRS in determining whether the foundation may claim exempt status is whether the foundation publicizes the results in a timely manner.
83 84 85 86 87 88
Rev. Rul. 71-506, 1971-2 C.B. 233. Tech. Adv. Mem. 78-46-002 (no date given). Rev. Rul. 65-1, 1965-1 C.B. 226; Gen. Couns. Mem. 32,451 (Nov. 28, 1962). Reg. §1.501(c)(3)-1(d)(iii). Reg. §1.501(c)(3)-1(d)(5)(iii)(c). See id. Rev. Rul. 76-296, 1976-2 C.B. 141, makes clear that an organization may delay publication of the results long enough for the sponsor to secure patents or copyrights resulting from the research, and still meet the publication test of the regulations.
䡲
711
䡲
c14.fm Page 712 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
A private letter ruling89 illustrates the complexity of the arrangements under which organizations may fund scientific research. In the situation described in that ruling, a long-established scientific research organization with private and public members in the electric utility industry created new levels of membership and sponsorship of the organization’s research projects. At most levels, the organization retains ownership of the results, access to a license for itself and its members, and the right to publish the results as promptly as possible. Even for projects fully supported by a member, as to which the organization does not retain any ownership rights, it nevertheless attempts to acquire publication rights. The IRS concluded that the organization’s new policies would meet the publication test in Rev. Rul. 76–296 and the requirements of Reg. §1.501(c)(3)– 1(d)(5)(iii) by making results available to the public in a timely manner. If the organization does not obtain publication rights to a project funded entirely by one sponsor, it would have to treat the funding as unrelated business income. Because this scenario would only apply to a small portion of the organization’s research activity, it would not jeopardize the tax-exempt status of the organization as a whole. (iv) General Public Interest. The general public interest requirement under IRC §501(c)(3),90 which dictates that the organization be operated exclusively for non-private interests, is incorporated by reference within the requirement that scientific organizations must be organized and operated for the benefit of the public.91 Thus, an organization is not organized or operated exclusively for charitable purposes unless it serves a public rather than a private interest.92 While these requirements do not specifically apply to joint ventures, the IRS will examine the activities of a joint venture when determining whether a nonprofit joint venture partner has jeopardized its exemption or is subject to UBIT as a result of its participation in the venture.93 The specific private benefit factors that establish that a nonprofit organization or a joint venture entity is not carrying on scientific research in the general public interest are as follows: • A joint venture performs research, not described in IRC §501(c)(3),
directly or indirectly, for its taxable joint venturers. • Private interests retain, directly or indirectly, ownership or control of
more than an insubstantial portion of the patents, copyrights, processes, or formulas resulting from its research. • The joint venture does not make the research available to the general public.94
89 90 91 92 93 94
Priv. Ltr. Rul. 9627023 (July 5, 1996). Reg. §1.501(c)(3)-1(d)(1)(ii). Reg. §1.501(c)(3)-1(d)(5)(I). Reg. §1.501(c)(3)-1(d)(1)(ii). See Section 14.1. Reg. §1.501(c)(3)-1(d)(5)(iv).
䡲
712
䡲
c14.fm Page 713 Thursday, March 15, 2007 10:45 AM
14.4 RESEARCH JOINT VENTURES GENERALLY
These strict requirements were instituted to ensure that scientific research is performed for the good of the general public. The obvious policy underlying IRC §501(c)(3) is that tax-exempt status should not be exploited for the private benefit of a few individuals or entities. This policy is evident from the regulatory stance taken by the IRS. (b)
IRS Rulings
Most research projects carry both public and private benefit. As in the hospital area, these benefits are weighed and balanced in the IRS rulings.95 Thus, an organization composed of members of a particular industry and created to develop new and improved uses for industry products was found not to qualify under IRC §501(c)(3), because any public benefit would be secondary to the specific private benefit to the members.96 Likewise, when the primary purpose of a contract between a university and a company was the perfection of a scientific instrument manufactured by the company, it outweighed any public benefit, even though the experiments with the instrument were of some scientific interest and their results were published.97 By contrast, research was found to be related to the exempt status of an organization by reason of predominant public benefit when the company reimbursed only the costs incurred by the university. Furthermore, the results were not only published in scholarly journals and presented at conferences, but were used directly in teaching students, some of whom assisted in the conduct of the research, and the purpose of the research was framed in terms of new methods of treating diseases.98 Similarly, when research resulted directly in multiple publications, colloquial seminars, and degrees, and the university screened projects for dovetailing with its educational functions, the research activity was viewed as having sufficiently predominant public benefit to be related to the university’s charitable, scientific purpose.99 (c)
Case Law
The definition of scientific research has rarely been litigated. The first court decision to analyze the definition of scientific research at length was Midwest Research Institute.100 In Midwest, the court concluded that projects conducted by an organization constituted scientific research “if professional skill [was] 95
96 97 98 99
100
For an example of how the courts balance public and private benefit, see American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). For a detailed discussion, see generally Chapter 5. Private inurement, which is not permitted under §501(c)(3), is generally not addressed in the IRS rulings, perhaps because most arrangements are with independent third parties who are not “insiders.” Rev. Rul. 69-632, 1969-2 C.B. 120. Priv. Ltr. Rul. 79-02-019 (Sept. 29, 1978). Priv. Ltr. Rul. 79-36-006 (May 23, 1979). Priv. Ltr. Rul. 84-45-007 (July 24, 1984). For an example of a ruling balancing public and private benefits of various research projects, with mixed outcomes, see Priv. Ltr. Rul. 80–28–004 (Mar. 26, 1980). See also Gen. Couns. Mem. 34,325 (July 31, 1970); Gen. Couns. Mem. 37,378 (Jan. 13, 1978). Midwest Research Inst. v. United States, 554 F. Supp. 1379 (W.D. Mo. 1983), aff’d per curiam, 744 F.2d 635 (8th Cir. 1984).
䡲
713
䡲
c14.fm Page 714 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
involved in the design and supervision of a project intended to solve a problem through a search for a demonstrable truth.” The court rejected the notion that publication of the results must occur in every case, or that the research must benefit an entire geographic area rather than a single industry. In IIT Research Institute, the Claims Court rejected the IRS contention that unrelated business income was generated by contract research projects for industry performed by an affiliate of a renowned academic institution.101 The projects were not mere “testing.” The court noted that the projects were conducted by sophisticated scientific professionals; the Institute did not get involved in commercialization of the products or processes developed; the projects were part of a larger area of scientific research activity already being conducted by Institute personnel; the results, although not published directly, were synthesized into the ongoing publications of the scientists; and every prospective contract was evaluated by a committee with a view to the project’s relationship to development of a particular scientific field and to the Institute’s research objectives.102 The IRS Chief Counsel expressed disagreement with the IIT Research Institute decision, but decided not to pursue an appeal because “there has been admittedly little guidance on what is ‘scientific’ and because the court’s findings are largely factual in nature.”103 In Dumaine Farms, the Tax Court approved, as scientific research, an experimental demonstration farm with ecological objectives.104 (d)
IRS Position
In General Counsel Memorandum 39,883,105 the activities of an organization created by a college to serve as an “incubator” (assisting new businesses and struggling existing businesses to promote economic development in a community) were found not to be scientific research, but rather incidental to commercial operations and not carried on in the public interest.106 The private benefit to the assisted businesses outweighed any scientific interest, because the original concept had already been developed; it was an adaptation of the concept to a specific locale. Publication of detailed information about the project in academic forums was irrelevant because there was no scientific research to be published.107 The IRS contrasted the project at length with that approved in General Counsel Memorandum 35,536,108 which involved the organization and operation of a prepaid legal services plan on an experimental pilot basis to research the feasibility of such plans. The experiment utilized the “scientific method” applied in traditional scientific experiments, and the legal services pilot was to terminate once the concept had been tested, unlike the incubator, which was to continue in operation indefinitely.109 101 102 103 104 105 106 107 108 109
IIT Research Inst. v. United States, 9 Cl. Ct. 13 (1985). See id. AOD CC-1986-034 (June 23, 1986). Dumaine Farms v. Commissioner, 73 T.C. 650 (1980), acq. 1980-2 C.B. 5. Gen. Couns. Mem. 39,883 (Oct. 16, 1992). See id. See id. Gen. Couns. Mem. 35,536 (Oct. 30, 1976). See id.
䡲
714
䡲
c14.fm Page 715 Thursday, March 15, 2007 10:45 AM
14.5 FACULTY PARTICIPATION IN RESEARCH JOINT VENTURES
14.5
FACULTY PARTICIPATION IN RESEARCH JOINT VENTURES
This chapter has largely assumed that the sole joint venturer with the university is an industrial concern. In fact, many productive joint ventures involve individual members of university faculties. An “in-house” venture is a more natural vehicle for the direct participation of students and faculty, which may solidify the broad educational mission of the university and, in the process, improve the chances of passing tax muster.110 Some ventures may even offer the institution an opportunity to participate to the exclusion of a private industrial concern. Apart from providing the challenge and opportunity for the institution to reap a greater share of entrepreneurial profits, keeping the endeavor independent of outside sources can also promote the retention of existing faculty and the recruitment of new faculty who might otherwise be hired away by private industry or competing institutions.111 Faculty joint ventures present at least one special problem to which all parties must be sensitive: the heightened potential for private inurement.112 A faculty member is often partly motivated to participate in a joint venture by the prospect of a healthy financial return. Indeed, the expertise brought to the table by faculty members may well be the key to the venture’s commercial success and, thus, in an unrestricted market, could warrant a demand by faculty members for a substantial share of the profits. However, high returns to faculty members could risk an IRS finding of excessive private benefit and, if the individual is found to be an insider, private inurement.113 The relevant considerations in this situation are discussed in Chapter 5. It may well be necessary, for example, to impose a ceiling on the amount ultimately payable to faculty members and to refrain from guaranteeing any minimum return. The IRS has not yet ruled on such a venture.
110
111
112
113
See, e.g., Gen. Couns. Mem. 39,863 (Nov. 21, 1991). The participation of students and faculty was a factor used in the IRS analysis of whether an activity was “substantially related” to a university’s exempt purpose or whether the activity was unrelated and therefore subject to UBIT. See also Rev. Rul. 76-402, 1976-2 C.B. 177; Iowa State Univ. of Sci. & Tech. v. United States, 500 F.2d 508 (Cl. Ct. 1974). A potential disadvantage of excluding industrial and commercial venturers from the research project is the consequent loss of private capital. However, such funding could be replaced by governmental research funding sources or §501(c)(3) grants. See statement of Howard Schoenfeld and Marcus Owens, “IRS Compliance Activities Involving §501(c)(3) Public Charities,” before the Subcommittee on Oversight of the House Ways and Means Committee (Aug. 2, 1993) (the IRS presents three scenarios that highlight inurement and compensation and sample Form 990s are analyzed). See R. Boisture and M. Cerny, “Second Oversight Subcommittee Hearing Explores Need for Intermediate Sanctions and More Disclosure,” Tax Notes Special Report (Sept. 6, 1993). See also Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” §342(10)(5)(Aug. 1994). One knowledgeable practitioner observed that although a faculty member may be able to influence the terms of a particular license on the project he or she is researching, he or she would rarely exert control over the whole organization. Thus, the scientific faculty member is unlikely to meet the statutory definition of disqualified person under the intermediate sanctions provisions, as one who “is in a position to exercise substantial influence over the affairs of the organization.” James K. Hasson, Jr., “Transfers of Scientific Research and Technology,” speech delivered at the Western Conference of Tax-Exempt Organizations (Oct. 27, 2000).
䡲
715
䡲
c14.fm Page 716 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
However, the IRS has provided informal guidance on royalty sharing with individual researchers. The IRS condones royalty sharing with researchers and faculty members provided that the compensation and relationships are usual and customary in the industry and were arrived at by parties dealing at arm’s length114. The IRS realizes that universities and other nonprofit research organizations must compete for talented scientists and enlist the market to bring the results of the research to commercial availability. One article by IRS employees describes the exploitation of intellectual property as “no less a fiduciary duty than managing its financial endowment.”115 Employees may be given cash royalties if those payments are reasonable compensation for services and comport with industry norms.116 Employees who are not in positions of authority may also be given royalties in the form of equity shares in the research venture.117 A 1997 revenue ruling concerning incentives for physician recruitment focuses on whether such incentives are necessary to advance the charitable purpose of the organization, whether they constitute reasonable compensation for services, and whether they were offered pursuant to established, written policies.118 Enactment of the intermediate sanction rules of IRC §4958, discussed in detail in Chapter 5, present another challenge to exempt organizations, including universities. The intermediate sanction rules allow the IRS to impose penalties upon persons who authorize or who receive financial benefits from a nonprofit where the benefits are deemed excessive.119 Final regulations on intermediate sanctions were issued on January 9, 2001.120 For a detailed discussion, see Section 5.4. Many universities and other educational organizations have adopted conflict-of-interest policies designed to prevent the institution’s intellectual and other resources from being inappropriately utilized by faculty and other “insiders.” Such a policy, particularly when implemented through an independent review panel, has the effect of protecting the institution from private inurement as well as breach of fiduciary constraints and application of intermediate sanctions as discussed in Sections 5.4 and 12.3(c).
14.6 (a)
NONRESEARCH JOINT VENTURE ARRANGEMENTS Basic Functions
For decades, universities have engaged in joint ventures (whether or not designated as such) to operate such basic facilities as bookstores, campus restaurants,
114 115 116 117 118 119 120
Roderick Darling and Marvin Friedlander, “Intellectual Property,” Fiscal 1999 CPE Text for Exempt Organizations (1999), 22, 31. Id. at 38 Priv. Ltr. Rul. 9530009 (July 28, 1995). Several universities with major research programs post their royalty-sharing policies on the Web, making comparisons easy. Id. Rev. Rul. 97-21, 1997-18 I.R.B. 8. §4958. Treas. Reg. §53.4958.
䡲
716
䡲
c14.fm Page 717 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
vending machines,121 laundry facilities,122 and even hotels.123 The IRS has wrestled with the issue of whether such arrangements are joint ventures, partnerships,124 or another type of financial transaction such as a lease.125 However, the purpose of such classification is not entirely clear, because IRC §513(a)(2)126 contains a specific exclusion from the definition of unrelated business income for any trade or business, without regard to structure, which is carried on . . . in the case of a college or university. . .by the organization primarily for the convenience of its members, students. . .which is the selling by the organization of items of work-related clothes and equipment and items normally sold through vending machines, through food dispensing facilities, or by snack bars, for the convenience of its members.127 Thus, the key to this “basic function” UBIT exclusion is convenience to the students and faculty. Still other examples of this “convenience” exclusion are suggested by early case law and IRS rulings, which were effectively codified by the enactment of IRC §501(c)(3). EXAMPLE: An organization was interested in operating a bookstore on the campus of a state college. The organization was owned beneficially by a student group (although the students’ ownership interests were held by the College Board of Regents in trust). The profits of the organization were to be used primarily for construction of a student union building that would become property of the state. Because the ultimate destination of the profits was the university itself and because the business enterprise obviously bears a close and intimate relationship to the functioning of the college, the joint venture arrangement between the student organization and the college would not jeopardize the college’s exempt status nor result in UBIT to the college.128 Provision of food and lodging to persons having a connection either to the students of the school or to the educational function of the school is a business activity related to the school’s exempt purpose; this conclusion simply recognizes that it is a proper exempt function of a school to furnish its students with an “educational environment,” extending beyond the mere provision of classrooms, libraries, and dormitories. 121 122 123 124 125
126 127
128
Rev. Rul. 81-19, 1981-3 I.R.B. 10, 1981-1 C.B. 353. See id. See Gen. Couns. Mem. 37,591 (June 19, 1978). Here the IRS held that the IRS was careful to exempt tourists, spectators at sporting events, and the general public from this exclusion. See generally Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” (Aug. 1994). Harlan E. Moore Charitable Trust v. United States, 812 F. Supp. 130 (C.D. III. 1993); Trust U/W Oblinger v. Commissioner, 100 T.C. 114 (1993); Gen. Couns. Mem. 35,301 (Apr. 12, 1973); Gen. Couns. Mem. 35,301 (Apr. 12, 1973). See also Gen. Couns. Mem. 35,811 (May 7, 1974). §513(a)(2); Reg. §1.513-1(e)(2). The regulations further illustrate this exception with a laundry facility operated by a college for the purpose of laundering dormitory linens and clothing of students. Reg. §1.513-1(e). This example is based in part on the factual situation presented in Squire v. Students Book Corp., 181 F.2d 1018, 51-2 USTCP 9473 (9th Cir. 1951). See also Rev. Rul. 58-194, 1958-1 C.B. 240; Rev. Rul. 69-538, 1969-2 C.B. 116. This example highlights the “ultimate destination test” for determining UBIT, espoused by the Supreme Court in Trinidad v. Sagrada Orden de Predicadores, 263 U.S. 578 (1924), and codified under the somewhat different “convenience” rubric in §513(a)(2).
䡲
717
䡲
c14.fm Page 718 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
In establishing this educational environment, a school may reasonably provide facilities that encourage or facilitate visits by families and friends of students and by persons who participate in, and thus contribute to, the educational activities and atmosphere of the school. The IRS has construed this exclusion as applying to a broad range of basic functions.129 However, with the advent of the special audit guidelines for colleges and universities, the IRS will be scrutinizing IRC §513(a)(2) exclusionary arrangements. The IRS is focusing on any businesslike arrangements130 carried on by universities to determine whether the relationship is a joint venture or merely a component function of the university.131 IRS examination personnel are instructed to distinguish joint venture arrangements from regular service departments of the university.132 Income from regular service departments is excluded from UBIT under §513(a)(2). Thus, if a joint venture undertakes to perform a basic university function for the convenience of the students, which is related to the university’s exempt purposes, the venture would likely not be subject to taxation under the UBIT provisions.133 It also appears that a separate entity conducting such activities could qualify for exemption as an integral part of the institution, whose otherwise commercial activity is “boosted” to educational status by the university affiliation.134 (b)
Entertainment, Sports, and Travel Activities
Educational and cultural entertainment activities135 and sporting events136 present universities with opportunities to engage in joint ventures that, if structured 129 130
131
132
133 134
135
136
See Gen. Couns. Mem. 37,591 (June 29, 1978). In the Guidelines, the IRS highlights business activities that may result in UBIT: travel study tours (Gen. Couns. Mem. 38,949 (Jan. 6, 1983)), operation of a parking lot for non-university activities (Gen. Couns. Mem. 39,825 (Aug. 27, 1990)), operation of a hotel (Gen. Couns. Mem. 38,060 (Aug. 22, 1979)), use of university facilities by unrelated entity (Gen. Couns. Mem. 39,863 (Dec. 9, 1991)), Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” (Aug. 1994). Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” §§342.41(5), 342(13) (Aug. 1994). Although a component function of a university carried on for the convenience of the students is excluded from UBIT under §513(e)(2), joint ventures always present the potential for unrelated income in the eyes of the IRS. However, the Guidelines offer scant guidance to differentiate regular service components of a university from joint ventures. Indeed, the Guidelines cryptically recognize that [t]he regular service departments may be indistinguishable from commercial business but for the fact that they are totally “captive” operating units of the university. Internal Revenue Manual, Exempt Organizations Examination Guidelines Handbook §7(10)69, “Colleges and Universities” §342.41(5) (Aug. 1994). §513(a)(2). See Rev. Rul. 81-19, 1981-1 C.B. 353. See Squire v. Students Book Corp., 191 F.2d 1018 (9th Cir. 1951) (corporation operating a bookstore and restaurant that sold college texts was exempt where it was wholly owned by a college, used college space free of charge, served mostly faculty and students, and devoted its earnings to educational purposes; it “obviously bears a close and intimate relationship to the functioning of the [c]ollege itself”); Rev. Rul. 63-235, 1963-2 C.B. 210 (law journal corporation was exempt as “adjunct to” exempt law school); Rev. Rul. 58-194, 1958-1 C.B. 240 (bookstore was exempt as integral part of exempt university). The “boost” theory was more fully articulated in Geisinger Health Plan v. Commissioner, 30 F.3d 494 (3d Cir. 1994), aff’g 100 T.C. 394 (1993), a non-university case discussed in Section 12.4. See Gen. Couns. Mem. 39,863 (Dec. 9, 1991). See also Priv. Ltr. Rul. 89-27-062 (Apr. 13, 1989) (partnership formed, with educational institution as a general partner, to ensure that the symphony would continue to participate in a summer educational program). See Gen. Couns. Mem. 39,860 (Sept. 26, 1991).
䡲
718
䡲
c14.fm Page 719 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
properly, will further their exempt purposes. On the question of whether a university is conducting activities that are related to its exempt purposes, the IRS has provided guidance: A trade or business not otherwise related does not become substantially related to an organization’s exempt purpose merely because incidental use is made of the trade or business in order to further the exempt purpose. A trade or business is considered related if operated primarily as an integral part of the educational program of the university, but is considered unrelated if operated in substantially the same manner as a commercial operation.137 (i) Entertainment. The IRS has examined numerous transactions in which a state university allowed entertainment events to be conducted at its on-campus multipurpose arena.138 The university received income from these events in the form of ticket sales, the tickets being sold through a commercial ticket service.139 The IRS held that the activities were not substantially related to the university’s exempt purposes for several reasons: • Although the university has a college of fine arts, neither the university
nor the students had any input into the selection, content, style, or performance of the events.140 • The fees charged to the general public are comparable to those of com-
mercial facilities, and students were infrequently given discounts.141 • Only the persons purchasing the goods or services are benefited, and the
benefits are in direct proportion to the fees charged.142 • The university’s reputation as an educational institution is of secondary
importance, if a factor at all, in attracting patrons.143 • Revenue maximization is a predominant element in the exempt organiza-
tion’s conduct of the activity.144 137 138 139
140 141
142
143
144
Rev. Rul. 55-676, 1955-2 C.B. 266. Gen. Couns. Mem. 39,863 (Dec. 9, 1991). Although the IRS did not refer to these transactions as joint ventures, these entertainment activities were a grouping of two or more persons or entities in a business undertaking for profit (e.g., ticket sales). In other words, the university conducted the entertainment events as a commercial enterprise and not as an educational or cultural program. See Rev. Rul. 55–676, 19552 C.B. 266. See Rev. Rul. 78-98, 1978-1 C.B. 167 (persons using a ski facility owned and operated by an exempt school were required to pay slope and lift fees that were comparable to those of commercial ski facilities). The costs to students were equal to the costs charged to the general public, and there was no difference between the cost of the university performance and that of commercial performances. See Gen. Couns. Mem. 39,863 (Dec. 9, 1991); Illinois Ass’n of Prof’l Ins. Agents v. Commissioner, 801 F.2d 987 (7th Cir. 1987) (insurance coverage offered to trade association benefited the individual members in direct proportion to the amount they paid, rather than as a benefit to the group as a whole; thus, insurance activity looked like a commercial business for profit). The university did not allow students or its fine arts college to have any input into the performance or the selection of the materials. See Rev. Rul. 76-402, 1976- C.B. 177 (exempt school provided tennis courts, furnished dormitory rooms, linens, meals, and maid service to an individual for use in conducting a tennis camp). The university sold tickets through a commercial ticket service at market prices and required a noncompete clause by all entertainers whereby entertainers agreed not to perform within a 75 mile radius of the university the day before and after the performance at the university. See Iowa State Univ. of Sci. & Tech. v. United States, 500 F.2d 508 (Cl. Ct. 1974) (universityowned television station affiliated with a major network was driven by profit maximization and not educational purposes).
䡲
719
䡲
c14.fm Page 720 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
This example highlights the fact that this venture would likely not be subject to UBIT if structured with greater participation and control by the students, faculty, and the fine arts department. Furthermore, the exempt educational purposes should have been stressed over any profit motivation. By contrast, a properly structured joint venture to conduct, for example, a summer symphony composed of professional and student musicians, whereby the students gain artistic training and expertise, may be expected to pass tax muster.145 (ii) Sports Activity. An athletic program is considered to be an integral part of the educational process of a university,146 and activities that provide necessary services to student athletes and coaches advance the educational program of the university.147 In addition, the income that universities earn from athletic events is protected from UBIT by the schools’ broad grant of exemption as educational organizations.148 This favorable tax treatment is secured by universities even though “college sports have become a major money making venture.”149 EXAMPLE: Notre Dame University signed an agreement with NBC to broadcast its six home football games. The five-year venture was reported to be worth $35 million, or approximately $1.2 million per game. Notre Dame reportedly did not pay taxes on the income.150 Similarly, joint venture arrangements that are ancillary to a university’s sports activities can expect favorable tax treatment despite the substantial revenue they produce. EXAMPLE: X University enters into a joint venture arrangement with T, a nationwide publisher of sports programs, to produce and publish football programs for its homecoming and final home games. T agrees to produce and publish the football programs under the name of X University. The revenue generated from the advertisements is substantial. Under these circumstances, the joint venture activity will 145 146
147 148
149
150
See Priv. Ltr. Rul. 89-27-062 (Apr. 13, 1989). H.R. Rep. No. 2319, 81st Cong., 2d Sess. 37 (1950) 1950-2 C.B. 380. The Committee Report on the Revenue Act of 1950 provided that [a]thletic activities of schools are substantially related to their educational functions. For example, a university would not be taxable on income derived from a basketball tournament sponsored by it, even where teams were composed of students from other schools. H.R. Rep. No. 2319, 81st Cong., 2d Sess. 37,109 (1950). See Rev. Rul. 67-291, 1967-2 C.B. 184; Rev. Rul. 64-275; 1964-2 C.B. 142. See S. Rep. No. 2375, 81st Cong., 2d Sess. 29 (1950) 1950–2 C.B. 483. The legislative history provides as follows: Of course, income of an educational organization from charges for admission to football games would not be deemed to be income from an unrelated business, since its athletic activities are substantially related to its athletic program. S. Rep. No. 2375, 81st Cong., 2d Sess. 29,107 (1950). Gaul and Borowski, “Colleges Score with Tax-free Income from Big-time Sports,” Philadelphia Inquirer (Apr. 20, 1993), A7. (quoting Richard L. Kaplan, a University of Illinois law professor) (hereinafter referred to as “Colleges Score”). “Colleges Score,” note 150. An attorney for Notre Dame stated that “all revenue from athletic contracts is considered related [to the school’s exempt purpose]. As an educational §501(c)(3) corporation, it’s considered related. We don’t pay taxes.” Id. See Rev. Rul. 80-296, 1980-2 C.B. 195 (sale of broadcasting rights to a national radio and television network by a university organization is not an unrelated trade or business). See also Rev. Rul. 80-294, 1980-2 C.B. 187 (sale of broadcasting rights by §501(c)(6) organization is not an unrelated trade or business); Rev. Rul. 80–295, 1980–2 C.B. 194 (sale of radio and television broadcasting rights to an independent producer by an exempt amateur athletics association is not an unrelated trade or business).
䡲
720
䡲
c14.fm Page 721 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
not jeopardize X’s exempt status. Furthermore, because the activity is seasonal and not “regularly carried on,” the income generated by X from the sale of the advertisements does not constitute unrelated business income.151 (iii) Corporate Sponsorship. In the Taxpayer Relief Act of 1997,152 Congress included a new statutory UBIT exception, IRC §513(i), relating to corporate sponsorship. IRC §513(i) provides that “unrelated trade or business” does not include the solicitation and receipt of “qualified sponsorship payments.”153 The latter term is defined as a payment made by a for-profit entity to a nonprofit where there is no expectation that the for-profit entity will receive any substantial benefit other than the use or acknowledgment of its name, logo, or product line.154 The exception does not apply to advertisements of the for-profit’s services or products or any payment whose amount is dependent on the level of attendance at an event, broadcast ratings, or other indicia of the degree of public exposure to the event.155 Factors that indicate that a message is an advertisement, as opposed to an acknowledgment, are the presence of comparative language, price information, an inducement to purchase, an endorsement, or any indication of savings or value.156 The exclusion is also inapplicable to payments for acknowledgments of the for-profit’s name, logo, or products in a nonprofit’s regularly published materials, such as a monthly newsletter; the published materials must be tied to a specific event for the exception to apply.157 IRC §513(i)158 contains an allocation provision that states that, to the extent a portion of a payment would be a “qualified sponsorship payment” and therefore not UBIT, it will not be “tainted” by a portion that would be UBIT.159 In other words, payments can be separated into UBIT and non-UBIT portions. These provisions apply to “qualified sponsorship payments” solicited or received after December 31, 1998. EXAMPLE: A university sponsors a track event and solicits and receives an endorsement by a well-known sneaker manufacturer. As long as the university uses the manufacturer’s name and logo only to acknowledge its support in its program materials or on other permissible items, the income for the acknowledgments will not be UBIT. On the other hand, if the university also receives payments for 151
152 153 154 155 156 157 158 159
National Collegiate Athletic Assn. v. Commissioner, 914 F.2d 1417 (10th Cir. 1990), rev’g 92 T.C. 456 (1989) (income received by the National Collegiate Athletic Association (NCAA) from program advertising is not subject to UBIT when advertising was completed by independent, taxable third party); Suffolk County Patrolmen’s Benevolent Ass’n v. Commissioner, 77 T.C. 1314 (1981). But cf. United States v. American College of Physicians, 475 U.S. 834 (1986) (income derived from soliciting, selling, and publishing commercial advertising in an exempt organization’s publication is subject to UBIT); See also Rev. Rul. 73-424, 1973-2 C.B. 190 (sale of advertising in an annual yearbook constitutes unrelated business income when completed by independent commercial firm). Taxpayer Relief Act of 1997, adding §513(i); see also Section 14.6(iii). §513(i)(1). §513(i)(2)(A). §513(i)(2)(A) and (B)(i). §513(i)(2)(A). §513(i)(B)(ii)(I) and (II). §513(i)(3). See id.
䡲
721
䡲
c14.fm Page 722 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
“acknowledgments” in its monthly alumni newsletter, those payments could well be UBIT if other UBIT rules are met, because these “acknowledgments” are not connected with a specific event but appear in a regularly published periodical.160 Subsequent to the promulgation of IRC §513(i), the IRS issued Technical Advice Memorandum (TAM) 98–05–001,161 which offers further guidance on determining the difference between an acknowledgment and an advertisement. The TAM involved a §501(c)(4) entity organized to increase public interest in certain breeds of animals that are pets. In furtherance of its purposes, the organization holds an annual animal show, which is its principal activity. The organization sells commercial television broadcast rights to the show. The television show generates most of the organization’s income and is watched by approximately 14 million people. The organization had an arrangement with a pet food company whereby the company made an annual payment to the nonprofit in return for numerous rights, including two free two-page advertisements in the show catalog, the right to advertise its support of the show, a discount on booth space at the show, and its product names and/or logo appearing on the judging program envelope, as well as on exhibitor arm bands. The IRS determined that the sale of broadcast rights did not generate UBIT, as it furthered the association’s purposes by exposing a larger audience to the show. The full-page ads examined by the IRS did not appear to go beyond permissible “acknowledgments,” as they did not contain comparative product information or quality claims. Significantly, the IRS also stated that the pet food company’s logos on arm bands and other materials were permissible acknowledgments and not advertising. This TAM provides useful guidelines for a nonprofit considering entering into a sponsorship arrangement with a for-profit entity. In April 2002, the IRS finalized regulations to implement the 1997 Taxpayer Relief Act and to address additional issues in corporate sponsorship.162 For a detailed description of the regulations, see Section 8.4(i). CAVEAT The IRS does not agree that income from sports program advertising is excluded from UBIT.* *
Gen. Couns. Mem. 39,860 (Oct. 7, 1991).
The IRS is closely examining the activities of major university athletic departments to determine whether any income-producing arrangements or taxable joint venture activities are present.163 The IRS specifically instructs its agents to “analyze agreements or contracts for endorsement or sponsorship arrangements to determine if the terms and conditions are such to indicate whether the income should be treated as a royalty excluded from the computation of unrelated business 160 161 162 163
§513(i)(B)(ii)(I) and (II). See Section 8.4(i) for a more detailed discussion of this issue. Oct. 7, 1997. Rev. Rul. 58-194, 1958-1 C.B. 240. See also Gen. Couns. Mem. 37,591 (June 19, 1978). Adv. Ann. 93-2, 1993-2 I.R.B. 39,342.41(6) and (7) (Dec. 21, 1992).
䡲
722
䡲
c14.fm Page 723 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
income”164 or taxable as UBIT.165 However, the income from a university sports joint venture can be excluded from UBIT166 if the university activity furthers its exempt purposes or is specifically excluded from UBIT.167 An important private letter ruling was issued in February 1997 about the operation of a golf course by a university supporting organization.168 In the ruling, the supporting organization retained a professional management firm to manage the golf course and contracted with the university’s provider for food services. The golf course served as the home course for the university’s golf team. The issue was whether use of the golf course by several categories of persons associated with the university generated UBIT. In the ruling, the IRS decided as follows: • Income derived from the use of the golf course by students, faculty, and
staff of the university does not constitute UBIT under IRC §512(a)(1), the convenience exception of §513(a)(2).169 • Income from alumni use of the golf course does generate UBIT. The IRS’s
reasoning on this question was that use of the golf course by alumni was not distinguishable from use of the golf course by the general public—use by both categories generated UBIT, as their use of the facilities did not substantially further the university’s exempt purposes. The IRS dismissed the organization’s contention that usage of the golf course helped generate alumni donations to the university; such donations would be made regardless, the IRS held. • Usage of the golf course by spouses and children of students, faculty, and
staff does generate UBIT as their usage does not satisfy the IRC §513(a)(2) convenience exception. Thus, the furnishing of sports and athletic facilities can further a university’s exempt purposes, but can also generate UBIT depending upon the relationship of the user to the institution.170 (iv) Pouring-Rights. Pouring rights contracts are agreements between beverage distributors and universities that provide distributors with an exclusive right to sell its beverages in on campus vending machines and at all official school functions, including athletic events. In exchange for carrying the products of one distributor, the university may receive funding reaching into the 164 165 166
167
168 169
170
Id., §512(b)(2); Reg. §1.512(b)–1(b). Ann. 93–2, 1993–2 I.R.B. 39,342.41(6) and (7) (Dec. 21, 1992). See National Collegiate Athletic Ass’n v. Commissioner, 914 F.2d 1417 (10th Cir. 1990), rev’g 92 T.C. 456 (1989) (income from sports program advertising is not unrelated business income (UBI) because the advertising activity was not “regularly carried on” within the definition of UBI). See §512(b) (modifications to UBIT) and §512(c) (special rules applicable to partnerships and joint ventures that allow the modifications of §512(b) to apply through such entities to the exempt organization). For a detailed discussion of commercial sponsorship of sports activities, see Section 14.6; Prop. Reg. §1.512(a)-1; Prop. Reg. §1.513-4. Priv. Ltr. Rul. 97-20-035 (Feb. 19, 1997). See also Rev. Rul. 60-143, 1960-1 C.B. 192 and Rev. Rul. 78-98, 1978-1 C.B. 167 (use by the general public of a ski facility was not substantially related, whereas use by students was substantially related). See also Priv. Ltr. Rul. 96-450-04 (July 17, 1996).
䡲
723
䡲
c14.fm Page 724 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
millions for mega-campuses such as Ohio State University and the University of Wisconsin--for school athletic, academic and recreational programs.171 With funding for state universities dependent on declining state revenues, and private schools facing increased costs, pouring contracts can offer cash-strapped schools a lucrative means to increase funding for expensive budget items, such as football programs, while providing concession services to students and spectators. Pouring rights contracts grew in popularity in the early 1990s. Penn State University was the first major system to partner with a beverage distributor; In 1992, the University entered into a 10-year, $14 million exclusive deal with Pepsi Co.172 While the exact terms of the agreement were confidential, the Pepsi Co. product and its logo became prolific and predominant on the campus, reaching from stadium signage to named academic scholarships.173 With other campuses soon following the Penn State model, the Service began to examine the exclusivity created by the pouring rights contract paradigm and namely, whether the relationships created between tax-exempt schools and the beverage companies amounted to, and were permissible as, corporate sponsorships, and whether the payments, or portions of the payments, comprised UBTI. Perhaps in response to these concerns, Congress enacted §513(i) in 1997. §513(i) provided that any amount considered a “qualified sponsorship payment” (i.e., amounts received by universities through contracts with distributors) would not be subject to UBIT.174 In 2002, the Service issued final regulations under new §513(i). For purposes of pouring rights contracts, these regulations state that payments that create exclusive arrangements with a school may be taxable as “substantial return benefits.” Under 513(i), a “qualified sponsorship payment” is any payment for which there is no agreement that the payer will receive a “substantial return benefit” apart from the use or acknowledgment of the payer’s name or logo.175 A “substantial return benefit” is more than goods or services or other “insubstantial” benefits and includes logo promotions and displays that rise to the level of advertising. Notably, the use or acknowledgment of the payer’s name or logo in connection with a university’s exempt function (i.e., having the distributor’s name on a stadium scoreboard used for school-related events), does not rise to the level of a “substantial return benefit.” In contrast, use of logos or slogans that contain qualitative comparisons or descriptions of the payer’s products may rise to the level of an endorsement or inducement to purchase. These types of logo uses may subject the university to UBTI. The regulations under 513(i) also clarify that “exclusive sponsorship arrangements” may be permissible so long as the payer’s is merely acknowledged and the use of logos or slogans does not cross into impermissible advertising.176 171 172 173 174 175 176
Kathy Hoke, Coke, “Pepsi Pour It On To Top Pop”, Business-First Columbus, April 3, 1998, at 1. Id. Anna White, “Coke and Pepsi are Going to School”, The Multinational Monitor, January 1999. Available at: http://www.essentialaction.org/spotlight/CokeSchool.html. IRC § 513(i). See Section 14.6(iii); Section 7.4(i). Id. Treas. Reg. § 1.513-4(c)(2)(iv).
䡲
724
䡲
c14.fm Page 725 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
Despite §513(i), the IRS appears to still be concerned about exclusivity agreements with certain vendors.177 In the future, the IRS may examine some universities' multimillion-dollar deals with soft drink companies, which provide exclusive pouring rights, to determine if these types of agreements rest outside the bounds of the §513(i) regulations on corporate sponsorship payments.178 (v) Travel Tours. An area that has received increased attention is universitysponsored travel tours.179 Generally, such tours involve a university entering a relationship with a travel agency whereby the university provides the students, professors, itinerary, and educational curriculum, and the travel agency books and arranges the trip, while making a tax-deductible contribution to the university. Profits are sometimes shared with the university, either directly or in the form of free travel for the university professors. Because travel tours by their nature appear to be “trades or businesses” and are “regularly carried on,” they present a potential UBIT problem for universities unless they are substantially related to a university’s educational purposes.180 The regulations define an educational purpose to include “the instruction or training of the individual for the purpose of improving or developing his capabilities.”181 Accordingly, to avoid UBIT, a travel tour must involve substantial instruction or training.182 The IRS issued final regulations on February 7, 2000.183 The final regulations reiterate that the IRS will decide whether tour activities are substantially related to an organization’s exempt purpose based on all the facts and circumstances, including the way the tour is developed, promoted, and operated. For three examples added by the final regulations, see Section 8.5(d). 177
178 179
180 181 182
183
In 1998, the NCAA first warned its member institutions of the possibility that the Service might begin to examine more critically pouring rights contracts. Available at: http:// www.ncaa.org/databases/register/register_19980504/govaffairs.html. NCAA Governmental Affairs Report, April 2000. Available at: http://www.ncaa.org/databases/reports/1/200007mc/200007_d1_mc_agenda_s06.htm. Internal Revenue Service Exempt Organizations CPE Technical Instruction Program Textbook 1995 (for Fiscal Year 1996) (hereinafter 1996 CPE), Part II, Chapter J, “Update on UBIT—Travel Tours,” §1 (Aug. 24, 1995). See generally Chapter 8. Reg. §1.501(c)(3)-1(d)(3). See Section 2.6(c). When unrelated travel tour activity is substantial, the organization may lose its exempt status— precisely what happened in Priv. Ltr. Rul. 95-40-002. In this ruling, an IRC §501(c)(3) entity was formed to promote the objectives of the People to People Program (a program designed to broaden understanding and friendship with people of other nations) through sports. The organization conducted many different activities, including exchanges of amateur soccer, baseball, boxing, sailing, tennis, and golf (among others) players. Its largest programs were its golf and tennis tours, whereby it arranged foreign tours for teams of amateur American players. Individuals paid significant amounts to participate in the tours. The tours represented the organization’s primary program activity and primary source of support. The organization relied exclusively on the services of one travel agency in promoting its golf and tennis tours. The tours were so successful, in fact, that the agency divided into two agencies—one to administer the golf tour and the other the tennis tour. The relationship between the travel agencies and the exempt organization was not, arguably, arm’s length, as the owner of one of the agencies was on the board of directors of the exempt organization. Moreover, the exempt organization never solicited competitive bids from any other agency, nor did it have a formal written contract documenting the travel service of either agency. Payments by customers were made directly to the exempt organization, which then deducted 5 percent of all monies collected for its “overhead and administrative fees” and remitted the balance to the travel agencies. Based on these facts, the IRS concluded that the exempt organization was operated substantially for the private benefit of the travel agencies and revoked its exempt status. Treas. Reg. §1.51.3-7, T.D. 8874 (Mar. 7, 2000).
䡲
725
䡲
c14.fm Page 726 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
To address this increasingly common activity, in May 1998 the IRS issued Prop. Reg. §1.513–7 on travel tours sponsored by tax-exempt organizations.184 This proposed regulation states in subsection (a) that facts and circumstances control the determination of relatedness to an organization’s exempt purposes and, in subsection (b), gives four illustrative examples. Hearings on the proposed regulation were held in February 1999.185 The first example demonstrates what is deemed to be an unrelated trade or business conducted by a university alumni association.186 The association offers travel tours to members and guests through a travel agency. Participants pay the travel agency, which then pays the association a per person fee. Even though the tours are advertised as continuing education and a university faculty member accompanies each tour as a guest, there is no scheduled curriculum or instruction on the tour. The regulation states that the tours therefore do not contribute to the organization’s exempt purpose. In addition, the tours actually produce revenues for the organization. Example 2 involves tours structured with an educational purpose and therefore are not held to be an unrelated trade or business.187 The exempt organization educates people in U.S. geography and culture by publishing books, providing courses, and offering study tours to national parks and other locations in the United States. Five or six hours a day on the tours are devoted to an educational curriculum related to the particular location visited. Teachers and other educational professionals use a library of materials and, at the end of the tours, give examinations that qualify participants for academic credit in the organization’s state. Because of the substantial nature of the instruction and study, these tours further the organization’s exempt purposes. The third example illustrates tours that further social welfare purposes and therefore are not found to constitute an unrelated trade or business.188 An exempt social welfare organization offers regular trips to Washington, D.C., for its members to engage in advocacy on the organization’s behalf. The members spend virtually all of their time in Washington attending meetings with legislators and other officials and briefings on developments in the organization’s issue area. Although the tours generate a profit for the organization, they are deemed to be sufficiently related to its exempt purpose. Example 4 involves an educational and cultural organization that organizes two types of tours for its members, who are Americans of a particular ethnicity as well as other Americans interested in that ethnic heritage.189 Each tour goes to the country of ethnic origin, but there is a difference in content. The first type of tour immerses the participants in the culture, language, and history of the country through organized instruction. The 184
185 186 187 188 189
Reg. §121268-97, IRS Doc. 98-12792. See Susan Cobb, “UBIT Traps in Alternative Revenue Sources,” delivered at the Federation of State Councils Conference, “Revenue Generating Strategies and Their Tax Implications,” Washington, D.C. (Nov. 20, 1998) (hereafter “UBIT Traps”) (on file with the author). Portions of this discussion are based on “UBIT Traps.” “IRS Schedules February Hearings on Travel and Tour Activity Regulations,” Daily Tax Report (Nov. 20, 1998), G-3. Prop. Reg. §1.513-7(b), Example 1. Prop. Reg. §1.513-7(b), Example 2. Prop. Reg. §1.513-7(b), Example 3. Prop. Reg. §1.513-7(b), Example 4.
䡲
726
䡲
c14.fm Page 727 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
other tour category offers no scheduled instruction or detailed itinerary other than optional guided tours of various locations. Participants have a substantial amount of free time in the second category of tours, and the destinations are mostly recreational. Although both kinds of tours are priced for profit, the regulations conclude that a tour of the first category is not an unrelated trade or business because of the substantial educational activity and focus. On the other hand, a tour of the second category does not contribute to the organization’s exempt purpose and therefore constitutes an unrelated trade or business.190 (A) TIPS FOR C ONDUCTING TRAVEL TOURS191 • Provide educational elements in the tour’s curriculum. Factors that tend to
show that an organization’s exempt purposes are furthered include a deliberate intent to educate, as opposed to providing for the casual or optional availability of education about the tour’s destination or focus. The presence of a formal education program, scheduled lectures, reading lists, availability of reference materials and library facilities, a mandatory attendance policy, and the availability of educational credit all favor a finding of an educational purpose.192 The administration of examinations and grading of students are positive factors, as is the utilization of certified instructors or experts in the field to enhance the tour’s educational quality. The fact that a tour offers substantial amounts of free time for social and recreational activities or provides for an extensive and structured social and recreational program will weigh against a finding that education purposes are being furthered, especially when such recreational activities occupy most of the participants’ time. Accordingly, as compared with the amount of social and sightseeing time, the amount of classroom and classroom-related activities should be significant. Moreover, nonclassroom activities should relate to and supplement the classroom time. 190
191 192
In Priv. Ltr. Rul. 97-02-004, which was issued prior to Prop. Reg. §1.513-7, the IRS determined that income from two of the four travel tour programs offered by a §501(c)(3) organization did not constitute unrelated business income. The IRS reviewed three critical factors to determine whether each tour was substantially related to the organization’s exempt purpose: first, whether the primary purpose in offering the tour was to further one of the organization’s exempt purposes; second, whether there was evidence that each tour was designed so that its primary purpose was to further an exempt purpose; third, whether there were relevant circumstances that demonstrated that a particular purpose was served. The exempt organization was formed to promote the creative survival and foster the unity of a particular ethnic group. One of the exempt purposes of the organization was to gather and disseminate information or otherwise educate its members about the group’s heritage and homeland. The travel tours were only one of the activities conducted by the organization. The two types of travel tours that were held not to produce UBIT were formed to be substantially related, because both tours involved “intensive learning” experiences. One tour involved traveling to the ethnic group’s homeland, and the itineraries included visits to places of historic, religious, and cultural significance. The other tour involved the discovery of the ethnic group’s heritage through lectures conducted by experts about its history and civilization. The IRS determined that these tours satisfied the aforementioned three factors and were therefore substantially related. The tours that were held to produce UBIT devoted a substantial portion of the itineraries to sightseeing. The countries visited were not the ethnic group’s homeland, and only a small portion of the activities related to the culture or background of the ethnic group. The IRS stated that these tours accomplished primarily social, recreational, and other purposes. See “UBIT Traps,” note 160. See Prop. Reg. §1.513-7(b), Example 2.
䡲
727
䡲
c14.fm Page 728 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
Although no one factor is determinative, the more closely the tour resembles a traveling college course, the more likely it is that the IRS will find the tour to be educational. • Emphasize educational nature in marketing the tour and designing marketing
materials. In marketing tours, exempt organizations must be careful to ensure that they do not jeopardize their educational nature. For example, although offering a tour to the general public will not per se cause the tour to be unrelated if there are substantial educational activities in comparison with recreational activities, the targeting of the tour to a group of persons who typically participate in the organization’s activities (i.e., students or alumni) will be more likely to help qualify the tour as a related activity. Similarly, although the use of a for-profit travel agency to book the tour and aid in itinerary planning and the generation of a profit will not necessarily lead to an unfavorable determination, the IRS will scrutinize the nonprofit organization’s focus in designing the tour in a particular fashion, to ensure that the educational aspects take precedence. In designing the materials used to market a tour to prospective participants, the nonprofit organization should be careful to stress the educational activities rather than the recreational aspects of the trip. • Documentation, documentation, and more documentation. The IRS empha-
sizes that nonprofits must be able to prove, through careful documentation, that a travel tour qualifies as substantially related to its educational purposes. Records dating as early as the planning stage should detail the purposes for the tour program and the specifics of its administration (i.e., the tour operator’s credentials, the amount of estimated time spent on educational lectures, etc.).193 Moreover, complete records regarding revenue and expenses should be maintained throughout the tour’s administration. • Form a for-profit subsidiary. In the event that a travel tour is not substan-
tially related to the organization’s exempt purposes, the activity may be conducted through a for-profit subsidiary.194 The subsidiary can pay dividends to its tax-exempt parent on a tax-free basis, pay royalties or fees to the parent for the use of the parent’s mailing list, logo, or name, or pay rent for the use of office space. However, royalty payments and rent may trigger UBIT for the parent.195 Nonetheless, the exempt status of the parent nonprofit would be protected by use of the subsidiary. • Conduct tours on a less frequent basis. To the extent that a tour is not consid-
ered “regularly carried on,” the activity is unlikely to be subject to UBIT. Thus, a travel tour program that is not substantially related but is conducted only once a year may be exempt from UBIT.196 193 194 195 196
See Prop. Reg. §1.513-7, Example 2. See Section 4.6. Id. Reg. §§1.152(a)-1(a) and 1.513-1(c)(1).
䡲
728
䡲
c14.fm Page 729 Thursday, March 15, 2007 10:45 AM
14.6 NONRESEARCH JOINT VENTURE ARRANGEMENTS
(B) B OOST T HEORY Boost theory refers to when a commercial activity is “boosted” to the level of an educational endeavor. This theory may apply in the construct of travel tours; it is possible that the travel tour may have both educational and non-educational components. The theory is significant because under it, an entity separate from the university might qualify for exemption if its commercial activity is “boosted” to the level of educational via its affiliation with the university.197 (vi) University Fitness Centers. In response to a growing trend to provide students, alumni, faculty, and staff with state-of-the-art and aesthetically pleasing sports and fitness centers, colleges and universities are expected to spend $8 billion in new athletic center construction over the next five years.198 Many of these projects involve facility management agreements between exempt universities and for-profit fitness corporations. The Service has determined that an athletic complex operated under this rubric may be exempt under §501(c)(3) where the center is operated as part of a larger tax-exempt system, such as a §501(c)(3) university.199 If the center is operated as part of a university, the prevailing question is whether center revenue constitutes unrelated trade or business. Under Treas. Reg. §1.513-1(d)(3), income generated from the operation of a university athletic facility may be deemed unrelated income even if the facility is found to be an integral part of university functions that are in furtherance of its exempt purpose. This concept, also known as the fragmentation rule, closely analyzes a fitness center operated as part of a larger §501(c)(3) organization to determine if it generates any UBTI. (c)
Two Exempt Venturers
When two exempt organizations form a joint venture, the partners must exercise great care to ensure that the joint venture furthers the specific charitable exempt purposes of both exempt organizations.200 EXAMPLE: X, a university exempt under IRC §501(c)(3), has an excellent communications department. Y, a public television and radio broadcasting organization exempt under §501(c)(3) with similar educational purposes, is interested in expanding its facilities. X and Y agree to form a joint venture to operate a state-ofthe-art national communications facility. The joint venture will be constructed on X’s campus. This arrangement will allow X’s students to have access to a premier communications facility (in essence, a communications laboratory) and will also afford the students an opportunity to study a working communications facility. Likewise, Y will have an expanded, modernized facility with quality equipment.
197 198 199 200
See discussion of the Geisinger case and the boost theory, Section 12.4(g)(iii). Goldie Blumenstyk, “Run. Lift. Climb. Swim.,” The Chronicle of Higher Education, March 25, 2005, at 7. I.R.S. INFO 2005-002 (March 31, 2005). See Rev. Rul. 81-29, 1981-1 C.B. (joint venture to operate a library database furthers the exempt purposes of the participating exempt institutions); Priv. Ltr. Rul 92-49-026 (Dec.4,1992) (computer database between two exempt educational organizations).
䡲
729
䡲
c14.fm Page 730 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
However, to ensure that the joint venture will meet and further the exempt purposes of both partners, the joint venture agreement provides as follows: •
Y agrees to consider qualified X students for internships under Y at the joint venture facility in the areas of television and radio broadcasting, production, news, programming, and communications engineering and to cooperate in ensuring that the joint venture facilities are available as research laboratories for X’s faculty and students.
•
X agrees to consider Y’s staff, when appropriate, for adjunct faculty appointments, guest lecturing sports, and communications advisory positions and to permit Y to have access to X’s library, research staff, and communications resources.
•
X and Y agree to create a task force to recommend areas of activity for the joint venture, including teleconferences, television productions, and educational videotapes.
•
X and Y agree to explore the joint sponsorship of communication events, seminars, workshops, and meetings and to allow educational tours of the joint venture facility, provided that such tours do not disrupt the classroom and educational activities of X and the broadcasting activities of Y.
•
X and Y agree to research, develop, and implement new technologies or communication inventions. Carefully structuring the joint venture activities will likely ensure that the national communications facility furthers the exempt purposes of both X and Y. With two exempt joint venturers, the equation becomes more complex, but the difficulty is not insurmountable.
Meeting the exempt purposes and needs of each organization requires detailed planning and structural specificity.
14.7 (a)
MODES OF PARTICIPATION BY UNIVERSITIES IN JOINT VENTURES Introduction
A university, like other exempt organizations, may potentially participate in joint ventures in various capacities—as an equity holder, a service provider, a ground lessor, or a lender—and may do so either directly or through a subsidiary.201 EXAMPLE: M is a university, exempt from taxation under IRC §501(c)(3), that operates a medical school and teaching hospital. N is a wholly owned exempt subsidiary of M. O is an unrelated for-profit entity. M, N, and O propose to form a limited partnership to develop and operate an educational/medical facility on land owned by M. M will have a 49 percent interest as a limited partner in the joint venture; N will have a 1 percent interest as a general partner; O will have a 50 percent interest as a general partner. O will provide development, construction, and management 201
Valuation of New-Economy companies, in which a university might invest, is covered in Section 5.2(e) (based on a paper written by Wayne Zell).
䡲
730
䡲
c14.fm Page 731 Thursday, March 15, 2007 10:45 AM
14.7 MODES OF PARTICIPATION BY UNIVERSITIES IN JOINT VENTURES
expertise to the venture under a professional services agreement. The venture will pay fair market rent to M as ground lessor. M will also provide a construction loan to the venture, secured by the leasehold interest and guaranteed by O. Because M operates a medical school and teaching hospital, it is apparent that M itself could advance its charitable and educational purposes by developing and operating another medical facility as part of its system. M’s use of a joint venture with a for-profit entity to pursue such development will not have an adverse effect on the relatedness of the activity to M’s charitable purposes. M’s participation as limited partner in the joint venture will advance M’s exempt function and will provide direct benefits to the community. M’s participation as a limited partner in the joint venture will not jeopardize its tax-exempt status. The distributive shares of partnership income received by M and N from their respective partnership interests will not be income from a trade or business unrelated to their respective exempt functions and, thus, will not be subject to UBIT. Moreover, under other specific UBIT exceptions, M’s rental income from the ground lease, interest received under the loan, and compensation under the professional services agreement will not be subject to UBIT.202 (b)
University Housing
Construction and management of housing for college students can be either an exempt purpose or a trade or business, depending on how it is structured. If a developer is unrelated to a particular school, provides housing and services at cost, and allows access to the general public when college is not in session, the IRS is likely to regard the organization as an ordinary trade or business. If the developer is controlled by a university, supplies housing to a charitable class of students, or supplies housing at substantially below cost, the IRS is likely to treat it as having an exempt purpose. A university may use a variety of corporate structures depending on its situation. If it believes that the development of housing would be profitable, and would like to benefit from the profits, it could create a for-profit subsidiary. The for-profit would operate like any other corporation, including paying taxes on its income. It would then pay dividends to its owner, the university. The university would not have to pay taxes on the dividend income.203 A university could also participate in a joint venture to develop housing. The participants could include other exempt organizations or for-profit entities. If the university maintained control of the venture, and organized the venture to assure that it would be operated to further the exempt purposes of the university, it would not generate UBI or jeopardize the exempt status of the university.204 The advantage to this method is that the university can bring in partners with capital and/or expertise. However, the university must ensure that operation of the housing venture does not result in private benefit through unreasonable contracts or real estate 202 203 204
This example is based on the factual situation presented in Priv. Ltr. Rul. 93-19-044 (Feb. 18, 1993). See also Section 4.3(a); Section 6.2(a); Section 4.6. IRC §512(b)(1). See discussion of Rev. Rul. 98-15 in Section 4.2(e).
䡲
731
䡲
c14.fm Page 732 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
transactions.205 The partnership itself would not be eligible for exempt status, and thus could not use §501(c)(3) bonds for financing. A third option is for the university to set up a supporting organization to develop the housing.206 This organization would have to apply to the IRS for recognition of its exempt status.207 However, supporting organizations typically share an exempt purpose with the organizations they support. Because this organization has its own exempt purpose, income from the housing would be related income, and not taxable. The direct involvement of the university could preclude unrelated business income issues from arising when an unrelated organization desires to rent college housing during the summer session even to persons who are not attending class at the university. CAVEAT The IRS made clear, in an article on college housing, that it will closely scrutinize any independent entity that petitions for §501(c)(3) status based on a purpose of providing housing for college students. Favorable factors include the organization planning to serve a “charitable” class of students, operating housing below cost, responding to a specific deficiency documented by the community, and control of the entity by a college. Conversely, the IRS regards the following as factors that would influence them to deny exempt status: independence of the entity from colleges or community organizations, provision of housing at or above cost, and provision of housing to a non-charitable class of students or to nonstudents.* *
See Id.
(c)
Distance Learning
Increasingly, educational institutions, museums, and other well-established exempt organizations are entering the digital age by offering distance learning as an alternative to the more traditional learning experience. Many of these distance learning endeavors are set up as for-profit entities in a variety of organizational structures, some similar to the joint ventures in the healthcare industry exemplified in Revenue Ruling 98–15. However, there are other ways to structure these distance learning organizations. It is well established that educational institutions fulfill an exempt purpose and are eligible for tax-exempt status. IRC §501(c)(3) states that an entity organized and operated for educational purposes is within the definition of an organization exempt from taxation under §501(a). Charitable contributions for which a deduction is available to the contributor include donations to “an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried 205 206 207
See the issues discussed in “Charter Schools,” in Exempt Organizations Continuing Professional Education FY2000. See Cowen, Kawecki, and Sack, “College Housing,” at 69. See Section 4.9 for a discussion of supporting organizations.
䡲
732
䡲
c14.fm Page 733 Thursday, March 15, 2007 10:45 AM
14.7 MODES OF PARTICIPATION BY UNIVERSITIES IN JOINT VENTURES
on.”208 Even in the distance learning model, there is an enrolled body of students—in attendance via cyberspace—with the instructor where that individual regularly carries on his or her educational activities. The benefits to an educational institution that carries on distance learning as a part of its exempt activities are substantial: • Revenue streams are tax free. • Contributions to it are tax deductible. • Traditional grants reserved for §501(c)(3) exempt organizations may be
available. • Tax-exempt financing may be available. • Assets can be transferred tax-free between §501(c)(3) organizations. • Compensation packages can be competitive with for-profit entities
because of Treasury regulations allowing for-profit comparables to establish reasonable compensation. Therefore, it seems to make more economic sense for an educational organization to pursue this new venture into learning as a tax-exempt educational institution rather than a for-profit business. One option is to set up a singlemember LLC within an existing educational institution that is already well established as an exempt organization. For federal tax purposes, a business entity that has a single owner and is not a corporation is “disregarded as an entity separate from its owner.”209 If an entity is disregarded as separate from its owner, then the business activity of the entity is “treated for federal tax purposes in the same manner as if it were conducted as a sole proprietorship, branch, or division of the organization’s owner.”210 Therefore, a single-owner LLC that would be disregarded if it were owned by an individual would also be disregarded if it were owned by a single tax-exempt organization.211 With this arrangement, many other issues, such as copyright ownership of the educational materials and financial aid for students, may be resolved more easily. Although the entity of a single-member LLC is disregarded, its activity is not disregarded. Accordingly, a truly unrelated activity could give rise to the §511 unrelated business tax. Also, should the LLC’s activities become so large as to overwhelm the exempt purpose of the institution and threaten its exempt status, it would be possible at that point to establish a for-profit entity that may purchase the assets at fair market value.212 Certain organizations currently engaged in distance learning are mere arrangers of the services. They are not, per se, educators. For example, NYU Online, Inc., is a for-profit corporation organized in the state of New York. It is a subsidiary of New York University, and offers online courses to a growing “student body.” An official from NYU who spoke at the Mid-Year American Bar 208 209 210 211 212
IRC §170(b)(1)(A)(ii). Treas. Reg. §301.7701-2(c)(2)(i). Simplification of Entity Classification Rules, 1996-1 C.B. 865, 868. Ann. 99-102, 1999-43 I.R.B. 545. But see Treas. Reg. §1.337(d)-4.
䡲
733
䡲
c14.fm Page 734 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
Association conference, describing NYU Online as a technology company and not a school.213 In that situation, it may seem that a for-profit entity is the educational institution’s only option. However, this activity is arguably substantially related to the university’s exempt purpose, because the technology enables a student to receive the instruction. In any event, the provision of the technology should be within the convenience exception of IRC §513(a)(2). An activity furthering the educational process and sold for the convenience of students is not an unrelated trade or business, but is excepted from UBIT214 and treated as related to the institution’s exempt purpose, similar to the income from the products sold in the university bookstore.215 Another option is for the educational institution to enter into a joint venture with a for-profit entity. Issues similar to those in the healthcare industry will arise in the distance learning area.216 Whenever a nonprofit is engaged in a joint venture with a for-profit entity, there is the potential for application of the intermediate sanction rules under §4958 for disqualified persons involved in both onsite learning and distance learning. Schools should decide carefully who will be equity participants in these arrangements or provide key employees with stock warrants. If a key official performs services for both the exempt organization and the related for-profit distance learning entity, his or her compensation will be aggregated to determine whether it is reasonable.217 Additionally, a forprofit subsidiary will ultimately pay tax on its earnings, as opposed to the taxfree revenue streams enjoyed by nonprofits. (d)
The Internet
As the Internet has had an impact on society in general, it has several new implications in the university world, where it was created. These issues range from the formation of Internet service providers that apply for tax-exempt status to the possible generation of UBIT from sales and services conducted on the Internet. The legal issues are new and are being examined by IRS. What can be stated with certainty is that the issues and answers will be constantly evolving and close attention must be paid to the “answers” as they develop at the IRS and in the courts. Universities create their own Internet service providers (ISP) for use by faculty, students, and staff. An ISP is the service dialed by a computer modem to establish a connection with the Internet. Universities provide this service so that, for example, students can conduct online research. Students are given a “user ID” and password that allows them to “log-on” to the university’s ISP from their home/dorm computer. The ISP in turn connects them to the Internet or to a specific research service such as the Lexis-Nexis service. Frequently, a university will establish a separate entity to operate the ISP. One of the issues facing the IRS involves exempt applications filed by ISPs. 213 214 215 216 217
Remarks of Kathy Schultz, Distance Learning Panel, Mid-Year Meeting of the American Bar Association, Jan. 12, 2001. IRC §511. See Gen. Couns. Mem. 35811 (May 7, 1974) for a discussion of the IRS’s position on whether the sale of an item to a student meets the convenience exception. See Section 12.3 for a discussion of Rev. Rul. 98-15 related to healthcare entities. Temp. Reg. §53.4958-4T(a)(2).
䡲
734
䡲
c14.fm Page 735 Thursday, March 15, 2007 10:45 AM
14.7 MODES OF PARTICIPATION BY UNIVERSITIES IN JOINT VENTURES
According to Marcus Owens, Former IRS Exempt Organizations Division director, applications were being filed under IRC §§501(c)(3), 501(c)(6), and 501(c)(12). Although there are older rulings on exemption and ISPs218, they do not address issues presented by modern technology.219 The IRS was, according to Owens, trying to develop standards for exemption of ISPs under §501(c)(3).220 In general, it appears that if an ISP is available to university faculty, staff, and students for use in research and other educational pursuits related to its exempt goals, exemption should be granted. However, the IRS is attempting to create more specific guidelines that address the issues raised by computer technology.221 Conveying educational material over the Internet has become known as “distance learning.” It is already a $2 billion per year business, which an analyst with Chase Bank predicts will increase to $9 billion by 2005.222 The joint ventures through which it is implemented and the roles of individual professors create risks to the tax-exempt status of the educational institutions involved. As with any joint venture, a distance learning project must be carefully analyzed to assure that it will further the educational purposes of the university, that it will not generate impermissible private benefit, and that it will not otherwise expose the assets of the exempt organization to unnecessary risk. In addition to exemption issues, the Internet raises potential UBIT issues. For example, if a university accepts advertising on its Web page, would that constitute UBIT? Presumably, Internet advertising will be subject to the same analysis as periodical advertising223—that is, is it regularly carried on, does it substantially further the university’s exempt purposes, or does it more closely resemble commercial advertising?224 On the other hand, activities which qualify as sponsorship, as discussed in Section 14.6 (b)(iii), would not generate UBIT. What if the university sells merchandise online? It would seem logical that the rules pertaining to merchandise sales in general should also pertain to online sales from, for example, the university’s bookstore.225 On the other hand, where fact patterns differ, there can be contrary results. For example, would Internet sales of merchandise typically sold in a bookstore qualify for the convenience exception of IRC §513(e)(2)? Even if online sales to students qualified for the convenience exception, would such sales to alumni also qualify? This is an area in which there will be a steady flow of new developments, which will be addressed in future supplements to this edition. (e)
Activities Involving Affinity Cards, Mailing Lists, and Logos.
Exempt organizations frequently exchange mailing lists with other organizations to increase their donor/membership base. They also sell their mailing lists to raise 218 219 220 221 222 223 224 225
See Rev. Rul. 74-614 and 81-29. “Internet Tax Issues,” 252. Id. See Section 8.5(f) in this supplement for a discussion of the evolving IRS thinking on the subject of Internet activities. Id. James Traub, “This Campus Is Being Simulated,” New York Times Magazine, Nov. 19, 2000, p. 90. Id. Statement of Celia Roady, Esq., Morgan, Lewis and Bockius, Washington, D.C. See Chapter 8. See “Internet Tax Issues,” 253.
䡲
735
䡲
c14.fm Page 736 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
revenue. The issue of whether income from the sale of mailing lists qualifies as a royalty, thus excluded from UBIT, is unsettled.226 IRC §513(h)(1)(B), enacted in the Tax Reform Act of 1986, provides an exception to UBIT for exchanges or rentals of membership lists between charitable and veterans organizations. However, §513(h)(1)(B) is silent in regard to the treatment of income derived from the sale of a mailing list to a for-profit entity. This silence has spawned a dispute between the IRS and nonprofits, which continues through a long line of cases. Despite numerous defeats in the Tax Court on this issue, the IRS has continued to maintain its position227 that the royalty exemption under IRC §512(b)(2) is not applicable when the exempt organization’s income is derived from a taxable corporation’s use of the exempt organization’s membership or mailing list. The IRS reasons that because Congress, in enacting §513(h)(1)(B), remained silent on all other types of mailing lists, then Congress “tacitly agree[d]” to taxation in all other cases. Thus, under the IRS rationale, all mailing list transactions are governed by §513(h)(1)(B), and because the section contains only a limited UBIT exception for exchanges and rentals of mailing and membership lists between specified exempt organizations, all other mailing list transactions are taxed.228 Thus, for example, the limited exception under §513(h)(1)(B) would not apply when a taxable entity, such as an insurance company, receives the use of a university’s alumni mailing list for commercial purposes.229 Similarly, affinity card arrangements that involve a credit card that carries the name or identifying logo of an exempt organization have received a great deal of attention from Congress and the IRS. Typically, the exempt organization receives a payment from the third-party licensee for use of its name or logo, based on the amount of sales generated by the credit card.230 Often, the exempt organization also furnishes its mailing list to the credit card company as part of a contract allowing the licensee exclusive use of the organization’s name or logo. The commercial entity then markets its products or services to the members of the exempt organizations. EXAMPLE: A is a university exempt under IRC §501(c)(3). C is a commercial taxable entity engaged in banking and credit card services. Pursuant to an agreement between A and C, A agrees to endorse a credit card service offered by C to A’s students and faculty through the inclusion of endorsement messages in C’s marketing materials. Under the agreement, A grants C an exclusive license to use A’s name on credit cards issued in connection with the agreement. A, however, retains all ownership rights in its mailing list. C will pay a royalty to A for each new membership or annual fee generated from the agreement.231 226
227 228 229 230 231
Sierra Club, Inc. v. Commissioner, T.C. Memo 1999-86 (March 23, 1999). See Section 8.5(c)(ii). The IRS has had additional defeats in the Sierra line of cases. Sierra Club, Inc. v. Commissioner, T. C. Memo 1999-86 (March 23, 1999); Oregon State University Alumni Assn. v. Commissioner, Nos. 96-70565, 96- 70593 (9th Cir. Oct. 1999). In Sierra, the Tax Court rejected all of the IRS’s theories that the income paid to the Sierra Club was for services rendered as opposed to royalty income. The 9th Circuit did the same in Oregon State. See Section 8.5(c) for a detailed discussion. Tech. Adv. Mem. 93-21-005 (Feb. 23, 1993). Gen. Couns. Mem. 39,727 (May 9, 1988). Gen. Couns. Mem. 39,827 (Aug. 20, 1990). This example is based on the factual situation presented in Tech. Adv. Mem. 93-21-005 (Feb. 23, 1993).
䡲
736
䡲
c14.fm Page 737 Thursday, March 15, 2007 10:45 AM
14.8 INCENTIVES AVAILABLE TO TAXABLE JOINT VENTURERS
Shortly after the Ninth Circuit issued the first appellate determination that an alumni association could treat income from affinity cards as tax-exempt royalty income,232 the IRS acknowledged its repeated losses in the area. It instructed area managers not to pursue litigation regarding affinity cards and to close cases in a manner cosistent with court decisions.233 On the other hand, “cause-related marketing”—that is, where a for-profit company advertises that for every purchase of its product, it will make a contribution to a certain charity—does not generate UBIT.234 See Chapter 8 for an in-depth discussion of these issues, many of which involve university alumni associations. After losing seven of eight court cases on the issue, the IRS has changed its policy. It will no longer regard income from affinity cards as “tainted” by a small amount of services rendered in addition to the licensing of the name or logo. Thus, universities may treat income from affinity cards as nontaxable royalties.235
14.8
INCENTIVES AVAILABLE TO TAXABLE JOINT VENTURERS
Taxable joint venturers, aside from enjoying the prospect of pecuniary remuneration, may benefit from certain tax incentives if they enter into research joint ventures with universities. These incentives stimulate commercial investment in research projects.236 One tax benefit is the business deduction for research and experimental expenditures under IRC §174.237 Section 174 provides that “a taxpayer may treat research or experimental expenditures which are paid or incurred during the taxable year in connection with a trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as deduction.”238 Research or experimental expenditures are defined as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”239 The deduction must be reduced by the amount of any research tax credit utilized by the taxpayer.240 However, the participants in joint venture arrangements that include an exempt college or university must be cognizant of the tax-exempt leasing rules. These rules do not apply to any property predominantly used by an exempt organization if the income derived from that property by the exempt organization is 232 233 234 235 236
237 238 239 240
Oregon State University Alumni Ass’n v. Commissioner, 193 F.3d 1098 (9th Cir. 1999). “IRS Memorandum to Area Managers on Affinity Card Cases,” Exempt Organization Tax Review (April 2000): 141. See Section 8.5(c). Debra Cowen, Debra Kawecki, and Gerry Sack, “College Housing,” Exempt Organizations Continuing Professional Education FY2001, 69. One tax incentive was the research and experimentation tax credit under IRC §41, claimed for amounts paid or incurred before July 1, 1995, as a component of the general business tax credit under §38; Reg. §1.38-1(a). §41(A); Reg. §1.41-2(a). The credit is available for amounts paid or incurred before July 1, 1995. §41(h)(1) as amended by §13111(a)(1)(A) of the 1993 Act. §174; Reg. §1.174-1. Id. Id. Id.
䡲
737
䡲
c14.fm Page 738 Thursday, March 15, 2007 10:45 AM
JOINT VENTURES WITH UNIVERSITIES
subject to UBIT. If the exception does not apply, the tax-exempt leasing rules will apply to two types of transactions. The first involves direct leases of property by taxable organizations to tax-exempt organizations, including sale-leaseback transactions. The second is applicable when partnership items of income, gain, loss, deductions, credits, and basis are not allocated to the tax-exempt entity in the same percentage share during the entire period that the exempt entity is a partner. If these rules apply, IRC §168(j) denies the investment tax credit and severely restricts depreciation deductions for many of these transactions. In addition, the restoration of a significant differential between capital gain and ordinary income tax rates places a premium on advantageous structuring of licensing agreements, patents, or transfers of research trademarks or trade names, because under certain circumstances the gain on these transactions can qualify for capital gains treatment
14.9
CONCLUSION
Joint ventures can be an effective tool in securing funding for universities and providing access to intellectual resources for commercial industry. Likewise, joint ventures can be utilized by universities to conduct basic functions of the university, such as a bookstore, in an efficient manner. A properly structured joint venture can even be used to conduct entertainment or sports events. Given the regulatory climate in the hospital joint venture context and the audit guidelines for universities, educational institutions must be increasingly sensitive to the impact of the federal tax rules governing their participation in joint ventures.
䡲
738
䡲
c15.fm Page 739 Thursday, March 15, 2007 10:49 AM
C H A P T E R
F I F T E E N 15
Business Leagues Engaged in Joint Ventures 15.1 (a)
OVERVIEW General Rules
Trade and professional associations may qualify for exemption from federal income tax under Internal Revenue Code (IRC) §501(c)(6).1 IRC §501(c)(6) provides for the exemption of business leagues, chambers of commerce, real estate boards, boards of trade, and professional football leagues2 that are not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.3 Professional associations may also qualify for exemption under §501(c)(3) if the association’s purpose is to advance a profession by engaging in primarily charitable, educational, or scientific activities, and if the association meets the requirements of the Code provision.4 The Internal Revenue Service (IRS) is more likely to grant an association exempt status under IRC §501(c)(6) than under §501(c)(3). Certain statutory requirements, such as the prohibition against private inurement, apply to organizations under both Code sections. Furthermore, the tax on unrelated business income (UBI) is equally applicable to §501(c)(6) and §501(c)(3) organizations. Generally, IRC §501(c)(3) organizations enjoy certain tax benefits, such as deductibility of contributions, that are unavailable to §501(c)(6) organizations.5
1 2
3 4 5
Tariff Act of 1913, §II G(a), 38 Stat. 172. See Gen. Couns. Mem. 38,179 (Nov. 29, 1979) (the exemption for professional football leagues in §501(c)(6) has been construed to include other professional sports leagues as exempt organizations). The IRS has recognized professional sports leagues as exempt organizations for more than 65 years. Gen. Couns. Mem. 34,013 (Jan. 14, 1969) (the IRS sets forth factors utilized in determining whether a professional sports league qualifies for exemption). §501(c)(6); Reg. §1.501(c)(6)-1. §501(c)(3); Reg. §1.501(c)(3)-1. See generally Chapter 2 (statutory requirements of §501(c)(3) organizations are highlighted and discussed). See §170.
䡲
739 䡲
c15.fm Page 740 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
However, §501(c)(3) organizations are subject to greater restrictions on the types of activities in which they may engage, such as lobbying.6 Trade associations, social welfare organizations, and most exempt organizations, other than charitable organizations under IRC §501(c)(3), may conduct unlimited lobbying activities without jeopardizing their exempt status.7 Under prior law, taxpayers were allowed a business deduction for “direct lobbying expenses.”8 No deduction, however, was allowed for amounts paid for political activities or grass roots lobbying.9 The Revenue Reconciliation Act of 1993 changed the prior law significantly by disallowing the business deduction under IRC §162(e)(1) for expenses paid or incurred in connection with influencing legislation.10 The phrase “influencing legislation” is broad, encompassing amounts paid for research, preparation, planning, and coordinating of any lobbying activity.11 An organization’s monitoring of legislation will be treated as influencing legislation if the organization subsequently attempts to influence legislation. The disallowance provisions affect IRC §501(c)(6) organizations because the 1993 Act contains a “flow-through” provision intended to prohibit a business deduction for the portion of membership dues paid to an exempt organization12 that is allocated to lobbying or political activity.13 6
7
8 9
10
11
12
13
A §501(c)(6) business league is not subject to the strict lobbying restrictions that hinder charitable organizations under §501(c)(3). Unlike charities, exempt business leagues may engage in any amount of legislative activity without jeopardy to the organization’s exempt status. In fact, in Prir. Ltr. Rul. 200103084 (Jan. 19, 2001), the service ruled that a §501(c)(6) business league could form a political action committee without forfeiting its exempt status. With the advent of the Revenue Reconciliation Act of 1993 (“the 1993 Act”), business deductions are not allowed for expenses paid or incurred in “influencing legislation.” See §162(e)(1)(A) as amended by §13222(a) of the 1993 Act. Furthermore, the 1993 Act disallows a business deduction for any portion of membership dues paid to an exempt organization that were used for lobbying or political expenditures. See §13222(a) of the 1993 Act; Reg. §1.162-20. See §501(c)(3); Reg. §1.501(c)(3)-1. In Priv. Ltr. Rul. 200041034 (Oct. 13, 2000), the IRS ruled that a §501(c)(3) organization could create a business league to fulfill traditional roles, including lobbying, that were not available to the §501(c)(3) EO. Direct lobbying expenses are expenditures for lobbying that are of direct financial interest to the taxpayer. See §162(e) (1992); §162(e) as amended by §13222(a) of the 1993 Act. Grass roots lobbying is lobbying to the general public or urging or encouraging the public to contact members of a legislative body for the purpose of proposing, supporting, or opposing legislation. See generally Reg. §1.162-20. This disallowance provision remains in effect under the 1993 Act. §162(e)(1). “Influencing legislation” is defined as “any attempt to influence any legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of legislation.” See Conference Report to the 1993 Act. The disallowance rule also applies to attempts to influence “covered executive branch officials.” Covered executive branch officials include the President, Vice President, any Cabinet member and his or her immediate deputy, any officer or employee of the White House Office of the Executive Office of the President, and the two most senior level officers of each agency in the Executive Office of the President. §162(e)(6). One exception to “influencing legislation” permits taxpayers to deduct direct lobbying expenditures incurred in attempts to influence legislative actions of a “local council or similar governing body.” The exception is intended to encompass a county or city council. This rule does not apply to organizations exempt under §501(c)(3), except that contributions to §501(c)(3) organizations are nondeductible if the organization engages in lobbying of direct financial interest to the taxpayer and a principal purpose of the donation is to avoid the nondeductibility rules. Furthermore, the 1993 Act does not alter the rules under §§501(c)(3) and 4911 regarding the impact of lobbying on a public charity’s tax-exempt status. The disallowed portion of those payments is the portion allocable to the lobbying or political expenditures incurred by the organizations.
䡲
740
䡲
c15.fm Page 741 Thursday, March 15, 2007 10:49 AM
15.1 OVERVIEW
Trade associations and other exempt organizations14 are required to report to their members a reasonable estimate of the portion of dues allocable to lobbying or political activities.15 This report must be made at the due date for payment of a member’s dues. An organization must also report its total amount of lobbying and political expenditures on the annual Form 990, as well as the total amount of dues allocable to such expenditures.16 As an alternative to disclosure, an exempt organization may elect to pay a proxy tax on the total amount of its lobbying expenditures during the taxable year.17 If an organization does not provide reasonable notice to its members of anticipated lobbying expenditures allocable to dues, then the organization is required to pay the proxy tax. The proxy tax is equal to the highest corporate tax rate in effect for the year. If the organization elects to pay the proxy tax in lieu of disclosure, then no portion of members’ dues will be deemed nondeductible because of the organization’s lobbying activities. An organization that underreports the total amount of its lobbying expenses in any tax year is required to pay the proxy tax on any undisclosed amount.18 The proxy tax may be imposed in addition to interest charges and other penalties that may apply. In November 1999, in American Society of Ass’n Executives v. United States, the D.C. Circuit Court affirmed a summary judgment in favor of the government in a case in which the American Society of Association Executives (ASAE) challenged the proxy tax, claiming that it violated the First and Fifth Amendments.19 ASAE alleged that the tax violated the First Amendment because it burdened freedom of expression and violated the Fifth Amendment by discriminating against lobbying organizations. The court found that the society’s First Amendment problem could be avoided by dividing the organization into two §501(c)(6) organizations, one that engaged in lobbying and one that refrained entirely.20 The 1993 Act contains a de minimis rule, which provides that an organization may expend less than $2,000 annually on “in-house” lobbying expenditures and be exempted from the disallowance provisions.21 Furthermore, if an organization can establish that substantially all of its dues are received from members who are not entitled to a deduction for their dues, then the organization is not subject to the disclosure requirements or the proxy tax.22 The IRS has issued several revenue procedures detailing the applicability of the Code’s notice and reporting requirements regarding the lobbying activities of exempt organizations.23 The most recent, Revenue Procedure 98-19, sets forth 14 15 16
17 18 19 20 21 22 23
This rule does not apply to §501(c)(3) organizations. §6033(e)(1)(A)(ii). §6033(e)(1)(A)(ii). §6033(e)(1)(C)(ii). The organization’s lobbying expenditures for the taxable year are allocated to the dues received in the taxable year. Any excess amount of lobbying expenditures is carried forward and allocated to dues received in the following taxable year. §6033(e)(2)(A)(i). This proxy tax can be paid up to the amount of dues and other assessments received by the organization during the taxable year. §6033(e)(2)(A)(ii). American Society of Ass’n Executives v. United States, 195 F.3d 47, 338 U.S. App. D.C. 432 (Nov. 9, 1999), cert. denied, 120 S. Ct. 1961 (1999). See also discussion of Branch Ministries, in Section 2.4, in which the D.C. Circuit Court instructed a church to set up a separately incorporated political organization. §6033(e)(1)(B)(ii); §162(e)(5)(B); payments to outside lobbyists are not considered “inhouse” lobbying expenditures. §6033(e)(3). Rev. Proc. 98-19, 1998-7 I.R.B. 30 (Feb. 17, 1998).
䡲
741
䡲
c15.fm Page 742 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
specific circumstances under which most tax-exempt organizations would be treated as satisfying the notice and reporting requirements.24 Revenue Procedure 98-19 provides a limited exemption for an IRC §501(c)(6) business league if more than 90 percent of its dues received are collected from tax-exempt organizations as described in §501(c)(3), nonveteran §501(c)(4) organizations, §501(c)(5) organizations, or state or local governments.25 Otherwise, a business league that does not satisfy the revenue procedure may apply for a private letter ruling.26 Business leagues that remain subject to the notice and reporting requirements must comply with the lobbying expense disallowance rules; member dues are non-deductible to the extent of the organizations’ lobbying expenditures. The IRS has issued final regulations detailing which activities constitute lobbying and what computational methods may be used in allocating an organization’s expenses to the lobbying activities.27 (b)
Internal Revenue Code §501(c)(6) and Joint Ventures
Like other types of exempt organizations, IRC §501(c)(6) business leagues may participate in joint ventures.28 A §501(c)(6) business league that enters into a joint venture arrangement must seek to ensure that the activities of the joint venture are sufficiently related to the organization’s exempt purposes, such as promoting the common business interest of the industry or line of business represented by the business league. If the joint venture activity is unrelated to the exempt purposes of the business league venturers, the result will be imposition of unrelated business income tax (UBIT) on any unrelated activity income.29 Joint ventures involving IRC §501(c)(6) organizations include the organization and operation of real estate ventures,30 professional football leagues,31 computer databases,32 and sales of broadcasting rights.33 Thus, organizations such as real estate boards, trade associations, and other §501(c)(6) entities may combine
24 25 26
27
28 29 30
31 32
33
See id. Rev. Proc. 98-19. See id. Rev. Proc. 98-19. See id. To receive a favorable ruling, the organization must provide the IRS with evidence establishing that 90 percent or more of the dues (or similar amounts) paid to the organization are not deductible without regard to §162(e) and notify the IRS that it is described in §6033(e)(3) (provision excepting certain organizations having nondeductible dues from the lobbying activity reporting requirements of §6033(e)(1)(A)) on Form 990. Id. Reg. §§1.162-20, 1.162-28, 1.162-29; T.D. 8602, 26 C.F.R. Part 1. See Priv. Ltr. Rul. 94-29016 (July 22, 1994) (application of proposed regulations to an exempt §501(c)(19) organization excepting the organization from the notice and reporting requirements of §6033(e)(1)(A)). For the rules and regulations pertaining to joint venture and partnership activity, see Chapters 3 and 4. See Section 15.3; see generally Chapter 8. See Priv. Ltr. Rul. 90-12-058 (Dec. 27, 1989). Here, a §501(c)(6) organization owned real property with improvements consisting of a building. To maximize the use of the property while minimizing risk, the organization formed a joint venture with another organization exempt under §501(c)(6); the joint venture will ultimately develop the real property. See generally Mid-South Grizzlies v. National Football League, 720 F.2d 772 (3d Cir. 1983), cert. denied, 467 U.S. 1215 (1984). Priv. Ltr. Rul. 89-09-029 (Dec. 6, 1988). The joint venture operated a computer database for numerous §501(c)(6) real estate boards. See also Priv. Ltr. Rul. 200244021 (Aug. 3, 2002), which refers to a trade association that is a joint venture between the public and private sectors to develop and operate an information network and maintain a database. Mid-South Grizzlies v. National Football League, 720 F.2d 772 (3d Cir. 1983), cert. denied, 467 U.S. 1215 (1984).
䡲
742
䡲
c15.fm Page 743 Thursday, March 15, 2007 10:49 AM
15.1 OVERVIEW
efforts through a joint venture to operate a computer system or other activity that benefits the common business interests of an industry as a whole.34 A classic joint venture involving an IRC §501(c)(6) organization is the National Football League and its sales of broadcasting rights to television networks.35 The NFL is a nonprofit business league, qualified for tax exemption under §501(c)(6).36 The league has 32 members, each of which is an entity organized for profit, engaged in the business of fielding a professional football team.37 The NFL has made joint sales of the regular season and postseason television rights to three major television networks. Revenues from the sale of television rights are divided equally among all member teams. Receipts from the sale of tickets are split between the home team, which receives 60 percent, and the visiting team, which receives the remaining 40 percent.38 Through this joint venture activity the NFL earns substantial income that is related to its exempt purpose. The activity benefits the member teams and furthers the common business interests of professional football. Determining whether a joint venture is an appropriate structural entity for a business league’s activity requires an analysis of the organization’s exempt purposes under IRC §501(c)(6).39 (c)
Definition of IRC §501(c)(6) Organizations
The traditional IRC §501(c)(6) business league is a membership organization composed of those entities that are active in a particular industry or line of business.40 EXAMPLE: X, a nonprofit organization, was created to promote the common business interests of the electric utility industry. The organization “is broadly representative of the electric utility industry as a whole.” Any utility located in the United States is eligible for membership. All members are entitled to have a direct voice in all organization decisions. Any technological discoveries relevant to the utility industry are made available to the entire electric utility industry on a nonexclusive, nondiscriminatory, royalty-free basis. Under these circumstances, X qualifies for exemption as a business league pursuant to IRC §501(c)(6).41
34 35 36 37 38 39 40 41
Rev. Rul. 74-147, 1974-1 C.B. 136; Priv. Ltr. Rul. 89-09-029 (Dec. 6, 1988) (real estate boards operated a computer hardware system). The National Football League is hereinafter referred to as the “NFL.” See Act of 1966, Pub. L. No. 89-800, §6(b)(1), 80 Stat. 1515, amending Pub. L. No. 87-331, §1, 75 Stat. 732 (1961), 15 U.S.C. §1291. Mid-South Grizzlies, 720 F.2d at 775. Mid-South Grizzlies, 720 F.2d at 776. See Section 15.2. Gen. Couns. Mem. 35,263 (Mar. 9, 1973); Rev. Rul. 69-632, 1969-2 C.B. 120. This example is based on the factual situation presented in Gen. Couns. Mem. 35,263 (Mar. 9, 1973). See also Rev. Rul. 69-106, 1969-1 C.B. 153; Rev. Rul. 69-632, 1969-2 C.B. 120.
䡲
743
䡲
c15.fm Page 744 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
IRC §501(c)(6) provides the statutory framework for exemption as a business league or trade association: [b]usiness leagues, chambers of commerce, real estate boards, of trade, or professional football leagues (whether or not administering a pension fund for football players),42 not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.43
Thus, a business league is an association of persons having some common business interest. The purpose of the organization is to promote the common business interests of the industry. The organization must not engage in a business that is ordinarily carried on for profit. The organization’s activities should be directed toward the improvement of business conditions of one or more lines of business, as distinguished from the performance of particular services for individual persons.44 The term business league has no well-defined meaning or common usage outside the parameters of IRC §501(c)(6).45 The term is “so general . . . as to render an interpretive regulation appropriate.”46 Thus, regulations were promulgated to clarify the precise meaning and purpose underlying §501(c)(6).47
15.2 (a)
THE FIVE-PRONG TEST Members with a Common Business Interest
The regulations define a business league as an association of persons having a common business interest.48 This prong of the regulatory test requires that the 42
43 44 45
46 47
48
“Professional football leagues” were added to the statutory language in 1966. Act of 1966, Pub. L. No. 89-800, §6(a), 80 Stat. 1515. This exempt category has expanded to include other professional athletic leagues. Gen. Couns. Mem. 38,179 (Nov. 29, 1979), revoking Gen. Couns. Mem. 37,595 (June 30, 1978). §501(c)(6); Reg. §1.501(c)(6)-1. Reg. §1.501(c)(6)-1; National Muffler Dealers Ass’n, Inc. v. United States, 440 U.S. 472 (1979); Engineers Club of San Francisco v. United States, 791 F.2d 686 (9th Cir. 1986). In determining whether an organization is a business association, courts often employ the maxim noscitur a sociis (“[i]t is known from its associates”). Uniform Printing & Supply Co. v. Commissioner, 9 B.T.A. 251, aff’d, 33 F.2d 445 (7th Cir. 1929), cert. denied, 280 U.S. 591 (1929); National Muffler Dealers, 440 U.S. at 474; Black’s Law Dictionary, rev. 4th ed. (1968), 1209. See also L.O. 1121, III-1 C.B. 77 (1925) (the Solicitor of the Internal Revenue Service was the first person to invoke this rule in 1924). Helvering v. Reynolds Co., 306 U.S. 110, 114 (1939); National Muffler Dealers, 440 U.S. at 478. In effect, the Code and regulations establish a five-prong test that must be satisfied by an organization seeking exemption under §501(c)(6): 1. The organization must be an association of persons promoting a common business interest. 2. The organization’s purpose must be to promote the common business interest. 3. Its activities must be directed to the improvement of business conditions of one or more “lines of business” as distinguished from the performance of particular services for individuals. 4. The purpose of the organization must not be to engage in a regular business of a kind ordinarily carried on for profit. 5. No part of its net earnings may inure to the benefit of any private individual. Reg. §1.501(c)(6)-1. Reg. §1.501(c)(6)-1. See Rev. Rul. 70-31, 1970-1 C.B. 130.
䡲
744
䡲
c15.fm Page 745 Thursday, March 15, 2007 10:49 AM
15.2 THE FIVE-PRONG TEST
organization represent all members in a general line of business or industry.49 This test is commonly referred to as the “line of business” test.50 Under this test, tax exemption is not available to aid one group in competition with another group in the same industry. Thus, the IRS defines a line of business as a “trade or occupation, entry into which is not restricted by a patent, trademark or similar device which would allow private parties to restrict the right to engage in the business.”51 The IRS defines business as “including almost any enterprise or activity conducted for remuneration,” including professions and various associations.52 Avocations or hobbies do not constitute “business” activity. Thus, organizations created to promote the common interests of hobbyists do not qualify for exemption under IRC §501(c)(6).53 Ordinarily, organizations that fail to meet the line of business test, in the view of the IRS, include organizations that market a single brand of automobile,54 have licenses to a single patented product,55 bottle one type of soft drink,56 or represent one business organization57 even though the business may encompass 70 to 75 percent of the market.58 In an early revenue ruling, the IRS delineated the general requirements of a business league:59 • The organization must be composed of members representing diversified
businesses within an industry. • The organization’s members must have common business interests. • The organizational purpose must be to promote the common business
interest of the members. The organization under scrutiny in the revenue ruling consisted of members who owned, rented, or leased computers produced by various manufacturers. The organization was formed to promote computer efficiency among its membership The common business interest represented within the organization was 49 50
51 52 53 54 55 56 57
58 59
See Gen. Couns. Mem. 35,263 (Mar. 9, 1973). The term “line of business” has been interpreted to mean an entire industry. National Muffler Dealers Ass’n, Inc. v. United States, 440 U.S. 472 (1979); American Plywood Ass’n v. United States, 267 F. Supp. 830 (W.D. Wash. 1967); National Leather & Shoe Finders Ass’n v. Commissioner, 9 T.C. 121 (1947); Rev. Rul. 83-164, 1983-2 C.B. 95, 96. The term has also been used to refer to components of an industry within a geographic area. Commissioner v. Chicago Graphic Art Fed’n, Inc., 128 F.2d 424 (7th Cir. 1942); Crooks v. Kansas City Hay Dealers’ Ass’n, 37 F.2d 83 (8th Cir. 1929); Washington State Apples, Inc. v. Commissioner, 46 B.T.A. 64 (1942). See also National Prime Users Group, Inc. v. United States, 667 F. Supp. 250 (D. Md. 1987); Gen. Couns. Mem. 35,263 (Mar. 9, 1973). IRS Exempt Organization Handbook (IRM 7751) §652. §501(c)(6); Reg. §1.501(c)(6)-1. Rev. Rul. 66-179, 1966-1 C.B. 139. Rev. Rul. 67-77, 1967-1 C.B. 138. Rev. Rul. 58-294, 1958-1 C.B. 244. Rev. Rul. 68-182, 1968-1 C.B. 263. But cf. Pepsi-Cola Bottlers’ Ass’n v. United States, 369 F.2d 250 (7th Cir. 1966). National Muffler Dealers Ass’n, Inc. v. United States, 440 U.S. 472 (1979); Rev. Rul. 83-164, 1983-2 C.B. 95. See also Guide Int’l Corp. v. United States, 948 F.2d 360 (7th Cir. 1991) (organization that served the interests of IBM and the users of IBM computers, rather than the interests of data processing as a whole, is not entitled to exemption as a business league); National Prime Users Group, Inc. v. United States, 667 F. Supp. 250 (D. Md. 1987). Guide Int’l Corp., 948 F.2d at 362. Rev. Rul. 74-147, 1974-1 C.B. 136.
䡲
745
䡲
c15.fm Page 746 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
the solution of problems associated with computer use.60 The primary objective of the organization was to provide a forum for the exchange of information that would lead to more efficient utilization of computers, thereby promoting and improving the efficiency of each member.61 Under these circumstances, the IRS held that this organization qualified for exemption under IRC §501(c)(6).62 However, a national automobile association composed of individual motorists, automobile clubs and associations, and commercial vehicle organizations did not qualify as a business league, because the association’s members did not have common business interests. Membership was available without regard to business or industry activity.63 In two published rulings, the IRS held that organizations created to promote interest in, elevate the standards of, and conduct tournaments in a professional sport qualify as business leagues.64 In one situation, an organization formed for the purpose of promoting and conserving the best interests and true spirit of a “game” was held to be a business league within the meaning of IRC §501(c)(6).65 The organization consisted of members with common interests in the sports activity. The organization received income from member dues, championship tournaments, and sales of rule books. It also received income from radio and television broadcasting rights. The ruling concluded that the organization’s activities were directly related to the purpose for which it was granted exemption.66 Thus, sponsoring tournaments and selling broadcast rights were held to be activities directly related to the organization’s exempt purposes, notwithstanding the substantial amount of income received from these activities.67 60 61
62 63
64 65 66
67
See id. Rev. Rul. 74-147, 1974-1 C.B. 136. Cf. Rev. Rul. 83-164, 1983-2 C.B. 95 (organization representing diversified businesses that utilize computers manufactured by only one company is not exempt). Rev. Rul. 74-147, 1974-1 C.B. 136. American Automobile Ass’n v. Commissioner, 19 T.C. 1146 (1953). See also Rev. Rul. 59-391, 1959-2 C.B. 151. Here an organization created for the purpose of exchanging information on business prospects composed of individuals and companies, each representing a different trade, had no common business interest, because its purpose was to increase individual members’ sales. Rev. Rul. 58-502, 1958-2 C.B. 271; Rev. Rul. 80-294, 1980-2 C.B. 187. Rev. Rul. 58-502, 1958-2 C.B. 271. Rev. Rul. 58-502, 1958-2 C.B. 271; Rev. Rul. 80-294, 1980-2 C.B. 1987 (another organization created to promote interest in, elevate the standards of, and conduct tournaments in “a certain professional sport” was held to be a business league within the meaning of §501(c)(6)). Moreover, its exempt status was not adversely affected merely because its primary support was derived from the sale of television broadcasting rights to tournaments that it conducted. IRS determined that the sponsorship of tournaments and the sale of broadcast rights by the organization directly promoted the interests of those engaged in the sport, by encouraging participation in the sport and by enhancing awareness in the general public of the sport as a profession. The amount of income derived from the sale of broadcast rights was found to be not determinative of whether the activity furthered the purposes specified in §501(c)(6). Notably, in Jockey Club v. United States, 137 F. Supp. 419 (Cl. Ct. 1956), cert. denied, 352 U.S. 834 (1956), the Court of Claims held that the Jockey Club, a New York membership corporation consisting of 50 members (most of whom owned breeding farms), and whose purpose was “to encourage the development of the thoroughbred horse and to establish racing on a footing commanding public confidence and interest,” was an association promoting a common business interest within the meaning of §501(c)(6). However, business league status was denied to the Jockey Club, based on the court’s conclusion that the Club was engaged in a business ordinarily carried on for profit, and because one of the Club’s principal activities and sources of income was the performance of particular services for individual persons. The Club promulgated rules, performed licensing and administrative functions, and offered other services that individual members of the racing community ordinarily receive from commercial businesses.
䡲
746
䡲
c15.fm Page 747 Thursday, March 15, 2007 10:49 AM
15.2 THE FIVE-PRONG TEST
(b)
Promoting the Common Business Interest
The second prong of the test requires that a business league must have as its purpose the promotion of the common business interest of the industry or line of business that it represents.68 In analyzing an IRC §501(c)(6) organization’s purposes, the IRS and the courts seek to ensure that the organization’s purposes are primarily beneficial to the industry as a whole, 69 and not merely the provision of particular services70 or the conduct of a business.71 In a private letter ruling,72 the IRS held that an organization’s purpose to promote professional sports qualified it as a business league.73 The organization, consisting of professional golfers, was exempt as a business league within the meaning of IRC §501(c)(6). The organization’s stated purpose was to promote the common business interest in golfing, elevate the standards of golf as a vocation, and hold meetings and tournaments for the encouragement and education of its members. The organization’s activities included the sponsorship of an annual merchandise show and the operation of golfing schools and training sessions. Furthermore, the organization directly participated in tournaments held throughout the country. The organization also engaged in joint venture activity by granting television rights incident to its sponsorship of championship golf tournaments. The IRS concluded that the organization was a business league within the meaning of §501(c)(6) and that its sponsorship of championship golf tournaments and its granting of television rights to those tournaments were primarily beneficial to the industry as a whole.74 (c)
Activities
(i) Entire Industry Benefited. The “line of business” requirement mandates that a business league must represent an entire industry, not merely a segment thereof. Hence, the activities of a business league must be directed to the improvement of business conditions in one or more lines of business within the industry.75 Business associations that have a narrow range of purpose or a private membership base are not entitled to classification as a business league. The leading case in this area is National Muffler Dealers Association, Inc. v. United States.76 This case involved the tax status of a trade organization of Midas 68 69 70 71 72
73 74
75 76
Reg. §1.501(c)(6)-1. Associated Indus. of Cleveland v. Commissioner, 7 T.C. 1449 (1946). Guide Int’l Corp., 948 F.2d at 362; National Muffler Dealers Ass’n, Inc. v. United States, 440 U.S. 472 (1979). See also Priv. Ltr. Rul. 89-09-029 (Dec. 6, 1988). Reg. §1.501(c)(6)-1; Gen. Couns. Mem. 35,263 (Mar. 9, 1973). See also National Prime Users Group, Inc. v. United States, 667 F. Supp. 250 (D. Md. 1987). Pursuant to §6110(j)(3), general counsel memoranda, technical advice memoranda, and private letter rulings are not legal precedent; they are cited merely to illustrate the IRS position in dealing with similar facts and circumstances. Priv. Ltr. Rul. 78-45-029 (Aug. 9, 1978). Id. Similarly, the IRS held that an organization that supervised and regulated auto races was a business league within the meaning of §501(c)(6). The organization’s purpose was to promote the common business interest in professional auto racing. Members of that organization included race organizers, corporate producers of automotive parts, manufacturers’ representatives, race car mechanics, owners and drivers, and race officials. Tech. Adv. Mem. 79-22-001 (Feb. 28, 1979). Reg. §1.501(c)(6)-1. National Muffler Dealers Ass’n, Inc. v. United States, 440 U.S. 472 (1979).
䡲
747
䡲
c15.fm Page 748 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
Muffler dealers, which confined its membership to dealers franchised by Midas Corporation and had as its principal activity bargaining with the corporation on behalf of its members. The Supreme Court held that Midas franchisees did not constitute a “line of business,” in that their efforts did not benefit a significantly broad segment of the industry.77 (ii) Limitation on Particular Services for Individuals. The activities of a business league must be directed to the improvement of business conditions of one or more lines of business, rather than the performance of particular services for members.78 However, an organization’s activity may benefit a line of business even though services are being rendered to its members, as long as a member’s benefit is incidental to the benefits to the industry as a whole.79 The particular service or business must not be the primary activity of the organization.80 There are many examples in which “incidental benefits” were conferred on members of an IRC §501(c)(6) organization without its tax-exempt status being jeopardized. Such examples include organizations that conduct negotiations for members and nonmembers within an industry; mediate and settle disputes affecting an industry;81 operate a bid registry;82 investigate criminal, fraudulent, or unethical aspects of claims against members;83 subsidize litigation;84 operate an insurance rating bureau;85 negotiate the sale of broadcast rights;86 conduct fire patrols and salvage operations for insurance companies;87 provide for equitable distribution of high-risk insurance policies among member insurance companies;88 and publish a magazine containing information of interest to an entire industry.89
77 78 79
80
81 82 83 84 85 86 87 88 89
Rev. Rul. 73-411, 1973-2 C.B. 180. Reg. §1.501(c)(6)-1. Retailers Credit Ass’n of Alameda County v. Commissioner, 90 F.2d 47 (9th Cir. 1937) (collection and credit reporting services); Evanston-North Shore Bd. of Realtors v. United States, 320 F.2d 375 (Cl. Ct. 1963); Gen. Couns. Mem. 39,259 (Jan. 5, 1984). American Plywood Ass’n v. United States, 267 F. Supp. 830 (W.D. Wash. 1967). Here, an association of plywood manufacturers was organized to promote the common business interests of the plywood industry. The IRS asserted that extensive quality control checks conducted by the association over the years constituted a regular business ordinarily engaged in for profit and resulted in services performed for individuals. The court looked at all of the organization’s interrelated activities to determine the principal activities of the organization, as distinguished from those that were incidental. The court stated: The rule is well established that a trade association whose main purpose justifies exemption from income tax will not forfeit tax-exempt status by engaging in incidental activities which, standing alone, would be subject to taxation. The court held that the quality control activities benefited the entire industry, thereby fulfilling the association’s exempt purposes. Furthermore, the benefit to individual members was incidental to the industry-wide benefit. See also Gen. Couns. Mem. 39,259 (Jan. 5, 1984); Gen. Couns. Mem. 38,559 (Nov. 7, 1980). American Fishermen’s Tuna Boat Ass’n v. Rogan, 51 F. Supp. 933 (S.D. Cal. 1943). Rev. Rul. 65-164, 1965-1 C.B. 238. Rev. Rul. 66-223, 1966-2 C.B. 224. Rev. Rul. 67-175, 1967-1 C.B. 139. Oregon Casualty Ass’n v. Commissioner, 37 B.T.A. 340 (1938). Tech. Adv. Mem. 79-22-001 (no date given). Minneapolis Bd. of Fire Underwriters v. Commissioner, 38 B.T.A. 1532 (1938). Rev. Rul. 71-155, 1971-1 C.B. 152. National Leather and Shoe Finders Ass’n v. Commissioner, 9 T.C. 121 (1947).
䡲
748
䡲
c15.fm Page 749 Thursday, March 15, 2007 10:49 AM
15.2 THE FIVE-PRONG TEST
A factor that the courts frequently examine to determine whether services are provided for particular individuals, as opposed to the industry as a whole, is whether the organization’s members pay fees and assessments in approximate proportion to the benefits they receive.90 When the fees are proportional to the benefits received, the courts generally conclude that the benefits received are for the good of the whole industry, because the organization is not seeking to benefit any particular member. In any event, courts have never gone so far as to hold that no benefit may accrue to members of a business league by virtue of their membership: [I]t can hardly be supposed that individuals would often join organizations without the expectation of receiving some benefit therefrom. National Leather and Shoe Finders Association v. Commissioner, 9 T.C. 121, 126 (1947). The ultimate inquiry is whether the association’s activities advance the members’ interests generally, by virtue of their membership in the industry, or whether they assist members in the pursuit of their individual businesses.91
In an internal memorandum,92 the IRS discussed the concept of a benefit to individual members as opposed to an industry-wide benefit. The organization described in the memorandum was an exempt business league that advanced and promoted scientific research in particular fields, collected funds from its members, and in some instances provided direct monetary benefits to certain individual members. The IRS focused on whether the organization was rendering particular services to private interests and, if it was, whether those services were the organization’s primary activity: [In a previous general counsel memorandum we discussed] the principle that inurement of the type proscribed by IRC §501(c)(6) exists if there is something more than an incidental benefit to members of the organization or those in privity with it. Inurement would occur in an expenditure of organizational funds that results in a benefit which goes beyond the scope of the benefits which flow logically from the organization’s performance of its 90
91
92
MIB, Inc. v. Commissioner, 734 F.2d 71, 79 (1st Cir. 1984); Evanston-North Shore Bd. of Realtors, 320 F.2d at 378-79. In MIB, the First Circuit reversed a Tax Court decision and held that a nonprofit corporation that provided life insurance underwriting information to its member insurance companies was not a business league. Even though the corporation benefited the life insurance industry as a whole, exemption was denied because a large portion of the corporation’s services were supported by direct service charges paid by its members, based on the number of their information requests. This indicated that the services were particular, rather than group, benefits. MIB, 734 F.2d at 78. Similarly, in the case of the auto racing association, the IRS noted that members of that organization could obtain greater television coverage at better prices by having the racing organization negotiate broadcast rights for the races. Tech. Adv. Mem. 79-22001 (no date given). In this regard, the IRS stated: When [the organization] negotiates a contract for national televising of a “package” of races, it has often achieved something that the individual organizers could not. Even in cases where individual organizers might have succeeded in securing network TV coverage, [the organization] is usually able to obtain a higher price from the network. This is certainly a benefit to the race organizers. But the increased prize money also enables more professional racers to compete. Furthermore, [the organization’s] proven ability, as a representative of members of the auto racing industry, to secure greater TV coverage, for a greater variety of races in more parts of the country, popularizes auto racing in a most effective way. As a result there is greater public demand for the spectacle provided by professional auto racing, attendance at races increases, and conditions improve for all members of the professional auto racing business regardless of whether they are members of [the organization]. In view of these broad benefits to the industry we believe that the situation is analogous to the negotiation of labor contracts described in Rev. Rul. 65-164 and that the benefits derived by individual members of [the organization] are incidental to the broad benefit to professional auto racing. Gen. Couns. Mem. 39,259 (July 13, 1984).
䡲
749
䡲
c15.fm Page 750 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
exempt functions. Further, . . . the proper performance of functions for which exemption was recognized will never result in proscribed inurement.93
(d)
Commercial Activity for Profit
The regulations provide that an organization does not qualify as a business league under IRC §501(c)(6) if its purpose is “to engage in a regular business of a kind ordinarily carried on for profit.”94 Courts have repeatedly held that the fact that a business league receives income does not mean that it is carrying on a regular business for profit. A frequently cited case in this area, Crooks v. Kansas City Hay Dealers’ Association, involved an association of hay merchants.95 The organization employed workers to inspect and weigh cars of hay and straw bought or sold to members, and shippers were charged fees for these services. Because, in some years, these activities generated a profit, the IRS claimed that the organization was not an exempt business league. The Eighth Circuit, however, found that “the mere fact that an association of this character may receive some income and arrange that income so as to carry on its work is not proof that it is organized for the sake of profit.”96 93
94 95 96
Gen. Couns. Mem. 39,259 (July 13, 1984). The Court of Claims held that a hardware trade association was denied tax exemption because it provided substantial services to individual members. For example, the association provided its members with managerial and bookkeeping services, performed audits, and prepared tax returns. Under these circumstances, the court held that the organization did not qualify as a business league. Indiana Retail Hardware Ass’n, Inc. v. United States, 366 F.2d 998 (Cl. Ct. 1966). The IRS ruled in a similar manner when an organization published and sold a consumer-oriented magazine to its members. The magazine was designed as a promotional device for the organization’s credit union members to distribute to their depositors. The IRS held that the §501(c)(6) organization was furnishing its members with a service that they could use in their own business operations. Therefore, the organization was subject to unrelated business income tax with respect to this activity. Rev. Rul. 78-52, 1978-1 C.B. 166. Reg. §1.501(c)(6)-1. See also Rev. Rul. 74-308, 1974-2 C.B. 168. Crooks v. Kansas City Hay Dealers’ Ass’n, 37 F.2d 83 (8th Cir. 1929). Crooks v. Kansas City Hay Dealers’ Ass’n, 37 F.2d 83 (8th Cir. 1929); Mid-South Grizzlies v. National Football League, 720 F.2d 772 (3rd Cir. 1983), cert. denied, 467 U.S. 1215 (1984). A similar issue was raised with respect to a printing industry association in Commissioner v. Chicago Graphic Arts Fed’n, Inc., 128 F.2d 424 (7th Cir. 1942). The organization’s purpose was to promote the welfare of the printing industry and develop better methods of management and ethical relations among the members of the industry. The organization operated a waste paper bureau and supplied a credit and employment service; up to 40 percent of the organization’s income in any given year was derived from these activities. IRS contended that the organization was carrying on a regular business for profit and that services were rendered to individual members. The court stated: Activities [conducted by a business league] must be directed to the improvement of business conditions or to the promotion of the general objects of one or more lines of business as distinguished from the performance of particular services for individual persons, but if the services are only incidental or subordinate to the main or principal purposes required by the statute, then exemption cannot be denied on the ground that the purpose is to engage in a regular business of a kind ordinarily carried on for profit. In Chicago Graphic Arts, the court found that the principal purposes of the organization were to promote fairness, honesty, and better conditions in the industry, that no cash dividend had been paid, and that no special service was rendered by the organization to its members without payment. Therefore, the court concluded that the commercial activities (which generated almost half of the organization’s income) were only incidental or subordinate to its principal exempt purposes. In Tech. Adv. Mem. 200020056, the IRS found that an organization that certifies commercial and legal documents to American exporters could retain its §501(c)(6) exempt status. The organization’s primary activity is providing a required certification of origin (“clearing document” for shipment) to American suppliers of goods and services. The IRS found that the certification activities were substantially related to the organization’s exempt purpose, which included the “promotion, through educational, cultural, and charitable activities, of understanding, dialogue, and bonds of friendship between the people of America” and the foreign country. Furthermore, the organization was not considered to be undertaking a regular business of any kind ordinarily carried on for profit.
䡲
750
䡲
c15.fm Page 751 Thursday, March 15, 2007 10:49 AM
15.2 THE FIVE-PRONG TEST
Compare the situation presented in Jockey Club v. United States.97 The Jockey Club was formed by breeders of thoroughbred race horses “to encourage the development of the thoroughbred horse and to establish racing on a footing commanding public confidence and interest.”98 The Club received income from initiation fees, annual dues, license and registration fees, proceeds from the sale of its publications, and compensation paid by New York and Delaware racetracks for the supervision of race meetings. The court held that the services performed by the Jockey Club were “essential to the individual who requests and pays for the services.” Because the Jockey Club sold these services to particular enterprises and the sales revenue produced practically all of the Club’s substantial income, the court held that the Jockey Club did not qualify for IRC §501(c)(6) exemption. The court viewed the activity as essentially a commercial enterprise carried on for profit. In summary, a §501(c)(6) organization may not engage in a commercial business for profit. (e)
No Inurement
IRC §501(c)(6) also requires that “no part of the net earnings of [the business league] inures to the benefit of any private shareholder or individual.”99 The inurement proscription is, in essence, the same prohibition found in §501(c)(3).100 This is an absolute proscription; there can be no inurement.101 The inurement proscription is directed at situations in which profits or earnings are utilized by interested persons rather than by the industry as a whole. Under the inurement prohibition, the IRS seeks to prevent any dividend-like distribution of exempt assets or expenditures from benefiting a private interest.102 Hence, “[i]nurement is likely to arise where the financial benefit represents a transfer of the organization’s financial resources to an individual solely by virtue of the individual’s relationship with the organization, and without regard to the accomplishment of exempt purposes.”103 When an exempt business league provides services or conducts a particular activity for nonmembers, it is not unusual for the business league to provide the same services to, or conduct the same activity for, members at a reduced price. This does not necessarily result in inurement of income to members, so long as it can be shown that members’ dues are used to support the particular activity and the difference in price charged to members versus nonmembers reasonably reflects that support. On the other hand, when the difference in price is achieved through a system of rebates to members only, there may be inurement of income.104 97 98 99 100 101 102 103
104
Jockey Club v. United States, 137 F. Supp. 419 (Cl. Ct. 1956), cert. denied, 352 U.S. 834 (1956). Jockey Club, 137 F. Supp. at 420. §501(c)(6); Reg. §1.501(c)(6)-1. §501(c)(3). Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See generally Chapter 5. Gen. Couns. Mem. 39,862 (Nov. 21, 1991). Gen. Couns. Mem. 38,459 (July 31, 1980). The IRS opines that “the proper performance of functions for which exemption was recognized will never result in proscribed inurement.” Gen. Couns. Mem. 39,259 (Jan. 5, 1984); Gen. Couns. Mem. 38,559 (Nov. 7, 1980). See also Priv. Ltr. Ruls. 200245062 and 200245063 (Aug. 15, 2002), in which the IRS determined that the payment of medical and dental insurance premiums by a welfare benefit fund will not result in a prohibited inurement that would jeopardize the tax-exempt status of a trade association. Michigan Mobile Home and Recreational Vehicle Inst., 66 T.C. 770 (1976).
䡲
751
䡲
c15.fm Page 752 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
15.3 (a)
UNRELATED BUSINESS INCOME TAX General Rules
IRC §501(c)(6) organizations are subject to the tax on unrelated business income.105 In testing whether an activity constitutes “unrelated trade or business,” the question of whether the activity is “substantially related” to the organization’s exempt purposes is relevant.106 The regulations provide that this criterion requires examination of the relationship between the activities that generate the particular income and the accomplishment of the organization’s exempt purposes.107 An activity is considered to be related to an organization’s exempt purposes only when the conduct of the activity has a substantial causal relationship to the achievement of exempt purposes, other than through the production of income.108 If the performance or exercise of the activity directly serves to further the organization’s exempt purposes, the relationship is considered to be causal.109 In addition, the regulations provide that a trade or business is “substantially related” if the activity “contributes importantly” to the accomplishment of those exempt purposes.110 The regulations thus require a case-by-case examination of the exempt purposes and an analysis of how the activity contributes to those purposes. In an exemplary ruling, the IRS stated: [w]here an organization is engaged in activities which are substantially related to the carrying out of the purposes for which the organization was granted exemption, the income derived therefrom should not be taxed as unrelated business income. The activities performed by the organization in the instant case, the sponsorship of championship tournaments, the sale of publications relating to rules, etc., are considered to be a means whereby the primary purpose of the organization is achieved. They are directly related to the purpose for which the organization was granted exemption.111
Accordingly, IRS ruled that all income derived from the sponsorship of tournaments was substantially related to the organization’s exempt purposes and did not constitute unrelated business income subject to UBIT.112 Similarly, the 105 106
107
108
109 110 111 112
See Gen. Couns. Mem. 33,641 (Oct. 3, 1967). Priv. Ltr. Rul. 90-12-058 (Dec. 27, 1989). See generally Chapter 8. See also Tech. Adv. Mem. 98-11-001 (March 13, 1998) (fees for managerial and management services were UBIT because the services were those typically performed for profit and they did not relate to the §501(c)(6)’s exempt purposes). Reg. §1.513-1(d)(1). See also Priv. Ltr. Rul. 200223067 (March 13, 2002), in which the IRS determined that the sponsorship on a new, restricted particular domain on the Internet by a trade association is an exempt activity and income from the activity will not constitute unrelated business taxable income. Reg. §1.513-1(d)(2). The IRS notes that “substantial relatedness, in the sense of advancing an exempt purpose, is the best by which an activity is to be measured to determine both its permissibility under §501(c)(6) as well as its taxability under §511.” Gen. Couns. Mem. 33,641 (Oct. 3, 1967). Gen. Couns. Mem. 33,641 (Oct. 3, 1967). Reg. §1.513-1(d)(2). See also Gen. Couns. Mem. 33,641 (Oct. 3, 1967). Rev. Rul. 58-502, 1958-2 C.B. 271. See id. Rev. Rul. 58-502, 1958-2 C.B. 271. The IRS has consistently held that the sale of media rights by an exempt organization formed to foster interest in a particular game, sport, or other athletic endeavor does not give rise to unrelated business taxable income. The rationale is that such income is substantially related to the organization’s exempt purposes, whether in the nature of education or in general promotion of sports and athletics. Rev. Rul. 80-296, 1980-1 C.B.; Gen. Couns. Mem. 37,618 (July 28, 1978).
䡲
752
䡲
c15.fm Page 753 Thursday, March 15, 2007 10:49 AM
15.3 UNRELATED BUSINESS INCOME TAX
IRS has ruled that income received for lobbying efforts on behalf of a §501(c)(6) organization’s members did not constitute UBIT.113 Although the activity was deemed to be a business regularly carried on, it was substantially related to the organization’s exempt purposes.114 On the other hand, where an IRC §501(c)(6) organization operated a recycling facility for members and nonmembers, the income was UBIT because operation of the facility was not related to the purpose of promoting members’ common business interests.115 However, income paid to the organization was not UBIT where it related to the negotiation of member and nonmember contracts, because the negotiation furthered the members’ common business interest.116 In the case of a sale of media or broadcasting rights, there is a further basis for exempting revenues from UBIT: These payments may constitute royalty income excluded from UBIT.117 Likewise, real estate joint venture activity can produce rental income that is excluded from UBIT.118 The IRS has also held that a business league did not incur unrelated business taxable income by dispersing advertisements to its members for publication.119 (b)
Exception for Indirect Investment in Ancillary Joint Ventures
In a recent Private Letter Ruling,120 the IRS determined that a business league, exempt from federal income tax under section 501(c)(6) of the Internal Revenue Code (IRC), was not subject to unrelated trade or business income tax (UBIT) for its indirect investment in a for-profit, ancillary joint venture. In PLR 200528029, a §501(c)(6) organization and its executive director were the sole members of a for-profit LLC, which was treated as a partnership for tax purposes. The IRS determined that this arrangement was permissible because: 1. The executive director’s 5 percent interest in the profits and losses of the LLC would be considered part of his total compensation from the §501(c)(6), 2. This compensation arrangement was approved by the disinterested members of the board of directors of the §501(c)(6), and 3. The IRS had previously issued a ruling that stated that the executive director’s equity interest in the LLC would not affect the §501(c)(6) organization’s exempt status. 113 114 115 116 117
118 119 120
Priv. Ltr. Rul. 99-05-031 (Nov. 5, 1998). See id. Tech. Adv. Mem. 98-48-002 (Nov. 27, 1998). See id. Reg. §1.512(b)-1. The income from the sale of media rights may be considered, in effect, “royalty” income, which is specifically excluded from unrelated business income under §512(b)(2). Although revenue from broadcasting has not heretofore been characterized as royalty income, the regulations indicate that all the facts and circumstances of each case must be examined to determine whether a particular item of income falls within any one of the exclusions from unrelated business income provided in §512(b). Thus, the actual nature of the income, not its designation by the parties, is controlling. The IRS stated that “royalty” for purposes of §512(b)(2) means a payment related to the use of a valuable right. Gen. Couns. Mem. 38,083 (Sept. 11, 1979). See Section 8.5(c). Priv. Ltr. Rul. 90-12-058 (Dec. 27, 1989); Priv. Ltr. Rul. 89-09-029 (Dec. 6, 1988). Tech. Adv. Mem. 200102051. Priv. Ltr. Rul. 2005-28-029 (Apr. 21, 2005).
䡲
753
䡲
c15.fm Page 754 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
In addition to these facts, the LLC at issue was formed to be a member of a second-tier partnership, the purpose of which was to create an online library of certain state and federal materials relevant to the profession of members of the §501(c)(6) organization. The other member of the second-tier partnership was an unrelated for-profit corporation, which had previously licensed searchable computerized databases to the 501(c)(6) organization, which in turn provided access to the databases to its members. The LLC initially had a 37.5 percent interest in the profits and losses of the second-tier partnership, with an option to increase its interest to 50 percent, which it subsequently exercised. The for-profit member of the second-tier partnership had the remaining 50 percent interest. The partnership was managed by its members, and actions generally required the vote of members holding a majority percentage interest, although certain actions required unanimous consent of the members. Operations of the partnership were overseen by a board of representatives, which was composed of four representatives, two appointed by each member of the partnership. The LLC also had the right to purchase the databases created by the second-tier partnership upon the occurrence of certain events, including dissolution of the partnership and withdrawal from the partnership by the LLC. The business league entered into the partnership in order to (1) gain greater control over the online library, ensuring that it would continue to be available to its members and that the services provided would be of high quality, and (2) to expand the materials in the databases so as to provide a greater benefit to its members and to members of other state associations. The partnership also entered into contracts to provide the online library to members of other state associations. In addition, PLR 200528029 applied a prior determination made by the Service in Rev. Rul. 2004-51 (that a §501(c)(3) exempt university was not subject to UBIT for income received from an LLC formed with a for-profit corporation because the activities of the LLC were an insubstantial part of the overall activities conducted by the university), to the situation when a §501(c)(6) organization participates in an ancillary joint venture. Thus, if a §501(c)(6) organization can show that the activities of the partnership in which it is a participant are substantially related to its exempt purposes, then it will not jeopardize its §501(c)(6) exempt status, nor will it be subject to UBIT for income generated by those activities. The IRS found that the activities of the second-tier partnership in PLR 200528029 were substantially related to the exercise and performance of the §501(c)(6) organization’s exempt purposes, because they were considered to be “educational” for the business league’s members within the meaning of IRC section §501(c)(6). Because the services provided by the partnership would be available to both members of the §501(c)(6) organization and other professionals in the industry who were not members of the organization, the activities were considered to be aimed at the improvement of business conditions in the industry as a whole, rather than particular services provided to individual members of the organization in the conduct of their businesses. Notably, the IRS did not analyze the issue of whether the §501(c)(6) organization needed to establish that it had control over the partnership sufficient to ensure furtherance of its exempt purposes. It may be of significance that this prong of the test to determine whether a nonprofit organization will jeopardize 䡲
754
䡲
c15.fm Page 755 Thursday, March 15, 2007 10:49 AM
15.3 UNRELATED BUSINESS INCOME TAX
its exemption or be subject to UBIT for its participation in an ancillary joint venture, set forth in Rev. Rul. 2004-51, is not discussed in the context of joint ventures involving §501(c)(6) organizations. This may be an indication that a §501(c)(6) organization that participates in an ancillary joint venture, but wishes to avoid jeopardizing its exemption or generating unrelated business taxable income, need only show that the activities of the joint venture are sufficiently related to its exempt purposes. (c)
Exception for Qualified Trade Show Activity
IRC §501(c)(6) organizations that engage in qualifying convention and trade show activity are not generally subject to UBIT on the income derived from the trade show activity.121 The traditional trade show involving a business league is one in which members of the industry or industries involved join in the exhibition of their products for the purpose of promoting and stimulating public interest.122 When this activity is conducted by an exempt business league, gross income from the trade show is not subject to UBIT.123 EXAMPLE: Y is an organization exempt under IRC §501(c)(6). The organization was formed to promote and represent the common business interests of the construction industry. Y holds an annual trade show at which its members exhibit their products and services in order to promote public interest in the construction industry. Potential customers are invited, and sales and order taking are permitted. Exhibition space is rented by the organization to members for a rental fee.124 This show is a qualified trade show under the regulations, and the income derived from the conduct of the trade show is not subject to UBIT.125 “Moreover, the IRS has determined that income from certain website activity carried out by trade associations in conjunction with trade shows is not subject to UBIT.126”
121
122
123 124 125 126
See §513(d)(1); Reg. §1.513-3(a)(1). In Tech. Adv. Mem. 95-09-002 (Mar. 3, 1995), however, the IRS ruled that although a convention newsletter was a qualified trade show activity, income generated from the sale of advertising space in the newspaper was subject to UBIT. The IRS reasoned that under the particular conditions, the advertisements were an exploitation of the otherwise qualified activity under Reg. §1.513-1(d)(4)(iv), and the gross income generated was subject to UBIT. The IRS notes that trade show activity is substantially related to the exempt purposes of §501(c)(6) business leagues because stimulation of demand for products from one or more lines of business or from one industry is a legitimate objective of a business league; exhibitions of a wide range of industry products have the effect of stimulating the industry-wide demand; trade show activity is sufficiently directed at promoting the common business interests of the industry or line of business represented by the business league. Gen. Couns. Mem. 33,641 (Oct. 3, 1967). Gen. Couns. Mem. 33,641 (Oct. 3, 1967); Rev. Rul. 67-219, I.R.B. 1967-28. See Rev. Rul. 85-123, 1985-2 C.B. 168. See Reg. §1.513-3. See also Reg. §1.513-3(e) (Examples); Rev. Rul. 78-240, 1978-1 C.B. 170. Rev. Rul. 2004-112, I.R.B. 2004-51. In the ruling, the IRS considered two trade associations which maintained websites accessible to the public with information, visual displays, and links to websites of trade association members and suppliers of goods and services. Each website also included order forms allowing viewers make online purchases from members and suppliers appearing on the website. The first trade association conducted semi-annual trade shows to promote and stimulate interest in and demand for the products of its industry as one of its substantial exempt purposes. The trade association typically held trade shows, open to members, nonmembers, and potential customers, at an exhibition facility for a period of ten days and charged exhibitors a fee for use of space at the show. The second trade association established a website accessible for a two week period not coinciding with the period of any trade show, convention, or annual meeting conducted by the trade association. The IRS ruled that the section of the
䡲
755
䡲
c15.fm Page 756 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
IRC §501(c)(6) organizations may enter into a joint venture among themselves to conduct a qualifying trade show or convention.127 However, at least one 1967 general counsel memorandum “reserves judgment” as to the ability of a §501(c)(6) organization to enter into a joint venture or partnership with a forprofit entity or individual to conduct a show, without raising questions as to whether the income is “substantially related” for purposes of the qualified convention and trade show exemption from UBIT.128 Moreover, even assuming the trade show qualifies as “substantially related,” the terms of the partnership arrangement could raise issues of private inurement, potentially jeopardizing the §501(c)(6) organization’s exempt status.129 (d)
Associate Member Dues
Associate member dues has been the subject of increased attention, both in Congress and at the IRS. In National League of Postmasters,130 the National League of Postmasters (NLP), a §501(c)(6) organization formed to assist and advance the interests and skills of postmasters, created a separate class of members—limited (or league) benefit members (LBMs)—and excluded their dues from UBIT as “substantially related” to its exempt function. The IRS challenged the characterization, alleging that because the LBMs were not entitled to rights and privileges similar to those of the full members (LBMs had minimal representation on the board; limited voting rights; limited access to the health care plan, legal services, and other league benefits; and were not required to be postmasters or even to work in a postal position), servicing the LBMs did not further the exempt purposes of the NLP. The Tax Court agreed, holding that the LBM activity was conducted not primarily in furtherance of the interests of the postmasters, but rather in a manner suggesting that the actual purpose of the activity was to generate income. In June 1996 the court of appeals affirmed the Tax Court, finding that the LBM activity was not “substantially related” to the NLP’s exempt purposes and was thus subject to UBIT.
website maintained by the first trade association in conjunction with its semi-annual trade show was considered “convention and trade show activity” and therefore any income derived from the website was not subject to UBIT. The determination was based on the following factors: 1) the trade association’s semi-annual trade show was considered a “show” within the meaning of the IRC because it took place during a limited time, at one physical location, where members, suppliers, and potential customers met together in person and interacted face to face; and 2) the internet activities were carried out in conjunction with the trade show, and served to augment and enhance the show by displaying the same information available at the show during essentially the same limited time period that the show was in operation. The IRS ruled that the second trade association’s operation of its website for the two week period did not qualify as “convention and trade show activity” and therefore any income derived from the website was subject to UBIT. 127
128 129 130
Priv. Ltr. Rul. 78-10-046 (Dec. 8, 1977). See also Priv. Ltr. Ruls. 200333031, 200333032, and 200333033 (May 21, 2003), in which the IRS determined that income derived from a limited liability company, created by three trade associations to combine their trade shows into one larger show, does not constitute unrelated business taxable income. Gen. Couns. Mem. 33641 (Oct. 3, 1967). Id. National League of Postmasters v. Commissioner, 69 T.C.M. (CCH) 2569 (1995), aff’d, 86 F.3d 59 (4th Cir. 1996).
䡲
756
䡲
c15.fm Page 757 Thursday, March 15, 2007 10:49 AM
15.4 CORPORATE SPONSORSHIP
Congress overturned this decision, in part, in the Small Business Job Protection Act of 1996; a new Code section, §512(d), provided that with respect to §501(c)(5) organizations, annual dues not exceeding $100 will be exempted from UBIT, whether paid by full or limited members.131 The IRS has now extended the nonrecognition treatment of §512(d) to §501(c)(6) organizations such as boards of trade, chambers of commerce, and business leagues.132 Furthermore, the creation of an associate member class that actually has involvement in an association’s exempt function activities will not be considered to have been done merely to generate income, and therefore dues above the exemption amount will not be considered UBIT.133 Accordingly, associate member dues received by a professional association were not considered UBIT, because the associate member category was not created for the principal purpose of generating income.134 In this regard, it is important that any promotional or marketing literature in connection with associate membership categories carefully describe the purposes behind the creation of the new class so that these materials will support the position that they were not established for the sole purpose of raising revenue.135 If the promotional materials are not properly drafted, the IRS may use them to bolster its contention that the class was created solely to raise revenue.
15.4
CORPORATE SPONSORSHIP
Corporate sponsorship of nonprofit events continues to grow in popularity and importance for exempt organizations and corporations alike.136 As traditional sources of funding have become scarce, many exempt organizations have actively sought out corporate sponsorship for their activities. EXAMPLE: The University of Maryland entered into a sponsorship arrangement with NationsBank whereby NationsBank agreed to pay the University $900,000 over three years in return for the placement of two bank logos in opposite corners of the university’s basketball court.137 The arrangement was generated by the fact that “[e]xpenses outpaced revenue growth at many schools naturally, according to a recent NCAA study.”138 When an exempt organization publicly acknowledges a corporate donor for its contribution, the issue is whether the income derived from the sponsorship payment is a nontaxable contribution or a payment in exchange for advertising 131 132 133
134 135 136
137 138
§512(d). This amount was indexed to §109.00 by Rev. Proc. 97-57, 1997-52 I.R.B. 20. Rev. Proc. 97-12, 199701 C.B. 631. See Tech. Adv. Mem. 97-51-001 (Apr. 25, 1997) for an analysis of the application of Rev. Proc. 97-12 to a §501(c)(5) labor union; see also Tech. Adv. Mem. 97-42-001 (June 26, 1997) for an analysis of this issue in regard to a §501(c)(6) organization. Tech. Adv. Mem. 98-47-001 (Nov. 20, 1998). Exempt Organization Tax Review 22, no. 2 (Nov. 1998): 251. Statement by Marcus Owens, Director, IRS Exempt Organizations Technical Division, before the Georgetown University Law Center’s Tenth Annual “Representing and Managing TaxExempt Organizations’ Conference” (Apr. 29–30, 1993). Mark Asher, “U-Md., Bank Reach a Sponsorship Deal: $900,000 Agreement Includes Logos on Court,” Washington Post (Oct. 31, 1998), D1. Id.
䡲
757
䡲
c15.fm Page 758 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
services provided by the exempt organization. In the latter case, the payments may be subject to UBIT,139 as exemplified in a technical advice memorandum in which the IRS concluded that the sponsorship income received by an exempt college football association was subject to UBIT because the exempt organization conducted advertising services for the corporate sponsor of its bowl games.140 Because this issue generated a great deal of controversy, Congress provided a statutory exemption for sponsorship, as opposed to advertising, payments. On August 5, 1997, President Clinton signed the Taxpayer Relief Act of 1997 (“the Act”), which specifically provides for a safe harbor exemption for “qualified sponsorship payments” from the UBIT by adding new IRC §513(i). For this purpose, “qualified sponsorship payments” are payments that persons engaged in a trade or business make to exempt organizations, for which such a person will receive no substantial return or benefit other than the use or acknowledgment of the name, logo, or product lines of that person’s trade or business in connection with the exempt organization’s activities.141 The Act’s provisions apply to qualified sponsorship payments solicited or received after December 31, 1997.142 The Act specifically excludes five types of payments from the definition of qualified sponsorship payments, which are discussed in the following paragraphs. (a)
Advertising
Qualified sponsorship payments do not include advertising, which for this purpose includes qualitative or comparative language, price information or other indications of savings or value, or an endorsement or other inducement to purchase, sell, or use a sponsor’s products or services.143 For instance, if, in return for receiving a sponsorship payment, an organization promises to use the sponsor’s name or logo in acknowledging the sponsor’s support for an educational or fund-raising event that the organization conducts, such payment will not be subject to UBIT.144 In contrast, if the organization provides advertising of a sponsor’s products, the payment the sponsor makes to the organization to receive such advertising will be subject to the UBIT, assuming that the transaction satisfies the other UBIT requirements.145 (b)
Contingent Payments
Qualified sponsorship payments also do not include payments whose amounts are contingent, by contract or otherwise, upon the level of attendance at an event, broadcast ratings, or other factors indicating the degree of an activity’s public exposure.146 However, the fact that a sponsorship payment is contingent 139
140 141 142 143 144 145 146
Even if corporate sponsorship income is found to be unrelated income, the exclusions from UBIT for royalty and rental income could apply. See Ann. 92-15, 1992-5 I.R.B. 51. See also Rev. Rul. 81-178, 1981-2 C.B. 135, 136; Gen. Couns. Mem. 38,997 (June 9, 1983): Priv. Ltr. Rul 92-11-004 (Mar. 18, 1992). Tech. Adv. Mem. 91-47-007 (Aug. 16, 1991). See also Tech. Adv. Mem. 92-31-001 (Oct. 22, 1991). §513(i)(2)(A). “Conference Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong., 1st Sess. pt. 2 (1997) at 6530. §513(i)(2)(A). “Conference Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong., 1st Sess. pt. 2 (1997) at 6530. See id. §513(i)(2)(B)(i).
䡲
758
䡲
c15.fm Page 759 Thursday, March 15, 2007 10:49 AM
15.4 CORPORATE SPONSORSHIP
upon an event actually occurring or being broadcast, by itself, will not cause the payment to fail to constitute a qualified sponsorship payment.147 Moreover, if either the sponsor or the tax-exempt organization distributes or displays the sponsor’s products to the general public at a sponsored event, whether for free or for remuneration, this will be considered to constitute “use or acknowledgment” of the sponsor’s product lines (as opposed to advertising). Thus, this will not affect the determination of whether a payment made by the sponsor is a qualified sponsorship payment.148 (c)
Advertising or Acknowledgment in Periodicals
Receipts from the sale of advertising or acknowledgments in tax-exempt organization periodicals do not constitute qualified sponsorship payments.149 For this purpose, regularly scheduled and printed material published by (or on behalf of) the payee organization that is not related to and primarily distributed in connection with a specific event conducted by the payee organization constitutes a periodical.150 For example, payments that lead to acknowledgments in a monthly journal will not constitute qualified sponsorship payments.151 Conversely, if a sponsor pays for an acknowledgment in a program or brochure distributed at a sponsored event, this will constitute a qualified sponsorship payment.152 (d)
Qualified Convention or Trade Show Activities
Qualified sponsorship payments do not include payments made in connection with “qualified convention or trade show activities,” pursuant to IRC §513(d)(3).153 The Act provides that the UBIT rules that existed before the Act will govern whether such payments are subject to the UBIT.154 (e)
Logos and Slogans Constituting Established Part of Sponsor’s Identity
The use of promotional logos or slogans that are an established part of a sponsor’s identity does not, by itself, constitute advertising for purposes of determining whether a payment is a qualified sponsorship payment.155 To the extent that part of a payment would constitute a qualified payment, such payment is deemed to be separate from any payment for advertising.156 Thus, if a sponsorship payment made to a tax-exempt organization entitles the sponsor to both product advertising and use or acknowledgment of the sponsor’s name or logo by the organization, the
147 148 149 150 151 152 153 154 155 156
“Conference Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong., 1st Sess. pt. 2 (1997) at 6530. See id. §513(i)(2)(B)(ii)(I). See id. See id. “Conference Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong., 1st Sess. pt. 2 (1997) at 6530. §513(i)(2)(ii)(II). “Conference Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong. 1st Sess. pt. 2 (1997) at 6530. §513(i)(2)(A). §513(i)(3).
䡲
759
䡲
c15.fm Page 760 Thursday, March 15, 2007 10:49 AM
BUSINESS LEAGUES ENGAGED IN JOINT VENTURES
UBIT will not apply to the amount of such payment that exceeds the fair market value of the product advertising provided to the sponsor.157 (f)
Further Guidance
Technical Advice Memorandum (TAM) 98-05-001,158 issued after the passage of IRC §513(i), offers further guidance on distinguishing between an acknowledgment and an advertisement. The TAM involved a §501(c)(4) entity organized to increase public interest in the different breeds of a certain pet. In furtherance of its purposes, the organization holds an annual show for which it sells commercial television broadcast rights. This television show generates most of the organization’s income and is watched by approximately 14 million people. The organization has an agreement with a pet food company whereby the company makes an annual payment to the nonprofit in return for numerous rights, including two free two-page “advertisements” in the show catalog, the right to advertise its support of the show, a discount on booth space at the show, and its product names and/or logo appearing on the judging program envelope, as well as on exhibitor armbands. The IRS determined that the sale of broadcast rights did not generate UBIT, as it furthered the association’s purposes by exposing a larger audience to the show. The full-page program ads examined by the IRS did not appear to go beyond permissible “acknowledgments,” as they did not contain comparative product information or quality claims. The IRS also stated that the pet food company’s logos on armbands and other materials were permissible acknowledgments and not advertising. This TAM provides useful guidelines for a nonprofit considering entering into a sponsorship arrangement with a for-profit entity.159
157 158 159
“Conference Report on H.R. 2014, Taxpayer Relief Act of 1997,” 105th Cong. 1st Sess. pt. 2 (1997) at 6530. Oct. 7, 1997. The IRS issued proposed regulations on the corporate sponsorship issue in 1993 (Prop. Reg. § 1.513(4)). The proposed regulations were finalized, effective April 25, 2002. Although they generally follow the proposed regulations, there are notable additions, including rules on exclusivity and on linking to sponsors’ Web sites on the Internet. In the regulations, the IRS holds that a charity may acknowledge its corporate (or individual) sponsors on its Web site. The charity may provide a hyperlink to the sponsor’s own Web site without being subjected to the unrelated business income tax (UBIT). However, if the hyperlink to the sponsor’s Web site is accompanied by an endorsement of the sponsor’s product by the charity, it is deemed to be advertising rather than acknowledgment, and as a result, subject to UBIT. The regulations define advertising as “any message or other programming material which is broadcast or otherwise transmitted, published, displayed or distributed in exchange for any remuneration, and which promote or markets any company, service facility or product.” However, acknowledgment is described as a mere recognition of sponsorship payments. Therefore, a charity’s message that has the effect of promoting the sponsor’s products or services, as opposed to merely identifying the sponsor, will be considered advertising. Only the portion of the sponsor’s payment to the charity that is not a qualified sponsorship payment (QSP) will be included in unrelated business income subject to tax. See T.D. 8991, I.R.B. 2002-21, 972 (May 28, 2002). (See Section 7.4 of this supplement for discussion of QSP.)
䡲
760
䡲
c15.fm Page 761 Thursday, March 15, 2007 10:49 AM
15.4 CORPORATE SPONSORSHIP
PRACTICE TIP If a sponsor’s name and logo are included in promotional materials relating to an athletic event sponsored by an exempt organization, then the activity is considered as sponsor acknowledgment. Likewise, if the corporate name and logo are displayed on T-shirts, helmets, and uniforms worn by the participants, on the scoreboard and playing field, and on cups used to serve drinks at the event, this is considered mere acknowledgment. EXAMPLE: S, an exempt organization, organizes a walkathon at which it serves food provided by a for-profit corporation. S acknowledges the for-profit’s financial assistance in promotional fliers, in newspaper advertisements of the event, and on T-shirts worn by participants. S also acknowledges prizes provided by the for-profit. S changes the name of its event to include the name of the sponsor. S’s activities are deemed to be sponsorship and not advertising.160 EXAMPLE: P conducts an annual college football bowl game. P sells to commercial broadcasters the right to broadcast the bowl game on television and radio. A major corporation agrees to be the exclusive sponsor of the bowl game. The sponsorship payment includes amounts to be paid to the colleges participating in the bowl game. The detailed contract between P and the corporation provides that the name of the bowl game will include the name of the corporation. The contract further provides that the corporation’s name and a special logo will appear on players’ helmets and uniforms, on the scoreboard and stadium signs, on the playing field, on cups used to serve drinks at the game, and on all related printed material distributed in connection with the game. The sponsorship agreement is contingent upon the game’s being broadcast on television and radio, but the amount of the sponsorship payment is not contingent upon the number of people attending the game or the television ratings.161 The contract provides that television cameras will focus on the corporation’s name and logo on the field at certain intervals during the game. P’s activities are acknowledgments of the payment, not advertising.162
160 161
162
Reg. §1.513-4(f), Example 1. Sponsorship payments that are contingent on factors such as total attendance at an event are considered advertising income, whereas payments contingent on the event’s actually taking place are not. Reg. §1.513-4(e)(2). Reg. §1.513-4(f), Example 4.
䡲
761
䡲
c16.fm Page 762 Thursday, March 15, 2007 10:51 AM
C H A P T E R
S I X T E E N 16
Conservation Organizations in Joint Ventures 16.1
OVERVIEW
In recent decades, the number of nonprofit organizations organized and operated to promote conservation or environmental preservation has increased substantially. The missions of these organizations vary, and include preservation and cleanup of lakes, streams, wetlands, forests, and other environmentally sensitive areas. Relying on IRS pronouncements dating back to the 1960s and 1970s, many of these organizations obtain federal income tax exemption on the basis that such conservation or preservation activities are charitable, educational, or scientific. Organizations that promote conservation or preservation but that fail to satisfy the public benefit test may qualify for exemption as a social welfare organization described within §501(c)(4). Some of these organizations are among the largest and most prominent charities in the country, and certain of the practices of these organizations have come under IRS and Congressional scrutiny as they employ innovative means to accomplish their mission.1 Areas currently under scrutiny include in-kind property fundraising strategies, joint ventures and similar arrangements with for-profit landowners and others, and ongoing monitoring and enforcement of conservation easements and similar restrictions to assure 1
The author gratefully acknowledges the contribution of Ronald Schultz in the development of this chapter. Ron was a Graduate Tax Scholar at Georgetown University Law Center during 2001-2002, and is an occasional lecturer at Georgetown in its Graduate Tax Program’s exempt organization classes. One means to measure the size and composition of the exempt sector comprised of environmental and conservation organizations is through the National Taxonomy of Exempt Entities (NTEE) system. This is a coding system developed by the Urban Institute National Center for Charitable Statistics to classify exempt organizations based on descriptive data in the organization’s application for recognition of exempt status. One broad NTEE category is “Environment,” which includes a number of subcategories such as pollution abatement and control, natural resources conservation and protection, botanical, horticultural, and landscape services, environmental beautification, and environmental education. As of early 2006, approximately 800,000 exempt organizations have been classified using the system. According to the Urban Institute National Center for Charitable Statistics, there were 23,305 registered nonprofit organizations within the NTEE “environment” category, with 13,479 of such organizations filing a Form 990. Those that filed a Form 990 reported gross receipts of $15.7 billion and assets of $29.5 billion (http://nccsdataweb.urban.org/NCCS/Public/index.php (last checked July 29, 2006) (reporting organizations that filed Form 990 within 24 months of the May release date)).
䡲
762 䡲
c16.fm Page 763 Thursday, March 15, 2007 10:51 AM
16.2 PUBLIC AND PRIVATE BENEFIT
that the restricted property remains perpetually dedicated to its conservation purpose. In any event, conservation organizations, including those determined to be exempt under §§501(c)(3) and (c)(4) as well as state and local government agencies, increasingly must rely on joint ventures and similar arrangements to raise needed financial capital and obtain private market technical and transactional expertise to further exempt purposes.
16.2
(a)
CONSERVATION AND ENVIRONMENTAL PROTECTION AS A CHARITABLE OR EDUCATIONAL PURPOSE: PUBLIC AND PRIVATE BENEFIT IRS Ruling Position
The IRS has examined the subject in a series of rulings that provide guidance as to the fundamental charitable nature of the organization, the first prong in the analysis. The IRS has ruled that an organization that is organized and operates to promote conservation purposes or environmental preservation may qualify for exempt status as an organization described within §501(c)(3).2 In Revenue Ruling 67-292, the IRS ruled that an organization formed for the purpose of purchasing and maintaining a sanctuary for wild birds and animals for the benefit of the public may qualify as an educational organization.3 CAVEAT The organization was formed to purchase and maintain a large tract of forest land to be reserved as a sanctuary for wild birds and animals and to be open to the public for educational purposes, with its income derived from contributions. The ruling noted that the regulations provided that the term “educational” relates to the instruction of the public on subjects useful to the individual and beneficial to the community, including museums, zoos, planetariums, and symphony orchestras.* The IRS likened a sanctuary for wild birds and animals and used for public educational purposes to a museum or zoo and concluded the organization’s activities were educational because they instructed the public on subjects useful to the individual and beneficial to the community. *
Treas. Reg. sec. 1.501(c)(3)-1(d)(3) (1966).
2 3
Rev. Rul. 67-292, 1967-1 C.B. 184; Rev. Rul. 70-186, 1970-1 C.B. 128; Rev. Rul. 76-204, 1976-1 C.B. 152; Rev. Rul. 78-85, 1978-1 C.B. 150. This position updated and restated a position first taken by the federal taxing authorities in 1925, when the Bureau of Internal Revenue held that a corporation, under the control of a state and organized for the purpose of securing and developing land for the education of the public and to be reserved as a sanctuary for wild birds and animals, was exempt from taxation and eligible to receive deductible charitable contributions (I.T. 2134, C.B. IV-1 (1925). In the 1925 pronouncement, the corporation received all of its income from donations from the public and expended its funds to purchase forest lands to be used as a sanctuary.
䡲
763
䡲
c16.fm Page 764 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
Similarly, in Revenue Ruling 70-186, the IRS ruled that an organization formed to preserve a lake used extensively as a public recreational facility and to improve the condition of the water in the lake to enhance its recreational features qualifies for exemption as a charitable organization. The lake was a large body of water bordering on several municipalities that had along its shores community-owned public beaches, launching ramps, and other recreational facilities of a public nature. The organization was financed by contributions from lakefront property owners, from members of the community adjacent to the lake, and from municipalities bordering on the lake. The organization’s principal activity was to treat the water, to remove algae, and to otherwise improve the condition of the water for recreational purposes. After concluding that the term “charitable” in its generally accepted legal sense and for purposes of tax exemption includes, among other things, the erection or maintenance of public structures and the lessening of the burdens of government, the IRS found that treating water, removing algae, and otherwise improving the condition of the water was a charitable activity. CAVEAT In addition, the IRS addressed the potential private benefit to the lakefront property owners as a result of the organization’s activities. The IRS addressed both the quantitative and qualitative aspects of the private benefit doctrine and concluded that the benefits derived from the organization’s activities flowed principally to the public, not the private lakefront owners, so that any private benefits did not lessen the public benefits, Further, the IRS concluded that the private benefits were incidental because “it would be impossible for the organization to accomplish its purposes without providing benefits to the lake front property owners.”* This ruling forms the basis for the treatment of many lake associations as exempt within §501(c)(3). *
See Chapter 5 generally.
A third IRS ruling that has had a significant impact on conservation organizations is Revenue Ruling 76-204, which in several respects resembles the organizational and operational plan of organizations such as The Nature Conservancy. In that ruling, the IRS found that efforts to preserve and protect the natural environment for the benefit of the public serve a charitable purpose.4
4
The organization described in that ruling was formed by scientists, educators, conservationists, and community representatives for the purpose of preserving the natural environment. The organization accomplished this purpose by maintaining ecologically significant undeveloped land, including swamps, marshes, forests, wilderness tracts, and other natural areas. It worked closely with federal, state, and local government agencies and private organizations concerned with environmental conservation and preservation. The organization acquired lands by multiple means, including by gift or purchase.
䡲
764
䡲
c16.fm Page 765 Thursday, March 15, 2007 10:51 AM
16.2 PUBLIC AND PRIVATE BENEFIT
CAVEAT Some of the organization’s lands were maintained by the organization itself and preserved in their natural state, while others were acquired by the organization for ultimate transfer to a government or another conservation organization that would conserve or preserve the land. In the case of land retained by the organization, public access to the land generally was limited so that the delicate balance of the ecosystem remained undisturbed, but the organization allowed educational and scientific research or study as long as such use did not disrupt the particular ecosystem. In the case of properties transferred to governments or other organizations, the organization usually acquired the property because the ultimate transferee was unable at the time to make the acquisition but the parcel was particularly suited for inclusion into a new or existing park, wilderness area, or wildlife preserve. In such cases, the organization would either transfer the parcel as an outright gift of the parcel or would be reimbursed by the government or other organization for the cost of the land. The organization received most of its funding from the general public. Relying on its earlier Revenue Rulings 67-292 and 70-186, case law,5 and Congressional policy,6 the IRS concluded that the organization was operated exclusively for charitable purposes and qualified for exemption under §501(c)(3). CAVEAT In Revenue Ruling 76-204, the IRS addressed the distinction between conservation and preservation of natural resources, and the limited public access to certain of the lands acquired and maintained by the organization. The IRS stated that the benefit to the public from environmental conservation derives not merely from the current uses that are made of the natural resources, but from their preservation as well, which works to assure that future generations will have the ability to enjoy the natural environment.
5
6
The IRS cited Restatement (Second) of Trusts §375 (1959), Noice v. Schnell, 137 A. 582 (N.J. 1927) (trust formed to preserve and protect from commercial development the Palisades along the Hudson River), President and Fellows of Middlebury College v. Central Power Corporation of Vermont, 143 A. 384 (Vt. 1928) (devise of land to preserve a specimen of original Vermont forest was a charitable bequest), Richardson v. Essex Institute, 94 N.E. 262 (Mass. 1911), Cresson’s Appeal, 30 Pa. 437 (1858), and Staines v. Burton, 53 P. 1015 (Utah 1898), for the proposition that efforts to preserve and protect the natural environment for the benefit of the public serve a charitable purpose. The IRS relied on 42 U.S.C. §4321 (1969), the National Environmental Policy Act of 1969, where Congress declared that the prevention and elimination of damage to the environment stimulates the health and welfare of man and enriches the understanding of ecological systems and natural resources important to the nation, thereby serving a broad public benefit for current inhabitants. The IRS relied on several pieces of federal legislation to support the proposition of a declared national policy of preserving unique aspects of the natural environment for future generations, 16 U.S.C. §1131, Wilderness Act (1964) (wilderness areas); 16 U.S.C. §1221, Estuarine Areas Act (1968) (estuaries); 16 U.S.C. §1271, Wild and Scenic Rivers Act (1968) (rivers); 16 U.S.C. §1301, Water Bank Act (1970) (wetlands).
䡲
765
䡲
c16.fm Page 766 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
The IRS noted that while the public benefits from environmental conservation are clearly recognized and measurable, an equally important public purpose is served by preserving natural resources for future generations. The IRS also concluded that the organization’s restrictions on current public access to certain of the lands were essential to the fulfillment of the organization’s charitable purpose,7 which was supplemented by the advancement of education and science resulting from the organization’s activities. The IRS found that the organization in Revenue Ruling 76-204 was charitable within the meaning of §501(c)(3) because it conserved natural resources for the present generation, preserved natural resources for future generations, advanced education and science, and furthered Congressionally declared national environmental policies. In Revenue Ruling 78-85,8 the IRS ruled that an organization with membership open to the general public and formed by residents to help preserve, beautify, and maintain a municipal public park was operated exclusively for charitable purposes and qualified for exemption under §501(c)(3). The organization’s support was derived from membership dues and contributions from the general public and was formed by the city’s residents to cooperate with municipal authorities to preserve, beautify, and maintain the park. CAVEAT The park was located in the center of the city in a heavily trafficked, easily accessible section of the city and surrounded by high-rise apartments, hotels, office buildings, and commercial establishments. The park was open to the general public and commonly used by the city’s residents and no charges were made to use the park. The organization’s activities consisted of planning the horticultural design of the park, planting trees, flowers, and shrubs, mowing the grass, picking up litter, and designing the trash containers to be used in the park. The IRS concluded that the organization’s activities insured the continued use of the park for public recreational purposes, an exempt purpose, and that the benefits to be derived from such activities flowed principally to the general public rather than to nearby property owners.9
7
8 9
The IRS cited Revenue Ruling 75-207, 1975-1 C.B.361 (holding that the value of an island, owned by a private foundation dedicated to preserve the natural ecosystem on the island to which access is limited to the invited public and private researchers, may be excluded from the foundation’s minimum investment return under §4942(e)). Rev. Rul. 78-85, 1978-1 C.B. 150. The IRS distinguished the facts of Revenue Ruling 75-286 (Rev. Rul. 75-286, 1975-2 C.B. 210), which held that an organization with membership limited to the residents, property owners, and business operators within a city block and formed to preserve and beautify the public areas within the block did not qualify for exemption as a charitable organization because it served the private interests of its members. In that earlier ruling, the organization was financed by voluntary contributions from its members and receipts from neighborhood block parties. The IRS instead ruled in Revenue Ruling 75-286 that the organization promoted social welfare and thus was exempt under section 501(c)(4) because, although its activities were limited to a particular city block, the community as a whole benefited from the activities.
䡲
766
䡲
c16.fm Page 767 Thursday, March 15, 2007 10:51 AM
16.2 PUBLIC AND PRIVATE BENEFIT
(b)
Judicial Holdings
Similarly, courts have held that such organizations may be charitable or educational and described within §501(c)(3).10 More recently, in Dumaine Farms,11 the United States Tax Court held that a perpetual, irrevocable trust organized to operate an experimental model demonstration farm and that conducted largescale research projects was operated exclusively for scientific and educational purposes within §501(c)(3) and was not operated for private benefit, even though it was open to the public on a partially restricted basis. The court examined whether the working farm was operated for commercial purposes or to further scientific and educational purposes, and also whether it was operated for private rather than public benefit.12 CAVEAT Although the public had limited access to the farmland, the general public would have access to the land at certain times throughout the year, and officials and employees of surrounding public agencies would have access to the land and to the organization’s research and experimental results. Federal and state agencies would work closely with the organization to establish soil surveys and modern forest management and conservation techniques. Based on the facts, the court concluded that the farm was organized and operated exclusively for scientific and educational purposes, and that its public benefit outweighed any private benefit derived by the founder of the organization. In particular, the court found that selling the produce and timber from the farm at a profit and in the usual farm markets was not for the purpose of operating a commercial farm, but rather was for the purpose of demonstrating that the farm could be operated both to restore ecological balance and be commercially successful, thereby serving as a model for surrounding area farmers.
10
11 12
As the IRS noted in Revenue Ruling 76-204, courts have addressed charitable trust and charitable gift issues since the late 1800s and early 1900s. Although those cases did not directly address federal tax exemption, they were instrumental in the evolution and expansion of the meaning of charitable, educational and scientific to encompass environmental organizations in the mid-to-late 1900s. Dumaine Farms v. Commissioner of Internal Revenue, 73 T.C. 650 (1980). The organization was organized and operated to maintain, improve, operate and manage an experimental and demonstration farm for the benefit of the general public and particularly the farmers and other people of Rockingham County, North Carolina. The purpose of the working farm was to improve the quality of farming by the selection of crops grown, the management and restructuring of the land, the planting and harvesting of trees, the selective preservation of native growth to demonstrate that farming can be profitable while maintaining sound, ecological principles and native wildlife. The surrounding farms had depleted the soil by planting cash crops which resulted in over cultivation and exhausted land. The farmland did not have any special environmental attributes, nor was the land part of an ecologically significant undeveloped area such as a swamp, marsh, forest, or other wilderness tract. The farm was to be operated to show that alternative crops could be grown to restore ecological balance to the land and at the same time be commercially successful as a working farm, by returning the land to its most useful productive state. The organization intended to sell the produce and timber grown on the land in the usual farm markets, with the proceeds to be used to cover operating costs and to pay for making the results of its experimental projects available to the general public.
䡲
767
䡲
c16.fm Page 768 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
The common thread to these rulings and cases is that a charitable or educational organization’s activities must be directed to educate or otherwise benefit the general public with regard to conservation or preservation. Some of the organizations conserve or preserve natural resources and educate the public, such as the organizations in Revenue Rulings 67-292 and 76-204 and Dumaine Farms, while others focus on conservation and preservation without regard to significant educational activities, such as the lakefront association in Revenue Ruling 70-186. In each of these cases, providing benefits to the public that predominated over benefits to private persons was critical to obtaining exempt status. CAVEAT Although restrictions on public access will be scrutinized, such limitations are not inconsistent with exemption if they further the organization’s charitable, educational, or scientific purposes. Exemption may be granted for organizations organized and operated to achieve localized environmental objectives, such as the lake associations and sanctuaries, but also is available for much larger organizations with regional, national, and global conservation and preservation objectives. While Dumaine Farms shows that the land need not possess special ecologically significant attributes, this will often be the case unless the organization uses the land to conduct scientific research or otherwise educate the public.
16.3 (a)
CONSERVATION GIFTS AND §170(H) CONTRIBUTIONS Qualified Conservation Easements
Contributions of conservation easements may be eligible for special charitable contribution deductions. Generally, §170 does not permit a deduction for a charitable gift of property consisting of less than the entire interest in that property (i.e., a partial interest). However, §170(h) provides an exception to the “no partial interest” rule and allows a charitable contribution deduction for income tax purposes if: (1) the contribution is a qualified real property interest; (2) the donee is a qualified organization; and (3) the contribution is exclusively for conservation purposes. A qualified real property interest includes, among other things, a conservation restriction granted in perpetuity concerning ways the real property may be used. CAVEAT The restriction on the use of the property must be perpetual and must be based upon legally enforceable restrictions (such as by recording the deed) that will prevent uses of the retained interest in the property that are inconsistent with the conservation purpose of the contribution. A qualified organization generally consists of a governmental unit or charitable organization, and is an eligible donee for such contributions if it has a 䡲
768
䡲
c16.fm Page 769 Thursday, March 15, 2007 10:51 AM
16.3 CONSERVATION GIFTS AND §170(H) CONTRIBUTIONS
commitment to protect the conservation purposes of the donation and has the resources to enforce the restrictions.13 A contribution is made exclusively for conservation purposes if the conservation purpose is protected in perpetuity and it: (1) preserves land for the general public’s outdoor recreation or education; (2) protects a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem (the natural habitat requirement); (3) preserves open space either for the scenic enjoyment of the general public or pursuant to a federal, state, or local governmental conservation policy and yields a significant public benefit (the open space requirement); or (4) preserves a historically important land area or a certified historic structure (the historic preservation requirement). These requirements are intended to limit the charitable contribution deduction to those conservation easements and other restrictions that are in perpetuity and that promote meaningful conservation benefits for the public.14 Conservation and preservation organizations described within §501(c)(3) are eligible to receive tax-deductible contributions of qualified real property interests such as conservation easements or other restrictions that satisfy the requirements of §170(h). (b)
Exclusively for Conservation Purposes: Enforceable in Perpetuity
Treasury Regulations §1.170A-14 amplify the statutory requirements regarding conservation purposes that must be enforced in perpetuity. In general, no deduction is available if the encumbered property may be put to a use that is inconsistent with the conservation purpose of the gift.15 Further, a contribution is not deductible if it accomplishes a permitted conservation purpose, but also destroys other significant conservation interests.16 In Glass v. Commissioner,17 the court considered the requirement that the contribution be made exclusively for conservation purposes, which in that case involved the natural habitat requirement. The taxpayers in that case owned property along the shore of Lake Michigan, which at the time of the contributions they used as a vacation home. The taxpayers contributed easements with respect to this property that restricted the development of the land, although the restrictions did not interfere with the taxpayers’ use or enjoyment of the property as a vacation home or as a primary residence. The Tax Court determined that the easements in that case protected a natural habitat of wildlife and plants (bald 13 14
15 16
17
Treas. Reg. §1.170A-14(c)(1). The organization need not set aside funds to enforce the restrictions that are the subject of the contribution. Id. H.Conf. Rept. 95-263, at 30-31 (1977), 1977-1 C.B. 519, 523 (quoted in Glass v. Comm., 124 T.C. 258, 279 (2005)) (“it is also intended that contributions of perpetual easements … qualify for the deduction only in situations where the conservation purposes of protecting or preserving the property will in practice be carried out. Thus, it is intended that a contribution of a conservation easement … qualify for a deduction only if the holding of the easement … is related to the purpose or function constituting the donee’s purpose for exemption (organizations such as nature conservancies, environmental, and historic trusts, State and local governments, etc.) and the donee is able to enforce its rights as holder of the easement … and protect the conservation purposes which the contribution is intended to advance.”). Treas. Reg. §1.170A-14(e)(2). Treas. Reg. §1.170A-14(e)(2). For a summary of the conservation purpose requirements, see Report of Staff Investigation of The Nature Conservancy (Volume I), Prepared by the Staff of the Committee on Finance United States Senate (June 2005), S. Prt. 109-27, Part One 15 – 17. Glass v. Commissioner, 124 T.C. 258 (2005).
䡲
769
䡲
c16.fm Page 770 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
eagles, piping plovers, kingfishers, Lake Huron tansy, pitcher’s thistle, and various other plants and animals along a Lake Michigan bluff) and were exclusively for conservation purposes. CAVEAT Noting that the taxpayers “gratuitously surrendered valuable property rights in the encumbered shoreline,” and that “those restrictions are legally enforceable to limit in perpetuity any inconsistent use of the encumbered shoreline,” the court determined the easements satisfied the conservation purpose requirement, even though the restrictions did not limit the particular use and enjoyment of the property by the taxpayers. The court’s opinion suggests that if the other requirements are satisfied, a taxpayer will not be denied a charitable deduction merely because the value of the conservation restriction relates to a restriction of activity that the contributing taxpayer likely would never permit while the taxpayer owned the property, so long as the restriction is legally enforceable in perpetuity and thus diminishes the value of the encumbered property.18 The IRS argued that there were defects in the deed conveying the easement, that the gift was not made exclusively for a conservation purpose, and that the property was developed according to its highest and best use and therefore no contribution was made. The court concluded the open space requirement was not satisfied because the scenic views were not protected by the development, and that the historic preservation requirement was not satisfied because the contribution did not preserve a historic structure or historically important land area. The court found there was no preservation of open space or anything that was historically unique about the property or its surrounding areas, and that the taxpayer “simply developed . . . property to its maximum yield within the property’s zoning classification.” In reality, the taxpayer contributed nothing that was not already required or permitted by law because the easement was no more restrictive with regard to development or preservation than existing zoning requirements. After denying the charitable contribution deduction, the court upheld the 20 percent negligence penalty under §6662 on the basis that the taxpayer showed a lack of care and due regard by claiming a deduction based on assumptions known to be false or erroneous. (c)
Qualified Farmers and Ranchers
The Pension Protection Act provided certain temporary incentives for farmers and ranchers to make contribution of real property for conservation purposes. The Act increased the percentage limitation applicable to such contributions made by qualified farmers and ranchers from 30% of the contribution base to 18
In Turner v. Commissioner, the court examined the open space and historic preservation requirements and concluded that the donor did not satisfy either requirement and thus was not entitled to a charitable contribution deduction for a gift of a conservation easement. In that case, an individual bought parcels of unimproved land located within a historical overlay district, with approximately half the land located in a floodplain where development was prohibited.
䡲
770
䡲
c16.fm Page 771 Thursday, March 15, 2007 10:51 AM
16.3 CONSERVATION GIFTS AND §170(H) CONTRIBUTIONS
100% of the base, and increased the carryover period for contributions that exceed the contribution limit from five to fifteen years. For this purpose, a qualified farmer or rancher means a taxpayer whose gross income from the trade or business of farming exceeds 50% of the taxpayer’s gross income for the tax year. The new rules do not apply to contributions made in tax years beginning after December 31, 2007. (d)
Valuation Issues
Treasury Regulations §1.170A-14(h)(3) provide that the value of a perpetual conservation restriction is the fair market value of the perpetual restriction at the time of the contribution. If there is a substantial record of sales of easements comparable to the donated easement, such as purchases pursuant to a governmental program, the fair market value of the donated easement is based on the sales prices of such comparable easements.19 CAVEAT Such a record generally is not available, however, and the regulations provide that in their absence, as a general rule the value is equal to the difference between the fair market value of property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction.* Although courts generally apply this “before and after” standard by looking at the objective uses of the property, at least one court has examined the subjective intentions of the contributing taxpayer to apply this standard.† * †
Treas. Reg. §1.170A-14(h)(3)(i). Report of Staff Investigation of The Nature Conservancy (Volume I), Prepared by the Staff of the Committee on Finance United States Senate (June 2005), S. Prt. 109-27, Part One 17 (citing McLennan v. U.S., 24 Cl. Ct. 102 (1991), for the proposition that the “highest and best use” used to determine value of the property refers to the “most profitable and probable use” of the property and that in that particular case, the taxpayer’s “strong aversion to development” meant that a valuation based on an assumption of subdividing the property was untenable and directly contracted the taxpayer’s clear intention to preserve the land from development).
The Pension Protection Act amended section 170 to provide statutory definitions of “qualified appraiser” and “qualified appraisal” for appraisals prepared for returns filed after August 17, 2006. These new rules relate to appraisals used by taxpayers to substantiate claims for charitable deductions for noncash contributions in excess of $5,000. Under the new rules, a qualified appraisal must be conducted by a “qualified appraiser” accordance with generally accepted appraisal standards. A qualified appraiser means an individual who (1) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements, 92) regularly performs appraisals for which the individual receives compensation, and (3) meets other requirements established by the IRS and Treasury. A person will not be treated as a qualified appraiser unless the individual demonstrates verifiable education and experience in valuing the type of property subject to the appraisal, and has not been prohibited from practicing 19
Treas. Reg. §1.170A-14(h)(3)(i).
䡲
771
䡲
c16.fm Page 772 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
before the IRS at any time during the three years ending on the date of the appraisal. The new provisions also impose an erroneous valuation penalty on any appraiser who prepared an appraisal if the claimed value based on the appraisal results in a substantial or gross valuation misstatement under §6662 and the appraiser knew, or reasonably should have know, the appraisal would be used to support a claimed contribution deduction. (§6695A.) The IRS has issued interim guidance regarding the new provisions in Notice 2006-96. IRS Notice 2004-41: The Tax Avoidance Transaction Settlement Initiative20
(e)
The IRS currently is scrutinizing claimed charitable contributions based on the gift of conservation easements in arrangements in which the donor also purchased the restricted property from the donee. Such arrangements, sometimes referred to as conservation buyer program (CBP) transactions, have been used by conservation organizations such as The Nature Conservancy to further conservation purposes by imposing conservation restrictions on property to be held by a person friendly to the organization. CAVEAT The types of transactions described in the Notice include those in which the charitable organization purchases the property and places a conservation easement on the purchased property, followed by the organization selling the property subject to the easement to a buyer for a price that is substantially less than the price paid by the organization for the property. In these transactions, as part of the sale, the buyer makes a second payment designated as a “charitable contribution” to the conservation organization, with the total of the payments from the buyer to the organization fully reimbursing the organization for the cost of the property.* *
2004-28 I.R.B. at 31.
The IRS stated in the Notice that “in appropriate cases” it would treat these transactions in accordance with their substance rather than their form, and thus may treat the buyer’s payments to the charitable organization as the purchase price paid by the buyer for the property.21 These transactions were included in the IRS abusive transaction settlement initiative announced on October 28, 2005, which included 21 separate transactions (16 “listed transactions” and 5 nonlisted transactions, including the CBP transactions).22 20 21 22
Notice 2004-41, 2004-28 I.R.B. 31. 2004-28 I.R.B. at 31-32. IRS Settlement Initiative, Fact Sheet 2005-17, October 2005 and Announcement 2005-80, 200546 I.R.B. 967. Under the settlement initiative released October 28, 2005, a taxpayer had until January 23, 2006, to notify the IRS of the taxpayer’s intent to participate in the settlement initiative. An electing taxpayer had to agree to settlement terms that generally required the taxpayer to agree to a disallowance of the claimed tax benefits associated with the transaction and an accuracyrelated penalty on the underpayment attributable to the transaction (5% in the case of conservation easement transactions). The conservation easement and conservation buyer transactions were included in the nonlisted transactions as “transactions that the IRS is concerned about but [that] have not been formally listed.” Fact Sheet 2005-17. The settlement initiative applied to conservation easements as follows: “Certain abusive charitable deductions and conservation easements (Deductions under §170 improperly claimed as a result of: (a) open space easements where the
䡲
772
䡲
c16.fm Page 773 Thursday, March 15, 2007 10:51 AM
16.4 UNRELATED BUSINESS INCOME TAX ISSUES
16.4 (a)
UNRELATED BUSINESS INCOME TAX ISSUES In General
Conservation organizations are subject to the generally applicable rules regarding the unrelated business income tax.23 CAVEAT Congress recently enacted legislation specifically applicable to conservation organizations that attempt to acquire, remediate, and sell contaminated brownfield properties. This provision is intended to provide an incentive for exempt organizations, directly or through partnerships, to clean up brownfield properties so they may be restored to a commercially productive use. Special rules apply to an organization that acquires, remediates, and sells multiple qualifying properties. The 2004 JOBS Act24 added a special unrelated business income provision regarding the treatment of gain or loss on the sale, exchange, or other disposition of certain brownfield sites. The provision, codified in §512(b)(18), generally provides an exclusion from unrelated business taxable income for the gain or loss from the qualified sale, exchange, or other disposition of a qualifying brownfield property by an eligible taxpayer. The exclusion from unrelated business taxable income generally is available to an exempt organization that acquires, remediates, and disposes of the qualifying brownfield property. In addition, it provides an exception from the debt-financed property rules for such properties. In order to qualify for the exclusions from unrelated business income and the debt-financed property rules, the eligible taxpayer is required to: (a) acquire from an unrelated person real property that constitutes a qualifying brownfield property; (b) pay or incur a minimum level of eligible remediation expenditures with respect to the property; and (c) transfer the remediated site to easement has no, or de minimis, value; (b) historic land or facade easements that have no, or de minimis value; and (c) so-called conservation buyer transactions where the charitable organization purchases the property, places an easement on it, and then “sells” the property with the easement to a buyer at a price substantially less than that paid for it and the buyer also makes a charitable contribution that approximates the price differential.” 2005-46 I.R.B. at 969. 23
24
See Chapter 8 for example, in Private Letter Ruling 200349008, an organization established by Congress and exempt under §501(c)(3) for the purpose of conserving and managing natural resources did not recognize unrelated business income on amounts derived from administering funds for the benefit of state and local governments to assist them in maintaining and conserving natural resources. In Private Letter Ruling 200041038, the IRS ruled that cutting and selling timber based solely on conservation objectives did not constitute an unrelated trade or business, but that cutting and selling timber based solely on revenue objectives, or where conservation objectives were merely incidental to revenue or other objectives, constituted an unrelated trade or business. In Private Letter Ruling 9535051, the purchase of lands with natural significance and purchase of properties for subsequent sale to a state department of natural resources were found to be substantially related to the exempt purpose of advancing land and water conservation. P.L. 108-357, §702(a), effective for any gain or loss on the sale, exchange, or other disposition of any property acquired by the taxpayer after December 31, 2004, subject to certain other requirements. The conference agreement modified the Senate amendment to provide a termination date of December 31, 2009. Accordingly, the provision applies to gain or loss on the sale, exchange, or other disposition of property that is acquired by the eligible taxpayer or qualifying
䡲
773
䡲
c16.fm Page 774 Thursday, March 15, 2007 10:51 AM
16.4 JOINT VENTURES INVOLVING CONSERVATION
an unrelated person in a transaction that constitutes a sale, exchange, or other disposition for purposes of federal income tax law.
CAVEAT A qualifying brownfield property means real property that is certified, before the taxpayer* incurs any eligible remediation expenditures† (other than to obtain a Phase I environmental site assessment), by an appropriate state agency in the state in which the property is located as a brownfield site within the meaning of §101(39) of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) (as in effect on the date of enactment of the proposal).‡ *
†
‡
The provision requires that the taxpayer's request for certification include a sworn statement of the taxpayer and supporting documentation of the presence of a hazardous substance, pollutant, or contaminant on the property that is complicating the expansion, redevelopment, or reuse of the property given the property's reasonably anticipated future land uses or capacity for uses of the property (including a Phase I environmental site assessment and, if applicable, evidence of the property's presence on a local, State, or Federal list of brownfields or contaminated property) and other environmental assessments prepared or obtained by the taxpayer. An eligible taxpayer with respect to a qualifying brownfield property is an organization exempt from tax under §501(a) that acquired such property from an unrelated person and paid or incurred a minimum amount of eligible remediation expenditures with respect to such property. The exempt organization (or the qualifying partnership of which it is a partner) is required to pay or incur eligible remediation expenditures with respect to a qualifying brownfield property in an amount that exceeds the greater of: (a) $550,000; or (b) 12 percent of the fair market value of the property at the time such property is acquired by the taxpayer, determined as if the property were not contaminated. An eligible taxpayer does not include an organization that is: (1) potentially liable under section 107 of CERCLA with respect to the property; (2) affiliated with any other person that is potentially liable thereunder through any direct or indirect familial relationship or any contractual, corporate, or financial relationship (other than a contractual, corporate, or financial relationship that is created by the instruments by which title to a qualifying brownfield property is conveyed or financed by a contract of sale of goods or services); or (3) the result of a reorganization of a business entity which was so potentially liable. Eligible remediation expenditures means, with respect to any qualifying brownfield property: (1) expenditures that are paid or incurred by the taxpayer to an unrelated person to obtain a Phase I environmental site assessment of the property; (2) amounts paid or incurred by the taxpayer after receipt of the certification that the property is a qualifying brownfield property for goods and services necessary to obtain the remediation certification; and (3) expenditures to obtain remediation cost-cap or stop-loss coverage, reopener or regulatory action coverage, or similar coverage under environmental insurance policies, or to obtain financial guarantees required to manage the remediation and monitoring of the property.
(b)
Special Partnership Rules
The brownfields unrelated business income provision contains a number of special rules for partnerships. In the case of a tax-exempt organization that is a partner of a qualifying partnership that acquires, remediates, and disposes of a qualifying brownfield property, the provision applies to the tax-exempt partner's partnership during the period beginning January 1, 2005, and ending December 31, 2009. Property acquired during the five-year acquisition period need not be disposed of by the termination date in order to qualify for the exclusion. For purposes of the multiple property election, gain or loss on property acquired after December 31, 2009, is not eligible for the exclusion from unrelated business taxable income, although properties acquired after the termination date (but during the election period) are included for purposes of determining average eligible remediation expenditures.
䡲
774
䡲
c16.fm Page 775 Thursday, March 15, 2007 10:51 AM
16.5 JOINT VENTURES INVOLVING CONSERVATION
distributive share of the qualifying partnership’s gain or loss from the disposition of the property. The provision's exclusions do not apply to a tax-exempt partner's gain or loss from the tax-exempt partner's sale, exchange, or other disposition of its partnership interest, which continue to be governed by present law. CAVEAT A qualifying partnership is a partnership that (1) has a partnership agreement that satisfies the requirements of §514(c)(9)(B)(vi) at all times beginning on the date of the first certification received by the partnership that one of its properties is a qualifying brownfield property; (2) satisfies the requirements of the proposal if such requirements are applied to the partnership (rather than to the eligible taxpayer that is a partner of the partnership); and (3) is not an organization that would be prevented from constituting an eligible taxpayer by reason of it or an affiliate being potentially liable under CERCLA with respect to the property. The exclusion is available to a tax-exempt organization with respect to a particular property acquired, remediated, and disposed of by a qualifying partnership only if the exempt organization is a partner of the partnership at all times during the period beginning on the date of the first certification received by the partnership that one of its properties is a qualifying brownfield property, and ending on the date of the disposition of the property by the partnership. The provision subjects a tax-exempt partner to tax on gain previously excluded by the partner (plus interest) if a property subsequently becomes ineligible for exclusion under the qualifying partnership's multiple-property election.25
16.5
JOINT VENTURES INVOLVING CONSERVATION ORGANIZATIONS AND FOR-PROFIT PARTICIPANTS
Tax-exempt conservation organizations face many of the same difficulties that other exempt organizations, such as healthcare systems, affordable housing organizations, and educational institutions, face in acquiring expertise and raising funds to meet the ever-increasing demands for their programs and services. This causes conservation organizations to look to nonexempt persons to serve as “partners” in a variety of activities and programs, both as a means to raise needed capital and to obtain the experience and talent to develop and implement the programs. In the environmental conservation and preservation context, examples of such ventures include cleanup of brownfields or other contaminated sites and preserving a rainforest or other area of environmental significance. Practitioners and conservation organizations should expect the IRS to subject such ventures to the same or a similar analysis that it conducts in other exempt organization joint venture contexts, such as in healthcare, affordable housing, and education.26 25
26
The Secretary of the Treasury is directed to prescribe such regulations as are necessary to prevent abuse of the requirements of the provision, including abuse through the use of special allocations of gains or losses, or changes in ownership of partnership interests held by eligible taxpayers. See, for example, Revenue Rulings 98-15 and 2004-51, discussed in Chapter 13.
䡲
775
䡲
c16.fm Page 776 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
In particular, certain environmental projects face significant contingent liability exposure, which often results in the nonexempt participant attempting to limit its financial exposure with respect to such liabilities. Accordingly, the participating exempt conservation organization must pay especially close attention to the representations, warranties, and covenants regarding such liabilities, conduct adequate due diligence (including obtaining environmental reports) to assess and minimize any environmental risk before entering into any agreements for environmental indemnification or funding obligation caps that benefit the nonexempt participants, and take steps to assure that the exempt organization’s financial arrangement with respect to capital contributions, distributions, and the sharing of profits or losses is fair and reasonable to the exempt organization. The IRS has issued a private ruling with regard to the participation by a §501(c)(3) conservation organization in a limited liability company (LLC) formed to acquire from owners of forest land the rights to maintain, conserve, selectively cut, manage, sell, retain the proceeds from, and regenerate the trees located on each owner’s property in exchange for units of membership in the limited liability company.27 The LLC membership interests entitled the ownerinvestors to preferred annual distributions based on the value of the timber rights they contributed to the LLC, and the limited right to withdraw the initial value of the timber rights contributed for cash. The LLC members would convey the timber rights to the LLC by means of a permanent and irrevocable forest conservation management easement, which gave the LLC the right to manage the member’s timber, including the right to maintain, conserve, selectively cut, sell, retain the proceeds from, and regenerate the trees located on the member’s property. The easements permanently prohibited any development of the land on which the contributed member rights resided for commercial purposes or in any manner inconsistent with the LLC’s conservation objectives, although the members continued to own the land and could continue to use it for recreational purposes. Members exchanged rights to cut and manage timber for rights to receive cash and other economic returns. The LLC governance provisions entitled the exempt conservation organization to control the operations of the LLC’s affairs, and the other members could not vote on any matter except the sale, merger, or consolidation of the LLC, which required the consent of two-thirds of the members and the exempt organization. In addition, the exempt organization provided management services to the LLC pursuant to a five-year management agreement. The IRS ruled that the exempt organization’s participation as a manager of the LLC and its obligations and activities with respect to the LLC would not impair its status as an organization described within §501(c)(3).
27
Priv. Ltr. Rul. 200041038.
䡲
776
䡲
c16.fm Page 777 Thursday, March 15, 2007 10:51 AM
16.6 SENATE FINANCE COMMITTEE INVESTIGATION
16.6
SENATE FINANCE COMMITTEE INVESTIGATION OF THE NATURE CONSERVANCY (TNC)28
In July 2003, the Senate Committee on Finance initiated an investigation by its staff of The Nature Conservancy.29 The investigation followed a series of articles published by the Washington Post that raised questions about the policies and practices of TNC, including issues of corporate governance, charitable contributions (including conservation easements), commercial activity and unrelated business income, and arrangements with insiders.30 The staff’s investigation took approximately two years and culminated in a Senate Finance Committee (SFC) hearing in June 2005, regarding the investigation and land reform measures. In conjunction with the hearing, the staff released the TNC Report. The TNC Report includes numerous recommendations made by the Committee staff as a result of its investigation. In the joint venture context, it proposed that: 1. The IRS consider modifying Form 990 to require more detail regarding joint ventures involving capital contributions, funding commitments, or assets of the exempt organization, and to clearly state the nature of the joint venture activity, whether and how the activity furthers exempt purposes, the type of state law entity or other arrangement, and identities and respective ownership interests of the parties to the venture 2. The IRS consider modifying the Form 990 to require reporting on joint ventures in which the exempt organization owns a 50 percent or less interest The SFC staff recommended that the IRS revise the Form 990 to require reporting by conservation organizations of its activities with regard to monitoring and enforcement of conservation easements, including a description of its policies regarding monitoring and enforcement. Because a conservation organization’s exempt purpose is premised on conserving and preserving the environment and natural resources, the failure by such an organization to monitor and enforce in perpetuity those conservation easements and similar restrictions that it is responsible for enforcing raises doubts both about the organization’s achievement of the purposes that form the basis for its exemption and the validity of the charitable contribution deduction for the gift of the property interest. Given the emphasis placed on conservation organizations by the Senate Finance Committee and the IRS, one can expect the revised Form 990 to include additional reporting requirements for organizations whose primary purpose is
28
29 30
See the Report of Staff Investigation of The Nature Conservancy (Volumes I and II), Prepared by the Staff of the Committee on Finance United States Senate, Charles E. Grassley, Chairman and Max Baucus, Ranking Member, June 2005, 109th Congress, 1st Session, S. Prt. 109-27 (the “TNC Report”). The full report of the staff of the Senate Finance Committee, Volumes I and II, is available online at http://finance.senate.gov at “Hearings.” TNC Report, Volume I, Introduction. TNC Report, Volume I, Introduction.
䡲
777
䡲
c16.fm Page 778 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
conserving or preserving the environment or natural resources, particularly those that acquire conservation easements and similar restrictions in order to achieve their exempt purposes.
16.7 (a)
EMERGING ISSUES Tax Treatment of Emissions Credits and Similar Arrangements
In its investigation of The Nature Conservancy, the staff of the Senate Finance Committee discovered certain emissions credit arrangements entered into by The Nature Conservancy with private parties. In essence these various arrangements obligated TNC to manage a rainforest or other conservation property with funds provided by a nonexempt participant, including General Motors and certain utility companies.31 CAVEAT The nonexempt participant had certain rights under the arrangement, including the right to all emissions credits that might be realized as a result of the project. These emissions credits potentially could be used by such participant to emit a specified amount of gases that are harmful to the environment or be sold in an emissions credit market. TNC’s emissions credit arrangements provided the nonexempt financial participants with the right to receive potential emissions credits or allowances in exchange for cash to be used by TNC to manage the conservation project. The respective rights and obligations of TNC and the financial participant were set forth in a contractual agreement. The Committee staff concluded that federal tax issues raised by the arrangements include: (1) whether the for-profit participant obtained an impermissible private benefit from the arrangement; (2) whether TNC owned the emissions credits or allowances and thus was required to receive fair market value for their current or future transfer to and use by the for-profit participants; (3) whether excess benefit rules applied to these arrangements; (4) whether income from such arrangements should be classified as income from a joint venture or as a management fee rather than as a charitable contribution; (5) whether the arrangements should be regarded as the conduct by TNC of an unrelated trade or business; (6) the tax consequences to the nonexempt participants with respect to the amounts paid to fund the projects; and (7) the tax consequences to the nonexempt participants if and when they receive the emissions credits or allowances.32 As stated above, the staff invited the IRS to study the use of emissions credit arrangements by other conservation organizations to determine the extent to which they are being used by conservation organizations and for-profit organizations.
31 32
TNC Report, Volume I at Part Two 20-32 and Part Three 62-65. TNC Report, Volume I at Executive Summary 16-17.
䡲
778
䡲
c16.fm Page 779 Thursday, March 15, 2007 10:51 AM
16.8 CONCLUSION
(b)
Promotion of Conservation or Environmental Preservation as an Essential Governmental Function
The ever increasing role of state and local governments and Indian tribal governments has resulted in such governments looking to participate in activities that raise issues regarding whether the activity constitutes an essential governmental function such that any income derived from the activity is not subject to federal income tax.33 Such governments increasingly are conducting new and innovative activities that must be assessed to determine whether the activity constitutes an essential governmental function. In the case of environmental conservation and preservation, unique issues might arise, such as with respect to timber cutting and logging in forests under the control of the government. The IRS has ruled privately that although management and development of forest land, including its natural and physical resources, may constitute an essential governmental function because it is the type of activity conducted by states, the harvesting and processing of timber is not an essential governmental function for purposes of §7871(e) and Indian tribal governments because states rarely engage in such activity.34 The IRS ruled that commercial logging, operating a sawmill, and manufacturing and marketing timber products were not an essential governmental function, even though some aspects of such operations may overlap with conservation purposes.35
16.8
CONCLUSION
The meaning of “charitable or educational” for purposes of §501(c)(3) has expanded over recent decades to include certain kinds of conservation and environmental preservation organizations. These organizations generally must provide meaningful access to the public in order to attain charitable or educational status. As such organizations struggle to raise capital and obtain technical expertise to conduct their programs, they employ innovative techniques, including joint ventures, which frequently involve for-profit participants. These techniques may raise exempt status, private benefit, private inurement, excess benefit transaction tax, and unrelated business income issues that increasingly are seen in other exempt sectors, including healthcare, affordable housing, and education. In addition, Congress and the IRS are closely scrutinizing various charitable contribution deduction issues, such as conservation purpose, valuation, and donative intent with respect to gifts of conservation easements. At the same time, Congress and the administration continue to develop proposals that would 33
34 35
See Section 115 (income of states and municipalities derived from the exercise of an essential governmental function) and 7871 (Indian tribal governments treated as states for certain purposes). In addition, the determination of whether an activity constitutes an essential governmental function may be relevant for other tax purposes, such as federal excise taxes on fuels. See §7871(a)(2) and (b) (an Indian tribal government will be treated as a state for purposes of exemption from taxes under Chapters 31 (relating to tax on special fuels) and Chapter 32 (relating to manufacturing excise taxes) only if, in addition to any other requirement applicable to similar transactions involving a state or political subdivision, the transaction involves the exercise of an essential governmental function of the Indian tribal government). Priv. Ltr. Rul. 199909013 (November 25, 1998). Priv. Ltr. Rul. 199909013.
䡲
779
䡲
c16.fm Page 780 Thursday, March 15, 2007 10:51 AM
CONSERVATION ORGANIZATIONS IN JOINT VENTURES
provide additional tax incentives to encourage conservation and preservation.36 This tension between promoting additional charitable incentives while attempting to prevent abuse within and overexpansion of the charitable sector is not unique to conservation organizations, but applies throughout the entire nonprofit tax-exempt sector.
36
Recent legislative and administrative proposals, if enacted, would provide additional tax incentives to promote conservation and environmental preservation. These include tax credits, tax-exempt bond financing, and capital gain exclusion provisions that would provide economic incentives to conserve and preserve land and natural resources. These proposals are premised on beliefs that existing tax incentives, including exemption from income tax and the ability to raise tax deductible charitable contributions, are inadequate to encourage conservation organizations and the private sector to invest in the acquisition and maintenance of certain types of conservation projects. For example, the forest conservation bond proposal would authorize the issuance of billions of dollars worth of tax-exempt bonds to acquire forests and forest lands across the nation, and provide that income derived from “qualified harvesting activities” on land financed with such bonds would not be subject to federal income tax. Partial capital gain exclusion proposals would reduce the selling landowner’s capital gains taxes if the seller transferred the property to a qualifying conservation organization to be held for qualifying conservation purposes.
䡲
780
䡲
c17.fm Page 781 Thursday, March 15, 2007 5:26 PM
C H A P T E R
S E V E N T E E N 17
International Joint Ventures
17.1
OVERVIEW
Each day, news of world events touches the American public and calls attention to the environmental travesty, human suffering, poverty, injustice, and conflict occurring internationally. Historically, other nations have looked to the United States for assistance in the aftermath of natural disasters or political upheavals that have left their countries traumatized. Charitable organizations such as the American Red Cross, CARE (Cooperative for Assistance and Relief Everywhere), the World Wildlife Fund, the World Alliance of YMCAs, the World Hunger Program, and United Way have been conducting activities in foreign countries for many years. In the aftermath of an almost unprecedented string of recent global disasters, notably the 2005 Southeast Asian tsunami and the 2006 Indonesian earthquake, donors are contributing in record numbers1 to aid in relief efforts. Over the last decade, the United States has seen an increase in the number of domestic charities2 responding to the needs of other countries by expanding their charitable activities into the international sector. The work of these respective U.S.-based charitable organizations has not been confined to disaster relief and aid for the impoverished; some charities, like the Ford Foundation,3 work in the international community to further democracy by supporting established international organizations such as universities, the judiciary, the private sector, community organizations, and government agencies. Foundations also work with nongovernmental organizations (NGOs), which are increasingly being used as nonprofit subcontractors for jobs that foreign countries have no interest in or can no longer afford. As an example, the Pan American Development Foundation has developed partnerships with international 1
2
3
See, e.g., Richard Friedman, “Behind Each Donation, A Tangle of Reasons,” New York Times, F4 (November 14, 2005); Stephanie Strom, “Giving in ’04 Was Up 2.3%,” New York Times, A6 (June 14, 2005). Unless otherwise noted, all references to “domestic charities” refer to organizations created or organized within the United States that have applied for and received a ruling from the Internal Revenue Service that recognizes them as §501(3)(c) tax-exempt organizations. The Ford Foundation has been active in South Africa, Nigeria, Uganda, Russia, Eastern and Central Europe, China, Vietnam, the Philippines, India, Latin America, and Mexico, among other countries. The Ford Foundation Annual Report (1994)
䡲
781 䡲
c17.fm Page 782 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
agencies, corporations, NGOs, private donors, and local governments to implement projects for agriculture and small business development, improving health services, community development, and skills training. Although some NGOs are household names, such as Save the Children and CARE, most are small, grass-roots charity operations. Tens of thousands of NGOs have sprung up across Latin America, Asia, Africa, and some of the domains of the former Soviet Union.4 In Mali, neighborhood groups pay NGOs to collect trash; in Bolivia, nongovernmental organizations operate national parks. In El Salvador, in addition to providing primary medical care, NGOs are involved in education, vocational training, environmental projects, and lending to would-be entrepreneurs.5 The Ford Foundation has supported an NGO, the Legal Resources Centre, in bringing cases before the South African Constitutional Court that will be crucial to the effectuation of that nation’s post-apartheid Constitution. Other techniques utilized by U.S.-based charities providing foreign aid involve program-related investments in undeveloped countries, “friends” organizations, and direct grant making, with the latter two methods governed by more stringent rules than those applied to joint ventures. This chapter initially reviews the measures that a U.S.-based charitable organization must take, and the legal framework that must be considered, when conducting charitable operations abroad to ensure that such activity does not jeopardize the deductibility of the contribution to the U.S. individual or corporate donor, or endanger the domestic organization’s tax-exempt status. As more charitable organizations enter the global arena, it is important for practitioners to be able to advise their clients as to the different methods by which overseas activities may be conducted and the legal consequences of those activities. This chapter examines, in the overall context of joint ventures with foreign entities, the different methods by which a domestic tax-exempt organization may expand its charitable activities overseas. Perhaps the most significant recent development in the area of international joint ventures has been the increase in the scrutiny of foreign grant making in the aftermath of the events of September 11, 2001. The U.S. government has become aware that some U.S.-based charities may be used to funnel resources to organizations sponsoring terrorist activities. As the massive international relief efforts stemming from the 2005 Southeast Asian tsunami, the 2006 Indonesian earthquake, or aid to the refugees in the Sudan, Chad, or Afghanistan illustrate, often a donor makes a contribution either to a U.S.-based charity for work to be done in a foreign country, or to a foreign aid organization operating abroad. While U.S. government oversight of charities allows for some protection from a misuse of donated funds, when money leaves the United States—either through 4
5
The proliferation of NGOs is closely linked to the collapse of Communism. During the Cold War, foreign aid was used as a weapon in the East-West struggle. Huge amounts were spent to win political loyalty, with little regard to whether it helped the poor or lined the pockets of leaders. Now, with the Soviet threat dissipated, the United States has neither the inclination nor the resources to be lavish with foreign aid. Thus, more governments are tapping into NGOs by providing block grants to deliver services more efficiently. Greenberger, “Developing Countries Pass Off Tedious Job of Assisting the Poor,” Wall Street Journal (June 5, 1995, A1.) See id.
䡲
782
䡲
c17.fm Page 783 Thursday, March 15, 2007 5:26 PM
17.2 DOMESTIC CHARITIES EXPENDING FUNDS ABROAD
a U.S.-based charity or when given directly to a foreign group—the oversight, too, may occasionally leave with the donation. Accordingly, the transactions of U.S.-based nonprofits are encountering increased scrutiny. This chapter further discusses issues relating to the use of local charities to fund international terrorist activities and the U.S. government’s response to this issue.
17.2 (a)
DOMESTIC CHARITIES EXPENDING FUNDS ABROAD Deductibility of Contributions Under §170
Section 170(a) of the Internal Revenue Code (IRC) allows a deduction for charitable contributions described in §170(c).6 Section 170(c) sets forth two general requirements that must be met if an individual and/or corporate donor is to claim a charitable deduction.7 First, the gift or donation must be made to an organization organized or created within the United States or in any possession thereof, or under the law of the United States or any state, the District of Columbia, or any possession of the United States.8 The fact that a U.S. charitable organization expends part or all of its funds in a foreign country does not affect the deductibility of the contribution by an individual.9 Contributions made to organizations not organized or created within the United States or a possession thereof are not deductible.10 In limited situations, however, contributions made directly to a foreign organization11 may be deductible under the provisions of a tax treaty established between the United States and the country in which the foreign organization was created or organized (see below).12 Second, the organization receiving the contribution must be organized and operated exclusively for charitable purposes.13 Rulings issued by the Internal Revenue Service (IRS) demonstrate that it is the nature of the activity conducted by the organization, not the location of the activity, that determines whether the organization qualifies as charitable.14 Thus, activities carried on by domestic charities overseas may still qualify as charitable. The term charitable has been broadly defined to include relieving the poor and distressed or underprivileged,15 providing a water supply system for a disparate populace in a Lebanese city, 16 furnishing tools and material to help 6 7 8 9 10
11
12 13 14 15 16
See §170(a)(1). See §170(c)(2)(A) and (B). See §170(c) (2) (A). See Reg. S1.170A-8(1); Rev. Rul. 63-252,1963-2 C.B. 101. See ErSelcuk v Commissioner, 30 T.C. 962 (1958); Welti v. Commissioner, 1 T.C. 905 (1943); Tobjy v. Commissioner, T.C.M. (P-H)¶386,062 (1986); Hess v. Commissioner, T.C.M. (P-H) ¶71,242 (1971); Herter v. Commissioner, T.C.M. (P-H) ¶61,019(1961); Rev. Rul. 76195,1976-1 C.B. 61. For purposes of this chapter, the term foreign organization refers to a charitable organization that was not organized or created within the United States, or in any possession thereof, or under the laws of the United States, or any state, the District of Columbia, or any possession in the United States. See Section 7.11 for a discussion on the effects of foreign tax treaties. See §170(c)(2)(B); Reg. §§501(c)(3)-1(d)(1)(i), 1.501(c)(3)-1(d)(1)(iii). See Rev. Rul. 66-177, 1966-1 C.B.132. See Reg. §1.501(c)(3)1-1(d)(2). Gen. Couns. Mem. 30710 (June 4, 1958).
䡲
783
䡲
c17.fm Page 784 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
improve living conditions of the underprivileged in Latin America,17 providing assistance to needy families in developing countries,18 addressing the problem of plant and wildlife ecology in a foreign country,19 providing temporary lowcost housing and related services for missionary families on furlough for recuperation or training in the United States,20 and establishing exchange programs for children of the United States and foreign countries.21 IRC §170(c)22 imposes an additional requirement on corporate donors. When the domestic organization receiving a corporate contribution is an unincorporated entity, such as a trust, chest, fund, or foundation, the charitable entity must use the funds received within the United States.23 This additional requirement for deductibility applies only when a corporation makes a charitable donation to an unincorporated entity.24 Thus, a donation made by a corporation to a U.S. charitable corporation that has obtained §501(c)(3) status and expends part or all of its funds abroad qualifies for a charitable deduction under §170.25 EXAMPLE: Corporation A makes a donation to HELP, an unincorporated organization that provides medical assistance to needy families. HELP uses part of its funds to provide assistance to the poor within a village in Eastern Europe. Under §170(c)(2), corporation A’s donation to HELP will not be deductible. Corporation B makes a donation to AID, a tax-exempt corporation that was organized and/or created under the laws of the United States and that has received a ruling from the IRS that it is a §501(c)(3) organization. AID provides medical assistance to needy families and uses part of its funds to provide assistance to a village in Eastern Europe. Corporation B’s donation to AID is deductible under §170. (b)
Effect of “Friends” Organizations
Donations made directly to foreign charitable organizations generally are not deductible under §170.26 Even when the direct recipient of a contribution is a domestic entity otherwise qualifying under §170(c), a charitable deduction may be disallowed if the donation is found to be made, in substance, to a foreign entity. The issue of whether a domestic charitable organization is acting as a 17 18
19 20 21
22 23 24 25 26
Rev. Rul. 68-165, 1968-1 C.B. 253. Rev. Rul. 68-117, 1968-1 C.B. 251 (an organization that assisted developing countries by providing self-help programs, teaching modern farming methods, facilitating access to markets, and furnishing other technical assistance was held to be carrying out a charitable and educational purpose). Rev. Rul. 75-65, 1975-1 C.B. 10. Rev. Rul. 75-434, 1975-2 C.B. 205. Compare Rev. Rul. 80-286, 1980-2 C.B. 179; Rev. Rul. 69-400,1969-2 C.B. 114; Rev. Rul. 65-191,1965-2 C.B. 157 (activities considered charitable under §501(c)(3)) with Rev. Rul. 67-327, 1967-2 C.B. 187 (arranging of group tours for students and faculty of a university, to allow them to travel abroad, but with no other activity or instruction, does not qualify as a charitable activity under §501(c)(3))and Rev. Rul. 73-440,1973-2 C.B.177 (the purpose of attempting to influence changes in the laws of a foreign country does not qualify as a charitable activity under§501(c)(3)). See §170(c)(2). See §170(c)(2); Reg. §1.17A-ll(a). See Rev. Rul. 69-80, 1969-1 C.B. 65; Rev. Rul. 71-460, 1971-2 C.B. 231. Rev. Rul. 69-80, 1969-1 C.B. 65; see also Rev. Rul. 71-460, 1971-2 C.B. 234. See, e.g., ErSelcuk v. Commissioner, 30 T.C. 962 (1958); Welti v. Commissioner, 1 T.C. 905(1943).
䡲
784
䡲
c17.fm Page 785 Thursday, March 15, 2007 5:26 PM
17.2 DOMESTIC CHARITIES EXPENDING FUNDS ABROAD
mere conduit for a foreign organization arises with the use of “friends” organizations. A friends charitable organization is one that is organized to “solicit and receive contributions in the United States and expend the funds on behalf of a charitable organization in another country.”27 When a gift made to a U.S. taxexempt organization is earmarked for a foreign organization, the courts and the IRS take the position that the true recipient of the donation is the foreign organization, thus barring a charitable deduction.28 Whether the U.S. charity will be considered a conduit for the foreign organization turns on the amount of discretion and control the U.S. charity maintains over the funds it receives. This was illustrated by the five-fact situations analyzed by the IRS in Rev. Rul. 63-252.29 In the first three examples, the domestic organization entered into an arrangement with a foreign organization that committed the domestic organization to remit all funds raised to the foreign organization. In each of these situations, the IRS held that contributions made to the domestic organization were not deductible under §170. In contrast, a charitable deduction under §170 was allowed in the fourth example, in which the domestic organization did not solicit funds for a specific foreign organization and at all times maintained complete discretion and control to decide which foreign organization would receive funds. The fifth and final example in Rev. Rul. 63-252 clarifies the point that a domestic charitable corporation does not jeopardize deductibility merely by transferring contributed funds to a wholly owned foreign subsidiary that carries on the charitable activity in a foreign country, provided that the foreign organization was formed for administrative purposes and the domestic organization controls every facet of its operations.30 Other IRS rulings have reinforced the prohibition against earmarking contributions for a foreign charity and the principle that earmarked contributions cannot be “cleansed” simply by passing them through a domestic charity that lacks complete discretion and control over how the funds are to be used.31 The following procedures have been approved by the IRS as indicating that the domestic charity has maintained adequate control and discretion over funds, thus preserving the §170 deduction: • Provisions in the bylaws of the domestic organization stating that deci-
sions with respect to the making of grants to the foreign organization lie exclusively with the board of directors and must be in furtherance of the domestic organization’s charitable purpose32
27 28
29 30 31
32
See B. R. Hopkins, The Law of Tax-Exempt Organizations, 7th ed. (New York: John Wiley &Sons, 1998), 986, Section 44.5. See Channing v. United States, 4F. Supp. 33 (D.Mass. 1933), aff’d, 67F.2d986 (1stCir. 1933), cert. denied, 291 U.S.686 (1934); Thomason v. Commissioner, 2 T.C. 441 (1943); Rev.Rul. 54-580, 1954-2 C.B. 997: Rev. Rul. 63-252, 1963-2 C.B. 101. Rev. Rul. 65-252,1 963-2 C.B.101. Id., Example 5 (amplified by Rev. Rul. 66-79, 1966-1 C.B. 48). Gen.Couns. Mem. 35339 (Apr. 27,1973) (not enough discretion and control maintained by the domestic organization when funds were distributed to a foreign organization for “humanitarian purposes”); Rev. Rul. 66-79,1966-1 C.B. 48; see also Gen. Couns. Mem. 33032 (June22, 1965); Rev. Rul. 75-65, 1975-1 C.B. 10. Rev. Rul. 66-79, 1966-1 C.B. 48.
䡲
785
䡲
c17.fm Page 786 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
• Automatic board review of all requests for grants to the foreign organiza-
tion33 • A field investigation or audit of the use of the funds conducted by the
domestic organization34 • Written agreement by the foreign recipient organization that funds
received will be used solely to further the purpose for which they were granted35 • Required periodic accountings by the recipient organization to show that
the funds are being used consistently with the purpose of the grant36 • Absolute board discretion to refuse to make grants for any or all of the
particular purposes for which funds are being requested37 • Power within the board of directors to, at any time, withdraw approval of
the grant and redirect the grant funds to another charitable organization38 Although such procedures place additional administrative burdens on the domestic charity, they lend assurance that funds are being used in furtherance of the organization’s exempt purpose and therefore serve to preserve the organization’s exempt status and the deductibility of contributions.
17.3
POTENTIAL FOR ABUSE: THE USE OF CHARITIES AS ACCOMMODATING PARTIES IN INTERNATIONAL TERRORIST ACTIVITIES
Exempt organizations have traditionally played an important role in providing aid to the international community, especially as it relates to relief of poverty. However, in light of reports touting the alleged use of U.S.-based charities to fund international terrorist organizations,39 the U.S. government has introduced oversight initiatives, such as: the assessment of significant monetary fines, the freezing or blocking of the charity’s assets, and the elimination of the tax deductibility for contributions made to terrorist organizations.40 However, these efforts 33 34 35 36 37 38
39
40
See id. Rev. Rul. 75-65, 1975-1 C.B. 10. See id. See id. See id. Id. See Rev. Rul. 63-252, 1963-2 C.B. 101; Rev. Rul. 66-79, 1966-1 C.B. 48; Rev. Rul. 54580, 1954-2 C.B. 997; see also, Edie, Beyond Our Borders: A Guide to Making Grants Outside the U.S. (Council on Foundations, Washington, D.C., 1994), 8 (noting that the U.S. entity should have a board and purpose distinct from those of the foreign organization and that all fund-raising material should emphasize the independent discretion of the U.S. organization). Four People, Charity Charged with Sending Millions to Iraq, Associated Press, <www.wjla.com>, Feb. 26, 2003; Saudis Act to Stop Charity to al Qaida, Anwar Iqbal, United Press International, Dec. 3, 2002; List Documents al-Qaida Money Trail, Associated Press, <www.msnbc.com>, Feb. 19, 2003. The U.S. government issued several blocking orders pursuant to an Executive Order issued by President Bush on September 23, 2001, in the aftermath of the September 11, 2001, terrorist attack on the United States. (Executive Order 13224: Blocking Property and Prohibiting Transactions with Persons Who Commit, Threaten to Commit, or Support Terrorism, Sept. 24, 2001. Available at <www.nara.gov/fedreg/eo2001b.html>.) This Order allows the government to block or freeze the assets of certain foreign persons or organizations, and assets of persons that
䡲
786
䡲
c17.fm Page 787 Thursday, March 15, 2007 5:26 PM
17.3 POTENTIAL FOR ABUSE
regarding charitable activities occurring abroad have been hindered, in some cases, due to a lack of information available, as well as by the limitations placed on governmental interference due to the constitutional and civil liberties granted to U.S. citizens, such as the right to religious freedom.41 In response to the potential threat of terrorism, and the particular susceptibilities of charities as aids in the laundering of monies overseas, the U.S. government has responded with legislation and executive initiatives aimed at preventing the use of U.S.-based charities as accommodating parties to terrorist activities. (a)
Implications of Global Terrorism on Exempt Organizations
(i) U.S. Government Initiatives. Although the channeling of funds from U.S.based charities to foreign terrorist organizations was a concern prior to 2001, the events of September 11, 2001 triggered a concentrated effort by the U.S. government to thwart transactions between U.S.-based charities and terror operatives. Several U.S. initiatives, such as Executive Orders 13224 and 13226, new §501(p) of the Code, the USA Patriot Act of 2001, and the Department of Treasury’s “Best Practices,” embody the first responses taken by the U.S. government following September 11. (A) E XECUTIVE O RDER 13224 President George W. Bush signed Executive Order 13224 on September 23, 2001, declaring a national emergency in response to the events of September 11, 2001. Notably, the Order provided a directive to disrupt the financial support network for terrorists and terrorist organizations by authorizing the U.S. government to designate and block the assets of foreign individuals and entities, including organizations operating as charities that commit, or pose a significant risk of committing, acts of terrorism. In addition, the Order authorized the U.S. government to block the assets of individuals and entities, including charities operating in the United States, that provide support, services, or assistance to, or otherwise associate with, terrorists and terrorist organizations designated under the Order, as well as their subsidiaries, organizations, agents, and associates. As of July 2005, agents of the U.S. government, acting on the authority set forth in Executive Order 13224, have frozen the assets of 400 individuals and 65 entities.42 It is not known how many of these individuals and entities have actually been shown to support terrorism.
assist, sponsor or provide material or financial support for terrorist acts, and assets of certain specified terrorists organizations or persons. The Order also prohibits donations to such persons or organizations by eliminating tax deductibility for donations made to such organizations. 41
42
Nancy Ortmeyer Kuhn, “Best Practices for Nonprofits to Stop Unintended Funding of Terrorists,” Daily Tax Report, May 19, 2003. Religious organizations are not required to supply any information about the organization to the government. IRC §6033(a)(2). In addition, the Code requires that multiple warnings be provided by the IRS to the religious organization before any action is taken, IRC §7611, thereby making it difficult for the government to obtain necessary information regarding terrorist activities that the organization may be involved in. Executive Order 13224 (September 23, 2001).
䡲
787
䡲
c17.fm Page 788 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
(B) E XECUTIVE O RDER 13226 On September 30, 2001, President George W. Bush signed Executive Order 13226 reestablishing the President’s Council of Advisors on Science and Technology (PCAST). Originally established in 1990, PCAST enabled the President to receive advice from the private sector and academic community on technology, scientific research priorities, and math and science education. Under PCAST, the Secretary of State was authorized with the primary responsibility for designating terrorist organizations and individuals meeting the stated criteria for Foreign Terrorist Organizations, derived from the Anti-Terrorism and Effective Death Penalty Act of 1996, Public Law 104-132, §302. In addition, the Secretary of the Treasury was given primary responsibility for freezing assets of persons or entities determined to be acting on behalf of or financially supporting terrorists.43 (C) T HE USA P ATRIOT A CT OF 2001 Following the events of September 11, 2001, several pieces of legislation emerged, including H.R. 3004, The Financial Anti-Terrorism Act (FATA). FATA contained key provisions allowing the federal government to have an increased ability to control and monitor financial criminals, including the authority to criminalize their acts, as well as conferring federal jurisdiction over foreign money launderers and over money laundered through a foreign bank. The bill also required all U.S. financial institutions to install money laundering prevention initiatives. The FATA passed in the U.S. House of Representatives on October 17, 2001. On October 26, 2001, the Financial Anti-Terrorism Act was combined with the USA Act, to form the USA Patriot Act of 2001 (“Patriot Act”). The Patriot Act, also signed into law by President George W. Bush on October 26, 2001, further enumerated the criminal sanctions and provisions for the revocation of tax-exempt status of organizations found to have aided in the divestiture of funds to known terrorist organizations. For U.S.-based charities, the criminal sanctions mean that organizations may be found to have knowingly or intentionally provided material support or resources for terrorism. Another concern for U.S.-based charities is potential civil liability imposed under the Act should their funds end up in the hands of a terrorist group. Most importantly, nonprofits should be made aware that immunity will not be granted from these provisions despite the nature of their charitable mission or humanitarian good works. The Patriot Act was renewed on March 2, 2006 by a vote of 89–11 in the Senate, and on March 7, 2006, by a vote of 280–138 in the House of Representatives. President Bush signed the renewal, making all but two provisions of the Act permanent,44 into law on March 9, 2006. (D) D EPARTMENT OF THE TREASURY G UIDELINES Executive Order 13224 directed the Department of the Treasury (“Treasury”) to work with other elements of the federal government and the international community to develop a sustained campaign against the sources of terrorist financing. 43 44
Id. “In Bush’s Words: Attack on Two Terrorist-Supporting Financial Networks,” New York Times, B1 (November 8, 2001).
䡲
788
䡲
c17.fm Page 789 Thursday, March 15, 2007 5:26 PM
17.3 POTENTIAL FOR ABUSE
In November 2002, Treasury released “Anti-Terrorist Financing Guidelines: Voluntary Best Practices for U.S.-Based Charities.” In releasing these “Best Practices,” Treasury specifically pronounced that the guidelines were voluntary, and that they were not intended to modify or supersede any existing laws. Treasury’s “Best Practices” provided guidelines for U.S.-based charities actively engaged in grant-making to foreign organizations, as well as an outline of a proposed antiterrorist financing compliance program for grant-making organizations. Although Treasury recognized shortly after their release that certain exigent circumstances (such as a natural disaster) may make an application of the Guidelines challenging, it did not provide any further guidance if such circumstances should occur. The nonprofit sector registered an immediate response with Treasury; while U.S.-based charities recognized the importance of caution and prudence when making grants to international organizations post–September 11, nonprofits ultimately concluded Treasury’s Guidelines as impractical, given the already cumbersome processes of getting aid overseas. Most notably, the nonprofit sector registered concerns that the Guidelines burdened charitable organizations with the duty to act as government agents in ferreting out potential terrorists. (E) IRC §501(p) Section 501(p) of the Code was enacted into law on November 11, 2003 as part of the Military Family Tax Relief Act of 2003 (P.L. 108-121).45 This new section suspends the income-tax-exempt status of any organization as described under §501(p)(2).46 An organization is defined in §501(p)(2) if the organization is designated or otherwise individually identified: (1) in certain provisions of the Immigration and Nationality Act as a terrorist organization; or (2) in or pursuant to an Executive Order that is related to terrorism and issued under the authority of the International Emergency Economic Powers Act or §5 of the United Nations Participation Act of 1945; or (3) in or pursuant to an Executive Order issued under the authority of any federal law, if the organization is designated or otherwise individually identified in or pursuant to the Executive Order as supporting or engaging in terrorist activity (as defined in the Immigration and Nationality Act) or supporting terrorism (as defined in the Foreign Relations Authorization Act) and the Executive Order refers to §501(p)(2).47 Under §501(p)(3) of the Code, suspension of an organization's tax exemption begins on the date of the first publication of a designation or identification with respect to the organization or the date on which §501(p) was enacted, whichever is later.48 This suspension continues until all designations and identifications of the organization are rescinded under the law or Executive Order under which such designation or identification was made. No deduction is allowed under any provision of the Code for any contribution to an organization during any period in which the organization's tax exemption is suspended under §501(p).
45 46 47 48
Military Tax Relief Act of 2003 (HR 3365). IRC §501(p)(2). See IRC Announcement 2004-56. IRC §501(p). Id.
䡲
789
䡲
c17.fm Page 790 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
Most significantly, donors are not permitted a charitable contribution pursuant to §170 (relating to the income tax). As of this writing, the tax-exempt status of six organizations has been suspended automatically by operation of §501(p).49 The IRS continued to employ various measures aimed at ensuring that no terrorist organizations receive or continue to receive tax-exempt status; applications for exemption are periodically screened for terrorist names and the IRS has developed the technologies to electronically review filed Forms 990 and 990-PF for known terrorist organizations.50 In addition, in 2005, the IRS launched a major overhaul of Form 1023, asking for more specific information from applicants with respect to the organization’s intended foreign activities.51 (b)
The Nonprofit: An Ideal Entity for Exploitation?
Nonprofits can offer an ideal target for exploitation by terrorist groups, in large part because of the nature of the work undertaken by the charities and the broad public support that many charitable organizations marshal. Specifically, the legitimate activities of charitable organizations, such as the operation of schools, hospitals, refugee camps, job training, and social welfare programs, may provide the ideal cover under which terrorist groups can generate support for their causes while covertly promulgating an extremist ideology. EXAMPLE: The Qu’ranic Literary Society, as a part of its religious, charitable mission, creates a literacy center to promote the teaching of the Qur’an, the Muslim holy text. Donors are solicited to contribute funds toward the building of a Qur’an Literacy Center, as well as for its maintenance. After the Society collects revenue from its donors, some of the funds are diverted to support an Al-Qaeda training camp. In addition to masking an illegitimate goal (such as training suicide terrorists) behind a seemingly valid and laudable purpose (like running a literary or religious school), charities are also ideal entities for terrorists because of their general ability to attract high numbers of witting and unwitting donors, thus increasing the amount of cash available to terror operatives. EXAMPLE: The Holy Land Foundation for Relief and Development (HLF), a U.S.based §501(c)(3) founded in 1987 in Los Angeles, California, solicited funds for Muslims displaced from their homes as a result of acts of war in the Middle East as part of its charitable mission to aid the poor. In addition to its work in the Middle East, HLF attested to raising funds for displaced refuges in Chechnya, Kosovo, and Turkey. Operating in Texas, California, Illinois and New Jersey, HLF raised millions of dollars from collections made by individuals at U.S. mosques, calling themselves the largest Muslim charity in the United States. In July 2004, the U.S. 49 50 51
Comments of Commissioner Mark Everson, Committee of Finance, United States Senate (April 5, 2005). Available at: http: finance.senate.gov/sitepages/hearing0305.htm Id. Id
䡲
790
䡲
c17.fm Page 791 Thursday, March 15, 2007 5:26 PM
17.3 POTENTIAL FOR ABUSE
Department of Justice handed down a 42-count indictment against the HLF and its leadership. The indictment charged HLF with conspiracy to provide aid to Hamas and to the families of Hamas-led suicide terrorists.52 Coupled with the public’s often unknowing and wide support of charities is a general disinclination of governments to investigate these charities and/or the lack of any oversight mechanisms in foreign countries. Even in the United States, fraudulent schemes involving charities often only come to light after an insider or a person with knowledge of the internal affairs of a charity makes a complaint. In addition to these factors, charities are also ideal entities for illegal exploitation because funds given by donors are designed to move in only one direction; accordingly, it is not unusual that a charity transfer a large sum of money without a corresponding return of value to the charitable entity. Finally, U.S.-based charities—in particular, those with an international focus—often direct their charitable efforts in regions of ongoing global conflict, such as the Palestinian territories or Afghanistan, areas that are also prime locations for terrorist networks. Consequently, the transfer of supplies under the auspices of “charitable work” may provide optimal concealment for the movement of goods, weapons, and cash used to support terror cells. (c)
Alternative Money Transfers: Tradition-Meets-Need or Vehicle for Terror?
One of the more complex matters involved in the possible use of nonprofit entities in money laundering schemes is a practical reality that in order for legitimate charities to accomplish their good works, they often must use locally acceptable means in order to get funds to affected areas. EXAMPLE: In the aftermath of the 2005 Southeast Asian tsunami, local aid workers in Banda Ache, Indonesia, without access to or familiarity with traditional banking systems, asked to receive amounts of cash from U.S. charities according to a cash courier system. In a couriered transaction, the U.S.-based organization gives funds directly to a person in the United States, with the U.S. person then transferring a code to a “cleared” person in Indonesia. The Indonesian designee then retrieves the funds from a local cash courier. The cash courier system, while helpful in exigent situations as in the proceeding example, likewise illustrates one of the primary accountability problems facing charities engaged in international relief efforts. Although the cash courier system sometimes presents the preferred (and in some cases, only) method for delivery of funds overseas, once the code leaves the hands of the U.S. intermediary, so, too, may oversight of the transferred funds. Nonetheless, the cash courier system is sometimes relied upon by major U.S. organizations wanting to aid in relief efforts quickly and directly. Adding to the complexity of this issue, cash couriers are most often utilized in Arabic countries where the involvement of charities in local aid efforts may be 52
“In Bush’s Words: Attack on Two Terrorist-Supporting Financial Networks,” New York Times, B1 (November 8, 2001).
䡲
791
䡲
c17.fm Page 792 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
more susceptible to terrorist interception. Hawala, a Middle Eastern system that began centuries ago on the Silk Road and Sahara desert caravans,53 still thrives upon a desire of expatriated relatives living in the United States to send aid to their relatives. The backbone of hawala is the trust relationship that exists between the hawala dealer and the ultimate transferee: EXAMPLE: A Pakistani expatriate now living and working in Washington, DC, as a taxi driver sends US$3,000 to his bother and his family in Lahore each month. Although he can go to a bank in DC to request a wire transfer, the bank will likely want him to open an account. In addition, the bank will most likely want to charge a fee commensurate with the amount of the transfer. As an alternative, the taxi driver chooses a well-known hawala dealer in suburban Maryland with whom he negotiates a fee and an exchange rate. He gives the hawala the US$3,000 and the fee, upon which the hawala then calls, faxes, or sends an e-mail to another hawala dealer in Lahore. The hawala dealer in Lahore then arranges to have the equivalent of US$3,000 delivered in rupees to the brother. The transaction takes place over the course of 24 hours, as opposed to a bank-wire transaction that could have taken up to a week or more. While it is estimated that millions of dollars are being transferred out of the United States each year by hawalas, the only reported crimes associated with hawalas have been limited to drug trafficking.54 On November 7, 2001, federal agents raided the U.S. offices of al-Barakaat, a chain of well-known hawalas founded by a Somali immigrant in 1985.55 However, no one was charged with any crime in connection with the raid harsher than fraud. Moreover, the federal September 11 Commission, after conducting an investigation of all al-Barakaat offices operating in the United States, found “no direct evidence at all of any real link between al-Barakaat and terrorism.”56 Although to date there have been no confirmed links of U.S. hawalas to terrorist organizations, the potential for hawalas to serve as vehicles for illegal transfers remains. While cash couriers and hawalas do provide a way to get cash into the hands of those in need of aid in the most efficient manner, the lack of oversight, and the fact that most of these alternative dealers do not maintain records of these transfers, provide ripe ground for abuse.
17.4
GUIDELINES FOR U.S.-BASED CHARITIES ENGAGING IN INTERNATIONAL AID AND INTERNATIONAL CHARITIES
Despite an ongoing (see below) criticism of the Treasury Department’s “Voluntary Best Practices” by charitable organizations and practitioners (i.e., that they are onerous and vague), there appears to be a consensus among professionals in 53 54 55 56
Id. Available at: http://www.ombwatch.org/npadv/PDF/treascomms/WGcomms.pdf. “In Bush’s Words: Attack on Two Terrorist-Supporting Financial Networks”, New York Times, B1 (November 8, 2001). Id.
䡲
792
䡲
c17.fm Page 793 Thursday, March 15, 2007 5:26 PM
17.4 GUIDELINES FOR U.S.-BASED CHARITIES
the grant-making field on how an organization can minimize the risk of violating Executive Order 13224, while also minimizing the burden to the organization.57 First, an organization should conduct a risk assessment to measure the probability that its grants might be diverted to fund terrorists or terrorist organizations. Second, an organization should develop a compliance program based on the outcome of the risk assessment. Finally, an organization should document compliance procedures and stay abreast of new laws, guidance, and interpretations. In conducting a comprehensive risk assessment, a grantor organization should first compile a list of all organizations and programs that receive grants. Second, the exempt organization should cross-reference the names on its list with the list of Specially Designated Nationals (SDNs) to ensure that the grantees are not recognized supporters of terrorists.58 Third, it should compile a list of factors that may reveal high-risk grantees. Such “risk factors” include: • Whether the grantee organization is an established organization with a
history of charitable accomplishments • Whether the grantor organization has prior experience dealing with the
grantee organization, and the grantee organization has a record of using grant funds for the intended purposes • If the grantmaker has no prior experience with the grantee organization
and it is not an established organization, whether the grantmaker can obtain references from other trusted sources (including nongovernmental organizations) • Whether the grantee organization has specific charitable objectives,
strong leadership, and internal controls • Whether the grantee organization currently receives funding from a U.S.
government agency that conducts its own vetting process • Whether the grantee organization meets the standards of an accrediting
organization that prescribes best practices for organizations in its own jurisdiction • Whether the grant agreement gives the grantee organization unlimited
discretion to use the funds of its charitable programs or restricts use of the funds for specific projects, activities, or expenditures • Whether the grantee organization or the project to be funded is located in
a country that has adopted antiterrorism legislation • Whether the grantee organization or the project to be funded is located in
a country designated by the U.S. Secretary of State as a state sponsor of terrorism
57
58
See, e.g., Janne G. Gallagher, “Grantmaking in an Age of Terrorism: Some Thoughts About Compliance Strategies,” International Dateline (Second Quarter 2004); Martin B. Schneiderman, “Seeking a Safe Harbor,” Foundation News & Commentary, p. 34 (May/June 2004). Department of the Treasury, Office of Foreign Assets Control, “Specially Designated Nationals (SDN) List,” available at http://www.treas.gov/offices/enforcement/ofac/sdn/.
䡲
793
䡲
c17.fm Page 794 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
• Whether the grantee organization or the project to be funded is located in
a country experiencing significant social unrest, civic turmoil, and/or internal violence59 This list is far from exhaustive.60 However, it does indicate the types of factors that should be considered in assessing the foreign organization’s risk. Finally, U.S.-based charity should apply the “risk factors” to each grantee organization. Because no single factor is dispositive, an organization should consider the aggregate of factors in determining the level of risk.61 Once the grantor organization has identified the grantee organizations that pose the greatest risk, it should develop a program to ensure compliance with Executive Order 13224. Under this program, the grantor should examine the grantee organization’s formation and operational documents and financial statements that pose the highest risks, require reports regarding the grantee’s use of grant funds, draft an agreement ensuring that the funds be used for charitable purposes, and even conduct a site visit if the risk assessment justifies the expense.62 Once again, the grantor organization should check the list of SDNs against the results of the compliance program to ensure that the grantee has no connection to recognized terrorists.63 Finally, a grantor organization should document all of the steps it has taken to comply with Executive Order 13224 in advance of an audit. The grantor should keep detailed records of the grantee organizations, the results of the risk assessment, and any compliance measures instituted to deal with the high-risk grantee organizations. These records should help ensure a speedy audit if one should occur. Furthermore, the grantor should keep abreast of all new laws, interpretations, and guidance regarding the antiterrorist financing laws to ensure continued compliance. A detailed analysis with respect to the most recent development in this area of the law concludes this chapter.
17.5
GENERAL GRANT-MAKING RULES
A “friends” organization is not the only vehicle by which a domestic charity may expand its activities beyond U.S. borders aside from a joint venture with a foreign entity. A domestic charity may be able to make a grant directly to a foreign organization. EXAMPLE: A domestic exempt organization, Shelter, which provides construction supervision and social services in connection with the building of low-income housing for the homeless, wishes to provide similar assistance to Survival, an NGO created and operating in the Philippines. Shelter proposes to make a direct cash grant to Survival to further the work that Survival is doing in the community. 59
60 61 62 63
Council on Foundations, “Comments on U.S. Department of the Treasury Anti Terrorist Financing Guidelines: Voluntary Best Practices for U.S.-Based Charities,” pp. 16–17 (June 20, 2003). See id. Id. Id.; Janne G. Gallagher, “Grantmaking in an Age of Terrorism: Some Thoughts About Compliance Strategies,” International Dateline (Second Quarter 2004). Department of the Treasury, Office of Foreign Assets Control, “Specially Designated Nationals (SDN) List,” available at: http://www.treas.gov/offices/enforcement/ofac/sdn/.
䡲
794
䡲
c17.fm Page 795 Thursday, March 15, 2007 5:26 PM
17.5 GENERAL GRANT-MAKING RULES
The legal framework that must be observed when a domestic charity makes a grant to a foreign organization depends on whether the domestic organization is a public charity, as distinct from a private foundation.64 In general, private foundations are subject to much stricter requirements when making grants, so as to ensure that the grant is treated as a “qualifying distribution”65 to satisfy the annual minimum payout requirements, and not as a “taxable expenditure,” which would subject the foundation to the imposition of excise taxes.66 (a)
Public Charity Grant-Making Considerations
No statutory requirements are imposed on a public charity when it makes a grant of its funds to another charitable organization, even if the recipient is a foreign organization. CAVEAT Nevertheless, public charities making grants to foreign organizations should take steps to ensure that the funds will be used by the foreign charity for charitable purposes. Such measures are necessary if only as a matter of substantiation of continuing entitlement to exempt status; the domestic public charity must at all times be able to demonstrate to the IRS that the organization’s funds are being used to further charitable purposes. An IRS publication noted that an otherwise qualified §501(c)(3) domestic organization that “fails to exercise, or has too little discretion and control over the use of such funds to assure their use exclusively for charitable purposes” may forfeit its exempt status, because the organization will not be able to show that it operates exclusively for charitable purposes.* *
See Chapter 2. See also Edie, Beyond Our Borders, 18 (citing to 1992 for Fiscal Year 1993) Exempt Organizations Continuing Professional Education Technical Instruction Program at 233); Rev. Rul. 68-489, 1968-2 C.B. 210.
Although the issue of discretion and control has been discussed in the context of friends organizations, the IRS has not directly addressed this subject with respect to public charity grants. To ensure that it does not jeopardize its taxexempt status, a domestic public charity should make certain that, at a minimum, it retains the discretion to decide to whom and under what circumstances grants will be made. A public charity making grants to foreign organizations may find it necessary to incur additional administrative or legal costs to make certain that the grants made to foreign organizations are used by the foreign organizations for charitable purposes. For example, the public charity should obtain documentation that the foreign organization will qualify as a public charity. To do so, it must enter into a written agreement with the foreign organization that the funds received will be used for specific charitable activities and obtain a
64 65 66
See Chapter 10 for a general discussion on the distinction between a public charity and a private foundation. See §4942(g)(1)(A); Reg. §53.4942(a)-3. See Section 16.3(b) for a discussion of private foundation grant making. See §§4945(a), (d)(3), and (d)(4).
䡲
795
䡲
c17.fm Page 796 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
year-end accounting from the foreign organization as to how the funds have been used and what funds still exist.67 (b)
Private Foundation Grant-Making Rules
Private foundations making grants to domestic or foreign charitable organizations have two basic concerns. First, the grants must be treated as qualifying distributions under §4942(g) in order to avoid an excise tax on undistributed income under §4942.68 Second, the grants must not be treated as taxable expenditures,69 which would subject the foundation to an excise tax under §4945.70 Under §4942, a grant by a domestic private foundation to a foreign organization will be treated as a qualifying distribution71 if the domestic charity has made a good faith determination72 that the foreign organization is the equivalent of a public charity73 or a private operating foundation.74 If the domestic charity cannot make a good faith determination that the foreign organization is the equivalent to a public charity or a private operating foundation, then the distribution to the foreign organization must meet the 12-month flow-through requirements of §4942(g)(3) to be treated as a qualifying distribution.75 Under §4945, a “taxable expenditure” by a private foundation is any amount paid or incurred: 1. To influence legislation 2. To influence a specific public election or carry on a voter registration drive 3. To grant funds to an individual for travel, study, or similar purposes unless certain requirements are met 4. To grant funds to an organization unless it is described in §§509(a) or 4940(d)(2) or unless the private foundation exercises expenditure responsibility with respect to the grant in accordance with §4945(h), or 5. For a non-§170(c)(2)(B) purpose76 67 68
69
70 71 72 73 74 75
76
See Edie, Beyond Our Borders, 18 (suggested procedures for public charities making grants to foreign organizations to ensure that the funds are being used for charitable purposes). See §4942(a)-(c).A qualifying distribution is a distribution of funds paid to accomplish one or more charitable purposes described in §170(c)(2)(B), other than any contribution to an organization controlled directly or indirectly by the foundation or one or more disqualified persons as defined in §4946 with respect to the foundation. For a discussion on who is a “disqualified person” with regard to a private foundation, see Section 10.2. See also §4942(g)(1)(A); Reg. §53.4942(a)-3; §4946(g). See §4945(d). Taxable expenditures include certain grants to individuals and grants to organizations that do not meet the requirements under §§4945(d)(4)(A) and (B). A grant will not be treated as a taxable expenditure if it is made to a public charity or private operating foundation, or if the foundation exercises expenditure responsibility for that grant. See Reg. §53.4945-5. See §4945(a). See Reg. §53.4942(a)-3(a)(6). See Reg. §53.4942(a)-3(a)(6); §§509(a)(1), (2), and (3). See §§509(a)(1)-(3) (describing organizations that qualify as public charities); Reg. §53.4942(a)-(3)(a)(6). See §4943(j)(3). See §4942(g)(3) and Reg. §53.4942(a)-3(c)(1), which set forth the rules pertaining to the “12-month pass-through rules” for qualifying distributions. For a general discussion of the 12-month pass-through rules of §4942(g)(3), see Hill and Kirschen, Federal and State Taxation of Exempt Organizations §13.06(2)(1994). See §4945(d).
䡲
796
䡲
c17.fm Page 797 Thursday, March 15, 2007 5:26 PM
17.6 FOREIGN ORGANIZATIONS RECOGNIZED BY THE IRS
Therefore, a private foundation will incur excise taxes under §4945 if it makes a grant where the funds are used for any of the purposes listed above. Furthermore, the IRS has ruled that the making of grants to foreign organizations is not, in itself, a business engaged in for profit and therefore not subject to UBIT.77 EXAMPLE : X, a private foundation, made a grant to M, an impoverished foreign country, for the purpose of overhauling M’s infrastructure. M is neither a disqualified person with respect to X nor controlled by a disqualified person. However, X hired an on-site project manager to supervise the project and ensure that the funds are spent properly. X will not be subject to excise tax because it is a qualifying distribution (a foreign country is typically equivalent to a foreign charity) and the grant is not a taxable expenditure. Furthermore, X will not recognize unrelated business income because it is not directly engaged in a business for profit with respect to the grant.78
17.6
FOREIGN ORGANIZATIONS RECOGNIZED BY THE IRS AS §501(c)(3) ORGANIZATIONS
The IRS has held that the determination as to whether an organization qualifies for tax-exempt status under §501(a) depends on the nature of the activity the organization conducts, not the location of the organization’s operations.79 Therefore, foreign organizations may apply for and obtain tax-exempt status under §501(c)(3) by filing a Form 1023 with the Covington, Kentucky, office of the IRS.80 If a foreign organization has received a ruling that it is a §501(c)(3) “public” charitable organization, a private foundation need not exercise expenditure responsibility for grants made to that organization, and a grant will not be a taxable expenditure to the private foundation under §4945.81 EXAMPLE: Hunger, an organization that was created and operates in the Philippines to provide food and shelter to needy persons, has applied for and received a ruling from the IRS recognizing it as a §501(c)(3) public charity. National, a domestic private foundation, makes a grant to Hunger for $5,000 to assist Hunger in its charitable activities in the Philippines. Under §4942, the grant to Hunger will be treated as a qualifying distribution and, under §4945, the grant will not be a taxable expenditure to National.
77 78 79
80
81
Priv. Ltr. Rul. 200408033. This example was based on Priv. Ltr. Rul. 200408033. See Rev. Rul. 66-177, 1966-1 C.B. 132 (“The fact that an organization has been formed under foreign law will not preclude its qualification as an exempt organization under section 501(a) of the Internal Revenue Code of 1954 if it meets the tests for exemption under that section”). Most foreign charities do not apply for §501(c)(3) status mainly because of the administrative cost involved and the burdens associated with applying for and maintaining §501(c)(3) status, such as the ongoing reporting requirements of filing annual tax returns on Form 990 for the organization. See §4945(d)(4)(A). The grant will also be treated as a qualifying distribution under §4942.
䡲
797
䡲
c17.fm Page 798 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
A caveat in regard to a private foundation’s ability to rely on a ruling that an organization is a public charity arises if the public charity has gone through a “substantial and material change” in its sources of support.82 The substantial and material change exception applies to an organization that qualifies for public charity status based on the sources of support it receives.83 Private foundations may rely on a public charity’s ruling, even when the organization has undergone a change in its sources of support, until notice of the organization’s disqualification is made public.84 A private foundation, however, may not rely on a public charity’s ruling when the foundation itself is responsible for the material and substantial change in the organization’s sources of support.85 The IRS has published guidelines in Rev. Proc. 81-6 as to when a private foundation will not be considered responsible for a substantial and material change in a public charity’s sources of support. 86 The Revenue Procedure outlines the method for determining whether the organization receiving the grant or contribution from the private foundation meets the “support test” so as to qualify as a public charity under §509(a)(1), (2), or (3). If the requirements of Rev. Proc. 81-6 are met, the foundation will not be considered responsible for the material and substantial change in the recipient organization’s sources of support.87 In 1989, the IRS proposed an alternate method by which a grantor organization would not be considered responsible for a substantial change in a public charity’s sources of support.88 Revenue Procedure 89-23 sets forth three requirements that must be met at the time the grant is made to the public charity: 1. The recipient organization has received a ruling or determination letter (or an advance ruling or determination letter) that it is a publicly supported organization.89 2. Notice of a change of the recipient organization’s status as a publicly supported charity90 has not been made public, and the private foundation has not acquired knowledge that the IRS has given notice to the recipient organization that it will be deleted as a publicly supported charity. 3. The recipient organization is not controlled directly by the grantor private foundation.91 82
83 84 85 86 87 88 89 90 91
See Reg. §§1.170A-9(e)(4)(v) and 1.509(a)-3(c)(1)(iii). See generally M. Sanders, “Support and Conduct of Charitable Operations Abroad,” Annual Notre Dame Institute on Charitable Giving, Foundations and Trusts (1976). See §§170(b)(1)(A)(vi) and 509(a)(2). See also Edie, Beyond Our Borders. See Reg. §§1.170A-9(e)(4)(v)(B), 1.509(a)-3(c)(1)(iii)(a). Notices of disqualifications are published weekly in the Internal Revenue Service Bulletin. See Reg. §1.170A-9(e)(4)(b). Rev. Proc. 81-6, 1981-1 C.B. 620. See M. Sanders and C. Roady, 298-3rd Tax Management (TM) Portfolio. Private Foundations-Taxable Expenditures (Sec. 4945), A-42. See Rev. Proc. 81-6, 1981-1 C.B. 620. See Rev. Proc. 89-23, 1989-1 C.B. 844; Sanders and Roady, 298-3rd T.M. Private Foundations–Taxable Expenditures (Sec. 4945), at A-43. See Rev. Proc. 89-23, 1989-1 C.B. 844. See also §§170(b)(1)(A)(iv) and 509(a)(2). See Rev. Proc. 89-23, 1989-1 C.B. 844. See Rev. Proc. 89-23, 1989-1 C.B. 844 (§3.03). Control is defined as the ability of the foundation and/or disqualified persons of the foundation to require the recipient organization to perform any act that significantly affects its operations, or to prevent the organization from performing such act.
䡲
798
䡲
c17.fm Page 799 Thursday, March 15, 2007 5:26 PM
17.7 PUBLIC CHARITY EQUIVALENCY TEST
A private foundation will also not be considered responsible for or aware of a material and substantial change if the foundation makes a grant to the public charity in reliance upon a written statement from the recipient public charity that the grant being made by the private foundation will not result in the public charity’s losing its status under §170(b)(1)(A)(vi).92 A foundation will not be considered responsible for a material and substantial change in a public charity’s sources of support if the grant made by the foundation qualifies as an “unusual grant.”93 An unusual grant, under the regulations,94 must meet six specific factors95 and must “adversely affect”96 the status of the recipient public charity organization. If the foundation is not considered to be responsible for, or aware of, the public charity’s change in status owing to a “material and substantial” change in its sources of support, then the foundation need not exercise expenditure responsibility for the grant, and the grant will not be treated as a taxable expenditure under §4945.97
17.7
PUBLIC CHARITY EQUIVALENCY TEST
In most cases, the prospective foreign grantee will not have obtained a ruling from the IRS recognizing it as a §501(c)(3) public charity. In such situations, the regulations pursuant to §4945 provide a public charity equivalency test under which a foreign organization may be treated as though it were a public charity described in §170(c)(2)(B).98 If the foreign organization meets the equivalency test, the domestic foundation is not required to exercise expenditure responsibility for grants made to the foreign organization. Further, a grant will not be treated as a taxable expenditure under §494599 but will be treated as a qualifying distribution under §4942.100 The equivalency test allows domestic foundations to treat grants made to foreign organizations that have not received a ruling from the IRS as though they were grants made to an organization meeting the requirements of §509(a).101 The test has two prongs, both of which must be satisfied. First, the 92 93
94 95 96 97 98
99 100 101
See Reg. §1. 170A-9(e)(4)(c). See Reg. §1.509(a)-(3)(c)(4), which sets forth nine factors used to determine whether a particular contribution may be treated as an “unusual grant.” No one factor is determinative, and all pertinent facts and circumstances are taken into account when applying the factors. See also Reg. §1.170A-9(e)(6)(ii). The unusual grant exception is generally intended to apply to substantial contributions and bequests from disinterested parties in situations where the contribution was attracted by reason of the publicly supported nature of the organization; they are grants or contributions that are unusual or unexpected as to the amount; and they are grants or contributions that would, by reason of their size, adversely affect the ability of the recipient organization to meet the one-third support test under Reg. §1.509(a)-3(c)(3). See Rev. Proc. 81-7, 1981-1 C.B. 621; Sanders and Roady, 298-3rd T.M. Private Foundations—Taxable Expenditures (Sec. 4945), at A-43. See Rev. Proc. 81-7,1981-1 C.B. 621. See Reg. §1.170A-9(e)(6)(ii); Reg. §1.509(a)-3(c)(3). See §4945(h). The grant will also be treated as a qualifying distribution under §4942(g). See Reg. §53.4945-5(a)(5). See also Sanders, “Support and Conduct of Charitable Operations Abroad”; Sanders and Roady, 298-3rd T.M. Private Foundations—Taxable Expenditures (Sec. 4945), at A-40. See Reg. §53.4945-5(a)(5). See Reg. §53.4942(a)-3(a)(6). See §509(a)(1)-(3).Organizations meeting the requirements of one of these sections are qualified as public charities for which the private foundation need not exercise expenditure responsibility.
䡲
799
䡲
c17.fm Page 800 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
domestic foundation manager must make a “reasonable judgment” that the foreign organization is an organization described in §501(c)(3).102 Second, the foundation must make a “good faith determination” that the foreign organization is an organization described in §509(a)(1), (2), or (3). 103 Until 1992, little guidance was available as to what would satisfy the reasonable judgment and good faith determination requirements. Then, in 1992, the IRS issued Rev. Proc. 92-94,104 outlining procedures a foundation may follow in determining whether a foreign organization will qualify as a public charity equivalent.105 A private foundation will be deemed to have satisfied the reasonable judgment and good faith determination requirements set forth in the regulations if the foundation bases its determination on a “current qualified affidavit.”106 The Revenue Procedure lists in detail what information the domestic foundation is required to obtain from the foreign organization to compile a current qualified affidavit.107 In reviewing the requirements for a current qualified affidavit, one finds that the information and detail required are almost identical to the information needed to complete a Form 1023, were the foreign organization to apply to the IRS for a determination letter recognizing it as a §501(c)(3) organization. A benefit of being able to use a current qualified affidavit is that a foreign organization that receives grants from more than one private foundation may use the same affidavit for all private foundations.108 Therefore, although the IRS appears to be providing some flexibility to foreign organizations in this area, it obviously prefers that foreign organizations desiring public charity status go through the formalities of applying for a ruling.
17.8
EXPENDITURE RESPONSIBILITY
If a domestic foundation makes a grant to a foreign organization that is not a public charity,109 an exempt foundation,110 or an organization that meets the public charity equivalency test, the foundation is required to exercise expenditure responsibility with respect to that grant.111 Expenditure responsibility requires that a foundation exert reasonable efforts and establish adequate procedures to ensure that the funds being granted are used solely for the purposes for which they were granted.112 Foundations are also required to obtain full and
102
103
104 105 106 107 108 109 110 111 112
See Reg. §§53.4945-6(a)(ii), 53.4945-6(c)(2)(ii), which state that the term “reasonable judgment” shall be given the generally accepted legal sense within the outlines developed by judicial decisions in the law of trusts. See Reg. §53.4945-5(a)(5). The good faith determination required under the equivalency test is identical to the good faith determination that must be made under §4942 for the grant to be treated as a qualifying distribution. See Rev. Proc. 92-94,1992-2 C.B. 507. See id. See Rev. Proc. 92-94, 1992-2 C.B. 507 (§4). See Rev. Proc. 92-94,1992-2C.B. 507. See generally Edie, Beyond Our Borders, 22-26. See §509(a)(1)-(3). See §§4945(d)(4)(A),4940(d)(2). See §4945(d)(4)(B). Failure by the foundation to exercise expenditure responsibility would result in a 10 percent tax imposed on the foundation. See §4945(h)(1).
䡲
800
䡲
c17.fm Page 801 Thursday, March 15, 2007 5:26 PM
17.8 EXPENDITURE RESPONSIBILITY
complete reports on how the funds are being spent113 and submit detailed reports to the IRS.114 Grants to foreign private foundations are subject to expenditure responsibility requirements, whereby the foundation must: (1) conduct a pre-grant inquiry about the foreign grantee,115 (2) obtain a detailed written commitment from the grantee regarding use of the funds and an agreement to return funds not so used,116 (3) obtain detailed periodic and final reports from the grantee,117 and (4) make detailed annual reports to the IRS regarding the grant. 118 To avoid the administrative burden imposed by these special requirements for grants to foreign private foundations, it is recommended that the foundation consider adopting a general policy that grants are to be made solely to public charities or their equivalents.119 Deviations from this strict public charity policy may still be entertained, but only upon careful case-by-case legal review. For example, a domestic private foundation might submit a grant proposal that its grants committee considers meritorious, notwithstanding that the prospective foreign grantee cannot meet the public charity requirements. At that point, the grant committee should determine whether to undertake the process of confirming the applicant’s eligibility to receive grant monies that may not qualify for minimum distribution purposes.120 The rules pertaining to expenditure responsibility are complex and can often be difficult to comply with in dealing with foreign grantees, owing to language barriers and the differences in record-keeping methods used in different countries. If a private foundation is required to exercise expenditure responsibility and fails to do so, however, or does not comply with all of the requirements, the foundation and its managers may be subject to taxes and penalties.121 113 114 115 116 117
118 119 120 121
See §4945(h)(2). See §4945(h)(3); Reg. §53.4946-5(b)-(e); see also Sanders and Roady 298-3rd T.M. Private Foundations—Taxable Expenditures (Sec. 4945),at A-46. See Reg. §53.4945-5(b)(2). Id. See Reg. §53.4945-5(b)(3). When the grantee organization is a foreign organization, Reg. §53.4945-5(b)(5) provides that the requirement that the written commitment include restrictions on the use of grant funds for certain types of activities will be deemed satisfied if such restrictions are stated in appropriate terms under the laws or customs of the country in which the foreign organization is located. To avail itself of this alternate provision, the domestic foundation must obtain from the foreign organization a written affidavit stating that such restrictions are imposed on the foreign organization under the foreign laws or customs and are substantially equivalent to the restrictions set forth in the regulations. Id. Many private foundations, however, find meeting the expenditure responsibility requirements to be less burdensome than relying on the equivalency qualification. See§4942(g)(1)(A). An initial tax of 10 percent of the amount of the taxable expenditure is imposed by §4945(a)(1). In addition, §4945(a)(2) imposes a tax on the foundation manager for “knowingly” agreeing to make a taxable expenditure. Additional taxes are imposed on the foundation and its managers for failing to correct the taxable expenditure. See §4945(b). This tax is imposed in addition to the initial tax imposed on the private foundation and foundation manager under §4945(a). For a more general discussion on the penalties related to taxable expenditures of private foundations, see Hopkins, The Law of Tax-Exempt Organizations, Section 24.6. See also Sanders and Roady, 298-3rd T.M. Private Foundations—Taxable Expenditures (Sec. 4945), at A-50; Hans S. Mannheimer Charitable Trust v. Commissioner, 93 T.C. 35 (1989) (Tax Court in effect issued a warning to all grantors that regardless of how technical and redundant they may seem at times, the expenditure responsibility requirements must be satisfied).
䡲
801
䡲
c17.fm Page 802 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
17.9
DOMESTIC CHARITIES ENTERING INTO JOINT VENTURES WITH FOREIGN ORGANIZATIONS
Historically, domestic organizations that extend their charitable efforts into the international sector have done so by expending funds they have received from contributions made by U.S. individuals and/or corporations, either through friends organizations or grants made directly to foreign entities. As noted, the administrative burden accompanying the use of friends organizations and grant making can be substantial. Moreover, since 1982, much of the federal support to domestic charities has decreased as a result of congressional budget cuts, thereby limiting the funds that domestic exempt organizations have to further their charitable purposes overseas. Thus, another alternative for a domestic taxexempt organization expanding its operations abroad may be to engage in a partnership122 or joint venture with foreign parties conducting charitable activities in a foreign country.123 EXAMPLE: A domestic tax-exempt organization, whose purpose is to provide technical support to communities by assisting homeless and needy persons in the community to be self-sufficient, wishes to expand its efforts into undeveloped countries in Africa. It establishes a farming and livestock operation to provide food to persons in the community. This operation necessitates the purchase of land, tools, and livestock. To raise the needed capital, the domestic organization proposes entering into a partnership in which the domestic organization would be the general partner and local merchants would be the limited partners. Net revenues generated from the partnership would go to purchase needed supplies and tools for the community. Currently, there is no IRS guidance on any special tax issues governing a partnership between a domestic charity and a foreign party or a joint venture operating in a foreign country. Analytically, the rules should be no different from those governing domestic joint ventures. Therefore, in utilizing a partnership or joint venture, the charitable organization should protect its exempt status by ensuring that the activity of the partnership is in furtherance of the organization’s charitable purpose. 124 If the activity does not further the organization’s charitable purpose, then the organization’s level of participation in the partnership must be insubstantial.125 EXAMPLE: X, a domestic tax-exempt organization, provides educational seminars in the Sandtown community in Baltimore to teach children in the community how to use computers. X decides to expand its operations to Haiti to help teach children 122 123
124 125
See generally Hopkins, The Law of Tax-Exempt Organizations. Other philanthropic organizations are experimenting with alternative methods to extend their charitable work in other countries. The International AIDS Vaccine Initiative, for example, has agreed to fund two AIDS vaccine research projects in exchange for a commitment that any successful product developed will be priced cheaply enough that poor countries may buy it. See David Brown, “AIDS Research Grants Tied to Pledge on Vaccines’Costs,” Washington Post (Nov. 26, 1998), A6, A7. See Section 4.2. See Reg. §1.501(c)(3)-1(b); Section 2.4 on the statutory requirements of a §501(c)(3) organization.
䡲
802
䡲
c17.fm Page 803 Thursday, March 15, 2007 5:26 PM
17.9 DOMESTIC CHARITIES ENTERING INTO JOINT VENTURES
about computers. X enters into a partnership with Y and Z, which are foreign forprofit computer software companies operating in Haiti. The partnership will establish a community center where children may learn how to use computers. Proceeds from the activity will be used to purchase additional equipment for the community center. Under the partnership agreement, X will serve as the general partner and conduct the managerial and administrative aspects of the partnership. Y and Z will be limited partners and make a capital contribution of 50 computers and the needed funds to establish the community center. Entering into a joint venture or partnership with a foreign organization may be more attractive to a domestic charity than grant making. First, capital may be more readily available overseas, especially for a project located within a foreign country. EXAMPLE: A domestic exempt organization, whose purpose is to provide food and clothing supplies to homeless and needy persons, decides to expand its efforts to Eastern Europe. The organization plans to establish and operate a market in an urban community in Poland. The market will provide food and clothing to the lowincome residents of the community. To accomplish its goal, the organization enters into a partnership with foreign businesses to raise the needed capital. The domestic organization serves as the general partner, with the foreign parties as limited partners who will provide the needed capital. Second, a domestic organization may find it desirable to occupy a more direct managerial role in the activities carried on in the foreign country so as to better ensure furtherance of the exempt purpose of the organization. Third, in addition to financial and administrative reasons for forming a partnership with a foreign party, entering into such a partnership may assist foreign governments in promoting and encouraging the growth and development of philanthropic organizations within their own countries. Fourth, and perhaps most significantly, the joint venture structure may effectively obviate the tax law restrictions inherent in making grants to foreign organizations. As discussed earlier, if the domestic charity is a public charity, grantmaking rules will entail additional administrative procedures to monitor the funds granted, enabling the public charity to establish that the funds are used exclusively to further a charitable purpose.126 EXAMPLE: X, a domestic public charity, provides food supplies to needy communities in the United States. X wants to expand its activity to a village in South Africa, where it will organize an educational program to teach the people in the village to farm and raise their own food. X can achieve this purpose by making a grant of monies to an organization in South Africa, but will have to incur the administrative costs of monitoring the funds granted to ensure that they are used for charitable purposes. X decides that rather than take on the administrative burden related to
126
See Section 2.4 on the statutory requirements of a §501(c)(3) organization.
䡲
803
䡲
c17.fm Page 804 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
making a grant, it will be more efficient to contribute the monies into a partnership that will provide the needed capital to establish the operation. Partnership proceeds will be used to purchase the supplies and tools required to educate the people of the South African village to become self-sufficient. Another method of implementing a charitable program in a foreign country is the use of program-related investments (PRIs). These below-market-rate loans or equity investments are treated as qualifying distributions if they serve societal and charitable purposes.127 Since 1971, the IRS has applied the same criteria to activities undertaken in foreign countries as to those undertaken in the United States.128 As is true with domestic PRIs, the IRS has not issued any generally applicable regulations to guide the innovations of the foundations. However, private letter rulings have approved individual expansions of the PRI by U.S. foundations. In a 1998 private letter ruling,129 the IRS concluded that investments by an operating foundation in several former communist countries qualified as PRIs and direct charitable expenditures. The foundation provided insurance to financial institutions to encourage deposits and offered several kinds of investments in businesses, including low-interest loans, loan guarantees, and equity investments. This economic development program was intended to enable new businesses to find investment capital. Another foundation made loans to the government, which in turn offered loans to private, local banks to provide grants to businesses to increase their economic activity. This foundation also made direct loans to or equity investments in businesses that were unable to otherwise obtain conventional financing.130 More recently, the IRS approved, as program related, an investment in a for-profit partnership to provide venture capital for economic development aimed at, inter alia, conservation, sustainable use of natural resources, biodiversity, and organic agriculture. Extensive review and oversight was required to ensure that the investments would actually further the exempt purpose of environmental protection.131 Similarly, if the domestic organization is a private foundation, its participation in a partnership should not require application of the expenditure responsibility rules. The role of the foundation is that of an investor, and the monies contributed to the partnership are a capital contribution for which the foundation will obtain a partnership interest. If the foundation is participating in a partnership that furthers the foundation’s charitable activity, then (unlike grant making) the foundation is not granting monies to another organization, but rather is making an investment for its own account in an activity related to its exempt purpose. Thus, rather than the foundation being required to comply with the grant-making rules under §§4945 and 4942, it should be able to maintain its exempt status by satisfying the requirements imposed on domestic taxexempt organizations that participate in partnerships and joint ventures.
127 128 129 130 131
See Section 4.9(a) for a more complete discussion of the advantages of PRIs. Rev. Rul. 71-460, 1971-2 CB 231. Priv. Ltr. Rul. 9826048 (June 26, 1998). Priv. Ltr. Rul 199943058. Priv. Ltr. Rul. 200136026 (Sept. 7, 2001).
䡲
804
䡲
c17.fm Page 805 Thursday, March 15, 2007 5:26 PM
17.9 DOMESTIC CHARITIES ENTERING INTO JOINT VENTURES
When a domestic tax-exempt organization acts as a general partner, the IRS will apply the tests set forth in the Plumstead 132 case and Rev. Rul. 98-15 in its close scrutiny of the joint venture arrangement to ensure that the venture’s activity is in furtherance of the charitable organization’s exempt purpose, and that there is no private benefit as a result of the joint venture arrangement.133 The first part of the Plumstead test looks to see whether the charitable organization is serving a charitable purpose in acting as general partner in a limited partnership or managing member of a limited liability company.134 If it can be established that a charitable purpose is being served, the second prong of the test will determine whether the joint venture arrangement itself permits the exempt organization to act exclusively in furtherance of the purposes for which exempt status was granted and not for the benefit of the nonprofit partners.135 As discussed earlier, the definition of charitable has been broadened through rulings issued by the IRS and in the regulations under §501(c)(3). In the foreign context, activities have included relief of the poor and distressed or of the underprivileged. 136 Thus, as with any other partnership arrangement in which a domestic tax-exempt organization may participate, the determination as to whether the activity of the partnership is in furtherance of the tax-exempt organization’s charitable purpose is dependent on the type of activity that the partnership is carrying on. Therefore, the fact that the partnership conducts its activity in a foreign country should not affect the determination of whether the partnership meets the first prong of the test. The second prong of the test requires an examination of the joint venture agreement to see whether the arrangement permits the exempt organization to act exclusively in furtherance of its exempt purposes and not for the benefit of the for-profit partners.137 In applying this test to a domestic tax-exempt organization that engages in a joint venture with foreign parties, the nationality of the for-profit partners should not alter the outcome of the test. Whether the limited partners are domestic or foreign for-profit entities, if the partnership agreement is structured so that the domestic charity has not put its assets at risk and the agreement allows the domestic charity to operate pursuant to its exempt purposes with only incidental benefits going to the for-profit partners, the IRS requirements should be satisfied.138 In contrast to a domestic tax-exempt organization acting as a general partner, with foreign parties as limited partners, a domestic organization may also serve as a limited partner in a foreign partnership. 139 In this context, the 132
133 134 135 136 137 138
139
See Plumstead Theatre Society v.Commissioner, 675 F.2d 244 (9th Cir. 1982) (per curiam), aff’g 74 T.C. 1324 (1980); and Rev. Rul. 98-15, 1998-12 I.R.B. 6 (March 23,1998). See also Section 4.2. See Section 4.2. See Gen. Couns. Mem. 39,005 (Dec. 17, 1982); see also Gen. Couns. Mem. 39,732 (May 27, 1988). See Gen. Couns. Mem. 39,005 (Dec. 17,1982). See Reg. §1.501(c)(3)-1(d)(2). See Section 4.2. See Section 4.2 (in-depth discussion regarding application of the second prong of the test and suggestions as to how joint venture agreements may be structured to ensure that the IRS requirements are met). See Section 4.3.
䡲
805
䡲
c17.fm Page 806 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
domestic tax-exempt organization’s concern is whether the partnership’s activity is in furtherance of the domestic organization’s charitable function or is an activity engaged in for profit. If the activity is one engaged in for profit, the domestic charity may have unrelated trade or business income to report.140 The existing body of IRS pronouncements on exempt organizations engaging in partnerships or joint ventures has uniformly involved domestic settings. There is, to date, little legal guidance for determining the tax treatment accorded domestic charities in partnerships with foreign parties in foreign countries. As domestic charities continue to respond to political and environmental crises abroad, the use of partnerships and joint ventures as a means to fund international activities will likely continue to be an area of great interest to the IRS.
17.10
APPLICATION OF FOREIGN LAWS IN OPERATING A JOINT VENTURE IN A FOREIGN COUNTRY
When a domestic tax-exempt organization engages in a joint venture in a foreign country, the first issue it faces is the need to ascertain the effect of the laws of the country in which the partnership conducts its activities, and what impact those laws will have on the venture and its partners, including the domestic charity. As a partner, the domestic charity has an interest in the profits and gains of the venture, which may be subject to taxation by the foreign government. In limited situations, there may be an existing bilateral tax treaty between the United States and the country in which the venture conducts its activities, which will govern the tax treatment accorded both domestic (generally, with respect to foreign taxation) and foreign (generally, with respect to U.S. taxation) parties of the partnership.141 Absent a tax treaty, the initial inquiry is to determine the tax treatment of the foreign operation under the laws of that particular country. As a preliminary matter, the domestic charity will have to determine whether the laws of the foreign country recognize charitable organizations and whether special tax treatment is given to these organizations. Certain registration, residency, licensing, or copyright requirements may have to be satisfied before operations can be commenced in that particular country.142 For federal tax purposes, the domestic charity is considered a “resident” of the United States. Accordingly, there may be U.S. tax consequences to the domestic tax-exempt organization on its distributive share of profits or gains 140 141
142
See Section 4.5. §894(c), effective August 5, 1997, may deny reduced withholding rate treaty benefits to certain foreign persons on items of income derived through a partnership if, among other things, the foreign country does not tax a distribution of such income. Two studies of the laws in foreign countries governing not-for-profit entities are currently under way. The International Center for Not-for-Profit Law (ICNL) is conducting a study, funded in part by the World Bank. Information about ICNL can be accessed through its Web page: http: //www.icnl.org/. The other study, the Comparative Nonprofit Law Project, conducted by the Asia Pacific Philanthropy Consortium, compares nonprofit legal and regulatory systems in Australia, China, Indonesia, Japan, Korea, Singapore, the Philippines, Taiwan, Thailand, and Vietnam. The first phase of the Comparative Nonprofit Law Project was conducted over three years and resulted in baseline studies of the nonprofit legal systems in each of the countries. The first phase also resulted in the production of a publication, Philanthropy and Law in Asia, edited by Thomas Silk, legal director of the Comparative Nonprofit Law Project and founder and president of Silk, Adler & Colvin in San Francisco.
䡲
806
䡲
c17.fm Page 807 Thursday, March 15, 2007 5:26 PM
17.11 APPLICATION OF FOREIGN TAX TREATIES
from the venture, which, in most cases, will be treated as foreign-source income to the domestic charity.143 The application of the foreign tax credit rules of §901 et seq. could be quite complex. Furthermore, the income derived from the foreign venture will have to be taken into consideration in determining whether the domestic organization satisfies the requirements for public charity status or must be classified as a private foundation.144
17.11
APPLICATION OF FOREIGN TAX TREATIES
In general, contributions made by U.S. citizens directly to foreign organizations are not deductible under §170.145 Similarly, a domestic tax-exempt organization that engages in a partnership with a foreign party or organization, and conducts the partnership activities in a foreign country, will likely be subject to taxation by the foreign country on its share of partnership profits or gains. In a limited number of situations, the tax treatment of contributions made directly to foreign organizations, and the income of the domestic charity engaging in a foreign partnership, may be governed, in whole or part, by a bilateral tax treaty between the United States and the foreign country in which the organization was created and operates. The recognition of foreign tax treaty provisions is found in §894(a)(1), which states that the provisions of the Code “shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.”146 Of the foreign treaties currently in force, only a small number contain provisions dealing with exempt organizations.147 Historically, the United States has been reluctant to approve treaty provisions that extend charitable deductions to contributions made to foreign charities. Thus, among those treaties providing for the treatment of tax-exempt organizations, even fewer contain provisions dealing with contributions made to foreign exempt organizations.148 (a)
The Effect of Foreign Treaty Provisions on Charitable Deductions
Currently, only the treaties between the United States and Canada, Israel, and Mexico contain charitable contribution provisions. The Canadian, Israeli, and 143 144
145 146 147
148
See §§861-865 and regulations thereunder. Some treaties may modify source rules contained in the Code or status of the foreign country. See Chapter 9. See also §509(a)(1)-(a)(2), regarding the public support tests; see also Rev. Rul. 75-435, 1975-2 C.B. 215 (support from a foreign government may be considered in determining whether a foreign organization would be treated as a public charity under §509(a)(1)). See Section 17.2(a). See §894(a)(1). See treaties between the United States and Canada, Mexico, Germany, Netherlands, Israel, and proposed treaty with Brazil. Other treaties which contained a provision on exempt organizations but which have since terminated or lapsed are the Honduran treaty, which lapsed on December 31, 1966, and the former Japanese treaty, which terminated on July 9, 1972. See treaties between the United States and Canada, Mexico, Israel, and the proposed treaty between the United States and Brazil. The proposed treaty between the United States and the Philippines (1964) contained a provision for charitable contribution deductions, but was never put in force; likewise, the 1965 proposed treaty between the United States and Thailand contained a provision for charitable deductions that was never put in force.
䡲
807
䡲
c17.fm Page 808 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
Mexican treaties allow a U.S. individual or entity to claim a charitable deduction for contributions made directly to Canadian, Israeli, or Mexican tax-exempt organizations, provided that certain requirements are met.149 The charitable deduction provisions in those treaties apply to contributions made by citizens of the United States150 and provide U.S. citizens a charitable deduction with respect to the income they have derived from either of the respective countries. The provisions under the U.S.–Canada and U.S.–Israel treaties are essentially the same. For a U.S. citizen to claim a charitable deduction for a contribution made directly to a Canadian (or Israeli) organization, the organization must be exempt from income taxation under the laws of Canada (or Israel) and the United States, or qualify to receive exempt status in the United States if it were to apply for tax-exempt recognition. A new notice grants automatic recognition of tax-exempt status to religious, scientific, literary, educational, or charitable entities organized under the laws of either the United States or Canada, provided that the entities have been recognized as charitable under the procedures of the country in which they organized.151 That is, Canada has agreed to give automatic recognition to organizations recognized under §501(c)(3) and the United States will grant automatic recognition to Canadian “registered charities.” Canadian charities are no longer required to submit a second application in the United States. Residents of each country may deduct contributions against income received from the other country: U.S. residents may only deduct contributions to Canadian charities against their Canadian-source income. Due to differences in the procedure, Canadian charities are presumed to be private foundations. Thus, U.S. residents may deduct only up to 30 percent of their charitable contributions.152 To overcome the presumption that a Canadian charity is a private foundation, it must submit to the IRS certain financial information. If the Canadian charity provides the information, it will be listed in Publication 78 as a foreign organization that gives potential donors assurance that their contributions will be deductible. If determined to be a nonprivate foundation (e.g., publicly supported §501(c)(3) organization), donors may deduct up to 50 percent of their contributions. Israeli charities must still apply for exempt status from the IRS. The Israeli treaty limits charitable deductions claimed pursuant to the treaty to 25 percent of taxable income.153 The recent ratification of the U.S.–Mexico tax treaty has been called a “breakthrough for cross-border philanthropy.”154 The terms of the Mexican treaty are essentially the same as those of the Canadian and Israeli treaties, with one major exception. The provisions of the U.S.–Mexico treaty place 149 150
151 152 153 154
See U.S.–Canada Income Tax Treaty, Article XXI; U.S.–Mexico Income Tax Treaty, Article 22. See U.S. –Canada Income Tax Treaty, Article IV, and U.S. –Mexico Income Tax Treaty, Article 3 (definition of resident). Under both treaties, “citizens of the United States” includes individuals, companies, partnerships, estates, and trusts. See U.S. –Canada Income Tax Treaty, Article XXI, ¶5; Rev. Proc. 59-31,1959-2 C.B. 949 (guidelines for establishing tax-exempt status of Canadian and Honduran charities). Id. See U.S. –Israel Income Tax Treaty, Article 15-A. See M. Cerny, “Cross-Border Grant Making and the US.-Mexico Tax Treaty,” Exempt Organization Tax Review 10 (1994): 875.
䡲
808
䡲
c17.fm Page 809 Thursday, March 15, 2007 5:26 PM
17.11 APPLICATION OF FOREIGN TAX TREATIES
the responsibility of determining the exempt status of the recipient organization on the taxing authority of each nation. Thus, under the U.S.–Mexico treaty, organizations that are recognized under Mexican tax law as exempt from income taxation will be deemed exempt for U.S. tax purposes.155 Therefore, if both the U.S. and Mexican taxing authorities agree that Mexican law provides standards for determining the exempt status of organizations authorized to receive deductible contributions, that are essentially equivalent to the U.S. standards in determining whether a domestic organization qualifies as a §501(c)(3) public charity, then donations made by U.S. citizens directly to Mexican organizations will be deductible under the terms of the treaty.156 Mexico has enacted laws that the United States has recognized as providing “essentially equivalent standards” for Mexican organizations, with the exception of churches.157 Thus, an organization that is recognized under Mexican tax laws as exempt from income taxation will not need to apply to the IRS for charitable status. As discussed later, however, deductions pursuant to the U.S.–Mexico treaty are subject to the limits as determined under the U.S. tax laws and are also deductions against Mexican-source income of the donor.158 This means that the charitable deduction available to a U.S. (or Mexican) donor is limited to the amount of the Mexican-source income for the U.S. resident, and U.S.-source income for the Mexican donor.159 For the U.S. donor, that deduction is limited to the general contribution percentage limitation for gifts to public charities (50 percent of adjusted gross income for individuals and 10 percent of taxable income for corporations), applied to the U.S. donor’s Mexican-source income. Thus, Mexican charities seeking to raise funds on a U.S. income-taxdeductible basis from U.S. residents without Mexican-source income will generally have to resort to the two approaches used by charities from other countries.160 For example, the Mexican charity may form a U.S. affiliate (i.e., a “friends of”) to raise funds for programs developed by the foreign charity, so long as the U.S. affiliate maintains sufficient discretion and control over the use of its own funds so as to avoid being viewed by the IRS as a “conduit” of the foreign charity.161 Or a U.S. affiliate may be formed to operate directly in the foreign country. A third option available to the Mexican charity may be to recommend to interested U.S. donors that, to the extent they are able to develop Mexican-source income through
155
156 157
158 159 160 161
See U.S.–Mexico Tax Treaty, Article 22, ¶2; paragraph 17 of the Protocol agreement to the treaty specifies that organizations recognized as exempt by the Mexican government under its income tax laws will be assumed to be exempt for U.S. purposes, and vice versa, unless “the competent authority of the other Contracting State determines that granting an exemption is inappropriate in a specific case or circumstance.” See U.S.–Mexico Treaty, Article 22 ¶2(b). See H.Dale, Tax Law “Foreign Charities,” 48 (spring 1995): 657. (citing First Protocol to the Treaty, Protocol with Respect to Taxes on Income, Sept. 18, 1992, U.S.–Mexico, S. Treaty Doc. No. 7,103d Cong., 1st Sess. Explanation of Proposed Income Tax Treaty (and Proposed Protocol) Between the United States and Mexico 89 (Comm. Print 1993)). See id. Dale, “Foreign Charities.” See Lederman and Hirsh, “U.S Mexican Tax Treaty Complements NAFTA,” Journal of Taxation 79 (1993): 100 (emphasis added). See Section 16.2(b).
䡲
809
䡲
c17.fm Page 810 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
Mexican-based investments, they will be able to deduct direct gifts to the Mexican charity, offsetting their Mexican-source income. (b)
The Effects of Foreign Treaty Provisions on the Taxation of Charitable Organizations
Currently, income tax treaties between the United States and Canada, Mexico, Germany, and the Netherlands have provisions for the tax treatment of charitable organizations.162 For an organization to avail itself of the benefits of the treaty provisions, it must qualify to be recognized as tax-exempt in both the United States and the respective foreign country. Thus, as with the charitable deduction provisions applicable to the U.S.–Canada treaty, in order for a charitable organization created in Canada, Germany, or the Netherlands to receive the benefits of tax exemption under the treaty provisions, it must apply for and obtain recognition as a §501(c)(3) organization with the IRS.163 In contrast, the U.S.–Mexico treaty provides for tax-exempt recognition of a U.S. or Mexican organization if, under the tax laws of the respective country, such organization qualifies as a tax-exempt organization.164 Thus, the charitable deduction provisions of this treaty have no requirement that a Mexican organization apply for and receive tax-exempt status with the IRS to avail itself of the benefits of tax exemption under the treaty. Another important provision included in the current tax treaties between the United States and Canada and Mexico is that a religious, scientific, literary, educational, or charitable organization, which is managed or incorporated in the foreign country and which receives substantially all its support from persons other than citizens or residents of the United States, will be exempt in the United States from the excise taxes imposed with respect to private foundations under §4948.165 Absent a treaty provision exempting the foreign private foundation from taxation, §4948 imposes a 4 percent tax on the organization’s gross 162
163
164 165
See Income Tax Treaties between the U.S. and Canada (Article XXI, §1); Mexico (Article 22, §1); Germany (Article 27); Netherlands (Article 36). The 1953 treaty with Australia contained an article (XIV) that provided for the treatment of exempt organizations, but it was omitted from the current treaty placed in force in 1982. Similarly, the 1954 treaty with Japan also contained an article (XV) on the treatment of exempt organizations, but it was omitted from the current treaty placed in force in 1971. Article XI of the 1946 treaty with South Africa and Article XIV of the 1956 Honduran treaty contained such provisions, but these treaties lapsed on July 1,1987, and December 31,1966, respectively. All these treaties provided charitable organizations an exemption from taxation on the organization’s income if the organization would have qualified for exemption under the laws of both the United States and the reciprocal foreign country. No provision with respect to the taxation of charitable organizations is contained in the US.–Israel treaty, which entered into force on December 30, 1994. See U.S.–Canada Income Tax Treaty Article XXI, ¶1; U.S.–Germany Income Tax Treaty, Article 27, ¶1; and U.S.–Netherlands Income Tax Treaty, Article 36, ¶1; see also Rev. Proc. 59-31,19592 C.B. 949, which sets forth the procedures for obtaining recognition as a §501(c)(3) from the IRS. See US.–Mexico Income Tax Treaty, Article 22, ¶1. See U.S.–Canada Income Tax Treaty, Article XXI, §4; U.S.–Mexico Income Tax Treaty, Article 22, §4; see also Rev. Rul. 74-183,1974-1 C.B. 328, which held that Canadian private foundations are exempt from both Canadian and United States income taxation that would otherwise have been imposed under S4948, by virtue of Article XXI of the United States-Canada Income Tax Convention, as amended. Compare Rev. Rul. 76-330, 1976-2 C.B. 488, which held that no such exemption from the tax imposed under §4948(a) was available to a Belgian private foundation because no treaty provision exists that exempts the organization from such tax.
䡲
810
䡲
c17.fm Page 811 Thursday, March 15, 2007 5:26 PM
17.12 CURRENT DEVELOPMENTS IN CROSS-BORDER CHARITABLE ACTIVITIES
investment income derived from sources within the United States.166 The 4 percent tax is in lieu of the 2 percent tax on investment income that is imposed on domestic private foundations under §4940.167 The current treaties between the United States and Germany and the Netherlands do not contain such a provision. The United States continues to negotiate with various foreign countries to establish income tax treaties. With the recent ratification of the U.S.–Mexico treaty, it appears that the United States may have become more receptive to treaty provisions providing for charitable deductions. 168 As more countries develop laws governing tax-exempt organizations, it is likely that future treaties will contain provisions addressing the deductibility of contributions made to tax-exempt organizations and the reciprocal tax treatment of such organizations between the countries. Thus, practitioners should be aware of possible treaty developments that may affect the ability of their clients to expand their philanthropic activities overseas.
17.12
CURRENT DEVELOPMENTS IN CROSS-BORDER CHARITABLE ACTIVITIES
Post-September 11, U.S.-based charities engaged in foreign aid have been faced with a compelling dilemma: how to respond adequately and in the immediate aftermath of natural disasters and political upheaval while, at the same time, remaining cognizant of the potential threat that some or all of the funds directed abroad could aid in terrorist activities against U.S. interests. The following section outlines the most current initiatives applicable to charities engaging in foreign aid. (a)
FATF (Financial Action Task Force on Money Laundering)
The Financial Action Task Force on Money Laundering (FATF), founded in 1989 by the G7 countries, is an intergovernmental organization whose purpose is to develop international policies to combat money laundering and terrorist financing. In 1990, the FATF issued “Forty Recommendations on Terrorist Financing” (“Recommendations”), which was subsequently revised in 1996 and 2003. In addition to the Recommendations, FATF issued “Eight Special Recommendations on Terrorist Financing” in October 2001, following the events of September 11, and in October 2004, issued “A Ninth Special Recommendation on Terrorist Financing.” FATF intends that all of its Recommendations be implemented at the national level through legislation and other legally binding actions. 166
167 168
See §4948(a); Rev Rul. 74-183, 1974-1 C.B. 328 (Canadian private foundation was exempt from tax imposed on gross investment income under §4948(a) by virtue of Article XXI of the United States–Canada Income Tax Convention, as amended). Compare Rev. Rul. 76-330, 1976-2 C.B. 448 (Belgian private foundation, which had investment income from U.S. sources, was subject to the 4 percent tax imposed by §4948(a) because the United States-Belgium Income Tax Convention did not contain a provision exempting the Belgian private foundation from the tax imposed). See §4940(a). See Mason, “Foreign Charitable Contribution Deductions: A Shift in U.S. Tax Treaty Policy?,” Exempt Organization Tax Review 7 (1993): 624.
䡲
811
䡲
c17.fm Page 812 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
The 2003 Recommendations require member nations to take steps against international money laundering, including: implementation of the relevant international conventions; adopting legislation to criminalize money laundering that will enable authorities to confiscate the proceeds of illegal money laundering; due diligence practices such as record keeping and suspicious transaction financial reporting requirements for financial institutions and designated nonfinancial businesses and professions; and establishment of a financial intelligence unit to receive and disseminate suspicious transaction reports. (b)
The Council on Foundations
In response to the concerns from the nonprofit sector, the IRS issued Announcement 2003-29, asking for comments on the Voluntary Treasury Guidelines. In June 2003, The Council on Foundations (COF), a 40-member working group of U.S.-based charitable organizations (including Independent Sector, InterAction, and Grantmakers Without Borders), responded to Treasury, expressing concerns about the Guidelines and offering an alternative approach to ensure that funds contributed to U.S.-based charities would not land in the hands of terrorist organizations. In April 2004, Treasury met with COF to discuss concerns raised by the Guidelines. As a result of this meeting, Treasury began a Guidelines revision project and again solicited comments. COF in turn modified its original alternative approach and, in March 2005, presented Treasury with “Principles of International Charity” (“Principles”), their revised alternative guidelines. COF’s Principles define eight fundamental doctrines to guide organizations engaged in international charity to ensure that charitable assets will be used for their intended purpose and not diverted for terrorist activities. Critical of the “riskaversion” method encouraged in Treasury’s 2002 Guidelines, the Principles encouraged charities to engage in “due diligence” when making grants to foreign organizations. COF maintains that its Principles are more practical given that international charitable work has become essential to fill the gaps in the global socioeconomic infrastructure, and that charities should be allowed to exclusively pursue their charitable purpose without becoming law-enforcement agents. (c)
U.S. Department of Treasury Recommended Guidelines
On December 5, 2005, the Treasury Department released its revised proposed Anti-Terrorist Financing Guidelines169 (the “Revised Guidelines”), which set forth voluntary best practices for charities based in the United States. The original proposed guidelines, released in 2002, were revised to reflect the ongoing dialogue between Treasury and the nonprofit sector. Comments on the Revised Guidelines have been submitted as indicated below, and will be considered in the process of finalizing the guidelines.
169
Available at: http://www.treasury.gov/offices/enforcement/key-issues/protecting/charitiesintro.shmtl.
䡲
812
䡲
c17.fm Page 813 Thursday, March 15, 2007 5:26 PM
17.12 CURRENT DEVELOPMENTS IN CROSS-BORDER CHARITABLE ACTIVITIES
The Revised Guidelines include guidance for U.S.-based charities regarding: 1. Corporate governance, such as the minimum number of board members that a charity should have, and the contents of a charity’s governing instruments 2. Financial practices, such as annual audits, and the form in which a charity should make disbursements 3. Maintenance of records concerning the home addresses, Social Security numbers, citizenship status, and so on, of directors, trustees, and key employees, as well as public disclosure of any affiliated organizations receiving resources from the charity 4. Antiterrorist financing, such as collection of detailed information about foreign recipients of charitable funds and in-kind contributions (i) Reaction of U.S.-Based Charities to Revised Treasury Guidelines. The Revised Guidelines have been met with resistance by some members of the nonprofit community, who have called for the Revised Guidelines to be replaced by the Principles developed by the COF. A letter sent on behalf of the Working Group by the President of the Council on Foundations, a membership organization of more than 2,000 grant-making foundations and giving programs worldwide, to the Treasury Department on February 1, 2006, describes the concerns of some in the nonprofit community with respect to the Revised Guidelines.170 The Working Group concluded that although the Treasury Department emphasized that the Revised Guidelines were intended to assist charities attempting to protect themselves from terrorist abuse, the Revised Guidelines suggested onerous and potentially harmful procedures to charities. The nonprofit community has also expressed its concern that the Revised Guidelines include language that might imply that charitable organizations are agents of the U.S. government. Exempt organizations contend that because many charities require humanitarian workers to provide services in dangerous parts of the world, any indication that these workers are closely associated with the U.S. government, rather than independent, might put their workers in jeopardy. Additionally, some members of the nonprofit community are concerned that the Revised Guidelines actually require charities to collect a burdensome amount of information on individuals and organizations. Information required to be collected under the Revised Guidelines include: for each recipient of the charity’s funds or in-kind contributions, the recipient’s name in English, in the language of origin, and any acronyms or other names used to identify the recipient; jurisdictions in which the recipient maintains a physical presence; any reasonably available historical information about the recipient that assures the charity of the recipient’s identity and integrity; the address and phone number of each place of business of a recipient; a statement of the principal purpose of the recipient; the 170
Available at: http://www.cof.org/files/Documents/International_Programs/ 2006%20Publications/Final_Comments_to_Treasury_Feb1-06.pdf.
䡲
813
䡲
c17.fm Page 814 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
names and addresses of individuals, entities, or organizations to which the recipient does, or will, provide funding or services; the recipient’s sources of income, such as grants, private endowments, and commercial activities; and the names, nationality, citizenship, country of residence, and place and date of birth for each of the recipient’s board members and key employees. The Working Groups has voiced particular concern that these information collection requirements may result in tension between domestic charities and foreign recipients of charitable funds and services, because foreign recipients may not want information about their board members and key employees reported to a U.S. charity. Finally, the Working Group has expressed concern that, although the Revised Guidelines are described by the Treasury Department as “voluntary,” they will evolve into de facto legal requirements through incorporation into other federal programs. For example, under current law, if a domestic private foundation makes a grant to a foreign entity, the IRS will treat the recipient as if it were an organization described in §501(c)(3) if the foundation manager “reasonably believes” the grantee is organized and operated as such171. Some charitable organizations have suggested that the “reasonably believes” standard could be altered such that a foundation manager will be considered to “reasonably believe” that a recipient foreign organization is operated as an organization described in §501(c)(3) only if the private foundation followed the Revised Guidelines. Additionally, on April 5, 2006, the American Bar Association Section of Taxation and Criminal Justice (ABA), submitted comments to the Department of the Treasury regarding the antiterrorist financing guidelines largely echoing the comments of the Working Group. The ABA also recommended that the Revised Guidelines be withdrawn and be replaced with the Principles of International Charity recommended by the Working Group, as discussed above. In late 2006, a third draft of the Revised Guidelines was issued by the Department of Treasury. Although Treasury did not incorporate all of the recommendations of the Working Group, this third draft was notable in that it removed the language making exempt organizations operating in foreign countries explicit agents of the U.S. government for record keeping and investigative purposes. (d)
IRS Exempt Organizations Work Plan
In October 2005, the IRS began examinations of a sample of foreign grant-making organizations to ensure that funds were being used for their intended charitable purpose and not diverted to support organizations engaged in terrorism. As part of its FY2006 Work Plan, the Service announced plans to complete the examinations begun in 2005 and identify a new set of target grant-making organizations for examination review in 2006. (i) IRS Form 990. In order to gain a more accurate picture of the activities of tax-exempt organizations, the Service recently undertook a significant redrafting 171
Treas. Reg. 53.4945-6(c)(2)(ii).
䡲
814
䡲
c17.fm Page 815 Thursday, March 15, 2007 5:26 PM
17.12 CURRENT DEVELOPMENTS IN CROSS-BORDER CHARITABLE ACTIVITIES
project of Form 990, the exempt organizations information return. The revised Form 990 has been released in two phases. The first phase, a draft of the revised Form 990A, was released in August 2005, and contains new sections on which organizations must disclose compensation for their five most highly paid independent contractors. The second phase of the redrafting is the revised Form 990. The two major revisions made to the Form also concern disclosure of compensation and benefits given for organizational management, directors, and employees. Significant to this discussion, the revised Form 990 also contains two new questions pertinent to the foreign activities of U.S.-based charities. The first question asks whether the organization owns or has signatory authority over a foreign account. This question is identical to that already asked taxable corporations on their tax returns. The second inquires whether the organization has an office in a foreign country. Both of these questions reflect an increased focus on nonprofit organizations’ foreign activities in accordance with current U.S. and international antiterrorism measures. (e)
Sarbanes-Oxley and Exempt Organizations
The American Competitiveness and Corporate Accountability Act of 2002, or the Sarbanes-Oxley Act172 (“the Act”), has had a significant impact on the corporate sector. Arising out of the Enron and Arthur Andersen scandals, the Act requires publicly traded companies to adhere to stringent new standards of accountability, including implementing new audit guidelines and requiring executives to certify financial statements. Currently, there is no federal requirement that exempt organizations comply with Sarbanes-Oxley. States, however, are passing legislation similar to Sarbanes-Oxley to ensure the financial integrity of public charities. (f)
State Legislation
In 2004, the California legislature enacted the Nonprofit Integrity Act of 2004 (“the NIA”), which became effective on January 1, 2004.173 The NIA requires, inter alia, all charitable organizations with annual gross revenues equal to or exceeding $2,000,000 to obtain an independent audit by a certified public accountant. Furthermore, if the charitable organization is a corporation, the board of directors must appoint an audit committee that is responsible for retaining and terminating the independent auditor and negotiating the auditor’s compensation. The audit committee must also act as a board representative in conferring with the auditor. Massachusetts and New York have made similar proposals requiring charitable organizations to obtain audits.
172 173
The American Competetiveness and Corporate Accountability Act of 2002, Pub. L. No. 116 Stat. 745(2002). 2004.Cal. Stat. 919.
䡲
815
䡲
c17.fm Page 816 Thursday, March 15, 2007 5:26 PM
INTERNATIONAL JOINT VENTURES
17.13
CONCLUSIONS AND FORECAST
Although the Revised Treasury Guidelines are ostensibly nonbinding “best practices” for domestic charities, some members of the nonprofit community are concerned that they may ultimately become requirements that must be met. As currently drafted, however, the Revised Guidelines contain provisions with which some nonprofit organization may find it impossible to comply. The Revised Guidelines are, at present, considered “voluntary”; charitable organizations may want to conduct their own risk-assessment, determine their level of exposure, and then implement those practices that are not too burdensome or that make sense for their organization. A word of caution, however: Charitable organizations are required to comply with both U.S. laws and relevant laws of foreign jurisdictions in which they conduct charitable work. Under U.S. laws, domestic charitable organizations engaged in charitable work abroad are barred from knowingly providing material support for specific acts of terrorism.174 U.S. charities are also prohibited from engaging in transactions with individuals and organizations appearing on the Specially Designated Nationals175 and Blocked Persons List.176 Additionally, under current law, certain charitable organizations that make contributions to foreign organizations are subject to expenditure responsibility and other monitoring and due diligence requirements. In sum, charitable organizations may choose to adopt certain practices, in addition to those required by the law, to ensure that their grant making does not raise concerns. To that extent, the Revised Guidelines and/or the Principles are sources of best practices that may help reduce the risk of inadvertently financing terrorist activities.
174 175 176
18 U.S.C. §2339A. The SDN list is maintained by the Office of Foreign Assets Control in the Treasury Department and is available at: http://www.ustreas.gov/offices/enforcement/ofac/sdn/t11sdn.pdf Exec. Order No. 13224, 66 Fed. Reg. 49,079 (September 25, 2001).
䡲
816
䡲
c18.fm Page 817 Wednesday, March 14, 2007 3:34 PM
C H A P T E R
E I G H T E E N 18
Private Pension Fund Investments in Joint Ventures 18.1
OVERVIEW
Tax-qualified pension, savings, and profit-sharing plans are a species of exempt organization.1 Like IRC §501(c)(3) charitable and educational organizations2 and §501(c)(6) trade associations,3 such entities, which we will refer to generically as pension funds, derive their tax exemption from §501(a).4 Their chief contributors—the sponsoring employers—may deduct contributions under §4045 in much the same way as contributors to other exempt organizations are entitled to deductions under §1706 or §162.7 Furthermore, the unrelated business 1 2 3 4
This chapter deals exclusively with private pension funds, exempt under §401(a) and §501(a), that invest in joint ventures. §501(c)(3); Reg. §1.501(c)(3)-1. §501(c)(6); Reg. §1.501(c)(6)-1. Reg. §1.501(a)-1(a). §501(a) provides in part that: “An organization described in(. . . ) §401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under §502 or §503.” §401(a) provides: “A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section.” . . . Provided that the trust meets certain qualifications, including: 1. Contributions are made to this trust by an employer, employee, or both, entitled to deduct contributions under §404(a)(3)(B) (relating to deduction for contributions to profit-sharing and stock bonus plans for the purpose of distributing to such employees or their beneficiaries the corpus and income to the stock bonus plans) for the purpose of distributing to such employees or their beneficiaries the corpus and income of the fund accumulated by the trust in accordance with such plan; 2. Under the trust instrument it is impossible for any part of the corpus or income to be used for purposes other than for the exclusive benefit of his employees; 3. The plan of which trust is a part satisfies the requirements of §410 (relating to minimum participation standards); and 4. The contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees.
5 6 7
These qualification requirements are detailed and complex, and as such are beyond the scope of this chapter. §404(a); Reg. §1.404(a)-1(a)(1). §170. §162.
䡲
817 䡲
c18.fm Page 818 Wednesday, March 14, 2007 3:34 PM
PRIVATE PENSION FUND INVESTMENTS IN JOINT VENTURES
income rules are expressly applicable to pension funds.8 Even the structure of the IRS reflects the interrelationship, as any practitioner who deals with the Tax Exempt and Government Entities Division (formerly the Employee Plans/Exempt Organizations branch) knows. This chapter does not cover the investment of private pension funds set aside under IRC §403(b)9 or IRC §457,10 nor of “public funds”11 set aside to provide pension benefits under plans established or maintained for persons employed by the U.S. government, the government of any state or political subdivision thereof, or by any agency or instrumentality of any of the foregoing. Both economically and legally, pension funds occupy a position that is sui generis in the constellation of exempt organizations. Economically, they represent a major source of liquid capital to potential joint venturers, and their cashrichness compels them to be ever-vigilant for advantageous investment vehicles.12 On the legal front, unlike other exempt organizations, pension funds are subject to a complex web of regulatory requirements administered by multiple government agencies in addition to the IRS. Such requirements include those prescribed by ERISA,13 which is administered generally by the Department of Labor (DOL) and the Pension Benefit Guaranty Corporation (PBGC), jointly with the IRS. Indeed, so far-reaching and complex is the body of law applicable to pension funds that it is beyond the scope of this book. This chapter aims merely to identify some of the more significant issues that may arise when a private pension fund considers participation in a joint venture.
18.2 (a)
PRIVATE PENSION FUND PARTICIPATION IN JOINT VENTURES Exclusive Benefit Purpose
Because pension funds are not governed by IRC §501(c)(3), they are not subject to the prohibition against private inurement or the requirement that they be organized and operated exclusively for charitable purposes. This is hardly surprising, because the raison d’être of such an arrangement is to provide employee 8 9 10
11
12
13
§511(a)(2)(A); Reg. §1.511-1. §403(b) plans, also known as tax-sheltered annuities, are limited in their investment options to annuities and registered investment companies (for example, mutual funds). §457 plans are sponsored by state and local entities as well as tax-exempt organizations and are generally required to be funded using the general assets of the plan sponsor. The requirement that IRC §457 plans of state and l0 local governments hold their assets in trust is codified in IRC §457(g). The Small Business Job Protection Act of 1996, however, requires state and local governments to hold their §457 plan assets in trust. These “public funds” may be §501(a) organizations, or the funds may be qualified under §457 or §403(b) as deferred compensation or pension plans. However, public funds are not subject to the same investment fiduciary restrictions as private pension funds. See, e.g., Priv. Ltr. Rul. 92-07-033 (Nov. 20, 1991) (joint venture, in which some of the §501(c)(3) organization partners are pension funds, has a pool of liquid capital to purchase timber tracts for investment). Pub. L. No. 93-406, 88 Stat. 832 (Sept. 2, 1974), the Employee Retirement Income Security Act of 1974 (ERISA). See ERISA §404(a)(1)(B) and (c). ERISA §404(b) states that a trustee will not be allowed to maintain an indicia of ownership of any assets of a plan outside the United States. Prudent investment is covered indirectly by (a)(1)(B) and (c).
䡲
818
䡲
c18.fm Page 819 Wednesday, March 14, 2007 3:34 PM
18.2 PRIVATE PENSION FUND PARTICIPATION IN JOINT VENTURES
benefits. Indeed, instead of a charitable purpose, §401(a)(2)14 and ERISA §§403(c) and 404(1)(a)(i) require the assets of a pension fund to be used and invested prudently for the exclusive benefit and purpose of employees and their designated alternate beneficiaries. Therefore, the controversial IRS position that a joint venture involving a §501(c)(3) organization must carry on an activity related to the organization’s charitable purpose15 does not apply to pension funds, and the IRS has not announced an analogous doctrine requiring the activity carried on by a joint venture with a pension fund to be intrinsically related to the employment relationship. Thus, it is unlikely that the exempt status of a pension fund would be jeopardized merely by participation in a joint venture, unless the investment in the venture were so imprudent, or involved self-dealing with persons related to the plan, as to raise a question as to whether the pension fund was benefiting employees exclusively. (b)
UBIT Exposure
The pension fund’s share of income from the venture could be subject to the tax on unrelated business income.16 Qualified pension funds and other exempt organizations are subject to tax on any unrelated business taxable income. Generally, unrelated business taxable income is income from any regularly carried on trade or business that is not substantially related to the organization’s exempt purpose. There is, however, a special rule for pension funds, which deems any trade or business regularly carried on by the pension fund or by a partnership in which it is a member to be an unrelated trade or business.17 In the case of a partnership or joint venture, a qualified pension fund that is a general or limited partner must report as UBI the exempt organization’s share in the partnership income, which, with respect to the exempt organization, is income from any unrelated trade or business. 18 Thus, taxability of the pension fund depends on the type of partnership activity that generated the income, determined as if the income had been earned directly by the exempt organization.19 Under the 1993 Act, a pension fund investment in certain publicly traded partnerships20 is now treated the same as investments in other partnerships for UBIT purposes.21 Therefore, income from a partnership interest held by a pension fund, whether the partnership interest is that of a general or limited partner,22 will be subject to UBIT unless the income is
14 15 16 17 18 19 20 21
22
§401(a)(2); TR. §1.401-1(a)(3)(ii). See, generally, Chapter 3. §511(a)(1) and (2); Reg. §1.511-1. See Chapter 8. §513(b)(2). See also Rev. Rul. 79-222, 1979-2 C.B. 236. §512(c)(1);S. Rep. No. 1402, 8th Cong., 2d Sess. 2 (1958). See, generally, §513(b)(2) (all trade or business activity is deemed unrelated by this provision). See §469(k)(2) for a definition of “publicly traded partnerships.” See §512(c) as amended by §13145(a)(1) of the 1993 Act. Under pre-1993 law, an exempt pension fund’s share of income from a publicly traded partnership was automatically treated as UBI. §512(c) makes no distinction between general or limited partner interests. Rev. Rul. 79-222, 1979-2 C.B. 236; S. Rep. No. 1402, 85th Cong., 2d. Sess. 2 (1958).
䡲
819
䡲
c18.fm Page 820 Wednesday, March 14, 2007 3:34 PM
PRIVATE PENSION FUND INVESTMENTS IN JOINT VENTURES
specifically excluded under one of the UBIT modifications23 (e.g., dividends, interest, and royalties). EXAMPLE: X is a qualified pension fund exempt from taxation. X is a partner in a joint venture that operates a factory. The joint venture also holds stock in a corporation. X, in computing UBIT, will include its share of gross income from the factory, but not its share of any dividends received by the joint venture from the corporation because dividends are excluded from UBIT under IRC §512(b).24 The Sixth Circuit Court of Appeals dealt with the UBIT issue in Service Bolt & Nut Co. v. Commissioner.25 There, three taxpayers were established as profitsharing trusts qualified under IRC §401(a) and exempt under §501(a). The trusts participated as limited partners in a partnership that actively engaged in the wholesale fastener distribution business. In affirming the Tax Court, the court of appeals cited §512(c) and §513(b), and stated that the trusts were subject to UBIT on income received from partnership interests.26 The Small Business Job Protection Act of 1996 permits a tax-qualified pension plan to be a Subchapter S corporation shareholder.27 (The plan is considered to be a single shareholder for purposes of determining the number of S corporation shareholders, regardless of the number of plan participants.) A pension plan’s interests in a Subchapter S corporation will be treated as an interest in an unrelated trade or business, giving rise to unrelated business taxable income that is subject to UBIT, as will any gain or loss on the disposition of the interest.28 This is different from a partnership, where the character of the income is preserved and passed through to the partner. Thus, when a choice of entity is available, and a significant portion of the income is attributable to income not subject to UBIT (such as interest, rents, or dividends), the investor might want to use the partnership form for doing business, rather than an S corporation. Gains and losses from the sale, exchange, or other disposition of property are generally excluded from UBIT29 (except for dispositions of S corporation interests, as described earlier). However, gains and losses from the sale or other disposition of property held primarily for sale to customers in the ordinary course of a trade or business are not excluded from the UBIT provisions.30 The “dealer UBIT rule” discourages investing by pension funds and other exempt organizations in properties bundled together by troubled financial institutions. 23 24 25 26
27 28 29 30
§512(c)(1); Reg. §1.512(c)-1; §512(b); Reg. §1.512(b)-1. This example was based on an example in Reg. §1.512(c)-1. See also Priv. Ltr. Rul. 86-20-051 (Feb. 19, 1986); §512(b)(1); Reg. §1.512(b)-1(a)(1). 724 F.2d 519 (1983), aff’g 78 T.C. 812 (1982). Service Bolt, 724 F.2d at 522–23. The court noted that the language in §512(c) or §513(b) is not limited to income from a general partnership interest. This is because §7701(a)(2) expressly defines the term partner to include members of a partnership. See also Rev. Rul. 79-222, 1979-2 C.B. 236; Hawkins v. Commissioner, 713 F.2d 347 (8th Cir. 1983). IRC§1361(c)(6)(A). §512(e). An exception applies for S corporation employer securities held by an employee stock ownership plan. §512(b)(5); Reg. §1.512(b)-1(d). This exclusion does not apply to debt-financed property under §514(b). §512(b)(5)(B); Reg. §1.512(b)-1(d)(1). This is the “dealer UBIT rule.”
䡲
820
䡲
c18.fm Page 821 Wednesday, March 14, 2007 3:34 PM
18.2 PRIVATE PENSION FUND PARTICIPATION IN JOINT VENTURES
The Revenue Reconciliation Act of 1993, however, creates an exception to the dealer UBIT rule. The exception was enacted to encourage pension funds and other exempt organizations to invest in bundled packages of properties offered by troubled financial institutions.31 The exception also provides the ancillary benefit of allowing such organizations to pass on some of the burden of an orderly liquidation of the properties. The 1993 Act exception excludes from UBIT all gains or losses from the sale, exchange, or other disposition of real property that is acquired from the following three: 1. A financial institution described in §581 (banks or trust companies) or §591(a) (mutual savings banks) that is in conservatorship or receivership32 2. The conservator or receiver of such an institution 3. Any government agency or corporation succeeding to the rights of the conservator or receiver33 To be eligible for the exclusion, the real property must be either: 1. Held by the financial institution at the time the institution entered conservatorship or receivership34 or 2. Foreclosure property that secured indebtedness held by the institution at the time the institution entered conservatorship or receivership35 and 3. Properly designated by the plan as eligible for this special treatment36 4. Sold, exchanged, or disposed of within 30 months after acquisition, or such time as designated by the IRS37 5. While held by the plan, the aggregate improvements and development activities included in the basis of the property must not exceed 20 percent of the net selling price of the property.38 UBIT liability will often render a pension fund’s after-tax yield from a joint venture uncompetitive relative to sources of income that are exempt from UBIT. Therefore, the types of joint ventures that private pension funds find to be permissibly prudent39 investments can be expected to fall into the relatively narrow range of activities exempt from UBIT. The principal example of such an exempt situation is the acquisition of real estate to be leased on a straight rental basis, not dependent on the lessee’s profits, and either free of debt financing or 31 32 33 34 35 36 37 38 39
§512(b)(16)(A), as amended by §13147(a) of the 1993 Act. §512(b)(16)(A)(i)(I). §512(b)(16)(A)(ii)(II). §512(b)(16)(B)(i). 512(b)(16)(B)(ii). See §514(c)(9)(H)(v), as added by §13144(a) of the 1993 Act. §512(b)(16)(A)(ii). §512(b)(16)(A)(iii). §512(b)(16)(A)(iv). See Section 16.2(c) for special rules applicable to private pension funds.
䡲
821
䡲
c18.fm Page 822 Wednesday, March 14, 2007 3:34 PM
PRIVATE PENSION FUND INVESTMENTS IN JOINT VENTURES
qualifying under IRC §514(c)(9).40 Pension funds are within the narrow class of exempt organizations that are permitted to avail themselves of the latter provision, which offers an exemption from the debt-financed income rules when partnership allocations are proportionate and there are no prohibited relationships among the pension fund, the seller of the property, the lessee, and the lender.41 Under the Revenue Reconciliation Act of 1993, pension funds are granted flexibility in investing in real estate investment trusts (REITs).42 A REIT is not taxed on income distributed to shareholders. A corporation does not qualify as a REIT if, at any time during the last half of its taxable year, more than 50 percent in value of its outstanding stock is owned, directly or indirectly, by five or fewer individuals (the “five-or-fewer rule”). Under prior law, a domestic pension trust was treated as a single individual for purposes of this rule, thereby making it more difficult to satisfy this test. The 1993 Act allows expanded pension fund involvement in REITs by providing that a pension trust generally is not treated as a single individual for purposes of the five-or-fewer rule. Rather, the beneficiaries of the pension trust are treated as holding stock in the REIT in proportion to their actuarial interests in the trust. Thus, the rules under the 1993 Act encourage investment in REITs by pension funds because measuring beneficial interests instead of pension fund participation allows more pension fund involvement without losing REIT classification and tax benefits.43 (c)
Special Rules
ERISA and companion provisions of the Internal Revenue Code generally impose three special rules on private pension funds: 1. Fiduciaries of pension funds must act solely in the interests of the pension fund beneficiaries and must prudently invest pension fund assets for the exclusive purpose of providing benefits to such beneficiaries. Fiduciaries that do not comply with this requirement risk criminal and/or civil penalties, as well as personal liability for any losses suffered by the pension fund.44 For this purpose, a fiduciary is any person who exercises any discretionary management authority or control over the pension fund, its assets, or administration of those assets, or who is paid to render investment advice to the fund.45 In addition, the plan could risk the loss of its tax-exempt status—a disastrous situation. 40
41 42 43
44
45
See Priv. Ltr. Rul. 86-20-051 (Feb. 19, 1986) (rental income to exempt trust from partnership is excluded from UBIT under §512(b)(3)); Priv. Ltr. Rul 92-07-033 (Nov. 20, 1991). See, generally, Chapter 8. §514(c)(9). See, generally, Chapter 9. See §856(h)(3)(A)(i). However, under the 1993 Act, if a pension fund owns 10 percent or more of the value of a REIT, it must treat a percentage of dividends from the REIT as UBI. IRC §856(n)(3)(c), as amended by §13149(a) of the 1993 Act. ERISA Title I, Subtitle B, Part 5, Administration and Enforcement; ERISA §409 (liability for breach of a fiduciary duty); ERISA §404; DOL Regs., 29 C.F.R. §2550.404a-1; ERISA §502(1) (civil penalties relating to knowing participation in an ERISA fiduciary breach). ERISA §3(21) (defining fiduciary); §4975(e)(3).
䡲
822
䡲
c18.fm Page 823 Wednesday, March 14, 2007 3:34 PM
18.2 PRIVATE PENSION FUND PARTICIPATION IN JOINT VENTURES
2. A pension fund is generally prohibited from financial dealings with a fiduciary, a service provider, the sponsoring employer, a majority owner of the employer, and other disqualified persons.46 These “prohibited transactions” trigger excise taxes and penalties and other sanctions that can become confiscatory if the transaction is not undone.47 These transactions may also give rise to action against the fiduciary for violation of duties to the pension fund, exposing the fiduciary to the penalties discussed in the first category. There are statutory exemptions for certain professional and banking services, and the DOL has provided certain “class exemptions” and will consider special individual requests for exemption.48 3. Pension funds must comply with detailed reporting and disclosure requirements with respect to their assets, including investments in joint ventures.49 For instance, pension funds generally must submit an annual report to the IRS and DOL on a Form 5500 series within seven months after the close of the pension fund’s tax year.50 (d)
Defining the Pension Fund’s Assets
(i) Complications. Looking through the joint venture. These special rules can become even more complicated if the pension fund invests in a joint venture. This is because the assets of the pension fund may be deemed to include not only the intangible undivided investment in the joint venture, but also all of the underlying assets held by the venture.51 “Looking through” the joint venture in this manner would lead to several adverse consequences. First, because the joint venture assets would now be considered pension fund assets, the fiduciaries of the pension fund would be potentially liable for any breaches of ERISA’s fiduciary standards with respect to internal management of the joint venture. The investment in such a joint venture could itself be found imprudent if the expense of continuous monitoring of internal management were excessive, relative to the size of the pension fund or the benefits derived therefrom.52 Conversely, the executives of the joint venture would become fiduciaries of the entire pension fund under ERISA, because they manage assets that are now considered to be plan assets. Such executives could find themselves unexpectedly saddled with potential co-fiduciary liability with 46 47 48
49
50 51 52
Although disqualified persons are referred to as parties-in-interest under ERISA §3(14), the definitions are not identical. See, e.g., §4975 (tax on prohibited transactions); ERISA §406. §4975(d); ERISA §408 (exemptions from prohibited transactions); see discussion in Section 16.2(e) regarding new guidelines and permitting of certain individual exemptions. The prohibited transaction excise tax is 15 percent of the amount involved. ERISA Title I, Subtitle B, Part 1, Reporting and Disclosure; 29 C.F.R. §2520.103-12(c) (limited exemption and alternative method of compliance for annual reporting of investments in certain entities). ERISA §101(b), §103, and §104(a); 29 C.F.R. §2520. 104a-5(a)(2); §6058; Reg. §301.60581(a). 29 C.F.R. §2510.3-101 ERISA §404(a)(1)(B) (fiduciary duties must be prudently exercised and fulfilled); 29 C.F.R. §2550.A.4a-1.
䡲
823
䡲
c18.fm Page 824 Wednesday, March 14, 2007 3:34 PM
PRIVATE PENSION FUND INVESTMENTS IN JOINT VENTURES
respect to pension fund assets that have nothing to do with the venture and that the venture executives do not actually manage.53 In that situation, their positions with the venture could trigger the “prohibited transaction” rules, because of the interrelationship between the venture and the plan-related parties.54 Furthermore, the pension fund effectively would be forced into the role of auditor and accountant of the joint venture, because all assets and liabilities of the venture would be considered those of the pension fund for purposes of the ERISA reporting and disclosure rules. (ii) Exceptions: Plan Asset Rules. Fortunately, it is possible in many cases to avoid having to look through the joint venture to its underlying assets. The DOL considers the issue so significant that it has promulgated extensive plan asset regulations to determine when investments by a pension fund in another entity (such as a partnership) are to be treated as investments in the underlying assts. 55 Additionally, effective August 17, 2006, Congress has now weighed in on the issue by defining the term “plan assets.”56 Although the general rule is to include underlying assets as plan assets,57 there are several exceptions. One exception applies when the pension fund keeps its interest in the joint venture below 25 percent.58 If more than one pension fund is involved in the venture, the aggregate of the interests of all pension funds involved in the venture must be less than 25 percent of all interests owned by parties other than venture managers or individuals who provide investment advice for a fee with respect to the assets of the joint venture.59 For purposes of determining the 25 percent threshold, the interests of certain governmental plans, church plans, and foreign plans are excluded.60 (e)
Prohibited Transactions between Plans and Parties in Interest—Expedited Exemption Process
Occasionally, a pension fund might want to engage in a joint venture with the plan sponsor, or some other person related to the plan. Usually, this is not possible because both the Internal Revenue Code and ERISA impose sanctions on socalled prohibited transactions.61 Prohibited transactions generally involve selfdealing transactions between a plan and “disqualified persons” (under the Code) or “parties-in-interest” (under ERISA).62 For example, prohibited transactions 53 54 55 56 57 58 59 60
61 62
See ERISA §405 (liability for a breach by a co-fiduciary). ERISA §406(a) (prohibited transaction rules). 29 C.F.R. §2510.3-101. ERISA 29 §3(42) as added by §611(f) of the Pension Protection Act of 2006 (P.L. 109-280). 329 C.F.R. §2510.3-101(a)(2). 29 C.F.R. §2510.3-101(a)(2). ERISA§3.(42); 29C.F.R. §2510.3-101(f). ERISA§3.(42); 29C.F.R. §2510.3-101(f)(1). ERISA §3.(42). The regulatory definition of “plan assets,” which existed prior to the statutory definition, included the interests of such governmental, church, and foreign plans in calculating the 25 percent threshold. See 29 C.F.R. §2510.3-101 (f)(2). §4975; ERISA §406. §4975(e)(2); ERISA §3(14). With minor exceptions, disqualified persons and parties-in-interest have the same meaning and include the plan fiduciaries, the plan sponsor, persons related to the plan sponsor, unions, and service providers. References herein are to parties-in-interest.
䡲
824
䡲
c18.fm Page 825 Wednesday, March 14, 2007 3:34 PM
18.2 PRIVATE PENSION FUND PARTICIPATION IN JOINT VENTURES
include (but are not limited to) the sale of property between the plan and the party in interest, the lending of money or other extension of credit between the plan and the party in interest, or the purchase or sale of employer securities or real property.63 Entering into such transactions, no matter how beneficial to the plan, will result in an automatic 15 percent excise tax penalty under the Code, which increases to 100 percent in some instances. Prohibited transactions also can result in the sanctions (that is, restoring losses to the plan and other equitable remedies) and civil penalties under ERISA.64 When the prohibited transaction involves a violation of the exclusive benefit rule, plan qualification also may be jeopardized. However, both the Code and ERISA require the Department of Labor to establish a process whereby an otherwise prohibited transaction can be exempted from Code and ERISA sanctions.65 Generally, the DOL must be able to determine that the exemption is administratively feasible, is in the interests of the plan and its participants and beneficiaries, and is protective of the rights of the participants and beneficiaries. Prohibited transaction exemptions are granted either by statute, as a result of an exemption applicable to a class of transactions, or on an individual basis. Although the exemption process does not address qualification issues, it is doubtful that an exempted transaction would result in the disqualification of the plan. Traditionally, individual exemptions have been difficult and expensive to obtain, even when the transaction was beneficial to the plan. Generally, DOL approval is granted only after a considerable period of time (two or more years is not uncommon). However, the DOL has issued rules (in the form of a class exemption) that permit individual prohibited transaction exemptions to be sought using an expedited prohibited transaction exemption process.66 The class exemption makes it significantly easier to seek and obtain approval for a wide variety of otherwise prohibited transactions. Under the streamlined process, prohibited transaction exemptions can be approved in as little as 78 days. Transactions that qualify for an individual exemption under this streamlined procedure will exempt parties in interest from the ERISA sanctions for prohibited transactions, as well as from the 15 percent (and possible 100 percent) excise tax sanctions imposed by the Code.67 (i) Class Exemption Conditions. Four basic conditions must be satisfied to obtain an individual exemption under the streamlined process. First, the transaction must be substantially similar to at least two individual exemptions granted by the DOL within the 60-month period ending on the date the prohibited transaction exemption submission is filed.68 Relief from prohibited transaction status will be granted only to the same extent as relief was granted with 63 64 65 66 67 68
§4975(c). See ERISA §§409, 502(l). See §4975(c)(2). Department of Labor Prohibited Transaction Exemption (PTE) 96-62, 61 Fed. Reg. 39,988 (July 31, 1996), reported in Pension Reporter (BNA) 23 (1996): 1946. §4976(a)-(b). PTE 96-62, §I(a).
䡲
825
䡲
c18.fm Page 826 Wednesday, March 14, 2007 3:34 PM
PRIVATE PENSION FUND INVESTMENTS IN JOINT VENTURES
respect to the transactions being relied on. A transaction will be considered substantially similar if it is alike in all material respects to the previously granted exemptions cited in the submission. This determination is made in the sole discretion of the DOL. For example, the DOL has provided that a loan transaction was considered substantially similar to cited exemptions when the only difference between the transaction terms (for example, the term of the loan, frequency of repayment, interest rate, and collateral) was the amount of the loan.69 Also, the DOL has indicated that the type of plan involved in the proposed transaction need not be the same as the type of plan involved in the transaction being relied on. Thus, for example, a defined benefit plan may rely on approvals granted to a 401(k) plan.70 The second condition is that there must be little, if any, risk of abuse or loss to the plan participants and beneficiaries as a result of the transaction.71 This must be demonstrated by the applicant in the written submission to the DOL. However, the DOL does not require the party involved in the transaction to guarantee the success of the transaction, or to be responsible for any unforeseen events that occur at a later date. Third, the transaction must undergo the class exemption process (formally known as the “authorization requirements”) prior to entering into the transaction.72 Thus, a transaction may not be retroactively sanctioned under the class exemption. The fourth condition applies in conflict of interest situations when a fiduciary would be dealing with the assets of the plan for its own account, or representing a party whose interests are adverse to those of the plan.73 In that case, an independent fiduciary representing the plan must be appointed.74 The independent fiduciary must review the proposed transaction and determine that the transaction would be in the interests of the plan, while still remaining protective of the plan, its participants, and beneficiaries.75 Also, if the transaction is continuing in nature (such as a lease or a loan), the independent fiduciary must continue to represent the interests of the plan during the entire transaction, continue to monitor the transaction, enforce all conditions of the transaction, and ensure that the transaction remains in the interests of the plan. The DOL has indicated that the fiduciary should be knowledgeable and experienced with respect to the type of transaction involved. In this regard, the parties should consider the qualifications of the independent fiduciaries in the transactions being relied on. The class exemption does not further specify who may or may not be an independent fiduciary, but cautions that consideration should be given to the independent fiduciary’s relationship to any parties involved in the transaction, as well as to whether the fiduciary is receiving more than de minimis compensation from the other parties to the transaction. 69 70 71 72 73 74 75
Preamble, PTE 96-62, Example 3 (23 BNA at 1951). Id. at 1964. PTE 96-62, §I(b). PTE 96-62, §§I(c), III. See ERISA §§406(b)(1), (2). PTE 96-62, §§II(d), III(b). See id.
䡲
826
䡲
c18.fm Page 827 Wednesday, March 14, 2007 3:34 PM
18.2 PRIVATE PENSION FUND PARTICIPATION IN JOINT VENTURES
(ii) Authorization Requirements. Under the class exemption, the applicant with respect to the proposed exempt transaction must satisfy the authorization requirements. This requires that a written exemption request be filed with the DOL that includes: 1. A written declaration by the party seeking the exemption that the submission is made with the intention of demonstrating compliance with the class exemption requirements.76 2. The information generally required to be submitted with an individual exemption application.77 3. A specific statement demonstrating that the transaction proposes little, if any, risk of loss or abuse to the plan participants and beneficiaries.78 4. A comparison of the proposed transaction to at least two other individual exemptions granted by the DOL with the 60-month period ending on the date of the written submission, with an explanation as to why any differences should not be considered material.79 5. A complete and accurate draft of the proposed individual exemption notice for distribution to interested persons.80 Generally, this notice must describe the proposed transaction and its material terms; state the approximate date of the proposed transaction; include a statement that the transaction has met the requirements for tentative authorization under the class exemption (discussed later in this section); and provide information regarding the right to comment to the DOL regarding the proposed transaction, including Federal Register citations regarding the exemptions identified as substantially similar to the proposed transaction and the expiration date of the comment period.81 If the transaction will require the appointment of an independent fiduciary, the submission must also identify the independent fiduciary and describe his or her independence from the parties in interest. The independent fiduciary must include a statement why the transaction would be in the interest of the plan. The submission also must include a copy of the agreement with the independent fiduciary and, if the transaction is continuing in nature, the procedures for replacing the fiduciary if necessary. (iii) Tentative and Final Authorization. Forty-five days after the submission is filed, the transaction will be considered tentatively authorized unless, within that period, the DOL advises the applicant that it cannot authorize the transaction under the class exemption. Provided that the 45-day period has passed without DOL comment, or if the DOL issues a written determination approving the transaction, the applicant must then give written notice (described earlier) to 76 77 78 79 80 81
PTE 96-62 §III(a)(1). PTE 96-62 §III(a)(2). PTE 96-62 §III(a)(3). PTE 96-62 §III(a)(4). PTE 96-62 §III(a)(5). PTE 96-62 §IV(a).
䡲
827
䡲
c18.fm Page 828 Wednesday, March 14, 2007 3:34 PM
PRIVATE PENSION FUND INVESTMENTS IN JOINT VENTURES
interested persons of the proposed transaction. Although the DOL does not specify how the notice is to be sent, the notice must be reasonably calculated to be received by the interested persons. The DOL should also be notified of when the distribution period is complete, as well as the end of the comment period. Interested persons will then have a 25-day period after the notice is filed to comment on the transaction. If the distribution was made by first-class mail, the 25-day comment period will begin on the third day following the mailing of the notice. After the fifth day following the end of the 25-day comment period (i.e., 78 days after the date the written submission is first filed), the transaction will be considered to be approved and may be carried out unless the DOL notifies the applicant that the transaction will not be permitted under this class exemption. Also, if a substantial number of adverse comments are received from interested persons, the applicant and the DOL may agree on a delayed approval date by which matters raised by the adverse comments are to be resolved.
18.3
CONCLUSION
Because of the plan asset rules, debt may be a better investment vehicle for pension funds than joint venture participation. Moreover, a prospective joint venture must be scrutinized for its potential as a prudent investment, which will normally restrict the pension fund to rental real estate ventures that are exempt from UBIT.
䡲
828
䡲
c19.fm Page 829 Thursday, March 15, 2007 5:29 PM
C H A P T E R
N I N E T E E N 19
Exempt Organizations Investing Through Limited Liability Companies 19.1
INTRODUCTION
Derived from various foreign laws, the limited liability company (LLC) is a state law creation that has become increasingly popular in the United States because it limits the personal liability of all its owners, like a regular corporation, but can qualify to be taxed as a partnership. If an LLC qualifies to be taxed as a partnership, the LLC is not subject to federal income tax and all the LLC’s income and losses flow through to the owners.1 All 50 states and the District of Columbia have enacted LLC legislation.2 In addition, both the American Bar Association (ABA) and the National Conference of Commissioners on Uniform State Laws (NCCUSL) have drafted model LLC acts.3 Because it combines the corporate advantage of limiting the members’ personal liability with pass-through tax treatment, the multiple-member LLC has emerged as an attractive alternative to limited partnerships for many business ventures and investments. The single-member LLC may be used by a nonprofit to spin off activities to a separate organization in which it can be the sole “member.” A single-member LLC has tax and limited liability advantages in addition to the management control it offers.4 This chapter explores the use of LLCs in structuring joint ventures between exempt organizations and for-profit entities. It outlines the advantages and disadvantages of single- and multiple-member LLCs as compared with a partnership or a corporation. It also discusses the manner in which the elective (check-the-box) classification rules apply to LLCs. 1 2 3
4
See Section 3.5. See Section 3.4(a). ABA Working Group, Prototype Limited Liability Company Act (Nov. 19, 1992); NCCUSL, Uniform Limited Liability Company Act, 1995, amended 1996. The Prototype Limited Liability Company Act and the Uniform Limited Liability Company Act are reproduced in Ribstein and Keatinge, Limited Liability Companies (1998), and Bamberger and Jacobson, State Limited Liability Company and Partnership Laws (1997). See §17.5A. See also Section 4.3(b); Grace, “Proposed Check-sthe-Box Regulations Would Streamline but Not Eliminate Entity Classification Process,” Tax Management Memorandum 37 (Sept. 30, 1996): (hereinafter “Entity Classification”); Grace and Becker, “Check-the-Box Top 40,” Tax Management Memorandum 37, no. 24 (Nov. 25, 1996): S-348.
䡲
829 䡲
c19.fm Page 830 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
The chapter then examines specific issues facing exempt organizations that seek to use LLCs in joint ventures with for-profit entities. The important ruling in the area of joint ventures, Rev. Rul. 98-15,5 involved two scenarios of hospital joint ventures between for-profit and nonprofit entities; both used an LLC as the venture entity. In Rev. Rul. 98-15, the IRS employs criteria similar to the doublepronged test of Plumstead6 to analyze whether a joint venture would jeopardize the exempt organization’s tax-exempt status. The Internal Revenue Service (IRS) will closely scrutinize the structure of an LLC joint venture arrangement to determine whether the exempt organization’s duty to operate exclusively for exempt purposes conflicts with any duties it may have to advance the private interests of the LLC’s for-profit members.7 To determine whether the exempt organization’s assets benefit the LLC’s for-profit members, the IRS will scrutinize any guarantee or capital call provisions, the management and control of the LLC, and, for private foundations, excess business holding issues.8
19.2 (a)
THE BASICS OF LLCS: STATE AND FEDERAL INCOME TAX LAW Limited Liability
An LLC properly formed under applicable state law shields all its owners from personal liability, beyond their capital contributions, from contractual obligations and tort claims.9 (b)
Federal and State Income Tax
An LLC can be structured to qualify as a partnership for federal tax purposes. If an LLC is classified as a partnership, the LLC itself will not be subject to federal income tax. The LLC will simply report its income, gains, losses, deductions, and credits to its owners, who will take those items into account in determining their own federal income tax liabilities.10 Many states treat LLCs consistently with their pass-through treatment under federal income tax law. However, some states impose entity-level taxes on LLCs. An LLC and its members must carefully consult the income tax laws of all states in which the LLC conducts business or earns income.11
5
6 7 8 9 10 11
Rev. Rul. 98-15, 1998-12 I.R.B. 6. See also “Whole Hospital Joint Ventures,” Exempt Organizations Continuing Professional Educational Technical Instruction Program for FY 1999 (hereinafter “1999 CPE”), and statement of IRS Exempt Organizations Division Director Marcus Owens, “Exempt Organizations Get Plenty to Chew on in L.A.,” Tax Notes (Nov. 16, 1998): 829. For details on how the two-prong test applies to LLC joint ventures, see Section 19.6. See Section 4.2(c). See Gen. Couns. Mem. 39,005 (June 28, 1983). Remarks of Marcus Owens, Meeting of the ABA Tax Section (Aug. 5, 1995). See, e.g., Va. Code Ann. §13.1-1019 (1995). See Section 3.5. See Ely and Grissom, “The LLC/LLP Score Card,” Tax Notes 77 (Nov. 17, 1997): 833, a chart summarizing the status of LLCs and LLPs (limited liability partnerships) in the 50 states and the District of Columbia.
䡲
830
䡲
c19.fm Page 831 Thursday, March 15, 2007 5:29 PM
19.3 COMPARISON WITH OTHER BUSINESS ENTITIES
CAVEAT The states generally have only provided for the formation of LLCs since the late 1980s. Thus, little, if any, judicial authority exists concerning the status and relationship of the LLC members to each other and to third parties, such as creditors. Because the state statutes vary considerably and no uniform act has been adopted, there is no consistent body of law governing the formation and operation of LLCs.* By contrast, partnerships and corporations are widely accepted, and the various state law provisions are modeled on uniform acts, such as the Revised Uniform Limited Partnership Act and the Model Business Corporations Act.† A body of case law also exists with respect to partnerships and corporations. This contrast between LLCs and more traditional entity forms will diminish with time now that all 50 states and the District of Columbia have enacted LLC statutes, especially if a uniform LLC statute achieves widespread acceptance. It is generally accepted that the state of formation of the LLC typically governs in the case of any conflict where the LLC operates in more than one state. It may prove difficult to comply with multiple, and perhaps conflicting, provisions of several states’ LIC acts. *
But See NCCUSL, Uniform Limited Liability Company Act (1995). All states (except California and Louisiana) and the District of Columbia have adopted the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA) with or without modification.
†
19.3
COMPARISON WITH OTHER BUSINESS ENTITIES
Those considering forming an LLC must compare its relative advantages and disadvantages to the features of other available types of entities. The alternatives to LLCs include partnerships and corporations. (a)
LLCs Versus Limited Partnerships
An LLC offers two major advantages over a limited partnership. First, a limited partnership must have at least one general partner with unlimited personal liability for a partnership’s debts to the extent that those debts exceed the partnership’s assets.12 If multiple general partners exist, that liability is either joint or joint and several.13 An LLC limits the liability of all its members, obviating the need for a general partner or other person to undertake personal liability for the entity’s debts14
12
13 14
Before LLCs were widely available, practitioners would seek to minimize the general partner’s exposure by forming a corporate general partner. Typically, however, commercial lenders would then require personal guarantees from the corporate general partner’s individual shareholders. Many states now allow a general partner of a limited partnership to limit its liability with respect to the general obligations of the partnership, if the limited partnership elects under the state’s laws to be treated as a limited liability partnership. The type of liability depends on whether it arises from a contractual or a tortious matter. Some LLC statutes do allow one or more members to assume personal liability for debts of, or claims against, the LLC, but most members find LLCs attractive precisely because they will not have personal liability. Under current law, a general partner’s personal assets could be protected by using a corporate general partner, subject to the uncertainty of how “substantial” its assets must be. See Rev. Proc. 89-12, 1989-1 C.B. 798.
䡲
831
䡲
c19.fm Page 832 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
and insulating the members from liability for acts of other members that may bind the LLC. Second, with few exceptions, limited partners technically enjoy liability protection only if they limit their involvement in partnership affairs to the types of acts allowed under the applicable state partnership statute.15 An LLC allows all members to participate in management without risking their limited liability. This is a highly attractive feature of LLCs, as it allows members the flexibility to become active, rather than passive, members of joint ventures. Freedom to participate actively in the conduct of the LLC business offers a number of advantages. For example, in the low-income housing area, those investors with special expertise in real estate development or housing may participate directly in business decisions without becoming personally liable to the LLC’s creditors. Although LLC members are limited to the same material participation tests as limited partners, LLC members may more easily satisfy those tests and thereby avoid having losses from LLC activities disallowed and suspended under the passive activity limitation.16 Section 19.5 explains the process of determining whether an LLC qualifies to be classified as a partnership for federal tax purposes. Until recently, LLCs were generally required to meet the “four-factor test” applied to partnerships and corporations in determining their classification for tax purposes. To be classified as a partnership for tax purposes, an LLC had to lack at least two of four hallmark corporate characteristics.17 Meeting the requirements for partnership classification often meant including restrictive provisions in an LLC’s operating agreement, the sole purpose of which frequently was to demonstrate the presence or absence of one of these factors.18 As a result, structural and operative simplicity was often sacrificed for the sake of the four-factor test. In late 1996, however, the final check-the-box elective entity classification regulations were issued, allowing business entities, including LLCs, to eliminate 15
16
17 18
In general, state partnership statutes derived from the RULPA allow limited partners to engage in a broader range of partnership affairs than statutes derived from the ULPA. Limited liability protection does not necessarily depend on whether a partner materially participates in one or more partnership activities within the meaning of §469. Under the passive activity loss limitation in §469, taxpayers may offset their losses from passive activities only to the extent of income attributable to passive activities. Generally, a passive activity is any rental activity and any activity that involves the conduct of a trade or business in which the taxpayer does not “materially participate.” A taxpayer “materially participates” if he or she is involved in the operations of the activity on a regular, continuous, and substantial basis. §469(h)(1). LLC members who materially participate may use losses attributable to participation in the LLC to offset gains from other “active” sources. As compared with a limited partner, an LLC member may more easily meet the requirements for “material” participation because he or she may participate freely in the management of the LLC without jeopardizing his or her limited liability protection. However, both LLC members and limited partners can materially participate in an activity only by satisfying three of the seven regulatory material participation tests available to other taxpayers. See Reg. §1.469-5T(e). For analysis and criticism of equating limited partners and LLC members, see Grace, “How the Passive Activity Limitations Apply to LLCs and Their Members,” Journal of Limited Liability Companies 1 (winter 1994): 99. As explained in Section 3.3, these characteristics were continuity of life, centralization of management, limited liability, and free transferability of interests. For example, great pains were often taken to disperse management responsibilities in an effort to demonstrate that the LLC lacked centralized management. For non-tax purposes, however, an LLC often preferred to centralize management functions in a particular individual or governing body.
䡲
832
䡲
c19.fm Page 833 Thursday, March 15, 2007 5:29 PM
19.3 COMPARISON WITH OTHER BUSINESS ENTITIES
many of these otherwise burdensome provisions and achieve partnership classification either automatically (through the operation of the default rules) or by filing a simple election form. 19 (b)
LLCs Versus C Corporations
A regular, or C, corporation is a corporation that does not elect to be subject to federal income tax under Subchapter S of the Internal Revenue Code. Because both LLC members and the shareholders of a C corporation have limited liability, LLCs and C corporations differ primarily in regard to their tax treatment. Normally, the earnings of a C corporation are subject to “double” taxation. Income is taxed at the corporate level when earned, and again when distributed to shareholders as a dividend. Conversely, profits and losses of an LLC that is classified as a partnership pass through to its members without being subject to an entity-level tax. In addition, an LLC may make special allocations under IRC §704(b),20 generally distribute appreciated property to its members without currently recognizing gain,21 and adjust the basis of property under the provisions of §754(b)—planning techniques unavailable to corporations. Further, although a corporate shareholder receives basis only for capital contributions made directly to the corporation, LLC members also receive basis for the entity-level debts of the company.22 The corporation, however, has certain advantages over the LLC. For example, because corporate tax rates are currently lower than individual rates, a shareholder may have a lower tax liability than an LLC member if the corporation makes no dividend distributions. Further, because the LLC passes through the character of the income generated by the LLC, a tax-exempt member may be required to recognize unrelated business taxable income (UBTI), which would not occur in the corporate context because the exempt organization receives dividends.23 Moreover, in some states certain businesses (banking, insurance, and other regulated activities) cannot be conducted through an LLC. In addition,
19 20
21
22
23
These rules are discussed in Section 19.5. A special allocation is an arrangement whereby partners agree to allocate items of income, gain, loss, deduction, or credit in a way that is different from their overall economic arrangement. See Reg. §1.704-1(b)(3); Section 3.6. But see §731(a) and (c), which require partners to recognize gain when a partnership distributes marketable securities under certain circumstances. See §§736 and 732 which may cause gain to be recognized at the partnership level. See also §704(c)(1)(b) (regarding previously contributed property being distributed within seven years of its contribution) and §737 (recognition of pre-contribution gain). See §752. Proposed Regulation §1.752-2(k) was issued August 12, 2004, which provides that in determining the extent to which a partner that is a disregarded entity under Regs. 301.77011 through 301.7701-3 bears the economic risk of loss for a partnership liability, such partners shall have a payment obligation only to the extent of the “net value” of the disregarded entity as of the date its share of partnership liabilities is determined. In addition, final Regs. 1.752-7 were issued on May 26, 2005, which ensure that tax losses cannot be duplicated by transferring contingent obligations to a partnership. §512(c) and §512(b)(1). See also Black and Gutcho, edited transcript of the sessions of the May 19, 1996, ABA Exempt Organizations Committee Meeting in Washington: Attachment C: Limited Liability Companies: Discussion for General Practitioners, Creditors, and Non-Tax Specialists, 12 Exempt Organization Tax Review 77.
䡲
833
䡲
c19.fm Page 834 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
unlike the shares of a C corporation, an LLC interest may not be publicly traded without losing partnership tax status for federal tax purposes.24 (c)
LLCs Versus S Corporations
An S corporation is a regular corporation that elects to be taxed under Subchapter S of the Internal Revenue Code. An S corporation is a hybrid entity, combining the pass-through tax treatment of a partnership with the limited liability of a regular corporation. Accordingly, an S corporation offers many of the advantages and disadvantages of an LLC but is subject to restrictions not placed on LLCs. For example, an S corporation may have only one class of stock, whereas an LLC may have multiple classes of membership interests and may specially allocate income and preferentially distribute cash or other property among members;25 entity-level liabilities do not increase the “outside basis” of the shareholders in their S corporation stock; S corporations must recognize gain upon distributing appreciated property;26 and restrictions on the number and types of persons who may own stock in an S corporation do not apply to LLCs.27 Subchapter S was amended in 1996 to remove some of the restrictions that had limited an S corporation’s flexibility. An S corporation may now have up to 100 shareholders, an increase from the 75-shareholder limit. 28 Eligible S corporation shareholders now include an “electing small business trust.”29 An S corporation may own 80 percent or more of another corporation.30 An S corporation that owns 100 percent of another domestic corporation (a “qualified subchapter S subsidiary”) may elect to disregard the subsidiary.31 For taxable years beginning after December 31, 1997, IRC §501(c)(3) organizations and tax-exempt organizations described in §401(a) (relating to qualified retirement plan trusts) may own stock in an S corporation.32 However, items of income or loss of an S corporation flow through to qualified tax-exempt shareholders as UBIT, regardless of the source or nature of the income. In addition, gain or loss on the sale or other disposition of stock of an S corporation by a qualified tax-exempt shareholder must be treated as UBIT. Finally, the basis of any stock a qualified tax-exempt organization acquired by purchase must be reduced by the amount of any dividends the organization receives with respect to the stock.33 Regulations may 24
25 26 27
28 29 30 31 32 33
Under §7704, publicly traded partnerships are treated as corporations for federal tax purposes unless their income is primarily passive. 3 Whitmire, Federal Taxation of Partnerships and Partners 2-23 (2d. ed. 1993). A partnership is publicly traded if partnership interests are (1) traded on an established securities market, or (2) readily tradable on a secondary market (or the substantial equivalent thereof). §7704(b). See §1361(b)(1)(D). §§311(b), 336. An LLC does not similarly recognize gain unless it distributes “marketable securities” in a transaction subject to §731(c). Generally only individual United States residents, estates, certain trust and certain exempt organizations may be shareholders of an S corporation. §1361(b)(1)(B); §1361(b)(1)(C), and Section 1361(c)(6). See §1361(b)(1)(A). See §1361(e). See §1361(b)(2) (amended to remove from the list of “ineligible corporations” a member of an affiliated group). See §1361(b)(3). See §1361(b)(7). See §512(e).
䡲
834
䡲
c19.fm Page 835 Thursday, March 15, 2007 5:29 PM
19.4 BACKGROUND AND DEVELOPMENT OF LLCS
provide that the basis reduction is limited to the extent the dividend was allocable to Subchapter C earnings and profits that accrued on or before the acquisition date.34 (d)
Other Disadvantages
The use of an LLC carries with it several minor drawbacks. Under some state laws, any LLC member (not just a managing member) may have apparent authority to bind the LLC. Further, some states impose franchise taxes or yearly organizational fees on LLCs that are not imposed on other entities, including partnerships.35
19.4
BACKGROUND AND DEVELOPMENT OF LLCS
Although Wyoming enacted the first LLC statute in 1977,36 the IRS did not rule until 1988 that it would treat an LLC formed under the Wyoming statute as a partnership for federal tax purposes.37 The ruling demonstrated the IRS’s willingness to accept, at least under limited circumstances, partnership classification of an entity despite the lack of a personally liable party.38 Soon after the IRS ruled that it would treat LLCs formed under the Wyoming Act as partnerships for tax purposes, other states enacted LLC legislation.39 The IRS issued numerous revenue rulings and private letter rulings on whether LLCs formed under particular state statutes qualified as partnerships for tax purposes. Eventually, all 50 states and the District of Columbia enacted LLC statutes. The check-the-box classification rules were later adopted, effective January 1, 1997.40 As a practical matter, the check-the-box rules generally obviate the need for an LLC to seek a ruling from the IRS concerning the LLC’s tax classification. The various state laws came to be categorized as either “bulletproof” statutes or “flexible” statutes. Bulletproof statutes were designed to ensure that LLCs formed under these laws would qualify as partnerships for tax purposes under the four-factor test. Bulletproof statutes require that the LLC lack free transferability of interests and continuity of life. Any LLC formed pursuant to a bulletproof statute would thus have been classified as a partnership for federal 34 35
36
37
38 39 40
For a chart comparing LLCs to S corporations and limited partnerships, see Standard Federal Tax Reporter 18 (CCH) ¶43, 087.02 (1999). California, for example, imposes on LLCs an annual $800 minimum franchise tax and a maximum gross receipts tax of $4,500. New York imposes an annual fee of $50 per member, subject to a $10,000 cap. For a chart conveniently summarizing the manner in which the 50 states and the District of Columbia tax LLCs, see Ely and Grissom, “The LLC/LLP Score Card.” Wyo. Stat. §§17-15-101 through -136 (1977). Wyoming passed the law at the insistence of oil and gas interests in the state. “Exempt Organizations Investing Through LLCs with For-Profits,” Exempt Organization Tax Review 12 (Dec. 1995): 1183 (remarks of Blake Rubin). Rev. Rul. 88-76, 1988-2 C.B. 360. The ruling stated that the IRS would consider an LLC a partnership for federal income tax purposes if it were formed pursuant to the Wyoming LLC statute and possessed limited liability and centralized management. For a summary of the events leading to Rev. Rul. 88-76, See Wirtz, “Check-the-Box: The Proposed Regulations on Entity Classification,” Taxes 74 (June 1996): 355, 357, note 9. Florida enacted LLC legislation in 1982, prior to the Wyoming ruling. See Section 19.5.
䡲
835
䡲
c19.fm Page 836 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
tax purposes.41 Flexible statutes allow the drafter of the LLC operating agreement to decide which, if any, corporate characteristics the LLC will possess, although many of the flexible statutes contain provisions that, unless specifically overridden by the drafter, were designed to result in partnership classification for the LLC.42 As compared with bulletproof statutes, flexible statutes afford the practitioner more leeway in drafting the operating agreement but, prior to the check-the-box regulations, also increased the risk that it might “footfault” into corporate status for tax purposes.43 Although the four corporate characteristics have become irrelevant for tax classification purposes, many state laws have not yet been correspondingly amended. Accordingly, the operating agreement of an LLC formed under a particular state’s statute may have to include certain language that was initially intended solely to enable the LLC to qualify as a partnership for federal tax purposes. With the promulgation of the final check-the-box regulations, it is expected that many states will modify their LLC statutes to comport with the new §7701 rules. Until such time, however, practitioners should be sure to include transfer or other state-required restrictions in their LLC operating agreements, so as to ensure compliance with state law. Practitioners should also keep in mind that the check-the-box regulations affect only classification for federal tax purposes, and some states continue to rely on the four-factor test analysis to determine the entity’s classification for state tax purposes.44
19.5 (a)
TAX CLASSIFICATION OF LLCS UNDER CHECK-THE-BOX REGULATIONS45 Introduction
Under the four-factor classification test, an organization would be classified as a partnership only if it did not possess more than two of the four corporate characteristics—continuity of life, centralized management, limited liability, and free transferability of interests.46 The presence or absence of these factors was, 41 42
43
44 45
46
See, e.g., Rev. Rul. 93-5, 1993-1 C.B. 227. Black and Gutcho, edited transcript, ABA Exempt Organization Committee Meeting in Washington, D.C., Attachment C. Exempt Organization Tax Review 12 (Dec. 1995): 77, 80. Some states with flexible statutes are California, Delaware, and New York. For a list of other flexible statutes, see Standard Federal Tax Reporter (CCH) ¶43887B.018. Notwithstanding the IRS rulings on the individual state statutes and numerous letter rulings addressing the classification of particular LLCs, until Revenue Procedure 95-10, some uncertainty existed with respect to the classification of LLCs. The Revenue Procedure set forth guidelines under which the IRS would consider ruling that an LLC should be classified as a partnership. Recently, however, the final elective classification rules (check-the-box) were adopted, rendering superfluous Rev. Proc. 95-10, and the application of the Kintner regulations. See Ely and Grissom, “The LLC/LLP Score Card,” and Bagley and Wynott, 3 The Limited Liability Company (1997), Appendix D. Although an in-depth discussion of check-the-box regulations is beyond the scope of this chapter, for an excellent discussion of these regulations, see footnote 4, “Entity Classification,” which served as a reference for much of the material in this section. The Final Regulations were adopted in 1996. T.D. 8697, 61 Fed. Reg. 66,584 (Dec. 18, 1996). The Final Regulations modified the Proposed Regulations in ways that generally have no effect on exempt organizations. These four factors were first articulated in Morrissey v. Commissioner, 296 U.S. 344, 36-1 T.C. ¶9020 (1935), and serve as the basis of the existing regulations. The regulations were promulgated to prevent a recurrence of the result reached in Kintner v. Commissioner, 216 F.2d 418 (9th Cir. 1954), in which the IRS believed that an organization had inappropriately achieved corporate classification.
䡲
836
䡲
c19.fm Page 837 Thursday, March 15, 2007 5:29 PM
19.5 TAX CLASSIFICATION OF LLCS UNDER CHECK-THE-BOX REGULATIONS
however, often difficult to determine with accuracy, and at times the results seemed somewhat counterintuitive. For example, an organization did not lack continuity of life simply because it would terminate on a predetermined date; rather, continuity of life was determined by reference to the effect of certain “dissolution events” on the entity and its members. Whether these characteristics were present often turned upon subtle variations in operational language or organizational structure.47 Accordingly, entity classification has historically been a somewhat arduous and inexact process. Regulations issued in late 1996 under §7701 have significantly altered and greatly simplified the entity classification process. Under the check-the-box regulations, most entities now may choose between being taxed as partnerships and being taxed as corporations, regardless of how many traditional corporate factors the entity possesses or lacks. Entities that do not choose a classification are classified under default rules predicated not on the four corporate characteristics, but rather on whether the organization is foreign or domestic, whether its member(s) have limited liability, and the number of members the entity has.48 The final check-the-box regulations apply to periods on or after January 1, 1997. (b)
Overview of the Check-the-Box Regulations
(i) Election Process in General. Unless it is described in a category of per se corporations, a business entity may elect whether it chooses to be taxable as a partnership or as a corporation (literally, “association taxable as a corporation”). These organizations are referred to as “eligible entities.”49 If an eligible entity has at least two members, it generally may choose to be treated as either a partnership or an association taxable as a corporation.50 If an eligible entity has a single member, the owner may elect to have the entity disregarded for tax purposes or classified as an association taxable as a corporation.51
47
48 49 50 51
Numerous rulings interpret these characteristics, or explain the conditions under which the IRS will rule on certain characteristics. See, e.g., Rev. Proc. 94-46, 1994-2 C.B. 688; Rev. Proc. 92-33, 1992-1 C.B. 782; Rev. Rul. 92-35, 1992-1 C.B. 790; Rev. Proc. 91-43, 1991-1 C.B. 477. See Reg. §301.7701-3. Reg. §301.7701-3(a)-(c). See id. Id. Eligible entities in existence prior to the effective date of the regulations need not select a classification. Rather, such entities will retain their pre–check-the-box classifications, unless the entity is a single-member organization claiming partnership treatment, in which case it will be disregarded as an entity separate from its owner. Reg. §301.7701-3(b)(3). Special transition rules apply to the classification of existing eligible foreign entities, but these are beyond the scope of this book. See footnote 4, “Entity Classification,” for a more thorough discussion of these issues. With respect to an eligible entity formed after the issuance of the final regulations, if no classification selection is made, the entity will be classified according to a set of “default” rules, under which (1) domestic entities will generally be classified as a partnership or be disregarded; and (2) foreign organizations will generally be classified as associations, unless any member has unlimited liability. See Reg. §301.7701-3(b)(1)-(2).
䡲
837
䡲
c19.fm Page 838 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
CAVEAT Note that the check-the-box regulations affect only classification for federal tax purposes. Entities must still determine their classification for state purposes (e.g., franchise, income, and/or gross receipts taxes, in addition to nontax purposes) under the law of the state of formation. It is possible for an entity to be taxed as a partnership for federal tax purposes, but taxed as a corporation or other nonpartnership entity for certain state tax purposes. Regulation §301.7701-2(b), however, lists eight categories of per se corporations. Unlike eligible entities generally, per se corporations may not choose their tax classification. They must be classified as corporations. The eight categories are as follows: 1. Business entities organized under a federal or state statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic 2. An association (as determined under Prop. Reg. §301.7701-3) 3. Joint-stock companies or joint-stock associations 4. A business entity that is taxable as an insurance company under Subchapter L, Chapter 1 of the Internal Revenue Code 5. A state-chartered business entity conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute 6. A business entity wholly owned by a state or any political subdivision thereof 7. A business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than §7701(a)(3) 8. Designated business entities formed in numerous foreign jurisdictions52 (ii) Mechanical Requirements. Eligible entities may elect their tax classification by filing Form 8832 with the IRS Service Center at which the entity files or expects to file its tax returns.53 The election must either be attached to the income tax return of the electing entity or, if the entity is not required to file a return, to the income tax returns of each owner of the electing entity, for the year in which the election was made.54 52
53 54
Reg. §§301.7701-2(b)(8)(i) includes 82 foreign entities deemed to be corporations under the proposed regulations. Reg. §§301.7701-2(b)(8)(ii)-(v) contains clarifications and exceptions to the general list of entities contained in -2(b)(8)(i). Reg. §§301.7701-3(c)(1)(i). Reg. §§301.7701-3(c)(1)(ii). With respect to the latter situation, the proposed regulations provided that the election must be attached to the return of “any” direct or indirect owner. The final regulations clarify that “any” member means “all” members, rather than “any one member.” See id. Note that the failure of one or more owners to attach copies of the election to their tax returns will not invalidate an otherwise valid election; rather, the nonfiling parties may be subject to other penalties under the Code. Id.
䡲
838
䡲
c19.fm Page 839 Thursday, March 15, 2007 5:29 PM
19.5 TAX CLASSIFICATION OF LLCS UNDER CHECK-THE-BOX REGULATIONS
The election must be signed by each member of the electing entity, or any person authorized by the members to make the election on behalf of the entity. The final regulations clarify that with respect to a current election being signed by “all members” rather than a single “authorized” member, all persons who are owners at the time the election is made must sign the election. An election may specify the date on which the entity intends the election to take effect. Elections thus may specify a retroactive effective date up to 75 days before the date the election is filed, or a prospective effective date up to 12 months after the election is filed. If a retroactive election is being made, all current owners as well as all persons who were owners during the retroactivity period (but who are not owners at the time the election is filed) must consent to the election. This is true whether the election is made by an authorized person or by all the members.55 If an election does not specify an effective date, it will take effect on the date filed.56 (iii) Restrictions on Changing Classification. As a practical matter, most eligible entities that elect a particular tax classification retain that classification for their duration. Limitations are imposed on those entities that may wish to change classification. Once an eligible entity has elected to change its classification, the entity generally must wait at least 60 months before again electing to change it.57 This 60-month waiting period applies only to elections to change a classification. Thus, for example, an entity that merely files a protective election need not wait 60 months before electing to change its classification.58 Similarly, an entity that elects out of its default classification at the entity’s inception need not wait 60 months before electing to change its classification.59 (iv) Consequences of Electing to Change Classification. Before electing to change its federal tax classification, an entity and its owners should carefully consider the potential consequences. The check-the-box regulations describe some consequences of electing to change an entity’s classification. The proposed regulations
55 56 57 58
59
Reg. §301.7701-3(c)(2)(ii). Reg. §301.7701-3(c)(1)(iii). Reg. §301.7701-3(c)(1)(iv). Often, a protective election is filed by a foreign organization unsure of its status because of corresponding uncertainties with respect to whether any member has unlimited liability. The protective election will serve to ensure partnership treatment if the entity is, in fact, eligible for such a classification. Assuming that the entity was entitled to partnership treatment by operation of the default rules, or the grandfathering rules, the protective election would not constitute a change, but merely an affirmation of classification, and thus would not prohibit additional elections within the 60-month period. Issues involving foreign entities are discussed in footnote 4 “Entity Classification.” Id. See Reg. §301.7701-3(c)(1)(iv). Note that the 60-month restriction does not apply if an organization’s business is transferred to a new entity through a merger, technical termination, liquidation into its parent followed by a reformation, or a similar arrangement These transactions will, of course, have attendant tax consequences, which must be weighed against the necessity of changing classification forms while under the 60-month restriction. The 60-month restriction was included to prevent (usually foreign) taxpayers from “playing games” in order to take advantage of frequent changes in foreign law, and to minimize the administrative burdens that might accompany frequent classification elections. Remarks of John Rooney, Highlights and Documents (Tax Analysts) at 986 (May 20, 1996).
䡲
839
䡲
c19.fm Page 840 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
describe four categories of elective changes and provide that they will be deemed to take the following forms: (A) P ARTNERSHIP TO A SSOCIATION The partnership contributes all its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter the partnership liquidates by distributing the stock of the association to its partners. (B) A SSOCIATION TO P ARTNERSHIP The association distributes all its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter the shareholders contribute all the distributed assets and liabilities to a newly formed partnership. (C) A SSOCIATION TO D ISREGARDED E NTITY The association distributes all its assets and liabilities to its single owner in liquidation of the association. (D) D ISREGARDED E NTITY TO AN A SSOCIATION The owner of the eligible entity (for example, a single-member limited liability company) contributes all the entity’s assets and liabilities to the association in exchange for stock of the association.60 The regulations do not prescribe the tax consequences of these elective changes. Instead, they merely state that the tax treatment is determined under all relevant provisions of the Code and general principles of tax law, including the “step transaction” doctrine.61 Under the Code and those general principles, the previously described elective changes appear to have the following consequences: (E) E LECTIVE C HANGES (A) AND (D) The partners (in the case of a partnership) or the owner (in the case of a disregarded entity) generally will not recognize gain or loss.62 However, they will recognize capital gain to the extent that the amount of the deemed transferred liabilities exceed the amount of the deemed transferred assets.63 (F) E LECTIVE C HANGES (B) AND (C) The corporation generally will recognize gain equal to the amount by which the fair market value of its assets exceed their adjusted basis; each shareholder will recognize gain to the extent that the fair market value of the stock exceeds the shareholder’s adjusted basis in the stock.64 Only in limited circumstances would such a conversion qualify as a nonrecognition event.65
60 61 62 63 64 65
Reg. Section §301.7701-3(g)(1). Section §301.7701-3(g)(2). §351(a). §357(c). §§336,331. It appears that gain on the conversion would not be subject to tax if an entity classified as a corporation is merged into an LLC that elects to be classified as a corporation in a transaction qualifying as a corporate reorganization under §368. The resulting LLC could achieve passthrough treatment by making an S election, assuming that all the requirements under Subchapter S are satisfied. This technique is illustrated in Priv. Ltr. Rul. 96-36-007 and Priv. Ltr. Rul. 95-43-017. A second situation in which the conversion apparently will not be subject to tax involves converting an 80 percent or more subsidiary into an LLC or other pass-through entity.
䡲
840
䡲
c19.fm Page 841 Thursday, March 15, 2007 5:29 PM
19.5 TAX CLASSIFICATION OF LLCS UNDER CHECK-THE-BOX REGULATIONS
(c)
Classification of Exempt Organizations
The check-the-box regulations provide a special classification rule for organizations exempt, or claiming to be exempt, from taxation under IRC §501 (a).66 Although not specifically included on the per se list, any such organization is deemed to have elected to be taxed as an association taxable as a corporation under Reg. §301.7701(b)(2). Accordingly, the government has implicitly underscored its position that pass-through status and exemption from taxation are mutually exclusive propositions. Note, however, that this “deemed election rule” applies only to an organization that itself is exempt or claims to be exempt. The rule does not govern the tax classification of a joint venture in which one or more exempt organizations invest, unless the joint venture entity itself is exempt or claims to be exempt. The IRS has decided that, under certain conditions, it will recognize the separate exempt status of a multiple-owner LLC.67 All of the owners of the LLC must be exempt organizations or governmental units. As long as the entity is claiming exemption, the IRS will treat it as an association, consistent with the long-standing IRS position that a partnership cannot qualify for exemption. The requirements that multi-owner LLCs must meet were detailed in an article in the Exempt Organization Instruction Program for FY2001. They ensure that the entity is organized and will be operated exclusively for exempt purposes. The organization must certify that it is consistent with state law. The organizational language of the entity seeking exempt status must: • Specify that the LLC will be operated exclusively to further charitable
purposes of its members • Require all members to be §501(c)(3) organizations or governmental units
or instrumentalities • Prohibit direct or indirect transfer of membership interest to an entity
other than a §501(c)(3) or governmental unit • Require that interests in and assets of the LLC may only be transferred to
individuals and noncharitable organizations for fair market value • Prohibit the LLC from merging with or converting into a for-profit entity • Contain an acceptable contingency plan for the possibility that one or
more members will cease to be §501(c)(3) organizations The IRS has also provided an additional classification for an LLC wholly owned by an exempt organization.68 The entity may either accept the default classification of a “disregarded entity” or elect separate-entity treatment, either by filing for This transaction generally should be characterized as a tax-free liquidation of the subsidiary under §§332 and 337 and a transfer of its assets and liabilities to the new entity. The order in which these steps occur, however, depends on applicable state law. 66 67 68
Reg. §301.7701-3(c)(1)(v). Richard A. McCray and Ward L. Thomas, “Limited Liability Companies as Exempt Organizations— Update,” Exempt Organizations Technical Instruction Program for FY2001. Ann. 99-102, 1999-43 I.R.B. 545 (also discussed in McCray and Thomas’s article).
䡲
841
䡲
c19.fm Page 842 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
exemption for itself on Form 1023 or Form 990 or separate-entity treatment on Form 8832. A separate entity affords additional liability protection to the owner from contractual, tort, and financial risks. It may also make the entity eligible for benefits available to §501(c)(3) organizations, such as state property tax exemption and use of qualified §501(c)(3) bonds, which are particularly useful to organizations in the healthcare and low-income housing fields. CAVEAT The IRS requires the exempt owner of a disregarded LLC to treat the operations and finances of the LLC as its own for tax and reporting purposes. A new part of Form 990 solicits information about these entities. A disregarded entity need not independently satisfy the operational test for §501(c)(3). However, its articles of incorporation may not prohibit the entity from operating exclusively for exempt purposes. The IRS has not yet determined whether contributors to the wholly owned LLC will be able to deduct their contributions under IRC §170. The IRS is also considering whether to change the current policy, which allows disregarded entities to choose whether to treat themselves as regarded or disregarded for the purpose of employment taxes. (d)
Single-Owner Organizations Generally
Under the check-the-box regulations, an unincorporated organization that one person owns (“single-owner organization”) can choose either to be classified as an association taxable as a corporation or to be disregarded for federal tax purposes.69 If a domestic single-owner unincorporated organization does not make an election, it defaults to being disregarded as an entity separate from its owner.70 If an entity is disregarded, its owner must report all of such entity’s income, gains, losses, deductions, and credits on its return. Thus, if an exempt unincorporated organization owns a single-owner organization, it is required to report all of the LLC’s items on its own return, which may result in UBIT. In many situations, a single-owner organization may be formed under state law as an LLC.71 In response to the check-the-box regulations rule concerning disregarded entities, many states have amended their LLC statutes specifically to recognize LLCs owned by one person. (e)
Impact on Joint Ventures
Anecdotal evidence suggests that the check-the-box classification system will most likely cause LLCs to emerge as the entity of choice for joint venturers seeking pass-through treatment. A domestic joint venture LLC will typically default to being classified as a partnership. Consequently, if the LLC’s trade or business constitutes an unrelated trade or business with respect to venturers that are exempt organizations, each such organization must, in computing its unrelated business income tax (UBIT), generally include its share (whether or not distributed) of the 69 70 71
Reg. §301.7701-(a)(4). Reg. §301.7701-3(b)(1)(ii). But see the discussion in Section 19.5(f) about the choices for single-owner entities available to exempt organizations.
䡲
842
䡲
c19.fm Page 843 Thursday, March 15, 2007 5:29 PM
19.6 EXEMPT ORGANIZATIONS WHOLLY OWNING OTHER ENTITIES
LLC’s gross income from the unrelated trade or business and its share of the LLC’s deductions directly connected with that gross income.72 If, on the other hand, the LLC elects to be classified as an association taxable as a corporation, the joint venture and its members will be subject to double taxation, but any dividends the LLC distributes will be excluded from the exempt organization ventures’ UBIT.73 A joint venture LLC classified as an association may elect to be taxed as an S corporation, assuming that it meets all the applicable requirements under Subchapter S.74 In that event, however, each exempt organization must treat as UBIT its entire share of income and deductions from the S corporation, whether or not attributable to an unrelated trade or business. In addition, any gain or loss an exempt organization recognizes upon disposing of stock in the S corporation must be included in UBIT. By contrast, UBIT from an LLC classified as a partnership includes only items attributable to unrelated trades or businesses conducted by the LLC.75 For this reason, a joint venture LLC seeking pass-through treatment will generally prefer to be taxed as a partnership rather than an S corporation.76 In summary, LLCs will likely become the preferable entity for structuring, establishing, and operating joint ventures between exempt and for-profit organizations. However, an LLC joint venture, like a partnership joint venture, must satisfy the IRS’s two-prong test.77
19.6
EXEMPT ORGANIZATIONS WHOLLY OWNING OTHER ENTITIES
An exempt organization often chooses to own a particular asset or conduct a particular activity through a separate wholly owned entity.78 As a result of the check-thebox regulations, such a wholly owned entity could be structured and classified for tax purposes in any of the following three ways: (1) as a wholly owned C corporation subsidiary, (2) as a wholly owned S corporation, or (3) as a single-member LLC. (a)
Wholly Owned Subsidiary
If the wholly owned entity is incorporated under state law, it will be subject to tax as a corporation. Double taxation will result, but the parent exempt organization’s income will take the form of dividends and, eventually, gain or loss from the sale of the stock, both of which will be excluded from the parent’s UBIT. Assuming that the subsidiary is respected as a separate corporation under applicable state law, the subsidiary will also be respected as a separate corporation for tax purposes.79 Regardless of the subsidiary’s activities, the parent’s ownership of the stock should not affect the parent’s exemption from tax.80
72 73 74 75 76 77 78 79 80
§512(c). §512(b)(1). See Section 19.3(c). §512(c). Contrast the discussion that follows concerning choice of entity for an organization of which an exempt organization owns 100 percent. See Section 19.7. See Section 4.6 and Priv. Ltr. Rul. 97-14-016. See Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943). See Section 4.6(b). See Priv. Ltr. Rul. 97-14-016, reaching this conclusion based on Moline Properties.
䡲
843
䡲
c19.fm Page 844 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
(b)
Wholly Owned S Corporation
If the wholly owned entity elects S corporation treatment, all the underlying income, deductions, and so on, of the S corporation will flow through to the exempt organization under the general rules governing the tax treatment of S corporations. The entire amount of such net income, however, will be subject to tax on unrelated business income (UBI) regardless of the income’s source.81 This factor in itself favors using a single-member LLC rather than an S corporation. However, unlike the situation in which the wholly owned entity is disregarded under the check-the-box rules, in this case the underlying assets or activities of the S corporation should not be attributed to the parent, with the result that the entity’s activities should not affect the parent’s exempt status.82 Accordingly, if an exempt organization has concerns that activities conducted through a wholly owned entity may jeopardize the parent’s exempt status, an S corporation may prove more attractive than a single-member LLC.83 (c)
Single-Member LLC
If the wholly owned entity is organized as a single-member LLC, it will be disregarded for federal tax purposes, assuming that it does not elect to be classified as an association. The parent exempt organization will be treated for federal tax purposes as owning the LLC’s assets and conducting its activities directly. Whether these deemed activities will jeopardize the parent organization’s exemption depends on whether the activities further an exempt purpose or function. The exempt organization will be treated as conducting the activities directly. The parent thus will be subject to tax under the general UBIT rules on any resulting items from any activity treated as an unrelated trade or business.84 Planning opportunities and issues raised by exempt organizations owning single-member LLCs have not escaped the IRS’s attention. The IRS National Office has announced that until further notice it will not issue letter rulings on how or whether owning a single-member LLC will affect an organization’s exemption.85 Consequently, at least for the time being, exempt organizations desiring to use single-member LLCs will not have the option of seeking the comfort level that a letter ruling provides. Single-member LLCs offer three important benefits. First, they statutorily limit their sole owner’s liability to the capital that the owner invests in the LLC. Second, they enable the sole owner to control the entity’s operations completely. Third, they offer the benefit of pass-through taxation without the complexities of partnership taxation. That is because a single-member LLC does not file its own 81 82 83
84 85
§512(e). See Moline Properties v. Commissioner, note 82. For additional discussion of these issues and the manner in which the check-the-box regulations affect joint ventures involving exempt organizations, see Sanders and Grace, “The Intended and Unintended Effects of the Check-the-Box Regulations on Tax-Exempt Organizations,” discussion outline distributed at meeting of the Exempt Organizations Committee, ABA Section on Taxation, May 9, 1997, in Washington, D.C. See also D. Mancino, Hospitals and Health Care Organizations ¶17.05[5] (1995 & Supp. 1997). §512(a)(1). Rev. Proc. 99-4, 1999-1 I.R.B. 115 (January 4, 1999).
䡲
844
䡲
c19.fm Page 845 Thursday, March 15, 2007 5:29 PM
19.6 EXEMPT ORGANIZATIONS WHOLLY OWNING OTHER ENTITIES
income tax returns. Instead, all of the entity’s gains, losses, deductions, and credits flow through to the single owner, who reports those items on the owner’s income tax returns. Single-member LLCs may be used for various desirable purposes. A singlemember LLC can be established to conduct a particular business, line of business, or activity. This facilitates accounting, recordkeeping, and financial reporting. A single-member LLC also can be used to isolate an owner’s potential liability from a particular activity. If an owner conducts an activity through a single-member LLC, those with tort or other claims stemming from the activity generally can collect only from the assets inside that particular LLC. Claimants can reach beyond those assets only by convincing a court to pierce the “LLC veil.” Single-member LLCs also can be used to ease a lender’s concerns about cross-collateralization and contingent liabilities. A lender can loan funds to a particular single-member LLC under terms giving the lender priority over other liabilities of or claims against the entity’s sole owner, including claims against properties or activities held in other entities. The lender’s priority often can be enhanced further by structuring the single-member entity to be “bankruptcy remote.” Before deciding to substitute single-member LLCs for regular corporations, however, exempt organizations should recognize that using the two types of entities can have dramatically different income tax consequences. If an exempt organization conducts an activity through a regular corporation, the organization’s income from the activity generally will consist of dividends or royalties from the corporation and gains from selling stock in the corporation. Those items generally are exempt from unrelated business income tax (UBIT). If, however, an exempt organization conducts an activity through a single-member LLC classified as a disregarded entity, all of the entity’s income, gains, and so on flow through to the organization as though (for tax purposes) the LLC does not exist. The items thus retain their character in the hands of the exempt organization and potentially are subject to UBIT. Certain exempt organizations may own stock in an S corporation.86 An S corporation, in turn, may own 100 percent of either of two types of entities disregarded for tax purposes: a noncorporate entity (such as a single-member LLC) or a qualified subchapter S subsidiary (QSSS). In either case, the disregarded entity’s income, gains, losses, deductions, and credits flow through to the S corporation, which must take those items into account on its own tax return. In either situation, an exempt-organization shareholder’s pro rata share of such flowthrough items may be treated as unrelated business income (UBI).87 (d)
Conversions between Partnerships and Disregarded Entities
Regulation §301.7701-3(f) decrees the tax result of a noncorporate entity changing to or from having one member. An entity taxed as a partnership whose membership is reduced to one member becomes a disregarded entity. Conversely, a disregarded single-member entity becomes a partnership for tax purposes once the entity has 86 87
Under IRC §1361(c)(6), an organization described in IRC §401(a) or §501(c)(3) and exempt from taxation under IRC §501(a) may be a shareholder in an S corporation. IRC §512(e).
䡲
845
䡲
c19.fm Page 846 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
CAVEAT A single-member LLC can enter into a “joint venture” with a nonmember manager as an alternate structure. “Control” and day-to-day management of the joint venture can be delegated to the nonmember manager, who through a consulting agreement may be compensated accordingly. Since the single-member LLC may be disregarded for tax purposes, it may enable the “sponsor” who has been awarded new markets tax credits to meet the qualified active low-income community business test of IRC §§45D(d)(2)(A)(V).* *
See Section 12.5 for discussion of the new markets tax credit program.
more than one member. The regulations, however, do not describe the steps deemed to occur in reaching these results. Revenue Rulings 99-5 and 99-6 fill in the details. Revenue Ruling 99-588 explains the federal income tax consequences when a single-member domestic LLC, disregarded for federal tax purposes, becomes classified as a partnership as a result of having more than one member. In Situation 1, B purchases 50 percent of A’s membership interest in a single-member LLC. The ruling concludes that B is treated as purchasing a 50 percent interest in each of the LLC’s assets. Immediately thereafter, A and B each are treated as contributing their respective interests in the LLC’s assets to a partnership in exchange for a 50 percent interest in the partnership. In Situation 2, B contributes cash to A’s single-member LLC in exchange for a 50 percent membership interest in the LLC. The ruling concludes that A and B each are treated as contributing property to a partnership in exchange for a 50 percent partnership interest. A is deemed to contribute to the partnership all of the single-member LLC’s assets, while B is treated as contributing cash. Revenue Ruling 99-689 explains the federal income tax consequences when one person purchases all of the membership interests in an entity taxed as a partnership, causing it to terminate under IRC §§708(b)(1)(A).90 In Situation 1, A and B are equal partners in the LLC. A sells his entire 50 percent interest to B, leaving B as the sole owner of a disregarded entity. A is treated as selling his partnership interest to B, but B is treated as acquiring the terminated partnership’s underlying assets. B acquires his own historical 50 percent interest in those assets in a deemed liquidation of the terminated partnership, but acquires A’s historical 50 percent interest in the assets by purchase. As a result, B may not “tack” the partnership’s holding period in the deemed purchased assets. In Situation 2, C and D are equal partners in the LLC. C and D sell their entire interests to E, causing the partnership to terminate and leaving E as the sole owner of a disregarded entity. The parties’ tax consequences parallel those in Situation 1.91 88 89 90 91
1999-1 C.B. 434 (Feb. 8, 1999). 1999-1 C.B. 432 (Feb. 8, 1999). See Section 3.11(c). For more details on Rev. Ruls. 99-5 and 99-6, see Grace, “Now You See It, Now You Don’t: Switching to and from Disregarded Entity Status,” Journal of Passthrough Entities (CCH) 2 (May–June 1999): 38; and Grace, “Continuing Adventures of Disregarded Entities 2000,” in Tax Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2000 1 (Practicing Law Institute, June 2000).
䡲
846
䡲
c19.fm Page 847 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
When an association is owned by a corporation, gain and loss from its liquidation are governed in part by §332. No gain or loss will be recognized on the receipt by another corporation of property distributed if there is a plan of liquidation. However, forming a plan of liquidation is potentially incompatible with an elective change under §301.7701-3. To remedy this inconsistency, the IRS proposed that a plan of liquidation is deemed adopted immediately before the deemed liquidation, incident to an elective change in entity classification, unless a formal plan of liquidation is adopted on an earlier date. 92 Section 332 may be implicated when an association owned by a corporation elects to convert to a partnership or a disregarded entity. Under §§332(b), a corporation recognizes no gain or loss upon receiving property in complete liquidation of an 80 percent or more subsidiary if certain requirements are satisfied. One of these requirements is that the liquidating subsidiary adopt a plan of liquidation. Proposed Regulation §§301.7701-3(g)(2)(ii) treats a subsidiary’s election to change its classification as the adoption of a plan of liquidation. This enables §§332 to apply to the deemed liquidation.93
19.7
IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
Besides qualifying to be taxed as a partnership, an LLC whose members include one or more exempt organizations must survive another layer of IRS scrutiny. These additional rules focus on whether owning an interest in the LLC will affect the organization’s tax-exempt status. Prior to the Plumstead decision, partnerships between exempt organizations and for-profit organizations were viewed with a high level of suspicion by the IRS.94 Over the past two decades, however, the IRS has had numerous opportunities to assess whether, and under what conditions, participation in a partnership with private investors will jeopardize an exempt organization’s charitable status. Because a carefully organized LLC will typically be classified as a partnership for federal income tax purposes, the IRS has indicated that it will apply the double-prong test of the “basic partnership GCM [General Counsel Memorandum]” and the guidelines of Rev. Rul. 98-15 in analyzing an exempt organization’s participation in an LLC.95 (a)
Elements of the Analysis
Under the first prong of the test, the activities of the joint venture must serve a recognized charitable purpose. The fact that an LLC is engaged in the activity in 92 93 94 95
66 Fed. Reg. 3959; 2001 WL 37407 (Jan. 17, 2001). Id. See generally Chapter 4. Gen. Couns. Mem. 39,005 (June 28, 1983). In Rev. Rul. 98-15, 1998-12 IRB 6, the IRS applied the double-prong test to an LLC formed between a tax-exempt corporation and a forprofit corporation to own and operate a hospital. The Ruling is discussed in detail in Section 4.2(e). See also M. Sanders and Grace, “When Non-Profits Meet Subchapter K: Joint Ventures and Other Exempt Uses of Passthrough Entities,” Journal of Passthrough Entities 1 (Sept.– Oct. 1998): 22.
䡲
847
䡲
c19.fm Page 848 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
no way simplifies (or complicates) the fulfillment of this first prong as compared with using a partnership. The second part of the test concerns three somewhat overlapping issues: first, whether the venture exposes charitable assets to unnecessary or unwarranted risk,96 second, whether the charitable organization can operate the joint venture exclusively in furtherance of its charitable purposes,97 and third, whether the activities or structure of the joint venture have the effect of conferring a private benefit on the for-profit members.98 Ultimately, this second prong has evolved into an examination of a variety of criteria that indicate whether the nonprofit has sufficient control in the venture to protect its assets and ensure that its purposes are fulfilled with no inurement to individuals.99 (b)
Exposure of Charitable Assets to Liability and Private Benefit Issues
A charity’s assets may be subject to risk in a joint venture in two primary ways: directly, through exposure to personal liability for the entity’s debts and obligations; and indirectly, by virtue of guarantee, indemnity, or penalty provisions contained within the joint venture or operating agreement. These same provisions can raise private benefit issues, particularly with respect to “capital calls,” which in and of themselves may cause the arrangement to threaten the charity’s exempt status. In April, 2006, the IRS released a Field Directive that provides guidance and contains a “safe harbor” for newly formed organizations intending to participate in such ventures. Section 13.6 contains a detailed discussion of the Field Directive and the various indemnifications and guarantees relevant to the analysis by the IRS, including, inter alia, the requirement for written representations along with the exemption application covering a statement of charitable purpose; a charitable override; limitations on the consent of the investor partners; requirement for removal of the nonprofit only for cause requirements regarding construction contracts and limitations on operating deficit guarantees; and tax credit adjuster provisions, right of first refusal, repurchase guarantees and requirements regarding environmental liability. (i) Exposure to Personal Liability. If a partnership structure is chosen, and if the exempt organization serves as a general partner, it will be liable for the debts and obligations of the partnership to the extent they exceed partnership assets. 96
97
98 99
See Rev. Rul. 98-15, 1998–12 I.R.B.6 (March 23, 1998) and Gen. Couns. Mem. 39,005 (June 28, 1983) in which the IRS first utilized the two-prong test to determine that a tax-exempt organization did not jeopardize its status by serving as one of several general partners in a limited partnership with for-profit partners. A critical factor in the IRS’s determination was that the structure of the arrangement insulated the exempt assets from risk of exposure to entity-level debt. See generally Chapter 4. See Gen. Couns. Mem. 39,005. See generally Chapter 2. Note that a single noncharitable purpose may prompt the IRS to deny or to revoke the tax-exempt status of an organization notwithstanding its charitable purposes. See, e.g., Better Business Bureau v. United States, 326 U.S. 279 (1945); Universal Life Church v. United States, 13 Ct. Cl. 567 (1987), aff’d, 862 F.2d 321 (Fed. Cir. 1988). See §501(c)(3); Reg. §1.501(c)(3)-1(d)(ii); Gen. Couns. Mem. 39,862 (Nov. 21, 1991). See Section 4.2(e) and (h).
䡲
848
䡲
c19.fm Page 849 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
This potential liability greatly concerns the IRS, which does not like to see charitable assets subjected to unlimited third-party claims. Conducting a joint venture through an LLC should eliminate the IRS’s concern, because an LLC generally limits its members’ liability.100 Thus, the charity need not place any amount at risk (beyond that initially invested or subsequently contributed pursuant to capital calls). This limitation on liability, inherent in an LLC, should allay many of the concerns expressed by the IRS and eliminate much of the intricate business structuring often associated with partnerships.101 (ii) Guarantees, Penalties, and Capital Calls. Another issue that raises concern is an exempt organization’s use of guarantees and penalty provisions.102 The typical case is where a subsidiary or LLC is organized to hold a single asset, but the tax-exempt parent is required to make certain guarantees. Although not all guarantees are problematic, those that have the effect of insulating the limited partners’ assets while increasing the potential risk to a tax-exempt partner raise serious private benefit issues. These rules are applied to LLCs in much the same manner as they apply to partnerships. Generally, guarantees that are payable from partnership assets may be allowed, whereas guarantees requiring an exempt general partner to pay an amount that would provide the investors a return on their investment would not be favorably regarded.103 The LLC operating agreement (or partnership agreement) must be carefully drafted to comply with the IRS two-prong test.104 (A) M INIMUM I NVESTMENT R ETURN Minimum investment return provisions are frequently used in limited partnerships that develop and operate low-income housing. Generally, the syndicator wants to assure persons investing as limited partners that should the project fail to qualify for the low-income housing tax credit through some fault of the managing general partner or member-manager (generally the exempt organization), the projected returns to the investors will not be diminished. The IRS’s concern with the minimum investment return and return of capital provisions (discussed in the following paragraph) may be minimized through the use of a monetary “cap” on the guarantee amounts. The partnership agreement may provide, for example, a separate tax credit adjuster provision where the guarantee is limited under each separate adjustable provision to an amount that does not exceed the aggregate amount of developer and other fees (both payable and deferred) that the exempt organization or any affiliate is entitled to receive in connection with the project. As an alternative, any payments by the nonprofit organization could be treated as a capital contribution or loan to 100 101 102
103 104
This conclusion assumes that no member assumes debts or obligations of the LLC or guarantees the LLC’s liabilities. See Section 19.3(a). See Section 13.6 for a detailed discussion of April 2006 IRS Field Directive (“Field Directive”) regarding nonprofit guarantees and indemnifications in LITCH. See generally “Recent Developments in Housing Regarding Qualification Standards and Partnership Issues,” Topic B, Part II 5, Exempt Organizations Continuing Professional Education Technical Instruction Program for FY 1996 (hereinafter “1996 CPE Housing Article”). See id. Priv. Ltr. Rul. 97-31-038 (May 7, 1997).
䡲
849
䡲
c19.fm Page 850 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
the LLC and the repayment must take priority over any distribution of residual assets to members upon sale or refinancing of the property. Payments under the second approach may be unlimited in amount; also it would be acceptable to combine the two approaches in the structure. (B) R ETURN OF C APITAL Provisions under which an exempt partner or member agrees to return all or part of the capital contributions of another member, or indemnify losses sustained in the course of the venture or partnership, are typical in low-income housing joint ventures,105 but they will be scrutinized by the IRS for impermissible private benefit and to ensure that the guarantees do not place charitable assets at unnecessary risk. Although LLCs are utilized to minimize liability, the IRS has taken the position that “return of capital” clauses may have the effect of shifting what minimal risk exists in the joint venture (loss of one’s capital investment) onto the exempt organization. If the exempt organization is required to guarantee the repurchase of the investor’s interest in the LLC in the case of a failure to meet certain requirements relating to the viability of the project, according to the IRS’s recently published Field Directive, the repurchase price may not exceed the amount of capital contributions. Under this representation, “markup” of the repurchase amount to cover syndication costs is not permitted regardless of whether the syndicator is a for-profit or tax-exempt entity. (C) I NDEMNIFICATION FOR E NVIRONMENTAL L IABILITY Whether indemnification from environmental liability is permissible depends, in large part, on whether it constitutes a mere representation (and corresponding warranty) by the exempt general partner to the limited partner(s) that no environmental contamination (or accompanying liability) exists as of the date the limited partner is admitted to the joint venture, or whether the exempt organization insures and/or indemnifies the investors against future losses. In the Field Directive, the IRS recognizes that the exempt organization may protect itself from environmental liability by agreeing to review an independent Phase I environmental report on the proposed project. (D) O THER G UARANTEES Other guarantee provisions may raise a “red flag” with the IRS. For example, the IRS will closely scrutinize guarantees involving construction contracts. Under the Field Directive, the LLC is required to enter into a fixed price construction contract with a bonded contractor or contractor that provides a performance letter of credit or adequate personal guaranty. If an operating deficit guaranty is required of the exempt organization, its liability must be limited to a period not more than five years from the date that the project achieves break-even operations or limited to an amount equal to no more than six months of operating expenses. 105
In the past, some ventures have attempted to circumvent return of capital provisions by not requiring the limited partners to make any contributions until after the project had been constructed and was ready to be occupied. Unfortunately, this creates a need for the general partner to secure outside bridge financing, which has become increasingly difficult to secure over the past several years.
䡲
850
䡲
c19.fm Page 851 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
(c)
The IRS’s Position
(i) IRS Field Directive. After years of discussion between representatives of the IRS and a coalition composed of nonprofit organizations involved in LIHTC projects, in April, 2006, the IRS released a Field Directive that provides guidance and contains a “safe harbor” for newly formed organizations intending to participate in the venture. Nonprofit organizations that comply with the provisions of the safe harbor should receive favorable determination of tax-exempt status and its impact should be helpful if the Service were to raise issues upon audit provided that the organization establishes standards consistent with the Field Directive. See Section 13.6 for a detailed discussion of the Field Directive and the various guarantees and indemnifications. The aforesaid safe harbor provisions are also applicable by analogy to transactions involving new market tax credits and historic rehab tax credits. (ii) Private Letter Ruling 97-31-038.106 lthough the recent issuance in April 2006 of the Field Directive referred to above, supercedes Priv. Ltd. Rul. 97-31038, a discussion of the letter ruling provides as historical prospective of the IRS position and its development. Initially, it was the IRS’s position that an exempt organization’s use of guarantees and penalty provisions,107 although not always problematic, had the effect of insulating the limited partners’ assets while increasing the potential risk to the tax-exempt partner, thereby raising serious private benefit issues. However, Priv. Ltr. Rul. 97-31-038, released in August 1997, illustrates a softening of the IRS’s per se prohibition of all exempt organization guarantees and acknowledges that with careful planning, an exempt organization can structure partnership or LLC agreements with for-profit entities without jeopardizing its tax-exempt status. In Priv. Ltr. Rul. 97-31-038, the IRS ruled that an IRC §501(c)(3) housing organization’s participation in a plan to revitalize deteriorated urban areas (“the Plan”) would not affect its tax-exempt status. It described a §501(c)(3) public charity, created pursuant to recommendations from a city task force, to assist the city in meeting its affordable housing needs and rehabilitating the deteriorated downtown area. After formation, the organization took over the city’s emergency housing repair program, significantly lowering the response time. The organization financed or renovated thousands of housing units and provided home ownership counseling to thousands of individuals. Approximately half of the organization’s funding came from the city or the city’s allocation of federal funds. The organization requested a ruling from the IRS regarding its proposed Plan to revitalize the city. The Plan’s overall objectives included the rehabilitation of existing housing and the development of new housing using low-income housing tax credits. The Plan involved the formation of several limited partnerships, each of which was formed to own and operate a particular low-income housing project. A newly created for-profit subsidiary of the exempt organization 106
107
This discussion of Priv. Ltr. Rul. 97-31-038 is based on Michael I. Sanders and Susan A. Cobb, “Recent Rulings Provide New Standards for Joint Venture Involving Charities,” Exempt Organization Tax Review 18 (Nov. 1997): 213. See, generally, the discussion of the Plumstead decision in Section 4.2(c) and 1996 CPE Housing Article, Topic B, Part II 5.
䡲
851
䡲
c19.fm Page 852 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
served as general partner of each of the partnerships, and private investors were the limited partners. Although more than half of the housing was priced below $80,000, the new housing development targeted mixed-income families as well, with single-family residences priced from $50,000 to $300,000. Moreover, in addition to housing rehabilitation and development, the organization proposed to further stabilize the area through education, commercial development, and rehabilitation of infrastructure. (iii) IRS Analysis of the First Prong: Charitable Purpose. The IRS ruled that the exempt organization’s involvement in the Plan furthered its charitable purposes for two reasons: (1) it operated to combat community deterioration, and (2) the activities of the exempt organization lessened the burdens of government. The IRS relied heavily on the second factor—lessening the burdens of government—noting that the city had created the organization, the organization took over an important housing program operated by the city, the city was represented on the organization’s board, and the city provided more than half of the organization’s funding. The IRS determined that these facts supported the conclusion that there was an objective manifestation of a government burden that was lessened by the organization’s activities. It is important to note, however, that this standard has not been an easy one to satisfy, and thus it has limited applicability for most organizations.108 (iv) IRS Analysis of the Second Prong: Insulation of the Exempt Organization’s Assets. Although the exempt organization did not itself serve as general partner in any of the partnerships, it did agree to provide certain indemnifications and guarantees. Each of the partnership agreements included (1) an indemnification of the limited partners for any environmental liability that might arise, (2) a credit adjustment guaranty, and (3) a completion guaranty. The IRS focused on whether the exempt organization’s assets were at risk, and whether the guaranty provisions in the partnership agreements conferred a private benefit to the investors, as discussed in the following paragraphs. (A) E NVIRONMENTAL I NDEMNIFICATION The partnership agreements each contained a standard provision that the exempt organization would indemnify the limited partners for any losses caused by the violation of any environmental laws. This indemnification also covered losses realized from the recapture of tax credits. The IRS determined that because Phase I environmental assessments had been conducted on each of the properties, and because losses attributed to the limited partners would require piercing the statutory protections afforded to limited partners under 108
The test for lessening the burdens of government is generally provided in Rev. Ruls. 85-1 and 85-2, 1985-1 C.B. 178. These rulings contain a two-part test for determining whether an organization lessens a burden of government. First, is the activity a “government burden?” and, second, does the exempt organization actually “lessen” that burden? This dual standard is generally difficult to achieve.
䡲
852
䡲
c19.fm Page 853 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
state law, the risk of loss to the exempt organization was reduced. In addition, the IRS determined that because the parties modified the partnership agreements to require indemnification by the exempt organization only to the extent losses arising from the recapture of credits are attributable to the gross negligence or willful misconduct of the general partners, the guaranty would not “overly benefit” the private investors. (B) C REDIT A DJUSTMENT G UARANTY In general, in order for a project to qualify for the low-income housing tax credits under IRC §42, a minimum number of units must be occupied by low-income tenants, rents must be restricted throughout a 15-year compliance period, and the owner must comply with certain other requirements set forth in §42. Failure to comply with these requirements results in loss of credits and/or recapture of credits previously awarded. In this ruling the exempt organization had originally agreed to indemnify the limited partners if the tax credits received were less than the tax credits projected to be received by the limited partners. In fact, before this ruling, the IRS had taken the position that any guarantee of credit adjustments would confer unwarranted private benefit to the limited partners and, therefore, would not be permitted. In this ruling, however, the IRS was persuaded to approve the guarantee by the tax-exempt organization after the parties amended each of the partnership agreements to treat any credit adjustment as a capital contribution, rather than a penalty for breach of warranty. The IRS noted that the recharacterization of the credit adjustment was an important factor in its determination, and that such recharacterization more appropriately reflected the transaction. Accordingly, although charitable assets could be used to cover a shortfall, by recharacterizing the exempt organization’s increased payment as a capital contribution, these assets were likely to be returned to the exempt organization upon dissolution, inasmuch as partnership distributions were to be based on an organization’s capital account. Based on these facts, the IRS concluded that the guaranty provision would not unduly benefit the private investors. (C) C OMPLETION G UARANTY The exempt organization also agreed to guaranty the completion of the housing projects. The IRS stated that the risk of not completing the projects in this case was “minimal,” for two reasons: (1) three of the projects were in operation, and (2) the organization was the developer and, therefore, in control of when the remaining projects would be completed. The IRS concluded that the completion guaranty would not “overly benefit” the private investors. (v) Impact of the Ruling. Although the Field Directive supersedes the Private Letter Ruling, it is significant historically in several respects. Most important, it represented a new direction for the IRS, whose previous position was that any guarantee of investor obligations and/or tax credits by an exempt general partner would violate the prohibition against private benefit and would therefore be unacceptable. Given the facts in this case, however, in particular the significant 䡲
853
䡲
c19.fm Page 854 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
involvement by the governmental agencies and the city, the IRS was persuaded to see that the public benefit outweighed any private benefit to the investors. Moreover, before this ruling, the standard for the second prong of the Plumstead test was whether the “private benefit to limited partners is quantitatively and qualitatively incidental to public benefits from the partnership.”109 In this ruling, the IRS noted several times that the guarantees would not unduly benefit the private investors. Using this new, more liberal standard, the IRS allowed the limited guarantees to remain in the partnership agreements without jeopardizing the tax-exempt status of the exempt organization. In this ruling, in which the exempt organization had such a close relationship with the local government and achieved its purposes through lessening the burdens of government, the IRS was persuaded that the public benefit outweighed any private benefit. Furthermore, guarantees provided by the exempt organization were limited, and the organization had a long track record of substantial charitable activities. Nevertheless, this ruling represents significant flexibility on the IRS’s part and a recognition that exempt organizations may safely enter into partnerships with private investors by tailoring their agreements so as not to jeopardize their tax-exempt status. (A) O THER P LUMSTEAD C ONCERNS The partnership agreement discussed in Priv. Ltr. Rul. 97-31-038 also provided for powers of substitution in the limited partner. These powers allowed the limited partner, or its representative, to assume managerial control of the partnership “if the limited partner regards [the general partner] to be in material violation of [the partnership agreement].” Inasmuch as any failure to make the required payments under the guarantee provisions (that is, failure to operate for a nonexempt purpose) would be considered a material breach, the IRS concluded that under the facts of the ruling, it was not possible for the would-be nonprofit organization to (1) operate exclusively for charitable purposes and (2) maintain the requisite control over partnership operations to meet the Plumstead requirements. CAVEAT The IRS will scrutinize guaranty and similar provisions to determine their actual impact on the partners or members in terms of the two-prong test. If the provisions have the effect of placing charitable assets at risk, insulating the investors from loss at the expense of the exempt member, or generating more than incidental private benefit, the charitable organization may jeopardize its exempt status. “Creative drafting” (that is, characterizing a guaranty, indemnity, or penalty payment as a “capital reduction amount” or “credit adjustment”) thus is not likely to pass muster under the IRS’s interpretation of the two-prong test.
109
Priv. Ltr. Rul. 89-38-002 (May 31, 1989).
䡲
854
䡲
c19.fm Page 855 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
(B) C APITAL C ALLS Frequently, LLC operating agreements contain provisions requiring members to contribute additional capital to the business upon the occurrence of some event or at specified periods. These “capital calls” are occasionally made for the purpose of meeting unforeseen or unexpected costs.110 More typically, capital call provisions exist to enable the LLC to raise funds to satisfy annual operating deficits or provide additional working capital. Although there are no specific guidelines relating to capital call provisions, it is important that the provisions address the concerns of the two-prong test and General Counsel Memorandum 39,005. In order to meet these requirements, capital calls should generally be structured to obligate exempt and for-profit members to the same extent, taking into account their respective ownership interests, and any penalties for noncompliance should be reasonable, based on the facts and circumstances. Similarly, a capital call provision requiring additional contributions solely from exempt organization members and not from for-profit members could result in a finding of private benefit. A capital call requiring an exempt member to make a disproportionate contribution without a corresponding increase in its profit interest may also be of concern, depending on the facts of the particular case.111 Conversely, a provision requiring pro rata contributions from all members if operating reserves fall beneath a certain level, should be acceptable. Occasionally, a member may be unwilling or unable to contribute additional capital or to “meet” a capital call. To address such situations, most capital call provisions impose penalties on a member failing to meet the financial obligation. These penalties usually take the form of liquidated damages, a diminution in interest, or a forfeiture of rights to distributions or privileges. Whatever form the penalty takes, in order to meet IRS standards, it must be reasonable in light of the circumstances. A liquidated damages clause that provides for an unreasonable or onerous penalty will be impermissible, whereas a penalty based on a reasonable formula will be allowed. Whether a forfeiture of rights is reasonable will depend on the nature and duration of the forfeiture as compared with the transgression. If a reduction in interest is to occur, a proportional dilution is far more likely to meet with IRS approval than a fixed or absolute percentage dilution. 110
111
Examples include damage suffered in a natural disaster, unforeseen increases in costs as a result of an embargo (i.e., the Arab oil embargo), and costs of complying with legislation, such as the Americans with Disabilities Act. Even if a corresponding increase is provided for, such a capital call may violate the principles of Gen. Couns. Mem. 39,005 by placing too much of the charity’s assets at risk. Whether the additional contributions (even if accompanied by increased interests) are permissible depends on the facts and circumstances. Further, if the activities of the partnership or LLC are not “functionally related” to the purposes of a participating private foundation, special care must be taken in drafting provisions that have the potential to alter the pro rata interests of the members, since they must comply with the excess business holdings rules of §4943. Under the excess business holdings rules, a private foundation generally may not hold more than a 20 percent profit interest in any (non-functionally related) business enterprise. The maximum permissible interest increases to 35 percent if it can be shown that independent parties effectively control the entity. Penalty provisions altering the pro rata interests of the partners or members could cause a private foundation to inadvertently exceed the maximum permissible percentage interests, should one of the other parties fail to meet its capital call. If this situation were to occur, the private foundation would be forced to divest itself of the excess interests within 90 days—an extremely short time frame, particularly if burdensome transfer restrictions are linked to the interests.
䡲
855
䡲
c19.fm Page 856 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
EXAMPLE 1: A is a tax-exempt low-income housing organization. B and C are forprofit individuals. A, B, and C form an LLC, in which A is the sole membermanager. A contributes $60,000 for a 50 percent interest, and B and C each contribute $30,000 for 25 percent interests. A capital call provision in the operating agreement provides that the LLC can require pro rata contributions from the members, based on their interests, not to exceed $40,000 each year. In the event a member is unable to meet its capital call, its profits interest will be proportionally reduced. A capital call is made. B and C contribute the required amount—$10,000 each—but A is unable to meet the full call and contributes only $10,000, rather than the required $20,000. B and C contribute the additional $10,000. Accordingly, A’s interest is reduced from 50 percent (60,000/120,000) to 43.7 percent (70,000/160,000), and B and C have their interests increased from 25 percent (30,000/120,000) to 28.15 percent (45,000/160,000). This penalty provision will not result in private benefit and is reasonable in light of the facts and circumstances. EXAMPLE 2: The facts are the same as in Example 1, except that the operating agreement provides that in the event a member is unable to meet its capital call, its profits interest will be reduced by 50 percent. A capital call is made. B and C contribute the required amount—$10,000 each—but A is unable to meet the call and contributes only $10,000. B and C contribute the additional $10,000. Pursuant to the penalty provision, A’s profit interest is reduced from 50 percent to 25 percent, despite the fact that A has provided 43.7 percent (70,000/160,000) of the capital. B and C have their profit interests increased from 25 percent to 37.5 percent, even though they have contributed only 28.15 percent (45,000/160,000) of the capital. Because this penalty is not reasonable in light of the facts and circumstances, it will result in private benefit and will cause the LLC to fail the two-prong test. EXAMPLE 3: The facts are the same as in Example 1, except that in the event a member is unable to meet its capital call, the member will lose its right to current distributions, which will be accumulated by the LLC and used to satisfy the member’s capital call deficiency plus interest at 2 percent above the prime rate. The member can reduce the deficiency by making required contributions at any time. A capital call is made. B and C contribute the required amount—$10,000 each— but A is unable to meet the call and contributes only $10,000. A will not be entitled to receive any current distributions until it contributes the remaining $10,000 or until the accumulated distributions make up for the $10,000 shortfall plus the specified interest. This penalty provision is reasonable and is not likely to result in private benefit. PRACTICE TIP To satisfy IRS scrutiny when an exempt organization is involved, capital call provisions must be reasonable. If a penalty is reasonable in light of the facts and circumstances, it should not raise private benefit concerns with the IRS. If a disproportionate reduction in interest or excessive damages are required under the operating agreement, the prohibition against private benefit may be violated, jeopardizing the exempt organization’s IRC §501(c)(3) status. 䡲
856
䡲
c19.fm Page 857 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
(C) C ONCLUSION Many practitioners believe that the IRS has been overaggressive in this area. For example, Congress, by providing for the nonprofit set-aside under IRC §42, recognized the need for private investors to become involved with nonprofits in order to effectively finance and construct a base of safe, affordable low-income housing. The existence of the set-aside clearly contemplates that some benefits will flow from the projects to the for-profit investors—the parties that make the projects financially viable. The nature of the industry is such that investors will be unwilling to invest significant sums of money in low-income housing without some modest measure of security—security that is provided by the guarantee and indemnity provisions. It is important that the IRS has issued the Field Directive in April 2006 providing guidance including a safe harbor covering fundamental provisions involved in LIHTC projects where nonprofit organizations serve as general partners or managing members of LLCs. In effect, the IRS has recognized that many of the guarantee, indemnity, capital call, and similar provisions negotiated in low-income housing operating agreements are market-driven rather than motivated by a for-profit partner’s interest in taking advantage of the nonprofit. Further, many low-income housing projects utilizing IRC §42 financing are structured so as to ensure that after the credit period (15 years), the housing is permanently put to charitable use, either through a right of first refusal on the sale of the property in favor of the general partner or through providing the exempt organization a right to buy out the interests of the limited partners. This is not to say that the IRS should allow private investors to impose any and all manner of guarantee or indemnity provisions on the exempt partner. Rather, the IRS should balance the public benefit realized from the continuing success of the lowincome housing program, and the significant societal benefits that flow therefrom, against the private benefits conferred as a result of certain operational arrangements. (d)
Revenue Ruling 98-15
(i) Management and Control. To meet the IRS’s two-prong test, a joint venture must operate exclusively for charitable purposes.112 Thus, it is important that an LLC be structured so as to give the exempt organization effective control over daily activities. Day-to-day control demonstrates to the IRS that the exempt organization can ensure that the joint venture is serving a charitable purpose; lack of control suggests the possibility of private benefit.113 With respect to an LLC this means that, except in rare circumstances,114 the charitable organization should always be a managing member, although not necessarily the only managing member. 112 113 114
See Reg. §1.501(c)(3)-1(c)(1). See 1996 CPE Housing Article, Part II, Topic B, Part II6. In certain situations, however, it may be acceptable for the charity to be a non-managing member. For example, in the case of an exempt organization that brings retail franchises to the inner city through the provision of financial support to individual minority entrepreneurs, who have substantial experience in such development, the project will provide jobs to the poor and underprivileged and serve to encourage minority business development. Under the circumstances, it may be important for the minority entrepreneur to be the managing member. Under this fact pattern, the IRS is likely to allow the charity to participate in a non-managing role, because substantial charitable purposes are being furthered by the activities of the LLC and the success of the project is dependent on the charity’s acting as a passive investor. (Note that this fact pattern closely resembles a program-related investment, discussed in Section 4.9). See also Section 4.3.
䡲
857
䡲
c19.fm Page 858 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
The importance of management and control issues came to the forefront in Rev. Rul. 98-15, which presents two situations involving a tax-exempt hospital operator.115 NOTE Although this ruling was long awaited in the healthcare area, the IRS has stated that its guidelines can also be applied to joint ventures between nonprofits and for-profit organizations in other areas, including low-income housing.* Furthermore, each of the ventures was organized as an LLC—a confirmation of the IRS’s acceptance of this structure as an acceptable vehicle for joint ventures involving nonprofits.† *
†
See 1999 CPE, Part I, Topic A. See also statement of former IRS Exempt Organizations Division Director Marcus Owens, “Exempt Organizations Get Plenty to Chew on in L.A.,” Tax Notes (Nov. 16, 1998): 829, and Section 4.2 (e)(i). Priv. Ltr. Rul. 95-17-029 (Jan. 27, 1995) is the only private letter ruling to date involving the use of an LLC in a joint venture between an exempt organization and a for-profit corporation. (See Priv. Ltr. Rul. 98-39016 (June 25, 1998) for an example of a joint venture between two nonprofits using an LLC as the joint venture vehicle.) In this ruling, N, a for-profit subsidiary of a for-profit corporation, owned two hospitals and their affiliated clinics. M, an exempt subsidiary of an exempt university, in large part operated the hospitals and used the facilities to train residents, medical students, and practicing physicians in coordination with its medical school and teaching hospital program. Unspecified difficulties arose between N and M regarding the operation of the hospitals. As a result, the continued successful operation of the hospitals, and the well-being of the community served by the hospitals, were jeopardized. (The hospitals were open to the public, had 24-hour emergency rooms that treated patients irrespective of ability to pay, and provided 40 percent of the charitable medical care in the area.) N and M agreed to form an LLC that would own and operate the hospitals and alleviate their operational difficulties. Presumably (although not stated in the ruling), an LLC was chosen because it allowed both organizations to participate in the management of the hospitals, while affording both organizations limited liability. In holding that the arrangement did not jeopardize the tax exemption of M or its university parent, the IRS relied on three factors, all of which are contained in the Plumstead two-prong test. First, the hospitals would continue to provide medical services in a manner consistent with IRC §501(c)(3) requirements; second, the teaching requirements of the university parent would continue to be met by the operation of the hospitals; and third, there were no disproportionate allocations of joint venture profits or losses under the LLC operating agreement. It is important to note that although the specific language of the articles of association and operating agreement was not included in the ruling, they necessarily played a key role in the IRS’s determination. Guarantee provisions, the structuring of capital calls (if any), and the designation of control over day-to-day affairs, for example, would have been issues of concern to the IRS had they not been satisfactorily addressed by the governing documents.
In each situation, a nonprofit formed an LLC with a for-profit entity, which then operated a hospital. The nonprofit in both cases contributed all of its operating assets, including a hospital, to the LLC in exchange for an ownership interest in the LLC. The parties’ ownership interest was proportional to their respective contributions. With regard to any LLC distributions, the nonprofit in each situation intended to use the proceeds to fund grants that would further its charitable purpose in the healthcare area.116 Although many facts in the two situations are similar, there were significant differences in the following areas: (1) control through board composition, (2) 115 116
Rev. Rul. 98-15, 1998-12 I.R.B. 6 (Mar. 23, 1998). See also G. Petroff, “Whole Hospital Joint Ventures: The IRS Position on Control,” Exempt Organization Tax Review (July 1998). See Section 4.2(e) for a detailed discussion.
䡲
858
䡲
c19.fm Page 859 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
overriding fiduciary duty, (3) provisions of the management contract, (4) related versus independent officers, (5) conflicts of interest, (6) minimum distributions, and (7) reserved powers. Based on the facts and circumstances, the IRS determined that the nonprofit in the first situation retained its exempt status because it continued to operate exclusively for charitable purposes and only incidentally for the benefit of the for-profit’s private interests. Specifically, the IRS looked to the governing documents of the LLC, which obligated the joint venture to provide healthcare services for the benefit of the community and to give charitable purposes priority over the maximization of profits. In addition, the ruling noted that the structure of the board gave the nonprofit’s appointees voting control, thus ensuring that the assets owned by the nonprofit and the activities it conducted through the joint venture were used primarily to advance the charitable purposes. Consequently, the nonprofit retained sufficient control over the joint venture’s activities to ensure that its charitable purposes would be fulfilled. On the other hand, in the second situation, there was no binding obligation to serve charitable purposes, so the LLC could deny treatment for the poor. Second, the nonprofit could not initiate new charitable programs without at least one vote from the for-profit. Third, the management company was a subsidiary of the for-profit organization, with broad discretion over the venture’s activities and assets. Fourth, the chief executives of the LLC had a prior relationship with the for-profit. Finally, the management company could unilaterally renew its contract. In these circumstances, the nonprofit could not establish that the venture would fulfill charitable purposes as opposed to private interests. Revenue Ruling 98-15 confirms that control by the exempt organization over the operational and organizational structure of the partnership is crucial. Thus, the organizational documents for partnerships involving tax-exempt organizations should contain a structure that provides participating exempt organizations with control over the venture. Consequently, in structuring a venture, the members should ensure that the exempt organization’s effective control over the day-to-day operations of the LLC cannot easily be circumvented or reduced. For example, for-profit members should not be able to amend the operating agreement without the consent of the charitable organization; otherwise, the IRS could argue that the exempt member does not actually control the LLC.117 Similarly, if the for-profit members have sole discretion regarding (or a veto power over) the sale of LLC assets, this may be construed as conferring final authority over the LLC to the for-profit’s members.118 Further, if the exempt organization can be removed from its management position without cause, or if its position is subject to periodic elections, the requisite control may be lacking.
117
118
Such a provision may raise private benefit concerns as well, because the for-profit members would be able to terminate the LLC or modify the organizational rules or structure to suit their own (presumably profit-motivated) purposes. See 1996 CPE Topic B, Part II6; Gen. Couns. Mem. 39,005 (June 28, 1983) (in which the IRS cited favorably the presence of a right of first refusal option on the partnership property in favor of the exempt organization).
䡲
859
䡲
c19.fm Page 860 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
The need to give the exempt organization member effective day-to-day control does not necessarily prevent for-profit members or persons from participating in day-to-day management. For example, a venture might not meet expectations or even succeed unless an expert in the particular line of business has the discretion to supervise employees, monitor inventories, resolve customer complaints, and otherwise actively participate in managing the business. Although no legal authority appears to address the issue, allowing this type of participation by forprofit persons should not result in a finding that the joint venture fails to operate exclusively for charitable purposes if the exempt organization has not abdicated daily control of the business. To help ensure this outcome, the exempt organization member should have the ability to override management decisions made by for-profit members or other for-profit persons such as line managers. (e)
Private Letter Ruling 97-36-039119
A private letter ruling reaffirms the IRS’s position that the tax-exempt co-general partner in a limited partnership120 formed to provide affordable housing must control the substantive functions of the partnership, including compliance with resident qualifications and rental restrictions, in order to ensure that the activities of the partnership further charitable purposes. The ruling at issue, Priv. Ltr. Rul. 97-36-039 (September 15, 1997), involved an IRC §501(c)(3) charitable organization formed to provide low-income housing, which proposed to develop a multi-unit, single-room-occupancy facility. The facility was to be partially funded with low-income housing tax credits that had been allocated to a limited partnership in which the charity was the managing general partner. The charity had only a 0.15 percent general partnership interest, and a for-profit/co-general partner who served as the developer of the property held a 0.85 percent general partnership interest. The investors held the remaining 99 percent interest in the partnership. Under the partnership agreement, the managing general partner (the charity) had responsibility for the day-to-day operations of the partnership. The charity and the developer were to control certain substantive matters jointly, such as compliance with resident qualifications and rental restrictions. However, the developer’s partnership interest enabled it to have effective control over qualification and substantive operation of the partnership. Under the partnership agreement, the developer/co-general partner was obligated to return funds to the investors if specified contingencies occurred, including (1) an allocation differential in which the projected credits exceeded the allocated credits, (2) a tax credit shortfall in which projected credits exceeded the actual credits, or (3) a tax credit recapture. In addition, the developer/co-general partner was obligated to acquire the entire interest of the investors if specified events did not occur on time. 119
120
This discussion of Priv. Ltr. Rul. 97-36-039 is based on Michael I. Sanders and Susan A. Cobb, “Recent Rulings Provide New Standards for Joint Ventures Involving Charities,” Exempt Organization Tax Review 18 (Nov. 1997): 213. Although this ruling involves a limited partnership, it is relevant by analogy to limited liability companies.
䡲
860
䡲
c19.fm Page 861 Thursday, March 15, 2007 5:29 PM
19.7 IRS ANALYSIS: THE DOUBLE-PRONG TEST AND REV. RUL. 98-15
The charity/co-general partner did not agree to any similar guarantees. However, the charity had entered into a pledge and security agreement, pledging its entire partnership interest, including its capital contribution and fees that could become payable for the performance of services, to secure a default under the partnership agreement, which included the failure of the developer to return funds to the investors or acquire the entire interest of the investors. Thus, from the IRS’s perspective, the charity’s pledge indirectly benefited the developer/cogeneral partner, because it could be exercised upon the failure of the developer to make good on its guarantees to the investors. The IRS was particularly concerned that the charity, because of its minority (in fact, de minimis) interest, lacked control over the substantive obligations of the partnership. Thus, the IRS concluded that the charity was not in a position to cause the partnership to carry out its exempt objectives. To ensure that the partnership operated for charitable purposes, the parties agreed to amend the partnership agreement to “redistribute control” among the general partners, so that the charity was delegated substantive authority formerly reserved jointly to the general partners. In particular, the amendment gave the charity the authority to use partnership resources to operate in a manner that would comply with the set-aside requirements, the regulatory agreement, the extended use agreement, and all material provisions of the project documents. Under the amendment, the charity maintained its authority as managing partner over the day-to-day operations of the partnership. Day-to-day control demonstrated to the IRS that the exempt organization could ensure that the joint venture was serving a charitable purpose, whereas lack of control suggested the possibility of private benefit.121 Moreover, in response to another IRS concern, the parties terminated the pledge and security agreement. The IRS had been troubled by the charity’s pledge to the investors of its entire partnership interest, including capital contributions and fees, arguing that the pledge not only benefited the investors but also the developer, because it could be exercised upon the failure of the developer to make good on its guarantees. This private letter ruling reaffirms the IRS’s continued reliance on the twoprong test of Plumstead and the importance, from the IRS’s perspective, of the charitable organization’s control of the partnership in order to ensure that charitable ends are served. (f)
United Cancer Council
In United Cancer Council v. Commissioner,122 the Tax Court held that a fund-raiser retained improper controls over a charity. In this case, the IRS and the Tax Court focused on the following factors, among others, which indicated to them that the fund-raiser had improper control: (1) the part of United Cancer Council’s (UCC) gross revenues that was available for it to use on charitable programs was very small—about 5 percent of the gross receipts; (2) the contracts under which the 121 122
See 1996 CPE, Topic B, Part II6. See also Section 13.2. 109 T.C. 17 (Dec. 2, 1997).
䡲
861
䡲
c19.fm Page 862 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
fund-raiser was compensated did not provide for any cap or upper limit, and thus, according to both the Tax Court and the IRS, was unreasonable; and (3) the fees were on a per-unit basis and exceeded the rates charged by others for similar types of services. Moreover, the Tax Court held that the fund-raiser constituted an insider for private inurement purposes because it had a “meaningful opportunity” to exercise substantial control over the tax-exempt organization’s activities so as to be able to “readily manipulate” it or its activities to the fund-raiser’s benefit, even though the fund-raiser lacked any formal voice in the selection of the charity’s directors or officers. This case was reversed and remanded to the Tax Court in February 1999, with the Seventh Circuit overruling the Tax Court’s conclusion that the fundraiser constituted an insider. The court ruled that there was no basis in law, tax or otherwise, for the Tax Court and IRS assertion that the fund-raiser “controlled” UCC and was therefore an insider by virtue of the contract. Rather, the court remanded the case for consideration of the issue of whether the UCC board was imprudent in approving the contract and allowing UCC’s assets to benefit a private party, the IRS’s alternative ground for revoking UCC’s exemption.123 The case was subsequently settled. (g)
Conflict with Fiduciary Duties
An LLC’s operating agreement can be drafted to minimize or eliminate the previously described issues concerning guarantees, capital call provisions, and issues of management and control. Many states, however, restrict members’ ability to eliminate all possible conflicts through the operating agreement. This is especially true with respect to fiduciary duties. A major area of concern, and that which initially proved most troublesome to the IRS, is the seemingly irreconcilable conflict between an exempt organization’s duty to operate exclusively for exempt purposes and the duty it may have to advance the private interests involved in a venture.124 Although compliance with common-law fiduciary duties may not prove unduly burdensome in some jurisdictions, the myriad of fiduciary duties and standards of care125 imposed on LLC managers and members (either through the LLC enabling statutes or common-law principles) must be taken into consideration and reconciled with the exempt member’s need to preserve its exempt status. Revenue Ruling 98-15126 reaffirmed the importance of a charitable override provision. The governing documents must allow the nonprofit’s purposes to be fulfilled.
123 124 125
126
165 F.3d 1173 (7th Cir.1999) rev’g and remanding 109 T.C. 326(1997). See Gen. Couns. Mem. 37,852 (Feb. 9, 1979). In addition to the statutory fiduciary standards discussed in the following paragraphs, common-law duties may apply to managers or even non-managing members. These common-law duties include the fiduciary duty of a majority shareholder to minority shareholders (or, in the case of an LLC, a controlling member to noncontrolling members); the duty of due care in the selection of managers; the duty to refrain from misappropriating the LLC’s business opportunities; and the implied obligations of “good faith” and “fair dealing.” S. Black, “Fiduciary Duty Issues in Limited Liability Companies with Exempt Organization Members” 3 (on file with author). See Section 18 and 4.2(e).
䡲
862
䡲
c19.fm Page 863 Thursday, March 15, 2007 5:29 PM
19.8 NONPROFIT-SPONSORED LIHTC PROJECT
The types of duties and degree to which duties are imposed vary considerably among the individual states’ enabling statutes. At one end of the spectrum is California, in which the member-managers have the same duties to an LLC and its members as a general partner has to a partnership and its partners.127 The “middle” position is represented by New York and Michigan, which impose a “business judgment” rule on the managing members—to act in the best interests of the LLC, perform in good faith, and use the care that an ordinarily prudent person in a like position would exercise under similar circumstances.128 At the other end of the spectrum are Delaware and Utah, which allow members the flexibility to set out in the operating agreement the standard of care that must be followed by the managers.129 Because it is critical that the exempt member be aware of, and abide by, the appropriate jurisdictional fiduciary requirements, the LLC should carefully consider the rules of its state of organization. An LLC organized under the LLC statute of Delaware or New Hampshire, for example, would allow the exempt organization managers much greater flexibility in maintaining the balance between operating for charitable purposes and operating for private benefit than would an LLC organized under California law.
19.8
NONPROFIT-SPONSORED LIHTC PROJECT
As previously discussed in Section 2.6(a), the IRS’s present position appears to be that, in the context of healthcare organizations, to satisfy the community benefit requirement it is important to have a “plus” factor to disprove any notion of the existence of impermissible private benefit.130 With regard to LIHTC ventures, the IRS often requires the nonprofit applicant to show how, or why, it is different from a for-profit sponsor since many for-profit sponsors operate high-quality, wellmanaged LIHTC projects, which, like those managed by nonprofits, play a vital role in providing affordable housing to the poor and underprivileged. A number of arguments have been made to the IRS distinguishing between nonprofit and for-profit sponsored projects that justify exemption to the nonprofit.131 Certain of these arguments are as follows: • Typically, nonprofit-sponsored projects are controlled by community-based
boards of directors who have a direct interest in the community where the 127
128
129
130 131
Id. See Cal. Corp. Code §17153 (Deering 1995). Generally, the duties of a general partner are the duty of loyalty, which entails refraining from self-dealing, competing with the partnership, and misappropriating business opportunities; the duty to exercise sound business judgment; the duty to act in good faith; and the duty to act in the best interests of the organization. See, e.g., Mich. Comp. Laws §450.4404 (1993) (Mich. Stat. Ann. §21.198(4404) (Callaghan 1993)); N.Y. Limited Liability Company Law §409 (Consol. 1994); Black, “Fiduciary Duty Issues in Limited Liability Companies with Exempt Organization Members” 3 (on file with author). See Del. Code Ann. tit. 6, §18-402 (1994); Utah Code Ann. §48-2b-125(3). An even more lenient standard is provided by New Hampshire, stating that managing members will be held liable only for gross negligence or willful misconduct, even if the operating agreement provides otherwise. See N.H. Rev. Stat. Ann. §304-C:31 (III-V). See Section 2.6 for discussion of the “plus” theory of the IHC case. These points were included in a letter that was submitted to Lois Lerner, Director, EO Rulings and Agreements, Office of TE/GE, Internal Revenue Service, on Feb. 20, 2003, written by Celia Roady and Michael I. Sanders.
䡲
863
䡲
c19.fm Page 864 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
project is located. As a result, the goal of the board is to use the housing project as a means of transforming the lives of the residents of that community. However, the typical for-profit LIHTC limited partnership is governed by the owners of that entity whose major goal is to make a profit. • In a nonprofit-sponsored project, the general partner is neither controlled
by nor affiliated with the for-profit investors. In addition, all negotiations and agreements between them are at arm’s length. In many for-profit partnerships, however, the general partners have established relationships with the investors. Furthermore, the for-profit general partner, unlike the nonprofit general partner in a nonprofit-sponsored project, has the primary goal of maximizing profits as opposed to maintaining the project as a low-income property in perpetuity. • While for-profit-sponsored projects may be selected based on where
opportunities lie and the ability to produce short- or long-term income for its owners, nonprofit-sponsored projects are often selected based on the needs of communities. In many cases, these projects involve rehabilitation of older and neglected projects housing low-income and senior residents or providing housing for people who have difficulty finding housing, including those suffering from HIV/AIDS, mental disorders, or substance abuse. Thus, most nonprofit-sponsored projects are selected for the main purpose of assisting the underprivileged, the poor, and the elderly.132 As a result, such projects are undertaken in the more difficult-to-develop areas, communities that have a shortage of low-income housing or housing designed for senior citizens, or areas that have numerous other issues that make development and successful operation extremely difficult and challenging. • Typically, in a nonprofit-sponsored venture, the nonprofit general partner
selects a management company with which it has no previous relationship or affiliation. The selection is made based solely on the qualifications of the company and its demonstrated ability to handle the responsibilities of managing a low-income housing project in a manner that meets the needs of the residents as opposed to maximizing profits for the venture. A forprofit-sponsored project has the ultimate goal of making profits; therefore, management is often vested in affiliates of the for-profit general partner whose objective is to manage the project in order to maximize its revenues. • Unlike for-profit-sponsored projects, nonprofit-sponsored projects often
focus on more than just the provision of affordable housing and offer a wide variety of community services designed to meet the ancillary needs of the project and community residents. In many cases, nonprofitsponsored projects offer computer learning services, health services for persons without health insurance (such as free diabetes screening, Pap tests, and mammograms), after-school programs, day care, summer camps, scholarship programs, local transportation, and similar programs.
132
See Gen. Couns. Mem. 39,005 (Dec. 17, 1982). The IRS has recognized that an organization engaged in such activities is one operating exclusively for charitable purposes.
䡲
864
䡲
c19.fm Page 865 Thursday, March 15, 2007 5:29 PM
19.9 PRIVATE FOUNDATIONS AS MEMBERS OF LLCS
• Nonprofit-sponsored projects often encourage and assist residents to
acquire the skills required to prepare for home ownership by engaging in lease-purchase programs, which make it possible for the families to purchase their homes or condominiums at a below-market price at the end of the LIHTC compliance period. Such programs encourage active involvement by the residents in the projects. Nonprofit-sponsored projects also encourage active involvement of the residents in the projects by providing support for the formation of nonprofit resident and neighborhood associations. • Nonprofit-sponsored projects are structured in a manner that produces
rental income that is “merely” enough to pay the reasonable expenses of operating the projects, unlike for-profit-sponsored projects that are structured to generate income for the participants. If a nonprofit-sponsored project generates income in excess of operating expenses, rather than making distributions to the investors, the funds are used to make repairs and capital improvements and to increase the size of the operating and capital reserves to meet future needs. • The most fundamental difference between for-profit- and nonprofit-
sponsored projects is the difference in the objectives of the two entities. The for-profit sponsors are engaged in the venture throughout the compliance period with the sole objective of making a profit and claiming the LIHTC. After the tax credit compliance period, the for-profit sponsor intends to either sell or convert the property to market-rate housing. For the nonprofit sponsors, however, the objective is not just to provide affordable housing, but also to maintain the project as low-income, affordable housing beyond the compliance period. The joint venture with the investor is viewed by the nonprofit sponsor only as a tool for obtaining required financing for the project. As a result, nonprofit-sponsored projects usually contain provisions giving the nonprofit sponsor a right of first refusal to acquire the property at the end of the tax credit compliance period for a purchase price set forth in §42(i)(7).133
19.9
PRIVATE FOUNDATIONS AS MEMBERS OF LLCS
Ensuring that the two-prong test is satisfied is of particular importance to private foundations participating as members in LLCs. This is because private foundations are subject to special restrictions on the non–functionally related business holdings they possess.134 “Functionally related” businesses, defined as “trade[s] or business[es] that [are] not unrelated trade[es] or business[es] as 133
134
Section 42(i)(7) was added to the Code by Congress so that nonprofit sponsors would have the opportunity to gain ownership of low-income projects after the tax credit period expires and continue to maintain them as low-income housing for the residents. As a result, nonprofit sponsors often negotiate at the outset for the right of first refusal to reacquire the property, regardless of the value of the property at the end of the tax credit period. See §§4943(d)(3) and 4942(j)(4).
䡲
865
䡲
c19.fm Page 866 Thursday, March 15, 2007 5:29 PM
EXEMPT ORGANIZATIONS INVESTING THROUGH LIMITED LIABILITY COMPANIES
described in IRC §513,” are excluded from excess business holdings restrictions.135 If a joint venture meets the two-prong test, it must have a charitable purpose and will thus necessarily fall outside the excess business holdings rules. However, if a private foundation invests in a business entity that is engaged in an activity that is unrelated to its charitable purposes, not only may it jeopardize its exemption or realize unrelated business income, but it will be required to dispose of its excess holdings within 90 days—a difficult task, given the transfer restrictions commonly imposed on LLC interests.136 It may be advantageous for a private foundation to invest in an LLC, as illustrated by Priv. Ltr. Rul. 9834033.137 A private operating foundation made a capital contribution to an LLC in which it had a 50 percent ownership interest. The LLC operated a family service support center. The IRS advised the foundation that it could treat the contribution as a program-related investment because it had a primary charitable purpose. This means that the amount of the capital contribution would qualify as an expenditure incurred for the active conduct of charitable activities, as defined in §53.4942(b)-1(a)(1)(ii). Because the LLC was taxed as a partnership, the foundation could also treat 50 percent of the LLC’s expenditures as its own “active conduct of direct charitable activities.”
135
136
137
In general, §4943 limits the degree to which a private foundation may control a business enterprise. Generally, a private foundation may hold up to a 20 percent profits interest in a joint venture. See §§4943(c)(2)(A), (c)(3). That interest may be as high as 35 percent if unrelated third parties effectively control the joint venture. See §§4943(c)(2)(B) and 4943(c)(3). If, for example, the private foundation member has the power to appoint or elect a majority of the “operating board” of the LLC, the IRS may raise excess business holdings concerns, even if the foundation owns less than 20 percent of the LLC, on the theory that “absolute control” (or the possibility of it) exists. Owens, Remarks at the Meeting of the ABA Tax Section (Aug. 5, 1995). See Reg. §53.4943-2(a)(1)(ii). Private foundations that receive gifts constituting excess business holdings have five years to divest themselves of the interest. §4943(c)(6). See Section 10.2. (Aug. 21, 1998).
䡲
866
䡲
c20.fm Page 867 Thursday, March 15, 2007 10:42 PM
C H A P T E R
T W E N T Y 20
Debt Restructuring and Asset Protection Issues 20.1
INTRODUCTION
Partnerships and joint ventures involving tax-exempt organizations—and the individuals participating in such ventures—like all other entities and individuals, have become much more concerned with debt restructuring and asset protection issues in recent years. This has been especially true for real estate ventures because the U.S. Department of Housing and Urban Development (HUD) and the Resolution Trust Company (RTC) have become more aggressive about disposing of their mortgage portfolios, and because lenders generally have intensified their collection efforts and have become less complacent about ignoring defaults by real estate owners. Welfare reform has also raised debt restructuring and asset protection concerns for partnerships and joint ventures involving tax-exempt organizations. To illustrate, the New York Equity Fund, a nonprofit syndicator of affordable housing in New York City, recently undertook a study of the impact of welfare reform proposals on low-income housing projects. Among other things, this study concluded that welfare reform may abruptly retract the economies of low-income communities: by (1) substantially reducing the income transfers represented by pre–welfare reform public-assistance programs, which at one time constituted as much as 45 percent of the dollars in those economies; (2) disrupting current immigration patterns that typically rebuild populations of low-income, distressed neighborhoods; and (3) reducing the operating performance and stability of the nonprofit housing that is often the core stabilizing factor in such communities.1 Bankruptcy is an integral part of debt restructuring and asset protection planning. Through chapter 11, an entity can dramatically restructure its balance sheet by extending, modifying, and even discharging its liabilities. The anticipated outcome from a chapter 7 liquidation is often the unspoken backdrop against which proposals are compared and negotiations unfold. Consequently, partnerships and joint ventures involving tax-exempt organizations, and especially real estate owners, have increasingly focused on bankruptcy as an option 1
New York Equity Fund, Welfare Reform: Background and Impacts, 2.
䡲
867 䡲
c20.fm Page 868 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
and an asset protection strategy.2 Even if partnerships and joint ventures, as borrowers, do not actually file bankruptcy, the leverage obtained by the credible threat of a bankruptcy filing, whether express or implied, can produce a consensual restructuring of debt outside of bankruptcy. Thus, knowledge of bankruptcy as it applies to partnerships and joint ventures involving tax-exempt organizations is a powerful strategic tool. This chapter introduces the issues and sets out the general considerations that apply to partnerships and joint ventures involving tax-exempt organizations in the bankruptcy context. In any given fact situation, expert analysis of the particular facts and circumstances will be necessary. PLANNING POINTER It is highly recommended that a bankruptcy specialist be consulted. Bankruptcy and debtor–creditor law, especially in light of the recent amendments to the Bankruptcy Code,* is a complex field. Each situation has its own nuances that, if not fully understood, could affect the advice and outcome. *
On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Act of 2005 (the 2005 Bankruptcy Code Amendments).
This chapter discusses the following: • General bankruptcy principles3 • Benefits and parameters of the automatic stay4 • Requirements to obtain a confirmable plan of reorganization in chapter 11
bankruptcies5 • Benefits and parameters of a bankruptcy discharge6 • Limitations on a debtor’s use of cash after entering bankruptcy7 • The 1994 Tax Reform Act provisions related to single-asset real estate
bankruptcies8 This chapter focuses on practical issues that partnerships and joint ventures involving tax-exempt organizations may face if they seek bankruptcy relief. Specifically, it discusses: • How joint ventures can use a bankruptcy technique or strategy to restruc-
ture or cram down debt in a joint venture situation when a tax-exempt organization is the general partner or managing member 2
3 4 5 6 7 8
For a discussion of bankruptcy, see David Tatge et al., Chapter 7 Bankruptcy Trustee’s Manual (John Wiley & Sons, 1996); Thomas J. Salerno et al., eds., Advanced Chapter 11 Bankruptcy Practice (John Wiley & Sons, 2d ed., 1996). For a discussion of asset protection planning, see Lewis D. Solomon and Lewis J. Saret, Asset Protection Strategies: Tax and Legal Aspects (John Wiley & Sons, 1993); Lewis D. Solomon and Lewis J. Saret, Asset Protection Strategies: Forms and Commentary (John Wiley & Sons, 1996). See Section 20.2. See Section 20.3. See Section 20.4. See Section 20.5. See Section 20.6. See Section 20.7.
䡲
868
䡲
c20.fm Page 869 Thursday, March 15, 2007 10:42 PM
20.2 OVERVIEW OF BANKRUPTCY
• The implications of bankruptcy for creditor tax-exempt organizations
involved in joint ventures • The implications of bankruptcy of joint ventures, partnerships, or limited
liability companies on for-profit limited partners and nonmanaging members
20.2
OVERVIEW OF BANKRUPTCY
Generally, two types of bankruptcy are available to business entities: (1) liquidation and (2) reorganization. A chapter 7 9 bankruptcy is a liquidation. In a typical chapter 7 bankruptcy, the bankruptcy trustee collects the debtor’s nonexempt property, converts that property to cash, and distributes the cash to the creditors.10 A chapter 1111 bankruptcy typically involves the debtor’s reorganization, although a debtor may also liquidate in chapter 11. In chapter 11, creditors look to the value of the debtor’s current and future assets to satisfy their claims, whereas in chapter 7 there are no future assets. A successful chapter 11 debtor typically retains its assets and pays its creditors from postpetition earnings pursuant to a court- and creditor-approved plan of reorganization. (a)
Chapter 7 Bankruptcy
Chapter 7 bankruptcy involves five stages: (1) commencement of the bankruptcy case; (2) collection of the debtor’s property; (3) sale of the debtor’s property; (4) distribution of the sale proceeds to creditors; and (5) determination of the extent of the debtor’s discharge from further liability to these creditors. When the bankruptcy case commences, an “automatic stay” immediately enjoins all collection efforts, harassment, and all foreclosure actions by the debtor’s creditors.12 PLANNING POINTER The chapter 7 bankruptcy and asset protection planner who advises the debtor must strive to achieve two goals: (1) shielding the debtor’s property from the reach of creditors to the maximum permissible extent; and (2) ensuring the discharge of the debtor’s debt to the fullest extent possible. A bankruptcy case commences when a petition is filed with the Bankruptcy Court.13 A bankruptcy case is “voluntary” if the debtor files the petition, or “involuntary” if the debtor’s creditors file the bankruptcy petition. After a chapter 7 petition is filed, a chapter 7 bankruptcy trustee is appointed, who will begin collecting and preserving the “property of the estate” after entry of the “order for relief.” The “order for relief” is automatic when a voluntary petition is filed. For this purpose, property of the estate includes all of the debtor’s 9 10 11 12 13
11 U.S.C. §701 et seq. Only individual debtors may claim exemptions. 11 U.S.C. §1101 et seq. See Section 20.3. 11 U.S.C. §§301, 303(b).
䡲
869
䡲
c20.fm Page 870 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
property interests owned as of the petition date.14 However, for individual debtors the Bankruptcy Code exempts certain property from the bankruptcy trustee’s collection and liquidation.15 Such property is generally referred to as exempt property. CAVEAT The exempt organization must keep in mind that the bankruptcy trustee, whom the U.S. Trustee typically appoints, is a private citizen whose compensation is based on a percentage of the value of assets distributed to creditors. Thus, the bankruptcy trustee has a vested interest in collecting and distributing to such creditors as much of the debtor’s property as possible. The bankruptcy trustee learns about the debtor’s property primarily from statements and schedules the debtor must file (signed under penalty of perjury) and from information gathered from other sources, including the debtor’s testimony at the “first meeting of creditors,” during which the debtor must submit under oath to questioning by the trustee and interested creditors.* Therefore, the debtor and its advisors must carefully prepare the statements and schedules that the debtor files and be well prepared for the first meeting of creditors. It should be noted that the trustee has extensive powers to investigate the debtor should the trustee decide to do so. *
11 U.S.C. §§341, 343, 521.
After collecting the property of the estate, the bankruptcy trustee will liquidate the debtor’s property by selling it. In this process, with court permission the trustee may “abandon” property that is burdensome or of inconsequential value, such as fully encumbered assets or, in some cases, environmentally contaminated property.16 Next, the trustee distributes the proceeds of the bankruptcy estate’s liquidation to creditors in their order of priority, which is established in the Bankruptcy Code. Generally, secured creditors receive priority treatment by the distribution of either the collateral securing their claims or the proceeds from the sale of such collateral. Next, creditors holding certain “priority” claims, which the Bankruptcy Code designates for special treatment, receive distributions. Finally, creditors holding unsecured claims are paid with whatever proceeds remain from the liquidation of the bankruptcy estate.17 14 15
16
17
1 U.S.C. §541. 11 U.S.C. §522. The type of property a debtor may claim as exempt varies from state to state. Congress created a set of exemptions in the bankruptcy code under 11 U.S.C. §522, but allowed each state to opt out of those exemptions in favor of state law exemptions. Sixteen states allow debtors to elect the bankruptcy code exemptions. In those states, debtors get their choice between the federal exemptions and those in the law of their state. For the balance of the states, only the state exemptions can be selected. The 2005 Bankruptcy Code Amendments substantially amend the exemption provisions of 11 U.S.C. §522. Principally the goal of the amendments was to tighten the exemption and eliminate the ability of individual debtors to forum shop for locations that permit unlimited homestead exemptions. 11 U.S.C. §554. See, e.g., In re H.F. Radandt, Inc., 160 B.R. 323 (Bankr. W.D. Wis. 1993). Cf. Midlantic Nat’l Bank v. New Jersey Dep’t of Envtl. Prot., 474 U.S. 494 (1986) (The trustee may not abandon property in violation of a state statute or regulation reasonably designed to protect the public health and safety from identified hazards.) 11 U.S.C. §§507, 726.
䡲
870
䡲
c20.fm Page 871 Thursday, March 15, 2007 10:42 PM
20.2 OVERVIEW OF BANKRUPTCY
In the typical chapter 7 case, the individual debtor receives a “discharge.” A discharge in bankruptcy releases the debtor from all prepetition debts and bars holders of prepetition claims from bringing future collection efforts.18 However, if a creditor proves that the debtor has engaged in certain proscribed conduct, the debtor may be prevented from receiving a discharge of certain specific debts or, in more extreme cases, from receiving a discharge of any debts whatsoever.19 PLANNING POINTER The client’s goal in bankruptcy is to discharge as much of its debt as possible. EXAMPLE 1: Dan Developer and E, a tax-exempt organization, form the D/E Partnership, a general partnership, for the purpose of developing an office building and then leasing space to E. D/E obtains a $10 million loan from Big Bank, which Dan guarantees, and proceeds to build the planned building. However, before D/E completes the construction, E experiences a budgetary shortfall that precludes it from occupying the new space. D/E is unable to find an alternative tenant, which causes it to default on its debt to Big Bank. Big Bank initiates collection action against Dan, whose only assets are his D/E partnership interest, which is worthless, and $100,000 in nonexempt marketable securities. Dan files for chapter 7 bankruptcy, the bankruptcy trustee liquidates Dan’s marketable securities and distributes the proceeds, and the bankruptcy court grants Dan a discharge. Two months after filing for chapter 7, Dan wins the lottery for $10 million. So long as Dan bought the lottery ticket after he filed for chapter 7, 20 and so long as Dan ultimately receives his discharge, Big Bank cannot reach this $10 million. EXAMPLE 2: The facts are the same as in Example 1, except that the court denies Dan a discharge or, because of fraud or other reasons, denies the discharge of Big Bank’s claim. Here, when Dan receives the $10 million, Big Bank can reach these funds by collection actions based on fraud or some other inappropriate conduct. EXAMPLE 3: The facts are the same as in Example 1, except that E guarantees the debt to Big Bank instead of Dan, Big Bank initiates collection action against E, and E files for bankruptcy. Here, the result is the same as in Example 1, except that E as an organization may choose to simply go out of business or file bankruptcy. If E chooses bankruptcy, it will file for chapter 11 if it wishes to reorganize and continue to function. Should E Choose to file for chapter 7 or to liquidate under chapter 11, E does not receive a discharge of its debts—it simply becomes moribund.21
18
19 20
21
11 U.S.C. §§524, 727. See, e.g., In re Kinion, 207 F.3d 751 (5th Cir. 2000) (A chapter 7 debtor’s bankruptcy discharge operates as an injunction against the commencement or continuation of any act to collect pre-petition unsecured debt from property of the debtor). Cf. Johnson v. Home State Bank, 501 U.S. 78 (1991) (A creditor’s right to foreclose on a lien survives bankruptcy notwithstanding the discharge of personal liability). 11 U.S.C. §§523, 727. The general rule is that whatever property the debtor obtains postpetition belongs to the debtor. However, certain assets, if obtained within 180 days after filing for bankruptcy, are included in the bankruptcy estate and thus, are liquidated by the trustee and distributed to creditors. These include inheritances, divorce settlements, and life insurance proceeds. 11 U.S.C. §541(a)(5). 11 U.S.C. §727(a)(1).
䡲
871
䡲
c20.fm Page 872 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
In chapter 11, E likely will file a plan of reorganization,22 and if the plan is “confirmed” (approved) by the court, E’s initial debt to Big Bank will be modified as provided under the confirmed plan of reorganization. CAVEAT As the second example suggests, not all individual debtors receive a discharge in chapter 7 bankruptcy. Bankruptcy Code §727(a) provides several grounds on which a discharge may be denied.* *
Grounds include, among others: (1) the debtor is not an individual (11 U.S.C. §727(a)(1)); (2) the debtor is guilty of intentional fraudulent conveyances within one year before filing for bankruptcy (11 U.S.C. §727(a)(2)); (3) the debtor has unjustifiably concealed, destroyed, mutilated, falsified, or failed to keep any recorded information from which its financial condition or its business transactions may be ascertained (11 U.S.C. §727(a)(3)); (4) the debtor has engaged in certain bankruptcy crimes (e.g., has engaged in bribery or extortion, or has made false claims) (11 U.S.C. §727(a)(4)); (5) the debtor has failed to obey a court order (11 U.S.C. §727(a)(6)); (6) the debtor received a prior discharge (a) in a chapter 11 case commenced within eight years or (b) in a chapter 12 or 13 case within six years before filing the bankruptcy petition in the current case (11 U.S.C. §727(a)(8), (9)); (7) the debtor failed to complete an instructional course on personal financial management as set forth in §111 of the Bankruptcy Code (11 U.S.C. §727(a)(11)); (8) the debt is one of certain types of taxes, including taxes for which no return was filed or for which a fraudulent return was filed (11 U.S.C. §523(a)(1); (9) the debt was obtained under false pretenses or by using false financial statements (11 U.S.C. §523(a)(2)); (10) the debt was not scheduled by the debtor (11 U.S.C. §523(a)(3)); (11) the debt is a fine, penalty, or forfeiture payable to a governmental entity, other than a tax penalty that relates to a nondischargeable tax liability or a penalty that relates to a transaction or event occurring more than three years before the debtor filed the bankruptcy petition (11 U.S.C. §523(a)(7)).
A creditor may also file an “objection to dischargeability” in which the creditor seeks to deny an individual’s discharge of a specific debt.23 For example, in Example 1, if Big Bank proves that Dan made a false statement on his financial 22 23
See Section 20.4. The Bankruptcy Code does not discharge certain categories of debt. Some are excepted from discharge automatically; others will be excepted only after the creditor successfully prosecutes a complaint objecting to dischargeability. In general terms, debts that may be excepted include: (1) taxes for which a tax return, which was required to be filed, was either not filed or was filed late and within two years of the commencement of the bankruptcy case, or for which a fraudulent tax return was filed, or debts incurred to pay such taxes; (2) property or credit renewals based on false information (e.g., financial statement containing false information), or certain consumer loans acquired within 60 days before the order for relief; (3) debts the debtor failed to schedule or list in time to allow the holder of such debt to file a proof of claim; (4) liabilities for engaging in fraud while acting as a fiduciary; (5) obligations for the support of a child, spouse, or ex-spouse in the form of alimony, maintenance, or support; (6) obligations arising from the debtor’s willful and malicious injury to another or another’s property (e.g., tort suit judgments); (7) fines, penalties, and forfeitures payable to governmental units, other than certain tax penalties; (8) student loans; (9) obligations arising from death or personal injury that the debtor caused while operating a motor vehicle under the influence of drugs or alcohol; (10) debts for which a discharge was denied or revoked in a prior bankruptcy of the debtor; (11) obligations contained in final judgments, unreviewable orders, or consent orders or decrees arising from fraud or defalcation while acting as a fiduciary with respect to a depository institution or credit union; (12) obligations stemming from the debtor’s failure to fulfill a commitment to a federal depository institution regulatory agency by failing to maintain the capital of an insured depository institution; and (13) restitution obligations pursuant to the Violent Crime Control and Law Enforcement Act of 1994. 11 U.S.C. §523(a). The 2005 Bankruptcy Code Amendments provides that a discharge under chapter 7, 11, 12, or 13 does not discharge an individual debtor from any debt owed to a pension, profit sharing, stock bonus, or other plan established under §§401, 403, 408, 408A, 414, 457, 501c of the Internal Revenue Code under “(i) a loan permitted under section 408(b)(1) of ERISA or subject to section 72(p) of the IRC; or (ii) a loan from a thrift savings plan permitted under subchapter 3 of chapter 84 of title 5 that satisfies the requirements of 8433(g) of such title.”
䡲
872
䡲
c20.fm Page 873 Thursday, March 15, 2007 10:42 PM
20.2 OVERVIEW OF BANKRUPTCY
statement (on which Big Bank reasonably relied) that induced Big Bank to make the loan, Dan can still discharge his other debts. Big Bank’s claim, however, would not be discharged. Thereafter, Big Bank could pursue collection remedies against Dan postpetition. (b)
Chapter 11 Bankruptcy
(i) Generally. Typically, joint ventures involving tax-exempt organizations are structured with the exempt organization or its wholly owned corporation serving as general partner or as the managing member of an LLC. Often, for-profit corporate investors will serve as limited partners or as nonmanaging members in an LLC. In such cases, the primary concerns related to bankruptcy will include: 1. If the joint venture files for bankruptcy, how will this affect the general partner and limited partners? 2. If the general partner/exempt organization files for bankruptcy, how will this affect both the joint venture and the for-profit investors? 3. If the limited partner/for-profit corporation files for bankruptcy on its own behalf, how will this affect both the joint venture and the exempt organization/general partner? The primary goal of chapter 11 bankruptcy is rehabilitation rather than liquidation. Typically, chapter 11 cases are business cases and involve seven issues: (1) commencement of the bankruptcy case; (2) operation of the business in chapter 11; (3) formulation of a disclosure statement and plan of reorganization (“plan”); (4) creditor acceptance of the plan; (5) court confirmation of the plan; (6) discharge of the debtor based on confirmation of the plan; and (7) payments made under the plan. (ii) Commencement of Chapter 11 Bankruptcy. A qualified entity (“debtor”), which may have an exempt organization as its general partner (or as managing member) or may be the joint venture (or LLC) itself, initiates a voluntary reorganization by filing a petition with a U.S. Bankruptcy Court. The debtor may voluntarily file under chapter 11 without regard to its financial condition and need not allege that it is insolvent or unable to pay its debts as they mature. A petition may be filed in the U.S. Bankruptcy Court for the federal district in which: • The principal place of business of the debtor is located • The principal assets of the debtor are located • The domicile of the debtor has been located for the majority of the 180-
day period preceding the filing of the bankruptcy petition24 • There is a pending bankruptcy case concerning such debtor’s affiliate,
general partner, or partnership
24
28 U.S.C. §1408(1).
䡲
873
䡲
c20.fm Page 874 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
A bankruptcy petition is “involuntary” when the petitioner is not the debtor. The number of petitioning creditors needed to sign a petition varies, but in all cases the aggregate debt owed to the petitioning creditors must equal at least $12,300 more than the value of any liens on the debtor’s property securing the petitioner’s claims.25 If the debtor has fewer than 12 unsecured creditors, any one such creditor may file the petition; otherwise, at least three such creditors must sign the petition.26 To qualify as a petitioning creditor, the debt asserted must not be subject to a bona fide dispute as to liability or amount.27 The petition in an involuntary proceeding must allege one of the two following grounds for relief: (1) the debtor is generally not paying its debts as they come due (equitable insolvency);28 or (2) a nonbankruptcy general receiver, assignee, or custodian (except one appointed to enforce a lien on less than substantially all the debtor’s property) was appointed for, or took possession of, substantially all the debtor’s property within 120 days before the filing of the petition.29 The latter provision is rarely used. Typically, in the partnership context, an involuntary petition is filed to buy time or to control the management of a partnership whose partners cannot agree on management issues. Otherwise, an involuntary petition is usually filed because creditors know or suspect that the debtor is making preferential payments, or that a large adverse judgment or restructured financing is about to obtain secured status. The filing of a petition causes every transfer made within the preceding 90 days to become subject to challenge, and if made to an insider within one year of the proceeding.30 Once the involuntary petition is filed, the court may, if a party so requests, appoint an interim trustee to operate the debtor’s business “if necessary to preserve the property of the estate or to prevent loss to the estate.”31 If a trustee is not appointed, the debtor may continue to operate its business and buy, use, or sell its property as if the bankruptcy case had not commenced, except to the extent the court otherwise orders.32 If the petition is timely contested, a trial will be held, during which the petitioners must establish one of the two grounds for relief set forth earlier. If the petitioners meet their burden of proof, or if the “alleged debtor” does not timely contest the involuntary petition, the court will enter an order for relief and the case will proceed in the same manner as a case commenced by a voluntary filing.33
25 26 27 28 29 30 31 32 33
11 U.S.C. §303(b)(1); 11 U.S.C §104; 66 Fed. Reg. 10,910 (eff. Apr. 1, 2002). 11 U.S.C. §303(b)(1), (2). 11 U.S.C. §303(b)(1). 11 U.S.C. §303(h)(1). 11 U.S.C. §303(h)(2). 11 U.S.C. §547. 11 U.S.C. §303(g). 11 U.S.C. §303(f). 11 U.S.C. §303(h).
䡲
874
䡲
c20.fm Page 875 Thursday, March 15, 2007 10:42 PM
20.2 OVERVIEW OF BANKRUPTCY
CAVEAT A party filing an involuntary bankruptcy petition faces risks if the debtor contests the filing and wins. Specifically, if the court dismisses the involuntary bankruptcy petition, the court may grant (1) judgment against the petitioner and in the debtor’s favor for costs and reasonable attorneys’ fees, or (2) judgment against any petitioner that filed the petition in bad faith for any damages proximately caused by such filing, plus punitive damages.* *
11 U.S.C. §303(i).
COMMENT In the overwhelming majority of chapter 11 reorganizations, the party who controls the debtor prepetition continues to control such entity postpetition, with the debtor referred to as the “debtor in possession” (DIP).
The creditors named on the debtor’s list of creditors (filed with a voluntary petition or after an order for relief in an involuntary case) will receive notice of commencement of the bankruptcy case. The debt to each creditor, even if disputed, contingent, or unliquidated, must be set forth in the debtor’s Schedule of Assets and Liabilities. The debtor must also file a prescribed Statement of Financial Affairs. If a trustee is appointed, the trustee must file the same information regarding the debtor.34 After the requisite financial information is filed, certain unsecured creditors have the opportunity to join a “creditors’ committee.” A committee will typically consist of the seven largest unsecured creditors that are willing to serve, though the U.S. Trustee has discretion in this regard.35 The 2005 Bankruptcy Code Amendments reduced the discretion of the United States Trustee in regard to committee appointments, giving the bankruptcy court the authority to change the membership of the committee.36 If the unsecured creditors form a committee before the bankruptcy petition is filed, the prefiling committee may serve as the official committee, provided the committee “was fairly chosen and is representative of the different kinds of claims to be represented.”37 The bankruptcy court
34
35 36 37
11 U.S.C. §1106(a)(2). In chapter 11 cases, creditors or shareholders of the debtor whose claims or interests are scheduled by the debtor or the trustee need not file a proof of claim or interest unless the list, schedule, or statement sets forth the claim or interest as “disputed, contingent, or unliquidated.” If a creditor’s claim or a shareholder’s interest is disputed, contingent, or unliquidated, it must file a proof of claim or interest, which is deemed allowed unless the debtor objects. If a secured creditor files a claim, the court, on application of the debtor or the trustee, may determine how much of the claim is secured and how much is unsecured. 11 U.S.C. §§506(a), 1111(b); Fed. R. Bank. P. 3003. 11 U.S.C. §1102(b). 11 U.S.C. §1102(a)(4). 11 U.S.C. §1102(b)(1).
䡲
875
䡲
c20.fm Page 876 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
may approve additional official committees if needed, including committees of secured creditors or shareholders.38 Prior to the 2005 Bankruptcy Code Amendments, it was a typical complaint that creditors were ignored by the debtor or the creditors’ committee. The amendments, however, now require that the committee provide creditors with access to information and solicit and receive comments from the creditors.39 (iii) Operation of Business. As previously noted, unless the court orders otherwise, the debtor’s management continues to operate the business as a debtorin-possession. If creditors believe that the debtor’s management is inept, or dishonest, or not carrying out its responsibility under the Bankruptcy Code, they may seek appointment of a trustee to assume responsibility for operating the business and formulating a plan of reorganization.40 After the 2005 Bankruptcy Code Amendments, the U.S. Trustee is required to move for the appointment of a trustee if there are reasonable grounds to suspect that the debtor’s top management participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or in the debtor’s public financial reporting.41 After the chapter 11 bankruptcy is filed, the debtor has the exclusive right to file a plan of reorganization for 120 days after the order for relief. On motion and for good cause, this “exclusive period” can be extended beyond 120 days. The 2005 Bankruptcy Code Amendments placed a limit on the amount of time that the “exclusive period” can be extended. Now the bankruptcy court may extend the initial 120-day period only up to 18 months from the date of the order for relief.42 The exclusive periods allow the debtor to control the case—assuming it wins the ability to use cash collateral, or secures financing, defeats motions by secured creditors to lift the automatic stay and foreclose on vital assets, defeats motions to dismiss the case as a bad-faith filing, defeats motions to appoint a trustee (which would cause the debtor to lose control of the case), and further assuming that the debtor can otherwise stay in business. The court may appoint a trustee (1) for cause (e.g., fraud, dishonesty, incompetence, or gross mismanagement, occurring before or after the bankruptcy petition is filed), (2) in the interests of the creditors and the shareholders, and (3) also if it is in the best interest of creditors and the estate even where grounds exist to convert or dismiss the case.43 The court cannot order the appointment of a trustee on its own initiative; it can do so only at the request of a party in interest (typically the creditors’ committee, but sometimes at the request of a shareholders’ 38
39 40 41 42 43
11 U.S.C. §1102(a)(2). Once organized, the official creditors’ committee: 1. Consults with the debtor or the trustee concerning administration of the bankruptcy case 2. Investigates the debtor’s conduct, business, and financial condition, including the desirability of continuing its business 3. Participates in formulating the plan of reorganization 4. Requests the appointment of a trustee or examiner 5. Performs such other services as will facilitate the preceding tasks 11 U.S.C. §1102(b)(3). 11 U.S.C. §1104. 11 U.S.C. §1104(e). 11 U.S.C. §1121(d)(2)(A). 11 U.S.C. §1104(a).
䡲
876
䡲
c20.fm Page 877 Thursday, March 15, 2007 10:42 PM
20.2 OVERVIEW OF BANKRUPTCY
committee, a creditor, a shareholder, or an indenture trustee), and only after notice and a hearing.44 EXAMPLE 4: TE and Big Co, Inc., a for-profit corporation, form the Develop Limited Partnership to develop low-income housing. TE will be a 1 percent general partner and will manage the joint venture. Big Co., Inc., will receive a 99 percent limited partnership interest in exchange for investing significant capital. Unfortunately, TE experiences high personnel turnover and poorly manages Develop Limited Partnership, resulting in significant financial losses. The partnership seeks bankruptcy protection from its creditors. In the bankruptcy negotiations, TE takes a hard-line position, does not concede any issues to the creditors, and continues to mismanage the business. Here, the creditors of Develop would benefit if the court appointed a trustee, because the source of Develop’s problems is TE’s poor management. A petition filed in bankruptcy operates as an automatic stay of actions against the debtor and its assets, including a stay of efforts to execute upon a judgment and foreclosure efforts by secured creditors. This stay gives a besieged debtor breathing room to make key operating decisions and to focus on restructuring its existing indebtedness.45 The automatic stay enjoins all actions against the debtor, with certain exceptions (for example, for governmental actions to enforce police or regulatory powers).46 Thus, the automatic stay enjoins any effort by creditors to initiate or continue any legal action, to enforce a judgment, or to create, perfect, or enforce a lien. The automatic stay of any act against property of the estate continues until such property is no longer part of the estate (for example, if the debtor abandons the property). The automatic stay of any other act continues until the earliest of the following events: (1) the case is closed; (2) the case is dismissed; (3) the debtor’s discharge is granted or denied; or (4) the court orders relief from the automatic stay.47 The automatic stay is critical to the debtor’s reorganization. If a secured creditor obtains relief from the stay and can foreclose on vital property, the case is effectively over. (See the discussion in Section 20.3.) To remain in business postpetition, the debtor-in-possession will usually require a source of cash flow, either from postpetition financing or from use of cash that is subject to a security interest (“cash collateral”). As discussed in Section 20.6, the debtor cannot use cash collateral without court permission, which can be granted only if the court determines that the secured creditor’s interest in the cash collateral is “adequately protected.” If the debtor does not obtain postpetition financing or permission to use cash collateral (or, as is usually the case, negotiate an agreed order with creditors), the case is over. (iv) Plan of Reorganization. As a general partner of the debtor, the exempt organization’s primary goal in chapter 11 bankruptcy is to formulate a plan of reorganization (“plan”) and have that plan confirmed, pursuant to which the 44 45 46 47
11 U.S.C. §1104(a), (b), (c). See Section 20.3. 11 U.S.C. §362. 11 U.S.C. §362(c),(d).
䡲
877
䡲
c20.fm Page 878 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
debtor modifies the repayment terms for its existing debt. Before the confirmation stage of a chapter 11 bankruptcy proceeding, the plan must be prepared and filed.48 Every plan must divide the creditors into classes, set forth how the creditors will be treated under the plan, state which claims (secured or unsecured) are not “impaired” under the plan, and treat each creditor in a class in the same manner as the others in that class.49 Creditors are included in classes to the extent their claims are “substantially similar.”50 (A) E XCLUSIVE P ERIODS A plan may be filed with the petition commencing a chapter 11 case, or may be filed later. If a trustee is not appointed, only the debtor can file a plan during the first 120 days of the case.51 If the debtor files a plan during the 120-day exclusive period, this exclusive period is automatically extended for an additional 60 days, for a total of 180 days, to obtain the necessary acceptances of the plan.52 If the debtor fails to file a plan during the 120-day period or fails to obtain confirmation of a timely filed plan within the first 180 days after the order for relief, the debtor, its creditors, or the trustee (if one is appointed) may propose a plan unless the court orders, for good cause shown, an extension of the applicable exclusive period prior to its expiration.53 The 2005 Bankruptcy Code Amendments now restrict the amount of time that the 180-day period may be extended to 20 months after the date of the order for relief in the case.54 In the case of a “single-asset real estate” debtor, the critical period for filing a plan is within 90 days after entry of the order for relief.55 Although the 120-day exclusive period remains in effect, a creditor secured by an interest in real estate 48 49 50 51 52 53
54 55
See Section 20.4. 11 U.S.C. §1123(a), (b). 11 U.S.C. §1122(a). 11 U.S.C. §1121(b). 11 U.S.C. §1121(c)(3). Other parties in interest, including the creditors’ committee, any creditor, the shareholders’ committee, any shareholder, or an indenture trustee, have two opportunities to reduce the debtor’s exclusive period to file a plan. First, such a party in interest may file an application with the court to reduce the debtor’s exclusive period. 11 U.S.C. §1121(d). Second, if a trustee is appointed, the debtor’s exclusive plan period expires upon the trustee’s appointment. Thereafter, any party in interest, including the trustee, a creditor, the creditors’ committee, or the debtor, may file a plan. 11 U.S.C. §1121(c). Regardless of who actually files the plan, the creditors’ committee generally plays a significant role in structuring the plan. Under the 2005 Bankruptcy Code Amendments, when the debtor has elected to be treated as a small business, the debtor’s first exclusive period is increased to 180 days (this time period may be extended only if the debtor demonstrates that it is more likely than not that the court will confirm a plan within a reasonable period of time), and the plan and disclosure statement must be filed no later than 300 days after the petition date. 11 U.S.C. §1121(e)(2). For this purpose, small businesses include any person or company engaged in commercial or business activities (except a person or company whose primary activity is the business of owning or operating real property and activities incidental thereto) that has noncontingent liquidated debts (secured and unsecured) totaling not more than $2 million. 11 U.S.C. §101(51D). To qualify as a small business debtor, the U.S. Trustee must not have appointed a creditors’ committee or the court must make a determination that the committee is not sufficiently active and representative to provide effective oversight of the debtor. Further, being a small business debtor is no longer elective but is required if the criteria are satisfied. 11 U.S.C. §1121(d)(2)(B). The 2005 Bankruptcy Code Amendments now permit the court to extend this period to 30 days after the court determines that the debtor is a single-asset real estate debtor.
䡲
878
䡲
c20.fm Page 879 Thursday, March 15, 2007 10:42 PM
20.2 OVERVIEW OF BANKRUPTCY
owned by such debtor will be granted relief from stay, upon request, unless the debtor has filed a plan: 1. that has a reasonable possibility of being confirmed within a reasonable time; or 2. has commenced monthly payments that (i) may, in the debtor’s sole discretion, be made from rents or other income generated before, on, after the date of the commencement of the case by or from the property to each creditor whose claim is secured by such real estate (other than a claim secured by a judgment lien or an unmatured statutory lien); (ii) and are in an amount equal to interest at the then applicable nondefault contract rate of interest on the value of the creditor’s interest in the real estate.56 Single-asset real estate is defined as “real property constituting a single property or project, other than residential property with fewer than four residential units, which generates substantially all the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.”57 One court has held that a series of semidetached houses owned by a real estate limited partnership constituted single-asset real estate.58 PLANNING POINTER The exclusive periods are powerful weapons for the debtor. So long as the debtor maintains exclusivity, the debtor controls the pace of the case and, practically, its outcome. (B) P OSTPETITION D ISCLOSURE AND S OLICITATION Acceptance or rejection of a plan may not be solicited unless the solicitation is accompanied or preceded by the plan and a bankruptcy court-approved written disclosure statement.59 The bankruptcy court will approve the disclosure statement only if it contains information adequate for a hypothetical reasonable investor to make an informed judgment about the plan.60
56 57 58 59 60
11 U.S.C. §362(d)(3). 11 U.S.C. §101(51B). In re Philmont Development Co., 181 B.R. 220 (Bankr. E.D. Pa. 1995). 11 U.S.C. §1125(b). 11 U.S.C. §1125(a). Pursuant to the 2005 Bankruptcy Code Amendments, when determining whether a disclosure statement provides adequate information, the court shall consider the complexity of the case, the benefit of additional information to creditors and other parties in interest, and the cost of providing additional information. The disclosure statement shall also include a discussion of the potential material federal tax consequences of the plan to the debtor, any successor to the debtor, and a hypothetical investor typical of the holders of claims or interests in the case.
䡲
879
䡲
c20.fm Page 880 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
(C) C ONFIRMATION The bankruptcy court must hold a hearing to consider confirmation of the plan after providing the parties in interest notice of the hearing and an opportunity to object to confirmation.61 Confirmation of a plan of a reorganization normally turns on whether each impaired class of claims or interests has accepted the plan; whether the plan satisfies the “best interests of creditors test”; and whether numerous other confirmation requirements are met. A class of claims has accepted the plan if such plan has been accepted by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims in such class that have accepted or rejected a plan.62 If a “cramdown” is involved, the other legal requirements for confirmation must be met as well, but unanimous acceptance by each class is not required. The plan, if otherwise legally sufficient, can be “crammed down” the throats of dissenting classes if it is accepted by at least one impaired class. That is, the terms of the confirmed plan will bind all parties in interest, whether they like it or not. To cram down a plan, the court must find that the plan does not discriminate unfairly and is fair and equitable to all creditors despite being rejected by one or more classes of creditors. (c)
Comparison of Chapter 7 Bankruptcy and Chapter 11 Bankruptcy
Exhibit 20.1 summarizes some of the key differences between chapter 7 and chapter 11 bankruptcies.
20.3
AUTOMATIC STAY
The commencement of a bankruptcy case triggers the automatic stay, which gives the debtor immediate protection from the collection efforts of creditors. In fact, a creditor’s collection activity is often the event that causes the debtor to invoke the protection of the automatic stay by filing for bankruptcy. EXAMPLE 5: W is a tax-exempt hospital organization, and Anna and Darrow are doctors affiliated with W. W., Anna, and Darrow form LIH, LLC, in which W is the sole member-manager, to develop a children’s research facility. LIH experiences a revenue shortfall that makes it difficult to pay its vendors’ accounts in a timely manner. Several vendors sue LIH, obtain judgments, and threaten to enforce their judgments against LIH’s bank accounts and rental receipts unless LIH promptly pays them. LIH fears that seizure of its bank accounts would cause LIH to default on its mortgage with HUD, a creditor, which (as discussed later) is not subject to the automatic stay. To prevent this result, LIH files for bankruptcy, which operates as an automatic injunction that restrains the judgment creditors from continuing any collection actions.
61 62
11 U.S.C. §1128. 11 U.S.C. §1126(c).
䡲
880
䡲
c20.fm Page 881 Thursday, March 15, 2007 10:42 PM
20.3 AUTOMATIC STAY
E XHIBIT 20.1 Comparison of Chapter 7 Bankruptcy and Chapter 11 Bankruptcy Characteristic
Chapter 7
Chapter 11
1. Presence of bankruptcy trustee
Every chapter 7 bankruptcyvolves a bankruptcy trustee.
Generally, chapter 11 cases do not involve a bankruptcy trustee.
2. Liquidation or rehabilitation
In chapter 7 bankruptcies, the trustee takes possession of the property of the estate and liquidates it. The trustee pays creditors from the liquidation of the bankruptcy estate’s property, and the amount a particular creditor receives is governed by statute.
In chapter 11 bankruptcies (although there can be “liquidating plans”), typically the debtor, operating as the debtor-in-possession retains the bankruptcy estate’s property after confirmation. The reorganized debtor generally pays creditors from the debtor’s postpetition earnings, and the plan of reorganization governs the amount that each particular creditor receives.
3. Availability and scope of discharge
In chapter 7 bankruptcy, the availability of a discharge depends on whether a creditor can establish a statutory ground for withholding such a discharge. (See Section 18.5.) Discharges are granted only to individuals, not to corporations or other entities.
In chapter 11 bankruptcies, the debtor may receive a discharge when its plan is confirmed, but see 11 U.S.C. SS1141(d)(2) and (d)(3). Under 11 U.S.C. SS114l(d) (3)(c), the chapter 11 discharge is broader than the chapter 7 discharge for individuals who confirma plan and continue in business after confirmation. No discharge is granted under a liquidating plan.
4. Typical debtor
Because only individuals can receive a discharge in chapter 7, the typical chapter 7 debtor is an individual.
The typical chapter 11 debtor is a business entity (e.g., corporation, partnership), but also may be an individual.
5. Means Test
If an individual debtor's yearly income exceeds the median income for the state in which the debtor resides, the debtor will be forced to file chapter 13 rather than chapter 7,
No means test requirement.
䡲
881
䡲
c20.fm Page 882 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
(a)
Automatic Stay: Generally
The automatic stay, a statutory injunction that arises automatically when a bankruptcy petition is filed, enjoins nearly all collection efforts aimed at the debtor.63 The following activities, described in Bankruptcy Code §362(a), are stayed: 1. The commencement or continuation of a judicial, administrative, or any other action against the debtor (including the issuance or employment of process) (a) that was or could have been initiated before the bankruptcy case began, or (b) to recover a claim against the debtor that arose before the bankruptcy case began 2. The enforcement, against the debtor or against property of the estate, of a judgment obtained before the bankruptcy case began 3. Any acts to obtain possession of property of the estate or of property from the estate, or to exercise control over property of the estate 4. Any act to create, perfect, or enforce any lien against property of the estate 5. Any act to create, perfect, or enforce against the debtor’s property any lien to the extent that such lien secures a claim that arose before the bankruptcy case began 6. Any act to collect, assess, or recover a claim against the debtor that arose before the bankruptcy case began 7. The setoff of any debt owing to the debtor that arose before the bankruptcy case began against any claim against the debtor 8. The commencement or continuation of a proceeding before the United States Tax Court concerning a corporate debtor’s tax liability for a taxable period or the tax liability of an individual debtor for a taxable period ending prior to the debtor’s petition date EXAMPLE 6: Hamlet Ventures, a tax-exempt organization, and Macbeth Corp., a for-profit entity, form the Shakespeare Development Limited Partnership to coproduce a Shakespearean play. Hamlet receives a 1 percent general partnership interest in Shakespeare, and Macbeth receives a 99 percent limited partnership interest. In 1996, Macbeth lends $2 million to Shakespeare, for which it receives a security interest in Shakespeare’s assets, including the revenues generated by the production. Subsequently, Macbeth becomes increasingly disappointed with Hamlet’s performance as general partner, but does not have an adequate remedy because the partnership agreement does not give it the power to remove Hamlet. When Shakespeare defaults on its $2 million debt to Macbeth, Macbeth initiates actions to foreclose on the project. However, before Macbeth completes this action, Shakespeare files a bankruptcy petition, giving rise to the automatic stay, which precludes Macbeth from continuing its foreclosure.
63
11 U.S.C. §362(a). See, e.g., In re Atlantic Business & Community Corp., 901 F.2d 325 (3d Cir. 1990).
䡲
882
䡲
c20.fm Page 883 Thursday, March 15, 2007 10:42 PM
20.3 AUTOMATIC STAY
EXAMPLE 7: The facts are the same as in Example 6, except that Shakespeare also defaults on its loan from Big Bank, at which Shakespeare maintains bank accounts, and Big Bank wants to exercise a right of setoff after the bankruptcy proceedings begin. The automatic stay stops Big Bank from exercising its right of setoff without seeking relief from the automatic stay.64 EXAMPLE 8: The facts are the same as in Example 6, except that Institutional Insurance, which issued an umbrella insurance policy to Shakespeare, immediately attempts to cancel the policy when Shakespeare files for bankruptcy, although Shakespeare is current on its premiums. The automatic stay enjoins Institutional from canceling Shakespeare’s insurance coverage.65 (b)
Exceptions to the Automatic Stay
Bankruptcy Code §362(b) provides for certain exceptions to the automatic stay. If an exception applies, there is no stay and the actions against the debtor or the property can proceed uninterrupted. These exceptions include, among others:66 1. Actions or proceedings by governmental units to enforce their police or regulatory authority, or the enforcement of judgments (other than money judgments) obtained in such actions or proceedings.67 2. The commencement of any action by HUD to foreclose a mortgage or deed of trust held by HUD that is (or was formerly) insured under the National Housing Act and covers property involving five or more living units.68 3. Audits by governmental units to determine tax liability, the issuance of a notice of tax deficiency by a governmental unit, a demand for tax returns, or the making of an assessment for any tax and issuance of a notice and demand for payment of such assessment. This exception does not extend, however, to tax liens that would otherwise attach to property of the estate by reason of such assessment unless (a) the underlying tax is a debt that 64
65 66
67 68
See, e.g., United States ex rel. IRS v. Norton, 717 F.2d 767 (3d Cir. 1983). See also Annotation, Violation of Automatic Stay Provisions of 1978 Bankruptcy Code (11 U.S.C. §362) as Contempt of Court, 57 A.L.R. Fed. 927 (1982). See, e.g., In re Minoco Group of Cos., 799 F.2d 517 (9th Cir. 1986). Other exceptions to the automatic stay, which are less important in the tax-exempt organization/joint venture context, are: 1. Criminal actions or proceedings. 11 U.S.C. §362(b)(1). 2. Actions or proceedings regarding certain domestic relations proceedings and proceedings dealing with certain licenses. 3. Acts to perfect, maintain, or continue the perfection of property interests to the extent that the trustee’s rights and powers are subject to such perfection under Bankruptcy Code §546(b), or to the extent that such acts are accomplished within the time frame provided by Bankruptcy Code §547(e)(2)(A). 11 U.S.C. §362(b)(3). 4. Acts by lessors to obtain possession of nonresidential real property possessed by the debtor under a lease that expires before or during the bankruptcy case. 11 U.S.C. §362(b)(10). 5. The creation or perfection of a statutory lien for an ad valorem property tax imposed by a governmental unit if such tax comes due after the commencement of the bankruptcy case. 11 U.S.C. §362(b)(18). 11 U.S.C. §362(b)(4). 11 U.S.C. §362(b)(8).
䡲
883
䡲
c20.fm Page 884 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
will not be discharged, and (b) such property or its proceeds are transferred out of the estate to, or otherwise revested in, the debtor.69 4. Acts by accrediting agencies concerning the debtor’s accreditation status as an educational institution.70 5. Acts by state licensing bodies concerning the debtor’s licensure as an educational institution.71 6. Acts by a guarantee agency, as defined by §435(j) of the Higher Education Act of 1965, or the Secretary of Education concerning the eligibility of the debtor to participate in programs authorized under such Act.72 7. Acts to enforce any lien against or security interest in real property following entry of an order finding presence of a scheme to delay, hinder, and defraud creditors that involved either: (a) a transfer of ownership in the property; or (b) multiple bankruptcy filings affecting the property, within two years of the entry of such order.73 8. Acts to enforce any lien against or security interest in real property if the debtor is ineligible to be a debtor under the Bankruptcy Code or if the case was filed in violation of a bankruptcy court order prohibiting the debtor from being a debtor.74 (c)
Effect of the Automatic Stay
The automatic stay, by itself, does not extinguish a creditor’s claim, lien, or other rights; it merely delays enforcement of such rights. Nevertheless, in reality the stay and the bankruptcy process may actually modify, reduce, or eliminate a creditor’s rights.75 EXAMPLE 9: The facts are the same as in Example 6, except that Shakespeare also obtained an unsecured loan for $1 million from Wave Bank before entering bankruptcy. The commencement of bankruptcy precludes Wave Bank from taking any collection action against Shakespeare. If Shakespeare discharges its debt to Wave Bank and the plan does not provide for full payment of Wave Bank’s claims, Wave Bank’s rights that survive Shakespeare’s bankruptcy have been modified (and likely have been reduced) by the combined effect of the automatic stay and the reorganization process.
69 70 71 72 73 74 75
11 U.S.C. §362(b)(9). 11 U.S.C. §362(b)(14). 11 U.S.C. §362(b)(15). 11 U.S.C. §362(b)(16). 11 U.S.C. §362(b)(20). 11 U.S.C. §362(b)(21). Under 11 U.S.C. §365, a debtor may opt to assume or reject executory contracts within a certain amount of time after filing for protection under the Bankruptcy Code. One court has found that a provisional workout agreement (PWA) with HUD is not assumable under §365. In re Crosscreek Apartments, Ltd., 213 B.R. 521, 526 n.4 (Bankr. E.D. Tenn. 1997), the court makes reference to the fact that a PWA is effectively terminated upon the debtor’s default under the terms of the PWA, and even if the PWA were not terminated based solely on a debtor’s default, the PWA is “a contract for financial accommodations for the benefit of the debtor, which was barred from assumption under 11 U.S.C. §365(c)(2).”
䡲
884
䡲
c20.fm Page 885 Thursday, March 15, 2007 10:42 PM
20.3 AUTOMATIC STAY
(d)
Acts Done in Violation of the Stay
The majority rule is that acts taken in violation of the automatic stay are void.76 Some courts, however, have held that acts taken in violation of the automatic stay are voidable rather than void.77 Nevertheless, the bankruptcy court has the power to annul the automatic stay pursuant to Bankruptcy Code §362(d) and treat the automatic stay as if it never existed. Accordingly, a subsequent court order annulling the automatic stay may sanction or validate acts that, but for the annulment, would have violated the stay.78 Typically, debtors may recover actual damages, including costs and attorneys’ fees, and, for willful violations of the automatic stay, punitive damages.79 EXAMPLE 10: The facts are the same as in Example 8. The cancellation of the umbrella insurance policy by Institutional is void under the majority rule. Moreover, Shakespeare will likely be able to recover actual damages resulting from the cancellation, including costs and attorneys’ fees. (e)
Duration of an Automatic Stay
The automatic stay of any act against property of the estate continues until such property is no longer part of the estate (e.g., if the debtor abandons the property). The automatic stay of any other act continues until the earliest of the following events: (1) the case is closed; (2) the case is dismissed; (3) the debtor’s discharge is granted or denied; or (4) the court orders relief from the automatic stay.80 EXAMPLE 11: The facts are the same as in Example 9. Upon discharge the automatic stay terminates. However, because Wave Bank’s prepetition loans to Shakespeare are discharged by the bankruptcy case, Wave Bank has no rights that survive termination of the automatic stay with respect to its prepetition loan. Its rights (and Shakespeare’s obligations) postpetition are defined by the confirmed chapter 11 plan. EXAMPLE 12: The facts are the same as in Example 11, except that Wave Bank’s loans to Shakespeare are not discharged in chapter 7 or in chapter 11 (pursuant to a confirmed reorganization plan). Here, when the bankruptcy case ends, the automatic stay terminates and Wave Bank may proceed with collection action against Shakespeare. The Bankruptcy Code now contains provisions to discourage abusive filings by individual (as opposed to corporate) debtors. The new provisions provide that 76
77
78 79
80
See, e.g., Hillis Motors, Inc. v. Hawaii Automobile Dealers’ Ass’n, 997 F.2d 581 (9th Cir. 1993); In re Schwartz, 954 F.2d 569 (9th Cir. 1992); Ellis v. Consolidated Diesel Electric Corp., 894 F.2d 371 (10th Cir. 1990); Far Out Productions v. Oskar, 247 F.3d 986 (9th Cir. 2001). See, e.g., In re Siciliano, 13 F.3d 748 (3d Cir.), on remand, 167 B.R. 999 (Bankr. E.D. Pa. 1994); Sikes v. Global Marine, Inc., 881 F.2d 176, reh’g denied, 888 F.2d 1388 (5th Cir. 1989); In re Brooks, 79 B.R. 479 (Bankr. 9th Cir. 1987), aff’d, 871 F.2d 89 (9th Cir. 1989). See, e.g., Algeran, Inc. v. Advance Ross Corp., 759 F.2d 1421 (9th Cir. 1985). 11 U.S.C. §362(K)(l). See, e.g., In re Atlantic Business & Community Corp., 901 F.2d 325 (3d Cir. 1990); In re La Tempa, 58 B.R. 538 (Bankr. W.D. Va. 1986). Cf. In re Am. Chem. Works Co., 235 B.R. 216 (Bankr. D.R.I. 1999) (finding that since §362(h) refers only to individuals, a corporate debtor is not entitled to damages under this section). 11 U.S.C. §362(c).
䡲
885
䡲
c20.fm Page 886 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
the automatic stay either (i) lapses after thirty days if no order is entered extending the stay or (ii) never becomes effective. Bankruptcy Code § 362( c )(3) provides, in part, that if the debtor files a case under chapters 7, 11, or 13 and if the debtor had a previous case pending in the preceding year which was dismissed, the automatic stay terminates with respect to the debtor on the thirtieth day after the filing of the most recent case unless the debtor files a motion to extend the stay.81 Further, Bankruptcy Code § 362(c)(4) provides that where a debtor files a case under any chapter and has had two or more cases dismissed within the preceding year, the automatic stay does not go into effect upon the filing of the later case.82 Creditors may seek a “comfort order” from the bankruptcy court confirming that the automatic stay has terminated or has not gone into effect.83 (f)
Relief from the Automatic Stay
Bankruptcy Code §362(d) sets forth the circumstances under which relief from the automatic stay may be granted. This statute provides that upon a request for relief by an interested party, the court may grant such relief in four instances. First, a court may grant relief from the automatic stay “for cause,” including lack of “adequate protection.”84 The following are examples of cases for which courts have granted relief for cause: • The need to continue, in another forum, litigation between the creditor
and the debtor that was initiated prepetition. In such cases, courts typically use a balancing test to decide whether sufficient cause exists to grant relief to the creditor to continue litigation in another forum85 (balancing (1) whether any “great prejudice” to either the bankruptcy estate or the debtor will result from continuation of the civil suit, (2) whether the hardship to the plaintiff that will result if the stay is maintained considerably outweighs the hardship to the debtor that will result if the stay is lifted, and (3) the probability that the party seeking relief will prevail on the merits of the nonbankruptcy litigation). • The debtor entered a prebankruptcy workout agreement that contained
the debtor’s prospective waiver of the automatic stay’s protection and the debtor’s consent to immediate relief from the automatic stay upon filing for bankruptcy.86 Such agreements are not favored and are enforced only after strict scrutiny involving all circumstances of the case. Factors weighed heavily include impact of dismissal on other creditors and overreaching in the agreement. • The debtor filed for bankruptcy lacking good faith, as determined by an
evaluation of its financial condition, motives, and local financial realities. 81 82 83 84 85 86
11 U.S.C. §362(c)(3)(A)-(C); see, e.g., Un re jumpp, 344 B.R. 21, 26-27 (Bankr. D. Mass 2006). 11 U.S.C. §362(c)(4)(A)(i). 11 U.S.C. §3620. 11 U.S.C. §362(d)(1). See, e.g., In re Bock Laundry Machine Co., 37 B.R. 564 (Bankr. N.D. Ohio 1984). See, e.g., In re Citadel Properties, Inc., 86 B.R. 275 (Bankr. M.D. Fla. 1988); In re Atrium High Point, Ltd. Partnership, 189 B.R. 599 (Bankr. M.D.N.C. 1995).
䡲
886
䡲
c20.fm Page 887 Thursday, March 15, 2007 10:42 PM
20.3 AUTOMATIC STAY
For example, the debtor may have filed for Chapter 11 bankruptcy with no reasonable prospects for a reorganization.87 • The debtor failed to comply with a bankruptcy court order.88 • The debtor’s actions or failure to act (for example, failure to pay property
taxes or maintain property insurance premiums) jeopardized the creditor’s collateral.89 • The debtor mismanaged real property collateral.90
The Bankruptcy Code provides that the court shall grant relief from the stay if the secured creditor’s interest in collateral is not “adequately protected.”91 Generally, the notion of adequate protection means that the value of the collateral must be preserved during the pendency of the case. To determine whether a creditor’s interest is adequately protected, the court considers the following: (1) the amount of the secured creditor’s claim up to the value of the security; (2) the risks to the interest of the secured creditor; and (3) whether the debtor’s proposal adequately protects the collateral’s value against likely risks to that value during the pendency of the bankruptcy.92 Second, a creditor may obtain relief from the automatic stay with respect to an action against property of the estate by showing that (1) the debtor does not have equity in such property; and (2) such property is not necessary to an effective reorganization. 93 The creditor must prove that the debtor lacks equity. 94 The debtor who wants the property to remain subject to the automatic stay must prove that the debtor needs the property for an effective reorganization. 95 Third, the court shall grant a creditor relief from the automatic stay in a single-asset real estate case on the conditions specified in 11 U.S.C. §362(d)(3), to wit: The debtor has not, within 90 days after the order for relief, (1) filed a plan that has a “reasonable possibility of being confirmed within a reasonable time,” and (2) commenced monthly payments (to such creditor) (a) that may be made from rents or other income generated before, on, or after the petition date or from property to each creditor whose claim is secured by the realty (other than by a judgment lien or unmatured statutory lien) and (b) “in an amount equal to interest at 87 88
89 90 91 92
93 94 95
See, e.g., Carolin Corp. v. Miller, 886 F.2d 693 (4th Cir. 1989). Note that this is also a basis for dismissing the entire case. See, e.g., In re Phelia Associates, Inc., 26 B.R. 235 (Bankr. W.D. Ky. 1982). See also Annotation, What Constitutes Lack of “Adequate Protection” of Interest in Property of Estate for Which Relief May Be Granted from Automatic Stay Provision of Bankruptcy Code of 1978 (11 U.S.C. §362(a)), 66 A.L.R. Fed. 505 (1984). See, e.g., In re Trident Corp., 19 B.R. 956 (Bankr. E.D. Pa.), aff’d, 22 B.R. 491 (E.D. Pa. 1982). See, e.g., In re GWF Investment, Ltd. 32 B.R. 308 (Bankr. S.D. Ohio 1983). 11 U.S.C. §362(d)(1). In re Martin, 761 F.2d 472 (8th Cir. 1985). But see United Savings Ass’n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365 (1988) (§362(d)(1) does not require the payment of lost opportunity costs because adequate protection only applies to the value of the property and not to a creditor’s right to repossess, resell, and realize a return from the proceeds of the collateral). 11 U.S.C. §362(d)(2). 11 U.S.C. §362(g)(1). 11 U.S.C. §362(g)(2).
䡲
887
䡲
c20.fm Page 888 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
the then applicable non-default contract rate on the value of the creditor’s interest in the real estate.” Fourth, with respect to an action against real property by a secured creditor, the court shall lift the stay if the court finds that filing the petition was part of a scheme to delay, hinder, or defraud creditors. The scheme must involve a transfer of all interest in the property without the secured creditor’s consent or court approval, or must involve multiple bankruptcy filings affecting the real property.96 (g)
Application of the Automatic Stay to Third Parties CAUTION
The automatic stay protects the debtor and the debtor’s property. It does not protect nondebtors, even if they have a substantial interest in the bankruptcy.* For example, limited partners of a debtor limited partnership or nonmanaging members of an LLC may have guaranteed the partnership’s or the LLC’s debts. In such cases, when creditors learn of the bankruptcy, they are likely to attempt to enforce the guarantees. The automatic stay will generally not protect these guarantors. *
See, e.g., In re Deist Forest Products, Inc., 850 F.2d 340 (7th Cir. 1988); Otoe County National Bank v. W&P Trucking, Inc., 754 F.2d 881 (10th Cir. 1985).
PLANNING POINTER The debtor’s co-obligors or guarantors (e.g., limited partners or officers of the exempt organization), if pursued by the debtor’s creditors, may seek an injunction against collection action by such creditors.* However, unlike the automatic stay, which is automatically triggered by commencement of the bankruptcy proceeding, co-debtors and guarantors must affirmatively request such relief, which is rarely granted. *
11 U.S.C. §105.
Under some circumstances, however, a bankruptcy court will extend the automatic stay to third parties.97 Such cases include situations when there is such a close identity between the debtor and the third party that the debtor may be deemed to be the real party in interest and a judgment against the third party would be, in effect, a judgment against the debtor. For example, one court enjoined a creditor from attempting to collect a debt from the debtor’s officer when such officer was not otherwise personally liable for the debt.98 Also, another 96 97
98
11 U.S.C. §362(d)(4). See generally A.H. Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir.), cert. denied, 479 U.S. 876 (1986); Annotation, Stay by Bankruptcy Court of Action Against Debtor’s Liability Insurer, 93 A.L.R. Fed. 102 (1989). See, e.g., In re Creative Cuisine, Inc., 96 B.R. 144 (Bankr. N.D. Ill. 1989).
䡲
888
䡲
c20.fm Page 889 Thursday, March 15, 2007 10:42 PM
20.3 AUTOMATIC STAY
extended the automatic stay to enjoin a creditor from pursuing a guarantor because the court concluded: (1) the debtor, being protected by the automatic stay, would not defend a lawsuit instituted by the creditor against both the debtor and the guarantor; and (2) the guarantor would potentially be exposed to inconsistent judgments if its claim against the debtor for contribution were disallowed in the bankruptcy case. Consequently, the court concluded that the interests of equity and judicial economy dictated that the issues between the debtor, the guarantor, and the creditor should be litigated in the same forum.99 Such injunctions are difficult to get. Often courts say that if the guarantor needs the protection of an injunction, it can file for bankruptcy itself and get the benefits of the automatic stay. (h)
Application of Automatic Stay to IRS Revocation of Tax-Exempt Status
Sometimes the financial troubles besetting a joint venture involving a tax-exempt organization coincide with the threatened loss of the organization’s exempt status. When this occurs, the exempt organization may assert that the automatic stay bars the IRS from revoking its tax-exempt status. Generally, courts have rejected this argument, on one of two grounds. First, some courts have held that the Anti-Injunction Act (IRC §7421(a)) precludes such an injunction.100 The Anti-Injunction Act prohibits suits in any court “for the purpose of restraining the assessment or collection of any tax.”101 The Supreme Court has held that actions seeking to enjoin the IRS from revoking taxexempt status or actions to compel reinstatement of tax-exempt status violate the Anti-Injunction Act because preventing the IRS from revoking tax-exempt status would necessarily preclude the collection of taxes.102 Still at issue is whether a court’s declaration that IRS action to revoke tax-exempt status violates the automatic stay is tantamount to an injunction against revoking tax-exempt status. Courts considering this issue have reached differing results, with some holding that the AntiInjunction Act trumps the automatic stay103 and others holding that it does not.104 Second, some courts have held that the automatic stay itself does not enjoin the IRS from revoking an exempt organization’s exempt status, either because the Bankruptcy Code does not enjoin such revocations or because the revocations fall within an exception to the automatic stay.105 To illustrate, in In re Universal Life 99 100
101 102
103 104
105
See, e.g., In re Metal Center, Inc., 31 B.R. 458 (Bankr. D. Conn. 1983). See, e.g., In re Heritage Church & Missionary Fellowship, 851 F.2d 104 (4th Cir. 1988). See also Emil Hirsch & David Sanders, “Memorandum re: Asset Protection Issues Involving TaxExempt Organizations” (Dec. 3, 1996), 6; and David Sanders, supplemental Memoranda I and II (papers on file with author). IR.C. §7421(a). Bob Jones University v. Simon, 416 U.S. 725 (1974). See also Supreme Court’s Construction and Application of Anti-Injunction Act (26 USC §7421(a)) Prohibiting Suits to Restrain Assessment or Collection of Federal Taxes, 46 L. Ed. 2d 956. See, e.g., In re Heritage Church & Missionary Fellowship, 851 F.2d 104 (4th Cir. 1988). See, e.g., In re Universal Life Church, Inc., 191 B.R. 433 (E.D. Cal. 1995), aff’d in part, appeal dismissed in part, 128 F.3d 1294 (9th Cir. 1997) (affirming on revocation of exempt status issue), cert. denied, 118 S. Ct. 2367, 141 L. Ed. 2d 736 (1998). See, e.g., In re Universal Life Church, Inc., 191 B.R. 433 (E.D. Cal. 1995), aff’d in part, dismissed in part, 128 F.3d 1294 (9th Cir. 1997), amended, reh’g denied, 1997 U.S. App. LEXIS 36358 (9th Cir. 1997), cert. denied, 1998 U.S. LEXIS 4288 (1998).
䡲
889
䡲
c20.fm Page 890 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
Church,106 the court concluded that the Bankruptcy Code exempted an IRS revocation of tax-exempt status from the scope of the automatic stay, because such act was an exercise of a police power function. The court reasoned that the IRS had revoked the debtor’s tax-exempt status not only with the aim of enforcing tax collection, but also with the aim of ensuring that funds would not be used for noncharitable purposes and protecting the public from fraudulent charitable solicitations.
20.4
CHAPTER 11 PLAN OF REORGANIZATION
The debtor’s ultimate goal in Chapter 11 bankruptcy is to formulate a plan of reorganization that the bankruptcy court will confirm. Confirmation of the plan of reorganization (“plan”) binds all interested parties to the plan’s terms. It also causes property not otherwise administered under the plan to revert to the debtor or its successors.107 As discussed in Section 20.2, typically the debtor proposes the plan. Generally, the debtor has an exclusive right to file the plan for 120 days following the order for relief under chapter 11.108 Other parties in interest may file a plan only if (1) the bankruptcy court has appointed a trustee; (2) the debtor has not filed a plan within the 120-day period and the court has not extended this time; or (3) within 180 days after the order for relief under chapter 11 (or as extended by court order) the debtor has not obtained confirmation of its timely filed plan.109 The Bankruptcy Code allows the bankruptcy court to extend the debtor’s exclusivity period to file a plan of reorganization. However, that period may not extend past eighteen months from the petition date.110 Further, the bankruptcy court may not extend the period within which any party may file a plan past twenty months after the petition date111 To develop a confirmable plan, debtors must evaluate their financial situation and resources, determine the changes and resources necessary to become profitable, and reconcile these items with creditor demands. The following issues must be analyzed and satisfactorily resolved: • Does the proposed plan contain the elements that satisfy the Bankruptcy
Code’s basic requirements? • Will each impaired class of claims or interests accept the plan? • If not, will at least one (impaired) class accept and the court cram down
the others? • Will the plan satisfy the “best interests of creditors” test? • What effect will plan confirmation have on a HUD regulatory agreement? 106 107 108 109 110 111
191 B.R. 433 (E.D. Cal. 1995). See, generally, Cicrl et al., “The Long and Winding Road: The Standard to Confirm a Plan of Reorganization,” 3 Journal of Bankruptcy Law & Practice 15 (1993). See 11 U.S.C. §1121(b), (d). 11 U.S.C. §1121(c). 11 U.S.C. § 1121(d)(2)(A). 11 U.S.C. § 1121(d)(2)(B).
䡲
890
䡲
c20.fm Page 891 Thursday, March 15, 2007 10:42 PM
20.4 CHAPTER 11 PLAN OF REORGANIZATION
(a)
Basic Contents of Plan
Bankruptcy Code §1129 sets forth the basic requirements that the debtor’s plan must satisfy to be confirmable. These requirements include: 1. The plan must comply with all applicable provisions of the Bankruptcy Code.112 2. The plan proponent must comply with all applicable provisions of the Bankruptcy Code.113 3. The plan proponent must propose the plan in good faith and not by any means forbidden by law.114 4. The plan must provide that all payments for administrative expenses and costs have been approved, or are subject to approval, by the court.115 5. The plan must fully disclose the identity and affiliations of specified individuals and entities, including the identity of insiders and their compensation terms.116 6. The debtor must obtain all necessary regulatory approvals.117 7. The plan must give the creditors at least as much as they would get in a chapter 7 liquidation (also known as the “best interests of creditors” test).118 8. The plan must provide for payment of administrative claims, in full, on the effective date of the plan.119 Thus, absent a waiver by the holder of such claims, the debtor must pay administrative claims in cash on the effective date of the plan. The Bankruptcy Code does not define “effective date,” but it is usually within a short period after confirmation (court approval of the plan). 9. The plan must provide for payment of certain wage and employee benefit claims on the effective date of the plan.120 10. Unsecured tax or customs claims must be paid as provided for in the Bankruptcy Code.121 11. If the plan impairs any class of claims, there must be an affirmative acceptance of the plan by at least one impaired class, excluding votes of insiders.122 12. Confirmation of the plan must be feasible. In other words, confirmation must be unlikely to be followed by liquidation or further reorganization 112 113 114 115 116 117 118 119 120 121 122
11 U.S.C. §1129(a)(1). 11 U.S.C. §1129(a)(2). 11 U.S.C. §1129(a)(3). 11 U.S.C. §1129(a)(4). 11 U.S.C. §1129(a)(4), (5). 11 U.S.C. §1129(a)(6). 11 U.S.C. §1129(a)(7). 11 U.S.C. §1129(a)(9)(A). 11 U.S.C. §1129(a)(9)(B). 11 U.S.C. §1129(a)(9)(C). 11 U.S.C. §1129(a)(10).
䡲
891
䡲
c20.fm Page 892 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
unless the plan specifically so provides (for example, when the plan is a liquidating plan).123 13. The plan must provide for payment of all applicable U.S. Trustee fees and assessments.124 14. The plan must provide for payment of all retiree benefits required under the terms of Bankruptcy Code §1114.125 15. All property transfers shall be made in accordance with applicable provisions of nonbankruptcy law that govern transfers of property by a corporation that is not a moneyed business or commercial corporation or trust.126 (b)
Acceptance Requirements
Bankruptcy Code §1129(a) provides that, before a bankruptcy court can confirm a plan, each class of claims or interests must either accept the plan or be unimpaired.127 The Bankruptcy Code deems an unimpaired class (and every member in such class) to have accepted the plan.128 Thus, the debtor need not solicit acceptances from members of a class unimpaired under the plan.129 PLANNING POINTER When the plan impairs one or more classes that do not accept the plan, the debtor may still obtain plan confirmation by using a cramdown provided there is at least one impaired, accepting class. Cramdown is discussed later in this section. 123 124 125 126 127 128 129
11 U.S.C. §1129(a)(11). 11 U.S.C. §1129(a)(12). 11 U.S.C. §1129(a)(13). 11 U.S.C. §1129(a)(16). 11 U.S.C. §1129(a)(8). 11 U.S.C. §1126(f). Section 1124 of the Bankruptcy Code provides that a class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan— 1. leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest; or 2. notwithstanding any contractual provision or applicable law that entitles the holder of such claim or interest to demand or receive accelerated payment of such claim or interest after the occurrence of a default— (A) cures any such default that occurred before or after the commencement of the case under this title, other than a default of the kind specified in section 365(d)(2) of this title [requiring the debtor to perform its obligations under real property leases or of a kind that section 365(b)(2) expressly does not require to be cured]; (B) reinstates the maturity of such claim or interest as such maturity existed before such default. (C) compensates the holder of such claim or interest for any damages incurred as a result of any reasonable reliance by such holder on such contractual provision or such applicable law; and (D) if such claim or interest arises from any failure to perform a nonmonetary obligation, other than a default arising from failure to operate a nonresidential real property lease subject to 365(b)(1)(A), compensates the holder of such claim (other than the debtor or an insider) for any actual or pecuniary loss incurred by the holder as a result of such failure; and (E) does not otherwise alter the legal, equitable, or contractual rights to which such claim or interest entitles the holder of such claim or interest.
䡲
892
䡲
c20.fm Page 893 Thursday, March 15, 2007 10:42 PM
20.4 CHAPTER 11 PLAN OF REORGANIZATION
(c)
Best Interests Test
The bankruptcy court will confirm a plan only if the plan satisfies the “best interests” test. This test requires the plan to give to each dissenting holder of a claim or interest property of a value that equals or exceeds the value such holder would receive in a hypothetical chapter 7 liquidation. This test protects each dissenting holder whose claim or interest is impaired, even if such holder’s class votes to accept the plan. The plan will not be confirmed over the objection of even one small creditor unless the debtor can show that this creditor will receive as much or more under the plan than under a chapter 7 liquidation.130 (d)
Cramdown
If the debtor satisfies all requirements for confirmation, except for unanimous class acceptance, the debtor must use “cramdown” to obtain plan confirmation. Cramdown is a bankruptcy technique that allows a plan to be confirmed, pursuant to Bankruptcy Code §1129(b), even though the plan is not accepted by all classes of claims and interests. To use cramdown, (1) at least one impaired class of claims must accept the plan,131 (2) the plan must not discriminate unfairly,132 and (3) the plan must be fair and equitable as to each impaired and nonaccepting class of claims or interests (the “fair and equitable requirement”).133 (i) Fair and Equitable Requirement: Generally. A plan satisfies the fair and equitable requirement of the Bankruptcy Code if it treats each dissenting class in the applicable manner provided by Bankruptcy Code §1129(b)(2). The applicable treatment hinges on whether the dissenting class consists of secured claims, unsecured claims, or ownership interests. (ii) Fair and Equitable Requirement: Secured Claims. The plan will give the holders of secured claims fair and equitable treatment if the plan satisfies one of three alternative tests with respect to their claims. Under the first test, the members of the class in question must each (1) retain their lien on the secured property to the extent of the allowed amount of their claims, and (2) receive cash payments (a) the total of which equals or exceeds the allowed amount of the secured claim, and (b) whose present value equals or exceeds the value of the collateral securing the claim.134 EXAMPLE 13: W Hospital, a tax-exempt organization, and several of the physicians associated with it form the WE Limited Partnership for the purpose of building a new cardiology wing of the hospital. W serves as general partner and the physicians invest as limited partners. WE LP obtains financing at 10 percent interest from Tolstoy Bank, which loan is secured by the building; principal is payable 130 131 132 133 134
11 U.S.C. §1129(a)(7). 11 U.S.C. §1129(a)(10). 11 U.S.C. §1129(b)(1). See id. 11 U.S.C. §1129(b)(2)(A)(i).
䡲
893
䡲
c20.fm Page 894 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
in annual installments over 20 years. Subsequently, the construction runs substantially over budget, causing WE LP to file for bankruptcy; WE’s assets are worth $3 million and it has $10 million of outstanding debts. The classes of interested parties are as follows: •
Tolstoy Bank, WE LP’s secured creditor, which holds a $5 million promissory note that is collateralized by the new building, with a remaining balance due of $4.8 million
•
Unsecured vendors, which hold $5 million of accounts payable from WE LP
•
Limited partners (the physicians), who have and will retain an aggregated 99 percent ownership interest in WE LP
•
General partner (Hospital), which has and will retain a 1 percent general partnership interest in WE LP
At the time the bankruptcy petition is filed, two annual installments have been paid to Tolstoy, with a remaining principal balance of approximately $4.8 million. The current market interest rate is 6 percent, and the current fair market value of the new wing at this time equals $3 million. WE’s proposed plan offers Tolstoy (1) retention of its security interest in the new hospital wing, (2) interest payments of $290,000 each year for 18 years,135 and (3) a balloon payment of $4.82 million in 18 years. The combined present value of the interest payments and the balloon payment exceeds $3 million. WE’s plan satisfies the first fair and equitable treatment test for secured claims because, under the plan, (1) Tolstoy retains its lien on its secured property, at least to the extent of the allowed amount of its claim, and (2) it will receive cash payments (a) the total of which equals or exceeds the allowed amount of the secured claim (that is, the secured claim equals the current value of its collateral, $3 million; total payments under the plan equal $10 million—$5.2 million interest, plus a balloon payment of $4.8 million), and (b) the present value of such payments exceeds the fair market value of the collateral. PLANNING POINTER Under this test, the debtor may accomplish the following: •
Cure defaults, decelerate, and reinstate the loans.
•
Present value calculation uses a market interest rate instead of the contract interest rate. However, if the original interest rate is lower than the market rate at the time of the calculation, the reorganization may effectively increase the debtor’s rate.
The second alternative treatment to satisfy the fair and equitable requirement with respect to secured claims is met if the plan provides for the sale of the encumbered property, free and clear of such encumbrances, with the creditor’s liens attaching to the sales proceeds. However, the plan must then provide for the treatment of the lien(s) on proceeds in accordance with one of the other two alternative cramdown treatments for secured claims (that is, either the first or third alternative treatment).136 135 136
This amount equals the $4,816,673.95 remaining principal balance multiplied by 6 percent. 11 U.S.C. §1129(b)(2)(A)(ii).
䡲
894
䡲
c20.fm Page 895 Thursday, March 15, 2007 10:42 PM
20.4 CHAPTER 11 PLAN OF REORGANIZATION
Under the third alternative treatment to cram down secured claims, the plan will satisfy the fair and equitable requirement if the holders of the class in question will realize the “indubitable equivalent” of their claims.137 In turn, this test depends on (1) whether the substituted security completely compensates the creditor, and (2) the likelihood that the creditor will receive payment.138 The plan will meet this test if the debtor surrenders the collateral to the creditor in return for a credit equal to the fair market value of the property.139 EXAMPLE 14140: X, an exempt organization, and SD, Inc., a for-profit entity, form the ES Limited Partnership to acquire and develop low-income housing. Biggs Bank provides $2.5 million of financing, secured by a first mortgage against Blackacre, which ES acquires. Subsequently, ES’s financial condition deteriorates and it files for bankruptcy protection. It proposes a plan in which, among other things, Blackacre is transferred to Biggs Bank for a credit on its debt equal to Blackacre’s fair market value. If Blackacre’s fair market value does not cover ES’s debt to Biggs, ES agrees to give Biggs an additional $100,000 of other real property. Only two classes of claims, representing 1 percent of the creditors (in dollar value), voted in favor of the plan and the remaining 99 percent of the creditors (in dollar value) rejected the plan. Biggs objects to the plan, arguing that it is not fair and equitable because Biggs would not realize the “indubitable equivalent” of its claim against ES because Blackacre’s value has declined to $1 million. Assuming that Blackacre’s value is $1 million, then Biggs’s debt is secured to the extent of $1 million (the value of Blackacre) and unsecured for the remainder of its $2.5 million of debt ($1.5 million). Assuming that all other requirements are met, the plan can be crammed down over Biggs’s objection because Biggs will receive the indubitable equivalent of its secured claim. This results because the plan gives Biggs property of a fair market value equal to the value of the property underlying its security agreement (as indeed it must in this case, since Biggs receives the actual property underlying the security agreement). COMMENT The Bankruptcy Code considers a claim to be an allowed secured claim only to the extent of the value of the collateral.* Therefore, if the claim is undersecured, the Bankruptcy Code treats the creditor as having two claims: one secured up to the value of the collateral, and the other unsecured for the portion of the debt that is “under water.” *
11 U.S.C. §506.
(iii) Fair and Equitable Requirement: Unsecured Claims—New Value. The plan satisfies the fair and equitable requirement with respect to unsecured claims if 137 138 139
140
11 U.S.C. §1129(b)(2)(A)(iii). In re Murel Holding Corp., 75 F.2d 941 (2d Cir. 1935). See In re Sandy Ridge Development Co., 881 F.2d 1346 (5th Cir.), reh’g denied, 889 F.2d 663 (5th Cir. 1989). See also Annotation, Time and Method of Valuation Under 11 U.S.C. §506 of Security Held by Creditor of Bankruptcy Estate, 134 A.L.R. Fed. 439 (1996). See id.
䡲
895
䡲
c20.fm Page 896 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
the plan satisfies the “absolute priority” rule. A plan satisfies the absolute priority rule for a dissenting class of unsecured creditors if the plan either (1) eliminates junior claims and interests, or (2) each member of the dissenting class receives property or a stream of payments the present value of which equals or exceeds the creditor’s allowed unsecured claim. However, the debtor may pay creditors over a period of time if the present value of the payments equals or exceeds the allowed amount of the claim.141 EXAMPLE 15: The facts are the same as in Example 14, except that S, the president of SD, Inc., made a $1 million unsecured loan to ES, payable in three years, and the only claims junior to S’s claim are the ownership interests of X and SD, Inc. Here, for ES’s plan to satisfy the absolute priority rule, it must either (1) eliminate junior claims by not giving anything to X or SD, Inc., in exchange for their ownership interests, or (2) give S property whose present value equals $1 million, the allowed amount of his claim. For example, ES may pay 5 annual installments of $200,000 plus interest at a rate that will compensate S for the time value of the deferred payments to S, assuming this is an appropriate interest rate. If the absolute priority rule comes into play, the equity owners may contribute “new value” to the debtor in exchange for equity interests in that entity. This is commonly referred to as the new value exception to the absolute priority rule (“new value exception”). For the new value exception to apply, the equity holders that supply new value must satisfy the following three requirements: 1. The equity owners must contribute the new value in money or money’s worth. 2. The contribution from the equity holders must be “necessary.” For example, a payment may be necessary because no other party will pay that amount and the lack of such payment will force the debtor to liquidate. 3. The contribution must be substantial (or it must equal or exceed the going-concern value of the debtor entity).142 EXAMPLE 16: The facts are the same as in Example 15, except that (1) ES needs a $1 million cash infusion to continue its operations; (2) X and SD, Inc., agree to contribute $250,000 and $750,000, respectively, to ES in exchange for a 25 percent general partnership interest and a 75 percent limited partnership interest, respectively, in the reorganized debtor; and (3) the going-concern value of ES is $1 million after the reorganization. Here, X and SD, Inc., have satisfied the new value rule because they have contributed new value in money, their contribution is “necessary” for the reorganization to be successful, and their contribution equals ES’s going-concern value. (iv) Fair and Equitable Requirement: Ownership Interests. The plan will satisfy the fair and equitable requirement concerning a dissenting class of equity 141 142
11 U.S.C. §1129(b)(2)(B). Bank of America v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999); Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1939).
䡲
896
䡲
c20.fm Page 897 Thursday, March 15, 2007 10:42 PM
20.4 CHAPTER 11 PLAN OF REORGANIZATION
interests if the plan either (1) eliminates all equity interests that are junior to the dissenting class in question; or (2) allows each equity interest holder in that class to receive or retain property with a fair market value, as of the plan’s effective date, that equals or exceeds the greater of (a) the allowed amount of any fixed liquidation preference that the holder is entitled to, (b) the allowed amount of any fixed redemption price that the holder is entitled to, or (c) the fair market value of such interest.143 (v) Unfair Discrimination. Finally, to be allowed, a proposed cramdown must not discriminate unfairly.144 The legislative history suggests that, for unsecured trade claims, there is no unfair discrimination if the total consideration given to all other classes of equal rank does not exceed the amount that would result from an exact aliquot distribution.145 (e)
Effect of Plan Confirmation on HUD Regulatory Agreement
In a few cases, debtors have attempted to alter HUD’s regulatory authority by seeking to approve a plan of reorganization that would modify HUD’s control over the debtor, over HUD’s objection.146 In Water Gap Village,147 the court addressed the issue of whether the debtor, a limited partnership that owned and operated residential townhouse units, could cram down a plan of reorganization over HUD’s objection. The plan did not disclose the proposed postconfirmation management of the debtor. HUD claimed that because its regulatory authority included the power to control a project’s management, the court could not confirm the plan. The court confirmed the plan, dismissing HUD’s argument on the 143 144 145
146
147
11 U.S.C. §1129(b)(2)(C). 11 U.S.C. §1129(b). H. Rep. No. 595, 95th Cong., 1st Sess. 417 (1977). In re Sagewood Manor Associates Ltd. Partnership, 223 B.R. 756 (Bankr. D. Nev. 1998) (plan confirmed over HUD assignee’s objection); In re Mallard Pond Ltd., 217 B.R. 782 (Bankr. M.D.Tenn. 1997) (confirmation denied because plan lacked feasibility in proposing to pay HUD assignee’s §1111(b) claim over 59 years); In re Seasons Apartments, Limited Partnership, 215 B.R. 953 (Bankr. W.D. La. 1997) (even though HUD assignee’s claim was to be paid in full, without interest, court held that the claim was impaired and consequently refused to approve disclosure statement). See also In re Crosscreek Apartments, Ltd., 213 B.R 521 (Bankr. E.D. Tenn. 1997) and In re Dwellco I Ltd. Partnership, 219 B.R. 5 (Bankr. D. Conn. 1998). In both Crosscreek and Dwellco, the court approved the plan submitted by the HUD assignee over the competing plan of the debtor. In both cases, the status as an assignee of HUD played no role in the decision. Courts have not preferred HUD over private secured lenders when there is no regulatory agreement at issue. There exists ample case law in which a debtor seeks to cram down HUD based not on any alteration to the contractual/regulatory relationship between HUD and the debtor, but rather strictly on an impairment of HUD’s claim with respect to the debtor’s proposed treatment of HUD as to payment of its claim. See, e.g., In re Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994) (plan could not be confirmed over HUD’s objection when HUD was only non-insider impaired class, and hence bankruptcy was dismissed); In re Way Apartments, 201 B.R. 444, 1996 U.S. Dist. LEXIS 15427 (N.D. Tex. 1996) (cramdown of HUD affirmed); In re Hillsdale Park Apartments Ltd. Partnership, 205 B.R. 177 (Bankr. W.D. Mo. 1997); In re Executive House Associates, 99 B.R. 266 (Bankr. E.D. Pa. 1989) (confirmation denied pending amendment of plan to adequately protect HUD’s interest); In re Smithfield Estates, Inc., 52 B.R. 220 (Bankr. D.R.I. 1985) (confirmation denied). See David Sanders and Lewis J. Saret, “Asset Protection and Affordable Housing Projects Involving Tax Exempt Organizations,” Journal of Asset Protection (May/June 1998) (hereinafter “Sanders and Saret”); cases cited in n. 130. In re Water Gap Village, 59 B.R. 23 (Bankr. D.N.J. 1985).
䡲
897
䡲
c20.fm Page 898 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
ground that HUD had not shown that its regulatory authority was plenary and therefore superior to the strictures of the Bankruptcy Code. As a result, the court confirmed a plan of reorganization that effectively abrogated HUD’s right to control the management of the debtor. The holding in Water Gap is inconsistent with another court’s ruling in In re Capital West Investors.148 The bankruptcy court in Capital West had confirmed a plan of reorganization in which the debtor, a limited partnership that owned and operated an apartment complex, deleted certain terms of the HUD regulatory agreement to which the debtor had been bound. The plan deleted the following terms of the regulatory agreement: (1) the debtor’s obligation to pay mortgage insurance; (2) the debtor’s obligation to procure HUD approval before allowing junior financing; and (3) the requirement that junior financing documents include language allowing HUD to foreclose in the event a deed in lieu of foreclosure was procured. In reversing the bankruptcy court, the district court found that the goals of chapter 11 of the Bankruptcy Code and the National Housing Act (NHA) are better served by a plan of reorganization that does not inject uncertainty into the nation’s low-income housing market. The goals of chapter 11 are to permit successful rehabilitation of the debtor and to maximize the value of the bankruptcy estate, whereas the goals of the NHA are to provide a decent home and suitable living environment for every American family by motivating lenders to lend money and assisting private industry to avoid foreclosure. The district court noted that allowing the debtor to abrogate the terms of the regulatory agreement would forestall foreclosure of the debtor’s property. However, this positive effect would be outweighed by the precedential effect of allowing a debtor to avoid the provisions of a HUD regulatory agreement. Allowing such avoidance, said the district court, would cause banks to require larger down payments or higher interest rates for mortgages, increasing the costs to prospective homebuyers in direct contravention of the purpose behind the NHA. Furthermore, the market value of the note to which the HUD regulatory agreement is attached would also be altered, thereby adding uncertainty to the secondary mortgage market and further increasing costs that would be passed on to homebuyers. Therefore, the district court held that a HUD regulatory agreement could not be modified pursuant to a plan of reorganization. The reasons behind the district court’s decision in Capital West compellingly illustrate the effect of allowing a debtor to modify a HUD regulatory agreement pursuant to a plan of reorganization. The Capital West decision, preventing the debtor from altering its regulatory agreement with HUD, is in accord with case law in which courts have refused to allow debtors to modify HUD’s rights to project income when the regulatory agreement specifically grants HUD a secured interest in that project income. In other cases, debtors have tried to separately classify HUD deficiency claims and pay HUD a substantially smaller portion of its claim, as compared to the general unsecured creditors, so that the unsecured creditors would vote in favor of the plan for cramdown purposes. In Hillside Park Apartments,149 the 148 149
186 B.R. 497 (N.D. Cal.), rev’g 178 B.R. 824 (Bankr. N.D. Cal. 1995). In re Hillside Park Apartments, Ltd. Partnership, 205 B.R. 177 (Bankr. W.D. Mo. 1997).
䡲
898
䡲
c20.fm Page 899 Thursday, March 15, 2007 10:42 PM
20.5 DISCHARGE
court refused to allow the debtor to classify HUD’s §1111(b) deficiency claim separately from the claims of the general unsecured creditors, because there was no evidence that the assignee had any noncreditor interests—specifically public interests under the National Housing Act—that would justify such disparate treatment.150 The plan contemplated treating the general unsecured creditors much more favorably than HUD, in order to encourage them to vote in favor of the plan, which would allow the debtor to cram down over HUD’s objections. By preventing such separate classification, HUD forced the debtor to treat it more favorably and pay it a greater amount on its claims. In Way Apartments,151 the court affirmed confirmation of a plan cramming down HUD, stating that there was a good business reason to separately classify HUD’s deficiency claim because HUD had noncreditor interests in the debtor’s property (specifically, the public interests under the National Housing Act).152 Similarly, in In re Briscoe Enterprises, Ltd., II,153 the court affirmed the bankruptcy court’s confirmation of a plan that classified the unsecured claim of the City of Forth Worth, Texas, separately from the claims of the general unsecured creditors, because the city had distinct noncreditor interests related to its urban housing program and contributed $20,000 per month in rental assistance.154 In Kings Gate Apartments, Ltd.,155 the court held that the use agreement between HUD and the debtor was an executory contract that could be rejected under 11 U.S.C. §365. The debtor’s plan sought to sell the apartment project to a buyer who would raze it and construct a supermarket. All creditors would receive payment in full. The use agreement mandated that the property be maintained as a lowincome housing project through the year 2014, at which time the last installment on the note would be due. The court held that the plan was feasible, despite the fact that HUD’s “equitable remedies” were not discharged or impaired, passed through the bankruptcy, and could be asserted at some time in the future.156
20.5
DISCHARGE
The debtor’s ultimate goal in bankruptcy is to obtain a discharge. When a bankruptcy court grants the debtor a discharge in bankruptcy, it releases the debtor
150 151
152 153 154
155 156
Id. at 188. In re Way Apartments, 201 B.R. 444 (N.D. Tex. 1996). In re Holly Garden Apartments, Ltd., 223 B.R. 822 (Bankr. M.D. Fla. 1998) (court refused to approve disclosure statement when plan classified HUD assignee’s deficiency claim differently from general unsecured creditors when debtor had no business reason for the separate classification). In re Way Apartments, 201 B.R. 444, 451 (N.D. Tex. 1996). 994 F.2d 1160, 1167 (5th Cir.), cert. denied, 510 U.S. 992 (1993). But see In re Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994) (classification of HUD’s unsecured claim separately from claims of general unsecured creditors was justified based solely on fact that a deficiency claim under §1111(b) is distinct from a general unsecured claim); In re Crosscreek Apartments, Ltd., 213 B.R. 521 (Bankr. E.D. Tenn. 1997). In Crosscreek, the court confirmed the plan submitted by the HUD assignee over the competing plan submitted by the debtor. With respect to the debtor’s plan, the HUD assignee’s objection to classifying its §1111(b) deficiency claim separately from general unsecured claims was overruled, but the objection to paying 50 percent of the deficiency claim—as opposed to 100 percent of the general unsecured claims—was sustained as unfair discrimination. In re Kings Gate Apartments, Ltd., 206 B.R. 233 (Bankr. W.D. Okla. 1996). Id. at 235.
䡲
899
䡲
c20.fm Page 900 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
from all of its debts (other than any that are excepted from the discharge) and bars all future proceedings to collect the discharged debts.157 A bankruptcy discharge also enjoins creditors from harassing the debtor after the discharge.158 A discharge in bankruptcy is personal to the debtor. For example, when a debtor receives a discharge of a loan that another party guaranteed, it discharges only the debtor’s liability for the debt. The guarantor remains liable on the debt (absent its own bankruptcy filing). In the context of joint ventures involving taxexempt organizations, an exempt organization serving as the general partner or managing member of a limited partnership or LLC will frequently guarantee debt of the limited partnership or LLC. In such cases, even if the debt of the partnership or LLC is discharged, the general partner or managing member guaranteeing the debt will remain liable on such debt after the partnership’s or LLC’s discharge. PLANNING POINTER Debtors should consider the following issues regarding a bankruptcy discharge:
*
•
When may a discharge be denied to debtors in a chapter 7 bankruptcy?
•
When may a court revoke a discharge?*
•
What debts will chapter 7 bankruptcy not discharge?
•
How does a discharge under chapter 11 differ from a discharge under chapter 7?
A court may revoke an individual’s chapter 7 discharge within one year after the discharge is originally granted if (1) discharge was obtained through the debtor’s fraud, of which the party requesting revocation was unaware until after discharge was granted; (2) the debtor knowingly and fraudulently failed to report that it acquired or became entitled to property that is property of the estate or to deliver or surrender this property to the trustee after discharge was granted; (3) the debtor failed to obey a lawful order of the court or to answer a material question approved by the court on a basis other than a properly invoked privilege against self-incrimination; or (4) the debtor has failed to explain satisfactorily a material misstatement in an audit referred to in 28 U.S.C. §586(f) or a failure to make available for inspection all necessary accounts, papers, documents, financial records, files, and all other papers, things, or property belonging to the debtor that are requested for an audit referred to in 28 U.S.C. §586(f). 11 U.S.C. §727(d).
Generally, bankruptcy courts grant an automatic discharge for individual debtors under chapter 7 bankruptcy unless one or more parties successfully object to the discharge for specified grounds. Nevertheless, discharge under chapter 7 is considered a privilege, not a right.159 CAVEAT Because a successful objection to discharge in chapter 7 has serious consequences, the debtor must carefully consider the risk of a valid objection to discharge before filing for chapter 7 bankruptcy. If grounds for a valid objection to discharge exist, the individual debtor should consider proceeding under a different bankruptcy chapter. For example, several bases for objection to discharge apply only in chapter 7 cases and would not bar a discharge in other types of bankruptcy (for example, chapter 11 bankruptcy). 157 158 159
11 U.S.C. §524(a). See, e.g., In re Reed, 11 B.R. 258 (Bankr. D. Utah 1981). See Congress Talcott Corp. v. Sicari (In re Sicari), 187 B.R. 861 (Bankr. S.D.N.Y. 1994).
䡲
900
䡲
c20.fm Page 901 Thursday, March 15, 2007 10:42 PM
20.6 SPECIAL ISSUES: USE OF CASH
A denial of a discharge differs from an exception to a discharge (discussed later in this section). Specifically, denial of a discharge leaves all of the debtor’s nonexempt assets and future income subject to the claims of all of the debtor’s creditors. In contrast, an exception to discharge applies only to the particular debt that is excepted from discharge. Because only individuals may discharge debt through chapter 7,160 understanding the exceptions to discharge (and the dischargeability of particular debts) has little relevance to the tax-exempt organization.161 Nonindividual debtors, such as corporations and partnerships, may obtain a discharge through chapter 11 bankruptcy. Except as specifically provided in the plan, and except in the case of a liquidating plan, confirmation of a nonindividual debtor’s chapter 11 plan of reorganization automatically discharges the debtor from all debts arising before confirmation, including debts arising after the commencement of the bankruptcy case and prior to the effective date of the confirmed plan.162 Unless the plan of reorganization provides otherwise, confirmation vests the property of the bankruptcy estate in the reorganized debtor, free and clear of claims.163 If the plan provides for the liquidation of a corporate or partnership debtor, however, the debtor will not receive a discharge.164 Instead, the entity liquidates and ceases its existence. Although the plan may provide for the release of claims against a corporation’s officers, a chapter 11 discharge, in and of itself, will not release the corporation’s officers from any claims against them.165 Rather, the plan must specifically provide for such a release. The efficacy of such releases is subject to question.166
20.6 (a)
SPECIAL ISSUES: USE OF CASH Use of Cash: Generally
Typically, the client’s goal when filing a chapter 11 petition is to stay in business. This inherently requires clients to retain at least a minimal level of cash flow to continue their operations. After initiating bankruptcy, clients often will have only two potential sources of cash: (1) cash collateral, which may be used only pursuant to the provisions of 11 U.S.C. §363, and (2) postpetition financing obtained under the terms of 11 U.S.C. §364. Note: In practice, postpetition financing is more common than surviving on cash collateral. The Bankruptcy Code limits a debtor’s use of cash collateral. Specifically, it prohibits debtors from using cash collateral unless either (1) every entity with an interest in such cash collateral consents to such use, or (2) the court authorizes such use.167 Thus, debtors must obtain either their creditors’ approval or court authorization before using cash collateral. 160 161 162 163 164 165 166
167
11 U.S.C. §727(a)(1). See supra nn. 18–20. 11 U.S.C. §1141(d)(1)(A). 11 U.S.C. §1141(a)–(c). 11 U.S.C. §1141(d)(3). See, e.g., In re Inforex, Inc., 26 B.R. 515 (Bankr. D. Mass. 1983). Ralph Brubaker, “Nondebtor Releases and Injunction in Chapter 11: Revisiting Jurisdictional Precepts and the Forgotten Callaway v. Benton Case,” 72 American Bankruptcy Law Journal 1 72 (Winter 1998). 11 U.S.C. §363(c)(2).
䡲
901
䡲
c20.fm Page 902 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
CAVEAT Some commentators have concluded that courts are becoming stricter about punishing unlawful use of cash collateral.* *
See Chobot, “Enforcing the Cash Collateral Obligations of Debtors in Possession,” 96 Commercial Law Journal 136 (Summer 1991); Note, “Standards and Sanctions for the Use of Cash Collateral under the Bankruptcy Code,” 63 Texas Law Review 341 (1984).
In the simplest terms, cash collateral includes liquid assets that are subject to a prepetition security agreement covering property the debtor acquired prepetition and to proceeds of such property.168 More specifically, cash collateral includes property that satisfies each of the following requirements: 1. It is made up of either (a) cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents in which both the bankruptcy estate and another entity have an interest; (b) the proceeds, products, offspring, rents, or profits from such property; or (c) fees, charges, accounts, or other payments for the use or occupancy of rooms or other public lodging facilities.169 2. It is subject to a security agreement that the debtor and creditor entered into before the bankruptcy case commenced.170 3. The security agreement extends to both (a) property the debtor acquired prepetition, and (b) to either: (i) the proceeds or profits of such property, or (ii) amounts paid as rents of such property.171 4. Applicable nonbankruptcy law does not prohibit the security agreement.172 When a debtor’s cash constitutes cash collateral, that debtor must either obtain the consent of every party that has an interest in such cash collateral, or file a motion for the use of such cash collateral. (b)
Use of Cash: HUD Context
Courts have uniformly refused to allow debtors to use HUD cash collateral in contravention of the HUD regulatory agreement. Typically, these cases arise in the context of a debtor seeking to pay its bankruptcy attorneys from project income that is subject to a secured interest of HUD.173 In both Indian Motorcycle 168 169 170 171 172 173
11 U.S.C. §§363(a), 552(b). 11 U.S.C. §363(a). 11 U.S.C. §552(b)(1). 11 U.S.C. §552(b). 11 U.S.C. §552(b)(1). See, e.g., Indian Motorcycle Associates III Ltd. Partnership v. Massachusetts Housing Finance Agency, 66 F.3d 1246 (1st Cir. 1995); In re EES Lambert Associates, 62 B.R. 328 (Bankr. N.D. Ill. 1986). See also In re Marion Carefree Ltd. Partnership, 1994 Bankr. LEXIS 398 (Bankr. N.D. Ohio 1994); In re Two-KMF Development Association, 63 B.R. 149 (Bankr. N.D. Ill. 1985); In re Hill Crest Apartments, 50 B.R. 610 (Bankr. N.D. Ill. 1985); In re EES Lambert Associates, 43 B.R. 689 (Bankr. N.D. Ill. 1984), aff’d, 63 B.R. 174 (N.D. Ill. 1986); In re Woodfield Gardens Associates, 1998 Bankr. Lexis 640 (Bankr. N.D. Ill. May 28, 1998) (prepetition retainer of $250,000 paid to debtor’s attorney held to be assignee’s cash collateral). Also see Sanders and Saret, supra note 131.
䡲
902
䡲
c20.fm Page 903 Thursday, March 15, 2007 10:42 PM
20.7 SPECIAL ISSUES: CONSEQUENCES OF DEBT REDUCTION
and EES Lambert, HUD was a secured creditor of the debtor. In each instance, the HUD regulatory agreement perfected HUD’s security interest in the debtor’s project and restricted the use of project income. Hence, the project income was HUD’s cash collateral. In Indian Motorcycle, the debtor paid $65,000 in project income to its attorneys prepetition. In EES Lambert, the debtor’s attorney filed a request for interim fees and compensation that could be satisfied only from project income. In both instances, the court refused to allow any funds to be disbursed unless they benefited the project as required under the regulatory agreement, and specifically held that fees to attorneys for the purpose of financing a bankruptcy benefited the debtor partnership and its partners, not the project itself. Hence, the court in EES Lambert said, “Lambert cannot simply file a bankruptcy petition and then relieve itself of the strictures of its Regulatory Agreement with HUD.”174 The court in Indian Motorcycle noted that the effect of the HUD regulatory agreement goes beyond that of an ordinary contract: Second, the assignment-of-rents provision in the Regulatory Agreement is not merely a term in a private loan agreement, but a contractual precondition to coinsurance that Congress expected HUD to enforce in the public interest. Permitting partnership debtors, or their individual partners, to divert public funds with any degree of impunity threatens significant depletion of the treasury, and ultimately undercuts public confidence in the efficacy of federal housing, lending, and insurance programs, thereby subverting Congress’s announced intention to promote private construction of low-income housing.175
Hence, courts are loath to allow a debtor to escape any of the terms of its agreement with HUD, whether it be in the context of use of cash collateral or confirmation of a plan of reorganization, because of the detrimental effect such modification would have on the goals of the NHA.
20.7
SPECIAL ISSUES: CONSEQUENCES OF DEBT REDUCTION
When debtors experience a debt reduction, they realize cancellation-of-debt income (“COD income”).176 When partnerships realize COD income, it flows through to the partners based on their distributive shares of partnership income under the partnership agreement.177 Thus, partners must recognize their shares of COD income unless an exclusion applies. (a)
Exclusions from Gross Income
Under IRC §108(a)(1), gross income generally does not include COD income that results from the entire or partial discharge of debt if: • The discharge occurs in bankruptcy. • The discharge occurs when the taxpayer is insolvent. 174 175 176 177
62 B.R. at 336. 66 F.3d at 1250 (citations omitted). §61(a)(12). §702 and Treas. Reg. §1.1017-1(g) regarding an election to treat a partnership interest as depreciable property.
䡲
903
䡲
c20.fm Page 904 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
• The debt discharged is qualified farm debt. • The debt discharged is qualified real property business debt. • The debt discharged is pursuant to a provision within a student loan.178
Debt cancellation must be analyzed under these exclusions in the order listed here. Thus, the last three exclusions do not apply to a discharge that occurs in bankruptcy, and the last two exclusions do not apply to the extent that the income is excluded under the “insolvency” exclusion. However, the amount excluded under the second category (the insolvency exclusion) may not exceed the amount by which the taxpayer is insolvent. For this purpose, the Code defines insolvency as the excess of liabilities over the fair market value of assets.179 (b)
Application to Partnerships
When a partnership owns property with respect to which debt is discharged, the transaction must be analyzed at both the partnership and the partner levels. Whether any COD income is realized must be determined at the partnership level. If the partnership realizes COD income, then each partner must determine whether any of the partner’s distributive share of the income is excluded from the partner’s gross income at the partner level.180 For example, if a partner qualifies for the bankruptcy exclusion, the partner’s share of the partnership’s COD income is excluded from the partner’s gross income. (c)
Exclusion of COD Income in Bankruptcy
Gross income does not include COD income if the discharge occurs in a chapter 11 bankruptcy case.181 Taxpayers excluding amounts from income under the 178
For individuals, cancellation of indebtedness income is excludable from the individual’s income when such income results from the discharge of any student loan because of a provision of such loan under which all or part of the debt would be discharged if the individual worked for a certain period of time within certain professions for any of a broad class of employers. For this purpose, a student loan includes any loan to an individual to assist him or her in attending an educational organization (as defined by IRC §170(b)(1)(A)(ii)), when such loan is made by any of the following: • The United States or an instrumentality or agency of the United States • A state, territory, or possession of the United States, or the District of Columbia, or any political subdivision of the foregoing • A public benefit corporation that is tax exempt under IRC §501(c)(3), which has assumed control over a state, county, or municipal hospital, and whose employees are deemed to be public employees under state law • Any educational organization described by IRC §170(b)(1)(A)(ii) if such loan is made: (1) pursuant to an agreement with any of the foregoing organizations (i.e., United States, state, etc.), or (2) pursuant to a program of the educational organization that is designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs and under which the services provided by the students are under the direction of a governmental unit or an IRC §501(c)(3) tax-exempt organization
179 180 181
However, this exclusion of cancellation of indebtedness income does not apply to a debt discharge of a loan made by an educational organization on account of services provided to that educational organization. §108(a)(3), (d)(3). §108(d)(6). §108(a)(1)(A).
䡲
904
䡲
c20.fm Page 905 Thursday, March 15, 2007 10:42 PM
20.7 SPECIAL ISSUES: CONSEQUENCES OF DEBT REDUCTION
bankruptcy exclusion must apply such excluded income to reduce certain specified tax attributes.182 When attribute reduction is required, it is done in one of two ways, depending on whether the taxpayer first elects to reduce the basis of depreciable property. If the taxpayer does not elect to reduce the basis of depreciable property, it must reduce the following tax attributes in the order in which they are listed:183 1. Any net operating loss (NOL) for the taxable year of the discharge, and any net operating loss carryover to that taxable year 2. Any carryover to or from the taxable year of the discharge of an amount representing the amount allowable as a general business credit under §38 3. The amount of the minimum tax credit available under §53(b) as of the beginning of the taxable year immediately following the taxable year of the discharge 4. Any net capital loss for the taxable year of the discharge, and any capital loss carryover to such taxable year 5. Basis as provided in §1017 6. Any passive activity loss or credit carryover of the taxpayer under §469(b) from the taxable year of the discharge 7. Any foreign tax credit carryover to or from the taxable year of the discharge The attribute reduction is made dollar-for-dollar except for credit carryover reductions, which are made 33.3 cents for each dollar excluded from income.184 Taxpayers can elect to reduce the basis of depreciable property before reducing other attributes.185 If taxpayers make this election, they would then reduce other attributes in the order specified in the preceding list after reducing the basis of depreciable property, including the taxpayer’s basis in nondepreciable property. The election to first reduce the basis of depreciable property allows taxpayers to sacrifice basis in depreciable property at a tax cost of having future depreciation deductions reduced (or later gain on sale increased) to preserve NOLs, NOL carryovers, and other attributes. PLANNING POINTER The election should be considered when the taxpayer anticipates using NOLs and other attributes at a faster rate than depreciation and when the taxpayer does not anticipate selling the depreciable property in the near term.
182 183 184 185
§108(b). §108(b)(2). §108(b)(3). §108(b)(5).
䡲
905
䡲
c20.fm Page 906 Thursday, March 15, 2007 10:42 PM
DEBT RESTRUCTURING AND ASSET PROTECTION ISSUES
(d)
Exclusion of COD Income for Insolvency
Gross income does not include COD income if the discharge occurs when the taxpayer is insolvent.186 The amount excluded from gross income by the insolvency exclusion cannot exceed the amount by which the taxpayer is insolvent.187 The amount excluded by the insolvency exclusion must be applied to reduce tax attributes in the same manner as amounts excluded by the bankruptcy exclusion. For this purpose, a taxpayer is considered insolvent to the extent of the excess of liabilities over the fair market value of assets, determined on the basis of assets and liabilities immediately before the discharge.188 Because insolvency, for this purpose, is determined immediately before the discharge, increases in the debtor’s equity that occur because of the discharge are not considered for purposes of determining the excludible amount under the insolvency exclusion. The amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt (that is, excess nonrecourse debt) is considered in determining whether, and to what extent, a taxpayer is insolvent only to the extent that the excess nonrecourse debt is discharged.189 Conversely, excess nonrecourse debt is not considered for purposes of determining a debtor’s insolvency, to the extent it is not discharged. (e)
Exclusion of COD Income from Qualified Farm Debt
Generally, taxpayers who are in the business of farming may reduce the basis of property used in farming, in lieu of recognizing COD income, if they satisfy two requirements.190 First, the debt must have been incurred directly in connection with the business of farming.191 Second, 50 percent or more of the taxpayer’s aggregate gross receipts for the three taxable years preceding the taxable year of the discharge must have been attributable to the trade or business of farming.192 The qualified farm debt exclusion is limited to the sum of the taxpayer’s adjusted tax attributes plus the aggregate adjusted bases of qualified property (property used or held for use in a trade or business or for the production of income) held by the taxpayer as of the beginning of the discharge year.193 For this purpose, the taxpayer’s adjusted tax attributes are those tax items, other than basis, that are reduced because of the discharge of qualified farm debt, except that any tax attributes constituting credits are multiplied by three. To the extent the discharged amount exceeds the sum of the relevant amounts, the taxpayer must recognize COD income. The taxpayer generally must reduce its tax attributes in the same manner as for the bankruptcy exclusion, previously discussed. One of the attributes required to be reduced by discharged qualified farm debt is basis.194 A special 186 187 188 189 190 191 192 193 194
§108(a)(1)(B). §108(a)(3). §108(d)(3). Rev. Rul. 92-53, 1992-2 C.B. 48. §108(a)(1)(C). §108(g)(2)(A). §108(g)(2)(B). §108(g)(3). §108(b)(2)(D).
䡲
906
䡲
c20.fm Page 907 Thursday, March 15, 2007 10:42 PM
20.7 SPECIAL ISSUES: CONSEQUENCES OF DEBT REDUCTION
ordering rule applies for basis reduction because of the discharge of qualified farm debt.195 Specifically, only property used or held for use in a trade or business or for the production of income (qualified property) is eligible for basis reduction.196 Moreover, the basis of qualified property must be reduced in the following order: 1. Depreciable property 2. Land used or held for use in the business of farming 3. Other qualified property197 (f)
Exclusion of COD Income from Qualified Real Property Business Debt
To be classified as qualified real property business debt (QRPD), debt must satisfy three requirements.198 First, it must have been incurred or assumed in connection with real property used in a trade or business and secured by that real property. Second, the debt must have been incurred or assumed before January 1, 1993, or must have been incurred or assumed to acquire, construct, reconstruct, or substantially improve the property. Third, the taxpayer must elect to exclude the COD income. The amount of COD income that may be excluded under the QRPD exclusion is subject to two limitations. First, the excluded amount may not exceed the amount by which the outstanding principal of the debt (immediately before the discharge) exceeds the fair market value of the property securing the debt. Second, the excluded amount may not exceed the total adjusted bases of all depreciable real property the taxpayer holds immediately before the discharge.199 To use the QRPD exclusion, two other procedural requirements must be satisfied. First, the taxpayer must elect to exclude the COD income on Form 982 and attach this form to its federal income tax return. Second, the taxpayer must reduce the basis of its depreciable real property by the amount of income excluded under this exclusion.200 In the partnership context, a partner may reduce its basis in its partnership interest by the excluded amount if the partnership correspondingly reduces its basis in its depreciable real property with respect to the partner.201 A debtor/partner also may reduce basis in other depreciable real property it owns. As previously explained, however, the amount of COD income that can be excluded under the QRPD exclusion may not exceed the taxpayer’s total adjusted basis in all depreciable real property. These adjustments resemble but do not precisely parallel the basis adjustments a partnership makes under an IRC §754 election. Future guidance under §108(c) will, one hopes, prescribe ordering rules for situations in which a partner owns other real property besides real property owned by the partnership whose debt is discharged. 195 196 197 198 199 200 201
§1017(b)(4). See id. §1017(b)(4)(A). §108(c)(3). §108(c)(2). §108(c)(1). §1017(b)(3)(C).
䡲
907
䡲
c20.fm Page 908 Thursday, March 15, 2007 10:42 PM
bindex.fm Page 909 Friday, March 16, 2007 10:51 AM
Index
Note: References are to book section numbers (§), complete chapters (Ch.), appendices (App.), and/or exhibits (Exh.). A zero section reference (e.g., §1.0) indicates unnumbered introductory material at the beginning of a chapter. Abuses charities as accommodating parties in international terrorist activities, §17.3. See also International joint ventures healthcare fraud and abuse statutes, §12.4(d) and intermediate sanctions, §§5.1, 5.4. See also Sanctions and nonprofit scandals, §5.1(a) tax shelter transactions. See Tax shelter transactions, exempt organizations as accommodating parties "Action" organization, §2.4(b)(iii) Advertising qualified sponsorship payments, §15.4(a) Web sites, §8.5(g)(i)(D) Affiliates reporting requirements, §4.14(c) structuring joint ventures, §1.8 Affinity credit cards, §§1.1, 8.5(c)(ii), 8.5(c)(ii)(B)–8.5(c)(ii)(D), 14.7(e) Affordable Housing Program, §§1.5, 13.2(c)(i) Allocation corporate sponsorship payments, §14.6(b)(iii) fractions rule, §§1.18(a), 1.18(b), 9.4–9.7 low-income housing tax credits, §13.2(d) New Markets Tax Credits, §§13.5(b), 13.5(m), 13.5(n) partnership profits, losses, and credits, §§3.6, 13.2(c)(iii) qualified allocations, §§1.15(a), 1.18(a), 9.4, 11.6(a)–11.6(c), 11.6(e), 11.6(f), 11.6(g) university and college joint ventures, §14.8 Ancillary joint ventures, §§1.10, 4.2(i), 4.6, 11.1(a)(i)–(iii), 12.2, 15.3(b) Anti-abuse regulations, partnerships, §3.12(g) Anti-Abuse Rule, §9.6(h) Anti-Terrorist Financing Guidelines, §17.3(a)(i)(D) Anti-Terrorist Financing Guidelines (revised), §§17.12(c), 17.13 Antikickback Statute, §§12.4, 12.4(b), 12.4(d), 12.4(e), 12.10 Antitrust law and healthcare joint ventures, §12.4(f) Arbitration, §12.5(c)
䡲
Articles of incorporation amendment of, notice to IRS, §1.13 organizational test, §2.4 Asset-based valuation, §5.2(f)(v) Associations partnerships treated as, tax consequences, §1.15(a) tax treatment, §3.3 At-risk rules and convertible debt, §6.4(c)(ii) limitations, §3.12(d) and low-income housing tax credit, §§13.2(c), 13.2(l) overview, §1.15(a) real estate, §9.7 Audit committees, §2.13(c) Audit Guidelines for Hospitals, §12.4(b) Auditors, independent, §2.13(a) Audits advance planning to minimize issues, §§2.10(a), 4.10(b) coordinated examination program (CEP audits), §14.2(b) as function of IRS, §§2.10, 4.10(a) guidelines, universities and colleges, §4.2(j)(i) internal compliance audits, §§2.10(a)(i), 2.10(b) low-income housing projects, §13.2(o) partnership unified audits, §3.12(f) and recent legislative trends, §8.8(a)(iii) responding to, §2.10(b) Automatic stay duration of, §20.3(e) effect of, §20.3(c) exceptions, §20.3(b) and loss of tax-exempt status, §20.3(h) overview, §§20.3, 20.3(a) relief from, §20.3(f) third parties, §20.3(g) violation of, §20.3(d) Bankruptcy automatic stay, §§20.3, 20.3(a)–20.3(h) cancellation-of-debt income, §§20.7, 20.7(a)–20.7(f) chapter 7 liquidation. See Chapter 7 bankruptcy (liquidation)
909 䡲
bindex.fm Page 910 Friday, March 16, 2007 10:51 AM
INDEX
chapter 11 reorganization. See Chapter 11 bankruptcy (reorganization) discharge, §20.5 and lease transactions, §6.5(c) overview, §§1.17, 20.2, 20.2(a), 20.2(b)(i)– 20.2(b)(iv) as part of debt restructuring and asset protection planning, §20.1 use of cash, §§20.6(a), 20.6(b) Bargain sales and "burned-out" shelters, §3.11(f) consequences of charitable contribution, §3.11(e) and partnership taxation, §1.15(b) Basis eligible basis, low-income housing, §§13.2(i), 13.2(j) historic investment and low-income housing tax credit projects, §13.3(e) inside, §3.8(b)(ii) outside, §3.8(b)(i) partnership interests, §3.8 qualified basis, low-income housing, §13.2(i) Board of directors, change in control, §1.13 Bonds abusive transactions, private benefit or inurement, §5.2(g) financing, §6.3(e) issuance of tax-exempt bonds, §4.13 tax-exempt enterprise zone facility bonds, §§13.4(b), 13.4(b)(i) tax-exempt financing of low-income housing project, §13.2(e) Boost theory healthcare systems, §12.4(g)(v) universities and colleges, §14.6(b)(v)(B) Branding relationships, §§1.1, 4.8(b)(ii), 8.5(g) Bridge loans, §§6.3(b), 13.2(c) Brownfield properties, §16.4 Business enterprise and excess business holding rules, §§6.6(c), 10.4 Business holdings, §1.8 Business leagues activities, §15.2(c) commercial activity for profit, §15.2(d) common business interest, §15.2(a) and corporate sponsorships, §§15.4, 15.4(a)–15.4(f) defined, §15.1(c) five-prong test, §15.2 general rules, §15.1(a) influencing legislation, §15.1(a) and joint ventures, §15.1(b) membership dues, §§15.1(a), 15.3(d) private benefit or inurement, §§15.1(a), 15.2(e) promotion of common business interest, §15.2(b) unrelated business income tax, §§15.1(a), 15.1(b), 15.3(a)–15.3(d) Bylaws, amendment of, §1.13
䡲
C corporations and earnings stripping rules, §6.2(b) limited liability company compared, §19.3(b) and low-income housing tax credit, §13.2(c) and tax credit projects, §1.5 wholly-owned subsidiaries, §19.6(a) California Equity Fund, §1.5 California Nonprofit Integrity Act of 2004, §2.14 Capital asset pricing model (CAPM), §5.2(f)(ii) Car donation programs Congressional hearings and legislation, §2.12 significant intervening use and material improvements, §2.12(b) substantiation requirements, §2.12(c) types of, §2.12 valuation of deduction, §2.12(a) Cause marketing, §2.11(f), §14.7(e) Chapter 7 bankruptcy (liquidation). See also Bankruptcy automatic stay, §§20.3, 20.3(a)–20.3(h) chapter 11 compared, §20.2(c) discharge, §20.5 overview, §§20.2, 20.2(a) Chapter 11 bankruptcy (reorganization). See also Bankruptcy acceptance of plan, §20.4(b) automatic stay, §§20.2(b)(iii), 20.3, 20.3(a)– 20.3(h) best interests test, §20.4(c) chapter 7 compared, §20.2(c) cramdown, §20.4(d) discharge, §20.5 fair and equitable requirement, §§20.4(d)(i)–20.4(d)(iv) filing for, §20.2(b)(ii) HUD regulatory agreement, effect of plan confirmation on, §20.4(e) HUD regulatory agreement and use of cash, §20.6(b) involuntary petition, §20.2(b)(ii) operation of business, §20.2(b)(iii) overview, §§20.2, 20.2(b) plan of reorganization, §§20.2(b)(iii), 20.2(b)(iv), 20.2(b)(iv)(A)–20.2(b)(iv)(C), 20.4, 20.4(a)–20.4(e) unfair discrimination prohibition, §20.4(d)(v) and use of cash, §§20.6(a), 20.6(b) voluntary petition, §20.2(b)(ii) Chargebacks and offsets, §§9.6(d), 9.7 Charitable contributions bargain sale treatment, §§3.11(e), 3.11(f) car donation programs, §2.12 cash, §2.11(a) conservation easements, §2.11(c), §16.3 corporate donors, §17.2(a) decline in giving, §1.1
910 䡲
bindex.fm Page 911 Friday, March 16, 2007 10:51 AM
INDEX
deductibility of, §§2.11, 17.2 donative intent, §2.11 "friends" organizations, §17.2(b) by joint venture, §2.11(d) long-term capital gain property, §2.11(b) ordinary income property, §2.11(a) and purchases of real property, §2.11(c)(i) registration for charitable solicitation, §2.11(f) short-term capital gain property, §2.11(a) substantiation and disclosure requirements, §2.11(e) Charitable defined, §§1.9, 2.6(a) Charitable organizations. See Section 501(c) organizations; Section 501(c)(3) organizations Charitable purpose, §§1.9, 2.6(a)(i)(A), 2.6(a)(i)(B), 2.6(a)(ii), 4.2(d)(ii)(A)– 4.2(d)(ii)(F), 4.2(d)(iii), 12.3(b)(i), 12.3(d)(ix)(A), 19.1, 19.7(a), 19.7(c)(iii), 19.7(d)(i), 19.7(g) Charleston Principles, §2.11(f) Check-the-box regulations, §§4.8(c), 13.2(g)(i), 19.1, 19.3(a), 19.4, 19.5(a)–19.5(e), 19.6 Checklists joint ventures, App. 4–1 New Market Tax Credit compliance and qualification, App. 13.1 Commercial joint ventures, §2.11(f) private benefit and private inurement rules, §§5.1, 5.2(c). See also Private benefit; Private inurement rules Community benefit standard, §§1.2, 2.6(a)(ii), §2.6(b), 4.2(i), 12.3(b)(i) Community Development Block Grant (CDBG), §§1.5, 13.2(c)(i), 13.2(h), 13.2(j)(i) Community development corporations (CDCs), §1.5 Community Development Entities (CDEs), §§1.5, 13.5(a)–13.5(o), 13.8 Community Development Financial Institutions Fund (CDFI Fund), §§13.5(b), 13.5(h), 13.5(m), 13.5(n) Community housing development organizations (CHDOs), §13.2(c)(i) Compensation comparability data, §5.4(c)(ii)(B) economic benefit, §5.4(c)(i) and excess benefit transactions, §1.21 excessive, §§5.1(a), 5.2(a) executive compensation, nonprofit hospitals, §12.9(b)(ii) incentive compensation limitations, §5.2(a)(iii) intermediate sanctions, §§5.4(c), 12.3(c)(ii)(A) and physician recruitment, §12.4(g) private benefit and private inurement, §5.2 reasonableness, §§1.21, 5.2(a)(ii), 5.4(c)(ii) for services, §5.2(a) stock, valuation issues, §5.2(f)(vii) Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), §16.4(a)
䡲
Conflicts of interest healthcare joint ventures, §§12.5(e), App. 12–1 overview, §1.9 university policies, §14.5 Conservation organizations charitable or educational purpose, §§16.2, 16.8 conservation easements, gifts of, §16.3 emissions credits, tax treatment of, §16.7(a) and Form 990, §16.6 government, role of, §16.7(b) joint ventures, §§1.6, 16.5 liability issues, §16.5 and limited liability companies, §16.5 The Nature Conservancy investigation, §§1.6, 16.2(a), 16.3(e)16.6, 16.7 overview, §§1.6, 16.1, 16.8 and Pension Protection Act §16.3(c) qualified conservation easements, §16.3(a) and Rev. Rul. 98-15, §1.9 tax avoidance transactions, §16.3(e) unrelated business income tax, §16.4 valuation of perpetual conservation restriction, §16.3(d) Construction loans, §§6.3(a), 6.7(a), 6.7(b) Control and 50-50 joint ventures, §4.2(g) ancillary joint ventures, §§1.10, 4.6 board of directors, change in control of, §1.13 case law, §4.2(f) insiders, §19.7(f) and limited liability companies, §§19.7(a), 19.7(d)(i), 19.7(e) overview, §1.9 St. David's Healthcare Systems, Inc. v. U.S. See St. David's Healthcare Systems, Inc. v. U.S. test, §§4.6(a), 4.6(b) transfer of to another tax-exempt organization, §1.13 "UBIT plus Control" test, §§4.6(b)–4.6(d) and unrelated business income tax (UBIT), §§4.6(a), 11.1(a)(i) Conversion from exempt to for-profit and forprofit to exempt, §4.11 Corporate Housing Initiatives, §1.5 Corporate sponsorships. See Sponsorships, corporate Corporations C corporations. See C corporations characteristics of, §19.5(a) and check-the-box regulations. See Checkthe-box regulations Model Business Corporations Act, §19.2(a) per se corporations, §§19.5(b)(i), 19.5(c) S corporations. See S corporations Cost recovery. See Depreciation Credit cards. See Affinity credit cards De minimis rules lobbying expenditures, §15.1(a)
911 䡲
bindex.fm Page 912 Friday, March 16, 2007 10:51 AM
INDEX
partnership taxation, §9.6(g) private foundations, §10.2 title-holding companies, §3.4(b) Debt-financed property, §1.15(a) acquisition indebtedness, §9.2(c) defined, §1.18(a) and ground lessors, §1.14 income from, §§9.1, 9.2(b) overview, §9.2(a) partnership rules. See Partnership taxation preferred returns, limitation on, §1.18(a) section 514(c)(9) exception for acquiring or improving real property, §9.3 unrelated business income tax, §§1.15(a), 1.16, 8.5, 8.5(a), 9.2(a), 9.4 Debt restructuring, §20.1. See also Bankruptcy Dedication of assets, §2.4(a)(ii) Depreciation modified accelerated cost recovery system (MACRS), §§1.18(c), 3.9(c), 11.2 partnerships, §3.9(c) and tax-exempt entity leasing rules, §§1.18(c), 11.2, 11.5(a), 11.5(b), 11.5(d) Disclosures and Form 990, §2.9 private pension funds, §18.2(c) public disclosure of tax returns, §8.8(a)(ii) public inspection of returns, §4.14(b) and reporting requirements, §4.14(a) Discounted cash flow (DCF) analysis, §5.2(f)(ii) Discrimination, operations contrary to public policy, §2.5(b) Disqualified persons and intermediate sanctions, §§5.4(a), 12.3(c)(i) organization managers, §12.3(c)(i)(B) per se disqualification, §12.3(c)(i) and private inurement, §§1.21, 5.1(b). See also Private inurement rules substantial influence, §12.3(c)(i)(A) Distributions partnership liquidating distributions, §3.11(d) partnerships, §3.10 Donor-advised funds, §10.2 Down payment assistance to homebuyers, §1.2. See also Low-income housing charitable purpose, §§4.2(d)(ii)(B)– 4.2(d)(ii)(D) Earnings-based valuation methods, §5.2(f)(iii) Earnings before interest, taxes, depreciation, and amortization (EBITDA), §5.2(f)(ii) Earnings before interest and taxes (EBIT), §5.2(f)(ii) Economic development organizations (EDCs), §§2.6(a)(i)(B), 2.6(a)(ii) Economic risk of loss, partnership liabilities, §3.8(c) Economic substance doctrine, §7.2(a)(ii)
䡲
Economic value added (EVA) model, §5.2(f)(ii) Educational organizations. See also Universities and colleges debt-financed property, section 514(c)(9) exception, §9.3 education defined, §2.6(d) full and fair exposition test, §2.6(d)(ii) methodology test, §2.6(d)(ii) other educational organizations, §2.6(d)(ii) public cultural organizations, §2.6(d)(iii) schools, §2.6(d)(i) Employee Plans and Exempt Organizations (EP/EO), §5.2(g) Empowerment zones defined, §13.4(b) employment credit, §13.4(b)(ii) overview, §13.4 section 179 expensing of qualified property, §§13.4(b), 13.4(b)(iii) Enterprise communities defined, §13.4(b) overview, §13.4(a) tax-exempt facility bonds, §13.4(b)(i) Enterprise Foundation, §1.5 Environmental organizations. See Conservation organizations Equity funds, corporate and low-income housing tax credit, §13.2(c) Equity investments and program-related investments, §4.12(a) and tax issues, §4.12(c) Equity kicker, §§1.14, 4.12(c), 6.2(c), 6.3(e), 6.4(a) Excess benefit transactions, §1.21, §5.1(b). See also Intermediate sanctions case law, §5.5 compensation, §12.3(c)(ii)(A) revenue sharing, §12.3(c)(ii)(B) Excess business holdings disqualified persons, §10.2 exclusions, §10.4 functionally related business, §10.4(a) general rules, §10.2 initial tax, §10.3 overview, §§1.22, 10.1 passive income, §10.4(c) private foundations, §1.22 program-related investment, §10.4(b) and sale of undeveloped land, §6.6(c) Excise taxes, §§1.20–1.22 disqualified person, §12.3(c)(i) excess benefit transactions, §5.4(b)(iii) indemnification agreements, §5.4(e) and intermediate sanctions, §§ 5.2, 5.4(b)(iii). See also Intermediate sanctions on political expenditures, §2.4(c)(ii)(B) private foundations, §10.1 tax shelter transactions, §7.3 Exclusive benefit purpose private pension funds, §18.2(a)
912 䡲
bindex.fm Page 913 Friday, March 16, 2007 10:51 AM
INDEX
Exempt Organization Instruction Program for FY2001, §19.5(c) Exempt Organizations Continuing Professional Education (CPE) Instruction Program for FY 2002, §12.3(b)(i) Exempt Organizations Continuing Professional Education Technical Instruction Program for FY 1999 (CPE), §4.2(i)(i) Exempt purpose, 1.9, §§1.12, 2.4, 2.4(a)(i), 2.4(b)(i), 12.3(b)(ii), 19.1 Federal Emergency Management Agency (FEMA) grants and loans, effect of on eligible basis, §13.2(j)(i) Federal housing programs, §1.5 Feeder organizations, §2.4(d) Fiduciary duties and limited liability companies, §19.7(g) private pension funds, §18.2(c) Financial Action Task Force on Money Laundering (FATF), §17.12(a) Financial Anti-Terrorism Act (FATA), §17.3(a)(i)(C) For-profit organizations conversion to tax-exempt, §4.11 healthcare joint ventures, tax-exempt structure compared, §12.5(d) low-income housing, "plus" standard, §2.6(b) low-income housing tax credit, §13.2(c) nonprofits distinguished (IRS theory), §2.6(b) shared Web sites, §§1.1, 8.5(g)(i)(C) as subsidiaries, §4.8(b)(iii) Form 990 affiliated organizations, §4.14(c) conservation organizations, §16.6 and excessive compensation issues, §5.4(c) and international joint ventures, §§17.3(a)(i)(E), 17.12(d)(i) lobbying and political expenditures, §15.1(a) and minimizing audit issues, §2.10(a)(iii) and nonprofit hospitals, §12.9(c) related organizations, §4.14(c)(iv) reporting requirements, §§1.13, 2.9, 4.14(a), 19.5(c) single-member LLCs, §4.8(c) subsidiaries, §§4.14(c)(i), 4.14(c)(ii) tax exemption, wholly-owned LLC, §19.5(c) Form 990-PF, §§2.9, 4.14(a) Form 990-T, §4.14(d) public disclosure of tax returns, §8.8(a)(ii) reportable transactions, §7.2(b) reporting requirements, §§8.8, 12.9(c) unrelated business income, reporting, §8.1(b) Form 1023 public inspection, §2.9 Form 1023 (application for exemption) disclosures, §4.14(a)
䡲
foreign organizations, §§17.3(a)(i)(E), 17.6, 17.7 group exemption, §2.8(b) individual organizations, §2.8(a) single-member LLCs, §4.8(c) tax exemption, wholly-owned LLC, §19.5(c) Form 1065, §§3.8(b), 4.14(a), 4.14(c)(iii) Form 8832 election of tax classification, §§19.5(b), 19.5(c) single-member LLCs, §4.8(c) Form 8886, §7.2(b)(vii) Fractions rule, §§1.18(a), 1.18(b), 9.4–9.7 Fragmentation rule, §14.6(b)(vi) Fraud, federal healthcare fraud and abuse statutes, §12.4(d) Functionally related business, §§10.4(a), 19.9 Gain sharing, §§12.4(c), 12.4(e) Golden parachutes, §§1.3, 4.2(i)(i) Grants Community Development Block Grant, §13.2(c)(i) federal grants, exclusion from eligible basis, §13.2(j)(i) FEMA grants and loans, §13.2(j)(i) foreign grant making, §§17.1, 17.5, 17.9 Ground lessor, exempt organization as advantages of equity ownership, §6.2(b) advantages of leasing arrangement, §6.2(a) ground lease with leasehold mortgage, §6.5 non-tax considerations, §6.5(c) overview, §§1.14, 4.12, 6.1, 6.8 participating ground lease, §6.6(d) reclassification of lease as joint venture, §6.2(c) rental income, treatment as unrelated business income, §6.5(b) sale-leaseback transactions, §6.5(c) tax advantages, §4.12(c) undeveloped land, sale of, §6.6 universities and colleges, §14.7(a) Growth of joint ventures, §1.1 Guarantees limitations, §6.7(e) limited individual recourse, §6.7(c) and limited liability companies, §§19.4(b)(ii), 19.4(b)(ii)(A)–19.4(b)(ii)(D), 19.7(c)(iv), 19.7(c)(iv)(B), 19.7(c)(v)(C), 19.7(e), 197(c)(iv)(C) low-income housing tax credit, §§13.2(c), 13.6(a)–13.6(h) master lease or convenience lease, §6.7(d) overview, §6.7(a) partnership payments, §§3.9(d)(iii), 9.6(c), 9.7 third-party, §6.7(b) Healthcare joint ventures ancillary joint ventures, §§12.2, 12.3(d)(x)
913 䡲
bindex.fm Page 914 Friday, March 16, 2007 10:51 AM
INDEX
Antikickback Statute, §§12.4, 12.4(b), 12.4(d), 12.4(e) antitrust guidance, §12.4(f) arbitration, §12.5(c) Audit Guidelines for Hospitals, §§12.4(b), 12.4(e) charitable assets used in furtherance of exempt purposes, §12.3(b)(ii) charitable purpose, §§12.3(b)(i), 12.3(d)(ix)(A) community benefit standard, §12.3(b)(i) compensation, §§12.3(c)(ii)(A), 12.5(e), 12.9(b)(ii) compliance, policies and procedures, §12.10 conflicts of interest, §12.5(e) conflicts of interest policy, sample, App. 12–1 control issues, §§12.3(b)(iv), 12.3(b)(v), 12.3(d)(iv), 12.3(d)(ix)(A), 12.3(d)(v), 12.3(d)(vii), 12.3(d)(viii), 12.5(e), 12.7(a) disqualified person, §12.3(c)(i) and economics of healthcare, §§1.1, 12.1 excess benefit transactions, §12.3(c)(ii) expert advice, need for, §12.11 50/50 control, §§12.5(a)–12.5(e) for-profit and tax-exempt structures compared, §12.5(d) foundation model, §12.3(d)(vii) fraud and abuse legislation, §12.4(d) gain sharing, §§12.4(c), 12.4(e) generally, §§1.3, 12.1 government scrutiny, §§12.9(a)–12.9(c), §12.11 health maintenance organizations, §12.4(g)(iii) Hospital Audit Guidelines, §12.4(e) Hospital Joint Venture Article (CPE 1999), §§12.2, 12.3(d)(vi), 12.3(d)(x), 12.6(d) independent delivery systems (IDS), §12.3(b)(i) integral part doctrine, §§12.4(g)(v), 12.7(a)–12.7(c) integrated delivery systems, §12.4(g) intermediate sanctions, §§12.3(c), 12.6(e), 12.7(d) joint operating agreements, §§12.2, 12.7(a)–12.7(e) limited liability companies, §§12.2, 19.1. See also Limited liability companies (LLCs) limited partnerships, §12.2 managed service organizations, §§12.4(g), 12.4(g)(ii) management issues, §§12.3(d)(viii), 12.5(e) Office of Inspector General violations, §§, 12.4(d), 12.4(e) operating agreements, drafting, §12.3(d)(ix) physician hospital organizations, §§12.4(g), 12.4(g)(i) Physician Recruitment Guidelines, §§12.4(c), 12.4(c)(i)
䡲
point of service HMOs, §12.4(g)(iv) policies and procedures, §12.10 private benefit, §§12.3(b)(iii), 12.3(d)(v), 12.3(d)(vi) private inurement, §12.3(b)(iii) reasons for, §§1.3, 12.1 record keeping requirements, §12.10 Redlands Surgical Services v. Commissioner. See Redlands Surgical Services v. Commissioner reporting requirements, §12.9(b)(i) Rev. Rul. 98-15, §§1.3, 1.8, 1.9, 12.3(d)(i)– 12.3(d)(xi), 12.5(a)–12.5(e), 12.8 revenue sharing, §§12.3(c)(ii)(B), 12.4(a)(i) revocation of exempt status, §§12.3(b)(vi), 12.3(c), 12.4(e), 12.6(b) San Antonio model, §12.3(d)(vii) St. David's Healthcare Systems, Inc. v. U.S. See St. David's Healthcare Systems, Inc. v. U.S. Stark Law, §§12.4, 12.4(d), 12.10 structure of, §§12.2, 12.3(d)(ix)(B) subsidiaries, use of, §12.3(d)(xi) tax restrictions, §12.3(a) tax treatment, historical, §12.3(b) unrelated business income, §12.3(a) unrelated business income tax, §§12.7(a), 12.7(b), 12.8 valuation issues, §§12.6(a)–12.6(e) veto authority, §§12.5(b), 12.7(b) virtual merger, §12.2 whole hospital, §§12.2, 12.3(d)(vii), 12.3(d)(viii), 12.6(a), 12.7(a) Historic investment tax credit certified historic structures, §13.3(c) claiming, §13.3(e) Historic Rehabilitation Tax Credit and Gulf Zone Opportunity Act of 2005, §13.8 overview, §13.3(a) profit motive, §13.3(f) provisions of, §13.3(b) qualified rehabilistation expenditures, §13.3(d) recapture, §13.3(g) Holding companies, §4.8(d)(iii) HOME Investment Partnerships Program, §§1.5, 13.2(c)(i) HOPE VI Public Housing Revitalization Program, §§1.5, 13.2(c)(i), 13.2(h), 13.2(j)(i) Hospitals, tax-exempt. See also Healthcare joint ventures community benefit standard, §§1.2, 2.6(a)(ii), §2.6(b), 4.2(i) conversion to for-profit, §4.11 and economics of healthcare, §12.1 and insiders, §4.2(i)(ii) joint ventures, §§1.3, 4.2(i), 10.2 promotion of health as charitable purpose, §2.6(a)(ii) research, income derived from, §14.3 whole hospital joint ventures, §12.2
914 䡲
bindex.fm Page 915 Friday, March 16, 2007 10:51 AM
INDEX
Indemnification excise tax liabilities, §5.4(e) and low-income housing tax credit, §§13.6(a)–13.6(h) Insiders asset sales to, §5.2(e) and private inurement, §§5.1(b), 5.1(c), 5.2(e), 19.7(f) university faculty, §14.5 Installment sales, §6.6(b)(i) Intangibles, licensing of, §1.20 Integrated delivery system (IDS), §12.4(g). See also Healthcare joint ventures Intellectual property, valuation issues, §5.2(f)(v) Intent, partnership formation, §3.2(a) Interest below-market loans, §§1.14, 4.12(b) contingent, §§6.4(b)(ii), 6.4(c) loans, §4.12 prepayment penalty treated as, §6.4(c)(vi) and unrelated business income tax (UBIT), §§1.14, 1.16, 1.18(a), 4.7(c)(i), 6.2(a), 6.2(c), 6.4(a), 6.4(b), 6.4(d), 8.5, 8.5(a) Intermediate sanctions compensation arrangements, §12.3(c)(ii)(A) disqualified person, §12.3(c)(i) donor-advised funds and supporting organizations, §10.2 excess benefit transactions, §§1.21, 12.3(c)(ii) healthcare organizations, §§12.3(c), 12.6(e), 12.7(d) organization managers, §12.3(c)(i)(B) private benefit and private inurement, §§5.1(a), 5.2, 5.4–5.6 revenue sharing, §12.3(c)(ii)(B) substantial influence, §12.3(c)(i)(A) universities, §14.5 Internal Revenue Service (IRS) audits. See Audits contact information, §2.7 Exempt Organization Instruction Program for FY2001, §19.5(c) Exempt Organizations Continuing Professional Education (CPE) Instruction Program for FY 2002, §12.3(b)(i) Exempt Organizations Continuing Professional Education Technical Instruction Program for FY 1999 (CPE), §4.2(i)(i) Field Directive (April, 2006), §§19.7(b), 19.7(c)(i), 19.7(c)(ii), 19.7(c)(v), 19.7(c)(v)(C) reporting requirements. See Reporting requirements structure of, §2.7 Tax Exempt and Government Entities (TE/ GE) unit, §2.7 International joint ventures accountability, federal and state legislation, §§17.12(e), 17.12(f)
䡲
Anti-Terrorist Financing Guidelines, §17.3(a)(i)(D) Anti-Terrorist Financing Guidelines (revised), §§17.12(c), 17.13 charities as accommodating parties in terrorist activities, §17.3 contributions, deductibility of, §17.2 Council on Foundations, response to Voluntary Treasury Guidelines, §17.12(b) domestic charities and foreign organizations, §17.9 Executive Orders, §§17.3(a)(i), 17.3(a)(i)(A), 17.3(a)(i)(B), 17.4 expenditure responsibility, §17.8 Financial Action Task Force on Money Laundering (FATF), §17.12(a) Financial Anti-Terrorism Act (FATA), §17.3(a)(i)(C) foreign laws, applicability of, §17.10 foreign organizations recognized as §501(c)(3) organizations, §17.6 foreign tax treaties, §§17.10, 17.11 Form 990, §§17.3(a)(i)(E), 17.12(d)(i) Form 1023, §§17.3(a)(i)(E), 17.6, 17.7 "friends" organizations, §§17.2(b), 17.5, 17.9 grant-making rules, §§17.1, 17.5, 17.9 guidelines, §17.4 and money laundering, §§17.3(c), 17.12(a) overview, §§1.23, 17.1, 17.13 private foundations, §§17.5(b), 17.9 program-related investments (PRIs), §17.9 public charity equivalency test, §17.7 USA Patriot Act of 2001, §§17.3(a)(i), 17.3(a)(i)(C) Internet advertising, §8.5(g)(i)(D) and branding issues, §8.5(g) and charitable contributions, §§2.11(e)(iii), 2.11(f) companies, valuation issues, §5.2(f), §5.2(f)(iv) and Form 990, §2.9 impact of, §1.24 income from and unrelated business income tax, §§8.5(f), 8.5(g)(i)(B) political activity, §2.4(c)(ii)(A) shared Web sites and separation of nonprofit and for-profit subsidiaries, §§1.1, 8.5(g)(i)(C) single publication issue, §8.5(g)(i)(B) and universities, §14.7(d) Investment company, partnership treated as, §3.12(i) John Gabriel Ryan Association v. Commissioner, §§4.2(g), 12.3(d)(x) Joint operating agreements (JOAs), healthcare joint ventures, §§12.2, 12.7(a)–12.7(e) Joint ventures checklist, App. 4–1 defined, §1.2
915 䡲
bindex.fm Page 916 Friday, March 16, 2007 10:51 AM
INDEX
with other exempt organizations, §4.4 overview, §4.1 proposed scheme for analysis of, §§4.5, 4.5(a)–4.5(d) structure of. See Structure of joint ventures "substantially related" charitable activity, §4.6(c) Lease agreements ground leases. See Ground lessor, exempt organization as as joint ventures, §1.16 master lease, §6.7(d) Leasing rules, tax-exempt organizations, §§1.15(a), 1.18(c) depreciation, restrictions on, §§11.2, 11.5(a), 11.5(b) disqualified lease, §11.4(b) five-year lookback rule, §11.3(b) and historic investment tax credit, §13.3(a) and low-income housing partnerships, §13.2(c)(iii) overview, §11.1 partnership rules, §§1.15(a), 11.2, 11.6(a)– 11.6(j) personal property, §§11.4(c), 11.5(a) real property, §§11.4(a), 11.5(b) short-term leases, §11.4(d) subsidiaries, §11.3(c) tax credits, §11.5(c) tax-exempt entity defined, §11.3(a) tax-exempt use property, §§11.4(a)–(d) transfer restrictions, §11.5(d) types of transactions covered, §11.2 universities and colleges, §14.8 Legislative activities exceptions from "influencing legislation," §2.4(c)(i)(C) Lobbying Disclosure Act of 1995, §2.4(c)(iii) lobbying election, §2.4(c)(i)(B) political campaigns, §2.4(c)(ii) proscription against, §2.4(c)(i) substantiality, §2.4(c)(i)(A) trade associations, §15.1(a) Lenders, exempt organization as. See also Loans below-market loans, §4.12(b) contingent interest debt, structuring, §6.4(c) debt-equity loan classification, §6.4(b) guarantees, §6.7 option to purchase and sale-leaseback provisions, §6.4(b)(iii) overview, §§1.14, 4.12, 6.1, 6.8 participating loans, §6.4 private foundations, §4.12(d) real estate loans, types of, §6.3 service and commitment fees, §6.4(d) tax advantages, §4.12(c) universities and colleges, §14.7(a)
䡲
Like-kind exchanges, §§1.15(b), 11.4(d) Limited liability companies (LLCs) as alternative to partnership, §§3.4(a), 19.3(a) C corporation compared, §19.3(b) capital, return of, §§19.7(b)(ii)(A), 19.7(b)(ii)(B) capital calls, §§19.7(b), 19.7(c)(v)(B) charitable purpose, §§19.1, 19.7(c)(iii), 19.7(d)(i), 19.7(g) check-the-box regulations, §§19.1, 19.3(a), 19.4, 19.5(a)–19.5(e), 19.6 control, §§19.7(a), 19.7(d)(i), 19.7(e) conversion between partnership and disregarded entity, §19.6(d) deemed election rule, §19.5(c) disadvantages of, §19.3(d) double-prong test, §§19.7, 19.7(a)–19.7(c) environmental liability, indemnification for, §§19.7(b)(ii), 19.7(c)(iv)(A) and exempt purpose, §19.1 fiduciary duties, conflict with, §19.7(g) Form 1023 group exemption, §2.8(b) guarantees, §§19.4(b)(ii), 19.4(b)(ii)(A)– 19.4(b)(ii)(D), 19.7(c)(iv), 19.7(c)(iv)(B), 19.7(c)(v)(C), 19.7(e), 197(c)(iv)(C) healthcare joint ventures, §12.2. See also Healthcare joint ventures IRS Field Directive (April, 2006), §§19.7(b), 19.7(c)(i), 19.7(c)(ii), 19.7(c)(v), 19.7(c)(v)(C) liability issues, §§19.7(b), 19.7(b)(i), 19.7(c)(iv), 19.7(c)(iv)(A)–19.7(c)(iv)(C) low-income housing projects, §§19.7(b)(ii), 19.7(c)(i), 19.7(c)(ii), 19.7(c)(iv)(B), 19.7(c)(v)(C), 19.7(e), 19.8. See also Lowincome housing tax credit (LIHTC) management, §§1.9, 1.11, 19.7(d)(i) minimum investment return provisions, §19.7(b)(ii)(A) model acts, §19.1 operating agreements, drafting, §§12.3(d)(ix), 19.7(b)(ii) overview, §19.1 and Plumstead doctrine, §§19.1, 19.7, 19.7(c)(v), 19.7(c)(v)(A), 19.7(f) private benefit issues, §§19.7(b), 19.7(d)(i) private foundations as members of, §19.9 Revenue Ruling 98-15. See Revenue Rulings Revenue Ruling 99-5, §19.6(d) Revenue Ruling 99-6, §19.6(d) S corporation compared, §19.3(c) safe harbor provisions, §§19.7(b), 19.7(c)(i). See also Safe harbors single-member, §§4.8(c), 19.5(d), 19.6, 19.6(c), 19.6(d) state laws, §§1.8, 19.2(a), 19.2(b), 19.4, 19.7(g) structuring joint ventures, §§1.2, 1.8, 1.9, 1.24, 4.3–4.4, 19.5(e) tax treatment, §§3.4(a), 19.2(b), 19.4
916 䡲
bindex.fm Page 917 Friday, March 16, 2007 10:51 AM
INDEX
unrelated business income tax, §§19.5(d), 19.5(e), 19.6(c) wholly-owned entities by exempt organization, §§19.6, 19.6(a)–19.6(c) Limited partnerships. See also Partnerships exempt organization as limited partner, §§1.11, 4.3 limited liability company compared, §19.3(a) Liquidations, §§4.8(e), 4.11, 19.6(d) Loans below-market, §4.12(b) bridge loans, §§6.3(b), 13.2(c) collateral, additional, §6.7(b) commitment fees, §§6.4(d), 8.5 construction, §§6.3(a), 6.7(a), 6.7(b) convertibility, state legislation, §6.4(c)(ii) debt-equity loan classification, §6.4(b) due on sale clause, §§6.4(c)(vii), 6.5(c) FEMA grants and loans, §13.2(j)(i) interest, §§4.12, 4.12(b) low-income housing projects, §1.5 nonrecourse, §§6.7(a), 6.7(c), 13.2(l), 13.5(o) participating, §§6.4, 6.4(a), 6.4(b), 6.4(c)(iii) permanent, §6.3(d) private benefit and private inurement rules, §5.2(b) and program-related investments, §§4.13, 4.13(a) real estate loans, types of, §6.3 reclassification as joint venture, §6.2(c) service and commitment fees, §§6.4(d), 8.5 unrelated business income tax, §§6.4(d), 8.5 wraparound or second mortgage loans, §6.3(c) Lobbying activities. See also Legislative activities; Lobbying Disclosure Act of 1995 expenses, §1.19 private foundations, §10.1 Lobbying Disclosure Act of 1995 federal funds ban, section 501(c)(4) organizations, §2.4(c)(iii)(F) lobbying activities and lobbying contacts, §2.4(c)(iii)(B) procedural requirements, §2.4(c)(iii)(D) provisions of, generally, §2.4(c)(iii) registration requirement, §2.4(c)(iii)(A) sanctions, §2.4(c)(iii)(D) and tax definition of lobbying activity, §2.4(c)(iii)(C) Local economic development corporations (LEDC), §1.5 Local Initiatives Support Corporation, §1.5 Look-through rule (trade or business involving intangibles), §13.5(j) Lookback rule, §§1.21, 11.3(b) Losses at-risk limitations, §3.12(d) loss limitation rules, basis in partnership interest, §3.8(a) passive activities. See Passive activity losses
䡲
Low-income community, §13.5(k) Low-income housing and business relationships, §13.1(a) charitable purpose, §§2.6(a)(i)(A), 4.2(d)(ii)(B)–4.2(d)(ii)(D) contractual arrangements, §13.1(c) down payment assistance to homebuyers, §1.2 federal programs, §13.2(c)(i) financing, §13.2(c) joint ventures, generally, §1.5 and limited liability companies. See Limited liability companies (LLCs) operating partnerships, §1.5 ownership formats, §13.1(b) and partnership tax issues, §§3.11.6(f). See also Partnership taxation and passive loss limitations, §3.11(f) "plus" standard for distinguishing forprofit entities, §2.6(b) project partnerships, §1.5 tax credit. See Low-income housing tax credit (LIHTC) and welfare reform, §20.1 Low-income housing tax credit (LIHTC), §1.5, §2.6(b) and abusive tax shelters, §7.5 and advantages of leasing land, §6.1 allocation of credits from state, §13.2(d) applicable credit percentage, §13.2(g) at-risk rules, §§13.2(c), 13.2(l) audits, §13.2(o) check-the-box regulations, impact of, §13.2(g)(i) Community Development Block Grant, §13.2(c)(i) compliance, §13.2(q) compliance period, §§13.2(c), 13.2(f), 13.2(k), 13.2(m) construction, development, and management of project, §13.2(c)(ii) credit adjustment guarantees, §19.7(c)(iv)(B) development fees, §13.2(o) difficult development area, §13.2(j)(ii) disposition of interest after compliance period, §13.2(m) eligible basis, §§13.2(j), 13.2(j)(i), 13.2(j)(ii) extended use commitments, §13.2(q)(i) federal grants, exclusion from eligible basis, §13.2(j)(i) federal subsidies, §13.2(h) fifteen-year issues, §13.2(n) financing, §§13.2(c), 13.2(c)(i) guarantees and indemnifications, IRS guidance on, §§13.2(c), 13.6(a)–13.6(h), 19.7(c)(iv)(A), 19.7(c)(iv)(C) and Gulf Zone Opportunity Act of 2005, §13.8 and historic tax credit, §13.3(e) HOME Investment Partnerships Program, §13.2(c)(i)
917 䡲
bindex.fm Page 918 Friday, March 16, 2007 10:51 AM
INDEX
HOME rent, §13.2(q)(ii) legislation, §13.2(a) and limited liability companies, §19.8. See also Limited liability companies (LLCs) minimum set-aside requirement, §13.2(f)(i) partnership allocations, §13.2(c)(iii) and partnership taxation, §§1.15(a), 3.12(b) qualified basis, §13.2(i) qualified census tract, §13.2(j)(ii) qualified low-income housing project, §13.2(f) recapture, §13.2(k) rent restriction requirement, §13.2(f)(ii) reportable transactions, §13.7 requirements, generally, §13.2(b) Revenue Ruling 2004-82, §§13.2(q)(i), 13.2(q)(ii) and right of first refusal to buy property, §13.2(c) "sale" of credit to for-profit investor, §13.2(c) state tax credits, §13.2(p) tax-exempt bond financing, §13.2(e) tax-exempt leasing rules, §13.2(c)(iii) and tax-exempt organizations, §13.2(c) vacant unit rule, §13.2(q)(iii) Mailing lists, sale of, §§8.5(c)(ii), 8.5(c)(ii)(A)– 8.5(c)(ii)(D), 14.7(e) Management and ground lease with leasehold mortgage, §6.5(a) limited liability companies, §19.7(d)(i) and participation loans, §6.4(c)(iii) senior, §2.13(b) Managers excess benefit transactions, intermediate sanctions, §5.4(a)(v) excise tax, tax shelter transactions, §7.3(a) Market value approach, §5.2(f)(vi) Material advisor, §3.12(e) Medicare and Medicaid Antikickback Statute, §§12.4, 12.4(b), 12.4(d), 12.4(e) and health maintenance organizations (HMOs), §12.4(g)(iii) and healthcare joint ventures, §§1.1, 1.3, 12.1 Minority enterprise small business investment companies (MESBICs), §1.5, §1.17 and use of subsidiaries, §4.8(a)(ii) Model Business Corporations Act, §19.2(a) Modified accelerated cost recovery system (MACRS), §§3.9(c), 11.2 Money laundering and international joint ventures, §§17.3(c), 17.12(a) National Register of Historic Places, §§13.3(a), 13.3(c) Nature Conservancy, The, §§1.6, 16.2(a), 16.3(e)16.6, 16.7
䡲
Net operating profit after taxes (NOPAT), §5.2(f)(ii) Net operating profit less adjusted taxes (NOPLAT), §5.2(f)(ii) Net unrelated income, §1.20 New Market Tax Credit (NMTC) and abusive tax shelters, §7.5 allocation of, §13.5(b), §13.5(m) compliance and qualification checklist, App. 13.1 compliance monitoring, §13.5(n) guarantees, §13.5(p) and Gulf Zone Opportunity Act of 2005, §§1.5, 13.5(b), 13.8 leveraged structure, §13.5(o) look-through rule (trade or business involving intangibles), §13.5(j) low-income community, §13.5(k) and other federal subsidies, §13.5(f) overview, §§1.5, 13.5(a) qualified active low-income community business, §13.5(g) qualified CDE, §13.5(c) qualified equity investments, §13.5(d) qualified low-income community investments, §13.5(e) recapture, §13.5(l) reportable transactions, §13.7 and single-member LLC, §19.6(c) substantial improvement of rental property, §13.5(h) timing rules, §13.5(i) No-change letter, §1.13 Nongovernmental organizations (NGOs), §§1.23, 17.1 Nonprofit Integrity Act of 2004 (California), §17.12(f) Nonrecourse deductions, partnership allocations, §3.6(b), §3.8(c) Nonrecourse loans, §6.7(a) and at-risk rules, low-income housing tax credit, §13.2(l) community development entities, §13.5(o) limited individual recourse guaranty, §6.7(c) Notice of Allocation Availability (NOAA), §§13.5(b), 13.5(m) Operating agreements drafting, §§12.3(d)(ix), 19.7(b)(ii) joint operating agreements, §§12.2, 12.7(a)–12.7(e) Operational test "action" organization requirement, §2.4(b)(iii) factors considered, §2.4(b) operating exclusively for exempt purposes, §2.4(b)(i) private benefit test, §§2.4(b)(i), 2.4(b)(ii) private inurement prohibited, §§2.4(b)(i), 2.4(b)(ii) Redlands Surgical Services, Inc. v. Commissioner, §12.3(b)(iv) statutory requirements, generally, §2.4
918 䡲
bindex.fm Page 919 Friday, March 16, 2007 10:51 AM
INDEX
Option to purchase, §§6.4(b)(iii), 11.4(b)(ii) Organizational expenses, partnerships, §3.9(b) Organizational test articles of incorporation, §2.4(a) dedication of assets, §2.4(a)(ii) exclusively organized for exempt purposes, §2.4(a)(i) statutory requirements, generally, §2.4 Participating loans debt-equity classification, §6.4(b) overview, §6.4(a) Partnership taxation allocation of profits, losses, and credits, §3.6. See also Allocation anti-abuse regulations, §3.12(g) at-risk limitations, §3.12(d) bargain sales, §§1.15(b), 3.11(e), 3.11(f) basis in partnership interests, §3.8 brownfield properties, §16.4(b) "burned-out" shelters, §3.11(f) cancellation-of-debt income, §§20.7, 20.7(a)–20.7(f) classification as, §3.3 cost recovery, MACRS, §3.9(c) de minimis rules, §9.6(g) debt-financed property, §§9.4, 9.5–9.7 deductions, partner-specific, §9.6(e) distributions, §3.10 foreign partnerships, §3.12(h) fractions rule, §§1.18(a), 1.18(b), 9.4–9.7 investment companies, §3.12(i) limited liability companies, §§19.2(b), 19.4, 19.5 liquidating distributions, §3.11(d) loss deferral rules, tax-exempt use property, §11.6(j) material advisor, §3.12(e) nonrecognition of gain or loss on contribution of property or services in exchange for partnership interest, §3.7 operations, §3.9(a) organizational expenses, §3.9(b) overall income and loss, §9.6(b) overview, §§1.15(a), 3.1 ownership of properties, §3.12(b) partnership liabilities, §3.8(c) pass-through system, §3.5 passive activity loss limitations, §3.12(c) profit motive test, §3.12 property, contribution of in exchange for partnership interest, §3.7(a) reporting requirements, §3.12(e) sale or other disposition of assets, §3.11(a) sale or other disposition of partnership interests, §§3.11(b), 11.6(e) services, contribution of in exchange for partnership interest, §3.7(b) tax-exempt entity leasing rules, §§1.15(a), 11.6(a)–11.6(j) termination of partnership, §3.11(c)
䡲
transactions between partner and partnership, §3.9(d) unified audits, §3.12(f) unlikely losses and deductions, §9.6(f) unrelated business income. See Unrelated business income tax (UBIT) Partnerships alternatives to, §§3.4, 19.3(a) assets, sale or disposition of, §3.11 and check-the-box regulations, §13.2(g)(i) with commercial entities, §5.2(c) defined, §1.15(a) exempt organization as general partner, §§4.2(a)–4.2(j) exempt organization as limited partner, §§1.11, 4.3 foreign, §3.12(h) formation of, §3.7 intent of parties, §3.2(a) and joint ventures, §1.2 liabilities, §3.8(c) limited liability company compared, §19.3(a) limited partnerships, §§1.8, 1.11, 3.2(b), 4.3 low-income housing joint ventures, §§1.5, 11.6(f). See also Low-income housing tax credit (LIHTC) operating, §1.5 operating agreements, drafting, §12.3(d)(ix) operations, §3.9 with other exempt organizations, §1.12 project, §1.5 qualifying as, §3.2 tax-exempt entity leasing rules, §§11.6(a)– 11.6(j) taxation. See Partnership taxation termination of partnership, §3.11(c) tiered, §§9.4, 9.6(i) Pass-through tax treatment. See also Limited liability companies (LLCs); Partnership taxation and classification of exempt organizations, §19.5(c) limited liability companies, §§19.2(b), 19.5(e) partnerships, §§1.15(a)3.5 Passive activity losses and burned-out shelters, §3.11(f) limitations on, §3.12(c) and low-income housing, §13.2(c) overview, §1.15(a) Penalties. See Sanctions Pension funds. See Private pension funds Pension Protection Act §§4.8(d)(ii)(A), 4.9, 8.5(b), 16.3(c) Pension trusts and debt-financed property, section 514(c)(9) exception, §9.3 Per se corporations, §19.5(b)(i) Permanent loans, §6.3(d) Personal property, tax-exempt use, §11.4(c) Planning guidelines for organizations subject to intermediate sanctions, §5.6
919 䡲
bindex.fm Page 920 Friday, March 16, 2007 10:51 AM
INDEX
Plumstead doctrine, §§1.8, 4.2(b), 4.2(c), 4.2(d), 4.2(h)(ii), 4.2(i)(i), 10.1, 12.3(b), 12.3(d)(vii), 12.7(a), 13.6(b), 17.9, 19.1, 19.7, 19.7(c)(v), 19.7(c)(v)(A), 19.7(e) Political campaigns. See also Legislative activities absolute prohibition, §2.4(c)(ii) definitions, §2.4(c)(ii)(A) excise tax on political expenditures, §2.4(c)(ii)(B) Internet political activity, §2.4(c)(ii)(A) political organizations, §2.4(c)(ii)(C) Pouring-Rights §14.6(b)(iv) Preferred returns debt-financed property, §1.18(a) fractions rule, §§1.18(a), 1.18(b), 9.6(a), 9.6(c), 9.7 tax-exempt entity leasing rules, §1.18(c) Price/sales ratio (PSR), §5.2(f)(iv) Private benefit asset sales to insiders, §5.2(e) business leagues, §§15.1(a), 15.2(e) compensation for services, §5.2(a) and conversion from tax-exempt to forprofit entity, §4.11 financial transactions characterized as, §5.2 healthcare joint ventures, §§12.3(b)(iii), 12.3(d)(v), 12.3(d)(vi) insiders, §5.7 intermediate sanctions, §§5.1(a), 5.4–5.6 joint ventures with commercial entities, §§5.1, 5.2(c) limited liability companies, §§19.7(b), 19.7(d)(i) loans, §5.2(b) and low-income housing projects, §13.2(c)(iii) operational test, 2.4(b)(i) overview, §§1.21, 5.1(a) private inurement distinguished, §5.1(c) prohibited, §2.4(b)(ii) secondary versus primary benefit, §5.1(c) and spin-offs, §4.8(e) university faculty research joint ventures, §14.5 and use of tax-exempt bonds, §5.2(g) and valuation issues, §5.2(f) Private foundations defined, §10.2 excess business holdings, §1.22 excise taxes, §10.1 Form 990-PF, §2.9 functionally related business, §19.9 grant-making rules, foreign organizations, §§17.5(b), 17.9 as lenders, §4.12(d) and Lobbying Disclosure Act of 1995, §2.4(c)(iii)(C) as member of LLC, §19.9 public inspection of returns, §4.14(b) Private inurement rules, 2.4(b)(i), 2.4(b)(ii), 5.1 business leagues, §§15.1(a), 15.2(e)
䡲
compensation for services, §5.2(a) and conversion from tax-exempt to forprofit entity, §4.11 financial transactions, §5.2 healthcare joint ventures, §§1.3, 4.2(i)(i), 12.3(b)(iii) insiders, §§4.2(i)(ii), 5.1(b), 5.2(e), 5.7, 12.3(b)(iii), 19.7(f) intermediate sanctions, §§5.1(a), 5.4–5.6 joint ventures with commercial entities, §§5.1, 5.2(c) loans, §5.2(b) and low-income housing projects, §13.2(c)(iii) overview, §1.21 per se private inurement, §5.2(d) private benefit distinguished, §5.1(c) and profit-making activities, §5.3 and spin-offs, §4.8(e) and tax-exempt bonds, §5.2(g) university faculty research joint ventures, §14.5 and valuation issues, §5.2(f) Private pension funds advantages of lender or lessor arrangements, §6.2(a) exclusive benefit purpose, §18.2(a) fiduciary duties, §18.2(c) fund assets and "looking through" the joint venture, §§18.2(d)(i), 18.2(d)(ii) prohibited transactions and class exemption, §§18.2(e), 18.2(e)(i)–18.2(e)(iii) regulation of, §18.1 reporting and disclosure requirements, §18.2(c) suitability of joint venture investments, §18.3 tax-exempt status, §18.1 unrelated business income tax issues, §18.2(b) Profit-making activities, §§5.3, 5.3(a), 5.3(b) Profit motive historic rehabilitation credit, §13.3(f) and unrelated business income tax, §§8.3(b)(i), 8.3(b)(i)(A) Program-related investments (PRIs), §1.14 and excess business holdings, §§10.4, 10.4(b) foreign charitable programs, §17.9 loans, §§4.12, 4.12(a) Qualified Active Low-Income Community Business (QALICB), §1.5, 13.5(g), 13.5(h), 13.5(i), 13.5(j) Qualified Allocations Rule, §9.4 Qualified equity investment (QEI), §13.5(d) Qualified low-income community investments (QLICI), §§13.5(e), 13.5(h), 13.5(o) Real estate investment trusts (REITs), §§1.16, 8.5(b) Real property exempt organization as ground lessor. See Ground lessor, exempt organization as
920 䡲
bindex.fm Page 921 Friday, March 16, 2007 10:51 AM
INDEX
historic. See Historic investment tax credit low-income housing. See Low-income housing real estate investment trusts. See Real estate investment trusts (REITs) tax-exempt use property, §11.4(a) undeveloped land, sale of. See Undeveloped land, sale of Recapture of credits historic investment tax credit, §13.3(d) low-income housing tax credit, §13.2(k) New Markets Tax Credit, §13.5(l) Redlands Surgical Services v. Commissioner, §§4.2(f), 4.6(a)–4.6(c), 12.3(b), 12.3(b)(iv), 12.3(d)(iv), 12.3(d)(viii), 12.3(d)(x) Rehabilitation of historic structures. See Historic investment tax credit Related parties, §3.9(d)(ii) Religious organizations, §2.2 church defined, §2.6(c)(ii) religion, judicial interpretation of, §2.6(c)(i) Rent. See also Ground lessor, exempt organization as and low-income housing tax credit, §13.2(f)(ii) and unrelated business income tax (UBIT), §§1.14, 1.16, 1.18(a), 4.7(c)(ii), 6.2(a), 6.2(c), 6.5(a), 6.5(b), 8.5, 8.5(b), 9.1. See also Debt-financed property Reporting requirements affiliated organizations, §4.14(c) intermediate sanction provisions, excess benefit transactions, §5.4(d) nonprofit hospitals, §12.9(b)(i) overview, §§2.9, 4.14(a) partnerships of exempt organizations, §4.14(c)(iii) private pension funds, §18.2(c) public inspection of returns, §4.14(b) reportable transactions, §7.2(b) subsidiaries, §§4.14(c)(i), 4.14(c)(ii) Research and development expenses, §14.8 Revenue Rulings 76-296, scientific research, §§14.4(a)(i), 14.4(a)(iii) 97-21, physician recruitment guidelines, §12.4(c)(i) 98-15, §§1.3, 1.8, 1.9, 4.2(e), 4.2(i), 4.5, 4.6(a), 4.6(c), 10.1, 11.1(a)(i), 12.3(d)(i)– 12.3(d)(xi), 12.5(a)–12.5(e), 12.8, 13.2(c)(iii), 14.7(c), 17.9, 19.1, 19.7, 19.7(d) 99-5, §19.6(d) 99-6, §19.6(d) 2004-51, ancillary joint ventures, §§1.10, 4.6, 4.6(c)–4.6(f), 11.1(a)(i)–(iii) 2004-82, low-income housing issues, §13.2(q) Revenue-sharing, §§1.21, 12.3(c)(ii)(B), 12.4(a) Revised Uniform Limited Partnership Act (RULPA), §§3.9(a), 19.2(a) Revocation of exempt status and automatic stay in bankruptcy, §20.3(h)
䡲
healthcare joint ventures, §§12.3(b)(vi), 12.3(c), 12.4(e), 12.6(b) Royalties licensing income, §1.20 mailing lists, sale of, §14.7(e) and university faculty joint ventures, §14.5 and unrelated business income tax, §8.5(c) S corporations limited liability company compared, §19.3(c) profit motive test, §3.12 qualified subchapter S subsidiary (QSSS), §19.6(c) wholly-owned by exempt organization, §§19.6, 19.6(b) Safe harbors Antikickback Statute, §12.4(d) and board of directors for independent delivery systems (IDS), §12.3(b)(i) de minimis associate member dues, §8.8 IRS Field Directive (April, 2006), §19.7(b) lobbying election expenditure limitations, §2.4(c)(i)(B) and low-income housing tax credit, §§13.6(a)–13.6(h) qualified sponsorship payments, §15.4 reasonable guaranteed payment amount, §9.6(c)(iii) substantial economic effect test, §§3.6, 3.6(c) Sale-leaseback transactions and ground lease with leasehold mortgage, §6.5(c) and option to purchase, §§6.4(b)(iii), 11.4(b)(iv) and tax-exempt use property, §11.4(b)(iv) Sanctions compensation, §5.4(c) disqualified person, §5.4(a) excess benefit transactions, §5.4(b) failure to allow public inspection of Form 990 and exemption application information, §2.9 indemnification agreements, use of, §5.4(e) intermediate sanctions. See Intermediate sanctions Lobbying Disclosure Act of 1995, §2.4(c)(iii)(D) Patriot Act, §17.3(a)(i)(C) private benefit or private inurement transactions, §2.4(b)(ii) reporting requirements, §§3.12(e), 5.4(d) state legislation, §5.7 Sarbanes-Oxley Act, §§2.13, 17.12(e) Scientific organizations commercial or industrial operations, §§2.6(e), 2.6(e)(ii) general public interest, §§2.6(e), 2.6(e)(iv) scientific defined, §2.6(e) scientific research, §§2.6(e), 2.6(e)(i) specific public interest, §§2.6(e), 2.6(e)(iii) tests for, §2.6(e)
921 䡲
bindex.fm Page 922 Friday, March 16, 2007 10:51 AM
INDEX
Section 501(a) organizations, §18.1. See also Private pension funds Section 501(c) organizations charitable organizations, §2.3 types of, §2.3 Section 501(c)(3) organizations, §2.3 application for exemption, §2.8 charitable, §§2.3, 2.6(a) charitable class, benefit to, §2.5(a) commensurate test, §§2.4 economic development organizations, §2.6(a)(i)(B) educational organizations, §§2.3, 2.6(d) feeder organizations, §2.4(d) foreign organizations, §17.6 legislative and political activities prohibited, §2.4(c) low-income housing, §2.6(a)(i)(A) nonprofit, distinguishing from for-profit (IRS theory), §2.6(b) operation contrary to public policy prohibited, §2.5(b) operational test, §§2.4, 2.4(b), 12.3(b)(iv) organizational test, §§2.4, 2.4(a) promotion of health, §2.6(a)(ii) relief of the poor, §2.6(a)(i) religious organizations, §§2.3, 2.6(c) requirements, §2.6(a) scientific organizations, §§2.3, 2.6(e) statutory requirements, §2.4 Section 501(c)(4) organizations and Lobbying Disclosure Act of 1995, §2.4(c)(iii)(F) Section 501(c)(6) organizations, §§15.1(a), 15.1(c). See also Business leagues Section 501(d) organizations, §§2.2, 2.6(c)(i), 2.6(c)(ii) Section 527 political organizations, §2.4(c)(ii)(C) Self-dealing, §5.1(b). See also Private inurement rules Services compensation for, §5.2(a) fees for, §5.3(b) service contracts, §11.6(i) Sham transaction doctrine, §7.2(a)(i) Shared services agreements, §1.19 Small business investment companies (SBICs), §§1.5, 1.17, 4.8(a)(ii) Solicitation, registration for, §2.11(f) Spin-offs, §4.8(e) and unrelated business income tax, §4.8(e) Sponsorships, corporate acknowledgments, §§15.4(c), 15.4(f) advertising, §§15.4(a), 15.4(c), 15.4(f) contingent payments, §15.4(b) logos and slogans, §§15.4(e), 15.4(f) overview, §§1.1, 4.2(j)(ii), 8.4(h), 15.4 qualified convention or trade show activities, §15.4(d) rules, §8.4(i) St. David's Healthcare Systems, Inc. v. U.S., §§4.2(f), 4.6(a)–4.6(c), 12.3(b)(v) Stark Law, §§12.4, 12.4(d), 12.10
䡲
State legislation accountability and audits, §§2.13, 2.14, 17.12(f) and convertibility of loans, §6.4(c)(ii) insider transactions, §5.7 limited liability companies, §§19.2(a), 19.2(b), 19.4, 19.7(g) low-income housing tax credits, §13.2(p) State taxes, limited liability companies, §§19.4, 19.5(a)–19.5(e) Step-transaction doctrine, §7.2(a)(v) Stock options, valuation, §5.2(f)(vii) Structure of joint ventures exempt organization as general partner, §§4.2(a)–4.2(j) favorable factors, §4.2(h)(i) guidance, §4.6(f) healthcare, §§12.2, 12.5(d). See also Healthcare joint ventures limited liability companies, §§1.2, 1.8, 1.9, 1.24, 4.3, 4.4, 19.3, 19.3(a)–(d), 19.5(e) overview, §1.8, §§1.8, 4.1 partnerships. See Partnerships and Rev. Rul. 98-15, §1.9 unfavorable factors, §4.2(h)(ii) Subsidiaries for-profit subsidiary, §4.8(b)(iii) and Form 990, §§4.14(c)(i), 4.14(c)(ii) and healthcare joint ventures, §12.3(d)(xi) intangibles, licensing, §1.20 reasons for use of, §§4.8(a)(i)–4.8(a)(iii) separate legal entity requirement, §§4.8(b), 8.5(g)(i)(A) single-member nonprofit LLCs, §4.8(c) spin-offs, §4.8(e) structuring joint ventures, §1.8 tax-exempt leasing rules, §11.3(c) and unrelated business income tax, §§1.16, 1.17, 4.8(d)(i)–4.8(d)(iii), 8.5(g)(i)(A) use of as participant in joint venture, §§1.17, 4.8, 14.7(a) wholly-owned by exempt organization, §§19.6, 19.6(a) Subsidies, federal and low-income housing, §13.2(h) and New Markets Tax Credit, §13.5(f) Substance-over-form doctrine, §7.2(a)(iv) Substantial economic effect test economic effect, §3.6(a)(i) overview, §§1.15(a), 3.6(a) reallocations, §3.6(c) substantiality test, §3.6(a)(ii) and tax-exempt use property, qualified allocations, §11.6(c) "Substantially related" charitable activity, §§4.6(c), 8.3(b)(iii) Supporting organizations, §§4.9, 10.2 Tax avoidance Tax Avoidance Transaction Settlement Initiative, §16.3(e) and use of joint ventures, §1.7
922 䡲
bindex.fm Page 923 Friday, March 16, 2007 10:51 AM
INDEX
Tax classification. See also Check-the-box regulations consequences of changing, §§19.5(b)(iv), 19.5(b)(iv)(A)–19.5(b)(iv)(F) election, partnership versus corporation, §19.5(b) exempt organizations, §19.5(c) Form 8832, §19.5(b)(ii) restrictions on changing, §19.5(b)(iii) Tax credits C corporations and tax credit projects, §1.5 empowerment zone employment credit, §13.4(b)(ii) historic investment tax credit, §§13.1(c), 13.3(a)–13.3(g) investment tax credit, §14.8 low-income housing. See Low-income housing tax credit (LIHTC) New Market Tax Credit. See New Market Tax Credit (NMTC) partnership allocation, §3.6 tax-exempt property, §11.5(c) and tax shelter transactions, §7.5 Tax-exempt bonds. See Bonds Tax-exempt entity leasing rules. See Leasing rules, tax-exempt organizations Tax-exempt financing, §§1.13, 11.4(b)(i), 13.2(e) Tax-exempt organizations (nonprofits), §§2.1, 2.2 section 501(a) organizations, §18.1. See also Private pension funds section 501(c) organizations, §2.3. See also Section 501(c)(3) organizations Tax-exempt use property, §§11.4(a)–11.4(d) Tax shelter registration, §3.12(e) Tax shelter transactions, exempt organizations as accommodating parties business purpose doctrine, §7.2(a)(iii) categories of abusive tax shelters, §7.2 disclosure requirements, §§7.2(b), 7.3(c) economic substance doctrine, §7.2(a)(ii) excise taxes and penalties, §7.3 judicial doctrines, §7.2(a) overview, §§1.7, 7.1 reportable transactions, §7.2(b) settlement initiatives, §7.4 sham transaction doctrine, §7.2(a)(i) step-transaction doctrine, §7.2(a)(v) substance-over-form doctrine, §7.2(a)(iv) and tax credit programs, §7.5 Tax treaties, §§1.23, 17.10, 17.11 Taxation joint ventures, §1.2 limited liability companies, §§3.4(a), 19.2(b), §19.2(b), 19.4 partnership taxation. See Partnership taxation reclassification of loan or lease as joint venture, §6.2(c) unrelated business income. See Unrelated business income tax (UBIT)
䡲
Terrorism and terrorist activities, §§1.23, 17.1. See also International joint ventures Title-holding companies as alternative to partnership, §3.4(b) de minimis rules, §3.4(b) debt-financed property, section 514(c)(9) exception, §9.3 IRC section501(c)(2), §3.4(b)(i) IRC section501(c)(25), §3.4(b)(ii) taxation, §3.4(b) Trade and professional associations. See Business leagues Trade or business defined, §8.3(b)(i) Trade show activity, qualified, §15.3(c) Travel tours, §§1.1, 1.4, 8.5(d) Undeveloped land, sale of excess business holding rules, §6.6(c) participating ground lease as alternative, §6.6(d) private letter rulings, §6.6(b) taxable subsidiary, use of, §6.6(e) unrelated business income considerations, §6.6(a) Uniform Commercial Code (UCC), Form UCC-1 financing statement, §1.13 Uniform Limited Partnership Act (ULPA), §3.9(a) Uniform Partnership Act (UPA), §3.9(a) Universities and colleges. See also Educational organizations affinity credit cards. See Affinity credit cards ancillary joint ventures, §§1.10, 14.1 audit guidelines, §4.2(j)(i) bookstores, §§14.2(b), 14.6, 14.7(d), 14.9 boost theory, §14.6(b)(v)(B) compensation issues, §14.2(b) coordinated examination program (CEP audits), §14.2(b) corporate sponsorship, §§4.2(j)(ii), 14.6(b)(iii), 15.4 and creative planning for increasing revenue, §§1.1, 14.1 distance learning, §§1.4, 8.5(f), 14.1, 14.7(c), 14.7(d) entertainment activities, §§14.6(b), 14.6(b)(i), 14.9 examination guidelines, §14.2(a) faculty, joint ventures with, §14.5 fitness centers, §14.6(b)(vi) housing, §14.7(b) Internet issues, §14.7(d) joint ventures, §§1.4, 14.1, 14.1(a) joint ventures, nonresearch, §§14.6(a)– 14.6(c) joint ventures with other exempt organizations, §§4.4, 14.6(c) logos, §14.7(e) mailing lists, §14.7(e) pouring-rights contracts, §14.6(b)(iv) research, income derived from, §14.3
923 䡲
bindex.fm Page 924 Friday, March 16, 2007 10:51 AM
INDEX
research joint ventures, §14.4 research joint ventures, incentives to taxable entity, §14.8 royalties, §14.5 scientific research, §§2.6(e), 14.3, 14.4, 14.4(a)–(d) sports activities, §§14.6(b), 14.6(b)(ii), 14.6(b)(iii), 14.9 structure of joint ventures, §§14.7(a)–14.7(e) tax-exempt status, loss of, §§11.1, 11.1(a) travel tours, §§1.1, 1.4, 8.5(d), 14.2(b), 14.6(b)(v), 14.6(b)(v)(A), 14.6(b)(v)(B) unrelated business income tax (UBIT), §§1.4, 4.2(j)(i), 4.2(j)(ii), 14.1, 14.1(a), 14.3, 14.4, 14.6, 14.7 unrelated commercial activity, §§1.4, 14.6 Unrelated business activity, §4.6(d) Unrelated business income tax (UBIT), §1.11 activities for convenience of members, exception for, §8.4(b) and ancillary joint ventures, §12.3(d)(x) bingo games, exception for, §8.4(g) business leagues, §§15.1(a), 15.1(b), 15.3(a)–15.3(d) calculation of, §§4.7(d), 8.7, 8.7(a), 8.7(b) and commercialism, §8.1(a) conservation organizations, §16.4 and control test, §§4.6(a), 11.1(a)(i) controlling exempt organizations, payments to, §8.8(a)(i) corporate sponsorship exception, §§8.4(h), 8.4(i), 14.6(b)(iii), 15.4, 15.4(a)–15.4(f) debt-financed property, §§1.15(a), 1.16, 8.5, 8.5(a), 9.2(a), 9.4 dividends, §8.5 donated merchandise, exception for sale of, §8.4(c) dues, associate member, §§8.4(j), 8.8 exceptions, §§8.4(a)–8.4(j) exclusion for income derived from research, §14.3 expenses, §§8.7(b)(i), 8.7(b)(ii) hospital services, exception for, §8.4(f) impact of, §8.1(b) income from debt-financed property. See Debt-financed property insurance programs for members, §8.5(c)(i) and intangibles licensing, §1.20 interest, §§1.14, 1.16, 1.18(a), 4.7(c)(i), 6.2(a), 6.2(c), 6.4(a), 6.4(b), 6.4(d), 8.5, 8.5(a) Internet activities, income from, §§8.5(f), 8.5(g)(i)(B) legislative history and historical background, §8.2 legislative initiatives, §§8.8, 8.8(a)(i)–(iii) lenders and ground lessors, §§1.14, 6.2(a) limited liability companies, §§19.5(d), 19.5(e), 19.6(c) liquidations, §4.8(e) loan commitment fees, §6.4(d), 8.5 loan service and commitment fees,
䡲
§§6.4(d), 8.5 mailing lists, affinity cards, names, and logos, payment for, §8.5(c)(ii) and minimizing audit issues, §2.10(a)(i) modifications to definition of UBI, §8.5 museums, sale of merchandise, §8.5(e) noninventory sales, §8.5 options, §8.5 organizations subject to, §8.3(a) partnership activities, §§1.16, 4.7(b), 8.6 partnerships with other exempt organizations, §1.12 and Pension Protection Act, §8.5(b) and Plumstead doctrine, §12.3(d)(vii) private pension funds, §18.2(b) and profit-making activities, §5.3 profit motive, §§8.3(b)(i), 8.3(b)(i)(A) public disclosure of tax returns, §8.8(a)(ii) qualified public entertainment activity, exception for, §8.4(d) qualified trade show activity, §§8.4(e), 15.3(c) rent, §§1.14, 1.16, 1.18(a), 4.7(c)(ii), 6.2(a), 6.2(c), 6.5(a), 6.5(b), 8.5, 8.5(b), 9.1 royalties, §8.5(c) and spin-offs, §4.8(e) subsidiaries, §§1.16, 1.17, 4.8(d)(i)– 4.8(d)(iii), 8.5(g)(i)(A) "UBIT plus Control" test, §§4.6(b)–4.6(d) undeveloped land, sale of, §6.6(a), 6.6(b) universities and colleges, §1.4, §§1.4, 4.2(j)(i), 4.2(j)(ii), 14.1, 14.1(a), 14.3, 14.4, 14.6, 14.7 unrelated trade or business defined, §8.3(b) volunteer activities, exception for, §8.4(a) Unrelated business income (UBI), §1.16 and advantages of equity ownership, §6.2(b) and debt-financed property, §1.18(a) defined, §§4.7(a), 6.4(d) dual-use facilities, §8.3(b)(i)(B) healthcare joint ventures, §12.3(a) reporting requirements, §§4.14(d), 8.1(b) and tax-exempt entity leasing rules, §11.2 and title-holding companies, §3.4(b) Unrelated trade or business, §§1.16, 4.3(b), 8.3(b). See also Unrelated business income tax (UBIT) Valuation approaches, §12.4(g) business enterprise value, §12.4(g) conservation easements, §16.3(d) discounted case flow analysis, §5.2(f)(ii) healthcare joint ventures, §§12.6(a)–12.6(e) new-economy and Internet companies, §5.2(f) purpose of, determining, §5.2(f)(i) stock options, §5.2(f)(vii) Web sites. See Internet
924 䡲
