Non-proﬁt organizations, which are exempt from federal income tax under Internal Revenue Code section 501(c)(3) (each a “Tax- Exempt Organization”), may ﬁnd it necessary or beneﬁcial for their operational goals to enter into various relationships with other entities, including individuals, business corporations, limited liability companies, partnerships, foreign entities and other Tax-Exempt Organizations. These relationships may include simple vendor agreements, management contracts, leases and a variety of other types of arrangements.
Tax-Exempt Organizations frequently enter into business arrangements with third parties. However, when such arrangements are considered to be “joint ventures,” they may be heavily scrutinized by governmental agencies, such as the Internal Revenue Service and the New York State Attorney General’s ofﬁce. Ill-structured joint ventures could result in severe repercussions to the Tax-Exempt Organization, including loss of tax-exempt status. For this reason, it is imperative that such agreements are structured properly and under the guidance of legal tax counsel.
WHAT IS A “JOINT VENTURE”?
A “joint venture” includes most arrangements undertaken by two or more parties who agree to pursue a common endeavor and share in the revenues, expenses and assets arising from their arrangement. Joint ventures are often attractive because they allow the involved parties to pool their strengths, minimize risks and build a competitive advantage. A formal agreement is not necessary for a business relationship to be treated as a joint venture for federal income tax purposes. For instance, a joint venture is likely formed if Organization A decides to partner with Organization B in the manufacture and sale of widgets under an arrangement in which both organizations agree to share in the related expenses and proﬁts. This would be true regardless of whether the organizations decide to formalize their relationship by adopting a written agreement. As a result, it is wise to analyze all business relationships, whether formalized or not, for signs of a joint venture.
COMMON JOINT VENTURES
Tax-Exempt Organizations commonly enter into joint ventures by creating a separate operating entity, such as a corporation, limited liability company or other statutory arrangement. Under these types of arrangements, the Tax-Exempt Organization and a third party act as owners of a newly-formed entity which will undertake their joint activities. They will share in the losses and proﬁts arising from the new entity. The speciﬁc structure adopted by the parties will determine the type of income that will result from their joint activities and whether such income will be subject to tax. It is thus important to choose the right structure for each speciﬁc business venture.
Tax-Exempt Organizations may also participate in joint ventures by entering into certain contracts, leases and joint operating agreements with third parties where no new entity is formed. Such arrangements can trigger a number of issues, including whether the third party’s activities could be attributed to the Tax-Exempt Organization and possibly cause the Tax-Exempt Organization to lose its tax-exempt status. Determinations of whether a speciﬁc relationship raises concerns depend on the facts and circumstances of each case. A well-structured agreement can avoid unintended results and help the Tax-Exempt Organization maintain control over its activities.
WHY ARE JOINT VENTURES SCRUTINIZED?
The Internal Revenue Service will generally scrutinize joint ventures to, among other things, assess whether a speciﬁc business relationship creates a “private beneﬁt.” A private beneﬁt arises if a Tax-Exempt Organization is not operated primarily for its tax-exempt purpose. Under the Internal Revenue Code, a Tax-Exempt Organization may be treated as failing to operate primarily for its tax-exempt purpose if its activities result in more than an incidental economic/private beneﬁt to a third party. A prohibited private beneﬁt (i.e., a private beneﬁt that is more than incidental) can thus result from a relationship in which a third party receives more than its “fair share” from dealing with the Tax-Exempt Organization. For example, a prohibited private beneﬁt is likely created where a Tax-Exempt Organization allows an individual (including a donor, director, ofﬁcer or employee) to use its facilities at no cost for personal use. A prohibited private beneﬁt could also result where a Tax-Exempt Organization provides free products or services to third parties.
In joint ventures, the issue of private beneﬁt often arises where the Tax-Exempt Organization enters a relationship that is not arm’s length in the eyes of the Internal Revenue Service. Whether a relationship is treated as arm’s length will depend on the facts and circumstances of the speciﬁc relationship.
For example, assume that a Tax-Exempt Organization decides to enter a joint venture with Organization B for the manufacture and sale of widgets. The Tax-Exempt Organization will purchase the materials and provide the workers to manufacture the widgets, while Organization B will provide the people to sell the widgets. Both organizations will equally share in the proﬁts. The Internal Revenue Service may question whether both organizations are equally contributing to the joint venture in order to justify the equal division of proﬁts. If the Tax-Exempt Organization is viewed as making a more valuable investment into the joint venture than Organization B, then the relationship will likely be treated as creating a prohibited private beneﬁt to Organization B (as Organization B is investing less than the Tax-Exempt Organization, but still receiving an equal share of the proﬁts).
Another common example of potential prohibited private beneﬁt arising in a joint venture includes an instance in which a Tax-Exempt Organization allows a third party to use its intellectual property for a fee that is lower than fair market value. When the use of a Tax-Exempt Organization’s intellectual property is being exchanged for a third party’s goods or services, then the arrangement must be evaluated to determine whether the third party unduly beneﬁts from the deal. Properly structured royalty or other intellectual property use agreements can generally prevent potential private beneﬁt concerns in these types of arrangements.
While the idea of “private beneﬁt” is conceptually clear, a multilayered analysis of different factors must generally be “Why Tax-Exempt Organizations Should Plan for Joint Ventures” undertaken to determine whether private beneﬁt results. Potential consequences of providing a prohibited private beneﬁt to a third party can be severe and include the loss of tax-exempt status. It is thus advisable for Tax-Exempt Organizations to properly structure a joint venture that prevents private beneﬁt from the start.
OTHER POTENTIAL ISSUES ARISING FROM JOINT VENTURES
In addition to private beneﬁt issues, joint ventures may also raise special concerns for Tax-Exempt Organizations involved in tax-exempt bond ﬁnancing, because improperly structured joint ventures could jeopardize the exclusion of interest on tax-exempt bonds from federal income tax. Moreover, in New York, the State Attorney General’s Ofﬁce could examine a joint venture for a potential breach of ﬁduciary duty if the Tax-Exempt Organization’s ofﬁcers and/or directors are treated as acting outside of the scope of their ﬁduciary duties under the New York Not-For-Proﬁt Corporation Law. Joint ventures can thus raise a number of concerns, and individual cases should be analyzed for signs of private beneﬁt and other potential issues.
ARE JOINT VENTURES A “MUST NOT”?
Planning for joint ventures may appear cumbersome, but joint ventures should not be feared. The numerous beneﬁts arising from a potential joint venture will often outweigh any burdens caused by undergoing the necessary multifaceted planning. With proper planning, Tax-Exempt Organizations can decide when and whether to enter joint ventures. Where a joint venture is desired, appropriate structuring can help a Tax- Exempt Organization manage its activities and accomplish its goals in an efﬁcient and effective way while preventing potential legal concerns.