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.