The Control Question for Nonprofit Joint Ventures: What is Enough?

Has your nonprofit ever engaged in joint activities with a business, perhaps with resulting revenues?  Such arrangements are increasingly common for many Section 501(c)(3) organizations. A key legal requirement is that the tax-exempt organization maintain control of the project, so that its charitable resources will be “exclusively” used in furtherance of tax-exempt purposes, as required by the Internal Revenue Code.  What does “control” mean for IRS purposes, and what happens to resulting revenues? Careful planning is essential to answering these questions for optimal tax compliance.

Joint Venture Overview

As defined in IRS Form 990 Instructions, a joint venture is "any joint ownership or contractual arrangement through which there is an agreement to jointly undertake a specific business enterprise, investment or exempt purpose activity." Thus, a joint venture could be a project, program, or business – anything done together by agreement of the parties involved.  For joint ventures between Section 501(c)(3) organizations and for-profit businesses, there is somewhat of an “apples and oranges” issue, since the nonprofits must legally be dedicated to public benefit and business are, by definition, dedicated to private benefit.

W&O attorney Ryan Oberly recently presented a webinar on joint ventures between exempt organizations and for-profit businesses, teaching on the key tax considerations for charities entering into these increasingly common arrangements.[1]  As Oberly shared, a nonprofit charity that enters a joint venture must maintain sufficient control over the joint venture to ensure that the charity's assets are not providing more than an incident level of private benefit.  The nonprofit must also ensure that the activities of the venture are substantially related to furthering the charity's exempt purposes, particularly to avoid potential “unrelated business income” tax liability.  These core concepts were established in the IRS' seminal Revenue Ruling 98-15.

How Much Control? – So Many Questions

What level of "control" is required? Does the Section 501(c)(3) nonprofit always have to have at least a level of majority voting power in the joint venture, which is most commonly organized under state law as a partnership or LLC? What happens if the nonprofit does not have a majority voting power? Is the nonprofit's exempt status under 501(c)(3) in jeopardy? Can the revenue generated by the joint venture's activities, even if substantially related to its exempt purposes, be subject to the unrelated business income tax due to a lack of sufficient control?

Current IRS guidance does not fully answer these questions. Moreover, the IRS continues to take a "no ruling" stance on these control issues for joint ventures. However, the lack of guidance by the IRS should not deter nonprofits from pursuing important joint venture opportunities.

Starting a Joint Venture – Thinking Through Control and Revenues

When entering into a joint venture, a nonprofit should first identify what percentage of the charity's total activities, assets, and revenue will be derived from the joint venture. In other words, a nonprofit must question whether or not its participation in the joint venture constitutes a “substantial” part of its overall exempt activities. While there is no bright line numerical test, a good rule of thumb may be 20% or less being insubstantial, 20-30% in the grey, and anything above, tipping toward substantial. For nonprofits entering into a joint venture where the activity constitutes an insubstantial part of the organization's overall activities, resources, and revenue, the nonprofit 's inability to secure control in a joint venture should not jeopardize the organization's exempt status. This is because the nonprofit is still primarily organized and operated for 501(c)(3) purposes. If, however, the joint venture is a substantial part of the nonprofit's activities, then the failure to maintain control over the joint venture could jeopardize the organization's exempt status under Revenue Ruling 98-15.

May the revenue generated by the joint venture's activities, even if substantially related to its exempt purposes and therefore ordinarily exempt from unrelated business income tax (“UBIT”), nevertheless be subject to UBIT due to a lack of sufficient control?  Maybe!  An important question left open from the IRS’s Revenue Ruling 2004-51 (discussed below) is whether it is sufficient for a nonprofit to evaluate income derived from its participation in a joint venture under the traditional UBIT analysis.  Or must a nonprofit also be able to demonstrate the control component (UBIT + control) to demonstrate that the activity is exempt from income taxes?  Under current IRS guidance, the answer unfortunately is “maybe.”

Is this level of control that is required of a nonprofit defined as “majority voting rights” in the partnership, LLC, or other legal entity operating the joint venture? Majority voting rights would certainly be the best set of facts. But, as is often the case, this may not be a reasonable position to the for-profit business partner(s). In these latter situations, the nonprofit should work hard to develop effective control mechanisms over all elements of the joint venture that are important to ensuring the joint venture furthers a 501(c)(3) purpose.

For example, in Rev. Ruling 2004-51, the IRS approved a 50/50 control relationship between a Section 501(c)(3) educational institution and a for-profit business that were collectively operating distance learning centers.  The educational institution maintained exclusive control over the educational functions of the joint venture (i.e. the curriculum, training materials, and instruction). The business had control over the locations of the centers, which was not a critical component to the exempt purpose. A similar analysis might be used for an economic development project where a nonprofit selected the site based on the charitable need and businesses that would operate there based on the charitable benefit to be provided to the community. The construction and financing decisions may be primarily controlled by the for-profit developer.  If the nonprofit maintains control over the exempt functions of the joint venture, this level of control would likely be sufficient for the UBIT + control test set forth above.  

Understanding and evaluating what percentage of a Section 501(c)(3) organization’s activities, assets, and revenue will be involved in a joint venture helps nonprofits understand the potential tax consequences to their inability to secure control.  It also creates greater structuring opportunities for those nonprofits that are determined to pursue the joint venture even without the traditional majority voting rights anticipated under Revenue Ruling 98-15.  Overall, nonprofit joint ventures with businesses may provide excellent opportunities for mission accomplishment and revenue generation, but they warrant careful attentiveness for protection of tax-exempt status and other tax compliance aspects.