Revenue Ruling 98-15 and Non-Profit Joint Ventures

An Internal Revenue Service (IRS) Revenue Ruling is an official interpretation of tax law for a specific set of facts, providing guidance to taxpayers and IRS personnel. Revenue Ruling 98-15 is guidance for tax-exempt organizations under Internal Revenue Code (IRC) Section 501(c)(3). It addresses how a non-profit, such as a hospital, can form a joint venture with a for-profit company without losing its tax-exempt status. The ruling presents and analyzes two different scenarios involving a non-profit hospital and a for-profit corporation that form a limited liability company (LLC).

The Two Scenarios in the Ruling

In both scenarios in Revenue Ruling 98-15, a non-profit hospital exempt under Section 501(c)(3) partners with a for-profit corporation through a limited liability company (LLC). The non-profit contributes its hospital and operating assets, while the for-profit partner contributes assets or cash. In return, each entity receives an ownership interest proportional to the value of their contribution.

In Situation 1, a non-profit hospital, A, and a for-profit corporation, P, formed an LLC where the governing documents gave the non-profit control. The LLC’s board of directors was composed of five members, and A had the authority to appoint three, giving it a perpetual majority. The documents also explicitly stated the LLC’s mission was to provide healthcare services to the community and promote health, mirroring the non-profit’s charitable purpose. This agreement required the LLC to operate in a manner satisfying the community benefit standard, with key decisions like adopting a budget and amending governing documents requiring a majority board vote.

In Situation 2, a non-profit hospital, C, formed an LLC with a for-profit corporation, F, under similar initial terms. However, the governing structure was markedly different. The board of directors was split evenly, with C and F each appointing half the members, so neither party had majority control. The governing documents for this LLC did not contain an explicit requirement that the venture operate to serve a charitable purpose. The agreement also established a long-term management contract with a subsidiary of the for-profit partner, granting it broad authority over daily operations with limited board oversight.

The IRS Holding and Control Test

The IRS’s analysis used a two-prong test to evaluate a non-profit’s participation in a partnership. First, the non-profit’s involvement in the venture must further its charitable purpose. Second, the structure of the partnership must permit the non-profit to act exclusively in furtherance of its exempt purpose and not for the private benefit of the for-profit partners, beyond an incidental level.

In Situation 1, the IRS concluded that the non-profit hospital, A, continued to qualify for tax exemption. The ruling reasoned that A’s participation in the LLC furthered its charitable purpose of promoting community health. The structure of the LLC allowed A to ensure that the venture’s activities were aligned with this purpose. The factor was control; because A appointed a majority of the LLC’s governing board, it retained the power to direct the venture’s operations. The explicit charitable purpose in the LLC’s documents and A’s authority over budgets and expenditures ensured the hospital would provide a community benefit, and any private benefit was considered incidental.

Conversely, the IRS found that the non-profit hospital in Situation 2, C, failed the test and its tax-exempt status was jeopardized. The arrangement did not guarantee that the venture would be operated for charitable purposes. With an evenly split board, C lacked the formal control necessary to ensure the hospital’s operations would prioritize community benefit over profitability. The absence of a binding charitable mission in the governing documents meant there was no formal commitment to serve the community’s health needs.

The lack of control was further compounded by the long-term management contract granted to an affiliate of the for-profit partner. This contract gave the for-profit entity significant power over daily operations, financial decisions, and strategic direction. The IRS viewed this structure as creating a situation where the non-profit’s assets were being used to generate profits for the for-profit partner, which constituted more than an incidental private benefit and violated tax exemption requirements.

Key Provisions for Governing Documents

To align with the favorable outcome in Revenue Ruling 98-15, a non-profit’s governing documents for a joint venture must be carefully drafted. The LLC operating agreement is the central document where these protections are established. It must be structured to demonstrate that the non-profit maintains control over the venture to ensure its charitable mission is the primary focus of the enterprise’s activities.

A foundational requirement is an explicit statement of purpose within the governing documents. This clause must clearly articulate that the joint venture’s primary objective is to further the non-profit’s specific charitable mission. For a hospital, this would mean stating that the venture’s purpose is to provide healthcare services to all members of the community and to promote overall community health. This provision serves as a guiding principle for all of the venture’s future decisions and operations.

The documents must also codify the non-profit’s control over the venture’s governing body. The most direct way to achieve this is by granting the non-profit the power to appoint a majority of the board members, as seen in Situation 1. This structural dominance ensures the non-profit can direct the vote on any matter requiring board approval.

Beyond board composition, the governing agreement should grant the non-profit specific veto powers over critical decisions. These powers act as a safeguard, allowing the non-profit to block actions that could conflict with its charitable mission. Important areas where such approval rights are needed include amending the operating agreement, changing the venture’s stated purpose, approving annual budgets, and authorizing significant capital expenditures.

Finally, a robust conflict of interest policy must be incorporated directly into the governing documents. This policy should define what constitutes a conflict, require disclosure from board members and key executives, and prohibit interested individuals from voting on matters where they have a financial interest. The agreement should also stipulate that any contracts with the for-profit partner or its affiliates, such as management agreements, must be for a reasonable duration and at fair market value compensation to prevent private inurement.