Gerhart Responds to Criticism of Proposed Rev. Rul. on Joint Ventures

Dear Mr. Miller:

[1] By letter dated August 1, 2002, I submitted to your office on behalf of the Tax and Accounting Interest Group of the Health Law Section of the American Bar Association a proposed revenue ruling on ancillary joint ventures between section 501(c)(3) exempt organizations and for-profit entities. The purpose of this letter is to respond to a letter dated October 2, 2002, from Sarah C. Harlan to your office in which Ms. Harlan objects to part of the analysis in the proposed revenue ruling.

[2] The same individuals who participated in preparing the proposed revenue ruling have also participated in preparing this letter. David Flynn and I exercised principal responsibility in preparing this letter. Substantive contributions were made by Bonnie S. Brier, Bernadette Broccolo, Michael A. Clark and Douglas M. Mancino. This letter was reviewed by, and suggestions regarding its text were made by, J.A. (Tony) Patterson, Jr., and Gregory Pemberton.

[3] The comments in this letter, as was the case with the proposed revenue ruling, are the individual views of the members of the Tax and Accounting Interest Group of the ABA Health Law Section who prepared them. They do not represent the position of the American Bar Association or the Health Law Section. The views expressed should not be construed as representing the position of any government participant in the Section, its Council, or its Interest Group leadership.

[4] The proposed revenue ruling deals with an exempt hospital that enters into a joint venture with a for-profit company to operate an ambulatory surgery center. In both Situation 1 and Situation 2 the joint venture represents an insubstantial part of the hospital's overall activities and the hospital and the for-profit company share equal voting control. A key difference is that in Situation 1 there are assurances that the joint venture will meet the community benefit standard of Rev. Rul. 69-545, whereas in Situation 2 those assurances are lacking and the joint venture's focus is on profitability. The proposed revenue ruling concludes that in Situation 1 the ancillary joint venture is substantially related to the hospital's exempt purposes and accordingly raises neither exemption nor unrelated business income tax issues. The proposed revenue ruling concludes in Situation 2 that the hospital's participation in the joint venture is subject to unrelated business income tax, but because the hospital's participation in the joint venture is an insubstantial part of its overall activities, the joint venture does not by itself threaten the hospital's exempt status.

[5] Ms. Harlan agrees with Situation 1. However, she objects to the conclusion in Situation 2 that the only tax risk arising from the Hospital's participation in the ancillary joint venture is the unrelated business income tax risk. She suggests that the Hospital's participation in the Situation 2 joint venture should threaten its exempt status under the private benefit test.

[6] It is true that the private benefit test has been applied by the Service to require that the private benefit arising from even an insubstantial activity must be incidental in both a qualitative and quantitative sense. However, that is not a concern where the insubstantial activity is conducted at arm's length based on fair market value. For example, in G.C.M. 37789 (Dec. 18, 1978), it was held that where a hospital loaned money and leased land to staff physicians, the transactions did not fail the private benefit test since the hospital received a fair return on the loan and a market rental for the land. Thus, an insubstantial activity should not fail the private benefit test so long as the activity is conducted on a reasonable and arm's length basis. In our proposed revenue ruling we stipulated in the statement of facts that the joint venture management agreement was negotiated at arm's length and contains terms "that are reasonable and comparable to industry practice." Perhaps the proposed revenue ruling could be made even clearer that the arm's length standard of G.C.M. 37789 is satisfied, but assuming (as we did) that the ancillary joint venture is negotiated and conducted at arm's length, then we were correct in concluding that the private benefit test is not a factor in Situation 2 and does not threaten the hospital's exempt status.

[7] Ms. Harlan does not raise or discuss the incidental test of private benefit reflected in G.C.M. 37789. Instead, she argues that an insubstantial activity can be a threat to exempt status depending on the degree of relatedness of the activity to the Hospital's exempt purposes. It is her view that a "totally unrelated" insubstantial activity may not threaten exempt status, which she expresses in her letter as follows:

[9] We disagree with Ms. Harlan's approach to private benefit. First, it is inconsistent with the incidental test reflected in G.C.M. 37789, which makes no mention of the degree of relatedness. We are aware of no basis for applying the private benefit test more favorably to an insubstantial activity that is "totally unrelated," such as food catering or interior decoration for unrelated parties (Ms. Harlan's examples), than it is applied to an activity that bears some relationship to an organization's exempt purposes.

[10] In dealing with a similar issue the regulations, in fact, take the opposite approach and favor activities that have some relationship to an organization's exempt purposes. The operational test of Reg. § 1.501(c)(3)-1(c)(1) states the general rule that an exempt organization may engage in activities that do not further an exempt purpose ("totally unrelated" activities) only to an insubstantial extent. However, Reg. § 1.501(c)(3)-1(e) states that a section 501(c)(3) organization may engage in an unrelated business to a substantial extent if the business furthers the organization's exempt purpose. Thus, an activity that furthers exempt purposes, even though not sufficiently related to avoid unrelated business income tax, is regarded more favorably by the regulations than a totally unrelated activity, which is contrary to Ms. Harlan suggestion.

[11] Ms. Harlan's approach would require the private benefit test of Reg. § 1.501(c)(3)-1(d)(1)(ii) to be read in a manner that is inconsistent with the operational test of Reg. § 1.501(c)(3)-1(c)(1). The operational test focuses on the overall activities of an organization and allows an activity to be disregarded if it is insubstantial. The private benefit test should be applied in a consistent manner so that it, too, focuses on the overall activities of an organization and disregards an insubstantial activity so long as it is conducted at arm's length.

[12] The unrelated business income tax allows an exempt organization to engage freely in an insubstantial unrelated activity. Unrelated businesses by their nature tend to promote profit-making interests over charitable interests. Exempt organizations have engaged in countless unrelated businesses on the assumption that they do not threaten exempt status if they are insubstantial and are conducted on a reasonable and arm's length basis. Ms. Harlan's suggestion is not only novel, it would upset long-standing and well- established practices and policies of both the Service and the exempt organization community.

[13] We also note Ms. Harlan's statement that the private benefit test should apply to "participation by the hospital or its taxable subsidiary in such JV . . ." (Emphasis added.) Although our proposed revenue ruling in no way involved the use of a taxable subsidiary, we note as a point of clarification that the Service has ruled many times that an exempt organization that conducted an unrelated business through a taxable subsidiary insulated itself from both unrelated business income tax and any threat to its exempt status if the taxable subsidiary was respected as a separate corporate entity.

[14] Finally, we have specifically not addressed the situation where a hospital engages in an insubstantial activity on some basis other than arm's length. Such an activity should be subjected to a case-by-case analysis. Even where an arm's length standard is not met, the private benefit may still be incidental in both a quantitative and qualitative sense, depending on the facts and circumstances. We recommend that the Service likewise reserve for case-by-case analysis any insubstantial activity that does not satisfy an arm's length standard.

[15] We hope that this additional analysis of the application of the private benefit test is helpful in your consideration of our proposed revenue ruling on ancillary joint ventures.