Nonprofit Tax-Exempt Organizations
as Members of LLCs:
An Analysis of Revenue Ruling 98-15

by Christopher M. Riser
Mayer & Riser, PLLC
Highlands, North Carolina

As nonprofit tax-exempt organizations seek more creative ways to fund their efforts, an increasing number of such organizations have entered into joint ventures with for-profit enterprises, particularly in the areas of health care, education and low-income housing. This trend has resulted in the need for clarification of federal rules applicable to business relationships between tax-exempt organizations and for-profit enterprises.

At the same time, limited liability companies (LLCs) have proliferated across the business landscape, and have become of increasing interest to nonprofit tax-exempt organizations as joint venture vehicles and as entity choices for new nonprofit tax-exempt organizations.  This article addresses the issue of nonprofit tax-exempt organizations as members of LLCs and the implications of Revenue Ruling 98-15, the most recent important IRS pronouncement regarding joint ventures between nonprofit tax-exempt organizations and for-profit enterprises.  For analysis of nonprofit tax-exempt organizations as LLCs, see my article "Nonprofit LLCs: Time for a New Experiment?."

Nonprofit Tax-Exempt Organizations as Members of LLCs

To qualify as tax-exempt under § 501(c)(3), an organization must pass an organizational test and an operational test.⁽¹⁾ The organizational test requires (1) that the organization's purposes are limited to one or more exempt purposes, and (2) that the organization is not expressly empowered to engage, other than as an insubstantial part of its activities, in activities that in themselves are not in furtherance of one or more exempt purposes.⁽²⁾ The operational test requires (1) that the organization be engaged primarily in § 501(c)(3) exempt activities, (2) that none of the earnings of the organization inure to the benefit of any private owner or individual, and (3) that the organization not be a political action organization.⁽³⁾ While a nonprofit tax-exempt organization has many tax issues to consider, such as unrelated business taxable income and intermediate sanctions, the most serious tax issue is maintenance of the organization's tax-exempt status.

Although the issue of imputation of the activities from a partnership to its partners is not new,⁽⁴⁾ Rev. Rul. 98-15 is the first IRS pronouncement dealing with the imputation of activities from an LLC to its members. When an LLC's business activities are imputed to a member, the member is be deemed to be engaged in the business of the LLC in its individual capacity. Thus, the activities of an LLC are considered to be the activities of a nonprofit tax-exempt LLC member when assessing whether the nonprofit organization is operated exclusively for tax-exempt purposes within the meaning of IRC § 501(c)(3). The organization risks losing its tax-exempt status if those activities are inconsistent with the charitable purposes of the nonprofit tax-exempt organization.

Rev. Rul. 98-15

In March 1998, the IRS issued Rev. Rul. 98-15, a highly anticipated pronouncement dealing with a whole-hospital joint venture in which a nonprofit tax-exempt hospital corporation and a for-profit corporation formed a joint venture LLC. The exempt hospital corporation then contributed all of its operating assets to the LLC, which then operated the hospital.⁽⁵⁾ The ruling posed two alternative situations. In Situation 1, the LLC's operating agreement and articles of organization (the "governing documents") provide that the LLC is to be managed by a governing board consisting of three individuals chosen by the exempt organization and two individuals chosen by the for-profit corporation. The exempt organization intends to appoint community leaders who have experience in hospital matters, but who are not on the hospital staff and do not otherwise engage in business with the hospital.

The governing documents further provide that they may be amended only with the approval of both owners and that a majority of three board members must approve certain major decisions, including decisions regarding the LLC's annual budgets, distributions of LLC earnings, selection of key executives, acquisition or disposition of health care facilities, contracts in excess of a certain dollar amount per year, changes to the types of services offered by the hospital, and renewal or termination of management agreements.

The governing documents require that the LLC operate any hospital it owns in a manner that furthers its charitable purposes, explicitly providing that the duty of the members of the governing board to operate the LLC in a manner that furthers its charitable purposes overrides any duty they may have to operate the LLC for the financial benefit of its owners.

The governing documents further provide that all returns of capital and earnings to the members shall be proportional to their ownership interests. The exempt member intends to use any distributions it receives from the LLC in furtherance of its charitable purposes.

The LLC enters into a management agreement with a management company unrelated to either member. The management agreement is for a five-year period, renewable for additional five-year periods by mutual consent. The LLC may terminate the agreement for cause. The management company will be paid a fee for its services based on the LLC's gross revenues, and the other terms and conditions of the agreement are reasonable and comparable to what other management companies receive for similar services at similarly situated hospitals.

Situation 2 poses a similar set of circumstances, with the following differences:

• the governing board consists of three individuals appointed by the exempt organization and three members appointed by the for-profit corporation;
• the major decisions requiring majority board approval include only the LLC's annual budgets, distributions over a required minimum level, "unusually large" contracts, and selection of key executives;
• the governing documents provide that the LLC's only purpose is to construct, develop, own, manage, operate, and take other action in connection with operating its health care facilities;
• the governing documents contain no override of the board members' fiduciary duty to operate the LLC for the financial benefit of its owners;
• the management company is a wholly-owned subsidiary of the for-profit corporation member;
• the management contract is renewable at the discretion of the management company; and
• the exempt organization agrees to approve the selection of two individuals to serve as the LLC's CEO and CFO, both of whom have previously worked for the for-profit corporation in hospital management. The CEO and CFO will receive compensation commensurate with that received by executives at similarly situated hospitals.

In Situation 1, the Service determined that the relevant facts and circumstances supported the conclusion that the nonprofit corporation will be operated exclusively for a charitable purpose and only incidentally for the purpose of benefiting the private interests of the for-profit corporation. Consequently, the nonprofit organization retains its tax-exempt status.

In Situation 2, the Service concluded that the relevant facts and circumstances cannot support a conclusion that the nonprofit corporation will be operated exclusively for a charitable purpose. The nonprofit organization cannot establish that the benefit to the for-profit corporation resulting from the activities of the LLC would not be more than incidental. The operational test is not met and the nonprofit organization will lose its exempt status.

Analysis

The Service has acknowledged that a nonprofit organization exempt from taxation under IRC § 501(c)(3) can satisfy the operational test by being a member of an LLC that conducts activities that further a § 501(c)(3) exempt purpose, even when the organization contributes all of its operating assets to the LLC.⁽⁶⁾ Indeed, the Service likely can be expected to apply the ruling to all joint ventures, whether the exempt organization involved contributes all or only a portion of its assets to a joint venture LLC.⁽⁷⁾

Situation 1 provides a safe harbor for the organizational, financial and managerial structure of pass-through joint ventures. In that respect, the ruling is a welcome clarification of the rules. The Service's analysis of Situation 2, however, seems to imply that the LLC's governing documents must contain specific provisions ensuring that the operational test will be met. Whether the operational test is met in a given case is a question of fact, not a matter for speculation. Until this ruling, in determining whether an organization's primary purposes are exempt or nonexempt, the Service and the courts have focused upon the manner in which the organization's activities are, in fact, carried out.⁽⁸⁾ While the governing documents do not prevent the for-profit corporation from causing the LLC in Situation 2 to act in a manner inconsistent with the nonprofit organization's exemption, there appears to be no basis for concluding that the LLC would, in fact, be operated in such a manner.

The Service appears to have created a new organizational test for joint ventures, consisting of at least the following questionable requirements:

• The nonprofit member must be in control of the LLC's governing board, without regard to its percentage ownership interest in the LLC, i.e., even if it owns less than fifty percent of the ownership interests.
• The nonprofit member must be able to initiate new LLC action to serve new exempt purpose needs. The Code does not prescribe how an organization must conduct or be able to conduct its activities.
• Neither the for-profit corporation nor a subsidiary of the for-profit corporation can serve as manager of the LLC, even if the terms and conditions of the management contract are entirely reasonable.
• LLC executives cannot be insiders of the for-profit corporation. In Situation 2, the Service apparently concludes that because the CEO and CFO of the LLC will be individuals with a prior relationship to the for-profit corporation, these executives will provide the governing board members appointed by the nonprofit organization with incomplete or inaccurate information.

These additional organizational requirements seem to be unjustified because they are based on speculation that the for-profit member will necessarily cause the LLC to act in a manner inconsistent with the nonprofit member's exempt purpose. Nothing in the Code or Regulations appears to require this preemptive strike against potential failure of the operational test for exemption.

One apparent additional organizational requirement imposed by Rev. Rul. 98-15, however, does seem justifiable. There appears to be a requirement that the LLC's governing documents provide that the governing board has a specific fiduciary duty to operate the LLC in a manner that furthers charitable purposes, which duty would override any state law fiduciary duty to operate the LLC for the financial benefit of its owners. Absent such an override, it is not speculative that the members of the governing board would have a fiduciary duty to consider the financial benefit of its members over any charitable purposes.

Conclusion

Rev. Rul. 98-15 reflects an increasing and perhaps misplaced emphasis on the control retained by a tax-exempt participant in a joint venture with a for-profit entity. On the one hand, the ruling provides significant guidance for relatively straightforward joint venture arrangements. On the other hand, however, it appears that the Service may have overstepped its bounds in effectively adding a new requirement that the operational test be satisfied not only in fact, but also in the joint venture's governing documents.

For more information, contact Chris Riser at 828-526-3731.

1. Treas. Reg. § 1.501(c)(3)-1.

2. Treas. Reg. § 1.501(c)(3)-1(b).

3. Treas. Reg. § 1.501(c)(3)-1(c).

4. See, e.g., Butler v. Comr., 36 T.C. 1097 (1961), acq., 1962-1 C.B. 3. Accord, Stanchfield v. Comr., T.C. Memo 1965-305; Smith v. Comr., T.C. Memo 1994-640.

5. Rev. Rul. 98-15, 1998-12 IRB 6.

6. Although perhaps a bit overdue, this aspect of the ruling is not an unexpected piece of guidance. See Plumstead Theatre Society, Inc. v. Comr., 74 T.C. 1324 (1980), aff'd, 675 F.2d 244 (9^th Cir. 1982), on which Rev. Rul. 98-15 relies in part.

7. The ruling does not contain an effective date, and so must be considered effective upon publication at the latest. The Service considers the ruling to be an interpretation of current law and can be expected to apply the ruling retroactively.

8. Church of Scientology of California v. Comr., 83 T.C. 381, 475 (1984), aff'd, 823 F.2d 1310 (9th Cir. 1987), cert. denied, 484 U.S. 9 (1988). See also, Linwood Cemetery Association v. Comr., 87 T.C. 1314 (1986). See also, Easter House v. U.S., 87-1 USTC Para.9359 (Ct. Cl. 1987), aff'd per curiam, 846 F.2d 78 (Fed. Cir. 1988). See also, Manning Association v. Comr., 93 T.C. 596 (1989). See also, Treas. Reg. § 1.501(c)(3)-1(e)(1). See also, GCM 3946, August 15, 1986.