Nonprofit Organizations in Partnerships and Llcs: Rev. Rul. 98-15 and H.b. 1221

Publication year1998
27 Colo.Law. 101
Colorado Lawyer

1998, June, Pg. 101. Nonprofit Organizations in Partnerships and LLCs: Rev. Rul. 98-15 and H.B. 1221


Vol. 27, No. 6, Pg. 101

The Colorado Lawyer
June 1998
Vol. 27, No. 6 [Page 101]

Specialty Law Columns
Advising Nonprofit Organizations
Nonprofit Organizations in Partnerships and LLCs: Rev. Rul 98-15 and H.B. 1221
by Robert R. Keatinge, Arthur A. Hundhausen

Over the past few years, the statutes governing unincorporated business organizations-general partnerships limited partnerships, limited liability companies ("LLCs"), limited liability partnerships ("LLPs"), limited liability limited partnerships ("LLLPs"), and limited partnership associations ("LPAs")-have changed dramatically.1 At the same time, tax-exempt organizations, particularly in the health care industry, are attempting to enter into new relationships with for-profit organizations. These developments have resulted in changes in the state and federal rules applicable to the participation of tax-exempt organizations in business relationships with for-profit organizations.2

This article considers some of the implications of participation of tax-exempt organizations as owners in unincorporated business organizations; particularly, the choice of entity for a joint venture involving a tax-exempt organization in light of Revenue Ruling ("Rev Rul.") 98-15, which deals with whole hospital joint ventures. In addition, it discusses House Bill 98-1221 ("H.B. 1221"), a new Colorado statute intended to regulate certain actions taken by nonprofit hospitals.


Interaction between nonprofit organizations and unincorporated business organizations can occur in two ways: (1) the nonprofit can organize as an unincorporated organization, or (2) the nonprofit organization can be a member or partner in an unincorporated organization. Not all nonprofit organizations qualify or are intended to qualify as tax-exempt organizations. The term "nonprofit" simply implies that the organization is not established for the purpose of making a pecuniary profit.

There are three common types of organizations that are not organized for profit: (1) organizations that are organized for public benefit, (2) organizations that are organized for the mutual benefit of their owners, although not for financial profit, and (3) religious organizations. The term "tax exempt" refers to the fact that an organization is exempt from federal income tax under Internal Revenue Code ("IRC") §§ 501(a) and 501(c)(3) and, generally, that contributions to the organization are deductible as charitable contributions. Organizations of this type are either religious or public benefit organizations.3

A tax-exempt organization that is a partner in a partnership or a member in an LLC risks being treated as if it were carrying on the activities conducted by the partnership or LLC. In this respect, to the extent those activities are inconsistent with the charitable purposes of the tax-exempt organization, the organization risks disqualification of its tax-exempt status, intermediate sanctions, and unrelated business taxable income ("UBTI"). These rules are designed to accomplish two distinct objectives: (1) to discourage an organization from conducting activities that may be inconsistent with the charitable purposes on which its exemption is based, and (2) to level the playing field between taxable and tax-exempt organizations conducting the same activities in competition with one another.

In order to qualify as tax exempt, an organization must be operated exclusively for one or more exempt purposes. It will satisfy this test only if it engages primarily in activities that accomplish one or more of the purposes specified in IRC § 501(c) (3).4 If more than an insubstantial part of the organization's activities is not in furtherance of an exempt purpose, the organization will not qualify as exempt.5 In addition, such an organization must both (1) be organized and operated so that no part of its net earnings inures to the benefit of any private shareholder or individual (the proscription against private inurement),6 and (2) not confer more than an incidental private benefit on any individual (the proscription against more than incidental private benefit).7

An organization may meet the requirements for exemption under § 501(c)(3) even though it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization's exempt purpose or purposes, and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business.8 If the nonexempt activities of an organization are more than incidental or insubstantial, the organization is not entitled to exemption, regardless of the number or importance of its exempt purposes.9

The critical distinction between the private inurement and private benefit rules is that the proscription against private inurement is absolute. An incidental amount of private benefit will not jeopardize tax-exempt status, but even the smallest amount of private inurement will. Possibly as a result of the draconian effects of disqualification of an organization's tax-exempt status as a result of any private inurement, Congress recently adopted intermediate sanctions rules under which a tax is imposed on a "disqualified person"10 who receives an "excess benefit" equal to 25 percent or 200 percent of the value of that excess benefit.11

In addition, there is a tax of 10 percent of the excess benefit transaction imposed on any "organization manager"12 who participates in an excess benefit transaction, knowing that it is such a transaction, unless the participation is not willful and is due to reasonable cause. In a partnership or LLC, most general partners, managers, and members of a member-managed LLC will have the right to participate in the management of the organization. Because the manager of the LLC is not an officer, director, or trustee of the charitable hospital, the determination of whether the manager is an "organization manager" under the intermediation sanctions rules would have to be made by determining whether the manager of the LLC, through its control of the LLC's business, would have "powers and responsibilities similar to those of officers, directors, or trustees" of the charitable member. Whether a partner, manager, or member would be a "disqualified person" will probably turn on the actual degree of control or influence held by such person in the operation of the organization.

Subject to certain requirements with respect to excess investments and the possibility that the income will be treated as UBTI, a tax-exempt organization may invest its funds in passive investments without threatening its exempt status. For this reason, a tax-exempt organization may generally receive dividends or income as a limited partner without jeopardizing its status. If, however, the organization's participation in the investment is more active, such as that of a general partner, that participation may cause a loss of tax exemption unless the participation meets more subtle tests and safeguards designed to ensure that the participation does not adversely affect the organization's fulfillment of the purposes giving rise to its exemption.

Tax-Exempt Organization As . . .

Shareholder of a Corporation

Generally, ownership of stock in a C corporation should not disqualify an organization as tax exempt, although certain payments from controlled corporations may give rise to UBTI.13 Recent legislation has allowed tax-exempt organizations to be shareholders in S corporations. However, it is unclear whether rules similar to those described below, being developed for LLCs, will be applied to tax-exempt S corporation shareholders.

"In order to qualify as
tax-exempt, an organization
must be operated exclusively
for one or more exempt

General Partner

Under both the Uniform Partnership Law14 and the Colorado Uniform Partnership Act of 1997,15 a general partner has the authority to bind the partnership and participate in the management of the partnership, and, except in LLPs and LLLPs, is individually liable for the debts and obligations of the partnership. When a tax-exempt organization is a general partner in a joint venture or partnership involving for-profit partners, a conflict may arise between the organization's exempt purposes and its fiduciary responsibilities to the for-profit general and limited partners.

This potential conflict has been the grist for IRS analysis for many years. Following the decision in Plumstead Theatre Society, Inc. v. Commissioner,16 the IRS released General Counsel Memorandum ("GCM") 39005 (June 28, 1983), reversing its prior policy under which the participation by an exempt organization as a general partner in a partnership that included for-profit limited partners was considered a per se violation of the exempt organization's tax-exempt status.

In GCM 39005, the IRS established a two-part test for when an exempt organization may participate as a general partner in a joint venture with a for-profit. Under the Memorandum, an organization's exemption under § 501(c)(3) will not be jeopardized because it acts as a general partner if:

(1) doing so furthers the tax-exempt purposes of the exempt organization; and

(2) as the general partner, the exempt organization is not prevented from acting exclusively in furtherance of its exempt purposes and does not confer a substantial private benefit on the for-profit partner.

The critical issue in both Plumstead and GCM 39005 was the degree of control that...

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