TAX EXEMPT AFFILIATIONS AND CONSOLIDATIONS:
COURTSHIP AND MARRIAGE IN THE EXEMPT SECTOR
By: John Leggett, Vinson & Elkins, LLP
The University of Texas School of Law
18th Annual Nonprofit Organizations Institute
January 10-12, 2001
(Printed with permission of the University of Texas School of Law CLE Department)
TABLE OF CONTENTS
I. OVERVIEW .........................................................................................................................1
II. CATEGORIES OF AFFILIATIONS ....................................................................................2
III. MERGERS AND CONSOLIDATIONS BETWEEN EXEMPTS: A FULL AND FAITHFUL
A. DESCRIPTION OF TRANSACTION FORMATS..................................................2
1. Statutory Merger............................................................................................2
2. Statutory Consolidation ..................................................................................3
3. De Facto Merger or Consolidation .................................................................3
B. PURPOSES AND OBJECTIVES .............................................................................4
C. TAX ASPECTS ........................................................................................................5
1. Section 501(c)(3) Status ................................................................................5
2. Unrelated Business Income Tax......................................................................5
3. Public Charity Status ......................................................................................6
4. Other .............................................................................................................6
IV. NON-MERGER AFFILIATIONS OF EXEMPTS: MARRIAGE, ENGAGEMENT
AND DATING .....................................................................................................................8
A. MERE SERVICE PROVIDER AND OTHER CONTRACTUAL
1. Description of Transactions ............................................................................8
2. Tax Aspects...................................................................................................9
B. PARENT-TYPE AFFILIATIONS ..........................................................................10
1. Acquisition/Change in Sponsorship ...............................................................10
2. New Parent Holding Company Affiliation......................................................11
C. “VIRTUAL MERGERS”: JOINT OPERATING ARRANGEMENTS....................12
V. JOINT VENTURES: MARRIAGE IN PART.....................................................................13
A. BETWEEN EXEMPTS AND TAXABLES.............................................................14
1. Traditional IRS Analysis ...............................................................................14
2. Rev. Rul. 98-15: Heightened Focus on Control.............................................14
a. Situation 1........................................................................................15
b. Situation 2........................................................................................16
c. IRS analysis .....................................................................................16
3. The Redlands Decision ................................................................................18
a. Facts ...............................................................................................18
b. Tax Court Opinion ...........................................................................19
4. Summary .....................................................................................................20
B. BETWEEN EXEMPTS ...........................................................................................21
Not surprisingly, parallels exist between the social activities of humans and those of the organizations
created by humans. People engage in courtship activities and may ultimately enter into marriage
“transactions” that achieve a uniting of lives. Similarly, after a period of study and due diligence,
organizations engage in a wide variety of transactions that are calculated to achieve differing degrees of
consolidation and affiliation. The analogy is, of course, strained in many respects (e.g., a three-organization
merger!), but is reasonably well taken in others.1
This outline discusses courtship and marriage in the exempt sector. Specifically, the outline (i)
explores various types of affiliations, consolidations and alliances that are undertaken by tax-exempt
organizations, (ii) examines certain federal income tax aspects of these transactions to the participating
exempt organizations, and (iii) analyzes several recent developments regarding the tax treatment of such
transactions. Unless otherwise indicated, references to tax-exempt organizations in this outline are to
organizations that are exempt from federal income tax by virtue of being described in section 501(c)(3)2 and
classified as public charities. Although there are a number of similar tax considerations in transactions
involving private foundations and non-charitable exempt organizations (such as section 501(c)(4) social
welfare organizations and section 501(c)(6) business leagues), there are also differences. For example, a
private foundation contemplating a merger that would cause it to cease to exist must consider the application
of the special termination tax rules of section 507, and the private foundation preparing to undertake a joint
venture transaction would do well to analyze the consequences under the section 4943 excess business
holding tax provisions, among other things.3
II. CATEGORIES OF AFFILIATIONS
There are many reasons for courtship and marriage in the exempt sector, and these reasons often
depend on the nature and extent of unification or affiliation that is brought about by the type of transaction
that is being proposed. A few very general comments related to various categories of affiliation:
o Integration of operations into a single structural family (“marriage”). Some common
reasons for this type of affiliation include: expanding the scope of coverage of each
organization’s exempt activities; achieving managerial and operational efficiencies and
synergies; eliminating duplicative functions; pooling and expanding organizational resources;
To avoid any unintended offense, perhaps a more abstract definition of the term “marriage” should be emphasized in this
outline, i.e., a “close union.” American Heritage Dictionary (1979) p. 801.
References to sections herein are to sections of the Internal Revenue Code of 1986, as amended (the “Code”).
In addition, for exempt organizations with tax-exempt bonds outstanding, issues under sections 103 and 141 through 150,
covering tax-exempt obligations, must also be faced in connection with the transactions discussed herein. A discussion of these issues
is beyond the scope of this outline.
achieving critical mass to maximize performance of exempt activities; expanding fundraising
capabilities and community profile; reducing costs of providing services; etc.
o Obtain particular services or resources from another unrelated exempt organization
(“dating”). Examples of this type of transaction include agreements between organizations
for the provision of management, administrative and consulting services, use of computer
or other property, etc. The service recipient organization is simply trying to obtain the
benefit of the expertise and resources of another exempt organization.
o Mezzanine relationships, involving a loose affiliation or relationship between two or
more exempt organizations (“steady dating” or even “engagement”). Sometimes
these types of transactions -- which usually attempt to achieve some part of the advantages
of a fuller integration – are precursors to more intimate affiliations.
o Joint ventures. Unlike marriages between people, exempt organizations can also unite to
varying degrees with respect to only a portion of their assets/operations -- not just through
“whole entity” combinations and affiliations -- and thereby obtain advantages of integration
and operational efficiencies and synergies.
III. MERGERS AND CONSOLIDATIONS BETWEEN EXEMPTS: A FULL AND
The transaction structure that offers the greatest degree of unification is an outright merger or
consolidation whereby one or more tax-exempt organizations become a single entity.
A. DESCRIPTION OF TRANSACTION FORMATS
1. Statutory Merger. When the transaction takes the form of a statutory merger, (i)
the “target” corporation or corporations are merged with and into the “acquiring” or “surviving”
corporation pursuant to a state statute setting forth the prerequisites to and effects of a merger;
(ii) the existence of the target corporation(s) ceases when the merger becomes effective; and (iii) the
surviving corporation becomes the owner of all target assets and assumes all target liabilities by
operation of law. Typically, a state merger statute will require that all parties to the merger adopt
and approve a plan of merger and then file articles of merger with the state’s secretary of state. The
merger will typically be effective upon the receipt of a certificate of merger from the secretary of
state. Note that the plan of merger can provide that changes be made to the organizational
documents of the surviving corporation in connection with the merger. Thus, the target organization
might condition the merger on, e.g., the adoption of governance provisions that would allow the
former management of the target organization to have some representation on the board of the
For an example of a state merger statute, see Tex. Rev. Civ. Stat. Ann., art. 1396 (Vernon 1997)
(“Texas Non-Profit Corporation Act”), §§5.01-5.07. Note that this statute contemplates that
domestic (Texas) and foreign (non-Texas) non-profit corporations may merge, subject to certain
requirements and conditions. Id. at §5.07.
2. Statutory Consolidation. When the transaction takes the form of a statutory
consolidation, (i) the consolidating corporations merge with and into a newly-created corporation
(“Newco”); (ii) the existence of the consolidating corporations ceases when the consolidation
becomes effective; and (iii) Newco becomes the owner of all assets, and assumes all liabilities, of
the consolidating corporations by operation of law. As with a merger, a state consolidation statute
will typically require that the participating parties adopt and approve a plan of consolidation and
then file articles of consolidation with the state’s secretary of state. The consolidation will usuallybe
effective upon the receipt of a certificate of consolidation from the secretary of state.
For an example of a state consolidation statute, see Texas Non-Profit Corporation Act, §§5.01-
The consolidation format is sometimes chosen to facilitate a combination between organizations
where a “merger of equals” psychology is desired. Since a new organization is created to effect the
combination, there is not – in form at least – an “acquiring” or “surviving” corporation.
3. De Facto Merger or Consolidation. In some cases, state law may not provide a
statutory mechanism to accomplish a merger or consolidation between two or more entities. In that
case, a de facto merger or consolidation might be achieved via a two-step process. For example, a
de facto merger might be accomplished by having the target organization (i) assign all of its assets
and liabilities to the acquiring organization and then (ii) dissolve.
B. PURPOSES AND OBJECTIVES
Mergers and consolidations between tax-exempt organizations are undertaken for a wide
variety of reasons. Examples include the following:
o Shifting state of incorporation of an organization to another state by merging with
newly-incorporated surviving corporation;4
o Lessening the administrative, management, and operational burdens of operating multiple
See, e.g., PLR 9309037 (December 7, 1992).
See, e.g., PLR 9314059 (January 15, 1993) (merger of section 501(c)(3) that provides financial support to other
section 501(c)(3)’s into section 501(c)(3) amateur golf organization that had been the recipient of contributions made by it); PLR
9527013 (M arch 31, 1995) (consolidation of two hospital systems).
o Reducing redundant functions and inefficiencies and saving costs;6
o Establishment of critical mass for more efficient allocation and utilization of resources;7
o Combining organizations with overlapping memberships;8
o Taking advantage of combined resources, knowledge and expertise;9
o Eliminating unnecessary and superfluous organizations in an affiliated group of exempt
o Reducing costs of services provided to exempt beneficiaries;11
o Assuring visability or leadership role in the community;12
o Centralize management to provide focus and facilitate long-range and strategic planning.13
C. TAX ASPECTS
See, e.g., PLR 9314059 (January 15, 1993) (better utilization of office space and personnel).
See, e.g., PLR 9738055 (June 26, 1997) (combining hospital operations to achieve such objectives, among others.)
See, e.g., PLR 9530036 (M ay 4, 1995) (merger of 3 section 501(c)(6) business leagues with overlap ping membership related to
one industry; complementary functions).
See, e.g., PLR 9527013 (M arch 13, 1995).
See, e.g., PLR 9303030 (October 29, 1992) (superfluous parent organization is merged "downstream" out of existence).
See, e.g., PRL 9551039 (September 28, 1995).
See, e.g., PLR 9511035 (December 19, 1994).
See, e.g., PLR 9738055 (June 26, 1997); PLR 9511035 (December 19, 1994).
1. Section 501(c)(3) Status. In the context of a merger between two or more
section 501(c)(3) organizations, the effect of the merger on the continued tax-exempt status
of the organizations should first be considered. In general, neither the surviving organization
nor the target organization(s) should jeopardize its tax-exempt status as the result of such a
merger because, among other things, the surviving organization continues to perform the
exempt activities of the target(s).14 In addition, the surviving organization may generally be
treated as a continuing (not a new) organization for purposes of the section 508(a)
2. Unrelated Business Income Tax. Another issue is whether the merger or
consolidation would give rise to unrelated business income tax under sections 511 through
514. In general, such a merger or consolidation does not give rise to unrelated business
taxable income, a result that may be based on one or more of the following theories: (i) the
transfer of assets effected by the merger or consolidation is related to and furthers the
exempt purposes of each of the parties to the transaction;16 (ii) the transfer of assets
effected through the merger or consolidation is in the nature of a contribution, which does
not give rise to unrelated business taxable income for either the donor or donee;17 (iii) the
merger or consolidation is a non-recurring transaction for an organization and does not
constitute the “regularly carried on” trade or business activity that gives rise to an unrelated
trade or business;18 and (iv) section 512(b)(5) excludes from unrelated business taxable
income certain gains from the sale of assets (generally including capital gain assets). 19
See, e.g., PLR 9635028 (M ay 30, 1996); PLR 9551039 (September 28, 1995); PLR 9541007 (June 30, 1995); PLR 9314059
(January 15, 1993). Other private letter rulings note that it is an exempt purpose to make contributions to another section 501(c)(3)
organization furthering exempt purposes. See, e.g., PLR 9303030 (October 29, 1992). See also Rev. Rul. 67-149, 1967-1 C.B. 133.
See, e.g., PLR 9314059 (January 15, 1993).
See, e.g., PLR 9314059 (January 15, 1993).
See, e.g., PLR 9738055 (June 26, 1997); PLR 9527013 (M arch 31, 1995).
See, e.g., PLR 9530036 (M ay 4, 1995); PLR 9541007 (June 30, 1995).
See, e.g., PLR 9738055 (June 26, 1997).
3. Public Charity Status. In most cases, a merger or consolidation involving two or
more section 501(c)(3) public charities will not alter the public charity status of the
participating organizations. For example, if two publicly-supported donative organizations
are merged, it is likely that the combined organization will continue to qualify as other thana
private foundation by virtue of being described in sections 509(a)(1) and 170(b)(1)(A)(vi).
This is not necessarily the case, however. In some cases, the basis for public charity status
may change. For example, the merger of a section 509(a)(1) or 509(a)(2) public charity
into a section 509(a)(3) supporting organization may result in the supporting organization
deriving its public charity status from section 509(a)(1) or 509(a)(2).20 Or the merger of a
public charity and a private foundation may result in the surviving organization possessing
private foundation status.21
a. Tax considerations other than those described above may also be present
in any particular merger or consolidation transaction, although they are not
discussed in detail in this outline. For example, there may be implications for the
tax-exempt status of bonds issued by one or more of the participating organizations
or state and local tax exemption consequences.
b. In addition, in the case of mergers, conversions and other combinations of
taxable entities into exempt organizations, the gain recognition provisions of section
337 and Treas. Reg. §1.337(d)-4 may be implicated, at least where the acquired
assets are not going to be used exclusively in an unrelated trade or business of the
acquiring exempt organization. In this regard, Regulations under section 337 of the
Code concerning certain asset transfers by taxable corporations to exempt
organizations were finalized on December 29, 1998 and bear a January 28, 1999
effective date. In general, the Regulations require taxable corporations that transfer
all or substantially all of their assets to an exempt organization to treat the transfer
as if the assets were sold at their fair market value. The same treatment applies to
taxable corporations that change their status to tax-exempt.
(i) Asset transfers. Section 1.337(d)-4 of the Regulations sets forth
the provisions governing the transfer of all or substantially all of the assets
of a taxable corporation to an exempt organization. The provisions are
See, e.g., PLR 9541007 (June 30, 1995) ("upstream" merger of hospital subsidiaries into section 509(a)(3) system "parent";
parent (surviving corporation) is reclassified from section 509(a)(3) public charity into section 509(a)(1)/170(b) (1)(A)(iii) (hospital)
public charity); PLR 9303030 (October 29, 1992) ("downstream" merger of section 509(a)(3) system "parent" into hospital
"subsidiary"; subsidiary (surviving corporation) retains its section 509(a)(1)/170(b)(1)(A)(iii) public charity status).
See, e.g., PLR 9522022 (M arch 1, 1995 (merger of section 509(a)(3) supporting organization into company foundation;
following merger, foundation continues private foundation status under section 509(c)).
designed to further codify the General Utilities decision and are not
intended to preclude in kind, corporate contributions. In general, a taxable
corporation that transfers all or substantially all of its assets to an exempt
organization, such as a liquidating taxable subsidiary, must treat the
transfer as a sale of the transferred assets for their fair market value as of
the date of transfer. Any built-in gain will be subject to tax.
(ii) Conversions treated as asset transfers. Section 1.337(d)-4(a)(2)
of the Regulations states that a taxable corporation that changes its status
to tax-exempt will be treated as having transferred all of its assets to an
exempt organization and will be required to treat such conversion as a sale
for fair market value of the transferred assets on the date of conversion.
Again, any built-in gain will be subject to tax.
(iii) Exceptions. The Regulations establish several exceptions fromthe
general rule to take into account certain special circumstances. The biggest
exception applies when the transferee organization uses the transferred
assets in an unrelated trade or business. To the extent the transferred
assets are used by the transferee exempt organization in an unrelated trade
or business, the taxable corporation is not subject to the Regulations. The
tax on any built-in gain will be imposed on the transferee exempt
organization upon any subsequent transfer of the assets or use of the
transferred assets in related activities. Either of these events will trigger a
deemed sale and, to the extent gain results, such gain will be subject to
UBIT. The Regulations include rules for determining the appropriate
allocation when only a portion of the transferred assets are to be used in an
unrelated trade or business.22
Other exceptions to the general rule include:
(1) Three-year rule. Regulations provide that a formerly exempt organization that becomes taxable but regains its
exempt status within three years of its becoming taxable is not subject to the asset transfer rules.
(2) Three-year transition rule. A corporation that was exempt or that applied for but did not receive exemption prior
to January 15, 1997 will not be subject to the rules if the corporation becomes tax-exempt within three years from
the effective date of the Regulations.
(3) Start-up period. A newly formed corporation that becomes exempt within three years of the date of its
organization will not be subject to the Regulations.
(4) M iscellaneous exceptions. In addition, the Regulations create certain specific exceptions for organizations
described in sections 501(c)(7), 501(c)(12) and 501(c)(15) of the Code to reflect the unique characteristics of such
organizations, including in certain circumstances their ability to elect exempt status on a year-by-year basis.
(5) Like-kind exchanges. To the extent an asset transfer would be subject to the Regulations but qualifies for
nonrecognition treatment under section 1031 or 1033 of the Code, the Regulations are not applicable.
IV. NON-MERGER AFFILIATIONS OF EXEMPTS: MARRIAGE, ENGAGEMENT OR
Tax-exempt organizations frequently affiliate in a manner short of outright merger or consolidation
into a single entity. These non-merger affiliations vary considerably in the degree of unification that they
produce. On the one hand, a joint operating agreement may be entered into among two or more exempt
organizations that produces the functional equivalent of a merger (i.e., “marriage”). Indeed, these
arrangements are sometimes referred to as “virtual mergers.” Similarly, in a parent company affiliation, two
or more tax-exempt organizations may come under the common control of a centralized parent entity in a
manner that effectively unites the two formerly independent organizations. On the other hand, unrelated
exempt organizations frequently enter into mere service provider and other contractual relationships that do
not, in themselves, unite the organizations in any fundamental way (i.e., “dating”). Between these points lie a
large number of mezzanine relationships that can exist between two or more tax-exempt organizations.
A. MERE SERVICE PROVIDER AND OTHER CONTRACTUAL
1. Description of Transactions. Many times, two or more unrelated exempt
organizations enter into contractual relationships pursuant to which one of the organizations
will provide goods or services to the other exempt organization(s). For example, an
exempt organization may provide to one or more other exempt organizations managerial,
administrative, consulting or other services, or use of property, such as computer
time/access, among other things. Through such a relationship, the recipient organization
may hope to gain the expertise, know-how and/or other resources of the providing
organization, with resulting efficiencies and operational advantages.
2. Tax Aspects.
a. When a tax-exempt organization provides support activities – such as
management, administrative or consulting services – to an unrelated exempt
organization for a fee, the provision of such services are generally considered by
the IRS to constitute an unrelated trade or business and, thus, to generate unrelated
business taxable income that is subject to tax under section 511.
(6) Gain otherwise recognized. Finally, to the extent the transfer by a taxable corporation to an exempt organization
otherwise triggers recognition under the Code, the Regulations are inapplicable.
o For example, an organization that provides investment services to other
exempt organizations at cost has been ruled by the IRS to be engaged in
the conduct of an unrelated trade or business.23
See Rev. Rul. 69-258, 1969-2 C.B. 127. See also Section 502 (setting forth general rule that organization operated for the
primary purpose of carrying on a trade or business for profit cannot establish exemption on the ground that all of its profit s are
payable to one or more exempt organizations). Congress has legislated two exceptions to Section 502 to accomodate cooperative
organizations whose purposes are to provide certain support services at cost to unrelated exempt members. Section 501(e) provides
exemption for hospital service corporations performing specific enumerated services on a cooperative basis for its members that are
tax-exempt hospitals. Section 501(f) provides exemption to cooperative service organizations, organized and controlled by schools and
certain state and municipal colleges and universities, for the collective investment of their funds in stocks and securities. Both sections
have been strictly construed by the IRS.
o By way of further example, the IRS recently ruled in technical advice that
an organization that provided comprehensive management services to a
group of unaffiliated tax-exempt hospitals was not operating for exempt
purposes and should have its exempt status revoked.24
o Similarly, an organization providing consulting services to non-profit
organizations at not less than the organization’s cost was held by the Tax
Court to be not operated exclusively for exempt purposes. 25
o In one of the landmark cases in this area, the U.S. Supreme Court held
that an organization providing laundry services on a centralized basis to
unrelated exempt hospitals does not qualify for exemption under section
501(c)(3), such activities not qualifying as related/exempt activities.26
b. On the other hand, where an organization assisted unrelated educational
organizations in managing investment funds for fees that were “substantially” below
cost (e.g., covering only 15% of costs), the IRS has ruled that such organizations
are performing a charitable activity.27 In addition, an organization may be able to
point to specific facts and circumstances that cause a particular arrangement to be
excepted from unrelated trade or business status, as was the case in a recent
private letter ruling in which a section 501(c)(3) specialty hospital leased empty
hospital space to an unrelated section 501(c)(3) rehabilitation hospital in
circumstances benefitting its own patients and furthering its exempt purposes. 28
See TAM 9822004 (M arch 1998).
See B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978).
See HCSC-Laundry v. United States, 450 U.S. 1 (1981).
See Rev. Rul. 71-529, 1971-2 C.B. 234.
PLR 200016023 (January 21, 2000).
c. Significantly, if the exempt service provider organization is sufficiently
“related” to the exempt service recipient organization – through the equivalent of a
parent/subsidiary-type relationship – the support activities are not treated as an
unrelated trade or business but simply as a mere matter of accounting between
d. Although a detailed discussion is beyond the scope of this outline, it should
be noted that the characterization of the exempt service provider’s activities as
unrelated trade or business activities should be considered in evaluating the service
recipient’s qualification for tax-exempt bond financing under the private business
B. PARENT-TYPE AFFILIATIONS
1. Acquisition/Change in Sponsorship. Parent-type affiliations take various
forms. Where the parties contemplate that one exempt organization will in effect acquire
another exempt organization and assimilate it into its corporate structure as a continuing
organization, a relatively simple and direct format can be used. In this case, the “acquiror”
could become the functional parent of the “target” and thereby exercise control over the
target via traditional corporate lines, reserved powers, or a combination of both. For
example, the organizational documents of the target might be amended to provide that the
acquiror becomes the sole member of the target, has appointment and removal powers
over the target’s board of directors, has organizational document amendment powers, and
has reserved powers over specified matters related to the target.
Assuming that the equivalent of a parent/subsidiary relationship is established by the
affiliation, the analysis of such a transaction would typically focus on whether the affiliation
results in any material change in the activities of the participating exempt organizations.
Where the activities continue as before and the transaction otherwise furthers exempt
purposes, there should generally be no adverse exemption-related consequences.
2. New Parent Holding Company Affiliation. Another parent affiliation format is
one in which formerly independent exempt organizations form affiliations under a newly-
created centralized parent holding company, which exercises absolute structural and
financial control over the affiliated entities. In the FY1997 Exempt Organizations CPE
Textbook (“FY1997 CPE Text”), the IRS discusses several examples of this type of
transaction, one of which involved Northwestern Healthcare Network. 30 In that case, the
See, e.g., Rev. Rul. 77-72, 1977-1 C.B. 157 (indebtedness owed to a labor union by its wholly owned tax-exempt subsidiary is
not acquisition indebtedness within the meaning of section 514 since the parent -subsidiary relationship shows the indebtedness to be
merely a matter of accounting). See also Geisinger Health Plan v. United States, 30 F.3rd 494 (3rd Cir. 1994).
FY1997 CPE Text, pp. 133-134. See also PLR 9609012; PLR 9623011.
centralized entity had the following powers to establish its parental relationship over the
(1) Appoint and remove the members of the boards of the
(2) Approve amendments to the Articles or Bylaws of the
(3) Approve or disapprove withdrawal of subordinates from the
(4) Monitor and audit the subordinates to assure compliance with its
(5) Authority over asset transfers, overall budgets and strategic plans,
and capital acquisition strategies of the subordinates; and
(6) Direct or approve the mergers, acquisitions or affiliations of the
subordinates and their affiliates with other entities.
Based on the nature of the parent corporation’s activities and its structural and financial
control over the subordinates, the IRS recognized the entity’s exempt status under the
integral part doctrine.
From a tax standpoint, it is important to be able to establish that the holding company
affiliation establishes a sufficient degree of control by the holding company over the
subordinate entities. First, this generally facilitates the newly-created holding company’s
ability to establish its section 501(c)(3) exemption under the “integral part” doctrine.31
Second, such a control relationship prevents payments for goods and services and transfers
of assets/resources between the affiliated companies from constituting unrelated business
By way of background, if an organization does not independently qualify for section 501(c)(3) exemption, it may qualify if it
is an integral part of a section 501(c)(3) organization, provided it is not a feeder organization within the meaning of section 502.
According to the IRS, an otherwise properly organized and operated organization could derivatively qualify for exemption as an
integral part if (1) it performs essential services for an exempt organization and the services, if performed by the exempt organization
itself, would not be an unrelated trade or business, and (2) the exempt organization exercises sufficient control and close supervision,
based on all the facts and circumstances, to establish the equivalent of a parent and subsidiary relationship. FY1997 CPE Text, p. 133-
See IRS CPE Text, p. 134; Rev. Rul. 77-72, 1977-1 C.B. 157. As noted above, unrelated trade or business classification with
respect to such transactions may raise tax-exempt bond issues.
C. “VIRTUAL MERGERS”: JOINT OPERATING ARRANGEMENTS
In recent years, tax-exempt hospitals (in particular) have been pursuing joint operating
agreement (“JOA”) arrangements in an effort to integrate their operations without actually
transferring assets. This may be the result of contractual or lease restrictions on the transfer of
property and church-affiliated hospitals seeking to retain their unique religious character, among
other things. According to the IRS, the “hallmark” of the joint operating agreement type of
affiliation is that participating hospitals retain their separate identities, boards of directors, and a
certain amount of autonomy, even though considerable management and financial authority is shifted
to the governing body of the joint operating agreement (usually a non-profit corporation, LLC or
partnership that serves as the joint operating company). 33 Powers ceded to the governing body of
the joint operating agreement and powers reserved by the participating hospitals may be spelled out
in a variety of documents, including a joint operating agreement, a partnership agreement, articles of
incorporation, bylaws, or management contracts. Because a JOA is not a true merger, it is
sometimes called a “virtual merger”.
According to the IRS, joint operating agreements between or among previously
independent hospitals and hospital systems usually do not provide the control over subsidiary
boards and assets that is present through the “parent” affiliations described above. Consequently,
in evaluating JOA arrangements, the IRS has indicated that it will look for other “explicit
manifestations of control” so that dealings between the hospitals (or parts of the hospital systems
that are completely financially integrated) under the agreement are between organizations that are
the equivalent of a parent and its subsidiary and thus not unrelated trades or businesses. In
evaluating exemption issues associated with JOA’s, the newly-created joint operating company,
and the impact on the participating hospitals, the IRS will apply a facts-and-circumstances analysis
which does not rely strictly on the degree of structural control, or on any one factor. Although
certain factors will be more significant than others, the IRS analysis will look to a preponderance of
all the facts and circumstances that demonstrates significant control over management and financial
decisions which have been ceded by the participating entities to a governing body under the JOA
model.34 As with the parent-type affiliations discussed above, the matter of control is relevant for
purposes of unrelated business income tax, exemption and bond issues, among other things. The
See IRS CPE Text, p. 132.
Specific facts and circumstances identified by the IRS as providing the basis for a more flexible control analysis include: (1) the
delegation to the JOA governing body of significant authority over long range and day -to-day management decisions; (2) the degree to
which the JOA arrangement is permanent (key factors include significant penalties or other hindrances to terminating the agreement,
and dispute resolution processes); (3) the ability of the JOA body to initiate action rather than merely to veto actions taken by the
participating hospitals; and (4) reservation by the participating hospitals of certain authority (e.g., on ethical or moral issues) will not
preclude a finding that a parent-subsidiary relationship had been established as long as the other facts and circumstances demonstrated
that sufficient authority had been ceded to the JOA governing body. FY1997 CPE Text, pp. 134-137.
IRS has released a number of private letter rulings addressing JOA consequences with respect to
V. JOINT VENTURES: MARRIAGE IN PART
Some of the most important recent developments in exempt affiliative transactions have occurred in
the area of joint ventures, particularly those between tax-exempt and taxable organizations. These
transactions often seek to achieve the efficiencies and synergies of other types of consolidation transactions,
but may involve only a portion of each participant organization’s assets/operations.
A. BETWEEN EXEMPTS AND TAXABLES
See, e.g., PLR 200036049 (June 13, 2000); PLR 9804054 (February 2, 1998); PLR 9752064 (January 5, 1998).
Whenever a tax-exempt organization participates in a joint venture or partnership with for-
profit or private interests, the potential for impermissible private benefit or, if insiders are involved,
private inurement exists.36
1. Traditional IRS Analysis. The traditional IRS approach to analyzing whether an
exempt organization’s participation in such partnerships jeopardizes its exempt status has
been to apply the following two-prong test:
(1) Is the organization serving a charitable or other exempt purpose through
the partnership (the "Exempt Purpose Prong")? and
(2) If so, does the partnership arrangement permit the exempt organization to
act (A) exclusively in furtherance of the purposes for which exemption is
granted and (B) only incidentally for the benefit of the limited partners and
without impermissible private benefit or inurement (the "Private Benefit
Among other things, under the Private Benefit Prong, (a) the exempt partner should receive
distributions of partnership income at least in proportion to its capital contribution, and the
exempt partner’s share of the losses should not exceed its share of the total partnership
capital, (b) the partnership and the exempt partner thereof should charge fair market value
for all services and property provided or sold, and all loans made, by the partnership or
such exempt partner to the partners, the partnership or third parties, and (c) the partnership
should pay no more than fair market value rates or reasonable compensation for services,
property and funds provided or loaned to it by non-exempt partners or third parties. See,
e.g., Gen. Couns. Mem. 39005 (December 17, 1982); Gen. Couns. Mem. 39862
(November 22, 1991); Gen. Couns. Mem. 39732 ((May 19, 1988). See generally
Fontenrose & Rotz, "Update on Partnerships and Joint Ventures," IRS Exempt
Organization Technical Instruction Program for FY 1993, pp. 44, 51-55.
2. Rev. Rul. 98-15: Heightened Focus on Control. In 1998, the IRS promulgated
Rev. Rul. 98-15, 1998-12 I.R.B. 6, addressing issues that arise when tax-exempt
organizations participate in joint ventures with for-profit organizations. Described by the
IRS as a clarification of existing law, Rev. Rul. 98-15 evidenced a shift in analytic emphasis
that represents a change in the analysis of joint ventures involving exempt organizations and
Rev. Rul. 98-15 addresses the issues involved in joint ventures between tax-exempt
organizations and proprietary organizations by means of two examples. Each example
Note that in addition to inurement and private benefit questions, issues under section 4958 – the so-called “intermediate
sanctions” provisions – may be raised.
addresses a situation involving an exempt organization that owns and operates a hospital
facility and, seeking to enhance its operations, contributes substantially all of its hospital
assets to a limited liability company ("LLC") that is jointly owned by the contributing
exempt organization and a proprietary organization. The first example describes a joint
venture the elements of which result in favorable treatment for the participating exempt
organization, including continued tax-exempt status, continuing status as a publicly
supported organization under section 509 and a determination that income of the LLC
allocable to the exempt organization participant is not subject to the unrelated business
income tax ("UBIT"). The second situation results in adverse consequences for the
participating organization, including loss of tax-exempt status.
a. Situation 1. The exempt organization in Situation 1 contributes
substantially all of its hospital assets into an LLC that is jointly owned with a
proprietary organization. Each organization contributes property and/or cashto the
LLC and each participant's ownership interest in the LLC reflects the initial
contribution. The LLC is controlled by a five person governing board, three
members of which are appointed by the exempt organization and two members of
which are appointed by the proprietary organization. Appointees to the governing
board are community leaders none of whom have a conflict of interest that would
preclude their impartial service on the LLC's governing board. Amendment of the
LLC governing documents can occur only with joint approval of both the exempt
organization and the proprietary organization. The following actions require
majority board approval: (i) adoption of capital and operating budgets; (iii)
distributions of earnings; (iii) selection of key executives; (iv) acquisition or
disposition of health care facilities; (v) entering into contracts in excess of a
specified dollar amount per year; (vi) any change to the type of services offered at
the LLC's facilities; and (vii) renewal or termination of any management
The governing documents of the LLC require that it operate for charitable
purposes and that the pursuit of charitable purposes take precedence over the
pursuit of financial return. Income and loss of the LLC is distributed based on the
respective ownership interests of the exempt organization and the proprietary
organization. Day-to-day management of the LLC is delegated pursuant to a
management agreement to an unrelated third party management company. The
management agreement has a five-year term and is renewable only with the mutual
consent of the LLC and the manager. The management agreement is cancelable
for cause. No inducement was provided to the exempt organization's directors or
employees to approve the exempt organization's participation in the LLC and
distributions received from the LLC are used to fund other community health care
b. Situation 2. The facts in Situation 2 involve an exempt
organization that contributes substantially all of its hospital operating assets to an
LLC that is jointly owned with a proprietary organization. Each organization
receives an ownership interest in the LLC that reflects the value of their initial
capital contributions. The LLC is governed by a six person governing body, three
members of which are appointed by the exempt organization and three members of
which are appointed by the proprietary organization. Members of the governing
body are community leaders none of whom have a conflict of interest that would
preclude their impartial service on the governing board. Amendment of the LLC
governing documents can occur only with joint approval of both the exempt
organization and the proprietary organization. The following actions require
majority board approval: (i) approval of the annual capital and operating budgets;
(ii) distributions of earnings over a specified minimum; (iii) selection of key
executives; and (iv) approval of "unusually large" contracts.
Income and loss of the LLC is distributed based on the respective ownership
interests of the exempt organization and the proprietary organization. Day-to-day
management of the LLC is delegated pursuant to a management agreement to a
management company that is an affiliate of the proprietary organization. The
management agreement has a five year term and is renewable at the option of the
management company. The management agreement is cancelable for cause. No
inducement was provided to the exempt organization's directors or employees to
approve the exempt organization's participation in the LLC and distributions
received from the LLC are used to fund other community health care initiatives.
The chief executive officer and chief financial officer of the LLC were previously
employed by an affiliate of the proprietary organization and the acceptance of these
individuals as the initial chief executive officer and chief financial officer of the LLC
was required by the proprietary participant.
c. IRS analysis. The IRS examined the two fact scenarios to
determine whether (i) the exempt organization would continue to be recognized as
an organization described in section 501(c)(3), (ii) the exempt organization would
avoid private foundation status under section 509 and (iii) income of the LLC
allocable to the exempt organization would be subject to UBIT. Before addressing
those specific questions, however, the IRS addressed one fundamental question --
how or whether to attribute the activities of a pass through entity, such as an LLC,
to a participating exempt organization. Applying the aggregate theory of
partnership law, the IRS concluded that the activity of a pass through entity, such
as an LLC, should be attributed directly to any exempt organization participants.
As a result, the tax consequences for the exempt organizations under analysis
would be determined by treating the exempt organizations as engaged directly in
the activities of the LLCs.
Turning next to Situation 1, the IRS concluded that the exempt organization would
continue to be exempt, qualify as publicly supported (avoiding private foundation
status) and receive no unrelated business taxable income from the LLC. The IRS
focused on the language of the LLC organizational documents that required the
pursuit of charitable purposes and the elevation of that pursuit above the pursuit of
financial return. The dedication of joint venture activities to charitable purposes is
clearly a prerequisite to favorable tax consequences for an exempt organization
joint venturer. Next, the IRS focused on the exempt organization's ability to
govern, through its majority position on the governing board, and manage, through
its control over the management company, the LLC. The IRS concluded that the
LLC's purposes were dedicated to the pursuit of charitable activities and that the
exempt organization had sufficient governance and control rights to ensure pursuit
of charitable activities. As a result, the exempt organization continued to qualify
under section 501(c)(3). In reaching its conclusion that the exempt organization
would not be a private foundation, the IRS concluded that attribution of the LLC's
activities to the exempt organization would result in the exempt organization being
publicly supported, within the meaning of section 509. Specifically, the IRS
concluded that the exempt organization still qualified as a hospital under sections
509(a)(1) and 170(b)(1)(A)(iii). Finally, allocations of LLC income were not
subject to UBIT since the activity of the LLC was deemed to further charitable
Situation 2 was determined by the IRS to represent a fact situation that does not
support continued tax-exempt status for the exempt organization participant. In so
concluding, the IRS noted a number of differences between Situation 1 and
Situation 2. First, the organizational documents of the LLC in Situation 2 did not
require that the LLC operate in furtherance of charitable purposes nor did it
subordinate the pursuit of financial gain to charitable purposes. In addition, the
composition of the governing board, evenly split between exempt organization
appointees and proprietary organization appointees, did not ensure that the exempt
organization could enforce the pursuit of charitable activities. Moreover, the
governing board did not have approval over all major decision points, leavingmuch
of the governance of the LLC to the discretion of the management company. With
respect to management, the management company was not only a related party to
the proprietary organization, but the terms of the management agreement allowed
the management company to renew the arrangement unilaterally, eliminating much
of the exempt organization's ability to control the management function. Finally, the
presence of the chief executive officer and the chief financial officer, each of whom
were executives with an affiliate of the proprietary organization, contributed to
control of the LLC by individuals who, in the opinion of the IRS, were not sensitive
to the pursuit of charitable activities. Attributing the activities of the LLC to the
exempt organization participant, the IRS concluded that continued tax-exempt
status was not warranted.
3. The Redlands Decision. The position set forth by the IRS in Rev. Rul.
98-15 was vindicated, at least with respect to the analysis of Situation 2, with the
Tax Court’s recent decision in Redlands Surgical Services v. Commissioner,
113 T.C. 3 (1999). In the Redlands decision, the Tax Court denies recognition of
Redlands Surgical Services, Inc. (“RSS”) as an organization described in section
501(c)(3), concluding that RSS, organized to participate in a joint venture with a
proprietary organization in the ownership and operation of an ambulatory surgery
center, was not operated exclusively for charitable purposes because it operated in
a manner that conferred substantial private benefit upon the proprietary partner.
a. Facts. RSS is organized as a controlled subsidiary RHS
Corporation, an organization that is described in section 501(c)(3) that serves as
the parent corporation of Redlands Community Hospital, an organization described
in section 501(c)(3) that owns and operates inpatient and outpatient health care
facilities. RSS is a 46 percent general partner in Redlands Ambulatory Surgery
Center (“RASC”), with the remaining 54 percent general partnership interest
owned by Redlands-SCA Surgery Centers, Inc. (“RSCA”), a for-profit subsidiary
corporation of Surgical Care Affiliates, Inc., (“SCA”). SCA is a publicly traded
corporation that, among other things, owns and operates ambulatory surgery
centers. RASC, in turn, owns a 59 percent general partnership interest in a limited
partnership that owns and operates Inland Surgery Center, the ambulatory surgery
center at issue (“ISC-LP”). A 41 percent limited partnership interest in ISC-LP is
owned by physicians who practice in the service area. Day-to-day operations of
the surgery center are managed by SCA Management, another for-profit
subsidiary of SCA.
The facts in Redlands closely parallel the facts of Situation 2 set forth in Rev. Rul.
98-15, leading many to conclude that Situation 2 is a thinly disguised effort by the
IRS to boost its litigation position in the Redlands case. For example, the
governing body of RACS is composed of an equal number of representatives
appointed by RSS and RSCA. Certain reserved powers over the operations of
the surgery center are retained by the management committee of RASC, including
preparation of the annual budget, approving capital expenditures, establishing fees
for procedures performed, overseeing the services performed, hiring and firing the
manager of the surgery center and entering into insurance contracts for the surgery
center. As noted above, day-to-day management of the surgery center is provided
by SCA Management pursuant to a management agreement, the initial term of
which is 15 years with two additional five year renewal terms. Importantly, none of
the organizational documents for RASC or ISC-LP contain any language
acknowledging RSS’s intent to qualify as an organization described in section
501(c)(3) or requiring operation of the ambulatory surgery center in a manner that
would comply with the community benefit standard established for tax-exempt
hospitals in Rev. Rul. 69-545, 1969-2 C.B. 117. In addition, RSS agreed that
during the term of the joint venture, neither RSS nor Redlands Community Hospital
would construct or acquire an ownership interest in competing ambulatory surgery
facilities and Redlands Community Hospital agreed that it would not expand its on-
b. Tax Court Opinion. Echoing the conclusions of the IRS in Rev.
Rul. 98-15, the Tax Court concluded as follows:
“Petitioner has ceded effective control over the operations of the
partnerships and the surgery center to private parties, conferring
impermissible private benefit. Consequently, Petitioner is not
operated exclusively for exempt purposes within the meaning of
I.R.C. § 501(c)(3).
An organization does not operate exclusively for exempt purposes
if it operates for the benefit of private interest. The proscription
against private benefit encompasses not only benefits conferred on
insiders having a personal and private interest in the organization,
but also benefits conferred on unrelated or disinterested parties.
To the extent that Petitioner cedes control over its sole activity to
for-profit parties having an independent economic interest in the
same activity, and having no obligation to put charitable purposes
ahead of profit-making objectives, the court is lead to the
conclusion that Petitioner is not operated exclusively for charitable
In its opinion, the Tax Court carefully reviewed not only the proposed operations
of RSS but the actual operations of ISC-LP. Despite this close scrutiny, the Tax
Court was unable to find any meaningful evidence that the activities of RSS,
including the activities of ISC-LP which the Tax Court attributed to RSS, were
charitable. Nowhere in any of the relevant documents was the operation of the
ambulatory surgical center compelled to provide benefits to the community served.
Access to underserved portions of the patient population were neither required
nor actually provided. Moreover, RSS and Redlands Community Hospital were
unable to address those needs outside the context of the joint venture due to the
noncompete provisions. Combining the lack of commitment to charitable purposes
with RSS’s inability to initiate action at the joint venture level and the noncompete
provisions, the Tax Court concluded that the benefits to the for-profit parties were
significant and precluded a determination that RSS qualifies as an organization
described in section 501(c)(3). An appeal of the Tax Court’s decision is pending
in the Ninth Circuit.
4. Summary. The lesson to be learned from Rev. Rul. 98-15, and the Redlands
decision is the need for control by an exempt organization participating in a joint venture
with a proprietary organization over the joint venture's pursuit of charitable activities. To
ensure that the Rev. Rul. 98-15 and Redlands standard will be met, the joint venture
organizational documents should require the pursuit of charitable purposes and the exempt
organization participant should retain governance and control rights sufficient to ensure that
the pursuit of charitable purposes will continue. Finally, management of the joint venture by
a management company must occur pursuant to a management agreement that does not
shift control over the pursuit of charitable goals to the manager and is reasonable in length.
Beyond these general statements, it is difficult to know precisely what conclusions can be
drawn from Rev. Rul. 98-15 and the Redlands decision. For example, it is not clear
whether an evenly split governing board will pass muster if the organizational documents of
the joint venture entity commit the joint venture to the pursuit of charitable purposes and
amendments of the organizational documents require the consent of both the exempt
organization participant and the proprietary organization participant. Both the IRS and the
Tax Court expressed concern that the exempt organization participant could not force the
joint venture to initiate charitable programs. It is not clear from this statement whether that
concern reflects the lack of language in the organizational documents committing the joint
ventures to the pursuit of charitable purposes or a lack of majority governing board control
by the exempt organization participant. The applicability of Rev. Rul. 98-15 and the
Redlands decision to ancillary joint ventures, in contrast to joint ventures where the exempt
organization commits substantially all of its assets and operations, is equally murky.
Applying a strict standard, an exempt organization participating in an ancillary joint venture
faces, at best, the receipt of income subject to UBIT unless the provisions of the joint
venture require it to pursue charitable purposes and the exempt organization retains
governance and management rights sufficient to ensure the pursuit of such purposes.
Application of this standard is particularly difficult in the context of ancillary joint ventures in
which the exempt organization participant owns less than a 50 percent interest. Recent
comments by senior IRS officials indicate that Rev. Rul. 98-15 and Redlands will be
applied to all joint ventures involving exempt organizations and proprietary organizations,
not just whole hospital and similar joint ventures. Thus, the playing field, or at least the
UBIT analysis of joint ventures, appears to have shifted significantly.
B. BETWEEN EXEMPTS
Partnerships between only tax-exempt organizations do not involve the level of risk of
impermissible private benefit or inurement that exists in the case of exempt/taxable joint
ventures. Rather the primary focus is on whether the joint venture furthers the exempt
purposes of each of the exempt partners, so that the income derived from the partnership is
exempt from taxation. To the extent that an exempt organization is a partner in a
partnership that regularly carries on a trade or business that would constitute an unrelated
trade or business if directly carried on by the exempt organization, the organization must
include its share of partnership income and deductions in determining its unrelated business
income tax liability.37 On the other hand, if the partnership’s trade or business would
constitute a related trade or business if directly carried on by the organization, the
organization’s allocable share of income does not constitute unrelated business taxable
Section 512(c)(1); Treas. Reg. §1.512(c)-1. Again, note that the existence of unrelated trade or business classification may raise
tax-exempt bond issues.
John W. Leggett is a partner in the Houston office of Vinson & Elkins L.L.P., where he has
practiced since 1986, except for the period during which he served as Majority Tax Counsel to the U.S.
Senate Finance Committee in Washington, D.C., from 1990 through January, 1993. Mr. Leggett's primary
area of practice is tax law, with an emphasis on tax-exempt organizations and business transactions.
Mr. Leggett is a member of the Taxation Section of the American Bar Association and the
American Health Lawyers Association. He is a frequent speaker at various tax conferences and seminars,
including those sponsored by the American Bar Association, the University of Texas School of Law, Tax
Executives Institute, the Texas Society of Certified Public Accountants, and the Southwestern Legal
Foundation. Mr. Leggett has authored "Whole Hospital Joint Ventures With Taxable Entities Raise Tax
Questions For Exempts," Journal of Taxation of Exempt Organizations; "Physician Recruitment and
Retention by Tax-Exempt Hospitals," The Health Lawyer; and "Production Payment Tax Issues,"
Southwestern Legal Foundation 45th Annual Institute on Oil and Gas Taxation (Matthew Bender).
Mr. Leggett graduated from Texas A&M University with a B.B.A. in Accounting in 1983, and the
University of Texas School of Law, J.D., in 1986.