A charitable nonprofit may engage in a joint venture (JV) with a for-profit entity subject to some important limitations. It’s critical for nonprofit leaders to understand these limitations in contemplating and negotiating a JV to avoid jeopardizing its tax-exempt status, unlawfully diverting charitable assets, and conferring a prohibited private benefit on the for-profit and/or its owners. For an introduction to nonprofit joint ventures, see this early post from 2006.
The following principles apply where the nonprofit invests more than an insubstantial amount of its resources in a JV with a for-profit entity. For purposes of this post, we’ll use the term nonprofit to refer to a nonprofit corporation classified as a public charity, and the term charitable purpose to refer to all 501(c)(3)-consistent exempt purposes.
The first limitation is that the nonprofit’s participation and investment in the JV must further its charitable purpose. There may be several mission-related reasons underlying the nonprofit’s involvement, including: to access capital to increase the reach of the nonprofit’s services, to share risks associated with the activities of the JV, and to acquire expertise and/or access to networks offered by the for-profit co-venturer.
No Private Benefit
The second limitation is that the partnership arrangement must permit the nonprofit to act exclusively in furtherance of its charitable purpose and only incidentally for the benefit of its for-profit partner or owners of the for-profit. The nonprofit must have adequate safeguards to protect against prohibited private benefits. Thus, the benefits to the for-profit partner may only be incidental, quantitatively and qualitatively, to furthering the nonprofit’s charitable purposes.
A benefit is quantitatively incidental only if it is “insubstantial when viewed in relation to the public benefit conferred by the activity”.
A benefit is qualitatively incidental only if it is “indirect or unintentional” or is “a necessary concomitant of the activity which benefits the public at large” and “the benefit to the public cannot be achieved without necessarily benefiting certain private individuals.”
If all of the assets of the nonprofit are contributed to the JV (whole JV), the nonprofit should control a majority of the JV governing body (e.g., the right to appoint a majority of the JV board members) or at least 50% of the JV governing body with additional protections. For example, the following control provisions may serve to provide the nonprofit with adequate control:
- a requirement that the JV board’s actions must be approved by both a majority of the nonprofit-appointed directors and a majority of the for-profit-appointed directors,
- the nonprofit’s power to select and terminate the CEO,
- the nonprofit’s right to unilaterally dissolve the JV if the nonprofit’s participation threatens its 501(c)(3) status, and
- a provision in the JV agreement requiring the JV board members to give precedence to the goal of advancing the charitable purposes of the JV over maximizing profits or distributions to owners.
If not all of the assets of the nonprofit are contributed to the JV (ancillary JV), the nonprofit is not required to have control over a majority of the JV governing body. However, the nonprofit must have control over the charitable activities of the JV, even if the for-profit has control over the other JV activities.
Form of Entity
The decision on the form of the JV is critically important to get right from the nonprofit’s perspective. If the JV will be operating activities that would not be consistent with 501(c)(3), a pass-through entity, like an LLC, may be problematic both in exposing the nonprofit’s 501(c)(3) status and in creating unrelated business income tax (UBIT) liability which might not otherwise be present if the nonprofit were receiving dividends from a JV created as a C corporation. But for large nonprofits contributing a relatively insubstantial amount of its resources to a JV or a JV that will operate exclusively for charitable purposes, an LLC might be preferable.
Benefit corporations, social purpose corporations, and other so-called hybrid entities are all possible vehicles for housing a JV, and these corporations are taxable and are generally, by default, considered C corporations for federal tax purposes. Nonprofits may be interested in further protecting their charitable purposes and reputation by choosing a form of JV that allows for more of a mission anchor, particularly on an exit event. But that’s for another post.