Revenue Sharing and a Further Observation on OpenAI’s Joint Venture
I am still trying to come to a conclusion on whether OpenAI should retain its tax exemption after entering a “whole hospital” joint venture with Microsoft and other private investors by which those investors receive a profit share “capped” at something like 100 times their initial investment. The joint venture, by the way, is on track to realize nearly $2 billion in revenues this year. And the insiders are in line to collect some of the “profit” — profit measured by whether the insiders think more or less revenue ought to go towards the charitable mission. The fewer revenues devoted to the charitable cause, the more profit for everybody, including the insiders. Even Stevie Wonder can see the problem here. And yet, its not an easy question whether as a normative matter, there is too much private profit going on for tax exemption.
Last week, the Service released PLR 202352021 (Oct. 4, 2023). Here are the simple facts:
You are incorporated in the State of B on C for the purpose of adding value to people’s lives. You are formed to provide education on the D that is depicted in the book E, a book that was published by the director of the organization. Your board of directors is comprised of only yourself. You accomplish your purpose by providing free audio podcasts to the public along with sessions via the internet. You are getting financial support from the sole director of the organization and the sale of books. You also create music for individuals for a fee along with giving the buyer commercial rights. You pay the creator of the music for their services. You provide compensation to your director based off the organization’s revenue. You compensate the director in two different ways. You have the Introductory compensation where the director can receive a percent of the revenue brought by their introductory efforts. You also have the Affirmative compensation [and] there are tiers to this compensation structure. Your first tier is determined by an internal estimate by leadership. Your second tier is a performance bonus based off the first tier that can be changed by leadership. Your third tier is the same structure as the second tier.
The analysis goes through some pretty mundane decisions — Better Business Bureau, and est of Hawaii, for example — and rulings before concluding that the organization does not qualify for tax exemption. Here is what the PLR says about revenue sharing:
Rev. Rul. 69-383 held that a hospital that enters into an arms-length agreement with a specialist for compensation based on a fixed percentage of the departmental income doesn’t jeopardize its exempt status under IRC Section 501(c)(3). The ruling found that the agreement wasn’t a way of distributing the hospital’s net earnings to the radiologist, and since the radiologist was getting a percentage of gross revenues- as opposed to net revenues- the transaction wasn’t considered a joint venture.
And in that regard, the ruling states, “you are similar to Rev. Rul. 69-383 by compensating the director of the organization based on revenue. However, you are dissimilar to Rev. Rul. 69-383 by compensating the director based on net revenue.” Its these simple rulings that help us figure out the complex cases. I will be talking about Open AI tomorrow at AALS and my macro-thinking has evolved since I first wrote a draft article.
The prohibition against private inurement cannot mean that insiders cannot profit from their charity in the strict economic or accounting sense. Because the market runs on profit. Capitalism cannot function otherwise. Every service provider profits from their labor for a charity. We work to earn profit and the law allows charities to pay that profit, even to insiders. That’s why the private inurement and excess benefit transactions allow payment of reasonable compensation for services and fair market value for goods. Reasonable compensation and fair market value are concepts that exclude profit. So the law actually allows payment of profit, it must because all vendors operate for profit. Nothing is accomplished without a charity paying somebody profit.
I think the profit prohibitions — private inurement and private benefit — serve two other functions. They enforce a fiduciary’s duty of loyalty. Thus, an insider does not engage in private inurement despite a clear conflict of interest, if the transaction meets what business law calls the “overall fairness” test. In the absence of a conflict, we need not be concerned. And the private benefit prohibition enforces the fiduciary duties of due care and good faith. Private benefit occurs when trustees don’t do their homework and as a result make a decision or enter a transaction for which stockholders would be entitled to get beyond the business judgment rule.
There is a huge conflict in the OpenAI joint venture. The insiders are sharing in “profit” (through a fairly transparent profit sharing plan in the joint venture). Profit that increases or decreases by insiders’ decisions regarding how much of the earnings should be devoted to the charitable mission. Does that prove private inurement? Not yet. The Service once said that revenue sharing was private inurement per se but has since thought that position too much. Still the presence of the conflict is enough to place the burden of proving “entire fairness” on the insiders. And certainly, the amount to be paid by profit sharing arrangement, the variability of which is controlled by the insiders, is a factor to determine entire fairness. The Service still has not adopted revenue sharing regulations under IRC 4958 yet, by the way. But those regulations ought to be very suspicious about a revenue sharing plan that allows insiders to increase “profit” from which their compensation is determined by decreasing costs (i.e., charitable spending) any way they feel like it.
darryll k. jones