COVID-19 update: A message from our partnersRead more
Many tax-exempt organizations allow for-profit entities to use the organization’s name or logo to market goods and services. Often, these agreements are structured as royalties because royalties are generally excluded from the definition of unrelated business taxable income (UBTI) by the IRS.
Unfortunately, the term “royalty” is not defined in the tax law. The regulations simply provide that whether a particular item of income is a royalty must be determined by the facts and circumstances of each case.
To be considered a royalty, a payment must generally relate to the use of a valuable intangible property right; a royalty does not include payments for personal services. Often, however, arrangements intended to qualify for the royalty exclusion include some level of service to be provided by the tax-exempt organization to the payor.
In issuing guidance, the IRS takes the position that providing what might be considered a relatively minor amount of services by the tax-exempt organization will preclude royalty treatment for the resulting income.
For example, in a private letter ruling in 1993, the IRS held that an organization was “directly and extensively involved” in an insurance program when it published advertisements for the insurance company in its magazine, granted the company a one-time access to its members, and permitted representatives of the insurance company to attend its board meetings and meet informally with members. The IRS concluded that the services provided precluded the exclusion from UBTI as a royalty.
The IRS later addressed a tax-exempt organization that engaged a marketing firm to arrange with corporations to make cash payments to the organization in return for the use of its name and logo. In some of the agreements, the corporations also obtained the right to place advertisements in the organization’s publications.
The IRS concluded that the payments were income from an unrelated trade or business, but were excluded from UBTI under the royalty exception. However, the payments attributable to advertising in the organization’s program were subject to UBIT and were not excludable royalties. This memorandum illustrates that a payment may be considered a royalty whether the amount of the payment is a flat fee or calculated as a percentage of sales.
More recent issues involved “affinity credit card” cases where organizations (often colleges and universities or their alumni organizations) received payments from banks or credit card companies for the use of their logos and mailing lists.
The banks and credit card companies used these in the marketing of credit cards to alumni. The IRS litigated a series of cases, taking the general position that any services provided by the organization to the banks or credit card companies took the payment out of the royalty category and resulted in UBTI.
The courts rejected the IRS’s “all or nothing” approach in these series of cases. In a case involving the Oregon State Alumni Association, the court stated the royalty exclusion cannot be an all-or-nothing proposition. The Commissioner is no more right, that even a little bit of service taints all the royalties, than the nonprofit association was right in Sierra Club, that it does not matter how much of the money results from services rather than passive licensing of a name. In this case, the Commissioner has not sought allocation, so we have no occasion to consider whether allocation would be appropriate in this or other cases.”
In light of this language, where there is some level of service provided by the tax-exempt organization to the payor, it may be advisable to allocate between the royalty and non-royalty portion of the payment when structuring royalty agreements.
Similarly, for-profit entities may pay a fee to sponsor – or have their name associated with – events conducted by the tax-exempt organization.
Depending on how these arrangements are structured, the resulting payments may subject the tax-exempt organization to the unrelated business income tax (UBIT). Soliciting and receiving qualified sponsorship payments is not an unrelated trade or business and the payments are not subject to UBIT.
A qualified sponsorship payment is any payment for which the person will receive “no substantial benefit” other than the use or acknowledgment of the business name, logo, or product lines in connection with the tax-exempt organization’s activities.
However, advertising the sponsor’s products or services is a separate transaction that may be subject to UBIT. Similarly, providing facilities, services or other privileges (for example, complimentary tickets or receptions for major donors) to a sponsor in connection with a sponsorship payment does not affect whether the payment is a qualified sponsorship payment. Instead, providing these goods or services is treated as a separate transaction in determining whether the organization has unrelated business income from the event.
Generally, if the services or facilities are not a substantial benefit or if providing them is a related business activity, the payments will not be subject to UBIT. If part of a payment would be a qualified sponsorship payment if paid separately, that part is treated as a separate payment. For example, if a sponsorship payment entitles the sponsor to both product advertising and the use or acknowledgment of the sponsor’s name or logo by the organization, then UBIT does not apply to the part of the payment that is more than the fair market value of the product advertising.
Both royalty and sponsorship agreements often may be structured to avoid UBTI implications. In reviewing such agreements, the fact that they may be labeled as “royalty” or “sponsorship” agreements by the parties is not controlling for tax purposes.
The key in analyzing the potential UBTI consequences of these agreements is to understand what the payor is receiving in exchange for the payment and how any return benefits to the payor impact the potential tax consequences.