The New Economics of Exempt Organizations

By Bruce M. Bird and Mark A. Segal

In Brief

With Careful Planning, UBIT Can Be Avoided

The significant growth in the number of organizations exempt from federal income taxation has heightened competition for charitable contributions, the traditional source of revenue for exempts. Managements of exempt organizations have extended their fundraising efforts to sponsorship and affinity programs in order to obtain adequate resources to support exempt activities. The growth of the exempt sector has motivated taxpayers concerned that exempt organizations could unfairly compete with their businesses. The IRS has scrutinized the activities of exempt organizations to determine their taxability.

With careful planning, these sponsorships and affinity programs can be structured to avoid the unrelated business income tax (UBIT). The authors trace recent developments in determining whether certain revenues constitute exempt royalties or taxable income.

Organizations satisfying certain IRC criteria qualify for tax-exempt status; however, these organizations remain subject to taxation on net earnings unrelated to their exempt purpose. In cases where unrelated business activities grow to a substantial level, the IRS may either initiate revocation of the exempt status or compel the spin-off of the activity into a taxpaying entity. Subjecting tax-exempt organizations to taxation when they enter the commercial realm has long been an objective of both the IRS and the taxable enterprises against which exempt organizations compete.

The IRS closely examines arrangements between tax-exempt organizations and other parties to determine whether the amounts received should be subject to the unrelated business income tax (UBIT). Disputes have arisen over the classification of some revenues: Should they be treated as excludable royalties or unrelated business taxable income (UBTI)? Environmental organizations, universities, and churches all have fallen under scrutiny, as the IRS focuses on revenues generated by advertising and mailing list rentals, as well as life insurance, credit cards, and other affinity products. More recently, exempt organizations have explored using the Internet to raise money.

Unrelated Business Taxable Income or Excludable Royalty?

At the core of the dispute between the IRS and exempt organizations is whether a revenue stream derives from unrelated business taxable income or from an excludable royalty not subject to taxation. The principal sources governing the treatment of unrelated business taxable income are IRC sections 511513 and the regulations thereunder. UBTI refers to the gross income from any unrelated trade or business regularly carried on by a tax-exempt organization, less the allowable deductions directly connected with the carrying on of such trade or business [Both gross income and deductions are computed with the modifications provided in IRC section 513(b)].

The analysis to determine whether an exempt organization's revenue-producing activity is subject to UBIT consists of three steps:

* Is the activity a trade or business?
* If yes, is the activity regularly carried on?
* If yes, is the activity not substantially related to the exempt purpose of the organization?

The answers to all these questions must be "yes" in order for the revenue from the activity to be subject to UBIT. A "no" answer to any of the three questions indicates that the revenues for that activity will not be subject to UBIT.

For the purposes of IRC section 513, the term "trade or business" has the same meaning as in IRC section 162 [(Treasury Regulations section 1.513-1(b)]. A trade or business generally includes any activity carried on for the production of income from the sale of goods or the performance of services. In addition, to be considered a trade or business, the activity must be conducted with some frequency and regularity [Treasury Regulations section 1.513-1(c); see also United States v. American College of Physicians v. Comm'r, 475 U.S. 834 (1986)].

The facts and circumstances must be examined to determine whether an activity is substantially related to the organization's exempt purpose. In making this determination, the controlling factor is the activity itself and its connection with the exempt purpose, rather than the utilization of revenue.

According to Treasury Regulations section 1.513-1(a), a trade or business is related to the exempt purpose only where the activity has a substantial causal relationship to the achievement of the exempt purpose (other than through the production of income). In contrast, IRC section 512(b)(2) expressly excludes royalties from the taxation of unrelated business income. However, neither the IRC nor the Treasury regulations defines "royalties" in this context.

The "Regularly Carried on" Requirement

In National Collegiate Athletic Association v. Comm'r [92 TC 456 (1989)], the Tax Court ruled that revenue received from program advertising by the NCAA constituted unrelated business taxable income. The NCAA contracted a publisher to print and publish the program for the 1982 Final Four men's basketball games. At trial, the NCAA conceded that advertising contained in the program was a "trade or business" not "substantially related" to its exempt purpose.

The Tax Court's analysis of whether the NCAA "regularly carried on" its program advertising examined Treasury regulations section 1.513-1(c), which indicates that "the frequency and continuity with which the activities productive of the income and the manner in which they are pursued" should be considered. The Treasury regulations also indicate that the normal time span of the particular activity should be considered, along with a determination of whether the length of time alone suggests that the activity is carried on regularly or intermittently.

If the activity is "of a kind normally conducted by nonexempt commercial organizations on a year-round basis, the conduct of such [activity] by an exempt organization over a period of only a few weeks does not constitute the regular carrying on of a trade or business." For example, a hospital auxiliary's operation of a sandwich stand for two weeks would not be considered a "regularly carried on" activity, whereas its operation of a parking lot every Saturday would be considered such an activity. Nevertheless, if the activity is "of a kind normally undertaken by nonexempt commercial organizations only on a seasonal basis, the conduct of such [activity] by an exempt organization during a significant portion of a season ordinarily constitutes the regular conduct of a trade or business."

To determine the time span of the activity, the Tax Court considered the business of selling advertising space and decided that, for the purposes of determining whether the organization "regularly carried on" the business of selling program advertising, the program publisher's activities should be attributed to those of the exempt organization. Because the NCAA failed to show that the services it received from the program publisher were intermittent activities conducted without the competitive and promotional efforts typical of commercial activity, the Tax Court held that the NCAA had engaged in the "trade or business" of selling advertisements and subjected its program advertising revenue to the UBIT.

The NCAA appealed the Tax Court's decision to the U.S. Court of Appeals, Tenth Circuit [NCAA v. Comm'r, 914 F2d 1417 (1990), 92 TC 456 (1989)]. In examining whether the NCAA's advertising was a seasonal or a year-round business and whether it was intermittent, the appellate court noted that the publication of paid advertising is a trade or business generally conducted on a year-round basis. The appellate court did not accept the Tax Court's holding that the publisher's activities should be attributed to the NCAA. In addition, the appellate court rejected the Tax Court's holding that the amount of preliminary time spent to solicit advertisements and prepare them for publication was relevant to the "regularly carried on" determination.

The appellate court noted that the next step of the analysis in Treasury Regulations section 1.513-1(c) would be to determine whether activities that are intermittently conducted are nevertheless "regularly carried on" because of the manner in which they are pursued. Activities that an exempt organization engages in only discontinuously or periodically will be considered "regularly carried on" if they are conducted with the competitive and promotional efforts typical of commercial efforts. As an example of an activity not characteristic of a commercial endeavor, the regulations refer to "the publication of advertising in programs for sports events or music[al] or drama[tic] performances." The appellate court held that, because the advertisements at issue were distributed over a time span of less than three weeks for an event that occurred only once each year, the advertising activities were not "regularly carried on."

Excludable Royalties

Whether income is a royalty depends on facts and circumstances, and the taxpayer bears the burden of proof [Texas Farm Bureau v. Comm'r, 75 AFTR2d 95-2323 (1995); Rule 142]. A royalty is a payment for the right to use valuable property, not a payment for services rendered by the owner of the property.

In Sierra Club v. Comm'r [TC Memo 1993-199 (1993). See also 103 TC 307 (1994), reversed and remanded in part by 86 F3d 1526 (1996, CA9)], the IRS argued that income derived from Sierra Club's participation (allowing its trade name, trademarks, and mailing list to be used in bankcard soliciting and credit card affinity programs) should be UBTI.

The Tax Court held that the amounts received by the Sierra Club were largely passive in nature--not from a trade or business--because its involvement consisted mainly of cooperating with the bank card company by soliciting and encouraging its members to use the credit card. The Sierra Club had no obligation for any costs. Accordingly, the Tax Court held that, because the revenue received was from the use of an intangible that involved neither a sale nor a service, it constituted a nontaxable royalty. (The Tax Court also noted that the lack of contributory service or alternate capital indicated that it was not a joint venture or partnership.)

The IRS appealed the Tax Court's decision to the Court of Appeals, Ninth Circuit (86 F3d 1526), which upheld summary judgment on the bank card solicitation arrangement but reversed summary judgment on the credit card affinity program. On this issue, the appellate court remanded the case to the Tax Court and indicated that it was necessary to look further into whether the amounts received should be considered payment for services rendered or passive income.

On remand, the Tax Court again ruled that the revenue from the credit card arrangement constituted excludable royalties (103 TC 307) because, in the court's opinion, Sierra Club received not payment for services, but payment for the use of its trade name, trademark, and mailing list. Because these were intangible assets, the amounts received came from a licensing arrangement and, therefore, constituted royalties.

In Mississippi State University Alumni Inc. v. Comm'r (TC Memo 1997-37), an exempt organization successfully structured its credit card affinity program so that the income received from it was excludable as royalty income. The alumni association provided the use of its name, letterhead, executive director's signature, membership list, and university's trademark to a bank in exchange for payments to the alumni association based upon the number of card transactions, membership fees, and annual fees paid by cardholders to the bank (TC Memo 1997-39).

The Tax Court reviewed the actions of the alumni association to decide whether the fees were rendered for the use of intangible property or for services and held that the activities were almost entirely limited to 1) giving the bank access to intangibles, 2) providing some direct membership-related benefits such as alumni messages on cardholder statements and indirect benefits such as increased advertising in a newsletter, and 3) protecting membership goodwill by reviewing mailings and responding to occasional inquiries. The court held that the services provided by the alumni association were minimal. Consequently, the payments constituted royalties.

The Tax Court decision in Common Cause v. Comm'r [112 TC 332 (1999)] clarified whether an amount should be classified as a royalty or a receipt derived from a trade or business. The case involved an IRC section 501(c)(4) organization that maintained a master list from which it derived a rental list. A third party stored and maintained the list of names and related data. A "listing broker" could promote, solicit rentals of, and rent the list under the conditions that Common Cause could adopt appropriate measures to protect the value of the list and to deny uses that conflicted with the organization's values. The IRS argued that amounts derived from this arrangement constituted UBTI, claiming that the storage company and the listing broker were agents engaged in a rental business.

The IRS and Common Cause agreed to follow the definition of "royalty" set forth under Revenue Ruling 81-178, which indicated that a payment merely for the use of "symbols, signatures, and the likeness of its members" to promote products does not constitute unrelated business taxable income. To constitute a royalty, the payment must be received for the use of a valuable property right, not for the rendering of personal services [112 TC No. 27 (1999].

In Common Cause, the Tax Court reviewed the Disabled American Veterans decision [Disabled American Veterans v. Comm'r (DAVII), 94 TC 60 (1990), 942 F2d 309 (1991). See also Disabled American Veterans, 227 Cl. Ct. 474, aff'd 704 F2d 1570 (Fed. Cir.)], in which the Court of Claims found that amounts received for mailing lists did not constitute a nontaxable royalty. A decisive factor was that Disabled American Veterans provided all of the list management and list fulfillment services, pushing its activities beyond the scope of a royalty and into that of an unrelated business.

In resolving this issue, the Tax Court noted that precedent had established that certain activities to exploit and protect the intangible were permissible without changing the characterization of the amount received from a rental royalty to a receipt for services: An owner may supervise the advertising, marketing, and quality of a product that bears the owner's trade name [Lemp Brewing Company v. Comm'r, 18 TC 586 (1952)]or a credit card program that bears the owner's name (Mississippi State). Through its review of the marketing and the use of the mailing, Common Cause did nothing at odds with established precedent.

The Tax Court also rejected the IRS contention that IRC section 513(h) made the mailing list rental subject to tax as unrelated business income. Although Common Cause was governed by prior law, IRC section 513(h) subsequently provided that certain distributions of low-cost articles without obligation to purchase and exchanges and rentals of mailing lists by a nonprofit organization are not subject to the UBIT rules. The court quoted the legislative history of IRC section 513(h):

No inference is intended as to whether or not revenues from mailing list activities other than those described in the provision, or from mailing list activities described in the provision, but occurring prior to the effective date, constitute unrelated business income.

Recently, in the consolidated cases of Oregon State University and University of Oregon Alumni Association [Oregon State University and University of Oregon Alumni Association v. Comm'r, consolidated cases at 193 F3d 1098 (9th Cir. 1999)], the Ninth Circuit held that amounts received from an affinity card program did not constitute UBTI. In reaching its decision, the court noted that the services attributable to the organizations were minimal to the amounts received and centered its analysis on identifying the source of the receipts. Nevertheless, this decision contains dicta that a portion allocable to services--the rendering of 50 hours of administrative services--could have been classified as unrelated business income by the IRS had it not sought to classify the entire amount as such.

Advertising vs. Sponsorship

1993 proposed regulations. Prior to the 1997 adoption of the corporate sponsorship rules under IRC section 513(i), the IRS issued Proposed Regulations sections 1.512(a)-1 and 1.513-4 (1/22/93) that focused on the nature of the services provided by the exempt organization rather than the benefit received by the sponsor. These proposed regulations distinguished "advertising" from "acknowledgment" of a sponsor's payment. Advertising was defined as material that is "broadcast or otherwise transmitted, published, displayed, or distributed" and "promotes or markets any trade or business, or any service, facility, or product." Advertising revenues are an unrelated trade or business activity for an exempt organization. Acknowledgments, however, merely recognize a sponsor's payment or identify the sponsor, and the receipt of payments for acknowledgments does not result in UBTI. Acknowledgments include: sponsor logos and slogans that do not contain comparative or qualitative descriptions, locations and telephone numbers, value-neutral descriptions involving displays or visual depictions, and sponsor brand or trade name and product or service listings.

The proposed regulations contained a "tainting rule": If any activities, messages, or programming material constituted advertising, then all related activities, messages, or programming materials that might otherwise be acknowledgments also would be considered advertising.

In addition, the proposed regulations clarified that the rules regarding corporate sponsorship apply uniformly to all sponsorship activities--broadcast or nonbroadcast--and, unless otherwise expressly stated, without regard to the local nature of the organization or the amount of the sponsorship payment. In addition, the rules do not apply to qualified convention and trade show activities or to the sale of advertising in exempt organization periodicals.

IRC section 513(i). The Taxpayer Relief Act of 1997 created IRC section 513(i), which provides that "qualified sponsorship payments" are not subject to UBIT. IRC section 513(i) defines qualified sponsorship payments as those made by a person engaged in a trade or business where there is no arrangement or expectation that any substantial return benefit will be received. In this regard, the use or acknowledgment of the payer's name or logo (or product lines) as it relates to the exempt organization's activities is permitted.

Unlike the 1993 proposed regulations, IRC section 513 has no "tainting rule." Where a payment represents both sponsorship and advertising and a portion of it, if made separately, would constitute a qualified sponsorship payment, then that portion would not be subject to UBIT.

The legislative history of IRC section 513(i) indicates that the use of a sponsor's promotional logos or slogans does not by itself constitute advertising. In addition, the display or distribution, whether for free or remuneration, of a sponsor's products by either the sponsor or the exempt organization to the public at a sponsored event is not considered advertising. By its terms, IRC section 513(i) does not apply to qualified convention and trade show activities or to the sale of an acknowledgment or advertising in exempt organization periodicals.

New proposed regulations. On February 20, 2000, the IRS issued new proposed regulations (REG-209601-92, 2/29/00) to amend the 1993 proposed regulations sections 1.512(a)-1 and 1.513-4 and provide guidance in the area of corporate sponsorship. The 2000 proposed regulations define the phrase "substantial return benefit" to mean any benefit other than the use or acknowledgment of the payer's name or logo in connection with the exempt organization's activities or certain goods or services that have an insubstantial value under existing IRS guidelines. Goods or services have an insubstantial value only if they have a fair market value of the lesser of 2% of the payment or $74 (adjusted for inflation).

The new proposed regulations clarify that sponsored events within the scope of the IRC section 513(i) safe harbor may be a single event, a series of related events, an activity of extended or indefinite duration, or continuing support of an exempt organization's operation. Moreover, the sponsored activity does not have to be substantially related to the organization's tax-exempt purpose.

Under the new proposed regulations, an exempt organization is permitted to enter exclusive sponsorship arrangements; however, payments attributable to an exclusive provider arrangement will be treated as unrelated business income. In an exclusive provider arrangement, an exempt organization agrees, in return for payment, that products or services that compete with the payer's products or services will not be sold or provided in connection with one or more of the organization's activities.

IRS memorandum. The IRS Exempt Organizations Division has decided not to litigate certain affinity credit card and mailing list rental programs [IRS Internal Memorandum (12/16/99). See also News-Federal, 2000 Taxday, 03/09/2000, Item 1.9]. The IRS recognized that it has litigated and lost every decision but one on this issue: The sole exception involved a tax-exempt organization that had provided extensive services in connection with its mailing list rental program [94 TC 60 (1990)]. Therefore, the IRS has conceded the issue for situations where the exempt organization provides minimal services but will look to litigate cases where the exempt organization provides extensive services or where a good case can be made for allocating the payments between the services provided and the intangibles, an approach consistent with the dicta in Oregon State.

Exempt Organizations and the Internet

Many exempt organizations are engaged in revenue-generating activities involving the Internet. Their websites contain advertising or sponsorship activities on behalf of for-profit businesses (e.g., banners, hyperlinks, promotional communications, and sponsorship acknowledgements), and the revenue generated takes many forms. For example, through its hyperlink to a for-profit business, an exempt organization may receive a flat fee, a fee based upon the number of "hits", a fee based upon the percentage of the for-profit's sales of related merchandise, or a fee based upon the percentage of the for-profit's sales of all merchandise. Alternatively, revenue received from Internet activities may be the result of an exclusive sponsorship or provider arrangement.

Determining whether certain Internet-related activities generate unrelated business income requires examining relevant legislative, administrative, and judicial sources in the tax law. Unfortunately, current tax law provides little direct guidance. For example, the 2000 proposed regulations explicitly do not address the Internet activities of exempt organizations as they relate to corporate sponsorship payments. Both the IRS and the Treasury Department, however, are reviewing the application of existing laws governing exempt organizations, including the UBIT rules, to Internet activities. In addition, they have requested comments on the application of the rules governing trade shows and periodicals [IRC section 513(i)(2)(B)(ii)] to websites, and on whether a link to a sponsor's website should be treated as advertising.

In structuring Internet-related activities, exempt organizations will typically be required to make analogies from traditional fact situations. For example, assume that the website for an exempt organization committed to preserving the environment contains a hyperlink to another portion of its own website in which an online consumer can purchase an audiotape of a recent speech denouncing the clear-cutting of old growth forests. Given the ubiquitous nature of the Internet, this activity would appear to be a "regularly carried on" trade or business under existing law. However, because the content of the audiotape contributes to the organization's exempt purpose--preserving the environment--the payments received should be excludable.

On the other hand, how should revenue from a second hyperlink connecting a potential consumer from the exempt organization's website to that of a for-profit retailer of audiotapes, videotapes, and books be treated? What if the consumer could purchase items related to, or unrelated to, preserving the environment? Under existing law, it would appear that an exempt organization could structure the receipt of certain payments as royalties excludable from its unrelated business income. The hyperlink contacting a for-profit business should not, in and of itself, constitute advertising. Nevertheless, the exempt organization must be vigilant to ensure that it does not provide more than insubstantial services to the for-profit business.

It would also appear that a website for an exempt organization could contain a sponsorship statement consistent with IRC section 513(i) if the payer does not receive any "substantial return benefit" in exchange for the sponsorship statement. The 1993 proposed regulations contain helpful distinctions between acknowledgments and advertising.

For many exempt organizations, the brave new world of the Internet brings with it the promise of generating significant supplemental sources of revenue at a minimal cost. In this regard, however, their expanded Internet presence may also attract IRS scrutiny.

Bruce M. Bird, JD, CPA, is a professor at the Richards College of Business, State University of West Georgia, Carrollton, and
Mark A. Segal, JD, LLM, CPA, is a professor at the College of Business and Management Studies, University of South Alabama, Mobile.

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