Greenberg Traurig Alert
IRS Likely to Stop Litigation of Affinity Credit Card Cases;
Intermediate Sanctions Enforced
By Harry J. Friedman, Greenberg Traurig, Miami
View or download the PDF version of this Alert here.
IRS Loses on Affinity Credit Cards
In a recent case, Oregon State University Alumni Association, Inc., et al, v.
Commissioner, the 9th Circuit Court of Appeals affirmed a Tax Court decision
that income earned by two university alumni associations from affinity credit card
programs constituted royalties for Federal income tax purposes. As royalty income, the
affinity credit card revenues were not subject to unrelated trade or business income tax
("UBIT") as the IRS had urged. The 9th Circuits decision was
the latest in a series of taxpayer victories in cases brought by the IRS involving UBIT
and credit card issues (see GT Alert, April 1999.) The Court rejected the position of the
IRS that any services provided in connection with royalty income tainted the entire
transaction. The issue before the Court was whether banks had paid the associations for
the use of their names and trademarks or for promotional services. While the Court found
that there were some services provided, the value of the services was small in comparison
to the sums paid by the banks. The Court concluded that the payments were for the right to
use the associations names. At a recent conference, Marcus Owens, Director of the
IRS Exempt Organization Division, advised that he did not foresee any more litigation on
this issue. He suggested that the IRS may follow a "reasonable allocation"
methodology. Under this approach the payments made by a for-profit party would be
allocated between the services provided by the exempt organization, which would constitute
unrelated trade or business income, and payments for royalties, which would be treated as
tax exempt royalties. The 9th Circuits decision does not preclude this
The stakes are high for exempt organizations that engage in transactions utilizing
their ownership of intellectual property or other intangible rights. The content of the
agreement between the exempt organization and the for-profit party may be critical. The
agreement should place the financial risk on the for-profit party. In addition, the
arrangement must not constitute a partnership and the services provided by the exempt
organization should be limited. Agreements for such transactions should be examined
carefully to present the best case for royalty treatment.
IRS Enforcement Actions
A recent statement by Division Director Owens evidenced that the IRS is serious about
enforcement of Intermediate Sanctions. Section 4958 of the Internal Revenue Code, commonly
referred to as Intermediate Sanctions, provides for excise tax penalties in the case of
excess benefit transactions. Excess benefit transactions can arise where, for example, a
senior employee receives compensation that exceeds reasonable compensation for the level
of services provided by the employee. Another example is a deal where an exempt
organization overpays for property. Intermediate Sanctions only apply, however, when the
exempt organization deals with a "disqualified person," a person who is able to
exercise substantial influence over the organization.
When an excess benefit transaction occurs, the excise tax of 25% of the excess benefit
is imposed on the disqualified person. The disqualified person is also required to return
the amount of the benefit, or pay a penalty of 200%. The penalties are intended to provide
the IRS with a sword short of revocation of exempt status.
Owens reported that the IRS has recently imposed Section 4958 Excise Tax penalties
totaling more than $83 million on several organizations. In addition, a number of the
involved organizations were also penalized by revocation of their exempt status. Owens
advised that paying the excise tax penalties would not be enough. The IRS will want
assurances from the organization that the infraction that created the penalty will not be
repeated. One method of obtaining this assurance would be to involve the State Attorney
General. It appears that Owens believes the State Attorney General will bring in oversight
to ensure that the charities fiduciary obligations are met.
Owens statements highlight two issues. First, merely paying excise tax will not
itself suffice. The exempt organization will have to take some steps to ensure that future
violations do not occur. Secondly, imposition of excise tax penalties will not prevent the
loss of exempt status for the charities involved in excess benefit transactions. The
legislative history of Section 4958 indicates that loss of exempt status would be an
unusual circumstance, only to be imposed 2 where the excess benefit transaction was
egregious. The purpose of Intermediate Sanctions was to provide a mechanism for imposing
penalties on the wrongdoer, the disqualified person, without injuring the exempt
organization. In part, the concern was that loss of exempt status was too draconian and
was rarely invoked. Nevertheless, Owens report suggests that excise tax penalties
have not eliminated loss of exempt status as a result from similar transactions.
Exempt organizations should consider that penalty from an excess benefit transaction
may not simply be a penalty imposed on the disqualified person but still may bring the
exempt status of the organization into question. Transactions with disqualified persons
should be scrutinized carefully. Further, exempt organizations should consider compliance
with requirements that will shift the burden of proof of reasonableness to the IRS.
As we move into the year 2000, the issue of political activity by charitable
organizations will be highlighted. Section 501(c)(3) organizations are strictly prohibited
from political activity including endorsement of candidates, political contributions, or
otherwise intervening in a campaign in a partisan manner. Section 501(c)(3) organizations,
other than private foundations, may engage in lobbying activities, either before
legislatures or grass roots lobbying of individuals so long as the lobbying does not
become a substantial activity. In cases where churches have participated in campaigns by
endorsing particular candidates, the IRS has taken the step of revoking the their exempt
The Federal Elections Commission ("FEC") recently approved a voter education
project in which two tax exempt organizations operate a website containing information
about candidates for public office. The FEC ruled that the activity did not violate the
Federal Election Campaign Act.
Owens indicated in a speech on November 17, 1999, that he thought the reasoning behind
the FEC opinion was good. He suggested that the FECs position was similar to the
IRS stand on candidate debates, requiring that all legally qualified candidates be
given an opportunity to participate. Absence of bias in any publication of voter
information is critical in any activity involving a Section 501(c)(3) organization.
In the past, the IRS has been active during presidential election years to strictly
enforce the prohibition of political candidate endorsements by exempt organizations. If an
organization intends to engage in informational activities, these activities should be
reviewed for compliance with the IRS position. Section 501(c)(3) organizations must
avoid any partisan activity.
© 1999 Greenberg Traurig
This GT ALERT is issued for informational purposes only and is not intended
to be construed or used as general legal advice. Greenberg Traurig attorneys provide
practical, result-oriented strategies and solutions tailored to meet our clients’
individual legal needs.