Greenberg Traurig Alert

IRS Likely to Stop Litigation of Affinity Credit Card Cases;
Intermediate Sanctions Enforced

December 1999
By Harry J. Friedman, Greenberg Traurig, Miami Office

  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 9^th 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 9^th Circuit’s 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 9^th Circuit’s decision does not preclude this approach.

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.

Political Activities

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 status.

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 FEC’s 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