Greenberg Traurig Alert

Increased IRS Scrutiny of Exempt Organization Revenues

October 1998
By Harry J. Friedman, Greenberg Traurig, Miami Office

  View or download the PDF version of this Alert here.

Jay Rotz, executive assistant to the director of the Exempt Organization Division of the IRS, recently addressed a conference of association executives on unrelated trade or business income ("UBIT") issues. Revenues that constitute UBIT are subject to federal and state corporate income taxes at the same rate as revenues of for-profit corporations. The exempt status of an exempt organization that has substantial UBIT may be in jeopardy. Exempt organizations should be aware of the interest of the IRS in reviewing the sources of revenues and the activities of the organization required to earn them. The tax-exempt community has in recent years been entering into various transactions that present more complex UBIT issues than in the past. The IRS has responded by scrutinizing activities more closely. The treatment of corporate sponsorships, initially highlighted by the IRS’s attempt to tax the Cotton Bowl on payments received from Mobil Oil as the title sponsor of the annual football game, thwarted only by an outcry from Congress and the enactment of legislation, evidences this trend.

Rent a Mailing List Plus Services Creates UBIT

Rotz told the conference that the IRS is continuing to look for cases to litigate in which exempt organizations have agreed to provide personal services as part of agreements with for-profit entities to pay royalties to the exempt organization. The addition of personal services to an agreement to use the name or logo of an exempt organization can change exempt royalty income into UBIT. Rotz indicated that the IRS is presently litigating six cases involving the issue of whether income treated by an exempt organization as a royalty constituted UBIT and has at least 70 open cases at the administrative level.

The treatment of income earned by exempt organizations from renting mailing lists and from contracts for the issuance of affinity credit cards has been a subject of substantial litigation. In the case of mailing lists, Rotz indicated that if the exempt organization markets its mailing list, the organization moves closer to providing personal services in connection with the rental of the list.

University alumni associations have been involved in a number of judicial decisions that address the treatment of payments from financial institutions in connection with affinity credit card programs. While the IRS has lost a number of these cases, the IRS continues to challenge the treatment of revenues from these contracts as exempt royalty income. As in the case of mailing lists, participation by the exempt organization in the revenue producing activity changes the treatment of the revenues. Rotz indicated that one of the factors the IRS considers is whether the financial institution or the exempt organization produced the solicitation materials sent to persons affiliated with the exempt organization.

One question that has been unanswered is whether royalty agreements may be split into two agreements, one to provide for the use of the organization’s name or logo, and the second to provide personal services. The UBIT taint would apply only to the income related to the personal services. Revenues earned strictly in connection with the licensing of the exempt organization’s name or logo would be exempt. This bifurcation of the transactions may be a method of preserving tax-free royalty treatment for a portion of the earnings from the activity. Nevertheless, if the organization’s UBIT is so significant that its exempt status may be in doubt, this course may not be appropriate.

Rotz also mentioned the IRS’s interest in exclusivity arrangements, e.g., a university agrees to sell only one brand of soft drink on its campus. The IRS is currently examining whether such arrangements may result in UBIT.

Sponsorship Payments May Still Be UBIT

Recent legislation addresses the distinction between corporate sponsorship payments that will be treated as UBIT because the payments are made in exchange for the exempt organization providing advertising services, and those sponsorship payments that are exempt from income tax. If the exempt organization merely acknowledges the contribution of the sponsor by the use of the contributor's name and logo in connection with the exempt organization’s activity, the payment will not constitute UBIT. Use of the sponsor’s name in the event, e.g., the FedEx Orange Bowl, does not affect the treatment of payments from the sponsor, notwithstanding that the sponsor may clearly benefit from the use of its name and logo in connection with the event. However, if the acknowledgment of the sponsor’s participation in the event includes advertising the sponsor’s products or services, or contains price comparisons, the revenue will constitute UBIT. Agreements with corporate sponsors should be reviewed to insure they are consistent with the new provisions of the Internal Revenue Code.

Travel Revenues May Be UBIT

For profit tour operators have frequently complained to the IRS about universities and other exempt organizations that sponsor tours and treat the income as exempt from taxation. In April, 1998, the IRS published proposed Treasury regulations intended to clarify when travel and tour activities of exempt organizations are sufficiently related to the organization’s exempt purposes so that the income earned would not constitute UBIT. The Proposed Regulations adopt a "facts and circumstances" test to determine if a tour is substantially related to the organization’s exempt purpose. Examples in the Proposed Regulations are intended to provided illustrations of the factors that the IRS will consider in determining if a tour is recreational or educational. The IRS has emphasized the importance of keeping contemporaneous written records to establish the relationship of the tour to the organization’s exempt purpose.

Associate Member Dues

The treatment of associate member dues paid to trade associations has come under scrutiny recently. Generally, the IRS will not treat associate member dues as UBIT unless the organization formed an associate member category simply for the purpose of producing income. It may be important that promotional materials soliciting associate members explain the purpose of the associate member category to justify that the category was not created merely as a mechanism to earn income for the organization.

Exempt Organizations Should Review Activities

The IRS has increased its scrutiny of revenue sources of exempt organizations in recent years. Complaints from for profit business about unfair competition from tax-exempt organizations have, in part, prompted this interest. The characterization of revenue as UBIT may result in significant economic impact on an exempt organization and may lead to revocation of exempt status if the amount of UBIT becomes substantial. Exempt organizations should review their revenue sources to ensure that the activities producing the revenue do not result in recharacterization of the income as UBIT.

©1998 Greenberg Traurig