Exempt Organizations
Determining whether receipts qualify as sponsorship payments or advertising income can be quite burdensome for most nonprofit organizations. If not structured properly, the impact of unrelated business taxable income will adversely affect the organization’s cashflow. Following a few simple steps can save the organization money in both taxes and filing fees.
Typical nonprofit organizations seek to obtain funding to carry on their exempt purpose through a variety of means, some of which may include annual banquets, charity walks, or the sale of raffle tickets. Many times the organizations will try to cover the costs for their annual events with the help of local businesses, either through the use of business facilities and equipment or through qualified sponsorship payments. Listing businesses in brochures or providing name recognition on the 18th hole of an annual golf tournament can bring in a considerable amount of money for an organization. It is important to understand how a qualified sponsorship payment distinguishes itself from advertising income and the exploitation of the organization’s exempt purpose, leading to an unrelated trade or business.
The definition of an unrelated trade or business in Regs. Sec. 1.513-1 states that the conduct of any trade or business that is not substantially related to the organization’s exempt purpose (charitable, educational, etc.) will be subject to the tax imposed by Sec. 511. An activity subject to the tax imposed by Sec. 511 is includible in the computation of unrelated business taxable income if:
- It is income from a trade or business;
- The trade or business is regularly carried on by the organization; and
- The conduct of the trade or business is not substantially related to the organization’s performance of its tax-exempt function.
All three must apply for an activity to constitute an unrelated trade or business. These definitions are key to determining whether an activity qualifies as a trade or business.
Secs. 162 and 513 define a trade or business, which is essentially any activity carried on with the intent to make a profit through the sale of goods or performance of services. The imposition of the unrelated business income tax was to ensure that nonprofit companies would not unfairly compete with for-profit companies by avoiding tax consequences. A trade or business activity does not lose its identity simply because it does not make a profit.
For a nonprofit organization that solicits sponsorship payments for an annual banquet, one can determine that the activity is not regularly carried on by the organization by analyzing the Regs. Sec. 1.513-1 guidelines. Activities will be deemed to be regularly carried on if there is “frequency and continuity, and [they] are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations.” In addition, preparation time for an event should not be a factor in determining whether an activity is performed in an ongoing manner; the duration of the event itself is the overriding factor. An activity would not be considered to be regularly carried on if it happens only occasionally or sporadically, as illustrated in National Collegiate Athletic Ass’n, 914 F.2d 1417 (10th Cir. 1990).
National Collegiate Athletic Ass’n
This case involved the National Collegiate Athletic Association (NCAA), an exempt organization, as the petitioner, appealing the decision of the Tax Court that the revenue received from program advertising constituted unrelated business taxable income. The NCAA had engaged a for-profit company to solicit sponsors to be included in its annual brochure for the men’s basketball tournament, and it appointed the for-profit company as its exclusive agent. The NCAA claimed that the tournament was intermittent and that it failed to meet the definition of “regularly carried on.” The IRS argued that the relevant period to be considered in making the regularly carried on determination was the tournament plus the time before the tournament involved in soliciting advertising and preparing the brochures. The Tenth Circuit disagreed with the IRS’s position, stating that
the tournament must be considered the actual time span of the business activity sought to be taxed here. The length of the tournament is the relevant time period because what the NCAA was selling, and the activity from which it derived the relevant income, was the publication of advertisements in the programs distributed over a period of less than three weeks, and largely to spectators. Obviously, the tournament is the relevant time frame for those who chose to pay for advertisements in the program. [Footnote omitted]
The court concluded that the advertising in the tournament brochures, which the NCAA conducted only once a year and for a relatively short time, was not regularly carried on for purposes of the unrelated business tax.
Exempt Purpose
If the activity is a trade or a business, it must be substantially related to the organization’s exempt purpose to avoid the tax imposed under Sec. 511. Understanding the relationship between the exempt purpose of the organization and the activities undertaken will determine if the trade or business activity is related and exempt from tax. A key in this identification process is the size and extent of the activities, as identified in Regs. Sec. 1.513-1. The regulation states that
where income is realized by an exempt organization from activities which are in part related to the performance of its exempt functions, but which are conducted on a larger scale than is reasonably necessary for performance of such functions, the gross income attributable to that portion of the activities in excess of the needs of exempt functions constitutes gross income from the conduct of unrelated trade or business.
The regulations provide several examples for the application of these principles.
As discussed in Sec. 513(i), qualified sponsorship payments do not constitute a trade or business and are defined as any payment made by any person engaged in a trade or business for which there is no arrangement or expectation that the person will receive any substantial return benefit other than the use or acknowledgment of the name or logo of that person’s trade or business in connection with the activities of the organization that receives the payment. The listing of a business in a brochure provided at an annual banquet should be done through acknowledgment only, which would preclude the use of any qualitative or comparative language or pricing information. Including language such as savings or value or endorsing a particular product or service could jeopardize the character of qualified sponsorship payments and be construed as advertising income in relation to an unrelated trade or business.
Substantial Return Benefit
Regs. Sec. 1.513-4 provides some additional detail for the concept of substantial return benefit. In general, if the payer receives any benefits other than the use or acknowledgment of their name or logo that exceeds 2% of the amount of the payment, a substantial return benefit exists. Such benefits may include advertising, exclusive provider arrangements, goods or other services, and rights to use an intangible asset of the exempt organization, such as trademarks or patents. A substantial return benefit could disqualify an otherwise qualified sponsorship payment, resulting in income tax.
Regs. Sec. 1.513-4 explains the concept of advertising. It is defined as “any message or other programming material which is broadcast or otherwise transmitted, published, displayed or distributed, and which promotes or markets any trade or business, or any service, facility or product.” Advertising differs from qualified sponsorships by using qualitative and comparative language.
The safe harbor listed under Sec. 513(i) (as noted above) has its limitations. It does not apply to any payments made by a payer with respect to a qualified convention and trade show activity, per Sec. 513(d)(3), if a qualified convention is organized with the purpose of promoting and stimulating interest in products and services of the payer. In addition, payments received for the use or acknowledgment of the name of a business will be taxable advertising if the name appears in a periodical published by a nonprofit organization for the use of its members.
It is important to identify the differences between qualified sponsorship payments and advertising receipts and their relationship to the organization’s tax-exempt activities prior to a solicitation campaign. Being proactive in a client’s business will benefit both the client and the tax adviser’s client retention.
EditorNotes
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
