Date: Winter, 1995

The Grantsmanship Center Magazine

Arrangements between non-profits and for-profits to sell goods and services can be very attractive from a marketing standpoint. The non-profit's tacit endorsement is likely to have a positive influence on members, clients, or constituents. In addition, the membership or clientele usually provides a ready market, with identifiable demographics, such as average income, age, or consumer preferences.

While the IRS continues to press its position that the income from such transactions may be taxable, recent Tax Court rulings have been favorable to non-profits by protecting their income as nontaxable royalties. That is why it is important for non-profits to structure these deals so that they can characterize as non-taxable royalty income all, or most, of what might be construed as taxable unrelated business income from sources such as advertising, insurance services, or mailing list rentals.

In one important case, Sierra Club, Inc. v. Commissioner of Internal Revenue, the Tax Court recently held that the income from a credit card deal constituted royalty income exempt from tax, and was not, as argued by the IRS, either (1) a share of profits from selling credit cards as a joint venturer with participating banks, or (2) payment for services performed as a sole proprietor marketing and endorsing credit cards with the banks participating as agents in running the business.

In an earlier decision concerning another issue in the same matter, the Tax Court held that mailing lists provided by the Sierra Club as part of the credit card deal were intangible property and hence, all payments received for the use of those lists were not taxable because they were royalty income.

Still, it should be noted that IRS will likely appeal the Sierra Club decision to the Ninth Circuit and the case could possibly end up in the Supreme Court. The ultimate outcome is uncertain and non-profits should use caution when arranging mailing list and affinity credit card programs. Indeed, they should carefully evaluate all their "affinity fundraising" arrangements to determine whether the amount of income derived is worth the risk of a finding of unreported taxable income, should they find themselves subjected to an IRS audit.

How can that risk be minimized? Here are some of the steps that non-profits can take to protect themselves:
o The royalty agreement should incorporate the typical commercial terms, rights, and obligations usually found in such agreements.
o In drafting the royalty agreement, expressly specify all the intangible property (such as the non-profit's name, logo, etc.) for which the royalty payment will be made,
o Avoid, as much as possible, any service obligations by the nonprofit to the for-profit company in the agreement.
o Confine your activity in the deal to quality control, which the IRS considers permissible to protect an organizations rights in an intangible. Making sure your logo is not devalued through misuse probably won't trigger taxation. On the other hand, actively promoting the product or service, such as through endorsements or ads, may well cause the IRS to characterize the income as taxable compensation for services or advertising.
o If you must undertake service obligations, make sure your organization is separately and independently compensated for such duties, and pay unrelated business income tax on that part of the income.
o Do not structure the royalty arrangement as a joint venture or partnership, or in any way indicate that the for-profit is in an active business relationship with you (e.g., acting as your agent in conducting the business).
o To minimize the chances of a finding that you are involved in a joint venture, make sure that you do not share any part of the risk of loss from the deal.
o If payments are based on a percentage formula, make sure royalty payments are a percentage of gross income-not a percentage of net profits.
o Do not provide for joint control of any major feature of the royalty arrangement. To the IRS, joint control means partnership or joint venture-and the income from either is taxable. Make sure each party independently controls its respective obligations.

If the deal cannot be clearly characterized as a royalty situation, the organization may consider requesting a formal private letter ruling from the IRS to assure itself of non-taxability before it enters into a contract.

Once the deal is in place-and the organization is confident that the royalty income is immune from IRS attack-the organization may consider specifically and separately reporting the royalty income on its Form 990. In this way the IRS is on notice, the statute of limitations begins to run, and that tax year will close after three years. (The downside is that such reporting may expose the organizations return to audit.)

Finally, for those organizations that have already reported and paid tax in such transactions, it may be a good idea to file a "protective" claim for refund, should the IRS ultimately lose in court. A "protective" claim, which is conditional on the outcome of litigation, will keep open the organization's option to request a refund in the future. Refunds are barred if a claim is not filed within three years from the date the return is filed (or two years after the tax is paid, whichever is later).

As non-profits seek new ways to raise money, for-profits seek to expand their markets, and the IRS continues to scrutinize the relationship between the two, more questions will inevitably arise over the taxability of income generated from these arrangements.

While the steps listed above can reduce a non-profits tax risk, careful tax planning must take into account the particular circumstances surrounding each individual transaction. The strategies suggested here can help, but for maximum protection, tax counsel experienced in these matters should be consulted before a deal is struck.