The Trade or Business Test – Section 513(c) and Its Regulations
In 1967, the Treasury Department issued regulations designed to interpret the unrelated business taxable income provisions that had been enacted in the Revenue Act of 1950. One of the more innovative aspects of those regulations was to establish a sort of “fragmentation” rule, one that defined a trade or business, not as “integrated aggregates or assets, activities and good will which comprise business for the purposes of certain other provisions of the Internal Revenue Code,” but as discrete activities “carried on for the production of income.”
Thus, the regulations announce, “[a]ctivities of producing or distributing goods or performing services from which a particular amount of gross income is derived do not lose identity as trade or business merely because they are carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.” Treasury Regulation § 1.513-1(b).
As an example, that same regulation states that “activities of soliciting, selling, and publishing commercial advertising do not lose identity as a trade or business even though the advertising is published in an exempt organization periodical which contains editorial matter related to the exempt purposes of the organization.”
Prior to that time, periodical publishing was widely considered to be a single, integrated business, consisting of the dissemination of information accompanied by advertising that helped pay for the costs of doing so, and the 1967 regulations were widely criticized, U.S. v. American College of Physicians, 475 U.S. 834, 106 S. Ct. 1591 (1986), fn. 3, and eventually determined to be invalid to the extent that they exceeded statutory authority at the time they were issued. See American College of Physicians v. U.S., 530 F.2d 930 (Ct. Cl. 1976); Massachusetts Medical Society v. U.S., 514 F.2d 153 (1st Cir. 1975).
Two years later, however, in the Tax Reform Act of 1969, Congress explicitly adopted the Treasury’s fragmentation principle, almost verbatim, in a new Section 513(c), which read in part as follows:
(c) Advertising, etc., Activities
For purposes of this section, the term “trade or business” includes any activity which is carried on for the production of income from the sale of goods or the performance of services. For purposes of the preceding sentence, an activity does not lose identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.
The application of Section 513(c) clearly extends beyond just advertising, but the fact that it includes the word “advertising” in its title and that it incorporates into the Code itself language from a regulation that specifically targeted periodical advertising lends overwhelming support to the notion that advertising within newsletters, journals, and other periodic publications is to be treated as unrelated business taxable income.
In fact, however, all that Section 513(c) and Treasury Regulation § 1.513-1(b) really do is to confirm that advertising is a trade or business. That is only one of the three requirements for imposing the unrelated business income tax on an activity. Two landmark cases suggest that inquiry into whether advertising is “regularly carried on” and is “related” to an exempt organizations tax-exempt purposes cannot be ignored.
The Regularly Carried On Test – National Collegiate Athletic Association
The NCAA is exempt under Section 501(c)(3) and is the major governing organization for collegiate athletics. Its premier event is the men’s Division I basketball championship, held in the Spring of every year. In 1982, the “Final Four” semifinal and final rounds took place at the New Orleans Superdome, and, in connection with the tournament, the NCAA published an “Official Souvenir Program,” which was 129 pages long, which featured articles on individual players, the Final Four teams, and prior year tournaments, but which also contained extensive advertisements, for beer, fast food, sports apparel, tourist accommodations, and so on.
The Internal Revenue Service assessed a deficiency on the NCAA’s $55,926.71 of net receipts from its program advertising. The NCAA petitioned the Tax Court for a redetermination of that deficiency. The Tax Court held that the advertising revenue was unrelated business taxable income, and that the Service’s assessment of tax on those moneys was proper. National Collegiate Athletic Association v. Comm’r, 92 T.C. 456 (1989).
The Tenth Circuit Court of Appeals reversed that decision. National Collegiate Athletic Association v. Comm’r, 914 F.2d 1417 (10th Cir, 1990), holding that the NCAA’s advertising business was not regularly carried on.
The guiding principles in this regard are set forth in Treasury Regulation § 1.513-1(c)(1), which states as follows:
In determining whether trade or business from which a particular amount of gross income derives is regularly carried on, within the meaning of section 512, regard must be had to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued. This requirement must be applied in light of the purpose of the unrelated business income tax to place exempt organization business activities upon the same tax basis as the nonexempt business endeavors with which they compete. Hence, for example, specific business activities of an exempt organization will ordinarily be deemed to be regularly carried on if they manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations.
Treasury Regulation § 1.513-1(c)(2) then suggests that, when applying these principles to specific activities, it is necessary to compare the frequency and continuity with which an exempt organization carries on an activity with that which is common within the commercial world:
Where income producing activities are of a kind normally conducted by nonexempt commercial organizations on a year-round basis, the conduct of such activities by an exempt organization over a period of only a few weeks does not constitute the regular carrying on of trade or business…. Treasury Regulation § 1.513-1(c)(i).
In determining whether or not intermittently conducted activities are regularly carried on, the manner of conduct of the activities must be compared with the manner in which commercial activities are normally pursued by nonexempt organizations…. For example, the publication of advertising in programs for sports events or music or drama performances will not ordinarily be deemed to be the regular carrying on of business…. Treasury Regulation § 1.513-1(c)(ii).
The Court of Appeals held that “the tournament must be considered the actual time span of the business activity sought to be taxed here ... because what the NCAA was selling, and the activity from which it derived the relevant income, was the publication of advertisements in programs distributed over a period of less than three weeks, and largely to spectators.” Even though the NCAA likely devoted considerable effort throughout the entire year to soliciting and designing advertisements in its souvenir programs, the court concluded that “[t]he programs containing the advertisements were distributed over less than a three-week span at an event that occurs only once a year,” and that, the court held, was “sufficiently infrequent to preclude a determination that the NCAA’s advertising business was regularly carried on.”
The Relatedness Test – American College of Physicians
The American College of Physicians is a prestigious organization, exempt under Section 501(c)(3), whose mission is to maintain high standards in medical practice and medical education, to encourage clinical research, and to prevent disease and improve public health. One of the ways it accomplished those goals was to publish a monthly journal, The Annals of Internal Medicine, which contained scholarly, peer-reviewed articles relating to the practice of internal medicine.
The College’s journal also included a number of advertisements for pharmaceuticals, medical supplies, and medical equipment that were considered to be of interest to doctors practicing internal medicine. In 1975, the College filed a return disclosing net income from the advertising in its journal of $153,388; it paid taxes on that amount and brought suit in the Court of Claims for a refund of the taxes paid. The Court of Claims held that the advertisements were not substantially related to the College’s exempt purposes and that the net proceeds from that activity were taxable. American College of Physicians v. U.S., 3 Ct. Cl., 531, 83-2 U.S. Tax Cas. (CCH) ¶ 9652 (1983). The Federal Circuit Court of Appeals reversed. American College of Physicians v. U.S., 743 F.2d 1540 (Fed. Cir. 1984).
In American College of Physicians v. U.S., 475 U.S. 834, 106 S. Ct. 1591 (1986), the U.S. Supreme Court reviewed the validity of Treasury Regulation § 1.513-1(b), ultimately upholding the ruling of the Court of Claims that the College’s advertising revenues were taxable, but the Court refused to hold that all advertising revenues are necessarily, invariably taxable. The Court observed that “the idea of a per se rule of taxation for all journal advertising revenue was sufficiently controversial, its effect so substantial, and its statutory authorization so tenuous, that we simply cannot attribute to the Treasury the intent to take that step in the form of an ambiguous example, appended to a subpart of a subsection of a subparagraph of a regulation.”
More importantly, the Court that the 1967 regulation and Congress’s adoption of Section 513(c) addressed only the character of advertising as a “trade or business” and did not foreclose further inquiry into whether or not advertising could be deemed “substantially related” to an organization’s exempt purpose.
Here, however, the Court agreed with the government and the Court of Claims that the proper analysis should focus, not on the usefulness of advertising content to a readership, but rather on the manner in which an organization accepts and publishes advertisements, citing Treasury Regulation § 1.513-1(d)(4)(iv), Example 7. In this regard, the Court quoted with approval the Court of Claims characterization of the College’s advertising activities:
The evidence is clear that plaintiff did not use the advertising to provide its readers a comprehensive or systematic presentation of any aspect of the goods or services publicized. Those companies willing to pay for advertising space got it; others did not. Moreover, some of the advertising was for established drugs or devices and was repeated from one month to another, undermining the suggestion that the advertising was principally designed to alert readers of recent developments (citing, as examples, ads for Valium, Insulin and Maalox). Some ads even concerned matters that had no conceivable relationship to the College’s tax-exempt purposes.
At the same time, the Court did leave open the possibly that some forms of advertising could be considered to contribute importantly to, and thus be substantially related to, an organization’s tax-exempt purposes:
This is not to say that the College could not control its publication of advertisements in such a way as to reflect an intention to contribute importantly to its educational functions. By coordinating the content of the advertisements with the editorial content of the issue, or by publishing only advertisements reflecting new developments in the pharmaceutical market, for example, perhaps the College could satisfy the stringent standards erected by Congress and the Treasury.
Sponsorship Payments
Technical Advice Memorandum 9147007 – The Cotton Bowl Ruling
On August 16, 1991, the Internal Revenue Service released Technical Advice Memorandum 9147007, the exempt organizations community immediately assumed, and it was subsequently reported, that the ruling concerned the Mobil Cotton Bowl Classic and payments that the Mobil Corporation paid to the Cotton Bowl Athletic Association, an organization described in Section 501(c)(3). See Crawford, IRS Attacks Exempt Organization Income from Corporate Sponsorship Fees, 76 J. Taxation 230, fn.1 (April 1992) (citing reports published in the Wall Street Journal on December 4 and 5, 1991, the New York Times on December 16, 1991, and Tax Notes on December 16, 1991, and mentioning that the payment made by Mobil to the Cotton Bowl Association was approximately $1.5 million).
A similar ruling was reported to have been issued with respect to the John Hancock Bowl. Crawford, supra, at 230 (characterizing the payment made by John Hancock Insurance to the Sun Bowl Association as being approximately $1 million).
Tax Analysts reported six months later that some of the provisions in the contract between the Cotton Bowl Association and Mobil included the following:
The Cotton Bowl Association must change the name of the Cotton Bowl to the Mobil Cotton Bowl, and add the Mobil logo to the Cotton Bowl logo. The new name and logo must be used exclusively and must be mentioned in all Cotton Bowl press releases.
At the site of the Cotton Bowl, the Cotton Bowl Association must imprint the new logo in a prominent place on the field.
During the football game, the Cotton Bowl Association must display Mobil’s commercial messages on the electronic sign in the stadium and broadcast Mobil’s commercial messages over the public address system.
If the Cotton Bowl is not televised, Mobil may cancel the contract.
The Cotton Bowl Association, on behalf of Mobil, must arrange for hospitality suites and hotel rooms, tickets to the game, and tickets to event-related activities.
In return, Mobil must pay the Cotton Bowl Association a sponsorship fee. If the Cotton Bowl achieves a Nielsen (television) rating above a stated level, the Cotton Bowl Association is entitled to an additional sponsorship fee from Mobil.
Streckfus, Some Details of Mobil Cotton Bowl Contract Now Available, 92 TNT 85-3 (April 21, 1992)
A little more colorfully, Paul Streckfus, then the editor of the Exempt Organizations Tax Review, described the broadcast as follows:
For anyone not familiar with the Mobil Cotton Bowl, here is what you see and hear when you turn on your television set New Year’s Day. First, you are told you will be watching the “Mobil Cotton Bowl Classic.” Then, as the announcers talk about the teams, you are shown the football field, with the name of the game -- Mobil Cotton Bowl Classic -- emblazoned on the 50-yard line, the Mobil logo at each 30-yard line, and the name “Mobil Cotton Bowl” filling each end zone. Each player has a patch on his uniform saying “Mobil Cotton Bowl Classic.” Each time the game score is flashed on the screen it is accompanied by the heading, Mobil Cotton Bowl. In case there is anyone who doesn’t know who or what Mobil is, regular ads, presumably purchased from NBC, extol the virtues of Mobil products during each advertising break.
Streckfus, IRS’ Pre-Inaugural Gift For Charities, 93 TNT 17-11 (January 25, 1993).
Although heavily redacted (e.g.: “The * * * part requires that the * * * shall (a) * * * and (b) * * *. The * * * requires that * * * further * * * and that * * *. Furthermore, the * * * has the right to * * *.”), the ruling noted that the proper analysis of this arrangement was to review “all the facts and circumstances to see if the payment was made with an expectation of receiving from the [Cotton Bowl Association] a substantial return benefit.” The ruling concluded that “[t]he amounts received from [Mobil Oil Corporation] by [the Cotton Bowl Association] constitute unrelated business taxable income under … section 512(a)(l) of the Code and, thus, are subject to tax under section 511.”
The reaction to the Technical Advice Memorandum, from the general public, the exempt organizations community, and even Congress, was immediate, almost universally hostile, and focused concern on, among other things, its effect on other events, including the PGA Tour, the Kentucky Derby, the Olympics, theatrical performances, and so on. Henderson, The Tax Treatment of Corporate Sponsorship Payments and the Aftermath of the Cotton Bowl Ruling, 13 Exempt Organizations Tax Review, No. 5, p. 789 (May 1996)
Announcement 92-15 – The Audit Guidelines
Piling on Texas A&M’s disappointing 10-2 loss to Florida State, the Internal Revenue Service, on January 17, 1992, released Announcement 92-15, 1992-5 I.R.B. 51, which was intended to serve as audit guidelines governing the tax treatment of corporate sponsorship payments.
In the audit guidelines, the Service indicated that it would try to determine who benefitted from sponsorship payments, and the guidelines suggested that the placement of a sponsor’s name or logo on players’ uniforms and making sponsorship payments contingent on attendance at an event benefitted only the sponsor and would be considered advertising.
Reaction to the audit guidelines was, again, hostile. The Service received written 310 comments on the proposed audit guidelines; 309 were unfavorable. Cherny and Mallon, Extensive New IRS Audit Guidelines Intensify Scrutiny of Colleges and Universities, 78 J. Taxation, No. 5, 298, at 303 (May 1993). Congress introduced at least seven bills to reverse the effect of Announcement 92-156.
The 1993 Proposed Regulations
A year later, on January 22, 1993, the Service reversed course entirely and issued proposed regulations on the taxation of corporate sponsorship payments.
Those regulations, Proposed Regulation § 1.513-4, 58 F.R. 5687, sought to distinguish between advertising, which generates income subject to tax, and recognition or acknowledgements of donations, which does not. See Crawford, IRS Softens its Position on Sponsorship as Advertising, 79 J. Taxation, No. 4, 214 (October 1993).
Enactment of Section 513(i)
Finally, in the Taxpayer Relief Act of 1997, P.L 105-34 (August 5, 1997), Congress enacted a new Section 513(i), which largely codified the rules set forth in the Services proposed regulations, effective with respect to payments solicited or received after December 31, 1997.
Section 513(i)(1) states that the “term ‘unrelated trade or business’ does not include the activity of soliciting and receiving qualified sponsorship payments.”
Under Section 513(i)(2)(A), a “qualified sponsorship payment” is “any payment made by any person engaged in a trade or business with respect to which there is no arrangement or expectation that such person will receive any substantial return benefit other than the use or acknowledgement of the name or logo (or product lines) of such person’s trade or business in connection with the activities of the organization that receives such payment.” The statute continues with the observation that “[s]uch a use or acknowledgement does not include advertising such person’s products or services (including messages containing qualitative or comparative language, price information, or other indications of savings or value, an endorsement, or an inducement to purchase, sell, or use such products or services).”
In other words, so long as there is no “arrangement or expectation” that the corporate sponsor will receive “any substantial return benefit” in exchange for its sponsorship payment, “other than the use or acknowledgement of the name or logo (or product lines)” of the sponsor in connection with the exempt organization’s activities, the payment is not unrelated business taxable income.
Also, in order that a sponsorship payment not be taxable, the acknowledgement cannot advertise the sponsor’s products or services, which is defined as including —
qualitative or comparative language
price information
other indications of savings or value
endorsements
inducements to purchase, sell, or use such products or services
There are kinds of payments that are not considered to be qualified sponsorship payments —
Contingent Payments
These are any payment where “the amount of such payment is contingent upon the level of attendance at one or more events, broadcast ratings, or other factors indicating the degree of public exposure to one or more events.” Section 513(i)(2)(B)(i).
This exception was presumably added in reaction to a provision in the Mobil - Cotton Bowl Association contract that awarded the Association a higher payment if the Neilson ratings for the football game exceeded a specified level.
Periodicals and Qualified Convention and Trade Show Activities
Section 513(i)(2)(B)(ii)(I) excludes “any payment which entitles the payor to the use or acknowledgement of the name or logo (or product lines) of the payor’s trade or business in regularly scheduled and printed material published by or on behalf of the payee organization that is not related to and primarily distributed in connection with a specific event conducted by the payee organization.” This exception does not necessarily mean that all acknowledgements in an exempt organization’s periodicals are taxable, but rather it was intended to preserve the existing law that distinguished taxable advertising in periodicals from non-taxable acknowledgements of contributions. See Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997, citing as “present-law” on this topic Section 513(c), U.S. v. American College of Physicians, supra, Treasury Regulation § 1.513-1(d)(4)(iv), Example 7; Revenue Ruling 82-139, 1982-2 C.B. 108; Revenue Ruling 74-38, 1974-1 C.B. 144; PLR 9137049; and PLR 9234002.
Section 513(i)(2)(B)(ii)(II) excludes “any payment made in connection with any qualified convention or trade show activity,” generally excluded anyway from the definition of an unrelated trade or business under Section 513(d).
One of Section 513(i)’s more important accomplishments was its elimination of the proposed regulation’s “tainting” rule, a rule that would have characterized all sponsorship payments as unrelated business taxable income, if any portion of the payments constituted advertising.
Section 513(i)(3) now provides that “to the extent that a portion of a payment would (if made as a separate payment) be a qualified sponsorship payment, such portion of such payment and the other portion of such payment shall be treated as separate payments.”
Thus, if an exempt organization provides a corporate sponsor with $100,000 of what is unquestionably advertising, in exchange for a $1 million sponsorship payment, then $900,000 of the sponsorship payment constitutes a non-taxable donation.
Final Regulations
On February 29, 2000, the Service withdrew its January 22, 1993 proposed regulations and proposed new regulations designed to interpret Section 513(i). 65 F.R. 11012-11019. See generally Woods, Tax Treatment of Corporate Sponsorship Payments to Exempt Organizations: Final Regulations, 97 J. Taxation, No. 3, p. 174 (September 2002).
Following a written comment period and hearings, the Service issued the regulations in final form on April 24, 2002, effective as of April 25, 2002 for sponsorship payments solicited or received after 1997.
The final regulations preserve the distinction in Section 513(i) between “advertising” and “acknowledgements,” and repeat the exceptions for qualified convention and trade show activities and for the sale of advertising and acknowledgements in periodicals.
For these purposes, Treasury Regulation § 1.513-4(b) states that a “periodical” is “regularly scheduled and printed material published by or on behalf of the exempt organization that is not related to and primarily distributed in connection with a specific event conducted by the exempt organization,” including any material that is published electronically.
That same regulation then cites to Treasury Regulation § 1.512(a)-1(f) for the rules governing the sale of advertising in periodicals.
Character of Sponsored Activity is Irrelevant. Treasury Regulation 1.513-4(c)(1) states that “it is irrelevant whether the sponsored activity is related or unrelated to the recipient organization’s exempt purpose,” and that it is equally irrelevant whether the activity is temporary or permanent. Thus, it is perfectly permissible for an exempt organization to receive and acknowledge sponsorship payments in connection with events like banquets, auctions, and runs and walk-a-thons that do not carry out an exempt purpose other than to raise funds.
Examples of Non-Taxable Acknowledgements. Treasury Regulation § 1.513-4(c)(2)(iv) lists a variety of benefits that may be provided to sponsors and that will be regarded as non-taxable acknowledgements —
exclusive sponsorship arrangements
logos and slogans that do not contain qualitative or comparative descriptions of the payor’s products, services, facilities or company
a list of the payor’s locations, telephone numbers, or Internet address
value-neutral descriptions, including displays or visual depictions, of the payor’s product-line or services
the payor’s brand or trade names and product or service listings
Logos or slogans that are an established part of a payor’s identity are not considered to contain qualitative or comparative descriptions.
The mere display or distribution, whether for free or remuneration, of a payor’s product by the payor or the exempt organization to the general public at the sponsored activity is not considered an inducement to purchase, sell or use the payor’s product and, thus, will not affect the determination of whether a payment is a qualified sponsorship payment.
Definition of Advertising. In contrast, under Treasury Regulation § 1.513-4(c)(2)(v), the term “advertising” generally means “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.” Examples of advertising include —
messages containing qualitative or comparative language, price information or other indications of savings or value
an endorsement
an inducement to purchase, sell, or use any company, service, facility or product
A single message that contains both advertising and an acknowledgment is advertising. For example, “This performance was brought to you by City Motors. Visit City Motors today and drive home in your new luxury car.”
The fact that a sponsor might purchase advertising separately, for example, from a network during a sporting event, will not convert payments to the exempt organization into advertising income.
Exclusive Sponsor and Exclusive Provider Arrangements. Treasury Regulation § 1.513-4(c)(2)(vi)(A) clarifies that an arrangement that acknowledges a sponsor as “the exclusive sponsor of an exempt organization’s activity, or the exclusive sponsor representing a particular trade, business or industry, generally does not, by itself, result in a substantial return benefit.” In other words, payments in exchange for acknowledgements that “Corner Sports is the exclusive sponsor (or exclusive sporting goods sponsor) of this tournament” are not taxable as advertising. On the other hand, Treasury Regulation § 1.513-4(c)(2)(vi)(B) takes the position that “arrangement that limits the sale, distribution, availability, or use of competing products, services, or facilities in connection with an exempt organization’s activity generally results in a substantial return benefit.”
An example would be an arrangement in which a university agrees to stock only Pepsi in the vending machines on its campus, or in which a youth sports organization agrees that its players will wear uniforms bearing only Nike’s logo on them.
Characterizing exclusive provider arrangements as providing a substantial benefit has been controversial, but Internal Revenue Service officials have attempted to lessen the controversy by observing that the Section 513(i) regulations are only a safe harbor, that exclusive provider arrangements may not result in unrelated business taxable income under other provisions of the Internal Revenue Code. For example, if a university that allows only Pepsi to stock its vending machines does nothing to maintain those vending machines, its activities may not amount to a trade or business. See Supplementary Information, T.D. 8991.
Insubstantial Benefits. Under Treasury Regulation § 1.513-4(c)(2)(ii), benefits that an exempt organization may provide to a sponsor will be disregarded if the aggregate fair market value of all such benefits within the taxable year do not exceed two percent of the payments that the sponsor makes to the organization. If such benefits do exceed two percent of the sponsorship payment, then the entire amount of the benefits (not just the excess portion) constitute a “substantial return benefit” (thus rendering the portion of the sponsorship payment attributable to such benefits taxable). Examples of the kinds of benefits the regulation contemplates include a dinner for executives of the sponsor, free admissions to a sponsored sporting event, the right to use the exempt organizations logo, trade name, or other intellectual property, and so on.
Effect on Deductibility and Public Support Tests. Treasury Regulation § 1.513-4(c)(3) clarifies that qualified sponsorship payments in the form of money or property (but not services) qualify as contributions received for purposes of measuring an exempt organization’s compliance with the public support tests of Sections 170(b)(1)(A)(vi) and 509(a)(2) for non-private foundation status. That regulation then adds that “[t]he fact that a payment is a qualified sponsorship payment that is treated as a contribution to the payee organization does not determine whether the payment is deductible by the payor under section 162 or 170.”
Mailing List Rentals
Rationale for Transactions
Most exempt organizations maintain databases containing the names, addresses, and other information relating to their donors, clients, members, and other persons who have an interest in their mission and activities. This information is difficult and expensive to keep accurate and up-to-date and therefore represents an asset that is of significant value to these organizations.
At the same time, commercial entities crave the ability to market goods and services they offer to specially targeted markets. Pharmaceutical companies, for example, would vastly prefer to deliver carefully crafted advertisements to an exclusively elderly population, than to broadcast over network or cable TV to the population as a whole, while an outdoor recreational equipment manufacturer might desire to market exclusively to persons who have demonstrated an interest in environmental causes.
As exempt organizations seek to supplement their revenues from the conduct of their exempt activities and from traditional fundraising sources, the pressure to make their mailing lists available to commercial entities seeking to expand their marketing reach is almost irresistible.
Disabled American Veterans Cases
In 1962, the Disabled American Veterans, a Section 501(c)(4) organization to which contributions are deductible under Section 170(c)(3), began a campaign of direct mail fundraising. In its early years, the DAV mailed “Idento-Tags” to every registered owner of an automobile in the United States it could locate. These were small replicas of a license plate and had negligible value, but were useful in luring recipients into opening envelopes that contained a fundraising appeal.
As the DAV’s direct mail campaign progressed, it slowly accumulated a list of contributors, which at times contained over 11 million names, together with information concerning the contributors’ giving history. The DAV devoted considerable time, effort, and expense to maintaining this list, purging the names of donors who had died or moved without a forwarding address, updating addresses when notified by the Postal Service, and adding new names as new contributors emerged.
From the very beginning of this program, the DAV rented its mailing list to others, generally other fundraising organizations, but also commercial entities such as catalogue retailers. The DAV was a member of the Direct Mail Marketing Association and followed normal industry practices in its mailing list rentals. It developed and circulated “rate cards” that itemized the rates that the DAV would charge per 1,000 names, additional charges for special services such as sorting names by zip code and providing the lists on various media. DAV estimated that it devoted approximately two man-years per year to the administration of its mailing list rental program.
Mailing List Rentals as an Unrelated Trade or Business – DAV I. In October of 1971, the Internal Revenue Service launched an audit of DAV’s tax returns and, at that audit’s conclusion, asserted that the revenues that the DAV realized from its mailing list rentals for 1970 through 1973 constituted unrelated business taxable income. In Disabled American Veterans v. U.S., 227 Ct. Cl. 474, 650 F.2d 1178 (1981) (“DAV I”), the DAV contested that determination. In that case, the Court of Claims undertook a conventional UBTI analysis.
The court noted that “there existed an active direct mail industry in the United States with its own trade practices,” that the DAV “was a part of this industry and followed its trade practices,” and that the “DAV operated in a competitive manner in renting its donor list.” This, the court concluded, established that the mailing list rental activity was a “trade or business.”
The parties stipulated that the mailing list rental activities were “regularly carried on,” thus satisfying the second test for unrelated business taxable income.
With respect to the third test, whether the mailing list rental activities were “related” to the DAV’s exempt purposes, the court stated that the DAV could cite only “the rental income it received to establish an important contribution attributable to this activity” and noted that “[t]he need for funds of the use made of funds cannot be used to demonstrate that the activity is related to the accomplishment of DAV’s exempt purposes.” Thus, the court concluded that the mailing list rental program was not a “related” activity.
DAV also argued that its revenues from renting its mailing lists should be excluded from UBTI because they represented “royalties” under Section 512(b)(2). Here, the court observed that “section 512(b)(2) excludes from taxation the conventional type of passive investment income traditionally earned by exempt organizations (dividends, interest, annuities, real property rents),” but concluded, without further discussion or citation, that “DAV’s receipts from the rental of its mailing list cannot be classified as ‘royalties’ as that term is used in section 512(b)(2) of the code.”
Section 512(b)(2) Royalty Exclusion – DAV II. Approximately a decade later, the Internal Revenue Service again audited the DAV and asserted that the revenues from its mailing list rentals for years 1974 through 1985 were taxable as unrelated business taxable income. This time, the DAV contested that determination in the Tax Court. Disabled American Veterans v. Comm’r, 94 T.C. 60 (1990), rev’d on other grounds, 942 F.2d 309 (6th Cir. 1991) (“DAV II”).
The parties agreed that a mailing list is intangible personal property, and the Tax Court quoted from the Direct Mail Marketing Association’s glossary for a description of a mailing list rental transaction – “An arrangement in which a list owner furnishes names on his or her list to a mailer, together with the privilege of using the list on a one-time basis only (unless otherwise specified in advance). For this privilege, the list owner is paid a royalty.”
The court also found that the DAV’s rental of its mailing list was a “continuous, on-going activity during the years at issue.” During one four-year period, it entered into list transaction with 75 different list brokers and rented portions of its list in 451 different transactions. The DAV conceded that the payments it received from these transactions were from an unrelated trade or business. Thus, the sole issue before that court was whether the mailing list rental revenues could be excluded from UBTI as royalties under Section 512(b)(2).
The Commissioner moved for summary judgment on the grounds that the DAV had raised the royalty issue in the Court of Claims and that collateral estoppel barred it from raising it here. The Tax Court denied that motion, ruling that collateral estoppel is applicable only if the applicable “legal climate” has remained unchanged.
In 1981, two months after the issuance of the Court of Claims decision in DAV I, the Service released Revenue Ruling 81-178, 1981-2 C.B. 135. That ruling discussed two different fact situations, both involving an exempt organization formed to improve the economic and working conditions of its members, who happened to be professional athletes.
In the first fact situation, the organization entered into licensing agreements that would authorize businesses to “use the organization’s trademarks, trade names, service marks, copyrights, and members’ names, photographs, likenesses, and facsimile signatures in connection with the distribution, sale, advertising, and promotion of merchandise or services offered by such businesses.” The licensing agreements allowed the organization to “approve the quality or style of the licensed products and services” and required the licensees “to refrain from engaging in any activity that would adversely affect the reputation of the organization or its members, or the value of the licensed products or services.”
The agreements in the second fact situation were identical, except that they dealt “solely with endorsing the products and services offered by such enterprises” and required “personal appearances by and interviews with members of the organization in connection with the endorsed products and services.”
The ruling described the applicable law as follows:
To be a royalty, a payment must relate to the use of a valuable right. Payments for the use of trademarks, trade names, service marks, or copyrights, whether or not payment is based on the use made of such property, are ordinarily classified as royalties for federal tax purposes. See Commissioner v. Affiliated Enterprises, Inc., 123 F.2d 665 (10th Cir. 1941), cert. den. 315 U.S. 812 (1942); Commissioner v. Wodehouse, 337 U.S. 369 (1949); Rohmer v. Comm’r, 153 F.2d 61 (2d Cir. 1946); and Sabatini v. Comm’r, 98 F.2d 753 (2d Cir. 1938). Similarly, payments for the use of a professional athlete’s name, photograph, likeness, or facsimile signature are ordinarily characterized as royalties. See generally Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969); Uhlaender v. Henricksen, 316 F. Supp. 1277 (D. Minn. 1970). On the other hand, royalties do not include payments for personal services.
With respect to the first fact situation, the ruling thus concluded that “since the payments are for the use of the organization’s trademarks, trade names, service marks, copyrights, and its members’ names, photographs, likenesses, and facsimile signatures such payments are royalties within the meaning of section 512(b)(2).”
With respect to the second fact situation, however, the ruling concluded that “since the agreements … require the personal services of the organization’s members in connection with the endorsed products and services, the payments received by the organization are compensation for personal services and therefore are not royalties within the meaning of section 512(b)(2).”
In DAV II, the Tax Court concluded that the Service’s release of Revenue Ruling 81-178 stated “legal principles to be used in interpreting ‘royalty’ for purposes of section 512(b)(2) that were not discussed in the Court of Claims’ analysis” and that this represented a “change in the legal climate” that justified fresh consideration of the DAV’s argument, unimpeded by concerns of collateral estoppel.
The Tax Court noted that Revenue Ruling 81-178 followed “a number of cases holding that royalties are payments for the use of valuable intangible property rights and … is a correct statement of the law.” The Service, however, relying on DAV I, sought to argue that “royalties” for Section 512(b((2) purposes had a narrower meaning and that payments for licensing intangible personal property could be considered royalties under Section 512(b)(2) only if the activities that generated those payments were passive and not the result of an active trade or business.
The Tax Court disagreed. The court observed that it is common for the licensee of valuable intangible personal property to devote significant effort to improving the value of that property, protecting its interests in the property, and making that property productive of income. Accordingly, the Tax Court ruled that the DAV’s receipts from its mailing list rental program were not taxable as unrelated business taxable income.
Of great significance, however, is the fact that the parties had stipulated that the revenues at issue were either rentals or royalties, The Service attempted to argue that the revenues should be recharacterized as income from the performance of personal services, but the court stated that it had stipulated away its right to raise that argument.
The Service appealed, and in Disabled American Veterans v. Comm’r, 942 F.2d 309 (6th Cir. 1991), the Sixth Circuit Court of Appeals held that Revenue Ruling 81-178 did not represent a sufficient “change in legal climate” to preclude the application of collateral estoppel, that the DAV was therefore bound by the Court of Claims decision in DAV I, and that its mailing list rental revenues were therefore taxable.
Passive versus Active Royalties – Sierra Club I
In Sierra Club, Inc. v. Comm’r, T.C. Memo 1993-199 (1993) (“Sierra Club I”), the Service again sought acceptance of its argument that Section 512(b)(2) excludes from the definition of “royalties” only those types of income that are passive in nature.
The Sierra Club’s mailing list rental program differed significantly from that of the DAV, which handled most of the administration of its program in-house. In contrast, the Sierra Club made intensive use of professional, third party list managers and brokers, as well as a fulfillment agency that actually maintained and fulfilled orders for its mailing list.
Nonetheless, the Service again raised the argument that “royalties” for Section 512(b)(2) purposes was used in some special sense and included only income from passive investment activities, principally citing the legislative history of the Revenue Act of 1950, which stated in part that “[d]ividends, interest, royalties, most rents, capital gains and losses, and similar items are excluded from the base of the tax on unrelated income because your committee believes that they are ‘passive’ in character and are not likely to result in serious competition for taxable businesses having similar income.” S. Rept. 2375, 81st Cong., 2d Sess. (1950). The Tax Court rejected that argument, again placing reliance on its common-sense interpretation of royalties as being the revenue generated from all licensing of intangible personal property.
The Service also argued that the enactment of Section 513(h) in 1986 represented an affirmation by Congress of the decision in DAV I and served as the exclusive provision under which royalty income from the rental of mailing lists could escape taxation as unrelated business taxable income.
Section 513(h)(1)(B) provides —
In the case of an organization which is described in section 501 and contributions to which are deductible under paragraph (2) or (3) of section 170(c), the term “unrelated trade or business” does not include--
* * *
(B) any trade or business which consists of —
(i) exchanging with another such organization names and addresses of donors to (or members of) such organization, or
(ii) renting such names and addresses to another such organization.
Since the Sierra Club, as a Section 501(c)(4) organization, was not one to which deductible charitable contributions may be made under Section 170(c), the Service argued that it could not take advantage of the exclusion set forth in Section 513(h).
In addition, the Service argued that the court should draw an inference from the enactment of Section 513(h), that Congress had always viewed income from renting mailing lists to be unrelated business taxable income, absent some specific exception.
The Tax refused to accept that argument, citing language from the 1986 legislative history to the effect that “[n]o inference is intended as to whether or not revenues from mailing list activities other than those described in the provision … constitute unrelated business income.” J. Comm. Print 1325 (1987). A colloquy on the House Floor during the House consideration of the legislation provided similar support for the Tax Court’s ruling on this issue.
The Service also raised the argument that what the Sierra Club actually sold was tangible personal property, in the form of magnetic tapes or pre-printed, gummed or ungummed mailing labels. The court held that there existed a genuine issue of fact with respect to that issue that would preclude summary judgment in favor of the Sierra Club.
Finally, the Service suggested that the Sierra Club had performed significant services in connection with its furnishing its mailing list to third parties. Again, the court held that there existed a genuine issue of fact concerning this issue and declined to issue summary judgment in the Sierra Club’s favor.
Subsequently, the Sierra Club and the Service settled their disagreement over these two issues that precluded summary judgment, and the Tax Court did not consider them further. See Sierra Club, Inc. v. Comm’r, 103 T.C. 307 (1994).
Royalties or Personal Services – Sierra Club I on Appeal
The Service appealed the Tax Court’s decision in Sierra Club I (as well as the same court’s decision in Sierra Club II, discussed below in connection with affinity arrangements) to the Ninth Circuit Court of Appeals. Sierra Club Inc. v. Comm’r, 86 F.3d 1526 (9th Cir. 1996).
The Court of Appeals cited Black’s Law Dictionary and Revenue Ruling 81-178 for the proposition that royalties are payments for the use of use of trade marks, trade names, service marks, copyrights, and other intangible property rights, It then framed the issues as follows:
The parties agree that the above definition of royalty is correct -- up to this point. The Commissioner argues that “royalty” must be further defined, claiming that a payment for the use of intangible property is not necessarily a royalty unless the subject of the payment is “passive in nature.” Sierra Club, on the other hand, contends that any payment for the use of an intangible property right constitutes a royalty. For the following reasons, we hold that under section 512(b)(2) “royalties” are payments for the right to use intangible property. We further hold that a royalty is by definition “passive” and thus cannot include compensation for services rendered by the owner of the property. (footnote omitted)
The court drew a middle ground, focusing on the true nature of the activities that generate the income, rejecting the “active v. passive” distinction that the Service had raised in Sierra Club I, but acknowledging that the true distinction is between royalties from licensing intangible personal property and payments for the performance of services:
[T]o the extent the Commissioner claims that a tax-exempt organization can do nothing to acquire such fees (e.g., providing a rate sheet listing the fee charged for use of each copyrighted design or retaining the right to approve how the design is used and marketed), the Commissioner is incorrect. However, to the extent that Sierra Club appears to argue that a “royalty” is any payment for the use of a property right – such as a copyright regardless of any additional services that are performed in addition to the owner simply permitting another to use the right at issue, we disagree.
In sum, we hold that “royalties” in section 512(b) are defined as payments received for the right to use intangible property rights and that such definition does not include payments for services.
The Court of Appeals noted that the Sierra Club had contracted with third parties for the performance of those services that the Court of Claims had held to be such an “extensive business activity” in DAV I. It did not market its lists, sort its lists, print its lists on labels, or provide any other services to list users, and the third parties to whom these services were contracted out charged the list renters for the costs of providing them.
In short, the Court held, the “Sierra Club’s activities with regard to the mailing list rentals were far less substantial than the activities other courts have found to prevent a claim that income was royalty income.”
Personal Services Through Agency Theories – Common Cause and Planned Parenthood
The Service launched one more attack on mailing list rental transactions in two companion cases involving Common Cause and Planned Parenthood. Common Cause v. Comm’r, 112 T.C. 332 (1999); Planned Parenthood Federation of America, Inc. v. Comm’r, T.C. Memo. 1999-206 (1999). Each of those two organizations had contracted with the very same or similar list managers and list brokers that had contracted with the Sierra Club in Sierra Club I, but, in these cases, the Service asserted that the list brokers and list managers were the organizations’ agents for purposes of carrying on the list rental business and that the services they performed should be attributed to the organizations themselves.
The Tax Court noted that the owner of an intangible asset may take actions necessary to preserve and exploit that property, without changing the character of the income received from its licensing, and then created a distinction between permissible “royalty-related activities” and other, non-royalty related services.
The court stated that the activities of the organizations’ list managers consisted of promoting list rental transactions through advertising, the distribution of rate cards, and personal sales calls, forwarding list rental orders for approval, arranging with the data maintenance company to fulfill an order, billing the mailer or the mailer’s broker, and remitting and forwarding payments. All these, the court stated, constitute royalty-related activities that do not change the character of revenues as royalty income.
The court also concluded that the fulfillment company’s production of mailing lists on the media requested by customers, whether magnetic media or labels, was a royalty-related activity, as was its sorting the list into different categories or compiling specialized sub-lists based on zip codes, demographic data, and other criteria.
With respect to list brokers involved in these transactions, the court concluded that their activities – searching advertisements for lists offered by list owners, coordinating rental transactions on behalf of mailers, analyzing the results of mailings, and so on – were not royalty-related activities, but were all conducted on behalf of mailers, not the list owners, Thus, those activities would not be attributed to the exempt organizations that owned and rented the lists.
Finally, in these cases, the Service once again raised the argument that Section 513(h) provided the only exclusion from unrelated business taxable income for royalty income. Citing the legislative history of the 1986 legislation, the Tax Court disagreed.
Use of For-Profit Subsidiaries – The AARP Ruling
Private Letter Ruling 200149043 (August 1, 2001), modifying Private Letter Ruling 199938041 (June 28, 1999), described an organization, widely believed to be AARP, that had a large number of dues-paying members to whom it distributed a magazine on such topics as financial planning, travel, and health and to whom it made available other programs and services.
The organization proposed to create a wholly-owned for-profit subsidiary to which it assigned all of its rights in agreements with third-party service providers, while retaining all rights to its intangible personal property. The organization proposed to license its intangible personal property directly to those service providers, while its subsidiary would handle all activities relating to monitoring the performance of those providers, communicating the programs to the organization’s members, marketing the organization’s membership list, and so on. Thus, the organization’s sole revenues from third parties would be limited to royalties for the use of its trade marks, trade names, and mailing list, while all revenues from performing services would be paid to the subsidiary.
The Service ruled that the income that the organization would receive under this arrangement would be limited to royalty income excluded from the definition of unrelated business taxable income under Section 512(b)(2).
Affinity Card Arrangements
Nature of the Transactions
The credit card industry has been especially aggressive in marketing its services to the nonprofit community. Its aims have been to offer credit cards to members and other supporters of nonprofit organizations.
Supporters who apply for and are issued a credit card in response to such solicitations are then typically offered a credit card that bears the nonprofit organization’s name and logo, and the organization typically receives a fixed amount for every new card member and a percentage of every dollar charged on the card.
Royalties or Joint Venture – Sierra Club II
Sierra Club, Inc. v. Comm’r, 103 T.C. 307 (1994) (“Sierra Club II”) dealt with an arrangement between the Sierra Club, a corporation known as American Bankcard Services, Inc., and the Chase Lincoln First Bank. In that agreement, the Sierra Club agreed “to cooperate with ABS on a continuing basis in the solicitation and encouragement of SC members to utilize the Services provided by ABS.” ABS was responsible, at its own expense, for the development or all promotional and solicitation materials for the program, although the Sierra Club retained the right to approve them.
The Service asserted that the Sierra Club had entered into the trade or business of promoting the use of credit cards either as a joint venturer with Chase Lincoln or as a sole proprietor. In either case, the Service argued that the revenues that the Sierra Club received were not exempt royalties.
The Sierra Club, on the other hand, argued that it simply licensed its name and logo to ABS and Chase Lincoln and that it did not perform any meaningful services in exchange for the royalty moneys it received.
The Tax Court concluded that the Sierra Club assumed none of the risks and rewards of the credit card marketing program, had no control over the management of that program, and therefore could not be deemed to have been engaged in a business of promoting and offering credit cards to consumers. Thus, the court ruled, the revenues that the Sierra Club realized were royalties.
On appeal, the Ninth Circuit Court of Appeals held that the Tax Court failed to view the facts in a light most favorable to the Commissioner in its making its summary judgment in favor of the Sierra Club and remanded the issue for trial. Sierra Club Inc. v. Comm’r, 86 F.3d 1526 (9th Cir. 1996).
On remand, the Tax Court issued a second opinion that described the operation of the affinity card program in considerable detail. The court concluded, following that review, that “the SC-ABS agreement made available for ABS’s use petitioner’s name, marks, logo, and certain other intangible property used in marketing (such as facsimile signatures of petitioner’s officers), as well as provided ABS access to the members by way of petitioner’s mailing lists” and that the “financial consideration petitioner received under the SC-ABS agreement (the receipts), therefore, was, at least in part, consideration for the use of valuable intangible property, and as such constituted royalties within the meaning of section 512(b)(2).” Sierra Club v. Comm’r, T.C. Memo. 1999-86 (1999).
The Service also contended that the income the Sierra Club received should have been taxable as compensation for the performance of the following services —
controlling the marketing plans,
offering the affinity credit card as a member service,
placing advertisements for the affinity credit card in its magazines and local publications,
allowing solicitations to be made using its nonprofit mail permit,
actively endorsing and sponsoring the acquisition of the affinity credit card through brochures and letters from its officers,
guaranteeing refunds of the annual fee if the Chase Lincoln imposed such a charge, and
attempting to persuade the Chase Lincoln to relax its credit tolerances so that additional affinity credit cards could be issued and higher profits realized.
The court analyzed the Sierra Club’s role with respect to each of these activities and concluded that the Club did not perform sufficient services that would have recharacterized its revenues from the affinity card program as anything other than royalties.
Developments Subsequent to Sierra Club II
In the years following the issuance of the Tax Court’s decision in Sierra Club II, the Service released a steady stream of private letter rulings and technical advice memoranda holding that revenues from affinity card arrangements were taxable, while consistently losing litigation over that issue.
Private Letter Ruling 9321005 (February 23, 1993) held that —
In passing section 513(h)(1)(B) of the Code, Congress intended to end taxation of mailing list income in cases where the income is derived from exchanges between two organizations to whom contributions are deductible under section 170(c) or from rentals between such organizations. Congress remained silent as to taxation in other cases involving mailing lists, therefore, tacitly agreeing to taxation in such cases.
The Service then considered that the organization’s license of its name and logo for use in an affinity credit card arrangement was “subsumed” by the organization’s rental of its mailing list and that all revenues that the organization received were taxable.
In two companion cases, Oregon State University Alumni Association, Inc. v. Comm’r, T.C. Memo. 1996-34 (1996), and Alumni Association of the University of Oregon, Inc., T.C. Memo. 1996-63 (1996), the Tax Court decided that the association’s activities in promoting affinity credit card arrangements were de minimis and intended only to bolster their relations with alumni. The court also, once again, rejected the Service’s inference that the enactment of Section 513(h) rendered all mailing list transactions outside its scope taxable. Both cases were affirmed on appeal, 193 F.3d 1098 (9th Cir. 1999).
In Private Letter Ruling 9724006 (February 28, 1997), the Service stated that —
The Service’s position is that income received from the use of membership lists in a credit card solicitation program is subject to unrelated business income tax. The royalty exclusion is not applicable in such a situation. The resolution of the issue is governed by the application of Code section 513(h)(1)(B). The exception to unrelated trade of business for the exchange of mailing lists only applies where both organizations involved are tax exempt under section 501, and contributions to which are deductible under section 170(c)(2) or (3). Thus, the exception to unrelated trade or business under section 513(h)(1)(B) is not applicable herein.
In Mississippi State University Alumni, Inc. v. Comm’r, T.C. Memo. 1997-397 (1997), the Tax Court concluded that the association received payments for the licensing of a valuable intangible property right when it entered into an affinity card arrangement, that it performed no substantial services in connection with that arrangement, that Section 513(h) was not the exclusive provision under which royalty income could be considered nontaxable, and that the association’s royalty income should not be subject to tax.
Finally, the Service has come to acknowledge that income received from the licensing of intellectual property and other intangible assets does indeed constitute tax-exempt royalty income, Private Letter Ruling 200601033 (October 14, 2005).
