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Navigating Various Tax Issues in Exempt Organization Licensing

June 28, 2022, 8:46 AM

Successful tax-exempt organizations such as business leagues and associations, public charities, and cause organizations—collectively, exempt organizations—increasingly have had the opportunity to leverage goodwill from their names, logos, and other intellectual property by licensing these items to private for-profit vendors eager to access and market to the exempt organization’s members and supporters.

This can generate welcome revenue for the exempt organization, but it must be careful if it gets involved in marketing and promoting the vendor’s products or services and related program administrative tasks, since this can raise significant tax risks.

Royalties Are King

Exempt organizations, while tax-exempt on mission-related revenues, remain subject to income tax on revenues from unrelated business activities, with such gross revenues being termed unrelated business income, or UBI. The tax on the net income from UBI is generally calculated using regular corporate income tax rules and rates.

Since nontaxable mission-related activities require a substantial relationship to exempt purposes, products and services offered from private vendors typically don’t qualify, even if they have a tangential connection to the exempt organization’s mission. However, there are several specific exceptions to UBI, including an exception for passive royalty income. Royalties are not specifically defined but generally are gross revenue payments for the use of a valuable intangible right, such as a trademark, trade name, service mark, or copyright.

The Taxman (May) Cometh

The royalty exception is helpful because it fits into these would-be private partners’ desire to use the exempt organization’s name, logo, and related intellectual property in their marketing efforts. At times, though, the private vendor may also request—or even insist—that the exempt organization cooperate in developing and refining marketing strategies and help to promote and administer the program. If the exempt organization is inclined to accommodate on this point, a problem arises: Payments for marketing, promotional, and related administrative activities are services income and not royalties.

The services will almost certainly be treated as an unrelated business, which simply requires a profit-making trade or business activity regularly carried on and unrelated to the exempt organization’s mission, with all three elements likely to be present here. In contrast, activities undertaken solely to protect the exempt organization’s intellectual property, such as review and approval of the vendor’s marketing plans, won’t affect exempt treatment of royalties.

In these cases, words matter. Explicitly denoting payments to the exempt organization as royalties can be critical in the first instance to avoid or overcome any challenge to tax treatment, while using words such as “services,” “market,” “promote,” or “advertise” are red flags suggesting non-exempt services income. While substance remains paramount, carelessness with terms can put the exempt organization in the awkward spot of contradicting its own labeling when defending its tax treatment of the income.

Furthermore, an unrelated business is a non-exempt purpose, potentially risking the organization’s tax exemption. For Section 501(c)(6) trade associations/professional societies and Section 501(c)(4) social welfare organizations, such non-exempt activities cannot be primary. Section 501(c)(3) charities have a lower bar in that non-exempt activities cannot be substantial. Thus, significant levels of UBI can risk tax exemption regardless of whether income tax is paid.

Court cases dealing with affinity credit cards and other licensing arrangements have addressed these royalty/services issues, and these courts have generally rejected the initial IRS view that any marketing service element taints all of the payments from being royalties. But these same courts have equally declined to endorse a converse position that the value of marketing and promotional and related services can be ignored.

Given that the IRS can assert its own determination as to the relative value of royalties versus marketing, promotional, and administrative services, it becomes incumbent upon the exempt organization to document and support any distinction between the two types of income. Failure to do so risks the income being treated as mostly or all taxable.

Separation Anxiety

So how to minimize the taxation of income from a mixed arrangement of nontaxable royalties and taxable services income? The simple answer is to separate the two income streams as much as possible in the deal documentation. In addition, it is highly recommended to develop objective market data support for the royalty value, including if possible a third-party valuation or appraisal. Otherwise, the IRS may dismiss or minimize the exempt organization’s allocation in any vendor agreement or agreements as self-serving and unsupported, especially since the private vendor has an economic incentive to negotiate the total amount paid but not necessarily the specific payment breakdown.

The cleanest way to set a hard break between royalty and services income is to use a wholly owned, for-profit corporate subsidiary—or LLC with a corporate election—of the exempt organization to perform any marketing, promotional and other services. Because this services income is UBI regardless this doesn’t create any additional tax cost and can even provide a benefit if the organization has multiple unrelated businesses. That’s because after 2017, an exempt organization must now generally compute tax liability separately for each unrelated business, while a for-profit subsidiary can offset income or gains from one unrelated business with losses from another.

When using a for-profit subsidiary, the optimum structure is to have the private vendor execute a royalty agreement with the exempt parent and a separate agreement with the for-profit subsidiary for any marketing, promotional, and administrative services. Unfortunately, the private vendor sometimes views the arrangement as a whole and will balk at separate contracts. Another option is a single vendor contract with both the exempt organization and the for-profit subsidiary as parties, with payments to the exempt organization solely for a stated royalty plus a fair market value services fee to the subsidiary for specific services. If the vendor won’t agree to adding the for-profit subsidiary as a party, the exempt organization should at minimum insist on separately documenting the payments for royalties and the taxable services. As mentioned above, having objective data and if possible third-party appraisal support for the royalty portion can be crucial.

In this last case, the exempt parent enters into a services contract with its for-profit subsidiary to perform the marketing, promotional, and administrative services for approximately the same fair market value fee as the exempt organization is paid in the vendor contract. For any for-profit subsidiary structure to work, the subsidiary must clearly act as a separate entity from the exempt parent. Both organizations should have separate boards and officers, separate meetings, and the subsidiary should observe all other standard corporate formalities. The services arrangement should be purely contractual with arms’ length terms, including a taxable profit element to the subsidiary.

For cost and other reasons, however, it’s not always feasible for the exempt organization to form a separate for-profit subsidiary. In this case, the exempt organization’s contract with the private vendor is the only means of bifurcating the payments between services and royalties. Accordingly, the separation and documentary support for the different payment streams becomes even more important.

None of these measures are proof against an IRS challenge. The IRS can always assert its own allocation of the royalty and services amounts and put the exempt organization to the test to justify its different allocation. However, the likelihood and potential success of an IRS challenge can be greatly reduced if the exempt organization has taken these careful advance steps to document the two separate payment streams and provides factual support for their relative valuations.

Conclusion

Successful exempt organizations may find themselves in the fortunate position of having the discretion to monetize their name and reputation by licensing to selected private vendors. Taking full advantage of these opportunities may require hands-on promotion and marketing efforts, but careful structuring of the economic arrangement with the private vendor can minimize any tax cost as well as avoid potential risk to the exempt organization’s tax exemption.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Robert Logan is a special counsel in Pillsbury Winthrop Shaw Pittman LLP’s Tax practice in Washington and Northern Virginia, with special expertise in advising nonprofit organizations in federal income tax exemption matters.

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