While finding new sources of revenue increasingly is a key for survival for many nonprofits, generating too much income from sources unrelated to their mission may endanger their tax exempt status, even if they pay tax on that income.
Too much unrelated business income taxknown as UBITas a percentage of total revenues can endanger an organization's tax exempt status. Noncompliance with Internal Revenue Service (IRS) requirements can damage a nonprofit through loss of revenue and reputation. Adding insult to injury, the IRS can levy penalties and sanctions, and even revoke the nonprofit status of the organization.
Here are a few tactics nonprofits commonly use to generate revenue and an overview of how the IRS views these activities in relation to UBIT.
Cause-related marketing, also known as affinity fundraising, describes a variety of fundraising techniques in which a charity partners with a business or corporation. Charities get vital funds while businesses are afforded the opportunity to tap into the loyalty of a nonprofits supporters who are passionate about the charitys cause. By associating with a nonprofit, the corporation aims to build an affinity for their own business.
Typically, nonprofits are required to help market the program by participating in percent-of-sales, or affiliate, programs. Heres how it works: the commercial enterprise gives the charity a rebate, commission, or percent of sales in exchange for driving customers to its store or website, often via hyperlinks on the charitys website. The more customers a nonprofit refers, the larger the contribution the commercial company makes.
Businesses love affinity marketing because they get free advertising, access to a nonprofits supporters, and the opportunity to enhance their reputation in the community. For the charity, benefits also abound: affinity programs are easy to set up and manage, and they are an effective way to increase the organizations visibility.
But how these programs are structured can play a leading role in whether the IRS is interestedand whether it considers the income generated taxable. Many nonprofits include on their websites links to commercial sites. The IRS has questioned whether a payment to the exempt organization by a commercial company is for advertising purposes or merely a sponsorship payment, and whether this payment constitutes licensing revenue that should be treated as a royalty. In practice, there have been instances where the same hyperlink has been treated in different ways for tax purposes depending on where on the website the hyperlink appeared.
Today, the question of whether hyperlinks to commercial websites by tax exempt organizations constitute unrelated trade or business activity is still unclear.
Paid advertisements are one of the most common sources of UBIT. For example, many nonprofits include paid advertising in their periodicals to offset the cost of publishing educational material. Advertising in periodicals, journals, and magazines that an organization publishes are considered unrelated business income unless the advertising activities contribute importantly to the accomplishment of an exempt purpose.
In terms of web sponsorship, if the sponsors website states that the nonprofit endorses the sponsors product, and the organization gave its permission for that endorsement to appear, the endorsement is considered advertising. The nonprofit can only claim as a tax exempt sponsorship payment the portion that exceeds the fair market value of the advertising on the sponsors website. The rest is considered advertising, which is taxable.
Licensing Agreements and Naming Rights
Exempt organizations are entitled to a royalty exclusion that allows them to withhold licensing fees from UBIT. With this in mind, the IRS generally agrees that the exempt organization is permitted to enter into a licensing arrangement as long as the charity plays a passive role. (The IRS considers interest, dividends, capital gains, rents, and royalties passive income.) However, if the exempt organization's involvement is active, such as by aggressively promoting the sale of a mailing list, the UBIT exemption is lost.
To prevent a licensing arrangement from becoming one that generates unrelated business income, nonprofits should:
Make mailing lists (or other items licensed by the charity) available on a selective basis only, devoting only minimal staff time and expenses to the maintenance and marketing of the list.
Avoid providing any specific services to the licensee that assist them in promoting their products or services (beyond something as simple as informing members of the availability of the product through an annual notice).
Make certain that fees charged for mailing list rentals or other licenses aren't based on the actual net income generated by the renter.
Whats in a Name?
An organizations name in itself has intrinsic value and could potentially provide a steady stream of tax exempt. For example, licensing the organizations logo, similar to what the Red Cross has done with their cross on ambulances and first aid kits, can generate significant royalties. The Tax Court ruled that as long as exempt organizations agreements do not require them to provide any personal services (e.g., promotion of the credit card), it is not considered taxable, but rather tax exempt royalties.
To steer clear of trouble, nonprofits should exercise caution when entering into licensing agreements or similar arrangements with any commercial entity, as well as when including hyperlinks to a commercial company. Also, they should execute written agreements for any advertising and any licensing of intangibles and conduct a thorough legal review of the charitys website content and layout.
While incurring UBIT liability is not inherently badand it is possible that there will be no added tax liabilityit is vital that the nonprofits report this income and any directly connected expenses on IRS Form 990-T.
Joseph Giso, CPA, MST, is a director in the Nonprofit & Education Tax Practice at CBIZ Tofias. Contact him at email@example.com.
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