how to raise revenue without raising taxes

This chapter mmmarizes the rules of the unrelated business income tax (WIT), analyzes the federal tax treatment of common income-producing opportunities for exempt organizations, and explains how nonprofits may structure new business opportunities to minimize or avoid mIT.

2 How to raise revenue without raising taxes

CeZia Roady

WITH THE DECLINE in traditional funding sources, exempt organizations are learning to become more creative and entrepreneurial in the search for funding to finance their exempt-purpose activities. This new entrepreneurship has led, in turn, to renewed charges of “unfair competition” by the business sector. And it has required exempt organizations to analyze their proposed business activities under “unrelated business income tax” (UBIT) laws, regulations, and rules that are, for the most part, more than a decade old-older than many of the business opportunities now available. Today’s exempt organizations must carefully evaluate these fundraising opportunities in light of the UBIT rules, to determine

The first section of this chapter originally appeared as part of an article written by Celia Roady published in the New York University 15th Conference on Tax Planning for the Charitable Sector, entitled “Competition Between Tax-Exempt and For-Profit Enti- ties: What Are the Ground Rules for Avoiding Unrelated Business Income?” 0 New York University, 1987. Used with permission from Matthew Bender & Company, Inc.

NEW DIRECTIONS FOR PHILANTHROPIC FUNDRAISING NO. 12. SUMMER 1996 0 JOSSEY-BASS PUBLISHERS

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30 ALTERNATIVE REVENUE SOURCES

whether or not the income to be generated will be tax-free or will be subject to UBIT a t the normal corporate rates applicable to business corporations. Some new business opportunities will make economic sense even if the income is subject to UBIT, and some can be structured to avoid or minimize UBIT. The critical issue for exempt organizations is to avoid audit surprises by understanding the operation of the UBIT rules and how they apply to particular income-producing activities.

This chapter briefly summarizes the UBIT rules; analyzes the federal tax treatment of some of the most common income-producing opportunities for exempt organizations; explains how expenses may be allocated against unrelated business income; and describes the rules governing how much unrelated business income is permissible, consistent with an organization’s exempt status.

Understanding the basics The Internal Revenue Code (IRC) Section 512 imposes a tax on an exempt organization’s income derived from an “unrelated trade or business.” There are three criteria for an activity to constitute an unrelated trade or business: (i) it must be a trade or business; (ii) it must be regularly carried on; and (iii) it must not be substantially related to the organization’s exempt purpose. IRC 5 13(a); Treas. Reg. § 1.513-1(a).

Trade or business

A trade or business is generally defined as any activity carried on for the production of income from the sale of goods or perfor- mance of services. Treas. Reg. 5 1.51 3-l(b). However, several special rules may apply in determining whether a particular activity is a trade or business.

Fragmentation mle. An activity will not lose its identity as a trade or business simply because it is carried on as part of similar activities that may, or may not, be related to an organization’s exempt purposes. IRC § 513(c). The fragmentation rule is applied to find

HOW TO RAISE R E V E N U E WITHOUT RAISING TAXES 31

unrelated business income (UBI) in many activities that are clearly related to the organization’s exempt purposes, such as advertising in an exempt-function publication. The regulations provide that advertising space in a publication is treated as a separate activity that will produce UBI. Treas. Reg. $ 1.513-1(b). The fragmentation rule also requires an item-by-item analysis of merchandising activities to determine which sales may produce UBI. Rev. Rul.

Exploitation. Exploitation of a product beyond what is reason- ably required for disposition may be treated as a trade or business. Treas. Reg. § 1.5 13-1(d)(4)(iv). For example, the regulations provide that the sale of milk or cream by an experimental dairy farm would not produce UBI, but the sale of ice cream or pastries produced with those products would. Treas. Reg. $ 1.5 13-1(d)(4)(ii).

Dual use. The use of facilities both for exempt functions and for commercial purposes will result in the treatment of the commercial use as a separate trade or business. Treas. Reg. $ 1.5 13- l(d)(4)(iii). The IRS has ruled that a college’s use of its tennis

73-105, 1973-1 C.B. 264.

facilities as a tennis club during the summer constitutes a separate trade or business that may produce UBI. Rev. Rul. 76-402, 1976-2 C.B. 177.

Regularly carried on

Trade or business activities are ordinarily deemed to be “regularly carried on” if they are pursued with the frequency and continuity of, and in a manner generally similar to, comparable commercial activities of nonexempt organizations. Conversely, income-producing activities conducted on an infrequent or intermittent basis do not meet the “regularly carried on” requirement. Treas. Reg. $ 1.5 13-1 (c)(2)(ii). For example, the operation of a sandwich stand by a hos- pital auxiliary for only two weeks a year at the state fair is not regularly carried on, nor is an annual dance or similar fundraising event. Treas. Reg. $ 1.513-1(~)(2)(i). However, the sale of advertising in an annual yearbook is regularly carried on, whether or not there is an extensive solicitation program during the entire year. Rev. Rul. 73424,1973-2 C.B. 190.


The “regularly carried on” criterion continues to generate substantial controversy. In National Collegiate Athletic Association v. Com- mhsione?; 914 E2d 1417 (10th Cir. 1990), action on decision 1991-015 (July 3 , 1991) (nonacq.), the Tenth Circuit held that income received from advertising by the NCAA in the program for the Final Four Tournament was not taxable because the activity was not regularly carried on. The program was produced by a commercial publisher, which was responsible for conducting the advertising campaign. This activity took place over a period of several months, although the programs were sold over a few weeks and the event occurred only once a year. The court looked only at the period of time during which the program was sold, and concluded that the activity was not regularly carried on.

The IRS has announced that it will not follow the NCAA case outside the Tenth Circuit, and that it will look for another case to challenge the decision. For example, IRS Technical Advice Mem- orandum 9137002 involved a university that contracted with a publisher to produce programs for the home football games. Advertising space in the programs was sold by a national advertising agency to national advertisers. The IRS has asserted that the advertiser was acting as the university’s agent in selling the advertising, and that the income received by the university should be subject to UBIT.

Substantially related Whether an activity is “substantially related” is a factual question, based on the relationship between the activity and the organization’s exempt purposes. If the activity conmbutes importantly to or furthers the organization’s exempt purposes (other than through the generation of revenues), the income produced will not be UBI. Treas. Reg. § 1.513-1(d)(2). For example, a museum’s sale of greeting cards that display printed reproductions of selected works from its collection is substantially related to the museum’s exempt purposes. Rev. Rul. 73-104, 1973-1 C.B. 263. In this regard, the IRS closely examines an organization’s exempt purposes as set forth in its incorporation documents and as reflected in its operations to

HOW TO RAISE REVENUE WITHOUT RAISING TAXES 33

determine whether the substantial relationship is present. The IRS has ruled that the sale of science books by a folk art museum was not substantially related to the museum’s exempt purposes, even though such sale might be considered to serve general educational purposes consistent with IRC Section SOl(c)(3). Id. When a non- profit organization undertakes a new income-producing activity, it is important to review the organizational documents to make sure the activity is within the scope of its exempt purposes.

Specific exclusions under Section 51 3 IRC Section 5 13 provides specific exclusions from the UBI tax for certain types of activities. These include the following:

Trade or business where substantially all of the work is carried on by volunteers, such as an orphanage operating a retail store. IRC § 513(a)(l). Trade or business carried on for the convenience of members, such as a university bookstore. IRC 513(a)(2). Note, however, that the fragmentation rule may be applied to treat sales of certain items as producing UBI. For instance, the IRS has held that a university bookstore’s sale of watches to students produced UBI. Ltr. Rul. 8004010. Trade or business where substantially all of the merchandise is donated, such as a thrift shop. IRC 513(a)(3). Distribution of low-cost articles as incidental to a charitable solicitation program. There is a safe harbor for distribution by a Section 501(c)(3) organization of low-cost items. IRC § 5 13(h). Qualified convention and trade show activity conducted by organizations described in Sections 501(c)(3), (4), (S), or (6). IRC 5 513(d).

Spec@ rnod$cations under Section Sl2(1) In addition to the exclusions described above, IRC Section 5 12 contains “modifications” that exempt certain items of income and related deductions from UBI treatment. These include:

D i v i M , interest, annuities, and rqalties, The royalty exclusion


includes payments for many different types of intangible property rights, including payments for the use of the name and logo of an exempt organization. IRC $§ 5 12(b)( 1) and (2).

Rents. This includes rents from real property, as well as rents from incidental personal property leased with real property (not exceeding 10 percent of total rent). IRC S 512(b)(3). The rental exception applies only to passive rental activities that do not involve rendering any significant services to the occupant, such as maid services. The exception does not apply if the rents are based in whole or in part on the income or profits derived from the leased property (other than an amount based on a fixed percentage of receipts or sales). This is an important distinction, since rental formulas based on net profits have become customary for commercial build- ings in many areas. However, such leases would have adverse tax consequences for tax-exempt landlords, who generally can achieve a comparable economic return on a tax-free basis by structuring the rental arrangement to come within the UBI exception.

The IRS has issued several public and private rulings that provide some flexibility in structuring various types of rental formulas that may be permissible under the UBI rental exclusion. For example, the IRS has held that a lease may provide for an annual fixed rent as well as a fixed percentage rent, computed quarterly, based on the tenant’s gross sales for each lease-quarter-year. Rev. Rul. 74-198, 1974-1 C.B. 171. It has also approved increases in rent based on an inflation adjustment factor. Rev. Rul. 69-107, 1969-1 C.B. 189. In its private rulings, the IRS has held that a rental for- mula that combines (i) a fixed minimum rent, (ii) a percentage rent above the fixed base measured by the appraised value of the land, (iii) additional rent from the sharing of sale or refinancing proceeds, and (iv) reimbursement for all or part of the increases in common area maintenance, real estate taxes, and property insurance is within the rental exclusion. Ltr. Rul. 81 3 305 1.

Securities income. This includes income from lapsed options and lending of securities. IRC $5 512(b)(l) and (5).

Capitalgains. This includes gains and losses from the disposition


of property, other than inventory or property held primarily for sale to customers. IRC S 5 12(b)(5).

Research income. This includes income from research performed for the government, and in the case of colleges and hospitals, all research. IRC $5 5 12(b)(7) and (8). However, research does not include activities carried on that are incidental to commercial operations, such as ordinary testing or inspection of products. Treas. Reg. 9 1512(b)-1(0(4).

Mairing list rentals. For Section 50 l(c)(3) organizations, income from the sale or exchange of a mailing list with another Section 501(c)(3) is not subject to UBIT IRC S 513(h)(l)(b).

Federal tax treatment of new income-producing opportunities Although the UBIT statute has not changed substantially since 1969, the nature and extent of income-producing activities by exempt organizations have increased dramatically. Many of the types of activities that are conducted now were not in existence when the statute was written, and it may be difficult for exempt organizations to determine the appropriate treatment of such income. The following are examples of some of the current UBIT issues faced by many exempt organizations.

Corporate spomwsbip Over the past decade, corporate sponsorship has emerged as a new form of fundraising activity by exempt organizations. The U.S. Olympics was a pioneer of the corporate sponsorship concept. The legal issue is whether the payments given to exempt organizations are nontaxable contributions for which appropriate donor recognition is given, or whether the payments constitute a quid pro quo for commercial advertising services provided by the organization. The treatment of corporate sponsorship payments appeared most prominently in the context of IRS audits of several college bowl


associations, where the IRS national office took the position that the income received by the college bowls from their corporate sponsors should be subject to UBIT because the sponsors receive substantial, valuable advertising and marketing benefits from the arrangement.

Proposed Regulations. In January 1993, the IRS issued Proposed Regulations concerning the treatment of corporate sponsorship payments. The Proposed Regulations provide definitions of “advertising” and “acknowledgments,” and they apply to all sponsorship payments received by exempt organizations, with a few important exceptions: not covered is sponsorship that is part of qualified convention and trade show activity, which is generally exempt from UBIT pursuant to Section 5 13(d) and Treas. Reg. 5 1.5 13-3; or sponsorship payments in the form of dividends, interest, and royalties that may be exempt from UBIT under Section 5 12(b). Most important, the new rules do not apply to the sale of advertising in publications that are not related to and primarily distributed in connection with a sponsored event. The treatment of such advertising income is not affected by the proposed regulations and remains subject to UBIT under the principles of Treas. Reg. § 1512(a)-l(f).

Advertising defined. The Proposed Regulations define “advertising” as “any message or other programming material which is broadcast or otherwise transmitted, published, displayed or distributed in exchange for any remuneration, and which promotes or markets any company, service, facility or product.” This includes messages that contain any of the following: qualitative or comparative language; price information or other indications of savings or value associated with a product or service; a call to action; an endorsement; or an inducement to buy, sell, rent, or lease the sponsor’s product. However, as noted in the preamble, for reasons of “administrative simplicity,” the sale or distribution of a sponsor’s product at the sponsored event is not considered an inducement to buy the sponsor’s product.

Under the Proposed Regulations, any sponsorship payment that is contingent on broadcast ratings or the attendance at a sponsored event is treated as advertising. The sponsorship payments in some


of the college bowl contracts are reportedly contingent on the Nielsen ratings; in such cases, at least a part of the sponsorship payment will be subject to UBIT under the Proposed Regulations. (See the discussion below on mixed-purpose payments.)

Acknowledgments defined. “Acknowledgments” are defined in the Proposed Regulations as “mere recognition of sponsorship payments.” All of the following are treated as acknowledgments, provided that the effect is identification of the sponsor rather than promotion of its goods, services, or products: (1) sponsor logos and slogans that do not contain comparative or qualitative descriptions of the sponsor’s products, services, facilities, or company (note, however, that logos or slogans that are an established part of a sponsor’s identity are not considered to contain comparative or qualitative descriptions); (2) sponsor locations and telephone num- bers; (3) value-neutral descriptions, including displays or visual depictions, of a sponsor’s product line or services; and (4) sponsor brand or trade names and product or service listings.

UBIT allocation rules. The Proposed Regulations indicate that the allocation rules in the current regulations governing the exploitation of exempt activities are applicable in the corporate sponsorship context. Treas. Reg. 5 1.5 lZ(a)-l(d)(Z) currently provides that an exempt organization engaging in an unrelated business activity through the exploitation of an exempt function of the kind carried on by taxable entities may offset the unrelated business income from the exploited activity by expenses associated with the exempt function activity. In effect, the exempt organization is permitted to allocate exempt-function expenses of a sponsored activity against the income from any deemed advertising, and there is UBIT liability only to the extent that the aggregate revenues from the sponsored activity exceed the aggregate expenses. This rule is based on the recognition that, but for the conduct of the sponsored event, there would be no opportunity to obtain the deemed advertising revenues.

Under these allocation rules, many exempt organizations would have little if any UBIT liability even if their sponsorship income were treated as unrelated business income, because they typically


rely on such income to offset part, but not all, of the cost of the sponsored event. However, these rules are applicable only if the event has a commercial counterpart. Most sponsored events will meet this requirement; clearly, athletic events, concerts, and tele- vision broadcasts have commercial counterparts. It is unclear, however, how this requirement will be applied to some traditionally noncommercial events, such as art exhibits and parades. Prop. Treas. Reg. $ 1512(a)-l(e), Example 4, applies the UBIT allocation rules in the context of an art museum’s photography exhibit with no discussion of the commercial counterpart requirement; presumably the example reflects a determination that an appropriate commercial counterpart exists for that activity.

Mixed-pulpose paFents. The preamble to the Proposed Regula- tions cites Rev. Rul. 67-246, 1967-2 C.B. 104, as the governing principle for mixed-purpose payments. That ruling permits an exempt organization that receives a sponsorship payment for advertising to exclude from UBI any portion of the payment that can be shown to be in excess of the advertising benefit received by the sponsor. The application of that principle is illustrated by Prop. Treas. Reg. $ 1.5 12(a)-l(e), Example 4, in which a sponsorship payment for an art museum’s photography exhibit is treated as advertising in its entirety because the exhibition materials promoted the sponsor’s products and the museum failed to show that “any portion of the sponsorship payment exceeds the fair market value of the advertising benefit’’ provided to the sponsor.

The Proposed Regulations also contain a so-called tainting rule, which provides that “if any activities, messages or programming material constitute advertising with respect to a sponsorship payment, then all related activities, messages or programming material that might otherwise be acknowledgments are considered advertising.” Prop. Treas. Reg. 5 1.5 13-4(~)(2). The latter statement is illustrated by Prop. Treas. Reg. $ 1.5 134(g), Example 8, involving a symphony orchestra that performs a series of concerts and distributes a program guide at each concert. The example provides that if any portion of the program guide promotes the sponsor’s products or services, all amounts received from the sponsor


with respect to that concert are treated as advertising, even if other items in the program guide would be treated as acknowledgments. Some commentators have expressed the view that there is some conflict between the tainting rule and the principles of Rev. Rul. 67-246, and have suggested that the treatment of mixed-purpose payments is a matter that will require further clarification in the final regulations.

Proposed Legislation-H. R. I1 61, H.R. 1 16 1, introduced on March 8,1995, by Reps. Camp and McDermott, would amend Sec- tion 5 13 to provide that “qualified sponsorship payments” with respect to “qualified public events” are not subject to the unrelated business income tax.

A “qualified sponsorship payment” is a payment from which the donor does not expect any return benefit other than the use of its name or logo in connection with the event, which use may (1) acknowledge the sponsorship or (2) promote the sponsor’s products or services. A “qualified public event” is (1) an event that is substantially related to the organization’s exempt purposes or (2) any event conducted only once during a calendar year for not more than thirty consecutive days.

H.R. 1161 is the same provision as that included in H.R. 1 1, the Revenue Act of 1992, which was vetoed by President Bush for reasons unrelated to the corporate sponsorship provision. As currently written, the proposed legislation would appear to cover most types of sponsorship arrangements, including sponsorship of all types of public events that further an organization’s exempt purposes. Moreover, the proposed legislation would appear to permit exempt organizations to promote the sponsor’s products and services without adverse UBIT consequences-an activity that is not permitted under the Proposed Regulations. This proposal may appeal to some exempt organizations, because sponsorship revenues may be expected to increase with greater latitude in the type of benefits that may be offered. However, other organizations may


be uncomfortable a t the prospect of increased pressure from sponsors to act as advertisers for products and services-something they must decline in order to qualify for the UBIT exemption under the Proposed Regulations. In addition, the proposed legislation does not provide a UBIT exemption for corporate sponsorship payments in connection with fundraising activities that occur more than once a year or extend beyond thirty days in duration.

Royalties, mailing lists, afinity car& Over the past decade, many exempt organizations have entered into arrangements that involve the licensing of their names and logos and the provision of their mailing lists to commercial parties. The UBIT treatment of these types of arrangements has been the subject of a continuing controversy since 1986, and there is no resolu- tion in sight. As expected, in Sierra Club, Inc. v. Commissionel; 103 T.C. 307 (1994), the Tax Court followed the court’s earlier decision in Disabled American Veterans v. Commissioner, 94 T.C. 60 (1990), rev’d on other grounds, 942 F.2d 309 (6th Cir. 1991), which was directly contrary to the decision in Disabled American Veterans v. United States, 650 F.2d 1178 (Ct. C1. 198 l), and the Court of Appeals decision in DAV-11, a second case brought in the Tax Court. Also as expected, the IRS has appealed Sierra Club to the Ninth Circuit. A recent Fifth Circuit decision in Texas Famn Bureau v. United States, No. 94-50034 (5th Cir. June 1, 1995), has held that an arrangement involving the use of name, logo, and mailing list by a farm bureau, as well as the provision of certain administrative services, was subject to UBIT. Several other cases involving affinity cards and/or mailing lists are pending in the Tax Court. The following is a review of the royalty/mailing list rules, including the DAV-I and DAV-11 cases, the Sierra Club case, and the Texas Farm Bureau case.

Use of Name and Logo: Royalty Exclusion. Under Section 5 12 (b)(2), royalty income has been statutorily excluded from UBIT since the enactment of the current UBIT legislation in 1969. Thus, royalty payments received by an exempt organization in exchange for use of its name or logo are not subject to UBIT. Rev. Rul.

HOW T O RAISE REVENUE WITHOUT RAISING TAXES 41

81-178,1981-2 C.B. 135, defines a “royalty” as a payment related to the use of a valuable property right, noting that “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.” How- ever, Rev. Rul. 81-178 notes that payments for personal services do not constitute royalties.

In PLR 9450028, the IRS ruled that income received by an exempt organization from a long-distance telephone service company, under an arrangement whereby the organization agreed to endorse the company to its members, did not qualify as a royalty because the organization provided endorsement services to the company. In this case, the organization did not provide its membership list to the company.

Mailing Lists. The treatment of income from the sale or exchange of an exempt organization’s mailing list is an uncertain area of the federal tax law. Under Section 5 13(h)( 1)(B), income from the sale or exchange of mailing lists between charities is exempt; the statute is silent on the treatment of such other sales or exchanges. The enactment of Section 5 13(h)(l)(B) was intended to overturn a prior decision of the court of claims in DAV-I; however, rather than add clarity, the legislation has spawned further litigation that is unlikely to be resolved for years to come.

The UBIT treatment of the sale or exchange of mailing lists between exempt and non-exempt organizations was the subject of a decision by the U.S. Court of Claims in Disabled American Veter- am v. United States, (“DAV-I”). The court held that income received by the Disabled American Veterans from other exempt organizations and commercial businesses for the use of its mailing lists constituted unrelated business income, and did not constitute “royalties” excluded from UBIT under Section 5 12@)(2).

Section 5 13(h)( l)(B), enacted as part of the Tax Reform Act of 1986, overturned one aspect of the holding in DAV-I (namely, that the sale or exchange of mailing lists between certain exempt organizations was income from an unrelated trade or business) and provides that income from the sale or exchange of a mailing list


between Section 501(c)(3) organizations (and other organizations eligible to receive deductible contributions, such as veterans’ organizations) is exempt from UBIT. The legislative history of Section 5 13(h)(l)(B) indicates that “[tlhe committee believes that the unrelated business income tax should not be imposed on income from exchanges or rentals of donor or member lists among tax-exempt organizations eligible to receive charitable contributions.” H.R. Rep. No. 426,99th Cong., 1st Sess. 867 (1986), 1986-3 C.B. (Vol. 2) 867; S. Rep. No. 313, 99th Cong., 1st Sess. 884-885 (1986), 1986-3 C.B. (Vol. 3) 884-885.

The Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, stated that by enacting the statutory exemption for exchanges between Section 501(c)(3) organizations, “no inference is intended as to whether or not revenues from [other] mailing list activities . . . constitute unrelated business income.” Notwithstanding this statement, the IRS has taken the position that, by negative inference, Section 5 13(h)( 1)(B) is the sole exemption from taxation of mailing list income. (See GCM 39827.)

The Disabled American Veterans continued to pursue the royalty treatment of its mailing list transactions in a second case brought in the Tax Court. In Disabled American Veterans v. Commis- sioner (“DAV-II”), the Tax Court upheld the royalty treatment of income from mailing list rentals. The Tax Court decision was reversed by the Sixth Circuit on the ground of collateral estoppel based on DAV-I; although the decision did not reach the merits, the Sixth Circuit also expressed the view that DAV-I was a correct interpretation of the royalty exclusion.

Sierra Chb, Inc. v. Commissioner involved the UBIT treatment of income received from the rental of mailing lists and from an affinity credit card program. On May 10, 1993, the Tax Court granted the Sierra Club‘s motion for partial summary judgment on the issue of whether receipts for mailing lists constitute royalties under Sec- tion 512(b); on August 24, 1994, the Tax Court ruled that the income received by the Sierra Club from its affinity card program


also was exempt under the royalty exemption. In so ruling, the Tax Court analyzed and rejected two additional IRS arguments: (1) that the affinity card arrangement constituted a joint venture rather than a royalty arrangement, and (2) that the credit card company had acted as an agent of the Sierra Club, and therefore its business activity should be attributed to the exempt organization.

With respect to the first argument, the court held that the following factors are relevant to the determination of whether there is a joint venture: (1) the agreement of the parties, (2) a co-propri- etorship interest in the profits of the venture, (3) a sharing of losses, (4) the maintenance of separate books of account for the venture, and (5) a joint participation in management. The court concluded that these factors were not present, and therefore there was no joint venture between the Sierra Club and the credit card company. On January 25, 1995, the IRS docketed an appeal of Siewa Club to the Ninth Circuit.

Following the 1993 Sierra Club opinion, the Disabled American Veterans filed a second Tax Court petition claiming royalty treatment for its mailing list transactions in 1986 and 1987, years covered by Section 513(h)(l)(B). On October 12, 1994, the Tax Court ruled against DAV on grounds of collateral estoppel, holding that the Sixth Circuit decision in DAV-I1 precluded the Tax Court from ruling in its favor. Disabled American Veterans v. Commissioner, T.C. Memo. 1994-505 (1994).

Mixed-Puvpse Arrangements. It is common for exempt organizations to enter into arrangements in which they license their names and logos and agree to provide mailing lists to commercial organizations. The issue in this instance is whether the mailing list component of the transaction will taint the entire arrangement, or whether the organization can have separate agreements that allocate the consideration on an arm’s-length basis between the mailing list (taxable) component and the licensing of name and logo (royalty) component. There appears to be an economic basis for such an allocation, since the value of each component is enhanced by the other. However, in private letter rulings, the IRS has repeatedly taken the


position that the mailing list rental taints the entire transaction. (Note, however, that this position was rejected by the Tax Court in its decision granting partial summary judgment to the Sierra Club with respect to the treatment of mailing list rentals as royalties under Section 5 12(b)(2).)

For example, in PLR 9029047 (April 27, 1990), the IRS determined that payments received under a licensing agreement for the use of an exempt organization’s name, logo, and mailing list were not exempt from UBIT under the royalty exception because the licensing and mailing list components were intertwined and inseparable. The IRS reached a similar conclusion in GCM 39827 (October 5, 1989). In that instance, the IRS determined that, regardless of whether payments for the use of the organization’s name and logo could be characterized as “royalties,” if those payments are contingent upon and inseparable from payments for the use of the organization’s membership list, the whole arrangement is subject to UBIT. See also TAM 9321005 (February 23, 1993), in which the IRS ruled that payments to an alumni association pursuant to an affinity credit card program were subject to UBIT because the use of the mailing list was inseparable from the use of the name and logo.

The private letter rulings and GCM make it clear than an exempt organization must exercise great care in structuring an arrangement that involves the use of name, logo, and mailing list. If there are separate arrangements that are not interdependent, it may still be possible to treat the consideration for the name as a royalty and for the mailing list as subject to UBIT, although the IRS position is clearly that the existence of a mailing list component will taint the entire arrangement and cause all proceeds to be subject to UBIT.

Mailing List Exchanges. Although the IRS initially appeared to challenge only mailing list sales, a recent private letter ruling shows a clear intention to treat mailing list exchanges as subject to UBIT as well. TAM 9502009 (November 10, 1994) involved a Section 501(c)(4) organization that exchanged its mailing list with other organizations on a one-time basis, and used a list broker to assist in


the exchanges. With respect to the determination of UBIT attributable to the mailing list exchanges, the IRS stated that the gross income should be based on the value of the lists being exchanged and that the “dual use” asset provisions in Treas. Reg. 1.5 12(a)- l(c) should be applied in allocating expenses.

Provision of Services. Although royalty payments for the use of an exempt organization’s name or logo are exempt from UBIT as discussed above, that exemption is not available if the payment is for services rather than merely for use of its name and logo. This issue frequently arises in the context of arrangements made by exempt organizations with insurance companies, where the organizations agree to participate to some extent in the administration of the programs.

Revenue Ruling 81-178, 1981-2 C.B. 135, discusses two situa- tions involving licensing agreements with various businesses. Situ- ation 2 of the ruling provides an example of a Section SOl(c)(S) organization that solicits and negotiates agreements with various businesses for the endorsement by members of the organization of the products and services offered by the businesses. The agreements require personal appearances by and interviews with members of the organization. The ruling categorizes the payments received by the organization as compensation for personal services, which is subject to UBIT. This scenario may be contrasted with Situation 1 of the ruling, where the organization licenses the use of its trademarks, trade names, members’ names, and photographs in connection with the licensees’ advertising, but provides no endorsement or promotion to the licensees. The ruling states that these payments are royalties.

In Texas Farm Bureau v. United States, the Fifth Circuit held that income received by the Texas Farm Bureau from casualty insurance companies in connection with the bureau’s participation in an insurance program marketed to its members was subject to UBIT because it involved the provision of services. Under the arrangement, the bureau provided administrative and clerical services on a reimbursement basis and also received a percentage of premiums paid by its members.


Travel tours

Some exempt organizations conduct travel tours as an income- producing activity, and attempt to treat the income earned from the tours as exempt from UBIT on the grounds that the tour programs further their exempt educationat purposes. Recently the IRS has been examining the area of travel tours to determine whether the activity is primarily educational, and thus in furtherance of an organization’s exempt purposes, or recreational, and thus subject to UBIT. In PLR 9027003, the IRS issued a ruling that addressed three different travel tour programs offered by an exempt organization. The first tour involved lectures on six of the tour’s seven days; the second involved seven optional hours of instruction during a sixteen-day period; the third was a fifteen-day tour, with six and a half days of required classes at a college and four days of field study. Participants in the third tour were also given a reading list to prepare for the program. The IRS concluded that the first and second tours were not educational, but the third tour was because a significant part of the activities was educational in nature.

Merchandising Merchandising has become an extremely lucrative fundraising activity for many exempt organizations; with the current popular- i ty of catalog sales, this activity is likely to become even more attractive. In the merchandising area, the trend is away from books and traditional educational materials, and toward items that com- bine consumer appeal with the exempt theme of the organization. As exempt organizations expand merchandising to include more popular and utilitarian items, the line between related and unrelated becomes harder to draw.

The IRS applies the fragmentation rule to examine, on an item- by-item basis, whether the sale of a particular line of merchandise is substantially related to an organization’s exempt purposes. This area of the law has been evolving steadily since the publication of Rev. Ruls. 73-104 and 73-105, which held that:


Sales by a museum of items related to its collection were substantially related to its exempt purposes, but sales of items that were souvenirs or that referred to materials relating to other periods or to other fields of study were not. Sales of greeting cards bearing copies of works of a r t in the collection, together with the name of the work, artist, location of the original, and name of the selling museum were substantially related.

The current IRS position, which must be gleaned from multiple private rulings issued over the past decade, is to focus on the nexus between the item that is sold and the organization’s exempt purposes. See, for example, Ltr. Rul. 80241 l l (items with logos are generally unrelated); Ltr. Rul. 8 107006 (faithful adaptation and reproduction of wildlife drawings are related); Ltr. Rul. 8145029 (replicas of facilities and household items in a museum’s collection are related). The IRS will look at whether the item sold is a copy of an item in the organization’s collection or another collection of the same subject and period. Products that are utilitarian in nature may be either related or unrelated. If the primary purpose is to interpret some facet of the museum’s collection and provide a learning experience, then the article is related. Conversely, if the article is predominantly utilitarian and the primary purpose is to produce income, it is not related. In order to determine the primary purpose, the IRS will examine such factors as the type of marketing employed, the nature and amount of goods sold, the pricing policy, the comparability to commercially available merchandise, the location where sales are made, and the direct commercial competition. Ltr. Rul. 8605002.

Calctllating UBIE Tbe allocations isslle Section 5 12 defines “unrelated business taxable income” as gross income from an unrelated trade or business, less business deductions


that are directly connected with that business. In the case of an exempt organization with more than one unrelated trade or business, the general rule is tha t UBIT is imposed on the net income from all businesses, and therefore excess expenses from one activity may offset excess income from another. (There is an exception to this rule in the case of publications, as discussed below.)

Expenses that are incurred solely in connection with the unrelated trade or business are fairly simple to identify. The treatment of mixed-purpose expenses that are attributable to both a related exempt-purpose activity and to an unrelated business activity is more complex. T h e IRS regulations provide that where facilities, personnel, or other items are attributable to both related and unrelated activities, the organization must allocate the expenses (such as salary, overhead, rent, and so on) between the related and the unrelated use on a “reasonable basis.” In Rensselaer Polytechnic Insti- tute v. C m m b m q 732 E2d 1058 (2d Cir. 1984), u f g 79 T.C. 967 (1982), the Tax Court and the Second Circuit considered a case involving the proper allocation of fixed expenses attributable to the operation of a university field house that was used for both related and unrelated purposes. The university argued that the allocation should be based on percentages of actual use; the IRS argued that the allocation should be based on percentages of available use.

T h e difference between the two methods can be substantial. Assume a field house is available for use 365 days but is actually used only 200 days, of which 150 days are related use and 50 days are unrelated. Under the university’s position, it would be able to deduct 25 percent of the costs of the field house in computing the UBIT; under the IRS position, the university would be able to deduct only about 14 percent of the costs. In Rensselaer, the court upheld the university’s position.

The IRS was unhappy with the Rensselaer decision, and it is likely to seek an appropriate case to challenge the holding of that court. A possible vehicle for such a challenge is the university described in GCM 39863, involving a campus multipurpose facility that was used for related and unrelated purposes. The IRS signaled its intention to require allocation based on available use rather than actual


use; if the university litigates this position, the IRS may be able to force a reconsideration of the methodology approved in the Rens- selaw case.

The issue of allocations arises frequently in the context of exempt-organization publications that generate advertising income. As discussed above, the fragmentation rule requires exempt organizations to treat the advertising income from the publication as unrelated business income that is subject to UBIT to the extent that the income exceeds the costs of the advertising activity. How- ever, there is a special rule that applies if the publication's reader- ship costs exceed circulation income; in that case, UBIT is imposed on the net income, if any, from the publication as a whole. Treas. Reg. l.S12(a)-l(f)(3). This rule permits nonadvertising expenses to offset advertising income where the publication would operate a t a loss but for the advertising. A common issue that arises for exempt organizations is determining how much of the membership dues should be allocated to circulation income, where the publication is made available to members. The IRS regulations provide that if more than 20 percent of the total circulation is made to non- members, then the subscription price charged to them will be determinative as the amount of membership receipts allocable to circulation income.

How much UBIT is too much? One question frequently asked by exempt organizations is how much unrelated business activity may be conducted without jeop- ardizing their tax-exempt status. There is a common misconcep- tion that this question can be answered by reference to some numerical safe harbor. No such safe harbor exists, although the answer is not as difficult as many exempt organizations may think.

The regulations under Section 501(c)(3) provide that an organization must meet both an operational test, which requires that it engage primarily in activities that further its exempt purpose ('Tireas. Reg. l.SOl(c)(3)-l(c)), and a purposes test, which provides that


an organization may qualify for exemption even though it engages in unrelated business activities, if those activities are not the primary purpose, taking into account the size and extent of the exempt-purpose activities and the size and extent of the unrelated business. Treas. Reg. 5 l.SOl(c)(3)-l(e). These two factors form the basis of what is known as the “commensurate test,” which provides that an organization that carries out a charitable program commensurate in scope with its financial resources will not fail to qualify for exemption under Section 501(c)(3), regardless of the amount of income from unrelated business sources.

CELIA ROADY is a partner in Morgan, Lewis & Bockius at their Wash- ington, D. C., office.

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