Latest UBIT Issues: Focus on the Royalty Exception
My colleagues, Mike Sorrells, Sandra Feinsmith, and I recently spoke about Unrelated Business Income Tax (UBIT) at the American Society of Association Executives (ASAE) Finance, HR, & Business Operations Conference in Washington, D.C. After we delivered our presentation, there was one question that people were asking again and again: What are the most important changes that could come about as a result of the Draft Tax Reform Act of 2014
As we’ve highlighted in past posts, one of the more significant potential changes is the proposed rule on the disallowance of the use of losses from one UBI activity to offset the income from a different UBI activity. Still, when it comes to TRA 2014, perhaps the biggest piece of UBIT-related news is the provision to limit the availability of the UBIT royalty exception, which has been in the Internal Revenue Code since 1950.
By way of background, a royalty is a payment for the right to use intangible property. Under TRA 2014, any sale or licensing by a tax-exempt organization of its name or logo, including any related trademark or copyright, would be treated as a per se unrelated trade or business, and royalties paid with respect to such licenses would be subject to UBIT. This could impact transactions such as affinity credit cards, insurance and other affinity programs, royalties from publications or films and licensing of logo apparel. According to the Joint Committee on Taxation (JCT), the bi-partisan staff that provides technical resources to Congress, this provision would increase government revenues by $1.8 billion between 2014 and 2023.
The law regarding royalties is fairly well established. Essentially, if the income is passive (i.e., the organization does not have to perform services to obtain the income), then it is not taxed. On the other hand, if the organization must perform services, such as with a personal appearance or endorsement of a product, this will turn the income into UBI.
Where does this proposal come from? The Ways and Means explanation of the draft states, “…the Subcommittee has learned that public charities are engaging in more commercial activities than ever before and are using more complex organizational structures to do so. Many organizations…are now earning significant profits licensing their own names to for-profit businesses (which is not taxable to an exempt organization) to avoid engaging in an active trade or business themselves.”
It’s important to note that this is not the first time that there has been a legislative proposal to limit the royalty exception. In 1988, the Oversight Subcommittee of the House Ways and Means Committee made note of the same trends noted above and offered several suggestions for how to ameliorate them, including one that would have attributed the activity of a related organization to the tax exempt entity in determining whether or not the royalty was merely passive and therefore, not taxed.
Ultimately, the 1988 proposal never moved forward, but it is clear that Congress is now still after the royalty exception to reign in abusive complex organization structures. Unlike the milder 1988 proposal, TRA 2014 eliminates the passive royalty exception for the entire universe of exempt organizations.
With the Tax Reform Act of 2014 now slowly making its way through the legislative process, which issues surrounding UBIT are on your organization’s radar?