The Focus on UBIT: Royalties and Affiliated Organizations

Back in July, I discussed how the Draft Tax Reform Act of 2014 (TRA 2014) could impact unrelated business income tax (UBIT) and the availability of the royalty exception for nonprofit entities. 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 per se unrelated trade or business, and royalties paid with respect to such licenses would be subject to UBIT. The new TRA provision would not only cause affinity credit card and other affinity arrangements to become taxable income; it could also potentially cause many sponsorship agreements to generate taxable income that had heretofore not been taxed.

As my colleague Sandy Feinsmith explained recently, a qualified sponsorship is an arrangement in which a sponsor receives acknowledgement from an organization. One of the common return benefits to a sponsor is the use of the organization’s name or logo in promotion of the sponsor’s; in exchange, the nonprofit may receive royalties. Under current law, nonprofits can exclude royalty income from unrelated business income (UBI) if it is a passive royalty (i.e., the organization does not have to perform services to obtain the income). Should the organization be required to provide services in exchange for the royalty, however, a portion of the payment will be considered UBI, since it is an unrelated activity.  This has been the IRS’ historical position in rulings and court cases.

There are some exceptions to this rule, however. IRC 512(b)(13) stipulates  that a purely passive royalty can be taxed if an exempt organization receives a royalty from a controlled subsidiary, such as a corporation, trust or a partnership. This provision is intended to prevent abusive situations in which a nonprofit organization creates an intangible of value, transfers it to a subsidiary, which then exploits this property, returning the profit to the parent organization in the form of a tax-free royalty that the subsidiary can then deduct. The concern would be that the subsidiary could pay the parent organization more than a fair market value royalty, deduct the higher amount against its income, and the parent organization would receive more money on a tax-free basis.

Organizations may be able to circumvent IRC 512(b)(13) by allowing a subsidiary to use its property on a royalty-free basis. In this arrangement, the subsidiary performs services to market the name and logo of the organization, and the parent then receives a tax-free royalty from an unrelated third party. This variety of abuse seems to be the specific trigger for the TRA provision eliminating the passive royalty exception.

While the provision may ultimately curtail organizations’ attempts to sidestep royalty taxes, it does not leave much room for interpretation and subjects organizations—many of whom operate on razor-thin margins—to additional tax burdens. A more nuanced approach would involve assessing whether the service has been provided by the organization or one of its affiliates, and evaluating situations on a case-by-case basis. Moreover, the IRS already possesses tools to help address these issues:  IRC section 482 allows the IRS to allocate items of income, deductions and credit among affiliated entities to more accurately reflect income.

While TRA 2014 continues to make its way through Congress, it is unclear whether the provision to eliminate the passive royalty exception will be enacted. However, nonprofits should consider the implications that this proposal would have on their organizational structures and financials so that they can be prepared if and when the legislation were enacted.