You’ve probably seen the American Heart Association’s seal of approval on a cereal box, perhaps the ING logo attached to the New York City Marathon, or a prominent law or accounting firm sponsoring a local theatre production. Undoubtedly, the nonprofit sector has increasingly become commercialized. Each year, for-profit corporations line up to spend millions of dollars on strategic cause-related marketing, sponsorships and strategic relationships with nonprofits. These relationships provide nonprofits with additional revenue streams, ultimately helping the organizations further their missions. The nonprofit also often benefits by the free publicity that may be generated by the for-profit. Despite such potential benefits, when accepting a joint marketing or sponsorship contract, there are a number of legal and non-legal issues that must be considered.
From a non-legal standpoint, it is of utmost importance that the relationship does not undermine the nonprofit’s mission, as in Susan G. Komen for the Cure’s marketing partnership with Kentucky Fried Chicken, Buckets for the Cure. Under this partnership, Komen stood to receive millions of dollars to support its cause, but this joint marketing effort is now seen as one of the leading case studies on cause dissonance. It was not long after the marketing efforts began that criticism ensued over a health-oriented nonprofit raising funds by encouraging the public to eat fast food. Hence, when reviewing this portion of the relationship, it is vital to not only evaluate who you are associating your nonprofit with but also how you will jointly market. Fortunately, most nonprofit managers and professionals evaluate relationships from these perspectives without being prompted.
A second—and often overlooked—aspect of entering into a joint marketing relationship is a careful (and sometimes complex) analysis of the relationship from a tax standpoint. This analysis may include whether the joint marketing relationship will subject the nonprofit’s revenue to unrelated business taxable income (UBTI) classification, or whether the relationship falls within one of the exceptions which would preclude UBTI classification. A major area of concern is whether the relationship is so significant that the nonprofit risks jeopardizing its federal tax-exempt status. The good news is that with prior planning, a nonprofit can often avoid running into such tax troubles.
Does Your Joint Venture Pass the UBTI Test?
UBTI is income that is subject to federal income tax, even though it is earned by a tax-exempt entity. You may also hear discussions of unrelated business income tax (UBIT), which is simply the actual tax assessed on the UBTI of a tax-exempt entity. In order to determine whether joint marketing revenue should be classified as UBTI, the joint marketing activity must first be analyzed under a three-part test, which looks to whether:
(1) the activity constitutes a trade or business; (2) the activity is regularly carried on; and (3) the activity is not substantially related to the organization’s exempt purpose. If the answer to all three of these questions is positive, then the joint marketing revenue is subject to UBIT unless a specific exception applies. As with many tax-related questions, the answers to these apparently straightforward questions are often not so simple.
Generally, a trade or business includes any activity carried on for the production of income from the sale of goods or services. While not dispositive, a significant indicator that an activity is a trade or business is that the activity was entered into for the purpose of making money. Since most joint marketing activities entered into by nonprofits are for this purpose, such activities would usually be considered a “trade or business” for purposes of the first part of the UBTI test.
The second part of the UBTI test looks to whether the activity is carried out with some level of frequency and regularity. What constitutes “regularly carried on” has been the subject of some debate. For instance in NCAA v. Commissioner, 914 F.2d 1417 (10th Cir. 1990), the court found that the NCAA’s printing of advertisements in its Final Four programs was not “regularly carried on” and, thus, the advertising revenue would not be treated as UBTI. The court favored the NCAA’s position opposing UBTI treatment after analyzing the frequency of the same conduct by for-profit businesses. The court reasoned that the selling of advertising space was an activity typically conducted on a year-round basis, as opposed to just a few weeks a year. However, discontinuous or intermittent activities could be construed as regularly carried on if conducted with the competitive and promotional efforts typical of commercial efforts. The classic example of this concept is a nonprofit that provides parking spaces for a fee each Sunday, and only during football season. Although this would be considered an intermittent activity, if for-profit parking providers were offering the same service, the activity can be considered to be regularly carried on.
When determining whether the activity is substantially related to the nonprofit’s exempt purpose, one must evaluate the nature of the activity itself and its connection to the nonprofit’s purpose. To avoid UBTI classification, it is not sufficient that the activity be related; the activity must have a direct connection to the fulfillment of the nonprofit’s exempt purpose. A finding that a substantial causal relationship exists between the activity and the achievement of the nonprofit’s exempt purpose is therefore critical. The use of the revenues derived from the activity is irrelevant; that is, even if the funds generated from the activity help the nonprofit achieve its exempt purpose, this is not a sufficient connection to prevent the revenue from being considered UBTI. Obviously, if the nonprofit’s use of the revenue would prevent characterization as UBTI, then virtually all joint marketing revenue would be exempt from taxation. However, because of the close connection required between the activity and the nonprofit’s exempt purpose, relatively few joint marketing activities would be considered substantially related to the nonprofit’s purpose. Fortunately, a number of exceptions have been carved out, two of which are highly relevant to joint marketing efforts.
Are You Eligible for an UBTI Exception?
In the joint marketing area, revenues are not considered UBTI if they can be characterized as either qualified sponsorship payments or royalties. If a joint marketing arrangement can be structured to fit either exception in whole or in part, that portion of revenue fitting the exception is not subject to UBTI.
Qualified sponsorship payments occur when a for-profit business makes a payment to a nonprofit organization where there is no expectation or arrangement that the for-profit will receive a substantial return benefit other than the use or acknowledgement of the name, logo or product lines of the for-profit in connection with the nonprofit’s activities. The New York City Marathon example that this article opened with would likely qualify as such a sponsorship arrangement. Uses or acknowledgements permitted by a nonprofit under qualified sponsorship arrangements are those that (a) do not contain qualitative or comparative descriptions regarding the for-profit’s company or products; (b) may contain the for-profit’s contact information or website address; (c) may contain value-neutral descriptions (e.g., a visual display of the for-profit’s product offerings); and (d) may contain the for-profit’s brand or trade names. Additionally, there is a safe harbor for annual benefits provided to the for-profit (or its designee) that are not in excess of two percent of the payment made to the nonprofit.
Royalties are also excluded from UBTI. In the joint marketing context, royalties are payments for the use of a nonprofit’s intangible property right. An example of a royalty relationship typically exists in affinity card agreements. Under an affinity card arrangement, a credit card company markets a credit card by stating that a percentage or a fixed amount of each purchase will go to a cause, which is typically on the face of the card. Another example where a royalty might exist is an arrangement where branded souvenirs are marketed and sold by a for-profit. Under this structure, the for-profit pays the nonprofit a fee for the for-profit’s selling of a souvenir bearing the nonprofit’s name and logo.
The key to royalty classification is passivity: the nonprofit may only provide de minimus (minimal) services in connection with the arrangement. However, there is no bright line delineation for what constitutes de minimus services. In one case, a relationship where a nonprofit, under an affinity card arrangement, allowed use of its name, letterhead, executive director’s signature, trademark and mailing list in exchange for various transaction-based and annual fees was deemed to be a royalty. The court found that the nonprofit’s activities under the arrangement were limited to providing access to its intangible assets, providing limited direct-member benefits (e.g., alumni messages on cardholder statements) and protecting member goodwill by responding to occasional inquiries and reviewing mailings. In this and other cases, courts have found that activities under which the nonprofit is maintaining its goodwill are not the types of forbidden services that would make the arrangement subject to UBTI. Conversely, in Disabled American Veterans v. Commissioner, 942 F.2d 309 (6th Cir. 1991), the amounts received for use of the Disabled American Veteran’s mailing list was not considered a nontaxable royalty because the nonprofit provided all of the list management and list fulfillment services under the arrangement. The services provided under this arrangement were simply too great and caused the entire payment to be subject to UBTI.
Is Your Tax-Exempt Status Secure?
Paying UBIT on a new revenue stream is not necessarily a bad result for a nonprofit; as long as tax rates are less than 100 percent, the nonprofit is still better off with the taxable income stream than without it. What nonprofit managers are often concerned about is the loss of tax-exempt status. Fortunately, loss of tax-exempt status is only a threat in the most extreme of cases in the realm of joint marketing. Loss of exemption would generally only occur when the revenues from the unrelated business activity were sufficiently high that the organization’s principal purpose ceased to be its charitable purpose. Although authorities’ positions on this vary, most practitioners would not be concerned until the level of unrelated business revenues constituted thirty percent or more of the organization’s overall revenues. Most joint marketing efforts do not give rise to a revenue level significant enough to warrant such a sanction, and strategies are available for dealing with higher levels of UBTI should they occur.
Joint marketing relationships can provide a nonprofit with a valuable strategic partner, an additional stream of income and free publicity. However, as you may surmise from some of the issues and complexities highlighted in this article, nonprofits should undertake proper planning and analysis with a competent tax professional before entering into such a relationship. Planning beforehand can maximize the nonprofit’s benefit from the relationship while avoiding characterization of the income derived from the relationship as UBTI, or, worse yet, putting the nonprofit’s tax-exempt status in jeopardy.
Mark D. Klimek, Esq., is chair of the Federal Tax Practice Group at the law firm of McDonald Hopkins, LLC, with over 20 years of experience representing nonprofit entities. Jeremy J. Schirra, Esq., C.P.A., is an associate attorney at McDonald Hopkins, LLC in the firm’s business law department.