Tax Issues to Consider

A. TAX-EXEMPT ACTIVITIES AND INCOME
Development professionals often use the terms “partnership” and “corporate sponsorship” to refer loosely to a wide array of interactions between businesses and nonprofit organizations. These can range from licensing agreements and use of mailing lists (on the one hand) to true joint ventures (on the other). For tax purposes, it is important to differentiate these activities into separate categories, because the tax ramifications vary greatly.

Although generally tax-exempt, nonprofit organizations are subject to unrelated business income tax (“UBIT”) on income derived from an “unrelated trade or business.” This tax does not apply to “related” income, i.e., income derived from activities that contribute importantly to the accomplishment of the organization’s tax-exempt mission. Certain types of passive income are also tax-exempt whether or not they are “related.” Earning income subject to UBIT does not jeopardize a nonprofit’s tax-exempt status. However, a nonprofit must report such income on a separate IRS form (Form 990-T), and it must pay tax on the net income at regular corporate rates.

The benefit or “consideration” that a nonprofit receives from a corporate partner will usually take the form of cash, but it also may be received in kind (e.g., under a barter or exchange arrangement). The three most common situations in which such consideration will be exempt from UBIT are where the income is allocable to:

• The nonprofit’s performance of its tax-exempt function “related income;”
  
• The nonprofit’s licensing of its intangible property “royalty income;” and
  
• The nonprofit’s receipt of “qualified sponsorship payments.” 

These three categories of tax-exempt activity are discussed below.

1. Related Income
A key activity for most nonprofit organizations is “getting their message out,” both to their own members and to the public at large. To the extent a nonprofit enlists the assistance of corporate partners in “getting its message out,” the nonprofit is engaging in related activity. This would include situations (for example) where:

• A corporate partner publishes on its web page articles extracted from the nonprofit’s newsletter or periodical;
  
• A corporate partner provides a link from its own web site to the nonprofit’s web site, whereby individuals can make contributions to the nonprofit or learn more about its activities. 

To the extent a nonprofit derives benefits of this type from a corporate sponsor—whether in cash or by way of an exchange—its income will be “related” and hence exempt from UBIT. In this connection, it generally will not matter whether the nonprofit’s relationship with a corporate sponsor is “exclusive.” 

2. Royalty Income
“Royalties” are explicitly excluded from UBIT. In order to qualify as “royalties,” amounts received from a corporate sponsor or affinity partner must be paid for the right to use intangible assets owned by the nonprofit. Such intangible assets include the nonprofit’s name, logo, symbols, and trademarks, as well as the facsimile signatures of its officers. A nonprofit’s membership list or mailing list (including segments thereof) also constitutes an intangible asset. Thus, consideration received from a corporate sponsor for use of a membership list is tax-exempt as “royalty” income.

On the other hand, “royalties” do not include income derived from the performance of services for a corporate sponsor. Thus, unless the nonprofit’s services are “related,” amounts received from a corporate partner will be taxable to the extent allocable to such services. Taxable services would include explicit product endorsements (e.g., where the nonprofit or its officials recommend purchase of a sponsor’s product by including comparative language, price information, or other indications of savings or value). Taxable services would also include promotional assistance provided to a corporate sponsor (e.g., where the nonprofit helps a corporate sponsor design a marketing approach keyed specifically to the needs or concerns of the nonprofit’s members).

The following are examples of activities that should generate tax-exempt “royalty” income:

• Licensing a corporate sponsor to use the nonprofit’s name, logo, and membership list in mailing commercial solicitations to its members;
  
• Allowing a corporate sponsor to place the nonprofit’s name and logo on the sponsor’s web page devoted to marketing the sponsor’s products or services;
  
• Allowing a corporate partner to put on its web page a statement identifying itself as the “exclusive sponsor” of an event or conference organized by the nonprofit;
  
• Issuing a joint press release announcing a corporate sponsorship, provided that the nonprofit’s officials do not explicitly endorse the sponsor’s products or services.

If a nonprofit agrees, in the context of a licensing arrangement, to provide more than de minimis services to a corporate partner, the nonprofit will be subject to UBIT on the net income allocable to its services. Where a corporate partner makes a single payment, it may be hard to disentangle the tax-free “royalty” from the taxable “compensation for services.” Thus, it is generally wise in this situation to have two separate agreements—a pure licensing agreement and a separate contract for services. The services contract should indicate how much time the nonprofit expects to spend performing services and specify a payment methodology (e.g., a fixed fee or a formula keyed to hourly billing rates). For further information on services contracts, see below under the caption “Services Income.”

3. Qualified Sponsorship Payments
In 1997, Congress enacted a new “safe harbor” that excludes from UBIT “qualified sponsorship payments.” The IRS issued final regulations on the on the treatment of such payments in April, 2002. A “qualified sponsorship payment” is a payment in exchange for which the corporate sponsor neither gets nor expects any return benefit other than:

• Goods or services, or other benefits, the total value of which does not exceed two percent of the sponsorship payment; or
• Recognition, i.e., use or acknowledgment of the sponsor’s name, logo, or product lines in connection with the nonprofit’s activities.

Thus, corporate payments are ineligible for this exclusion to the extent they represent consideration for advertising the sponsor’s products or services, unless the value of such advertising does not exceed two percent of the total payment. “Advertising” includes any message containing an endorsement, qualitative or comparative language, price information, other indications of savings or value, or any inducement to purchase, sell, or use the sponsor’s products or services.

“Qualified sponsorship payments” would include, for example, amounts received from a corporate sponsor for:

• Displaying the sponsor’s logo on signage at an athletic event;
• Describing the corporate partner as “the exclusive sponsor” of an art exhibit or conference in a brochure about the event; or
• Including the sponsor’s name and logo in newspaper ads about a walkathon and on T-shirts worn by participants.

The UBIT exclusion for “qualified sponsorship payments” is narrower than many people think, because it is unavailable for acknowledgments of corporate support appearing in a nonprofit’s “regularly scheduled and printed material,” such as newsletters and magazines. For these purposes, “printed material” includes materials that are published electronically. Expressions of corporate support appearing in newsletters and periodicals are governed by other legal rules—discussed below under the caption “Advertising Income”—which draw a hazy line between nontaxable “donor recognition” and taxable “advertisements.”

There are also special rules that address when hyperlinks to a corporate sponsor’s web page will convert what would otherwise be an acknowledgment into advertising. Where a nonprofit posts a list of sponsors on its website, and includes in that list a hyperlink to a sponsor’s website, the hyperlink is merely an acknowledgement. However, such a hyperlink will constitute advertising if it leads to a website that features the nonprofit’s endorsement of the sponsor’s products.

A sponsorship payment that otherwise qualifies will remain eligible for the UBIT safe harbor even though the corporate partner is listed as the exclusive sponsor of an event. However, a payment will generally fall outside this safe harbor if, in return for the payment, the nonprofit agrees to limit the sale or use of products or services that are in competition with those of the sponsor. Such an agreement provides a substantial return benefit to the sponsor and will cause at least a portion of the sponsorship payment to be taxable unless it is otherwise excludable from UBIT, as rental or royalty income, for instance.

Where a corporation makes a sponsorship payment but also receives a return benefit of some sort, the law allows the payment to be allocated into tax-exempt and taxable components. However, the final regulations require the nonprofit to prove the value of the return benefit in this situation. If the nonprofit fails to make a “reasonable and good faith valuation” of the return benefit, the IRS may treat the entire sponsorship payment as taxable. Thus, in order to take advantage of this allocation rule, the nonprofit will need to retain contemporaneous evidence to establish the amount of any gross income it derives from performing taxable services or publishing advertisements. Generally, the fair market value of the return benefit is determined when the benefit is provided. However, if the parties enter into a binding, written sponsorship contract, the value of any return benefits are determined on the date that contract is executed.

B. TAXABLE ACTIVITIES AND INCOME
Any portion of a payment received from a corporate sponsor that does not fit into one of the categories discussed above will likely constitute gross income from an unrelated trade or business, potentially subject to UBIT. Taxable income that nonprofits receive from corporate partners will usually take one of two forms: income from performing services for the sponsor, or income from advertising the sponsor’s business or products. 

1. Services Income
Taxable services income may arise in a variety of corporate sponsorship contexts, depending on how “active” a role the sponsor wishes the nonprofit to play in the relationship. Such services may include:

• Marketing and promotional assistance (e.g., where nonprofit staff draft promotional copy for a sponsor, or help prepare a marketing plan designed to assist the sponsor in “reaching” members);
  
• Sending out application forms for a sponsor’s product or service;
  
• Assistance with fulfillment (e.g., fielding phone calls or complaints from members about a sponsor’s products); 
  
• Providing explicit product endorsements. Of course, some level of endorsement is necessarily implied whenever a nonprofit allows use of its name and logo in connection with a commercial product. Without more, this kind of “endorsement” does not give rise to taxable services income. Rather, a taxable “endorsement” will generally occur only if the nonprofit’s officials provide evaluative information about the sponsor’s product (e.g., commenting on the product’s low price, high value, or superiority to competing products). A taxable endorsement may also arise where nonprofit officials explicitly urge people to purchase a particular product. 
  
• Providing testing or evaluation services. For example, a corporate sponsor might pay a nonprofit to “field test” its product (such as computer software), provide the sponsor with suggestions for improvements, and publish a report about its experience. Depending on the facts, this scenario risks generating two types of unrelated business income: (1) income from performing testing services, of the sort that a laboratory or the sponsor’s own staff would otherwise perform; and/or (2) income from endorsing the sponsor’s product.

To avoid realizing taxable services income, a nonprofit should limit its involvement to “quality control” review of marketing materials prepared by the sponsor, aimed to ensure factual accuracy, good taste, and appropriateness for distribution to members. In its corporate sponsorship contracts, nonprofits should refrain from boilerplate promises to “cooperate with” the sponsor on the marketing front, whether or not staff members actually intend to spend much time doing this. To minimize the risk of taxable “endorsements,” nonprofits should limit discussion of corporate sponsorships in their periodicals and press releases to (a) announcing the corporate sponsorship and (b) explaining the benefits that the arrangement offers to the nonprofit and its members. 

If a nonprofit agrees to perform marketing or other taxable services for a corporate sponsor, these services should be covered by a separate contract providing for distinct compensation (as recommended above). The compensation should enable the nonprofit to make a modest profit from rendering the services, after deducting all applicable costs (e.g., allocable salary and benefits of the staff involved, plus applicable overhead). Staff members performing taxable services will generally have to keep timesheets to document these costs. 

2. Advertising Income
“Advertising income” may arise from garden-variety commercial advertisements, direct-mail inserts in magazines, or product samples or promotions included in nonprofit mailings. In the case of print media, moreover, “advertising income” may be generated not only by traditional ads featuring product displays, but also by innocuous-looking “acknowledgments” of a corporate sponsor’s support. As noted earlier, acknowledgments of support appearing in regularly scheduled printed material, such as newsletters and magazines, cannot qualify for the “qualified sponsorship payment” safe harbor. 

Where a nonprofit publishes print advertisements or taxable “acknowledgments” for a sponsor, the resulting gross advertising income will normally be obvious, based on the “going rate” in that periodical for similarly-sized ads. There may also be “going rates” for banner advertisements on web sites. However, it is less clear what value attaches to the provision of an electronic link to a sponsor’s web site, the cost of which is virtually zero to the nonprofit. The value to a corporate sponsor of an “exclusive provider” arrangement may also be difficult to determine objectively. In short, a nonprofit that ventures outside the safe harbors for “qualified sponsorship payments” and “royalties” may find itself saddled with an awkward valuation issues.

C. AVOIDING IMPROPER “PRIVATE BENEFITS”
Traditional corporate sponsorships and licensing arrangements usually present fairly straightforward questions under UBIT. Where a business and nonprofit will be collaborating more directly on a substantial joint project, concern may arise about whether the nonprofit is conferring an impermissible “private benefit” on its commercial partner. In contrast with the ban against “private inurement,” which addresses only transactions with “insiders,”—e.g., officers or directors—the ban against “private benefits” embraces transactions with outside parties who may have no on-going relationship with the nonprofit. 

However, improper “private benefits” will generally not be a serious concern where the business and the nonprofit are completely unrelated parties and their agreement results from hard bargaining on arm’s-length terms. A few basic guidelines will help nonprofits keep their arrangements on the right side of the line:

• The joint project must clearly advance a tax-exempt purpose of the nonprofit. For example, if a nonprofit educational organization agrees to provide a for-profit Internet site with policy briefings and other documents, the nonprofit would need to be clear the web site will grant access to the materials in a way that is consistent with the nonprofit’s educational mission. Similarly, if a nonprofit policy institute wanted to partner with a for-profit research organization to create and maintain a database of statistical information, the nonprofit would need to ensure that the data is used for specifically charitable or educational purposes—perhaps by granting free access to scholars or using the data in the nonprofit’s own publications.
  
• The nonprofit must be able to show that the benefits received by the for-profit party are a necessary concomitant—i.e., a predictable and inevitable result—of achieving this tax-exempt purpose. Under this standard the fact that the Internet publisher or the research organization made a reasonable profit from the joint project is not a disqualifying “private benefit” because providing an element of profit is a necessary inducement to obtaining their participation. Similarly, any incidental benefits the for-profit might receive—like increased visibility or market exposure for its product in the case of the Internet publisher—would be an inevitable by-product of conducting the joint program, and therefore perfectly permissible.
  
• The deal must be economically fair to the nonprofit. Usually, fairness will be presumed if the nonprofit can show that it bargained at arm’s length with the other side. However, in determining whether a transaction is economically fair, it is important to consider all the benefits the for-profit will receive under an arrangement. So, in the case of the nonprofit educational organization that partners with a for-profit to create a database, it would be appropriate for the nonprofit to consider any revenues the for-profit expects to make from using the database in determining how expenses and revenues should be split between the parties. When in doubt—or if the transaction involves major assets of the nonprofit—it may be advisable to get a professional appraisal or “fairness opinion.”

Please note that this information is provided as general guidelines and should not substitute for individual legal advice. 

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Page last updated: March 2003