This edition of Nonprofit Advisor delivers an attorney’s insights on representing clients whose revenue streams have come under Internal Revenue Service (“IRS”) scrutiny and the importance of planning ahead to ensure that revenue generating practices are compliant with the regulations affecting nonprofit organizations. In the case analyzed, an IRS audit of potentially $4 million of Unrelated Business Income (“UBI”) resulted in a no change.
Initially, the nonprofit organization under scrutiny recognized that circumstances surrounding the audit would require the input of a tax attorney. The issue primarily concerned corporate sponsorship payments received in connection with the organization’s agreements with for-profit companies.
A nonprofit is permitted to engage in business with for-profit companies, but can be subject to unrelated business income tax (“UBIT”) when that business is determined to not be “substantially related to the purpose that is the basis of the organization’s exemption from tax.”
The IRS perspective on the agreements that generated income for the nonprofit was that they were very broad in terms of their language, and suggested that the nonprofit may be subject to UBIT on the basis of the contract’s language. Generally there are exceptions to generating income not “substantially related to the purpose that is the basis of the organization’s exemption from tax” and the revenue stream must fall within a precise set of rules to not be subject to UBIT.
In this case the attorney was able to successfully argue that the business activity in which the nonprofit engaged did fall within the corporate sponsorship exception, as well as other exceptions.
In order to avoid IRS scrutiny and potentially hefty fines associated with noncompliance, nonprofits should take steps to ensure their contracts will stand up to the IRS’ review. In this case the language of the agreements did not account for the specific rules governing the activity of nonprofit organizations and included room for interpretation by the IRS that was not favorable. Drafting precise contracts is one area in which a legal professional specializing in nonprofit work can be particularly helpful. It is always advisable to ensure that business contracts leave as little room as possible for any misinterpretation.
What to know About UBIT Exceptions for Qualified Sponsor Payments:
In order to be exempt from UBIT, corporate sponsorships must be classified as a qualified sponsorship payment (“QSP”). A QSP is a payment (whether in money, property, or services) by an entity engaged in a trade or business (i.e., the for-profit sponsor) to an exempt organization (i.e., the nonprofit recipient) without an arrangement or expectation that the sponsor will receive any substantial return benefit [IRC Sec. 513(i)(2)(A)]. This is the only requirement. It does not matter whether the sponsored activity is related or unrelated to the recipient's exempt purpose or whether the sponsored activity is temporary or permanent [Reg. 1.513-4(c)(1)]. QSP’s are excluded statutorily from UBI [IRC Sec. 513(i)(1)].
Sponsor recognition promoting (i.e., advertising) the sponsor's products, facilities, or services is a substantial return benefit that prevents all or a portion of a payment from being a qualified sponsorship payment (QSP). Only the portion that exceeds the fair market value of the advertising is a QSP [Reg. 1.513-4(d)]. Advertising is defined as any sponsor recognition or message that contains qualitative or comparative language (e.g., “sponsor's product is better than competitor X's product”); price information (or other indications of savings or value); an endorsement; or an inducement to purchase, sell, or use the sponsor's products or services [IRC Sec. 513(i)(2)(A)]. Logos or slogans that are an established part of a sponsor's identity are not considered to contain qualitative or comparative descriptions. A single message containing both advertising and an acknowledgment is advertising by statute [Reg. 1.513-4(c)(2)(v)].
How to Protect Your Nonprofit:
Every nonprofit should approach contracts as if they will be reviewed by the IRS. Organizations need to understand that they should take extra care when drafting hiring and business contracts because those agreements lay out the intent of a transaction. It’s very important that nonprofits word agreements appropriately and demonstrate that they know the rules they’re beholden to; their employees know those rules; and they are working in good faith to document each activity and agreement with industry-wide best practices in mind. In summary, it’s essential that nonprofit clients take what is in writing very seriously.
Thank you to Farah N. Ansari, Esq. of Schenck, Price, Smith & King, LLP for providing an attorney’s perspective.
If you have questions about your nonprofit’s UBIT exceptions, an upcoming audit or the steps you can take to ensure your organization is compliant with IRS statutes, contact Sarah Avery at firstname.lastname@example.org.