Clarifying Unrelated Business Income

TAX CASE

Although tax-exempt organizations are exempt from federal taxation on their principal activity, they must pay tax on any unrelated business income. Numerous court cases have considered what constitutes unrelated business income. Recently the Eighth Circuit Court of Appeals clarified the taxation of royalty income.

The Arkansas State Police Association signed an agreement with Brent-Wyatt West (BWW) to publish a magazine called the Arkansas Trooper. Labeled a royalty agreement, the document required BWW to pay the police association $25,200 per year plus between 26% and 27% of the magazine’s advertising revenue. BWW had total responsibility for marketing the magazine and paying all publication costs. The association’s vice-president of public relations spent only 15 to 20 hours a year on magazine-related activities including reviewing content for suitability and encouraging members to submit articles and photographs.

The Tax Court agreed with the IRS that the association’s receipts of about $877,000 in the years at issue were taxable unrelated business income and not nontaxable royalty income. The association appealed.

Result. For the IRS. The taxpayer argued that the proceeds were passive royalty income exempt from tax under IRC section 512(b). It equated its case to the affinity-card cases in which the courts held that the payments an exempt organization had received for the right to use its name were nontaxable royalty income. They also relied on two examples from revenue ruling 81-178, 1981-2 CB 135.

In both instances the tax-exempt entity licensed its name to a taxable organization, which used the name to sell a product. In the second situation, however, the exempt entity required its members to perform services endorsing the taxable entity’s product. The ruling concluded the payments in the first example—simple use of name—were nontaxable royalties whereas the payments in the second—name plus services—were taxable unrelated business income. According to the police association the existence of the services made the payments taxable. Since it did not perform any services for BWW, the association said, it did not have any taxable income.

The Eighth Circuit was able to distinguish the precedents the association cited. In both cases the taxable entity used the tax-exempt entity’s name to market its own product. In this case the taxable BWW, instead, was marketing the association’s product—its magazine. The court determined the appropriate precedent was National Collegiate Athletic Association, which held that the publication and sale of the Final Four basketball brochures were taxable unrelated business income since the product promoted the tax-exempt organization.

In most cases the decision on the taxability of proceeds will be determined based on whether members of the tax-exempt organization performed personal services. However, if the product being marketed is the exempt organization itself, the proceeds will be taxable even without performing personal services.

Arkansas State Police Association v. Commissioner, 282 F3d 556, 2002-1 USTC 50, 269.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.