IRS Clarifies Royalty Exception to UBIT

Provisions in the Tax Cuts and Jobs Act have brought renewed attention to nonprofits’ potential liability for unrelated business income tax (UBIT). Organizations generally are subject to a 21% tax on unrelated income, but exceptions apply — including one for royalties.

Although “royalties” aren’t defined in the U.S tax code or regulations, a recent IRS Technical Advice Memorandum shot down one nonprofit’s claim that some of its income qualified for an exception. The memo applies only to the situation it considered. However, it can shed light on the factors the IRS weighs when evaluating whether income qualifies for the royalty exception.

Failure to Report

The income in question was received by an unidentified association, which publishes academic journals and earns revenues from advertising sales. The organization also has offered a job placement program — charging employers and job seekers fees — for more than 40 years. It developed a web application for the program, but, after encountering technical problems, contracted with a for-profit vendor to manage it.

On audit, the IRS found that the association failed to report income from the online program on its Forms 990-T. The association conceded that its online placement service is an unrelated trade or business but argued that it doesn’t conduct the connected services. Rather, it asserted, the vendor conducts the service and any income received by the association constitutes royalties.

IRS’s Stand

The IRS memo finds the online placement services to be a trade or business of the association. It rejects the nonprofit’s argument that the income stems from the licensing of its website, trademarks and members list.

The memo identifies several factors that support this conclusion, including:

  • Lack of licensing language. The agreement between the association and the vendor includes no reference to the association’s tangible or intangible property — such as its name or trademarks. And it doesn’t mention the transfer or use of such property to the vendor. The memo further points out that the online program isn’t a vendor web page with the association’s name, but part of the association’s website.
  • Income share. The association receives almost all of the income from users of the service, less a nominal credit card transaction fee. The IRS contrasted this arrangement with the situation where a nonprofit receives as little as 50% of the income from a member’s use of an affinity credit card. The latter is much more likely a royalty.
  • Service agreement. The agreement is titled “Website Operator Service Agreement,” suggesting it outlines the terms of services provided by the vendor, not a licensing agreement. In addition, it refers to the vendor as “provider” and the association as “customer,” meaning the vendor provides the services for the benefit of the taxpayer. A licensing agreement would establish that the association’s intangible assets are provided for the benefit of the vendor.
  • Overall operations. The association operated the service on its own for decades. It also provides significant services for the job placement activity. For example, it sets the prices and determines the content, type and timing of any advertising for the service. Moreover, it maintains a small team that provides career and resume advice as part of the placement services.

Proceed with Caution

The IRS memo (https://www.irs.gov/pub/irs-wd/202039018.pdf) highlights some facts and circumstances that might lead to taxation of the income a nonprofit considers exempt royalties. Your Hood & Strong financial advisor can help you review your vendor arrangements to see if you’re potentially at risk for unexpected taxes.