When an association endorses a vendor's product or service to its members - and is compensated by the vendor for that endorsement - is that compensation taxable to the association? In whole or in part? How can association endorsement contracts be structured to minimize the adverse tax consequences to the association? What can the association do or provide to the vendor that is still consistent with the tax-free treatment of such compensation? The answers to the questions have been slowly evolving in recent years. While definitive answers are still not available, it is important for associations to know where the law stands at this point in time so their endorsement deals can be structured to maximum tax advantage. This article seeks to accomplish that task. It also provides detailed, practical guidance for structuring association endorsement contracts, based on the current state of the law.
Unrelated Business Income. While income derived from association activities that are substantially related to the association's tax-exempt purposes is generally exempt from federal corporate income tax, income from unrelated business activities - regularly carried on business activities that are not substantially related to the association's purposes - is generally taxable as unrelated business income ("UBI"). However, in certain circumstances, even income from activities that fit this definition and that would otherwise constitute taxable income may be exempt from tax if the income qualifies for one of several exclusions from UBI contained in the federal tax code. One of the most important and widely-utilized exclusions is that for "royalty" income.
Royalties. "Royalties" (and deductions directly connected with royalties) are excluded in computing the unrelated business taxable income ("UBTI") of tax-exempt associations. This exclusion does not apply to debt-financed income or to royalties received from a "controlled subsidiary." The Internal Revenue Service ("IRS") defines a royalty as any payment received in consideration for the use of a valuable intangible property right, whether or not payment is based on the use made of the intangible property. Payments for the use (even on an exclusive basis) of trademarks, trade names, service marks, copyrights, photographs, facsimile signatures, and members' names are ordinarily considered royalties and are tax-free. However, payments for services (such as marketing or administrative services) provided in connection with the granting of this type of right are not royalties - and are generally taxable as UBI (unless such services are substantially related to the association's purposes, which, in most cases, they are not).
1. In an example provided a federal appeals court in the Sierra Club case, if the Sierra Club manufactured and sold T-shirts with the organization's logo or other designs on them, the income earned from the sale of such T-shirts would be taxable, as the activity of manufacturing and selling T-shirts is not substantially related to the Sierra Club's tax-exempt purposes. However, if the Sierra Club created the designs to be screened onto the T-shirts and then licensed those designs to a T-shirt manufacturer in exchange for a fee (perhaps calculated as a percentage of gross T-shirt sales), that income would constitute tax-free royalty income.
2. In an example provided by the IRS in a pair of Revenue Rulings, payments for the use of a professional athlete's name, photograph, likeness, and/or facsimile signature (provided by and through a tax-exempt organization) are generally considered royalties. However, payments for personal appearances and interviews by the athlete (similarly provided by and through a tax-exempt organization) are not excluded as royalties and must be included as income from an unrelated trade or business.
Endorsements. When an association endorses a vendor's product or service (often referred to as an association "affinity" program) but does nothing to market the product or service to its members (leaving this task to the vendor), this can be viewed as, in essence, nothing more than an exclusive license of the association's name, logo and (generally) membership mailing list to the vendor (in connection with the vendor's promotion and sale of that product or service to the association's members, and possibly to others in the industry as well). As stated above, if the association gets paid for this exclusive license - even if such payments are calculated as a percentage of gross sales of the endorsed product or service to the association's members - then the payments will constitute royalties and will be tax-free to the association. If, however, the association does market the product or service to its members, then the tax issues become more complex, as described more fully below.
Endorsements can be a useful means for associations to generate non-dues revenue from both members and non-members; promote the association's name and identity, and, by extension, the industry or profession in general; and provide a service (e.g., "tailored" products and services, discounted rates/fees, etc.) to members.
Evolving IRS Position.
For many years, IRS rulings and court decisions have left associations uncertain as to the taxability of the endorsement arrangements described above, as well as of income earned from the rental of their membership mailing lists to others. The litigation that has been undertaken regarding the proper characterization of income as a (tax-free) royalty or as payment for services (and therefore taxable) has focused on the role of the association - namely, what is the association providing in exchange for its compensation. Is it merely providing a license of intangible property (and exercising quality control over its use), or is it also providing marketing and administrative services in connection with the license? In other words, is the vendor paying the association merely for its license of intangible property, or is it also paying for promotional and/or administrative services to be provided by the association?
Note that, even under the IRS' historic positions on this issue, payments for the licensing of intangible property are eligible for royalty treatment even if the intangible property (such as the association's name and logo) is licensed on an exclusive basis, and even if the payments are calculated as a percentage of gross sales of the product or service. As a cautionary note, payments calculated as a percentage of net sales of the product or service can turn otherwise tax-free income into taxable income, as income based on net revenues is indicative of a joint venture.
In the past, the IRS has taken the position that the provision of services of any kind by the association (even in de minimis amounts) in connection with an endorsement/licensing arrangement will "taint" all of the income earned under the arrangement and make it ineligible for royalty treatment, no matter how passive the association's role. In other words, the IRS has maintained that if the association did anything to generate the income beyond the licensing of its intangible property (and exercising quality control over the use of such property by the vendor), then all of the income generated under the arrangement would be taxable. Moreover, the IRS also has historically maintained that the provision of an association's membership mailing list to a vendor in connection with an endorsement arrangement will similarly taint all of the income earned under the arrangement, as the IRS has historically not viewed a mailing list as a form of intangible property.
In many respects, though, the courts that have addressed these issues have held very different views of them, consistently rebuffing the IRS' attempts to tax what the courts consider tax-free royalty income, expressly permitting certain limited association activity in connection with the licensing of intangible property, and clearly stating that association mailing lists are merely another form of intangible property.
Senior IRS officials have recently suggested in public comments that the IRS is considering abandoning its long-held positions on these royalty issues and submitting to the will of the courts that have addressed these issues of late. Moreover, at the suggestion of the U.S. Tax Court, the IRS reportedly is considering the institution of a new enforcement scheme whereby the provision of services (such as marketing or administrative services) by an association in connection with a royalty arrangement would not "taint" the royalty income (as the IRS has maintained in the past), but rather would generate a stream of taxable income for the provision of services, separate but alongside the tax-free royalties earned for the licensing of intangible property (e.g., name, logo, mailing list). The division of the association's two income streams presumably would be based on a fair market allocation.
While recent decisions by an array of federal courts provide guidance to associations in structuring endorsement and licensing arrangements, unless and until the IRS formally conforms its enforcement policy to these decisions, there remains ambiguity and many unclarified issues - and thus potential tax risk - in this area.
Options for Structuring Endorsement Arrangements.
1. Royalties-Only. The endorsement or licensing contract that carries the lowest risk of unrelated business income tax ("UBIT") liability is one in which the association license(s) its name, logo and/or mailing list, exercises quality control over the use of its intangible property by the vendor, and not much more. However, even under this scheme, the IRS and the courts have indicated that the association may engage in certain limited activities without jeopardizing the tax-free royalty treatment of its income. Guidelines for what the association may and may not do under this scheme are set forth below.
2. Royalties to Association; Services Income to Third-Party or Taxable Subsidiary. If administrative and/or marketing services are required, from a tax perspective, it is generally preferable to "outsource" such services to an unrelated third-party, or to the association's taxable subsidiary (with the association and subsidiary entering into separate, independent contracts with the vendor). In a 1999 Private Letter Ruling issued to the American Association of Retired Persons ("AARP"), the IRS validated the use of an AARP-owned taxable subsidiary to provide such administrative and/or marketing services, provided it is done on an arm's length basis (e.g., fair market valuation of the payments to each entity, financial separation, employee time records, etc.).
3. Royalties to Association; Services Income to Association. If such services must be provided by the association directly, then separate, independent, unrelated contracts should be drafted to provide for the name, logo and/or mailing list licensing on the one hand, and the administrative and/or marketing services on the other - recognizing that (at least for now) such a bifurcation of contracts by no means ensures that the IRS will respect such bifurcation and not treat all of the income as UBI. The fees earned by the association should be divided between the two contracts pursuant to some fair market valuation. The former should be treated as tax-exempt royalty income; the latter as taxable UBI. Public comments by senior IRS officials indicate that for such a structure to be respected by the IRS (at least for now), evidence must exist that the contracts are truly separate and not interdependent - in other words, that the parties might have entered into one contract without entering into the other. If the contracts were entered into at significantly different points in time, for instance, this might constitute such evidence, according to IRS officials. In most cases, this will be very difficult to establish. Of course, at some point in the future, the IRS may officially determine that separate contracts are not necessary, and that a fair market division between the tax-free licensing and the taxable services can be done within the same contract. However, based on current IRS precedent, such an approach carries with it a certain degree of tax risk. In some cases, though, the unwillingness of a vendor to enter into separate contracts may give the association no practical choice.
Guidelines for Drafting Association Endorsement Contracts. In light of the recent court decisions and IRS rulings in this area and pursuant to current legal precedent, the following guidelines should be followed when drafting endorsement contracts to minimize an association's potential UBIT liability. Note that, among other things, the guidelines below set forth what activities an association may engage in and what an association may provide to an endorsed vendor without jeopardizing the tax-free royalty treatment of its endorsement income. The same guidelines apply for purposes of all three options set forth above. In each instance, the association earns a stream of royalty income, and the following guidelines describe what activities the association may engage in directly without jeopardizing the tax-free status of that income. Other activities that are not consistent with royalty treatment may be provided by the vendor, by the association's taxable subsidiary, by an unrelated third-party, or, if necessary, by the association itself (in exchange for a separate stream of taxable services income). The guidelines below presume that the provision of marketing and/or administrative services (by whomever will be providing them) will be addressed in a separate contract (or, if necessary, in a separate section of a single contract):
1. The contract should be called a "Royalty Agreement" or "License Agreement," and the fees to be earned by the association should be expressly referred to in the contract as "royalties."
2. The contract should specify that fees to be earned by the association are solely in consideration for the association's licensing of its intangible property (and not for any services), and such intangible property to be licensed should be specified (e.g., name, logo, membership list, facsimile signatures, letterhead stationery design, etc.). Moreover, the contract should expressly state that it is a wholly independent contract that is not tied to any other agreement or obligation of the association.
3. The contract should specify that the association may exercise quality control over all uses of its intangible property. Specifically, the contract should reserve to the association the right to review and approve in advance all marketing materials and all other uses of its intangible property in order to protect the association's name and goodwill. Note that under federal trademark law, trademark owners are obligated to exercise control and supervision over the use of their trademarks by others to avoid jeopardizing their trademark rights. Moreover, the IRS has clearly stated that the exercise of such quality control rights is fully consistent with tax-free royalty income.
4. The contract should not list any required duties or activities pursuant to which the association will assist the vendor in the marketing or administration of its products or services (e.g., providing free advertising space in the association's magazine, providing free exhibit space at the association's trade show, drafting and sending letters to the association's members to promote the product or service, processing applications for the product or service, answering questions about or fielding problems with the product or service). All marketing and administration of the product or service should be conducted and paid for - at fair market rates - by the vendor, an unrelated third party, or the association's taxable subsidiary (e.g., the association's regular rates should be paid for advertising space in the association's publications, exhibit booth space at the association's trade shows, etc.). The association's programs or facilities (such as the association's magazine, trade show, membership mailings, or broadcast fax or e-mail system) may only be used to promote the vendor's product or service if such promotions are created and paid for by the vendor or a party other than the association. For instance, the association should not be involved in or pay for the cost of creating magazine advertisements, designing trade show booths, or drafting marketing letters. The association, may, however, review, edit and approve such items as part of the exercise of its quality control rights. However, the vendor or other party must then pay fair market value for the placement of the ad in the association's magazine (taxable advertising income to the association), for the exhibit booth at the association's trade show (tax-free trade show income to the association), or for the right to be included in an association membership mailing, new member packet, broadcast fax or e-mail, etc. (taxable advertising income to the association). The association should not share in the vendor's expenses for such items.
5. The association may list and refer to one or more endorsed products or services in printed lists of member benefits, but such listings should be of minimal descriptiveness so as to not be construed as ads or promotions on behalf of the vendor. Similarly, it should be permissible for a staff member or volunteer leader of the association to verbally mention an endorsed product or service at an association meeting or conference, but anything more than a brief mention in passing could be construed as a promotion of the vendor. If a listing of the endorsed product or service is provided on the association's Web site, it currently is unclear whether the association also may, consistent with royalty treatment, provide a hyperlink to the vendor's Web site. If the association charges other vendors for the right to maintain a hyperlink to their Web site on the association's site, then the association certainly should charge an endorsed vendor in the same manner. Moreover, the IRS has suggested informally that if the link goes directly to a page on the vendor's Web site where the endorsed product or service may be ordered, this is more likely to constitute the provision of an advertising service and should be paid for by the vendor. Even if the association does not otherwise charge vendors for the right to maintain hyperlinks, and even if the link is to the home page of the endorsed vendor's Web site, a modest charge to the endorsed vendor in consideration for this right would be prudent, at least unless and until the IRS says otherwise. Of course, such charges will constitute taxable income to the association.
6. It is permissible for the association to license the facsimile signature of one of its staff members or volunteer leader for use on a marketing letter that is drafted and paid for by the vendor; this is merely the licensing of intangible property. Moreover, it is permissible for the association to license its letterhead stationery design to the vendor for use in preparing such marketing letters - again a mere license of intangible property - so long as the vendor pays or reimburses the association for the costs of the printing and paper on which the letterhead design is printed. Finally, of course, the vendor should pay the costs of sending the letters (through whatever medium - email, mail, etc. - they are sent).
7. Always use gross income as a measurement tool for determining royalty payments (e.g., royalties calculated as a percentage of gross sales of the endorsed product or service to members). The association should never contract for any percentage of net profits from the sale of the product or service, as this is indicative of a joint venture and can turn otherwise tax-free royalty income into taxable UBI.
8. The contract should expressly state that it is not intended to create a "joint venture" or "partnership" between the parties. In addition, the contract should avoid the word "agent." The vendor should not be referred to as an agent of the association, nor should the association be referred to as an agent of the vendor.
9. The endorsed product or service always should be referred to as the vendor's product or service, and should never be referred to as a product or service of the association.
10. All miscellaneous documents, such as marketing materials, correspondence and board meeting minutes, should be consistent with the contract. A "paper trail" that is inconsistent with the terms of the contract can undermine the beneficial tax treatment the association might otherwise enjoy.
For more information, contact the author at jtenenbaum@TenenbaumLegal.com.