unrelated business income: sponsorship, social media …€¦ · unrelated business income:...

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UNRELATED BUSINESS INCOME: SPONSORSHIP, SOCIAL MEDIA AND MORE

MIKE SORRELLS, LAURA KALICK AND SANDRA FEINSMITH OCTOBER 10 2013

Unrelated Business Income: Sponsorship, Social Media and More

Your Presenters

Mike Sorrells National Director Nonprofit Tax Services [email protected] Laura Kalick National Director Nonprofit Tax Consulting [email protected] Sandra Feinsmith Southeast Director Nonprofit Tax Services [email protected]


Disclaimer

• To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this presentation (including any handouts) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

• Material discussed in this tax presentation is meant to provide general

information and should not be acted on without professional advice tailored to your organization’s or firm's individual needs.


Agenda

• IRS Focus on Unrelated Business Income Tax (UBIT) • College and University Report

- UBIT Findings • UBIT Expenses • State UBIT • Corporate Sponsorships vs. Advertising • The Internet and Social Media • Q and A


Focus on UBI

• IRS has focused on UBI in their Workplan and in the College and University Compliance Program

• Determining whether an item is substantially related is difficult because it is a facts and circumstances analysis

• There is a lot more potential revenue from disallowing losses for income that an organization has already declared as unrelated.

• Another area for potential revenue that runs across several segments of the nonprofit community is sponsorship/advertising income.

• The revised Form 990 provides a roadmap—let us begin here.


Form 990 and UBI

• Page 1 reveals gross UBI reported on Form 990 and net UBI reported on Form 990-T

• Page 2 provides explanations of various programs that could potentially create UBI

• Page 9 reveals how an organization has characterized various revenue streams as either related or unrelated or excluded

• Schedule K indicates whether there is any unrelated business use of bond financed property.


IRS 2013 IRS EO Workplan UBIT

EO will continue on its Unrelated Business Income Project begun in 2012 Statistics of Income

- 2006 tax year, less than 50% of returns filed showed positive amounts of UBTI

- This year IRS will be examining a “statistically valid” sample of nonprofits that have reported “substantial” UBI for 3 consecutive years but have reported no income tax due

- We see a lot of organizations in exactly this situation

• May be legitimate (e.g., LLC/LP investments and/or business activities that will eventually turn around)

• May be result of aggressive expense allocations

• May be caused by netting a perennial loss activity (that does not qualify as a trade or business) with other activities which do produce UBI

• Sometimes, all of the above


IRS Colleges and Universities Compliance Project (CUCP)—UBI

• The Project was begun in 2008 when the IRS sent a 33-page questionnaire to 400 colleges and universities that included public, private, small, large and medium sized institutions. An interim report was issued in 2010.

• As a result of the answers to the questionnaire, IRS decided to examine 34 of the schools and waited until those examinations were completed to come out with the final report

• April 25, 2013—IRS issued the CUCP Final Report • In addition to UBIT the Final Report also focused on a variety of compensation

issues. • This is a good report to be familiar with: http://www.irs.gov/pub/irs-

tege/CUCP_FinalRpt_042513.pdf

http://www.irs.gov/pub/irs-tege/CUCP_FinalRpt_042513.pdf

http://www.irs.gov/pub/irs-tege/CUCP_FinalRpt_042513.pdf


Importance of CUCP to Other Exempt Orgs

• On May 8, 2013, the House Ways and Means Subcommittee on IRS Oversight held a hearing on the CUCP Final report and indicated that the findings were “troubling” and asked IRS whether the level of noncompliance was pervasive throughout the tax exempt sector.

• IRS is currently conducting a study to determine if the noncompliance found in the University sector is pervasive throughout the entire EO community.

• Congress may legislate based upon the findings of the Final Report and the IRS study!

• Expect more targeted IRS inquiries and audits! • Here are the examination results…


CUCP—UBI Examination Results

• Underreporting of UBTI resulted in an increase in UBTI for the schools totaling approximately $90 million in the aggregate and disallowance of more than $170 million in losses and net operating losses (NOLs)

• Disallowance of losses due to lack of profit motive; - NOLS’s disallowed - Offsetting against profitable activities not allowed

• Improper expense allocations, such as where expenses for related activities were used to offset unrelated income or where an allocation of overhead to unrelated activities was unreasonable;

• Errors in computations or substantiation of NOLs; and • Misclassification of an activity as exempt when it was really unrelated • Let’s look at UBI expenses


UBI Expenses

• Item must first be a deductible item under the IRC - E.g. nonqualified deferred compensation is not deductible - Only 50% of meals are deductible

• If there are losses from the activity on a continual basis, the IRS and the courts have taken the position that there is no profit motive and therefore the trade or business requirement has not been met. - Portland Golf Club, 497 US 154(1990) - Groetzinger, 480 US 23(1987) - There may be a legitimate reason for the loss


College and University Survey Possible Reasons for UBI Losses

A = Business was in start-up phase B = Actual costs were significantly greater than anticipated or

budgeted C = Competitive pressures prevented pricing to allow for full

recovery of costs D = Less demand for product or service than was projected E = Business was in business cycle downturn F = Budgeted to operate at breakeven or a loss because doing so contributed to

the organization’s exempt mission G = Business was in winding-up phase H = Other


Three Baskets of Expenses

• Directly connected to UBI activity—proximate and primary—deduct in full • Exempt/related expenses-do not deduct at all • Dual use—allocate on a reasonable basis


Directly Connected to Unrelated Activity

• Under section 1.512(a)-1(a) of the Regulations, an item of expense is directly connected with an unrelated trade or business it if has a “proximate and primary relationship” to the conduct of that trade or business.

• Deduct full amount of directly connected expenses against UBI.

- Example: Individual’s only activity is procuring advertising for a publication


Related Expenses

• Identify those expenses that are strictly for exempt purposes and do not use those expenses to offset unrelated business income. Also, do not include those expenses in management and general administration that are program or fundraising related

• Examples:

- Development officer and fundraising expenses - Government relations - Community benefit studies


Dual Use Expenses

Dual use of facilities or personnel. Where facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses, depreciation and similar items attributable to such facilities (as, for example, items of overhead), shall be allocated between the two uses on a reasonable basis. Similarly, where personnel are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses and similar items attributable to such personnel (as, for example, items of salary) shall be allocated between the two uses on a reasonable basis.


Salary Allocation

• Assume that X, an exempt organization subject to the provisions of section 511, pays its president a salary of $20,000 a year. X derives gross income from the conduct of unrelated trade or business activities. The president devotes approximately 10 percent of his time during the year to the unrelated business activity. For purposes of computing X's unrelated business taxable income, a deduction of $2,000 (10 percent of $20,000), would be allowable for the salary paid to its president.

• To support such an allocation, it is always recommended that there be time records or other documentation for the allocation!


Allocation of Overhead

• Gross receipts allocation method is never reasonable if users are charged different amounts

• Example: Hospital laboratory - Different patients, whether patients of the hospital or patients of private

physicians may be charged more or less depending upon the rate negotiated with the insurance company


Rensselaer Polytechnic Institute (RPI) • RPI argued and won:

- Fixed expenses should be allocated on same basis as variable—Time of actual use vs. total time used

• IRS position: - Time of actual use versus total time available


Reasonable Method

• More than one method may be reasonable and may not have to be the best • Rennselaer Polytechnic--Action on Decision (1987-014, 6/29/1987)

- IRS will not litigate until regulations changed and “reasonableness” test is amended


Tax Exempt Bond Implications

• IRC 145 provides that an IRC 513 unrelated trade or business use is not a qualified use for purposes of the private activity bond rules.

• If an organization allocates a portion of a building to unrelated business activity, that is documentation regarding the use of the proceeds.

• Be sure that Schedule K disclosure is not at odds with debt-financed UBIT calculation or other UBIT reported in terms of unrelated use of bond financed assets

• Note: the IRS has started a program of audits on tax exempt bonds; so a good analysis of bond activity is a very timely idea. Consider bringing in bond counsel on this analysis


Statute of Limitations and UBI • In general, for federal income tax purposes, the government has three years

from the date a tax return is filed to go back and assess taxes and otherwise, there is a statute of limitations on going back further unless there is a material understatement of tax liability, i.e., greater than a 25% understatement and then the statute of limitations is generally six years.

• If an organization never filed a tax return, then there is no limitation on how far back the government can go to assess taxes, interest and penalties.

• Net Operating Losses (NOL)—IRS can go back to the year that the NOL was generated to see if the losses were legitimate.


State UBI

• Most states tax UBI (exceptions include among others, PA, NJ)

• Most organizations are in compliance with state filings in states where they have a physical location and employees and it is clear that there is nexus in the state

• It may be unclear whether an alternative investment sited in a particular state establishes nexus—Partnerships send K-1s stating state tax information


State UBI

• If no return is filed, in addition to unlimited ability of the government to assess taxes, interest and penalties, a loss in one year cannot be used to offset income in another year unless a return establishes the loss

• ASC 740-10(FIN 48)--An organization that has not filed a tax return may have to establish a reserve to take into account the liability. The reserve should take into account all the income earned when the organization held the investment and the interest and penalties associated with that liability. If the organization continues to not file returns, the reserve will keep growing.


Introduction to Corporate Sponsorships

• More and more nonprofits are seeking sponsorship dollars to support their activities

• Much of this is in the form of corporate sponsorships which can be very complex arrangements

• What kind of income is a corporate sponsorship? - Contribution? - Payment for services? - Unrelated Business Income (UBI)?

• As you will see, it is often a combination of all three • Are there ways to structure sponsorships so they avoid UBI?


Background

• In early 1990’s, IRS audited certain college bowls, most notably the Mobil Cotton Bowl, and concluded that sponsorship income was UBI

- IRS held that these payments were not royalties and were regularly carried on

- Not a popular decision– attempts were made to have sponsorship excluded from UBI

• Proposed regulations in 1993 with criteria for excluding from UBI • In 1997 Congress added Section 513(i) which provided that qualified

sponsorship payments were not UBI • Final regulations (Reg. Sec. 1.513-4) were released in 2002 which contain

good definitions and good examples which fall within the safe harbor


Sponsorships

Qualified Sponsorship Payment • No “substantial return benefit” • Mere acknowledgement vs. advertising

- Name, logo, address, etc. - No comparison or sales information

• Does not matter whether sponsor takes a charitable or business deduction • Website click through okay


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Safe Harbor – Qualified Sponsorship Payment • Acknowledgement does not count toward substantial return benefit • Benefits cannot exceed 2% and contract still qualifies under safe harbor • Burden of proof on exempt organization to establish fair market value of

benefits, not the corporate sponsor • Safe harbor does not apply to periodicals nor to trade shows • Payment may be exempt for other reasons


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Acknowledgement

• Mere recognition of a sponsor • Logos and slogans that do not contain comparative and qualitative descriptions

of the sponsor’s products, services, facilities, or company • Sponsor locations and telephone numbers • Value-neutral descriptions, including displays or visual depictions of a sponsor’s

product line or services • Sponsor brand or trade names and product or service listings • Logos or slogans that are an established part of a sponsor’s identity are not

considered to contain comparative or qualitative descriptions


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Advertising

• Subject to unrelated business income tax • “Any message or other programming which is broadcast, published, displayed or

distributed in exchange for any remuneration, and which promotes or markets any company, service, facility or product.”

• Advertising does not include acknowledgements • Advertising includes:

- language containing qualitative or comparative language, price information, other indications or savings or value, endorsements or inducement to buy

- Message of endorsement by the organization on the sponsor’s website


Corporate Sponsorship Regulations Reg. Sec. 1.513-4

• Definition of Qualified Sponsorship Payment: “Any payment made by any person engaged in a trade or business with respect to

which there is no arrangement or expectation that such person will receive any substantial return benefit other than the use or acknowledgement of the name or logo (or product line) of such person’s trade or business in connection with the activities of the organization that receives such payment.”

• Qualified sponsorship payments are treated as contributions by the organization even

though the sponsor may treat them as promotion or advertising for tax purposes.

• Note: Payments contingent upon level of attendance, broadcast ratings or other factors indicating degree of public exposure are not qualified sponsorship payments.


Sponsorship Regulations (Con't)

• Substantial Return Benefit may include the following - Advertising - Exclusive provider arrangements - Goods, facilities, services or other privileges - Exclusive or nonexclusive rights to use an intangible asset such as a

trademark, patent, logo or designation of the exempt organization

• Benefits may be disregarded if aggregate value of all the benefits is not more than 2% of the payment



• Allocation of payment: - If there is substantial return benefit, then only the portion of payment which

exceeds the fair market value of the benefit(s), is considered a qualified sponsorship payment

- FMV is price that would be paid by a willing recipient and willing provider of the product or service at date the service is provided unless there is a binding contract and the FMV “of any substantial return benefit provided pursuant to that contract is determined on the date the parties enter into the sponsorship contract”

- With multiple benefits, the value of each must be established - Some of the benefits may be taxable, while others, while not qualified

sponsorship, will be related to exempt purpose of the organization (will illustrate later in example)

• IRS will make allocations if organization does not make a “reasonable and good

faith valuation of any substantial return benefit”



Exclusive Provider • Exclusive Provider Arrangement “limits the sale, distribution, availability, or use of

competing products or services in connection with an organization’s activities” • Example: Sole soft drink brand to be sold at a university • Exclusive provider arrangements are not qualified sponsorships but not necessarily

UBI unless the organization provides services unrelated to its exempt purposes as part of the agreement

Exclusive Sponsor • Right to be the only sponsor for an event • This is a qualified sponsorship payment although there may be other substantial

return benefits included in the payment that must be allocated.


Example

• Organization has annual meeting with a trade show in one of the hotel halls • Platinum level sponsors, for a $50,000 payment receive the following:

- Banner in main venue of meeting saying that X is a platinum sponsor along with their corporate logo and slogan

- Name on tote bags and logo on all presentation materials - Free booth at trade show (value $5,000) - 6 Free admissions to the entire annual meeting (value $1,000 each) - Executive of the sponsor allowed to introduce keynote speaker - 2 full page ads in the organization’s monthly magazine (value $4,000 each)

• What is return benefit, amount of corporate sponsorship, and how much is taxable UBI?


Example Answer

• Banner acknowledgement, tote bag and logo on presentation materials, and intro of speaker is qualified sponsorship

• Free booth at trade show is a return benefit but not taxable as income from qualified trade show is excluded from UBI

• Free admissions to the meeting are return benefits, but not taxable as meeting income is related to exempt purpose

• Full page ads are taxable as advertising income and value is included in the advertising UBI calculation along with traditional payments for advertising


Example Breakdown

• Return benefits= trade show booth ($5,000), free admissions ($6,000), and ads in magazine ($8,000)

• Total return benefits = $19,000 • Amount in excess of return benefits is Qualified Sponsorship (donation) =$31,000


The Internet and Social Media

• Cost effective way for nonprofits to increase communications and fundraising to wide audience

• Most popularly used: - Websites - Emails - Facebook - Twitter - YouTube


IRS Activity With Social Media

IRS is actually very active with social media. They have: • Multiple Twitter accounts • Facebook pages

• Very little guidance has been given to organizations regarding social media • Official IRS stance: Treat online communications (Internet, Facebook,

Twitter) same as other forms of communications


Why should organizations be concerned about social media from tax perspective?

• IRS agents have been trained to look at your website and social media • Free access to organization’s information and potential audit trail for IRS and

states regarding: - Political activities/ lobbying - Are online and social media activities in accordance with organization’s

exempt purpose - Potential sources of UBIT such as:

• Advertising vs. Qualified Sponsorship Income - Charitable solicitation (also of interest to state regulators)


UBIT Implications of Social Media

• As discussed earlier, IRS Code and Regulations are enforced and applied to an organization’s online and social media activities same as normal activities.

• Example of UBIT potential implication of Social Media - Advertising versus Qualified Sponsorship Payments - Examples of what qualifies as a Qualified Sponsorship Payment versus

Advertising in online activities are shown in IRC Reg. 1.513-4(f)


IRS Regulations

Example (11). W, a symphony orchestra, maintains a website containing pertinent information and its performance schedule. The Music Shop makes a payment to W to fund a concert series, and W posts a list of its sponsors on its website, including the Music Shop's name and Internet address. W's website does not promote the Music Shop or advertise its merchandise. The Music Shop's Internet address appears as a hyperlink from W's website to the Music Shop's website. W's posting of the Music Shop's name and Internet address on its website constitutes acknowledgment of the sponsorship. The entire payment is a qualified sponsorship payment, which is not income from an unrelated trade or business.


IRS Regulations

Example (12). X, a health-based charity, sponsors a year-long initiative to educate the public about a particular medical condition. A large pharmaceutical company manufactures a drug that is used in treating the medical condition, and provides funding for the initiative that helps X produce educational materials for distribution and post information on X's website. X's website contains a hyperlink to the pharmaceutical company's website. On the pharmaceutical company's website, the statement appears, “X endorses the use of our drug, and suggests that you ask your doctor for a prescription if you have this medical condition.” X reviewed the endorsement before it was posted on the pharmaceutical company's website and gave permission for the endorsement to appear. The endorsement is advertising. The fair market value of the advertising exceeds 2% of the total payment received from the pharmaceutical company. Therefore, only the portion of the payment, if any, that X can demonstrate exceeds the fair market value of the advertising on the pharmaceutical company's website is a qualified sponsorship payment.


UBIT Implications of Social Media (continued)

Example: Organization tweets that one of its corporate sponsors is running a special on

hammers and receives a commission based on number of tweeters who access the sponsor’s site • In applying IRS current rules and regs regarding this:

- Tweet would be considered advertising - Commission would constitute UBI - Could that tweet taint the overall Corporate Sponsorship agreement with

sponsor?


Best practices regarding Social Media

• Develop and enforce social media policies for the organization as well as guidelines for its employees.

• Remember a lot of damage can be done in 140 characters with an attachment.

• Nightmare stories of “drunken” or “destructive “ tweets or Facebook posts from disgruntled employees or representatives of the organization.

• As with normal offline activities, consult your tax advisor and legal counsel regarding making sure the organization’s online and social media activities are structured correctly in order to minimize IRS and legal scrutiny and exposure as well as to protect the organization’s reputation.

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Summary

• Unrelated Business Income is a very hot topic with the IRS and it is a good time to get one’s house in order in this area

• The recently completed IRS college and university report is an eye-opener in the UBI area and many lessons are there for all of us

• UBI expense allocation is a major issue and organizations should address this on a regular basis

• Corporate sponsorship, if done properly, can be a great source of non-taxable income, but can also contain advertising– know the rules!

• Social media and the internet can also cause UBI problems– know what your organization is doing online

unrelated business income: sponsorship, social media …€¦ · unrelated business income:...

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