IRS exams and tax-exempt organizations: sponsorship payments and UBTI

This is the second in a series of articles that address common issues raised during U.S. Internal Revenue Service (IRS) Examinations of tax-exempt organizations.  In the first article, we focused on two interrelated issues: (1) Dual Use Facility Expense Allocations and (2) Hobby Loss Activities.  This second article focuses on the many pitfalls that tax-exempt organizations may encounter when benefits are provided in exchange for sponsorship payments.  All tax-exempt organizations that receive sponsorship payments should be cognizant of these rules to avoid harsh tax results. For instance, the IRS will aggressively attempt to re-characterize messaging provided on behalf of sponsors as advertising, which would generate unrelated business taxable income (UBTI). The good news is that proactive tax-exempt organizations can consult with tax advisors to ensure that sponsorship payments are structured and administered in a tax-efficient manner.

Qualified sponsorship payments and UBTI, generally

UBTI does not include “qualified sponsorship payments.” A qualified sponsorship payment is defined as a payment made by a person engaged in a trade or business if the sponsor has no arrangement or expectation that there will be a “substantial return benefit.” In other words, if a sponsor gives money to a tax-exempt organization solely for philanthropic reasons, there is no UBTI. However, if a sponsor gives money to a tax-exempt organization and receives benefits in return, then there is potential UBTI. 

Also a substantial return benefit does not include the use or acknowledgement of the name, logo or product lines of the sponsor. This includes exclusive sponsorship arrangements; logos and slogans that do not contain qualitative or comparative descriptions of the sponsor’s product, services, facilities or company; a list of the sponsor’s locations, telephone number or internet address; value-neutral descriptions, including displays or visual depiction, of the sponsor’s product-line or services; and the sponsor’s brand or trade names and product or service listings.

Benefits that create UBTI concerns

There are four specific benefits that can, when provided to a payer, create UBTI concerns, including:

  1. Advertising
  2. Exclusive provider arrangements
  3. Goods, facilities, services and other privileges
  4. Exclusive or nonexclusive rights to use a tax-exempt organization’s logo
I.  Advertising defined

Generally, advertising is the return benefit that most sponsors receive that results in taxable income to the tax-exempt organization. Advertising is defined as messaging that promotes or markets the sponsor’s trade or business. Advertising includes messages containing qualitative or comparative language, price information or other indications of savings or value, an endorsement, or an inducement to purchase, sell or use any company, service, facility or product. Messages that include only the sponsor’s logo, phone number, internet address, physical locations or value-neutral description of the sponsor’s product do not constitute advertising. 

The treasury regulations contain this example of advertising: “This program has been brought to you by the Music Shop, located at 123 Main Street. For your needs, give them a call today at 555-1234. This station is proud to have the Music Shop as a sponsor.”[1] Because this messaging is an inducement to patronize the Music Shop, the payee tax-exempt organization has a UBTI problem. Unfortunately, the regulations do not provide an example of how this seemingly innocuous messaging could be changed to create a qualified sponsorship. An example of messaging that constitutes a qualified sponsorship might be: “This program has been brought to you by the Music Shop, located at 123 Main Street. The Music Shop’s phone number is 555-1234.”

The regulations note, however, that a sponsor’s established slogans do not constitute advertising. For instance, a tax-exempt organization sponsored by Papa Johns could include a message with “Better Ingredients, Better Pizza” without creating UBTI concerns. Moreover, the mere display of a sponsor’s product at an event does not constitute advertising. Thus, a tax-exempt organization sponsored by Ford could display a Mustang at an event sponsored by Ford without creating UBTI concerns.  

In Technical Advice Memorandum (TAM) 9805001, the IRS ruled that a kennel club, exempt from tax under section 501(c)(4), did not generate UBTI for a pet food company’s sponsorship payments related to the club’s annual show. As a result of the sponsorship payments, the pet food company was provided with certain messaging at the club’s annual show. The IRS stated:

The ad that was furnished to us by M does not constitute prohibited advertising, as it merely shows a can of R's pet food made to look like a trophy, and contains two “tag lines” or slogans long used by R in its advertising. No language is used comparing R's product with the products of other manufacturers, or claiming that it is rated best by veterinarians, or any similar such claim.

While TAM 9805001 provides some direction on the sponsorship versus advertising issue, this is not a well-developed area of law. Thus, taxpayers are forced to make a subjective determination regarding whether messaging rises to the level of advertising.

II. Other problematic benefits defined

If a sponsor is given an exclusive provider arrangement in exchange for payment, then the tax-exempt organization potentially has UBTI. An exclusive provider arrangement limits the sale or use of a sponsor’s competing products in connection with a tax-exempt organization’s activity. An example of an exclusive provider arrangement would be a college that receives payment from a soft drink manufacturer in exchange for the soft drink manufacturer to be the exclusive provider of all drinks on campus. 

Likewise, if a sponsor is given goods, facilities or services in exchange for payment, then the tax-exempt organization has UBTI concerns. This benefit is straightforward – the ongoing sale of goods and services that does not relate to a tax-exempt purpose creates UBTI. Consider, for instance, a tax-exempt organization that operates a college football bowl game. If a sponsoring corporation receives tickets to the bowl game annually, there are UBTI concerns. Finally, if a sponsor is given the exclusive right to use a tax-exempt organization’s logo, there are UBTI concerns.

2 percent De minimis rule and payments in excess of fair market value (FMV)

Providing any of the above-mentioned benefits does not create UBTI if the fair market value of the total benefits received by the sponsor does not exceed 2 percent of the sponsor’s payment. Under this 2 percent de minimis rule, sponsors can receive very small benefits in exchange for large payments without creating UBTI concerns. Consider, for instance, where a bank that pays $1,000,000 to sponsor a higher education institution’s fundraising event receives t-shirts and refreshments at the event with a FMV less than 2 percent (or $20,000), there are no UBTI concerns.

Furthermore, to the extent a sponsorship payment exceeds the fair market value of a benefit received, the portion of the sponsorship payment in excess of FMV is not UBTI. Thus, if the bank in the previous example received t-shirts, refreshments and advertising with a fair market value of $200,000, then only $200,000 of the bank’s payment to the higher education institution would be analyzed to determine if it constitutes UBTI. Note that, because the bank does not qualify for the de minimis rule, the entire $200,000 is considered for inclusion in UBTI (not just the amount in excess of 2 percent). The remaining $800,000 is still considered a qualified sponsorship payment made with a philanthropic intent, and not in exchange for a benefit. 

Client call to action

Tax-exempt organizations that provide benefits to sponsors should be cognizant of these rules.  If benefits create UBTI concerns then two things can be done. First, exempt organizations should consider “tweaks” to benefits provided to avoid UBTI. For instance, messaging can be changed to avoid re-characterization as advertising. Likewise, tax-exempt organizations can quantify the FMV of benefits provided to reduce UBTI. Contemporaneous documentation of FMV is far more likely to withstand IRS scrutiny. 

If a tax-exempt organization discovers that it has amounts that should have been reported as UBTI in prior years (particularly where the tax results could be substantial), tax-exempt organizations should consider a voluntary disclosure to the IRS. In general, taxpayers that voluntarily disclose are treated more favorably, e.g., limited look-back periods and penalty relief, versus taxpayers that are “caught” by the IRS.

Finally, it should be acknowledged that UBTI is not necessarily harmful to tax-exempt organizations. The tax rules allow for a certain amount of UBTI, and some tax-exempt organizations may choose to provide benefits and create UBTI. In any event, it’s important to identify, manage and report UBTI appropriately to avoid undesirable tax results.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

[1] Section 1.513-4(f).