Tax Matters

Clarifying Unrelated Business Income
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.

Some Severance Not Subject to Employment Taxes
Over the past decade, many businesses have had to downsize their workforce to stay competitive. Severance payments to workers generally are considered wages subject to withholding for

Income taxes under IRC sections 3401 and 3402.

Federal Insurance Contributions Act (FICA) under IRC section 3121.

Federal Unemployment Tax Act (FUTA) under IRC section 3306.

Railroad Retirement Tax Act (RRTA) under IRC section 3231.

Revenue ruling 90-72 excludes certain supplemental unemployment compensation benefits (SUCBs) from the definition of wages for FICA, FUTA and RRTA purposes. However, section 3402(o) extends income tax withholding to certain payments other than wages, such as SUCBs.

CSX Corp., the parent of a consolidated group of railroad companies, was forced to downsize its workforce from 1984 to 1990 due to a decline in rail transportation and increased competition. The number of CSX’s railroad-related employees decreased to 34,000 from 54,000 during that period. The management workforce declined by 33%, the union workforce by 39%. CSX accomplished the reduction through a combination of job layoffs, reductions in the number of hours of work and rates of pay and permanent separations from employment.

Affected employees received payments as follows:

Those laid off received biweekly or monthly payments.

Those with reduced hours or pay rates received payments of at least a guaranteed minimum amount.

Those who agreed to terminate their employment with CSX received either lump-sum payments or monthly payments for an agreed-upon period of time.

In accordance with RRTA and FICA, the company paid the employer’s share of employment taxes and withheld and remitted the employees’ share of those payments. It then filed refund claims for the employment taxes, maintaining those payments were not wages or compensation but, rather, SUCBs and as such not subject to tax. The IRS disallowed the claims. CSX took the case to the U.S. Court of Federal Claims.

Result. For the taxpayer. The court concluded that some of the payments were not wages subject to FICA or RRTA. Specifically, the payments that met the definition of SUCBs under section 3402(o)—paid to an employee because of his or her involuntary separation from employment resulting from a reduction in workforce—were not considered wages subject to employment taxes. In reaching this conclusion the court interpreted the U.S. Supreme Court decision in Rowan Cos. and the subsequent “decoupling amendment” to section 3121 to mean the definition of “wages” is consistent for FICA and income tax withholding purposes unless the IRS promulgates regulations to identify differences between the two. No such regulations have been issued. The IRS argued that if Congress had intended SUCBs to be exempt from FICA, it specifically would have excluded such payments in section 3121. The court disagreed since SUCBs were not wages in the first place.

The IRS also argued that the payments did not qualify as SUCBs because they did not meet the conditions in revenue ruling 56-249 and related rulings. Revenue ruling 56-249 dealt with whether benefits from an employer-funded trust were subject to FICA and income tax withholding. The trust’s purpose was to supplement state unemployment benefits for employees laid off in a workforce reduction. Payments were based on the size of the trust, the amount of state unemployment benefits, the duration of the layoff, the time worked before layoff and other conditions. On the basis of those eligibility conditions, the revenue ruling concluded the payments were income but not wages subject to employment taxes and withholding. In the CSX case, the court declined to consider these conditions since the revenue ruling did not explain how the conditions supported the ruling’s conclusion that the benefits were not subject to FICA. In addition, the conditions were not incorporated into later amendments to section 3402.

Based on its interpretation of the issues discussed above, the court held

The biweekly or monthly payments to laid-off employees were SUCBs, not subject to FICA or RRTA.

Payments to those workers with reduced hours or pay rates were subject to FICA and RRTA because they were “underemployed” but not separated from employment.

Separation payments employees elected to receive voluntarily rather than stay in their current positions or accept reduced rates or hours were subject to FICA and RRTA.

This decision is significant for any taxpayers that have paid employment taxes on severance payments similar to the CSX workforce reduction payments. Those taxpayers should consider filing claims for refund of FICA taxes they paid as well as withheld and remitted on behalf of employees. The IRS is likely to appeal this decision to the Federal Circuit Court of Appeals.

CSX Corp. v. United States, 89 AFTR2d 2002-1935.

Prepared by Karyn Bybee Friske, CPA, PhD, associate professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both at the T. Boone Pickens College of Business, West Texas A&M University, Canyon.