Sponsorship Prop. Regs. May Increase UBIT Liability

Charities and other related tax-exempt organizations should carefully consider the effect of recently released proposed regulations under Secs. 512 and 513, addressing corporate sponsorship payments, to avoid or minimize unrelated business income tax (UBIT) liabilities in connection with both current and future sponsorship arrangements. Whether a corporate sponsorship payment (such as income from a "pouring rights" arrangement with a beverage supplier) is subject to UBIT depends on whether it constitutes a "qualified sponsorship payment," which, in turn, depends on what the sponsor receives in return for its payment.

The proposed rules replace earlier proposed regulations released in January 1993, to reflect enactment of Sec. 513(i) by the Taxpayer Relief Act of 1997 (TRA '97). Sec. 513(i) excludes from the definition of unrelated trade or business the activity of soliciting and receiving qualified sponsorship payments, defined as payments made by individuals or business entities for which the contributor received no substantial return benefit other than the use or acknowledgment of the name, logo or product lines of the trade or business in connection with the exempt organization's activities.

Background

Prior to Sec. 513(i), the IRS sometimes took the position that corporate sponsorship payments were advertising income (not contributions) and, therefore, determined that the exempt organization recipient was carrying on an unrelated trade or business, generating income taxable under Sec. 511.

The debate over the tax treatment of corporate sponsorship payments began with Letter Ruling (TAM) 9147007, concluding that payments by Mobil Corporation to sponsor the Cotton Bowl Athletic Association were for advertising and, therefore, subject to UBIT. Before the enactment of Sec. 513(i), the Service focused on an exempt organization's services, not the benefit received by the sponsors. Advertising was defined as any message, programming material or broadcast transmitted, displayed or published in exchange for remuneration. The initial IRS guidance and apparent reversals (as a result of intervening legislation) left many unanswered questions.

Qualified Payments

The new proposed regulations would (1) clarify the notion of substantial return benefit, (2) limit qualified sponsorship payments when exclusivity arrangements exist and (3) restrict the deductible expenses that can be used to offset unrelated business income (UBI) from sponsorship activities. The proposed regulations provide 11 examples (similar to those proposed in 1993) to assist exempt organizations in determining the tax treatment of sponsorship payments.

"Substantial return benefit" would be defined to mean any benefit other than (1) the use or acknowledgment of a payor's name or logo in connection with the exempt organization's activities or (2) certain goods or services that have an insubstantial value under existing IRS guidelines. (Benefits are generally considered insubstantial in value if they have a fair market value (FMV) of not more than 2% percent of the payment or $74 (for tax years beginning in calendar year 2000), whichever is less.) According to Prop. Regs. Sec. 1.513-4(c)(2)(iv), an activity gives rise to a substantial return benefit if there is an advertising arrangement that includes messages containing qualitative or comparative language, price information or other indications of value, or an endorsement or other inducement to purchase, sell or use a sponsor's products or services. These situations likely would require payment or a portion of the payment to be included in income.

The 1993 regulations included a "tainting rule" that would have prevented the apportionment of income to contributions if advertising was a part of a sponsorship payment. If any activity, message or programming constituted advertising connected to a sponsorship payment, all the activities, messages or programming that might otherwise be acknowledgments would be considered advertising.

Sec. 513(i) eliminated any "tainting rule." The Sec. 513(i)(3) allocation method described in its legislative history provides that, "to the extent that a portion of a payment would (if made as a separate payment) be a qualified sponsorship payment, such portion of such payment and the other portion of such payment shall be treated as separate payments." If an exempt organization wishes to use the allocation method, a portion of the sponsorship payment must exceed the FMV of a payor's substantial return benefit; only the excess is treated as a qualified sponsorship payment. The proposed regulations would place the burden on the exempt organization to determine the FMV of any substantial return benefit. To prevent abuse, if an exempt organization fails to make a good-faith estimate of the substantial return benefit, the IRS will determine the portion allocable to such benefit (Prop. Regs. Sec. 1.513-4(d)(2)).

The proposed regulations would further provide that a payment generally will be treated as a qualified sponsorship payment, even if the payment is subject to an exclusivity arrangement in which the payor is guaranteed recognition as the sole sponsor of the exempt organization's activity. However, if an arrangement exists that prevents an exempt organization from using the services or selling the products of a competing business, the payor is considered to receive a substantial return benefit; the portion of the payment attributable to the exclusivity arrangement would not be considered a qualified sponsorship payment (Prop. Regs. Sec. 1.513-4(c)(2)(v)). Examples of potentially troublesome arrangements include "pouring rights" arrangements with beverage suppliers and exclusive arrangements with athletic gear companies. Also, payments contingent on the level of attendance at events, broadcast ratings or other factors indicating the public's exposure would not be treated as qualified sponsorship payments (Prop. Regs. Sec. 1.513-4(e)(2)).

Other Issues

The 1993 proposed regulations would have interpreted Regs. Sec. 1.512(a)-1(d) broadly and allowed exempt organizations to apply excess expenses from an exempt activity to offset the UBI from a separate activity. The example included with the new proposed regulations would narrow the allowable expenses to include only those incurred when "the unrelated business activity and the exempt activity are closely connected, such that a taxable entity pursuing the same business activity would normally also conduct the exempt activity" (Prop. Regs. Sec. 1.512(a)-1(e)).

It had been widely speculated that any proposed regulations under Sec. 513(i) would include guidance on the use of the Internet for qualified sponsorship payments and UBI. However, the proposed regulations do not specifically address issues related to Internet activities; instead, the Service asked exempt organizations and tax practitioners for their comments, in particular, on whether an electronic link to a sponsor's Web page constitutes advertising. The IRS will probably continue to evaluate the implications of the Internet and issue separate guidance for exempt organizations. (See Blazek, "The Internet and Tax-Exempt Organizations," TTA, May 2000, p. 344.)

The proposed regulations will be effective on the date the final regulations are published in the Federal Register. However, the Service states that exempt organizations may rely on the proposed regulations for payments received between Jan. 1, 1998 and the date final regulations are issued when evaluating existing and future sponsorship arrangements. Exempt organizations should pay particular attention to arrangements that involve exclusive rights or situations in which they must estimate the FMV of a substantial return benefit. Exempt organizations also should reconsider their method of allocating expenses against taxable sponsorship income to determine the strength of the link to the sponsored activity.

From William H. Hall, CPA, and Travis L. Patton, B.A., Washington, DC