IRS Issues Prop. Regs. on Corporate Sponsorships and Exclusivity Payments

On March, the IRS issued proposed regulations on the tax treatment of corporate sponsorship payments made to exempt organizations. The regulations indicate that exempt groups could face additional income taxes on sponsorship payments for agreements not to provide or sell products or services that would compete with the sponsor (i.e., exclusivity payment arrangements).

Background

Corporate sponsorships often provide significant revenue for exempt organizations. Under Sec. 513(i)(2)(A), a “qualified sponsorship payment” is a payment made by a person or entity engaged in a trade or business, in which there is no arrangement or expectation that the person or entity will receive any substantial return benefit other than the use or acknowledgement of its name or logo with the organization’s activities.

Under Prop. Regs. Sec. 1.513-4(c)(2)(v), exclusive payment arrangements are either exclusive (1) sponsorship arrangements or (2) provider arrangements. In an exclusive sponsorship arrangement, the sponsor has the right to be the only sponsor or the only sponsor representing a particular trade, business or industry of an exempt organization’s activity.

In an exclusive provider arrangement, the exempt organization agrees that products or services that compete with the sponsor will not be sold or provided in connection with the exempt organization’s activities.

UBIT

Prop. Regs. Sec. 1.513-4(c)(2) further defines or modifies the definition of “substantial return benefit.” A substantial return benefit is any benefit other than (1) a use or acknowledgement of a payer’s logo in connection with the exempt organization’s activities or (2) certain goods or services that have an insubstantial value under existing guidelines. Generally, items such as complimentary tickets, receptions for donors and pro-am playing spots, have an insubstantial value only if they have a market value of the lesser of 2% of the payment or $74. If a payer receives a substantial return, the amount considered unrelated business income (UBI) must be determined under Secs. 511–514.

In general, qualified sponsorship payments do not generate UBI to the exempt organization or a substantial return benefit for the sponsor. Substantial return benefits would include payment arrangements that require advertising of a person’s or entity’s products or services (including any qualitative or comparative data) or pricing information, or endorsements or other inducements to sell or use the products or services. In such cases, the payments are taxable advertising revenue. Substantial return benefits also include payment arrangements in which the sponsor provides services, facilities or exclusive rights to use intangible assets. Qualified sponsorship payments do not include payments contingent on attendance, broadcast ratings or other degrees of public exposure to an exempt organization’s activity.

Generally, exclusive sponsorship arrangements, in and of themselves, do not generate a substantial return benefit. However, exclusive provider arrangements generally do, and would not be considered qualified sponsorship payments. Additionally, classification as a nonqualified sponsorship payment is not necessarily deemed UBI. Such a determination must be made under the regular UBI rules.

The portion of payments not considered qualified sponsorship payments must be valued separately; UBI tax attributable to each benefit must be separately determined under Secs. 511–514. The burden of determining a benefit’s fair market value falls on the exempt organization, because it has superior access to the sponsorship arrangements. This determination must be reasonable and in good faith; otherwise, the entire payment may be considered a nonqualified sponsorship payment.

The proposed regulations further limit an exempt organization’s ability to offset UBI with expenses from exempt activities. Broad interpretation of 1993 proposed regulations have allowed exempt organizations to offset excess expenses directly connected to their activities (such as conducting bowl games) against income from separate UBI activities (such as selling clothing that features bowl game logos). Under the new proposed regulations, this treatment is disallowed, unless the unrelated and related activities are “connected.”

Clearly, the new proposed regulations impose additional burdens on exempt organizations that are parties to exclusive provider arrangements. Classifying these arrangements as nonqualified sponsorship arrangements gives an exempt organization the responsibility of valuing any substantial return benefit, determining if it will be considered UBI and allocating expenses under narrower rules.

Public Comments

In June, an IRS hearing generated comments primarily on the definition of substantial return benefit and the effects of Internet links on classifying arrangements.

Most speakers found the definition of exclusive provider arrangements to be too broad and the expense allocation rules too narrow. Specific comments included:

• Payments under exclusive provider arrangements can properly be characterized as covenants not to compete or royalties, both of which are excluded from the definition of UBI.
• It is unreasonable to change the interpretations of the examples in the 1993 proposed regulations on expense allocations, because taxpayers have relied on them in good faith.
• The $74 amount is not practical in determining a substantial return benefit and imposes a significant burden on the staff of small charitable entities to make this determination.
• The following comments were made on the use of Internet links to a sponsor’s Web page. Internet links are:
• Similar to any other medium that provides information about a sponsor.
• Electronic equivalents to a telephone number or mailing address and, therefore, should not constitute a substantial return benefit.
• Not promoting or marketing anything; they can only be activated by the viewer on demand.

The new proposed regulations that cover sponsorships and exclusivity payments will require additional interpretation and expertise for those entering into these types of arrangements. Advisers should carefully consider exclusive provider contracts, which, as discussed, do not involve qualified sponsorship payments. Although these arrangements may not be subject to UBI tax under the general rules, they are certainly subject to intense scrutiny by the Service and carry additional inherent risks.

From James B. Champer, CPA, Elkhart, IN