You’re no doubt aware of the risk of generating unrelated business taxable income (UBTI). But you might not realize that the terms of your relationship with an outside publisher for your membership magazine or journal can trigger the tax on UBTI by creating an agency relationship. Some recent guidance from the IRS sheds light on how you can avoid this liability.
Tax issue summed up
Nonprofits are required to pay income tax on UBTI. UBTI is defined as income 1) from a trade or business, 2) regularly carried on and 3) not substantially related to the organization’s exempt purpose (aside from the organization’s need for funding or the way it uses any profits).
An activity doesn’t stop qualifying as a business simply because it’s conducted within a context of exempt activities. So, selling commercial advertising in your magazine or journal is considered a business even if the publication includes content related to your exempt purpose.
Discussions of UBTI often focus on its third element. A 2018 IRS technical advice memorandum (TAM 201837014), however, illustrates that the “regularly carried on” element also can trip up a nonprofit. In the memo, the IRS discusses a nonprofit that receives UBTI from advertising in its international, peer-reviewed journal. The journal is published under a contract with a for-profit publisher.
The agreement with that publisher gives the nonprofit complete responsibility for its editorial content. But the publisher is solely responsible for selling ad space in the journal, subject to the nonprofit’s advertising standards. (The relationship between the two is described as that of independent contractors.)
According to the agreement, the publisher paid an annual stipend for salaries and expenses of the journal’s editorial office, as well as expenses for the annual editorial board meeting. The agreement also states that the publisher will publish, produce, sell, distribute and promote the journal at its own expense. It pays the organization a percentage of “revenues” as an “earned royalty” for publishing and distribution rights. The agreement specifically excludes ad revenues from its definition of “revenues.”
The IRS concludes that publishing commercial advertising is a trade or business not substantially related to the nonprofit’s exempt purpose. The real issue, according to the tax agency, is whether it’s regularly carried on by the organization. Although the nonprofit itself wasn’t directly engaged in advertising activities, the publisher’s regularly carried-on activities were attributable to the organization — if the publisher acted as its agent with respect to those activities.
Agency arises when a principal (for example, a nonprofit) authorizes an agent (such as an independent publisher) to act on its behalf. Although the parties may label their relationship in some way other than “agency” in an agreement, that designation isn’t the controlling factor for tax purposes. Instead, the IRS considers the facts and circumstances of each case.
In the TAM case, for instance, the IRS concluded that the agreement’s provisions were consistent with the description of the publisher as an independent contractor. Citing earlier court opinions for guidance, the IRS noted that under the agreement the:
- Nonprofit didn’t retain tight control over the method and manner of ad solicitation,
- Payments for ads weren’t made to or collected by the nonprofit,
- Publisher’s payments didn’t vary based on ad revenue (so the publisher assumed all potential for gain and loss from ad sales), and
- Publisher didn’t purport to act on behalf of the nonprofit.
Moreover, the agreement didn’t require the publisher to seek advertising for the journal.
Review your agreement
While TAM conclusions apply only to a specific taxpayer’s circumstances, they can give valuable insights on IRS thinking. If your organization has a relationship with an outside publisher, review the agreement in light of this memo — particularly the revenue allocation and compensation provisions.
Don’t count on the royalty exclusion
Royalty income generally is excluded from a nonprofit’s unrelated business taxable income (UBTI) if it’s generated “passively” — or not in competition with taxable businesses. As explained in the main article, though, labels don’t matter to the IRS or courts. Titling an agreement as a “Royalties and Licensing Agreement” won’t help if the agreement is actually an agency relationship.
In one case, for example, a federal court of appeals rejected a nonprofit’s claim that payments it received from a company, which published the nonprofit’s magazine three times a year, were passive royalty payments. The “passive” part wasn’t in doubt — the court acknowledged that the organization spent little time working on the magazine.
But the court found that the payments weren’t royalties because the publisher used the organization’s name to promote the organization, not its own products. The court noted that the publisher’s ad solicitors indicated they were calling on behalf of the nonprofit. Plus, the advertisers’ checks were payable to the nonprofit. The payments, therefore, weren’t royalties and qualified as UBTI.