We’re fast approaching the 990 filing deadline for calendar year nonprofit organizations. With that comes the often complex task of determining which, if any, of your revenue streams may be considered unrelated business income,or UBI. In the second article of our UBI series, we’re going to tackle royalties.
Q: Slow down. First can you tell us how UBI is defined?
A: Of course, before we get too far into royalties specifically, let’s cover how the IRS defines UBI. For most organizations, an activity is considered an unrelated business if it meets three criteria:
- It is a trade or business
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
Of course, there are some specific exceptions to this rule. One of the exceptions is actually royalties, which are are explicitly excepted from being included in the calculation of unrelated business taxable income (UBTI) by Internal Revenue Code (IRC) section 512(b)(2). Given that this should be a short article, right? It would be if every agreement with payment streams called “royalties” actually met the definition set by the IRS, but that would be too easy.
Q: Can you give us a little more information? Don’t be cryptic.
A: Fair point. The IRS, through Revenue Ruling 81-178, has defined royalty as “a payment that relates to the use of a valuable right”. It further states that “…Payments for the use of trademarks, trade names, service marks, or copyrights, whether or not payment is based on the use made of such property, are ordinarily classified as royalties for federal tax purposes…On the other hand, royalties do not include payments for personal services.” The potential for trouble comes when there are services provided by the nonprofit organization to the payer of the “royalties”, particularly when the terms for the payment of royalties and the payment for services are not separated in the agreement. If you review your “royalty” agreements and find that your organization is required to perform services in conjunction with the agreement, you’ll want to dig a little (or maybe a lot) deeper. If the activity is completely passive – you do nothing other than sign the agreement and collect money – you’re probably not going to have a UBI issue with your payments.
Q: Anything else we need to think about?
A: One other fairly common revenue stream for nonprofit organizations is income from the rental of mailing lists. The concept of “royalty” can also apply to those. As I mentioned above, there are some specific exceptions which allow you to exclude income from UBI. One of those exceptions is income from the exchange of or rental of member or donor lists between organizations described in section 501 that are eligible to receive charitable contributions. So, if you are a 501(c)(3) and you rent your mailing or donor list to another 501(c)(3), then you’re more than likely going to be okay – that income probably isn’t going to be includable in your calculation of UBTI. However, if you’ve rented the mailing list to a different type of organization – nonprofit or for profit – then in order for it to be excludable from your calculation of UBTI (assuming it otherwise meets the definition of an unrelated business, which it probably does) it will have to meet the definition of a royalty. There have been a number of court cases in this area, and while it is possible to do some work associated with the list you’re renting or selling in conjunction with your agreement, such as setting the rates for the rental, reviewing requests to rent the lists and approving proposed mailing material, the more services you perform the more risk there is in having the IRS conclude that the payment stream is not, in fact, a royalty. There is no bright line provided by the IRS or the court cases, so if you’re thinking of including services in the agreement, proceed with caution. You have been warned.
Of course, we can’t cover every potential scenario in a short article, but this should be enough to get you thinking about where you might have problem areas. If you want to take a deeper dive, please feel free to contact us. We’d be glad to help.