Overview
On September 25, Technical Advice Memorandum (TAM) 202039018 was released. The TAM provides some additional insight into the IRS's approach to a perennially vexing issue for tax exempt organizations: the distinction between royalty income and services income under the unrelated business income tax (UBIT).
In general, UBIT applies a 21% tax to the net income that a tax exempt organization earns from a trade or business that is not related to its exempt purposes. However, certain kinds of income—including royalties—are excluded from UBIT by statute, regardless of whether or not they are earned through an unrelated trade or business. Treasury regulations provide that it is the actual nature of a particular item of income, determined under all of the relevant facts and circumstances—rather than the designation of the income by the parties—that will control whether one of these statutory exemptions applies.
A long line of IRS guidance and case law has addressed the recurring issue of whether income is treated as royalty income or as services income. The term "royalty" is not defined by the statute or the Treasury regulations. Nevertheless, to be a royalty, a payment must relate to the use of a valuable right to use an intangible asset, and does not include payments for services. Payments for the use of trademarks, trade names, service marks, or copyrights are ordinarily classified as royalties. Cases have held that, in at least some circumstances, the sale or rental of mailing lists or the operation of certain affinity credit card programs, in which an organization licenses its name and logo for use by a bank on a credit card, can generate royalties. In contrast, payments for personal appearances and interviews are not royalties but are compensation for personal services.
TAM 202039018 illustrates the kinds of facts that the IRS will consider in distinguishing royalty and services income for UBIT purposes. In the TAM, the IRS considered whether payments received by a public charity from a third-party vendor in connection with an online job placement service constituted royalties. The charity was a membership organization that publishes academic journals covering a particular subject matter. Over the past 40 years, the charity has offered a job placement program that seeks to connect employers to qualified candidates in this field and to provide job seekers access to job opportunities. In recent years, the charity contracted with an unrelated, for-profit vendor to manage the job placement program on the charity's website.
The charity argued that any payments remitted to it from the vendor should be treated as royalties for the vendor's use of the charity's name, trademarks, website address, and mailing list and that the online placement service was a trade or business of the vendor and not the charity. The IRS Office of Chief Counsel disagreed.
In characterizing the income receive by the charity, the TAM focuses on a range of factors, including:
- There was no mention of the charity's tangible or intangible property to be used by the vendor in any agreement.
- The program website was not a vendor web page with the charity’s name on it, but rather was a part of the charity's website and used software owned by the vendor.
- The charity received the bulk of the revenue earned through the program, with only a nominal percentage of revenue (plus a fixed charge) going to the vendor. The IRS contrasts this with affinity credit card programs where a charity may receive as little as 50% of the relevant revenue.
- The charity bore the operating costs of the program, such as credit card transaction fees.
- The vendor was consistently described as a "provider" while the charity was described as a "customer," the agreement between the parties was titled a "Service Agreement" and the key provision in the contract was headed "Services Provided," all of which indicated a services relationship.
- The charity had operated the job placement service for many years prior to contracting it out to the vendor. The IRS contrasts this with affinity card programs, where a charity generally would be unable to offer an affinity card program on its own.
- The charity—and not the vendor—set the prices on the service and the content, type, and timing of advertising.
- Email communications between the charity and vendor were more consistent with a services relationship.
The TAM demonstrates the importance of carefully considering all of the relevant facts—and carefully drafting agreements—before relying on the statutory exemption to UBIT for royalties. If you have any questions about structuring royalty agreements and UBIT, please contact the authors of this alert whose contact information can be found in the Professionals tab.
