THE

NONPROFIT COUNSEL

WlLEY

THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins

CORPORATE SPONSORSHIP REGULATIONS ISSUED IN FINAL FORM

orporate sponsorship regulations were issued C in final form on April 24, effective April 25 (T.D. 8991). These regulations, which pertain to the income tax treatment of corporate sponsorship payments received by tax-exempt organizations, accompany and amplify the statutory rules enacted in 1997 (IRC 5 5131i)). A summary of these regula- tions in proposed form is in the May 2000 issue.

Basic Law The core issue in this area is whether these corpo- rate sponsorship payments are taxable as unre- lated business income. These payments are not taxable if they are qualified sponsorship payments (IRC 5 513(i)(l); Reg. 5 1.513-4(a)).

A qualified sponsorship payment is a payment made by a person engaged in a trade or business (almost always a for-profit one) to a tax-exempt organization, with respect to which there is no arrangement or expectation that the person will receive from the exempt organization a substantial return benefit other t h a n the use or acknowledgement of the name or logo (or product lines) of the person’s trade or business in connec- tion with the exempt organization’s activities. This shielded use or acknowledgement does not cover advertising, including messages containing quali- tative or comparative language, price information, or other indications of savings or value, or an endorsement or other inducement to purchase, sell, or use a sponsor’s products or services (IRC 5 5 13(i)(2)(A)).

To the extent that a portion of a payment would (if made as a separate payment) be a qualified sponsorship payment, that portion of the payment and the other portion of the payment are treated as separate payments (IRC 5 513(i)(3)).

The protections of IRC 5 513(i) amount to a safe-harbor rule. If a transaction is outside of the safe-harbor rule, the taxation of it depends on the application of the rules for unrelated business rules generally. Thus, the transaction would be

Vol. X I X , No. 6, June 2002

evaluated as to whether it is abusiness, whether it is regularly carried on, whether it is subject to an exception for income or activities, and the like.

This body of law does not apply to qualified convention and trade show activities (IRC 5 513(d)(3)(B); Reg. 5 1.513-3). [27.2(f)I It also does not apply to the sale of an acknowledgement or advertising in the periodical of a tax-exempt organization (IRC 5 513(i)(2)(B)(ii)). The term periodicalmeans regularly scheduled and printed material published by or on behalf of an exempt organization that is not related to and primarily distributed in connection with a specific event conducted by the exempt organization. There are separate rules governing the sale of adver- tising in an exempt organization’s periodicals (Reg. 5 1.512(a)-l(f)). [26.5(f)1 For purposes of the corporate sponsorship rules, at least, the phrase printed material includes material that is published electronically (Reg. 5 1.5 13-4(b)).

Qualified Sponsorship Payment As noted, a qualijied sponsorship payment is a payment by a person engaged in a trade or busi- ness to a tax-exempt organPLation, with respect to which there is no arrangement or expectation that the person will receive a substantial return benefit (Reg. 8 1.513-4(~)(1)).

Analysis of curreiit developments in tax and related law lor nonprofit organizations and their professional advisors.

0 2002 Wiley Periodicals, Inc. Published online in Wiley Interscience (www.interscience.wiley.com). DOI: lO.l002/npc. 10009

It is irrelevant whether the sponsored activ- ity is related or unrelated to the recipient tax- exempt organization’s exempt purpose. It is also irrelevant whether the sponsored activity is tem- porary or permanent (Id.).

Theword paymentmeansthe payment ofmoney, transfer of property, or performance of services (Id).

Substantial Return Benefit A substantial return beneJt is a benefit other than certain uses or acknowledgments (see below) and other than certain disregarded benefits (Reg. 3 1.5 13-4(c)(2)(i)).

Benefits are disregarded if the aggregate fair market value of all the benefits provided to the payor, or persons designated by the payor in connection with the payment during the organization’s tax year, is not more than 2 percent of the amount of the payment (Reg. 3 1.513- 4(c)(2)(ii)). If the aggregate fair market value of the benefits exceeds 2 percent of the amount of the payment, then-with an exception (see below)- the entire fair market value of the benefits is a substantial return benefit (Id.).

Benefits provided to the payor or a designated person may include advertising (see below); an exclusive provider arrangement (see below); goods, facilities, services, or other privileges; and/or ex- clusive or nonexclusive rights to use an intangible asset (such as a trademark, patent, logo, or desig- nation) of the exempt organization (Reg. fj 1.513- 4( c) (2) (iii)) .

Protected Uses and Acknowledgments As noted, a substantial return benefit does not include the use or acknowledgment of the name, logo, or product lines of the payor’s trade or busi- ness in connection with the activities of the exempt organization. While a use or acknowledgment does

not include advertising (see below), it may include the following:

An exclusive sponsorship arrangement Logos and slogans that do not contain qualitative or comparative descriptions of the payor’s products, services, facilities, or company A list of the payor’s locations, telephone numbers, or Internet address Value-neutral descriptions, including displays or visual depictions, ofthe payor’s product line or services Reference to the payor’s brand or trade names and product or service listings (Reg. 3 1 .5 1 3-4( c) (2) (iv))

Logos or slogans that are an established part of a payor’s identity are not considered to contain qualitative or comparative descriptions. Mere dis- play or distribution, whether for free or remunera- tion, of a payor’s product by the payor or the exempt organization to the general public at the sponsored activity is not considered an induce- ment to purchase, sell, or use the payor’s product and thuswill not affect the determination ofwhether a payment is a qualified sponsorship payment (Id.)

Advertising The term aduertising means any message or other programming material that is broadcast or other- wise transmitted, published, displayed, or distrib- uted, and that promotes or markets any trade or business, or any service, facility, or product (Reg. 5 1.513-4(~)(2)(v)). The term includes messages con- taining qualitative or comparative language; price information or other indications of savings or value; an endorsement; or an inducement to purchase, sell, or use any company, service, facility, or prod-

The Nonprojit Counsel (Print ISSN: 0742-3497; Online ISSN: 1520-6785 at BoldIdeas, www.bold-ideas.com) is published monthly by Wiley Subscription Services, Inc., a Wiley Company, 605Third Avenue, New York, NY 10158. Address subscription inquiries and address changes to The NonproJt Counsel, c/o John Wiley & Sons, Subscription Department, 605 Third Avenue, New York, NY 10 158. Application to mail at periodicals rate is pending at New York, NY, and at additional mailing offices. Copyright 0 2002 by Wiley Periodicals, Inc., a Wiley Company. All rights reserved. Reproduction or translation of any part ofthis work beyond that permitted by Section 107 or 108 of the 1976 United States Copyright Act without the permission of the copyright owner is unlawful. Requests for permission or further information should be addressed to the Permissions Department, c/o John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012; (212) 850-601 1: fax (212) 850-6008; e-mail: permreqQwiley.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understandingthat the publisher is not engaged in rendering legal. accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Subscription price: Print only: $360 worldwide. Electronic only: $360.00 worldwide. A combination price of $378.00 worldwide, includes the subscription in both the electronic and print formats. All subscriptions containing a print element, shipped outside the US. , will be sent by air. Payment must be made in U.S. dollars drawn on a U S . bank. Claims for undelivered copies will be accepted only after the following issue has been received.

2 /The NonproJt Counsel June 2002

uct. A single message that contains both advertising and an acknowledgment is advertising (Id.)

These rules are inapplicable to activities con- ducted by a payor on its own. For example, if a payor purchases broadcast time from a television station to advertise its product during commercial breaks in a sponsored program, the activities of the tax-exempt organization are not thereby converted to advertising (Id.).

Exclusivity Arrangements An arrangement that acknowledges the payor as the exclusive sponsor of a tax-exempt organization’s activity, or the exclusive sponsor representing a particular trade, business, or in- dustry, generally does not, by itself, result in a substantial return benefit (Reg. 1.513- 4(c)(2)(6)(A]). For example, if in exchange for a payment, an exempt organization announces that its event is sponsored exclusively by the payor (and does not provide any advertising or other substantial return benefit to the payor), the payor has not received a substantial return benefit.

An arrangement that limits the sale, distri- bution, availability, or use of competing prod- ucts, services, or facilities in connection with an exempt organization’s activity generally results in a substantial return benefit (Reg. 5 1.513- 4(c)(2)(6)(B)). For example, if, in exchange for a payment, an exempt organization agrees to allow only the payor’s products to be sold in connec- tion with an activity, the payor has received a substantial return benefit.

Allocation of Payment If there is an arrangement or expectation that the payor will receive a substantial return benefit with respect to any payment, then only the portion, ifany, of the payment that exceeds the fair market value of the substantial return benefit is a qualified sponsor- ship payment (Reg. § 1.513-4(d)(l)). If the exempt organization, however, does not establish that the payment exceeds the fair market value of a substan- tial return benefit, then no portion of the payment constitutes a qualified sponsorship payment (Id.).

Again, the unrelated business treatment of a payment, or portion of a payment, that is not a qualified sponsorship payment is determined by application of the general rules. For example, payments related to (1) the provision of facili- ties, services, or other privileges by a tax-ex- empt organization to a payor, or designated person: (2) advertising: (3) exclusive provider arrangements: (4) a license to use intangible assets of an exempt organization: or (5) other substantial return benefits are evaluated sepa- rately in determining whether the exempt orga- nization realizes unrelated business income (Reg. Cj 1 .5 13-4( d) ( 1) (i)) .

The fair market value of a substantial return benefit provided as part of a sponsorship arrange- ment is the price at which the benefit would be provided between a willing recipient and a willing provider of the benefit, neither being under any compulsion to enter into the arrangement and both having reasonable knowledge of relevant facts, and without regard to any other aspect of the sponsor- ship arrangement (Reg. § 1.513-4(d)(l)(ii)).

In general, the fair market value of a substan- tial return benefit is determined when the benefit is provided (Reg. § 1.513-4(d)(l)(iii)). If the parties enter into a binding, written sponsorship con- tract, however, the fair market value of any sub- stantial return benefit provided pursuant to that contract is determined on the date the parties enter into the sponsorship contract. If the parties make a material change to a sponsorship con- tract, it is treated as a new sponsorship contract as of the date the material change is effective. A material change includes an extension or renewal of the contract, or a more-than-incidental change to any amount payable (or other consideration) pursuant to the contract (Id.).

To the extent necessary to prevent avoidance of the rules concerning determination of substantial return benefits and allocation of payments, when a tax-exempt organization fails to make a reasonable and good faith valuation of a substantial return benefit, the IRS may determine the portion of a payment allocable to the substantial return benefit and/or may treat two or more related payments as a single payment (Reg. 1.513-4(d)(2)).

Written Agreements The existence of a written sponsorship agreement does not, in itself, cause a payment to fail to be a qualified sponsorship payment (Reg. 1.513- 4(e)(l)). The terms of the agreement, not its exist- ence or degree of detail, are relevant to the determination of whether a payment is a qualified sponsorship payment. Similarly, the terms of the agreement and not the title or responsibilities of the individuals negotiating the agreement deter- mine whether a payment, or a portion of a pay- ment, made pursuant to the agreement is a qualified sponsorship payment. (Id.)

Contingent Payments The term qualijkd sponsorship payment does not include any payment that is contingent, by contract or otherwise, on the level of attendance at one or more events, broadcast ratings, or other factors indicating the degree of public exposure to the sponsored activity (IRC 5 13(i) (2) (B) (i)): Reg. 5 1.5 13- 4(e)(2)). The fact that a payment is contingent on sponsored events or activities actually being con- ducted does not, by itself, cause the payment to fail to be a qualified sponsorship payment (Id.).

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Public Support Qualified sponsorship payments in the form ofmoney or property--but not service-are contributions re- ceived by the tax-exempt organization involved. For organizations that are required to or need to compute public support, these payments are contributions for this purpose (Reg. § 1.513-4(e)(3)1.

Deductibility of Payments The fact that a payment to a tax-exempt organiza- tion constitutes a qualified sponsorship payment, which is treated as a contribution to the payee organization, does not determine whether the pay- ment is deductible by the payor (id.). The payment may be deductible as a charitable contribution (IRC § 170) or as a business expense (IRC 3 162).

Hyperlinks These regulations address the matter of the import of Web-site links by means of two examples. The essence of these examples is that the mere existence of a link from the sponsored tax-exempt organiza- tion to the corporate sponsor does not cause a payment to fail to be a qualified sponsorship pay- ment, but material on the linked site can cause the payment to entail a substantial return benefit.

The first of these examples concerns a tax- exempt organization with a symphony orchestra as its exempt function. The organization maintains a Web site containing information such as the orchestra’s performance schedule. A music shop makes a payment to the organization to fund a concert series: the exempt organization posts a list of its sponsors on its site, including the name of the shop and its Internet address. The Web site of the exempt organization does not promote the shop or advertise its merchandise. The shop’s Internet address appears as a link from the exempt organization’s site to the shop’s site. The organization’s posting of the shop’s name and Internet address on its Web site constitutes an acknowledgment of the sponsorship. The entire payment is a qualified sponsorship payment, which is not taxable as unrelated business income (Reg. fj 1.513-4(d)(f), Example 11).

The other example concerns a health-based charity that sponsors a year-long initiative to edu- cate the public about a particular medical condi- tion. A large pharmaceutical company manufactures a drug that is used in treating this medical condition; it provides funding for the ini- tiative that helps the charity produce educational materials for distribution and post educational information on the charity’s Web site. The charity’s site contains a link to the company’s site. On the company’s site, this statement appears: “Charity endorses the use of our drug, and suggests that you ask your doctor for a prescription if you have this medical condition.” The charity reviewed the

endorsement before it was posted on the company’s site and gave permission for the endorsement to appear. The endorsement is advertising. The fair market value of the advertising exceeds 2 percent of the total payment received from the company. Therefore, only the portion of the payment, if any, that the charity can demonstrate exceeds the fair market value of the advertising on the pharmaceu- tical company’s Web site is a qualified sponsorship payment. The payment in exchange for the adver- tising is not a qualified sponsorship payment. (Reg. 3 1.513-4(d)(f), Example 12) [27.2(n)1 Note: Some of the details of these regulations, embedded in examples, will be explored in one or more subsequent issues.

IRS INFORMATION LETTER STATES CRITERIA FOR INCENTIVE COMPENSATION

he IRS has issued an information letter con- T cerning the permissible provision of incentive payments to staff physicians by tax-exempt hospi- tals (INFO 2002-0021). The program involved con- cerns the provision of services to Medicare beneficiaries but the principles set forth in this letter are applicable in the larger context and, for that matter, to the tax law consequences of incen- tive compensation programs maintained by tax- exempt organizations generally.

The IRS observed that, overall, the amounts paid pursuant to these arrangements must be reasonable. This is the case under either the private inurement doctrine (which requires the involve- ment of an insider) or the private benefit doctrine (which does not require an insider). Reversing its earlier stance, the IRS wrote that physicians are not automatically insiders with respect to exempt hos- pitals. Rather: “Whether a physician is an insider depends on an analysis of all the facts and circum- stances concerning whether the physician’s rela- tionship with the organization offers the physician the opportunity to make use of the organization’s income or assets for personal gain.”

The 1RS said that “[iln analyzing any physician incentive compensation arrangement,” the agency has “generally considered various factors to deter- mine whether the arrangement violates the pro- scriptions against private inurement and impermissible private benefit.” The IRS will ask these questions:

Was the compensation arrangement established by an independent board of directors or by a n independent compensation committee? To be tax- exempt, a health care organization must complywith a community benefit standard. One element of this standard is whether independent persons who are

4/The Nonprofit CounSel June 2002