AN UPDATE ON ROYALTY TREATMENT FOR AFFINITY ARRANGEMENTS

Barbara Schwartz Bromberg

INTRODUCTION

Many executives of exempt organizations, including fraternal organizations, who are involved in the negotiation of affinity arrangements, have wrongly assumed that, be­ cause of the favorable court decisions in the Sierra Club case and similar recent cases, the Internal Revenue Service was giving up on its position that at least some affinity arrangements produce income that does not qualify as royalty income for purposes of the Internal Revenue Code. Of course, the result of a non-royalty characterization is that such income is taxable to a Code Section 501(c)(3) charitable organization, and also is not eligible for set aside treatment by Code Section 501(c)(7) organizations, and is therefore taxable to those organizations as well. In two cases currently pending before the United States Tax Court (Planned Parenthood v. Commissioner and Common Cause v. Commissioner), the IRS is again arguing for non-royalty treatment. The purpose of this article is to provide guidelines for use by negotiators and drafters of these agreements to utilize in hopefully achieving royalty treatment.

GUIDELINES

Of course, it should go without saying that in describing the revenues to be derived under such agreements, the words “royalty” or “royalties” should be used exclusively. In recent drafts of affinity agreements which this writer has been asked to review, such income has been described as “compensation,” “revenues” and other phrases – this should be avoided. While terming the revenue as royalties is not dispositive of the issue, it is certainly difficult, if not impossible, to argue that something is in fact a royalty when it has not even been treated as such by the parties. Similarly, payments that are made as advances against royalties should also be denominated in such a way that they are clearly royalty payments.

The issue on which the IRS has apparently centered its efforts involves the argument that  the exempt organization in the typical licensing agreement has provided services to the for-profit licensee, which violates the rule that royalties are passive investment income, and instead converts such income into active income not related to an exempt purpose. An example of such impermissible services is where the exempt organization agrees to assist the for-profit in marketing activities. It is very common to encounter such provisions which are often included unthinkingly by the for-profit organization which will often remove them quite willingly when the reason is explained. Accordingly, such agreements should very clearly state that the exempt organization is not required to participate in such marketing activities. In fact, it is recommended that the exempt organization be required to do no more than supply a copy of its regular mailing list (not a special list created for the for-profit organization) and have approval rights over the materials to make sure that quality and content standards are followed.

Other items that have been observed in recent proposed affinity agreements which should be avoided include the following:

1. Provision of a free advertisement for the affinity card in the fraternity’s
2. Provision of free materials to the for-profit organization the for-profit organization should clearly bear all of the costs of the
3. All materials should be produced in the first instance by the for-profit organization and reviewed only by the exempt
4. All costs should be incurred by the for-profit organization. Even reimbursement by the for-profit organization to the exempt organization for costs it incurs can be attacked by the IRS. (See the United States Tax Court’s decisions in the Oregon State Alumni Association and University of Oregon cases, now on appeal).
5. The exempt organization should not handle complaint calls about the program or perform oversight.
6. As indicated above, the exempt organization should agree to provide only its standard mailing list or diskette, not a special list created for the licensee.

Recent public comments by an IRS representative concerning these types of arrangements also sounded a warning about using nonprofit postal privileges to mail affinity promotional materials. It is virtually certain that the IRS would view this as a definite negative factor.

CONCLUSION

If the above guidelines are observed in structuring and carrying out affinity agreements and arrangements, it is likely that the fraternal organization will be in a strong defensive position should the Internal Revenue Service raise this issue on audit. Those organizations which have problematic provisions in their current affinity agreements should consult their counsel to determine whether it is possible for those agreements to be amended so as to preserve the organization’s right to claim royalty treatment for what are increasingly substantial sources of revenue for fraternal organizations.