Part 1231-1: ¶1231.1 Relatedness

An organization may avoid characterization of income as arising from an unrelated trade or business if the activity is "substantially related" to the organization's exempt purposes. This determination requires an examination of the relationship between the business activities that generate the particular income and the accomplishment of the organization's exempt purposes (IRS Treas. Reg. § 1.513-1(d)(1)). To avoid characterization as income from an unrelated trade or business, the activity from which the income is generated must contribute importantly to accomplishment of the organization's exempt purposes (aside from the organization's need for funds) (IRS Treas. Reg. § 1.513-1(d)(2)).

There are several grounds on which colleges and universities may seek to establish that a business activity is related to its exempt purpose:

• Education mission
• Health care mission
• Scientific research mission

While the education mission is the most fundamental basis for relatedness, for purposes of intellectual property from research, the scientific research mission is of most use.

¶1231.1.1 Education Mission

The most fundamental basis for proving relatedness is to show that the activity furthers an institution's teaching mission. For example, in St. Luke's Hospital of Kansas City v. United States, 494 F. Supp. 85 (W.D. Mo. 1980), the court held that an exempt hospital's performance of diagnostic laboratory testing upon specimens taken from patients of the hospital's staff physicians was not an unrelated trade or business because the hospital needed the specimens to carry on its educational activities.

Along the same lines, the IRS, in Rev. Rul. 80-296, 1980-2 C.B. 195, considered the sale of broadcasting rights by a regional college athletic conference that was exempt from tax under IRC § 501(c)(3). The Service referred to prior rulings in which it concluded that: (1) college and university athletic organizations may be exempt from tax because they are generally held to engage in educational activities; and (2) income from ticket sales to college and university athletic events is not taxable because such events are related to the educational purposes of colleges and universities.

Based on these prior rulings, the Service concluded that the sale of broadcasting rights to college and university athletic events also contributes importantly to an organization's exempt educational purposes, and income from the sale of broadcast rights is not UBTI. The Service reasoned that it should not make a difference whether the audience is physically present at a game or watching on television (see also Rev. Rul. 80-295, 1980-2 C.B. 194 (income from sale of broadcasting rights by amateur athletic organization was not UBTI)).

In contrast to the decisions described above, activities may not be considered substantially related to an organization's exempt purposes if the activities are overly commercial in nature. For example, in Iowa State University of Science & Technology v. United States, 500 F.2d 508 (Ct. Cl. 1974), the issue was whether income earned through a university-owned television station constituted UBTI. The university argued that operating the station contributed importantly to the university's education purposes. For example, the university noted that the station helped prepare students for careers in broadcasting and was used for closed-circuit broadcasts to a number of classrooms. However, the IRS argued, and the court agreed, that, notwithstanding the modest degree to which the station furthered the organization's exempt purposes, the station did not contribute importantly to those purposes because the station was largely operated as a commercial television station, in competition with other stations. As a result, operation of the station was not substantially related to the university's exempt educational purposes and constituted an unrelated trade or business.

A similar result was reached in Rev. Rul. 78-385, 1978-2 C.B. 174, which involved an organization formed to advance education and religion. To accomplish these purposes, the organization produced religious and educational programming for a television station that it owned. However, a relatively small amount of its broadcasting time was devoted to nonreligious and noneducational programs that were commercially sponsored. After first concluding that the organization would qualify for exemption under IRC § 501(c)(3) notwithstanding the insubstantial commercial broadcasting activity, the IRS considered whether income from the commercially sponsored activities would be UBTI. The Service concluded, without elaboration, that the commercial programming and the sale of advertising for airtime in connection with that programming were not substantially related to the organization's exempt educational and religious purposes, and thus the activity constituted an unrelated trade or business.

¶1231.1.2 Health Care Mission

In the case of teaching hospitals affiliated with universities, relatedness may be established on the grounds that the activity contributes to the health care mission. As illustrated by the revenue rulings represented in the examples below, the IRS's general approach is to treat an activity as related if it involves care of the hospital's patients and to treat it as unrelated if it involves care of nonpatients.

Example 1231-1

The sale of pharmaceutical supplies by an exempt hospital to private patients of physicians who have office space in the hospital-owned medical buildings constitutes unrelated business income. The pharmacy was operated in the hospital for the convenience of patients visiting their physicians' offices on the premises and was not for patients admitted in the hospital. The majority of the income of the pharmacy is from sales of prescription and nonprescription pharmaceuticals to private patients of physicians practicing in the building. (Rev. Rul. 68-375, 1968-2 C.B. 245.)

Example 1231-2

The sale of pharmaceutical supplies by an exempt hospital to patients of the hospital does not constitute unrelated trade or business of the hospital. According to the IRS, hospital "patients" include (1) persons admitted to the hospital for inpatient treatment; (2) persons receiving general or emergency diagnostic, therapeutic, or preventive health, services from outpatient facilities of a hospital; (3) persons directly referred to the hospital's outpatient facilities by his private physician for specific diagnostic or treatment procedures; (4) persons refilling prescriptions written during the course of treatment as patients of the hospital; (5) persons receiving medical services as part of a hospital administered home care program; and (6) persons receiving medical care and services in a hospital-affiliated extended care facility (Rev. Rul. 68-376, 1968-2 C.B. 246).

However, it may be possible to show special facts and circumstances that will support a conclusion that research or laboratory testing for nonpatients is related to the hospital's mission. In Hi-Plains Hosp. v. United States, 670 F.2d 528 (5th Cir. 1982), the sale by a hospital of pharmaceuticals to private patients of physicians was found to be related where the hospital was located in a rural community that had lacked medical services before the hospital was established. The court agreed with the hospital that the pharmacy sales served as an inducement to attract and maintain physicians in the rural community.

¶1231.1.3 Scientific Research Mission

Colleges and universities also may seek to establish relatedness on the grounds that an activity contributes to the institution's scientific research mission. In determining whether an activity furthers an organization's scientific mission, the courts have generally relied on the definition of scientific research under IRC § 501(c)(3). As discussed in ¶1222 and further illustrated by the authorities below, courts frequently discuss whether an activity meets the general § 501(c)(3) scientific research standards together with an analysis under IRC § 513 of whether an activity is "substantially related" to the organization's exempt purposes, demonstrating that the two analyses are closely intertwined.

In Midwest Research Institute v. United States, 554 F. Supp. 1379 (W.D. Mo. 1983), aff'd, 744 F.2d 635 (8th Cir. 1984), a federal district court considered whether income from scientific research conducted by a tax-exempt corporation on behalf of private and governmental sponsors was taxable as unrelated business income. The taxpayer argued that income from the research projects was not taxable as unrelated business income because the projects "contributed importantly" to the organization's exempt purpose of performing scientific research to encourage industry in a particular geographic area. In so arguing, the organization contended that the projects were "substantially related," for purposes of IRC § 513, to the organization's exempt purposes.

To determine whether the projects were, in fact, substantially related, the court first examined whether the projects involved scientific research in the public interest, under standards set forth in IRC § 501(c)(3) (see ¶1222.1.) The court found that the vast majority of the research projects satisfied the§ 501(c)(3) standards, and then concluded, rather summarily, that the projects contributed importantly to the accomplishment of the organization's exempt purposes under IRC § 513. As a result, income from those projects did not constitute UBTI. However, the court found that certain other activities — including, for example, the rental of usage time on the organization's computer system — did not contribute importantly to the organization's exempt scientific purposes. As a result, income from these activities did constitute UBTI and was subject to tax.

Interestingly, beyond considering whether various activities of the organization did or did not constitute scientific research in the public interest under the IRC § 501(c)(3) standards, the court performed little in the way of specific analysis under the § 513 standard, which requires that an activity contribute importantly to the organization's exempt purposes for the activity to be considered "substantially related."

Similarly, in IIT Research Institute v. United States, 9 Cl. Ct. 13 (1985), a court considered whether income an organization earned through sponsored research contracts constituted UBTI. IIT Research Institute (IITRI) was a nonprofit research institute that performed research on a contract basis for governmental entities, and, to a lesser extent, for commercial sponsors. IITRI charged a price for a project that included the salaries of employees involved with the project, overhead expenses, and an additional fee. In some cases, patents developed through the projects became the property of the sponsors.

The IRS challenged two groups of projects undertaken by IITRI, claiming that the projects were not substantially related to IITRI's exempt scientific purposes and thus gave rise to UBTI. With regard to the first group of projects, the court found that there was nothing in the record to suggest that the projects did not involve scientific research in the public interest under the § 501(c)(3) standards, and that under IRC § 513, the projects were substantially related to the organization's exempt purposes. The court concluded that any of the contracts could be considered "scientific" for one or more of the following reasons: (1) it involved the use of observation or experimentation to formulate or verify facts or natural laws; (2) it could only have been performed by an individual with advanced scientific or technical expertise; (3) it added knowledge within a particular scientific field; (4) it involved the application of mathematical reasoning; and/or (5) it was an attempt to systematize or classify a body of scientific knowledge by collecting information and presenting it in a useful form.

Of particular interest, the court stated:

The testimony further indicated that IITRI was not involved in the commercialization of the products or processes developed as a result of its research. IITRI would only develop a project to the point where the research principles were established. At this point, the sponsors would make the principles available to different customers, usually in the form of newly developed products or equipment.

The court then concluded that the projects could not be said to involve "commercial operations" in violation of IRS Treas. Reg. § 1.501(c)(3)-1(d)(5)(ii).

With regard to the second group of projects, the IRS argued that they did not involve scientific research in the public interest under IRC § 501(c)(3), because the results of the research were not published. However, in analyzing the record, the court found that the results were, in fact, published, or were at least synthesized with the results of other studies or projects and published in a combined form. The court also concluded that the projects were, under IRC § 513, substantially related to the organization's exempt purposes.

Although the court in IIT Research Institute, like the Midwest Research Institute court, principally performed an analysis under IRC § 501(c)(3) to determine whether activities were substantially related for purposes of § 513, the court in IIT explicitly recognized that the applicable standards for determining entitlement to exemption under IRC § 501(c)(3) and for determining whether an activity is "substantially related" under the UBTI rules in IRC § 513 are different:

Plaintiff responds that the special definition of "scientific" promulgated by the regulations for qualification for exemption under § 501(c)(3) is irrelevant to whether, pursuant to §§ 511 to 513, the challenged sources of income are unrelated to the accomplishment of plaintiff's exempt purpose. It may be true that the operation of a cafeteria to serve plaintiff's staff would not be unrelated to the accomplishment of plaintiff's scientific purposes, even if the cafeteria were not run scientifically in any sense of the word. But since plaintiff argues that the challenged projects are related because each project is similar to the others and therefore its performance causes or contributes importantly to the accomplishment of plaintiff's exempt purpose of offering multidisciplined scientific research to the government or industry, the qualification of each project to accomplish the exempt purpose remains relevant.

Part 1232-1: ¶1232.1 Exclusion of Royalties

In structuring transactions involving the commercialization of intellectual property, one of the most frequently used exclusions is the royalty exclusion. Indeed, the exclusion of royalty income from UBTI drives a great deal of tax planning for intellectual property transactions, particularly those that do not qualify for the research exceptions, which are discussed in ¶1232.2.

¶1232.1.1 Defining a 'Royalty'

IRC § 512(b)(2) provides that the definition of UBTI excludes all royalties including overriding royalties, whether measured by production or by gross or net income from the property, and all deductions directly connected with such income.

The leading ruling on the definition of royalties, Rev. Rul. 81-178, 1981-2 CB 135, defines a "royalty" as a payment for the use of a valuable right and distinguishes it from a payment for services. ¹

In Rev. Rul. 81-178, an organization exempt under IRC § 501(c)(5) was paid for the right to use its trademarks, trade names, service marks, and its members' names, photographs, likenesses, and facsimile signatures in connection with the promotion and advertising of various types of merchandise and services. The IRS used these facts to present two situations.

In Situation 1, the organization's purposes are to improve the economic and working conditions of its members, who are professional athletes. The organization had the right to approve the quality and style of the use of the licensed products and services. The IRS held that payments received by the organization were payments for the use of a valuable right, i.e., the right to use the organization's trademark, trade name, service mark, or copyright, and thus were royalties for federal tax purposes. In reaching this conclusion, the Service defined royalties as follows:

To be a royalty, a payment must relate to the use of a valuable right. 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. … Similarly, payments for the use of a professional athlete's name, photographs, likeness, or facsimile signature are ordinarily characterized as royalties. … On the other hand, royalties do not include payments for personal services.

In Situation 2, the facts were the same, except that the agreements were "concerned solely with endorsing the products and services offered" by the licensees and required personal appearances and interviews with the members of the organization. The Service determined that the income from this type of activity, in its entirety, was compensation for personal services and thus did not constitute royalties.

Rev. Rul. 81-178 made clear, however, that an organization may retain the right to approve the quality and style of the use of the licensed products and may retain the right to prohibit the licensee from engaging in any activity that would adversely affect the reputation of the organization without jeopardizing the royalty treatment of the income from the licensee.

In PLR 8003014 (Oct. 29, 1979), a § 501(c)(3) organization had been formed, among other things, to arouse and maintain interest in a sporting event. In pursuit of its goals, the organization entered into business arrangements with various business corporations to allow the corporations to use the organization's symbols and identifying language on their products and packaging and in commercial advertising. In return, the corporations would make contributions of varying amounts and/or provide, without charge, equipment or other supplies to sports teams. The corporations were not permitted to state that the product is endorsed by or is the official product of the organization.

After first concluding that the activity was the conduct of an unrelated trade or business because there was no clear causal relationship between the manner of use and the furtherance of the exempt purposes of the organization, the IRS considered whether payments for the right to use the symbols and identifying language constituted a royalty, excludable from the computation of UBTI. The Service concluded that the payments were royalties within the meaning of IRC § 512(b)(2). However, to the extent the arrangements involved payments for the right of a licensee to advertise in a publication of the organization, such payments would constitute taxable advertising income.

In PLR 9527031 (Apr. 10, 1995), a § 501(c)(3) exempt organization (EO) developed technologies for the long-term preservation of written and audiovisual records and patented some of the technologies. To transform the technology into usable preservation technology, EO had previously contracted with another entity to perform the necessary manufacturing. The other entity came to believe that the technology would be of interest to a wide range of other organizations and created a new corporation to obtain a license to use the technology. EO proposed to enter into a license arrangement with the new corporation under which it would license the technology, including "all trade secrets, confidential information technical information, knowledge, experience, and know-how," in exchange for a fee. The agreement included a number of protections against unauthorized use of the technology. Based on these facts, the Service concluded that the fees were royalties, excludable from UBTI under IRC § 512(b)(2).

¶1232.1.2 Licensor Ownership Interest

For income received under a license to constitute a royalty excludable from UBIT under IRC § 512(b)(2), the licensor must own both the legal and beneficial interests in the licensed intellectual property.

Example 1232-1

In Rev. Rul. 73-193, 1973 C.B. 262, an exempt organization dedicated all its resources to the advancement of science, and its principal activity in that regard was providing financial support, in the form of grants, for scientific research. An organization was formed to evaluate, promote, and manage the inventions of faculty members and staff of educational institutions. Under agreements with such persons, the organization accepted bare legal title to inventions solely for the purpose of promoting the inventions. Pursuant to the agreement, upon termination, legal title was to be returned to the inventors. The organization collected income from licenses with third parties, deducted and retained an amount that represented a fee for the organization's services, and turned the remainder of the income over to the inventors. The organization failed to qualify for the royalty exception because it did not own both the legal and beneficial interests in the licensed intellectual property. The Service concluded that, because the organization did not hold the beneficial interest in the licensed intellectual property, but only bare legal title, the amounts deducted and retained by the organization constituted payments for services rather than royalties excludable from UBIT under IRC § 512(b)(2).

In Rev. Rul. 76-297, 1976-2 C.B. 178, the IRS distinguished Rev. Rul. 73-193 in examining whether income collected by a similar organization established to manage intellectual property constituted royalty income under IRC § 512(b)(2).

Example 1232-2

In Rev. Rul. 76-297, the exempt organization accepted inventions of individuals associated with a university for evaluation and possible patent consideration. If the organization chose to pursue a patent application, the inventor assigned all legal and beneficial rights in the invention to the organization, which, in return, agreed to pay the inventor a specified percentage of any royalties subsequently received by the organization through licenses of the invention. Because the organization owned both legal and beneficial interest in the licensed inventions, the IRS concluded that any income the organization received under licenses of the intellectual property would constitute excludable royalties.

Example 1232-3

In PLR 8827017 (Apr. 5, 1988), the IRS considered a § 509(a)(3) supporting organization formed to obtain and administer patents discovered during scientific research performed by "A." The supporting organization was the legal and beneficial owner of the patents, which it licensed to third parties in exchange for payments. The organization then turned these funds over to A to help fund A's scientific research activities. Because the supporting organization was both the legal and beneficial owner of the patents that it licensed to third parties, the payments it received constituted royalties excludable from UBIT under IRC § 512(b)(2).

¶1232.1.3 Impact of 'Services' on the Royalty Exclusion

Courts have considered the scope of the royalty exception under IRC § 512(b)(2) in numerous situations, some involving traditional forms of intellectual property (such as patents, copyrights, or trademarks) and others involving other intangible assets (such as mailing lists). Four of the main lines of authority involve the following:

1. Affinity credit card arrangements
2. Mailing list rentals
3. Publishing
4. Insurance programs

From the decisions discussed below, one can draw certain principles and guidelines that are relevant when structuring intellectual property commercialization arrangements, with a focus on the degree of services the licensor can provide and still preserve the royalty exclusion. (See also ¶130.)

Affinity Card Arrangements

Many colleges and universities engage in affinity credit card arrangements, under which a bank issues a credit card bearing the name and logo of a school or other exempt organization in exchange for a fee per card issued and/or fees based on a percentage of purchases made with the card. The tax treatment of affinity card arrangements has been the subject of extended litigation. Exempt organizations have taken the position that the fees from the bank are royalties. The Service, on the other hand, has claimed that the exempt organizations provide services to the bank, and that the provision of such services causes the fees to fail to qualify as excludable royalties.

In a series of cases, courts have held that either (1) services provided by the exempt organizations were de minimis and, therefore, should not adversely affect the royalty treatment of payments, or (2) the purported "services" were not services at all, but were instead actions to protect the value of an organization's intellectual property. ² In a memorandum from the IRS National Office to exempt organization area managers (Dec. 16, 1999), the Service announced that it will not pursue cases presenting similar fact patterns in the future.

Mailing List Rentals

Along the same lines, an organization's mailing list is frequently a valuable asset and, if rented to third parties, can be a source of significant revenue. The segmentation of mailing lists, i.e., the selection of the names most suitable for a particular mailing, is a sophisticated marketing function.

A mailing list is generally viewed as an intangible asset. Thus, payment for the right to use a mailing list fits comfortably within the definition of royalty for purposes of § 512(b)(2). Because of the substantial industry that supports the mailing list rental business, exempt organizations have been able to structure their mailing list rental activities so that the organizations do not provide more than de minimis services to the lessee. As a result, such organizations have obtained royalty treatment for amounts paid for use of the lists. ³

The cases seem to stand for the proposition that at least some activities directed at advertising the mailing list, such as creating a rate card, are permissible, but the cases stop short of permitting sales activity. Thus, while the Tax Court has found that preparing a rate card was permissible "royalty-related activity," it has found that brokerage activities were not. It is unclear what the result would be if, for example, a college retained a broker to actively market the college's mailing list on behalf of the college.

The mailing list cases, like the affinity card cases, also make it clear that activities undertaken to protect the value of an organization's intangible property are permissible. The difficulty is in determining which activities fall within this coveted "royalty-related" class. Colleges and universities would be well-advised to tailor their transactions as closely as possible to the decided cases.

Publishing

In contrast to the affinity card and list rental cases, exempt organizations have been less successful in structuring agreements for the publication of magazines so that they give rise only to excludable royalty income. The Service has attributed the publisher's activities to the tax-exempt organization under the agency rationale ⁴ and has used this attribution to characterize the resulting income as compensation for services rather than royalties. In addition, at least one court has held that income from licensing the organization's intangibles to a service provider in connection with publishing the organization's own publication will be treated as UBTI regardless of whether the organization provides any services, because the publication is used to promote the organization itself rather than the licensee's product. ⁵

Insurance Programs

Many exempt organizations enter into agreements with private insurance companies to provide insurance to the organizations' members. Many such organizations have argued that the income they receive under such agreements is not taxable as unrelated business income because it is substantially related to the organization's exempt purposes. ⁶

The courts, however, have uniformly found that insurance programs sponsored by tax-exempt organizations are a trade or business engaged in for profit and that such insurance programs are not substantially related to the organizations' exempt purposes (see, e.g., United States v. American Bar Endowment, 477 U.S. 105 (1986)).

Many organizations have also tried to characterize income from insurance programs as royalties for the use of the organization's name. Where the issue of royalties has been raised, exempt organizations have lost, primarily because the arrangements have been structured to require provision of substantial services by the organization to the insurance brokers, as well as endorsements by the exempt organizations (see, e.g., Nat'l Water Well Ass'n v. Comm'r, 92 T.C. 75 (1989)). Efforts to allocate income received between amounts paid for the use of the organization's name, marks, and logo and amounts paid for services also have been unsuccessful, in part because the agreements between the parties did not reflect such an arrangement (see Texas Farm Bureau v. United States, 53 F.3d 120 (5th Cir. 1995), aff'g in part, rev'g in part, 822 F. Supp. 371 (W.D. Tex. 1993)).

Most of these cases, however, preceded the success of exempt organizations in the affinity card and mailing list cases. With the guidance provided by these cases, exempt organizations may be able to structure insurance programs to come within the definition of a royalty.

¶1232.1.4 Strategies for Dealing with Services

A college or university that licenses intellectual property and also provides services to the licensee may be able to minimize its exposure to UBIT by providing services through a for-profit subsidiary or by using third-party vendors, as in the mailing list cases.

For-Profit Subsidiaries

A college or university may be able to minimize its exposure to UBIT by conducting its UBTI-producing activities through a for-profit subsidiary. For federal income tax purposes, a parent corporation and it subsidiaries are considered separate entities so long as the subsidiary incorporates for purposes that are the equivalent of business activities, and the subsidiary carries on business activities (see Moline Properties, Inc. v. Comm'r, 319 U.S. 436, 438 (1943)). Where a for-profit subsidiary is organized with a bona fide intention that it will have some real business function, its existence may not be disregarded for tax purposes, and its income will not be attributed to its tax-exempt parent. Further, the subsidiary must not be an agent of the parent corporation, (see Commissioner v. Bollinger, 485 U.S. 340 (1988)), must observe corporate formalities, and should have on its board of directors some outsiders, i.e., persons who are not officers or directors of the parent corporation (see, e.g., PLR 9542045 (July 28, 1995); PLR 8625078 (Mar. 27, 1986)).

In at least one ruling, the Service approved an organizational structure that allowed a tax-exempt parent to bifurcate payments received in connection with the organization's licensing agreements into two parts: one part was a royalty to the organization for the use of its intellectual property, and the other part was a payment to the organization's wholly owned taxable subsidiary for various services rendered by the subsidiary to the licensees.

Example 1232-4

In PLR 199938041 (June 28, 1999), X was a social welfare organization described in § 501(c)(4). ⁷ Through contractual agreements with third-party service providers, X offered various programs and services to its members. X endorsed these programs, advised its members of their availability, and maintained a staff to oversee the operation of these programs and to act as coordinator to resolve any problems its members may have with any of the programs. The service providers were entitled to the use of X's name and logo, and some of them were also given access to X's mailing list. Some of the service providers had the exclusive right to provide a specific service to X's members. X received payments from the service providers based upon the amount each service provider received from X's members. All of the agreements with service providers authorized or required X to perform certain monitoring, reviewing, and auditing activities.

X created Y, a wholly owned taxable subsidiary, and assigned to Y a portion of X's right, title, and interest in X's agreements with the service providers, reserving for itself all of its right, title, and interest in its name, logos, symbol, mark, service marks, and acronym (X's Marks). In conjunction with these assignments, X entered into royalty agreements with the service providers for the use of X's Marks. To minimize its exposure to UBIT, X delegated a number of functions relating to its service provider agreements to Y. These functions included the following:

• Receiving, reviewing, and recommending modifications to strategic and operating plans of the service providers
• Auditing and inspecting management reports, complaints, finances, and statistical data of the service providers
• Approving the nature and timing of communications of the service providers with X's members
• Monitoring performance of the service providers and helping resolve claims, disputes, and other problems with the service providers
• Creating marketing services respecting X's membership list
• All other activities as are necessary to promote the service providers

Y entered into a separate agreement for the provision of these services with each service provider. Y was compensated by the service providers for the services rendered in an amount equal to the fair market value of such services. X was compensated by the service providers for the use of X's Marks, pursuant to a royalty agreement with each provider.

X provided its mailing list to Y under a no-fee license. Y then sublicensed the list to each service provider, whose contract with X authorized use of such list for the term of the contract. In return for a fee, Y performed all actions necessary for the management of its sublicenses of the list, including segmentation, transfer, security, audits of use and misuse, and collection of rentals.

An agreement between X and Y provided that a majority of the members of Y's board of directors would not be current or former officers or directors of X. The agreement also provided that Y's board would be the sole governing and policymaking body of Y, and that Y would have its own employees, separate offices, separate telephone numbers, separate telephone listings, separate bank accounts and separate stationery.

On these facts, the Service determined that X and Y were separate entities. Therefore, the nonexempt commercial activities of Y were not attributable to X for purposes of determining X's continued qualification for tax-exempt status, or for purposes of determining X's potential liability for UBIT. Because most of the services in connection with the programs and services offered to X's members by the service providers were performed by Y rather than X, the provision of such services did not affect the character of payments received by X for the use of X's Marks under the royalty agreements. Thus, the payments made by the service providers to X under the royalty agreements with X were royalties within the meaning of IRC § 512(b)(2).

Subsequent to the issuance of PLR 199938041, X terminated the no-fee license of its mailing list to Y and licensed the use of such mailing list directly to the service providers. In exchange for the license, X was entitled to a fee equal to the fair market value of the raw mailing list information. List-related services such as segmentation, transfer, security, audits of use and misuse, and collection of rentals, continued to be performed by Y. To simplify payment to the service providers, X and Y hired an unrelated financial institution as their agent to receive the total payment from the service providers. The agent then allocated this payment to the accounts of X and Y in accordance with the contracts of X and Y with the service providers. X also made changes to the way Y was compensated for its services relating to the use of X's Marks. Under the arrangement approved in the earlier ruling, service providers were required to pay Y for all such services, even though some of such services benefited X and not the service providers. Under the new arrangement, Y billed X directly for those services that benefited X, and X paid Y directly. All activity of Y benefiting X was billed to X at fair market value and the total income to Y from these activities did not change. The Service approved all of these changes in PLR 200149043 (Aug. 1, 2001).

Thus, a college, university or other tax-exempt organization that performs services in connection with a licensing agreement may be able to avoid UBIT on its licensing income by establishing a wholly owned for-profit subsidiary and transferring all nonroyalty-related services to the subsidiary. As long as the subsidiary is separately incorporated and separately run, the activities of the subsidiary should not be attributed to the tax-exempt parent. If the arrangement is properly structured, the royalty income received by the exempt parent under such a licensing agreement should be excludable from UBTI, and should not be recharacterized as compensation for services.

Allocation

If setting up a separate subsidiary is not feasible or not desirable, a college or university should maintain careful records of the time and resources spent on providing services to commercial entities in licensing the institution's intangibles to such entities. Only the portion of the payment received that is commensurate with the value of the services devoted to the program by the organization should be treated as compensation for services, which is taxable as UBTI.

In published authorities on the issue of royalties versus services, the Service has taken the position that the provision of services by a tax-exempt organization in connection with a license taints the entire payment received by the organization. In Oregon State University Alumni Ass'n v. Commissioner, 193 F.3d 1098 (9th Cir. 1999), however, the Ninth Circuit expressed its dissatisfaction with this all-or-nothing approach and indicated, in dictum, that it would be willing to allocate the payment between royalties and services if the parties requested such allocation.

The Tax Court has also indicated a willingness to allocate payments between amounts paid for services and amounts paid for use of intellectual property, although the court has never been squarely presented with the issue. ⁸ In aid of the allocation argument, institutions should make an effort to execute separate agreements for royalty income and services income. The courts in Sierra Club and Oregon State University Alumni Association concluded that paying for services under a separate agreement generally does not affect the character of royalty income paid under a different agreement. The institution should make sure that it receives reimbursement for any services it provides to its commercial partners and that such reimbursements are not combined with royalty payments. For example, if a college or university contemplates mailing promotional materials to its alumni advertising a program that is otherwise expected to generate royalties, the institution should be reimbursed for such mailing by its commercial partner separately from the payment of royalties.

Third-Party Vendors

A college or university also may wish to consider hiring an unrelated third party to provide some or all of the services in connection with the institution's licensing agreements. While the cases are not entirely clear on this point, it appears that having a third party conduct activities through a contractual relationship may protect the organization's royalty treatment, provided that the third party is not an agent for the organization.

¶1232.1.5 Other Limitations on Royalty Exclusion

In addition to the provision of services, the royalty exclusion does have some limits.

Debt-Financed Property

Although the factual circumstances for application of the debt-financed property rules may not arise frequently in the context of intellectual property transactions, college and university administrators and their advisors should be aware that these rules present an additional limitation on the passive-income exclusions, such as the royalty exclusion. IRC § 514(a)(1) requires an exempt organization to include in UBTI a percentage of income derived from "debt-financed property" equal to the "average acquisition indebtedness" for the taxable year over the average amount of the adjusted basis for the taxable year. A like percentage of deductions is allowed in computing UBTI. IRC § 514(a)(2).

"Debt-financed property" is defined in IRC § 514(b)(1) as any property held to produce income with respect to which there is an acquisition indebtedness at any time during the taxable year or, if the property is disposed of during the taxable year, at any time during the 12-month period ending with the disposition. The statute contains several exceptions to the definition of debt-financed property, including an exception for any property to the extent income is excluded under IRC § 512(b)(7) relating to government research, § 512(b)(8) relating to college, university, and hospital research, and § 512(b)(9) relating to fundamental research the results of which are made freely available to the public. IRC § 514(b)(1)(C). Although there is no definition of property for purposes of § 514, the term "property" generally includes intellectual property for federal tax purposes. Thus, these rules are potentially applicable to royalties received from the licensing of intellectual property that was acquired with borrowed funds.

"Acquisition indebtedness" is defined in IRC § 514(c) as the unpaid amount of:

• indebtedness incurred by the organization in acquiring or improving debt-financed property;
• indebtedness incurred before the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement; and
• indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement and, the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement.

There are a number of exceptions from the definition of acquisition indebtedness that are not relevant to royalty transactions.

If none of the statutory exceptions is applicable, then, to determine whether there is acquisition indebtedness, one must first determine whether there is indebtedness and then determine whether the indebtedness is traceable to the acquisition or improvement of income-producing property.

Royalties from Controlled Subsidiaries

IRS § 512(b)(13) contains another rule that may limit availability of the passive-income exclusions, such as the royalty exclusion. That section provides that an exempt organization (the "controlling organization") must include the following in UBTI: royalties, interest, rent, and annuities paid to it by a "controlled organization" to the extent such payments reduce the "net unrelated income (or increase any net unrelated loss)" of the controlled organization, although Congress has modified this rule between January 1, 2006, and December 31, 2007 (see "Pension Protection Act" below). If the controlled organization is not exempt from tax, "net unrelated income" means any income earned by the controlled organization that would be included in UBTI by the controlled entity if the controlled entity were tax-exempt and had the same exempt purpose as the controlling organization. For purposes of section 512(b)(13), "control" means ownership (by vote or value) of more than 50 percent of the stock in a corporation. The constructive ownership rules of section 318 apply in determining control.

If a controlling parent college or university grants a license to use intellectual property to a controlled subsidiary that is not tax-exempt, the college or university may not be able to completely avoid taxation under the royalty exclusion of IRC § 512(b)(2) (see PLR 9705028 (Nov. 5, 1996.)

Pension Protection Act of 2006 Modification. Section 1205 of the Pension Protection Act of 2006 (Pub. L. 109-280) modified IRC § 512(b)(13). As modified, the rule that requires a controlling organization to include royalties, interest, rent, and annuities in UBTI applies only to the portion of payments that exceeds an arm's-length or fair-market-value amount if such amount is paid pursuant to a binding written contract in effect on August 17, 2006, (the date of enactment of the law) or a renewal of such contract under substantially similar terms. A 20 percent penalty is imposed on the portion of the payment that exceeds fair market value. This modification is effective for payments received after December 31, 2005, and before January 1, 2015.

The provision also adds new reporting requirements. The reporting amendment applies to returns with a due date after August 17, 2006.

¹ Rev. Rul. 81-178 is posted on the IRS Web site at www.irs.gov/pub/irs-tege/rr81-178.pdf#search=%22Rev.%20Rul.%2081-178%22. [back to text]

² See, e.g., Sierra Club, Inc. v.Comm'r, 86 F.3d 1526 (9th Cir. 1996), aff'g in part, rev'g in part, 103 T.C. 307 (1994) and 65 T.C.M. 2582 (1993); Oregon State Univ. Alumni Ass'n, Inc. v.Comm'r, 193 F.3d 1098 (9th Cir. 1999), aff'g, 71 T.C.M. 1935 (1996) and 71 T.C.M. 2093 (1996). [back to text]

³ See, e.g., Disabled Am. Veterans v. United States, 650 F.2d 1178 (Ct. Cl. 1981); Disabled Am. Veterans v. Comm'r, 94 T.C. 60 (1990); Sierra Club, Inc. v. Comm'r, 86 F.3d 1526 (9th Cir. 1996), aff'g in part, rev'g in part, 103 T.C. 307 (1994) and 65 T.C.M. 2582 (1993); Common Cause v. Comm'r, 112 T.C. 332 (1999); Planned Parenthood Fed'n of Am., Inc. v. Comm'r, 77 T.C.M. 2227 (1999). [back to text]

⁴ The presence of an agency relationship is determined by all relevant facts and circumstances and is characterized by the principal's direction and control of the agent. (In re Shulman Transp. Enters., Inc., 744 F.2d 293, 295 (2nd Cir. 1984)). [back to text]

⁵ Arkansas State Police Ass'n, Inc. v. Comm'r, 282 F.3d 556 (8th Cir. 2002), aff'g, 81 T.C.M. 172 (2001); see also State Police Ass'n v. Comm'r, 125 F.3d 1 (1st Cir. 1997). Cf. Rev. Rul. 69-430, 1969-2 C.B. 129 (income from transfer of publication rights to a book to commercial publisher is a royalty). [back to text]

⁶ Note that, in the college and university context, insurance programs undertaken for students and employees will likely be excluded from the definition of "unrelated trade or business," under a convenience exception set forth in IRC § 513(a)(2). See Section 100, ¶121, for a discussion of the convenience exception. [back to text]

⁷ It is understood that this ruling was issued to the American Association of Retired Persons (AARP). [back to text]

⁸ See Common Cause v. Comm'r, 112 T.C. 332 (1999); Planned Parenthood Federation of America, Inc. v. Comm'r, 77 T.C. Memo 2227 (1999); Sierra Club, Inc. v. Comm'r, 65 T.C. Memo 2582 (1993). See also Memorandum from the IRS National Office to EO Area Managers (Dec. 16, 1999) (stating that the issue of allocation was under consideration in IRS National Office)). [back to text]

Part 1232-2: ¶1232.2 Exclusion of Research Income

There are three separate statutory exclusions from UBIT for income from research:

1. Research performed by a college, university or hospital
2. Government research
3. Fundamental research

¶1232.2.1 Research Performed by a College, University or Hospital

All income from research performed by a college, university, or hospital is excluded from UBTI (IRC § 512(b)(8)). It does not matter for whom the research is performed or the nature of the research, as long as the activity is considered research. The regulations contain a definition of "research" that is essentially the same as the definition that applies in determining whether an organization qualifies for tax-exempt status as a scientific research organization. Specifically, the regulations provide that research "does not include activities of a type ordinarily carried on as an incident to commercial or industrial operations, for example, the ordinary testing or inspection of materials or products or the designing or construction of equipment, buildings, etc." (IRS Treas. Reg. § 1.512(b)-1(f)(4)).

¶1232.2.2 Research Performed by Affiliated Entities

If research is performed by an entity affiliated with, but separate from, the college or university, it will not qualify for the exclusion for research performed by a college, university, or hospital discussed in ¶1232.2.1. It may, however, qualify under the exclusion for government research or the exclusion for fundamental research.

Governmental Research

Under IRC § 512(b)(7), all income derived from research for (1) the United States or any of its agencies or instrumentalities or (2) any state or political subdivision thereof is excluded from UBTI. This exception applies to research performed by any exempt organization that is subject to UBIT.

Fundamental Research

The exclusion for fundamental research is the most restrictive, as it is limited to organizations operated primarily for the purpose of carrying on fundamental research and requires that the results be made freely available to the public (IRC § 512(b)(9)). However, if an organization qualifies for this exclusion because it is engaged primarily in fundamental research and makes its results freely available, then any income earned from research conducted by it will be excluded from UBTI, even if the particular research from which income is earned is not fundamental research and is not made freely available to the public. Of course, such research must be limited, or the organization will lose its status as a fundamental research organization, which is the prerequisite for qualifying for the exclusion under IRC § 512(b)(9) in the first instance.

For purposes of this provision, fundamental research is not defined by the regulations, except to exclude "research carried on for the primary purpose of commercial or industrial application." (IRS Treas. Reg. § 1.512(b)-1(f)(4)). Although colleges and universities often conduct fundamental research, they are not operated primarily for the purpose of carrying on fundamental research. Consequently, the exclusion for fundamental research is generally not useful to such institutions.

Part 1232-3: ¶1232.3 Exclusion of Capital Gains and Losses

IRC § 512(b)(5) excludes from UBTI all gains and losses from the sale, exchange, or other disposition of property, other than property that would be properly includable in inventory and property held primarily for sale to customers in the ordinary course of business (see IRC § 512(b)(5)(A), (B); IRS Treas. Reg. § 1.512(b)-1(d)). Thus, in order to avail itself of the exclusion provided by IRC§ 512(b)(5), an institution must satisfy two requirements:

1. It must show that it has sold, exchanged, or disposed of intellectual property and not merely licensed it. However, because a license would result in a royalty payment that would be excluded under IRC § 512(b)(2), it will not make any difference whether a transaction is characterized as a license or a sale or disposition in many cases.
2. It must show that the property is not inventory and is not held primarily for sale to customers.

Although IRC § 512(b)(5) is often referred to as the exclusion for capital gains and losses, the availability of the exclusion is not dependent upon a finding that the sale or disposition would result in a capital gain or loss. Instead, the language of IRC § 512(b)(5)(A) and (B) tracks the language of IRC § 1221(a)(1) and (2), which defines a capital asset. Unlike IRC § 1221(a), which excludes certain copyrights from the definition of a capital asset, ⁹ IRC § 512(b)(5) does not exclude any copyrights from its applicability. Thus, whether the sale or disposition of a copyright would result in ordinary income should not affect the exclusion of income under IRC § 512(b)(5). There is, however, no direct authority on this point.

⁹ IRC §1221(a)(3) excludes from the definition of a capital asset a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by: (A) a taxpayer whose personal efforts created such property, (B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or (C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B). [back to text]

Part 1232-4: ¶1232.4 Safe Harbor for Corporate Sponsorships

The IRC and regulations also contain a safe harbor, under which the activity of soliciting or receiving "qualified sponsorship payments" is not considered an unrelated trade or business (see IRC§ 513(i)(1)). A sponsorship payment is a payment to an exempt organization typically to obtain the right to sponsor an event, such as a college bowl game. For a sponsorship payment to constitute a "qualified sponsorship payment," there can be no arrangement or expectation that the sponsor will receive any substantial return benefit in exchange for the sponsorship payment, other than the use or acknowledgment of the name or logo (or product lines) of the sponsor's trade or business in connection with the activities of the recipient organization (see IRC § 513(i)(2)(A)). An acceptable acknowledgment for such purposes does not include advertising the sponsor's products or services. Impermissible advertising could consist of, among other things, messages containing qualitative or comparative language, price information, an endorsement, or inducement to purchase, see or use the sponsor's products. The rules regarding qualified sponsorship payments are covered in greater detail in Section 100, ¶123.