July 1995
Nonprofits' Affinity for Credit Cards,
Legal Times
In recent years, many associations and other membership organizations have become involved in affinity credit card programs as a way to offer additional benefits to their members and as an important source of nondues revenue to support their activities.
As such programs have become quite popular and lucrative for many organizations, the Internal Revenue Service has also taken a strong interest in these programs and threatens to tax a substantial part of their revenue.
Congressional interest in this issue may also pick up as the result of the current questions being raised by Sen. Alan Simpson (R-Wyo.) and others about the increasing reliance by exempt organizations on revenues from commercial activities and federal grants rather than membership sources.
In these affinity card programs, the tax-exempt organization permits the use of its name, logo, and mailing list by a credit card issuer; endorses the program; and, in some cases promotes and helps administer the program. The organization typically receives payments based on the number of credit card applications or renewals that are generated from solicitations of the organization's members, the volume of credit card charges or interest charges by members, or some other formula based on activity generated by the program.
There is a considerable controversy and dispute as to whether payments received in affinity credit card programs or for the use of an exempt organization's mailing list are taxable. The IRS has taken the position that all revenues from affinity credit card and other endorsement programs involving the use of an organization's mailing list of the provision of even fairly minimal services by the organization are taxable as unrelated business income and not excluded from such taxation as royalties.
The U.S. Tax Court held last year that the Sierra Club's income from an affinity credit card program was not taxable. The IRS has had mixed results in litigation on the taxation of mailing-list rentals. These issues will remain subject to further litigation unless Congress intervenes to resolve them.
Under current law, payments received by a tax-exempt organization as royalties for the use of its name, logo, or other valuable intangible property rights generally are exempt from federal income taxes, while income received for services provided by the organization in an unrelated trade or business is subject to the unrelated business is subject to unrelated business income tax, commonly known as UBIT.
Section 511 of the Internal Revenue Code of 1986 imposes a tax on the unrelated business taxable income (UBTI) of organizations that are otherwise exempt from federal income taxation under §501(a). Section 512(a) defines such revenue as the gross income an organization derives from any unrelated trade or business regularly carried on, less allowable deductions directly connected with such trade or business. An "unrelated trade or business" is any trade or business not substantially related to the exercise or performance by an organization of its exempt purposes.
Where goodwill or other intangibles generated in the performance of exempt functions are exploited by an exempt organization in commercial activities, the resulting income is considered gross income from an unrelated business unless the commercial activities themselves contribute importantly to the accomplishment of an exempt purpose.
Section 513(h)(1)(B), added as part of the Tax Reform Act of 1986, provides that organizations to which deductible charitable contributions may be made will not have unrelated business income from exchanging or renting donor or membership lists with other such organizations. The organizations referred to in that section generally include those exempt under §501(c)(3), but not professional and trade associations, labor unions, and many other kinds of exempt organizations.
If an affinity credit card program is treated as an unrelated business or trade, net income from the arrangement may still not be unrelated business income if the payments received by the exempt organization are for the use of its name, logo, and mailing list, and qualify for royalty treatment. Section 512(b)(2) excludes from UBTI "all royalties (including overriding royalties) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income."
Neither the U.S. Code nor the Treasury Department's Income Tax Regulations define the term "royalties" for these purposes, although it is defined for other purposes under the code. The personal holding company regulations, for example, define royalties (other than mineral, oil, or gas royalties, or certain copyright royalties) as "amounts received for the privilege of using patents, copyrights, secret processes and formulas, good will, trade marks, trade brands, franchises, and other like property." In Revenue Ruling 81-178, 1981-2 C.B. 135, the IRS stated that, in order to be considered a royalty within the meaning of §512(b)(2), a "payment must relate to the use of a valuable right," and that "[p]ayments 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 income tax purposes." Although there are relatively few court cases addressing the royalty exclusion under §512(b)(2), the courts have articulated similar definitions of royalties in other contexts.
The IRS has taken the position that the royalty exclusion from UBIT is limited to income derived from passive sources, so that an organization's provision of services in connection with a license of the right to use its name and logo will preclude royalty treatment. But recent decisions of the Tax Court have rejected the IRS view.
IRS technical advice memorandums and a prior general counsel memorandum specifically hold that affinity credit card receipts are UBIT and are not excludable as royalties. These rulings rely heavily on the IRS position that income from the use of an exempt organization's mailing list is taxable unless it is exempted under §513(h)(1)(B) as income from exchanges or rentals between certain exempt organizations. (Technical advice and general counsel memorandums do not constitute legal precedent applicable to all taxpayers. But in the absence of authoritative guidance, they do provide important information about the IRS's views on an issue.)
In Revenue Ruling 72-431, 1972-2 C.B. 281, the IRS held that regular sales of membership mailing lists by an exempt organization resulted in unrelated business income. The IRS reasoned that such sales constituted the exploitation of an intangible resulting from the organization's exempt function under §1.513-(d)(4)(iv) of the regulations. More recently, the IRS position has been that, by enacting §513(h)(1)(B), Congress intended to tax revenues from all rentals or exchanges of mailing lists not expressly covered by that section.
CONTRARY TO HISTORY
The IRS position on the impact of §513(h)(1)(B) is contrary to statements in the legislative history that Congress did not intend to create any influence "as to whether or not revenues from mailing lists other than those described in the provision. . .constitute unrelated business income."
The IRS rulings concluding that affinity card program receipts are not royalties also rely in part on the endorsements and services provided by the organization. This reasoning is similar to the position the IRS has taken in rulings on insurance and other programs sponsored by exempt organizations for their members.
Notwithstanding these unfavorable rulings, the IRS recognizes that there can be qualifying royalty arrangements in some cases, such as where there is no evidence that mailing lists are provided and the organization does not have an active role through the performance of extensive services.
In some rulings on insurance programs, however, even where the exempt organization itself has been passive, the IRS has concluded that the activities of the insurance program administrators should be attributed to the exempt organization. In these situations, the attribution of the "agents" activities to the exempt organization causes the latter to be viewed by the IRS as providing extensive services and, thereby, ineligible to treat its receipts as royalties.
The courts on a number of occasions have rejected IRS ruling positions, as the Tax Court has done with respect to the affinity credit card. The IRS position on the taxation of mailing-list rentals also has been rejected in two Tax Court cases. Two other federal courts, however, have upheld the taxation of mailing-list rentals, and the courts generally have supported IRS attempts to tax the income that exempt organizations derive from insurance programs they sponsor and promote.
SIERRA CLUB II
In Sierra Club Inc. v. Commissioner, (Sierra Club II), the Tax Court in 1994 granted the Sierra Club partial summary judgment on its claim that revenues received for its participation in an affinity card program were exempt from UBIT as royalties, since the payments were for the use of intangible property, including the Sierra Club name, logo, and mailing lists. The Sierra Club had entered into an agreement with a bank card issuer to offer credit cards to the club's members. The bank was responsible for the development of all promotional and solicitation materials and programs, subject to the Sierra Club's approval. The club was obligated to cooperate fully with the bank in encouraging the use of the credit card program and other services to be offered by the bank. The club agreed not to authorize any other bank to issue credit cards to its members. The club received a royalty fee based on the total sales volume generated by members using the card.
In determining that the payments received by the Sierra Club were royalties, the Tax Court rejected the IRS argument that the Sierra Club itself was in the business of selling credit card services. The court found that Sierra Club did not participate directly in any marketing efforts, except with regard to use of its mailing permit. The court also concluded that the organization's exercise of its right to advise and consent with respect to the bank's marketing proposals was in furtherance of protecting the value of its name and trademarks and was not an indirect way to put the Sierra Club in the business of marketing to members.
The IRS position in Sierra Club II was that the organization was in the business of selling credit card goods and services either as a joint venturer with the bank card issuer or as a sole proprietor using the bank as its agent.
In rejecting the IRS's joint venture position, the Tax Court gave special emphasis to the absence of an interest in net profits for the Sierra Club. The Tax Court found that the Sierra Club received only a share of the gross profit from the credit card program, with its compensation based on total cardholder sales volume. The Sierra Club did not share in marketing expenses, the bank's costs or its credit risk, although the group's royalty fee did vary with the bank's cost of funds.
The Tax Court also rejected the IRS's agency theory, again emphasizing the absence of a net profits interest for the Sierra Club. The court also found that the Sierra Club's rights of approval over the bank's marketing materials and its other actions indicated more of a cooperative arrangement than a master-servant relationship.
Earlier Tax Court decision in Sierra Club and in Disabled American Veterans v. United States (DAV I) hold that mailing-list rentals may be exempt royalties and thus cast doubt on the IRS ruling with respect to affinity credit card programs. These decisions have expressly rejected the IRS view of the royalty exception as applying only to passive sources of income. The IRS, however, has fared better on these issues in other federal courts.
In 1981, the Court of Claims in DAV I, held that the rental of an organization's donor lists in the years 1970 to 1973 constituted a regularly carried on trade or business and that the receipts from such rentals could not be classified as royalties within the meaning of §512(b)(2).
The court concluded that the rentals were the "product of extensive business activity by the veterans group and do not fit within the types of `passive' income set forth in §512(b)." The Court of Claims thus accepted the IRS position that the royalty exclusion applies only to passive sources of income.
In 1990, in Disabled American Veterans v. Commissioner, (DAVII), the veterans group challenged the IRS characterization of payments it received for the use of its mailing list in later years. Unlike the Court of Claims, the Tax Court held that the mailing-list payments were royalties, concluding that §512(b) is not limited to income from passive sources.
The Tax Court reasoned that there would be no need to exclude royalties under §512(b) unless those amounts otherwise were attributable to an unrelated trade or business. In the Tax Court's view, the IRS position confused the issue of whether an exempt organization is engaged in an unrelated business with the issue of whether a payment is a royalty.
The Tax Court noted, however, that the services provided by the veterans group were de minimis. If the services had been more predominant, the conclusion about the character of the income might have been different, since it might then be viewed as compensation for services rather than for use of intangible property.
The Tax Court's decision in DAV II, was reversed by the U.S. Court of Appeals for the 6th Circuit on the ground that the Disabled American Veterans were collaterally stopped from relitigating in Tax Court the same issues decided in DAV I.
Although the 6th Circuit's holding is technically limited to the issue of collateral estoppel, the court expressed doubt about the Tax Court's holding in DAV II that income from mailing-list rentals is excludable as royalties.
In a 1993 memorandum decision in Sierra Club Inc. v. Commissioner, (Sierra Club I), which preceded the decision on the Sierra Club's credit card program, the Tax Court again held that income from the rental of mailing lists constituted tax-free royalties. In granting partial summary judgment in favor of the Sierra Club, Tax Court Judge Halpern reaffirmed the position in DAV II that the term royalty includes "payments for the use of valuable intangible property rights" and is not limited to income from passive sources.
In other cases where an organization actively provides services in connection with an insurance or other endorsement program courts generally have held that the payments are more akin to compensation for services rendered and thus do not constitute royalty income.
The rulings and cases discussed above illustrate three arguments that the IRS might make in seeking to tax the income of an association from affinity credit card programs offered to members:
· Use of the organization's mailing list makes all of the net income in any program taxable, on the theory that payments for the mailing list are inseparable from payments for the use of the organization's name and logo, which otherwise would be tax-free royalties.
· None of the income is excludable as royalties if the organization provides endorsements or services in addition to the use of its name and logo because the organization is providing services in an active business undertaking.
· Services provided by a separate subsidiary or an unrelated party may be attributed to the exempt organization based upon a perceived joint venture or principal-agent relationship. Those attributed services would then be viewed as making the payments active income that is ineligible for the royalty exclusion.
With the Sierra Club case on appeal to the 9th Circuit and two other cases involving affinity credit card programs filed with the Tax Court last year, the final outcome of litigation over revenues from affinity card programs and mailing-list rentals remains uncertain. And given the current state of the law, many exempt organizations have begun to review their affinity credit card arrangements in order to position themselves for an IRS challenge.
In the face of the IRS's current posture on this issue, careful tax planning can be critical to improving an organization's chances for avoiding federal income taxation of its net revenues from an affinity card program.
Meanwhile, the associations should keep a watchful eye on Capital Hill. While there is no legislation currently moving that is directly targeted at affinity credit card programs, Congress has considered such legislation in the past and could revisit the issue.
As such programs have become quite popular and lucrative for many organizations, the Internal Revenue Service has also taken a strong interest in these programs and threatens to tax a substantial part of their revenue.
Congressional interest in this issue may also pick up as the result of the current questions being raised by Sen. Alan Simpson (R-Wyo.) and others about the increasing reliance by exempt organizations on revenues from commercial activities and federal grants rather than membership sources.
In these affinity card programs, the tax-exempt organization permits the use of its name, logo, and mailing list by a credit card issuer; endorses the program; and, in some cases promotes and helps administer the program. The organization typically receives payments based on the number of credit card applications or renewals that are generated from solicitations of the organization's members, the volume of credit card charges or interest charges by members, or some other formula based on activity generated by the program.
There is a considerable controversy and dispute as to whether payments received in affinity credit card programs or for the use of an exempt organization's mailing list are taxable. The IRS has taken the position that all revenues from affinity credit card and other endorsement programs involving the use of an organization's mailing list of the provision of even fairly minimal services by the organization are taxable as unrelated business income and not excluded from such taxation as royalties.
The U.S. Tax Court held last year that the Sierra Club's income from an affinity credit card program was not taxable. The IRS has had mixed results in litigation on the taxation of mailing-list rentals. These issues will remain subject to further litigation unless Congress intervenes to resolve them.
Under current law, payments received by a tax-exempt organization as royalties for the use of its name, logo, or other valuable intangible property rights generally are exempt from federal income taxes, while income received for services provided by the organization in an unrelated trade or business is subject to the unrelated business is subject to unrelated business income tax, commonly known as UBIT.
Section 511 of the Internal Revenue Code of 1986 imposes a tax on the unrelated business taxable income (UBTI) of organizations that are otherwise exempt from federal income taxation under §501(a). Section 512(a) defines such revenue as the gross income an organization derives from any unrelated trade or business regularly carried on, less allowable deductions directly connected with such trade or business. An "unrelated trade or business" is any trade or business not substantially related to the exercise or performance by an organization of its exempt purposes.
Where goodwill or other intangibles generated in the performance of exempt functions are exploited by an exempt organization in commercial activities, the resulting income is considered gross income from an unrelated business unless the commercial activities themselves contribute importantly to the accomplishment of an exempt purpose.
Section 513(h)(1)(B), added as part of the Tax Reform Act of 1986, provides that organizations to which deductible charitable contributions may be made will not have unrelated business income from exchanging or renting donor or membership lists with other such organizations. The organizations referred to in that section generally include those exempt under §501(c)(3), but not professional and trade associations, labor unions, and many other kinds of exempt organizations.
If an affinity credit card program is treated as an unrelated business or trade, net income from the arrangement may still not be unrelated business income if the payments received by the exempt organization are for the use of its name, logo, and mailing list, and qualify for royalty treatment. Section 512(b)(2) excludes from UBTI "all royalties (including overriding royalties) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income."
Neither the U.S. Code nor the Treasury Department's Income Tax Regulations define the term "royalties" for these purposes, although it is defined for other purposes under the code. The personal holding company regulations, for example, define royalties (other than mineral, oil, or gas royalties, or certain copyright royalties) as "amounts received for the privilege of using patents, copyrights, secret processes and formulas, good will, trade marks, trade brands, franchises, and other like property." In Revenue Ruling 81-178, 1981-2 C.B. 135, the IRS stated that, in order to be considered a royalty within the meaning of §512(b)(2), a "payment must relate to the use of a valuable right," and that "[p]ayments 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 income tax purposes." Although there are relatively few court cases addressing the royalty exclusion under §512(b)(2), the courts have articulated similar definitions of royalties in other contexts.
The IRS has taken the position that the royalty exclusion from UBIT is limited to income derived from passive sources, so that an organization's provision of services in connection with a license of the right to use its name and logo will preclude royalty treatment. But recent decisions of the Tax Court have rejected the IRS view.
IRS technical advice memorandums and a prior general counsel memorandum specifically hold that affinity credit card receipts are UBIT and are not excludable as royalties. These rulings rely heavily on the IRS position that income from the use of an exempt organization's mailing list is taxable unless it is exempted under §513(h)(1)(B) as income from exchanges or rentals between certain exempt organizations. (Technical advice and general counsel memorandums do not constitute legal precedent applicable to all taxpayers. But in the absence of authoritative guidance, they do provide important information about the IRS's views on an issue.)
In Revenue Ruling 72-431, 1972-2 C.B. 281, the IRS held that regular sales of membership mailing lists by an exempt organization resulted in unrelated business income. The IRS reasoned that such sales constituted the exploitation of an intangible resulting from the organization's exempt function under §1.513-(d)(4)(iv) of the regulations. More recently, the IRS position has been that, by enacting §513(h)(1)(B), Congress intended to tax revenues from all rentals or exchanges of mailing lists not expressly covered by that section.
CONTRARY TO HISTORY
The IRS position on the impact of §513(h)(1)(B) is contrary to statements in the legislative history that Congress did not intend to create any influence "as to whether or not revenues from mailing lists other than those described in the provision. . .constitute unrelated business income."
The IRS rulings concluding that affinity card program receipts are not royalties also rely in part on the endorsements and services provided by the organization. This reasoning is similar to the position the IRS has taken in rulings on insurance and other programs sponsored by exempt organizations for their members.
Notwithstanding these unfavorable rulings, the IRS recognizes that there can be qualifying royalty arrangements in some cases, such as where there is no evidence that mailing lists are provided and the organization does not have an active role through the performance of extensive services.
In some rulings on insurance programs, however, even where the exempt organization itself has been passive, the IRS has concluded that the activities of the insurance program administrators should be attributed to the exempt organization. In these situations, the attribution of the "agents" activities to the exempt organization causes the latter to be viewed by the IRS as providing extensive services and, thereby, ineligible to treat its receipts as royalties.
The courts on a number of occasions have rejected IRS ruling positions, as the Tax Court has done with respect to the affinity credit card. The IRS position on the taxation of mailing-list rentals also has been rejected in two Tax Court cases. Two other federal courts, however, have upheld the taxation of mailing-list rentals, and the courts generally have supported IRS attempts to tax the income that exempt organizations derive from insurance programs they sponsor and promote.
SIERRA CLUB II
In Sierra Club Inc. v. Commissioner, (Sierra Club II), the Tax Court in 1994 granted the Sierra Club partial summary judgment on its claim that revenues received for its participation in an affinity card program were exempt from UBIT as royalties, since the payments were for the use of intangible property, including the Sierra Club name, logo, and mailing lists. The Sierra Club had entered into an agreement with a bank card issuer to offer credit cards to the club's members. The bank was responsible for the development of all promotional and solicitation materials and programs, subject to the Sierra Club's approval. The club was obligated to cooperate fully with the bank in encouraging the use of the credit card program and other services to be offered by the bank. The club agreed not to authorize any other bank to issue credit cards to its members. The club received a royalty fee based on the total sales volume generated by members using the card.
In determining that the payments received by the Sierra Club were royalties, the Tax Court rejected the IRS argument that the Sierra Club itself was in the business of selling credit card services. The court found that Sierra Club did not participate directly in any marketing efforts, except with regard to use of its mailing permit. The court also concluded that the organization's exercise of its right to advise and consent with respect to the bank's marketing proposals was in furtherance of protecting the value of its name and trademarks and was not an indirect way to put the Sierra Club in the business of marketing to members.
The IRS position in Sierra Club II was that the organization was in the business of selling credit card goods and services either as a joint venturer with the bank card issuer or as a sole proprietor using the bank as its agent.
In rejecting the IRS's joint venture position, the Tax Court gave special emphasis to the absence of an interest in net profits for the Sierra Club. The Tax Court found that the Sierra Club received only a share of the gross profit from the credit card program, with its compensation based on total cardholder sales volume. The Sierra Club did not share in marketing expenses, the bank's costs or its credit risk, although the group's royalty fee did vary with the bank's cost of funds.
The Tax Court also rejected the IRS's agency theory, again emphasizing the absence of a net profits interest for the Sierra Club. The court also found that the Sierra Club's rights of approval over the bank's marketing materials and its other actions indicated more of a cooperative arrangement than a master-servant relationship.
Earlier Tax Court decision in Sierra Club and in Disabled American Veterans v. United States (DAV I) hold that mailing-list rentals may be exempt royalties and thus cast doubt on the IRS ruling with respect to affinity credit card programs. These decisions have expressly rejected the IRS view of the royalty exception as applying only to passive sources of income. The IRS, however, has fared better on these issues in other federal courts.
In 1981, the Court of Claims in DAV I, held that the rental of an organization's donor lists in the years 1970 to 1973 constituted a regularly carried on trade or business and that the receipts from such rentals could not be classified as royalties within the meaning of §512(b)(2).
The court concluded that the rentals were the "product of extensive business activity by the veterans group and do not fit within the types of `passive' income set forth in §512(b)." The Court of Claims thus accepted the IRS position that the royalty exclusion applies only to passive sources of income.
In 1990, in Disabled American Veterans v. Commissioner, (DAVII), the veterans group challenged the IRS characterization of payments it received for the use of its mailing list in later years. Unlike the Court of Claims, the Tax Court held that the mailing-list payments were royalties, concluding that §512(b) is not limited to income from passive sources.
The Tax Court reasoned that there would be no need to exclude royalties under §512(b) unless those amounts otherwise were attributable to an unrelated trade or business. In the Tax Court's view, the IRS position confused the issue of whether an exempt organization is engaged in an unrelated business with the issue of whether a payment is a royalty.
The Tax Court noted, however, that the services provided by the veterans group were de minimis. If the services had been more predominant, the conclusion about the character of the income might have been different, since it might then be viewed as compensation for services rather than for use of intangible property.
The Tax Court's decision in DAV II, was reversed by the U.S. Court of Appeals for the 6th Circuit on the ground that the Disabled American Veterans were collaterally stopped from relitigating in Tax Court the same issues decided in DAV I.
Although the 6th Circuit's holding is technically limited to the issue of collateral estoppel, the court expressed doubt about the Tax Court's holding in DAV II that income from mailing-list rentals is excludable as royalties.
In a 1993 memorandum decision in Sierra Club Inc. v. Commissioner, (Sierra Club I), which preceded the decision on the Sierra Club's credit card program, the Tax Court again held that income from the rental of mailing lists constituted tax-free royalties. In granting partial summary judgment in favor of the Sierra Club, Tax Court Judge Halpern reaffirmed the position in DAV II that the term royalty includes "payments for the use of valuable intangible property rights" and is not limited to income from passive sources.
In other cases where an organization actively provides services in connection with an insurance or other endorsement program courts generally have held that the payments are more akin to compensation for services rendered and thus do not constitute royalty income.
The rulings and cases discussed above illustrate three arguments that the IRS might make in seeking to tax the income of an association from affinity credit card programs offered to members:
· Use of the organization's mailing list makes all of the net income in any program taxable, on the theory that payments for the mailing list are inseparable from payments for the use of the organization's name and logo, which otherwise would be tax-free royalties.
· None of the income is excludable as royalties if the organization provides endorsements or services in addition to the use of its name and logo because the organization is providing services in an active business undertaking.
· Services provided by a separate subsidiary or an unrelated party may be attributed to the exempt organization based upon a perceived joint venture or principal-agent relationship. Those attributed services would then be viewed as making the payments active income that is ineligible for the royalty exclusion.
With the Sierra Club case on appeal to the 9th Circuit and two other cases involving affinity credit card programs filed with the Tax Court last year, the final outcome of litigation over revenues from affinity card programs and mailing-list rentals remains uncertain. And given the current state of the law, many exempt organizations have begun to review their affinity credit card arrangements in order to position themselves for an IRS challenge.
In the face of the IRS's current posture on this issue, careful tax planning can be critical to improving an organization's chances for avoiding federal income taxation of its net revenues from an affinity card program.
Meanwhile, the associations should keep a watchful eye on Capital Hill. While there is no legislation currently moving that is directly targeted at affinity credit card programs, Congress has considered such legislation in the past and could revisit the issue.
