In TAM 201837014, the IRS has concluded that an exempt organization did not receive unrelated business taxable income (UBTI) from advertising sales under the terms of an agreement that the organization had with a for-profit publisher in connection with the publication of the organization's scholarly journal.

Facts

"Organization" is a Section 501(c)(6) professional society that, among other things, publishes a scholarly, peer-reviewed journal (Journal) that serves as a primary educational resource for Organization's members. Preparing the editorial content of Journal is one of Organization's core tax-exempt activities.

"Publisher" is a for-profit multinational company that publishes various journals and books. Organization entered into an agreement with Publisher to publish Journal. The agreement specifies that Publisher is an independent contractor.

The agreement between Organization and Publisher gives Organization complete editorial control over Journal, including selecting editors and covering editorial expenses. Under the agreement, however, Publisher pays Organization an annual stipend for salaries and other editorial expenses. In addition, Publisher produces, sells and distributes Journal at its own expense to various subscribers, including Organization's members and various institutional subscribers.

Under the agreement, Publisher also has sole responsibility for selling advertising space in Journal, at rates that it determines. The agreement, however, prohibits Publisher from publishing advertisements that fail to meet Organization's reasonable advertising standards. In practice, Publisher has sent the advertisements to Journal's editor for approval — although there is no indication that the editor has ever declined to approve an advertisement.

Publisher pays Organization a percentage of "revenues" as an "earned royalty" for Journal's publishing and distribution rights. For this purpose, the agreement defines "revenues" as total revenues less certain specified expenses and excluding advertising revenues. The agreement further provides for a "minimum guaranteed royalty" — which exceeded the earned royalty, and Publisher paid to Organization, in the tax years at issue.

Law

The IRS cited several cases in its consideration of whether Organization received UBTI under the terms of its agreement with Publisher.

In Arkansas State Police Association, Inc. v. Commissioner, 282 F.3d 556 (8th Cir. 2002), the court concluded that a Section 501(c)(5) organization's income from publishing a magazine was not a royalty because the publisher was acting to benefit the organization, not paying for the use of the organization's name to promote its own separate product. Relevant facts included:

1. The publisher paid the organization a fixed amount each year to publish the magazine plus 25-26% of the advertising revenue.

2. The publisher solicited advertisements by saying it was calling "on behalf of" the organization.

In State Police Association of Massachusetts v. Commissioner, 125 F.3d 1 (1st Cir. 1997), the court concluded that a publisher was an agent of a Section 501(c)(5) organization for purposes of advertising activities. Relevant facts included:

1. Telemarketers jointly employed by the organization and the publisher solicited advertisements by saying they were calling "on behalf of" the organization.

2. Payments for ads were made to organization and deposited into organization's bank account, out of which organization paid telemarketers and the publisher.

3. The publication was distributed free of charge and there was no cost for a subscription.

In National Collegiate Athletic Association (NCAA) v. Commissioner, 92 T.C. 456 (1989), rev'd on other grounds, 914 F.2d 1417 (10th Cir. 1990), the court attributed a contractor's advertising activities to the exempt organization based on the agency relationship between the two entities. Relevant facts included:

1. The written contract explicitly provided that the contractor was the organization's "exclusive agent for the sale of advertising."

2. The contractor had the duty to account for all profits from its activities, and the organization was entitled to examine the contractor's financial records at any time.

3. The publication was distributed free of charge and there was no cost for a subscription.

Analysis

The IRS acknowledged that producing editorial content for publication in Journal is substantially related to the performance of Organization's exempt purpose, but added that selling advertising in Journal would still amount to an unrelated trade or business because such activity is not substantially related (other than through production of funds) to Organization's exempt purpose. Accordingly, the issue for the IRS's consideration was whether Organization regularly carried on the trade or business of publishing advertising.

While Organization does not directly engage in the selling of advertising under the agreement with Publisher, those activities could be attributed to Organization if Publisher acts as Organization's agent in this respect. To assess whether Publisher acts as Organization's agent with respect to publishing, the IRS compared their agreement to the arrangements in the aforementioned cases.

The IRS determined that Organization's agreement was not like the one in NCAA v. Commissioner, which specified that the publisher was the agent of the organization (and included additional facts to support such a designation). Rather, Organization and Publisher's agreement specifies that Publisher is an independent contractor, and the agreement provisions are consistent with that description.

Moreover, the IRS stated that the agreement between Organization and Publisher does not meet any of the factors set forth by the court in State Police Association of Massachusetts as indicating an agency relationship with respect to advertising in an exempt organization periodical. In this respect, the IRS noted several factors, including:

1. Organization did not retain tight control over the manner of soliciting advertisements.

2. The marketers of the advertisement were not employed jointly by Organization and Publisher.

3. The agreement between Organization and Publisher does not indicate that Publisher acted as Organization's agent, and there was no indication that checks for advertising are made payable to Organization or are collected by Organization.

The IRS further distinguished Organization's agreement from the facts in Arkansas State Police Association v. Commissioner, noting that the publisher in that case paid the organization a specific percentage of the advertising revenue (in addition to a fixed payment that was also sourced from advertising revenue). In the case at hand, Publisher's advertising revenue was excluded from the calculation of the royalty to be paid to Organization under the agreement.

Having determined that Organization did not engage in the sale of advertising, and that Publisher did not act as its agent in doing so, the IRS found there was no basis for allocating advertising income to Organization. Accordingly, the IRS concluded that Organization did not receive income from an unrelated trade or business in connection with its agreement with Publisher.

Implications

TAM 201837014 highlights the importance of establishing an arm's-length relationship between tax-exempt organizations and third-party publishers that solicit advertising and distribute publications associated with the tax-exempt organizations. Under Treas. Reg. Section 1.513-1(b), income derived from advertising is generally considered UBTI even though the advertising is published in an exempt organization periodical that contains editorial matter related to the exempt purposes of the organization. Conversely, if an organization does not engage directly in the activity of soliciting, selling and publishing commercial advertisements, and instead outsources this responsibility to a publisher, then the advertising may not be UBTI to the organization because it fails to meet the "regularly carried on" requirement.

Even well-drafted agreements can affect UBTI and an organization's tax-exempt status, however, if the IRS attributes control of the publisher's advertising solicitation and collection activities to the exempt organization. A determining characteristic for whether a publication agreement will result in an exempt organization carrying on an unrelated business activity is whether the organization has such control over the advertising activity of the publisher that the publisher is deemed to be an agent of the organization. In reviewing the arrangements, the IRS will look to the terms of the agreement and the activities of the parties to determine whether the publisher is acting as an organization's agent.

While control over advertising activity remains a significant factor, the revenue allocation and compensation structures were important factors in the present case. Specifically, because portions of the payments to the organization were fixed, and royalty calculations excluded advertising income, the risk of loss for advertising sales fell mainly on the publisher and therefore the publisher was not acting as the agent of the organization.

A TAM is guidance furnished by the IRS that interprets and applies tax laws to a specific Taxpayer's set of facts and circumstances, and may not be used or cited as precedent by other taxpayers or by IRS personnel. Thus, although the ruling is instructive on how the IRS might rule regarding a particular matter, organizations are cautioned not to rely on the ruling as authority and to consult with their tax advisors to determine the tax consequences of their own situations.

Please contact your Ernst & Young LLP professional for further information.

———————————————

———————————————