It’s been more than four years since the Internal Revenue Service finalized–and nonprofits had to start complying with–tax regulations regarding sponsorship income. So what have been the developments in the interim? What do we know now that we didn’t know then?

Not much, say tax advisors, attorneys and nonprofit executives that deal with the issues regularly. And that’s not necessarily a bad thing, some of those experts point out.

“The IRS has not yet had aggressive enforcement in this area,” said attorney Ben Tesdahl, of counsel to law firm Powers, Pyles, Sutter & Verville and a specialist in tax-exempt-organization law.

In the nonprofit arena, the IRS has concentrated its recent audit activity on charities’ executive compensation, political activities and international grant-making, along with hospital charity care, credit counseling organizations and private foundations.

The IRS also has not issued any further guidance or clarifications on the elements of the sponsorship regulations that are universally agreed to be limited and/or vague.

But just because the IRS has, for now, found bigger fish to fry and not made any official pronouncements regarding sponsorship, does not mean nonprofits should not stay on top of what they have to do to keep their sponsorship revenue tax free.

This is especially true given that IEG SR estimates corporate spending on sponsorship of causes is expected to rise 20.5 percent to $1.34 billion in ’06.

Sponsorship And UBIT: An Overview Of The IRS Regulations
At the heart of the matter, the IRS’s interest in sponsorship income is to determine whether or not payments for specific sponsorship benefits constitute revenue to the nonprofit that is allowed within its tax exempt status, or whether such revenue should be defined as unrelated business income, which is taxable.

The key to making that determination lies in defining the benefits provided to the sponsor as either insubstantial or substantial.

Insubstantial benefits qualify as allowable ways to recognize and express appreciation to the sponsor. Substantial benefits could be viewed as the provision of advertising or related services to the sponsor, which the IRS says meets the definition of unrelated business as “a regularly carried on trade or business not substantially related to furthering the exempt purpose of the organization.”

The IRS released its first proposed sponsorship guidelines in 1993. Following nearly a decade of public and Congressional debate over what constituted “qualified sponsorship payments”–revenue not subject to unrelated business income tax (UBIT) because it does not carry the expectation of “substantial return benefit”–the IRS in April 2002 issued its final regulations.

The key development during that nine-year period was the passage by Congress of the Taxpayer Relief Act of 1997, which addressed the sponsorship issue by adding section 513(i) to the Internal Revenue Code. The new section effectively defined payments for most traditional sponsorship benefits as not subject to tax.

The final regulations addressed the differences between the 1993 proposed regulations and section 513(i). The final regs, for the most part, maintained the ’97 legislation’s safe harbor for the most common types of sponsorship benefits and actually added an additional benefit to the insubstantial column: links from nonprofits’ Web sites to sponsors’ sites (see table).

The ’02 regulations also address the division between qualified payments and payments for substantial benefits within a sponsorship. When a sponsorship provides both insubstantial and substantial benefits, the IRS requires the nonprofit to determine the portion of the fee that is a qualified payment, as well as the fair market value of the substantial benefits.

The regulations state that the IRS will accept “reasonable and good faith” valuations, but they also make it clear that if the property does not establish a value for substantial benefits, “no portion of the payment constitutes a qualified sponsorship payment.”

It is important to note that even for those benefits that are defined as providing substantial return to sponsors, the regulations do not say that payments for those benefits are automatically taxable.

The determination that a payment is non-qualified only means that it cannot be excluded from UBIT. Whether it should be included as unrelated business income is evaluated separately under the tax code’s UBIT rules.

For example, granting a sponsor the right to use a nonprofit’s trademarks is defined under the sponsorship regulations as a substantial benefit. However, under the UBIT regulations, most payments for that benefit will not be taxable because they will qualify as an allowable royalty payment.

The Devil In The Details
On the one hand, it is relatively simple for nonprofits that want to avoid even the possibility of triggering UBIT to stay out of harm’s way by only offering sponsors the benefits the IRS defines as insubstantial.

However, many nonprofit properties want to offer some substantial benefits, and the IRS regulations can be daunting, confusing and burdensome when it comes time to calculate how much, if any, of a sponsorship payment is then at risk for UBIT.

In particular, the rules regarding the provision to sponsors of tangible benefits such as complimentary tickets, receptions, pro-am spots and private viewings, as well as those dealing with category exclusive sales rights have caused the most consternation among nonprofits.

Tickets, pro-am spots, receptions, etc. IRS regulations treat such deliverables as insubstantial only if the total “fair market value” of those benefits is less than two percent of the total fee paid by the sponsor during an organization’s taxable year.

If a property provides other types of substantial benefits, such as advertising or the right to use its marks, the IRS will look at whether the combined value of those benefits exceeds two percent, essentially lowering the ceiling on the acceptable amount of tickets or other inventory.

If the value exceeds two percent, the total value of the substantial benefits is potentially subject to UBIT, not merely the difference between the total amount and the two-percent level.

Category-exclusive sales rights. What the IRS terms an “exclusive provider arrangement” is defined as a substantial benefit to the sponsor and thus the portion of the sponsorship payment attributable to those rights may be taxable under UBIT. The regulations do offer an exception “when the nature of the goods and services to be provided necessitates the use of only one provider because of limited space or because the competitive bidding process requires only the lowest bid be accepted.”

The real challenge for properties is that the regulations put the burden of establishing the dollar value of sales rights and other substantial benefits on the nonprofit.

In the case of tangible benefits with face values, such valuations are not difficult. The IRS even allows the use of equivalents–for example the average cost of a restaurant dinner may be used to estimate the value of an evening reception.

But valuing benefits such as the value of a property’s trademarks or of its exclusive sales rights is another matter. The regulations themselves note that “the Treasury Department and the IRS appreciate the difficulty” in determining those values, but stop short of offering advice on how it should be done.

Marcus Owens, who served as director of the IRS Exempt Organizations Division from 1990 to 2000 and is now an attorney with law firm Caplin & Drysdale, noted that the IRS hasn’t expanded its guidance in the area of valuation since the regs were finalized and doesn’t expect it to do so.

“My sense is that the IRS is assuming that most tax-exempt organizations will be unable to establish the value of the exclusive marketing right, thus triggering the default rule that the entire amount of the payment they receive for providing the exclusive right is taxable as unrelated business income,” he said.

Owens’ advice for determining the market value of benefits such as sales rights is to “base the calculation on as much objective data as possible.” For example, he said, in the case of soft drink sales, the property should attempt to get historic sales figures or other estimates from the sponsor.

Tesdahl again sees the lack of action by the IRS to be as much a blessing as a curse. “To some degree (the lack of guidance on valuation) is good because it allows for considerable bargaining room in the event of an IRS audit,” he noted.

Editor’s note: This article does not constitute legal advice and should not be regarded as a substitute for legal advice.