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Royalty income — the money nonprofits receive from commercial entities that have the right to use the nonprofit’s name in marketing a product or service — is specifically exempt from taxation. But the IRS questioned what constitutes royalty income and what doesn’t.

When a nonprofit expands its activities in connection with royalty agreements beyond awarding the right to use its name, the money received may end up being categorized as taxable unrelated business income instead of a royalty payment. As this line becomes increasingly blurred, the IRS has challenged some royalty agreements, claiming that the income is indeed subject

to taxes.

In general, a nonprofit is subject to unrelated business income tax (UBIT) if it receives income from a trade or business that is regularly undertaken and is not substantially related to its tax-exempt purpose. In determining whether royalty income might be considered unrelated business income, the IRS looks at how involved the exempt organization is in the activity generating the income. If the IRS concludes that the commercial entity is receiving substantial services from the exempt organization for the active promotion of the commercial entity’s products, the income may be deemed subject to UBIT. This issue has been contested between the IRS and nonprofits in such areas as the rental of mailing and membership lists, issuance of affinity credit cards and sponsorship of insurance products.

The key to avoiding UBIT on royalty income from licensing agreements is to make sure that you don’t actively provide any services on behalf of the commercial entity in connection with the licensing of your nonprofit’s name, trademark or member list. If your nonprofit is required to endorse and advertise the commercial entity’s products and services, the income you receive from the agreement may not pass as royalty income and thus may be subject to tax. If you must provide some services as part of your royalty agreement, make sure they are courtesy services.

If you cannot avoid providing more than de minimis services, sign a separate agreement for the services portion of the royalty arrangement. That portion will be subject to UBIT, but the act of separation will avoid tainting all the licensing fees as unrelated business income.

If you would like to discuss further strategies that your tax-exempt organization may be able to use, or if you’d like more information on royalty issues, please don’t hesitate to contact us.