The IRS is watching: 'Agency' can cause tax headaches. (Taxing Issues).

How many agency relationships does your organization have? If you think the answer is "none," you may be surprised. Business life today is quite complicated, and many situations can result in agency relationships for tax purposes.

These relationships can bring both welcome and unwelcome tax consequences, depending on their purpose and how they are structured.

The Internal Revenue Service (IRS) prepares a continuing education text for its exempt organization agents each year. This text is made public and the edition for 2002 was recently released. One of the interesting articles discusses agency relationships. As agents will now have training, expect these issues to come up in dealings with the IRS. You need to have some knowledge in this area.

The tax code and regulations do not address the issue of agency relationships. Most of the legal principles come from common law. There have been court cases that have dealt with specific fact patterns, and the IRS has issued numerous Revenue Rulings and Private Letter Rulings on agency situations. It can come up in the context of unrelated business income tax (UBIT), charitable contributions and tax-exempt status, among others.

General rules

An agency relationship involves two parties that have a fiduciary relationship. A principal authorizes an agent to act on its behalf. The agent is under the principal's control, and can act only if the principal consents. The principal does not have to pay the agent for its services; the agent may be a volunteer.

"Agency" typically arises from a written agreement, but the actions of the parties can create the relationship more informally. Even if the agent acts beyond its formal authority, the principal can ratify the action. This is done by affirming the transaction or accepting its consequences. For tax purposes, the characterization of a relationship in an agreement will not be determinative. The IRS will look to the facts and circumstances in deciding whether there is an agency relationship.

An agent can be either an employee or an independent contractor. In tax situations, agents are typically unrelated individuals or organizations. The questions are often whether the "agent" is acting for the principal or for its own account. The Supreme Court, in the case of National Carbide v. Commissioner, 336 U.S. 422 (1949), established two requirements for there to be an agency relationship.

First, the relationship must not be driven by the principal's ownership of the agent. Thus, a wholly owned subsidiary will not become an agent of its parent due to the ownership. Second, the agent's business must be to act for the principal. This is manifested by four factors:

1. Does the agent operate in the principal's name and for its account;

2. Does the agent bind the principal by its actions;

3. Does the agent transmit money received to the principal; and

4. Does the agent receive income attributable to the services of the principal's employees or the use of the principal's assets?

UBIT

Agency is an issue in UBIT when one organization receives income that could belong to another. A nonprofit organization can attempt to avoid UBIT if it contracts with another organization to conduct an activity. the other organization agrees to pay part of the profits to the nonprofit as a royalty, or in some other form that is exempt from UBIT.

Examples of this type of transaction have arisen in cases involving advertising. In these cases, the nonprofit licenses the other organization to produce a publication and pay a royalty for the right to publish in the name of the nonprofit. The publisher sells the ads and receives the money for them.

The IRS has challenged the tax treatment of these transactions. The IRS argues that the publisher is acting as the nonprofit's agent in producing the publication and selling the advertising. Often the nonprofit provides all of the substantive material, or reserves the right to approve such material provided by others.

The IRS has won most of these cases so far, most recently Arkansas State Police Association v. Commissioner, TCM 2001-38. In that case, which is currently on appeal, the association and the publisher signed a "royalties and licensing agreement." The publisher solicited the advertising in the name of the association. The association approved the sales material and editorial content, as well as the advertising. The association received 27 percent of the profits, the publisher kept 73 percent.

The Tax Court held that the association substantially participated in the production of the publication and maintained control over it. It rejected the characterization of license and royalty and held that the publisher was the association's agent.

The IRS also made agency arguments in the affinity credit card and mailing list cases. They lost those arguments, as the courts found that the contractors involved were not subject to the control of the nonprofit. There fore, their activities in marketing the credit cards or mailing lists were not attributed to the nonprofits. Consequently the income was treated as royalties rather than compensation for services.

UBIT cases can also arise if your organization receives funds that it alleges are held as agent for someone else. The IRS will try to argue that you received the payments for services and there is no agency relationship involved. The income results in a UBIT liability.

A number of these situations involve insurance. In one line of cases, the insurance company paid refunds to the association, which had required members to assign them to the association as a condition to participating in the program. The association argued that it received the refund as agent for the members, who then were entitled to a charitable deduction for assigning the refund.

The IRS rejected the agency argument and the U.S. Supreme Court agreed. The justices found that the assignment of the refunds were additional payments for the insurance and resulted in UBIT to the association. (See United States v. American Bar Endowment, 477 U.S. 105 (1986)).

However, in other situations the organizations made refund opportunities clear to their members, some of whom allowed the organizations to keep the refunds. In those cases, the IRS accepted the agency argument and did not tax the organizations on the refunds kept. (See G.C.M. 38955 (1982) and PLR 8725056).

In two other situations, Rev. Rul. 74-321, 1974-2 C.B. 16 and Michigan Retailers Association v. U.S., 676 ESupp. 151 (1988), associations that operated group insurance programs for members were found to be agents or trustees for the members, had only ministerial powers over the funds, and, therefore, were not subject to UBIT.

Charitable contributions

As in the UBIT cases, the contribution cases involve others as agents for the nonprofits and nonprofits as agents for others. Generally, a contribution made to your organization's agent is considered as made to you. Thus, when utility companies collect contributions to assist needy individuals in paying utility bills, the funds are deductible to the utility customers and are not income to the utility companies, as long as they are transferred to the charity shortly after receipt. (See Rev. Rul. 85-184, 1985-2 C.B. 8).

The issue can also arise in the context of used car donations. While there haven't been any cases as yet, the IRS is looking closely at some of the relationships between the charities and the dealers who solicit, pick up and dispose of the cars. If the charities exercise supervision over the dealers, they can sustain the agency relationship. If the dealer is not the charity's agent, the donors may not be entitled to deductions for the cars.

If your organization is involved in a car donation program, you should carefully review all of the documents and relationships to make sure you are doing it properly.

The agency issue can arise if your organization receives funds on behalf of another organization. Donations to foreign charities are not deductible. If you receive funds as the agent of a foreign charity, and transfer the funds shortly after receipt, the donors cannot deduct the payments.

On the other hand, it you exercise sufficient discretion over the funds so that there is no agency relationship, the donor can deduct the payment, even though most of the funds ultimately end up overseas. (See Rev. Rul. 63-252, 1963-2 C.B. 101).

The issue here is whether the organization is acting as agent for other organizations or is actively conducting exempt activities on its own. The cases are fairly fact specific. For example, in Rev. Rul. 75-283, 1975-2 C.B. 201, the IRS granted exemption to an organization that was formed to be the agent for public housing tenant organizations to negotiate solutions to statewide problems.

The organization also conducted substantial educational programs for public housing tenants. However, in Rev. Rul. 67-377, 1967-2 C.B. 187, the IRS denied exemption to an organization whose only activity was arranging group tours as a travel agent for university students and faculty.

As you can see, agency issues can arise in a number of contexts. You should review any situations in which your organization is involved with others to make sure there are no problems waiting in the wings. The IRS will be looking for them in future examinations.

Harvey Berger is a partner and national director of not-for-profit tax services in Alexandria, Va., for the accounting and management consulting firm Grant Thornton LLP.