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Advertising income rumbles.

Advertising Income Rumbles

An unexpected decision in the recent case for the National Collegiate Athletic Association (NCAA), Overland Park, Kansas, may herald a significant shift in taxable advertising law. The case is the first time an appellate court has addressed the definition of regulatory carried on.

Under the law, the advertising income of trade association and other exempt organization publications is taxable as unrelated business income if it is derived from a trade or business that is regularly carried on and is not substantially related to the organization's exempt purpose or function.

Soliciting, selling, and publishing commercial advertising do not lose identity as trades or businesses even if an exempt organization publishes the advertising in a periodical with editorial matter related to its exempt purposes. The Internal Revenue Service (IRS) considers such advertising "fragmented" from the trade or business of publishing.

Under Internal Revenue Code (IRC) 513(c), an exempt organization's publications are divided under the fragmentation principle into two components: (1) the tax-exempt publication of the periodical's editorial or "readership content," and (2) the taxable enterprise of selling and publishing advertising. Detailed rules for determining taxable advertising income are in section 1.512(a)-1(f) of the regulations.

An important aspect of the computation is the allocation of expenses between the organization's other activities and the publication. In addition, publication expenses are divided between advertising and readership costs.

The amount of taxable advertising income is determined by subtracting direct advertising costs from gross advertising income. If this results in a loss, no further adjustments are made. The loss enters into the computation of unrelated business taxable income, and may be used to offset other unrelated business income.

In most cases, however, subtracting advertising costs from advertising income will result in a gain. Then the organization is allowed to deduct against such gain the excess of readership costs over subscription income. There is no tax on advertising income unless the overall publication is profitable. If the excess readership costs are not fully absorbed by net advertising income and result in a net loss from the publication, this loss cannot be offset against any other unrelated business income, nor can it be used in computing a net operating loss carryback or carryover.

Subscription income consists of direct sales - usually to nonmembers - and sales as a portion of membership dues. IRS regulations explain that "allocable membership receipts" should generally represent the amount a taxable organization would have charged for the periodical in an arm's-length transaction with the member. The regulations discuss the factors to be considered in determining allocable membership receipts and provide methods for determining the share of membership receipts that constitute a member's payment for the right to receive the periodical.

There have been several federal court decisions involving advertising issues with respect to exempt organization publications. In the 1986 American College of Physicians case, the Supreme Court unanimously held that income from drug advertisements in a medical journal published by an exempt organization constituted unrelated business income because the advertisements were not substantially related to the organization's exempt purposes. However, the court stated that the legislative history of IRC 513(c) was not sufficiently clear to conclude Congress intended that income from any advertisement published by an exempt journal must be per se unrelated.

On September 20, 1990, the U.S. Court of Appeals for the Tenth Circuit held that the National Collegiate Athletic Association is not subject to tax on income received from advertisements in programs for its annual basketball championship tournament. The court reasoned that the advertising activity is not a business "regularly carried on." The programs were distributed for less than three weeks at an event that occurs only once a year. The court stated that the amount of preliminary time spent to solicit ads and prepare them for publication is not to be considered in determining whether NCAA regularly carried on its program advertising business. The court concluded that the duration of the advertising activity itself was not sufficiently long lasting. It also held that the advertising is an intermittent activity of infrequent conduct.

IRS has long taken the position that preparatory time should be included in the time frame for measuring regularity. Nevertheless, a trade association that has an annual publications with paid advertising can now allege that there is no unrelated income to report. Although such a position is defensible in light of the NCAA decision, IRS is certainly looking for another case to seek a contrary appellate court decision.

During the past few years the House Ways and Means Oversight Subcommittee has considered income-producing activities of tax-exempt organizations. Formal recommendations have not been submitted to the full committee, but advertising income is often raised at public hearings and in draft proposals. One suggestion is to adopt a rule that advertising income is per se unrelated and deductions for advertising be restricted to direct costs only.

George D. Webster is general counsel to ASAE and a partner in Webster, Chamberlain & Bean, a Washington, D.C., law firm.
COPYRIGHT 1991 American Society of Association Executives
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Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Webster, George D.
Publication:Association Management
Article Type:column
Date:Mar 1, 1991
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