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IRS revokes favorable royalty ruling.

The IRS and exempt organizations have been engaged in a longrunning dispute over "royalty" income. The recent revocation of a favorable 1992 ruling suggests that tax-exempts should review all current royalty agreements, assess their exposure to the unrelated business income tax (UBIT) and, if possible, amend agreements to provide the strongest tax return position. Practitioners should also monitor a Tax Court case on this issue involving the Sierra Club.

Under Sec. 512(b)(2), exempt organizations may generally receive royalties without incurring a liability for UBIT. Exempt organizations have sought to apply the "royalty exception" to mailing list rentals, income from endorsed insurance programs, "affinity cards" and many other activities. In most "endorsement" arrangements, an exempt organization will license the use of its name and logo to a commercial entity for a royalty-generally a percentage of the licensee's gross revenues from the program; typically, the organization will also supply its mailing list to the licensee. The commercial licensee, in turn, solicits the organization's members for the insurance, credit card or other services.

The Service normally treats such arrangements as fully taxable for two reasons. First, the IRS views Sec. 513(h)(1)(B) as the sole UBIT exclusion for the rent or exchange of mailing lists; because the licensee is typically not a charitable organization, this exclusion does not apply. Second, because the organization's mailing list is an essential ingredient of most licensing arrangements, the Service contends that it is not possible to separate the income received for taxable mailing list rents from that received for a theoretically nontaxable name-and-logo royalty; see, e.g., GCM 39727.

However, in 1992 the IRS issued a favorable letter ruling that characterized an exempt organization's income from an insurance program as a tax-free royalty. In Letter Ruling 9220054, the organization had agreed to "endorse" insurance programs by permitting a commercial insurance broker to use the organization's name, letterhead and logo in promoting insurance products to the organization's members. The organization acknowledged that it had supplied the broker with its mailing list on one occasion, but agreed that it would not do so again. Interestingly, the organization did not retain approval rights over the broker's solicitation materials even though such a retained right, under Rev. Rul. 81-178, would not normally taint the tax-free nature of a royalty.

The original letter ruling also provided that the broker would develop all mailings, ads and promotional materials at its own expense. In addition, the organization did not determine the types, amounts or conditions of the insurance policies. Noting the organization's "limited involvement" in the program, and the fact that the mailing list (or updates to the previously supplied list) would not be provided again, the Service concluded that the organization's income would be a tax-free royalty under Sec. 512(b)(2).

As early as last summer, however, IRS National Office personnel were hinting that Letter Ruling 9220054 might be revoked. In Letter Ruling 9306030, this revocation became fact.

Letter Ruling 9306030 provided that the organization was "directly and extensively involved in the insurance program" by publishing advertisements for the program in its magazine, providing its membership list to the broker on at least one occasion, and permitting the broker to attend the organization's board and other membership meetings.

Based on these facts, the IRS concluded that the income from the broker was compensation for the organization's services, and not simply a royalty for the use of the name, logo and letterhead. The Service also concluded that use of the organization's mailing list was an "inseparable" element of the agreement. Thus, the "royalty" was not excludible under Sec. 512(b)(2) and was taxable as unrelated business income under Sec. 511.

Letter Ruling 9306030 does not disclose whether the organization was paid separately for advertisements in its magazine. However, the prior ruling was revoked prospectively, suggesting that the IRS had been aware of all of the facts when it issued the favorable ruling.
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Author:Kelin, Stephen J.
Publication:The Tax Adviser
Date:Jun 1, 1993
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