Non Profit Report - June 2012
Is Your Publication's Ad Revenue Taxable?
By: Jonathan May
Publications that generate "circulation income," such as subscription payments, and net income from advertisements can be an important source of revenue for a tax-exempt organization. Revenues from circulation income generally are not subject to federal income tax, but net advertising income generally is taxable as unrelated business income.
However, when the costs of publishing exceed the amount of circulation income generated, exempt organizations can take advantage of a special exception to the rule, which excludes from taxation the amount of net advertising income equal to the amount of publishing costs that exceed circulation income.
A specific aspect of this rule was considered in a recent U.S. Tax Court decision, National Education Association of the United States v. Commissioner of Internal Revenue. NEA is exempt from tax under IRC Section 501(c)(5). In the case before the court, NEA had not reported net advertising income from its publication as taxable because publishing costs far exceeded circulation income. The IRS asserted that NEA had essentially underreported its circulation income because members did not pay a subscription fee, and no part of their membership dues were allocated as payment for the publications they received from NEA.
At issue in the case was how the wording of a Treasury regulation should be interpreted. The regulation provides, in short, that when members have the "right to receive" an exempt organization's publications and don't pay for the subscriptions, a portion of their membership dues must be allocated to circulation income for purposes of determining whether net advertising income is taxable.
The initial question the court wrestled with was the meaning of the phrase "right to receive." NEA argued that for the regulation to apply, the right must be legally enforceable, whereas the government took the position that something less than a legal right will suffice. The NEA won the battle on this point, but it would ultimately lose the war based on the facts of the case.
The court next embarked on a review of NEA operations and documents to determine whether its members had a legal right to receive its publications. The court noted that NEA's bylaws explicitly stated that members were eligible to receive its publications and pointed out that membership enrollment forms, handbooks, and the publications' mastheads described the publications as member benefits. The court believed that other factors demonstrated that NEA had a practical obligation to continue publishing its periodicals, including that the publication schedule was set a year in advance and that contracts with advertisers required NEA to maintain a certain level of circulation.
Considering all these factors, the court determined that NEA's members did have the right to receive its publications. This finding required NEA to allocate a portion of membership dues to circulation income -- and this meant that NEA was required to pay taxes on its net advertising income.
The case is not likely to be the final word on this issue, but it provides instructive guidance that exempt organizations should consider. An association that has a publication with paid advertising but neither charges its members for subscriptions nor allocates a portion of membership dues to circulation income should determine whether its members have the right to receive the publication. In addition to the items described above, several other factors should be considered, including:
- membership materials (applications and agreements, benefits policies, dues statements, and agreements with affiliates and chapters)
- corporate documents (charter, constitution, and bylaws)
- marketing materials
- availability of the publication to subscribers and nonsubscribers in print and online
If the analysis indicates an association's members do not have the right to receive the publication, then the association's related net advertising income may not be taxable. But if an association determines that its members do have this right, it may be required to report and pay tax on some or all of its net advertising income.
This article first appeared in the June issue of Associations Now, the publication of ASAE, and is reproduced by permission.
Establishing and Association Foundation
By: Jeff Glassie & Megan Spratt
Many nonprofit Section 501(c)(6) organizations set up separate foundations to carry on certain charitable or educational activities for the parent organization. We have helped many nonprofit organizations set up subsidiary foundations--this is very common and can enhance the activities and fundraising options for the parent organization. Provided below is background information on setting up a foundation.
By establishing an affiliated foundation, a trade or professional association can attract charitable contributions to support charitable and educational activities in the field. Foundations are typically established as nonprofit corporations and obtain tax exempt status under Section 501(c)(3) of the Code.
Benefits: There are several benefits associated with Section 501(c)(3) status such as:
- The organization's revenues will not be subject to income tax (unless they constitute unrelated business income).
- Contributions to Section 501(c)(6) organizations are not deductible as charitable donations, but contributions to 501(c)(3) organizations or the foundation will be tax deductible to the donors as charitable donations.
- Since many private foundations and other funding groups will only make grants to 501(c)(3) organizations, the foundation may have access to more sources of funds than the parent association.
- In certain situations, the foundation may be exempt from state and local sales tax and eligible for certain reduced postal rates.
Supporting Organizations: There are two basic types of Section 501(c)(3) organizations: “public charities” (which are publicly supported) and “private foundations” (which generally have a small number of donors, e.g., the Ford Foundation, or the Bill and Melinda Gates Foundation). The preferred status, and the status that most association-related foundations have, is to be a public charity, since private foundation status carries with it significant administrative and tax burdens, such as expenditure guidelines and excise taxes for insufficient expenditures. The fact that an affiliated 501(c)(3) organization is called a “foundation” does not mean it is a private foundation, but “foundation” is a common term used for most association foundations.
Different Types of Public Charities: There are several ways that a 501(c)(3) organization can obtain a determination from the IRS that it is a public charity. Organizations can meet the public support test under Code Section 509(a)(1) (at least one third government or other public support) or Section 509(a)(2) (at least one third government or public support, such as grants, gifts, admission fees, etc., and not more than one third investment income or unrelated business income subject to tax). Another route is under Section 509(a)(3), establishing the foundation as a “supporting organization.” Most association foundations are supporting organizations.
Of course, this being the Internal Revenue Code, there are wrinkles to this approach. There are three types of supporting organizations:
- Type I is where at least a majority of the foundation’s Board is appointed by the “parent” association.
- Type II is where there is at least a majority overlap of the parent and charitable organization boards.
- Type III involves more of a loose affiliation between the two entities.
Type III is not as preferred, because some funders do not want to give grants to Type III supporting organizations. Type I is the safest category, and also ensures that the foundation would be a publicly supported organization rather than a private foundation, whether or not it meets the public support tests. Further, we do not believe that contributions from the typical association or the association’s directors to the foundation would jeopardize the Type I supporting organization status of the foundation.
As a result, we generally recommend that supporting organizations take the form of Type I.
How to Set Up Your Foundation
Outlined below are the basic steps required to establish a subsidiary foundation.
- Articles of Incorporation. The first step is to prepare Articles of Incorporation to incorporate the foundation. The Articles will have to be drafted to meet applicable state law requirements for nonprofit corporations, as well as the IRS rules for Section 501(c)(3) organizations.
- Bylaws. The foundation also must develop Bylaws to govern its operations. As indicated above, the Bylaws of many affiliated foundations provide that the 501(c)(6) association will appoint all or a majority of the directors of the foundation, or that some or all of the directors of the association will also be the directors of the foundation. The Bylaws of the foundation may also provide that the parent association must approve any amendments to the foundation’s Bylaws. This type of relationship between the foundation and the parent association is permissible and assists in maintaining control of the foundation over the long term.
- Organizational Resolutions. Newly incorporated corporations are required by law to hold an organizational meeting, where initial corporate resolutions are approved. It is through these resolutions that the foundation typically adopts Bylaws, elects the first full Board of Directors and officers, and authorizes bank accounts to be set up, the tax exemption application to be filed, and the like.
- Form SS-4. An Employer ID Number (also called a Taxpayer ID Number) will be obtained from the IRS by filing Form SS-4. This serves as the foundation’s ID number for all communications with the IRS. The Form is fairly simple and filed after the foundation is incorporated. The EIN can nowadays be obtained in an on-line filing to the IRS.
- Cost Sharing Agreement. We also recommend a pro forma Cost Sharing Agreement between the parent association and the foundation to properly allocate expenses and avoid unrelated business income tax to the parent association for revenues that might otherwise be characterized as “management fees.” This agreement formalizes the arrangement for tax and management purposes, and also confirms the separateness of the corporations to help protect the association from liability for the foundation’s actions. (These might arise, for instance, from a contract dispute or a tort claim at the foundation level.) We often include provisions regarding licensing of intellectual property by the parent association to the foundation in this Agreement.
- Tax Exemption Applications. Once we have finalized these documents, a tax exemption application must be drafted and filed with the IRS via Form 1023. The application form requires information about the foundation, including a full description of the substantive proposed activities of the foundation and proposed budgets for the next two years. Copies of the Articles of Incorporation, Bylaws, Cost Sharing Agreement, and other relevant documents of the foundation, including a conflict of interest policy, will have to be included with the application filed with the IRS. Assuming the application is filed on a timely basis (within 27 months of the date of incorporation) and is approved, the foundation‘s tax exempt status will be retroactive to the date of incorporation and all contributions received by the foundation after that date will be tax deductible to the donors.
The IRS generally responds with a determination letter within about three or four months of filing (depending on the IRS’s caseload), and also may ask additional questions or request more information. Therefore, the entire process usually takes six to eight months.
Once the IRS has granted tax-exempt status under federal law, an exemption under state income tax law should then be obtained. In some states, such as Virginia, income tax exemption is automatically granted. In other jurisdictions, however, such as Maryland and the District of Columbia, one must apply for state income tax exemption.
In sum, it is very common for membership organizations to set up Section 501(c)(3) charitable foundations, and we have done this many times for our client associations.