Income derived by an exempt organization from the sale of advertising by a 3rd party may be unrelated business taxable income (UBTI), depending on the facts and circumstances. IRC Section and Treas. Regulation IRC Section 512(a)(1) General rule IRC Section 512(b)(2) Modifications IRC Section 513(a) General rule IRC Section 513(c) Advertising Treas. Reg. 1.513-1(d)(4)(iv) Exploitation of exempt functions Treas. Reg. 1.512(b)-1 Modifications Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources) Rev. Rul. 69-430, 1969-2 C.B. 129, held that an exempt organization's activities in connection with the publication, distribution, and sale of a book, in a manner that did not contribute to its exempt purposes, was the conduct of a trade or business regularly carried on and that the income derived was unrelated business taxable income under IRC Section 512. However, had the organization transferred the publication rights to a commercial publisher in return for royalties, the royalty income derived would have been excluded from the computation of unrelated business taxable income under IRC Section 512(b)(2). Rev. Rul. 73-424, 1973-2 C.B. 190, held that income derived by an exempt organization from the sale of advertising in its annual yearbook is unrelated business taxable income where an independent commercial firm under a contract covering a full calendar year conducts an intensive advertising solicitation campaign in the organization' s name and is paid a percentage of the gross advertising receipts for selling the advertising, collecting from advertisers, and printing the yearbook. Rev. Rul. 81-178, 1981-2 C.B. 135, describes a royalty as a payment related to the use of a valuable right. The Service found that payments an exempt labor organization received under a license agreement that were for the use of trademarks, trade names, service marks, or copyrights were royalties. On the other hand, payments for personal services that required members to endorse products or services in personal appearances and interviews were not royalties. In Fraternal Order of Police, Illinois State Troopers Lodge No. 41 v. Commissioner, 833 F.2d 717 (7th Cir. 1987), the court upheld a Tax Court determination that income received by an exempt organization from sale of advertising in the organization's magazine was subject to tax as unrelated trade or business income, even though the right to solicit such advertising was sold to a third party in return for a percentage of the gross advertising revenues. The court also upheld the Tax Court's determination that the organization's role in the publication of the magazine was not passive and, therefore, the receipts from advertising were not excludable as royalties under IRC Section 512(b)(2). The court noted that the record established that the Fraternal Order of Police (FOP) had the final authority over the editorial content, could appoint the magazine's executive editor, could prepare the editorials and feature articles, could oversee and control the solicitor's activities in the business listings program, and could control the program's bank account and the reprint of any material published. In Arkansas State Police Association, Inc. v. Commissioner, 282 F.3d 556 (8th Cir. 2002), the court held that payments received by an exempt organization under an agreement with a commercial publisher to publish a magazine three times a year were not royalty payments excludable under IRC Section 512(b)(2) because the agreement created an agency relationship because the publisher was acting to benefit the organization, not paying for the use of the organization's name to promote its own separate product. The essence of the agreement was to impose a duty to perform publishing services on Arkansas State Police Association's (ASPA) behalf and under ASPA's control and not as payment for the use of a name or promotion of a separate product. The payments at issue were not passive royalty income even if ASPA spent very little time working on the magazine. In State Police Association of Massachusetts v. Commissioner, 125 F.3d 1 (1st Cir. 1997), an exempt organization received payments under an agreement with a commercial publisher to publish an annual yearbook which were determined to be unrelated business taxable income. Based on the organization's control over the manner and means of performing the work, the financial aspects of the arrangement, the use of the organization's name, the advertising formats, and the contents of the yearbook, the court concluded that publisher was an agent of the organization for purposes of the advertising activities. Therefore, the publisher's activities were attributable to organization in determining whether it engaged in business of advertising and whether its earnings were taxable as unrelated business income. Analysis When an exempt organization produces editorial content for its own publication, that activity may be substantially related to the performance of the organization's exempt purpose if the editorial content is related to the organization's exempt purpose. If this is the case, some or all of the income from the sale of the publication is not unrelated business taxable income (UBTI). The publication of commercial advertising, however, is generally a trade or business that is not substantially related (other than through the production of funds) to the performance of an organization's exempt purpose and therefore income from this activity is UBTI. Activities such as soliciting, selling, and publishing commercial advertising do not lose identity as unrelated trades or businesses just because the advertisements appear in a publication that contains editorial material related to the organization's exempt purpose. See IRC Section 512 and IRC Section 513 and Treas. Reg. 1.513-1(d)(4)(iv). Also See: State Police Association of Massachusetts v. Commissioner, 125 F.3d 1 (1st Cir. 1997); Rev. Rul. 69-430 and Rev. Rul. 73-424. Sometimes, exempt organizations characterize advertising income from a publication that was prepared jointly with independent publishers as royalty income, which is excludable from UBTI. See IRC Section 512(b). Whether payments are correctly treated as royalties is to be determined from all the facts and circumstances. Treas. Reg. 1.512(b)–1. Ordinarily, royalties reflect payment for the use of valuable intangible property rights and not payment for personal services. See e.g. Rev. Rul. 81-178. The facts developed during an examination with this issue may show that the organization plays an active role in the publishing process, such as writing articles, soliciting, selling and or performing administrative tasks including accepting advertising payments. In these cases, income from the sale of advertising is not properly treated as royalty income because the payments are received in exchange for personal services and not for the use of an intangible property right. See Fraternal Order of Police, Illinois State Troopers Lodge No. 41 v. Commissioner, 833 F.2d 717 (7th Cir. 1987). Another factual scenario in which treatment of advertising income as royalty payments is inappropriate is when the facts and circumstances demonstrate that the publisher acted as the organization's agent with respect to advertising activities. If the facts and circumstances, such as the terms of a written agreement, show that ultimate control over the activity is maintained by the organization, the third-party publisher may be the agent of the organization, in which case the publisher's activity is attributed to the organization. In such cases the advertising income would not be properly be considered a royalty excludable from UBIT under IRC Section 512(b). See: Arkansas State Police Association, Inc. v. Commissioner, 282 F.3d 556 (8th Cir. 2002). State Police Association of Massachusetts v. Commissioner, 125 F.3d 1 (1st Cir. 1997). Issue Indicators or Audit Tips Analyze expenditures for advertising, publications, etc. Analyze payments for royalties, commissions, advertising, publications, etc. Review contracts/ licensing agreements with 3rd party publishers. Review the organization's website. Review correspondence between the organization and 3rd party publishers. Interview personnel tasked with advertising and publications.