Journal advertising is not the exempt society's unrelated business income

Plain-English summary

A 501(c)(6) professional society publishes a scholarly journal through a contract with a for-profit publisher. The society controls the editorial content, but under the contract the publisher alone sells and prints the advertising, keeps all the ad revenue, and pays tax on it. The IRS examination team argued the ad income should be taxed to the society as unrelated business taxable income (UBTI). This Technical Advice Memorandum, requested by the Appeals office, sided with the society. Selling advertising is an unrelated trade or business, but the society was not "regularly carrying it on": the publisher acted as an independent contractor, not the society's agent. Weighing the factors from cases like NCAA and State Police Association of Massachusetts, the memo found the society lacked tight control over ad solicitation, ad checks did not run through the society, the publisher bore all the gain and risk on ads (advertising revenue was excluded from the royalty formula), and no contract term made the publisher solicit ads "on behalf of" the society. Because the ad activity could not be attributed to the society, there was no UBTI, and the IRS did not need to reach whether its calculation method was reasonable. Exempt organizations that license a journal to a commercial publisher would care: structuring the deal as an arm's-length independent-contractor arrangement can keep ad revenue from becoming the nonprofit's taxable income.

Ruling snapshot

• Question: Did the exempt society receive UBTI from advertising in its journal, given that a for-profit publisher ran the advertising under contract?
• Outcome: advice (no UBTI; the publisher was an independent contractor, not the society's agent)
• Key authorities: IRC §§ 511, 512(a), 513(a), (c); Treas. Reg. § 1.513-1(a), (b); NCAA v. Commissioner, 92 T.C. 456; State Police Ass'n of Massachusetts v. Commissioner, 125 F.3d 1

Full text (IRS public release)

                         INTERNAL REVENUE SERVICE
               NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                            May 01, 2018

Number:     201837014
Release Date:    9/14/2018
                                                 Third Party Communication: None
                                                 Date of Communication: Not Applicable

Index (UIL) No.:     512.00-00, 512.05-00, 513.02-00
CASE-MIS No.:        TAM-133427-17

Director
Appeals

      Taxpayer's Name:                          [redacted]
      Taxpayer's Address:                       [redacted]
                                                [redacted]
      Taxpayer's Identification No              [redacted]
      Year(s) Involved:                         [redacted]
      Date of Conference:                       [No Conference]


LEGEND:

Organization   =   [redacted]
Publisher      =   [redacted]
Journal        =   [redacted]
Year 1         =   [redacted]
Year 2         =   [redacted]
Year 3         =   [redacted]
Year 7         =   [redacted]
$A             =   [redacted]
B%             =   [redacted]
$C             =   [redacted]
$D             =   [redacted]
$E             =   [redacted]
F%             =   [redacted]
G%             =   [redacted]
H%             =   [redacted]
$I             =   [redacted]
$J             =   [redacted]

K                =   [redacted]
$L               =   [redacted]
$M               =   [redacted]
$N               =   [redacted]
$O               =   [redacted]
P%               =   [redacted]
Q%               =   [redacted]


ISSUE(S):

Whether Organization received unrelated business taxable income from advertising
under the terms of the agreement with Publisher in connection with publishing Journal,
and if the income is taxable, whether the Service's method of calculating the unrelated
business income was correct and reasonable.

CONCLUSION(S):

Organization did not receive unrelated business taxable income from advertising under
the terms of the agreement with Publisher in connection with publishing Journal.

FACTS:

Organization is a section 501(c)(6)1 professional society formed for the purpose of
enhancing the field of [redacted]. Journal is the official, scholarly journal of
Organization published under a contract with Publisher, a for-profit entity. Journal is an
international, peer-reviewed publication that provides articles on clinical advances and
techniques, case reports, literature reviews, editorials, and other types of coverage of
recent progress in the field of [redacted]. Journal is published monthly, receives
over [redacted] manuscripts for publication consideration annually, and maintains rigorous
acceptance standards. Journal is one of the primary educational resources for
Organization members in the field of [redacted] at large. Preparation of editorial
content in Journal is one of Organization's core tax-exempt activities.

Publisher is a multinational company that publishes over [redacted] journals and more than --
[redacted] books. In Year 1, Organization entered into an agreement with Publisher to
publish Journal for a term covering Year 2 through Year 7. The agreement provides
that the relationship between Publisher and Organization is that of independent
contractors.

The agreement provides that Organization has complete responsibility for all of the
editorial content of Journal. This control is exercised through an editor selected by and

1
 All references to "section" refer to sections of the Internal Revenue Code (Code) of 1986, unless
otherwise specified.

serving as an agent of Organization. The editor will be assisted by an editorial board
composed of candidates nominated by the editor and officially appointed (or removed)
by Organization.

Organization covers all expenses of gathering and preparing editorial material for
publication in Journal; however, the agreement provides that Publisher will pay an
annual stipend for salaries and expenses of Journal's editorial office and expenses for
the annual editorial board meeting. The amount of the stipend for Year 2 is $A and is
increased by B% each subsequent year.

The agreement provides that Publisher will publish, produce, sell, distribute, and
internationally promote Journal at its own expense. Publisher is responsible for fulfilling
subscription orders for Journal. The three types of subscribers are: (a) individual
members of Organization, (b) individuals who are not members of Organization, and (c)
corporations, libraries, institutions, organizations, and all other institutional subscribers.

The agreement provides that Organization will order one subscription for each individual
member at the annual individual member rate of $C for the term of the agreement and
provide Publisher with the full names and addresses of individual member subscribers,
which will be used by Publisher to fulfill individual member subscription orders.

For Year 2, the individual non-member subscriber rate is $D and the institutional
subscriber rate is $E. Publisher sets the yearly rate, provided that an increase in the
individual non-member subscriber rate greater than F%, or the institutional subscriber
rate greater than G%, requires Organization's prior approval.

Pursuant to the agreement, Publisher is solely responsible for selling advertising space
in Journal at rates determined at Publisher's sole discretion. However, the agreement
provides that Publisher shall not publish any advertisement in Journal that fails to meet
Organization's reasonable advertising standards. The agreement further provides that
the editor has the right to ensure the appropriate application of Organization's
advertising standards. In practice, Publisher sent copies of advertisements for each
issue to the editor for approval as complying with Organization's advertising standards.
There is no indication that the editor ever failed to approve an advertisement.

The agreement provides that Publisher pays Organization H% of "revenues" as an
"earned royalty" for the publishing and distribution rights of the journal. The agreement
defines "revenues" as total revenues less deductions for commissions, discounts,
returns and taxes. The agreement specifically excludes advertising revenues from the
definition of "revenues" for purposes of calculating the "earned royalty."

In addition, the agreement provides that Publisher pays Organization a "minimum
guaranteed royalty" ranging from $I to $J for Year 2 through Year 7 provided that
Organization enters a minimum of K individual member subscriptions each year. The

agreement provides that the "minimum guaranteed royalty" is deducted from and
reduces the "earned royalty" in a given year, but not below the amount of the "minimum
guaranteed royalty." If Organization enters fewer than K individual members, then the
"minimum guaranteed royalty" is reduced proportionally.

For all of the tax years at issue, the "minimum guaranteed royalty" that Publisher paid to
Organization exceeded the "earned royalty" calculated under the agreement, but the
"minimum guaranteed royalty" never exceeded "revenue." For example, in Year 3
Organization's "earned royalty" was $L, calculated as H% of Journal's Year 3 "revenue"
($M). Journal's Year 3 advertising revenue was $N. Pursuant to the agreement,
Publisher paid Organization the "minimum guaranteed royalty" of $O. O was equal to
P% of "revenue" or Q% of total sales ("revenue" plus advertising revenue), but there is
no indication that $O was measured or determined by reference to "revenue" or total
sales.

Publisher provided an affidavit stating that all advertising activity associated with Journal
was conducted solely by Publisher without assistance from Organization. Additionally,
the affidavit provided that none of the payments to Organization included any portion of
the advertising revenue from Journal. Furthermore, the affidavit provided that Publisher
reported all advertising revenue from Journal on its tax return and paid appropriate
taxes on net advertising income.


LAW AND ANALYSIS:

Section 511 imposes a tax upon the unrelated business income of certain exempt
organizations.

Section 512(a) defines the term "unrelated business taxable income" as the gross
income derived by an organization from any "unrelated trade or business" (as defined in
section 513), regularly carried on by it, less the allowable deductions which are directly
connected with the carrying on of such trade or business, both computed with the
modifications provided in section 512(b).

Section 513(a) defines the term "unrelated trade or business" as any trade or business
the conduct of which is not substantially related (aside from the need of such
organization for income or funds or the use it makes of the profits derived) to the
exercise or performance of its tax-exempt purpose.

Section 513(c) provides that an activity does not lose its identity as a trade or business
merely because it is carried on within a larger aggregate of similar activities or within a
larger complex of endeavors which may, or may not, be related to the exempt purpose
of the organization.

Section 1.513-1(a) provides, in part, that the gross income of an exempt organization
subject to the tax imposed by section 511 is includible in the computation of unrelated
business taxable income if: (1) it is income from trade or business; (2) such trade or
business is regularly carried on by the organization; and (3) the conduct of such trade or
business is not substantially related (other than through the production of funds) to the
organization's performance of its exempt functions.

Section 1.513-1(b) of the regulations provides that activities of soliciting, selling, and
publishing commercial advertising do not lose identity as a trade or business even
though the advertising is published in an exempt organization periodical which contains
editorial matter related to the exempt purposes of the organization.

In Arkansas State Police Association, Inc. v. Commissioner, 282 F.3d 556 (8th Cir.
2002), a section 501(c)(5) organization received payments under an agreement with a
commercial publisher to publish a magazine three times per year. The publisher paid
the organization $25,200 each year to publish the magazine plus 25-26% of the
advertising revenue. The publisher bore all the costs of producing and distributing the
magazine and solicited advertisements by saying they were calling "on behalf of" the
organization. The magazine has no subscription cost and publisher distributed copies
free of charge to organization's members, to advertisers who paid at least $100 for
advertisements, and to Arkansas state legislators. The court concluded that the
organization's income from publishing the magazine was not a royalty 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.

In State Police Association of Massachusetts v. Commissioner, 125 F.3d 1 (1st Cir.
1997), a section 501(c)(5) organization received payments under an agreement with a
commercial publisher to publish an annual yearbook sometimes called the "ad book."
Telemarketers jointly employed by the organization and the publisher solicited
advertisements by saying they were calling "on behalf of" the organization using a
canned solicitation format approved by the organization. Payments for ads were made
to organization and deposited into organization's bank account, out of which
organization paid telemarketers and the publisher. The yearbook has no subscription
cost and the organization distributed copies free of charge at various state troopers'
barracks, the organization's annual picnic, and other occasions. 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.

In National Collegiate Athletic Association (NCAA) v. Commissioner, 92 T.C. 456
(1989), rev'd on other grounds, 914 F.2d 1417 (10th Cir. 1990), the court attributed a
contractor's advertising activities to the exempt organization based on the agency
relationship between the two entities. The written contract explicitly provided that the

contractor was the organization's "exclusive agent for the sale of advertising," and
required the contractor to conduct advertising sales in an "efficient and workmanlike
manner." Additionally, the contract placed limits on the types of advertisers and
provided the organization with the unqualified right of final approval for all advertising.
The contractor had the duty to account for all profits from its activities and the
organization was entitled to examine the contractor's financial records at any time.

Organization is subject to the tax imposed by section 511 on its unrelated business
taxable income (as defined in section 512). Producing editorial content for publication in
Journal is substantially related to the performance of Organization's exempt purpose.
However, activities of soliciting, selling, and publishing commercial advertising do not
lose identity as an unrelated trade or business because the advertisements are
published in Journal. See Treas. Reg. § 1.513-1(b).

As such, the publication of commercial advertising is a trade or business that is not
substantially related (other than through the production of funds) to the performance of
Organization's exempt purpose. See Treas. Reg. § 1.513-1(a). In this case, the issue
is whether the trade or business of publishing commercial advertising is regularly
carried on by Organization. See id.

As provided in the agreement, Organization is not engaged directly in the activities of
soliciting, selling, and publishing commercial advertising. However, Publisher's
regularly carried on activities of soliciting, selling, and publishing commercial
advertisements would be attributed to Organization if Publisher acted as Organization's
agent with respect to those activities. See State Police Ass'n of Massachusetts v.
Commissioner, 125 F.3d 1, 7 (1st Cir. 1997); NCAA v. Commissioner, 92 T.C. 456, 466
(1989), rev'd on other grounds, 914 F.2d 1417 (10th Cir. 1990).

In NCAA v. Commissioner, the contract specifically provided that the publisher was the
NCAA's "exclusive agent for the sale of advertising." While the contract's designation
of that relationship was not controlling, the Tax Court found that the contract's
provisions manifested the intent for the publisher to engage in advertising activities for
NCAA's benefit and under its control consistent with the description of the publisher as
an agent. See NCAA, 914 F.2d at 467.

By contrast, the agreement in this case provided that Publisher is an independent
contractor and the provisions of the agreement are consistent with the description of the
publisher as an independent contractor. The substance of the contractual relationship
between Organization and Publisher does not meet any of the factors listed by the court
in State Police Association of Massachusetts as indicating an agency relationship with
respect to advertising in an exempt organization periodical. See 125 F.3d at 7.

First, the agreement suggests that Organization did not retain tight control over the
method and manner of the solicitation of advertisements. The agreement provides that

Publisher is solely responsible for the advertising content of Journal, subject only to the
restriction that advertisements will not violate Organization's advertising standards.
Consistent with the agreement, the editor reviews advertisements for compliance with
Organization's advertising standards.

Unlike the unqualified final right of approval described in NCAA, Organization had only
the right of quality control for purposes of maintaining the Journal's quality as an official
exempt organization journal. See id.

Second, Organization is not like the organization in State Police Association of
Massachusetts, where telemarketers were employed jointly by the organization and
publisher and the solicitation format was subject to the organization's approval. See
125 F.3d at 7.

Third, the financial arrangement between Organization and Publisher does not indicate
that Publisher acted as Organization's agent. Consistent with the affidavit, there is no
indication that checks for advertising are made payable to Organization or are collected
by Organization, unlike the organization in State Police Association of Massachusetts.
See id. at 7.

In NCAA, the Tax Court concluded that the compensation structure, which shifted risk of
loss to the publisher, did not negate the agency relationship established under the
contract. By contrast, the compensation structure here reinforces the other aspects of
the agreement indicating that Publisher was not Organization's agent for advertising
activities. Because advertising revenues are specifically excluded from the calculation
of the "earned royalty" and the "minimum guaranteed royalty" is fixed, the payment to
the organization does not vary based on advertising revenue. As such, the
compensation structure in this agreement distributes all potential for gain and risk of
loss from advertising sales to Publisher.

Unlike the contract in NCAA, the agreement does not provide that Publisher is required
to account for advertising profits and does not provide Organization the right to examine
Publisher's financial records at any time. See NCAA, 914 F.2d at 46. Under the
agreement, Publisher is only required to provide a "reasonably detailed annual financial
statement" showing Journal revenue and expenses. Revenue is defined under the
agreement as excluding advertising revenues; thus, Publisher is not required to account
for advertising profits. Although Publisher's report to Organization included the status of
advertising sales, Organization did not have the contractual right to obtain that
information.

Fourth, unlike the contracts in NCAA and State Police Association of Massachusetts,
the agreement does not establish that Publisher solicits, sells, and publishes
commercial advertisements on behalf of Organization as its agent. See State Police
Ass'n of Massachusetts, 125 F.3d at 7; NCAA, 914 F.2d at 46. No provision of the

agreement requires Publisher to seek out advertising to publish in Journal or grants
Organization the right to control the manner in which Publisher seeks out advertising.
Although Publisher is permitted to mention its collaboration with Organization in
connection with promoting and distributing Journal, there is no indication that Publisher
purports to act "on behalf of" Organization in soliciting advertising.

Arkansas State Police Association v. Commissioner does not alter this conclusion. Like
the arrangement in State Police Association of Massachusetts, the publisher in
Arkansas State Police Association solicited advertising by calling "on behalf of" the
organization and advertisers made checks payable to the organization, not the
publisher. See 282 F.3d 556, 557 (8th Cir. 2002). Unlike the agreement in this case,
the publisher in Arkansas State Police Association paid the organization a specific
percentage of advertising revenue in addition to a fixed payment that was also based on
advertising revenue because the magazine's only source of revenue was advertising.
See id. at 557. Furthermore, the issue in Arkansas State Police Association was
whether the payments were royalties. Thus, the analysis is not applicable here because
the issue of whether Publisher acted as Organization's agent with respect to advertising
activities is separate from the question of whether the payment was nonetheless
excluded from unrelated business income tax as a royalty under section 512(b)(2).

Activities that are carried on within a larger aggregate of similar activities or within a
larger complex of endeavors are considered separately to determine whether the
activity is an unrelated trade or business. See Treas. Reg. § 1.513-1(b). Thus, within
the larger complex of publishing an exempt organization periodical, advertising activities
are considered separately from the activities of producing editorial material. As such,
Organization's significant control over editorial activities related to Journal, including
Organization's control over the editor, are not relevant to determining whether Publisher
acted as Organization's agent with respect to advertising activities.

Absent extenuating circumstances, the agreement of contracting parties as to the
services to be performed and the compensation to be received for each service cannot
be ignored. There is no indication that, in conflict with the agreement, Organization
engaged in any advertising activities or any portion of the payment from Publisher is
attributable to advertising. As such, there is no basis for reallocating advertising income
to Organization. Therefore, Organization did not receive unrelated business taxable
income from advertising because commercial advertising was not regularly carried on
by Organization within the meaning of section 512(a).

Accordingly, because we conclude that Organization did not receive unrelated business
taxable income from advertising under the terms of the agreement with Publisher in
connection with publishing Journal, it is unnecessary to address whether the Service's
method of calculating the unrelated business income was correct and reasonable.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.