Qualified sponsorship payments (QSP) often play a key role in funding not-for-profits and bring mutual benefits to both the not-for-profit organization and the sponsoring company. The not-for-profit receives tax-exempt funding that eases budgetary pressures, and the sponsoring company can demonstrate its commitment to a charitable cause. Not-for-profits should be careful with sponsorship arrangements, however, because if certain precautions are not taken, there can be tax implications.
A QSP arrangement occurs when a trade or business makes a payment to a not-for-profit without the expectation of a substantial benefit, save for formal acknowledgement of the sponsorship. An organization can use its sponsor’s business name, logo, or product lines in connection with any of the organization's activities (even if those activities do not relate to the organization’s exempt purposes). So long as the arrangement meets these terms, the QSP is tax-exempt. When organizations go beyond the standard use or acknowledgement guidelines, they risk getting into substantial benefits territory. Substantial benefits receive different tax treatment than QSPs and may trigger unrelated business taxable income (UBTI).
A substantial return benefit is any benefit provided to the sponsor with a value that exceeds 2 percent of the sponsorship payment. Advertising, certain privileges and uses of intangible property that exceed this 2 percent threshold qualify as substantial return benefits. So long as organizations know where their 2 percent threshold lies, they can provide benefits to their sponsors without risking their sponsorship payments’ tax-exemption.
Let us examine how the 2 percent threshold plays out in a hypothetical arrangement between a deli and a not-for-profit organization. The two entities enter into a contract where the deli agrees to pay the not-for-profit $10,000 in exchange for advertising. At the time the not-for-profit enters the sponsorship contract, the fair market value of the advertising to be provided each year is $175, which is less than 2 percent of the $10,000 sponsorship payment (2 percent of $10,000 is $200). Even though advertising is technically a substantial return benefit, the $175 falls beneath the 2 percent threshold. The entire payment still qualifies as a QSP and therefore, the $10,000 is tax-exempt.
Sponsorship payments face different tax treatment if the fair market value of the sponsor’s substantial return benefit exceeds the 2 percent threshold. Let’s say that at the time the deli and the not-for-profit enter the sponsorship contract, the fair market value of the advertising to be provided in a given year is $225. Part of the $10,000 payment would then be subject to UBTI.
The not-for-profit may still classify part of the $10,000 as a QSP if it separates out the fair market value of the substantial benefit given. In this case, the not-for-profit could classify $9,775 of the original payment as a QSP. The remaining $225, the fair market value of the advertising, would be subject to tax.
It is critical that not-for-profits determine the fair market value of their substantial return benefits in order to maximize the benefits of the 2 percent threshold. If the organization does not make reasonable and good faith valuations of its substantial return benefits, then no part of the payment constitutes a QSP.
The right sponsorship strategy minimizes the amount of sponsorship payments that may be subject to tax. Below are three ways to help protect your not-for-profit organization’s sponsorship payments against UBTI treatment.
Avoid Advertisements and Endorsements
Acknowledgements are typically part of a sponsorship agreement, but the acknowledgement needs to be value-neutral to mitigate the risk of substantial return benefits. Not-for-profits should thank sponsors for their support without using comparative adjectives or language that promotes the sponsors’ goods or service offerings. An acknowledgment with any amount of comparative or advertising-type language is considered advertising, which can trigger UBTI.
As part of the acknowledgement, not-for-profits may use sponsors’ value-neutral logos and branding. If a sponsor contributes a substantial amount of money for an event or is the sole sponsor of an event, not-for-profit organizations can include the sponsor’s name as part of the title of the event (commonly seen in college football bowl games). Other items not-for-profits can use as part of the acknowledgment of a sponsor’s support include the sponsor’s physical address, web address and telephone number. Samples of a sponsor’s product may also be distributed at a sponsored event without an issue.
In all forms of sponsor acknowledgement, even verbal thank-yous, not-for-profits should be careful not to use any calls to action about their sponsors’ goods or services. Requests for the public to use a sponsor’s goods or services are considered endorsements, which fall outside of the tax exemption.
Monitor Exclusivity Arrangements
Not-for-profits should tread carefully when it comes to exclusivity agreements. Organizations are permitted to have exclusive sponsorships, but the terms of the exclusive contract should not include any language that binds the not-for-profit to exclusively using the sponsor’s goods or services. For example, if as part of the exclusive sponsorship between a T-shirt manufacturer and a food bank, the food bank agrees to order T-shirts only from the manufacturer, then that exclusive provider relationship likely qualifies as a substantial return benefit for the T-shirt manufacturer. In most cases, sale, distribution, availability or use of competing products cannot be limited by any sponsorship arrangement without triggering a substantial return benefit.
This rule applies only when an exclusive provider relationship is guaranteed in exchange for a sponsorship payment. Should a not-for-profit organization engage in an exclusive provider agreement with an exclusive sponsor that is wholly separate from the sponsorship agreement, then the exclusive provider contract would not qualify as a substantial return benefit.
Sometimes not-for-profit organizations do not have a choice about whether to use an exclusive sponsor as an exclusive provider. For example, organizations may enter into an exclusive arrangement because there are no comparable goods or services that meet the organization’s space or use requirements. Not-for-profits may also fall into an exclusive arrangement when the competitive bidding process requires only the lowest bid be accepted. In these situations, the exclusive provider arrangement is exempt for UBTI consideration.
Use of Facilities, Licenses and Other Sponsor Privileges
As part of the sponsorship arrangement, not-for-profits may provide privileges such as tickets, receptions or use of their facilities to their sponsors. So long as the fair value of the combined benefits offered to the sponsor fall below 2 percent of the total sponsorship amount, the sponsorship payments are considered QSPs and are not subject to tax. Any benefit above the 2 percent threshold would be valued and treated as UBTI.
The same rule applies to the licensing of the not-for-profit’s name and branding. In exchange for their support of the not-for-profit, sponsors may receive licenses to use the not-for-profit’s name and branding for their advertising and other collateral materials. If the fair market value of that license exceeds the 2 percent threshold, though, then the use of the branding would be classified as a substantial return benefit and be subject to tax.
To avoid unnecessary UBTI treatment in your sponsorship arrangement, it is critical to understand when the benefits from sponsorship arrangements become taxable. Not-for-profits that establish a strategy for how to handle sponsorships in light of UBTI risks can maximize the value of their sponsorships while keeping their sponsors happy.
If you have questions about whether your sponsorships put you at risk for UBTI, please contact us here.