Organizations that utilize sponsors can structure the sponsorship in a few different ways. Sometimes, a sponsor is simply giving a donation without expecting or receiving a return benefit. Other times, a sponsor is contracting for a return benefit so both parties understand there is a mutual exchange. Finally, in some circumstances, what is perceived as a donation turns into an exchange. In situations where the sponsor income is a donation, the income is not taxable. However, when there is a return benefit to the sponsor, all or a portion of the sponsor income must be reported by the charity as unrelated business income (UBI), subject to tax.
Determining the difference between these situations requires a close look at Treasury Regulation 1.513-4. Below is an explanation of the main takeaways from the official regulation: the difference between a qualified sponsorship payment (donation), and a substantial return benefit (exchange of services).
Qualified Sponsorship Payment
When looking at whether a donation is a qualified sponsorship payment, it is important to know the 2% rule and what the IRS means when it says “use and acknowledgement.”
Use and Acknowledgement
Generally, the IRS expects that the only thing a sponsor should get for its donation is use and acknowledgement. For example, if a sponsor’s donation is their product or service, then the organization may use the product or service for the event that is being sponsored.
An organization may also acknowledge that they have received a donation by the sponsor. This includes an acknowledgement of any money received or any products or services the organization is using during the event. However, this acknowledgement must be made carefully so that it does not become an advertisement on behalf of the sponsor.
Acknowledgements may not include value judgements of the sponsor’s products or services, information on pricing, or any inducement to purchase the products or services.
The regulation addresses a few actions that might seem like they cross the line but are actually permitted. These are:
- Exclusive sponsorship arrangements – You can agree to have an exclusive sponsor and even announce that the sponsor is exclusive without crossing the line.
- Value-neutral descriptions and displays – Interestingly, an established slogan that is generally associated with the sponsor, even if it includes a value judgement, is considered value-neutral.
- Giving away or selling to the general public – A sponsor or the nonprofit may give away or sell the products and services of the sponsor to the general public at the event. However, if the right to sell products or services is restricted to the sponsor, then the sponsor has received a substantial return benefit.
The 2% Rule – Incidental Benefits
A sponsor might receive incidental benefits associated with its sponsorship. These incidental benefits cannot rise above 2% of the value of the donation. Benefits are assessed in the aggregate and at fair market value. Benefits received could be advertising, exclusive provider arrangements, exchanged goods and services, or rights to the organization’s intangible assets. This is not an exhaustive list, but mere examples of types of benefits. As long as these return benefits stay under 2% of the value of the donation, then the donation remains a qualified sponsorship payment and is not subject to tax.
Substantial Return Benefit
A substantial return benefit is any benefit aside from use and acknowledgement, or incidental benefits above the fair market value of 2% of a donation. If a sponsor receives a substantial return benefit, the revenue associated with the substantial return benefit is taxed as UBI.
A sponsor and an organization may have a mixed arrangement where part of a sponsor payment is a donation and part of the payment is in exchange for goods and services such as advertising. This is permitted and the nonprofit may report part of the sponsorship revenue as a qualified sponsorship payment and the other portion as UBI.
For example, an organization agrees that a sponsor shall be the exclusive provider of all food sold at a fundraising fair. The sponsor pays the organization $20,000 for this arrangement but both the organization and the sponsor agree that the fair market value of this exchange is $10,000. As long as this arrangement is in writing, then 50% of the sponsorship payment is in exchange for a substantial return benefit and will be taxed as UBI while the other 50% of the payment is a true donation and is a qualified sponsorship payment. If there was no written agreement, 100% of the “donation” is considered payment for a substantial return benefit and taxed as UBI.
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By Julia K. Morrison