Unrelated business income (“UBIT”) is defined as the gross income derived by any organization from any unrelated trade or business (as defined in IRC 513) regularly carried on by it (less certain allowable deductions) which are directly connected with the carrying on of such trade or business.  Section 512(b)(2) of the Internal Revenue Code specifically excepts from UBIT royalty payments:  “There shall be excluded all royalties (including overriding royalties) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income.” 

Discussion of Sierra Club Case

Courts have created differing opinions regarding the definition of royalty, which seems to hinge on whether the monies are earned passively or actively.  In Sierra Club v. Commissioner IRS (86 F. 3d 1526 (1996)), the court considered whether the payments received by the Sierra Club in connection with the licensing of their name and trademark to a credit card company for use on the credit card were royalty payments.  In this case, Sierra Club also had the option to generate higher royalty payments if the organization elected to pay production and mailing costs associated with the card.  In its decision, the court laid out the basic framework surrounding royalty payments and nonprofit organizations: 

A tax-exempt organization under I.R.C. § 501(c) must pay taxes at normal corporate rates on “unrelated business taxable income.” UBIT is defined as “the gross income derived by any organization from any unrelated trade or business ... regularly carried on by it, less the deductions allowed ... both computed with the modifications provided in subsection (b).” Section 512(b)(2) provides that “[t]here shall be excluded all royalties (including overriding royalties) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income.” …

“Royalties” as used in § 512(b