Advisories June 21, 2024

Tax Advisory | NIL Collectives: Don’t Be Blindsided by an IRS Challenge

Executive Summary
Minute Read

If the IRS challenges the tax-exempt status of a name, image, and likeness (NIL) collective, the collective must understand how best to respond. Our Federal Tax Group details what NIL collectives need to know to make the cut.

  • If the application for tax-exempt status is challenged or the IRS later chooses to audit the NIL collective, the NIL collective may need to demonstrate it’s operated exclusively for exempt purposes
  • If audited and challenged, NIL collectives will likely need to show that compensating student-athletes is incidental to its public purpose of benefiting its partnered charities or another exempt purpose
  • NIL collectives are advised to hire an attorney following the first communication from the IRS about an audit, rather than speaking with the IRS directly

Since the National Collegiate Athletic Association’s (NCAA) adoption of its policy allowing student-athletes to profit from the use of their name, image, and likeness (NIL) in 2021, organizations have formed to pool contributions and fund, develop, or otherwise facilitate NIL opportunities for student-athletes. These organizations, called NIL collectives, are sometimes formed as nonprofit entities under state law and many have applied for and in some cases received federal tax-exempt status under Section 501(c)(3) of the Internal Revenue Code.

However, some NIL collectives’ attempts to venture into the 501(c)(3) tax-exempt space have been rejected by the Internal Revenue Service (IRS). Two recently published private letter rulings (PLR 202414007 and PLR 202416015) in response to exemption applications received by the IRS held that the applicant NIL collectives did not qualify as tax-exempt because the NIL collectives failed the “operational test,” meaning the NIL collectives operated substantially for the private interest of paying student-athletes rather than for a public interest. The private interests served were more than incidental to the exempt purpose.

Recent Private Letter Rulings

In PLR 202414007, the IRS explained that because the NIL collective "distribute[d] the majority of funds received to student-athletes, and not for a charitable purpose, [the NIL collective had] a substantial non-exempt purpose.” Because the NIL collective’s “activities [were] designed to increase the number of paid NIL opportunities for the student-athletes,” the IRS concluded that this “intentional private benefit from [its] activities cannot be considered qualitatively incidental to the accomplishment of an exempt purpose.” Similarly, in PLR 202416015, the IRS held that an NIL collective did not qualify because it was “providing a direct economic benefit to the student-athletes through compensation for the use of their NIL.” The IRS concluded that “the benefit to other charities [was] incidental to [the NIL collective] managing compensation for the use of a specific athlete’s NIL.” These rejections, though not precedential or binding on other NIL collectives, are certainly instructive for other NIL collectives interested in obtaining or maintaining tax-exempt status.

While these rejections, and similar statements from the IRS, indicate its heightened interest in the NIL space, they are not indicative of a prohibition on NIL collectives operating in the tax-exempt space. What they do indicate is the fine line an NIL collective must walk to ensure its application for tax-exempt status reflects a substantially charitable purpose. Additionally, if an NIL collective’s application is approved, it must continue to operate in a way that meets its charitable mission to avoid a later challenge from the IRS. If the IRS questions or challenges the tax-exempt status of an NIL collective, either when the NIL collective applies for tax-exempt status or via an audit of an existing tax-exempt NIL collective, it is key for the NIL collective to understand the process and how best to respond.

IRS Challenges to Form 1023

If an NIL collective does not sufficiently demonstrate that it is organized and operated primarily for exempt purposes in its initial application for tax-exempt status on Form 1023, the IRS may respond to the application with requests seeking more information or changes to organizational documents or may flatly deny the application for tax-exempt status. If it intends to deny the application, the IRS will issue a proposed adverse determination in response to Form 1023. The NIL collective generally has 30 days to respond to the IRS with a written protest of the proposed adverse determination. The IRS will next review the protest and decide whether it provides a basis to reconsider its determination. If the IRS decides to reconsider its initial determination, it will continue to process the Form 1023. If not, the IRS will either send a revised proposed adverse determination letter or send the case to the IRS Appeals Office, where the NIL collective can appeal the determination through the IRS’s administrative process. After the administrative process is exhausted, the NIL collective may seek a declaratory judgment in court as explained in more detail below.

Likewise, if the NIL collective has received a favorable IRS determination letter granting it tax-exempt status, it is imperative that it continue to operate as outlined in its Form 1023 application as reviewed and approved by the IRS, or if the NIL collective desires to change its operations, that it first discuss such plans with an attorney. Changing activities and operations that have already been deemed approved by the IRS may require that such changes be disclosed on the NIL collective’s next Form 990, which may unnecessarily result in the reexamination of its qualification for tax-exempt status.

The IRS Audit Process

For NIL collectives that have received a determination of tax-exempt status from the IRS, it is still possible that the IRS might eventually audit the NIL collective to confirm it is in fact operating primarily for tax-exempt purposes or to examine other matters of interest. It is therefore important for collectives to understand the audit process and timing of responses, to ensure appropriate best practices for day-to-day operations, document collection, and retention of funds.

Generally, the statute of limitations on the assessment of federal income tax is three years from the date an NIL collective’s return (such as Form 990) is filed, or the due date, if later. This period may be extended in certain cases (such as for fraud), but generally, the IRS will not audit returns before the past three years. It is advised that an NIL collective hire an attorney following the first communication from the IRS regarding an audit, rather than speaking with the IRS directly.

An NIL collective selected for audit will first receive notice by a letter from IRS Exempt Organization Examinations. The communication may initiate a field audit, in which the IRS sets up an appointment for an IRS agent to visit the NIL collective’s premises, or an office or correspondence audit, in which the IRS asks the NIL collective to produce documents. The audit starts with this initial contact and continues until the IRS issues a closing letter. Throughout the audit, the IRS may contact the NIL collective again for further information.

Issues in an audit may include a variety of matters, such as whether the NIL collective paid employment taxes or tax on unrelated business income if required, or whether the NIL collective filed all required returns and reports. NIL collectives that have full-time employees or operate both a for-profit and tax-exempt arm in particular should be diligent in ensuring no tax-exempt funds subsidize the taxable arm and should consult their accountants to avoid these potential tax and filing issues.

For NIL collectives specifically, the audit might focus on the NIL collective’s qualification for tax-exempt status. If so, the IRS could request a variety of information from the NIL collective, such as proof of charitable activities, bank statements, records of donations received and amounts distributed, contracts with athletes and charities, justification for valuations of certain athletes’ NIL rights, and board or committee minutes or resolutions showing how reasonable compensation was determined and approved.

If the IRS assesses taxes, fees, or penalties or seeks to revoke tax-exempt status because of one of these matters, rather than appealing, the NIL collective may choose to pay whatever taxes, fees, or penalties are determined owed and then continue as a tax-exempt organization, or continue as a taxable organization, if tax-exempt status remains revoked. If the IRS does issue a determination that the NIL collective does not qualify for tax-exempt status, however, the NIL collective must appeal the determination to keep its tax-exempt status and to avoid any taxes or penalties it may owe as a result of a retroactive revocation. Following such determination, the NIL collective would be a taxable entity for the time the IRS determines the revocation to be effective.

Note also that generally, officers and directors of an NIL collective would not be personally liable for actions of the NIL collective or any taxes or fees the IRS determines are owed. Whether to initiate an audit is at the discretion of the IRS, so if the IRS uncovers improper activity of a director or officer during an audit of the NIL collective, it is possible that could then trigger an audit of the personal returns of the director or officer.

The IRS Appeals Process

After an audit, if the IRS determines that the NIL collective does not qualify for tax-exempt status, the IRS will issue a proposed adverse determination letter that may be appealed via a conference with an IRS agent. If the NIL collective still disagrees with the determination after the conference, it can file a protest within 30 days of the IRS’s letter. As with challenges to an adverse determination related to Form 1023, if the IRS disagrees with the protest, the matter will be forwarded to the Appeals Office.

Similarly, if the IRS assesses additional taxes, fees, or penalties, the IRS will issue a letter with proposed changes to the return at issue, and the NIL collective generally has 30 days to tell the IRS whether it wishes to appeal the proposed changes through the Appeals Office. If the NIL collective does not respond, then it will receive a notice of deficiency, and the NIL collective will then have 90 days to file a petition with the tax court if it wishes to challenge the deficiency.

A settlement through the Appeals Office could result in a variety of arrangements, depending on the facts of the dispute. For example, the parties could agree that tax or penalties will be paid, but the entity will continue with tax-exempt status; that no tax or penalties will be paid, but the entity will continue as a for-profit; or any other combination of results.

If a settlement can’t be reached with the Appeals Office, the IRS will issue a letter to the NIL collective with its final decision. If tax-exempt status is revoked, the NIL collective has the right to petition the U.S. Tax Court, the U.S. Court of Federal Claims, or the U.S. District Court for the District of Columbia for a declaratory judgment on its tax-exempt status. The court will only issue this judgment if the NIL collective filed its petition within 90 days of the IRS’s final determination letter and has exhausted all administrative remedies available to it within the IRS. 
If taxes, fees, or penalties are assessed, the NIL collective may either pay the tax and seek a refund in the district court or the claims court, or not pay the tax and file a petition in the tax court for a redetermination (if within 90 days of the notice of deficiency).

Avoiding and Responding to Challenges

If Form 1023 is challenged or the IRS later chooses to audit the NIL collective, it will likely be key for the NIL collective to demonstrate that it does not fail the “operational” test for 501(c)(3) organizations, meaning it is operated exclusively for exempt purposes, such as charitable, educational, or religious.

In responding to IRS audits and challenges, it will generally be necessary for NIL collectives to show that compensating student-athletes is incidental to the substantial public purpose of benefiting its partnered charities or another exempt purpose, rather than vice versa. Although many NIL collectives are in practice operating primarily for a public benefit, such as promoting other charities or putting on free camps for underserved communities, some NIL collectives may unintentionally respond to the IRS using language that unduly highlights compensation for student-athletes, rather than sufficiently explaining that such compensation is merely incidental to the primary exempt purpose of the NIL collective. In both day-to-day operations and communications with the public, tax-exempt NIL collectives should be thoughtful in how they approach and promote their charitable mission and accurately reflect that to the IRS.

For more information, please contact Jake Kaplan at +1 404 881 4296, George Abney at +1 404 881 7980, Nicole Brown at +1 404 881 7167, or Trenton Hafley at +1 202 239 3167.

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