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University-Industry Engagement Week

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With closer industry ties in sponsored research agreements, ignore tax issues at your peril

More universities are getting comfortable with deeper, more integrated forms of sponsored research as they attempt to improve industry relationships and move more IP to market. But industry-sponsored research programs must be careful not to violate certain tax rules that these arrangements can violate — such as restrictions on the use of publicly funded buildings by for-profit entities. Without attention to detail in constructing these agreements, the severe consequences of violating the tax rules could outstrip by far any gains made by the sponsored research office.

The biggest area of concern is the clash between sponsorship and the tax-exempt bond issues that most 501(c)3 organizations use for capital improvements such as university buildings, says Tom Wintner, JD, a partner at the law firm of Edwards Wildman in Boston who has extensive experience with IP litigation and other legal issues involving universities. The bonds and the earned interest are not taxed, which makes them quite attractive and gives universities an advantage in the marketplace, Wintner explains. “They have to be careful, though, that the money they are raising does not go to so-called private business uses,” he explains. “Instead, money must be used for the purpose and the mission of the institution.”

The tax issue can arise unexpectedly, Wintner says. If a university wants to build a new laboratory for $100 million, for instance, it issues that amount in bonds to investors. Once completed, the lab might be used for a few years by faculty, staff and students. But then a biochemist strikes up a relationship with a pharmaceutical company that spurs an offer to fund cancer research at the lab. “Now you have a researcher working in a facility that was financed with tax-exempt bonds but they’re doing something that could constitute private use,” Wintner says. “So the question becomes how you can fulfill your agreement with this company and also comply with IRS tax law. That is not always so easy.”

A key determinant of compliance with the IRS requirements is known as the “5% rule,” he explains. This rule of thumb says that 5% of the bond funds — or 5% of the lab in this example – can go toward private use without triggering problems with the IRS, Wintner says. “There’s always a little bit of a safe harbor built in because the IRS realizes there may be some minimal private use that should not invalidate everything else that happens in the building,” he says.

How to measure that 5% is not detailed by the IRS. The 5% could be a measure of floor space, annual revenue, or other factors that represent a percentage of the funds coming from the bonds.

The IRS has provided two more safe harbors for sponsored work in a bond-funded facility,

Wintner adds. Both apply only to “basic research,” which the IRS defines as “original investigation for the advancement of science and technology, not having a specific commercial objective.”

“The intricacies of that definition can be debated, but there are some things that are obviously not basic research,” Wintner says. “A company can’t give the university a bunch of compounds for clinical testing. That’s not basic research.”

Sponsored research agreements that involve more specific research that has an easy connection to the commercial market cannot be performed in a publicly funded building. The risk of non-compliance lies with the university, not the sponsor, so sponsored research offices must be careful to structure the deals properly with the aid of legal counsel, Wintner says.

A detailed article offering specific guidance on avoiding tax compliance issues in industry collaborations appears in the premiere issue of Industry-Sponsored Research Management. To subscribe and access the full article, or to request a free copy of the premiere issue, CLICK HERE.

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