Not surprisingly, the Internal Revenue Service (IRS) expects a tax-exempt club to remain in compliance with the requirements of Section 501(c)(7) of the Internal Revenue Code (IRC). But, surprisingly, certain clubs that secure tax-exempt status still operate in a manner inconsistent with the IRS’ requirements.
These clubs’ actions don’t go unnoticed, however. In 2007 alone, the IRS revoked the tax-exempt status of the following six clubs for various violations of the federal tax law.
A closer look at the IRS’ revocations of the tax-exempt status for these six clubs reveals why it is imperative clubs have a strong understanding of the current IRS activity regarding the applicability of IRC Section 501(c)(7).
After all, a thorough understanding of the IRC helps club management avoid operational issues that could place the club’s tax-exempt status at risk and helps board members meet their fiduciary obligations with respect to the club’s non-profit and tax-exempt status.
Let’s take an in-depth look at how these six social clubs violated Section 501(c)(7) requirements and how your club can avoid similar pitfalls in the future.
Club A – Comply with the IRS
Club A, a tax-exempt club, was organized for social and recreational purposes. When evaluating the club, the IRS considered whether Club A, which received more than 15 percent of its revenue from nonmembers on a continuous and recurring basis, continued to qualify for exemption as a social club pursuant to Section 501(c)(7) of the IRC.
The IRS’ evaluation revealed that during a three-year period the club’s nonmember receipts exceeded the 15 percent safe-harbor amount provided by Public Law 94-568. The nonmember receipts in those three years were 19 percent, 21 percent and 26 percent, respectively.
During a previous IRS audit, Club A was advised it had to lower its nonmember revenue to comply with federal tax law requirements, because a social club exempt from federal income tax under Section 501(c)(7) may lose its exemption if it makes its club facilities available to the general public on a regular and recurring basis. This is because the club may no longer be considered to be organized and operated substantially for its exempt purpose.
The IRS’ review of Club A’s Form 990, as well as the club’s activities, resulted in the IRS concluding the primary purpose of Club A had changed. The club was no longer principally operated to provide for the social and recreational purposes of its members. Instead, the IRS determined the club’s primary purpose and function was to operate a restaurant in a commercial manner.
In short, the club’s lack of Section 501(c)(7) compliance resulted in the IRS determining the club no longer qualified for tax exemption.
Club B – Activities and Income Tests
Club B, a tax-exempt club, held an annual street festival to raise money from the general public. The IRS questioned whether this particular club satisfied the activities test, the member income test, and the nontraditional activities test.
Let’s first review the activities test, which provides that an exempt club must be organized for pleasure, recreation, and other similar non-profitable purposes. Substantially all of the club’s activities must be for these purposes.
The member income test states exempt clubs are permitted to receive up to 35 percent of their gross receipts, including investment income, from sources outside their membership without losing tax-exempt status. Within that 35 percent amount, not more than 15 percent of the gross receipts should be derived from the use of a club’s facilities or services by the general public.
As for the nontraditional activities test, nontraditional activities apply to business conducted with either members or nonmembers (General Counsel Memorandum 39115). Traditional business activities are those that further a social club’s exempt purposes. A nontraditional business activity is any business that, if conducted on a membership basis, would not further the club’s exempt purposes.
After reviewing the club’s activities in relation to these tests, the IRS declared Club B was not operating pursuant to Section 501(c)(7) of the IRC, stating the street festival activity was nontraditional and did not further the club’s exempt purpose. In addition, Club B’s income from its annual street fair was far in excess of the 35 percent safe-harbor provided by Public Law 94-568.
In the end, the IRS revoked Club B’s tax-exempt status. This case is particularly important to note considering nontraditional activities and excessive income problems are common issues club management should constantly strive to manage effectively.
Club C – Avoid Excessive Investment Income
Club C, a tax-exempt club, was formed for the pleasure and recreation of its members. Yet, Social Club C did not provide activities or programs to promote the commingling of its members, had no social or recreational programs, and lacked personal contact and fellowship among its members.
To prove a club is organized and operated for pleasure, recreation and other non-profitable purposes, the club must have an established membership of individuals, personal contacts and fellowship. And a commingling of the members must play a material part in the life of a social club (Revenue Ruling 69–635). Person-to-person interaction among members is imperative; clubs that don’t provide opportunities for personal contact among members—or such contact exists but is incidental to the primary purpose—are not entitled to tax-exempt status.
Club C was also actively involved in securities trading. Remember, exempt clubs are permitted to receive up to 35 percent of their gross receipts, including investment income, from sources outside their membership. However, the club’s investment income—80 percent of its total income far exceeded the permissible investment income limitation.
Therefore, the IRS revoked Club C’s tax-exempt status because it did not meet the operational test of an exempt club and because the club’s trading activities didn’t prove that the club was organized for the pleasure, recreation and other non-profitable purposes. Also, Club C exceeded the 35 percent limitation on gross receipts set forth in Public Law 94-568.
Club D – Keep Club Activities on Site
Social Club D did not own the building it was located in and entered into a management agreement with the building owners. The building owners believed the building should be a community resource and available for weddings and trade shows. When such events were held, Club D operated the bar and kept the proceeds.
Club D also conducted “pull-tab” gambling activities and held tournaments open to both members and nonmembers. Interestingly, the gambling activities didn’t occur on the club’s premises, so the activity didn’t promote the social and recreational activities of its members. The club did report the gambling income on its Form 990-T, Business Income Tax Return.
Note that the operation of gaming devices by a tax-exempt club for the pleasure of its members and guests doesn’t affect the club’s exempt status, even though the operation of gaming devices is illegal under local law (IRS Revenue Ruling 69–68).
However, the IRS held that the gambling activity was a nontraditional activity, and the management agreement—and related activities—was a nontraditional business activity. Remember, activities conducted by a social club need to further its exempt purposes, and a nontraditional business is any business which, if conducted on a membership basis, would not further the club’s exempt purposes.
Because Club D generated a substantial amount of nontraditional income and received more than 35 percent of its gross receipts from nonmembers, Club D’s tax-exempt status was revoked.
Club E – Attention to Advertising Limitations
Club E, a tax-exempt club that conducted motocross races, provides an excellent example of the IRS’ focus on club Web sites.
Club E’s Web site advised that “[a]ll that is needed to race at [Club E’s] events, is an AMA card and a District Card from any district within the U.S.” Also, the club’s bylaws provided that “[a]ll persons entering the club property on the day of the event … will be considered a member for that day only.”
Based on these points, the IRS concluded the club’s Web site disclosures provided prima facie evidence that Club E was inviting the public to participate in its activities. In other words, solicitation by advertisement or otherwise for public patronage of its facilities is prima facie evidence a club is engaging in business and is not being operated exclusively for pleasure, recreation, or social purposes (Treasury Regulation §1.501(c)(7)-1(b)).
The IRS also determined that a minimum of 34 percent of the club’s income was from nonmembers and concluded Club E was being operated to conduct business with the public. (Internal Revenue Manual 7.25.7.3(2) provides the organization and operations of a club in a manner that constitutes a subterfuge for doing business with the public is inconsistent with the term “club” as used in IRC Section 501(c)(7) and disqualifies it from exemption.)
As a result of Club E’s subterfuge and the prima facie evidence regarding the club’s business engagements with the public, the IRS revoked Club E’s tax-exempt status.
Club F – Aware of Income Restrictions
Club F was formed to operate all types of amusement facilities for its members and their guests and hosted a variety of social and corporate functions, including weddings, business meetings, association meetings, lectures and other functions.
In its first year, Club F generated 46 percent of its gross receipts from the general public. In its second year, the club generated 36 percent of its gross receipts from the general public’s use of its facilities.
The IRS concluded that if a club makes its facilities available to the general public to a substantial degree, then the club doesn’t meet the requirements for exemption pursuant to Section 501(c)(7) of the IRC. Not surprisingly, the IRS revoked Club F’s tax exemption.
Final Thoughts
Clubs can lose tax-exempt status for many reasons, most of which are avoidable. Here’s a quick review of the various reasons why these six particular clubs lost or jeopardized their tax-exempt status.
- A club advised by the IRS to lower its nonmember income should understand non-compliance will likely result in revocation of tax-exempt status.
- Clubs without sufficient activities promoting recreation and pleasure for members and in substantial nontraditional activities will likely lose their tax-exempt status.
- A club must provide for the commingling of its members to meet the criteria for tax-exemption.
- An exempt club’s substantial purpose cannot be a for-profit activity. Such activity, as well as the absence of established social or recreational programs, will put its tax-exemption at risk.
- A club engaging in substantial nontraditional activities will lose its tax-exempt status.
- A club that is a subterfuge for doing business with the public will lose its tax-exempt status.
- A club that makes its facilities available to the public to a substantial degree will likely lose its tax-exempt status.
The reasons for these clubs’ revoked exempt status are varied. But, these case studies provide a detailed road-map of potential pitfalls regarding tax-exempt status about which club management should be aware and constantly look to avoid.
James J. Reilly, CPA, JD, is a partner with Condon O’Meara McGinty & Donnelly LLP, a certified public accounting firm which provides audit and tax services to more than 275 social clubs.
Securing Revenue Safely
Remember, it is good for tax-exempt clubs to attempt to secure revenue from as many sources as possible. But, private clubs should not:
- Violate Public Law 94-568 with respect to excessive nonmember and investment income
- Discount agreements entered into with the IRS
- Fail to meet the activities test—the club must provide sufficient member activities
- Conduct other than insubstantial nontraditional activities
- Fail to provide adequate opportunities to commingle the membership
- Enter management agreements for non-social, non-club-related functions
- Ignore advertising limitations
- Generate new revenue sources resulting in the club being viewed as a subterfuge
What Is Section 501(c)(7)?
Section 501(c)(7) of the Internal Revenue Code (IRC) provides an exemption from income taxes for social clubs organized and operated for pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder.
Public Law 94-568, which passed on October 20, 1976, amended IRC Section 501 as follows:
- Defined gross receipts as receipts from normal and usual activities of a club, including charges, admissions, membership fees, dues, assessments, investment income, and normal recurring capital gains on investments, but excluding initiation fees and capital contributions.
- Provided that social clubs should be permitted to receive up to 35 percent of gross receipts, including investment income, from sources outside of their membership without losing exempt status. Within this 35 percent amount, the club should not derive more than 15 percent of its gross receipts from the general public’s use of the club’s facilities or services. Thus, a social club could, provided the club didn’t have any other nonmember income, receive investment income up to the full 35 percent amount of its gross receipts.
- Provided that a club’s unusual income, such as the sale of a clubhouse or similar facility, should not be included in the gross receipts of a club in determining compliance with the 35 percent/15 percent safe-harbors.