Editor’s note: This article was submitted to Club Director in response to the July/August 2008 “By the Numbers” column, which identified eating patterns in America. Despite a growing trend for takeout food, the author urges tax-exempt clubs to avoid nontraditional activities.
Congress and the Internal Revenue Service are serious in their position that “nontraditional” business activities should be held to a minimum at 501(c)(7) tax-exempt clubs or loss of status looms.
The club industry has embraced recent trends in food and beverage activities that are extremely worrisome, tax wise, if the club has applied for and been granted 501(c)(7) tax-exempt status. “To go” orders, wine sales for consumption off club premises, Thanksgiving turkeys, holiday hams, baked goods, and catering parties to members’ personal residences are classified by the IRS as “nontraditional” and gross receipts from these activities are to be “de minimis,” held to a minimum.
This specific issue was addressed in a recent visit to the IRS in Washington, D.C., on behalf of a 501(c)(7) tax-exempt client. In an attempt to better serve clubs’ members in the increasingly mobile society, clubs are studying alternatives to ways a member uses the club. A study by the Brookings Institution estimates that up to one-third of all jobs are now located beyond a 10-mile radius of central business districts and that 36 percent of all commutes are from suburb to suburb. The old paradigm of drawing members from a relatively fixed geographic radius around a club’s physical location has become outmoded. Even if members live or work close to their club, the study indicates it may or may not be convenient for them to go, especially for families trying to reconcile the demands of commuting, working and taking care of children—all while chasing an almost endless routine of errands, activities and commitments.
In an attempt to address this new paradigm, the activities club members are specifically interested in clubs providing—ones the IRS call nontraditional—are as follows:
- Take-out: Clubs providing a take-out food and beverage service for members, as an accommodation to those members on the run, consuming the product off club premises, is deemed nontraditional. Being able to utilize the talents of the club’s chef and kitchen staff can be one reason to have a club membership, but the IRS disapproves of too much income from this source.
- Off-Site Catering: This includes catering in their members’ offices while holding working lunches, consuming the product in their office rather than getting in automobiles and bringing the group to the club. It makes good business sense, but is not encouraged, so says the IRS. Clubs also want to consider providing such food and beverage products and services to members of the club at their homes, and believe catering food and beverages to club members in the community can provide word of mouth advertising for the club. This may be an excellent means of marketing the quality expected if club membership is obtained, but it is nontraditional.
- Wine Sales: Wine groups have flourished within the club industry, bringing like-minded individuals together to experience offerings from around the world and from vineyards not necessarily well known. Members who find a sampling that meets their liking may want to make purchases of case lots to be consumed off premises. Clubs may consider sales of these products as a drawing card to the benefits of club membership. Sell members wine for consumption at the club and it is member-related income. Selling it to take home is nontraditional.
Tax Problem For 501(c)(7) Tax-Exempt Clubs
This may be technical, but is required reading:
Section 1.501(c)(7)-1(b) of the Income Tax Regulations provides, in part, that a club which engages in business, such as making its social and recreational facilities available to the general public or by selling real estate, timber, or other products is not organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, and is not exempt under section 501(a). (These Regulations have not been amended reflecting the changes made to Section 501(c)(7) in 1976, changing the word “exclusively” to “substantially”.)
Section 501(c)(7) was amended in 1976 by Public law 94-568 to provide that section 501(c)(7) organizations could receive some outside income without losing their exempt status. Senate Report No. 94-1318 (1976), 2d Session, 1976-2 C.B. 597, at page 599 explains that a social club is permitted to receive up to 35 percent of its gross receipts, including investment income, from sources outside of its membership without losing its tax-exempt status. It is also intended that within this 35 percent amount, not more than 15 percent of the gross receipts should be derived from the use of a social club’s facilities or services by the general public. In effect, the latter modification increases from 5 percent (Rev. Proc. 71-17, 1971-1 C.B. 683) to 15 percent the proportion of gross receipts a club may receive from making its club facilities available to the general public without losing its tax-exempt status. (Now, do not overlook this.) The Senate Report also states that it is not intended that these organizations should be permitted to receive, within the 15 percent or 35 percent allowances, income from the active conduct of businesses not traditionally carried on by these organizations.
Because of recent rulings and the inclusion of the topic in the IRS training material in the recent years, a club needs to review the operations of a 501(c)(7) organization in light of the General Council Memorandum 39115, Revenue Ruling 68-535 and PLR 9212002. Tax-exempt status can be terminated if more than a “de minimis” amount of “nontraditional” business activity occurs. “De minimis” does not have a formal percent safe harbor limitation amount attached to it. This Latin word can be summarized as small, insignificant, and non-reoccurring. Thus, why would a club budget, plan for, and market an activity that was de minimis?
In one Private Letter Ruling reflecting the termination of 501(c)(7)’s tax-exempt status, a club was found to have had nontraditional income that exceeded 5 percent of the club’s qualified gross income, which was deemed to exceed a de minimis amount. (Caution: Clubs cannot rely on this 5 percent to apply in their situation. Based only upon facts and circumstances in that one Private Letter Ruling did the IRS conclude that income exceeding 5 percent of the club’s qualified gross receipts was more than de minimis. Be aware that the agent who wrote this ruling verbally stated that he was concerned that an amount in excess of $100,000 from nontraditional activities may not be deemed de minimis.)
To add insult to injury, the nontraditional activities with members is considered non-member income and subject to UBIT when computing the 15/35 percent limitations.
In conclusion, 501(c)(7) tax-exempt clubs should immediately STOP their “to go” activities if they want to preserve their tax status. Clubs wanting to pursue these nontraditional activities will invariably ask whether 501(c)(7) tax-exempt status is of value and question whether being tax-exempt is important as nontraditional is not a problem with a taxable club. To answer this question, one must understand that there are probably only six times in the life of a club that 501(c)(7) tax-exempt status saves a club tax dollars. Each of those times may be associated with $1 million or more in income tax liabilities.
Mitchell L. Stump, CPA is the author of Club Tax Book, “An Accumulation of Tax Issues Specific to Clubs.” This quarterly, updated subscription-based publication has been written to assist clubs in understanding the ever-changing federal tax laws. Celebrating its 12th year in circulation, information regarding Club Tax Book can be found at www.clubtax.com.