Over the last six months, NCA has received numerous inquiries from member clubs regarding the true importance of maintaining their tax-exempt status. It is a question all general managers and board members are undoubtedly posing right now as the economy continues to tighten. But would the removal of your club’s 501(c)(7) tax-exempt status really benefit your club?
In an effort to secure the Internal Revenue Service’s tax-exempt status, most clubs were formed by incorporating under the not-for-profit statutes of the state in which they reside. Having completed this task, the club owners then applied to receive status as a tax-exempt entity under 501(c)(7) of the Internal Revenue Code. The IRS authorizes clubs to be exempt from federal taxation if, and only if, they meet the following requirements:
- The club is organized primarily for pleasure, recreation or other nonprofit purpose;
- Substantially all of the activities of the club are for pleasure, recreation or similar purposes;
- The club’s written organizational documents—its articles of incorporation, charter, bylaws—do not discriminate on the basis of race, color or religion (certain exceptions may apply for strictly religious clubs);
- The club fosters and encourages personal contact, commingling and fellowship among its members;
- The club’s members are united in a common objective or interest; and
- No part of the club’s net earnings may inure to the benefit of any private shareholder of the club.
The rationale given by the IRS for providing such a benefit to clubs is that the activities in which the members of a club engage are not intended to generate a profit for anyone in the club—that there is no commercial benefit to the activities for the club members. By definition, such sharing of expenses and activities justifies being tax exempt.
Thus, the process through which a club goes to become tax exempt is not a simple one and it is not something that should be abandoned without great consideration. Once the tax-exempt status is gone, it is extremely difficult—some would say nearly impossible—to get it back. So, what will your club really receive if it relinquishes its tax-exempt status?
When one looks at what the IRS allows a tax-exempt club to do, there is certainly a sense that little is permitted. In an effort to ensure that clubs only focus on those activities that further the pleasure, recreational or other nonprofit purposes of a club, the IRS has a prohibition on activities it did not deem as furthering the club’s tax-exempt purposes.
Thus, the IRS imposes limits on income from nonmember activities. To remain tax exempt, a club must limit its investment and nonmember income to a level not exceeding 35 percent of its total gross receipts. The IRS defines gross receipts as income from normal or usual activities of the club (membership fees, admission dues, special member assessments and investment income). Capital contributions and initiation fees are not included in gross receipt totals.
Additionally, the IRS limits the total income a tax-exempt club can receive from opening the facilities or services for use by nonmembers to no more than 15 percent of the club’s gross receipts. This poses challenges to clubs that wish to supplement their income by renting out facilities for weddings or through participation in reciprocal arrangements.
By forgoing tax-exempt status, a club could unshackle itself from these relatively restrictive tethers provided by the IRS. The first specific benefit club leaders may see in removing their club’s tax-exempt status would be the immediate termination of the IRS’ 15/35 limitations. With aggressive marketing, a club could expect to see a large up-tick in its bottom-line with the influx of nonmember cash.
Another rationale for removing a club’s tax-exempt status might be the fact that nontraditional activities would no longer be scrutinized so strictly by the IRS. By removing its tax-exempt status, a club could provide services like takeout food and liquor sales for off-site events. Services like a barber shop could be brought back into the club and other revenue streams could be created.
In each of these cases, it is easy to see the immediate and perceived positive effects dropping the 501(c)(7) status could have on a club. However, there are consequences. Naturally, a club will now have an income tax liability—the kind and size of which it did not have before. Additionally, there are quite a few unforeseen consequences that should temper club leaders’ desires to become a taxable entity.
To begin, with an increase in nonmember activities and by offering new services that were once deemed off limits, a club will invariably increase its employee staffing costs, tax liability for those employees, insurance costs and maintenance costs. Naturally, these costs will all be figured into the charges for these new activities and services, but the administrative time may not be. In addition to these costs, your membership may begin to feel less and less like they are part of a private club. These factors, alone, may be enough for a club to jettison the idea of giving up its tax-exempt status.
If these issues are not a major concern, then what about the impact on a club’s private status when the tax-exempt status is removed? To be considered a private club, the club leaders must ensure it is exclusive and selective with its membership policies, the club is used for social and not commercial purposes, and nonmembers do not use the facilities.
While clubs do not have to be tax exempt to be private, that tax exemption—the 501(c)(7) designation—has been acknowledged by federal courts as a strong indicator that a club is indeed truly private. And, the designation as a private facility is what differentiates private clubs from all other facilities open to the general public. It is this designation that clubs must covet above all else and it is the first thing that could be jeopardized by removing the club’s tax-exempt designation.
Once you open your club doors to more banquet and reception attendees, you may be opening the door to a claim that your club functions just like the local banquet hall. Once you let reciprocal guests enter the club, you are allowing those who have not been vetted by your nominating committee and approved by your membership committee walk the halls of what was an exclusive facility. Once you allow takeout food service, your club could be seen as fostering not a spirit of collegiality and fellowship, but a spirit of entrepreneurialism that rivals the public dining establishments in your community. All of these things can be used against your club to claim it is not private.
Finally, and most importantly, by removing your club’s designation as a tax-exempt facility, you are relinquishing its exemption from two of the most significant employment laws on the books: The Americans with Disabilities Act and the Civil Rights Act of 1964. Each of these laws specifically provides an exemption for bona fide private clubs that are exempt from taxation under the Internal Revenue Code.
The reason these laws were created with an exception for private clubs is because tax-exempt, private clubs were seen as worthy and justified to receive a pass from the requirements with which every other commercial, taxable entity must comply. Because clubs are not commercial enterprises and because they are meant to be exclusive groups that bring together like-minded individuals for social and recreational purposes, they really could not be included in these laws.
Of course, each club has different factors it must evaluate before determining whether to drop its tax-exempt status. NCA realizes that clubs have different needs at different times and that this may be the time for such a change. However, this is not a decision to be made simply because the economy is not what it has been in the past.
In the final analysis, the costs of changing your club’s tax status could easily total tens of thousands of dollars and place your very existence as a private club on the line. With that much at stake, NCA advises all clubs to discuss the ultimate costs and benefits with their club accountants and attorneys and, of course, to contact us at anytime to discuss any other concerns your club may have regarding this topic—or any other.
In addition, our book, Private and Tax-Exempt Status, can help guide you through the maze of complicated issues that arise when dealing with this issue.