The Internal Revenue Service (IRS) has been conducting a compliance project with respect to the reporting of investment income by the social clubs exempt from income tax under Section 501(c)(7) of the Internal Revenue Code (IRC). In its Fiscal Year 2011 Work Plan, the IRS’s Exempt Organizations Division reported the findings of its Investment Income Compliance Project for social clubs exempt from income taxation.
The Tax Exemption
IRC Section 501(c)(7) provides an exemption from income taxation for social clubs provided:
a) the club is organized for pleasure, recreation, and other non-profitable purposes;
b) substantially all of its activities are for the aforementioned purposes; and
c) no part of the club’s earnings may inure to the benefit of a private shareholder.
The tax exemption for social clubs is designed to allow individuals to join together to provide themselves with social or recreational activities and facilities without tax consequences. The tax-exempt status provides that members of social clubs are in substantially the same position as if the individual members had spent his or her after-tax income on pleasure or recreation. Social clubs are exempted from tax not as a means of conferring tax advantages, but as a means of ensuring that the members are not subject to tax disadvantages as a consequence of their decision to pool their resources for the purchase of social or recreational services.
Clubs are Really Semi-Tax Exempt
Because social clubs are not exempt as a means of conferring a tax advantage, it is not surprising that exempt social clubs do not receive certain of the tax benefits conferred on exempt organizations that serve the general public, e.g., IRC Section 501(c)(3) public charities. Generally speaking, the investment income of an IRC Section 501(c)(3) public charity is not subject to income taxation but the investment income of a tax-exempt social club is subject to income taxation. Investment income consists of interest, dividends, royalties and the like.
Social clubs are only tax-exempt with respect to income from providing social and recreational activities and facilities to their members and guests, and social clubs are, as a general matter, subject to tax on income from non-members and investment income. Social clubs pretty much have a unique status in that exempt social clubs are taxed on passive investment income. It should be noted that there are certain statutory provisions that provide that social clubs are not taxed on investment income that has been set-aside for charitable purposes and certain gains from the sale of property.
The IRS Findings
In 2010, the IRS’s Exempt Organizations Division reviewed Form 990 filings of tax-exempt social clubs to determine whether such clubs were reporting investment income but not reporting investment income on Form 990-T or paying the unrelated business income tax. The IRS’s Exempt Organizations Division examined over eighty organizations, and it reported non-compliance with the appropriate federal tax law for sixty percent of the examined organizations. The non-compliance with the federal tax laws discovered by the IRS with respect to the investment income of a social club prompted the IRS to take the following actions:
- secured delinquent Forms 990-T and collected the unrelated business income tax,
- revocation of tax-exempt status, or
- modification of the exemption subsection.
Recommendations
The substantial degree of non-compliance uncovered by the IRS will likely prompt the IRS to continue to monitor the reporting of investment income by tax-exempt clubs. Club personnel and their advisers who prepare tax returns for tax-exempt clubs should be mindful of the unique status of exempt social clubs under the federal tax laws with respect to the taxation of investment income.
With respect to the proper reporting of investment income and the payment of the related tax, clubs should:
1. Engage a Tax Professional with Experience with Tax-Exempt Social Clubs
The failure to properly report, and pay taxes on, investment income by certain tax-exempt clubs is not surprising as it seems at first blush because the number of tax-exempt charitable organizations dwarf the number of tax-exempt clubs, and tax advisers working with such tax-exempt charitable organizations properly understand that such tax-exempt organizations are not, as a general matter, subject to income taxes, on investment income. Not surprisingly, there may be some carryover of the treatment of investment income by tax-exempt charitable organizations over to tax-exempt social clubs but such carryover is inappropriate. As a general rule, investment income of tax-exempt social clubs is subject to the unrelated business income tax.
With respect to the failure of sixty percent of the audited, or examined, tax-exempt clubs to be in compliance with the federal tax laws regarding the reporting of investment income, it is prudent to recommend that clubs should be engaging tax advisors with a knowledge of the tax laws applicable to tax-exempt clubs.
2. Officer and Director Review of the Form 990 and Form 990-EZ to Identify Investment Income
The Form 990 (2010), Part VI. Governance, Management, and Disclosure, Line 11a asks “Has the organization provided a copy of this Form 990 to all members of its governing body before filing the form,” and Line 11b states “Describe in Schedule O the process, if any, used by the organization to review this Form 990.” Part I. Summary, Line 10, of Form 990 (2010) requires disclosure of the tax-exempt club’s investment income.
Even smaller clubs (clubs with gross receipts of less than $200,000 and total assets of less than $500,000) must disclose their investment income on Part I. Revenue, Expenses, Changes in Net Assets or Fund Balances, Line 4, of Form 990-EZ (2010).
The investment income reported on the Form 990 and Form 990-EZ is readily available for review by club officers and directors, as well as by the IRS. After identification of investment income, the appropriate officer(s) or director(s) should follow-up to ascertain as to whether or not the club is paying any applicable tax in connection therewith.
3. Utilize the Form 990-T to Compute the Tax on Investment Income
In addition to reporting its investment income on its Form 990 or Form 990-EZ, a social club must typically report its investment income on Form 990-T (2010), Exempt Organization Business Income Tax Return, Part I. Unrelated Trade or Business Income, Line 9. Among other things, the tax related to the investment income of a tax-exempt social club is computed on Form 990-T.
James J. Reilly, CPA, JD, is a partner at Condon O’Meara McGinty & Donnelly LLP, which currently serves more than 275 private membership clubs in thirteen states.