With the coronavirus pandemic and the adverse impact of the pandemic on clubs, many clubs are giving thought as to whether tax-exempt status, which limits the amount of nonmember business that a club may receive, is worthwhile to maintain. This question also was discussed after the financial crisis in 2008.
In March 2009, I read comments consistent with the following:
- I am willing to bet that, in 10 years, 50% of clubs that are currently tax-exempt will not be anymore, and
- The private club is not going away. In 10 years, there will be about 4,000 private clubs and about 12,000 other golf facilities, just like we have now.
In the National Golf Foundation’s 2019 Golf Facilities Report, it was reported that “at the end of 2018, there were 14,613 golf facilities in the U.S. with 16,693 courses, and there were 3,708 private golf facilities with 4,339 courses.” The golf industry has proven resilient.
If a club is contemplating a change in tax status, club board members should carefully consider various factors with respect to member use and tax implications. A prudent consideration of such factors will assist in making judgements in the best interests of the club and club members.
Tax-Exempt v. Taxable Club, Generally
Internal Revenue Code (IRC) § 501(c)(7) provides social and recreational clubs with an exemption from federal taxation of income derived from providing services related to their tax-exempt missions. Tax-exempt clubs are subject to income tax on net income from nonmembers and investment income. In addition, as a general matter, a tax-exempt club may receive up to 15% of its gross revenues from nonmember activities.
Clubs that relinquish or have their tax-exemption exempt status revoked become subject to regular corporate income tax. Generally speaking, the clubs report all revenues from members (including dues, initiation fees and assessments) and nonmembers. Taxable clubs may receive an unlimited amount of nonmember revenues. Such clubs are required to be compliant with IRC § 277 (discussed below).
May a Club Terminate Tax-Exempt Status?
The threshold question is whether a tax-exempt club may voluntarily terminate its tax-exempt status. In a dated letter July 24, 2009, the IRS advised a club, in response to the club’s request for a termination of its tax-exempt status, that the club could not voluntarily relinquish its tax-exempt status. Tax-exempt status could be terminated only 1) if the club either dissolves and disposes of its assets consistent with the law or 2) if the IRS revokes the club’s tax-exempt status because of an IRS examination.
The filing requirements imposed by Internal Revenue Code (IRC) § 6033…militate against the Internal Revenue Service (IRS) allowing an organization to relinquish its exempt status. Organizations exempt under IRC 501(a) are required by IRC § 6033(a)(1) to file an annual information return (unless excepted by IRC § 6033(a)(2)). IRC § 6104(b) provides that information gathered pursuant to IRC § 6033 shall be made available to the public. Therefore, allowing an organization … to avoid the information return requirement by voluntarily relinquishing tax exempt status would constitute an abdication of the IRS’s responsibility to the public under IRC § 6104(b). The IRS cannot discharge or avoid this responsibility by acquiescing in an organization’s “voluntary relinquishment” of its exempt status. (See 1985 EO CPE Text K. Voluntary Relinquishing of Tax Exempt Status.)
An approach to the July 24, 2009, letter, absent attempting to have the IRS change its position, may be to simply have the club, that desires to function as a taxable club, operate as a for-profit club provided that it reports the proper nonmember business income percentage and pays the appropriate unrelated business income tax. Over time, the IRS may focus on the excess nonmember business income being reported, examine the club, and revoke the exemption.
Nontraditional Income, Pandemic Matter of Concern
An immediate concern to many clubs is the amount of their nontraditional revenue because, during the coronavirus pandemic, tax-exempt clubs turned to food-to-go activities due to partial or complete shutdown requirements imposed by state and/or local governmental authorities. Social clubs that provided food-to-go activities in their struggle to survive and service their members during the pandemic are now concerned that the revenue associated with such nontraditional activities may put their tax-exempt status at risk.
Remember, a traditional business activity of a tax-exempt club is an activity that, if engaged in with members, furthers the exempt purpose of a club, but a problematic nontraditional business activity does not further the exempt purpose of a club, even if conducted solely on a membership basis. Tax-exemption will be denied if the income from nontraditional business activity is substantial.
Examples
- Club A was organized for social and recreational purposes. It provided a take-out service which furnished food and beverages to members for personal consumption away from the club facility and a catering service for member special events. Income from the takeout and catering services constituted less than 5% of A’s gross receipts for the taxable year.
The take-out and catering services provided by Club A are nontraditional business activities that did not further the pleasure and recreational needs of club members. However, the income from the take-out and catering services was less than 5% of the club’s gross receipts for the year in question and did not constitute a substantial part of the club’s gross receipts. Thus, neither service, nor the two combined, prevented Club A from qualifying for exemption from federal income tax pursuant to IRC § 501(c)(7). (Source: Internal Revenue Service (“IRS”) 1996 EO CPE Text C. Social Clubs – IRC § 501(c)(7), Jim Langley and Conrad Rosenberg.)
- Club B, a tax-exempt club had sales-to-go activity involving various food products that was not deemed insubstantial, trivial or nonrecurrent (6.07% of its gross revenues) by the IRS. The sales-to-go activity is a service to members that is neither related to, nor in furtherance of, the club’s exempt purposes. Therefore, it is a nontraditional business activity prohibited under IRC 501(c)(7). Consequently, the Club B’s exempt status should be revoked. (Source: IRS Private Letter Ruling 9212002.)
The concern about excessive food-to-go activities during the pandemic has been prompting some clubs to consider whether tax-exempt status is worthwhile maintaining.
In a recent ruling with respect to the receipt of carbon offset credits, the IRS stated that several factors show that the unusual amount of income received by the club from the credits would not be derived from active conduct of a nontraditional business:
- The club did not purchase property to engage in this transaction;
- The club purchased the property and has used the property for exempt activities;
- The transaction will not be a regular recurring event; and
- The club represents that the carbon offset credit transaction will be a unique event, and although it is not a sale, it is a one-time transaction analogous to the permitted incidental sale.
Although admittedly a different fact scenario, a club that is providing food-to-go activities because of the coronavirus pandemic 1) did not purchase property to engage in such activity, 2) property utilized has been used for exempt activities pre-coronavirus pandemic, 3) significant food-to-go activities will not continue post-coronavirus pandemic and 4) the food-to-go activities during the pandemic should reasonably be viewed as analogous to a “one-time” transaction. This ruling and the fact that the U.S. government has been struggling mightily to keep organizations viable and people employed should result in a relaxed view of the food-to-go activities by the IRS during the pandemic, although the IRS has not yet published guidance directly on point.
Tax Benefits of Tax-Exempt Status
Capital Assessments Received by a Tax-Exempt and Taxable Club
With respect to tax-exempt clubs, capital improvement fund assessments paid to the club by members are not subject to income taxation.
However, capital assessments paid to taxable clubs may be subject to income taxation.
The following excerpts from a case and IRS rulings discuss whether “capital contributions” to a taxable club are treated as taxable income:
- In Washington Athletic Club v. United States, 45 AFTR 2d 80-1257 (614 F.2d 670), (CA9), 02/28/1980), the Washington Athletic Club (WAC) established a capital improvement fund for the purpose of funding WAC’s capital improvement programs. Members had no right to refuse to contribute to the capital improvement fund, and the members who failed to pay lost the privileges of club membership, including the use of club facilities. The question is whether such payments to WAC were exempt from federal income tax as contributions to capital within the meaning of IRC 118. If such payments are to be treated as capital contributions, it is necessary that the members have other entitlements that are characteristic of capital contributions in order to establish that the payments were not made primarily for the privileges and services provided by the club to members. When a membership was terminated, the member simply forfeited all amounts paid to WAC and lost any right to share in WAC’s assets on liquidation. The court’s consideration of all the relevant facts resulted in the conclusion that the dominant, if not the sole, motive for the payment to the club by the members was to obtain the privilege of using the club’s facilities. The members of WAC had no investment motive for their payments. The court held that the payments in issue were not capital contributions by WAC’s members.
- In Field Service Advice 199911004, it was stated that the test for determining whether a payment qualifies under IRC 118(a) as a capital contribution is whether the payor had a motive in making a contribution to capital. United Grocers, Ltd. v. United States, 308 F.2d 634 (9th Cir. 1962). If the payor had an investment motive in making the payment, then the payment would constitute a contribution to capital. In this case, it was concluded that the applicant for full membership had an investment motive in purchasing a full membership and, therefore, his or her initial membership fee constitutes a contribution to capital.
- In Private Letter Ruling 200411028, it was noted that the club established a redemption mechanism that enabled the founding members to sell their memberships and potentially profit thereby. Upon the death, resignation or expulsion of a founding member, the founding member is entitled to receive a refund equal to a percentage of the amount of the membership contribution then charged by the club for an equity membership. It was noted that the prospect of a founding member receiving a refund for his equity interest in the club is conditioned upon the club approving another candidate for regular membership and the approved candidate paying the required capital contribution. Nonetheless, the IRS did not think that these two conditions are significant obstacles to a founder member’s ability to receive a refund. Accordingly, the IRS concluded that founding members have an opportunity to profit from their membership contributions.
Initiation Fees Received by a Tax-Exempt and Taxable Club
With respect to tax-exempt clubs, initiation fees paid to the club by members are not subject to income taxation.
Courts and the IRS have developed a two-prong test to assess whether a taxable club has received money or other property “in exchange for stock” for purposes of IRC § 1032(a): (1) whether the transferor received a significant proprietary or equity interest in the corporation, and (2) the transferor’s motive for transfer of the money or other property.
- Equity Interest: Where traditional stock is not present, apply the same substantive analysis to the membership interest received. In general, an equity interest implicates three basic rights: 1) the right to vote, and thereby to exercise control, 2) the right to participate in current earnings and accumulated surplus, and 3) the right to share in net assets on liquidation.
In the context of social clubs, the second right, that is the right to participate in current earnings and accumulated surplus, deserves additional consideration. Typically, under state law, a nonprofit corporation is not permitted to pay dividends to members. This prohibition prevents members from sharing in the club’s assets on an annual basis, but to the extent members share in the corporation’s assets on liquidation, their ultimate equity ownership in the club’s assets is unaffected. Consequently, this represents a neutral factor.
Other relevant factors:
- Payment must be made as an investment in the capital of the corporation, rather than in consideration of goods or services.
- Members pay significant annual dues to fund the corporation’s operating expenses.
- Investment Motive: Ltr Rul. 200411028 noted that no court has yet set forth a test for determining investment motive under IRC 1032(a); therefore, the test for investment motive developed in the context of contributions of capital contained in the preceding discussion of IRC § 118(a) is relevant.
Non-Recognition of Gain on Sale of Property
Tax-exempt clubs have a methodology for deferring the gain on sale of exempt property that is unavailable to taxable clubs. IRC § 512(a)(3)(D) provides, in part, that if property that was used directly in the performance of the exempt function of an IRC § 501(c)(7) club is sold by the club and, within a period beginning one year before the date of such sale and ending three years after the date of such sale, other property is purchased and used by the social club directly in the performance of the club’s exempt function, gain from such sale shall be recognized only to the extent that the club’s sales price of the old property exceeds the club’s cost of purchasing the other property.
So, with exempt purpose property, there is a methodology for deferring tax payments available to tax-exempt clubs. Tax-exempt clubs have sold exempt-use property (land, paintings, building) for millions of dollars and have deferred tax payment because of the availability of IRC § 512(a)(3)(D).
IRC Section 277
If the club lost its tax-exempt status, the club, if it continued operating, would fall within the ambit of IRC Section 277, which in short, does not permit a taxable club to offset losses from member generated operations against profits from nonmember business in computing its membership activities. This provision prevents a taxable, or a non-exempt club, from subsidizing its membership operations with nonmember income and is not generally viewed as a beneficial tax provision versus tax-exempt status.
- IRC Section 277(a) applies to transactions with members. As a result, deductions for a taxable year attributable to furnishing services to members in excess of member income earned during such taxable year are not permitted to offset income derived from transactions with nonmembers (nonmember income) during such taxable year. Instead, the excess deductions are permitted to reduce income derived from furnishing services to members in the next succeeding taxable year.
For example, if the taxable club had an overall loss of $<20,000>, which consisted of a $<50,000> loss on membership operations and a $30,000 net profit on nonmember income, the club would have to pay a tax on the $30,000 net profit on nonmember income.
Relinquishing Tax Exemption Potpourri
A club that is considering relinquishing its tax-exempt status should discuss the implications of the following with its legal counsel regarding, among other topics, the impact, if any, on the club with respect to the following:
- Civil Rights Act of 1964 – Generally speaking, the CRA shall not apply to a private club or other establishment not in fact open to the public.
- Americans with Disabilities Act – “Private membership clubs do not have to comply with ADA regulations exceptwhen they open their facilities to the general public.” (ADA National Network, Private Clubs under the Americans with Disabilities Act, 2018.)
- Club Liquor Licenses – “Club licenses are only issued to not-for-profit organizations. If you have a club license, you may only serve alcoholic beverages to members of your organization and to guests that accompany the member to the licensed premises.” (2019 NYS Liquor Authority Handbook for Retail Licensees.)
- State Public Accommodation Laws – Generally speaking, public accommodation laws prohibit businesses from refusing service, or providing discriminatory service, to customers and members of the public. Many states have exceptions from such law for distinctly private clubs. While the definition of distinctly private can vary by jurisdiction, generally speaking, whether a club is distinctly private turns on factors such as whether the club 1) carefully screen applicants, 2) limits the use of the facilities and services to members and bona fideguests of members, 3) is controlled by the membership, 4) is nonprofit and operated solely for the benefit and pleasure of the members, and 5) directs its publicity exclusively and only to members for their information and guidance.
The preceding information is provided only for your consideration, but information regarding the preceding must be discussed with legal counsel prior to any reliance thereon.
James J. Reilly, CPA, JD, is a partner at Condon O’Meara McGinty & Donnelly LLP. He can be reached at 212-661-7777 or [email protected].