As we know, truly private clubs can be exempt from federal income tax on their proceeds. Indeed, most clubs take advantage of this benefit offered by the federal government. Under Section 501(c)(7) of the Internal Revenue Code, a club organized for pleasure, recreation or other non-business purpose is exempt from paying federal taxes on its income generated from membership dues and other operating levies.
As clubs adapt to a changing marketplace, update their programs, and look for services that better meet member needs, they must work diligently to ensure they do not call into question their tax-exempt status. The Internal Revenue Service (IRS) does allow a tax-exempt club to earn some minimal income that is not related to member dues and charges (member income). Most in the industry know this as the “15/35% Rule.” For a private club to maintain its tax-exempt status, it must never break this rule.
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, which are defined as income from normal or usual activities of the club, including membership fees, admissions, dues, special member assessments, and investment income. Capital contributions and initiation fees are not included. Additionally, the IRS limits the total income a tax-exempt club can receive from nonmembers to no more than 15 percent of the club’s gross receipts. This poses the greatest challenge to clubs that wish to supplement their income, for example, by renting out facilities for weddings or through participation in reciprocal arrangements.
On occasion, we encounter a cautionary tale that can provide real-life examples of what can go wrong if a club fails to meet the 15/35% Rule. Unfortunately, there have been more of these cautionary tales emerging in the recent months, so we thought it useful to pass on one such story in the hopes that it will help you keep your club’s eye on the ball.
Recently, a private club lost its 501(c)(7) tax-exempt status. In its private letter ruling, the IRS described the clubs infractions in detail as well as its failure to comply with the 15/35% rule. In its review, the IRS found, among other things, the following problems:
- The club had a “public welcome” sign along the highway and in front of the clubhouse;
- It advertised that that pro shop and restaurant were open to the public;
- The club advertised that the clubhouse was open for group and private party reservations;
- The club sold liquor off club premise (e.g. at a holiday festival); and
- There were no logbooks recording member and nonmember use of the clubhouse, restaurant, pro shop or golf course, and the examining agent found the club had not maintained member/nonmember participation records for more than 20 years.
For many club leaders, the problems mentioned above are issues they would never let arise at their club. However, let’s look more closely at one of the problems encountered by the offending club: the failure to maintain accurate records.
If a club doesn’t record who uses its facilities, how will it know what percentage of revenue nonmembers are generating? More often than not, private clubs do not require their club members to adequately disclose who is a part of a large group and who is paying. However, by not doing this, the club could very well find itself unable to substantiate whether it is within the 15/35% Rule.
Remember, the tax code states that all club revenue is taxable unless documentation exists to prove it comes from members. Therefore, a club must maintain adequate records to prove what is taxable (nonmember income) and what is not taxable (member income). The IRS does provide us some basic assumptions:
- If a group of eight or fewer individuals uses the club’s facilities, the IRS will assume that the proceeds derived from the group is member income if payment for the activities came directly from a member. If audited, it will still be helpful to have records showing the club received payment from a member.
- If a group has more than eight individuals with at least 75 percent of them being members, the IRS will assume that the revenue generated is member income as long as payment came from a member or the member’s employer. Again, having a record of this will simplify the audit process should the IRS show up.
- However, if a group has more than eight individuals and the 75-percent member test is not met, then the IRS will only see this as member income if you have a record showing a member paid for the event and was not reimbursed. If he was reimbursed by an employer, the IRS will deem it member income only if the use of the club was for some personal, social or direct business purpose of the member. If he was reimbursed by someone else, it will be nonmember income.
While asking for this information may make you uncomfortable because it is annoying or aggravating to your members, the fact is it will be more annoying and aggravating to them if the club loses its tax-exempt status—especially when that first tax bill comes due.
When asking for the information, a club’s “member use” record should seek the following information:
- Date of the event
- Total number in party
- Number of nonmembers in party
- Total charges
- Charges attributable to nonmembers
- The charges paid by nonmembers
- Where a member pays all or part of the charges attributable to nonmembers, a statement signed by the member indicating whether he has been or will be reimbursed for such nonmember use and, if so, the amount of the reimbursement
- Where the member’s employer reimburses the member or makes direct payment to the club for the charges attributable to nonmembers, a statement signed by the member indicating the name of his employer; the amount of the payment attributable to the nonmember use; the nonmember’s name and business or other relationship to the member; and the business, personal, or social purpose of the member served by the nonmember use
- Where a nonmember, other than the employer of the member, makes payment to the club or reimburses a member and a claim is made that the amount was paid gratuitously for the benefit of a member, a statement signed by the member indicating the donor’s name and relationship to the member, and containing information to substantiate the gratuitous nature of the payment or reimbursement
At NCA, we hate to see a private club’s tax-exempt status in danger. By making sure that you keep accurate records of who uses the club, you will ensure that your tax-exempt status is not jeopardized and that your club is not the subject of the next cautionary tale we tell!
As always, we are available to help you navigate the rules and regulations in this area. NCA offers a comprehensive publication, Private and Tax-Exempt Status. This guide provides an overview of both concepts to assist leaders in making informed decisions regarding operations and planning, including: a comprehensive checklist for evaluating club policies and activities, requirements for tax exempt status, member and nonmember income tracking forms, and outlines of landmark cases.