MLB regularly receives questions regarding the activities of social clubs, such as golf clubs, beach clubs, etc. There is a long history with regard to the IRS and its position on the various issues faced by these organizations. Three specific areas that receive IRS attention and scrutiny are discussed below.
Social clubs are organized for pleasure, recreation and other non-profit purposes for the benefit of their members and are afforded tax-exempt status under the Internal Revenue Code section 501(c)(7). The tax-exempt status of social clubs is designed to allow individuals to join together to provide themselves with recreational or social facilities on a mutual basis, without tax consequences. This tax treatment has been justified on the theory that, to the extent the club is funded by the members, each individual member will be in the same position as if they had paid for the benefits directly. Three rules that social clubs must understand potentially subsidize club members, and therefore threaten a clubs exempt status if not properly understood or followed.
Why do these rules matter? It is important to know the requirements and limitations of the three rules. A failure to do so will likely result in the IRS revoking a social clubs exempt status. There are various situation involving the three rules that would threaten a club’s exempt status. In general:
1. No more than 35% of a club’s gross receipts can come from non-member sources, including investment income.
2. Of the 35%, no more than 15% can come from non-members.
3. Gross receipts from non-traditional activities (from members or not) of more than 5% put the club’s exempt status at risk. Amounts below 5%, but increasing over a couple of years, may also put exempt status in jeopardy.
4. Not maintaining membership records and records of activities will result in revocation of exempt status and taxation of all revenue.
The rules are as follows:
1. Unrelated business taxable income rule
Social clubs have special rules regarding what is considered unrelated business income. Contrary to other exempt organizations, passive income of social clubs (dividends, interest, rent, etc.) is taxable, as is non-member income. IRC 512 defines UBTI for social clubs as “gross income (excluding exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income…”
IRC 512 further defines exempt function income as “gross income from dues, fees, charges, or similar amounts paid by members of the organization as consideration for providing such members or their dependents or guests goods, facilities, or services…”
To simplify all these technical definitions – social clubs income is all taxable, except for income received from members pursuant to exempt purposes. Gross receipts from UBTI cannot exceed 35% of the clubs gross receipts.
2. Traditional vs. non-traditional activities rule
Traditional activities of a social club may be conducted with members and non-members. An activity is considered traditional if it were engaged in with members, it would further the exempt-purpose of the club. Income from traditional activities conducted with members is not taxable. Income from traditional activities from non-members is taxable.
Some examples of traditional activities would be the operation of a golf course or the operation of a bar or restaurant that is used by club members, their guests, or non-members.
Non-traditional activities are defined by the IRS as an activity which, if conducted on a membership basis, would not further the club’s exempt purposes. An example of non-traditional business activity includes the sale of liquor or food to members for consumption off the club’s premises. This activity was considered “neither related to nor in furtherance of the social club’s exempt purposes.” Income derived from non-traditional activities is taxable, whether from members or not.
Anything other than an insubstantial amount of non-traditional activity is likely to result in revocation of exempt status, whether provided to members or not. There is no safe harbor, but the IRS and tax court has generally looked at amounts under 5% to be insubstantial.
3. Record keeping requirements (rule)
IRS regulations provide that every exempt organization must keep such permanent books of account or records as are sufficient to show specifically the items of gross income, receipts and disbursements. This burden falls to the social club to maintain adequate records to demonstrate member vs. non-member use. Failure to do so likely would result in a determination from the IRS that all receipts are from non-members, therefore subjecting income to taxation and putting the organizations exempt status at risk. This treatment was most recently applied in a private letter ruling issued by the IRS in 2006 (plr 200624069).
All social clubs should review IRS Rev. Proc. 71-17 concerning assumptions about non-member use. The Rev. Proc. outlines the record keeping requirements and it provides a set of assumptions that would allow non-member use to be classified as income from “guests” and treated as if from members.
These three areas will continue to be an area of IRS scrutiny. Please contact Rich Bienvenue at (508) 255-2240, or at rich@mlbcpa.net if you have any questions or if MLB can help your organization.