Determination 200850035: a historic club lost its exemption over rentals it never tracked, in a package whose own cover letter names the wrong subsection

Plain-English summary

A social club that had been exempt since January of a redacted year in the 1900s lost that exemption because it rented out its own ballroom and kept no records of who was in the room. The cover letter is short: "This is a Final Adverse Determination as to your exempt status under section 501(c)(7) of the Internal Revenue Code." It comes from "One Cleveland Center-Suite 815" at "1375 East Ninth Street", "Cleveland, OH 44114-1739", dated September 18, 2008 and released 12/12/08.

The stated grounds are two. First, "Your organization fails to meet the requirements for exemption under IRC section 501(c)(7)." as that section reads after the Tax Reform Act of 1969, which exempts clubs organized for pleasure and recreation "substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder." Second, the safe harbour was blown: "Public Law 94-568 states that it is intended that social clubs should be permitted to receive up to 35 percent of their gross receipts, including investment income, from sources outside of their membership without losing their exempt status." with a sub-limit that "not more than 15 percent of the gross receipts should be derived from the use of a social club’s facilities or services by the general public." On audit "it was determined that your organization has exceeded the safe harbor limitations on non-member income as outlined in Public Law 94-568." and separately "the extent of nonmember use of your facility established a nonexempt purpose."

The club must now file as a taxable corporation. "You are required to file converted Forms 1120, U.S. Corporation Income Tax Return, for any years which are still open under the statute of limitations", sent first to "Internal Revenue Service TEGE: EO: 1100 Commerce St. MC 4920 DAL: Mandatory Review, Dallas, TX 75242-1027." and later to the "Cincinnati Service Center, Cincinnati, OH, 45999-0012."

The examination report attached behind the letter is the interesting part, because it describes a building. The club "was established in 18XX as a society to provide aid and benefit to *** immigrants in the ***. area." and "In January, 19XX, the club obtained exemption from taxation as an organization described in IRC section 501(c)(7)." The premises are "a Greek revival structure with a colonnaded portico and a domed rotunda serving as an entry." Upstairs, "Spiral staircases lead to the second floor that is almost entirely occupied by a large ballroom with a stage and theatrical curtains. The space is lighted with eight to ten large gilded chandeliers." The club year runs on "the annual meeting held on St. Patrick’s Day in March, parties at New Years, Christmas, and Easter, and the President’s ball."

Membership was scarce and the waiting list was long. "The membership of the organization has been capped at maximum of 500 members with annual dues of $*** per member." and "A waiting list of membership applicants is kept and the current estimate of time to become a member is 15 years." Those waiting pay an annual fee and "are invited to participate in a limited way in some of theclub’s activities." By the time of the audit "the membership has recently been increased from 500 members to 600 members."

That elegant ballroom is what destroyed the exemption. Because upkeep of the building was expensive, "the club regularly rents the facility to private groups." Rentals to outsiders were reported as unrelated business income. "However, rentals to members of the club for their private functions have not been reported as unrelated business income." And on the very first visit, "it was learned that no records have been kept as required by Revenue Procedure 71-17 with respect to the rental of the facility to members in these instances." The club conceded the consequence up front: "In fact, it was agreed that if the records had been kept, the conditions for the presumption of these member rental functions to be considered exempt membership activities, would not have been met."

The record-keeping rule is what converts that concession into a revocation. "Revenue procedure 71-17 requires section 501(c)(7) organizations to substantiate the status of individuals that use the organization’s facility as either member or non member." For a small party the club gets the benefit of the doubt: "For groups of eight people or less, the presumption is that the non members in that party are guests of the member provided the member or the member’s employer pays for such use of the facility." For a larger party it must prove it: "For groups larger than eight persons, the organization can substantiate the status of the non members as guests if records are kept that show that 75% or more of the persons in such a group are members" and that a member paid. Fail to keep the records and the default is total: "However, if the club fails to maintain these records and can not show that the conditions set forth above have been met, all such income derived by the club is assumed to be non member income". The club's own facts put every member rental on the wrong side of both tests, since "the club has confirmed that these rentals invariably involved groups in excess of 8 individuals and that rarely if ever, did any of these groups consist of 75% or more member participation." The report repeats the point later in blunter words, that the member rentals were "invariably attended by groups of more that 8 people and that rarely, if ever did these groups consist of 75% members."

So the member rentals were reclassified as public income, and the ceiling fell. "Gross receipts from the general public (non members) has been established to consist of all of the rental income received from non members and from members due to the failure to maintain records", and "Because Public Law 94-568, limits such income to 15% of the “total gross receipts” of the club, the standard has been exceeded by a factor of more than two times the permitted percentage." The usage test failed too, since "the club facilities have been used substantially (***% of the total usage in the year ended February 20XX) for the benefit of non members."

The club's two defences are quoted and both are rejected on the facts. "The club maintains that the rental income “is not more than trivial” when compared with the fair market value of the club’s facilities." The answer is that triviality is measured against club receipts, not against real estate: "Gross receipts that exceed 35% of the club’s income from normal or usual member sources is not trivial." The club also argued the rentals were "unusual income because of the unforeseen and entirely unpredictable changes that are unique to its situation". The examiner answers that with a calendar. "The club has provided the agent with a calendar of rental events scheduled for the calendar year" as Exhibit 1, and on inspection "these events have been scheduled nearly every week of the year with some periods showing nearly daily engagements." He adds the principle behind it: "a club that has the good fortune to be the beneficiary of appreciation of the fair market value of its facility is not entitled to a tax subsidy by the disallowance of such income as “unusual”."

The clinching arithmetic is the amended returns. The club had reported net income on its 990-T filings after deducting only the extra costs the rentals caused. "Subsequently, the club amended the returns to include a pro rata portion of the fixed overhead expenses attributable to the space used for rental purposes." and once the fixed overhead was allocated the reported profits became losses. That is the finding, since the outside money was therefore paying the club's standing costs, and those contributions "amount to a subsidy of the social and recreational activities of the organization by members of the general public."

The club's own lawyer disagreed, and the report says so and attaches the memo: "The club’s representative has indicated that the club’s legal council has advised the club that the “excess rents are not fatal to the tax exempt status of the ***”." with "At Exhibit 2 is a copy of the memorandum the club has received from its legal council". Council for counsel is printed twice and left as released. The conclusion is that "The club no longer qualifies as an exempt organization under the provisions of section 501(a) as an organization described in section 501(c)(7)." and "Therefore, your exempt status should be revoked effective March 1, 20XX."

Then a sentence that should stop any reader relying on this document. The report ends: "Please note that this is not a final report. This report is subject to review by our Mandatory Review staff that may modify it as a result of their review." The released package therefore pairs a final Appeals determination at the front with a report that says on its face it is not final. That combination occurs elsewhere in this corpus and it means the reasoning shown is the examiner's, not necessarily the reasoning that survived review.

The package also carries two bound-in proposal letters, both signed "Marsha A. Ramirez" as "Director, EO Examinations", and the first of them names the wrong subsection. It says "We have enclosed a copy of our report of examination explaining why we believe revocation of your exempt status under section 501(c)(3) of the Internal Revenue Code (Code) is necessary." This is a 501(c)(7) social club, and that is the only place in the document where 501(c)(3) appears. It is listed in code_sections because it is genuinely printed, not because it is correct. The second letter, a Letter 3610 from "TE/GE: EO Examinations" at "1100 Commerce Street" in Dallas, describes a mere "adjustment of your organization's exempt status" and offers "If you accept our findings, please sign and return the enclosed Form 6018, Consent to Proposed Adverse Action." with returns due to "the Ogden Service Center within 60 days from the date of this letter". The Letter 3618 form number appears twice and the Letter 3610 form number three times.

Now the index. The row for 0850035 gives UILC 501.03-00 and the subject Religious, Charitable, etc., Institutions and Community Chest. The document prints "UIC: 501.07-05", which is the social club code, and every line of it concerns business done with nonmembers. The charitable row belongs to the neighbouring file docs/2008/0850036.md, which is a charitable-exemption denial and which carries this document's social club code in its own frontmatter. The two index rows are transposed. This corpus takes frontmatter uilc and subject from the index row without exception, so both files carry each other's classification, and the conflict is recorded in both rather than silently repaired.

Two OCR corrections were made and both are disclosed. The revocation sentence itself was printed as "we are revoking your organization's exemption from Federal income tax under section 501(c)(7) of the Internal Revenue Co“e", with an opening curly quote standing in for the d of Code, and that was corrected once. The first proposal letter opened "lf you accept our findings, take no further action. We will issue a final revocation letter." with a lowercase l for the capital I, and that was corrected once. Nothing else was altered.

Everything else is flagged and left standing, and there is a great deal of it. The statute reference is wrong twice: the regulation discussion prints "( “exclusively” is the standard exercised prior to the 1976 enactment of P.L. 58-568)" and then "Following the enactment of P.L. 58-568 in 1976, the term “exclusively” should be replaced with the terms “substantially", where 94-568 is meant. The same document prints Public Law 94-568 correctly four times and P.L. 94-568 correctly once, so the reader can resolve it from the document itself, and this corpus reproduces the defective form rather than repairing a citation. The revenue procedure is capitalised inconsistently, printed as Revenue Procedure 71-17 three times and Revenue procedure 71-17 three times, splitting neatly between the law section and the government's position section. The catalog number of the second proposal letter prints three ways in three places, as "Catalog Number 34801 V", as "Catilog Number 34801 V", and as "Catalog Number 34801V". The Form 886-A masthead band is garbled at every page break, appearing nine times in seven distinct spellings, from "Form 886- Avrev.468)" through "Form 886-Avrev.+68)", "Form 886- Acrev.4-68)", "Form 886-Acrev.+68)", "Form 886- A;rev.468)", "Form 886- Acrev.+68)" and "Form 886- Acrev.468)". Ordinary words are damaged too: "They were orginally granted exemption from federal income tax in the Revenue Act of 1916.", "the entertainment of the non members as bona fide quests of members is not unrelated business income.", "determines that the-organization involved has exhausted its administrative remedies within the Internal Revenue Service.", and the missing space in "theclub’s activities." The header of the first page prints "REKEKK In Re:" over "ewe EO Examination", and the Dallas letterhead of the second proposal letter dissolves into "Utes (Seat Tu STs, Dallas, TX 75242".

The redaction engine also damages the tables and tax years in this document. Every dollar column is blanked into garble, so the tables of receipts survive only as rows of stray characters, and the tax years print as 20XX except in one table where a space intrudes and they print as 20 XX three times. One estimate line survived as "Rentals in (estimate of usual) A" with a bare letter where a number belonged. Most telling, the sentence that introduces the revised usage figures reads "Subsequently, however, G revised his estimates with respect to the use of the facilities.", where a bare G stands in a document whose redaction tokens are otherwise three asterisks. A letter escaped where a token should have been, while other redacted portions are also garbled.

The signature raises a question this corpus will not answer by guessing. The letter is signed "Douglas H. Schulman" above "Commissioner", then By, then "Charles F. Fisher —" as "Appeals Team Manager". The corpus spells the Commissioner's surname the other way far more often, and both spellings already exist in it, with the Schulman form in docs/2009/0909072.md and the Shulman form in docs/2008/0850059.md. Because the spelling used here is not unique in the corpus, it is treated as printed rather than as a scanner error, and is reproduced exactly as released. The dash after the Appeals Team Manager's name is the scan catching the edge of a signature.

The document cites Public Law 94-568, Revenue Procedure 71-17, and regulations under section 501(c)(7). The P.L. number, the revenue procedure, and the regulation each appear more than once. The defective P.L. 58-568 form is reproduced as released rather than silently fixed.

Ruling snapshot

• Question: Does a social club keep its section 501(c)(7) exemption when it rents its historic ballroom to the public and to members' private parties, and kept none of the records Revenue Procedure 71-17 requires to show who actually used it?
• Outcome: Revoked, effective March 1 of a redacted year. Without the records the member rentals are presumed nonmember income, which put the club at more than twice the 15 percent ceiling, and the extent of nonmember use established a nonexempt purpose in its own right.
• Key authorities: IRC sections 501(a), 501(c)(7), 512(a)(3) and 512(a)(3)(A); Regulations section 1.501(c)(7)-1(b); Revenue Procedure 71-17; Public Law 94-568 and the Tax Reform Act of 1969; and sections 6104(c) and 7428(b)(2) in the enclosed proposal letters.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Appeals Office
One Cleveland Center-Suite 815 Person to Contact:
1375 East Ninth Street
Cleveland, OH 44114-1739 Employee ID Number:
Release Number: 200850035 Tel:
Release Date: 12/12/08 Fax:
Date: September 18, 2008 Refer Reply to:
AP:FE:
REKEKK In Re:
ewe EO Examination
. Tax Period(s) Ended:
EIN:
UIC: 501.07-05

CERTIFIED MAIL

Dear

This is a Final Adverse Determination as to your exempt status under section
501(c)(7) of the Internal Revenue Code.

Our adverse determination was made for the following reasons:

Your organization fails to meet the requirements for exemption under IRC
section 501(c)(7). IRC section 501(c)(7), as amended by the Tax Reform Act
of 1969 provides for the exemption of clubs organized and operated for
pleasure, recreation, and other non-profitable purposes, substantially all of
the activities of which are for such purposes and no part of the net earnings
of which inures to the benefit of any private shareholder.

Public Law 94-568 states that it is intended that social clubs should be
permitted to receive up to 35 percent of their gross receipts, including
investment income, from sources outside of their membership without losing
their exempt status. It is also intended that within this 35 percent amount
not more than 15 percent of the gross receipts should be derived from the
use of a social club’s facilities or services by the general public.

As a result of a recent audit of your organization's activities and Forms 990,
it was determined that your organization has exceeded the safe harbor
limitations on non-member income as outlined in Public Law 94-568.

Further, an analysis of all facts and circumstances surrounding your
organization’s operations revealed that the extent of nonmember use of your
facility established a nonexempt purpose.

Based on the above, we are revoking your organization's exemption from
Federal income tax under section 501(c)(7) of the Internal Revenue Code
effective

You are required to file converted Forms 1120, U.S. Corporation Income Tax
Return, for any years which are still open under the statute of limitations
beginning with the year ending a and ending with the year
ending . You should file any returns due for these years
with the Internal Revenue Service TEGE: EO: 1100 Commerce St. MC 4920
DAL: Mandatory Review, Dallas, TX 75242-1027. Forms 1120 for tax
periods beginning on and after ' ~ should be filed with the
Cincinnati Service Center, Cincinnati, OH, 45999-0012.

You have the right to contact the office of the Taxpayer Advocate. However,
you should first contact the person whose name and telephone number are
shown above since this person can access your tax information and can help
you get answers. You can call 1-877-777-4778 and ask for Taxpayer
Advocate assistance. Or you can call the Taxpayer Advocate for the IRS
office that issued this letter. See the enclosed Notice 1214, Helpful Contacts
for Your “Notice of Deficiency” for Taxpayer Advocate telephone numbers

and addresses.

Taxpayer Advocate assistance cannot be used as a substitute for established
IRS procedures, formal appeals processes, etc. The Taxpayer Advocate is
not able to reverse legal or technically correct tax determinations, nor
extend the time fixed by law that you have to file a petition in the United
States Tax Court. The Taxpayer Advocate can, however, see that a tax
matter that may not have been resolved through normal channels, gets

prompt and proper handling.

If you have any questions, please contact the person whose name and
telephone number are shown in the heading of this letter.

Sincerely yours,
Douglas H. Schulman

Commissioner
By

Charles F. Fisher —
Appeals Team Manager

Enclosure: .
Notice 1214 Helpful Contacts for your “Notice of Deficiency”

Issue:

This is to consider if the club continues to qualify for exemption under the provisions of IRC
section 501(a) as an organization described in IRC section 501(c)(7).

Facts:

The *** (the club) is an organization exempt from income tax under the provisions of IRC
section 501(a) as described in section 501(c)(7). The club was established in 18XX as a society
to provide aid and benefit to *** immigrants in the ***. area. In 18XX the club completed
construction of its current facility at ***. In January, 19XX, the club obtained exemption from
taxation as an organization described in IRC section 501(c)(7).

*#** is a Greek revival structure with a colonnaded portico and a domed rotunda serving as an
entry. The first floor of the building is dominated by a large meeting room and adjacent
conference rooms. At the rear of the first floor is a bar and space for relaxation and conversation.
The bar area, storage rooms and an office adjacent to the rotunda are used exclusively for exempt

purposes.

Spiral staircases lead to the second floor that is almost entirely occupied by a large ballroom with
a stage and theatrical curtains. The space is lighted with eight to ten large gilded chandeliers.

The club meets monthly at its facility on ***. in a large meeting room on the first floor of the
facility. The management committee also meets monthly in a conference room located on the
first floor. Other events include the annual meeting held on St. Patrick’s Day in March, parties at
New Years, Christmas, and Easter, and the President’s ball.

The membership of the organization has been capped at maximum of 500 members with annual
dues of $*** per member. A waiting list of membership applicants is kept and the current
estimate of time to become a member is 15 years. Those on the waiting list pay

$*** annually to remain on the list and are invited to participate in a limited way in some of
theclub’s activities. ***, the club’s representative and CPA has told the agent that the
membership has recently been increased from 500 members to 600 members.

Because the restoration and maintenance of the club’s large and historically significant facility is
increasingly expensive, the club has sought other sources of income to defray these costs. The
elegant grandeur of the building with its large ballroom on the second floor, lends itself to serve
as host to wedding receptions and other social functions. Because of the general public’s interest
in the facility for such functions, the club regularly rents the facility to private groups. Rentals to
individuals or groups not associated with the club are reported on form 990-T as unrelated
business income. However, rentals to members of the club for their private functions have not
been reported as unrelated business income.

Form 886- Avrev.468) Department of the Treasury - Internal Revenue Service
Page: -1-

In the agent’s initial discussion with the president and the organization’s representative, it was
learned that no records have been kept as required by Revenue Procedure 71-17 with respect to
the rental of the facility to members in these instances. In fact, it was agreed that if the records
had been kept, the conditions for the presumption of these member rental functions to be
considered exempt membership activities, would not have been met.

I. Use of the Facility

Most of the building is used primarily for the rental to groups from the general public and to
members for their own private functions. In an effort to establish a reasonable basis for the
allocation of expenses for the unrelated business income derived from the rental of the facilities,
the agent sought to define the parts of the facility that are used for exempt purposes and those
that are generally subject to rental for private functions.

The club’s representative, ***, explained that the bar at the back of the first floor, storage space,
and an office adjacent to the rotunda are used exclusively for exempt social and recreational
activities of members, and administration of the club. Of the *** square feet of space in the club
facility, *** square feet is dedicated to the bar and *** square feet are occupied by the various
storage and office spaces. The remaining *** square feet are generally rented for private
functions, but parts of this space are occasionally used for exempt club functions. *** described
the nature of those functions and the estimated usage in terms of time as summarized below.

Annual meeting (St Patrick’s Day) *** hours
Monthly meetings *** hours
News Years party *** hours
Christmas party *** hours
Easter party *** hours
Presidents Ball *** hours
Total exempt purpose activities (Of space generally used for rent) *** hours

At the same time, *** estimated the use of these rental areas for uses not related to the exempt
functions of the club to be as summarized below.

Average use per rental *** hours
Rentals in (estimate of usual) A
Total hours used for rental *** hours

*** estimated that the bar and other areas used exclusively for exempt purpose activities were
used approximately *** hours per week, *** weeks per year, or *** hours annually.

Form 886-Avrev.+68) Department of the Treasury - Internal Revenue Service
Page: -2-

Based on these estimates, the facility was used a total of *** hours for all of the various uses
described above. The uses of the facilities unrelated to the exempt purposes of the club
represent ***% of the total use of the facilities.

Subsequently, however, G revised his estimates with respect to the use of the facilities.
These revised estimates are summarized below.

Year Ended February

20XX 20XX
Spaces used exclusively for club activities (the bar, etc.) *** hrs *#** hrs
Rental areas used for club functions eK hrs #** brs
Rental areas used for private functions *** hrs *** hrs
Total hours of use of the facility #4 hrs #** hys

Based on these revised estimates of the usage of the facility, the club has utilized the facility ***
% of the time and ***% of the time in 20XX and 20XX respectively for unrelated business
purposes.

Il. Total Gross Receipts compared with Gross Receipts from the General Public:

The club has received substantial income from the rental of its facilities to the general public and
to members that have used the facility for their private functions. With respect to the rentals to
members, the club has confirmed that these rentals invariably involved groups in excess of 8
individuals and that rarely if ever, did any of these groups consist of 75% or more member
participation. Gross receipts from the rental of the facilities for these private purposes are
detailed below.

Year Ended February

20XX 20XX
Rentals to non members g #*K ¢ #ex
Rentals to members for private functions § ga
Total receipts from unrelated activities: gree g KKK

The gross receipts received by the club during this period included the following:

Year Ended February
20XX 20XX

Form 886- Acrev.4-68) Department of the Treasury - Internal Revenue Service
Page: -3-

Receipts from admissions, membership fees, dues, assessments,

exempt activities, etc. G RK g
Initiation fees & capital contributions gee ge
Rents Gee ¢ ee
Interest and Dividends gee $  #KK
Non-Recurring Unusual Sales $ kK g  #K
Law:

IRC Section 501(a) exempts from income tax organizations described in subsections (c) and (d).

IRC Section 501(c)(7) describes “clubs organized for pleasure, recreation, and other
nonprofitable purposes, substantially all of the activities of which are for such purposes and no
part of the net earnings of which inures to the benefit of any private shareholder” from taxation.

Reg. 1.501(c)(7)-1(b) provides in part, that a club which engages in business, such as by making
its social and recreational facilities available to the general public or by selling real estate, timber,
or other products is not organized and operated exclusively ( “exclusively” is the standard
exercised prior to the 1976 enactment of P.L. 58-568) for pleasure, recreation, and other
nonprofitable purposes, and is not exempt under IRC Section 501(a). Following the enactment
of P.L. 58-568 in 1976, the term “exclusively” should be replaced with the terms “substantially

all’’.

IRC Section 512(a)(3)(A) stipulates that all income derived by an organization exempt under the
provisions of 501(c)(7) is taxable income except for the income derived from members for dues,
assessments, or participation by members and their bona fide guests for activities traditionally
considered to be exempt purpose activities of a social or recreational club.

Revenue Procedure 71-17 provides the record keeping requirements for social clubs to
substantiate the member and non member character of the income derived by the organization for
products or services provided.

Public Law 94-568 amends Revenue Procedure 71-17 to allow organizations exempt from
income tax to have up to 15% of their gross income from non member sources and an additional
20% from investment income without jeopardizing the organization’s exempt status. It also
amends the language of IRC Section 501(c)(7) from “operated exclusively for pleasure,
recreation, and other nonprofitable purposes” to “substantially all of the activities” are for such

purposes.

Government’s Position:

Social clubs are exempt from federal income tax under IRC Section 501(a) as organizations
described in IRC Section 501(c)(7) if they are ‘‘organized for pleasure, recreation, and other

Form 886-Acrev.+68) Department of the Treasury - Internal Revenue Service
Page: -4-

nonprofit purposes.” They were orginally granted exemption from federal income tax in the
Revenue Act of 1916.

The central purpose of social clubs is to provide benefits to members, including access to social
and recreational facilities such as clubhouses, golf courses, and swimming pools. When such
benefits are funded by members, exemption has been justified by Congress on the theory that the
member will be in the same position as if they had paid for the benefits directly. The practical
effect of the exemption is to allow individuals to join together to provide themselves with
recreational or social opportunities on a mutual basis without further tax consequences. The
individual member is in substantially the same position as if he or she had spent his or her after-
tax income on pleasure or recreation without the intervening organization.

A social club’s exemption does not operate properly when it receives income from sources
outside its membership, because the members will receive a benefit not contemplated by the
statute in that untaxed dollars are used by the organization to provide pleasure or recreation to its
membership. To prevent club members from receiving benefits not contemplated by IRC Section
501(c)(7), the receipt of nonmember income and investment income is permitted up to certain
limits without jeopardizing exemption, but the net income from these sources is made taxable to

the clubs by IRC Section 512(a)(3).

Enactment of IRC Section 512(a)(3) in 1969 created an almost unique status for social club in
that they alone among exempt organizations are taxed on dividends, rents and interest.

Revenue procedure 71-17 governs the record keeping, and substantiation requirements with
respect to use of the facilities of a section 501(c)(7) social club. In addition, a minimum gross
receipts standard, and the rules for assumption as to status of non-members are promulgated.

Revenue procedure 71-17 requires section 501(c)(7) organizations to substantiate the status of
individuals that use the organization’s facility as either member or non member. For groups of
eight people or less, the presumption is that the non members in that party are guests of the
member provided the member or the member’s employer pays for such use of the facility. For
groups larger than eight persons, the organization can substantiate the status of the non members
as guests if records are kept that show that 75% or more of the persons in such a group are
members and that a member or the member’s employer pays for such use of the facility. In either
of these circumstances described above, the activities involving these individuals is considered to
be an exempt social function carried on by the club and the income derived by the club for the
entertainment of the non members as bona fide quests of members is not unrelated business
income. However, if the club fails to maintain these records and can not show that the conditions
set forth above have been met, all such income derived by the club is assumed to be non member
income, the income is subject to taxation as unrelated business income and is not considered
exempt function income.

Exempt organizations described in 501(c)(7), prior to the enactment of P.L. 94-568, were
required to operate exclusively for pleasure, recreation , or other non profitable purposes.
Revenue procedure 71-17 established guidelines to be used to determine when gross receipts

Form 886- A;rev.468) Department of the Treasury - Internal Revenue Service
Page: -5-

from the general public have violated the exclusivity standard set forth for 501(c)(7)
organizations. Initially the revenue procedure indicated that non member gross receipts of

$ 2500 or less would not violate the standard. If non member gross receipts exceed $ 2500, the
non member gross receipts can not exceed 5% of the total gross receipts of the organization.
“Total gross receipts” of the organization is defined as normal and usual activities of the club
including charges, admissions, membership fees, dues, and assessments. Excluded for this
purpose are initiation fees and capital contributions.

In 1976 Congress amended IRC Section 501(c)(7) to liberalize prior limitations on the portion of
income social clubs could receive from non member use of their facilities and from investment
income without jeopardizing their exempt status. The legislation changed the statutory test for
exemption from an exclusivity test (‘‘...operated exclusively for....””) to a substantiality test
(“‘...substantially all the activities of which are for ...”)

The Senate and House Committee reports show that this wording change was intended to make
clear that social clubs may receive outside income, without losing their exempt status. However,
the Committee reports also specified clearly defined limits on this outside income, which if
exceeded then invoke the applications of a facts and circumstances test. Because social clubs
have historically been granted exemption largely for the convenience of the government as
contrasted with justification of other exempt organizations that provide some form of community
benefit or public service, the courts have recognized that the exemption of social clubs should be
strictly construed. Thus, only a limited number of facts and/or circumstances would warrant
continued exempt status where the percentage guidelines are exceeded. Among those
considerations are the actual percentage of non member receipts, the frequency of use of the club,
and the generation of profits when only direct marginal expenses are considered.

Activities of social clubs are classified as “traditional or nontraditional”. Traditional activities
may be conducted with members or non members, but are those types of activities that if engaged
in with members further the exempt (i.e. social or recreational) purposes of the social club.
Making the club’s facility available to the general public on a rental basis for social purposes is
an example of a traditional activity which is carried on by non members. A nontraditional
activity is considered to be a business in which, if conducted on a membership basis, would not
further the club’s social or recreational exempt purpose. The exempt status of social clubs that
engage in nontraditional business activities will be precluded unless such activities are
insubstantial, trivial, and nonrecurrent.

The club has acknowledged that it has failed to keep records with respect to the member or non
member status of the individuals that used the facility for private functions. The organization has
separately accounted for this rental income as those that were paid by nonmembers and those that
were paid by members. The club has also acknowledged that the “member rentals” were
invariably attended by groups of more that 8 people and that rarely, if ever did these groups
consist of 75% members. Accordingly, if records had been kept, the audit presumption would
not have been established and all of these activities would be required to be treated as non
member unrelated business income.

Form 886- Acrev.+68) Department of the Treasury - Internal Revenue Service
Page: -6-


With respect to the “total gross receipts” of the organization for the purpose of establishing the
minimum gross receipts standard, the following information is extracted from the books and
records of the club.

2/28/XX 2/28/XX
Total Income per Form 990 (As Amended) G ##* g **
Less:
Initiation fees & capital contributions (***) (#**)
Non-Recurring Unusual Sales (##*)
Total Gross Receipts for the years ended 2/28/XX & 2/28/KX $ *** § *¥**

Gross receipts from the general public (non members) has been established to consist of all of the
rental income received from non members and from members due to the failure to maintain
records or substantiate the status of the participants of these private functions. Such nonmember
income amounted to ***% ($***/$***) and ***% ($***/$***) of the “total gross receipts” of
the organization in the years ended February 28, 20XX and 20XX respectively. Because Public
Law 94-568, limits such income to 15% of the “total gross receipts” of the club, the standard has
been exceeded by a factor of more than two times the permitted percentage. It has also been
established that based on the estimates of the organization, the club facilities have been used
substantially (***% of the total usage in the year ended February 20XX) for the benefit of non
members. Such a substantial use by non members provides additional evidence of the use of the
club’s facility which is inconsistent with the use contemplated of a social club exempt from
income tax.

The club maintains that the rental income “is not more than trivial” when compared with the fair
market value of the club’s facilities. They also suggest that the rental income should be
considered to be “unusual income because of the unforeseen and entirely unpredictable changes
that are unique to its situation”. (i.e. the increase in the fair market value of the facilities and the
popularity of its use for private functions)

These lines of reasoning are not consistent with the history or the intent of the legislation.
Income derived from non member sources is compared with the gross receipts from the normal
or usual activities of social clubs of similar types. (i.e. those activities that such clubs have
traditionally conducted) Gross receipts that exceed 35% of the club’s income from normal or
usual member sources is not trivial. In fact, the evidence shows that the club has depended on
this income to subsidize the maintenance and upkeep of the facility without resorting to
substantial increases in membership dues, assessments or other such contributions by the
membership. Additionally, a club that has the good fortune to be the beneficiary of appreciation
of the fair market value of its facility is not entitled to a tax subsidy by the disallowance of such
income as “unusual”. In fact, the income has not been unusual. Inspection of the forms 990
show the recurrent nature of the rental income received by the club.

Year Ended February 28, Gross Rents % of Gross Receipts

Form 886- Acrev.468) Department of the Treasury - Internal Revenue Service
Page: -7-

20XX § +44 +H,

20XX $ 38K ** Of

20 XX $ a6 ok 7K %
20 XX q *** Of,
20 XX g ee EK Of,

The club has provided the agent with a calendar of rental events scheduled for the calendar year
as a representative example of the frequency of the rental events. That calendar is attached
to this report as Exhibit 1. A cursory inspection of this document shows that these events have
been scheduled nearly every week of the year with some periods showing nearly daily
engagements. Based on the consideration of these circumstances, the characterization of these

events as unusual is not appropriate.

In the years ended February 28, 20XX and 20XX, the club reported rental income from non
member sources on form 990-T, deducting principally those additional expenses the club
incurred as a consequence of the rental income. Net income was reported in those years of $ ***
and $ *** respectively. Subsequently, the club amended the returns to include a pro rata portion
of the fixed overhead expenses attributable to the space used for rental purposes. Addition of
these overhead expenses resulted in net losses of $ *** and $ *** in the years ended February
XX and XX respectively. Accordingly, it can be seen that the collection of rents from non
members have contributed to the payment of expenses in each of these years that the membership
would otherwise have to assume on their own behalf. These contributions to the operating
overhead amounted to $ *** and $ *** in the years ended February 28, 20XX and 20XX
respectively. These contributions to the fixed costs associated with the maintenance and
operation of the club’s facilities amount to a subsidy of the social and recreational activities of
the organization by members of the general public. Such benefits to members are not consistent
with the proper operation of an exempt social club.

Taxpayer’s Position:

The club’s representative has indicated that the club’s legal council has advised the club that the
“excess rents are not fatal to the tax exempt status of the ***”. At Exhibit 2 is a copy of the
memorandum the club has received from its legal council, ***. which it is relying on to support
its position that revocation of the club’s exemption is not appropriate.

Conclusion:

The club no longer qualifies as an exempt organization under the provisions of section 501(a) as
an organization described in section 501(c)(7). The activities of the club are not substantially all
activities described as exempt function activities in IRC section 501(c)(7). These activities are

Form 886- Acrev.468) Department of the Treasury - Internal Revenue Service
Page: -8-

not trivial with respect to the exempt activities income nor are they unusual or nonrecurrent in
nature. Therefore, your exempt status should be revoked effective March 1, 20XX.

Should this revocation be upheld you are required to file Form 1120 for all periods, starting with
the effective date, whether or not you have taxable income.

Please note that this is not a final report. This report is subject to review by our Mandatory
Review staff that may modify it as a result of their review. You will receive the final report from

Mandatory Review.

Form 886- Acrev.4-68) Department of the Treasury - Internal Revenue Service
Page: -9-

DEPARTMENT OF THE TREASURY
Internal Revenue Service
I.

TAX EXEMPT AND ,
GOVERNMENT ENTITIES ATTN:
DIVISION

Taxpayer Identification Number:

Form:
990
Tax Year(s) Ended:

Person to Contact/iD Number:

Contact Numbers:
Telephone:
Fax:

Certified Mail - Return Receipt Requested

Dear

We have enclosed a copy of our report of examination explaining why we believe
revocation of your exempt status under section 501(c)(3) of the Internal Revenue Code
(Code) is necessary.

If you accept our findings, take no further action. We will issue a final revocation letter.

If you do not agree with our proposed revocation, you must submit to us a written
request for Appeals Office consideration within 30 days from the date of this letter to
protest our decision. Your protest should include a statement of the facts, the
applicable law, and arguments in support of your position.

An Appeals officer will review your case. The Appeals office is independent of the
Director, EO Examinations. The Appeals Office resolves most disputes informally and
promptly. The enclosed Publication 3498, The Examination Process, and Publication
892, Exempt Organizations Appeal Procedures for Unagreed Issues, explain how to
appeal an Internal Revenue Service (IRS) decision. Publication 3498 also includes
information on your rights as a taxpayer and the IRS collection process.

You may also request that we refer this matter for technical advice as explained in
Publication 892. If we issue a determination letter to you based on technical advice, no
further administrative appeal is available to you within the IRS regarding the issue that
was the subject of the technical advice.

Letter 3618 (04-2002)
Catalog Number 34809F

If we do not hear from you within 30 days from the date of this letter, we will process
your case based on the recommendations shown in the report of examination. If you do
not protest this proposed determination within 30 days from the date of this letter, the
IRS will consider it to be a failure to exhaust your available administrative remedies.
Section 7428(b)(2) of the Code provides, in part: "A declaratory judgment or decree
under this section shall not be issued in any proceeding unless the Tax Court, the
Claims Court, or the District Court of the United States for the District of Columbia
determines that the-organization involved has exhausted its administrative remedies
within the Internal Revenue Service." We will then issue a final revocation letter. We
will also notify the appropriate state officials of the revocation in accordance with section
6104(c) of the Code.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate
assistance is not a substitute for established IRS procedures, such as the formal
appeals process. The Taxpayer Advocate cannot reverse a legally correct tax
determination, or extend the time fixed by law that you have to file a petition in a United
States court. The Taxpayer Advocate can, however, see that a tax matter that may not
have been resolved through normal channels gets prompt and proper handling. You
may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance. If you
prefer, you may contact your local Taxpayer Advocate at:

if you have any questions, please call the contact person at the telephone number
shown in the heading of this letter. If you write, please provide a telephone number and
the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Marsha A. Ramirez
Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Report of Examination

Letter 3618 (04-2002)
Catalog Number 34809F

DEPARTMENT OF THE TREASURY
Internal Revenue Service
TE/GE: EO Examinations
1100 Commerce Street
Utes (Seat Tu STs, Dallas, TX 75242

GOVERNMENT ENTITIES
DIVISION

Taxpayer Identification Number:
Form:

Tax Year(s) Ended:

Person to Contact/ID Number:

Contact Numbers:
Telephone: |
Fax:

CERTIFIED MAIL - RETURN RECEIPT REQUESTED

Dear

We have enclosed a copy of our report of examination explaining why we believe an
adjustment of your organization's exempt status is necessary.

if you do not agree with our position you may appeal your case. The enclosed
Publication 3498, The Examination Process, explains how to appeal an Internal
Revenue Service (IRS) decision. Publication 3498 also includes information on your
rights as a taxpayer and the IRS collection process.

If you request a conference, we will forward your written statement of protest to the
Appeals Office and they will contact you. For your convenience, an envelope is
enclosed.

If you and Appeals do not agree on some or all of the issues after your Appeals
conference, or if you do not request an Appeals conference, you may file suit in United
States Tax Court, the United States Court of Federal Claims, or United States District
Court, after satisfying procedural and jurisdictional requirements as described in
Publication 3498.

Letter 3610 (04-2002)
Catalog Number 34801 V

You may also request that we refer this matter for technical advice as explained in
Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues. If a
determination letter is issued to you based on technical advice, no further administrative
appeal is available to you within the IRS on the issue that was the subject of the
technical advice.

If you accept our findings, please sign and return the enclosed Form 6018, Consent to
Proposed Adverse Action. We will then send you a final letter modifying or revoking
exempt status. If we do not hear from you within 30 days from the date of this letter, we
will process your case on the basis of the recommendations shown in the report of
examination and this letter will become final. In that event, you will be required to file
Federal income tax returns for the tax period(s) shown above. File these returns with
the Ogden Service Center within 60 days from the date of this letter, unless a request
for an extension of time is granted. File returns for later tax years with the appropriate
service center indicated in the instructions for those returns.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate
assistance is not a substitute for established IRS procedures, such as the formal
appeals process. The Taxpayer Advocate cannot reverse a legally correct tax
determination, or extend the time fixed by law that you have to file a petition in a United
States court. The Taxpayer Advocate can, however, see that a tax matter that may not
have been resolved through normal channels gets prompt and proper handling. You
may Call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance. If you
prefer, you may contact your local Taxpayer Advocate at:

If you have any questions, please call the contact person at the telephone number
shown in the heading of this letter. If you write, please provide a telephone number and
the most convenient time to call if we need to contact you.

Letter 3610 (04-2002)

Catilog Number 34801 V

Thank you for your cooperation.

Enclosures:
Publication 892
Publication 3498
Form 6018

Report of Examination
Envelope

Sincerely,

Marsha A. Ramirez
Director, EO Examinations

Letter 3610 (04-2002)
Catalog Number 34801V