PLR 1213035: IRS revokes prior ruling on gain from a social club's property sale

Plain-English summary

The IRS revoked and superseded a 2003 ruling for a section 501(c)(7) club that planned to dissolve and sell land used in its exempt activities. The earlier ruling had concluded that the sale would not create unrelated business taxable income. The IRS now concluded that the club would retain its section 501(c)(7) exemption, but gain from the sale would be unrelated business taxable income because the proceeds would be distributed to members rather than reinvested in other exempt-function property. The determination explains that the prior ruling was in error under the section 512(a)(3)(D) rules.

Ruling snapshot

• Question: Would the club's land sale preserve its exemption and avoid unrelated business taxable income?
• Outcome: Revocation, prior ruling superseded; exemption retained but gain treated as unrelated business taxable income
• Key authorities: IRC §§ 501(c)(7), 511, and 512; Rev. Rul. 58-501; Rev. Proc. 2011-4

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201213035 Employer Identification Number:
Release Date: 3/30/2012
Date: January 5, 2012 Person to Contact and ID Number:

Contact Telephone Number:

FAX Number:

UIL: 501.07-02
512.09-03

Legend:

M=
Year 1 =
Year 2 =
x=

Dear

This ruling revokes and supersedes our prior ruling that was issued to Mas PLR
200314030 on January 6, 2003. The ruling was issued in response to M's letter dated June 25,
2002, regarding whether any gain realized by M on the sale of certain property would cause it to
lose its tax exempt status and whether it would be considered unrelated business taxable
income under § 512 of the Internal Revenue Code.

The June 25, 2002, request indicated that M was incorporated in Year 1. In Year 2, it
received a determination letter from the Internal Revenue Service (Service) recognizing it as tax
exempt under § 501(c)(7). The activities of M included raising and training beagles to compete
in field trials. Several years prior to 2002, M purchased x acres of land that it held and used
directly in furtherance of its exempt activities.

Because of the age of M’s members, the members decided to dissolve the club. M also
stated that the members planned to sell the land as part of the dissolution and distribute the
sales proceeds to themselves in liquidation. M’s members did not intend to make any
improvements to the land for purposes of the sale.

Based on the information furnished by M, we ruled in our January 6, 2003 letter that:

1. Any gain which M realizes on the sale of the x acres of land in question will not cause it
   to lose its tax exempt status under § 501(c) (7).

2. Any gain which M realizes on the sale of the x acres will not be treated as unrelated
   business taxable income under § 512.

LAW:

Section 501(c)(7) provides for the exemption of clubs organized and operated for pleasure,
recreation, and other nonprofitable purposes, substantially all 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.

Section 511 imposes a tax on the unrelated business taxable income (as defined in § 512)
of organizations exempt from tax under § 501(c), including those described in § 501(c)(7).

Section 512(a)(3)(A) provides, in part, that with respect to an organization described in
§ 501(c)(7), the term “unrelated business taxable income” means the gross income (excluding
any exempt function income), less the deductions allowed by this chapter which are directly
connected with the production of the gross income (excluding exempt function income), both
computed with certain modifications provided in § 512(b).

Section 512(a)(3)(B) defines “exempt function income” to mean the gross income from
dues, fees, charges, or similar amounts paid by members of the organization as consideration
for providing such members of their dependents or guests goods, facilities, or services in
furtherance of the purposes constituting the basis for the exemption of the organization to which
income is paid.

Section 512(a)(3)(D) provides, in part, that if property used directly in the performance of
an exempt function of a organization described in § 501(c)(7) is sold, and within a period
beginning one year before the date of such sale and ending three years after such date, other
property is purchased and used by the organization directly in the performance of its exempt
function, gain (if any) from such sale shall be recognized only to the extent that such
organization's sales price of the old property exceeds the organization’s cost of purchasing the
other property.

Section 512(b)(5), in part, excludes from the term “unrelated business taxable income” all
gains or losses from the sale, exchange, or other disposition of property, other than property
held primarily for sale to customers in the ordinary course of trade or business.

Section 1.501(c)(7)-1(a) of the Income Tax Regulations states that the exemption provided
to organizations described in § 501(c)(7) applies only to clubs which are organized and
operated exclusively for pleasure, recreation, and other nonprofitable purposes, but does not
apply to any club if its net earnings inures to the benefit of any private shareholder. The
regulation also states that, in general, this exemption extends to social and recreation clubs,
which are supported solely by membership fees, dues, and assessments. However, a club
otherwise entitled to exemption will not be disqualified because it raises revenue from members
through the use of club facilities or in connection with club activities.

Section 1.501(c)(7)-1(b) provides that a club which engages in business, such as 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 for pleasure, recreation,
and other nonprofitable purposes, and is not tax exempt. Solicitation by advertisement or
otherwise for public patronage of its facilities is prima facie evidence that the club is engaging in
business and is not being operated exclusively for pleasure, recreation, or social purposes.
However, an incidental sale of property will not deprive a club of its exemption.

Rev. Rul. 58-501, 1958-2 C.B. 262, holds that where a social club described in § 501(c)(7)
finds it impracticable to continue to conduct its exempt activities and sells its property and
liquidates, such a sale is incidental to its exempt purposes. The revenue ruling states that the
club is still considered to be operating exclusively for pleasure, recreation, and similar purposes
up through the date of the sale and distribution of the liquidated asserts to its active members.
The revenue ruling concludes that profit from the sale by the club of all its property in
conjunction with the termination of its activities and liquidation does not deprive the club of the
exemption provided by § 501(c)(7).

Section 13.04 of Rev. Proc. 2011-4, 2011-1 1.R.B. 152, states, in part, that a letter ruling
found to be in error or not in accord with the current views of the Service may be revoked or
modified. A letter may be revoked or modified due to a notice to the taxpayer to whom the letter
ruling was issued.

Tamarisk Country Club v. Commissioner, 84 T.C. 756 (1985), involved an organization
exempt under § 501(c)(7) that used realized gain from a property sale to purchase other
property for an amount less than the consideration it received from the land sale, taking into
account the selling expenses. Both sold and purchased properties were used directly in the
performance of the organization’s exempt function activity. The court found that § 512(a)(3)(D)
requires that gain realized on the sale of property used directly in the performance of the
exempt function of a § 501(c)(7) organization be recognized, to the extent that the consideration
for the sale, less selling expenses and expenses for work performed to assist in the sale of the
property, exceeds the cost of other property purchased by the organization and used directly in
the performance of its exempt function. This case was the first judicial consideration of the
1969 Tax Reform Act provision, § 512(a)(3)(D), which sheltered gain on the sale of property by
a social club. The court held that the amount of gain reinvested by a club in new property for its
exempt purpose was sheltered from tax, but the amount of gain distributed to the members was
subject to tax.

In Atlanta Athletic Club v. Commissioner, 980 F.2d 1409 (1993), the court held that a gain
on the sale of land that was fully reinvested in other exempt property qualified for non-
recognition of gain under § 512(a)(3)(D), even though it had not been in continuous or direct use
before the sale.

In Deer Park Country Club v. Commissioner, 70 T.C.M. (CCH) 1445 (1995), the court held
that the sale of land that was never actually used for club purposes was not qualified for non-
recognition of gain under § 512(a)(3)(D) regardless of the fact that the organization originally
purchased the land with the intent of using it for its exempt function.

Public Law 91-172 (1969) extended unrelated business income tax to all exempt
organizations. With specific reference to § 501(c)(7), the Senate Report 91-552 (1969), 1969-3
C.B. 423, at 470, stated:

... where the organization receives income from sources outside the membership, such
as income from investments..., upon which no tax is paid, the membership receives a
benefit not contemplated by the exemption...the extension of the exemption to such
investment income is, therefore, a distortion of its purpose.

However, Congress afforded social clubs a special exception for revenue earned by the
sale of exempt function property that had been used directly in the performance of its exempt
function. If the proceeds are used within a specified period to purchase other property used
in the performance of its exempt function, no tax is assessed. Section 512(a)(3)(D). The
legislative history discusses the reason to protect proceeds that are reinvested in the exempt
purpose. Proceeds that are reinvested in the exempt function of the club:

...are not being withdrawn for gain by the members of the organization. For example,
where a social club sells its clubhouse and uses the entire proceeds to build or purchase
a larger clubhouse, the gain on the sale will not be taxed if the proceeds are reinvested
in the new clubhouse within three years. Senate Report 91-552 (1969), 1969-3 C.B.
423, at 471.

ANALYSIS:

Organizations exempt under § 501(c)(7) are subject to a particular unrelated business
income tax regime which treats gain on sale of their property differently from gain received by
other types of § 501(c) organizations. Section 512(a)(1) provides the general rule for unrelated
business income tax, which applies to § 501(c) organizations and is defined narrowly as gross
income derived by any organization from any unrelated trade or business that is regularly
carried on. The statute further states that the modifications under § 512(b) apply.

In contrast, § 512(a)(3)(A), which provides the unrelated trade or business income tax rule
for taxing organizations exempt under § 501(c)(7) (as well as § 501(c)(9), (c)(17), and (c)(20)
entities), defines gross income broadly by not referencing the more narrow “unrelated trade or
business regularly carried on” standard. Rather than isolating the actual unrelated business
income and taxing it, § 512(a)(3)(A) instead isolates “exempt function income’ for exemption
and taxes all other income. It does so by negatively defining unrelated business taxable income
for social organization to mean all income that is not “exempt function income,” irrespective of
whether the income generating activity meets the “trade or business regularly carried on”
standard that is generally applicable under the unrelated business income tax regime.

Hence, the only § 501(c)(7) income excluded from tax is “exempt function income” and the
only applicable modifications are specifically listed as §§ 512(b)(6), (10), (11), and (12). This list
explicitly does not include § 512(b)(5), which excludes from unrelated business income tax all
gains or losses from the sale, exchange, or other disposition of property, (excluding stock or

other property, held primarily for sale to customers in the ordinary course of trade or business,
and gains and losses from investment activities) and which, in this case, would have allowed M
an entity level exemption for its dissolution proceeds.

Several courts have ruled on the application of the unrelated business income tax to the
sale of property by a social club. In Tamarisk Country Club, 84 T.C. 756, the court ruled that the
club did owe tax on the portion of the proceeds from sale of its property that exceeded the
amount used to purchase new exempt property because it was not reinvested, but withdrawn for
gain by the members of the organization. The court applied the principle that revenue from the
sale of property will be taxed, except if it is reinvested in exempt function property.

In Atlanta Athletic Club, 980 F.2d 1409, the property did qualify for non-recognition of gain
because the property was used in exempt functions and reinvested in other property used in
exempt functions within three years after the sale. In Deer Park Country Club, 70 T.C.M. (CCH)
1445,, the property had never been used for exempt functions, and so was not eligible for the
non-recognition of gain.

The facts surrounding the proposed sale of M’s assets show that such property had been
used to carry out M’s exempt activities, but circumstances had changed, specifically the aging of
the club membership. Thus, M, in 2002, wished to sell its assets in conjunction with the
dissolution of the club. As in the case of the sale of club property by the organization described
in Rev. Rul. 58-501, supra, the purpose of the sale of M’s assets was to facilitate the club’s
dissolution rather than to make a profit. As noted in § 1.507(c)(7)-1(b), an incidental sale of
property will not adversely affect a social club’s tax exempt status. Furthermore, the distribution
of liquidated assets to M’s members will not result in the revocation of the club’s tax exempt
status.

However, Rev. Rul. 58-501, supra, does not address unrelated business income tax. Also,
it was issued prior to the 1969 Act’s enactment of the special unrelated business income tax
rules, codified in § 512(a)(3)(D). Since M intended to sell its property but not use the income to
purchase other property for the performance of its exempt function, the gain from the sale must
be recognized as unrelated business taxable income. Section 512(a)(3)(D). Thus the conclusion
regarding unrelated business income that was expressed in the ruling issued to M as PLR
200314030 on January 6, 2003, is in error. Pursuant to Rev. Proc. 2011-4, supra, PLR
200314030 should be revoked.

CONCLUSION:

Based on the foregoing, we rule as follows:

(1) Any gain which M realizes on the sale of the x acres will not cause it to lose its tax
exempt status under § 501(c)(7).

(2) The gain on the sale of M’s property is considered to be unrelated business taxable
income under § 512.

This ruling revokes and supersedes our prior ruling that was issued to M as PLR
200314030 on January 6, 2003.

This ruling does not address the applicability of any section of the Code or regulations to
the facts submitted other than with respect to the sections described above.

If M or its authorized representative have any questions about this letter, contact the
person whose name and telephone number are shown in the heading.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

Sincerely yours,

Michael Seto

Acting Manager,

Exempt Organizations
Technical

cc: