PLR 1235024: IRS approves tax treatment for a social club's conservation easement proceeds

Plain-English summary

The IRS ruled that a section 501(c)(7) social club's gain from selling a conservation easement would be exempt from tax under section 512(a)(3)(D) if the proceeds were reinvested in property used for the club's exempt social and recreational function. The club planned to use the proceeds to demolish and rebuild a lodge used for administration, member activities, and guided tours. The IRS found that the easement was property attached to land directly used for the club's recreational purposes and that the rebuilt lodge would also be directly used for those purposes. The ruling applies only if the proceeds are reinvested within the statutory period and the facts do not materially change.

Ruling snapshot

• Question: Can a social club exclude gain from a conservation easement sale when it reinvests the proceeds in a lodge used for its exempt function?
• Outcome: Approved, to the extent the proceeds are reinvested in qualifying property within the one-year-before to three-years-after period.
• Key authorities: IRC §§ 501(c)(7), 512(a)(3)(A), 512(a)(3)(D), and 6110; Atlanta Athletic Club v. Commissioner, 980 F.2d 1409 (11th Cir. 1993); Tamarisk Country Club v. Commissioner, 84 T.C. 756 (1985); Deer Park Country Club v. Commissioner, 70 T.C.M. (CCH) 1445

Full text (IRS public release)

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Release Number: 201235024 Contact Person:
Release Date: 8/31/2012
Date: June 7, 2012 Identification Number:
UIL: 512.09-03

Telephone Number:

Employer Identification Number:

Legend:

Taxpayer =
Town =
City =
Department =
Forest =
x1 =
x2 =
x3 =
Date1 =
Date2 =
Date3 =

Dear

This is in response to your letter dated December 18, 2010, in which you requested certain
rulings with respect to section 512(a)(3)(D) of the Internal Revenue Code (“Code”).

Background:

According to your ruling request you are an exempt organization under section 501(c)(7) of the
Code. You are a social and recreational club located in Town formed for the purpose of outdoor
recreation. You have been operated continuously as a social club for several decades, being
recognized as exempt for most of that time. You have annually filed your Form 990 with a fiscal
year beginning Date1.

You were formed for the primary purpose of providing space and activities for social interaction
among families and enjoying outdoor recreation. Throughout hundreds of acres of woodland
and waterways your members enjoy hiking, mountain and road biking, trail running, cross-
country skiing, snow shoeing, horseback riding, sailing, swimming, canoeing and kayaking, ice
skating, tennis, field sports, archery, fishing, and trap shooting. Your facilities currently include
two lodges, six tennis courts, playing fields, a stable, a trap range, a boathouse, picnic areas, a
skating house, clubhouse, and a waterfront snack bar. There is a well developed system of
trails that run throughout your property that were originally developed within your first decade of
operations and are continuously maintained by members. These trails, which consist of a
primary system and many connector trails, have various uses but many are dedicated to

specific uses such as horseback riding, hiking, or mountain biking. One central feature of your
property is a sixty acre lake used for recreation and forbidden to power boats. Your land also
holds the head waters to this lake as well as one other smaller pond.

Your land includes an area of approximately x1 acres, which constitutes a little more than a
quarter of your land, in the northwest portion of your property known as Forest. Your club has
owned this land since its inception. Your members use the land for many activities including
hiking, skiing, horseback riding, snow shoeing, camping, picnicking, running, mountain biking,
and general enjoyment. Included on this land is the tallest point on your property, which is a
popular destination for hiking and picnicking, as well as two prominent trails. Other enjoyable
features include an intact root cellar, a cliff for rope climbing, and a cave. Activities occurring on
Forest are enjoyed by members throughout the year.

On Date2 you entered into an agreement with Department, a city department of environmental
protection, for a conservation easement attaching to Forest. Department is interested in an
easement attaching to this property since Forest contains a watershed leading to one of the
reservoirs used by the residents of City. After Department has conducted its due diligence and
appropriately surveyed the land, you will close on Date3. Department will pay approximately x2
for the easement to prevent pollution of water running through or collecting on Forest. As part
of the easement you have agreed that you will not construct new paved roads; create new
building envelopes with subsurface sewage treatment systems, paved surfaces, or wells;
commercially mine gravel, sand, shale or bluestone of more than x3 square feet; or store, bury,
or dispose of hazardous materials designated by local, state, or federal regulations or dispose of
cars, trash, sewage, or uncomposted animal waste. Furthermore, the easement restricts your
ability to farm, build, and remove timber, though it does not remove those options entirely.
Additionally, Department will have the right to enter the land for inspections in order to monitor
your use of the land. The easement will run with the land in perpetuity, thus restricting any
future sale of the land. Your members can, and will, continue to use the land for all of your
traditional recreational activities such as hiking, mountain biking, and horseback riding.

You decided to enter the agreement with Department so that you could raise capital to demolish
and rebuild one of your two lodges. The lodge was constructed not long after your inception
and has reached the end of its usable life. You represented that you are committed to using all
of the funds earned through the sale of the easement in the demolition and construction of the
new lodge within the statutory period. This lodge is located at the center of your property near
many of your other buildings, tennis courts, the central athletic field, the largest playground, and
the dining room. It also contains your administrative offices, meeting and map rooms, tennis
office and shop, locker rooms, and mail rooms. Due to its location this lodge serves as a natural
meeting point for your members and is the starting point for many of your guided hikes and
other tours.

Rulings Requested:

You request a ruling that the gain on the sale of the conservation easement, approximately x2
given your nominal basis in the property, is exempt from tax under Code Section 512(a)(3)(D),
provided that the proceeds are reinvested entirely on property to be used in your exempt social
and recreational function within the period beginning one year prior to the sale and concluding
three years after the sale.

Law:

Section 512(a)(3)(A) of the Code provides that in the case of 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.

Section 512(a)(3)(D) of the Code provides that if property used directly in the performance of
the exempt function of an organization described in 501(c)(7) is sold by such organization, and
within a period beginning 1 year before the date of such sale, and ending 3 years after such
date, other property is purchased and used by such organization directly in the performance of
its exempt function, then gain from such sale shall be recognized only to the extent that the
sales price exceeds the cost of purchasing the other property.

In Atlanta Athletic Club v. Commissioner, 980 F.2d 1409 (11th Cir. 1993), the court determined
that, “The statute speaks in terms of use rather than intent. Therefore, the Tax Court correctly
observed that the Club's various plans for the land were irrelevant. The analysis must
concentrate on the ways in which the Westside Property was or was not ‘used directly.’ This
process entails factual findings as to the activities that occurred on tracts A and B of the
Westside Property, and legal conclusions as to whether those activities constituted sufficient
recreational uses by the Club.”

In Tamarisk Country Club v. Commissioner, 84 T.C. 756 (1985), the court interpreted
“organization’s sale price” to mean, “the amount realized, reduced by the aggregate of the
expenses for work performed on the old property to assist in its sale.” When discussing use of
the funds to pay debts of the organization and refund money to members the court stated, “By
discharging the indebtedness on its loan and by currently refunding the assessment, which its
membership previously had agreed was refundable only upon death or resignation from the
club, petitioner did not ‘merely reinvest’ its funds from the land sale in other types of assets. In
the language of the Committee Report, funds were ‘withdrawn for gain by the members of the
organization,’ who benefited through decrease in petitioner's debt and return of the assessment.
Petitioner's gain therefore constitutes unrelated business taxable income.” Additionally, the
court provides an example of an allowable transaction stating, “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.”
Id. at 763-64, citing S. Rept. 91-552 (1969), 1969-3 C.B. 423, 470-71.

In Deer Park Country Club v. Commissioner, 70 T.C.M. (CCH) 1445, the court concludes, “that
the plain and ordinary meaning of the phrase “used directly in the performance of the exempt
function of an organization” as set forth in section 512(a)(3)(D) connotes an exempt
organization's use of assets or property that is both actual and direct in relation to the
performance of its exempt function. Given petitioner's concession that no part of the 4.8-acre
tract on which the 11 homesites are situated was ever physically used by petitioner for
recreational activities, it follows that the gain realized on the sale of the 11 homesites does not
qualify for nonrecognition under section 512(a)(3)(D), but rather is subject to the unrelated
business income tax.”

Analysis:

You have requested a ruling that gain from the sale of a conservation easement will not be
taxable income if reinvested in a lodge used by your members. Section 512(a)(3) of the Code
provides special rules defining taxable income for organizations described in 501(c)(7).
Specifically, gains from the sale of property, which has been used for the exempt purpose of
certain organizations, will not be recognized, and therefore will not be taxed, to the extent that
the sale price is reinvested in property used for the organization’s exempt purpose, if that
reinvestment occurs within one year prior to and three years following the sale of property.
Section 512(a)(3)(D). This statute is further clarified by case law, which stipulates that the
property being sold must have been “directly used” for the exempt purposes of the organization,
see Atlanta Athletic Club, 980 F.2d 1409, not for some other benefit of the organization, see
Deer Park Country Club, 70 T.C.M. (CCH) 1445, and must be reinvested into property up to the
“organization’s sales price” and not “withdrawn for the gain by the members of the organization.’
See Tamarisk Country Club, 84 T.C. 756.

The sale of the easement is widely considered by the Service to be a sale of property within the
Internal Revenue Code. The easement will be attached to the land in perpetuity affecting all
future transactions regarding the land. The easement removes your ability to construct new
paved roads; create new building envelopes with subsurface sewage treatment systems, paved
surfaces, or wells; commercially mine gravel, sand, shale or bluestone of more than x3 square
feet; or store, bury, or dispose of hazardous materials. It additionally hinders your ability to
farm, build, and remove timber, though it does not remove those options entirely. The
easement also gives access of your land to Department in order to ensure such activities are
not taking place. Given the significant restrictions on you, and any purchaser of the land, and
the rights provided to Department, you have sold property.

You are selling an easement to land that is substantially used by your members for the social
and recreational activities for which you were formed. These activities include hiking, mountain
biking, horseback riding, picnicking, skiing, and snow shoeing among others. You also provided
several trails through this land and picnic tables to encourage these activities. The land
contained other popular features visited by members, specifically, the highest point on the
property, a cave, and an active root cellar. Based on the above factors we conclude that the
easement property was used heavily for recreational purposes. Your use of the Forest appears
to be more frequent than the activities found to constitute exempt purpose use in Atlanta Athletic
Club, 980 F.2d at 1412-13, where the organization held foot races, pasture parties, kite flying
contests, fishing contests, and allowed jogging by members on the land sold. Furthermore, the
court states that an activity need not be organized by the club in order to be sponsored by the
club. Id. at 1413. Thus, we conclude that the sale of the easement meets the first criteria
because it is attached to land “directly used” for your exempt purposes. The fact that you
continue to use the land under the easement for your exempt purposes does not alter the
conclusion that you have sold property that you used for an exempt purpose. The restriction of
your rights and the rights granted to Department remain, thus you have still sold property used
for an exempt purpose.

You have represented that you are committed to using the sales proceeds from the sale of the
easement to demolish and reconstruct one of two lodges on your property. The court in
Tamarisk Country Club, 84 T.C. at 764, cites S. Rept. 91-552 (1969), 1969-3 C.B. at 470-71,

Providing, by way of example, that, “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.” Your lodge has been, and
will continue to, serve as the home of your administrative offices, the starting point for many
hiking and skiing tours, the mail rooms, and a prominent meeting point for your members. As
such, the gains from your sale of the easement will be reinvested in property that will be “directly
used” for your exempt purposes within the meaning of section 512(a)(3)(D) of the Code.

Finally, you said that you would fulfill the statutory requirement by making these investments
within one year prior and three years following the closing of your sale of the easement. In
doing so, you will have met all three requirements under section 512(a)(3)(D) and gain will not
be recognized on your sale of the easement to the extent that your sale price is reinvested
within the four year window. You also stated that you understand that any money not spent in
this time period is subject to tax.

Ruling:

The gain on the sale of the conservation easement, approximately x2 given your nominal basis
in the property, is exempt from tax under Code Section 512(a)(3)(D), provided that the proceeds
are reinvested entirely on property to be used in your exempt social and recreational function
within the period beginning one year prior to the sale and concluding three years after the sale.

This ruling will be made available for public inspection under section 6110 of the Code after
certain deletions of identifying information are made. For details, see enclosed Notice 437,
Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make
available for public inspection is attached to Notice 437. If you disagree with our proposed
deletions, you should follow the instructions in Notice 437.

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

This ruling is based on the facts as they were presented and on the understanding that there will
be no material changes in these facts. 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. Because it could help resolve questions concerning your federal income tax status,
this ruling should be kept in your permanent records.

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

In accordance with the Power of Attorney currently on file with the Internal Revenue Service, we
are sending a copy of this letter to your authorized representative.

Sincerely,

Ronald Shoemaker
Manager, Exempt Organizations
Technical Group 2

Enclosure
Notice 437