IRS revokes a scuba club’s exemption after nonmember trip income exceeds the limit

Plain-English summary

The IRS revoked a scuba-diving club’s exemption under IRC section 501(c)(7), effective January 1 of a redacted year. The club allowed nonmembers to attend its scuba trips and received nonmember income from those trips. The IRS concluded that the nonmember income exceeded 15 percent of gross receipts, and the club agreed to the proposed revocation because it was no longer operating and planned to terminate. The organization was required to file Form 1120 for future periods.

Ruling snapshot

• Question: Does a social club continue to qualify for exemption when nonmember income from scuba trips exceeds the applicable limit?
• Outcome: Revocation
• Key authorities: IRC §§ 501(c)(7) and 512(a)(3)(A); Treas. Reg. § 1.501(c)(7)-1; Rev. Proc. 71-17

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
Attn: Mandatory Review, MC 4920 DAL

1100 Commerce St.
TAX EXEMPT AND Dallas, TX 75242 501.07-00
GOVERNMENT ENTITIES
DIVISION
Date: June 13, 2012
Number: 201240025 Employer Identification Number:
Release Date: 10/5/2012 Person to Contact/ID Number:
Contact Numbers:
Voice:
Fax:

CERTIFIED MAIL — RETURN RECEIPT REQUESTED #
Dear

In a determination letter dated July 19XX you were held to be exempt from Federal
income tax under section 501(c)(7) of the Internal Revenue Code (the Code).

We have determined you have not operated in accordance with the provisions of
section 501(c)(7) of the Code. Accordingly, your exemption from Federal income tax is
revoked effective January 1, 20XX. This is a final adverse determination letter with
regard to your status under section 501(c)(7) of the Code.

We previously provided you a report of examination explaining why we believe
revocation of your exempt status is necessary. At that time, we informed you of your
right to contact the Taxpayer Advocate, as well as your appeal rights. On March 25,
20XX, you signed Form 6018-A, Consent to Proposed Action, agreeing to the
revocation of your exempt status under section 501(c)(7) of the Code.

You are required to file Federal income tax returns on Form 1120. Those returns
should be filed with the appropriate Service Center for all years beginning after
December 31, 20XX.

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 contact the person whose name and telephone
number are shown at the beginning of this letter.

Sincerely,

Nanette M. Downing
Director, EO Examinations

Internal Revenue Service Department of the Treasury
Tax Exempt and Government Entities Division

Exempt Organizations: Examinations

12301 Research Blvd

Building 4 Suite 270

Austin, TX 78759

Date: March 16, 2012 Taxpayer Identification Number:
Form:
LEGEND Tax Year(s) Ended:
ORG - Organization name Person to Contact/ID Number:
XX - Date Address - address Contact Numbers:
Telephone:
Fax:
ORG
ADDRESS

Certified Mail — Return Receipt Requested
Dear

We have enclosed a copy of our report of examination explaining why we believe revocation 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.

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 revoking your 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

Letter 3610 (Rev 11-2003)
Catalog Number 34801V

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.

Thank you for your cooperation.

Sincerely,

Nanette M Downing
Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Form 6018

Report of Examination
Envelope

2 Letter 3610 (Rev 11-2003)
Catalog Number 34801V

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX
LEGEND
ORG - Organization name XX - Date State - state
ISSUE

1. Does the organization, ORG, continue to qualify for exemption under IRC section 501(c)(7)?
   FACTS

ORG (herein after referred to as the ORG) was incorporated in the State of State on December
23, 19XX. The ORG was determined to be exempt from Federal income tax under section
501(c)(7) of the Internal Revenue Code on July 15, 19XX. According to the articles of
incorporation, the purpose of the corporation is “to engage in all activities necessary, useful, or
expedient to further skin and scuba diving; to educate, equip and train skin and scuba divers in
techniques and safety; and to further the sciences involved in diving and oceanography, all of this
to be done in a social and fraternal atmosphere”.

The ORG has five classes of members: Single, Family (2 or more living in the same household),
Lifetime (recognized by the board for their service, have the same voting rights), Honorary (not
required to pay dues, and have no voting rights) and Scholarship (not required to pay dues, and
have no voting rights).

The ORG allowed members and nonmembers to attend the scuba diving trips. The ORG received
income from nonmembers from the scuba diving trips. There were 5 scuba diving trips scheduled
during the 20XX year. See attachment A for a breakdown of the trips and the nonmember
income.

LAW

Internal Revenue Code (IRC) section 501(c)(7) provides that clubs organized for pleasure,
recreation, and other nonprofitable purpose, which substantially all of the activities are for such
purposes and no part of the net earnings of which inures to the benefit of any private shareholder
are exempt from tax.

Treasury Regulation section 1.501(c)(7)-1 states that the conduct of business activities, including
public use of a club’s social and recreational facilities, is incompatible with exemption. It has not
yet been changed to reflect the amendment to P.L. 94-568.

Revenue Procedure 71-17 sets forth guidelines for determining the effect gross receipts derived
from use of a social club’s facilities by the general public have on the club’s exemption from
Federal income tax under section 501(c)(7) of the Internal Revenue Code of 1954. These
guidelines will be used in connection with the examination of annual returns on Forms 990 and
990-T filed by social clubs. This Revenue Procedure also describes the records required when

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service

Page: -1-

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

nonmembers use a club’s facilities and the circumstances under which a host-guest relationship
will be assumed, which are relevant both for purposes of determining adherence to the exemption
requirements and for computing exempt function income under section 512(a)(3) of the Code.

This Revenue Procedure allows social clubs to receive up to 35% of their gross receipts,
including investment income, from sources outside their membership without losing their exempt
status. Within this 35%, no more than 15% of gross receipts may be derived from nonmember
use of club facilities and/or services. Gross receipts are defined for this purpose as those receipts
from normal and usual activities that have been traditionally conducted by the club or by other
social and recreational clubs of the same general type. For example, in the case of country clubs,
gross receipts include receipts from activities traditionally conducted by country clubs. Unusual
amounts of income, such as from the sale of a clubhouse or similar facility are not to be included
in either the gross receipts of the club or in the permitted 35 or 15 percent allowances. It should
be emphasized that gross receipts from the conduct of a nontraditional business or other activity
previously forbidden may not be included within the percentage guidelines. The conduct of a
business not traditionally carried on by social clubs unless it is insubstantial, trivial, and
nonrecurrent, should preclude exemption.

Section 4.04 of Revenue Procedure 71-17 provides that if a club fails to maintain or make
available the records required by Revenue Procedure 71-17, the percentage guidelines may not be
used in the determination of whether the club has a non-exempt purpose. If the records are
unavailable, then the club’s income may be considered to be from nonmembers, and its exempt
status could be in jeopardy. Even if the amount of nonmember income does not exceed either of
the limitations, the club’s nonmember income is still included in the computation of unrelated
business taxable income.

IRC section 512(a)(3)(A) provides that in the case of organizations described in paragraph (7) of
section 501(c), the term “unrelated business income” means the gross income (excluding any
exempt function income, i.e. income from dues, fees, charges, or similar amounts paid by
members of the organization), less the deductions allowed by this chapter which are directly
connected with the production of the gross income.

TAXPAYER’S POSITION

The ORG has agreed with our proposed revocation because of the fact that they are no longer in
operation, and were planning to terminate within the year.

GOVERNMENT’S POSITION

Revenue Procedure 71-17 allows social clubs to receive up to 35% of their gross receipts,
including investment income, from sources outside their membership without losing their exempt

Form 886-A(Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -2-

Form 886-A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

status. Within this 35%, no more than 15% of gross receipts may be derived from nonmember
use of club facilities and/or services. Gross receipts are defined for this purpose as those receipts
from normal and usual activities that have been traditionally conducted by the club or by other
social and recreational clubs of the same general type. The conduct of a business not traditionally
carried on by social clubs unless it is insubstantial, trivial, and nonrecurrent, should preclude
exemption.

As shown in Attachment A, the income from nonmembers was significantly higher than the
allowed 15%, for the year ending December 31, 20XX. The nonmember income was received for
travel services for the scuba diving trips.

Since the ORG received over 15% of gross income from nonmembers, it is the Government’s
position that the ORG does not meet the requirements to be exempt from tax under IRC section
501(c)(7), see Treasury Regulation section 1.501(c)(7)-1.

CONCLUSION

Based on the foregoing reasons, the ORG does not qualify for exemption under section 501(c)(7)
and it is the Government’s position that its tax exempt status should be revoked.

The ORG has agreed with the proposed revocation for exemption under IRC section 501(c)(7),
by signing Form 6018-A on March 25, 20XX.

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