IRS revokes a social club's tax exemption for excessive public and nonmember activity

Plain-English summary

The IRS revoked a social club's exemption under section 501(c)(7). The club regularly opened events to the general public, and its nonmember receipts exceeded the limits described in Public Law 94-568 and Revenue Procedure 71-17. The IRS concluded that the club was not operated substantially for pleasure, recreation, and other nonprofitable purposes. The determination also explains the alternative unrelated-business-income analysis under sections 511, 512, and 513 if the revocation were not upheld.

Ruling snapshot

• Question: Did the organization continue to qualify as a tax-exempt social club, and if not, what unrelated business income reporting would apply?
• Outcome: Revocation, with alternative unrelated business income analysis
• Key authorities: IRC §§ 501(c)(7), 511, 512, and 513; Treas. Reg. § 1.501(c)(7); Rev. Proc. 71-17; Rev. Rul. 66-149; Public Law 94-568

Full text (IRS public release)

Internal Revenue Service. Department of the Treasury
Appeals Office

• 2525 Capitol Street, MS 201: Employer Identification Number:
  Fresno, CA 93721 Cc
  Number: 201408035 Person to Contact:

Release Date: 2/21/2014
Employee ID Number:

Tel: ( )
November 27, 2013 Fax: ( )
A Tax Period(s) Ended:
B D
UIL: 0501.07-00
Certified Mail
Dear

This is a final determination that you do not qualify for exemption from Federal income tax under Internal
Revenue Code (the “Code”) section 501(a) as an organization described in Code section 501(c)(7).

The revocation of your exempt status was made for the following reason(s):

Your organization is not operated exclusively for pleasure, recreation and other non-profitable purposes
as the majority of its activities are open to the general public. In addition, the Club’s non-member income
exceeds the limits on such income as per Public Law 94-568 and Revenue Procedure 71-17.

You are required to file Federal income tax returns on Forms 1120 for the tax periods stated in the
heading of this letter and for all tax years thereafter. File your return with the appropriate Internal
Revenue Service Center per the instructions of the return. For further instructions, forms, and information
please visit www.irs.gov.

Please show your employer identification number on all returns you file and in all correspondence with
Internal Revenue Service.

We will make this letter and the proposed adverse determination letter available for public inspection
under Code section 6110 after deleting certain identifying information. We have provided to you, in a
separate mailing, Notice 437, Notice of Intention to Disclose. Please review the Notice 437 and the
documents attached that show our proposed deletions. If you disagree with our proposed deletions, follow
the instructions in Notice 437.

You also 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 matters
that may not have been resolved through normal channels get prompt and proper handling. If you want
Taxpayer Advocate assistance, please contact the Taxpayer Advocate for the IRS office that issued this
letter. You may call toll-free, 1-877-777-4778, for the Taxpayer Advocate or visit www.irs.gov/advocate
for more information.

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

Sincerely Yours,

Appeals Team Manager

Enclosure: Publication 892 and/or 556

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

Exempt Organizations: Examinations

801 Tom Martin Dr

Room 263

Birmingham, AL 35211

Date: October 26, 2012 Taxpayer Identification Number:
Form:
Tax Year(s) Ended:
December
ORG Person to Contact/ID Number:
ADDRESS 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 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. \f 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
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.

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

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 886A Department of the Treasury - Internal Revenue Service

Explanation of Items
Name of Taxpayer Year/Period Ended
ORG 20XX
20KX
20XX

ISSUE

e Does ORG (EO) continue to qualify for exemption under Internal Revenue Code
§ 501(c)(7) given that it receives more than % of its gross receipts including
investment income, from sources outside their membership,

e Within the % limitation, no more than % of gross receipts may be derived from
nonmember use of club facilities and/or services.

FACTS

ORG opens its events to the general public and/ or non-members.

During these events, nonmembers pay an entry fee higher then members pay, and are allowed
to purchase food and drinks. Nonmembers enter the events hosted by the ORG and receive a
nonmember ticket once the nonmember admission is paid. The main activity that nonmembers
have access to is the Event which is hosted in conjunction with the City of City. In 20XX the EO
charged an entry fee for the Event and did not separate nonmember income from member
income. In 20XX and 20XX the EO stated that no entry fee was charged for the Event but the
event is open to the general public and no records were kept to separate member and
nonmember income; therefore all monies received are considered nonmember income.

The ORG is organized and operating as an organization described in Internal Revenue Code §
501(c)(7) to provide social, recreational and other activities to its members. The benefits
provided to the members include, but are not limited to priority ticketing to all of the dances and
dinners and a member rate on tickets to all events.

The objective of the ORG, per its’ Bylaws, is

a. To promote good fellowship among members and friends.

b. To retain and cherish our German Cultural Heritage.

c. To extend our traditional sociability to the community at large.

d. To provide land for future use, to erect a Event for members and friends in which to cultivate
the above.

Your organization reported the following sources and amounts of revenue on Forms 990 for
periods ending December 31, 20XX, December 31, 20XX and December 31, 20XX.

TABLE DELETED

While reviewing the general ledger, your website, as well as other internal documents provided
by your organization, such as register reports and Income/Expense Report, it has been noted

Form 886- Acrev.4-68) Department of the Treasury - Internal Revenue Service
Page: -1-

Form 886A Department of the Treasury - Internal Revenue Service

Explanation of Items
Name of Taxpayer : Year/Period Ended
ORG : 20XX
: 20XX
20XK

that your organization is open to the general public on a regular basis, as stated previously. The
nonmember income has been recorded in the following accounts:

TABLE DELETED
TABLE DELETED

The register report is utilized by the organization during their events to record all member and
nonmember activity and lists each event separate.

Based on conducting a three year analysis of gross receipts, it has been noted that the
organization received %, %, and % respectively, during tax years ending December 31, 20XX,
December 31, 20XX and December 31, 20XX from non-member sources. The gross receipts
received by your organization are well over the % and % threshold permitted in Public Law 94-
568.

LAW

Internal Revenue Code § 501(c)(7) exempts from Federal income tax: “Clubs organized for
pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which
are for such purposes and not part of the net earnings of which inures to the benefit of any
private shareholder.”

Section 1.501(c)(7) of the Income Tax Regulations provides that, in general, the exemption
extends to social and recreation clubs supported solely by membership fees, dues and
assessments. However, a club that engages in a business, such as making its social and
recreational facilities open to the general public, is not organized and operated exclusively for
pleasure, recreation and other non-profitable purposes, and is not exempt under section 501 (a).

Prior to its amendment in 1976, IRC § 501(c)(7) required that social clubs be operated
exclusively for pleasure, recreation and other nonprofitable purposes. Public Law 94-568
amended the “exclusive” provision to read “substantially’ in order to allow an IRC § 501(c)(7)
organization to receive up to 35 percent of its gross receipts, including investment income, from
sources outside its membership without losing its tax exempt status. The Committee Reports for
Public Law 94-568 (Senate Report No. 94-1318 2d Session, 1976-2 C.B. 597) further states;

(a) Within the 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. This means
that an exempt social club may receive up to 35 percent of its gross receipts from a combination
of investment income and receipts from non-members, so long as the latter do not represent
more than 15 percent of total receipts.

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

Explanation of Items
Name of Taxpayer Year/ Period Ended
ORG 20XX
: 20XX
20XX |

(b) Thus, a social club may receive investment income up to the full 35 percent of its
gross receipts if no income is derived from non-members’ use of club facilities.

(c) In addition, the Committee Report states that where a club receives unusual amounts
of income, such as from the sale of its clubhouse or similar facilities, that income is not to be
included in the 35 percent formula.

Revenue Ruling 66-149 holds a social club as not exempt as an organization described in
Internal Revenue Code § 501(c)(7) where it derives a substantial part of its income from
non-member sources.

Revenue Procedure 71-17 sets forth the guidelines for determining the effect of gross receipts
derived from the general public’s use of a social club’s facilities on exemption under Internal
Revenue Code § 501(c)(7). Where nonmember income from the usage exceeds the standard
as outlined in this Revenue procedure, the conclusion reached is that there is a non-exempt
purpose and operating in this manner jeopardizes the organization’s exempt status.

TAXPAYER’S POSITION

Taxpayer's position has not been provided.

GOVERNMENT’S POSITION

Your organization has exceeded the %/% non-member threshold on a recurring basis during tax
years ending December 31, 20XX, December 31, 20XX and December 31, 20XX and therefore
revocation of your organization’s exempt status is warranted.

CONCLUSION

ORG no longer qualifies for exemption under § 501(c)(7) of the Internal Revenue Code as your
nonmember income has exceeded the %/ % nonmember threshold as outlined in Public Law 94-

568. Therefore, your exempt status under § 501(c)(7) of the Internal Revenue Code should be
     revoked effective January 1, 20XX. Should this revocation be upheld, Form 1120 must be filed
     Starting with tax periods ending December 31, 20XX, December 31, 20XX and December 31,
     20XX.

Note: If you are planning to appeal the proposed revocation, please refer to Publication 892
which is enclosed. Appeal should contain statement of facts declared true under penalties of
perjury. Please refer to Publication 892, page 3 for example of statement signed under penalties
of perjury.

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

Form 886A Department of the Treasury - Internal Revenue Service

Explanation of Items
Name of Taxpayer Year/Period Ended
ORG 20KX
20XX
20XXK

ALTERNATIVE ISSUE

In the alternative, if the organization continues to qualify for exemption under Internal
Revenue Code § 501(c)(7), should the net income derived from nonmembers be
taxable as unrelated business income under section 511 of the Code?

FACTS

The ORG did not file a Form 990-T, Exempt Organization Business Income Tax Return,
for the years ending December 31, 20XX, December 31, 20XX and December 31,
20XX. Its register report and bank statements, however, showed the following in gross
receipts derived from nonmember and investment income:

TABLE DELETED
TABLE DELETED
LAW

Internal Revenue Code § 511(a) imposes a tax upon the unrelated business taxable
income of organizations exempt from federal income tax.

Internal Revenue Code § 512(a)(1) states, (1) General Rule--Except as otherwise
provided in this subsection, the term “unrelated business taxable income” means the
gross income derived by any organization from any unrelated trade or business (as
defined in section 513) regularly carried on by it, less the deductions allowed by this
chapter which are directly connected with the carrying on of such trade or business,
both computed with the modifications provided in subsection (b).

Internal Revenue Code § 512(a)(3) of the Code states, Special Rules Applicable to
Organizations described in paragraph (7), (9), (17), OR (20) of section 501(c). —

IRC § 512(a)(3)(A) General Rule —In the case of an organization described in
paragraph (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 the modifications
provided in paragraphs (6), (10), (11), and (12) of subsection (b). For purposes
of the preceding sentence, the deductions shall be treated as not directly
connected with the production of gross income.

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

Form 886A Department of the Treasury - Internal Revenue Service

Explanation of Items
Name of Taxpayer Year/Period Ended
ORG . 20XX
20XX
20XX

IRC § 512(a)(3)(B) Exempt function income —For purposes of subparagraph
(A), the term “exempt function income” means the gross income from dues, fees,
charges, or similar amounts paid by members of the organization as
consideration for providing such members or their dependents or guests goods,
facilities, or services in furtherance of the purposes constituting the basis for the
exemption of the organization to which such income is paid. Such term also
means all income (other than an amount equal to the gross income derived from
any unrelated trade or business regularly carried on by such organization
computed as if the organization were subject to paragraph (1)), which is set
aside --including reasonable costs of administration directly connected with a
purpose described in clause (i) or (ii). If during the taxable year, an amount which
is attributable to income so set aside is used for a purpose other than that
described in clause (i) or (ii), such amount shall be included, under subparagraph
(A), in unrelated business taxable income for the taxable year.

Internal Revenue Code § 513(a) defines the term unrelated trade or business as any
trade or business the conduct of which is not substantially related (aside from the need
of such organization for income of funds or the use it makes of the profits derived) to
the exercise or performance by such organization of its exempt functions.

Internal Revenue Code § 513(c) provides that a trade or business includes any activity
which is carried on for the production of income from the sale of goods. An activity does
not lose its identity as trade or business merely because it is carried on within a larger
aggregate of similar activities or within a larger complex of other endeavors which may
not be related to the exempt purposes of the organization.

Section 1.512(a)-1 of the Income Tax Regulations provides the following:
(a) In general. —Except as otherwise provided in §1.512(a)-3, §1.512(a)-4, or
paragraph (f) of this section, section 512(a)(1) defines “unrelated business taxable
income” as the gross income derived from any unrelated trade or business
regularly carried on, less those deductions allowed by chapter 1 of the Code which
are directly connected with the carrying on of such trade or business, subject to
certain modifications referred to in §1.512(b)-1. To be deductible in computing
unrelated business taxable income, therefore, expenses, depreciation, and similar
items not only must qualify as deductions allowed by chapter 1 of the Code, but
also must be directly connected with the carrying on of unrelated trade or business.
Except as provided in paragraph (d)(2) of this section, to be “directly connected
with” the conduct of unrelated business for purposes of section 512, an item of
deduction must have proximate and primary relationship to the carrying on of that
business. In the case of an organization which derives gross income from the
regular conduct of two or more unrelated business activities, unrelated business
taxable income is the aggregate of gross income from all such unrelated business

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

Explanation of Items
Name of Taxpayer Year/Period Ended
ORG 20KXK
20XX
20KX

activities less the aggregate of the deductions allowed with respect to all such
unrelated business activities. For the treatment of amounts of income or loss of
common trust funds, see §1.584-2(c)(3).

(b) Expenses attributable solely to unrelated business activities. Expenses,
depreciation and similar items attributable solely to the conduct of unrelated
business activities are proximately and primarily related to that business activity,
and therefore qualify for deduction to the extent that they meet the requirements of

. section 162, section 167 or other relevant provisions of the Code. Thus, for
example, salaries of personnel employed full-time in carrying on unrelated
business activities are directly connected with the conduct of that activity and are
deductible in computing unrelated business taxable income if they otherwise qualify
for deduction under the requirements of section 162. Similarly, depreciation of a
building used entirely in the conduct of unrelated business activities would be an
allowable deduction to the extent otherwise permitted by section 167.

(c) Dual use of facilities or personnel. —Where facilities are used both to carry on
exempt activities and to conduct unrelated trade or business activities, expenses,
depreciation and similar items attributable to such facilities (as, for example, items
of overhead) shall be allocated between the two uses on a reasonable basis.
Similarly, where personnel are used both to carry on exempt activities and to
conduct unrelated trade or business activities, expenses and similar items
attributable to such personnel (as, for example, items of salary) shall be allocated
between the two uses on a reasonable basis. The portion of any such item so
allocated to the unrelated trade or business activity is proximately and primarily
related to that business activity, and shall be allowable as a deduction in computing
unrelated business taxable income in the manner and to the extent permitted by
section 162, section 167 or other relevant provisions of the Code. Thus, for
example, assume that X, an exempt organization subject to the provisions of
section 511, pays its president a salary of $20,000 a year. X derives gross income
from the conduct of unrelated trade or business activities. The president devotes
approximately 10 percent of his time during the year to the unrelated business
activity. For purposes of computing X's unrelated business taxable income, a
deduction of $2,000 (10 percent of $20,000) would be allowable for the salary paid
to its president. 7

TAXPAYER’S POSITION
Taxpayer's position has not been provided.

GOVERNMENT’S POSITION

Form 886- Acrev.4-68) 4 Department of the Treasury - Internal Revenue Service
Page: -6-

a

Form 886A. Department of the Treasury - Internal Revenue Service

Explanation of Items
Name of Taxpayer Year/Period Ended
ORG ‘ 20KX
20XX
20XX

ORG is open to the public for the following activities and events:

TABLE DELETED

During these events, nonmembers pay an entry fee higher then members pay, and are
allowed to purchase food and drinks. Nonmembers enter the events hosted by the
ORG and receive a nonmember ticket once the nonmember admission is paid. The
main activity that nonmembers have access to is the Event which is hosted in
conjunction with the City of City. In 20XX the EO charged an entry fee for the Event and
did not separate nonmember income from member income. In 20XX and 20XX the EO
Stated that no entry fee was charged for the Event but the event is open to the general
public and no records were kept to separate member and nonmember income;
therefore all monies received are considered nonmember income. Internal Revenue
Code § 512(a) defines unrelated business taxable income as the gross income from
any unrelated trade or business regularly carried on by the organization. The ORG
operates from September until May each year. The organization is closed during the
Summer months. The organization rents a facility 6 times a year to hosts its
member/non-member events. It is abundantly evident that ORG activity of being open
to the public and inviting the general public to socialize at each event the organization
host is considered to be regularly carried on and a great indicator that the club
welcomes nonmembers.

The objective of the ORG, per its’ Bylaws, is

a. To promote good fellowship among members and friends.

b. To retain and cherish our German Cultural Heritage.

Cc. To extend our traditional sociability to the community at large.

d. To provide land for future use, to erect a Event for members and friends in which

to cultivate the above.

Being open to members of the general public on a regular basis does not contribute
importantly to ORG purposes aside from the need for income or funds to exercise its
functions. Therefore, the activity is not substantially related to ORG exempt purposes.
In the case of an organization described under Internal Revenue Code § 501(c)(7),
Internal Revenue Code § 512(a)(3), 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). The term “exempt function income” means
the gross income from dues, fees, charges, or similar amounts paid by members of the
organization as consideration for providing such members or their dependents or
guests goods, facilities, or services in furtherance of the purposes constituting the basis
for the exemption of the organization to which such income is paid.

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

__ Explanation of Items
Name of Taxpayer ; Year/Period Ended
ORG 20XX
20XX
20XX

If revocation is not upheld, ORG is responsible for filing a delinquent Form 990-T for
period ending December 31, 20XX, December 31, 20XX, and December 31, 20XX with
the following entries: .

TABLE DELETED
These amounts were derived utilizing the following allocations:

Each register report provided by your organization listed each event including
member and nonmember income and expenses.

The expenses were allocated using the Gross Receipts Method. This means
that the expenses pertaining to each event were allocated using the total of
nonmember income over the total gross receipts. The percentage on
nonmember income over total gross receipts was then multiplied by the total
expenses per event.

For all future returns, expenses should be allocated on a reasonable basis and as they
pertain to the activity.

If revocation is not upheld,.an adjustment will be made ORG Form 990-T for period
ending December 31, 20XX, December 31, 20XX and December 31, 20XX with the
following entries:

TABLE DELETED

“The UBIT amount does not include any penalties or interest.***

CONCLUSION

If revocation is not upheld, as a result of our examination of your Forms 990 for periods
ending December 31, 20XX, December 31, 20XX, and December 31, 20XX and Form
990-T for period ending December 31, 20XX, December 31, 20XX, and December 31,
20XX we have determined that ORG is liable for filing Form 990-T on an annual basis.

Please see attached Form 4549 and its Exhibits A and B for computations of the
Income Tax Examination Changes.

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