202150024: IRS disqualifies a hunting club's 501(c)(7) status because oil and gas royalties, not membership, drive its income

Plain-English summary

A social club, a hunting and shooting club that also does firearm-safety education and land conservation, had never gotten an IRS determination letter but had filed for years as a self-declared tax-exempt social club under Internal Revenue Code § 501(c)(7). The IRS determined it does not qualify, because most of its money comes from leasing its land for oil and gas extraction, not from its members. A § 501(c)(7) club must operate substantially for pleasure, recreation, and other nonprofit purposes. Under the 1976 law (Public Law 94-568) a club may take up to 35 percent of its gross receipts from outside its membership (with no more than 15 percent of receipts from the general public's use of its facilities), but Congress also said clubs may not run businesses "not traditionally carried on" by such clubs, and that kind of nontraditional business can destroy the exemption even when the dollar limits are met. Here the oil and gas royalties were substantial, recurring, and nontraditional, so the club failed both the "gross receipts" test and the "facts and circumstances" test. The club did not dispute this; it had even tried to file a corporate return (Form 1120), only to have the IRS return it and tell the club to keep filing Form 990. The IRS proposed to disqualify the self-declared exemption for two tax years, meaning the club must file income tax returns. The lesson: a club's outside profits must be incidental and either negligible or nonrecurring; steady royalty income that dwarfs member dues is neither.

Ruling snapshot

• Question: Does a self-declared § 501(c)(7) social club still qualify when the majority of its income comes from a substantial, nontraditional, recurring business (oil and gas lease royalties) outside its membership?
• Outcome: revocation (disqualification of self-declared § 501(c)(7) status) for the two tax years at issue; income tax returns required
• Key authorities: IRC § 501(c)(7); Treas. Reg. § 1.501(c)(7)-1(b); Public Law 94-568 (S. Rep. No. 94-1318); Rev. Rul. 68-589; Rev. Rul. 66-149; Rev. Rul. 69-220; Santee Club v. White, 87 F.2d 5 (1936); National Mah Jongg League v. U.S., 75 F. Supp. 769 (1947); United States v. Fort Worth Club of Fort Worth, Texas, 345 F.2d 52 (5th Cir. 1965)

Full text (IRS public release)

This document is an OCR transcription of a scanned IRS release. Wording is preserved verbatim; obvious scanning misreads have been corrected, and page furniture and footers are transcribed as scanned. In the Government's Position "testing results," dollar and percentage figures were redacted in the original and are shown as [redacted]. Unreadable spots are marked [illegible].

[Page 1]

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
1100 Commerce Street, MC 4920DAL
Dallas, TX 75242

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: August 6, 2020
Taxpayer ID Number:
Number: 202150024
Release Date: 12/17/2021 Form:
Tax Period(s) Ending:
Person to Contact:
Identification Number:
UIL: 501.07-00 Telephone Number:
Fax Number:

CERTIFIED MAIL — Return Receipt Requested
LAST DAY FOR FILING A PETITION WITH THE TAX COURT:

Dear

This is a final determination explaining why your organization does not qualify as an
organization described in Internal Revenue Code (IRC) section 501(c)(7) for the tax period(s)
listed above.

In the future, if you believe your organization qualifies for tax-exempt status and would like a
determination letter from the Internal Revenue Service, you can request a determination by
filing Form 1024, Application for Recognition of Exemption Under Section 501(a), or Form
1024-A, Application for Recognition of Exemption Under Section 501(c)(4) of the Internal
Revenue Code (as applicable) and paying the required user fee.

Our adverse determination as to your exempt status was made for the following reasons:

You do not meet the requirements for exemption under IRC section 501(c)(7).
You meet neither the gross income test nor the facts and circumstances test. You
receive the majority of your income from sources outside of your membership by
engaging in substantial, nontraditional, recurring trade or business activity outside
of your membership. Therefore, you do not operate substantially for pleasure,
recreation, or other nonprofitable purposes.

We propose to disqualify your self-declared tax-exempt status under IRC section
501(c)(7) for the years ending December 31, 20XX and December 31, 20XX.

Organizations that are not exempt under IRC Section 501 generally are required to file
federal income tax returns and pay tax, where applicable. For further instructions, forms,
and information please visit www.irs.gov.

If you decide to contest this determination, you may file an action for declaratory judgment
under the provisions of IRC Section 7428 in one of the following three venues: 1) United
States Tax Court, 2) the United States Court of Federal Claims, or 3) the United States
District Court for the District of Columbia. A petition or complaint in one of these three courts
must be filed within 90 days from the date this determination was mailed to you. Please
contact the clerk of the appropriate court for rules and the appropriate forms for filing
petitions for declaratory judgment by referring to the enclosed Publication 892. You may
write to the courts at the following addresses:

United States Tax Court
400 Second Street, NW
Washington, DC 20217

U.S. Court of Federal Claims
717 Madison Place, NW
Washington, DC 20005

U. S. District Court for the District of Columbia
333 Constitution Ave., N.W.
Washington, DC 20001

Processing of income tax returns and assessments of any taxes due will not be delayed if
you file a petition for declaratory judgment under IRC Section 7428.

You may be eligible for help from the Taxpayer Advocate Service (TAS). TAS is an
independent organization within the IRS that can help protect your taxpayer rights. TAS can
offer you help if your tax problem is causing a hardship, or you've tried but haven't been able
to resolve your problem with the IRS. If you qualify for TAS assistance, which is always free,
TAS will do everything possible to help you. Visit www.taxpayeradvocate.irs.gov or call
1-877-777-4778.

Taxpayer Advocate assistance can't be used as substitute for established IRS procedures,
formal appeals processes, etc. The Taxpayer Advocate is not able to reverse legal or
technically correct tax determination, nor extend the time fixed by law that you have to file a
petition in 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 can get any of the forms or publications mentioned in this letter by calling 800-TAX-
FORM (800-829-3676) or visiting our website at www.irs.gov/forms-pubs.

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,

Sean E. O'Reilly
Director, EO Examinations

Enclosures:
Publication 892

[Page 2]

Department of the Treasury Date: December 10, 2019
Internal Revenue Service
IRS Tax Exempt and Government Entities

Taxpayer ID number:
Form:
Tax periods ended:
Person to contact:
Name:
ID number:
Telephone:
Fax:
Address:
Manager's contact information:
Name:
ID number:
Telephone:
Response due date:

CERTIFIED MAIL — Return Receipt Requested

Dear

Why you're receiving this letter

We enclosed a copy of our audit report, Form 886-A, Explanation of Items, explaining that your
organization doesn't qualify as an organization described in Internal Revenue Code (IRC)
Section 501(c)(7).

This letter is not a determination of your tax-exempt status under IRC Section 501 for any period
other than the tax periods above.

If you agree

If you haven't already, please sign the enclosed Form 6018, Consent to Proposed Action, and
return it to the contact person shown at the top of this letter. We'll issue a final adverse letter
determining that you aren't an organization described in IRC Section 501(c)(7) for the periods
above.

If you disagree

1. Request a meeting or telephone conference with the manager shown at the top of this
   letter.

2. Send any information you want us to consider.

3. File a protest with the IRS Appeals Office. If you request a meeting with the manager or
   send additional information as stated in 1 and 2, above, you'll still be able to file a protest
   with IRS Appeals Office after the meeting or after we consider the information.

Letter 3618 (Rev. 8-2019)
Catalog Number 34809F

The IRS Appeals Office is independent of the Exempt Organizations division and
resolves most disputes informally. If you file a protest, the auditing agent may ask you to
sign a consent to extend the period of limitations for assessing tax. This is to allow the
IRS Appeals Office enough time to consider your case. For your protest to be valid, it
must contain certain specific information, including a statement of the facts, applicable
law, and arguments in support of your position. For specific information needed for a
valid protest, refer to Publication 892, How to Appeal an IRS Determination on Tax-
Exempt Status.

Fast Track Mediation (FTM) referred to in Publication 3498, The Examination Process,
generally doesn't apply now that we've issued this letter.

4. Request technical advice from the Office of Associate Chief Counsel (Tax Exempt
   Government Entities) if you feel the issue hasn't been addressed in published precedent
   or has been treated inconsistently by the IRS.

If you're considering requesting technical advice, contact the person shown at the top of
this letter. If you disagree with the technical advice decision, you will be able to appeal to
the IRS Appeals Office, as explained above. A decision made in a technical advice
memorandum, however, generally is final and binding on Appeals.

If we don't hear from you

If you don't respond to this proposal within 30 calendar days from the date of this letter, we'll
issue a final adverse determination letter.

In the future, if you believe your organization qualifies for tax-exempt status and would like a
status determination letter from the IRS, you can request a determination by filing Form 1024,
Application for Recognition of Exemption Under Section 501(a), and paying the required user
fee.

Contacting the Taxpayer Advocate Office is a taxpayer right

The Taxpayer Advocate Service (TAS) is an independent organization within the IRS that can
help protect your taxpayer rights. TAS can offer you help if your tax problem is causing a
hardship, or you've tried but haven't been able to resolve your problem with the IRS. If you
qualify for TAS assistance, which is always free, TAS will do everything possible to help you.
Visit www.taxpayeradvocate.irs.gov or call 877-777-4778.

For additional information
You can get any of the forms and publications mentioned in this letter by visiting our website at
www.irs.gov/forms-pubs or by calling 800-TAX-FORM (800-829-3676).

If you have questions, you can contact the person shown at the top of this letter.

Sincerely,

Maria Hooke
Director, Exempt Organizations
Examinations

Enclosures:
Form 886-A
Form 6018
Publication 892
Publication 3498

Letter 3618 (Rev. 8-2019)
Catalog Number 34809F

[Page 3]

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items

Name of taxpayer Tax Identification Number (last 4 digits) Year/Period ended
December 31, 20XX
December 31, 20XX

Whether the qualifies for self-declared tax-exempt status under Internal Revenue
Code (IRC) section 501(c)(7) when it derives significant income from a substantial, nontraditional, ongoing
business activity outside of its membership.

FACTS

The , hereinafter referred to as the Club, was formed as an association in the
. The Club has never been issued a determination letter by the Internal Revenue
Service (IRS) and has been filing its exempt organization returns as a self-declared organization since 20XX. The
Club's calendar year ends on December 31.

The Club provides pleasure and recreation to hunters and marksmen in the practical shooting of firearms.
Additionally, its activities include education in the use of firearms as well as the promotion of natural resource
conservation. Its educational activities include presentations by its members and state/local officials about
firearm use and safety. Its conservation activities include being a good steward of its land as well as participating
in an ongoing program directed by the Department of Natural Resources where the efficacy of a
is being tested.

The Club is a membership organization that has active members and retired members possessing the same voting
rights. The use of the Club is for members and bona fide guests.

The Club receives modest amounts of income from membership dues, interest earned on deposits in a savings
account, and land rented for crop production. Its primary income source is royalties from the leasing of its land
for oil and gas extraction.

LAW

Prior to its amendment in 1976, IRC section 501(c)(7) provided exemption from federal income tax for social clubs
organized exclusively for pleasure, recreation, and other nonprofitable purposes where no part of the club's net
earnings inures to the benefit of any private shareholder. Subsequently, 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 nonmembers, so long as the latter do not represent more than 15 percent of total receipts.

(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 nonmembers' 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.

Catalog Number 20810W Page 1 www.irs.gov Form 886-A (Rev. 5-2017)

[Page 4]

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items

Name of taxpayer Tax Identification Number (last 4 digits) Year/Period ended
December 31, 20XX
December 31, 20XX

The Committee Reports for Public Law 94-568 state that it is not "intended that these organizations should be
permitted to receive, within the 15 or 35 percent allowances, income from the active conduct of businesses not
traditionally carried on by these organizations." This language means that Congress intended that exempt social
clubs should not be permitted to receive income from activities not conducted in furtherance of their exempt
purposes. Therefore, a club that engages in nontraditional business activity can jeopardize its exempt status even
when its gross receipts are within the permissible limits.

Revenue Ruling 68-589, 1968-2 C.B. 266 states that a social club's business activity will defeat exemption unless
such activity is incidental, trivial or nonrecurrent which the IRS has interpreted to mean "insubstantial" for this
purpose.

Treasury Regulation section 1.501(c)(7)-1(b) states 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
exempt under section 501(a). However, an incidental sale of property will not deprive a club of its exemption.

Revenue Ruling 66-149, 1966-1 C.B. 146 provided that a social club is not exempt from federal income tax as an
organization described in IRC section 501(c)(7) if it regularly derives a substantial part of its income from
nonmember sources such as, for example, dividends and interest on investments. In this instance, the club's
funds were invested primarily for the purpose of producing income through dividends, interest, or capital
appreciation. It was evident that 1) such income was regularly derived from nonmember sources, 2) that the
income was received in fulfillment of and pursuant to a profit motive, and 3) that the income from investments
was substantial in relation to total income.

Revenue Ruling 69-220, 1969-1 C.B. 154 held that a social club that receives a substantial portion of its income
from the rental of property and uses such income to defray operating expenses and to improve and expand its
facilities is not exempt under IRC section 501(c)(7).

Santee Club v. White, 87 F. 2d 5 (1936) held that, where a club engages in income producing transactions which
are not a part of the club purposes, exemption will not be denied because of incidental, trivial, or nonrecurrent
activities such as sales of property no longer adapted to the club's purpose.

National Mah Jongg League v. U.S., 75 F. Supp. 769 (1947) stated that a corporation that was organized for the
purpose of promoting the game of Mah Jongg; where its income from memberships was insufficient to meet
expenses and where the corporation engaged in the commercial enterprise of selling to the public lists and tiles
where the income therefrom enabled the corporation to meet its deficit, carry on without an increase of dues or
curtailment of operations, and accumulate a surplus which was donated to charity, was not operated exclusively
for social purposes or charitable purposes. Therefore, the corporation was not exempt from federal
income tax under IRC section 501(c)(7) or IRC section 501(c)(8).

United States of America v. Fort Worth Club of Fort Worth, Texas, 345 F. 2d 52, 57 (5th Cir. 1965) held that a
social club which derived over half of its receipts, in amounts of hundreds of thousands of dollars, from profitable
outside business was not exempt from federal income taxes on grounds it was organized and operated exclusively
for pleasure, recreation, and other nonprofitable purposes. The court declared that for a social club to qualify for
exemption under IRC section 501(c)(7), its outside profits must be 1) strictly incidental to club activities, not a
result of an outside business, and 2) either negligible or nonrecurring.

Catalog Number 20810W Page 2 www.irs.gov Form 886-A (Rev. 5-2017)

[Page 5]

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items

Name of taxpayer Tax Identification Number (last 4 digits) Year/Period ended
December 31, 20XX
December 31, 20XX

GOVERNMENT'S POSITION

Utilizing the guidance provided in Public Law 94-568, as well as previous revenue rulings and court cases, the
Service prescribes two tests that a club can use to demonstrate it is organized substantially for pleasure,
recreation, and other nonprofitable purposes: a "gross receipts" test and a "facts and circumstances" test.

• The gross receipts test is an income test where its limitations reflect those of Public Law 94-568:

Clubs may receive up to 35 percent of their gross receipts, including investment income, from sources
outside of their membership.

Within the 35 percent limitation, no more than 15 percent of gross receipts may be derived from
nonmember use of club facilities and/or services.

If a club's income sources are within these limits, the club will be considered to be operated substantially
for pleasure, recreation, and other nonprofitable purposes.

• If a club's income sources are outside of the limits of the gross receipts test, then the club may still be able
to show through facts and circumstances that substantially all of its activities are for pleasure, recreation,
and other nonprofitable purposes.

The Club's testing results are as follows:
20XX
• Gross Receipts Test — fail

• [redacted] gross receipts from sources outside of the club's membership
• [redacted] total gross receipts
• [redacted]%
  • Facts and Circumstances Test — fail
• For a social club, the leasing of land for oil and gas extraction:
  o is a nontraditional business activity
  o is an ongoing/recurring business activity
  o is not an insubstantial business activity
  o does not further an exempt purpose

20XX
• Gross Receipts Test — fail

• [redacted] gross receipts from sources outside of the club's membership
• [redacted] total gross receipts
• [redacted]%
  • Facts and Circumstances Test — fail

Catalog Number 20810W Page 3 www.irs.gov Form 886-A (Rev. 5-2017)

[Page 6]

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items

Name of taxpayer Tax Identification Number (last 4 digits) Year/Period ended
December 31, 20XX
December 31, 20XX

• For a social club, the leasing of land for oil and gas extraction:
  o is a nontraditional business activity
  o is an ongoing/recurring business activity
  o is not an insubstantial business activity
  o does not further an exempt purpose

The Club is like the organization in Revenue Ruling 66-149 that did not qualify for exemption under IRC section
501(c)(7) because it regularly derives income from nonmember sources that is substantial in relation to its total
income.

The Club is like the organization in Revenue Ruling 69-220 that did not qualify for exemption under IRC section
501(c)(7) because it receives a substantial portion of its income from sources other than members.

The Club is not similar to the organization in Santee Club v. White because its royalties from its oil and gas lease
are not incidental, not trivial and are recurring.

The Club is similar to the organization in National Mah Jongg League v. U.S. because the majority of the Club's
revenue is from oil and gas lease royalties where its royalty income exceeds the income from its members many
times over. The revenue from royalties is recurring and more than incidental. While the Club may have been
organized for pleasure, recreation, and other nonprofitable purposes, its revenues show that it is not operating for
these purposes.

Per United States of America v. Fort Worth Club of Fort Worth, Texas, the Club's royalty income must be
incidental to the Club's activities and either negligible or nonrecurring. Instead, the Club's royalty income is both
recurring and substantial.

As prescribed in Treasury Regulation section 1.501(c)(7)-1(b), the Club is engaging in business activities and is
therefore not organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes.

TAXPAYER'S POSITION

In 20XX, the Club recognized it no longer qualified as exempt under IRC section 501(c)(7). As a result, it filed a
20XX Form 1120, U.S. Corporation Income Tax Return, with the IRS and intended to do the same in future
years. However, the IRS returned this 20XX Form 1120 to the Club with correspondence indicating that the Club
must continue filing Form 990-series returns because it was a tax-exempt organization. Therefore, the Club
continued filing Form 990-series returns along with their related Forms 990-T, Exempt Organization Business
Income Tax Return.

The Club has not yet been presented with this report. However, it has communicated that it agrees with the
disqualification of its tax-exempt status under IRC section 501(c)(7).

CONCLUSION

The Club does not meet the requirements for exemption under IRC section 501(c)(7). It meets neither the gross
income test nor the facts and circumstances test. The Club receives the majority of its income from sources
outside of its membership by engaging in a substantial, nontraditional, recurring trade or

Catalog Number 20810W Page 4 www.irs.gov Form 886-A (Rev. 5-2017)

[Page 7]

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items

Name of taxpayer Tax Identification Number (last 4 digits) Year/Period ended
December 31, 20XX
December 31, 20XX

business. Therefore, the Club does not operate substantially for pleasure, recreation, or other nonprofitable
purposes.

We propose to disqualify the Club's self-declared tax-exempt status under IRC section 501(c)(7) for the years
ending December 31, 20XX and December 31, 20XX.

Catalog Number 20810W Page 5 www.irs.gov Form 886-A (Rev. 5-2017)