IRS revokes a 501(c)(7) social club's exemption for taking too much oil-and-gas royalty (non-member) income

Plain-English summary

A tax-exempt social club under IRC § 501(c)(7) leased part of its property to an
exploration company and, for years, collected substantial oil-and-gas royalty income on a
monthly basis. Section 501(c)(7) clubs are meant to be supported mainly by their members
(dues, fees, and assessments). By law (P.L. 94-568), such a club may take no more than 35%
of its gross receipts, including investment income, from outside its membership, and within
that 35% no more than 15% may be non-member business income. The club's royalty income
consistently exceeded those limits.

The IRS concluded the royalties count as non-member income (a 501(c)(7) gets no passive-income
exception here), that the club's situation closely mirrored Coastal Club, Inc. (a duck-hunting
club that leased land for oil and gas), and that both the 35%/15% test and the backstop
facts-and-circumstances test were failed. It therefore issued a final adverse determination
that the organization no longer qualifies as a 501(c)(7) social club. The practical effect:
the club must file federal income tax returns and pay tax where applicable, and it would have
to reapply (Form 1024) to regain exempt status. The lesson for member clubs: sizable, recurring
outside income (here, mineral royalties) can cost a club its exemption even when the money is
plowed back into club facilities.

Ruling snapshot

• Question: Does the social club fail the 35%/15% gross-receipts / non-member income limits by deriving a substantial part of its income from oil-and-gas royalties?
• Outcome: Revocation (final adverse determination that the club does not qualify under § 501(c)(7))
• Key authorities: IRC §§ 501(c)(7), 501(a), 7428; Treas. Reg. § 1.501(c)(7)-1; P.L. 94-568; Rev. Rul. 66-149; Rev. Rul. 69-220; Rev. Rul. 58-589; Rev. Rul. 55-716; Coastal Club, Inc. v. Commissioner, 43 T.C. 783 (1965); Pittsburgh Press Club v. United States

Full text (IRS public release)

Transcriber's note: The text below is a proofread OCR transcription of the scanned
release, which comprises the final adverse determination letter (Letter 6337), the
proposed-revocation cover letter (Letter 3618), and a 4-page Form 886-A (Explanation of
Items). The repeating Form 886-A header/footer furniture has been replaced with [Page N]
markers, and obvious OCR misreads have been corrected where the intended word is
unambiguous; wording is otherwise verbatim, so some minor scanning artifacts remain. The
IRS redacted names, dates, dollar amounts, and other identifying details before release,
so figures and identities appear as gaps in the original.

Department of the Treasury Date: April 12, 2021
Internal Revenue Service
IRS Tax Exempt and Government Entities

Number: 202216022
Release Date: 4/22/2022

Taxpayer ID number:
Form:
Tax periods ended:

Person to contact:
Name:

ID number:
Telephone:
Fax:

UIL: 5071.07-00
CERTIFIED MAIL RETURN RECEIPT REQUESTED
Dear

Why we are sending you this letter

This is a final determination explaining why your organization doesn’t qualify as an organization described in
Internal Revenue Code (IRC) Section 501(c)(7) for the tax periods 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: During the tax year in
question, you did not qualify for exemption as a social club described in IRC Section 501(c)(7) because your
gross receipts have consistently exceeded the limitation of 35%, including investment income, from sources
outside of your membership.

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.

What you must do if you disagree with this determination
If you want to contest our final determination, you have 90 days from the date this determination letter was
mailed to you to file a petition or complaint in one of the three federal courts listed below.

How to file your action for declaratory judgment

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.

Please contact the clerk of the appropriate court for rules and the appropriate forms for filing an action for
declaratory judgment by referring to the enclosed Publication 892, How to Appeal an IRS Determination on
Tax-Exempt Status. You may write to the courts at the following addresses:

United States Tax Court U.S. Court of Federal Claims U.S. District Court for the District of Columbia
400 Second Street, NW 717 Madison Place, NW 333 Constitution Ave., N.W.
Washington, DC 20217 Washington, DC 20439 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.

Information about the IRS Taxpayer Advocate Service

The IRS office whose phone number appears at the top of the notice can best address and access your tax
information and help get you answers. However, you may be eligible for free help from the Taxpayer Advocate
Service (TAS) if you can't resolve your tax problem with the IRS, or you believe an IRS procedure just isn't
working as it should. TAS is an independent organization within the IRS that helps taxpayers and protects
taxpayer rights. Contact your local Taxpayer Advocate Office at:

Or call TAS at 877 777 4778 For more information aboul TAS and your rights under the Taxpayer Bill of Rights,
go to taxpayeradvocate.irs.gov. Do not send your federal court pleading to the TAS address listed above. Use
the applicable federal court address provided earlier in the letter. Contacting TAS does not extend the time to
file an action for declaratory judgment.

Where you can find more information
Enclosed are Publication 1, Your Rights as a Taxpayer, and Publication 594, The IRS Collection Process, for
more comprehensive information.

Find tax forms or publications by visiting www.irs.gov/forms or calling 800-TAX-FORM (800-829-3676).
If you have questions, you can call the person shown at the top of this letter.

If you prefer to write, use the address shown at the top of this letter. Include your telephone number, the best
time to call, and a copy of this letter.

Keep the original letter for your records.

Sincerely, — «_
tram eee

Sean [. O'Reilly 7
Director, Exempt Organizations Examinations

Enclosures:
Publication 1
Publication 594
Publication 892

Department of the Treasury

¥i0) Internal Revenue Service Date: 2/21/2020
Tax Exempt and Government Entities

IRS Taxpayer ID number:

Form:
Tax periods ended:

Person to contact:
Name:
1D number:
Telephone:
Fax:
Address:

Manager's contact Information:
CERTIFIED MAIL — Return Receipt Requested Name
ID number:
Telephone:
Response due date:

Dear

Why you’re receiving this letter
We enclosed a copy of our audit report, Form 886-A, Explanation of Items, explaining that we propose to revoke
your tax-exempt status as an organization described in Internal Revenue Code (IRC) Section 501 (c)(7)..

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’lI still be able to file a protest with IRS Appeals Office after
the meeting or after we consider the information.

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 fora
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.

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. Lf you qualify for TAS assistance, which is always free, TAS
will do everything possible to help you. Visit www. luxpayeradvocale.irs.gov or call 8// 777 4778.

Additional] information
You can get any of the forms and publications mentioned in this letter by visiting our website at
www.its.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,

For Maria Hooke

Director, Exempt Organizations Examinations
Enclosures:
Form 886-A
Form 6018

ISSUE: Does the Social Club fail the Gross Receipts Test and Non-member income?

FACTS:

is a social club that currently has an assigned status as a 501(c)(7) Social
Club. They received their tax-exempt designation in 19xx. Since that time has entered
into a agreement with an exploration company in 20xx. As part
of this agreement to lease the of their property, they receive royalty revenue on a
monthly basis. While the royalty revenue has been declining, it is still a substantial part of the
income received by the social club Its royalty revenue accounted for almost % of the total
revenues In the tax period ended , 20x% Prior and subsequent years, with slight
deviation, also received substantial non-member income from these royalties. has been
filing returns and paying taxes on these Royalties. There is currently no termination date for
when these royalties will cease or be reduced to a much lower level.

Non-Member Income Calculation from Return
TaxPeriodEnded / /20xx
Name Amount

Royalties | i)

15/35% Income Issue
Exempt Org Income

Member Dues S Non-Member Royalties
Interest S Revenue Percentage
Royalties S %
Adjustedincome S

LAW

IRC 501(c)(7) lists a type of organization exempt from federal income tax under section 501(a)
described as clubs organized for pleasure, recreation, and other nonprofitable purposes.

Treas. Reg. 1.501(c)(7)-1 provides that section 501(c)(7) organizations are those which are
organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, but
does not apply to any club if any part of its net earnings inures to the benefit of any private
shareholder. In general, this exemption extends to social and recreation clubs which are
supported solely by membership fees, dues, and assessments.

Rev. Rul. 66-149, 1966-1 C.B. 146, held a social club is not exempt from Federal income tax
under IRC 501(c)(7) of the Code where it regularly derives a substantial part of its income from
nonmember sources, such as dividends and interest on investments that it owns.

[Page 1]

Rev. Rul. 69-220, 1969-1 C.B. 154, held 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 section 501(c){7) of the Code.

Public | aw 94-568, indicates that social clubs may receive some outside income, including
investment income, without losing their exempt status and permit them to derive a higher
percentage of gross receipts from the use of their facilities and services by nonmembers than
would have been permitted under published Service guidelines. The law allows organizations to
receive up to 35 percent of their gross receipts, including investment income, from sources outside
their membership without losing their exempt status. Within this 35 percent, not more than 15
percent of gross receipts should be non member income. Gross receipts are defined as:
“,.those receipts from normal and usual activities of the club (that is, those activities they had
traditionally conducted) including charges, admissions, membership fees, dues, assessments,
investment income (such as dividends, rents and similar receipts) contributions.”

If the club earns more than is permitted under this law, a facts and circumstances test will be
applied.

In Coastal Club, Inc., 43 T.C. 783 (1965), the Tax Court held a corporation organized as a duck-
hunting club which repeatedly leased its property for the exploration for and the production of oil
and gas was not exempt from income tax under section 501(c)(7). The Court noted that the oil and
gas lease income exceeded the amounts received from its members in the form of dues and
service and guest charges and also supplied more than half of the amounts required and
expended for operations, repairs, maintenance, and improvements, the Court felt that if the
petitioner were held exempt under the statute, such holding would attribute an intent to Congress
that in enacting section 501(c){7), Congress had not intended. Its opinion held that the facts show
not only were the leasing activities not incidental or related to those purposes but in disregard
thereof they were entered ‘for the purpose of profit’ and that the profits therefrom have been both
regularly recurring and substantial.

In Pittsburgh Press Club v. U.S., 536 F.2d 572 (1976); 579 F.2d 751 (1978); and 615 F.2d 600
(1980), the court found that a substantial portion of the club’s total gross receipts was from
nonmember use of club facilities (determined to be between 11-17% of gross income). This
indicated to the court that the club was engaged in business with the general public. Other factors
noted by the court to consider in addition to the level of nonmember income include the purposes
for which the club’s facilities were made available to nonmember groups, the frequency of use of

the club facilities by nonmembers, and the amount of net profits derived from the nonmember
income.

Rev. Rul. 58-589, 1958-2 C.B. 266, To meet the first requirement, there must be an established
membership of individuals, personal contacts and fellowship. A commingling of the members must
play a material part in the life of the organization.

[Page 2]

Rev. Rul. 55-716, 1955-2 C.B. 263, states face to face interaction is important for members of a
social club. Organizations that do not afford opportunities for personal contact among members,
(or there is such contact, but it is incidental to the primary purpose) are not entitled to exemption
even though organized not for profit with no part of their earnings inuring to the benefit of
shareholders.

The cited Code and Regulations above, provide criteria for recognition of a tax-exempt
organization under IRC 501(c)(7). Generally, an organization is to be organized and operated
exclusively for pleasure, recreation, and other nonprofit purposes, but docs not apply to any club if
any part of its net earnings inures to the benefit of any private shareholder.

In the case of the organization under examination, it was granted exemption, in , aS a social
club, under IRC 501(c)(7) to acquire . At the

time of recognition, it appears to have met the requirements of Treas. Reg. 1.501(c){7)-1 at time of
application.

The cited revenue rulings and case law provide precedent as to how an organization can, based
on its activities and sources of income, be denied recognition of exemption or have their tax -
exempt status revoked.

As outlined in Rev. Rul. 66-149 and Rev. Rul. 69-220, a social club is not exempt from federal
income tax where the organization derives a substantial part of its income from nonmember
sources.

P.L. 94-568, states an organization is allowed to receive up to 35% of its gross receipts,

including investment income, from nontraditional business activities without losing its exempt
status. Within the 35%, not more than 15% of gross receipts should be nonmember income. If an
organization earns more than permitted, a facts and circumstance test is applied.

Nontraditional business activities are activities that don’t further the pleasure or recreation or
other nonprofitable exempt purposes of a social club, even if conducted solely on a membership
basis. Social clubs may lose or be denied their tax-exempt status if the nontraditional business
activities are not incidental, trivial, or nonrecurrent.

It is not intended that Section 501(c)(7) 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. See S. REP. 94-1318, 4, 1976 U.S.C.C.A.N. 6051, 6054.

In the case of Coastal Club, Inc., a duck hunting club, which leased its property for the

exploration of and the production of oil and gas, the Court held that “for the years before us
petitioner was not operated exclusively for pleasure, recreation, and other nonprofitable purposes
within the meaning of the statute...the petitioner on brief concedes that its oil and gas income has

[Page 3]

made it possible for Coastal Club to operate and maintain its hunting facilities for the use of its
members and their guests, and to make improvements, without the necessity of raising its dues or
increasing its charges to members. And the facts show, as noted, that this has been so even
though the club expenditures have ranged from approximately two to five times the total of dues
and other charges to members.” In the Court’s opinion it stated, “the club members were to a most
substantial extent enjoying a free ride from the nonrecreational use of their properties.”

GOVERNMENT’S POSITION

The facts provided about the organization under examination are that the entity receives over %
of its income from royalties from This has gone on for almost —-years

Based on the general facts provided, the subject case under examination closely mirrors the
Coastal Club case. Receipt of over % of the organization’s gross receipts from nonmember
investment income appears to exceed the 35/15 percent threshold outlined in P.L. 94-568.

Based on the case law provided, royalties should be included in the calculation of the non-member
income test. A 501(c)(7) does not receive an exception as passive income for this as do other
entities. This is evident in the case law or revenue rulings pertinent to the 35/15% test based on

royalties (particularly or royalties). Since exceeds the
35/15 percent test and the facts and circumstances test is failed, then that is grounds for
revocation. Failure of this non-member income test indicates that no longer

meets the legal requirements of a tax-exempt organization under IRC 501(c)(7) and may be
revoked.

CONCLUSION

it appears that the income of this organization exceeds the allowable limits on non-member
income for an organization to be exempt from taxation under IRC 501(c)(7). As a result, the
organization fails to meet the requisite legal requirements for exemption under IRC 501(c)(7).

[Page 4]