IRS removes a social club from its group exemption for exceeding the 35% investment-income limit

Plain-English summary

A social club that housed and served a group of students had its 501(c)(7) exemption pulled after an IRS audit. The club was a subordinate under a parent organization's group ruling; one related entity managed the housing and investments while another coordinated the members' activities. A 501(c)(7) club can take no more than 35 percent of its gross receipts from outside its membership (with a tighter 15 percent sub-limit for income from nonmember use of club facilities), counting investment income toward the 35 percent. The audit found that investment income (dividends and interest) exceeded 35 percent of the club's gross receipts, not just once but on a continuous basis over several years, with no single unusual event to explain it and no funds set aside for charitable or similar purposes. Unlike some other cases, the club had properly reported and paid tax on its nonmember investment income, but the recurring size of that income showed it was no longer operated substantially for the pleasure and recreation of its members. The IRS therefore removed the club from the group exemption effective a stated date, meaning it must file federal income tax returns going forward. The letter also reminds the group of IRC § 277, which governs taxable membership organizations.

Ruling snapshot

• Question: Does a 501(c)(7) social club keep its exemption when investment income exceeds 35% of gross receipts year after year?
• Outcome: Revocation (removed from the group exemption; nonmember/investment income exceeds the 35% limit on a recurring basis)
• Key authorities: IRC § 501(c)(7); Treas. Reg. § 1.501(c)(7)-1; IRC § 512(a)(3)(A), (B); Public Law 94-568 (35% / 15% gross-receipts limits); Rev. Rul. 58-589; Rev. Rul. 60-324; Rev. Rul. 66-149; Rev. Rul. 68-119; Rev. Proc. 71-17; IRC § 277

Full text (IRS public release)

Department of the Treasury
Internal Revenue Service
Tax Exempt and Government Entities
Date: May 10, 2021

Taxpayer ID number:
Form:
Tax periods ended:

Person to contact:
Name:
ID number:
Telephone:
Fax:
Release Number: 202237018
Release Date: 9/16/2022
UIL Code: 501.07-00

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: You have not
established that you are operated substantially for pleasure and recreation of your members or other non-
profitable purposes and no part of the earnings inures to the benefit of any private shareholder within the
meaning of IRC Section 501(c)(7). You have exceeded the non-member income test for tax year ending

We'll notify the parent organization (as permitted by law) of our determination that you aren't an organization
described in IRC Section 501(c)(7) and are no longer covered under their group exemption.

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.

Letter 6337 (12-2020)
Catalog Number 74808E

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
400 Second Street, NW
Washington, DC 20217

U.S. Court of Federal Claims
717 Madison Place, NW
Washington, DC 20439

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.

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:

Internal Revenue Service
Taxpayer Advocate Office

Or call TAS at 877-777-4778. For more information about 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.

Enclosures:
Publication 1
Publication 594
Publication 892

Letter 6337 (12-2020)
Catalog Number 74808E

Department of the Treasury
Internal Revenue Service
Tax Exempt and Government Entities
Date: March 25, 2020

Taxpayer ID number:
Form:
Tax periods ended:

Person to contact:
Name:
ID number:
Telephone:
Fax:
Hours:

Manager's contact information:
Name:
ID number:
Telephone:
Response due date: April 25, 2020

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 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.

After we issue the final adverse determination letter, we'll announce that your organization is no
longer eligible to receive tax deductible contributions under IRC Section 170.

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.

— Only Applicable to Group Exemption Parent Organizations

[Revenue Procedure 80-27 requires that, in the event your tax-exempt status is revoked, your
group exemption will also be revoked. If that occurs, none of your subordinates will be able to
rely on the group ruling for tax-exempt status. You should notify each subordinate of this
proposed action.]

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.

Enclosures:
Form 886-A
Form 6018
Form 4621-A
Publication 892
Publication 3498

Sincerely,

Maria Hooke
Director, Exempt Organizations
Examinations

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

Form 886-A
Department of the Treasury - Internal Revenue Service
Explanation of Items

Name of Taxpayer Year/Period Ended

ISSUE:
Does continue to qualify for exemption under Internal Revenue Code § 501(c)(7) given that it
receives more than 15% of its income from investment income on a recurring basis?

FACTS

Organizational Documents

is a subordinate of ( ). was recognized as exempt social club under
the Internal Revenue Code Section 501(c)(7) from a group ruling of the parent;
The organization is recognized to operate at to manage the activities of the .
is also known as the .

Its purposes as stated in its Articles of Incorporation dated as a
"... organized exclusively for charitable, religious, education, and
scientific purposes, including, for such purposes, the making of distributions to
organizations that qualify as exempt organization under section 501(c)(3) of the Internal
Revenue Code, or the corresponding section of any future federal tax code...".

The recognized under the same group
ruling works in conjunction with . The
manages the housing and investments
whereas the coordinates the
membership activities and interaction of the members.

Activities
fulfilled its purposes by promoting
; , and community service in a of
students. The holds events a to award .
There was a rental agreement between and the .
The agreement stated that the organization can
rent the for its members. Each member is responsible for paying
their portion of the rent directly to the . The provides and maintains all
furniture and furnishings for the , with printer and
primary lounge. The is responsible for all repairs and maintenance. The
is responsible for obtaining liability
insurance.

The had a " " also known as
a , . This individual performed regular maintenance, such as cooking
and cleaning for the where the
was compensated through the .
When retired, the
decided to provide additional income for . The amount would be matched
by each member of the . The amount was considered a gift, gathered by all the
members . The contributed $ and
matched the gift with a contribution of $ .

Form was issued to .

Examination of Forms

The organization received revenues from dividends and interest from investments that
generated from . They also received membership dues from
. They incurred operating and payroll expenses during the period ended .
The summary of revenues and expenses are displayed below:

Revenue and Expenses

Source Revenue Expenses
Membership Dues $
Total Revenue $
Fees $
Repair
Retirement Party
Federal and State Taxes
Total Expenses $

During the examination, it was determined that the club properly reported nonmember
income generated from investment income by preparing and filing Form

Below is a historical chart of the investment income reported over the last

Activities-Members
Membership Dues and Assessments
Activities-Non-Member
Investment Interest Income
Total Non-Member income A
Total Investment Income B
Total Non-Member Income and Investment Income C
Total Income
Non-Member % - A/C
Total Non-Member and Investment % - B/C % % % % %

Based on conducting a analysis of gross receipts, it has been noted that the
organization received % and %, during tax years ending and
respectively.

The organization did not set aside any funds during the year under examination.

LAW:

Organizations exempt from federal taxes as described in IRC Section 501(c)(7) include
clubs organized for pleasure, recreation, and other non-profitable purposes,
substantially all of the activities of which are for such purposes, and no part of the net
earnings of which inures to the benefit of any private shareholder.

Internal Revenue Code Section 512(a)(3)(A) - In the case of an organization
described in paragraph (7), (9), or (17) of section 501(c), 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 provided by
sections 243 and 245 (relating to dividends received by corporations) shall be treated
as not directly connected with the production of gross income.

Internal Revenue Code section 512(a)(3)(B) - 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—

° for a purpose specified in section 170(c)(4), or

° in the case of an organization described in paragraph (9) or (17) of
section 501(c), to provide for the payment of life, sick, accident, or other benefits,
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.

Section 1.501(c)(7)-1 of the Income Tax Regulations, relating to the requirements of
exemption of such clubs under section 501(a), reads in part as follows:

(a) The exemption provided by section 501(a) for organizations described in section
501(c)(7) applies only to clubs which are organized and operated exclusively for
pleasure, recreation, and other nonprofitable purposes, but does not apply to any
club if its net earnings inure 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. However, a club otherwise
entitled to exemption will not be disqualified because it raises revenue from
members through the use of club facilities or in connection with club activities.

(b) 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).
Solicitation by advertisement or otherwise for public patronage of its facilities is
prima facie evidence that the club is engaging in business and is not being
operated exclusively for pleasure, recreation, or social purposes. However, an
incidental sale of property will not deprive a club of its exemption.

Prior to its amendment in 1976, IRC Section 501(c)(7) required that social clubs be
operated exclusively for pleasure, recreation, and other non-profitable purposes. Public
Law 94-568 amended the "exclusive" provision to read "substantially" in order to allow a
section 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 further state:

(a) Within this 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. These percentages supersede those provided in
Revenue Ruling 71-17, 1971-1 C.B. 683.

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

(c) In addition, the Committee Reports state 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.

(d) The Senate report also indicates that even though gross receipts from the
general public exceed this standard, it does not necessarily establish that there is
a nonexempt purpose. A conclusion that there is a nonexempt purpose will be
based on all the facts and circumstances including, but not limited to, the gross
receipts factor.

Revenue Ruling 58-589 sets forth the criteria for exemption under section 501(c)(7) of
the Code and provides that a club must have an established membership of individuals,
personal contacts, and fellowship. It also provides that, while the regulations indicate
that a club may lose its exemption if it makes its facilities available to the general public,
this does not mean that any dealings with nonmembers will automatically cause a club
to lose its exemption. A club may receive some income from the general public, that is,
persons other than members and their bona fide guests, or permit the general public to
participate in its affairs, provided that such participation is incidental to and in
furtherance of the club's exempt purposes, such dealings with the general public and
the receipt of income there from does not indicate the existence of a club purpose to
make a profit, and the income does not inure to club members.

Revenue Ruling 60-324 provides that a social club that made its social facilities
available to the general public through its member-sponsorship arrangement cannot be
treated as being operated exclusively for pleasure, recreation, or other nonprofitable
purposes and the club no longer qualified for exemption under 501(c)(7) of the Code.

Revenue Ruling 66-149 provides that a social club is not exempt from federal income
tax as an organization described in section 501(c)(7) of the code if it regularly derives a
substantial part of its income from non-member sources such as, for example, dividends
and interest on investments.

Revenue Ruling 68-119 provides that a club will not necessarily lose its exemption if it
derives income from transactions with other than bona fide members and their guests,
or if the general public on occasion is permitted to participate in its affairs, provided
such participation is incidental to and in furtherance of its general club purposes and the
income there from does not inure to members.

Revenue Procedure 71-17 sets forth guidelines for determining the effect of gross
receipts derived from nonmember use of a social club's facilities on exemption under
Internal Revenue Code Section 501(c)(7) and recordkeeping requirements. Failure to
maintain such records or make them available to the Service for examination will
preclude use of the minimum gross receipts standard and audit assumptions set forth in
this Revenue Procedure.

If a club exceeds the 15/35% test, then it will maintain its exempt status only if it can
show through facts and circumstances that "substantially all" of its activities are for
"pleasure, recreation and other nonprofitable purposes."

The following are important facts and circumstances to take into account to determine
whether a club may maintain its exemption under IRC 501(c)(7):

• The actual percentage of nonmember receipts and/or investment income.

• Frequency of use of the club facilities or services by nonmembers. An
unusual or single event (that is, nonrecurring on a year to year basis) that
generates all the nonmember income is viewed more favorably than
nonmember income arising from frequent use by nonmembers.

• Record of nonmember use over a period of years. A high percentage in one
year by nonmembers, with the other years being within permitted levels, is
viewed more favorably than a consistent pattern of exceeding the limits, even
by relatively small amounts. (See S. Rept. 94-1318, 2d Sess., 1976-2 C.B.
597, 599).

• Purposes for which the club's facilities were made available to nonmembers.

• Whether the nonmember income generates net profits for the organization.
Profits derived from nonmembers, unless set aside, subsidize the club's
activities for members and result in inurement within the meaning of IRC
501(c)(7).

Set Aside Law

The unrelated business taxable income (UBTI) of organizations described in Internal
Revenue Code sections 501(c)(7), 501(c)(9), 501(c)(17), or 501(c)(20), includes all
gross income, less deductions directly connected with producing that income, but not
including exempt function income. Also, the dividends received deductions for
corporations are not allowed in computing UBTI, because they are not expenses
incurred in producing income. Exempt function income is gross income from dues, fees,
charges, or similar items paid by members for the purposes for which exempt status
was granted to the organization. Exempt function income also includes income that is
set aside for qualified purposes.

The investment income of these types of organizations generally is not taxed if it is set
aside to be used for religious, charitable, scientific, literary, or educational purposes or
for the prevention of cruelty to children or animals. In addition, for a section 501(c)(9),
501(c)(17), or 501(c)(20) organization, investment income is generally not taxed if it is
set aside to provide for the payment of life, sick, accident, or other benefits. However,
income on any amounts set aside that exceed the qualified asset account limit, figured
under Code section 419A, is unrelated business income. Special rules apply to the
treatment of existing reserves for post-retirement medical or life insurance benefits.
Income derived from an unrelated trade or business may not be set aside and therefore
cannot be exempt function income. In addition, any income set aside and later spent for
purposes other than those specified must be included in unrelated business taxable
income.

TAXPAYER'S POSITION:
position has not been provided.

GOVERNMENT'S POSITION:

An organization exempt from federal income taxes as described in IRC section
501(c)(7) must meet the gross receipts test in order to maintain its exemption. In order
to meet the gross receipts test, an organization can receive up to thirty-five percent
(35%) of its gross receipts, including investment income, from sources outside its
membership without losing its tax-exempt status. Within this 35% amount, not more
than fifteen percent (15%) of the gross receipts should be derived from the use of a
social club's facilities or services by non-members.

After reviewing and comparing the books and records with the Form
for period ending , the percent of gross receipts from investment
income exceeded 35% for the year. It was also determined that previous years
returns show investment income also exceeded 35%.

has exceeded the 35% gross receipts (including investment
income) standard for nonmember income on a continuous basis for at least
years. The nonmember receipts are earned throughout the year. There was no one
single or unusual event that caused the to exceed the threshold.
investment income during the year
represents % of the total of nonmember income.

During the interview process and review of books and records there was no
indication by the organization records showing that the investment income was set
aside to be used for religious, charitable, scientific, literary, or educational purposes
or for the prevention of cruelty to children or animals.

historical revenue comparison

Activities-Members
Membership Dues and Assessments
Activities-Non-Member
Investment Interest Income
Total Non-Member Income A
Total Investment Income B
Total Non-Member Income and Investment Income C
Total Income
Non-Member % - A/C
Total Non-Member and Investment % - B/C % % % % %

Based on the large percentages of gross nonmember income to total gross receipts
of the (i.e., % and %, as noted in the above table), which
exceeds the limitation of 35% as set forth by IRC 501(c)(7) for each of these years, it
is the government's position that the organization is no longer operated exclusively
for the pleasure and recreation of its members and is not exempt under section
501(c)(7).

CONCLUSION:
The IRC Section 501(c)(7) tax exempt status of
should be removed from the group level exemption since the nonmember
income received by the exceeded 35% of the total gross
receipts for the years under examination.

Your books and records show that out of the $ of total income received, % of
your total income is derived from non-member and investment income. Based on the
fact that you received substantial income from investments, you have exceeded the
35% limitation.

no longer qualifies for group level
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 will be
removed from the group level exemption effective . Should this removal be
upheld, Form must be filed starting with tax periods ending

Additionally, the organization is reminded of the provisions of IRC 277 concerning
membership organizations which are not exempt organizations.

Note: If you are planning to appeal the proposed removal from exemption, 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-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -10-