An Unfair Exemption?
What do private country clubs, amateur sports groups, and college Greek societies share in common? Federal income tax exemption. Under Section 501(c)(7) of the Internal Revenue Code (“IRC”), such “social clubs” may be organized “for pleasure, recreation, and other nonprofitable purposes.” 26 U.S.C.A. § 501. Under this section, the following organizations may qualify for exemption: “(1) college fraternities operating chapter houses for students; (2) country clubs; (3) amateur hunting, fishing, tennis, swimming, and other sport clubs; (4) dinner clubs that provide a meeting place, library, and dining room for members; (5) variety clubs; (6) community associations; and (7) hobby clubs.”
At first blush, the (c)(7) exemption seems odd: How is it that the U.S. Tax Code waives tax liability for such social and pleasure seeking organizations? Ordinary businesses pay income tax, even businesses seemingly similar to the examples above -- public golf courses, recreational outfits, and restaurants, for example. On what basis does the IRC provide exemption for private member-based clubs with similar activities to these taxed entities?
By Us, For Us
Consider the following example: Imagine a collection of families in a neighborhood in one of the many Chicago suburbs. These families have kids who are all close to the same age. These kids love soccer. They play pick up games together all the time. The parents support their kids’ soccer playing and decide to form a soccer club. The club is comprised of the kids in the neighborhood and exists to help the kids enjoy the game, and to help improve their skills. The club’s benefits are for member kids only. The club will not compete as a team. The parents pay dues, which help to buy the kids’ equipment, to lease practice fields, and to bring in a coach to help improve the kids’ soccer skills. Sometimes the dues are used for picnics and other outings. One of the parents is a lawyer and advises the parents to incorporate the club so as to protect the families from liability.
Should this club be taxed on the revenue it generates from the dues for the kids’ soccer-related activities? Probably not. After all, the parents are simply pooling their money (paying dues) for their kids’ benefit, and they’ve already paid income tax on the money they’re using to pay such dues. Taxing dues paid to the club would probably discourage the club’s formation. This is the basic rationale that justifies the 501(c)(7) exemption. As one author puts it, “The purpose of exempting social clubs is to permit individuals to pursue common interests through an organization without paying a second level of tax on the money they contribute to such organization. Dues or other contributions to a social club are not deductible, so all amounts received by social clubs are subject to one level of tax [Income tax at the taxpayer level].” Hill & Mancion, Taxation of Exempt Organizations ¶16.02. Social Clubs, 2003 WL 1891186, 1.
Business Limits on Social Clubs
That is not to say 501(c)(7) organizations may operate like most business entities. The IRC requires (1) that substantially all of the activities are for such pleasure, recreation, and other nonprofitable purposes, and (2) that no part of the net earnings inures to the benefit of any private shareholder.
Let’s take the second prohibition first. Suppose the soccer club is a tremendous success. Not only do the kids have a great time, but through their activities and training, the kids develop skill in the sport. Word gets out about the club, and soon other families want their kids to take part. Some additional parents would like to join the club and pay dues. A few enterprising parents see the potential for a personal windfall. “What if we distribute the revenues we receive to the original members of the soccer club? None of us will retire, but it would be a nice little chunk of change.” As Lee Corso might put it, “Not so fast, my friend.” Any dividend or other “return on investment,” like that contemplated by the enterprising parents, constitutes private inurement. Such personal financial benefit is strictly impermissible under 501(c)(7).
What about the first prohibition – that “substantially all” of the activities must be for pleasure, recreation, and other nonprofitable purposes? In the nearby area, there might be other families interested in the club. The other families are not interested in the substantial financial commitment it would take to become a full member, but they would like for their children to receive training services from the club and are willing to pay to have their kids join in on certain training days. They approach the club member parents with the idea. The club member parents reason, “What if we offer a menu of soccer-related services to nonmembers? Training? Equipment sales? We will put the money back into the programs. Outside fees would provide more income for us to improve our programs.” Is this a good idea or even permissible under the IRC?
Probably not. If a (c)(7) receives income from outside the club, the IRS will likely consider such income to be business-related and not in pursuit of the recreational purposes of the club. “The main question is whether the activity as actually conducted under the facts and circumstances of a particular case constitutes recreation or business.” Id. Remember that for social clubs, “substantially all” of the organization’s activities must be pleasure, recreation, and other nonprofitable activities. The IRS has interpreted that phrase to mean that no more than 15% of a (c)(7)’s gross receipts may come from providing services to non-members, and no more than 35% of a (c)(7)’s gross receipts may come from non-member sources, including investment income. Priv. Ltr. Rul. 201306027 (Nov. 15, 2012). Many social clubs have lost their tax-exempt status for failing to observe these thresholds, through too-enterprising efforts to seek outside revenues. Accordingly, social clubs should implement policies that strictly limit the receipt of such outside revenues.
Remember Your Roots
Exemption for 501(c)(7) organizations removes obstacles from the association of people who have shared recreational and social interests. So long as (c)(7) clubs operate in furtherance of those shared interests, exempt status should be secure. On the other hand, if a (c)(7)’s members get a case of “mission drift” and forget the main reasons for which it was formed, the club may lose its exemption. Whether it be a private club of golfers whose club serves members’ shared golfing interests, a member-only dinner club, or our example neighborhood soccer club, remember the exempt reasons for which your organization was formed. Stick to them. This is probably the one case in which the IRS insists that your members socialize and recreate!