Critical unrelated business income tax tips for social clubs
One of the most important considerations for section 501(c)(7) social clubs is best ensuring that they do not generate “too much” unrelated business income (UBI) that could jeopardize the tax-exempt status of the entity. Even if clubs are successful in this, the entity will most likely still be liable for the UBI tax on their income earned from conducting “unrelated” activities.
When discussing the potential UBI liability of section 501(c)(7) social clubs, one first must determine whether an activity being conducted by the club is considered to be a member or a nonmember activity. Member income for a section 501(c)(7) social club is defined as those gross receipts derived from the normal, usual and typical activities of the social club, including member dues, member assessments, member initiation fees and sales revenue received from members. Please see section 512(a)(3)(B) of the Internal Revenue Code (IRC) related to this.
It is debatable whether certain gross receipts of a club should be considered member income or not. For example, a club might have viable arguments that rental income generated from members should be considered member income. To wit, we successfully argued such with the Internal Revenue Service (IRS) for a social club client that was generating short-term rental income from its members. In another example, a club generating parking revenue from members was held by the IRS to be generating member income when the member parking revenue was related to parking that facilitated access to club events, but generated nonmember income (subject to the UBI tax) when the parking revenue was related to parking for other than club events. Please note that Rev. Proc. 71-17 and GCM 39115 are both excellent resources addressing the normal and usual activities of a social club.
All of the nonmember income of a section 501(c)(7) social club is generally considered to be UBI (including investment income; see Rev. Rul. 81-69) and, hence, subject to taxation. In those situations when a club is recognizing nonmember UBI, it is permitted to deduct its direct unrelated expenses and allocate a portion of its indirect expenses to the club’s unrelated activities. Regarding the allocation of indirect expenses, it is essential that the social club contemporaneously document its “reasonable” indirect expense allocation methodology so it can withstand a challenge by the IRS.
The determination of whether this type of club has generated “too much” UBI has changed over the years. Before 1976, in order for a social club to be considered tax-exempt pursuant to section 501(c)(7) of the IRC, it had to operate exclusively for its members. Following the amendment of section 501(c)(7) in 1976, a social club could be considered tax-exempt pursuant to section 501(c)(7) of the IRC if such a club operated in a manner where substantially all of its activities were for its members. “Substantially all” has been defined as being 85% or greater. Accordingly, a club that recognizes greater than 35% of its total income as nonmember income will not be considered tax-exempt pursuant to section 501(c)(7) of the IRC. Additionally, within that upper 35% nonmember income ceiling, if more than 15% of the total income of the club is derived from the use of its facilities or services by the general public, then the club will not be considered tax-exempt pursuant to section 501(c)(7) of the IRC.
For example, let’s assume that the total income for a section 501(c)(7) social club for a particular tax year was $100,000. Of that $100,000, $67,000 was received from members, another $19,000 was investment income and the remaining $14,000 was from the use of the club’s facilities by the general public; in such a situation, the club’s tax-exempt status would not be in jeopardy. However, to tweak the facts just a bit, let’s assume that the total income for the club for a particular tax year was $100,000. Of that $100,000, $67,000 was received from members, another $17,000 was investment income and the remaining $16,000 was from the use of the club’s facilities by the general public. In that scenario, the club’s tax-exempt status under section 501(c)(7) would be in severe jeopardy.
There are a few other UBI considerations for section 501(c)(7) social clubs. First, related to the activities of some clubs during the ongoing pandemic, it is debatable whether revenue from the sale of food and/or beverages by a club to members for off-premises consumption would be considered UBI. It is the position of the IRS that “non-traditional” activities undertaken by a section 501(c)(7) social club should not be considered member income. One of those typically identified “non-traditional” activities has historically been the selling of food and beverages to members for off-premises consumption. In this regard, in light of the ongoing pandemic, Baker Tilly recommends social clubs contemporaneously document their reasoning for treating such revenue as nontaxable member income by, for example, detailing their justification that the members were not permitted to consume the food or beverages on-site because COVID-19 governmental orders were in effect.
Second, section 501(c)(7) social clubs now need to be cognizant of the relatively recently enacted section 512(a)(6) of the IRC which provides for the “siloing” of a not-for-profit’s UBI and related expenses on a separate activity basis. That said, a section 501(c)(7) social club which is conducting more than one unrelated business activity now cannot offset the losses of one of those unrelated activities against the income of another unrelated activity.
Any type of not-for-profit organization needs to constantly consider whether they are generating any type of UBI. This is especially true for section 501(c)(7) social clubs since, as set forth above, they are more susceptible to the requirement to report UBI; and if they are reporting “too much” UBI, their tax-exempt status pursuant to section 501(c)(7) could be jeopardized.
For more information on this topic, or to speak with a not-for-profit tax specialist, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
