Final 337 Regulations: Bad News For Clubs Wanting To Be 501(c)(7)
By Mitchell L. Stump, CPA
The Internal Revenue Service has concluded that only certain clubs can become 501(c)(7) tax exempt without paying a tax on gain recognition for the opportunity. On December 29, 1998, Treasure Decision 8802 was issued bringing bad news to some clubs. How will the rule adversely affect membership organization? Consider this scenario:
Members of Augusta National Golf Club become fed up with professional athletes demanding more of the profits for playing in "The Masters," an annual golfing event. (Sound familiar this professional "non-basketball" season?) Club members vote to cancel "The Masters" golf tournament and return the club to members the first week in April for their personal pleasure. Proceeds from "The Masters" prohibited the club from being 501(c)(7) in prior tax years. Now, without the nonmember income from their annual tournament, club members want to pursue the election of 501(c)(7) tax exempt status, similar to the benefits allowed other member owned clubs.
The tax cost of making a 501(c)(7) election is computed as follows: Compare the tax basis of the club assets that was first built in the early 1900's to the fair market value of the club assets on the date of the 501(c)(7) election. This difference, which is termed "gain or loss recognition", will be subject to corporate federal and possibly state income tax. What is the club's tax basis of its assets? One could estimate a few million dollars? What do you think the IRS would claim as the fair market of Augusta National? One may guess at least a zillion dollars. The corporate tax would be computed on the gain of a zillion dollars less a few million in tax basis.
In its wisdom, the IRS believes similar club entities that have been in existence for more than 7 years should not benefit from 501(c)(7) status without a tax on gain recognition. Here is what the IRS has said in the preamble to Treasure Decision 8802 and the Final Regulations for Code Section 337:
"Some commentators suggested that social clubs that are tax-exempt as organizations described in section 501(c)(7) should be removed from the list of tax-exempt entities for purposes of section 337(d). Commentators also suggested that tax-exempt social clubs be allowed to defer gain on transaction's subject to the regulations, because social clubs may be subject to tax on gains from asset sales. Section 512(a)(3)(A) generally taxes the income of a section 501(c)(7) social club except for the social club's "exempt function income," as defined in section 512(a)(3)(B). Section 512(a)(3)(A) also applies to tax-exempt organizations described in section 501(c)(9), (17), or (20). The final regulations, however, do not provide relief from the general rules of the regulations for section 501(c)(7) organizations. Unlike section 528 homeowners associations, section 501(c)(7) social clubs are permitted to avoid gain recognition on certain asset sales. For example, if the club replaces the property sold with other property used directly in the performance of its tax-exempt function, no tax is owed on any gain recognized. Because of these exceptions, the IRS and Treasury Department believe that deferring tax on transfers of assets to section 501(c)(7) organizations would not be consistent with General Utilities repeal. Accordingly, the final regulations follow the proposed regulations and apply to transfers of assets to section 501(c)(7) organizations. 2. Change in Status Rule."
"A number of commentators urged exempting newly formed social clubs from the application of the regulations if they become tax-exempt within seven years of their formation, rather than within the three-year period provided for other tax-exempt entities. Those commentators explained that some social clubs are organized when a real estate developer acquires land to be used for a housing development and a social club for the homeowners. The assets of the future social club are held by a corporation, but it cannot qualify as a tax-exempt section 501(c)(7) organization until several years later, after the stock or membership interests in the corporation have been transferred to the homeowners. Commentators familiar with development practices advised that it often takes up to seven years to transfer the club to the members' control. Furthermore, because the developer is forming the club as a business venture, the developer will work to realize the increase in the value of the club's assets as part of the transfer. For these reasons, providing additional time for newly-formed clubs to become tax-exempt does not conflict with General Utilities repeal. Therefore, the final regulations incorporate the recommendation made in the comments and provide that a social club will not be subject to the Change in Status Rule if it converts to tax-exempt status within seven taxable years after the year in which it was formed."
The example of August National is an exaggeration as we all know that "The Masters" golf tournament will not go by the way side in the near future. The realities of the facts are that clubs that do not, or can not, make the decision to be 501(c)(7) tax exempt in the first seven years of their existence may be out of luck. Developers that take too long to sell their real estate surrounding the club and do not relinquish control of the club to the members within seven years of the entity's formation may prohibit their member clubs to be 501(c)(7).
Technical Issues
There are a variety of technical issues that need to be addressed and answers provided by the IRS. Many of the tax issues will be forced upon club members by club developers. This list is not all inclusive due to the fact that the regulations have just been issued. Additional situations will arise for which more answers will need to be developed
Change in corporation's tax status treated as asset transfer: Section 1.337(d)-4(a) states in part; "...a taxable corporation's change in status to a tax-exempt entity will be treated as if it transferred all of its assets to a tax-exempt entity immediately before the change in status becomes effective in a transaction..." If a club elects 501(c)(7) tax exempt status to be effective for the first day that the entity is member controlled, will the tax be due and payable in the tax year immediately preceding the first day of the election? If this is the case, developer controlled clubs may be at risk of paying the tax on gain recognition since they may have structured their ownership whereby they make up any deficit spending of the club while in control of the club board. Developers would be quite surpassed if this is the tax conclusion reached. In the alternative, will an interim tax return be required, such as a one day return, reflecting only the 337 tax on gain recognition? An interim tax return may more logically tax the individuals making the decision to be 501(c)(7) tax exempt than the developer that just sold the club to the members.
Retroactive provisions: "1.337(d)-4(e) Effective date. This section is applicable to transfers of assets as described in paragraph (a) of this section occurring after January 28, 1999, unless the transfer is pursuant to a written agreement which is (subject to customary conditions) binding on or before January 28, 1999." If a club is available to become 501(C)(7) tax exempt for a year beginning on or before January 1, 1999, but does not file for exempt status until after January 28, 1999, will the retroactive provisions of 501(c)(7) avoid the 337 tax on gain recognition? It is assumed that the answer to this question would be that the tax on gain recognition would be avoided. Since clubs can obtain retroactive 501(c)(7) exempt status back to the first date the club qualifies, not filing the exempt application prior to January 28, 1999, should not prevent avoidance of the 337 tax on gain recognition. If a club waits five or ten years to file for 501(c)(7) exempt status, retroactively back to January 1, 1999, which is allowable, there is a risk that the IRS will attempt to apply the 337 tax on gain recognition as some sort of tax avoidance scheme.
Seven year rule: "1.337(d)-4(a)(3)(i)(D) A newly formed corporation that is tax-exempt under section 501(a) as an organization described in section 501(c)(7) within seven taxable years from the end of the taxable year in which it was formed." If a developer forms a shell corporation to receive club assets in the future, when does the seven year grace period of Section 1.337(d)-4(a)(3)(i)(D) begin? It is assumed that the IRS will begin the seven years counting period from the end of the taxable year in which the corporation was formed, not seven years from when the club entity owns assets or begins operations. Thus developers that form shell corporations as part of their initial corporate formations can undermine the future membership organizations' ability to be Section 501(c)(7) tax exempt.
If a developer forms a shell corporation to receive club assets too early, can a new shell corporation be formed with a later incorporation date? If there is an attempt to avoid tax by altering the corporate structure, the IRS could possibly argue that the initial incorporation date is to be used to assess the Section 337 gain recognition tax.
In a Section 351 transfer of assets to a club corporation, which is very common in the industry, when does the seven year period begin to run? Because there is a transfer of an active trade or business enterprise from one taxable entity to another taxable entity, the seven year period possibly begins to run from the initial date of the transferring entity's formation. This could be true due to the fact that a Section 351 transfer is deemed to be a nontaxable event. The net result of this interpretation would be a Section 337 gain recognition tax on Section 501(c)(7) elections where the developer does not exit the development within seven years from the initial formation. The initial formation of a club entity will probably occur with the initial purchase of land for future development. In a Section 351 transfer, club assets generally have a lower tax basis than fair market value. In many cases, developers structuring their deal as a Section 351 transfer will prevent member owned clubs from becoming Section 501(c)(7) tax exempt due to the tax cost.
When will the issue be challenged? If there is a challenge to the valuation of club assets, will the IRS allow a club to rescind Section 501(c)(7) tax exempt status to avoid the Section 337 tax on gain recognition? Currently, there are not provisions in the Code or Regulations for Section 501(c)(7) tax exempt organizations addressing this issue.
Will the Section 337 tax on gain recognition become an issue with the Exempt Organization Division of the IRS at the time of the Section 501(c)(7) application or will the IRS attack the issue in subsequent audits of the taxable clubs final 1120? Because the Section 337 tax on gain recognition assume will be included in the final 1120 tax return, the Exempt Organization Division of the IRS will not make this tax any of its concern. Thus, Section 501(c)(7) tax exempt status will be obtained and tax returns filed prior to any challenge as to the fair market value of the assets.
Fair Market Value: 1.337(d)-4(a)(1) states "...if a taxable corporation transfers all or substantially all of its assets to one or more tax-exempt entities, the taxable corporation must recognize gain or loss immediately before the transfer as is the assets transferred were sold at their fair market values." What is the fair market value of a membership owned club? Due to the fact that member owned clubs are not readily marketable, there will be challenges from the IRS as to any valuation set forth by a club that does not reflect a tax on gain recognition.
Will clubs be required to engage a qualified appraiser to value the club and its assets as an operating entity? Due to the fact that clubs are multi-million dollar operations, owning multi-million dollars of land, buildings and equipment, taking a cavalier attitude to valuations will be risky. The tax on gain recognition is not just on the fixed assets such as land, building and golf course equipment. The tax will also be on any goodwill of this going concern and other intangible assets such as the club name and reputation. Additionally, in the valuation process, what credence will be given to the fact that much of a development's land will not be usable for purposes other than open green space. Will the IRS want to value club land at its highest and best use as residential or commercial real estate rather than being unusable for anything other than a golf course. One fact is for sure, relying upon county property tax valuations as evidence of fair market value will leave the club subject to challenge by the IRS as not properly reflecting the fair market value a willing buyer and seller would determine.
Several approaches can be taken in determining the fair market value of a member owned club. One approach, which has significant support in use, is to value the club based upon the current price of a membership times the number of memberships available at the date of the election. This method will be used when there is an asset purchase from a developer by club members. The developer receives cash on the day of the transfer for each classification of membership sold in exchange for title to all of the club amenities and operations. If the members elect 501(c)(7) status within 7 taxable years from the end of the taxable year in which the club entity was formed, using this amount will undoubtedly represent fair market value and not cause a tax to be due on gain recognition. Making a 501(c)(7) election several years after the initial purchase of assets, when the acquisition price of the membership certificates has been increased, will probably cause the fair market value to increase accordingly.
Will the IRS accept replacement values as fair market value? They probably will, if replacement value gives the IRS a larger gain on recognition. Keep in mind that valuations are subject to wide ranges of interpretation. Valuation professionals will struggle to utilize a multiple of earnings method as clubs invariably loose money and are not intended to be engaged in for a profit. Turnover price and joining fees may be the most readily available information and probably the highest valuation amount.
If the IRS fully understands that many clubs will be using the purchase price method of valuation, they will surely try to use this same method where a club was acquired using a Section 351 transfer. With generally a lower tax basis of assets being transferred to a member owned club, there can be a significant amount of Section 337 tax on gain recognition due. Section 501(c)(7) exempt status has historically been recommended for these clubs obtaining their assets in a Section 351 transfer due to the fact that there is often less depreciation deductions available to offset future club income. Thus, where Section 501(c)(7) tax exempt status is needed the most, it will be least available due to the 337 gain recognition tax.
Conclusion: The final regulation 1.337(d)-4 reflects that the IRS and Treasury listened to the arguments presented by the club industry and its professionals and concluded that it was the intent of Congress to tax clubs electing Section 501(c)(7) tax exempt status. Developers will be controlling how membership organizations will be structured and operated by intent or by accident. Club members failing to obtain adequate tax advice and guidance will be surprised at the tax results of becoming 501(c)(7) tax exempt.
Can the club industry take action to rescind this interpretation of law? It appears that only a tax law change by Congress can correct what appears to be an improper attack against clubs. Clubs not currently 501(c)(7) tax exempt may have just lost the opportunity in the interim.
