The Times They Are Confusing
For Membership Organizations

By Mitchell L. Stump, CPA

Members of the Board of Directors of clubs, especially those that have elected to be federally tax-exempt under Section 501(c)(7) of the Internal Revenue Code, and those contemplating making the election in the future, are being faced with questions their predecessors never before encountered as leaders of their clubs.  Whether it is in regards to club operations or governmental regulations, club Boards are facing tough questions and are finding the landscape very confusing.

Today, there is a great deal of competition for an individuals' social, athletic and entertainment dollar.  Five star resorts are easily accessible, both in the US and around the world, to those with the time and means to get there.  In a more localized area, fine dining abounds to the masses.  What was once only available to a privileged few, tennis courts, swimming pools, golf courses and athletic facilities welcome all interested participants. 

An example of the above is ever present in the golf industry.  Golf has blossomed in recent years with one new golf course being opened someplace around the country every day of the year.  Many of these golfing facilities, which were once primarily available only to the private club member, are now available to the general public.  Competition for rounds of golf has become much tougher as these new courses are being built.  As one golf publication has written, to successfully market a golf course, "The key to rising above your competition is to implement a successful marketing plan." 

There are so many other activities vying for the potential club member's time and resources.  Health clubs, tennis centers, and weekends at the kids' soccer field, not to mention work, all place demands on a person's time and finances.  Private clubs are finding themselves in a position of needing to get the word out, better known as marketing to the general public, about the benefits and rewards of private club membership. 

The continued existence of private clubs depends on their ability to bring individuals together for their stated purpose of pleasure and/or recreational purposes, generally on a not-for-profit basis.  Clubs that fail to maintain their proper level of memberships, to share in the expenses, will find that the costs to maintain the private club facilities becomes a burden to those that remain members.  Based upon the annual club budgets for the year, each and every private club has a preferred number of members needed to operate at a break-even point.  Whether a club chooses to limit membership to an exclusive 250 members, or to make membership available to a much larger group, is dependent upon the ability of the members to financially afford the annual dues and assessments.  One club marketing group has gone so far as to state "A private club is in the business of one primary thing;  collecting dues.  All services provided to members are a function of being able to collect the proper amount of dues."

Changing Times

The club industry is attempting to adjust to the times in which they find themselves.   Below are some of the issues clubs are facing in this, the twenty first century:

  • The local Country Club may no longer have the best-designed and maintained golfing facility in a community.
  • A Downtown Athletic Club may no longer be the only facility in the neighborhood offering the opportunity to use the latest exercise equipment.
  • The City Club, which may have been the primary gathering place for businessmen and women working in the downtown area, now has stiff competition due to the sprawling suburbs and quality, upscale restaurants.
  • Tennis courts, which were at one time available to only the privileged, are now available to the masses via a city's parks and recreation department.
  • Children of club members are not flocking to acquire club memberships as their parents once did.
  • An older generation of members, accustomed to club life, is using the club facilities less and less.
  • Loss of members, due to declining health and death are depleting some club member lists.

What Do Private Clubs Offer?

What does a private membership organization have to offer members that public and for-profit facilities do not?  Why do private clubs continue to exist with the competition from the outside so stiff? 

Not attempting to determine the motivation of all club members, some of the following may apply:

  • Individuals continue to have a desire to belong.
  • Many individuals continue to want to socialize with persons with similar interests.
  • Another reason may be to get away from the hustle and bustle of everyday life.
  • Private club membership offers an atmosphere of being a part of a family.
  • Others may gravitate to private clubs because they like to be catered to, pampered and addressed by name.

There will be a number of other reasons a person chooses to join a club not listed above.  The question that faces many private clubs is this:  How does a membership organization get its message out to the general public that there is an opportunity available to qualified individuals to be a part of this lifestyle? 

Clubs must change with the times.  They must determine how best to structure their entity, comply with the applicable rules and regulations, and they must "market" themselves to current members, as well as to prospective members to remain in existence.

Is The IRS Keeping Up With The Changing Times?

Congress saw a need to provide tax-exempt status for organizations that were 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. [i]   For this, the private club industry is very appreciative.  It allows those organizations that make an election under Section 501(c)(7) of the Internal Revenue Code, to avoid tax on member net income and still receive income from nonmembers. 

There are, however, some specific issues the IRS could address to assist private clubs, and their professionals, clearing up confusion currently existing.  There could be some changes in the interpretation of the law to bring it up to date, and then provide more guidance in the application of the law as it applies to tax-exempt status.  Below are a few suggestions that would help in this effort:

Regulations under 1.501(c)(7)-1 [ii]

Public Law 94-568 amended Section 501(c)(7), effective for tax years beginning after 10/20/76, deleting, among other things, the words "and operated exclusively" from the law.  These changes made it possible for more clubs to maintain their tax-exempt status, while receiving income from nonmembers.  In effect clubs can now generate a portion of its gross income from nonmembers and still retain its tax-exempt status.  (15/35% limitations) [iii]

Regulation 1.501(c)(7)-1 has not incorporated the 1976 law change into its interpretation.  A reader of this Regulation can get extremely confused about which terminology will apply and not apply.  The Treasury could clear up this confusion with updated Regulations. 

In its update of Regulations to 501(c)(7), it would be helpful if a full discussion of the 15/35% limitation were included therein, the limitation percentages which are currently in use as a safe harbor.  In this way, it would be easy to find the IRS's position as part of the interpretation of law as opposed to searching for references in other IRS documents.

Revenue Procedure 71-17 [iv]

If a reader of the 1.501(c)(7) Regulations has become confused, they are not helped with the existence of active Revenue Rulings and Procedures that do not reflect the 1976 changes to the law.  One of the primary Revenue Procedures applicable to clubs, 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 the club's exemption under Section 501(c)(7) of the Code.  Additionally, this Procedure sets forth record keeping requirements that can be used by a club to document member vs. nonmember usage.  This Revenue Procedure could be updated to incorporate the changes made to the Code effective in 1976.  In particular, the 15/35% limitation safe harbor should be set forth in an update.  Again, a reader of this important ruling can get extremely confused about the amount of nonmember and investment income that can be generated by a social club, without potentially effecting its 501(c)(7) tax-exempt status.

If this Revenue Procedure were updated, it could prove helpful if it stated that it applied to "membership organizations" in general and not just specifically to 501(c)(7) tax-exempt clubs.  Because membership organizations that do not elect to be tax-exempt under Section 501(c)(7) are subject to similar accounting for member and nonmember income under Section 277 of the Internal Revenue Code [v] , it is assumed that this same 15/35% safe harbor rule should apply.  If this assumption is correct, it could be made clear in an updated Revenue Procedure that applies to "membership organizations".

Section 1.337

Who would ever think to look outside of the tax-exempt sections of the law to determine if there could be a tax to pay to become tax-exempt?  Treasury has, by its actions stated in Regulations 1.337(d)-4(a)(3)(D), eliminated the viability of many clubs to elect to be 501(c)(7) tax-exempt.  Unless a newly formed club corporation is eligible to elect tax-exempt status within seven taxable years from the end of the taxable year in which it was formed, there is a potential Section 337 tax to be paid, just to be tax-exempt. [vi]   Older, as well as newer clubs are being affected by this new interpretation of Section 337 of the Code.  This potential tax is a trap for the uninformed, whether it is intended or not.  The Section 337 potential tax situation can be summarized the following way:   The difference between the tax basis and fair market value of the club assets, at the time of making the election, can generate a tax that is prohibitive of making a 501(c)(7) election. 

Examples of the significant problem caused by this new interpretation of Section 337 can be demonstrated by situations real estate developers face every day.  Because the economics of building a new golf club often requires the development of residential lots surrounding the course, to be owned by prospective club members, many new clubs will not be able to afford to be tax-exempt if the developer takes more than seven years to turn control over to the club members. [vii]   If the assets are transferred to the members after seven years in a 351 tax-free exchange [viii] , the carryover tax basis rule usually prohibits 501(c)(7) elections.

There could be some type of remedy to these problems if the Exempt Organization Division were to be concerned (c)(7) are being adversely affected, or will be eventually eliminated by this Section 337 interpretation.  Revisiting and eliminating the 7-year rule for clubs would be an easy fix.  

In the past, clubs were able to obtain 501(c)(7) status retroactively, back to the first date in which the entity became eligible. With the new Section 337 interpretation applicable to clubs, guidance would be helpful on whether retroactivity still applies.  Can the 337 taxes be avoided if the effective date of a 501(c)(7) election precedes the effective date of the new 337 Regulations but is applied for after the enactment date of the 337 Regulations?  This question is being debated between professionals but has not been specifically addressed by the IRS in any published rulings.

Another issue generated by the Section 337 Regulations deals with valuation.  What will be the fair market value be of a private club?  Guidance on determining value of a private club would be helpful, especially since private clubs are not regularly sold on the open market.  How does one distinguish between asset values and "private club" value?  What a person is willing to pay for membership in a particular club has little to do with the underlying value of the assets.  A case in point can be found within a two mile radius of this writers office.  The cost to join one most prestigious club that has the #2 ranked golf course in the state is around $12,000.  The obstacle of joining this particular club is that the waiting list is two miles long and they probably do not want my type.  Alternatively, a second club, just down the street, wants $300,000 from prospective members to join.  It too does not want me as a member at this time.  How would the IRS suggest going about valuing these two clubs, if they were in a position of applying for 501(c)(7) tax-exempt status, since neither have, nor will sell its assets on the open market?

Finally, allowing clubs to make a 501(c)(7) election after members own more than 50 percent of the membership certificates could help many developer controlled clubs, as the developer invariably insists that they maintain "control" of certain items while selling the remainder of the real estate lots. 

There could be other possible fixes which would allow a club to become tax-exempt under 501(c)(7) after the 337 Regulations.  This author does not like the idea of placing the tax exemption question in the hands of the real estate developer.  They generally have no vested interest in whether a club can be tax-exempt after they turn over control to the members.

Section 277

A number of years ago, Treasury gave an attempt to write Regulations explaining Internal Revenue Code Section 277.  These Regulations were never finalized and were subsequently withdrawn.  A reading of these old Proposed Regulations provides great insight into how clubs can comply with Section 277.  With it a fact that many membership organizations will not be eligible to be 501(c)(7) tax-exempt in the future, there could be more definitive guidance to membership organizations that, by default, will be subject to Section 277.  It is suggested that the Corporate and Tax-Exempt Organization Divisions of the IRS coordinate their efforts to assist clubs in complying with the intended rules and regulations.

Advertising For New Members

What says the IRS and the 501(c)(7) tax-exempt rules and regulations on the topic of "advertising" for new club members?  Can a not-for-profit organization, qualifying for tax-exemption as clubs organized for pleasure, recreation and other nonprofitable purposes, substantially all of the activities of which are for such purpose under Section 501(c)(7) "advertise" for qualified members?  Can a 501(c)(7) tax-exempt club rise above its competition by implement a successful marketing plan?

In addressing the issue regarding advertising for prospective members, 501(c)(7) clubs are not advertising for public patronage or participation in club activities on a limited basis.  They are wanting to make it known there are potential memberships available to qualified applicants.  Clubs are concerned, however, that the only existing ruling against "advertising" is all encompassing and are afraid to jeopardize their tax-exempt status.

Revenue Ruling 65-63 [ix] represents one of the few times the IRS has taken a position on the question of 501(c)(7) tax-exempt organizations "advertising".  This ruling was issued at a time when Section 501(c)(7) required clubs to be organized "and operated exclusively" for pleasure, recreation and other nonprofitable purposes. 

Although this ruling was issued under an old definition of 501(c)(7) organizations, it may continue to have relevance in this debate.  In this ruling, public patronage or participation in club activities was permitted upon the payment of an admission fee.  This public patronage was solicited by "advertising."   The income from this public patronage was used to cover club expenses, improve club property and otherwise make the observing of the club event possible.  In coming to its conclusion, the ruling states that the activities of the club, in permitting public patronage of its facilities, are of such magnitude and recurrence as to constitute engaging in business and he club uses the income derived therefrom to acquire additional assets and to pay club expenses normally borne by its members.  Thus, the club failed to qualify for tax-exemption under section 501(c)(7) of the Code.

The issue of advertising, of any type, is being debated within the club industry.  Some believe that because Revenue Ruling 65-63 was issued prior to the 1976 change to 501(c)(7), it is not applicable to any situation.  Because clubs can have up to 15% of their gross income from nonmembers, some believe tax-exempt clubs can actively advertise for public patronage.  Others take a more conservative stance on advertising and caution clubs of the existence of Revenue Ruling 65-63.  The IRS could shed light on the advertising dilemma with clear guidance in what types of "advertising" is allowed under current law.

Conclusion

Are 501(c)(7) clubs going to be a structure of the past?  Will some clubs die a slow death from a lack of members?  Many clubs are giving strong consideration to remaining taxable or dropping their tax-exempt status to save tax dollars and to be competitive in the market place.  Confusing tax law and being unclear as to what they can and cannot do is not giving clubs a lot of encouragement to obtain or retain tax-exempt status.  Although not a vary large segment of the tax-exempt community, additional guidance from the IRS will be greatly appreciated.

Mitchell L. Stump, CPA is a consultant to the club industry and the author of Club Tax Book, "An Accumulation Of Tax Issues Specific To Clubs" and Club Sales & Use Tax Book - Florida.  More information on Mitch and his club related publications can be found at  www.clubtax.com.


[i] 501(c)(7) as amended by P.L. 94-568

[ii] Regulation 1.501(c)(7)-1

[iii] IRM 7.8.2 Exempt Organizations Technical Guidelines Handbook

[iv] Rev. Proc. 71-17, 1971-1 CB 683

[v] Section 277 Of the Internal Revenue Code

[vi] See Preamble to Regulation 1.337(d)-4 for further discussion regarding comments to proposed Regulations.

[vii] See Stump, "Final 337 Regulations Bad News For Clubs Wanting To Be 501(c)(7)," The Exempt Organization Tax Review, February, 1999

[viii] Section 351 of the Internal Revenue Code

[ix] Rev. Rul. 65-63, 1965-1 CB 240