At the end of last year, many clubs received the exact same form letter from the Internal Revenue Service (IRS), Letter 6176 (4-2019) Catalog Number 72211B. The letter appears to have been generated by the IRS and sent to many  501(c)(7) exempt organizations reporting nonmember income regardless of the nonmember percentage of gross receipts. The IRS is putting all clubs on notice that it will be stepping up its enforcement of nonmember revenue reporting.

The IRS letter is a good reminder that a 501(c)(7) membership organization is exempt from federal income taxes based on its membership activity. To maintain its exempt status, a club should be serving its members.  A club can receive up to 35 percent of its gross receipts, including investment income, from sources outside of membership without losing its exempt status. No more than 15 percent of gross receipts can come from nonmember use of club facilities and services. This is a good time to review the rules. Gross receipts are defined for this purpose as receipts from normal and usual activities of the club including charges, admissions, membership fees, dues, assessments, investment income (dividends, rents, etc.), and normal recurring capital gains on investments, but excluding initiation fees and capital contributions. Income received from members of other clubs using your club under a reciprocal agreement is nonmember income and is subject to the 15 percent limit as well as UBI tax.

Clubs may not engage in a nontraditional activity. This can, in and of itself, jeopardize the tax-exempt status. However, the IRS has provided an unofficial five percent safe harbor for nontraditional activities. This five percent is part of the 15 percent mentioned above. For example, the sale of alcoholic beverages by a club for off-premises consumption is nontraditional.

One large source of unrelated business income is reciprocal income. The issue as to whether reciprocal income is, or should be, treated as member income has been raised a number of times. It seems that the result is clear. Reciprocal income is income received from members of clubs not your own.  As a result, it is nonmember income.  Prior to 1971, the definition of a guest of a member was broader than it exists today. Under that definition, a member from a reciprocal club could potentially be treated as a guest.  However, since that time, the IRS has been clear that such income is nonmember income. The IRS issued a general counsel memorandum (GCM 39343) concluding “it seems clear that the Service’s current position is to treat income derived from a social club pursuant to a reciprocal agreement with a social club of like nature as income from non-members. Absent any formal modification, the Service must, of course, continue to follow the rule……”

The IRS has not addressed the issue since the publication of the GCM almost 30 years ago, but its position has never been rejected in any court proceeding. However, it is unclear whether it as ever been challenged. Several years ago, the Exempt Organization Examination Branch questioned whether this position was still applicable. In an internal response, the IRS upheld the GCM and indicated that it should still be enforced. While not unexpected, it is a blow particularly to large city clubs with rooms since a large portion of that revenue comes from usage of the club by members of reciprocal clubs.

Two safe harbors are provided to determine if income is member income. If payment is made directly to the club by a member or the member’s employer, a host-guest relationship will be assumed:

  1. Where a group of eight or fewer individuals, at least one of which is a member, uses the club’s facilities.
  2. Where 75 percent or more of a group using club facilities are members.

In all other situations, a host-guest relationship must be substantiated by the club. The classic example of this is where a controller of a corporation hosts a meeting of his accounting staff at his club and his employer pays the cost of the meeting. In this situation, the staff are guests of the member because their presence is related to a direct business objective of the employee-member. Alternatively, if the controller sponsors a meeting of his corporation’s board of directors at the club, the persons invited are not guests of the member since the directors’ presence is not related to a direct business objective of the particular employee-member.

The IRS letter pointed out the record requirements as described by Revenue Procedures 71-17. Clubs are required to maintain records of all nonmember activities.  Adequate records must be maintained to substantiate that there was, in fact, a member in a group of eight or fewer or that 75 percent of a larger group were members and that payment was made directly by members or their employers. The club need not inquire about reimbursement where payment is made directly by the member.

The information that must be obtained in all situations involving groups of more than eight (even if a member pays the club directly) includes the date; total number and the number of nonmembers in the party; total charges; charges attributable to and paid by nonmembers; as well as a statement signed by the member indicating:

  • whether the member has been or will be reimbursed for such nonmember use and if so, the amount of the reimbursement;
  • the name of his employer; the amount of the payment attributable to the nonmember use; the nonmember’s name and business or other relationship to the member; and, the business, personal, or social purpose of the member served by the nonmember use where the member’s employer reimburses the member or makes direct payments to the club. If a large number of nonmembers are involved and they are readily identifiable as a particular class of individuals, the class rather than the individual names of the nonmembers may be recorded; and,
  • the donor’s name and relationship with sufficient information to substantiate the gratuitous nature of the payment or reimbursement where a nonmember, other than the employer of the member, makes payment to the club or reimburses the member and a claim is made that the amount is paid gratuitously for the benefit of a member.

Be forewarned that the IRS may follow up on this form Letter with additional enforcement in the near future.  Provided your club is maintaining gross receipts below the 35 percent and 15 percent thresholds and maintaining adequate records of nonmember activity, you should have no problems maintaining your federal tax-exempt status. Should you have any concerns about your revenues from outside of your membership or the IRS Letter, please contact PBMares for specific guidance.

As previously published in The Boardroom magazine.