Regulating Exempt Organizations By Committee Report

Consolidated Sportsmen of Lycoming County v. Commissioner, pending before the Tax Court, concerns a social club that provides hunting, fishing and conservation activities for its members.  The Service revoked the club’s (c)(7) exemption because in the 7 tax years in issue (2017 – 2023), the social club received between 51 and 93% of its total income from an oil and gas lease on the club’s land.  The Service determined that the revenues proved that the club’s activities were not substantially for pleasure or recreation as required by 501(c)(7).  The club argues that whether it is operating substantially for pleasure or recreation should be determined by looking at the members’ activities not its revenue source.  Other than one member’s monitoring of the oil and gas lease revenues, the members spend all of their time hunting, fishing, and fixing up the place to keep it suitable for hunting and fishing. 

The Club does not dispute the revenues derived from the oil and gas lease, it objects to the application of a standard articulated only in a Senate Finance Committee Report.  The Report explains why taxing a social club on all of its income, not just its member dues, is appropriate when a social club engages in too much unrelated trade or business.  In such cases,  according to the Committee Report, the club can be deemed to exist primarily to operate a business the proceeds of which pay for members’ recreational activities.  Here is the uncodified legal standard the Social Club disputes:

Generally, the Internal Revenue Service has not challenged the exempt status of these organizations if the income derived from providing goods and services to persons other than members and their guests is small in relation to the total activities of the organization. Thus, as an audit standard (Rev. Proc. 71-17, 1971-1 CB 683), the Service has indicated that it generally will not disturb a social clubs, certain fraternities and sororities, and employees’ beneficiary if the club’s annual income from outside sources either is not more than $2,500 or is not more than 5 percent of the total gross receipts of the organization. Where gross receipts from nonmembers dealings exceed this 5-percent figure, all facts and circumstances are taken into account in determining whether the organization continues to qualify for exempt status. In the case of investment income, the Service applies no percentage rule, but instead looks to whether a substantial part of the club’s income is from investment sources club’s exempt status solely on the basis of its nonmember activities (Rev. Rul. 66-149, 1966-1 CB 146).

[3] Reasons for change

However, since the passage of the 1969 Act, this strict line of demarcation between the exempt and nonexempt activities of social clubs appears unnecessary. Since the passage of the 1969 Act all of the income derived from nonmembers as well as investment income is subject to tax, even though the organization itself is still classified as an exempt organization. Thus, while it is necessary to require that a social club must still be substantially devoted to the personal, recreational, or social benefit of members, the extent to which such a club can obtain income from nonmember sources can be somewhat liberalized. In view of these considerations the committee’s bill clarifies existing law to permit somewhat larger amounts of income to be derived by exempt social clubs from nonmembers and also from investment income sources.

. . . 

[4] Explanation of provision

The decision in each case as to whether substantially all of the organization’s activities are related to its exempt purposes is to continue to be based on all the facts and circumstances. However, the facts and circumstances approach is to apply only if the club earns more than is permitted under the new guidelines. If the outside income is less than the guidelines permit, then the club’s exempt status will not be lost on account of nonmember income.

It is intended that these organizations be permitted to receive up to 35 percent of their gross receipts, including investment income, from sources outside of their membership without losing their tax-exempt status. It is also intended that within this 35-percent amount not more than 15 percent of the gross receipts should be derived from the use of a social club’s facilities or services by the general public. In effect, this latter modification increases from 5 percent (current audit standard: Rev. Proc. 71-17) to 15 percent the proportion of gross receipts a club may receive from making its club facilities available to the general public without losing its exempt status. This also means that a club exempt from taxation described in sec. 501(c)(7) is to be permitted to receive up to 35 percent of its gross receipts from a combination of investment income and receipts from nonmembers so long as the latter do not represent more than 15 percent of total receipts.

The 35 and 15% rules are clear enough.  The only problem is that they were never adopted by statute or regulation.  They are articulated only in a Finance Committee report.  The rules make good policy sense but they were never adopted as law.  Of course, the requirement that a social club’s activities be “substantially” in pursuit of recreation could be interpreted to mean that too much unrelated business precludes tax exemption even in the absence of a committee-articulated safe harbor. In any event, the Government’s motion argues for a straight-forward application of the Finance Committee report.    

The committee report is from 1976.  Its substance ought to have been adopted by regulations by now.  It would only have required some quick cut and  paste.  Even in the absence of formal adoption the rules have been applied on more than a few occasions in private letter rulings. But no such regs exists and the statute doesn’t mention the rules either.  At best, the rules constitute a nearly 50 year old  Finance Committee recommendation. 

Predictably, the social club is challenging the rules’ legitimacy.  It wants the Court to ignore the Committee report and determine that it’s members’ activities are substantially in pursuit of recreation despite the oil and gas revenue.  The statute appears to support the argument, I gotta admit it.  The oil and gas lease revenues are taxed in any event, by the way, because they constitute unrelated business income.  The social club is trying to prevent the taxation of its membership dues, too, because if it loses tax exemption all together, everything will be taxable.  The Court, being cognizant of fundamental tax policy, will probably reject the social club’s argument.  But it might go a long way to inject some needed statutory and regulatory discipline by declaring the social club tax exempt in accordance with the sparse or nonexistent statutory and regulatory articulation.

darryll k. jones