Social clubs organized under IRC section 501(c)(7) have faced unique challenges in tax compliance before, during, and after the COVID-19 pandemic. Management and board members who serve these types of tax-exempt organizations should be aware of several key areas that could impact the organization such as those identified below and should make sure these areas are monitored regularly.
The 15/35 Test
Arguably, one of the most important areas for a social club is maintaining its tax-exempt status. One of the key calculations that the Internal Revenue Service (IRS) uses to assess this for a club is what is commonly known as the “15/35 test.”
This 15/35 test refers to the percentage of gross revenue derived from nonmember revenue. More specifically, a social club that recognizes greater than 35% of its total income as nonmember income (including investment income), may be in jeopardy of losing its exempt status because in the eyes of the IRS, the club is not being operated where “substantially all” of its activities are for the members of the club.
Furthermore, within that 35% nonmember income bucket, if more than 15% of the club’s revenue is derived from the use of its facilities or services provided to the public, then the club may also be in jeopardy of losing its tax-exempt status.
If these thresholds are exceeded, the club should be prepared to support its position to remain a tax-exempt organization through the facts and circumstances of its situation.
Years ago, the IRS indicated that gross revenue generated by a club from the sale of items to be consumed off-premises would be considered “nontraditional business activities” that do not actually further the tax-exempt purpose of the club to provide pleasure and recreation to its members and therefore, those sales would be treated as nonmember income. Common examples of these types of activities often include curbside pick-up for food, sales of bottles of wine or other beverages, and even catering services. The IRS indicated that clubs should not receive more than a “de minimis amount” (or 5%) of its gross revenue from these types of activities, otherwise the club could run the risk of losing its tax-exempt status.
Prior to the COVID-19 pandemic, social clubs may have had some of these nontraditional activities. However, as access to club activities continued to be restricted due to the pandemic, many clubs adapted by increasing these types of off-premises sales. Club management should document these types of sales during the governmental shutdowns in effect where the club operates to substantiate the amounts generated in the event the club is challenged by the IRS. As operations return to normalcy, club management should revisit the need for these nontraditional sales and monitor the amount of revenue generated from them accordingly.
Membership referrals & Form 1099 reporting
Oftentimes, a club will offer incentives to its members to recruit more members to the club. Club management should be aware of the reporting requirements around these situations. Incentives like this are commonly known as referral bonuses and these bonuses can be in a variety of forms, such as: cash being given directly to the member, a reduction in the member’s dues, or another form of a credit to be used at the club.
Club management should consider the Form 1099 reporting rules when such bonuses are offered to club members. If the total value that is ultimately received (whether directly or indirectly) by any one member throughout the year including any of these “referral bonuses” is greater than the Form 1099 reporting threshold of $600, the club may need to issue a Form 1099-MISC to that member.
Failure to treat these amounts as compensation to the club members could result in the IRS determining that this group of club members is receiving the same club benefits as other members for lower dues (the “benefitted class of club members”). The IRS could then argue that the benefitted class of club members received an inurement of income resulting in the loss of the club’s tax-exempt status if the IRS is able to sustain this position upon examination. Club management should review this issue annually.
Record keeping requirements under Rev. Proc. 71-17 (aka The Rule of 8)
As stated above, determining nonmember revenue is critical for a Club and a common question that can come up for these types of organizations is whether an individual or a group would in fact be deemed a guest of a member through the eyes of the IRS, also known as having a “guest-host” relationship. Based on that determination, sales made by the Club in those instances would be categorized as member or nonmember revenue.
It is important that club management have the appropriate procedures and documentation practices in place to determine whether revenue generated by the club is from member or nonmember sources.
Under Rev. Proc. 71-17, the IRS provides guidance on what qualifies as a “guest-host” relationship, what sort of documentation should be maintained to support these determinations, and the impact on nonmember revenue in those instances.
This guidance specifies that a guest-host relationship will be assumed if:
For situations where either of these two criteria are met, the club should be sure to maintain adequate records to support the makeup of the party and if payment is received from a club member or their employer. If the group dining or using the club facilities does not meet the two criteria above, there are more intensive recordkeeping requirements that need to be met in order for the revenue to be considered member revenue.
The failure to maintain sufficient records or furnish them to the IRS may result in all income derived from the use of club facilities in these cases to be considered nonmember revenue. Nonmember revenue is generally subject to unrelated business income tax and also counts against the club’s 15/35 test.
Please reach out to your Baker Tilly advisor for more information or to speak with a not-for-profit tax specialist, please 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.