Thursday, August 22, 2013

Getting tax exempt status under section 501(c)(7) as a Social Organization

Social clubs and other recreational organizations can be tax exempt under Code Sec. 501(c)(7) if organized and operated in adherence with the Tax Code, IRS officials said during an August 21 IRS phone forum on the organizational and operational requirements for tax-exempt social clubs. The speakers generally discussed the basic requirements for Code Sec. 501(c)(7) organizations, which generally include social clubs organized for pleasure, recreation or other similar nonprofit purposes.
Typical examples of Code Sec. 501(c)(7) organizations include country clubs, fraternities and sororities, dinner clubs, amateur hunting clubs, golf, swimming and other sport clubs, said Larisse Ghougasian, supervisory internal revenue agent, IRS Exempt Organizations. Like other tax-exempt organizations, they must have an exempt purpose, and substantially all of their activities must further this purpose. In return for fulfillment of these and other requirements, the organization’s income from its exempt functions is tax-exempt. However, unlike tax exempts organized under different subsections of Code Sec. 501(c)501(c)(7)s are taxed on their investment income.
Benefits of 501(c)(7) Clubs
Tax-exempt status is a major reason why social organizations would choose to organize under Code Sec. 501(c)(7), Larisse explained. This would essentially mean that the club would not be taxed on the income derived from its exempt function to provide recreational and social facilities and services to its members. Examples of "exempt function income" would be income from member dues, fees and similar charges.
The benefits available to Code Sec. 501(c)(7) organizations, however, are more limited than they are for other types of tax-exempt organizations, such as those organized under Code Sec. 501(c)(3). One of the major limitations is that a Code Sec. 501(c)(7)organization’s income from investments and other nonexempt functions is taxable. Another limitation is that members of exempt social clubs cannot deduct their dues payments, while dues paid to Code Sec. 501(c)(6) professional organizations, such as unions and bar associations, are generally deductible.
Organization Requirements
In order to qualify as a Code Sec. 501(c)(7), an organization must be a club organized for recreational, pleasure or similar purposes."Substantially all" of its activities must further its exempt purposes, and there must be no inurement of benefit to organizational insiders, such as officers or directors. This provision is meant to prevent use of income by organizational insiders for personal reasons as opposed to activities related to the organization’s exempt purposes, said Tim Berger, tax law specialist, IRS Exempt Organizations. The prohibition against inurement is an "absolute prohibition," Berger cautioned.
Other requirements for Code Sec. 501(c)(7)s include:
  • There must be no written policy that discriminates against individuals seeking membership on the basis of race, color, or religion;
  • Members must generally be individuals and not corporations;
  • The club must be based on common goals or interests; and
  • The club must provide opportunities for face-to-face commingling.
"The club requirements are to ensure that we aren’t granting tax-exempt status for an organization that is really just doing business with the public like any other taxable business," Berger explained.
Organizational Purpose
There are also some limitations on the purposes for which a Code Sec. 501(c)(7) can be organized, Ghougasian said. An important question to ask is whether the club is meant to further recreational, pleasure or similar purposes.
Ghougasian provided the example of a club that contained a provision in its governing articles making members eligible for disability or death benefits. Ghougasian explained that, even if the club did not actually pay such benefits, that club would not be eligible for Code Sec. 501(c)(7) tax-exempt status because the provision of death benefits is not in furtherance of a recreational purpose.
“Substantially all” test
Code Sec. 501(c)(7) must operate as a tax-exempt as well, Berger said. In other words, it must make sure that substantially all of its activities must further its exempt purposes. It must also receive substantially all its income from members for traditional activities. As much as 35 percent of the organization’s gross receipts, which include investment income, can come from sources outside its membership without violating the "substantially all" requirement. In addition, up to 15 percent of the organization’s gross receipts can be derived from nonmember use of its club facilities or services. This is called the "35/15" test, Berger noted.
Gross receipts generally include a club’s receipts from normal and usual ("traditional") activities of the club, although there are exceptions. For example, if an organization receives an "unusual amount" of income from holding an event that is held on an irregular and nonrecurring basis, then that amount would not be considered for purposes of the 35/15 test.
"Failing the 35/15 test does not mean that an organization automatically fails the substantially all test," said Ghougasian. If nonmember gross receipts exceeds 35 percent, the IRS would apply a facts and circumstances test to determine an organization’s status.
Another test requires that a club have no more than a de minimis amount of income from nontraditional activities. In other words, Berger explained, nontraditional activities are held to a stricter standard than traditional activities. Generally, he said, income from nontraditional activities is treated as incidental or trivial if it is less than 5 percent of an organization’s gross receipts. "If it is more than this, the organization generally cannot be exempt," he said.
All of a club’s income that is not considered "exempt function" income is generally unrelated business taxable income (UBTI), Berger explained. Such income would include income from "nontraditional" activities; "traditional" activities income from nonmembers; and passive investment income. Exceptions would include investment income that was set aside for a charitable, educational or other exempt purpose, according to Berger. For example, if a sorority set aside an amount of investment income to pay for educational scholarships, that amount would not be considered UBTI.
Code Sec. 501(c)(7) organizations that have UBTI must report it on Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)), Ghougasian said. "If you have to file, review the instructions carefully," she added. "The UBTI rules apply differently for 501(c)(7)s than they do for other tax exempts."
Determination Letters
Potential Code Sec. 501(c)(7) organizations may apply for a determination letter from the IRS that recognizes exempt status. They may do so by filing Form 1024, Application for Recognition of Exemption Under Section 501(a).
However, an organization may also choose not to make a request, Ghougasian said. It can operate as a tax exempt under Code Sec. 501(c)(7), provided that it files all the requisite annual returns with the IRS. However, the organization would be operating without assurance that the IRS agrees it is exempt. After several years, the IRS might still choose to examine the organization, which if found to be nonexempt would then be subject to taxes for prior tax years. (212) 588-1113

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