Membership Exempt Organization Tripped Up by Gross Revenue from Nonmembers Test

An issue that often arises in the area of exempt organizations is that they are governed by a number of special rules that, if violated, will cause an organization to lose its exempt status.  And often these organizations, as circumstances change, end up taking actions that run smack into these problems.

This was case for the organization whose loss of exempt status is detailed in PLR 201612014.  The organization was organized as a social organization under IRC §501(c)(7) to provide trap shooting, hunter safety and clubhouse activities to its members.

IRC §501(c)(7) provides that such organizations are:

Clubs organized for pleasure, recreation, and other nonprofitable 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.

The “substantially all” language was placed in the provision in 1976, removing prior language that demanded that they be operated exclusively for such purposes.  In the Senate Committee report accompanying the law change Congress explained that it intended to allow such organizations to be able to, on a limited basis, offer such items to non-members, but subject to a general numerical test based on gross revenue.

The Senate report (Committee Reports for S 94-1318, P.L.94-568, p. 4) provides:

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.

It is important to note that violating these rules triggers the loss of status—this does not simply mean the organization pays the tax on unrelated business income, but rather that it converts to a fully taxable member organization.

The organization, while organized for members originally, had opened up its activities to the general public.  The major problem arose when the organization began selling calendars to the general public to raise money for operations and for programs to promote conservation to the general community.

While those activities supported by the calendar sale may seem praiseworthy and worthwhile, the problem is that, being a §501(c)(7) organization, the entity has that pesky gross receipts from nonmembers test to be considered—one that the organization clearly failed.

The organization thus was now required to file a Form 1120 for all open years from the point of revocation of its status.  As well, being a member organization that is not tax exempt it is subject to the rules of IRC §277.

Specifically IRC §277(a) will limit the deductions incurred for furnishing services to members are limited to income derived from members, with any excess carried forward to future years.  Or, put more succinctly, services to members can’t be “subsidized” by payments made for services by nonmembers or by other income received by the organization.