Sale of Social Club Assets Upon Liquidation
By Steven B. Long and David P. Heeren
Since 1916, Congress has exempted from income tax clubs formed to facilitate social interaction among their members. As a result, country clubs, hunting and fishing clubs, college sororities and fraternities, and tennis, swimming, and other sport clubs, among others, are generally exempt from taxation on income derived from their members. IRC § 501(c)(7). The exemption applies to 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.”
Prohibited inurement under IRC § 501(c)(7) pertains to use of club assets or facilities to generate income from the public rather than club members. For example, use of a tennis club to generate income from the general public attending a national tennis tournament is private inurement by the social club. West Side Tennis Club v. Commissioner, 39 BTA 149 (BTA 1939). In 1976, Congress loosened the rules to allow social clubs to generate up to 35% of their annual revenue from non-member income, such as rents charged to the public and income from investments. S. Rep. No. 94-1318, 94th Cong., 2nd Sess. 4 (1976), 1976-2 C.B. 597, 599; see also H.R. Rep. No. 94-1353, 94th Cong., 2d Sess. 4 (1976). Thus, clubs may rent their facilities to non-members or generate investment income to a limited degree.
Eventually, social clubs desire to end their operations. The question arises of what impact the sale and eventual distribution of net profits has on the club and its members. Based on several IRS rulings, a liquidating sale of assets, such as a clubhouse or sporting facilities, does not cause a social club to lose its tax exemption. While a club generally can earn no more than 35% of its annual income from non-membership income, unusual income is excluded from this calculation. Gain from the sale of assets upon dissolution of a club qualify as unusual income. Thus, clubs that sell their assets remain tax-exempt through the date of sale, and the distribution of the liquidated assets to its active members. Rev. Rul. 58-501 and PLR 201003022 (revenue from the sale of social club property is excluded from calculation required to determine whether club derives its primary support from members).
Although a liquidating social club remains tax-exempt, that does not mean the club escapes taxation on income from the sale of its assets. The net gain from such a sale is unrelated business taxable income (UBTI) that is taxed at the highest federal corporate rate of 21%. IRC § 512. UBTI must be reported on Form 990-T filed by the club for the year of the sale.
Distribution of the net liquidation proceeds to club members is not private inurement that causes the club to lose its tax exemption. See GCM 39658 (citing Rev. Rul. 58-501) (“The fact that a portion of the profit resulting from the sale was distributed to the members does not cause the club to lose its exemption. Every social and recreational group has a prospect of eventually being disbanded and dissolved. Therefore, the fact that the assets of a club will, upon dissolution, be paid to members or shareholders is not alone sufficient to make the organization liable to render income tax returns.”).
A club can avoid taxation of gain from the sale of its assets if, within a period beginning one year before the sale and three years after the sale, it purchases other property to use in operating a social club. IRC § 512(a)(3)(D). That allows existing members to transfer control over the club to another group of members who may want to continue the club’s activities in another location. However, if the sale proceeds are not used directly for the social club’s exempt function, regardless of the social club’s intent, gain is recognized in the year of sale. Deer Park Club v. Commissioner, 70 T.C.M. 1445 (1995). The purchase of undeveloped land for constructing a new clubhouse qualifies for this special treatment, even if the clubhouse is not actually constructed within the requisite time. Conversely, the purchase of undeveloped land with no discernable intent on how it will be used does not qualify. Social clubs wishing to utilize Code Section 512(a)(3)(D) should notify the IRS of the sale and their intent to use the proceeds for the social club’s exempt function by an attachment to their Form 990-T for the year of sale or otherwise notify the IRS. See 2024 Instructions for Form 990-T, page 26. The sale may also have to be reported on the club’s Form 990 as a significant disposition of club assets, depending on the value of the clubhouse and any other assets owned by the club.
After a club has sold all its property and liquidated its assets, it may distribute the resulting net income to its members. The members realize capital gain on the distribution, which is treated as a sale of their club memberships. The tax basis of a member’s membership equals the amount paid initially for the interest. Annual dues are deemed to be for annual club membership benefits and are not included in the tax basis of the membership. Rev. Rul. 55-737 (cited in GCM 39658).
Steven B. Long and David P. Heeren are attorneys with Ward and Smith in Raleigh.