Recurring oil and gas royalties cost social club its exemption

Plain-English summary

A section 501(c)(7) social club operated recreational facilities for members and received revenue from dues, assessments, cabin rentals, and oil and gas rights. For several years, royalties and an oil and gas lease produced a substantial, recurring share of its total revenue, exceeding member income many times over. The IRS distinguished incidental or nonrecurring property income from the club's regular outside business income. It concluded that substantially all of the club's activities were not devoted to pleasure, recreation, and other nonprofitable purposes. The IRS revoked the exemption effective July 1 of the redacted year.

Ruling snapshot

• Question: Does the social club remain exempt under section 501(c)(7) when recurring oil and gas income is a substantial share of total revenue?
• Outcome: revocation
• Key authorities: IRC § 501(c)(7); Treas. Reg. § 1.501(c)(7)-1(b); Rev. Ruls. 66-149 and 69-220

Full text (IRS public release)

DEPARTMENT OF THE TREASURY

Internal Revenue Service
TE/GE EO Examinations

1100 Commerce Street MC 4920 DAL
Dallas, TX 75242

TAX EXEMPT AND

GOVERNMENT ENTITIES Date: JUN. 22 2017
DIVISION

Person to Contact:
Identification Number:

Number: 201751022 Contact Telephone Number:
Release Date: 12/22/2017 In Reply Refer to:
EIN:

LAST DATE FOR FILING A PETITION
WITH THE TAX COURT:

UIL: 501.07-00
CERTIFIED MAIL — Return Receipt Requested
Dear

This is a Final Adverse Determination Letter as to your exempt status under section
501(c)(7) of the Internal Revenue Code. Your exemption from Federal income tax under
section 501(c)(7) of the code is hereby revoked effective July 1, 20xx.

Our adverse determination was made for the following reasons:

You have not established that you are organized and operated exclusively
for pleasure, recreation, and other non-profitable purposes and are not
exempt under Internal Revenue Code (IRC) section 501(a) as described
under IRC section 501(c)(7).

You have received a substantial portion of your income from leasing oil
and gas rights and receives royalties which does not fulfill a non-profitable
purpose for s social club as described under IRC section 501(c)(7).

You are required to file Federal income tax returns on Form 1120. These returns should be
filed with the appropriate Service Center for the year ending June 30, 20xx and for all years
thereafter.

Processing of income tax returns and assessment of any taxes due will not be delayed should
a petition for declaratory judgment be filed under section 7428 of the Internal Revenue
Code.


If you decide to contest this determination in court, you must initiate a suit for declaratory
judgment in the United States Tax Court, the United States Claim Court or the District
Court of the United States for the District of Columbia before the 91st day after the date this
determination was mailed to you. Contact the clerk of the appropriate court for the rules for
initiating suits for declaratory judgment.

The Taxpayer Advocate Service (TAS) is an independent organization within the IRS that
can help protect your taxpayer rights. We can offer you help if your tax problem is causing a
hardship, or you’ve tried but haven’t been able to resolve your problem with the IRS. If you
qualify for our assistance, which is always free, we will do everything possible to help you.
Visit taxpayeradvocate.irs.gov or call 1-877-777-4778.

If you have any questions, please contact the person whose name and telephone number are
shown in the heading of this letter.

Sincerely yours,

Maria Hooke
Director, Exempt Organizations Examinations

Enclosures:
Publication 892


Department of the Treasury Date:
Internal Revenue Service March 29, 2017
IRS Tax Exempt and Government Entities Division Taxpayer Identification Number:

Form:
Tax year(s) ended:

Person to contact / ID number:

Contact numbers:
Phone Number:

Fax Number:
Manager's name / ID number:

Manager's contact number:
Phone Number:
Response due date:

Certified Mail - Return Receipt Requested
Dear

Why you are receiving this letter
We propose to revoke your status as an organization described in section 501(c)(7) of the Internal Revenue
Code (Code). Enclosed is our report of examination explaining the proposed action.

What you need to do if you agree

If you agree with our proposal, please sign the enclosed Form 6018, Consent to Proposed Action — Section
7428, and return it to the contact person at the address listed above (unless you have already provided us a
signed Form 6018). We'll issue a final revocation letter determining that you aren't an organization described in
section 501(c)(7).

If we don't hear from you

If you don't respond to this proposal within 30 calendar days from the date of this letter, we'll issue a final
revocation letter. Failing to respond to this proposal will adversely impact your legal standing to seek a
declaratory judgment because you failed to exhaust your administrative remedies.

Effect of revocation status
If you receive a final revocation letter, you'll be required to file federal income tax returns for the tax year(s)
shown above as well as for subsequent tax years.

What you need to do if you disagree with the proposed revocation
If you disagree with our proposed revocation, you may request a meeting or telephone conference with the
supervisor of the IRS contact identified in the heading of this letter. You also may file a protest with the

Letter 3618 (Rev. 6-2012)
Catalog Number 34809F

IRS Appeals office by submitting a written request to the contact person at the address listed above within 30
calendar days from the date of this letter. The Appeals office is independent of the Exempt Organizations
division and resolves most disputes informally.

For your protest to be valid, it must contain certain specific information including a statement of the facts, the
applicable law, and arguments in support of your position. For specific information needed for a valid protest,
please refer to page one of the enclosed Publication 892, How to Appeal an IRS Decision on Tax-Exempt Status,
and page six of the enclosed Publication 3498, The Examination Process. Publication 3498 also includes
information on your rights as a taxpayer and the IRS collection process. Please note that Fast Track Mediation
referred to in Publication 3498 generally doesn’t apply after we issue this letter.

You also may request that we refer this matter for technical advice as explained in Publication 892. Please
contact the individual identified on the first page of this letter if you are considering requesting technical
advice. If we issue a determination letter to you based on a technical advice memorandum issued by the Exempt
Organizations Rulings and Agreements office, no further IRS administrative appeal will be available to you.

Contacting the Taxpayer Advocate Office is a taxpayer right

You have the right to contact the office of the Taxpayer Advocate. Their assistance isn’t a substitute for
established IRS procedures, such as the formal appeals process. The Taxpayer Advocate can't reverse a legally
correct tax determination or extend the time you have (fixed by law) to file a petition in a United States court.
They can, however, see that a tax matter that hasn't been resolved through normal channels gets prompt and
proper handling. You may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate assistance. If you
prefer, you may contact your local Taxpayer Advocate at:

Internal Revenue Service
Office of the Taxpayer Advocate

For additional information

If you have any questions, please call the contact person at the telephone number shown in the heading of this
letter. If you write, please provide a telephone number and the most convenient time to call if we need to
contact you.

Thank you for your cooperation.
Sincerely,

Maria Hooke
Director, EO Examinations

Enclosures:

Report of Examination
Form 6018
Publication 892
Publication 3498

Letter 3618 (Rev. 6-2012)
Catalog Number 34809F

Schedule No. or
Exhibit

U.S. Treasury Department-Internal Revenue Service

EXPLANATION OF ITEMS

Form
886-A

Year/Period Ended
June 30, 20xx

Name of Taxpayer

ISSUE:

Whether ( ) continue to qualify for exemption
under IRC Section 501(c)(7) when its investment income consistently exceeds the

percent (xx%) limitation of total income?

FACTS:

was formed as a corporation in the state of and was granted exemption
under IRC 501(c)(7) in March 19xx. The Articles of Incorporation states that
formed for the following purposes: To organize, construct and maintain a club house or lodge:
to establish and maintain a hunting and fishing park or preserve; to establish and maintain a golf
course and tennis courts and to provide for such other forms of recreation and amusement as the

was

management may deem proper or necessary.

The Form 990 for the tax year ended June 30, 20xx was selected for examination. The Form 990
states that                 is a                 providing recreation for its members.
provides a meeting place and facilities for individuals with common interests in

During the examination it was noted that membership is based on xx% of the membership
accepting the applicant. Membership is also limited to the number of shares available, which is
currently xx shares. There is only one class of membership and all members have voting
privileges. The bylaws state that the use of the club grounds and cabins are for members, their
immediate families and bon-a-fide guests only.

receives its revenue from membership dues, assessments, cabin rentals, and royalties
from oil and gas rights. For the tax year ended June 30, 20xx, xx% of the total revenue received
was from an oil and gas lease. A review of additional Forms 990 which were not audited shows
that for the tax years ended June 30, 20xx and 20xx respectively, xx% and xx% of total revenue
received was from royalties.

6/30/20xx | 6/30/20xx _ | 6/30/20xx
Royalties XX,XXX XX,XXX XX,XXX
Total Revenue on F990 XX,XXX XXX,XXX XXX,XXX
Percentage of Royalty Income over Total Revenue xx% xx% Xx%
Department of the Treasury - Internal Revenue Service Form 886-A

Page 1


Form U.S. Treasury Department-Internal Revenue Service | Schedule No. or
886-A EXPLANATION OF ITEMS Exhibit
Name of Taxpayer Year/Period Ended

June 30, 20xx

LAW:

Section 501(c)(7) of the Internal Revenue Code ("Code") provides for exemption from federal
income tax for clubs organized for pleasure, recreation, and other non-profitable 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.

Section 1.501(c)(7)-1(b) of the regulations states that a club which engages in business, such as
making its social and recreational facilities available to the general public or by selling real
estate, timber, or other products, is not organized and operated exclusively for pleasure,
recreation, and other non-profitable purposes, and is not exempt under section 501(a). An
incidental sale of property will not deprive a club of its exemption.

Revenue Ruling 66-149, 1966-1 C.B. 146, provides that a social club is not exempt from federal
income tax as an organization described in section 501(c)(7) of the Code if it regularly derives a
substantial part of its income from nonmember sources such as, for example, dividends and
interest on investments. In this instance, the club’s funds were invested primarily for the purpose
of producing income through dividends, interest, or capital appreciation. It is evident that 1) such
income is regularly derived from nonmember sources, 2) that the income is received in
fulfillment of and pursuant to a profit motive, and 3) that the income from investments is
substantial in relation to total income.

Revenue Ruling 69-220, 1969-1 C.B. 154, held that a social club that receives a substantial
portion of its income from the rental of property and uses such income to defray operating
expenses and to improve and expand its facilities is not exempt under section 501(c)(7) of the
Code.

Santee Club v. White. 87 F. 2d 5 (1936), held that where a club engages in income producing
transactions which are not a part of the club purposes, exemption will not be denied because of
incidental, trivial, or nonrecurrent activities such as sales of property no longer adapted to club

purpose.

National Mah Jongg League v. U.S.. 75 F. Supp. 769 (1947), stated that a corporation that was
organized for the purpose of promoting the game of Mah Jongg, but income from memberships
was insufficient to meet expenses and the corporation engaged in the commercial enterprise of
selling to the public lists and tiles, and the income therefrom enabled the corporation to meet its
deficit, carry on without an increase of dues or curtailment of operations, and to accumulate a
surplus which was donated to charity was not operated exclusively for social purposes or
charitable purposes. Therefore, the corporation was not exempt from federal income tax under
section 501(c)(7) of the Code or section 501(c)(3) of the Code.

Department of the Treasury - Internal Revenue Service Form 886-A
Page 2


Form U.S. Treasury Department-Internal Revenue Service | Schedule No. or
886-A EXPLANATION OF ITEMS Exhibit
Name of Taxpayer Year/Period Ended

June 30, 20xx

In United States of America v. Fort Worth Club of Fort Worth, Texas. 345 F. 2d 52, 57 5th Cir.
1965), a social club which derived over half of its receipts, in amounts of hundreds of thousands
of dollars, from profitable outside business was not exempt from federal income taxes on ground
that it was organized and operated exclusively for pleasure, recreation, and other non-profitable
purposes. The court declared that for a social club to qualify for exemption under section
501(c)(7) of the Code, its outside profits must be 1) strictly incidental to club activities, not a
result of an outside business, and 2) either negligible or non-recurring.

GOVERNMENT’S POSITION:

does not meet the qualifications for exemption under section 501(c)(7) of the Code.
Although was initially formed for pleasure, recreation, and other non-profitable
purposes, substantially all of the activities are not for such purposes. is engaged in
leasing oil and gas rights and receives royalties from this activity which does not fulfill a
pleasure, recreation, or other non-profitable purpose.

is like the organization in Rev. Rul. 66-149 that did not qualify for exemption under
section 501(c)(7) of the Code. regularly derives income from nonmember sources,
specifically an oil and gas lease as well as royalties revenue. Based on the financial data
provided for the income is regularly derived from these nonmember sources and the income from
these sources is substantial in relation to EO’s total income. EO is also similar to the
organization in Rev. Rul. 69-220 because it receives a substantial portion of income from
sources other than the members. Under section 501(c)(7) of the Code, transactions with
outsiders should not be a regular source of income.

is not similar to the organization in Santee Club v. White. income from
the oil and gas lease and royalties are not incidental or trivial. In addition, they are recurring.
For the past several years, has received a substantial amount of revenue from these
sources. Per Section 1.501(c)(7)-1(b) of the regulations, is engaging in business
activities and is not organized and operated exclusively for pleasure, recreation, and other non-
profitable purposes.

is similar to the organization in National Mah Jongg League v. U.S. The majority of
its revenue is from an oil and gas lease and from royalties therefrom. income from
these sources exceeds the income from your members many times over. The revenue from oil
and gas lease and from royalties is recurring and more than incidental. While may
have been organized for pleasure and recreation, the EO’s revenue clearly shows that it is not
operating for these purposes.

Per United States of America v. Fort Worth Club of Fort Worth, Texas, royalty
income must be incidental to your club activities and either negligible or non-recurring. Instead

Department of the Treasury - Internal Revenue Service Form 886-A
Page 3


Form U.S. Treasury Department-Internal Revenue Service | Schedule No. or
886-A EXPLANATION OF ITEMS Exhibit
Name of Taxpayer Year/Period Ended

June 30, 20xx

the royalty income is both recurring and substantial. For the tax years ended June 30, 20xx -June
30, 20xx, over xx% of revenue was received from nonmember sources on a
recurring basis.

TAXPAYER POSITION:
The taxpayer position is unknown at this time.

CONCLUSION:

does not meet the requirements for exemption under section 501(c)(7) of the Code.

receives the majority of its income from nonmember sources on a recurring basis. By
leasing oil and gas rights and receiving royalties, is engaging in a regular trade or business and
derive a significant profit from the activity. As a result, does not operate substantially for
pleasure recreation, or other non-profitable purposes. We are proposing revocation of the IRC Section
501(c)(7) tax exemption for effective July 1, 20xx.

Department of the Treasury - Internal Revenue Service Form 886-A
Page 4