Restaurant alcohol club denied social club exemption

Plain-English summary

A nonprofit formed a private club inside a public restaurant so members could purchase alcoholic beverages under state licensing rules. Membership was broadly available to adult county residents dining at the restaurant, preliminary memberships could be obtained immediately, and the organization had no separate area for member interaction. The restaurant owner financed the initial liquor inventory, managed the club, leased it space, and received percentages of gross alcohol revenue under agreements signed for both sides by the same individual. The IRS concluded that alcohol sales to nominal members were effectively business with the general public, meaningful member commingling was absent, and earnings inured to an insider through the restaurant arrangements. It therefore denied exemption under section 501(c)(7).

Ruling snapshot

• Question: Did the restaurant-based alcohol club operate primarily for member pleasure and recreation without private inurement?
• Outcome: denied (its activity resembled public alcohol sales, lacked substantial commingling, and benefited an insider)
• Key authorities: IRC § 501(c)(7); Treas. Reg. §§ 1.501(a)-1(c) and 1.501(c)(7)-1(b); Rev. Ruls. 58-588, 58-589, 66-225, and 69-635

Full text (IRS public release)

Department of the Treasury
Internal Revenue Service
IRS P.O. Box 2508

Cincinnati, OH 45201

Date:
January 27, 2020

Number: 202017037 Employer ID number:
Release Date: 4/24/2020

Contact person/ID number:
Contact telephone number:
Form you must file:

Tax years:

UIL: 501.07-00, 501.07-05

Dear

This letter is our final determination that you don’t qualify for tax-exempt status under Section 501(c)(7) of the
Internal Revenue Code (the Code). Recently, we sent you a proposed adverse determination in response to your
application. The proposed adverse determination explained the facts, law, and basis for our conclusion, and it
gave you 30 days to file a protest. Because we didn’t receive a protest within the required 30 days, the proposed
determination is now final.

You must file federal income tax returns for the tax years listed at the top of this letter using the required form
(also listed at the top of this letter) within 30 days of this letter unless you request an extension of time to file.

We’ll make this final adverse determination letter and the proposed adverse determination letter available for
public inspection (as required under Section 6110 of the Code) after deleting certain identifying information.
Please read the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the instructions in the Notice
437 on how to notify us. If you agree with our deletions, you don’t need to take any further action.

If you have questions about this letter, you can contact the person listed at the top of this letter. If you have
questions about your federal income tax status and responsibilities, call our customer service number at
1-800-829-1040 (TTY 1-800-829-4933 for deaf or hard of hearing) or customer service for businesses at
1-800-829-4933.

Letter 4040 (Rev. 7-2014)
Catalog Number 47635Z

Sincerely,

Stephen A. Martin
Director, Exempt Organizations
Rulings and Agreements

Enclosures:

Notice 437
Redacted Letter 4034, Proposed Adverse Determination under IRC Section 501(a) Other Than 501(c)(3)

Redacted Letter 4040, Final Adverse Determination under IRC Section 501(a) Other Than 501(c)(3) - No
Protest

Letter 4040 (Rev. 7-2014)
Catalog Number 47635Z

Department of the Treasury
Internal Revenue Service
IRS P.O. Box 2508

Cincinnati, OH 45201

Date:

December 4, 2019
Employer ID number:

Contact person/ID number:
Contact telephone number:

Contact fax number:

Legend: UIL:

B = State 501.07-00
C = Date 501.07-05
D = Law

E = Restaurant

F = Company

g percent = Amount

H = County

J = Individual

k percent = Amount
M = Number

N = Number

o dollars = Amount
p dollars = Amount

Dear

We considered your application for recognition of exemption from federal income tax under Internal Revenue
Code (IRC) Section 501(a). We determined that you don’t qualify for exemption under IRC Section 501(c)(7).
This letter explains the reasons for our conclusion. Please keep it for your records.

Issues
Do you qualify for exemption under IRC Section 501(c)(7)? No, for the reasons stated below.

Facts
You were incorporated in the state of B on C. You are incorporated as a nonprofit corporation formed for “any

lawful purpose.” Your Bylaws state that you are organized for social, civic, and benevolent purposes including
for the purpose of forming a private club under the D law. D is the law in B concerning requirements for private
club alcohol licenses. Furthermore, you will provide social interaction, service of food and alcoholic beverages
and may provide other forms of entertainment for club members.

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K

2

You provide recreational opportunities for your members where they can meet and discuss their social and
family issues. In addition, you provide a forum where members will discuss participation in community
services. Your facility is located within the already established local restaurant, E, that is open to the public. E is
owned by F. You have entered into a management agreement with F to provide food to your members.

The only qualification necessary to become a member is to be 21 years old or older and be a resident of H
County. You have two membership options in accordance with the D law. A preliminary membership in which
a member has all of the privileges of a member for at least -------- days. The membership committee must vote
on whether or not to approve the member within -------- days. You also have non-preliminary members which
must be voted on and accepted by the membership committee prior to being served alcohol. There are M
preliminary memberships available. You stated that this number remains below the amount set by D because the
new members become inactive after -------- months of no activities. The original N members stay active, but the
preliminary members fluctuate. The membership fee assessed to preliminary members is p dollars, which
includes a drink. You charge a service fee by the glass, which covers the upkeep of the club and related

expenses.

Your preliminary membership application solicits basic biographical information including name, address, date
of birth, phone number, and occupation. The application also includes the statement under the signature line that
the applicant wishes to consume alcoholic beverages upon completing the application.

Your Bylaws state that the initial liquor purchase shall be made from the promissory note agreed upon by your
initial charter members. You have obtained a zero percent interest loan from F to purchase the initial inventory
of liquor. The loan agreement with F is signed by J as both President of F and as your President.

Future purchases will be made up of equal contributions from the members derived from charges for alcoholic
beverages. Alcoholic beverages are required under B state law to be owned by the members. This is
accomplished by members pooling their money and purchasing the alcoholic beverages served in the club.
Money is pooled by the members through the assessment of the service fee. A pool system of storage will be
used whereby a set percent of charges will be deposited into the liquor pool account. The initial percentage you
have selected, k percent, may be adjusted if needed.

Your facility is located within E, a restaurant that does not have a permit to sell alcohol. The D law states that
because you and E are located in one premise only one permit can be issued. You do not meet in a designated or
reserved area of E. Any individual that is aged 21 or older resides in H County, and is ordering food at E can
immediately become a preliminary member. You open at -------- a.m. each day and close at -------- p.m., except on
weekends when you close at -------- p.m.

The management agreement between you and F states that it is entered into pending authorization of the liquor
commission. The duties of the manager under the agreement include furnishing adequate facilities to serve
alcoholic beverages and provide food service, insuring liquor stock is replenished, prompt bill payment, and
proper record keeping of cash and membership. The manager’s compensation is set at a rate of g percent of
gross revenue. The agreement is signed by J as both President of F and as your President.

You have also entered into a commercial sub-lease agreement with F for the use of E. Rent is g percent of gross
revenue not to exceed o dollars per month, plus a portion of the property taxes. The agreement states that the

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K

3

property will be used for carrying on food business or trade/activity of any kind. The agreement is signed by J
as both President of F and as your President.

Your revenue is derived solely from the sale of alcoholic beverages to members. Your expenses consist of
management fees, rent, liquor license fees, and the cost of alcoholic beverages.

Law
IRC Section 501(c)(7) provides for the exemption from federal income tax of clubs organized and operated for

pleasure, recreation, and other nonprofitable purposes, substantially all 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.

Treasury Regulation Section 1.501(a)-1(c) provides that the term "private shareholders or individuals" refers to
persons having a personal and private interest in the activities of the organization.

Treas. Reg. Section 1.501(c)(7)-1(b) 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 nonprofitable purposes,
and is not exempt under Section 501(a).

Revenue Ruling 58-588, 1958-2 C.B. 265, found that a social club that sells an unlimited number of
memberships to so-called "members," who have no voice in the management of the club and whose only rights
are to use the club's facilities upon payment of specified fees, is not a tax-exempt social club within the meaning
of IRC Section 501(c)(7). Income from the members was, in reality, income from the general public.

Rev. Rul. 58-589, 1958-2 C.B. 266, discusses the various criteria for recognition of exemption under IRC
Section 501(c)(7) of the Code. In order to establish that a club is organized and operated for pleasure,
recreation, and other nonprofitable purposes, "there must be an established membership of individuals, personal
contacts and fellowship. A commingling of the members must play a material part in the life of the
organization."

Rev. Rul. 66-225, 1966-2 C.B. 227, determined that a nonprofit organization which provides entertainment to
its members does not qualify for exemption under IRC Section 501(c)(7) where it is controlled by a taxable
corporation and operated as an integral part of such corporation's business.

Rev. Rul. 69-635, 1969-2 C.B. 126, found that an automobile club whose principal activity is rendering
automobile services to its members but has no significant social activities, does not qualify for exemption under
IRC Section 501(c)(7). The basis for this conclusion is the fact the club had no significant commingling of its

members.

In Chattanooga Automobile Club v. Commissioner, Warren Automobile Club, Inc. v. Commissioner, 182 F.2d
551 (6th Cir. 1950), the United States Court of Appeals 6th Circuit held that to be exempt under the Act of
Congress, a club must have been organized and operated exclusively for pleasure, recreation, and other
nonprofitable purposes. The court further specified that the words "other non-profitable purposes" must be
construed as coming within the same classification as pleasure and recreation. In addition, there must be at least
some sort of commingling of members to constitute a club. The court held that the two automobile clubs

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K

4

petitioning the court were not exempt under IRC Section 101(9) of 1939 as social clubs because the members of
these clubs did not commingle.

In Keystone Automobile Club v. Commissioner, 181 F.2d 402 (1950), the United States Court of Appeals 3rd
Circuit defined the word "club" to include some type of mingling of people together as well as a common
object. In this case, the court held that the Keystone Automobile Club was not exempt under IRC Section
101(9) for a number of reasons one of which was because they saw no evidence of the commingling of

members.

Application of law
You do not qualify for exemption under IRC Section 501(c)(7) because you are not organized and operated for

pleasure, recreation, or other nonprofitable purposes. You do not meet the requirements in Treas. Reg. Section
1.501(c)(7)-1(b) which states, in part, that if a club engages in business, such as making its social and
recreational facilities available to the general public, it is not exempt under Section 501(a).

You also do not meet the requirements of IRC Section 501(c)(7) because your earnings are inuring to J through
F. As provided in Treas. Reg. Section 1.501(a)-1(c) the term "private shareholders or individuals" refers to
persons having a personal and private interest in the activities of the organization. Your tax-exempt status will
enable you to apply for and obtain an alcohol license as a private club. F is owned by J as evidenced by your
loan, management, and sub lease agreements. F is willing to loan you start up funds because the restaurant, E,
will benefit. In addition, your management agreement with F is contingent upon you getting a private club
alcohol license in accordance with B state law. The lease agreement provision that F gets g percent of gross
alcohol sales as well as the comprehensive management agreement showing F gets another g percent of gross
alcohol sales. Finally, the agreements with F were not negotiated at arm's length as substantiated by the fact that
J signed the agreements on your behalf as well as on F's behalf. Inurement is evident through the arrangements

which benefit J’s restaurant.

You are similar to the organizations described in Rev. Rul. 58-588 and Rev. Rul. 58-589. Like the organizations
in these rulings, social activities are not one of your primary purposes, but are merely incidental to the purpose
of engaging in the sale of alcohol to the general public. Anyone can become a member by meeting the minimum
age and residency requirements. Therefore, income from your members is, in reality, income from the general
public, as most of your “members” are not bone fide members.

You are also like the organization in Rev. Rul. 66-225. You were organized by J as an integral part of E's
business so that E can benefit from your alcohol license to increase sales. Your sole activity is the sale of
alcoholic beverages to your members under a contract with F, who owns E, a restaurant that is open to the
general public. Your activities are conducted at E, where you do not have a designated or reserved space. F also
provides food to your members at E. Any individual who is of legal drinking age, resides in H County, and is
eating at E may immediately become a member and purchase alcohol by paying a fee of p dollars. The fact that
you have very limited requirements for membership and will issue preliminary memberships that only last for
seven days demonstrates you are not operating exclusively for pleasure, recreation, and other nonprofitable

purposes.

Like the organization described in Rev. Rul. 69-635, you are primarily providing services with insignificant or
no commingling. You do not have a designated or reserved space in E for your members to commingle. By
operating in such a way, you do not qualify for exemption under IRC Section 501(c)(7).

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K

5

You are like the organizations described in Chattanooga Automobile Club, Warren Automobile Club, Inc., and
Keystone Automobile Club. You have not demonstrated that members have any interaction other than being at
the same location to purchase alcohol. There is no common interest among your members and your social
activities are only incidental. Because you have demonstrated very little, if any, personal contact among
members and there is no expectation of personal contact among members, commingling is not a substantial part
of your activities. Therefore, you are not primarily operating in accordance with IRC Section 501(c)(7).

Your position
You say that you are established not only to serve alcohol to members, but also a place for them to gather and

interact with each other on matters of mutual concern. While F sells food for a profit, your members own the
alcohol inventory. You believe you qualify for exempt status as a social club because you have limited
membership, are organized for pleasure, recreation and other non-profit purposes, and you provide a place for
members to commingle. In addition, you don’t operate like a business because you serve your members at
replacement cost which also covers your expenses. Finally, you do not have a written policy that discriminates

against individuals seeking membership.

Our response to your position
While you do charge your members fees based on replacement cost, rather than a profit margin, you do not

qualify for exemption under IRC Section 501(c)(7). You do not have bone fide members engaging in the
requisite commingling activities. In addition, your net earnings inure to the benefit of J through your agreement

with F.

Conclusion
Based on the information provided, we conclude that you are not operated for pleasure, recreation, or other

nonprofitable purposes described in IRC Section 501(c)(7). Any such activities that you engage in are merely
incidental to the purpose of serving alcoholic beverages to individuals dining at E. You do not meet the
membership and commingling requirements for organizations qualifying for exemption under Section
501(c)(7). Furthermore, your net earnings inure to insiders through your contracts. Accordingly, you do not
qualify for recognition of exemption under Section 501(c)(7).

If you agree

If you agree with our proposed adverse determination, you don’t need to do anything. If we don’t hear from
you within 30 days, we’ll issue a final adverse determination letter. That letter will provide information on

your income tax filing requirements.

If you don't agree
You have a right to protest if you don’t agree with our proposed adverse determination. To do so, send us a

protest within 30 days of the date of this letter. You must include:

• Your name, address, employer identification number (EIN), and a daytime phone number
• A statement of the facts, law, and arguments supporting your position
• A statement indicating whether you are requesting an Appeals Office conference

• The signature of an officer, director, trustee, or other official who is authorized to sign for the

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K

organization or your authorized representative

• The following declaration:

For an officer, director, trustee, or other official who is authorized to sign for the organization:
Under penalties of perjury, I declare that I have examined this request, or this modification to the
request, including accompanying documents, and to the best of my knowledge and belief, the request
or the modification contains all relevant facts relating to the request, and such facts are true, correct,

and complete.

Your representative (attorney, certified public accountant, or other individual enrolled to practice before the
IRS) must file a Form 2848, Power of Attorney and Declaration of Representative, with us if they haven’t
already done so. You can find more information about representation in Publication 947, Practice Before the

IRS and Power of Attorney.

We’ll review your protest statement and decide if you gave us a basis to reconsider our determination. If so,
we’ll continue to process your case considering the information you provided. If you haven’t given us a basis
for reconsideration, we’ll send your case to the Appeals Office and notify you. You can find more information
in Publication 892, How to Appeal an IRS Decision on Tax-Exempt Status.

If you don’t file a protest within 30 days, you can’t seek a declaratory judgment in court later because the
law requires that you use the IRC administrative process first (IRC Section 7428(b)(2)).

Where to send your protest
Send your protest, Form 2848, if applicable, and any supporting documents to the applicable address:

U.S. mail: Street address for delivery service:
Internal Revenue Service Internal Revenue Service

EO Determinations Quality Assurance EO Determinations Quality Assurance
Mail Stop 6403 550 Main Street, Mail Stop 6403

P.O. Box 2508 Cincinnati, OH 45202

Cincinnati, OH 45201

You can also fax your protest and supporting documents to the fax number listed at the top of this letter. If you
fax your statement, please contact the person listed at the top of this letter to confirm that they received it.

You can get the forms and publications mentioned in this letter by visiting our website at www.irs.gov/forms-
pubs or by calling 800-TAX-FORM (800-829-3676). If you have questions, you can contact the person listed at

the top of this letter.

Contacting the Taxpayer Advocate Service
The Taxpayer Advocate Service (TAS) is an independent organization within the IRS that can help protect your

taxpayer rights. TAS can offer you help if your tax problem is causing a hardship, or if you’ve tried but haven’t

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K

7

been able to resolve your problem with the IRS. If you qualify for TAS assistance, which is always free, TAS
will do everything possible to help you. Visit www.taxpayeradvocate.irs.gov or call 877-777-4778.

Sincerely,

Stephen A. Martin
Director, Exempt Organizations
Rulings and Agreements

Letter 4034 (Rev. 11-2018)
Catalog Number 47628K