Does a nonprofit that is a 501(c)(7) social club — not a 501(c)(3) charity — owe New Mexico gross receipts tax on liquor sales to its members, and can it avoid the penalty for following a bookkeeper's wrong advice?

Plain-English summary

The Canon de Carnue Land Grant Heirs Association is a New Mexico nonprofit whose members are heirs of the original grantees of a land grant near Albuquerque. Its main activity is running a social club that sells liquor to its members four nights a week. The IRS had recognized it as a 501(c)(7) social club — after denying its application for 501(c)(3) charitable status. Before 1991 the Association paid gross receipts tax on its member liquor sales, but a hired bookkeeper (James Sanchez) wrongly advised that a 501(c) nonprofit doesn't owe tax on member sales unless it profits, so it stopped. In 1997 the Department assessed the underreported tax for June 1991–March 1997 — about $8,114.76 in gross receipts tax, a $797.49 penalty, plus interest (Assessment No. 2141443).

The Hearing Officer split the decision:

• The tax was owed (exemption denied). New Mexico's nonprofit exemption, § 7-9-29, applies only to organizations the IRS has actually granted 501(c)(3) status. This Association had been denied 501(c)(3) status and was a 501(c)(7) social club organized for its members' benefit — not "organized and operated exclusively" for charitable purposes, as the federal regulations require. Its hope of applying for retroactive 501(c)(3) recognition didn't matter; without an actual grant, § 7-9-29 didn't apply, and the member liquor sales were taxable.
• The penalty was abated for part of the period only. The negligence penalty (§ 7-1-69(A)) can be excused by reasonable reliance on a competent tax advisor (3 NMAC 1.11.11(4)). For 1991–1993, while Mr. Sanchez was the Association's hired bookkeeper/accountant, the secretary — not tax-savvy herself — reasonably relied on his advice, so that reliance was not negligent and the penalty for those years was abated. But after the Association replaced Sanchez with a new firm in 1993, it kept excluding member liquor sales without ever discussing the issue with the new firm — even though it knew its two bookkeepers had disagreed about this exact point and the secretary found it confusing. That continued reliance on a former advisor's advice was negligent, so the penalty stood for the post-1993 periods.

Result: denied in part, granted in part — the gross receipts tax stands, and the Department was ordered to abate the penalty for 1991–1993.

What this means for you

Nonprofits and clubs

Being a nonprofit — even a federally tax-exempt one — does not automatically exempt you from New Mexico gross receipts tax. The § 7-9-29 exemption is narrow: it requires an actual IRS determination that you are a 501(c)(3) organization. A 501(c)(4) social welfare group or a 501(c)(7) social club does not qualify, so a club's sales (including liquor sales to members) are generally taxable. If you rely on a tax exemption, make sure you actually hold the specific status the statute requires, in writing.

Any taxpayer relying on a bookkeeper or tax advisor

Reliance on a competent advisor can defeat a negligence penalty — but only while the reliance is reasonable. When you change advisors, or when you know your advisors have disagreed about how something should be reported, ordinary care requires you to raise the issue with your new advisor. Coasting on a former advisor's advice, especially on a point you know is disputed, can turn an excusable mistake into negligence.

Accountants and tax professionals

This decision is a clean illustration of the reliance-on-advisor penalty defense under 3 NMAC 1.11.11(4): it protected the client for the years its advisor was engaged and fully informed, but not once the client retained a new firm and failed to surface a known, disputed reporting position. It also confirms that § 7-9-29 tracks an actual federal 501(c)(3) grant, applying the federal "organized and operated exclusively" tests (Treas. Reg. § 1.501(c)(3)-1) — a social club fails them.

Common questions

Q: The Association is a tax-exempt nonprofit — why did it owe gross receipts tax?
A: Because New Mexico's exemption (§ 7-9-29) applies only to organizations the IRS has granted 501(c)(3) status. The Association was a 501(c)(7) social club and had been denied 501(c)(3) status, so its member liquor sales were subject to gross receipts tax.

Q: Could it fix this by getting 501(c)(3) status retroactively?
A: The Hearing Officer wasn't persuaded. The Association offered no evidence it now qualifies (it was denied in 1991 and its activities hadn't changed) or that the IRS would grant retroactive status. Without an actual grant covering the periods at issue, the exemption didn't apply.

Q: Why was the penalty only partly abated?
A: For 1991–1993, the Association reasonably relied on the advice of its hired bookkeeper, which is a recognized defense to a negligence penalty. After it replaced him in 1993, it kept following his old advice without checking with the new firm — despite knowing the treatment was disputed — which was negligent, so the penalty stood for the later periods.

Q: Does this decision apply to my organization?
A: Not directly. A Decision and Order resolves one taxpayer's protest on its specific facts and the law in effect at the time. It illustrates how New Mexico applies the § 7-9-29 nonprofit exemption and the reliance-on-advisor penalty defense, but your facts may differ.

Citations and references

Statutes and regulations:

• § 7-9-29 NMSA 1978 — exempts receipts of organizations the IRS has granted federal income tax exemption as 501(c)(3) organizations; does not apply to unrelated trade or business income (IRC § 513)
• § 7-1-69(A) NMSA 1978 — penalty for negligent failure to pay (2% per month, up to 10%)
• § 7-1-13 NMSA 1978 — taxpayers are liable for tax at the time of the transaction giving rise to it
• § 7-1-24 NMSA 1978 — taxpayer protest procedure
• 3 NMAC 1.11.10 — definition of negligence; 3 NMAC 1.11.11(4) — reasonable reliance on competent tax counsel or accountant as a penalty defense
• 26 U.S.C. § 501(c)(3), (c)(4), (c)(7) — charitable, social welfare, and social club exemptions
• Treas. Reg. § 1.501(c)(3)-1(b)(iii), (d)(1)(ii) — an organization empowered to operate a social club, or operated for private rather than public interests, is not exclusively charitable

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Canon de Carnue Land Grant Heirs Ass’n
• Decision PDF: D&O 98-09

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
CANON DE CARNUE LAND GRANT HEIRS ASS’N 98-09
ID. NO. 01-817079-00 0
ASSESSMENT NO 2141443

DECISION AND ORDER

This matter came on for formal hearing on February 6, 1998 before Margaret B. Alcock,

Hearing Officer. The Canon de Carnue Land Grant Heirs Association (“the Associa-tion”) was

represented by Narciso Garcia, Jr., Esq. The Taxation and Revenue Department (“the

Department"), was represented by Gail MacQuesten, Special Assistant Attorney General. Based

upon the evidence and the arguments presented, IT IS DECIDED AND ORDERED AS

FOLLOWS:

FINDINGS OF FACT

1. In July 1974, the Canon de Carnue Grant Heirs Association was incorporated as a

nonprofit corporation under the laws of the State of New Mexico.

2. Membership in the Association is limited to heirs of the original grantees of the

Canon de Carnue Land Grant, located in the east mountain area near Albuquerque, New Mexico.

3. The Association charges an annual membership fee of eight dollars and has

approximately 150 members and associate members;

4. The objectives and purposes of the Association, as stated in its articles of

incorporation, include encouraging a closer personal acquaintance and a friendly spirit of mutual

cooperation among members; promoting the general welfare and prosperity of members; protecting
the ecology and beauty existing within the Land Grant boundaries; improving public facilities and

safety; and promoting educational, philanthropic, civic improvement and social uplift.

5. Article IX of the Association’s bylaws prohibits activities “not permitted to be taken

or carried on by an organization/exempt under Section 501(c)(3) of the Internal Revenue Code...”

6. The Association’s office in Tijeras, New Mexico, is located in a building the

Association leases from the Canon de Carnue Land Grant for one dollar a year.

7. The building includes a small club with an adjoining hall. There is a separate area

with a refrigerator, but no cooking facilities.

8. The Association operates a social club at which liquor is sold by the Association to

its members. The club is open four nights a week and is a local gathering spot for heirs of the

Canon de Carnue Land Grant. The Association holds a liquor license that restricts the Association

to serving liquor to members and guests.

9. The Association allows the Land Grant and other community groups to use the hall

adjoining the social club. No fee is charged for use of the building, although groups must pay for

security if social functions are held late at night and, except for short meetings, must pay for a

janitorial service to clean up after the function. Groups usually pay the Association, which passes

the payment on to the security and janitorial services.

10. In addition to being used for Land Grant meetings, the Association building is used

by a senior citizens meal center for serving daily lunches to senior citizens; by a food cooperative as

a drop off and distribution point; by local church parishes for summer fiestas and other benefit

functions; and by groups such as acequia associations, the Girl Scouts, the East Mountain Legal

2
Defense Fund, and the East Mountain Neighborhood Association for meetings and social functions.

11. The Association is planning to set up a scholarship for Land Grant heirs and has

collected about $1,200 to $1,500 for this purpose. No scholarship money has yet been awarded.

12. The Association does not conduct any fund raising activities although it

occasionally makes small contributions of $50 or $100 to local groups.

13. In March 1975, the Association received a determination letter from the Internal

Revenue Service (“IRS”) stating that the Association was exempt from federal income tax because

it qualified as a social welfare organization under Section 501(c)(4) of the Internal Revenue Code.

14. In 1991, the IRS notified the Association that the IRS had questions concerning the

Association’s status as a social welfare organization.

15. As a result of this inquiry, the Association submitted an application seeking

recognition as a charitable organization under the provisions of Section 501(c)(3) of the Internal

Revenue Code. The Association was subsequently notified that it did not qualify as a 501(c)(3)

organization.

16. At the suggestion of the IRS, the Association submitted a second application

seeking recognition as a social club under Section 501(c)(7). In January 1992, the IRS issued a

determination letter stating that the Association was exempt from federal income tax because it

qualified as a social club under Section 501(c)(7) of the Internal Revenue Code.

17. Prior to 1991, the Association paid New Mexico gross receipts tax on its receipts

from selling liquor to its members.

3

18. In 1991, the Association’s bookkeeper resigned for personal reasons and Pauline

Lovato, who has held the office of secretary since 1988 or 1989, hired James Sanchez to help the

Association with its bookkeeping and tax reporting.

19. Ms. Lovato located Mr. Sanchez from his advertisement in the yellow pages of the

telephone book. Mr. Sanchez held himself out as a bookkeeper/accountant and maintained a

business office in Albuquerque.

20. At the time the Association hired Mr. Sanchez, he was still attending classes at the

University of Albuquerque to obtain his accounting degree, which was awarded in 1992. Mr.

Sanchez became a certified public accountant in 1995.

21. Mr. Sanchez did not have any experience working with nonprofit organizations at

the time he was hired by the Association, but it was his understanding that a nonprofit organization

qualifying under any provision of Section 501(c) of the Internal Revenue Code did not have to pay

gross receipts tax on receipts from sales to its members unless the organization made a profit on

those sales.

22. Based on his understanding of the law and his knowledge that the Association

originally qualified as a Section 501(c)(4) organization and was later recognized as a Section

501(c)(7) organization, Mr. Sanchez advised Pauline Lovato that the Association did not have to

pay gross receipts tax on receipts from sales of liquor to its members.

23. Ms. Lovato worked with Mr. Sanchez on the applications for tax exempt status filed

with the IRS in 1991, but did not understand the distinctions among 501(c) organizations.

24. Ms. Lovato found Mr. Sanchez’s advice concerning payment of gross receipts tax

somewhat confusing, but believed he was knowledgeable in tax matters and relied on his advice.

4

25. Based on Mr. Sanchez’s advice, the Association stopped paying gross receipts tax

on its receipts from sales of liquor to its members. The Association continued to pay gross receipts

tax on receipts from activities that were open to the general public.

26. In 1993, the Association terminated Mr. Sanchez’s services and hired Barela &

Associates, Inc.

27. At some point after Mr. Sanchez stopped working for the Association, he became

aware that the advice he had given Ms. Lovato concerning receipts from sales of liquor to members

was incorrect. Mr. Sanchez did not take any action to notify the Association of his error.

28. At the time the Association replaced Mr. Sanchez, Ms. Lovato met with Celene

Barela and showed her copies of the Association’s articles of incorporation and bylaws. Ms.

Lovato did not have any discussions with Ms. Barela concerning the Association’s payment of

gross receipts tax.

29. The gross receipts tax returns filed by the Association for subsequent tax periods

continued to exclude receipts from sales of liquor to Association members.

30. In 1997, the Department determined that the Association had underreported its gross

receipts for the period 1991 forward. On June 5, 1997, the Department issued Assessment No.

2141443 in the amount of $8,1114.76 gross receipts tax, $797.49 penalty and $3,41.35 interest for

tax periods June 1991 through March 1997.

31. On June 13, 1997, the Department received the Association’s written protest to the

assessment.

DISCUSSION

I. Assessment of Gross Receipts Tax.

5
The first issue to be determined is whether the Association is entitled to the exemption from

gross receipts tax provided by Section 7-9-29, NMSA 1978, which states:

A. Exempted from the gross receipts tax are the receipts of
organizations that demonstrate to the department that they have been
granted exemption from the federal income tax by the United States
commissioner of internal revenue as organizations described in
Section 501(c)(3) of the United States Internal Revenue Code of
1954, as amended or renumbered.

...

C. This section does not apply to receipts derived from an
unrelated trade or business as defined in Section 513 of the United
States Internal Revenue Code of 1954, as amended or renumbered.

The Association argues that it is entitled to claim the exemption in Section 7-9-29 because the

Association qualifies as a charitable organization under IRC Section 501(c)(3) and intends to apply

to the IRS for retroactive recognition of 501(c)(3) status.

Section 7-9-29 does not provide a deduction for organizations that qualify for tax exempt

status under Section 501(c)(3). The exemption is limited to organizations “that have been granted

exemption from the federal income tax....” (emphasis added). This determination must be made by

the IRS, and the exemption from gross receipts tax is contingent on a taxpayer’s receipt of a written

IRS determination. In this case, the taxpayer has not been granted a federal tax exemption under

Section 501(c)(3) for the reporting periods at issue.

At the hearing, Pauline Lovato testified that the Association intends to submit an

application for recognition as a charitable organization qualifying for tax exempt status under

Section 501(c)(3) and intends to ask that this status be retroactive. Ms. Lovato did not explain why

the Association believes it will qualify for 501(c)(3) status now when it was expressly denied such

status in 1991. There is no indication that the Association’s activities have changed since 1991.

6
Although the Association allows various outside groups free use of its facilities for meetings and

social functions, the primary purpose of the Association as set out in its articles of incorporation is

to benefit heirs of the Canon de Carnue Land Grant. The Association’s primary activity in carrying

out this purpose is the operation of a social club. IRS regulations make it clear that a corporation

must be organized exclusively for charitable purposes before it will qualify for 501(c)(3) status. As

stated in IRS Regulation § 1.501(c)(3)-1(b)(iii):

an organization that is empowered by its articles...”to engage in the
operation of a social club” does not meet the organizational test
regardless of the fact that its articles may state that such organization
is created “for charitable purposes within the meaning of section
501(c)(3) of the Code.”

With regard to the operation of a 501(c)(3) organization, IRS Regulation § 1.501(c)(3)-1(d)(1)(ii)

states that an organization is not operated exclusively for exempt purposes unless it serves a public

rather than a private interest:

to meet the requirement of this subdivision, it is necessary for an
organization to establish that it is not organized or operated for the
benefit of private interests, such as designated individuals, the
creator or his family, shareholders of the organization, or persons
controlled, directly or indirectly, by such private interests.

Here, the Association is organized and operated for the benefit of its members. Membership is not

open to the general public but is limited to individuals who are heirs of the original grantees of the

Canon de Carnue Land Grant. Based on the evidence presented, the IRS’s previous determination

that the Association qualifies as a social club under Section 501(c)(7) but does not qualify as a

charitable organization under Section 501(c)(3) is consistent with IRS statutes and regulations.

Section 7-1-13, NMSA 1978, states that taxpayers are liable for tax at the time of and after

the transaction or incident giving rise to tax until payment is made. When the Association sold

7
liquor to its members during the period June 1991 through March 1997, it had not been granted

exemption from federal income tax as an organization described in IRC Section 501(c)(3). The

Association has not presented any evidence to support a conclusion that it now qualifies as a

501(c)(3) organization or that the IRS would grant such exempt status retroactive to the period

covered by the Department’s assessment. The Association is not entitled to claim the exemption

provided in Section 7-9-29, NMSA 1978, for reporting periods June 1991 through March 1997.

II Assessment of Penalty.

The second issue to be determined is whether the Association is liable for the ten percent

negligence penalty imposed by Section 7-1-69(A), NMSA 1978. The version of Section 7-1-69 in

effect during the assessment period imposed a penalty of two percent per month, up to a maximum

of ten percent:

in the case of failure, due to negligence or disregard of rules and
regulations, but without intent to defraud, to pay when due any
amount of tax required to be paid...

The statute imposes penalty based upon negligence (as opposed to fraud) for failure to timely pay

tax. There is no contention that the Association’s failure to report and pay gross receipts tax was the

result of bad faith or fraud. What remains to be determined is whether the Association was

negligent in failing to report its taxes properly.

Taxpayer "negligence" for purposes of assessing penalty is defined in Regulation 3 NMAC

1.11.10 (formerly TA 69:3) as:

1) failure to exercise that degree of ordinary business care and
prudence which reasonable taxpayers would exercise under
like circumstances;

2) inaction by taxpayers where action is required;

8
3) inadvertence, indifference, thoughtlessness, carelessness,
erroneous belief or inattention.

In this case the Association’s decision to stop paying gross receipts tax on its receipts from liquor

sales was based on the advice of James Sanchez, who had been hired to assist the Association with

its bookkeeping and tax reporting. Regulation 3 NMAC 1.11.11 (formerly TA 69:4) provides a list

of situations which may indicate that a taxpayer has not been negligent for purposes of imposing

penalty. Number 4 provides:

the taxpayer proves that the failure to pay tax or to file a return was
caused by reasonable reliance on the advice of competent tax counsel
or accountant as to the taxpayer's liability after full disclosure of all
relevant facts; failure to make a timely filing of a tax return,
however, is not excused by the taxpayer's reliance on an agent;

The first question is whether the Association was entitled to rely on the tax advice given by

Mr. Sanchez during the period 1991 through 1993. At the time Pauline Lovato retained the services

of Mr. Sanchez in 1991, he maintained a business office in Albuquerque and held himself out as a

“bookkeeper/accountant.” Although Mr. Sanchez did not have his accounting degree when he

began working for the Association, he was attending classes at the University of Albuquerque and

obtained his degree in 1992. Mr. Sanchez worked with Ms. Lovato on the applications for exempt

status filed with the IRS and had full knowledge of the Association’s status as a social club under

Section 501(c)(7) of the Internal Revenue Code.

Ms. Lovato was not knowledgeable in tax matters. Recognizing that she was not qualified

to make decisions concerning the Association’s tax liability, she retained the services of an outside

tax advisor. Based on Mr. Sanchez’s advertisement and representation that he was a “bookkeeper/

accountant”, Ms. Lovato believed Mr. Sanchez was knowledgeable in tax matters and relied on his

9
advice. Given the circumstances, Ms. Lovato’s reliance on Mr. Sanchez’s advice during the time

he worked for the Association was not unreasonable.

The more difficult question is whether the Association’s continued reliance on Mr.

Sanchez’s advice was reasonable during the period after Mr. Sanchez was replaced by Barela &

Associates, Inc. Mr. Sanchez testified that he was “let go”, indicating that the Association made the

decision to terminate his services. Ms. Lovato did not explain the reasons for Mr. Sanchez’s

departure, nor did she explain how Barela & Associates, Inc. was selected to replace him. There is

nothing in the record concerning the qualifications of Celene Barela or anyone else in the firm. Ms.

Lovato testified that she provided Ms. Barela with copies of the Association’s articles of

incorporation and bylaws. Ms. Lovato did not discuss the Association’s method of reporting gross

receipts tax with Ms. Barela. Instead, Ms. Lovato continued to rely on the advice she had received

from James Sanchez.

Ms. Lovato’s failure to discuss the Association’s gross receipts tax liability with Ms. Barela

does not meet the requirements of ordinary business care and prudence. There are many situations

where a taxpayer’s continued reliance on advice provided by a former tax advisor would be

reasonable. In this case, however, Ms. Lovato was aware of facts that should have alerted her to the

need to consult with the Association’s new tax advisor concerning the payment of gross receipts

tax.

Ms. Lovato began serving as secretary of the Association in 1988 or 1989. At that time, the

Association’s bookkeeper was reporting and paying gross receipts tax on all of the Association’s

receipts, including its sales of liquor to members. After James Sanchez assumed the duties of

bookkeeper in 1991, the Association changed its method of reporting gross receipts tax on those

10
sales. When the Association terminated Mr. Sanchez’s services in 1993 and hired Barela &

Associates, Inc., Ms. Lovato knew that the Association’s two former bookkeepers had disagreed

concerning the proper gross receipts tax treatment of the Association’s liquor sales. In addition,

Ms. Lovato did not have a clear understanding of the basis for Mr. Sanchez’s advice concerning the

exemption from gross receipts tax and testified that she found the distinction between sales to

members and sales to nonmembers confusing. Under these circumstances, a reasonable taxpayer

would have discussed the Association’s inconsistent gross receipts tax reporting with its new tax

advisor and sought advice as to whether the Association should continue to exclude liquor sales to

members when reporting gross receipts tax. Given the specific facts of this case, Ms. Lovato’s

failure to consult with Barela & Associates, Inc. concerning the Association’s liability for gross

receipts tax was negligent under Section 7-1-69(A).1

CONCLUSIONS OF LAW

1. The Association filed a timely written protest to Assessment No. 2141443 pursuant

to Section 7-1-24, NMSA 1978, and jurisdiction lies over the parties and the subject matter of this

protest.

2. The Association does not qualify for the exemption from gross receipts tax provided

in Section 7-9-29, NMSA 1978, to taxpayers that have been granted exemption from federal

income tax as organizations described in Section 501(c)(3) of the Internal Revenue Code.

1
The Association’s 1993, 1994 and 1995 federal tax returns were prepared by Barela & Associates, Inc.
(Taxpayer Exhibits 7, 8 and 9). The Association’s 1996 federal tax return was prepared by Jackson Hewitt Tax
Service (Taxpayer Exhibit 10). There is nothing in the record to explain whether Jackson Hewitt replaced Barela
& Associates, Inc. or whether Ms. Lovato had any discussions with Jackson Hewitt concerning the Association’s
gross receipts taxes.

11

3. The Association reasonably relied on the advice of its bookkeeper/accountant James

Sanchez during the years 1991-1993 and was not negligent in failing to report gross receipts tax

during this period.

4. The Association was negligent in continuing to rely on the advice of James Sanchez

after his services were terminated, rather than discussing its gross receipts tax liability with the firm

hired to replace Mr. Sanchez.

For the foregoing reasons, the Association’s protest IS DENIED IN PART AND

GRANTED IN PART and the Department is ordered to abate the penalty assessed against the

Association for underreporting of gross receipts tax during the period 1991-1993.

DONE this 16th day of February 1998.

12