CMAA 2010 World Conference on Club Management Avoiding IRS Audit Risks:
Protecting Your Club’s Tax Exemption Matthew T. Journy, Esq. Venable LLP Washington, DC February 12, 2010
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© 2009 Venable LLP
Objectives
To inform club managers about how to protect their clubs from IRS scrutiny prior to an examination.
To inform club managers about information that may be a red flag in an IRS filing.
To inform club managers about how to protect their club’s tax-exempt status during an examination.
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Topics Discussed
Introduction and Background Pre-Examination Type of Examinations Potential Results Common Issues How to Deal with the IRS Other Issues
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Introduction and Background
Requirements under 501(c)(7) – Activities – Revenue – Limitations
Trends – Increased examinations – Increased number of revocations
Focus of IRS Examinations – Common reasons for revocation
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There are doubtless more different kinds of clubs than there are clubs in a deck of cards… Some clubs feature exclusively the intellectual, or artistic; some amateur athletics and sports; and other epicurean, terpsichorean, or social side: all falling clearly within the exemption. - Chattanooga Auto Club v. Commissioner, 182 F.2d 551.
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Requirements under 501(c)(7)
The Purpose of this exemption is to promote socialization by eliminating duplicative taxation on individuals pursuing recreational and pleasurable activities in a social setting.
The theory behind this exemption is that individuals are paying for these activities with income that has previously been taxed, and an additional layer of taxation at the entity level will act as an impediment to the social pursuit of such activities.
The type of activity is of little consequence and acceptable activities include: – Golf; – Swimming; – Flying planes; – Playing cards; and – Almost any other social and pleasurable activity, even other less than “G rated” pursuits.
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Requirements under 501(c)(7)
General requirements: 1.
Must be a club of Individuals.
2.
The club must be organized for its members’ pleasure, recreation, or communal purposes.
3.
Substantially all of the club’s activities must be for pleasure, recreation, or communal purposes.
4.
No part of the club’s earnings may inure to the benefit of private individuals.
5.
The club is prohibited from discriminating on the basis of race, color, or religion.
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Requirements under 501(c)(7)
General requirements – individuals: –
This requirement is because the purpose of this exemption is to allow individuals the opportunity to interact with others of similar interests and hobbies.
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Members cannot be corporations or other business entities; however, corporations or other business entities may sponsor members.
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Clubs cannot be organized to provide individuals with business connections, e.g., business leagues, community benefit organizations, or chambers of commerce.
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Requirements under 501(c)(7)
General requirements – must be organized and operated for the recreation and pleasure of members: –
Members must have a common recreational interest; property ownership is not a recreational interest.
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Clubs cannot be organized to further the business interests of its members.
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A club cannot engage in activities that do not further its recreational purposes or provide benefits to nonmembers.
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Requirements under 501(c)(7)
Prohibited non-recreational/nonmember activities: –
Nontraditional business activities: vehicle repair, hosting events, or property ownership. • A qualifying recreational activity may appear to be a nontraditional business, e.g., horse racing or auto racing events open to members and nonmembers. • Factors used to determine whether an activity is a nontraditional business include: – – – –
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Whether there was a profit motive; Whether the activity is regularly carried on; Whether the activity was advertised in a manner that seeks public patronage; and Whether the activity was incidental to, and in furtherance of, the club’s purposes.
Prohibited nonmember activities or services include: allowing more than insubstantial amount of nonmember use of facilities (i.e., golf course club restaurant) or selling products to nonmembers (i.e., takeout food/alcohol). © 2009 Venable LLP
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Requirements under 501(c)(7)
Whether a non-recreational/nonmember activity is “substantial”: –
Gross Receipts Test • A 501(c)(7) organization may receive no more than 35% of its gross revenue from nonmember sources. • Also, without respect to whether a Club meets the 35% test, a club cannot receive anymore than 15% of its gross revenue from the provision of facilities or services to nonmembers, including: – –
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Fees for use of club facilities; and The sale of products or services.
Facts and Circumstances Test • If a club fails the “Gross Receipts Test,” the IRS will determine whether the organization should continue to be exempt when considering all of the facts and circumstances. • In one instance a club passed the facts and circumstances test because it donated a substantial amount of its nonmember proceeds to public charities. © 2009 Venable LLP
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Requirements under 501(c)(7)
General requirements – earnings must not inure to the benefit of private individuals: –
Clubs cannot use revenue from fees or services to nonmembers or lower membership classes to subsidize the activities of members or higher membership classes.
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Clubs cannot sell membership property and provide the proceeds of the sale to select membership classes.
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Requirements under 501(c)(7)
General requirements – must not discriminate on the basis of race, color, or religion: –
The prohibition on religious discrimination does not apply to clubs that, in good faith, limit membership to individuals of a certain religion for the purpose of furthering the teachings of that religion.
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Organizations may limit membership based on gender or sexual orientation.
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Clubs that limit membership based on ethnic background or national origin will not be in violation of this provision.
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Trends
As the economy has slowed and the tax base has become depleted, the Service has become more aggressive with respect to: – The number of examinations; and – Examination tactics.
Between March 2008 and May 2009, the Service has revoked the tax-exempt status of more than 15 501(c)(7) membership organizations. – Only represents the number of revocations, not all examinations.
Examination selection process: – Historically – Random – Recently – Industry Compliance Projects. © 2009 Venable LLP
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Focus of IRS Examinations
Improper Revenue Sources
Unrelated Activities
Impermissible Benefits
Improper Membership
Governance Issues
Unrelated Business Income
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Focus of IRS Exams – Improper Revenue Sources
The majority of the revocation letters published by the IRS note that one of the reasons for the revocation was the club’s failure to meet the “Gross Receipts Test.”
In recent examinations, the IRS determined that: – A substantial amount of revenue from gaming activities was grounds for revocation.
– A substantial amount of revenue from providing “goods/services for wedding supplies & services, special events, reunions” such as receptions, lighting, lighted parking, dance floor, catering, and bar” was grounds for revocation. – A substantial amount of revenue generated from the sale of parachute training and services was grounds for revocation where the club’s website “solicited individuals to purchase Tandem Jumps packages, Static Line classes, and Student Free Fall jumps.” © 2009 Venable LLP 16
Focus of IRS Examinations – Unrelated Activities
Substantially of all of a club’s activities must be for the social and recreational benefit of its members.
The IRS has determined that: – The provision of services usually provided by homeowners associations, maintenance of community property and administration of covenants for the preservation of architecture and appearance of homes was grounds for revocation even when the club also provided recreational activities for the homeowners. – The provision of boat and auto maintenance were grounds for the revocations of clubs for boating and automobile enthusiasts because the clubs offered these services to nonmembers. – Renting property and engaging in real estate transactions were grounds for revocation.
– Offering death benefits to its members resulted in a club’s revocation. – Holding auto races for the general public was grounds for revocation of a recreational auto racing club. © 2009 Venable LLP 17
Focus of IRS Examinations – Impermissible Benefits
Generally, the provision inurement of a club’s earnings to its members or a group of its members is prohibited.
Common examples of impermissible benefits include: – Compensation paid to members; – Distributions to members;
– Income from nonmember sources used to benefit members; and – Disproportionate payments made to particular classes of members.
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Focus of IRS Examinations – Impermissible Benefits
With respect to whether a membership benefit is impermissible, the IRS has determined that: – Reasonable compensation provided to members for the provision of necessary services is not an impermissible benefit. – An award of a cash prize to a member of a stock car club was an impermissible benefit when it was paid from revenue received from nonmember admissions to the race; however, a cash prize awarded to a member of a bowling club was not an impermissible benefit where the prize was paid from member entry fees. – Members received an impermissible benefit when nonmember proceeds from a professional tennis tournament were used to improve the member facilities of a tennis club. Similarly, an impermissible benefit was found where a club’s investment income was used to defray the cost of club improvements that would otherwise have been paid by its members. – Disproportionate fees charged to members with equal rights to use club facilities will result in an impermissible benefit.
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Focus of IRS Examinations – Improper Membership
A club must be comprised of individuals who wish to engage in recreational activities.
The IRS has ruled that a club comprised of individuals owning property in a particular area failed to demonstrate that the members were commingling in a recreational manner.
A court has ruled that where there was no evidence that members of an auto club commingled, the club failed to qualify for exempt status under 501(c)(7).
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Focus of IRS Examinations - Governance
Failure to keep records demonstrating that the club qualifies for tax exempt status is grounds for revocation.
Failure to demonstrate that an organization was engaged in the provision of recreational activities for its members was grounds for revocation.
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Focus of IRS Examinations - UBI
To the extent that income is derived from nonmember sources, the income is taxable as Unrelated Business Income.
As such, net income from the nonmember use of club facilities or services is subject to tax and should be reported on the Form 990-T.
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Pre-Examination Compliance
Activities
Annual Reporting
Important Policies
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Pre-Examination Compliance – Activities
Try to limit the activities of your club to those that provide social and recreational opportunities to your members.
Annually review the amount of nonmember services that your club provides as measured by
gross revenue.
Limit advertising of your club to advertisements for new members or for events that further your
club’s stated exempt purpose.
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Pre-Examination Compliance – Reporting
IRS Forms: – Form 990, annual information return; – Form 990-T, annual tax return for UBI – if your organization provides any nonmember services or sells any products to nonmembers, it is very likely that it will need to file a Form 990-T, even if the activities produce a net loss. – Employment tax returns, Form 941 and Form W-2. – Other: • Form 1099 for independent contractors. • Form W2-G for payment of gambling/raffle winnings.
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Pre-Examination Compliance – Policies
Conflict of interest policy – there is a question about this on the Form 990.
Policy providing for the public disclosure of the organization’s three most recent Forms 990, its IRS Form 1023, tax-exemption application
(including all correspondence to and from the IRS), and its IRS determination letter.
Policy regarding annual audit or review of
financial statements.
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Type of Examinations
Correspondence Examinations – The Service requests information through correspondence mailed to the organization.
On-site Examinations
– General exemption issues – Political activities and lobbying
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Type of Examinations – Correspondence Exams
A wide net – This allows the IRS to review the activities of many organizations while expending fewer resources. – The IRS will mail organizations questionnaires seeking information about particular issues that the IRS believes are indicative of larger issues. – Based on the information provided, the IRS will decide whether to open an on-site examination, conduct an industry wide investigation, or accept the organization's Form 990. Less intrusive Respond to all information requests – A failure to respond, or the provision of incomplete information is more likely to result in an on-site examination than the provision of information that demonstrates that the organization has a few minor imperfections. – Congress has noted with disfavor the failure of members of certain industries to respond to compliance requests. © 2009 Venable LLP
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Type of Examinations – On-Site Exams
Focused – The IRS will provide a substantial list of specific information, and Information Document Request (“IDR”) prior to visit by IRS Agent. – The Agent will spend time at the club’s offices reviewing information and interviewing individuals. Intrusive – Agent will expect to review the information requested and interview individuals with knowledge about the requested information. Slow moving – It is very likely that the Agent will issue additional IDRs and request follow up interviews. – The examination process can take anywhere from several months to several years.
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Potential Outcomes
No Change – Best result.
No Change with Advisories – Very good result.
Closing Agreement – Positive outcome with penalties.
Revocation – BAD.
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Potential Outcomes – No Change
No Change – This is the best result. – This essentially means that following its review the IRS will continue to recognize the organization as exempt.
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Potential Results – No Change with Advisories
No Change with Advisories – This is a very good result. – The cover letter will provide that the IRS will continue to recognize the organization as exempt. – In an attached addendum, the IRS will provide the organization with a list of advisories that will tell the organization how to conduct its affairs in the future.
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Potential Outcomes – Closing Agreement
Closing Agreement – This is a positive result. – Through a closing agreement, the IRS will continue to recognize the organization as tax-exempt; however, the agreement will likely provide the organization with specific requirements for such recognition and possibly require the payment of a tax or penalty. © 2009 Venable LLP
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Potential Outcomes – Revocation
Revocation – This is the worst result. – Upon receipt of this letter, the organization is revoked as of the effective date provided in the letter.
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Dealing with the IRS
Prior to an Examination
During an Examination
After the Close of an Examination
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Prior to an Examination
Filings – Make all required filings complete and timely. – Be aware of potential UBI. – Be aware of potential red flags on the Form 990. Governance – Qualified, independent officers and directors are best. However, small organizations that are unable to pay highly qualified individuals to provide such services should still seek the best available governance committees. – Be aware of specific state requirements. – Institute IRS preferred policies, such as a conflict of interest policy. Records – Maintain records that demonstrate the club’s exempt activities. – Of specific importance to social clubs – maintain records demonstrating the amount of member income and nonmember income, including the method for determining whether income is derived from members. – Be aware of the public disclosure requirements and make the required documents available for public disclosure. – For board meeting minutes – keep good records demonstrating the club’s exempt purpose, it is not necessary to have transcripts or recordings.
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During an Examination
Notification – The examination will start with a notification sent by the Agent responsible for the examination. – The notice will provide the name, ID number, and contact information for the Agent. – The notice will also include a proposed date for the initial visit by the Agent. If that date is bad for you or your organization, call the Agent and request a new date and time. Initial IDR – This will probably be attached to the Notification. – The initial IDR will request a substantial amount of information about the tax period under examination as well as other tax periods. Generally, unless the information is very difficult to obtain, we recommend providing the information from other tax periods because the IRS has very broad discretion in reviewing information during exams. – To the extent possible provide all of the requested information in an organized manner, but don’t provide information not requested. – If you have information that you want to provide that is not requested, ask the agent to provide an additional IDR requesting such information. – Review documents thoroughly before providing and withhold any documents that may be privileged.
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During an Examination
Initial Visit – Try to have as much of the requested information available to the Agent for review at the initial visit. – Have a meeting with the Agent prior to his review so that you can explain the information provided in response to the IDR. – Have a copy of all of the information provided to the Agent. – Every agent is different, some Agents will discuss the information provided for hours and others will simply read the information behind closed doors. – Office space, lunch, and other amenities. © 2009 Venable LLP
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During an Examination
Subsequent IDRs – Expect subsequent IDRs, there are always unresolved issues. – The subsequent IDRs will likely give an indication as to the Agent’s plan.
Requests for Extensions of the Statute of Limitations, Form 872 – You should usually sign these when requested. – Failure to sign the Form 872 will result in the revocation of the club’s exempt status.
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After the Close of an Examination
If the Service recommends a No Change
If the Service recommends a No Change with Advisories or a Closing Agreement
If the Service recommends a Revocation
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Upon Receipt of a No Change Letter
Continue to do what you are doing.
Celebrate!
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Upon Receipt of a No Change Letter with Advisories
Continue to do what you are doing while making all of the adjustments required by the written advisories.
Celebrate!
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Upon Receipt of a Closing Agreement
If the IRS is seeking to enter into a closing agreement, you should consult with an attorney or an accountant who is experienced with both the IRS and nonprofit organizations.
Closing agreements are contracts between the organization and the IRS, and a club’s failure to live up to its end of the bargain will likely result in revocation.
Also, the terms of the closing agreement are subject to negotiation, and in these situations experience is extremely beneficial. © 2009 Venable LLP
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After the Close of an Examination Resulting in a Revocation
The revocation process:
– The Agent may inform you of his intention and give you the opportunity to dispute the factual basis for his proposed ruling in a closing conference. – The Agent may provide a draft proposed revocation for you to review and dispute any factual errors.
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After the Close of an Examination Resulting in a Revocation
Proposed Revocation – the 30-day Letter. – This will provide you with the position of the IRS and the opportunity to dispute the proposed ruling through the IRS Appeals Division. – You only have 30 days to file the protest unless the Agent provides you with an extension. – If you do not agree with the proposed revocation FILE A PROTEST.
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After the Close of an Examination Resulting in a Revocation
Proposed Revocation – 30-day Letter.
– Upon receipt of the protest, the Agent will transfer the case to the Appeals Division.
Appeals – In the Appeals Division, the club will have a right to a conference with an Appeals Officer who is independent of the IRS examination. – Throughout this process, the club will continue to be recognized as an exempt organization. – Based on the information provided in the administrative record, the proposed revocation, and the protest, the Appeals Officer will make a determination on the case.
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After the Close of an Examination Resulting in a Revocation
Appeals
– If the Appeals Officer agrees with the club, she can: • Send the case back to the Agent for additional factual development or to issue a No Change Letter; or • Enter into a closing agreement. – If the Appeals Officer agrees with the Agent, she will prepare a Revocation – the 90 Day Letter – which will revoke the organization’s tax-exempt status.
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After the Close of an Examination Resulting in a Revocation
The 90-Day Letter:
– Upon receipt of the 90-day letter, the organization will be revoked. – At this point, the club will have no more administrative remedies within the IRS. – If the club wishes to contest the case at this point, the only venue to do so will be in court, and the club will have 90 days within which to file a petition for declaratory judgment with respect to its taxexempt status.
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Questions Matthew T. Journy Venable LLP 575 7th Street NW Washington, DC 20004 (202) 344-4589
[email protected]
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