If it can be said that social events and activities are heart of a social club, then members are its lifeblood. As such, the goal of a social club would seem to be to attract the perfect audience, in quantity and character, to the greatest number of social events. Due to the many traps and pitfalls found in Internal Revenue Code (the "Code") § 501(c)(7), this can be a complicated task for the manager of a tax-exempt social club.
While the Code itself does not explicitly restrict the type or amount of advertising in which a social club is allowed to engage, the many restrictions imposed on social club activities and revenue sources have the effect of imposing their own limits on advertising. For instance, the Internal Revenue Service (the "Service") has determined that a club organized to hold auto races that advertised its races to the general public violated the requirements of the Code, while a club for equestrian enthusiasts that advertised its annual steeple chase race to the general public in the same manner did not violate the requirements of the Code. Herein lies the complexity of the Code's treatment of advertising: these two activities that seem so similar in nature led to completely opposite results.
The reason for this complexity is that the Code does not define appropriate advertising activities, only allowable results. Generally, the Code prohibits organizations from engaging in activities that serve the general public, are profit-motivated, and provide pecuniary benefits to the club members.
For instance, when ruling on the auto racing club, the Service noted that the club advertised to the general public, charged the public an admission fee in excess of the cost of holding the event, and used the income generated from the admission fees to pay for expenses that would otherwise be born by club members. On the other hand, even though the equestrian club engaged in substantially similar advertising activities, the Service noted that it charged the general public the same admission fee paid by its members, the revenue generated was generally equal to the cost of holding the event, and all proceeds were donated to charity. As these examples indicate, consideration of the advertising restraints on tax-exempt social clubs should begin with an analysis of the exemption requirements.
General Code § 501(c)(7) Requirements
Generally, clubs organized and operated for pleasure, recreation, and other similar nonprofit purposes may be exempt from federal income tax. To qualify for tax exemption, substantially all of a club's activities must be for the pleasure and recreation of its members and no part of its net earnings may inure to the benefit of its members. Each advertising activity needs to be examined within the parameters of these core requirements.
In determining whether a club is operated for the pleasure and recreation of its members, the Service has looked to the sources of its revenue. Generally, a social club's support should be from membership fees, dues, and assessments. As such, a club is limited to receiving a maximum of 35% of its gross receipts from sources outside of its membership without risking its tax-exempt status. Within this 35%, no more than 15% of the club's gross receipts are to be derived from the use of its facilities or services by the general public. Additionally, it should be noted that the Service has ruled that income received by a club from members for non-recreation services should be characterized as nonmember income for purposes of the gross receipts limitation..
In determining whether a benefit inures to club members, the Service has looked to whether members receive a benefit for which they are not charged. For example, in the situation with the auto racing club, the Service found inurement where members received the benefit of improvements to the racing facilities without a corresponding increase in membership dues.
Advertising Activities
As a club's goals will greatly impact its promotional methods, a discussion of advertising is best done in the context of its purpose. Clubs frequently advertise for the following reasons: 1) to attract new members, 2) to inform existing members of club activities and services, and 3) to inform and attract the public to club events.
1) New Member Advertising
Generally, there is no prohibition against advertising to potential members. Though the Service has not published guidance on this particular issue, through its silence, the Service has indicated that such advertising will not affect a club's tax-exempt status. This is understandable, as any revenue that would be received by new members would generally qualify as membership dues. However, while advertising is generally not a concern, other promotional activities may cause problematic issues.
As social clubs are frequently selective in their membership, it is conceivable that, instead of advertising, a club will engage in a member-driven recruitment activity or provide discounted memberships. When engaging in these activities as part of a membership drive, a club can, in certain instances, run afoul of the requirements provided in the Code, as explained below.
For instance, if a promotional activity includes opening the club to the general public with trial memberships, then income received from nonmembers during the trial period may be considered nonmember income. Moreover, seeking additional members through corporate memberships, whereby a corporation membership pays dues to a social club and the corporation is allowed to select the individuals who will represent it at the club without the usual membership approval process, will likely result in income from the general public. However, if the situation were changed such that the individuals selected by corporation were subject to the usual membership approval process, then the membership dues would be characterized as member income.
As another example, if an organization were to seek additional members through an introductory or promotional membership rate, the Service may determine that there is inurement to the members paying the promotional rate. However, the Service has ruled that there is no inurement where a club seeks to increase membership by offering current members cash or other incentives in exchange for the referral of individuals who become members.
2) Advertising Events and Services to Current Members
Similar to advertising to potential members, revenue generated from the advertisement of recreational and social activities directed toward current members will likely result in membership income. However, there are potential traps which club managers should avoid. First, club managers should take the necessary precautions to ensure that the advertisements, as well as the events being advertised, are truly directed toward members only. For instance, if a club has a website available to the public and, on its website, it advertises an event that is open to the general public, the Service may determine that there was solicitation of public support, as opposed to member advertising.
Another potential trap is advertising to members for non-recreational services. For instance, if a country club has a restaurant that provides carry-out meals, then advertisements for the carry-out food service will likely be characterized as a nonmember activity even if the advertisement (and the food service itself) were exclusively for club members.
3) Advertising Events and Services to the General Public
Advertising to the general public is where the greatest potential for trouble lies. First, as a general rule, revenue derived from services advertised to the general public will be considered nonmember income. As such, country clubs that advertise their restaurants to nonmembers and sports clubs that advertise the services of a personal trainer to the general public are engaging in a non-exempt activity.
Second, similar to the examples provided at the beginning of this article, when advertising an event to the general public, the determination of whether the activity will put the club's exemption in peril is very much dependent upon the specific event being advertised. If the event generates a profit that is used to benefit club members, then the activity may jeopardize the club's tax-exempt status. However, if, similar to the equestrian club's steeple chase, the event is conducted in a manner that clearly demonstrates that it furthers the club's social purpose and there is no profit motive, then it is unlikely that the activity will adversely affect the club's exempt status.
Conclusion
As the summary above makes clear, the complexity of the impact of the requirements of Code § 501(c)(7) on a club's advertising activities can be a precarious trap for the unwary club manager. Understanding and paying careful attention to the purpose of the activity being promoted and the benefits conferred on club members will allow you to take full advantage of the multiple opportunities for growth and fulfillment, while staying in compliance with the Code.
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For more information, contact the authors at 202-344-4000 or at jstenenbaum@venable.com.
This article is not intended to provide legal advice or opinion and should not be relied on as such. Legal advice can only be provided in response to specific fact situations.