A Social Club and Marcellus Shale

 

There is a type of tax-exempt which - on first glance - might not strike one as tax-exempt.

Let me give you an example: a duck hunting club.

Chances are it owns land, equipment to maintain the land and vehicles to traverse the land. At certain times during the year, members of the club will use the land to hunt.

What makes it tax-exempt?

The idea here is that - if an activity does not have a trade or business component - then multiple people coming together to conduct the activity should not change the tax result. Not every activity has a billionaire laying around who can singlehandedly pay for it all.

This is how we have tax-exempt status for fraternities and sororities, social clubs, golf clubs - and hunting clubs. In tax-jargon, they are referred to as 501(c)(7)s.

They are not taxed the same as the “true” tax-exempts - that is, the 501(c)(3)s. The (c)(3) is top-of-the-line: it does not generally pay tax, and donations to it are tax deductible.

A (c)(7) can only wish.

The reporting regime for a (c)(7) accounts for economic activity using three income buckets:

(1)   Member income

(2)   Nonmember income

(3)   Passive income, including investment income

Member income is straightforward: visit a golf club and this will be the dues, green fees, cart, restaurant and bar charges to club members.

Swap out nonmembers for nonmembers and you (generally) have nonmember income.

COMMENT: The word “generally” in the preceding sentence is intentional. The IRS does allow some free play with the member/nonmember dichotomy, as otherwise the separation would be unworkable. Consider, for example, a member who takes his/her spouse and kids to the club for dinner. It is doubtful that the kids are members, but it makes no sense to treat them as nonmembers. The IRS provided (some) relief decades ago in Revenue Procedure 70-17.

Here is another way a (c)(7) can vary greatly from a (c)(3): the (c)(7) pays tax on its net nonmember income as well as its net investment income. It is therefore an oddball tax-exempt: it pays no tax on member-related income (referred to as “exempt function” income), but it will pay tax on “nonexempt function” and investment income.

NOTE: There can be creative accounting for “net” nonexempt function income. Speaking for a friend here.

OK, so a social club - maybe, possibly, conceivably – might pay tax. Any other traps?

You betcha.

There are two big traps.

The traps are not about paying tax. They are about losing that (c)(7) status altogether. Lose that status and you are just another business taxpayer.

The first trap is nonmember income (including investment income) cannot exceed 35% of gross receipts.

This is why you must be accompanied by a member, and – even then – only so many nonmembers are allowed. It is also why you cannot have a wedding reception at a country club if you are not a member.

The second trap is a subset of the first: no more than 15% of trap one’s 35% can be from nonmember use of club facilities. 

I do remember years ago worrying about a client losing its (c)(7) from selling (some of) its land and generating capital gain. There is case called Santee Club where the court held that an incidental, nonrecurring sale of club property would not strip a club of its tax-exempt status. We may have squeezed everything possible from Santee Club to support our desired tax position.

I am looking at a recent (c)(7) case. There are not a lot of them.

Consolidated Sportsmen of Lycoming County (CSLC) was a nonprofit corporation in Pennsylvania. It obtained (c)(7) status in 1981.

CSLC owned 230 acres and sat on top of the Marcellus Shale formation.

Talk about winning the lottery. 

The members enjoyed camping, picnic areas, rifle ranges, skeet and trap shooting, canoeing, kayaking and swimming, among other activities. CSLC was the dictionary definition of a social club.

In 2011 it entered into an oil and gas lease granting extraction rights. CSLC received a signing bonus of $921,800, and extraction commenced December, 2016.

The amounts were significant:

While the dollar amounts were significant, CSLC members and officers spent minimal hours on mineral activities.

The IRS audited years 2016, 2017, 2018 and 2019.

Seeing the above numbers, the examiner proposed to revoke CSLC’s tax-exempt status.

CSLC had no intention of capitulating. It reasoned that a social club is defined by its activities. The officers and members of SCLC spent virtually all their time on social and recreation activities and almost no time on mineral extraction activities. The IRS was barking up the wrong tree by looking only at revenues. The effort associated with mineral extraction was minimal.

This went (no surprise) to Appeals, which agreed with the IRS.

Then off to Tax Court.

And we are walked through a history of social club taxation starting in 1916. The 35% test appeared decades later in a 1976 Senate Finance Committee report. The test however never made it to statute, Treasury Regulations or IRS rulings.

So why was the IRS clinging to 35%?

Had the Tax Court looked at this issue before?

While not codified, the test took on the mantle of Code-lite by repeated cite and use over the decades.

But CSLC was not challenging the 35% test head-on. It could live with 35%, but it argued that total member hours were as valid a measuring stick as total revenues.

The Court looked at the Code and had an issue with CSLC’s argument.

The Court observed that the Code does not provide a tax exemption for “members,” but it does for “clubs.” CSLC was narrowing its lens too tightly by focusing on member activities rather than club activities overall. A club can act through its members, but a club can also act through nonmembers (such as the contractor conducting the O&G extraction).

Let’s take this a step further. If the Court were to substitute hours for revenues in the 35% test, then it would also have to include O&G contractor hours. After all, the contractor had to employ people to produce the gas generating the royalties. Given the size of the royalty payments, the Court was … skeptical … that CSLC could keep the math below 35% - and the Court would still have to agree that hours were an acceptable alternative to revenues.

CSLC never provided the contractor hours.

The failure was ruinous. The history - what there is - of Section 501(c)(7)s 35% wordsmithing revolves around revenues. CSLC was presenting a novel methodology. It not only had to convince the Court that the methodology made sense, it also had to prove that it met the requirements of its own methodology. CSLC had the burden of proof.

It failed.

Absent an alternative measuring stick, the Court could and did look at revenues. There were years when royalties exceeded 50% of the club’s gross income. For those years it would be impossible to argue that “substantially all” of the club’s activities were social and recreational.

CSLC lost its (c)(7) status.

Our case this time was Consolidated Sportsmen of Lycoming County v Commissioner, T.C. Memo 2026-109.