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.

Is A Zero-Return Partnership A Valid Tax Filing?

 

I remember when they were called Chief Counsel Advices. IRS employees – think revenue agents or officers in the field – would reach out to their employer – the IRS – for guidance on an issue.

I am looking at something called a Chief Counsel Email.

Everything changes.

It caught my eye because I was talking with a CPA last week on the very same issue.

And the IRS position is initially disturbing.

Let’s go over this.

A revenue agent (commonly called an auditor) wanted to know if an initial partnership return showing partner information but zeros for activity would constitute a valid tax return.

COMMENT: I have seen this situation many times, including last week. Someone obtains a federal EIN, putting the entity on the IRS radar. The entity then goes on to do … nothing. It never starts or starts a year or two later. Meanwhile the entity is on the IRS Christmas card list. Fail to file a return and the IRS may send a letter asking why you did not file. In response, practitioners usually file an initial return but show zeros as activity because… well because there has been no activity.

Here is the Email:

We agree with the RA’s memo that the initial return showing ownership information, but containing all 0s would most likely be considered invalid under application of the Beard test.

Not good.

To be fair, however, I do not think that it is difficult to work with this Email.

Let’s first talk about Beard.

Beard was a tax protestor.

He found himself in Tax Court over his 1981 return. He received a Form W-2, which he reported on the form 1040. He then inserted a line he described as “Non-taxable receipts” and subtracted his W-2. The result was that he owed – according to him – no taxes and was entitled to a full refund of his withholding.

The IRS wanted tax, of course, and also wanted penalties for failure to file a return. He filed something, but tampering with the forms voided the filing.

Beard responded that he obviously filed a return. The IRS was out of line saying that he had not.

The issue before the Court was: what is a tax return?

The Court presented a four-part test:

1. Does it purport to be a tax return?
2. Is it signed under penalties of perjury?
3. Does it include enough information to calculate a tax?
4. Does it represent an honest effort to satisfy the tax laws?

Beard – a protestor – missed the third test by altering the form.

Here was the Court on the fourth test:

The tampered form here is a conspicuous protest against the payment of tax, intended to deceive respondent’s return-processing personnel into refunding the withheld tax. Since such intentional tampering could go undetected in computer processing, respondent was forced to develop and institute special procedures for handling such submissions. The critical requirement that there must be an honest and reasonable attempt to satisfy the requirements of the Federal income tax law is clearly not met."

Back to our Email.

Numerous tax court decisions have found that a return (typically a 1040) containing all zeros, even if filed on an official IRS form, does not constitute a valid tax return.”

True, but …

However, these are all in the tax protestor context and other cases have held that a zero return may be valid if there is reason to believe that it is an accurate reflection of the taxpayer’s activity.”

Got it.

I will start including a schedule or attachment to the partnership tax return stating the following:

XXX Partnership/LLLC was formed on XX/XX/XX and no business operations occurred during its initial tax year ending XX/XX/20XX.”

Easy.

But it is a trap for a non-tax specialist.

This time we discussed CCA 2026030612260600 a/k/a Chief Counsel Email 202634014.

 

Whose Job Is It Anyway?

One of our accountants asked me recently:

R:      Do you think [so and so] qualifies as a real estate professional?

CTG: I do not know [so and so]. Tell me a little.

R:      Husband pulls a W-2.

CTG: How much and how many hours?

R:      Blah blah dollars.

CTG: Works in real estate?

R:      Nah.

CTG: Hours?

R:      Maybe 2,000.

CTG: Is the wife in real estate?

R:      No.

I have told you (almost) everything you need to answer the question.

Let’s look at the Warren case.

James Warren organized Warren Assisted Living, LLC in 2015.

He purchased a group home in 2016.

He started repairing the home almost immediately.

In 2017 he worked at Lockheed Martin for 1,913 hours as an engineer.

On his 2017 tax return he claimed a $41 thousand-plus loss from the group home. He claimed he was a real estate professional.

Warren did not keep time logs.

What sets this up are the passive activity rules under Section 469. As initially passed, that Section considered rental activities (with minimal exceptions) to be “per se” passive.

The passive activity rules would then stifle your ability to claim losses. You – for the most part – had to wait until you had income from the activity. You could then use the losses against the income. 

Well, that caught real estate landlords and others around the country by surprise. When you do one thing, it is difficult to have a Congressional staffer decide that your thing is not a regular thing like the next thing across the street.

Congress made a change.

(c)(7)  Special rules for taxpayers in real property business.

 

(A)  In general. If this paragraph applies to any taxpayer for a taxable year-

 

(i)  paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

(ii)  this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

 

Notwithstanding clause (ii) , a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

 

(B)   Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if-

 

(i)  more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii)  such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

 

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

The above is called the real estate professional exception. It is a mercy release from the per se rule that would otherwise inaccurately (and unfairly) consider people who work in real estate all day to not be working at all.

It has two main parts:

(1) You have to spend at least 750 hours working in real estate, and

(2)  You have to spend more than 50% of your “working at something” total hours actually “working in real estate.”

If you are a real estate professional, you avoid the “per se” label. You have not yet escaped the passive activity rules – you still have to show that you worked - but at least you have the opportunity to present your case.

The Court looked at Warren’s 1,913 hours at Lockheed. That means he would need 3,827 total hours for real estate to be more than ½ of his total work hours. (1,913 times 2 plus 1).

First of all, 3,827 total hours means he was working at least 74 hours a week, every week, without fail, for the entire year.

Maybe. Doubt it.

Warren is going to need really good records to prove it.

Here is the Court:

Mr Warren did not keep contemporaneous logs of his time renovating the group home.”

Not good, but not necessarily fatal. I represented a client who kept Outlook and other records. She created her log after the fact but from records which themselves were contemporaneous. Mind you, we had to go to Appeals, but she won.

In preparation for trial, Mr Warren created – and presented – two time logs.”

Good grief.

The first log maintained that he worked 1,421 hours at the group home; it was created one week before trial.”

End it. That is less than his 1,913 hours at Lockheed.

The second log maintained that Mr. Warren worked 1,628 at the group home; it was created the night before trial.”

Why bother?

This was a slam dunk for the Court. They did not have to dwell on contemporaneous or competing logs or believability or whether the Bengals will turn their season around. Whether 1,421 or 1,628, he could not get to more-than-50%.

Warren lost.

As a rule of thumb, if you have a full-time W-2, it will be almost impossible to qualify as a real estate professional. The exception is when your full-time W-2 is in real estate, maybe with an employer such as CBRE or Cushman & Wakefield.  At 1,900-plus Lockheed hours, I have no idea what Warren was thinking, although I see that it was a per se case. That means he represented himself, and it shows.

I suppose one could have a W-2 and work crazy hours and meet the more-than-50% requirement, but your records should be much tighter. And skip the night before thing.

BTW another way to meet this test is by being married.

Look at (B)(ii) again:

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

If your spouse can meet the test (both parts), then you will qualify by riding on the shoulders of your spouse.

Our case this time was Warren v Commissioner, T.C. Summary Opinion 2024-20.

A Real Estate Course – And Dave

 

The case made me think of Dave, a friend from long ago – one of those relationships that sometimes surrenders to time, moving and distance.

Dave was going to become a real investor.

That was not his day job, of course. By day he was a sales rep for a medical technology company. And he was good at sales. He almost persuaded me to join his incipient real estate empire.

He had come across one of those real estate gurus – I cannot remember which one – who lectured about making money with other people’s money.

There was even a  3-ring binder or two which Dave gave me to read.

I was looking over a recent case decided by the Tax Court.

The case involved an engineer (Eason) and a nurse (Leisner).

At the start of 2016 they owned two residential properties. One was held for rent; the other was sold during 2016.

COMMENT: Seems to me they were already in the real estate business. It was not a primary gig, but it was a gig.

Eason lost his job during 2016.

A real estate course came to his attention, and he signed up – for the tidy amount of $41,934.

COMMENT: Say what?

In July 2016 the two formed Ashley & Makai Homes (Homes), an S corporation. Homes was formed to provide advice and guidance to real estate owners and investors.  They had business cards and stationary made and started attending some of those $40 grand-plus courses. Not too many, though, as the outfit that sponsored the courses went out of business.

COMMENT: This is my shocked face.

By 2018 Eason and Leisner abandoned whatever hopes they had for Homes. They never made a dime of income.

You know that $40 grand-plus showed up on the S corporation tax return.

The IRS disallowed the deduction.

And tacked on penalties for the affront.

This is the way, said the IRS.

And so we have a pro se case in the Tax Court.

Respondent advances various reasons why petitioners are not entitled to any deductions …”

The respondent will almost always be the IRS in these cases, as the it is the taxpayer who petitions the Court.

And we have discussed “pro se” many times. It generally means that a taxpayer is representing himself/herself, but that is not fully accurate. A taxpayer can be advised by a professional, but if that professional has not taken and passed the exam to practice before the Tax Court the matter is still considered pro se.

Back to the Court:

          … we need to focus on only one [reason].”

That reason is whether a business had started.

Neither Homes nor petitioners reported any income from a business activity related to the disputed deductions, presumably because none was earned.”

This is not necessarily fatal, though.

The absence of income, in and of itself, does not compel a finding that a business has not yet started if other activities show that it has.”

This seems a reasonably low bar to me: take steps to market the business, whatever those words mean in context. If the context is to acquire clients, then perhaps a website or targeted advertising in the local real estate association newsletter.

Here, however, the absence of income coupled with the absence of any activity that shows that services were offered or provided to clients or customers […] supports respondent’s position that the business had not yet started by the close of the year.”

Yeah, no. The Court noted that a business deduction requires a business. Since a business had not started, no business deduction was available.

The Court disagreed with any penalties, though. There was enough there that a reasonable person could have decided either way.

I agree with the Court, but I also think that just a slight change could have changed the outcome in the taxpayers’ favor.

How?

Here’s one:  remember that Eason and Leisner owned a rental property together?

What if they had broadened Homes’ principal activity to include real estate rental and transferred the property to the S corporation? Homes would have been in business at that point. The tax issue then would have been expansion of the business, not the start of one.

Our case this time was Eason and Leisner v Commissioner, T.C. Summary Opinion 2024-17.

Navigating The Tax Code On Your Own

 

I received a phone call recently from the married daughter of a client. I spoke with the couple – mostly the son-in-law – about needing an accountant. They had bought property, converted property to rental status and were selling property the following (that is, this) year.

It sounds like a lot. It really isn’t. It was clear during our conversation that they were well-versed in the tax issues.

I told them: “you don’t need me.”

They were surprised to hear this.

Why would I say that?

They knew more than they gave themselves credit for. Why pay me? Let them put the money to better use.

Let’s take an aside before continuing our story.

We - like many firms - are facing staffing pressure. The profession has brought much of this upon itself – public accounting has a blemished past – and today’s graduates appear to be aware of the sweatshop mentality that has preceded them. Lose a talented accountant. Experience futility in hiring new talent. Ask those who remain to work even harder to make up the shortfall. Be surprised when they eventually leave because of overwork. Unchecked, this problem can be a death spiral for a firm.

Firms are addressing this in different ways. Many firms are dismissing clients or not accepting new ones. Many (if not most) have increased minimum fees for new clients. Some have released entire lines of business. There is a firm nearby, for example, which has released all or nearly all of its fiduciary tax practice.

We too are taking steps, one of which is to increase our minimum fee for new individual tax clients.

Back to the young couple.

I explained that I did not want to charge them that minimum fee, especially since it appeared they could prepare their return as well as I could. 

They explained they wanted certainty that it was done right.

Yeah, I want that for them too. We will work something out.

But I think there is a larger issue here.

The tax Code keeps becoming increasingly complex. That is fine if we are talking about Apple or Microsoft, as they can afford to hire teams of accountants and attorneys. It is not fine for ordinary people, hopefully experiencing some success in life, but unable – or fearful - to prepare their own returns. Couple this with an overburdened accounting profession, a sclerotic IRS, and a Congress that may be brewing a toxic stew with its never-ending disfigurement of the tax Code to solve all perceived ills since the days of Hammurabi.

How are people supposed to know that they do not know?

Let’s look at the Lucas case.

Robert Lucas was a software engineer who lost his job in 2017. He was assisting his son and daughter, and he withdrew approximately $20 grand from his 401(k) toward that end.

Problem: Lucas was not age 59 ½.

Generally speaking, that means one has taxable income.

One may also have a penalty for early distribution. While that may seem like double jeopardy, such is the law.

Sure enough, the plan administrator issued a Form 1099 showing the distribution as taxable to Lucas with no known penalty exception.

Lucas should have paid the tax and penalty. He did not, which is why we are talking about this.

The IRS computers caught the omission, of course, and off to Tax Court they went.

Lucas argued that he had been diagnosed with diabetes a couple of years earlier. He had read on a website that diabetes would make the distribution nontaxable.

Sigh. He had misread – or someone had written something wildly inaccurate about – being “unable to engage in any substantial gainful activity.”

That is a no.

Since he thought the distribution nontaxable, he also thought the early distribution penalty would not apply.

No … again.

Lucas tried.

He thought he knew, but he did not know.

He could have used a competent tax preparer.

But how was he to know that?

Our case this time was Robert B. Lucas v Commissioner T.C.M. 2023-009.