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.

Why is Kinder Morgan Buying Its Own Master Limited Partnerships?

I am reading that Kinder Morgan, Inc (KMI) is restructuring, bringing its master limited partnerships (MLPs) under one corporate structure. We have not spoken about MLPs in a while, and this gives us an opportunity to discuss what these entities are. We will also discuss why a company would reconsolidate, especially in an environment which has seen passthrough entities as the structure of choice for so many business owners.

As a refresher, a plain–vanilla corporation (which we call a “C” corporation) pays tax at the corporate level. The United States has the unenviable position of having one of the highest corporate tax rates in the world, which is certainly a strike against organizing a business as a C corporation. Couple this with the tax Code’s insistence on taxing the worldwide income of a C corporation (with certain exceptions), and there is a second strike for businesses with substantial overseas presence.

A passthrough on the other hand generally does not pay tax at the entity level. It instead passes its income through to its owners, who then combine that income with their personal income and deductions (for example, salary, interest and dividends, as well as mortgage interest and real estate taxes) and pay taxes on their individual tax returns. This is a key reason that many tax professionals are opposed to ever-higher individual tax rates. The business owner’s personal income is artificially boosted by that business income, pushing - if not shoving - him/her into ever-higher tax rates. This is not generally interpreted as an admonition from our government to go forth and prosper. 

MLPs are relatively recent creations, entering the tax Code in 1986. They can be the size of publicly-traded corporations, but they are organized instead as publicly-traded partnerships. They are required to generate at least 90% of their revenues from “qualifying sources,” commonly meaning oil, natural gas or coal. The stock market values MLPs on their cash flow, so the sponsor (in this case, KMI) has great incentive to maximize distributions to the unitholders. MLPs have consequently become legitimate competitors to bonds and dividend-paying stocks. You could, for example, purchase a certificate of deposit paying 1.4%, or you could instead purchase a MLP paying 7%. Introduce a low interest rate environment, couple it with expanded activity in shale and natural gas, and MLPs have been in a very favorable investment environment for a while.

One of the granddaddies of MLPs is Kinder Morgan Inc, which placed its operating activities in three principal MLPs: Kinder Morgan Energy Partners, Kinder Morgan Management and El Paso Pipeline Partners. To say that they have done well is to understate.

There is a tax downside to MLP investing, however. A MLP does not pay dividends, as Proctor & Gamble would. Instead it pays distributions, which may or may not be taxable. You do not pay tax on the distributions per se. You instead pay tax on your distributable income from the MLP, reported on a Schedule K-1. A partner pays tax on his/her income on that K-1; by investing in a MLP you are a partner. To the extent that the K-1 numbers approximate the distribution amount, your tax would be about the same as if you had received a dividend. That, however, almost never happens. Why? Let’s look at one common reason: depreciation. As a partner, you are entitled to your share of the entity’s depreciation expense. Depreciation reduces your share of the distributable income. To the extent that there is heavy depreciation, less and less of your distribution would be taxable. What type of entity would rack up heavy depreciation? How about a pipeline, with hundreds of millions of dollars tied-up in its infrastructure? 

This leads to an (almost) win:win situation for the investor. To the extent there is outsized depreciation, or perhaps depletion or tax credits, you can receive generous distributions but pay tax on a considerably smaller number. There is a tax downside however. To the extent that the distributions exceed the K-1 income, you are deemed to have received a return of your capital. This means that you are getting back part of your investment. This matters later, when you sell the MLP units. Your “basis” in the MLP would now be less (as your investment has been returned to you bit by bit), meaning that any gain on a subsequent sale would be larger by the same amount. Many MLP investors have no intention of ever selling, so they do not fear this contingency. No later sale equals no later tax.

Almost all MLPs pay someone to actually manage the business, whether it is a pipeline or timberland. That someone would be the sponsor or general partner (GP). The general partner receives a base percentage to manage the operations, and many MLPs also further pay an incentive distribution right (IDR) to the general partner, which amount increases as the MLP becomes more and more profitable. For example:

·        A GP receives 2% base to manage the business

·        Then there is an IDR at certain steps

o   At step one, the GP receives 15% of the increment over the first step,

o   At step two, the GP receives 25% of the increment over the second step

o   At step three, he GP receives 35% of the increment over the third step

How high can this go? Well, KMI and its MLPs have done so well that approximately 50% is going to an IDR payment.

This means that KMI is receiving up to 50% of the MLP income it is managing, so 50% comes back to the KMI (a C corporation) anyway. One really has not accomplished much tax-wise as far as that 50% goes.

But that leaves the other 50%, right?

MLPs can have difficulty borrowing money because they pay-out such an outsized percentage of their income, whether as IDRs or distributions. A banker wants to see a profitable business, as well as see the business retain some of that profit, if only to repay the bank. This leads to complicated bank loans, as the GP has to step in as a borrower or a guarantor on any loan. Banks also like to have collateral. Problem: the GP does not have the assets; instead the MLP has the assets. This causes banking headaches. The headache may be small, if the MLP is small.  Let the MLP grow, and headaches increase in intensity. 

Remember what we said about KMI? It is one of the granddaddies of MLPs. Banking and deal making have become a problem.

So KMI Inc has decided to do away with its MLP structure. It has proposed to buy back its MLPs in a $44 billion deal, bringing everything under the corporate roof. It now becomes the third largest energy company in the United States, behind only Exxon Mobil and Chevron.

The stock market seemed to like the deal, as KMI’s stock popped approximately 10% in one day.

What is the tax consequence to all this? Ah, now we have a problem. Let us use Kinder Morgan Energy Partners as an example. These investors will have a sale, meaning they will have to report and pay taxes on their gains. Remember that they have been reducing their initial investment by excess distributions. I have seen estimates of up to $18 tax per KMEP MLP unit owned. Granted, investors will also receive almost $11 in cash per unit, but this is a nasty April 15th surprise waiting to happen.

The restructuring should reduce KMI’s taxable income as much as $20 billion over the next dozen years or so, as KMI will now be able to claim the depreciation on its corporate tax return. In addition, KMI will be able to use its own stock in future acquisitions, as C corporations can utilize their stock to structure tax-free mergers. Standard & Poor’s has said it would upgrade KMI’s credit rating, as its organizational chart will be easier to understand and its cash flow easier to forecast. KMI has already said it would increase its dividend by approximately 10% annually for the rest of the decade.

By the way, are you wondering what the secret is to the tax voodoo used here? Kinder Morgan is bringing its MLPs onto its depreciation schedule, meaning that it will have massive depreciation deductions for years to come. There is a price to pay for this, though: someone has to report gain and pay tax. The IRS is not giving away this step-up in depreciable basis for free. It is however the MLP investors that are paying tax, although KMI is distributing cash to help out. To the extent that KMI optimized the proportion between the tax and the cash, the tax planners hit a home run.   

President’s “Plan For Economic Growth and Deficit Reduction”

I was reviewing the tax provisions of the President’s “Plan for Economic Growth and Deficit Reduction.” It is possible that the “Super Committee” may adopt some of the tax provisions, so perhaps it is worthwhile to review the proposals.

(1)  Extend through 2012 the 100% bonus first-year depreciation.

(2)  Reduce the employer portion of the social security tax from 6.2% to 3.1%.

a.       This would cap-out at $5 million in payroll.

b.      Therefore the maximum cut would be $155,000 ($5,000,000 times 3.1%).

(3)  Create a tax credit for hiring employees who have been out-of-work for more than 6 months.

(4)  Create a tax credit to offset the increase in social security tax attributable to payroll increases over the corresponding period of the preceding year.

a.       So if your payroll was $1 million last year and $1.5 million this year, you would receive a credit for the social security taxes on the $0.5 million increase.

b.      There is a cap of $50 million.

c.       The credit would be good for the last quarter of this year and all of 2012.

(5)  The pre-EGTRAA tax rates would return for those making over $200,000 and $250,000.

OBSERVATION: Senator Schumer thinks these limits should be higher for New Yorkers. He is the senator from … New York.

(6)  Limit the tax rate at which high-incomes can reduce their tax to 28% for itemized deductions, excluded foreign income, health insurance and other selected deductions.

OBSERVATION: Right… make the calculation so complicated that even tax software won’t be able to get it right. Perhaps Congress and the WH should start with eliminating the phase-outs for personal exemptions, itemized deductions, student loan interest, education credits, child credit, AMT exemption and etc that would make this a circular calculation to stress even a mathematics graduate student.

(7)  Reduce the employee social security tax from 6.2% to 3.1%.

OBSERVATION:  Read this in conjunction with (2) above.

(8)  Repeal last-in first-out accounting (LIFO).

OBSERVATION: There is no accounting reason for this, as LIFO is considered to be a generally accepted accounting principle. It forms the tax accounting backbone of virtually every vehicle dealership in the nation.

(9)  Repeal the use of lower-of-cost –or-market inventory accounting.

OBSERVATION: Again, there is no accounting reason for this.

(10)  Increase the net FUTA tax from 0.6% to 0.8%.

OBSERVATION:  FUTA was increased on a “temporary” basis from 0.6% to 0.8% in 1976, although it went back to 0.6% this year. Does that sound “temporary” to you?

(11)  Eliminate the percentage depletion and intangible drilling cost provisions for oil and gas companies.

(12)  Eliminate coal activity expensing of exploration and development costs, as well as percentage depletion for hard mineral deposits and capital gains for royalties.

(13)  Modify the transfer-for-value exception on life insurance contracts.

OBSERVATION: Seems the viatical industry has drawn attention to itself.

(14)  Require business jets to be depreciated over 7 years rather than 5.

(15)  Revise the rules on transfers of intangibles to controlled foreign corporations.

OBSERVATION:  Think Google.

(16)  Revise the rules on the deductibility of interest paid to foreign persons.

I leave it to you to deem how serious you consider these proposals.