Many Private Member-Owned Clubs that have not already elected to become Section 501(c)(7) tax-exempt are now asking whether they should do so to save on income tax dollars in the future. When does this happen? When initiation fees and capital assessments must be included in taxable income to a taxable Club and Code Section 277, ” excess expense carryovers” are no longer available. Clubs need to know about a significant income tax deterrent many attorneys and tax return preparers are unaware of. This potential income tax to be paid by an existing taxable Club to become 501(c)(7) tax-exempt is scary.

Internal Revenue Regulation Section 337 states (highlights added) :
1.337(d)-4 Taxable to tax-exempt.(a) Gain or loss recognition.

(1) General rule.
Except as provided in paragraph (b) of this section, if a taxable corporation transfers all or substantially all of its assets to one or more tax-exempt entities, the taxable corporation must recognize gain or loss immediately before the transfer as if the assets transferred were sold at their fair market values. But see section 267 and paragraph (d) of this section concerning limitations on the recognition of loss.

(2) Change in corporation’s tax status treated as asset transfer.
Except as provided in paragraphs (a)(3) and (b) of this section, a taxable corporation’s change in status to a tax-exempt entity will be treated as if it transferred all of its assets to a tax-exempt entity immediately before the change in status becomes effective in a transaction to which paragraph (a)(1) of this section applies. . . .

(3) Exceptions for certain changes in status.
(i) To whom it is available. Paragraph (a)(2) of this section does not apply to the following corporations—
(A) A corporation previously tax-exempt under section 501(a) which regains its tax-exempt status under section 501(a) within three years from the later of a final adverse adjudication on the corporation’s tax-exempt status, or the filing by the corporation, or by the Secretary or his delegate under section 6020(b), of a federal income tax return of the type filed by a taxable corporation.

(B) A corporation previously tax-exempt under section 501(a) or that applied for but did not receive recognition of exemption under section 501(a) before January 15, 1997, if such corporation is tax-exempt under section 501(a) within three years from January 28, 1999.

(C) A newly formed corporation that is tax-exempt under section 501(a) (other than an organization described in section 501(c)(7)) within three taxable years from the end of the taxable year in which it was formed;

(D) A newly formed corporation that is tax-exempt under section 501(a) as organization described in section 501(c)(7) within seven taxable years from the end of the taxable year in which it was formed;

What is the IRS saying in layperson’s terms?

If a Club has been in existence for more than 7 years and wants to convert from being a Code Section 277 taxable Club, filing IRS Form 1120, to become a 501(c)(7) tax-exempt Club, filing IRS Form 990, there is a potential tax to be paid on the difference between the tax basis of the assets and the fair market value of those same assets as of the date of election.

Thus, if a Club’s tax return balance sheet shows a tax basis of assets, due to the Club taking depreciation, as being $2,000,000 and the determined fair market value of those same assets is deemed to be $6,000,000, there is $4,000,000 of taxable income to be reported in the year of making the 501(c)(7) tax-exempt election.

Yikes! At the 21% federal income tax rate, that tax due to become 501(c)(7) tax-exempt would be $840,000.

What is the Fair Market Value of the Club?

This is when and where a quality appraisal, performed by an experienced club appraiser is necessary. If the actual fair market value of the Club assets is less than the IRS tax basis, no tax is due when making the 501(c)(7) election. Clubs need an objective, valid and compliant appraisal demonstrating fair market value.

When is the Fair Market Value of a Club less than the tax basis?

  • When there is a downturn in the economy, as happened in 2008, with Clubs losing Members and the sales value of Clubs tanks.
  • When significant monies are spent on new Club amenities that are aspirational but add little to increasing the fair market value of the Club.
  • When there is significant deferred maintenance that can diminish the club’s market value.
  • When does the Fair Market Value of the Club exceed the tax basis?
  • When the club reinvests in a way that expands the club’s revenues and cash flows, thereby enhancing market value.
  • When market conditions indicate that value is appreciating and the fair market value exceeds the tax basis.

Conclusion:

If a Code Section 277 taxable Club were to consider applying for 501(c)(7) tax-exempt status, it is imperative to have confidence that the fair market value is less than the tax basis. We advise all our club clients nationwide to seek expert and specialized appraisal services to ensure that the process will be as smooth as possible.