Monday, June 28, 2010
As reported by Tax Notes Today, at 2010 TNT 123-33, the IRS has determined that a winemaking organization purporting to operate as a club does not qualify for federal income tax exemption under section 501(c)(7) of the Internal Revenue Code because it is operated as a commercial business and its earnings inure to the private benefit of its founders. The ultimate determination is unsurprising on the facts, but one aspect of the IRS’s rationale is suspect.
By way of brief background, Code section 501(c)(7) exempts from federal income taxation clubs organized for pleasure, recreation, and other non-profitable purposes, substantially all of the activities of which are for these purposes, and no part of the net earnings of which inures to the benefit of any private shareholder. The United States Treasury regulations under this Code section state that a club which engages in business, such as making its social and recreational facilities available to the general public or selling real estate, timber, or other products, is not organized and operated for pleasure, recreation and other non-profitable purposes, and therefore is not exempt. Solicitation for public patronage of its facilities is prima facie evidence that the club is engaging in business and is not being operated exclusively for pleasure, recreation, or social purposes.
The adverse determination letter issued by the IRS concludes that the “club” in question fails the test of the statute and regulations. It conducts commercial advertisements for public patronage of its wine making facility. Any person wishing to purchase the organization’s services and products automatically becomes one of its members upon payment of a large fee. Membership, however, confers no voting rights or any other of the privileges and responsibilities normally associated with membership in a genuine social club. For example, ostensible members could not vote for officers or directors, and their prospects of social commingling were limited and seemingly secondary to the commercial nature of the organization’s operations.
More troubling is the superficial reasoning of the IRS on the distinct issue of whether the “club” failed the test of exemption additionally on grounds of private inurement. The adverse determination letter states as follows, in relevant part:
You fail to meet the requirement of section 501(c)(7) of the Code that your earnings must not inure to the benefit of private individuals. You are completely controlled by your founders Mr. and Mrs. X, who are in the winemaking business or who have winemaking as their profession. Mr. and Mrs. X, acting as both landlord and tenant, rented their winemaking facility to you. The fact that Mr. and Mrs. X charged you rent based on the fair market value of their facility (which was only established almost a year after the date of the lease agreement) does not mean that they did not realize a financial gain from this transaction. On the contrary, a prudent landlord would expect to make a financial gain by leasing a facility at a monthly rent equivalent to its fair market value. Renting the facility to you, an entity that they completely controlled, also relieved Mr. and Mrs. X of the expense of marketing the facility to an unknown, unrelated tenant. Thus, the lease between the closely related parties produced prohibited inurement and this reason, standing alone, constitutes sufficient justification for denying your request for exemption from income tax under section 501(c)(7), independent of the other reasons described in this letter. . . .
Your plan to pay Mr. X as your wine steward or winemaker as soon as you are financially able to do so confirms that your earnings will inure to the benefit of your founders, Mr. and Mrs. X. You asserted that the annual salary that you will pay Mr. X will be reasonable in comparison to salaries paid by other employers for employees providing similar services. However, the inurement derives more from your hiring methodology than from the specific amount of the compensation. As stated above, Mr. and Mrs. X formed you and made all of your business decisions. Your plan (formulated by Mr. and Mrs. X) to hire Mr. X provides a valuable economic benefit to Mr. X even if his salary does not exceed what is reasonable for his services. At a minimum, this arrangement relieves Mr. X of the time, effort and expense of seeking employment from an unrelated employer. This second form of inurement, standing alone, provides sufficient justification for the proposed denial of exemption independent of the other reasons described in this letter. . . .
These sweeping statements in the determination letter reflect an understanding of “private inurement” that is more expansive than that supported by the weight of federal case law. Although exclusive financial arrangements with insiders and promotion of the financial interests of a founder can indeed produce private inurement, or confer an unlawful private benefit even in the absence of private inurement, the payment of reasonable compensation or market rent for necessary services and facilities does not, “standing alone, provide sufficient justification” for denying tax exemption. Under the reasoning of the determination letter, no social club – and, by analogy, no public charity – could pay reasonable compensation for services or market-rate consideration for goods and facilities provided by insiders. Such a view is inconsistent with judicial decisions and, in the case of public charities claiming exemption under section 501(c)(3), would largely render moot the excess benefit transactions excise tax (i.e., the so-called “intermediate sanctions” regime) of Code section 4958.