The Tax Court held that a Sec. 501(c)(7) social club could not deduct losses from nonmember sales to offset investment income because the club failed to establish a profit motive for its nonmember activity.
Facts: Losantiville Country Club is a Sec. 501(c)(7) social club that operated a golf course, a swimming pool, tennis courts, and other facilities for use by its members in Ohio. Members paid dues and fees to use the facilities. Nonmembers paid surcharges for the same use.
Losantiville had filed a Form 990-T, Exempt Organization Business Income Tax Return, annually since it was founded in 2002. On its Forms 990-T, Losantiville reported gross receipts as well as expenses related to its nonmember sales activity. For 2010 through 2012, the years at issue, Losantiville reported losses with respect to its nonmember sales. Losantiville calculated the losses using the gross-to-gross method, the ratio of nonmember sales to total sales, to determine the deductible indirect expenses taken against nonmember sales. On the returns, Losantiville claimed the losses against investment income earned in those years, resulting in no unrelated business taxable income (UBTI).
In a notice of deficiency, the IRS determined that nonmember sales were not entered into for profit, so the losses could not offset investment income and the investment income was UBTI. The Service determined deficiencies relating to 2010, 2011, and 2012, and assessed accuracy-related penalties under Sec. 6662. Losantiville challenged the determinations in Tax Court.
Issues: Under Sec. 511(a)(1) and Sec. 512(a)(1), tax-exempt organizations must pay federal income tax on their UBTI, which generally consists of income derived from any trade or business not substantially related to the conduct of their exempt purpose. Sec. 512(b) generally excludes most forms of investment income from UBTI for certain charitable organizations. However, Sec. 512(a)(3)(B) limits the "exempt function income" of Sec. 501(c)(7) social organizations to amounts paid by members or their dependents or guests for goods, services, or facilities within the organization's purposes, leaving UBTI to include nonmember and investment income. Losses from nonmember sales can be used to offset other UBTI only to the extent the sales were undertaken with an intent to profit from them (see Portland Golf Club, 497 U.S. 154 (1990)). Losantiville argued that its intent to profit could be established by the factors set forth in Regs. Sec. 1.183-2(b) (the "hobby loss" rules). The IRS argued that the reported losses from nonmember sales demonstrated a lack of profit motive.
Holding: Citing Portland Golf Club, the Tax Court held that Losantiville did not demonstrate an intent to profit from its nonmember sales because its nonmember sales did not exceed the direct and indirect costs relating to those sales and therefore it could not use the losses to offset its taxable investment income. The court dismissed Losantiville's contention that its profit motive could be established by the factors set forth in Regs. Sec. 1.183-2(b) because, it said, those regulations do not apply to Sec. 501(c)(7) organizations.
In addition, the Tax Court held that the returns were not prepared in good faith, and sustained the IRS's penalty determinations. Although the returns were prepared by professionals, the court found that there was no evidence that the preparers had sufficient expertise to justify reliance, that Losantiville provided them with accurate information, or that Losantiville relied in good faith on the preparers' judgment.
- Losantiville Country Club, T.C. Memo. 2017-158
—By Maria M. Pirrone, CPA, LL.M., assistant professor of accounting and taxation, St. John's University, Queens, N.Y.