Avoiding IRS Audit Risks: Protecting Your Club`s Tax

Report
CMAA
2010 World Conference on Club Management
Avoiding IRS Audit Risks:
Protecting Your Club’s Tax Exemption
Matthew T. Journy, Esq.
Venable LLP
Washington, DC
February 12, 2010
1
© 2009 Venable LLP
Objectives

To inform club managers about how to protect
their clubs from IRS scrutiny prior to an
examination.

To inform club managers about information that
may be a red flag in an IRS filing.

To inform club managers about how to protect
their club’s tax-exempt status during an
examination.
© 2009 Venable LLP
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Topics Discussed
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Introduction and Background
Pre-Examination
Type of Examinations
Potential Results
Common Issues
How to Deal with the IRS
Other Issues
© 2009 Venable LLP
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Introduction and Background

Requirements under 501(c)(7)
– Activities
– Revenue
– Limitations

Trends
– Increased examinations
– Increased number of revocations

Focus of IRS Examinations
– Common reasons for revocation
© 2009 Venable LLP
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There are doubtless more different kinds of clubs
than there are clubs in a deck of cards… Some
clubs feature exclusively the intellectual, or artistic;
some amateur athletics and sports; and other
epicurean, terpsichorean, or social side: all falling
clearly within the exemption.
- Chattanooga Auto Club v. Commissioner, 182 F.2d 551.
© 2009 Venable LLP
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Requirements under 501(c)(7)

The Purpose of this exemption is to promote socialization by
eliminating duplicative taxation on individuals pursuing
recreational and pleasurable activities in a social setting.

The theory behind this exemption is that individuals are
paying for these activities with income that has previously
been taxed, and an additional layer of taxation at the entity
level will act as an impediment to the social pursuit of such
activities.

The type of activity is of little consequence and acceptable
activities include:
– Golf;
– Swimming;
– Flying planes;
– Playing cards; and
– Almost any other social and pleasurable activity, even
other less than “G rated” pursuits.
© 2009 Venable LLP
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Requirements under 501(c)(7)

General requirements:
1.
Must be a club of Individuals.
2.
The club must be organized for its members’ pleasure,
recreation, or communal purposes.
3.
Substantially all of the club’s activities must be for
pleasure, recreation, or communal purposes.
4.
No part of the club’s earnings may inure to the benefit
of private individuals.
5.
The club is prohibited from discriminating on the basis
of race, color, or religion.
© 2009 Venable LLP
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Requirements under 501(c)(7)

General requirements – individuals:
–
This requirement is because the purpose of this
exemption is to allow individuals the opportunity to
interact with others of similar interests and
hobbies.
–
Members cannot be corporations or other
business entities; however, corporations or other
business entities may sponsor members.
–
Clubs cannot be organized to provide individuals
with business connections, e.g., business
leagues, community benefit organizations, or
chambers of commerce.
© 2009 Venable LLP
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Requirements under 501(c)(7)

General requirements – must be organized and
operated for the recreation and pleasure of members:
–
Members must have a common recreational
interest; property ownership is not a recreational
interest.
–
Clubs cannot be organized to further the business
interests of its members.
–
A club cannot engage in activities that do not
further its recreational purposes or provide
benefits to nonmembers.
© 2009 Venable LLP
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Requirements under 501(c)(7)

Prohibited non-recreational/nonmember activities:
–
Nontraditional business activities: vehicle repair, hosting
events, or property ownership.
• A qualifying recreational activity may appear to be a
nontraditional business, e.g., horse racing or auto
racing events open to members and nonmembers.
• Factors used to determine whether an activity is a
nontraditional business include:
–
–
–
–
–
Whether there was a profit motive;
Whether the activity is regularly carried on;
Whether the activity was advertised in a manner that
seeks public patronage; and
Whether the activity was incidental to, and in
furtherance of, the club’s purposes.
Prohibited nonmember activities or services include:
allowing more than insubstantial amount of nonmember
use of facilities (i.e., golf course club restaurant) or selling
products to nonmembers (i.e., takeout food/alcohol).
© 2009 Venable LLP
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Requirements under 501(c)(7)

Whether a non-recreational/nonmember activity is
“substantial”:
–
Gross Receipts Test
• A 501(c)(7) organization may receive no more than
35% of its gross revenue from nonmember
sources.
• Also, without respect to whether a Club meets the
35% test, a club cannot receive anymore than 15%
of its gross revenue from the provision of facilities
or services to nonmembers, including:
–
–
–
Fees for use of club facilities; and
The sale of products or services.
Facts and Circumstances Test
• If a club fails the “Gross Receipts Test,” the IRS will
determine whether the organization should
continue to be exempt when considering all of the
facts and circumstances.
• In one instance a club passed the facts and
circumstances test because it donated a
substantial amount of its nonmember proceeds to
public charities.
© 2009 Venable LLP
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Requirements under 501(c)(7)

General requirements – earnings must not inure to the
benefit of private individuals:
–
Clubs cannot use revenue from fees or services
to nonmembers or lower membership classes to
subsidize the activities of members or higher
membership classes.
–
Clubs cannot sell membership property and
provide the proceeds of the sale to select
membership classes.
© 2009 Venable LLP
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Requirements under 501(c)(7)

General requirements – must not discriminate on the
basis of race, color, or religion:
–
The prohibition on religious discrimination does
not apply to clubs that, in good faith, limit
membership to individuals of a certain religion for
the purpose of furthering the teachings of that
religion.
–
Organizations may limit membership based on
gender or sexual orientation.
–
Clubs that limit membership based on ethnic
background or national origin will not be in
violation of this provision.
© 2009 Venable LLP
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Trends

As the economy has slowed and the tax base has
become depleted, the Service has become more
aggressive with respect to:
– The number of examinations; and
– Examination tactics.

Between March 2008 and May 2009, the Service has
revoked the tax-exempt status of more than 15
501(c)(7) membership organizations.
– Only represents the number of revocations, not all
examinations.

Examination selection process:
– Historically – Random
– Recently – Industry Compliance Projects.
© 2009 Venable LLP
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Focus of IRS Examinations

Improper Revenue Sources

Unrelated Activities

Impermissible Benefits

Improper Membership

Governance Issues

Unrelated Business Income
© 2009 Venable LLP
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Focus of IRS Exams – Improper Revenue Sources

The majority of the revocation letters published by the IRS
note that one of the reasons for the revocation was the club’s
failure to meet the “Gross Receipts Test.”

In recent examinations, the IRS determined that:
– A substantial amount of revenue from gaming activities
was grounds for revocation.
– A substantial amount of revenue from providing
“goods/services for wedding supplies & services, special
events, reunions” such as receptions, lighting, lighted
parking, dance floor, catering, and bar” was grounds for
revocation.
– A substantial amount of revenue generated from the sale
of parachute training and services was grounds for
revocation where the club’s website “solicited individuals
to purchase Tandem Jumps packages, Static Line
classes, and Student Free Fall jumps.”
© 2009 Venable LLP
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Focus of IRS Examinations – Unrelated Activities

Substantially of all of a club’s activities must be for the social
and recreational benefit of its members.

The IRS has determined that:
– The provision of services usually provided by homeowners
associations, maintenance of community property and
administration of covenants for the preservation of architecture
and appearance of homes was grounds for revocation even when
the club also provided recreational activities for the homeowners.
– The provision of boat and auto maintenance were grounds for the
revocations of clubs for boating and automobile enthusiasts
because the clubs offered these services to nonmembers.
– Renting property and engaging in real estate transactions were
grounds for revocation.
– Offering death benefits to its members resulted in a club’s
revocation.
– Holding auto races for the general public was grounds for
revocation of a recreational auto racing club.
© 2009 Venable LLP
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Focus of IRS Examinations – Impermissible Benefits

Generally, the provision inurement of a club’s earnings to its
members or a group of its members is prohibited.

Common examples of impermissible benefits include:
– Compensation paid to members;
– Distributions to members;
– Income from nonmember sources used to benefit
members; and
– Disproportionate payments made to particular classes of
members.
© 2009 Venable LLP
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Focus of IRS Examinations – Impermissible Benefits

With respect to whether a membership benefit is
impermissible, the IRS has determined that:
– Reasonable compensation provided to members for the
provision of necessary services is not an impermissible benefit.
– An award of a cash prize to a member of a stock car club was
an impermissible benefit when it was paid from revenue
received from nonmember admissions to the race; however, a
cash prize awarded to a member of a bowling club was not an
impermissible benefit where the prize was paid from member
entry fees.
– Members received an impermissible benefit when nonmember
proceeds from a professional tennis tournament were used to
improve the member facilities of a tennis club. Similarly, an
impermissible benefit was found where a club’s investment
income was used to defray the cost of club improvements that
would otherwise have been paid by its members.
– Disproportionate fees charged to members with equal rights to
use club facilities will result in an impermissible benefit.
© 2009 Venable LLP
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Focus of IRS Examinations – Improper Membership

A club must be comprised of individuals who wish to
engage in recreational activities.

The IRS has ruled that a club comprised of individuals
owning property in a particular area failed to
demonstrate that the members were commingling in a
recreational manner.

A court has ruled that where there was no evidence
that members of an auto club commingled, the club
failed to qualify for exempt status under 501(c)(7).
© 2009 Venable LLP
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Focus of IRS Examinations - Governance

Failure to keep records demonstrating that the club
qualifies for tax exempt status is grounds for
revocation.

Failure to demonstrate that an organization was
engaged in the provision of recreational activities for its
members was grounds for revocation.
© 2009 Venable LLP
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Focus of IRS Examinations - UBI

To the extent that income is derived from nonmember
sources, the income is taxable as Unrelated Business
Income.

As such, net income from the nonmember use of club
facilities or services is subject to tax and should be
reported on the Form 990-T.
© 2009 Venable LLP
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Pre-Examination Compliance
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Activities
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Annual Reporting
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Important Policies
© 2009 Venable LLP
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Pre-Examination Compliance – Activities

Try to limit the activities of your club to those that
provide social and recreational opportunities to
your members.

Annually review the amount of nonmember
services that your club provides as measured by
gross revenue.

Limit advertising of your club to advertisements
for new members or for events that further your
club’s stated exempt purpose.
© 2009 Venable LLP
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Pre-Examination Compliance – Reporting

IRS Forms:
– Form 990, annual information return;
– Form 990-T, annual tax return for UBI – if your
organization provides any nonmember services or
sells any products to nonmembers, it is very likely
that it will need to file a Form 990-T, even if the
activities produce a net loss.
– Employment tax returns, Form 941 and Form W-2.
– Other:
• Form 1099 for independent contractors.
• Form W2-G for payment of gambling/raffle
winnings.
© 2009 Venable LLP
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Pre-Examination Compliance – Policies

Conflict of interest policy – there is a question
about this on the Form 990.

Policy providing for the public disclosure of the
organization’s three most recent Forms 990, its
IRS Form 1023, tax-exemption application
(including all correspondence to and from the
IRS), and its IRS determination letter.

Policy regarding annual audit or review of
financial statements.
© 2009 Venable LLP
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Type of Examinations

Correspondence Examinations
– The Service requests information through
correspondence mailed to the organization.

On-site Examinations
– General exemption issues
– Political activities and lobbying
© 2009 Venable LLP
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Type of Examinations – Correspondence Exams


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A wide net
– This allows the IRS to review the activities of many
organizations while expending fewer resources.
– The IRS will mail organizations questionnaires seeking
information about particular issues that the IRS believes
are indicative of larger issues.
– Based on the information provided, the IRS will decide
whether to open an on-site examination, conduct an
industry wide investigation, or accept the organization's
Form 990.
Less intrusive
Respond to all information requests
– A failure to respond, or the provision of incomplete
information is more likely to result in an on-site
examination than the provision of information that
demonstrates that the organization has a few minor
imperfections.
– Congress has noted with disfavor the failure of members
of certain industries to respond to compliance requests.
© 2009 Venable LLP
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Type of Examinations – On-Site Exams



Focused
– The IRS will provide a substantial list of specific
information, and Information Document Request (“IDR”)
prior to visit by IRS Agent.
– The Agent will spend time at the club’s offices reviewing
information and interviewing individuals.
Intrusive
– Agent will expect to review the information requested
and interview individuals with knowledge about the
requested information.
Slow moving
– It is very likely that the Agent will issue additional IDRs
and request follow up interviews.
– The examination process can take anywhere from
several months to several years.
© 2009 Venable LLP
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Potential Outcomes

No Change – Best result.

No Change with Advisories – Very
good result.

Closing Agreement – Positive
outcome with penalties.

Revocation – BAD.
© 2009 Venable LLP
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Potential Outcomes – No Change

No Change
– This is the best result.
– This essentially means that
following its review the IRS will
continue to recognize the
organization as exempt.
© 2009 Venable LLP
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Potential Results – No Change with Advisories

No Change with Advisories
– This is a very good result.
– The cover letter will provide that the
IRS will continue to recognize the
organization as exempt.
– In an attached addendum, the IRS
will provide the organization with a list
of advisories that will tell the
organization how to conduct its affairs
in the future.
© 2009 Venable LLP
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Potential Outcomes – Closing Agreement

Closing Agreement
– This is a positive result.
– Through a closing agreement, the
IRS will continue to recognize the
organization as tax-exempt; however,
the agreement will likely provide the
organization with specific
requirements for such recognition and
possibly require the payment of a tax
or penalty.
© 2009 Venable LLP
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Potential Outcomes – Revocation

Revocation
– This is the worst result.
– Upon receipt of this letter, the
organization is revoked as of the
effective date provided in the
letter.
© 2009 Venable LLP
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Dealing with the IRS

Prior to an Examination

During an Examination

After the Close of an Examination
© 2009 Venable LLP
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Prior to an Examination



Filings
– Make all required filings complete and timely.
– Be aware of potential UBI.
– Be aware of potential red flags on the Form 990.
Governance
– Qualified, independent officers and directors are best. However,
small organizations that are unable to pay highly qualified
individuals to provide such services should still seek the best
available governance committees.
– Be aware of specific state requirements.
– Institute IRS preferred policies, such as a conflict of interest policy.
Records
– Maintain records that demonstrate the club’s exempt activities.
– Of specific importance to social clubs – maintain records
demonstrating the amount of member income and nonmember
income, including the method for determining whether income is
derived from members.
– Be aware of the public disclosure requirements and make the
required documents available for public disclosure.
– For board meeting minutes – keep good records demonstrating the
club’s exempt purpose, it is not necessary to have transcripts or
recordings.
© 2009 Venable LLP
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During an Examination


Notification
– The examination will start with a notification sent by the Agent
responsible for the examination.
– The notice will provide the name, ID number, and contact information for
the Agent.
– The notice will also include a proposed date for the initial visit by the
Agent. If that date is bad for you or your organization, call the Agent and
request a new date and time.
Initial IDR
– This will probably be attached to the Notification.
– The initial IDR will request a substantial amount of information about the
tax period under examination as well as other tax periods. Generally,
unless the information is very difficult to obtain, we recommend providing
the information from other tax periods because the IRS has very broad
discretion in reviewing information during exams.
– To the extent possible provide all of the requested information in an
organized manner, but don’t provide information not requested.
– If you have information that you want to provide that is not requested, ask
the agent to provide an additional IDR requesting such information.
– Review documents thoroughly before providing and withhold any
documents that may be privileged.
© 2009 Venable LLP
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During an Examination

Initial Visit
– Try to have as much of the requested
information available to the Agent for review
at the initial visit.
– Have a meeting with the Agent prior to his
review so that you can explain the
information provided in response to the IDR.
– Have a copy of all of the information
provided to the Agent.
– Every agent is different, some Agents will
discuss the information provided for hours
and others will simply read the information
behind closed doors.
– Office space, lunch, and other amenities.
© 2009 Venable LLP
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During an Examination

Subsequent IDRs
– Expect subsequent IDRs, there are always
unresolved issues.
– The subsequent IDRs will likely give an
indication as to the Agent’s plan.

Requests for Extensions of the Statute of
Limitations, Form 872
– You should usually sign these when
requested.
– Failure to sign the Form 872 will result in the
revocation of the club’s exempt status.

Communication
© 2009 Venable LLP
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After the Close of an Examination

If the Service recommends a No Change

If the Service recommends a No Change
with Advisories or a Closing Agreement

If the Service recommends a Revocation
© 2009 Venable LLP
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Upon Receipt of a No Change Letter

Continue to do what you are doing.

Celebrate!
© 2009 Venable LLP
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Upon Receipt of a No Change Letter with Advisories

Continue to do what you are doing while
making all of the adjustments required by
the written advisories.

Celebrate!
© 2009 Venable LLP
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Upon Receipt of a Closing Agreement

If the IRS is seeking to enter into a closing
agreement, you should consult with an
attorney or an accountant who is
experienced with both the IRS and
nonprofit organizations.

Closing agreements are contracts
between the organization and the IRS,
and a club’s failure to live up to its end of
the bargain will likely result in revocation.

Also, the terms of the closing agreement
are subject to negotiation, and in these
situations experience is extremely
beneficial.
© 2009 Venable LLP
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After the Close of an Examination
Resulting in a Revocation

The revocation process:
– The Agent may inform you of his
intention and give you the opportunity
to dispute the factual basis for his
proposed ruling in a closing
conference.
– The Agent may provide a draft
proposed revocation for you to review
and dispute any factual errors.
© 2009 Venable LLP
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After the Close of an Examination
Resulting in a Revocation

Proposed Revocation – the 30-day Letter.
– This will provide you with the position of the
IRS and the opportunity to dispute the
proposed ruling through the IRS Appeals
Division.
– You only have 30 days to file the protest
unless the Agent provides you with an
extension.
– If you do not agree with the proposed
revocation FILE A PROTEST.
© 2009 Venable LLP
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After the Close of an Examination
Resulting in a Revocation

Proposed Revocation – 30-day Letter.
– Upon receipt of the protest, the Agent will transfer
the case to the Appeals Division.

Appeals
– In the Appeals Division, the club will have a right to
a conference with an Appeals Officer who is
independent of the IRS examination.
– Throughout this process, the club will continue to
be recognized as an exempt organization.
– Based on the information provided in the
administrative record, the proposed revocation,
and the protest, the Appeals Officer will make a
determination on the case.
© 2009 Venable LLP
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After the Close of an Examination
Resulting in a Revocation

Appeals
– If the Appeals Officer agrees with the club, she can:
• Send the case back to the Agent for additional
factual development or to issue a No Change
Letter; or
• Enter into a closing agreement.
– If the Appeals Officer agrees with the Agent, she
will prepare a Revocation – the 90 Day Letter –
which will revoke the organization’s tax-exempt
status.
© 2009 Venable LLP
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After the Close of an Examination
Resulting in a Revocation

The 90-Day Letter:
– Upon receipt of the 90-day letter, the organization
will be revoked.
– At this point, the club will have no more
administrative remedies within the IRS.
– If the club wishes to contest the case at this point,
the only venue to do so will be in court, and the
club will have 90 days within which to file a petition
for declaratory judgment with respect to its taxexempt status.
© 2009 Venable LLP
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Questions
Matthew T. Journy
Venable LLP
575 7th Street NW
Washington, DC 20004
(202) 344-4589
[email protected]
© 2009 Venable LLP
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