Social Club Did Not Show Profit Motive for Sales to Nonmembers

In the arena of tax law, often minor differences in a situation may create major differences in how a situation is evaluated for tax purposes.  What a taxpayer must show to demonstrate an activity was entered into with an intention to make a profit is one of those areas where there are different tests depending on the situation.

Specifically, a not for profit organization seeking to offset unrelated business taxable income from one activity with losses from another unrelated business activity faces a very different hurdle to show that the second activity was entered into with the intent to make a profit.  This issue was discussed recently in the case of Losantiville Country Club v. Commissioner, TC Memo 2017-158.

In the case of Portland Golf Club v. Commissioner, 497 US 154 (1990), the United States Supreme Court held that a tax exempt organization could only offset unrelated business taxable income from one activity with a loss from another unrelated activity if the organization can show that it intended to profit from that activity.[1]  As the Supreme Court continued later in the opinion:

In our view, Congress’ use of the term “unrelated business taxable income” to describe all receipts other than payments from the members hardly manifests an intent to define as a “trade or business” activities otherwise outside the scope of § 162. Petitioner’s reading would render superfluous the words “allowed by this chapter” in § 512(a)(3)(A): If each taxable activity of a social club is “deemed” to be a trade or business, then all of the expenses “directly connected” with those activities would presumably be deductible. Moreover, Portland Golf’s interpretation ignores Congress’ general intent to tax the income of social clubs according to the same principles applicable to other taxpayers. We therefore conclude that petitioner may offset losses incurred in sales to nonmembers against investment income only if its nonmember sales are motivated by an intent to profit.

Like the taxpayer in Portland Golf Club, the Losantville Country Club was looking to offset unrelated business taxable income (in this case the investment income of a social club taxable under IRC §501(c)(7)) with losses incurred by the club for sales to nonmembers.

The club had computed a loss from sales to nonmembers by using the gross to gross allocation method.  That method is described in the Tax Court’s opinion as follows:

At all relevant times, petitioner computed the indirect expenses relating to its nonmember sales using the gross-to-gross allocation method. Pursuant to the gross-to-gross allocation method, petitioner used the ratio of nonmember sales to total sales to determine what portion of indirect expenses was attributable to nonmember sales.

The result of this for the years in question was that the loss from sales to nonmembers was more than the investment income the organization reported.  In fact, these losses were many times greater than the investment income the taxpayer looked to offset.

The taxpayer argued that the proper test for whether it had a profit motive as to look the “hobby loss” rules applicable under IRC §183.  Those rules allow for many rationales to be used to show an intent to make a profit, and do not look solely at generating operational income on a regular basis.

But the Tax Court ruled that because §183 does not apply to IRC §501(c)(7) organizations, the tests found in the regulations under that section are not applicable.

Rather, the Court found, the taxpayer had to show an intent to generate profits more than costs, including those indirect costs allocated to the activity under the gross to gross allocation method.  It is important to note that, in the Portland Golf Club case the Supreme Court had rejected the argument that a taxpayer could establish a profit motive by showing the sales to nonmembers covered the variable costs (and thus the organization was “better off” than if no sales were made to nonmembers), noting that the charity then turned around and tried to deduct a portion of those fixed costs it was ignoring as part of the loss to be used to offset unrelated business income.[2]

Thus, as the Tax Court concluded, the club had a major problem since its total costs (direct and indirect) greatly exceeded its sales to nonmembers.


[1] Portland Golf Club v. Commissioner, 497 US 164 (1990)

[2] Id¸168