Recently, we have seen an increase in exempt private clubs owing income tax. This might seem counter intuitive to most individuals. You might ask yourself, how can a “tax-exempt” private club owe tax?
Even though they are exempt from income taxes on most activities, clubs may have a tax liability if they receive income from activities which are unrelated to the club’s exempt purpose. The IRS requires the related expenses on these activities to be directly connected to the source of income. Therefore, the clubs must separate unrelated business activities into several different categories to properly match income to its related expenses. The three main categories of unrelated business income are divided into income from reciprocal arrangements and guests of members, income from investment activities, and income from rental and land leases.
Income from reciprocal arrangements and guests of members is considered taxable unrelated business income; however, because many of the amenities are subsided by dues, there are usually more expenses than income. This is generally not an area where we see exempt clubs paying income tax.
Investment activities such as bank interest, dividends and any other income from brokerage statements are also taxable unrelated business income. Interest income from members are an area where we see some mistakes. If the interest income is paid by the member, it is considered exempt income and, therefore, is not taxable for exempt private clubs. For investment activity, a few examples of a directly connected expense are bank fees and advisor fees from brokerage statements. Bank fees from regular operating accounts are another area where we see mistakes. Assuming the accounts are not interest bearing, they are not directly connected to the income and, therefore, not deductible against investment activity. For investment activities in general, there are usually a limited amount of expenses that are directly connected. This causes some income tax due for clubs with large investment activities.
Income from rental and land leases is the last major category of unrelated business income. Examples from this category include the clubhouse rental to third parties such as a spa or real estate company as well as cell tower land leases. Some examples of directly connected expenses include insurance, real estate taxes and maintenance. Depending on the type of rental, there may not be enough directly connected expenses to offset the income. This is another area where we have seen clubs pay income tax, especially in land leases which usually have very little directly connected expenses.
The directly connected expense rule is also important because it does not allow any net losses from these categories to offset any other category. For example, if clubs have a net loss on reciprocal and guest activities but net income from investment activities, the loss cannot be used to offset the income from investment activities, and the club would owe income tax. Some clubs qualify for credits to offset the tax liability so even though the club owes income tax, it doesn’t mean the club is making a payment to the IRS. State income tax is a little different. As an example, in Florida the first $50,000 of net income is not taxable. However, in other states, there is little to no exemption that can cause clubs to have state income tax payments on the smallest amount of net income.
Over the past few years, we have seen investment activities steadily increase to where clubs have started owing income tax again. However, the tax liability is fairly small in comparison to the tax liability of the rental and land lease area. While the rental of the clubhouse or a land lease can help increase the club’s cash flow, it sometimes creates a sizable tax payment to the IRS as well. If the club is considering these activities or is already paying tax on them, it is important to understand the federal credits available to minimize the tax. Even if the club does not currently qualify for a credit, there are changes that can be made so it can qualify. This could save the club a significant amount on taxes.