Legal Requirements to Start and Run a California 501(c)(7) Social Club

Legal Requirements to Start and Run a California 501(c)(7) Social Club

Federal and state laws recognize and provide particular benefits to organizations that are set up as social clubs. Section 501(c)(7) of the Internal Revenue Code carves out exemption from taxation for social clubs that meet the below definition:

Clubs organized for pleasure, recreation, and other nonprofitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder.

Examples of social clubs include city clubs, hobby clubs, garden clubs, certain dinner clubs, amateur sports clubs, yacht clubs, country clubs, variety clubs, some college alumni associations, and college fraternities or sororities operating chapter houses for students.

Interestingly, many of these types of clubs may also qualify under Section 501(c)(3) and therefore be eligible to receive tax-deductible donations. It will depend on how the organization is structured and carries out its activities.

Rules for Running a 501(c)(7) Social Club

There are a set of strict criteria that a social club must meet to qualify as a 501(c)(7) organization:

  • The primary purpose and activities of the club must be for the pleasure and recreation of its members.
  • The club must have an established and limited membership of individuals, with the opportunity for personal contact and fellowship among the members.
  • The club’s earnings may not be used for the private benefit of any particular person, outside the general benefits to members of pleasure and recreation.
  • The club must be primarily supported by membership fees, dues and assessments, with a limited amount of income from nonmembership sources and investment income.
  • The club’s governing instrument may not contain a provision that provides for discrimination against any person on the basis of race, color, or religion.

Established for Pleasure or Recreation

The primary purpose of the social club must be pleasure, recreation, or other nonprofitable purpose. “Other nonprofitable purposes” means purposes similar to pleasure and recreation. The members really need to be in the organization for the fun of it.  The organization needs to be geared toward joining its members so they can meet people, share interests, relax and enjoy themselves. If the primary purpose is to exchange business information, the nonprofit will likely better qualify be a 501(c)(6) business league. If the purpose is to provide services to members, such as insurance, the organization may be a taxable business. Members may be able engage in gambling, despite its illegality under state and local laws, and retain exemption.

Established Membership of Individuals

It is not enough that the nonprofit have a membership; there must be a “fellowship” among the members. This fellowship is evidenced through both a common interest and a commingling of the members. Organizations that solely have members with a common interest but no comingling such as automobile clubs – think AAA, not vintage car clubs – have been denied exemption. Corporations may pay the individual membership dues of their employees without risking the exempt status of the social club; however, a social club made up exclusively of entities rather than individuals does not qualify.

No Private Inurement

Under the rules for a 501(c)(7) social club, no part of its net earnings may inure “to the benefit of any private shareholder.” In practice, this means that the social club may not issue dividends to its members, nor may it confer private benefit to individuals through pretextual transactions such as excessive compensation of its employees or excessive payment of rents to an insider. It also cannot benefit one class of members over another by charging them all the same fees but providing restricted services to a subset. However, upon dissolution of the social club, assets may be distributed to members.

Running a Business and Generating Nonmembership income

A club that engages in a business, by making its facilities and service available to the general public and/or generating income from nonmembers, may not qualify as an exempt social club. The IRS considers advertising the club to the public as clear evidence of engaging in a business. This is particularly true where the purpose of the business is to increase the benefit to members without a corresponding increase in member dues. For example, a social club that generates business revenue to improve its facilities or sustain its services to members, without requiring the members themselves to pay more in dues, will have its 501(c)(7) status revoked.

Luckily, the Internal Revenue Service has articulated a safe harbor to allow social clubs to engage in some income generation from nonmembers without jeopardizing their exempt status. Social clubs may receive up to thirty-five percent of their gross receipts from nonmembership sources, including investment income. Within that thirty-five percent, fifteen percent of total gross receipts may come from nonmember use of club facilities.

However, this safe harbor applies only to “traditional” social club activities, that is, activities that further the club’s purpose of recreation and pleasure for members. For example, nonmember use of a city club ballroom or public participation in a vintage car show. A social club can lose its exemption if it receives five percent or more of its total gross receipts from “nontraditional” activities, such as sale of food or liquor to be consumed off-premises. What constitutes a traditional activity will depend on the type of club at issue. Income from unusual sources, such as one-time sale of real estate, will not be included in those limits.

Sometimes it is difficult to know when income is coming from a member or from the public. Many social clubs include in memberships that ability to host family members and guests at club facilities and to participate in club activities. In the context of traditional club activities, to determine whether the organization has received income from members, their families, and their guests, as opposed to the general public, the IRS formulated the following assumptions:

  • Where a group of eight or fewer individuals, at least one of whom is a member, uses club facilities, it will be assumed that the nonmembers are the guests of the member, provided payment for such use is received by the club directly from the member or the member’s employer.
  • Where seventy-five percent or more of a group using club facilities are members, it will likewise be assumed that the nonmembers in the group are guests of members, provided payment for such use is received by the club directly from one or more of the members or the member’s employer.
  • Payment by a member’s employer will be assumed to be for a use that serves a direct business objective of the employee-member.
  • In all other situations, a host-guest relationship will not be assumed but must be substantiated.

Appropriate records must be kept of club facilities’ use to substantiate the member versus nonmember use. Members from another social club are treated as nonmembers, even if there is a reciprocity agreement between the clubs.

The income generated from traditional activities from nonmembership sources and from nontraditional activities will be subject to unrelated business income tax.

If a social club generates more than thirty-five percent of its gross receipts from nonmembership sources or more than fifteen percent from use of its services or facilities by nonmembers, the IRS will look at other factors to determine whether it should nonetheless retain its 501(c)(7) status. Factors the IRS will consider include:

  • frequency of use by nonmembers,
  • records of nonmember use over a period of years,
  • purposes for which club facilities were made available to nonmembers, and
  • whether the club earned a net profit from providing services to nonmembers.

Nondiscrimination

A social club may not have a written policy that provides for discrimination against any person on the basis of race, color, or religion. Oddly, the law does not provide that the social club may not behave in a manner that is discriminator; it only applies to the written policy. Further, there are certain exceptions in the context of religious discrimination.

No Deductibility of Dues

Contributions and membership dues to a social club do not qualify for a charitable or business expense deduction by the donor/member.

How to Form a California 501(c)(7) Social Club

California requires the formation of a California nonprofit mutual benefit corporation to qualify as an exempt social club. Here are the general steps necessary for formation of a California 501(c)(7) without a voting membership:

  • Draft bylaws.
  • Have an initial meeting of the board to elect initial directors, adopt bylaws, appoint officers and establish basic board policies.
  • Secure a federal employer identification number.
  • Open up a bank account and establish a bookkeeping system.
  • File Form SI-100 with the California Secretary of State within 90 days of incorporation.
  • File for 501(c)(7) status with the Internal Revenue Service using Form 1024.
  • File for exemption with the California franchise tax board under Section 23701e using Form 3500 or 3500A.
  • Secure any necessary business licenses with local authorities.

What further resources are there on 501(c)(7) organizations?

The IRS has excellent resources on the requirements of a 501(c)(7) organization located here.
Written by Cameron Holland.