Unrelated Business Income

The IRS grants tax exempt status to social clubs under Internal Revenue Code Section 501(c)(7). This exemption is based on the concept that friends should be able to get together without paying additional tax on income already taxed when they earn it. Accordingly, tax exemption is generally limited to activities of members pursuing social activities as defined in the tax rules governing social clubs. In yacht clubs these activities typically include nautical pursuits in addition to dining and beverage. Most yacht clubs also want to provide education in the nautical arts and competition in sailing through regattas. But when too many non-members join in these activities there can be conflicts with the federal tax-exempt rules.

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The federal government (and most states) tax all net non-member income under the Unrelated Business Income (“UBI”) rules at the highest marginal corporate tax rate. In addition, there are also limits on the amount of UBI which may be earned without risking the tax-exempt status of the club. This is due to the government’s stated purpose of preventing unfair competition with for-profit restaurants, bars, and athletic facilities. Federal and state taxation is a large expense for most for- profit businesses and competition from tax exempt entities is considered highly unfair.

 

 

However, the gross income limitation for UBI is by far the greatest risk for clubs as this can put the club’s tax-exempt status at risk even if the activities are not profitable. If tax exempt status is lost, the club will be taxed as a C-Corporation and may also lose favorable leases, grants and other benefits.

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In general, UBI is limited by IRS guidelines to 15 percent of the gross annual income of a club. The amount is increased to 35 percent if investment income is included (the “15/35 percent test”). This test is applied to income without deductions and includes non-member sailing school tuition, non-member regatta entry fees, non-member social events

such as weddings and member gifts (more on this below). It does not matter if the activity is profitable or not.

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Most sailing school programs in the US have between 50 and 80 percent non-member students. Even local regattas usually involve non-member participants and often sponsorship, while large regattas may attract non-members from many US and non-US clubs. In addition, non-member weddings and parties are generally quite profitable and may be desirable to help offset other club costs. UBI issue arise frequently due to these activities. Further, many clubs misunderstand the UBI rules and are therefore unaware of UBI exposure until IRS examination occurs.

 

 

The definition of UBI in the hands of a social club can be surprising. The tax-exempt income must arise from income in the form of “dues, emoluments, and services” received from members. Members may attend club activities, such as member dining and sailing events, and enjoy sailing education without recognizing UBI. Dues and special assessments proportional to dues are also not UBI. But other streams of income, even if from members, are UBI. This includes money raised for capital improvements and equipment such as boats and engines from members. There are no “contributions” made to social clubs! These funds are considered “gifts” and are subject to the UBI rules as well as impacting the estate and gift tax for donors. In addition, regatta sponsorship, even if received from members, is also UBI. Note that club initiation fees are excluded from the UBI computation and not included in either the numerator (member income) or the denominator (all income).

 

 

There are exceptions to these rules for applying the 15/35 percent test, which can allow an unusual and non-recurring income stream occasionally without issue. For example, a club that hosts a world level regatta once every ten or more years may benefit from this exception. However, since the UBI rules are guidelines, not law, the ultimate result is up to the government in the form of IRS examiners and in extreme cases, the courts. This income remains subject to tax as UBI.

 

 

As stated above, net income from UBI (income less deductions) is taxed at the top marginal corporate rates. The actual tax liability is often quite low since most clubs do not have a strong profit motive. However, the more profitable activities, for example non-member

parties and weddings, may not have allocable deductions that match the low profit status of the club as a whole. Many clubs use an even “spread” of expenses but the IRS does not have to accept an expense apportionment method unless it is “reasonable.” This allows the IRS to identify income streams that are more (or less) profitable and allocate expenses accordingly.

 

 

Many yacht clubs choose to form tax exempt charities (sometimes called foundations) in order to engage in beneficial activities involving non-members without running a foul of the UBI rules. A public charity may be organized as a stand-alone entity or as a subsidiary of social club or other tax-exempt entity. These are incorporated under state not-for-profit statues and enjoy many federal, state and local tax benefits.

 

 

Forming a public charity under 501(c)(3) solves many UBI issues since the definition of UBI differs from a social club which is tax exempt under 501(c)(7). A public charity may have the tax-exempt purpose of “education in the nautical arts and fostering amateur athletics in sailing and boating.” In this case, sailing school tuition, adult education, regatta entry fees, sponsorship, grants and charitable contributions are NOT considered UBI. A club can effectively move many otherwise taxable activities to the charity, lowering the overall tax burden on income from these activities and ensuring that the 15/35 percent test is met at the club level. In addition charities are exempt from state income tax, sales tax and real estate tax in many jurisdictions. This can be a material savings if the charity chooses to buy its own boats and equipment or rents, leases or owns land and building for use in its programs.

 

 

Many club members have concerns about the use of a public charity. For example, most sailing schools have entry requirements such as a swim test and “good behavior” requirements. As long as non-member students have the opportunity to attend, and tuition structure does not favor club members or their children, the same entry requirements can be applied. After all, Harvard and many other selective universities are tax exempt under 501(c)(3) and are very selective about students. In general, sailing school and regattas look the same as when operated directly by a club.

 

 

A club may lease facilities, boats and equipment to the charity at up to fair market value. If the club decides to charge less they can enjoy a charitable contribution that is a direct

offset to tax on other UBI. If the charity chooses to acquire assets, it may lease them back to the club for member use as long as the charity receives fair market value payments. The charity can even loan money to the club, provided the terms are arm’s length, including repayment terms and interest.

 

 

Between tax liability, sales and real estate tax savings, and certainty in the 15/35 percent tax, an entity that is tax exempt under 501(c)(3) is a good idea for yacht clubs, whether large or small.

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Contact Copley Square Tax Group to learn more about UBI.