Review the governing instruments, i.e., articles of organization, bylaws, and any policy statements to determine the following:

Review membership requirements to determine if there are prerequisite conditions or limitations imposed on members, such as an interest in a particular hobby. Examples of social organizations that share a common goal or mutuality of interests could include flying and gardening clubs.

Review bylaws, club handbook, brochures and newsletters to determine if members have the opportunity for fellowship, commingling or other personal contact. Commingling is present if such things as meetings, social gatherings and recreational facilities are available for the membership. Generally, the lack of commingling of members is an indication the basic purpose of the organization is to provide personal services and goods in a manner similar to commercial enterprises.

Review membership applications, club handbooks and any brochures or other information provided to prospective members to determine requirements and procedures for obtaining membership. Determine the types of memberships available and whether they include corporations. Corporate memberships do not automatically disqualify a club, as long as there are sufficient individual members to provide the requisite amount of fellowship and commingling required by IRC § 501(c)(7). See Rev. Rul. 74-489, 1974-2 C.B. 169.

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An exempt social club can not provide pleasure and recreation on a commercial basis.

Activities that are not in furtherance of a social club's exempt purpose are referred to as nontraditional business activities.

A social club is prohibited from conducting more than an insubstantial amount of nontraditional business activities.

The prohibition against the conduct of nontraditional business activities applies equally to business with members and nonmembers.

IRC § 501(c)(7) organizations can receive up to 35 percent of their gross receipts, including investment income, from sources outside their membership without losing their exempt status.

Within the 35 percent, not more than 15 percent of gross receipts should be derived from the use of the social club's facilities or services by the general public (nonmembers).

Rev. Proc. 71-17, 1971-1 C.B. 683, describes the circumstances under which nonmembers who use a club's facilities will be assumed to be guests of members. The host-guest relationship will be presumed as follows, provided that payment is received directly from the member or the member's employer:

Clubs relying on either of the host-guest assumptions described above are required to maintain adequate records to substantiate the appropriate facts.

For all other occasions involving use by nonmembers, the club must maintain books and records of each use and the amount of income earned. This requirement applies even if the member pays initially for the use.

For organizations exceeding the 35% and 15% percent limitations a facts and circumstances test must be applied.

During the initial interview, ask whether the club manager, a director, or an officer receives a percentage of gross or net profit.

Analyze distributions to identify any dividends or bonuses. Distributions of condemnation proceeds and fees paid to bring in new members were not found to constitute inurement. See Rev. Rul. 65-64, 1965-1 C.B. 241 and Rev. Rul. 80-130, 1980-1 C.B. 117.

Review classes of membership to determine if nonvoting members pay disproportionately more for services or benefits. Pay particular attention to memberships with varied dues structures or clubs with voting and nonvoting classes having different fee schedules. Determine if a reasonable basis exists for the difference in dues and/or fees charged. See Rev. Rul. 70-48, 1970-1 C.B. 133.

Review fee schedules to determine whether any class of member is favored.

Consider the impact of IRC § 277 when reviewing converted forms 1120 or when calculating a revoked club's taxable income.

A social club is generally taxed on income derived from the following sources:

A social club can set aside its investment income to be used for religious, charitable, scientific, literary, and educational and other purposes specified in IRC § 170(c)(4). If the investment income is properly set aside, it is not subject to the tax on unrelated business income but must be reported on Forms 990 and 990-T.

Taxable unrelated business income is gross unrelated business income less those deductions allowed by chapter 1 of the IRC which are directly connected with the carrying on of such trade or business, subject to certain modifications referred to in Treas. Reg. § 1.512(b)(1). To be "directly connected with" the conduct of a unrelated business for purposes of IRC § 512, an item of deduction must have a proximate and primary relationship to the carrying on of that business. See Treas. Reg. § 1.512(a)-1(a).

Expenses deductible from gross unrelated business income fall into two general categories:

Losses on unrelated business activities lacking a profit motive can not be used to reduce taxable unrelated business income from investments or activities entered into for a profit. See Rev. Rul. 81-69, 1981-1 CB 351 and Portland Golf Club v. Commissioner, 497 U.S. 154, 169 (1990).

A club can use any method to allocate expenses possessing a proximate and primary relationship to the unrelated trade or business income they are allocated against, so long as the allocation method is reasonable. See Treas. Reg. § 1.512(a)-1(c). By definition, the "reasonableness" standard indicates that more than one method of allocation may be reasonable. Thus, a reasonable method of allocating expenses must be allowed even though it may not be the best method.

The Service has generally classified expenses in three categories as follows:

One method of allocation frequently used is the allocation of all three categories of expenses based on gross receipts. This allocation method is commonly referred to as the "Gross Receipts Allocation Method " . The "Gross Receipts Allocation Method" is seldom a "reasonable" method for allocating variable or fixed expenses. Also, the "Gross Receipts Allocation Method" would not be reasonable for the allocation of direct expenses if:

A example of a "reasonable" method of allocation was published by the Service in 1975 in supplemental instructions for completing Form 990, Package 990 Supplement (Section 501(c)(7)). The hypothetical organization in the Package 990 Supplement was named "The Big Divot Country Club, Inc." This allocation method became commonly known as " The Big Divot Allocation Method." An example of the " Big Divot Allocation Method" has been included in the IRM since 1984. Using the "Big Divot Allocation Method," the expenses are allocated as follows:

The use of the "Big Divot Allocation Method" for fixed expenses was litigated in Rensselaer Polytechnic Institute v. Commissioner, 732 F.2d 1048 (2nd Circuit 1984). In Rensselaer taxpayer argued that fixed expenses should be allocated on the same basis as variable expenses, the ratio of the estimated hours of nonmember use to the total hours the facility was used during the year instead of the ratio of the estimated hours of nonmember use to the total hours in the year as proposed by the Service. The Court held for the taxpayer stating an allocation based on the time of actual use is "reasonable" within the meaning of Treas. Reg. § 1.512(a)-1(c).

Exhibits 4.76.16-2 through 4.76.16-4 show the computation of the net profit from nonmember use of a club's restaurant and bar based on the facts stated in Exhibit 4.76.16-1. Exhibit 4.76.16-2 shows the computation of net profit using the "Gross Receipts Allocation Method." Exhibit 4.76.16-3; shows the computation of net profit using the allocation method upheld by the Court in Rensselaer. This allocation method is referred to in the Exhibits as the "Actual Usage Allocation Method." Exhibit 4.76.16-4 shows the computation of net profit using the "Big Divot Allocation Method."

IRC §§ 3121(b)(2), 3306(c)(2) and 3306(a)(3) provides an exception from the definition of employment or employer for FICA, FUTA and income tax withholding purposes for certain domestic service in local college clubs or local chapters of a college fraternity or sorority.

The FICA exemption extends to students enrolled and regularly attending classes at a school, college or university.

The FUTA exemption covers any such service, but only if cash remuneration to all individuals employed in such service is less than $1,000 in any calendar quarter during the current or preceding calendar year.

The regulations provide that excepted services are those "of a household nature in or about the club rooms or house" and include services rendered by "cooks, waiters, butlers, maids, janitors, laundresses, furnace men, handymen, gardeners, housekeepers and housemothers." Treas. Reg. § 31.3121(b)(2)-1(b) (FICA); Treas. Reg. § 31.3306(c)(2)-1(b)(2) (FUTA); and Treas. Reg. § 31.3401(a)(3)-1(b)(2) (ITW).

See also Rev. Rul. 72-174, 1972-1 C.B. 315 where the Service held that services performed by students in a university women's club, were not excepted. Also see Rev. Rul. 68-448, 1968-2 C.B. 481, which held that payments to a sorority "housemother" for services performed during a university's summer term when the house was primarily used to accommodate nonmembers were not within this exception.

Social clubs that employ waiters, waitresses, or any other employees receiving tips as part of their compensation are generally subject to certain withholding and reporting requirements.

For additional information on the proper reporting and withholding of tip income refer to IRM 4.23 Employment Taxes

Interview the club manager and determine if any compensation, particularly casual labor, is paid in cash and whether any workers receive tips.

Review service contracts to identify any potential misclassifications of workers as independent contractors.

Identify any workers meeting the service-based exceptions described above in IRM 4.76.16.10.1.