18 August 2017 Social club may not deduct losses from non-member sales against its investment income, Tax Court holds In Losantiville Country Club v. Commissioner, T.C. Memo. 2017-158, the Tax Court has held, in a Memorandum Opinion, that a Section 501(c)(7) social club may not use losses from non-member sales to offset investment income because the club failed to establish that the non-member activity was undertaken with a profit motive. Losantiville Country Club (Losantiville) is a Section 501(c)(7) social club in Ohio that operates a golf course, a swimming pool, tennis courts and dining facilities for use by its members. Members pay dues and various fees for the use of these facilities, while non-members pay surcharges to use the facilities. Losantiville had filed Form 990-T since 2002, the year it was founded. For 2010-2012, the years at issue, Losantiville filed its Form 990-T (Exempt Organization Business Income Tax Return), reporting net losses with respect to its non-member sales. It wasn't clear from the facts in the case whether Losantiville had reported losses on its Forms 990-T filed for earlier years. Losantiville calculated these losses using the gross-to-gross method, the ratio of non-member sales to total sales to determine the amount of deductible indirect expenses (e.g., salaries, grounds maintenance and other overhead) taken against the non-member sales. On its returns, Losantiville claimed these losses against investment income earned in those same years, resulting in no reportable unrelated business taxable income (UBTI) in the years at issue. The IRS issued notices of deficiency, asserting that Losantiville could not offset its investment income with losses from its non-member sales activities because it did not establish that the sales activities were entered into for profit. In addition, the IRS assessed accuracy-related penalties for negligence under Sections 6662(a) and (b)(1). In a case involving substantially similar facts, the Supreme Court, in Portland Golf Club v. Commissioner, 497 U.S. 154 (1990), held that a Section 501(c)(7) social club may use losses from non-member sales to offset investment income only if the sales were entered into with the intent of earning a profit. The Supreme Court based its determination on the language of Section 512(a)(3), which applies special unrelated business income tax rules to tax-exempt social clubs and certain other types of tax-exempt entities. However, instead of focusing on the absence of "trade or business" in Section 512(a)(3), it focused on the presence of "allowed by this chapter" as indicating that losses must satisfy Section 162 before they can offset UBTI. As the Supreme Court held, "a taxpayer's activities fall within the scope of Section 162 only if an intent to profit has been shown." This intent to profit is evidenced by an intent to generate receipts in excess of costs. The Supreme Court further held that in, establishing an intent to profit, the taxpayer must use the same method it used in calculating the losses that it wishes to use to offset its investment income. In other words, it could not try to separately establish a profit motive based on a different method for allocating fixed expenses than that which it used on its tax return to calculate its actual losses. Although not discussed in detail, the Supreme Court noted in a footnote that repeat losses do not, by themselves, prove the lack of a profit motive, but the taxpayer must demonstrate an intent to earn a profit despite such losses. Importantly, the Supreme Court also noted that Portland Golf Club had generated losses from non-member sales for a 10-year period. Losantiville acknowledged that, in preparing their returns, both they and their outside accountants were aware of the Portland Golf Club precedent. However, Losantiville argued that it may establish its intent by the factors set forth in Treas. Reg. Section 1.183-2(b). The Tax Court summarily dismissed this argument, stating that Section 183 and the corresponding regulations do not apply to Section 501(c)(7) social clubs. (Section 183 is generally referred to as the "hobby loss" provision, and applies to individuals and S corporations.) As a result of its failure to demonstrate an intent to profit from its non-member sales, the Tax Court held that Losantiville could not use the losses from those sales to offset its taxable investment income. With respect to the accuracy-related penalties, the Tax Court acknowledged that Losantiville's returns were prepared by professionals, but added that there was no evidence that (1) the professionals had sufficient expertise to justify reliance, (2) Losantiville provided the professionals with necessary and accurate information, or (3) Losantiville relied in good faith on the professionals' judgment. Accordingly, the Tax Court held that the returns were not prepared in good faith and sustained the IRS's penalty determinations. The recent decision in Losantiville should serve as a reminder to Section 501(c)(7) social clubs and other tax-exempt organizations that the IRS will disallow losses for unrelated activities that lack a profit motive. Based on precedent established in Portland Golf Club, tax-exempt social clubs, in particular, cannot offset taxable investment income with losses from an unrelated activity in which the taxpayer cannot demonstrate a profit motive. Portland Golf Club and Losantville both specifically apply to Section 501(c)(7) social clubs, which are taxed under Section 512(a)(3)(A), whereas most other tax-exempt organizations are taxed under Section 512(a)(1). There is precedent to applying a profit motive to other tax-exempt organizations. For example, the Court of Appeals in West Virginia State Medical Association v. Comm'r, 89-2 USTC ¶9491 (4th Cir. 1989), cert denied (U.S. 1/16/90), held that Section 512(a)(1) requires a profit motive for a loss activity as a prerequisite to offsetting its losses against the profits of another unrelated trade or business. In the court's opinion, the West Virginia Medical Association's 20-year history of continued unprofitability disproved any claims of a profit motive. Under these authorities, the IRS has rejected deductions from tax-exempt organizations attempting to offset taxable income with losses from activities that it considers to lack a profit motive. Organizations should be aware that there is no general definition of intent to profit as it applies to tax-exempt organizations, such as the guidelines of Section 183 (sometimes referred to as the "hobby loss" rules) which apply to individuals and S corporations. The Supreme Court's inference in Portland Golf Club that factors such as those used in the Regulations under Section 183 might be applied to show profit motive appears to have been summarily dismissed by the Tax Court in Losantiville. Further, there is no specific number of years an activity must sustain a loss to demonstrate a lack of profit motive, and the IRS will presumably look at the facts and circumstances of each case. In the Losantiville case, the facts aren't clear on whether the taxpayer had reported losses on its Forms 990-T filed for years before 2010. Nonetheless, the Tax Court appeared to base its decision on 2010-2012, in which the taxpayer sustained losses for a three-year period. This was enough to establish lack of a profit motive. It was clear that the Portland Golf Club and West Virginia Medical Association cases dealt with taxpayers who sustained losses over longer periods of years. Tax-exempt organizations reporting losses from ostensible unrelated trade or business activities should be cognizant of the Losantiville decision, because it suggests that the generation of losses, even for a short amount of time, can show a lack of profit motive — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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