October 22, 2018 Sixth Circuit affirms social club may not deduct losses from non-member sales against its investment income In Losantiville Country Club v. Commissioner, No. 17-2394 (6th Cir. Oct. 15, 2018), the US Court of Appeals for the Sixth Circuit (the Sixth Circuit) has affirmed a Tax Court's holding 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. Background Losantiville Country Club (Losantiville) is a Section 501(c)(7) social club that operates a golf course, 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. For 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. 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 it entered into sales activities for profit. In addition, the IRS assessed accuracy-related penalties for negligence under Sections 6662(a) and (b)(1). Tax Court decision The Tax Court upheld the IRS's determinations, holding that Losantiville could not use the losses from the sales to offset its taxable investment income, because it failed to demonstrate an intent to profit from its non-member sales. In so holding, the Tax Court cited Portland Golf Club v. Commissioner, 497 U.S. 154 (1990), in which the Supreme Court held that a Section 501(c)(7) social club may use losses from non-member sales to offset investment income only if it entered into the sales with the intent of earning a profit. The Tax Court also dismissed Losantiville's attempt to establish its intent based on the factors set forth in Treas. Reg. Section 1.183-2(b). Section 183 is generally referred to as the "hobby loss" provision, and applies to individuals and S corporations. The Tax Court stated that Section 183 and the corresponding regulations do not apply to Section 501(c)(7) social clubs. For further discussion of the Tax Court decision, see Tax Alert 2017-1350. Sixth Circuit decision Although the Sixth Circuit affirmed the decision of the Tax Court, it differed slightly from the Tax Court in its reasoning and interpretation of the law. The Sixth Circuit stated that the Tax Court's interpretation of Portland Golf Club "was not quite right," and clarified that Portland Golf Club does not require showing actual profitability to establish intent to profit. Regarding the application of Section 183 "hobby loss" factors, the Sixth Circuit stated that it understood the Tax Court's reluctance to apply the factors to analyze a social club's profit motive, acknowledging that the factors do not directly apply. It added however, that courts have found the factors helpful in analyzing profit motive even when they do not apply. Nonetheless, the Sixth Circuit concluded that, even if the Tax Court erred in failing to consider the hobby loss factors, the error was harmless because the factors were insufficient to establish profit motive in Losantiville's case. Although this issue was presented as a question of fact, the Sixth Circuit determined that the record before it was adequate to resolve the issue without remanding to the Tax Court. The Sixth Circuit explained that establishing profit motive is more difficult in the absence of an actual profit, because it requires showing that the intent to profit was thwarted somehow. It becomes even more difficult in the context of consistent unprofitability, as in Losantiville's case. Despite its unprofitability, Losantiville attempted to establish its intent to profit based on just two of the nine hobby loss factors: businesslike approach and land appreciation. The Sixth Circuit found neither factor compelling in establishing Losantiville's profit motive. Implications With the Sixth Circuit's decision to side with the Tax Court in Losantiville, Section 501(c)(7) social clubs and other tax-exempt organizations are reminded that the IRS will disallow losses for unrelated business activities that lack a profit motive. As established in Portland Golf Club, tax-exempt social clubs cannot offset taxable investment income with losses from an unrelated activity in which the taxpayer does not demonstrate a profit motive. In contrast to the Tax Court's reasoning, however, the Sixth Circuit suggests that the nine "hobby loss" factors listed in Treas. Reg. Section 1.183-2(b) can be used in establishing profit motive for an unrelated trade or business. The Sixth Circuit's approach aligns with inferences made by the Supreme Court in Portland Golf Club, that Section 183 factors can be helpful in analyzing profit motive, even when there is no actual profit. As illustrated in Losantiville however, an organization does not demonstrate profit motive by satisfying a small number of the hobby loss factors. Furthermore, it is unclear whether the Sixth Circuit would have sided with Losantiville, had the organization satisfied more factors. While there is no general definition of intent to profit as it applies to tax-exempt organizations, the examination in Portland Golf Club provides insight into the Court's analysis. The Court in Portland Golf Club did not specify a number of years that an activity must sustain a loss to demonstrate lack of profit motive. Prior cases show that the IRS will look at the facts and circumstances of each case. While Portland Golf Club involved a taxpayer that sustained losses over a longer period of years, tax-exempt organizations should note that the decision in Losantiville indicates that the generation of losses over three years is enough to suggest a lack of profit motive. Please contact your Ernst & Young tax professional with any questions. ———————————————
| |||||||||||
| |||||||||||
