Gas Leases Can Blow Up Tax-Exempt Club

By Charles J. Russo, CPA, PhD, CMA, Julius C. Green, CPA, JD, and A. Blair Staley, CPA, DBA

Landowners of all types—including Section 501(c)(7) social clubs—are often approached by gas companies with land lease and royalty agreements concerning rights to the natural gas beneath the land. Each landowner-lessor’s fact situation may present challenges to tax professionals, but Section 501(c)(7) lessors, particularly some of the hunting clubs in Pennsylvania, may present special challenges. Case law reveals that more than one hunting club has run afoul of its federal tax-exempt status because of gas leases.

Special Treatment of Social Clubs
Social club tax exemption was designed to allow the operation of these entities for social or recreational activities without tax consequences. The goal was to allow individuals to end up in the same position as if they had spent their personal funds on vacation or other recreational purposes. If, however, a Section 501(c)(7) social club receives income from sources other than membership dues, the IRC would be bestowing a substantial advantage to members by allowing normally taxable income to become tax-free dollars.¹ Therefore, Section 501(c)(7) social clubs are subject to Unrelated Business Taxable Income (UBTI) on all income other than gross receipts from exempt function income sources, such as membership dues.

A Section 501(c)(3) tax-exempt organization may exclude certain types of income from UBTI under Section 512(b), including rents and royalties, but Section 501(c)(7) organizations do not get the full benefits of Section 512(b) modifications. Therefore, rental income from gas leases and any royalty income from an active gas well would be considered UBTI for Section 501(c)(7) social clubs.

In addition, if a social club had gross receipts from "other than exempt function sources of income" in excess of 35 percent of gross receipts, its exempt status would be terminated.²

Gross receipts are defined for this purpose as those receipts from normal and usual activities of the club, including charges, admissions, membership fees, dues, assessments, investment income—such as dividends, rents, and similar receipts—and normal recurring capital gains on investments, but excluding initiation fees and capital contributions. Where a club receives unusual income, such as from the sale of a clubhouse or similar facility, that income is not to be included in the formula.

Consequences of Land Lease Income
Rental income from a gas lease would be UBTI for hunting clubs, and, if the club has gross receipts from "other than exempt function sources of income" in excess of 35 percent of gross receipts, exempt status under Section 501(c)(7) would be terminated. However, if the rental payment is structured as a one-time event, a club may not lose exempt status. Generally, a hunting club is not in the business of selling land-lease rights. According to Senate Report No. 94-1318 (1976), gross receipts as defined for purposes of the 35 percent test are those receipts from normal and usual activities of the club.

If receipt of income from an up-front land-lease payment is a one-time, unusual receipt of income, it would not be included in the 35 percent allowance formula. Thus, notwithstanding other inurement or personal benefit rules, the status as a Section 501(c)(7) organization may be preserved. The club would be subject to tax on the upfront payment, and would file Form 990-T Exempt Organization Business Income Tax Return.

Consequences of Royalty Income
In addition to upfront payments, lessors to gas companies often receive royalty income on the sale of gas produced beneath their land. Royalty payments are not a one-time event, and would continue over the life of the gas well. The Section 501(c)(7) social club would lose its tax-exempt status if the amount of royalty payments exceeded 35 percent of gross receipts.

Gas rights and land surface use are separate assets. If a club receives only a land-lease payment, with no agreement to commence gas drilling, the mineral rights still have a zero, or close to a zero, value. There is no guarantee that the gas company will ever drill on the property. The decision to drill is dependent upon many variables, including whether it is cost-effective to drill and the relative price of gas, among other influences. When a club receives a commitment to drill for gas, a geologist will provide an estimate of the gas reserves and an estimate of the value of the rights.

To solve the 35 percent gross receipts issue with regard to the royalty rights, the members of the social club should consider forming a new flow-through entity. The royalty rights could be moved from the Section 501(c)(7) to a newly formed LP or LLC. To accomplish this, the club can sell its mineral rights to the newly formed flow-through entity, before any commitment to drill, for the amount valued by an expert. Since the new entity is purchasing the royalty rights at fair market value, there should be no inurement issues associated with the royalty rights. The income from any future royalty payments will flow through the LP or LLC and be subject to tax at the partner/member level.

The mineral rights sale will be another one-time event, and would not be included in the gross receipts of the club for purposes of the 35 percent limitation and would not result in a loss of exempt status. Again, the club would be subject to tax on the sale of the rights, and would file Form 990-T.

Personal Benefit Rules
Preserving Section 501(c)(7) status by structuring rental and royalty income deals that would not be in excess of the 35 percent of gross receipts is dependent on not violating the Section 501(c)(7) prohibition against personal benefit.

The IRS explains its inurement rules for social clubs on its Web page. In brief, the statute prohibits exemption if any part of a organization’s net earnings inures to the benefit of anyone having a private interest in the organization.³

Where a social club receives payment for the lease of land, inurement can result if members receive cash distributions, if the income is used to subsidize club operations, or if the income offsets an increase in dues to cover increased services. By selling the mineral rights to a newly formed LP for fair market value, before any commitment to drill, inurement issues related to the royalty rights should be avoided.

Pennsylvania Nonprofit Law
A nonprofit corporation is allowed to make an incidental profit based on its lawful activities, provided such profits are applied to the maintenance and operation of the corporation and not distributed to the members.⁴ It is unlawful for a nonprofit to receive profits beyond what is reasonably necessary to accomplish the purposes for which it was incorporated.⁵

The club may be able to convert to a for-profit corporation under 15 P.S. Section 5966. However, if a hunting club received gas lease or royalty revenue before conversion, there is an issue as to whether the club must dissolve under Pennsylvania law or be allowed to convert to a for-profit entity. If the nonprofit is dissolved, the federal liquidation rules of Sections 331 and 336 may apply. Clubs that have received gas lease or royalty revenue prior to conversion must consult with a qualified attorney.

Conclusion
Gas leases for Section 501(c)(7) hunting clubs present unique planning and compliance challenges. By carefully structuring leases, tax practitioners can help clients avoid unintended consequences, such as termination of their Section 501(c)(7) status or double taxation.

¹ Rolling Rock Club v. U.S., 785 F.2d 93, 96 (3d Cir. 1986); Ye Mystic Krewe of Gasparilla v. Comr., 80 T.C. 755, 767 (1983)
² S. Rep. No. 94-1318, 94th Cong., 2d Sess. 4 (1976)
³ http://www.irs.gov/charities/nonprofits/ article/0,,id=96189,00.html
⁴ PA Code 15 P.S. Section 5545
⁵ Dettling-Hamilton Co v. Forest Lawn Gardens Inc. 113 Pitts. L.J. 222 (1964)

Charles J. Russo, CPA, PhD, CMA, is a manager with Parente Randolph LLC in Philadelphia, and Julius C. Green, CPA, JD, is a partner with the firm. Russo can be reached at crusso@parentenet.com, and Green can be reached at jgreen@parentenet.com.
A. Blair Staley, CPA, DBA, is a professor at Bloomsburg University of Pennsylvania in Bloomsburg. He can be reached at astaley@bloomu.edu.

LAST UPDATED 4/3/2009

Gas Leases Can Blow Up Tax-Exempt Club

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