Having fun with friends doesn’t necessarily have to generate a tax bill. Section 501(c)(7) of the Internal Revenue Code grants tax-exempt status to some clubs organized as not-for-profit entities and operated for the enjoyment or recreation of their members. These can include fraternities and sororities, country clubs, dinner clubs, amateur sport clubs, yacht clubs and hobby clubs. The chief benefit for a 501(c)(7) tax-exempt club is that it does not pay federal taxes on its day-to-day activities, but there are other advantages as well to the club having tax-exempt status.
Not-for-profit social clubs are organized for pleasure and recreation. Congress exempts these clubs from paying federal income tax, reasoning that members band together for mutual enjoyment, and had they paid money to have fun on their own, the members wouldn't have been liable for income tax. Social clubs can run members-only golf courses and swimming pools, build clubhouses, encourage model railroaders and other hobbyists or even operate yacht clubs. Unlike other tax-exempt organizations, 501(c)(7) tax-exempt clubs need not provide a public service or other community benefit.
If a 501(c)(7) club's money comes entirely from membership dues, it is generally okay with the Internal Revenue Service. However, many clubs are corporations, created under state laws, and corporations can own land, buildings, stock, bank accounts and other assets. In those types of cases, club income from rents, dividends and interest may be subject to federal taxation. In order for a 501(c)(7) tax-exempt club to abide by IRS requirements, a "substantial" amount of the club's activities must further the club's exempt purposes. Generally, no more than 35 percent of the club’s revenues can come from non-member sources. Additionally, a 501(c)(7) club could be subject to taxation or lose its tax exempt status if it engages in business outside of its exempt purpose or if it receives too much income from non-members. For example, a dining room or library may be okay; a gas station, barbershop or liquor store probably is not, even if members' take recreation to mean personal grooming, oil changes and partying hard.
In a for-profit club, when new members replace old members and (usually) pay higher dues, there's a taxable-income gain to the club. The 501(c)(7) tax-exempt club, however, can avoid that tax. Taxable clubs also must pay Uncle Sam on member assessments, such as when the boiler bursts or the leaky roof needs replacing. Tax-exempt clubs can avoid those levies, too because they may qualify for tax breaks that won’t be available to for-profit clubs. Any windfall must be carefully documented and used only for the exempt club's stated purposes.
Most of a tax-exempt club's money should come from membership dues. Clubs that derive revenues from activities that the IRS deems to be commercial can jeopardize their tax-exempt status, just like a hospital that runs a hotel or a university that operates a restaurant. Clubs that discriminate based on on race or religion in choosing members can lose their tax-exempt status. The jury is still out on discrimination linked to ethnic origin or sex. Also, it should be noted that the benefits of 501(c)(7) tax exemption flow to the club, not to its members. One difference between 501(c)(7) tax-exempt clubs and traditional charities is that donations to the club, including dues, are not deductible as charitable contributions on the members’ individual tax returns.