Santa Barbara Club v. Commissioner

68 T.C. 200, 1977 U.S. Tax Ct. LEXIS 107

• Court: United States Tax Court
• Decided: May 23, 1977
• Docket: Docket No. 8544-74
• Status: Published

Opinions

Tannenwald, Judge:

Respondent determined the following deficiencies in petitioner’s Federal income taxes:

Year Income tax

1969. $774

1970. 912

1971. 743

The sole issue for our consideration is whether a social club’s status as a tax-exempt organization under section 501(c)(7)¹ can be revoked because the club sold liquor to its members for consumption away from the club’s premises.

FINDINGS OF FACT

Some of the facts are stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated herein by reference.

The Santa Barbara Club (hereinafter petitioner or the club) is a nonprofit corporation organized in 1894 and existing under the laws of the State of California with its principal place of business in Santa Barbara, Calif., at the time of the filing of the petition herein. It filed its Federal corporate income tax returns for the years in question with the Internal Revenue Service Center at Fresno, Calif.

Petitioner is a social club organized solely for the entertainment and diversion of its members. Its primary function is to provide downtown facilities for members and their guests. It is also used for approximately 15 social events each year. Among the services provided are the serving of food and liquor for consumption on the premises of the club, the sale of package liquor for consumption off the premises, and the sale of tobacco products for consumption on or off the premises. It is open only to members (and guests accompanied by a member) and the services listed above, including the sale of package liquor, are provided solely to such persons.

For approximately 40 years, petitioner has sold alcoholic beverages for consumption both on and off its premises.² Package liquor could be purchased only from the club’s general manager or his secretary and could not be consumed at the club. Usually a member desiring to purchase package liquor would place his order with the general manager or his secretary and the member would take the liquor with him as he left the club. Occasionally, an order would be placed over the telephone, in which case the club would deliver the liquor to the member’s home.

The package liquor sold by the club consisted of both "name brands” and "club brands.” "Name brand” liquor was sold under the label of individual distillers. Club brands were standard brands of bourbon, scotch, vodka, and gin sold under the label of the club. Prices of the name brand liquor were the minimum retail price permitted by the California Fair Trades Act for such brands. Club label liquor was priced at 12 to 15 percent above its wholesale cost, which was somewhat cheaper than the price charged for the same liquor sold under the label of its distillery. Sales of club label liquor accounted for between 75 and 80 percent of the package liquor sold. Other clubs in southern California employed similar procedures for selling package liquor to their members.

Club members were charged for food served in the dining room, liquor sold by the drink at the bar, tobacco and package liquor sold at the club, and the special social events held each year. For the years in question, the sales, gross income, and net income from the sale of package liquor and other activities were as follows:

Year Package liquor Other activities Total

1969: Sales. $27,955.65 $27,851.22 $55,806.87

Gross income.. 4,515.91 15,104.50 19,620.41

Net income. 4,060.95 (10,505.69) (6,444.74)

1970: Sales. 29,314.00 27,642.00 56,956.00

Gross income 4,708.00 15,132.00 19,840.00

Net income. 4,165.00 (10,635.00) (6,470.00)

1971: Sales. 29,444.00 26,379.00 55,823.00

Gross income 4,833.00 14,303.00 19,136.00

Net income. 4,255.00 (11,486.00) (7,231.00)

In addition to sales income, petitioner had the following amounts of membership income, rental income, and interest in 1969, 1970, and 1971:

Year Membership income Rental income³ Interest?

1969.. $43,920 $3,199.23

1970.. 49,593 1,050 4,044.00

1971.. 46,617 1,080 3,378.00

By letter dated January 15, 1943, respondent determined that petitioner was exempt from Federal income taxes under the provisions of section 101(9) of the Internal Revenue Code of 1939, now section 501(c)(7) of the Internal Revenue Code of 1954. Respondent revoked petitioner’s tax-exempt status, effective as of January 1, 1969, in a ruling dated September 6, 1972, on the ground that petitioner "derived a substantial amount of income from the sale of liquor by the package to [its] members for off-premises consumption.”

OPINION

Among organizations granted an exemption from the general provisions of the income tax are social clubs, which are defined in section 501(c)(7) as "Clubs organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, no part of the net earnings of which inures to the benefit of any private shareholder.”⁴ The question before us is the extent to which petitioner should be deprived of the benefits of this provision.

Initially, we think it important to emphasize what is not in issue. Although the club realized a profit from the liquor sales in question, which was utilized to offset operating expenses, respondent has not argued that such profits "inure[d] to the benefit of’ the club’s members in violation of the latter part of section 501(c)(7).⁵ Moreover, respondent has specifically renounced, at least for the purposes of decision herein, any contention that such profit constituted "unrelated business income” for the taxable years 1970 and 1971 within the meaning of section 512(c); under such circumstances, we will not consider whether petitioner should in any event be subject to tax on the income from its bottled liquor sales under section 511.⁶

Clearly, the bottled liquor sales were an ongoing and recurring operation of the club and petitioner does not contend otherwise. Nor is there any dispute between the parties that the major, or even predominant, purpose of the club’s existence was, and continued to be, during the taxable years in issue, the carrying on of social and recreational activities through the commingling of its members. Similarly, we are not confronted with the problem of income derived from "outsiders” — a problem with which the courts and the Congress have had to struggle oyer the years. See, e.g., Pittsburgh Press Club v. United States, 536 F.2d 572 (3d Cir. 1976); United States v. Fort Worth Club, 345 F.2d 52 (5th Cir. 1965); S. Rept. No. 94-1318 (1976), 1976-2 C.B. 597.

We now turn to the narrow issue which we must resolve, namely, whether petitioner should be deprived of its exemption because of its sales of bottled liquor to its members for consumption away from its premises. We approach its resolution mindful of two general principles which have been applied in this area and which to some degree are in conflict: (1) Although the statute uses the word "exclusively,” case law and respondent’s regulations have abjured a literal application and permitted nonexempt activity of an insubstantial, though recurring, nature (see Pittsburgh Press Club v. United States, supra; see and compare Aviation Club of Utah v. Commissioner, 162 F.2d 984 (10th Cir. 1947), affg. 7 T.C. 377 (1946), with Aviation Country Club, Inc. v. Commissioner, 21 T.C. 807 (1954)); and (2) where an exemption is designed to facilitate private activities rather than public goals, any doubts as to proper construction should be resolved in favor of the Government (see The Associates v. Commissioner, 28 B.T.A. 521, 524 (1933)). The issue is not without its difficulties both conceptually and pragmatically and unfortunately we do not have the benefit of any conclusive guidance from the applicable statutory provisions, legislative history, or the decided cases.

In Rev. Rul. 44, 1953-1 C.B. 109, respondent ruled that a social club did not forfeit its exemption because it derived its principal income from the operation of a bar or restaurant used only by members and their guests. In so ruling, respondent stated, "Exemption has been granted * * * to many clubs where considerable revenue was derived from the sale of merchandise and services to the members, but such exemption has been denied where substantial revenue was derived from dealings with nonmembers.” Since 1958, section 1.501(c)(7) — 1(a), Income Tax Regs., has provided that "a club otherwise entitled to exemption will not be disqualified because it raises revenue from members through the use of club facilities or in connection with club activities.” Petitioner relies heavily on this language and the administrative practice adverted to, coupled with legislative reenactment of the language contained in section 501(c)(7), to support its position that Rev. Rul. 68-535, 1968-2 C.B. 219, in which respondent specifically ruled that, effective January 1,1969, a club which sold bottled liquor to members only for off-premises consumption was not operated exclusively for the purposes prescribed by section 501(c)(7), is an unwarranted interpretation of that statutory provision.

Essentially, petitioner contends that, since the activity in question was confined to members, its exempt status should be unaffected. In so arguing, petitioner points to language in McGlotten v. Connally, 338 F.Supp. 448 (D. D.C. 1972), and Rochester Liederkranz, Inc. v. United States, 456 F.2d 152 (2d Cir. 1972), to the effect that revenue arising from activities restricted to members should not serve' as the basis for removing the exemption of a social club. But, it is clear that limiting activities to members is not enough in and of itself. Thus, in Allied Trades Club, Inc. v. Commissioner, 23 T.C. 1017 (1955), affd. per curiam 228 F.2d 906 (3d Cir. 1956), we held that the operation of a death-benefits fund for members caused a social club to lose its exempt status on the ground that such activity "could not be classified as an operation for pleasure, recreation or social purposes” (see 23 T.C. at 1019). And in McGlotten v. Connally, supra, the court stated that "any 'profit’ which results from overcharging for the use of the facilities still belongs to the same members.”⁷ 338 F.Supp. at 458 (emphasis added). In a similar vein, the legislative observation in H. Rept. No. 91-413 (1969), 1969-3 C.B. 200, 231, that the exemption was designed to place the members in "substantially the same position as if [they] had spent [their] income on pleasure or recreation without the intervening separate organization” does not in our opinion bless every instance in which members of a social club "wash each other’s linen.”

Respondent’s main contention is that the absence of the element of commingling, as set forth in Rev. Rul. 68-535, supra, is determinative. While we are not prepared to accept such an absolute standard,⁸ it cannot be gainsaid that commingling is an important consideration. See Chattanooga Auto. Club v. Commissioner, 182 F.2d 551, 554 (6th Cir. 1950); Augusta Golf Assn. v. United States, 338 F.Supp. 272, 278 (S.D. Ga. 1971).

The liquor sales involved herein did not involve commingling to any significant extent. Nor did the sales further any other exempt purpose. Under these circumstances and the further fact that the liquor sales were recurring, they will destroy the exemption if such activity is substantial and not negligible in nature. See United States v. Fort Worth Club, supra.

For taxable years beginning prior to January 1, 1970, social clubs were not subject to the tax on unrelated business income under section 511. It has been held that for such years the amount of outside income which a club could receive without losing its exemption was strictly limited in order not to confer upon social clubs greater benefits than were granted to organizations subject to the unrelated business tax. United States v. Fort Worth Club, supra; Coastal Club, Inc. v. Commissioner, 43 T.C. 783, 805-806 (1965), affd. per curiam 368 F.2d 231 (5th Cir. 1966).

The Tax Reform Act of 1969 (Pub. L. 91-172, 83 Stat. 487) subjected social clubs to the tax on unrelated business income for taxable years beginning after December 31, 1969. However, both legislative committees stated, in the course of considering the applicable legislation, that it was not their intention to change the test for determining whether nonexempt activities were sufficient to require that the social club should lose its exemption. S. Rept. No. 91-552 (1969), 1969-3 C.B. 423, 471; Conf. Rept. No. 91-782 (1969), 1969-3 C.B. 644, 652. This legislative history strongly suggests that the pre-1969 standard be applied for the taxable years 1970 and 1971 as well.⁹

In each of the years involved herein, the dollar volume from the sale of bottled liquor for off-premises consumption was substantial (in excess of 25 percent of the petitioner’s gross receipts from all sources), and the gross income (i.e., gross profit) derived from this service to members was not insignificant (in excess of 7 percent of petitioner’s gross income from all sources). In the light of petitioner’s both ongoing and recurring sales of bottled liquor and the sizable percentages of gross receipts and gross income which such sales represent, we conclude that petitioner is not entitled to an exemption under section 501(c)(7) in any of the years in issue. In so concluding, we are not unmindful that, prior to the issuance of Rev. Rul. 68-535, supra, respondent apparently issued rulings in the disputed area recognizing that other social clubs conducting the activity involved herein were nevertheless entitled to exemption under section 501(c)(7). But the record herein is not sufficient to furnish a foundation for decision based upon a contemporaneous interpretation of the applicable statute by the agency charged with its administration. Cf. Hanover Bank v. Commissioner, 369 U.S. 672 (1962). Indeed, we are inclined to the view that the instant case fits the mold of those cases which accord considerable latitude to respondent in terms of changing his position (if, indeed, he did so change herein).¹⁰ See Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957); United States v. Leslie Salt Co., 350 U.S. 383 (1956).

Decision will be entered for the respondent.

Reviewed by the Court.

Drennen, J., did not participate in the consideration and disposition of this case.

1 All references are to the Internal Revenue Code of 1954 as amended and in effect from time to time during the years in issue.

2 Since 1936, petitioner has had both an on-sale and off-sale liquor license issued by the State of California.

3 The parties are in agreement that rental and interest income constitute unrelated business income for 1970 and 1971. See sec. 512.

4 A corporate exemption has been in the Code since 1916. For a thorough review of the legislative antecedents of sec. 501(c)(7) and subsequent related legislative action, see United States v. Fort Worth Club, 345 F.2d 52 (5th Cir. 1965).

5 Nor has respondent advanced any "inurement” argument based upon the sale of club brands of liquor at less than the cost of standard brands. See p. 201 supra.

6 We express no opinion as to whether a decision for petitioner herein will preclude respondent from issuing a further deficiency notice in respect of any such tax. Compare sec. 6211(a) and 6212(a) and (c) with Crowell-Collier Pub. Co. v. Commissioner, 259 F.2d 860, 864 (2d Cir. 1958), and Rowan Cotton Mills Co. v. Commissioner, 140 F.2d 277 (4th Cir. 1944), affg. on this issue 1 T.C. 865 (1943).

7 Rochester Liederkranz, Inc. v. United States, 456 F.2d 152 (2d Cir. 1972), involved the issue of "inurement” — an issue which is not before us herein — and the language of the Court of Appeals regarding the derivation of earnings from members was made in the context of that issue. See 456 F.2d at 156. We recognize that Allied Trades Club, Inc. v. Commissioner, 23 T.C. 1017 (1955), affd. per curiam 228 F.2d 966 (3d Cir. 1956), also dealt with the increment issue but did so only as an additional ground for decision.

8 Respondent himself has recognized that commingling in every aspect of a social club’s activity is not essential. See Rev. Rul. 74-30, 1974-1 C.B. 137.

9 By Pub. L. 94-568, 90 Stat. 2697, sec. 501(c)(7) was amended to read:

(7) Clubs organized for pleasure, recreation, and other nonprofitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder.

The legislative history reveals that Congress believed that by making social clubs subject to the unrelated business tax, it was no longer necessary to severely limit the amount of outside income that such a club could receive without losing its tax exemption. Although the reports of both the House Committee on Ways and Means and the Senate Committee on Finance indicate that this measure was designed to serve as a clarification of existing law (H. Rept. No. 94-1353, 1-5 (1976); S. Rept. No. 94-1318, 1-5, 8 (1976), 1976-2 C.B. 597-601, the act is effective only for taxable years beginning after Oct. 20, 1976. Pub. L. 94-568, sec. 1(d). Consequently, we see no basis for utilizing this provision or its legislative history in determining petitioner’s status during the taxable years before us in any manner.

10 Rev. Rul. 44, 1953-1 C.B. 109, and Rev. Rul. 68-535, 1968-2 C.B. 219, are not necessarily inconsistent, nor does sec. 1.501(c)(7), Income Tax Regs., necessarily permit unrestricted dealings with members.