The largely untapped natural gas reserves in the Marcellus Shale formation has resulted in tremendous interest in the exploration, development and drilling of these reserves. Gas companies have been negotiating land lease and royalty agreements with landowners throughout the Marcellus Shale region for the right to explore and potentially drill on their property. These opportunities are accompanied by a myriad of tax consequences which for exempt social clubs are particularly troubling and warrant considerable review.
Social clubs as that term is defined by Section 501(c)(7) of the Internal Revenue Code include clubs organized for pleasure and recreation. Many of the social clubs located throughout the Appalachian Basin where the Marcellus Shale formation is located have substantial land holdings. Keep in mind that hunting and sportsmen clubs as well as country clubs and public golf courses are included in the definition of social clubs. The potential for revenue and cash flow associated with gas exploration and drilling activities has produced tremendous excitement in a sector plagued by declining membership; however, it is critical that these transactions are properly structured to avoid unintended tax consequences.
A social club is generally exempt from income tax under 501(c)(7) of the Internal Revenue Code (Code); however, the exemption only applies to revenue generated by membership fees, dues and assessments and investment income. Income generated by additional activities or too much investment income will be subject to unrelated business income tax and may jeopardize the clubs tax-exempt status. More specifically, the Code provides that a club is only permitted to receive up to 35% of its gross receipts including investment income, from non-member sources to avoid losing its exempt status. Therefore, at least 65% of a club's revenue must be generated by "normal and usual" club activities. The Code, however, allows clubs to exclude "unusual income" from the income test. What is "unusual" under the circumstances is the crux of the issue especially when evaluated in connection with land lease payments and royalty payments.
Lease and Royalty Payments
A rental payment from a gas lease constitutes unrelated business taxable income for a social club, and the rental payment may be includible in the club's annual gross receipts test. If the rental payment is a one-time event, however, and depending upon the terms of the agreement, the rental payment may qualify as an unusual event and not be included in the 35 percent gross receipts test. Hence, receipt of a one-time lease payment, although taxable, will not necessarily jeopardize the social club's exempt status.
On the other hand, most lease agreements pertaining to gas rights also provide for royalty payments over the life of the gas well. Such royalty payments also constitute unrelated business taxable income for the social club. However, because royalty payments are not a one-time event, the royalty payments will not qualify as an unusual event for purposes of the 35% gross receipts tests. As a result, a Section 501(c)(7) club will lose its tax-exempt status when the amount of annual royalty payments exceeds 35 percent of the club's annual gross receipts.
Private Inurement/Private Benefit Concerns
Section 501(c)(7) also prohibits exemption if any part of a club's net earnings inures to the benefit of its members. Accordingly, if income from a lease and natural gas royalty agreement is used to subsidize the club's operations or offset members' dues, the social club may also jeopardize its tax exemption. It should be noted that private inurement/private benefit issues will result if cash distributions are made to the club's members. The presence of private inurement will cause the club to lose its tax exempt status.
Although lease and royalty payments for natural gas rights may provide needed cash flow for a social club, such agreements also present unique tax compliance challenges to clubs exempt under Section 501(c)(7) of the Code. In addition to giving rise to unrelated business income, payments received by a social club may jeopardize the club's federal tax exemption if the agreement in connection with the payments is not carefully structured to minimize any unintended tax consequences. Hence, before entering into agreements in connection with its natural gas resources, a social club should review any proposed agreement with its tax advisors.
Schneider Downs provides accounting, tax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.