North Ridge Country Club v. C.I.R.

• Decision Date: 06 June 1989
• Docket Number: No. 88-7062,88-7062
• Citation: 877 F.2d 750
• Parties: -5020, 57 USLW 2744, 89-1 USTC P 9363 NORTH RIDGE COUNTRY CLUB, Petitioner-Appellee, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 750

877 F.2d 750

64 A.F.T.R.2d 89-5020, 57 USLW 2744, 89-1

USTC P 9363

NORTH RIDGE COUNTRY CLUB, Petitioner-Appellee, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellant.

No. 88-7062.

United States Court of Appeals Ninth Circuit.

Argued and Submitted March 6, 1989.

Decided June 6, 1989.

Kenneth L. Greene, Asst. Atty. Gen., Tax Div., Washington, D.C., for respondent-appellant.

Alvin R. Wohl and Michael P. Casterton, Sacramento, Cal., for petitioner-appellee.

Appeal from a Decision of the Tax Court of the United States.

Before CANBY, THOMPSON and LEAVY, Circuit Judges.

LEAVY, Circuit Judge:

OVERVIEW

The Commissioner of Internal Revenue ("the Commissioner") appeals a tax court decision rejecting its deficiency assessment of North Ridge Country Club's ("the Club") taxable income for 1979. A social club such as the Club is taxed on non-member income. I.R.C. Secs. 501(c)(7), 512(a)(3). ¹ The Club's income from a non-member activity exceeded the direct costs of conducting the activity, but the Club reported a tax loss after considering indirect costs such as overhead. The tax court concluded that the loss was properly deductible under section 512(a)(3)(A) of the Tax Code, and could offset the gains from other non-member activities. North Ridge Country Club v. C.I.R., 89 T.C. 563 (1987). The Commissioner appeals. We reverse.

FACTS AND PROCEEDINGS

The facts are undisputed. The Club operates a golf club, a restaurant and bar, and other facilities for the benefit of members and guests. In 1979, the year at issue, the Club obtained revenues from membership dues and fees, but also from three non-member sources. ² One source of non-member revenue was interest from a savings account. Another source was non-member golf tournaments, in which the Club charged a variety of user fees and produced food and bar revenues from obligatory post-tournament banquets. A third source was food and bar earnings from non-member banquets unrelated to golf tournaments.

At non-member tournaments and banquets, the prices charged to non-members were higher than would be charged to members. The prices were competitive yet designed to maximize revenue. In calculating the profitability of non-member activities, the Club only took into account "direct expenses," i.e. those which would not have been incurred but for the activity (e.g. additional labor costs and cost of goods sold). Based on such an analysis, 1979 produced overall non-member profits. The Club sought to generate profits from non-member activities to produce cash flow and contribute to its "indirect expenses," i.e. fixed or quasi-fixed expenses such as overhead. ³

For tax purposes, however, the Club did take into account indirect expenses in determining the profitability of its non-member activities. This method of computation produced a loss from the Club's food and bar non-member activities in 1979. Allowing the loss to offset gains from the other non-member activities produced an overall loss.

The Club qualifies as a social club under the Tax Code, entitling it to an exemption from taxation of income. Sec. 501(c)(7). The The Commissioner assessed a deficiency for 1979, believing the Club could only deduct expenses for each non-member activity to the extent of that activity's gains, i.e. it could not deduct losses. The Commissioner reasoned losses are non-deductible unless incurred in a trade or business entered into with a profit motive, and that here the profit motive was lacking. The Club sought judicial review.

                exemption does not apply to income from non-member sources.  Sec.   512(a)(3)(B).  But since in 1979 the Club's tax computations revealed losses in non-member activities, the Club reported no tax liability from non-member income in that year.  According to the Commissioner, the Club reported no liability for non-member income for 1974 to 1978 for the same reasons
                

The tax court rejected the Commissioner's position. It found that the Club had the required profit motive to deduct its losses, and concluded the food and bar losses properly offset the net gains from the other non-member revenue sources. The Commissioner timely appealed within the ninety day statutory period. Sec. 7483. The National Club Association filed an amicus brief in support of the Club.

DISCUSSION

The narrow question before us is whether the Club could properly deduct losses ⁴ incurred in conducting non-member activities. ⁵

In 1969, Congress decided to tax the "unrelated business income" of certain tax exempt organizations. Sec. 512(a). ⁶ As applied to social clubs, income from member sources remained tax exempt ("exempt function income") but income from non-member sources did not. Sec. 512(a)(3)(B). The legislative history behind Sec. 512(a) reveals Congress believed that a Club's income from members is properly exempt, since the members would not suffer tax consequences if they spent their income on recreation independent of a social club. S.Rep. No. 552 91st Cong., 2nd Sess. (1969), 1969-3 C.B. 423, 469-70, reprinted in 1969 U.S.Code Cong. & Admin.News 1645, 2027, 2100. However, if the club's non-member income would likewise be exempt from taxation, it could subsidize the members' recreation. The members would then improperly receive a tax-free subsidy:

Since the tax exemption for social clubs and other groups is designed to allow individuals to join together to provide recreational or social facilities or other benefits on a mutual basis, without tax consequences, the tax exemption operates properly only when the sources of income ... are limited to receipts from the membership. Under such circumstances, the individual is in substantially the same position as if he had spent his income on pleasure or recreation (or other benefits) without the intervening separate organization.... For example, if a social club were to receive $10,000 of untaxed income from investments in securities, it could use that $10,000 to reduce the cost or increase the services it provides to its members. In such a case, the exemption is no longer simply allowing individuals to join together for recreation ... without tax consequences.... The extension of the exemption to such investment income is, therefore, a distortion of its purpose.

Id.

Section 512(a)(1) defines the term "unrelated business income" generally, as "the gross income derived by any organization from any unrelated trade or business, ... less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business." Section 512(a)(3)(A), however, provides a specific definition for social clubs, which omits mention of the term "trade or business":

In the case of [a social club], the term "unrelated business taxable income" means the gross income (excluding any exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income).....

Sec. 512(a)(3)(A).

I. The profit requirement

The Commissioner's position is that the omission of the term "trade or business" from section 512(a)(3)(A) does not reflect Congress' intent to allow social clubs to deduct losses in non-member activities other than trades or businesses. The Commissioner reasons that the chapter reference in section 512(a)(3)(A) is to Chapter 1 of the Code, and therefore that the Club's food and bar loss deductions are allowed only if they fall under a Chapter 1 deduction provision. The deduction sought here would fall under section 162, which allows deductions of losses incurred in a trade or business. The well-established rule is that to qualify as a trade or business under section 162, an activity must be regular and profit-seeking. Commissioner v. Groetzinger, 480 U.S. 23, 25, 107 S.Ct. 980, 982, 94 L.Ed.2d 25 (1987). The Commissioner urges that the same requirements apply here. The Commissioner believes the Club's food and bar non-member activity was not profit-seeking, as evidenced by the losses reported since 1974. ⁷

The Club and amicus contend that the omission of the trade or business requirement from section 512(a)(1), (3) denotes Congressional intent to allow Club's losses from non-member activity to be deductible even if not profit-seeking.

The issue has produced a conflict of decisions between circuits. In Cleveland Athletic Club v. United States, 779 F.2d 1160 (6th Cir.1985), an athletic club reported no non-member taxable income after offsetting investment gains against food and bar losses. As here, the club received a net gain if it considered only its direct expenses, but obtained a loss after considering overhead. Id. at 1161. The court of appeals held that the food and bar losses were deductible. Id. at 1165. The court reasoned that the omission of the terms "trade or business" in section 512(a)(1), (3) was intentional, and that no profit motive was required to make losses from a non-member activity deductible. Id. The court required only that the activity be motivated by a desire to obtain "economic gain," to ensure that the activity was not merely a hobby, id., since a hobby only allows the deduction of expenses up to the amount of income. Sec. 183(b)(2).

The same argument was rejected in virtually identical circumstances in Brook, Inc. v. C.I.R., 799 F.2d 833 (2d Cir.1986). The court of appeals in Brook explicitly rejected Cleveland Athletic, disagreeing that the omission of the term "trade or business" in Sec. 512(a)(3) meant that a profit motive was not required for loss deductibility. First, the court found no legislative history supporting the argument. Id. at 841. Second, the court thought that Congress included the term "trade or business" in section 512(a)(1) because the general rule in that section applied to charitable or educational organizations which were only taxed on unrelated business income relating to a "trade or business." By contrast, social clubs are taxed on all income from...