DORMANT CHAPTER HOUSES

Dianne Chipps Bailey & Seth Huffstetler, Robinson, Bradshaw & Hinson, PA, dbailey@rbh.com & shuffstetler@rbh.com

When a collegiate chapter of a national fraternity or sorority loses its charter or otherwise becomes dormant, whether permanently or temporarily, special attention must be paid to the operation and management of the chapter house. Without careful planning, significant negative tax and related consequences could result.

Background

National housing corporations and local chapter houses typically are organized as non-profit corporations that qualify as social clubs exempt from taxation under § 501(c)(7).  Maintaining an exemption under § 501(c)(7) subjects an organization to a number of rules and restrictions, including restrictions on sources of gross receipts.

The tax-exempt purpose of a 501(c)(7) organization is to provide pleasure and recreation to its members. The Internal Revenue Service labels a social club’s activities that are in pursuit of its exempt purposes as “traditional activities,” while those activities that are not in pursuit of exempt purposes are “nontraditional activities.” Engaging in nontraditional activities jeopardize a 501(c)(7) organization’s tax exemption.  Limited IRS guidance indicates that if the percentage of gross receipts from nontraditional activities is less than 5%, the nontraditional activities would be insubstantial and would not affect an organization’s tax exempt status.  This guidance is informal and subject to change.  A 501(c)(7) organization conducts nontraditional activities at its own peril.

Limitations on gross receipts from traditional activities depend, in part, on whether the gross receipts are from members or nonmembers. A 501(c)(7) organization generally is supported by its members through membership fees, dues and assessments and other revenue from the use of club facilities by members. Up to 35% of a 501(c)(7) organization’s gross receipts, including investment income, can be from sources outside of the organization’s membership. Within that 35%, not more than 15% of a social club’s gross receipts can be derived from the use of a club’s facilities or services by the general public. If a social club fails the gross receipts test, then all of the facts and circumstances will be considered in determining whether the club should qualify for tax exempt status.

The Problem

When a local chapter is dormant, no member income is available to support the financial obligations of the 501(c)(7) that holds the chapter house. In many cases, the natural reaction is to replace that income stream as quickly as possible, especially if the property is mortgaged. But if maintaining tax-exempt status is important – and it usually is if there is any hope for reinstatement of the local chapter – you must carefully evaluate under what circumstances member income may be replaced with income from nonmembers.

The problem is the same whether the local chapter house is owned by a national housing corporation that owns multiple properties or a separate organization that owns only the local chapter house, although the solutions may differ.

Possible Solutions

National Housing Corporation

1) If the organization is not dependent on the income stream, it may be able to leave the property dormant and simply wait for reinstatement of the local chapter.

2) If the local chapter house is owned by a national housing corporation that owns multiple properties, renting one house to non-members may not cause the national housing corporation to lose its tax-exempt status. If there is sufficient member income from other sources, new gross receipts from non-members may be below the permitted thresholds under the nontraditional income and gross receipts tests.  The non-member income likely would be taxable to the national housing corporation.

3) If the national housing corporation does not have enough cushion in the gross receipts test to absorb additional non-member income, the corporation could consider placing the property in a subsidiary that qualifies for tax-exempt status as a title holding corporation under § 501(c)(2). This approach typically would be an option only if the property were mortgaged or there are related operating expenses. A 501(c)(2) entity must exist for the sole purpose of owning property, collecting income from the property and turning over that income (less expenses) to another tax exempt entity. A 501(c)(2) entity may only break even and have no additional funds to pay to its parent corporation (in this instance, the national housing corporation). Under this scenario, the local chapter house could satisfy its own carrying costs without adversely affecting the national housing corporation’s tax-exempt status. The parent corporation and the 501(c)(2) subsidiary must file separate tax returns. If the two entities were to file one consolidated return, then the subsidiary’s gross receipts (without subtracting expenses) would also be gross receipts of the national housing corporation.

Locally-owned Chapter House

1) Under the right circumstances, a locally-owned chapter house may choose to do nothing and remain dormant. This typically would be an option only if there were no mortgage or other significant expenses and the local chapter expected to be reinstated within a reasonable amount of time. Dormancy could solve the nontraditional income and gross receipts issue, but it could lead to another problem. The IRS has revoked the tax exempt status of dormant organizations that had no prospects for returning to active status.

2) A dormant locally-owned chapter house may not accept any non-member income because it has no member income to offset income from non-members. One solution is to temporarily redefine the membership of the chapter house. For example, a 501(c)(7) originally organized for the benefit of Fraternity X could amend its charter or articles of incorporation to include members of Fraternity Y. This approach must be employed with careful attention to detail.  It is essential that Fraternity X retain control of the board of directors of the 501(c)(7) such that the board may amend the charter or articles of incorporation to redefine the membership class in its sole discretion. This solution ensures that rent received is income from members, thus averting any issues with the nontraditional income and gross receipts tests.

3) Creating a § 501(c)(2) subsidiary might also be an option for a locally-owned chapter house. As described above, if the property is rented on a break-even basis, the subsidiary would have no income to turn over to the 501(c)(7) parent and, accordingly, the parent organization would not risk violating the gross receipts test. This is not a viable long term solution, however, if the local chapter has no prospects for becoming active again.

4) A final option is to intentionally fail the § 501(c)(7) rules and operate on a for-profit basis. If there is any hope of reinstatement of the dormant chapter, however, this should be avoided using one of the solutions described above. If the chapter were reinstated, the local chapter house would be required to seek reinstatement of its tax-exempt status with the IRS. In addition, if a significant period of time passes between the transition from non-profit to for-profit and back to non-profit occurs, the transfer of the property back to non-profit ownership could be taxable.

Questions?

Should you have any questions or require assistance, please do not hesitate to contact the authors.

About Robinson, Bradshaw & Hinson, P.A.

Robinson, Bradshaw & Hinson, P.A. is distinctive in its commitment to providing specialized legal services to nonprofit organizations.  As a full-service, business-oriented law firm, we are uniquely positioned to provide sophisticated and cost-effective counseling and representation to our nonprofit organization clients including national fraternities, sororities and their affiliate foundations and housing corporations.  We have extensive experience representing a diverse group of nonprofits in all aspects of their organization, administration and management.