IRS APPLIES 20TH CENTURY ANALYSIS TO 21ST CENTURY SOCIAL ORGANIZATION

Code §501(c)(7) provides an exemption from federal income tax for clubs organized substantially for pleasure, recreation, and other nonprofitable purposes if no part its net earnings inures to the benefit of a private shareholder. Thus, social clubs, sororities, and fraternities, for example, can often qualify for income tax exemption.

In a recent private letter ruling, the IRS was asked to rule that an "online sorority" qualified as an exempt social club.

The sorority was organized to operate a national online sorority for students of an online for-profit university. Its purpose was to encourage members to succeed academically and professionally. Its members communicate among each other over the Internet via email, blog posts, and online classes, and by telephone. When new members are added, there is an online ceremony for admission. Most of the activities of the sorority occur online, including meetings and seminars. However, members who live near each other may meet to perform activities for nonprofit organizations, and there is an annual meeting held each year at 3 locations throughout the U.S. where organizational activities are discussed and addressed.

The IRS concluded that the sorority did not qualify. The ruling stated that "[f]ace-to-face interaction is important for members of a social club. Organizations that do not afford opportunities for this personal contact among members are not entitled to exemption." The ruling also provided that the club operates "primarily to advance the individual interests of your members. You do not engage in meetings and gatherings as a primary activity that involves personal contact among or between your members." The lack of a fixed facility where members could meet to engage in fellowship was also found relevant, as was the lack of expenditure of funds for social or recreational purposes, and that the face-to-face annual meetings were not social meetings but organizational meetings.

It is true that prior precedent emphasizes face-to-face interaction. For example, Rev.Rul. 58-589 provides that there must be an established membership of individuals, personal contacts, and fellowship, and that a commingling of the members must play a material part in the life of the organization. However, such parameters were developed well before there were electronic methods of meeting that provided for immediate communication and feedback (including instant messaging and email), online group meetings, and online seminars. It is possible today to engage in extensive social activities and commingling online that were not possible even a few years ago. Thus, one can legitimately argue that an online social organization can have the same practical camaraderie and interaction as a more traditional organization that meets in person, and that perhaps the IRS should loosen (i.e., modernize) its standards in this regard.

It is also true that a social organization needs to focus on social and recreational activities, and not be an organization that is simply providing personal growth or other benefits to its members. Thus, for example, a flying club that provides economical flying facilities for its members but had no organized social or recreational program, was not recognized as exempt in Revenue Ruling 70-32. This was appropriately contrasted in the subject private letter ruling with another such club in Revenue Ruling 74-30, where the flying club members constantly commingled in informal meetings and had regular person-to-person association. The club in Revenue Ruling 70-32 was problematic because it was open to all persons interested in flying, the members did not participate as a group in the hobby for recreation, and the members had no expectation of a personal relationship with other members.

It may be that the subject sorority was more focused on providing a benefit to its members than providing a social interaction environment, in which case exempt status may be inappropriate. However, one can image other online organizations that are there just for social interaction purposes. Applying the explanations provided in this ruling, they would not qualify for exempt status. Is it appropriate that they be barred from social club status just because the contact and interaction is electronic and not in person?

PLR 201434022, August 22, 2014

TIME LIMITATIONS ON RECEIVING LATE PROOF OF FOREIGN STATUS FOR PORTFOLIO INTEREST EXEMPTION PAYMENTS

Code Section 871(h) provides non-U.S. persons with a valuable exemption from U.S. income taxes on interest paid on registered U.S. obligations, commonly referred to as the portfolio interest exemption. Before a payor is authorized to make an interest payment without withholding taxes under the exemption, the payor must have received a W-8BEN form within the last 3 years establishing the foreign residency of the interest recipient.

In the real world, payors often fail to have the required Form W-8BEN before a payment is made. Treas. Reg. § 1.871-14(c)(3)(i) provides protection against liability for the withholding tax to such a payor that did not withhold, if the required documentation “is furnished before expiration of the beneficial owner's period of limitation for claiming a refund of tax with respect to such interest.” This raises interesting issues relating to that period of limitation, such as when or whether the recipient filed an income tax return, and whether the nonpayment of withholding tax or other payment of tax starts this statute of limitations period.

In a Chief Counsel Advice, the IRS addresses two common factual circumstances and discusses what the statute of limitations is for providing the required documentation. Under both examples, the payor paid the interest without withholding any tax from the payment.

Under the first example, the payee did not file a U.S. tax return or pay any U.S  tax for the taxable year. The CCA concludes that in this circumstance no tax has been paid that starts the statute of limitations for refund, nor is there a filing of a tax return that starts the statute. Thus, there essentially is no statute of limitations that applies for purposes of obtaining the required documentation.

Under the second example, the payee timely filed a U.S. tax return reporting taxable income unrelated to the interest payments and paid the tax due on such income. In this circumstance, both the payment of tax and the filing of the return start the limitations period. Thus, either one of them triggers a limitations that expires after the later of 3 years from the time the return was filed or 2 years from the time the tax was paid.

Note, however, that in both circumstances, the payor may be required under Treas. Reg. § 1.1441-1(b)(7)(ii), to provide additional proof to support its claim for a reduced rate of withholding.

CCA 201434021 (08/22/2014)

PERSONAL GOODWILL OF EMPLOYEE REDUCES ESTATE TAX VALUE OF CORPORATE STOCK

The question of “personal goodwill” often comes up in sales of corporate assets. When a business is sold, the shareholder will often seek to sell his or her “personal goodwill” in the business separately from the corporation’s sale of its assets, so as to obtain individual capital gains rates on the goodwill portion. But personal goodwill can also have relevance to estate tax valuation of stock, as illustrated by a recent Tax Court case.

In the case, the decedent owned all of the shares of stock of a corporation that were being valued for estate tax purposes. However, the son of the decedent was heavily involved in the business, including having various personal relationships with outsiders that assisted in revenue generation. Thus, a reduction in the value of the stock was sought for the personal goodwill of the son in the business. The Tax Court agreed, and resolved a dispute as to the value of the reduction in value for the son’s personal goodwill.

The Court noted that goodwill is often defined as the expectation of continued patronage by existing customers. Citing the well-known case of  Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 207-208 (1998), the Court acknowledged that a key employee may personally create and own goodwill independent of the corporate employer by developing client relationships. While the corporation may benefit from that goodwill, it does not own it and thus it is not a corporate asset for valuation purposes. The Tax Court accepted a multi-million dollar charge to operating expenses in computing value for the value of the son’s relationships.

The Tax Court noted one limitation on deducting employee personal goodwill – a covenant noncompete or similar agreement that transfers the exclusive use and benefit of the relationships to the employer. Here, the son did not have such an agreement, but they are common in business for unrelated employees so they may often operate to negate adjusting value in this manner.

Estate of Franklin Z. Adell, et al. v. Commissioner, TC Memo 2014-155