Plenty of hunting clubs, golf clubs, and lake associations own land that is worth far more than the club ever paid for it. A gas company comes knocking. It offers a signing bonus and royalties, and the board votes yes. The members keep shooting skeet and fishing the creek. Nothing about the club seems to change.
The tax picture can change, though. A social club is exempt from federal income tax only if “substantially all” of its activities are for pleasure and recreation. The members may never lift a finger on the drilling. But the royalty checks still land in the club’s bank account.
So whose activity is the drilling? And does it matter how you measure it–by the hours the members spend, or by the dollars that come in?
The tax court answered both questions in Consolidated Sportsmen of Lycoming County v. Commissioner, T.C. Memo. 2026-109. The case provides an opportunity to consider how passive income earned through a third-party contractor can cost a social club its tax-exempt status.
Facts & Procedural History
The taxpayer is a sportsmen’s club in Pennsylvania. It was incorporated in 1936. It owns hundres of acres of forest and meadow.
Members use the property for rifle ranges, trap and skeet shooting, hunting, fishing, kayaking, camping, and picnics. The club was recognized as a tax-exempt social club in 1981. The IRS did not dispute that these are exactly the kind of recreational activities the exemption is meant to cover.
The land happens to sit on top of the Marcellus Shale, a major natural gas formation. In 2011, the board unanimously approved an oil and gas lease with a drilling company. The club received a signing bonus of over $900,000. Royalties did not start until the company began extracting gas in late 2016. Then the money came in. From 2017 through 2023, the club received about $2.2 million in mineral royalties. In most of those years, the royalties alone were more than half of the club’s total revenue. In 2022, they were about 90%. Counting its other investment income, the club’s non-member income exceeded 50% of its gross revenue in every one of those years. Its net assets grew by more than $1 million. The club reported the royalties on its Forms 990 and 990-T.
Its application for non-profit status said nothing about mineral royalties. The IRS’s favorable letter said the determination assumed the club would operate as described, and it asked the club to let the IRS know if its purposes or method of operation changed.
The members spent virtually no time on the mineral activity. The officers spent very little. The drilling company did the work.
An IRS agent audited its 990-T returns for 2016 through 2019 and proposed revoking the exemption retroactive to 2017. The agent’s report said the royalties caused the club to consistently exceed a 35% limit on non-member income. The club protested. Almost two years later, the IRS Office of Appeals issued a final adverse determination revoking the exemption effective January 1, 2023.
The club then filed a petition for declaratory judgment in the U.S. Tax Court to contest that determination. The IRS initially asked the court to make the revocation retroactive to 2017, but it later conceded that point. That left the core question. Did the club still qualify at all?
Why Are Social Clubs Tax-Exempt in the First Place?
Most people think of charities under Section 501(c)(3). Social clubs fall under a different provision, Section 501(c)(7).
Section 501(a) exempts dozens of types of organizations from federal income tax. It covers “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 reason for the exemption is different from the reason charities are exempt. A charity serves the public. A social club serves its members. The exemption exists so that people who pool their money for recreation are not taxed just because they pooled it.
The tax court used a simple example to make the point. If one woman buys a kayak and enjoys using it, there is no income tax issue. If ten women pay dues to buy and maintain kayaks together, a question arises. Is their pooled money now a taxable entity? The tax code says no as long as the club stays a club. The Supreme Court has described the exemption the same way. It is not meant to give club members a tax advantage. It is meant to keep them from suffering a tax disadvantage for pooling their resources.
Doesn’t the Club Already Pay Tax on the Royalties?
But doesn’t the club already pay tax on the royalties? The answer is yes, it does. This surprises people.
An exempt social club is not exempt on all of its income. Member dues are “exempt function income” and are not taxed. But the tax code taxes social clubs on “unrelated business taxable income” (“UBTI”), and for social clubs that term is broader than it is for charities. It sweeps in investment income and other non-member income.
So the club owed tax on its gas royalties either way. The tax court said this and the club did not argue otherwise as this was not the dispute. The dispute was not about the tax on the royalties. It was about whether the royalties cost the club its exempt status altogether. Losing that status means the club is taxed and files as a regular corporation going forward with tax on the member dues and with all the compliance and planning headaches that come with it.
Where Does the 35% Rule Come From?
So where does the 35% rule come from? Where can it be found?
Before 1976, the statute required social clubs to be operated “exclusively” for recreation. Congress loosened that in 1976 to “substantially all.” The statute does not say what “substantially all” means. A Senate Finance Committee report did. It said clubs should be allowed to receive up to 35% of their gross receipts, including investment income, from outside their membership without losing their exemption. Above that line, the report said the decision should turn on all the facts and circumstances.
So the answer is that the 35% figure is not in the tax code. There is no regulation. There is no revenue ruling. The IRS admitted all of this in its brief. It has simply applied the 35% figure from the legislative history to social clubs for about four decades. That is the number the IRS agent used here. And according to the court, the tax court had never applied the 35% standard to a social club for any year after the 1976 amendment.
That gave the club an opening. If the 35% test is not law, the tax court has to apply the statutory text—”substantially all of the activities.” Activities, the club argued, are what people do. And its members spent nearly all of their club time on recreation.
Whose Activities Count; the Members’ or the Club’s?
This was the heart of the club’s case. It wanted the court to look only at what the members were doing. Measured that way, the club was almost entirely recreational. Nobody was out there running a drilling rig on a Saturday.
The court rejected that reading. The word “members” does not appear in Section 501(c)(7). The exemption is for “clubs,” and the phrase “activities of which” refers back to the club. A club can act through its members. It can also act through employees. And it can act through contractors. If a club hired employees to run a fundraiser, that fundraising would be the club’s activity. The court saw no difference when a club contracts with a drilling company to extract gas from the club’s own land.
The tax court leaned on a few prior cases for this. In a charity case, it had treated fundraising done by an outside professional fundraiser as the charity’s own activity. And in Coastal Club, Inc. v. Commissioner, 43 T.C. 783 (1965), aff’d, 368 F.2d 231 (5th Cir. 1966), the court denied exemption to a social club that leased its land for oil and gas production and earned royalties that overshadowed its member revenue. That case was decided under the old “exclusively” standard, so it is not a perfect match. But the tax court found it significant that the earlier opinion treated the oil and gas operation as an activity of the club.
The tax court also relied on a federal district court case involving an organization similar to a family reunion fund. All of its income came from investments. It argued that its trustees spent less than 1% of their time on investment matters. The district court pointed out that if the test turned only on what members were doing, a club could run any side venture it wanted, at any level of profit, so long as the members kept pursuing the club’s stated purpose. The tax court agreed. A club’s status turns on all of its activities, whether they are carried out by members, trustees, employees, or contractors.
Can a Club Measure Its Activities in Hours Not Dollars?
The club also argued that dollars are the wrong yardstick. Activities should be measured in hours, it said, and the members’ hours were nearly all recreational.
The tax court did not say hours are irrelevant. Hours can be a fair way to measure an activity. But if the club wanted to use hours, it had to count all of the hours–including the drilling company’s hours on the club’s land. The club offered no evidence of those. It showed only its members’ recreation hours, in what the court called “a virtual vacuum,” and asked the court to ignore the royalty dollars. Because the club had the burden of proof, the court assumed the drilling company’s personnel spent substantial time on the extraction each year. Minerals do not extract themselves, as the tax court put it.
The tax court also held that investment can be a non-exempt “activity” of a social club, and that the income an activity produces can be an important way to measure it. Other courts had looked at the share of a club’s income that comes from outside sources as a signal of whether substantially all of its activities were exempt. There was nothing unusual about the IRS doing the same.
There is a practical lesson in how this argument failed. The club’s theory was not necessarily hopeless. But it only showed half of the comparison. When a taxpayer picks a measuring stick, it has to apply it to both sides of the ledger.
How Much Outside Income Is Too Much?
The court did not adopt the 35% test. It assumed, without deciding, that the IRS can use 35% as an administrative safe harbor. Then it said it did not need to decide whether 35% is the right line.
When royalties alone make up more than half of a club’s gross income in most years, the tax court said, under any reasonable standard it cannot be said that “substantially all” of the club’s activities are recreational.
The kayak example came back here. A kayak club funded by its members’ after-tax dues has no income tax problem. If the members ran a business on the side to fund their kayaking, that business would be a separate activity. The club would keep its exemption only if the business stayed insubstantial. And the club could not get around this by having employees or contractors run the business, or by buying land with mineral reserves and using royalties instead of dues to fund half of its budget.
The club also argued that the IRS never considered all the facts and circumstances, as the Senate report contemplated. But the club never really said which facts mattered. Most of what it offered was a list of the harms it would suffer from a retroactive revocation. That had nothing to do with whether its activities were substantially recreational. Its honest reporting of the royalties on its returns did not help either. Disclosure does not preserve an exemption. So the tax court sustained the revocation, effective January 1, 2023.
That leaves an open question. What about a club with 40% or 45% outside income? The tax court expressly declined to say whether 35% is the right line or how much weight the IRS’s long-standing practice deserves. It did note that when a taxpayer relies on a published IRS position, the tax court has at times treated that position as a concession by the IRS.
So for a club just over 35%, there is a position that the statute allows more room than the IRS’s guideline. There is also a real risk that a tax court looks at the same facts and finds the outside activity substantial. And royalties are not steady. This club went from about 20% royalty income in one year to about 90% the next. One good year of production can blow past any line.
The best time to deal with this is before the lease is signed–and for many clubs, the board is focused on the signing bonus at that point, not the exemption, by the way. A club in this position should run the numbers on projected royalties against its dues and other member income. It may make sense to look at whether the mineral interests can be held or structured differently, keeping in mind that money cannot simply be passed through to members without creating an inurement problem. A private letter ruling may also be an option for a club that wants certainty before committing. None of these options is free of tax issues. But they are much easier to consider before an IRS agent shows up than after.
The Takeaway
Tax-exempt status is not a one-time grant. It depends on what the organization does every year. The IRS can revisit it when circumstances change. For social clubs, this case makes clear that “activities” means everything the club does, including what it contracts with others to do on its property. Members spending their weekends at the rifle range will not save the exemption if gas royalties pay most of the bills. And the IRS’s 35% guideline may not be the outer limit, but more than half is clearly too much. If your club owns land with mineral value, run the numbers before signing a lease and track the club’s non-member income percentage every year.
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