PORTLAND GOLF CLUB, PETITIONER V. COMMISSIONER OF INTERNAL REVENUE

   No. 89-530

   In The Supreme Court Of The United States

   October Term, 1989

   On Writ Of Certiorari To The United States Court Of Appeals For The
Ninth Circuit

   Brief For The Respondent

            TABLE OF CONTENTS
   Question Presented
   Opinions below
   Jurisdiction
   Statutory provisions involved
   Statement
   Summary of argument
   Argument:
      Petitioner's reported net losses from sales of food
      and drink to nonmembers may not be used to reduce
      its unrelated investment income
      A. A social club may not offset against its investment
         income net losses from nonmember sales
         activity that is not conducted with a profit
         motive
         1. Section 512(a)(3) differentiates the tax
            treatment of social clubs from other tax-exempt
            organizations by making their passive
            investment income taxable while preserving
            the rule that deductions generally
            available to other taxpayers under Chapter
            1 of the Code may be taken if directly connected
            to the taxable activity
         2. Because Section 512(a)(3) provides no
            authority for deductions not permitted in
            other contexts by Chapter 1 of the Code,
            petitioner's excess "business expenses" are
            not deductible unless they are incurred in
            connection with profit-motivated activity
         3. Petitioner misreads the statute in contending
            that Section 512(a)(3) creates a special
            rule for social clubs that eliminates the
            profit motive requirement for the deduction
            of excess "business expenses"
      B. An activity is not motivated by profit when it
         is not intended that the gross receipts from
         that activity will exceed the expenses properly
         allocable to it, both fixed and variable
   Conclusion

                            OPINIONS BELOW

   The opinion of the court of appeals (Pet. App. 1a-3a) is
unreported.  The memorandum opinion of the Tax Court (Pet. App.
6a-42a) is unofficially reported at 55 T.C.M. (CCH) 212.

                             JURISDICTION

   The judgment of the court of appeals (Pet. App. 4a-5a) was entered
on June 1, 1989.  On August 28, 1989, Justice O'Connor extended the
time within which to file a petition for a writ of certiorari to and
including September 29, 1989.  The petition was filed on September 28,
1989, and was granted on January 16, 1990.  The jurisdiction of this
Court is invoked under 28 U.S.C. 1254(1).

                     STATUTORY PROVISIONS INVOLVED

   Sections 511 and 512 of the Internal Revenue Code (26 U.S.C.) are
set forth in pertinent part in a statutory appendix (App., infra,
1a-3a).

                          QUESTION PRESENTED

   Petitioner, a tax-exempt social club, earns gross income from the
sale of food and drink to nonmembers.  The variable costs of
conducting this activity are less than the gross receipts, but
petitioner reports a net loss from the nonmember sales because the
total expenses allocated to it (both fixed and variable) always exceed
the gross receipts.  The question presented is whether, in determining
petitioner's "unrelated business taxable income" (26 U.S.C. 511-512),
these reported net losses from nonmember sales can be used to offset
petitioner's unrelated investment income.

                               STATEMENT

   1. Petitioner is a corporation exempt from income tax as a "social
club" under Section 501(c)(7) of the Internal Revenue Code, /1/ which
grants tax-exempt status to "(c)lubs organized for pleasure,
recreation, and other nonprofitable purposes" that meet certain other
requirements.  Petitioner operates a private country club that has a
golf course, restaurant and bar, swimming pool, and tennis courts,
primarily for use by members and their guests.  Nonmembers are
permitted to use petitioner's restaurant and bar for banquets,
receptions, and similar functions, if they are sponsored by members.
Petitioner receives gross income that is unrelated to its exempt
purposes -- and hence subject to unrelated business income tax under
Sections 511-512 of the Code -- from two sources:  sales of food and
drink to nonmembers and interest upon its investments.  Pet. App.
8a-11a.  /2/

   On its tax returns for 1980 and 1981, petitioner computed its gain
or loss from the nonmember sales by deducting from gross income both
"direct" or "variable" expenses (i.e., those that vary with the volume
of sales, such as food and beverage costs, payroll, and supplies) and
also an allocable share of "indirect" or "fixed" expenses (such as
taxes, depreciation, insurance, and other fixed overhead), which
petitioner would have incurred to operate its facilities whether or
not it served nonmembers.  The allocable share of fixed expenses was
deducted on the basis of petitioner's claim that those expenses were
"directly connected with the production of" nonexempt income (I.R.C.
Section 512(a)(3)(A));  the allocation was made based on the ratio of
petitioner's gross receipts from nonmember sales to its total gross
receipts from sales of food and drink to both members and nonmembers.
Pet. App. 11a-13a.  /3/

   Petitioner's gross receipts from the nonmember sales for each year
exceeded the variable expenses of that activity, but were less than
the sum of the variable and allocated fixed expenses.  Accordingly,
petitioner reported that the nonmember food enterprise generated net
losses for each year -- $28,433 for 1980 and $69,608 for 1981.  /4/
Those losses were greater than petitioner's interest income of $11,752
for 1980 and $21,414 for 1981.  Petitioner offset the losses against
the interest income, and therefore it reported no unrelated business
income tax liability for 1980 or 1981.  Pet. App. 21a-22a.  /5/

   On audit, the Commissioner determined that the losses reported by
petitioner from its nonmember sales were not deductible -- i.e., that
while the expenses allocated by petitioner to nonmember sales could be
applied to reduce its income from those activities, the excess
expenses could not be used to offset its unrelated investment income
and shelter it from taxation.  Accordingly, the Commissioner asserted
tax deficiencies of $1,828 for 1980 and $3,470 for 1981 to reflect the
tax due on petitioner's investment income.  Pet. App. 7a;  J.A. 48-51.
 The Commissioner reasoned that the excess expenses of a social club's
nonmember activities are deductible only if petitioner carries on the
nonmember sales activity with a profit motive.  /6/ The Commissioner
found that petitioner lacked the requisite profit motive for the
nonmember activity because the food and drink were priced at a level
insufficient to recover the total costs allocated to that activity, so
that the nonmember sales consistently yielded net losses.  Pet. App.
22a-23a;  J.A. 51.

   2. Petitioner challenged the Commissioner's determination in the
Tax Court, which ruled in its favor (Pet. App. 6a-42a).  The court
held that the expenses allocated to petitioner's nonmember activities
could be deducted in full and therefore used to reduce its unrelated
investment income.  The court assumed (without deciding) that
petitioner could deduct against other income its expenses from
nonmember sales only if that activity was profit-motivated, but the
court concluded that that standard was satisfied because petitioner
intended that its gross receipts from the nonmember sales would exceed
the related "direct costs" (id. at 35a), i.e., "the cost related to
those sales which would not have been incurred absent those sales"
(id. at 37a).  See id. at 34a-42a.  The court stated that the net
losses consistently reported on petitioner's tax returns were not
evidence that the sales lacked a profit motive, because those losses
resulted "only by allocating a part of the expenses which petitioner
would have in all events incurred" (id. at 37a-38a).  Thus, although
petitioner had allocated a portion of its fixed overhead expenses to
its nonmember activity in order to generate tax losses from that
activity (on the assertion that those fixed expenses were "directly
connected" to the activity), the court permitted petitioner to
disregard those overhead expenses in determining whether it had the
requisite profit motive with respect to the nonmember activity to
allow it to be able to use those losses to reduce its investment
income (see id. at 38a-39a).  The Tax Court relied heavily on its
reviewed decision in North Ridge Country Club v. Commissioner, 89 T.C.
563 (1987), rev'd, 877 F.2d 750 (9th Cir. 1989), where it had ruled
that it would not evaluate a club's profit motive from the standpoint
of "taxable profit," but would look instead to the "incremental
increase in available funds" realized by the club from the activity
(89 T.C. at 572).

   3. The court of appeals reversed and remanded (Pet. App. 1a-3a), on
the authority of its opinion reversing the Tax Court in North Ridge,
where the court of appeals had held that losses from nonmember
activity cannot be used to offset a social club's investment income,
unless the nonmember activity is conducted with a profit motive --
taking into account fixed, as well as variable, expenses.  In North
Ridge, the court of appeals had expressly rejected the position taken
by the Sixth Circuit in Cleveland Athletic Club v. United States, 779
F.2d 1160, 1165 (1985), to the effect that net losses from nonmember
activity may be applied to reduce investment income so long as the
nonmember activity is carried on for "economic gain," i.e., with the
intent of collecting gross receipts in excess of variable costs.
Instead, the Ninth Circuit agreed with The Brook, Inc. v.
Commissioner, 799 F.2d 833, 839 (2d Cir. 1986), that "a social club
must pursue a nonmember activity with a profit motive before it can
properly deduct its losses under section 512(a)" (877 F.2d at 754).
The court grounded that conclusion both upon the language of the
statute, which limits a social club's deductions to those "allowed by
this chapter," and upon the statute's legislative history, which
indicates that a social club's nonexempt income should be taxed
according to the same principles that apply generally to other
taxpayers under the Code.  In particular, the court found that Section
512(a)(3) incorporates the principles applicable to Section 162, so
that expenses of the kind claimed by petitioner are deductible (in
excess of gross receipts) only if the operation is conducted with a
profit motive (ibid.).

   The Ninth Circuit in North Ridge proceeded to hold that the profit
motive test imposed as a condition to deducting excess expenses of a
nonmember activity under Section 512(a)(3) is not satisfied unless a
social club conducts that activity for "the production of gains in
excess of all direct and indirect costs" (877 F.2d at 756).  The court
specifically rejected the Tax Court's view that a club's "intent to
derive economic benefit from nonmember activity, before considering
indirect costs," can satisfy the profit motivation requirement of the
statute (ibid.).  The court concluded that the Tax Court's
interpretation of the statute would erroneously allow a portion of the
club's nonexempt income to go untaxed, thus "manifestly" producing
"the sort of tax-free subsidy to social club members that section
512(a) sought to prevent" (ibid.).

   In this case, the court of appeals stated that the Tax Court had
"appl(ied) the same standards we rejected in North Ridge," and
accordingly it reversed (Pet. App. 2a).  The court remanded to the Tax
Court "for a determination of whether (petitioner) engaged in its
non-member activities with the intent required under North Ridge to
deduct its losses from those activities" (id. at 3a).  /7/

                          SUMMARY OF ARGUMENT

   A. 1. Since 1950, tax-exempt organizations have been subject to tax
on certain income unrelated to their exempt purposes.  The general
operation of the relevant Code provisions is to classify some of the
organization's income as "unrelated business taxable income," and then
to tax that income in conformity with the same principles applicable
to other taxpayers.  In 1969, Congress enacted Section 512(a)(3) of
the Code, which differentiates the tax treatment of social clubs from
that of most other tax-exempt organizations.  Congress determined that
it was inconsistent with the rationale for the tax exemption of social
clubs to allow them to use tax-exempt outside income to subsidize the
recreational activities of their members.  Accordingly, it provided
that all income received by a social club from a nonmember source,
including passive investment income, would be subject to the tax on
unrelated business income.  This provision deliberately expands the
income tax base for social clubs as compared to most other tax-exempt
organizations, which are taxed only on income produced by an unrelated
"trade or business" (I.R.C. Section 512(a)(1)).

   The principle that tax-exempt organizations are to be taxed on
their nonexempt income in essentially the same manner as other
taxpayers was made fully applicable to social clubs.  Thus, Section
512(a)(3) does not independently render any particular expenses
deductible from a social club's taxable gross income;  rather, like
the parallel provision applicable to other tax-exempt organizations,
it addresses the question of allowable deductions by cross-reference.
A social club's nonexempt gross income may be reduced by "the
deductions allowed by this chapter (Chapter I of the Code) which are
directly connected with the production of the gross income."

   2. Petitioner must demonstrate that its nonmember activity was
conducted with a profit motive in order to deduct its excess expenses
against unrelated investment income.  For purposes of deducting
expenses, the Code generally draws a distinction between activities
that are undertaken for profit and those that are not.  Although the
gross income from any activity may be reduced by the expenses incurred
to produce that income, excess expenses of an activity (which produce
tax "losses") may be deducted from income derived from other sources
only if the activity is intended to produce a profit.  Because Section
512(a)(3) limits a social club's deductions to those "allowed by this
chapter," this distinction is controlling here.

   As petitioner acknowledges (Br. 10), the expenses that it seeks to
deduct here are almost entirely "business expenses," such as payroll,
insurance, and cost of goods sold.  These expenses are rendered
deductible under the Code, if at all, only by Section 162 and related
provisions, which allow such deductions if incurred in a "trade or
business." And it is well settled that the existence of a profit
motive is essential to finding that an activity constitutes a "trade
or business." Thus, in the absence of a profit motive, deductions of
the kind of expenses at issue here are not "allowed by (Chapter 1)" of
the Code and therefore are not allowable to petitioner.

   B. The court of appeals correctly rejected petitioner's contention
that its nonmember activity was profit-motivated because it was
designed to produce gross receipts in excess of variable costs, albeit
not in excess of the sum of variable costs and the fixed costs
allocated as "directly connected" (Section 512(a)(3)) with that
activity.  The established approach for determining the existence of a
profit motive is to examine the taxpayer's intent to generate gross
receipts that will exceed all properly allocated expenses -- both
fixed and variable.  Distinguishing between these two kinds of
expenses is potentially significant in a "dual use" situation such as
this one or, more typically, where a taxpayer uses property primarily
for personal reasons but also to produce income.  The courts have
consistently held in the latter situation that it is not sufficient to
establish profit motive for the taxpayer to show merely that he
engages in an income-producing activity to defray the expenses of
maintaining the property -- such as renting a vacation home that is
primarily held for personal use.  The mere fact that the rental or
other activity may bring in funds in excess of variable costs does not
establish a profit motive that would allow the taxpayer to deduct
excess expenses (whether variable or fixed) against unrelated income.

   Petitioner's position also should be rejected because it rests on
an inherent contradiction.  The fundamental premise of petitioner's
claim is that the expenses it seeks to deduct -- including an
allocated portion of the fixed expenses -- were "directly connected"
with the production of nonmember income.  Petitioner should not then
be permitted to reverse its field and maintain that these "directly
connected" expenses are to be disregarded in the profit motive
calculation.  Either the allocable portion of the fixed expenses are
"ordinary and necessary costs of generating" the nonmember income
(Pet. Br. 33) or they are not.  Moreover, the consequence of
petitioner's interpretation would be to allow most social clubs, by
engaging in the common practice of providing some goods and services
to nonmembers, to utilize their normal overhead expenses to eliminate
the tax on their investment income -- thereby subverting the specific
purpose for which Section 512(a)(3) was enacted.

                               ARGUMENT

   PETITIONER'S REPORTED NET LOSSES FROM SALES OF FOOD AND DRINK TO
NONMEMBERS MAY NOT BE USED TO REDUCE ITS UNRELATED INVESTMENT INCOME

   In Sections 511-513 of the Code, Congress has established a
comprehensive scheme governing the taxation of some of the income
received by organizations that are generally tax-exempt under Section
501(c).  For most of these organizations, Congress has determined that
income generated by an unrelated trade or business should be taxable,
but passive investment income should be tax-exempt.  For social clubs
like petitioner, however, Congress has determined that investment
income should also be taxable, and it enacted a separate provision of
the Code, Section 512(a)(3), to accomplish that goal.  Petitioner here
argues for a statutory interpretation that would substantially defeat
that congressional determination -- by allowing social clubs pursuing
their usual activities to escape taxation on their investment income.

   It is a common practice for social clubs periodically to make their
facilities and food services available to nonmembers for a fee, in
order to raise money to defray the expenses of operating the club.
Petitioner maintains that, through an allocation of its fixed
operating expenses to such nonmember sales, it can treat this activity
as generating tax losses that completely eliminate taxation of its
investment income.  If correct, this approach would allow social clubs
routinely to use untaxed income from their investments to subsidize
their members' recreational activities -- in clear derogation of
Congress's specific decision to the contrary.

   But petitioner's analysis is fallacious.  It is able to read
Section 512 to accomplish this result only by disregarding settled
rules regarding the deductibility of expenses or by manipulating the
allocation of expenses to the nonmember sales in a manner that
violates both traditional tax analysis and basic principles of
consistency.  Specifically, petitioner argues that social clubs have
been granted a unique exemption from the generally applicable
limitation that certain kinds of expenses are deductible only if
incurred in connection with profit-motivated activity.  And,
alternatively, petitioner contends that it can demonstrate the
existence of a profit motive by disregarding the fixed expenses
allocated to its nonmember activity, while at the same time employing
an allocable share of those fixed expenses to generate the tax losses
that it seeks to use to shelter its investment income.  Both
contentions violate basic tax principles embodied in Section 512(a)(3)
and would eviscerate the congressional policy underlying that
provision.

   A. A Social Club May Not Offset Against Its Investment Income Net
Losses From Nonmember Sales Activity That Is Not Conducted With A
Profit Motive

   Petitioner acknowledges (Br. 10) that the expenses of its nonmember
sales activity that it seeks to deduct from its investment income --
such as cost of goods sold, payroll, depreciation, insurance, and
similar items (see Pet. App. 11a) -- are "the types of corporate
expenses" whose deductibility ordinarily must be grounded in Section
162 and related provisions of the Code allowing certain deductions for
"business expenses." See also Br. 21-22.  Petitioner also recognizes
that, under the Code in general, "a profit motive is a necessary
factor in determining whether an activity is a trade or business" (Br.
23;  see also id. at 10, 22).  But petitioner disputes the logical
consequence of these principles -- namely, that a social club cannot
deduct from investment income such "business expenses" of its
nonmember activity unless that activity is profit-motivated.  Instead,
petitioner argues (Br. 16-35) that Section 512(a)(3) confers a unique
tax benefit upon social clubs by enabling them to take deductions not
allowed to other taxpayers, i.e., unlimited "business expense"
deductions incurred in an activity not conducted for the purpose of
making a profit.  This contention is antithetical to the very reason
for the existence of Section 512(a)(3).  That provision was designed
to subject social clubs to a greater tax burden than other tax-exempt
organizations, not to give them a special tax benefit.  Petitioner's
interpretation is not supported by either the language or legislative
history of the provision, and it was correctly rejected by the court
of appeals.

   1. Section 512(a)(3) Differentiates The Tax Treatment Of Social
Clubs From Other Tax-Exempt Organizations By Making Their Passive
Investment Income Taxable While Preserving The Rule That Deductions
Generally Available To Other Taxpayers Under Chapter 1 Of The Code May
Be Taken If Directly Connected To The Taxable Activity

   Congress first imposed the "unrelated business income tax" upon
tax-exempt organizations as part of the Revenue Act of 1950, ch. 994,
64 Stat. 906, in response to the concern that some of those
organizations were gaining an unfair advantage from their tax-exempt
status by carrying on businesses in competition with taxpaying
corporations.  See generally United States v. American College of
Physicians, 475 U.S. 834, 837-838 (1986);  United States v. American
Bar Endowment, 477 U.S. 105, 109-110 (1986).  The tax is imposed, at
regular corporate rates, on the "unrelated business taxable income" of
organizations that otherwise qualify for tax exemption.  For most
categories of tax-exempt organizations (but excluding social clubs),
the term "unrelated business taxable income" is generally defined by
Sections 512(a)(1) and 513 to mean income from a "trade or business *
* * regularly carried on" that is not substantially related to the
exempt purpose of the organization, reduced by deductions "allowed by
this chapter which are directly connected with the carrying on of such
trade or business." Section 512(b)(1) expressly excludes dividends,
interest, and other investment income from the reach of the tax.  The
reason for this dichotomy is that passive sources of funding are not
regarded as creating unfair competition with taxpaying businesses, and
hence taxation of investment income would not serve the purpose for
which the tax was imposed.  See S. Rep. No. 2375, 81st Cong., 2d Sess.
30-31 (1950).

   Social clubs were first subjected to the unrelated business income
tax in 1969, when the scope of the tax was extended to virtually all
tax-exempt organizations.  Tax Reform Act of 1969, Pub. L. No. 91-172,
Section 121(a)(1), 83 Stat. 536.  Congress determined, however, that
social clubs should receive different, and somewhat less favorable,
tax treatment than other tax-exempt organizations -- specifically,
that their investment income should also be taxed.  Accordingly,
Section 121(b)(1) of the 1969 Act (83 Stat. 537) added Section
512(a)(3), which provides a separate and more inclusive definition of
"unrelated business taxable income" for social clubs and certain other
tax-exempt membership groups.  /8/ Under that definition, a social
club's "exempt function income," such as membership dues and other
payments that it receives from members in exchange for rendering
social and recreational services to them or their guests, is excluded
from unrelated business income tax.  The tax is imposed, however, on
the remainder of the club's "gross income * * * less the deductions
allowed by this chapter (Chapter 1 of the Code, Sections 1-1399) which
are directly connected with the production of the gross income"
(Section 512(a)(3)(A)).  Thus, in contrast to most other tax-exempt
organizations, social clubs are taxed on all income from nonmembership
sources, whether or not produced by a trade or business;  both income
received from sales of goods and services to nonmembers and income
from interest and dividends accruing upon the club's investments are
subject to the tax.  The deductions allowed to be taken from this
expanded definition of gross income are analogous to those provided to
other organizations -- expenses may be deducted only if they are
"directly connected" with the production of the taxable income and are
otherwise allowable under Chapter 1 of the Code.

   The reason for the distinction between social clubs and other
tax-exempt organizations was explained in detail in the legislative
history of Section 512(a)(3).  Social clubs receive a tax exemption,
not because they provide a public service to the community, but rather
on the basis of their serving the mutual interests of their members.
Congress has allowed the members of social clubs to pool their
resources for their mutual benefit without having adverse tax
consequences attach from the use of a corporation for that purpose.
See generally B. Hopkins, The Law of Tax-Exempt Organizations 340-341
(5th ed. 1987).  Profits generated by the provision of club services
to members are used to benefit the members and therefore fall within
the rationale of the tax exemption.  But profits received from
nonmember sources are an outside subsidy for the recreational
activities of the members, and therefore the rationale for the tax
exemption does not apply to such profits.  Specifically, Congress
determined that "all income (of social clubs) other than that derived
from rendering services to the members" should be taxed because "where
a social club has income from interest, dividends, rents, royalties,
etc., this income reduces the members' costs below the actual cost of
providing the personal facilities made available by the organization"
(H.R. Rep. No. 413, 91st Cong., 1st Sess. Pt. 1, at 47 (1969)).  The
committee reports further commented that "the tax exemption operates
properly only when the sources of income of the organization are
limited to receipts from the membership," and characterized extension
of the exemption to investment income as "a distortion of its
purposes" (id. at 48;  S. Rep. No. 552, 91st Cong., 1st Sess. 71
(1969)).  /9/

   In broadening the definition of taxable income for social clubs
beyond activities that qualify as a "trade or business," Congress
correspondingly broadened the deductions available to social clubs as
compared with those allowable to other tax-exempt organizations.  It
did not, however, change the kind of deductions that may be taken.
Section 512(a)(3) allows a social club to deduct expenses directly
connected with the production of all gross income (other than exempt
function income), including expenses connected with activity that does
not rise to the level of a trade or business.  But Congress retained
in Section 512(a)(3) the limitation that the permitted deductions are
those "allowed by this chapter." /10/ Thus, the deductions allowed in
connection with the expanded definition of taxable income for social
clubs are analogous to those provided to other tax-exempt
organizations -- expenses may be deducted only if they are "directly
connected" with the production of the taxable income and are otherwise
allowable under Chapter 1 of the Code.  Neither Section 512(a)(1), for
most tax-exempt organizations, nor Section 512(a)(3), for social
clubs, independently renders deductible an expense that would not
otherwise be deductible for other taxpayers under Chapter I of the
Code.  See generally 4 B. Bittker, Federal Taxation of Income, Estates
and Gifts Paragraph 102.4.4, at 102-26 (1981) (social club may deduct
"otherwise allowable deductions directly connected" with production of
nonexempt income).  /11/

   2. Because Section 512(a)(3) Provides No Authority For Deductions
Not Permitted In Other Contexts By Chapter 1 Of The Code, Petitioner's
Excess "Business Expenses" Are Not Deductible Unless They Are Incurred
In Connection With Profit-Motivated Activity

   a. The deduction provisions of Chapter 1 of the Code draw a
fundamental distinction between activities that are undertaken for
profit and those that are not.  In effect, the Code treats a taxpayer
as having two personalities -- "one is (as) a seeker after profit who
can deduct the expenses incurred in that search;  the other is (as) a
creature satisfying his needs as a human and those of his family but
who cannot deduct such consumption and related expenditures." United
States v. Gilmore, 372 U.S. 39, 44 (1963) (brackets in original)
(quoting S. Surrey & W. Warren, Cases on Federal Income Taxation 272
(1960)).  The Code specifically enumerates a few expenses -- such as
interest, taxes, and casualty losses -- that can be deducted in
computing taxable income even if they do not relate to profit-seeking
endeavor.  See I.R.C. Sections 163, 164, 165(c).  Apart from specific
exceptions, however, excess expenses of a not-for-profit activity
cannot be applied to offset taxable income from other sources.  See
generally 1 B. Bittker & L. Lokken, Federal Taxation of Income,
Estates and Gifts Paragraphs 20.1.1, 22.5.4 (1989);  note 6, supra.

   Among the most important of the provisions of Chapter 1 to which a
profit-motive limitation applies is Section 162, which grants a
deduction for "the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business." The
indicia of a "trade or business" for purposes of Section 162 include
the regularity, continuity, and extensiveness of a taxpayer's
commercial activities.  See, e.g., McDowell v. Ribicoff, 292 F.2d 174,
178 (3d Cir.), cert. denied, 368 U.S. 919 (1961).  But "(i)t is well
established that the existence of a genuine profit motive is the most
important criterion for the finding that a given course of activity
constitutes a trade or business." Lamont v. Commissioner, 339 F.2d
377, 380 (2d Cir. 1964) (citing cases);  see also Independent Elec.
Supply, Inc. v. Commissioner, 781 F.2d 724, 726 (9th Cir. 1986)
(existence of profit motive is "primary inquiry").  Noting the
"voluminous jurisprudence" to that effect, this Court has recognized
that "(t)he standard test for the existence of a trade or business for
purposes of Section 162 is whether the activity 'was entered into with
the dominant hope and intent of realizing a profit.'" United States v.
American Bar Endowment, 477 U.S. at 110 n.1 (quoting Brannen v.
Commissioner, 722 F.2d 695, 704 (11th Cir. 1984)).  Accord,
Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987) ("the taxpayer's
primary purpose for engaging in the activity must be for income or
profit" if it is to qualify as a trade or business);  see also Pet.
Br. 23.  /12/

   b. Petitioner acknowledges (Br. 10) that the expenses it treated as
"directly connected" with its sales of food and drink consist almost
entirely of the kind of expenses rendered deductible, if at all, by
Section 162 and related provisions of the Code -- i.e., they are
"business" expenses, such as payroll, depreciation, insurance, and
cost of goods sold.  See Pet. App. 11a.  Under the established rules
of Chapter 1, excess expenses of that kind may not be deducted from
other income of the taxpayer unless they are sustained in an activity
that is intended to make a profit.  Section 512(a)(3) expressly
incorporates the rules generally governing deductions permitted by
Chapter 1, and therefore petitioner may not use excess expenses from
its nonmember sales to reduce its taxable investment income, unless it
engaged in that sales activity with a profit motive.  No provision of
the Code -- neither Section 512(a)(3) nor anything elsewhere in
Chapter 1 -- authorizes the deduction of excess "business" expenses
incurred in an activity not motivated for profit.

   Moreover, if this profit-motive limitation were not retained in
Section 512(a)(3), the statute would not achieve its basic goal of
putting the members of a social club on an equal footing with other
taxpayers with respect to the club's income from sources outside the
membership, specifically including income from investments.  The
underlying policy reason for the enactment of Section 512(a)(3) would
also be defeated.  If a social club could eliminate taxation of its
investment income by means of a deduction that would be denied to
other taxpayers -- i.e., a deduction of excess "business" expenses
incurred in a not-for-profit activity -- it could thereby use
tax-exempt investment income to subsidize the recreational activities
of the members.  That is precisely the result Congress sought to avoid
by enacting Section 512(a)(3) because it recognized that this would
give the members of social clubs an unfair tax "advantage" over other
taxpayers who, "without the intervening separate organization," must
spend after-tax earnings on recreational pursuits.  See H.R. Rep. No.
413, supra, at 48;  S. Rep. No. 552, supra, at 71.  Thus, both the
language and the purpose of Section 512(a)(3) require that social
clubs be subject to the same profit motive limitations that govern
deductions generally made available to other taxpayers in Chapter 1 of
the Code.

   The courts of appeals that have construed Section 512(a)(3), with
the exception of the Sixth Circuit in Cleveland Athletic Club, Inc. v.
United States, 779 F.2d 1160 (1985) (see note 15, infra), haave
recognized that it should not be read to eliminate the profit motive
limitation on the deductibility of "business" expenses.  In North
Ridge Country Club v. Commissioner, 877 F.2d 750, 754 (1989), the
Ninth Circuit concluded that it would be "at odds with the language of
section 512(a)(3)(A) to permit the Club to deduct losses from
nonmember activities without grounding the deduction on a provision of
Chapter 1 of the Code." The court explained that the only provision of
Chapter 1 that could authorize deduction of the losses claimed by the
club in that case -- losses indistinguishable from those claimed by
petitioner here -- was Section 162, "which requires a profit motive."
Ibid.  And the court also observed that an interpretation that failed
to retain the profit motive requirement would contravene the very
purpose for enactment of Section 512(a)(3) because it would confer an
unwarranted tax benefit upon social clubs (ibid.):

      Congress sought to eliminate the differences between the tax
      treatment afforded individuals seeking independent recreation,
      and the treatment given to those seeking recreation through a
      social club.  It is contrary to this purpose to read section
      512(a) to allow social clubs to deduct losses in activities not
      entered into for profit, while denying individuals the same
      deduction.

   In The Brook, Inc. v. Commissioner, 788 F.2d 833 (1986), the Second
Circuit also concluded that the language and underlying policy of
Section 512(a)(3) preclude a social club from reducing its investment
income by the net losses generated by nonmember activity not conducted
for profit.  Construing the "plain language and legislative history of
Section 512(a)(3)(A)," the court held that a social club is "required
to establish that Section 162 of Chapter 1, which is incorporated by
reference in Section 512(a)(3)(A), authorizes its deduction from its
investment income of the losses suffered from its serving of meals to
non-members." 799 F.2d at 838.  That requirement, the court continued,
means that the expenses may be deducted "only if the taxpayer engaged
in the activity with the intention of making a profit" (ibid.).  The
court further observed that the contrary interpretation "would negate
Congress' express purpose that social clubs be treated neutrally with
respect to their unrelated business income and neither suffer nor
benefit under the Code" (ibid.).  If Section 512(a)(3) did not include
the profit motive limitation on the deductibility of "business
expenses," it would grant social clubs a special tax advantage "by
allowing them to take Section 162 deductions unavailable to other
taxpayers, i.e., for expenses incurred in activities not engaged in
for a profit" (799 F.2d at 839).  Accordingly, the court below was
entirely correct in reaffirming its prior holding in North Ridge that
"a social club must pursue a nonmember activity with a profit motive
before it can properly deduct its losses under section 512(a)" (877
F.2d at 754).

   3. Petitioner Misreads The Statute In Contending That Section
512(a)(3) Creates A Special Rule For Social Clubs That Eliminates The
Profit Motive Requirement For The Deduction Of Excess "Business
Expenses"

   Petitioner has not questioned that the interpretation of Section
512(a)(3) by the court below best effectuates the policy concern that
led Congress to enact the provision -- namely, to prevent social clubs
from using tax-free investment income to subsidize their members'
recreational activities.  Indeed, petitioner does not appear to take
issue with the Ninth Circuit's observation in North Ridge that the
interpretation of the statute proffered by the taxpayer in that case
(indistinguishable from petitioner's) would yield "the sort of
tax-free subsidy to social club members that section 512(a) sought to
prevent" (877 F.2d at 756).  Moreover, petitioner concedes that, under
the terms of Section 512(a)(3), deductible "expenses must be of a kind
which is allowed as a deduction to a business under Chapter 1 of the
Code" (Pet. Br. 21-22 (emphasis added)), and it recognizes (id. at 10,
22-23) that, apart from social clubs, no taxpayer, including a
tax-exempt organization governed by Section 512(a)(1) (Br. 19), is
permitted to deduct excess expenses of this sort unless they are
incurred in a profit-motivated activity.  Petitioner's principal
contention therefore (Pet. 16-35) is that, regardless of the policies
underlying Section 512, the text of the statute (read literally but
not "too literally" (see Pet. Br. 27, 28)) necessarily creates a
unique tax benefit for social clubs -- one that permits them to deduct
(against unrelated investment income) excess "business expenses"
incurred in an activity not motivated by profit.  This contention
simply misinterprets the language of Section 512(a)(3);  nothing in
that provision, which was enacted to subject social clubs to a greater
tax burden than other tax-exempt organizations, has the effect of
conferring upon social clubs a special tax benefit not available to
other taxpayers.

   a. Petitioner's primmary contention (Br. 16-26) is that, because
Section 512(a)(3) taxes income that is derived from activity not
rising to the level of a trade or business and allows associated
deductions, the provision necessarily eliminates any requirement that
"business" expenses actually be incurred in connection with a
business, i.e., a profit-motivated activity.  Petitioner buttresses
this contention by arguing that, because all of this nonexempt income
has been classified as "unrelated business taxable income" for
purposes of levying the tax, all nonexempt activities of social clubs
"are by definition unrelated business activities" (Br. 22).  "Where
Congress has defined an activity as a 'business,'" petitioner
continues, "there is no need to test the activity further for profit
motivation" (Br. 23).  Petitioner also ascribes great significance to
the absence from Section 512(a)(3) of the phrase "trade or business"
(Br. 23-26).

   Petitioner's analysis suffers from two major flaws:  First, it
ignores the historical context of Section 512(a)(3) and the logical
reasons why the language upon which petitioner relies was chosen;
second, it disregards -- indeed, nullifies -- the one phrase in
Section 512(a)(3) that is specifically addressed to the question of
what expenses are deductible -- viz., "the deductions allowed by this
chapter."

   As we have noted (p. 15, supra), Congress first determined in 1950
to tax some of the income of certain tax-exempt entities.  At that
time, the only kind of income taxed was income derived from a "trade
or business" unrelated to the organization's exempt purposes, and that
income was referred to in the statute as "unrelated business taxable
income." When Congress determined in 1969 that social clubs should be
taxed on a broader class of income, including investment income, it
accomplished that goal within the existing statutory framework of
Sections 511-513 by providing that such income "would be treated and
taxed as business income" (H.R. Rep. No. 413, supra, at 47).  The
statute continues to use the term "unrelated business taxable income"
to describe the taxable income of social clubs simply because that was
the term historically used with respect to other tax-exempt
organizations to identify the base on which the unrelated business
income tax was imposed.  Congress manifestly did not intend that
non-business activity -- such as management of investments or activity
not motivated by profit -- would be transformed by Section 512(a)(3)
into a "trade or business" for all purposes.

   Similarly, the differences in language between the definitions of
taxable income for social clubs (Section 512(a)(3)) and for other
tax-exempt organizations (Section 512(a)(1)) do not operate to
eliminate for social clubs the profit motive requirement for the
deduction of "business expenses." Prior to 1969, only income derived
from a "trade or business" was subject to the unrelated business
income tax.  It logically followed that the only allowable expense
deductions should be for those "connected with the carrying on of such
trade or business," as Section 512(a)(1) provided.  The motivation for
enacting Section 512(a)(3) was to expand for social clubs the kinds of
income that would be subject to taxation;  once the source of taxable
income was no longer restricted to that derived from a "trade or
business," Congress naturally also removed the restriction that
deductions be connected to a "trade or business." But while this
change allowed social clubs to deduct from their nonbusiness income
expenses that the Code generally allows other taxpayers to deduct from
such income (e.g., certain taxes and interest), it plainly was not
designed to give social clubs the right to deduct excess "business"
expenses connected with nonbusiness (i.e., not-for-profit) activity.
/13/ As the Second Circuit stated in The Brook, 799 F.2d at 841, "it
may not * * * be inferred from the difference in language between
Section 512(a)(1) and Section 512(a)(3) that Congress intended social
clubs to be relieved from the requirements of Section 162 so that they
would receive an advantage over other taxpayers claiming deductions
under that provision." Rather, "the difference is rooted in Congress'
intent to tax entities such as social clubs more comprehensively than
charitable and religious organizations, which are dedicated to more
altruistic purposes." Id. at 840;  see also North Ridge, 877 F.2d at
753-754.  /14/

   Moreover, by expressly limiting deductions under Section 512(a)(3)
to those "allowed by this chapter," Congress ensured that social clubs
could not take deductions against their nonexempt income that would be
unavailable to other taxpayers -- including deductions for "business
expenses" not incurred in a profit-motivated activity.  Although
petitioner has conceded that the requirement that deductions be
"allowed by this chapter" is one "prong" of a "two prong" test under
Section 512(a)(3) (see Pet. Br. 21-22), petitioner's theory would
effectively nullify that requirement.  Under petitioner's reading of
the statute, every ordinary and necessary expense connected with the
production of a social club's non-exempt income would automatically be
converted into a deductible business expense that satisfies the
"allowed by this chapter" limitation, irrespective of whether the
expense would qualify for deduction under Section 162 or another
provision of Chapter 1.  A test that is always satisfied is no test at
all.  Furthermore, petitioner's interpretation would violate what it
concedes is one of the basic commands of Section 512(a)(3) -- that a
social club's nonexempt activities "are subject to tax in the same
manner as any taxable business is taxed" (Pet. Br. 20).  In sum, both
the statutory text and its underlying policy are inconsistent with
petitioner's contention that Section 512(a)(3) excuses social clubs
from the general rule that "business expenses" may be deducted only if
incurred in connection with a profit-motivated activity.  /15/

   b. Petitioner contends (Br. 29-32) that Section 512(a)(3)
contemplates that a social club should "aggregate" its expenses,
instead of breaking them down on an activity-by-activity basis, and
therefore that net losses from its nonmember sales automatically
reduce its investment income, without the need for any inquiry into
profit motive.  Otherwise, petitioner maintains, social clubs would be
disadvantaged in comparison with nonexempt taxpayers who allegedly
"are allowed to deduct net losses from one business activity against
net income from a different business activity" (Br. 30).  As an
example, petitioner invokes the case of a gambling establishment that
consistently incurs losses from serving food and drink to patrons of
the casino;  the business would not be prevented from offsetting those
losses against its casino income.  This argument is misconceived.

   Contrary to petitioner's contention, the decision of the court of
appeals does tax social clubs on their nonexempt income according to
the same rules that apply to other taxpayers.  The reason that a
gambling casino is able to deduct excess expenses of its food and bar
service is because of the close business connection with its gambling
operations;  the food service is designed to facilitate the production
of income from the gambling operation.  In short, the two activities
should not be viewed separately;  they are part and parcel of the same
business.  By contrast, there is no connection between petitioner's
meal service and the production of the interest income that accrues
upon its investments.  Where there exists a sufficient nexus, losses
from one component of an activity appropriately can be netted against
gains from another component of the same activity without examining
each separately for profit-motivation.  Cf. Treas. Reg. Section
1.183-1(d)(1) (operations bearing sufficient "economic
interrelationships" comprise one "activity" for purposes of combining
gains and losses);  1 B. Bittker & L. Lokken, supra, at Paragraph
22.5.3.  Because petitioner's sale of food and drink to nonmembers
constitutes an entirely separate activity from its receipt of income
from a savings account, this kind of netting to enable petitioner to
shelter its investment income is improper.

   More generally, neither the statute (see Pet. Br. 25 & n.15) nor
the Commissioner's proposed regulation concerning social clubs (see
Pet. Br. 30-32) supports petitioner's contention that expenses are to
be aggregated in a way that does not require consideration of profit
motive.  Prop. Treas. Reg. Section 1.512 (a)-3(b), 36 Fed. Reg. 8806
(1971) (which petitioner concedes had no force or effect (see Pet. Br.
32 n.23) and has been withdrawn), stated that the unrelated business
taxable income of a social club deriving income from more than one
source "is computed by aggregating its gross income from all such
sources and by aggregating its deductions allowed with respect to such
gross income" (Prop. Treas. Reg. Section 1.512(a)-3(b)(3) (emphasis
added)).  Because the proposed regulation addressed the aggregation
only of deductions that are "allowed," it did not suggest that
petitioner could mingle losses from its nonmember sales activity
together with income from its investments, if the sales activity were
not engaged in with a profit motive.  In accordance with the text of
the statute, the word "allowed" in the proposed regulation must be
read in the context of the regulation's general statement that, "to be
deductible in computing unrelated business taxable income (under
Section 512(a)(3)), expenses, depreciation, and similar items * * *
must qualify as deductions under chapter 1 of the Code" (Prop. Treas.
Reg. Section 1.512(a)-3(b)(1).  See also Prop. Treas. Reg. Section
1.512(a)-3(b)(2) (expense must be "otherwise allowable under chapter 1
of the Code").  Unless petitioner's nonmember sales activity is
carried on with an intent to make a profit, the expenses allocated to
that activity are "allowed" only to the extent of offsetting the
income that it produces;  no excess expenses are "allowed" to be
deducted and hence there is no available loss that can even enter into
the aggregation process.  See The Brook, 799 F.2d at 838 (social club
is entitled to "aggregate deductions * * * as permitted by Section 162
to other taxpayers");  North Ridge, 89 T.C. at 571-572 (social club's
income production must be broken down on activity-by-activity basis so
that profit motive for each activity can be determined).  /16/

   Finally, petitioner argues (Br. 33) that it is irrational to
prevent it from deducting, even for the purpose of sheltering
investment income, all of the expenses that it allocates to its
nonmember sales because those expenses "are the ordinary and necessary
costs of generating the economic gains which were provided by the
unrelated business activities." This description obscures the true
effect of petitioner's claimed deduction and the extent to which it
subverts the statutory purpose.  The Commissioner does allow
petitioner to offset the ordinary and necessary costs of generating
"economic gains" against its nonmember sales receipts.  So long as the
gross receipts do not exceed the costs of that activity, the
Commissioner would not require petitioner to recognize any net income
from the activity and would not collect any tax upon it.  But
petitioner is not satisfied with this tax treatment.  Petitioner seeks
to use the allocated fixed costs not simply to offset its income from
the activity, but rather to generate "tax losses," which it can then
use to offset its unrelated investment income.  A deduction of that
sort must be authorized by Section 162, which means that the activity
generating the losses must be conducted with a profit motive.

   B. An Activity Is Not Motivated By Profit When It Is Not Intended
That The Gross Receipts From That Activity Will Exceed The Expenses
Properly Allocable To It, Both Fixed And Variable

   Petitioner's secondary argument (Br. 35-48) is that, even if a
profit motive is required for it to deduct the excess expenses of its
nonmember sales, it has demonstrated such a profit motive because it
intended the nonmember activity to produce "economic gain" -- defined
as gross receipts in excess of variable costs of the activity.  In
other words, petitioner argues that, even though it has allocated a
portion of the fixed expenses to its nonmember sales in order to
generate steady losses (totalling more than $400,000 for the years
1974-1984 (J.A. 91)), those expenses can be completely disregarded in
testing the nonmember sales activity for the profit motive necessary
to establish deductibility because the fixed expenses would be
incurred even if there were no nonmember sales activity.

   The court of appeals correctly rejected this contention.  The
established approach for determining profit motivation in resolving
whether an activity is a "trade or business" is to compare gross
receipts with all properly allocated expenses, fixed as well as
variable.  There is no support for petitioner's assertion that the
profit motive inquiry should exclude one segment of the economic costs
of producing income -- the allocable portion of fixed costs.

   Indeed, petitioner's argument rests on an inherent contradiction.
The net losses reported from the nonmember sales that petitioner seeks
to offset against its investment income result from petitioner's
allocation of a portion of the fixed expenses as "directly connected"
to that nonmember activity (I.R.C. Section 512(a)(3)).  If these
expenses are directly connected to the production of nonmember income,
there is no logical justification for excluding them from the cost
calculation when trying to determine whether that activity is
profit-motivated.  Finally, allowing petitioner to manipulate the
fixed expense allocation in this manner would eviscerate the
effectiveness of the statute.  Petitioner's argument would make it
relatively easy for any social club to allocate fixed expenses to
nonmember activity so as to generate net losses from that activity
that could then be used to eliminate the tax on the club's investment
income.

   1. Petitioner's interpretation of profit motive finds no support in
other contexts.  The standard approach for deciding whether an
activity is conducted with the profit motivation required to
constitute a "trade or business" is to measure gross receipts against
all of the expenses of the activity, drawing no distinction based on
whether the expenses are fixed or variable.  On many occasions, the
courts of appeals have identified "profit" for these purposes with
"taxable income," which necessarily contemplates reduction of gross
income by both fixed and variable expenses.  In Hirsch v.
Commissioner, 315 F.2d 731, 736 (1963), the Ninth Circuit observed
that the primary inquiry when determining whether a particular
activity constitutes a trade or business under Section 162 is whether
it was "entered into, in good faith, with the dominant hope and intent
of realizing a profit, i.e., taxable income, therefrom." Accord,
Independent Elec. Supply, Inc. v. Commissioner, 781 F.2d at 726;
Bessenyey v. Commissioner, 379 F.2d 252, 256 n.5 (2d Cir.), cert.
denied, 389 U.S. 931 (1967);  Weir v. Commissioner, 109 F.2d 996, 998
(3d Cir.), cert. denied, 310 U.S. 637 (1940).  Similarly, in Miller v.
Commissioner, 836 F.2d 1274, 1278-1279 (1988), the Tenth Circuit
reasoned that the phrase "transaction entered into for profit" in
Section 165(c) of the Code connotes "an ultimate objective of
producing taxable income." And numerous decisions construe the
business deduction provisions of the Code to disallow, for failure to
satisfy the profit motive requirement, losses from activities that
produce some gross income, but not enough to recoup all the related
expenses.  See The Brook, 799 F.2d at 838-840 (collecting cases).

   The salient feature of this case is that, according to petitioner's
reported allocation, the fixed expenses are incurred in connection
with two very different purposes -- primarily in connection with the
exempt purpose of furthering the social and recreational interests of
the club's members, and partially in connection with the nonmember
sales.  The primary reason for the nonmember sales activity is to
produce a positive "cash flow" (an excess of gross receipts over the
extra expenses occasioned by the sales) that will help to defray some
of the fixed costs that are being incurred anyway.  See Pet. Br.
38-39, 46-47.  This situation is closely analogous to the relatively
common "dual use" situation where fixed overhead may be regarded as
being expended both for personal reasons and for income production.
There are many cases where a taxpayer owns property (such as a farm,
yacht, or vacation home) primarily for personal reasons, but in order
to defray the expenses of its maintenance, he also puts the property
to use in an income-producing activity.  In these "dual use" or
"hobby" cases, the secondary activity will help defray expenses by
bringing in gross income that exceeds the variable costs of conducting
that activity;  typically, however, the income will not be sufficient
to cover the sum of the variable expenses and an allocable portion of
the fixed expenses that might be reported as directly connected with
the income-producing activity.  In such a situation, an individual may
offset the expenses of the secondary activity against the income it
produces, but he may not deduct any excess expenses if the activity is
"not engaged in for profit." See I.R.C. Section 183(a) and (c).

   There is no authority suggesting that the portion of the fixed
expenses allocated to the income-producing activity may be ignored in
determining whether the activity is engaged in with an intent to make
a profit, on the ground that those expenses would have been incurred
by the taxpayer anyway in the absence of the income-producing
activity.  To the contrary, because the tax law draws a fundamental
distinction generally allowing deduction of business expenses while
precluding deduction of personal expenses, the nonbusiness origin of
those allocated fixed expenses strongly suggests that they must be
taken into account in making a profit motive determination that will
decide their deductibility.  For example, in Carkhuff v. Commissioner,
425 F.2d 1400 (6th Cir. 1970), the court rejected the taxpayers'
attempt to offset against other income losses generated by
depreciation deductions on a vacation home that was rented for part of
the year.  The court acknowledged that the purpose of renting could
have been to "minimiz(e) the cost of maintaining a resort home" (id.
at 1405), but it held that this desire to produce a positive cash flow
did not demonstrate a "profit motive".  See also Carter v.
Commissioner, 645 F.2d 784, 789 (9th Cir. 1981) (although taxpayers
chartered yacht in an "attempt() to recoup some of their costs," that
does not constitute profit motive);  Antonides v. Commissioner, 893
F.2d 656, 660 (4th Cir. 1990), aff'g 91 T.C. 686, 697 (1988);  Martin
v. Commissioner, 50 T.C. 341, 364 (1968) (same);  cf. also I.R.C.
Section 280A (limiting deduction of expenses connected with rental of
vacation home).  Thus, a mere intent to produce gross receipts in
excess of variable costs is insufficient to establish a "profit
motive." If the rule were otherwise, there would be a large loophole
in the Code enabling individuals to use what are primarily personal
expenses to shelter taxable income.  /17/

   Accepting petitioner's interpretation of profit motive in this
context would open the same kind of loophole in the taxation scheme
for social clubs.  Petitioner has received income from its investments
that is presumptively subject to taxation.  Petitioner then engages in
another activity, sales of food and drink to nonmembers, that
assertedly is designed to defray the costs of operating the club.
Although this activity brings additional funds into the club's coffers
(see Pet. Br. 47), petitioner maintains that the tax effect of this
additional infusion of funds is to eliminate any tax on the investment
income.  This is accomplished by deducting against the investment
income fixed overhead expenses that petitioner acknowledges are
incurred in order to further the club's recreational activities, and
would be incurred irrespective of the club's nonmember activity.
Section 512(a)(3) does not permit this untoward result because "profit
motive" means an intent that an activity produce an excess of gross
income over all the expenses properly allocated to the activity.  To
the extent that an allocable portion of petitioner's fixed expenses is
"directly connected" to its nonmember activity so as to warrant offset
against the gross income generated by that activity, those expenses
must also be considered in determining whether that activity was
engaged in with the requisite profit motive.  See North Ridge, 877
F.2d at 754;  The Brook, 799 F.2d at 839 ("The mere fact that hobbies
generate receipts, or 'economic gain', does not entitle them to
Section 162 tax treatment.").  /18/

   2. Petitioner errs in asserting (Br. 39-42) that its position is
supported by a line of cases stating that the "profit motive" inquiry
should be based on the intent to earn an "economic profit." Despite
the superficial similarlity between the language used in those cases,
which almost all concern tax shelters, and the term "economic gain"
that petitioner uses here, the concepts are quite different.  It is,
to be sure, well established that a taxpayer's profit motive must be
demonstrated in terms of "economic profit" -- in the sense that
accompanying tax benefits are not relevant.  Thus, in the tax shelter
context, where a motive to achieve "economic profit" must be shown in
order to offset a loss against other income, the taxpayer must have
intended his investment to yield profits apart from the tax benefits
generated by the shelter itself (in the form of claimed deductions for
economic losses).  /19/ But those cases do not suggest that fixed
expenses are to be disregarded in determining whether an activity is
conducted for "economic profit." Indeed, those cases do not even arise
in a "dual use" situation, which is essentially the only context in
which the distinction petitioner seeks to draw between fixed and
variable expenses would be significant for tax cases.  Thus, the
authority relied upon by petitioners has no bearing on the question
presented here.  /20/

   Petitioner erroneously contends (Br. 43-46) that the court of
appeals' interpretation of "profit motive" is inconsistent with the
fact thatt many business corporations report large losses on their tax
returns while realizing substantial book profits.  But, in contrast to
this case, such losses do not reflect the economic costs of the
activity in question, but rather the operation of various tax
preferences specifically provided by Congress in the Code.  The
corporate losses cited by petitioner result from accelerated
depreciation, investment tax credits, and other tax preferences and
incentives.  See Citizens for Tax Justice, 130 Reasons Why We Need Tax
Reform 8-10 (July 1986).  The policy underlying such tax incentives is
to stimulate investment and business enterprise by enabling a taxpayer
to report a smaller profit (or larger loss) in a given year than it
actually experiences in economic terms;  indeed, petitioner recognizes
that such deductions used by corporations to generate tax losses do
not "accurately measure net income" (see Pet. Br. 44 n.47).  For
example, accelerated depreciation may allow the cost of property to be
recovered, in the initial years after the property is placed in
service, faster than the property in fact wears out or becomes
obsolete, thus permitting a taxpayer to show a tax loss in a year in
which an investment produces "a positive cash flow" or is
"economically profitable." S. Rep. No. 552, supra, at 212;  see H.R.
Rep. No. 658, 94th Cong., 2d Sess. 30-31 (1976).  /21/

   Thus, these examples are fully consistent with the decision of the
court of appeals that "profit motive" must be determined by taking
into account all of the economic costs associated with the activity --
both fixed and variable.  The losses reported on petitioner's tax
return do not stem from tax preferences not designed to reflect net
income;  rather, they stem from standard "business expenses," such as
payroll, cost of goods sold, insurance, and the like.  See J.A. 52-59,
64-65, 69-72.  /22/ Since petitioner does not intend to receive gross
income in excess of these basic economic costs of its nonmember sales,
it does not conduct that activity with the kind of "profit motive"
needed to allow deduction of business expenses.  /23/

   3. Petitioner's position with respect to the meaning of "profit
motive" rests on an inherent contradiction, and should be rejected for
that reason alone.  Petitioner asserted on its tax returns that the
allocated portion of its fixed expenses were "directly connected with"
(I.R.C. Section 512(a)(3)) the production of gross income from the
nonmember sales.  In petitioner's words, those were "the ordinary and
necessary costs of generating" the income (Br. 33).  When it comes to
the profit motive inquiry, however, petitioner ignores those expenses
-- i.e., it maintains that, despite the nonmember activity, the fixed
expenses were sustained solely in connection with petitioner's
recreational and member functions.  /24/

   Petitioner is simply trying to have it both ways -- insisting that
these fixed costs are actual expenses of its nonexempt activity when
it wants to offset the gross receipts from that activity, and then in
turn denying that these fixed costs are actual expenses when it wants
to demonstrate that it intends the gross receipts from that activity
to exceed expenses (a prerequisite to deducting the excess expenses
against unrelated investment income).  There is no reason to
countenance this manipulation of the fixed expenses to generate either
"profits" or "losses," at petitioner's whim;  either the allocated
fixed costs are directly connected, ordinary costs of generating the
income from the nonmember activity or they are not.  Indeed,
petitioner's attempt to ignore the fixed expenses in the profit motive
determination is particularly inappropriate in this context where
those are the very expenses whose deductibility turns on the question
of profit motivation.  If the costs are connected with the nonmember
activity for purposes of generating the reported net losses, they must
also be connected with the activity for purposes of determining
whether petitioner contemplated that the activity would produce
profits or losses, which in turn determines whether the reported
losses can be used to offset unrelated income.

   Petitioner's interpretation of profit motive would essentially
defeat the statutory purpose of taxing the investment income of social
clubs.  Every social club has fixed overhead, and many clubs provide
food and drink or other goods or services to nonmembers -- at prices
that exceed variable costs but do not exceed the sum of the variable
and fixed costs that can reasonably be allocated to such activity.  If
petitioner were correct that fixed costs may be used to generate tax
losses and then ignored in determining profit motive, it would be easy
for social clubs to use this kind of nonmember activity to convert
their normal overhead, incurred for "pleasure, recreation, and other
nonprofitable purposes" (I.R.C. Section 501(c)(7)), into
tax-deductible losses that would eliminate the tax on their investment
income.  See North Ridge, 877 F.2d at 756;  The Brook, 799 F.2d at
840.  This result would effectively insulate the investment income of
most social clubs from taxation, thereby reinstating the very problem
that Section 512(a)(3) was enacted to solve.  See pp. 17-18, supra.
/25/

                              CONCLUSION

   The judgment of the court of appeals should be affirmed.

   Respectfully submitted.

   KENNETH W. STARR

      Solicitor General

   SHIRLEY D. PETERSON

      Assistant Attorney General

   LAWRENCE G. WALLACE

      Deputy Solicitor General

   ALAN I. HOROWITZ

      Assistant to the Solicitor General

   ROBERT S. POMERANCE

   KENNETH L. GREENE

      Attorneys

   APRIL 1990

   /1/ Unless otherwise noted, statutory references are to the
Internal Revenue Code of 1954 (26 U.S.C. (1976)), as in effect during
1980 and 1981, the tax years involved (the Code or I.R.C.).

   /2/ The Code imposes a tax, at regular corporate rates, on an
exempt organization's "unrelated business taxable income." I.R.C.
Section 511.  The "unrelated business taxable income" of a social club
is defined by Section 512(a)(3)(A) as "the gross income (excluding any
exempt function income), less the deductions allowed by this chapter
(Chapter 1 of the Code) which are directly connected with the
production of the gross income (excluding exempt function income."
Because the "exempt function income" is confined to membership dues
and other receipts from members (see I.R.C. Section 512(a)(3)(B)), all
of the income that a social club receives from nonmembers, as well as
interest and dividends that accrue upon its investments, is subject to
unrelated business tax, whether or not the income derives from a trade
or business.  This treatment differs from that accorded by the Code to
most other tax-exempt organizations, including charitable
organizations granted exemption by Section 501(c)(3).  Their
"unrelated business taxable income" is defined by Section 512(a)(1) as
limited to gross income from an "unrelated trade or business," reduced
by "the deductions allowed by this chapter which are directly
connected with the carrying on of such trade or business." Thus, in
contrast to the Code's treatment of social clubs, investment income
earned by these other kinds of tax-exempt organizations is not
taxable.

   /3/ Under Treas. Reg. Section 1.512(a)-1(c), where expenses are
incurred or facilities are used for both exempt and nonexempt
purposes, depreciation, overhead, and similar expenses should be
allocated on a reasonable basis.  Expenses that are so allocated to
the nonexempt activity are treated as "directly connected" to the
nonexempt activity.  The Commissioner did not challenge the allocation
made by petitioner in this case;  the parties stipulated that the
allocation was reasonable.  Pet. App. 12a-13a & n.5;  J.A. 17.

   /4/ Petitioner's income tax returns did not reflect that the gross
income from the nonmember sales exceeded the variable expenses.  See
J.A. 53, 65.  In fact, the return for 1981 reported that the "cost of
goods sold * * * and operations" for the nonmember sales exceeded the
gross receipts.  J.A. 65.  But a schedule prepared by petitioner for
this litigation reflected that gross receipts from nonmember sales
exceeded variable costs (J.A. 85), and the Tax Court found this to be
the case (Pet. App. 14a-16a, 37a n.11).  According to that schedule,
the net losses from nonmember sales claimed by petitioner may be
reconstructed as follows:

                                    1980            1981
     Gross income                 $84,422        $106,547
     Variable expenses            (61,821)        (78,407)
     Allocated fixed expenses     (51,034)        (97,748)
     Net loss                    ($28,433)       ($69,608)

   /5/ Petitioner likewise reported net losses from nonmember sales on
its tax returns for every year during the 1975-1984 period (Pet. App.
13a).  As of the close of 1984, petitioner's cumulative net operating
loss from nonmember sales was $418,449.  J.A. 91.

   /6/ The general rule under the income tax law is that the expenses
of a not-for-profit activity may be offset against the income from
that activity, but excess expenses may not be applied against income
from other sources.  See 1 B. Bittker & L. Lokken, Federal Taxation of
Income, Estates and Gifts Paragraph 22.5.4, at 22-63 to 22-64 (1989);
Five Lakes Outing Club v. United States, 468 F.2d 443, 446 (8th Cir.
1972) (expenses of not-for-profit activity are allowable up to, but
only up to, gross income from the activity;  this is "the procedure
the Commissioner has long used with court approval");  cf. I.R.C.
Section 183.  This rule reflects the Code's general determination to
tax, not gross income, but net income, i.e., gross income reduced by
the expenses necessary to produce that income.  The deduction of
excess expenses (i.e., those that produce losses) against income from
a different source however, does not implicate this principle;  there
is nothing inherently unreasonable about taxing what are genuine
earnings from one source even if the taxpayer has incurred losses
elsewhere.  Accordingly, such excess expenses may be deducted only if
specifically authorized by the Code.  While the deduction of excess
expenses ordinarily is authorized by the Code only when incurred in
profit-motivated activity, Sections 163 and 164 of the Code are
exceptions to that rule;  interest and taxes may be deducted whether
or not the taxpayer engaged in the activity with a profit motive.  In
this case, the sum of the interest and taxes claimed by petitioner as
deductions connected with its nonmember sales was only $2,862 for 1980
and $3,686 for 1981 (J.A. 53, 65), and therefore those items were
encompassed in the amounts that the Commissioner allowed petitioner to
offset against its gross receipts from nonmember sales.

   /7/ Petitioner had argued in the Tax Court that it could have shown
a net profit on its nonmember sales if it had chosen a different
method of allocating the fixed costs to that activity -- specifically,
if it had allocated the costs according to actual use of facilities
instead of gross receipts.  See Pet. App. 14a-16a;  J.A. 22.  The
purpose of the remand appears to be to allow the Tax Court to consider
the argument that petitioner should be allowed to demonstrate a profit
motive by using an actual use (or other) method of allocation, while
continuing to use the gross receipts method of allocation in computing
its taxes in order to generate tax losses that can be used to reduce
its taxable income from investments.

   /8/ Under the present Code (26 U.S.C.), Section 512(a)(3) also
applies to "voluntary employees' beneficiary associations" (Section
501(c)(9)), supplemental unemployment compensation benefit trusts
(Section 501(c)(17)), and group legal services organizations (Section
501(c)(20)).

   /9/ The committee reports set forth the rationale for the special
treatment of social clubs in considerable detail.  S. Rep. No. 552,
91st Cong., 1st Sess. 71 (1969) (see also H.R. Rep. No. 413, supra,
Pt. 1, at 48):

         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 of the organization 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
      without the intervening separate organization.  However, where
      the organization receives income from sources outside the
      membership, such as income from investments, * * * upon which no
      tax is paid, the membership receives a benefit not contemplated
      by the exemption in that untaxed dollars can be used by the
      organization to provide pleasure or recreation to its
      membership.  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 or pleasure without tax consequences.
      Rather, it is bestowing a substantial additional advantage to
      the members of the club by allowing tax-free dollars to be used
      for their personal recreational or pleasure purposes.  The
      extension of the exemption to such investment income is,
      therefore, a distortion of its purpose.

   /10/ This phrase is used in other provisions of Chapter 1 of the
Code to incorporate by reference otherwise allowable deductions.  See,
e.g., I.R.C. Sections 172(c) (definition of net operating loss),
183(b)(1) (activities not engaged in for profit), 280A(a) (business
use of home).

   /11/ The impetus for the enactment of Section 512(a)(3) came in
part from a recommendation by the Treasury that all of a social club's
receipts from investments and nonmember activity be treated as gross
income subject to the unrelated business income tax, for the reasons
later reiterated by Congress in its committee reports.  See Staff of
House Comm. on Ways and Means and Senate Finance Comm., 91st Cong.,
1st Sess., Tax Reform Studies and Proposals, United States Treasury
Department, Jt. Publication 42, 324-325 (Comm. Print 1969)
(hereinafter Treasury Proposal).  The provision ultimately enacted by
Congress tracks the recommendations of the Treasury Proposal with
respect to both taxable income and allowable deductions.  The Treasury
Proposal explained (at 324-325) that deductions should be allowed only
for expenses "directly connected with an activity generating income
subject to tax" and indicated that the expenses would have to be
"otherwise deductible" under the Code.  The phrase "allowed by this
chapter" embodies in Section 512(a)(3) the recommendation of the
Treasury Proposal that expenses must be "otherwise deductible" in
order to be deducted by a social club;  Section 512(a)(3) does not
independently allow deductions for any particular kind of expenses.

   /12/ Section 212, which grants individuals a deduction for expenses
sustained for "the production of income," albeit not in an activity
that rises to the level of a trade or business, likewise contains a
profit-motive test.  This Court explained in United States v. Gilmore,
372 U.S. at 46, that "the only kind of expenses deductible under (the
predecessor of Section 212) are those that relate to a 'business,'
that is, profit-seeking, purpose." See also Snyder v. United States,
674 F.2d 1359, 1364 (10th Cir. 1982).  Section 167(a) limits
depreciation deductions to property that is "used in the trade or
business" or that is "held for the production of income." See, e.g.,
Duffy v. United States, 690 F.2d 889, 901-902 (Ct. Cl. 1982).

   /13/ The legislative history cited by petitioner (Br. 20-21) adds
nothing to its argument based on the statutory language.  The language
quoted from the House Report and from the Treasury Proposal merely
helps to confirm what is undisputed -- namely, that Congress sought to
expand the definition of taxable income for social clubs to include
income from activities that do not rise to the level of a "trade or
business," and to allow the deduction of expenses directly connected
with those nonbusiness activities, so long as the expense is
"otherwise deductible" (Treasury Proposal at 325), i.e., allowed by
Chapter 1 of the Code.  As the Ninth Circuit noted in North Ridge, the
Treasury's explanation "clearly does not say that deduction of losses
is proper even if the non-member activity was not entered into for
profit" (877 F.2d at 755).

   /14/ Petitioner's argument that it is "unfair" to tax a social club
on its nonbusiness income, and then confine its deductions to trade or
business deductions (see Pet. Br. 27), is misconceived.  The
deductions allowed by Section 512(a)(3) are properly tailored to the
income subjected to tax.  See The Brook, 799 F.2d at 841.  Petitioner
is permitted the full range of deductions, business and nonbusiness,
that are authorized by the Code and connected with the production of
its nonexempt income.  The expenses whose deductibility is in question
here, however -- namely, the allocable expenses of petitioner's
nonmember sales in excess of gross receipts -- are of the kind
allowed, if at all, only by Section 162.  They accordingly must meet
the requirements of that provision, which means that they must be
incurred in a profit-motivated activity, in order to be allowable
under Section 512(a)(3).

   /15/ Significantly, even petitioner recognizes (Br. 27-29) that
some kind of profit motive requirement -- that receipts exceed
variable costs (which it terms "economic gain") -- must be embodied in
Section 512(a)(3) in order to avoid eviscerating the statutory
purpose.  Accordingly, petitioner cautions against reading the statute
"too literally" (Br. 27, 28), embracing the Sixth Circuit's holding in
Cleveland Athletic Club v. Commissioner, supra, that all expenses
incurred in an activity intended to produce this kind of "economic
gain" are deductible under Section 512(a)(3).  See 779 F.2d at 1165.
In our view, the imposition of this "economic gain" requirement (or
defining "profit" under Section 162 in terms of "economic gain," which
leads to the same result (see point B, infra)) does not prevent
petitioner's interpretation from doing violence to the congressional
intent.  In any event, petitioner's theory is not consistent with the
statutory text.

   /16/ There is similarly no merit to petitioner's assertion (Br. 26
& n.16) that the computation of a social club's unrelated business
taxable income from nonmember sales activity "becomes impracticable"
if a profit motive test is imposed on the allowance of deductions.
The computation of the taxable income from nonmember sales is
essentially a two-step process.  First, the club computes the expenses
"directly connected with" the production of income from the sales;
this may require an allocation of fixed expenses, which in this case
was made using a gross receipts method.  Second, the expenses must be
examined to determine whether their deduction (in excess of the gross
income from the sales) is "allowed by this chapter." This
determination requires resolving whether the sales activity is
motivated by profit.  This two-step procedure is eminently practicable
as a matter of computation;  indeed, this procedure is required to
implement the "two prong test" that petitioner concedes to be
established by Section 512(a)(3) (see Pet. Br. 21-22).

   /17/ For example, suppose an individual, who still receives
substantial income from an annuity, retires to live on a large farm
where he raises horses for pleasure.  Though he undisputedly does not
raise the horses to make a profit, he does engage in one activity to
defray some of the expenses of the operation.  On several occasions
during the year, the taxpayer allows schools and summer camps to bring
their students to visit the farm and pet the horses.  The taxpayer
charges the organizations a fee for the right to visit.  Although the
fee is relatively modest, it exceeds the minimal variable costs of the
activity, which consist of hiring one college student per visit to
keep an eye on the group.  Under petitioner's interpretation of profit
motive as "economic gain," the taxpayer in this example could claim
that he operates his "horse petting" activity with a pprofit motive
and then could reduce his annuity income by an allocable share of the
substantial costs of raising the horses.

   /18/ Indeed, even the Sixth Circuit's decision in Cleveland
Athletic Club appears to recognize that petitioner errs in generally
interpreting "profit motive" to mean an excess of gross receipts over
variable costs.  The court there stated that "the challenged
deductions need not necessarily come within the Section 162 trade or
business allowance, but rather, the deductions are allowable as
ordinary and necessary to the production of income with a basic
purpose of economic gain" (779 F.2d at 1165).  Thus, the court did not
rule for the taxpayer because it thought that an intent to produce
"economic gain" satisfies the profit motive standard of Section 162;
instead, it held that, because Section 512(a)(3) does not contain the
phrase "trade or business," there is a special rule for social clubs
that permits them to deduct expenses incurred with the intent of
producing income in excess of variable costs.  See 779 F.2d at 1165.
As we have explained (pp. 27-30, supra), the Sixth Circuit
misinterpreted Section 512(a)(3) in this regard because omission of
the phrase "trade or business" was integral to accomplishing the
purpose for which the provision was enacted;  it was not designed to,
nor does it in effect, allow a social club to take a deduction not
otherwise allowable to other taxpayers under the Code.  The Tax Court
in North Ridge, on the other hand, did accept petitioner's position
that profit motive is to be determined by comparing gross receipts
with variable costs.  89 T.C. at 572-573.  The court cited no
authority and did not elaborate on its conclusion.

   /19/ See, e.g., Simon v. Commissioner, 830 F.2d 499, 500 (3d Cir.
1987) ("'profit' means economic profit independent of tax savings");
Gefen v. Commissioner, 87 T.C. 1471, 1490 (1986) ("A transaction has
economic substance and will be recognized for tax purposes if the
transaction offers a reasonable opportunity for economic profit, that
is, profit exclusive of tax benefits.");  Waddell v. Commissioner, 86
T.C. 848, 894 (1986) ("taxpayers were just buying tax deductions, not
entering into economically motivated investments");  Estate of Baron
v. Commissioner, 83 T.C. 542, 560 (1984) (inquiry into "economic
consequences of the transaction aside from its tax benefits");  Treas.
Reg. Section 1.512(a)-1(f)(7)(ii)(b) (activity "will result in
economic profit (without regard to tax consequences)").

   /20/ By the same token, the IRS's ruling addressing this issue,
Rev. Rul. 81-69, 1981-1 C.B. 351, in referring to the "cost of sales"
does not distinguish between fixed and variable costs.  Cf. Pet. Br.
42.  Quite apart from the fact that the Commissioner is the best judge
of the meaning of his own rulings and regulations (see, e.g., National
Muffler Dealers Ass'n v. United States, 440 U.S. 472, 484 n.19
(1979)), there is no basis for failing to read the ruling as stating
that a deduction must be denied where a social club does not intend
its gross income from nonmember sales to exceed all the costs of those
sales.  Every court that has considered the ruling has so construed
it.  See The Brook, 799 F.2d at 835-836 & n.4;  Cleveland Athletic
Club, 779 F.2d at 1165-1166.  Rather than looking to the dictionary to
define "cost of sales" (see Pet. Br. 42 n.45), petitioner should look
to its own representations on which its claim for deduction rests --
namely, that the allocated fixed costs here were the "ordinary and
necessary costs" of producing the nonmember sales income (id. at 33).

   /21/ Moreover, many of these tax incentives operate only to effect
a deferral, rather than a permanent reduction, in taxes.  For example,
accelerated depreciation provides a special tax benefit only in the
early years of a property's life;  as the property ages, there arrives
a crossover point at which accelerated depreciation begins to provide
a smaller annual deduction than would have been available under
straight-line depreciation (which is supposed to reflect the true
economic depreciation).  Thus, tax losses in early years may be
counterbalanced by gains in later years, so that the total taxable
income reported over time remains unaffected.  In addition, some of
the tax savings otherwise provided by such tax shelter items is
currently subject to recapture through the minimum tax imposed by 26
U.S.C. 56 and 57.  See Pet. Br. 43-44.  In petitioner's case, however,
the deductions that generate the tax losses it reports from its
nonmember activity are not subject to recapture and do not merely
reflect deferral of taxation.  If petitioner continues to allocate a
portion of its fixed expenses to nonmember sales as it has done in the
tax years at issue here, it likely will report losses from that
nonmember activity forever.  See J.A. 63.

   /22/ No commercial establishment would stay in business if it
continued indefinitely to sustain losses of the magnitude claimed by
petitioner year after year.  The "economic gain" (i.e., excess of
gross receipts over variable costs) to which petitioner points would
not be generated if an unsubsidized commercial establishment operated
petitioner's nonmember activity.  The apparent gain is achieved only
by ignoring the fixed overhead, i.e., by treating the commercial
nonmember operation as being able to use the premises without paying
any rent, insurance, etc.  Clearly, it is not appropriate to calculate
petitioner's tax liability on the assumption that nonexempt activity
will be subsidized in this manner by the club, when the original
impetus for the enactment of the unrelated business income tax was to
prevent tax-exempt organizations from using their exemption to
subsidize unrelated business activity.  Thus, looking at the nonmember
operation as if it were a private operation, it is apparent that it is
not organized and operated in a way that it can make a profit.

   /23/ Petitioner also suggests (Br. 34-38) that the question of
"profit motive" in this case is a factbound one, and that the court of
appeals impermissibly interfered with the Tax Court's discretion to
consider the "facts and circumstances" of each case.  This is
mistaken.  The extent to which a taxpayer operates an activity in a
professional manner (see Pet. Br. 36-37) can be a relevant factor in a
case where it is not otherwise apparent whether the activity was
intended to produce a profit.  But if it is apparent that the taxpayer
does not intend to produce a profit, there is no "profit motive"
regardless of how the operation was run.  Here, there is no dispute
over the material facts.  Sales of food and drink to nonmembers were
priced at a level "intended to result in profit to the club over the
direct cost associated with the activity" (Pet. App. 20a-21a).  On the
other hand, when the total costs allocated to the activity are
considered, petitioner reported a substantial loss every year
totalling more than $400,000 over an 11-year period (J.A. 91), and
there has never been any suggestion that petitioner intended to bring
in gross receipts that would exceed these total costs.  Thus, the Tax
Court's conclusion that the profit motive standard was satisfied did
not turn on any factual findings;  rather, it turned entirely on the
legal question of the correct definition of "profit" for these
purposes.  The Ninth Circuit correctly concluded that the Tax Court
had evaluated uncontroverted facts according to an incorrect legal
standard.  See North Ridge, 877 F.2d at 755.

   /24/ There may be room to debate whether the fixed costs allocated
by petitioner to its nonmember sales constitute true economic costs of
that activity that ought to be treated as "directly connected" to the
production of the nonmember sales income.  It might be argued that
only the variable costs are "directly connected with" the nonmember
activity, and therefore that only those variable costs should offset
the gross receipts from the nonmember income.  Cf. North Ridge, 89
T.C. at 573 & n.18.  That approach would tend to increase the tax on a
social club's nonexempt income by reducing the costs that could be
used to offset the nonmember receipts.  Petitioner and other social
clubs, however, have maintained that an allocable portion of the fixed
costs should be treated as "directly connected" with the production of
the nonmember income, and the Commissioner has acquiesced in that
treatment.  Not satisfied with eliminating all tax liability for its
nonmember sales, petitioner now seeks to eliminate any tax liability
for its unrelated investment income as well -- by manipulating its
characterization of the fixed expenses.  But having identified these
costs as "directly connected," i.e., as genuine economic costs
associated with the nonmember activity -- a position that is critical
to its deduction claim -- petitioner should not be permitted to
reverse its field and disregard these costs in determining the
existence of a profit motive.

   /25/ Petitioner suggests (Br. 47-48) that, even if the court of
appeals' analysis of profit motive is correct, this Court should
nonetheless reverse the judgment below because the Tax Court found
that, if a different method were used to allocate fixed expenses,
petitioner could show that the receipts from nonmember sales were
intended to exceed the total costs of the activity.  We submit that
this argument is untenable basically for reasons discussed above (see
pp. 44-46, supra);  in using different methods of allocation for
different purposes, petitioner would be asserting that the same fixed
costs are connected to nonmember activity when it wants to generate
tax losses and are connected to exempt activity when it wants to show
the possibility of profit from the nonmember activity.  In any event,
it would clearly be inappropriate for this Court to rule for
petitioner on this theory when the court of appeals declined to rule
upon it;  instead, the court below appears to have left it open to
petitioner to make this argument in the Tax Court on remand.  See note
7, supra.

   APPENDIX