Source: https://supreme.justia.com/cases/federal/us/497/154/
Timestamp: 2019-04-26 03:42:41+00:00

Document:
"the gross income (excluding any exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income)."
costs. The court remanded the case for a determination whether petitioner engaged in its nonmember activities with the required intent to profit from those activities.
Held: Petitioner may use losses incurred in sales to nonmembers to offset investment income only if those sales were motivated by an intent to profit, which is to be determined by using the same allocation method as petitioner used to compute its actual profit or loss. Pp. 497 U. S. 163-166.
(a) The statutory scheme for the taxation of social clubs was intended to achieve tax neutrality by ensuring that members are not subject to tax disadvantages as a consequence of their decision to pool their resources for the purchase of social or recreational services, but was not intended to provide clubs with a tax advantage. Pp. 497 U. S. 160-163.
(b) By limiting deductions from unrelated business income to those expenses allowable as deductions under "this chapter," § 512(a)(3)(A) limits such deductions to expenses allowable under Chapter 1 of the Code. Since only § 162 of Chapter 1 serves as a basis for the deductions claimed here, and since a taxpayer's activities fall within § 162's scope only if an intent, to profit is shown, see Commissioner v. Groetzinger, 480 U. S. 23, 480 U. S. 35, petitioner's nonmember sales must be motivated by an intent to profit. Dispensing with the profit-motive requirement in this case would run counter to the principle of tax neutrality underlying the statutory scheme. Pp. 497 U. S. 163-166.
(c) The Commissioner correctly concluded that the same allocation method must be used in determining petitioner's intent to profit as in computing its actual profit or loss. It is an inherent contradiction to argue that the same fixed expenses that are attributable to nonmember sales in calculating actual losses can also be attributed to membership activities in determining whether petitioner acted with the requisite intent to profit. Having chosen to calculate its actual losses on the basis of the gross-to-gross formula, petitioner is foreclosed from attempting to demonstrate its intent to profit based on some other allocation method. Pp. 497 U. S. 166-170.
(d) Petitioner has failed to show that it intended to earn gross income from nonmember sales in excess of its total costs where fixed expenses are allocated using the gross-to-gross method. P. 497 U. S. 171.
BLACKMUN, J., delivered the opinion of the Court, in which REHNQUIST, C.J., and BRENNAN, WHITE, MARSHALL, and STEVENS, JJ., joined, and in which O'CONNOR, SCALIA, and KENNEDY, JJ., joined except as to Parts III-B and IV. KENNEDY, J., filed an opinion concurring in part and concurring in the judgment, in which O'CONNOR and SCALIA, JJ., joined, post, p. 497 U. S. 171.
reflected tax owed on petitioner's investment income. App. 48-51.
"petitioner is entitled to offset its unrelated business taxable income from interest by its loss from its nonmember food and beverage sales computed by allocating a portion of its fixed expenses to the nonmember food and beverage sales activity in a manner which respondent agrees is acceptable."
"can properly deduct losses from a nonmember activity only if it undertakes that activity with the intent to profit, where profit means the production of gains in excess of all direct and indirect costs."
"Because Portland Golf Club could have reported gains in excess of direct and indirect costs, but did not do so, relying on a method of allocation stipulated to be reasonable by the Commissioner, we REMAND this case to the tax court for a determination of whether Portland Golf Club engaged in its nonmember activities with the intent required under North Ridge to deduct its losses from those activities."
Because of a perceived conflict with the decision of the Sixth Circuit in Cleveland Athletic Club, Inc. v. United States, 779 F.2d 1160 (1985), [Footnote 9] and because of the importance of the issue, we granted certiorari. 493 U.S. 1041 (1990).
§ 512(a)(3)(A). [Footnote 11] The salient point is that § 512(a)(1) (which applies to most exempt organizations) limits "unrelated business taxable income" to income derived from a "trade or business," while § 512(a)(3)(A) (which applies to social clubs) contains no such limitation. Thus, a social club's investment income is subject to federal income tax, while the investment income of most other exempt organizations is not.
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."
S.Rep. No. 91-552, p. 71 (1969), U.S.Code Cong. & Admin. News 1969, pp. 1645, 2100.
"the term 'unrelated business taxable income' means the gross income (excluding any exempt function income), less the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income)."
sales exceeded its variable costs. Since Portland Golf's fixed costs, by definition, have been incurred even in the absence of sales to nonmembers, the Tax Court concluded that these costs should be disregarded in determining petitioner's intent to profit.
The Commissioner has taken no firm position as to the precise manner in which Portland Golf's fixed costs are to be allocated between member and nonmember sales. Indeed, the Commissioner does not even insist that any portion of petitioner's fixed costs must be attributed to nonmember activities in determining intent to profit. [Footnote 17] He does insist, however, that the same allocation method is to be used in determining petitioner's intent to profit as in computing its actual profit or loss. See Brief for Respondent 44-46. In the present case, the parties have stipulated that the gross-to-gross method provides a reasonable formula for allocating fixed costs, and Portland Golf has used that method in calculating the losses incurred in selling food and drink to nonmembers. The Commissioner contends that petitioner is therefore required to demonstrate an intent to earn gross receipts in excess of fixed and variable costs, with the allocable share of fixed costs being determined by the gross-to-gross method.
deductions and preferences which do not purport to mirror economic reality. Therefore, petitioner argues, taxpayers may frequently act with an intent to profit, even though the foreseeable (and, indeed, the intended) result of their efforts is that they suffer (or achieve) tax losses. Much of the Code, in petitioner's view, would be rendered a nullity if the mere fact of tax losses sufficed to show that a taxpayer lacked an intent to profit, thereby rendering the deductions unavailable. In Portland Golf's view, the parties have stipulated only that the gross-to-gross formula provides a reasonable method of determining what portion of fixed expenses is "directly connected" with the nonexempt activity for purposes of computing taxable income. That stipulation, Portland Golf contends, is irrelevant in determining the portion of fixed expenses that represents the actual economic cost of the activity in question.
We hold that any losses incurred as a result of petitioner's nonmember sales may be offset against its investment income only if the nonmember sales were undertaken with an intent to profit. We also conclude that, in demonstrating the requisite profit motive, Portland Golf must employ the same method of allocating fixed expenses as it uses in calculating its actual loss. Petitioner has failed to show that it intended to earn gross income from nonmember sales in excess of its total (fixed plus variable) costs, where fixed expenses are allocated using the gross-to-gross method. [Footnote 22] The judgment of the Court of Appeals is therefore affirmed.
"[c]lubs organized for pleasure, recreation, and other nonprofitable purposes, substantially all of the activities of which are for such purposes and no part of the net carnings of which inures to the benefit of any private shareholder."
Section 511 of the Code provides that the "unrelated business taxable income" of an exempt organization shall be taxed at the ordinary corporate rate. The term "unrelated business taxable income," as applied to the income of a club such as petitioner, is defined in § 512(a)(3)(A). That definition encompasses all sources of income except receipts from the club's members.
For 1980, gross receipts from nonmember sales in the bar and diningroom totalled $84,422, while variable expenses were $61,821. For 1981, gross receipts totalled $106.547, while variable expenses were $78,407. App. 85.
For example, if 10% of petitioner's gross receipts were derived from nonmember sales, 10% of petitioner s fixed costs would be allocated to the nonexempt activity. That method of allocation appears rather generous to Portland Golf. The club charges nonmembers higher prices for food and drink than members are charged, even though nonmembers' meals presumably cost no more to prepare and serve. It therefore seems likely that the gross-to-gross method overstates the percentage of fixed costs properly attributable to nonmember sales. The parties, however, stipulated that this allocation method was reasonable. Id. at 17.
The general rule under the Code is that losses incurred in a profit-seeking venture may be deducted from unrelated income; expenses of a not-for-profit activity may be offset against the income from that activity, but losses may not be applied against income from other sources. See 1 B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts ¦¦ 20.1.2, 22.5.4, pp. 20-6, 22-63 to 22-64 (2d ed. 1989).
"did intend to make a profit, and did make a profit between the amount received from sales to nonmembers and the costs related to those sales which would not have been incurred absent those sales."
55 TCM at 216. The Tax Court, in articulating this standard for determining whether intent to profit had been shown, relied on its earlier reviewed decision in North Ridge Country Club v. Commissioner, 89 T.C. 563 (1987). That decision subsequently was reversed. 877 F.2d 750 (CA9 1989).
The basis for the Court of Appeals' remand order is not entirely clear to us. It appears, however, that the court left open the possibility that petitioner could establish its intent to profit by using some other method of allocating fixed costs (such as the "actual use" method, see n. 5, supra), while continuing to use the gross-to-gross formula in computing actual losses. Both parties interpret the Court of Appeals' decision in this manner, and both express disapproval of that approach. See Brief for Respondent 47, n. 25 ("this argument is untenable"); Brief for Petitioner 48 ("While the Ninth Circuit's formula is better than that of the Government, it is basically unprincipled"). Our disposition of the case makes unnecessary precise interpretation of the Court of Appeals' opinion.
See also The Brook, Inc. v. Commissioner, 799 F.2d 833 (CA2 1986), Rev.Rul. 81-69, 1981-1 C.B. 351; A. Scialabba, Unrelated Business Taxable Income of Social Clubs, 10 Campbell L.Rev. 249 (1988).
"any trade or business the condduct of which is not substantially related . . . to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption. . . ."
"the gross income from dues, fees, charges, or similar amounts paid by members of the organization as consideration for providing such members or their dependents or guests goods, facilities, or services in furtherance of the purposes constituting the basis for the exemption of the organization to which such income is paid."
See S.Rep. No. 2375, 81st Cong., 2d Sess., 28 (1950) ("The problem at which the tax on unrelated business income is directed is primarily that of unfair competition. The tax-free status of [these] organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes"); H.R.Rep. No. 2319, 81st Cong., 2d Sess., 36 (1950). The tax on "unrelated business income" was added to the Code by the Revenue Act of 1950, ch. 994, 64 Stat. 906.
See S.Rep. No. 2375, at 30-31; H.R.Rep. No. 2319, at 38.
Portland Golf appears to concede this point, too. See Brief for Petitioner 10 ("The partics agree that all of the expenses in issue . . . are the types of corporate expenses allowed as deductions by Code Section 162"). Petitioner does not identify any other Code provision which would serve as a basis for the deduction claimed in this case.
Section 183 of the Code permits a taxpayer to offset expenses incurred in a not-for-profit activity against income from that activity up to the amount of the income. Even before the enactment of § 183, moreover, the courts and the Commissioner had not required that revenues earned in activities showing a net loss be declared as taxable income. See 1 B. Bittker & L. Bokken, n. 6, supra, ¦ 22.5.4, p. 22-63. Although § 183 is inapplicable to a nonprofit corporation such as Portland Golf, the Commissioner has followed longstanding tax principles in permitting the deduction of expenses incurred in nonmember sales up to the amount of petitioner's receipts. See Brief for Respondent 33. At issue in this case is petitioner's right to offset losses from nonmember sales against income from unrelated investments.
The Code distinguishes a social club's "exempt function income" from its "unrelated business taxable income" by looking to the source of the payment: "exempt function income" is limited to money received from the members. § 512(a)(3)(B). However, a social club could easily organize events whose primary purpose was to benefit the membership, yet arrange for nonmembers to make modest contributions toward the cost of the event. Those contributions would constitute "unrelated business taxable income," but, if losses incurred in such activities could be used to offset investment income, it would be relatively easy for clubs to avoid taxation on their investments.
"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 nonmemher sales income. It might be argued that only the variable costs are 'directly connected with' the nonmember income, and therefore that only those variable costs should offset the gross receipts from the nonmember income."
Brief for Respondent 45, n. 24.
See n 8, supra. The Tax Court noted that petitioner would have shown a profit on sales to nonmembers in both 1980 and 1981 if fixed costs had been allocated under the "actual use" method. See 55 TCM at 213.
The Tax Court consistently has held that the possibility of realizing tax benefits should be disregarded in determining whether an intent to earn an economic profit has been shown. (That is, the reduction in tax liability cannot itself be the "profit.") See, e.g, 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"); Seaman v. Commissioner, 84 T.C. 564, 588 (1985) ("profit' means economic profit, independent of tax savings"); Surloff v. Commissioner, 81 T.C. 210, 233 (1983) (same). Accord, Simon v. Commissioner, 830 F.2d 499, 500 (CA3 1987). Portland Golf does not dispute this principle. See Brief for Petitioner 39 ("The cases have uniformly held that taxable businesses, in order to deduct expenses in excess of income, need only show an `economic profit' independent of tax savings, or `economic gain' independent of tax savings") (footnotes omitted). We therefore assume, without deciding, that potential reductions in tax liability are irrelevant to the determination whether a profit motive exists.
"There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
Thus, the expenses petitioner seeks to deduct will constitute "deductions allowed by this chapter" only if they are "the ordinary and necessary expenses paid or incurred" in selling food and drink to nonmembers.
We do not hold that, for other cases, any particular method of allocating fixed expenses must be used by social clubs. We hold only that the allocation method used in determining actual profit or loss must also be used in determining whether the taxpayer acted with a profit motive. Petitioner here has stipulated, however, to the reasonableness of the gross-to-gross method, and has used that method in calculating its actual losses. We note that no other allocation method, used consistently, would have produced a result more favorable to petitioner. Had petitioner employed the actual use method, or ignored fixed costs entirely, it could have established its intent to profit, but it would have realized a net gain from nonmember sales and its "unrelated business taxable income" would have been higher.
The fact that petitioner suffered actual losses in 1989 and 1981 does not, by itself, prove that Portland Golf lacked a profit motive. A taxpayer's intent to profit is not disproved simply because no profit is realized during a particular year. See Treas.Reg. § 1.183-1(c)(1)(ii), 26 CFR § 1.183-1(c)(1)(ii) (most activities presumed to be engaged in for profit if gross income exceeds costs in any 2 of 5 consecutive years); Treas. Reg. § 1.183-2(b)(6), 26 CFR § 1.183-2(b)(6) (1989) ("A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit"). Petitioner could offset these losses against investment income if it could demonstrate that it intended to earn gross income in excess of total costs, with fixed expenses being allocated under the gross-to-gross formula. Portland Golf has not asserted, however, that it possessed such a motive. The club's reluctance to make that argument is understandable: in every year from 1975 through 1984, petitioner incurred losses from its sales to nonmembers when fixed costs are allocated on a gross-to-gross basis. 55 TCM at 213.
Internal Revenue Code of 1954, 26 U.S.C. § 162(a), and it allowed the Club to deduct expenses associated with the activity from its income. 55 TCM 212 (1988). The Court of Appeals reversed because it found the Club's profit motive unclear. App. to Pet. for Cert. 1a. Although the Tax Court had determined that the Club intended the gross receipts from the nonmember activity to exceed the direct costs, the Court of Appeals held that § 162(a) requires an intent to produce gains in excess of both direct and indirect costs. The Court of Appeals remanded the case to allow the Tax Court to reconsider the Club's profit motive, taking account of the overhead and other fixed costs attributable to the nonmember activity. I agree with that decision, and so would affirm the Court of Appeals.
reached the question, however, I must state my disagreement with its conclusion.
"There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. . . ."
26 U.S.C. § 162(a). Although the section does not require a profit motivation by its express terms, we have inferred such a requirement because the words "trade or business," in their ordinary usage, contemplate activities undertaken to earn a profit. See Commissioner v. Groetzinger, 480 U. S. 23, 480 U. S. 27-28 (1987); Flint v. Stone Tracy Co., 220 U. S. 107, 220 U. S. 171 (1911). Yet I see no justification for making the profit motive requirement more demanding than necessary to distinguish trades and businesses from other activities pursued by taxpayers. See Whipple v. Commissioner, 373 U. S. 193, 373 U. S. 197 (1963). Because an activity may be a trade or business even if the taxpayer intended to show losses on its income tax forms under a permissible accounting method, the Court endorses an improper conception of profit motivation.
the Club's accountants. I find this interpretation of the words "trade or business" simply "to affront common understanding and to deny the facts of common experience." Helvering v. Horst, 311 U. S. 112, 311 U. S. 118 (1940). A taxpayer does not alter the nature of an enterprise by selecting one reasonable allocation method over another.
must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit."
26 CFR § 1.183-2(a) (1989). To facilitate the application of this general standard, the IRS has supplied a list of nine factors, also based on a wide body of case law, for evaluating the taxpayer's profit motive. These factors include: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) the elements of personal pleasure or recreation. See id. at § 1.183-2(b)(1)-(9).
as a trade or business. But the solution to this inconsistency lies in altering the stipulation in other cases, not in changing the longstanding interpretation of profit motivation.
The precise effect of the Court's holding with respect to the Club remains unclear. The Court states only that the Club may not offset its losses from nonmember sales against its investment income. But I do not understand how the Court can confine its ruling to investment income alone. If the Club's nonmember activity does not qualify as a trade or business, then the Club cannot use § 162(a) to deduct any of the expenses associated with the nonmember activity, not even to the extent of gross receipts. Confronted with this difficulty at oral argument, respondent stated that, in the absence of statutory authority, the IRS has allowed an offset of expenses against gross receipts out of its own "generosity," a characteristic as rare as it is implausible. Tr. of Oral Arg. 42-43. The IRS, indeed, asserts the authority to disallow the offset in the future. See id. at 44. Cf. 26 U.S.C. § 183 (authorizing individuals and S-corporations to offset hobby losses). This possibility further counsels against making the profit motive requirement more stringent than necessary to determine whether the Club undertook the nonmember activity as a trade or business. For these reasons, I join the Court's opinion, with the exception of Parts III-B and IV, and concur in the judgment.

References: § 512
 § 162
 § 162
 v. 
 v. 

§ 512
 § 512
 § 512
 § 512
 v. 
 v. 
 § 183
 § 183
 § 512
 v. 
 v. 
 v. 
 v. 
 § 1
 § 1
 § 1
 § 1
 § 162
 § 162
 § 162
 v. 
 v. 
 v. 
 v. 
 § 1
 § 1
 § 162
 § 183