As a nonprofit corporation that owns and operates a private
social club, petitioner's income derived from membership fees and
other receipts from members is exempt from income tax. However, all
other income is nonexempt "unrelated business taxable income,"
defined in § 512(a)(3)(A) of the Internal Revenue Code as
"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)."
Petitioner has nonexempt income from sales of food and drink to
nonmembers, and from return on its investments. During its 1980 and
1981 tax years, petitioner offset net losses on nonmember sales
against the earnings from its investments, and reported no
unrelated business taxable income. In computing its losses,
petitioner identified two categories of expenses incurred in
nonmember sales: (1) variable (direct) expenses, such as the cost
of food, which, in each year in question, were exceeded by gross
income from nonmember sales; and (2) fixed (indirect) overhead
expenses, which would have been incurred whether or not sales had
been made to nonmembers. It determined what portions of fixed
expenses were attributable to nonmember sales by employing an
allocation formula known as the "gross-to-gross method," based on
the ratio that nonmember sales bore to total sales. The total of
these fixed expenses and variable costs exceeded petitioner's gross
income from nonmember sales. On audit, the Commissioner determined
that petitioner could deduct expenses associated with nonmember
sales up to the amount of receipts from the sales themselves, but
could not use losses from those activities to offset its investment
income because it had failed to show that its nonmember sales were
undertaken with an intent to profit. Petitioner sought
redetermination, and the Tax Court ruled in petitioner's favor,
concluding that petitioner had adequately demonstrated that it had
a profit motive, since its gross receipts from nonmember sales
consistently exceeded the variable costs associated with those
activities. The Court of Appeals reversed, holding that the Tax
Court had applied an incorrect legal standard in determining that
petitioner had demonstrated an intent to profit, because profit in
this context meant the production of gains in excess of all direct
and indirect
Page 497 U. S. 155
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.
876 F.2d 897, (CA9 1989) affirmed.
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.
Page 497 U. S. 156
Justice BLACKMUN delivered the opinion of the Court.
This case requires us to determine the circumstances under which
a social club, in calculating its liability for federal income tax,
may offset losses incurred in selling food and drink to nonmembers
against the income realized from its investments.
I
Petitioner Portland Golf Club (Portland Golf) is a nonprofit
Oregon corporation, most of whose income is exempt from federal
income tax under § 501(c)(7) of the Internal Revenue Code of 1954,
26 U.S.C. § 501(c)(7). [
Footnote
1] Since 1914, petitioner has owned and operated a private golf
and country club with a golf course, restaurant and bar, swimming
pool, and tennis courts. The great part of petitioner's income is
derived from membership dues and other receipts from the club's
members; that income is exempt from tax. Portland Golf also has two
sources of nonexempt "unrelated business taxable income": sales of
food and drink to nonmembers, and return on its investments.
[
Footnote 2]
Page 497 U. S. 157
The present controversy centers on Portland Golf's federal
income tax liability for its fiscal years ended September 30, 1980,
and September 30, 1981, respectively. Petitioner received
investment income in the form of interest in the amount of $11,752
for fiscal 1980 and in the amount of $21,414 for fiscal 1981. App.
18. It sustained net losses of $28,433 for fiscal 1980 and $69,608
for fiscal 1981 on sales of food and drink to nonmembers.
Petitioner offset these losses against the earnings from its
investments, and therefore reported no unrelated business taxable
income for the two tax years. In computing these losses, petitioner
identified two different categories of expenses incurred in selling
food and drink to nonmembers. First, petitioner incurred
variable (or direct) expenses, such as the cost of food,
which varied depending on the amount of food and beverages sold
(and therefore would not have been incurred had no sales to
nonmembers been made). For each year in question, petitioner's
gross income from nonmember sales exceeded these variable costs.
[
Footnote 3] Petitioner also
included, as an unrelated business expense, a portion of the
fixed (or indirect) overhead expenses of the club --
expenses which would have been incurred whether or not petitioner
had made sales to nonmembers. In determining what portions of its
fixed expenses were attributable to nonmember sales, petitioner
employed an allocation formula, described as the "gross-to-gross
method," based on the ratio that nonmember sales bore to total
sales. [
Footnote 4] When
fixed
Page 497 U. S. 158
expenses, so calculated, were added to petitioner's variable
costs, the total exceeded Portland Golf's gross income from
nonmember sales. [
Footnote
5]
On audit. the Commissioner took the position that petitioner
could deduct expenses associated with nonmember sales up to the
amount of receipts from the sales themselves, but that it could not
use losses from those activities to offset its investment income.
The Commissioner based that conclusion on the belief that a profit
motive was required if losses from these activities were to be used
to offset income from other sources, and that Portland Golf had
failed to show that its sales to nonmembers were undertaken with an
intent to profit. [
Footnote 6]
The Commissioner therefore determined deficiencies of $1,828 for
1980 and $3,470 for 1981; these deficiencies
Page 497 U. S. 159
reflected tax owed on petitioner's investment income. App.
48-51.
Portland Golf sought redetermination in the Tax Court. That
court ruled in petitioner's favor. 55 TCM 212 (1988). The court
assumed, without deciding, that losses incurred in the course of
sales to nonmembers could be used to offset other nonexempt income
only if the sales were undertaken with an intent to profit. The
court, however, held that Portland Golf had adequately demonstrated
a profit motive, since its gross receipts from sales to nonmembers
consistently exceeded the variable costs associated with those
activities. [
Footnote 7] The
court therefore held that
"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."
Id. at 217.
The United States Court of Appeals for the Ninth Circuit
reversed. App. to Pet. for Cert. 1a. The Court of Appeals held that
the Tax Court had applied an incorrect legal standard in
determining that Portland Golf had demonstrated an intent to profit
from sales to nonmembers. The appellate court relied on its
decision in
North Ridge Country Club v. Commissioner, 877
F.2d 750 (1989), where it had ruled that a social club
"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."
Id. at 756. The same court in the
Page 497 U. S. 160
present case concluded:
"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."
App. to Pet. for Cert. 2a-3a. [
Footnote 8]
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).
II
Virtually all tax-exempt business organizations are required to
pay federal income tax on their "unrelated business taxable
income." The law governing social clubs, however, is significantly
different from that governing other tax-exempt entities. As to
exempt organizations other than social clubs, the Code defines
"unrelated business taxable income" as
"the gross income derived by any organization from any unrelated
trade or business (as defined in section 513) regularly carried on
by it, less the deductions allowed by this chapter which are
directly connected with the carrying on of
Page 497 U. S. 161
such trade or business."
26 U.S.C. § 512(a)(1). [
Footnote 10] As to social clubs, however, "unrelated
business taxable income" is defined as
"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)."
§ 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.
This distinction reflects the fact that a social club's
exemption from federal income tax has a justification fundamentally
different from that which underlies the grant of tax exemptions to
other nonprofit entities. For most such organizations, exemption
from federal income tax is intended to encourage the provision of
services that are deemed socially beneficial. Taxes are levied on
"unrelated business income" only in order to prevent tax-exempt
organizations from gaining an unfair advantage over competing
commercial enterprises. [
Footnote 12]
See United States v. American College of
Physicians,
Page 497 U. S. 162
475 U. S. 834,
475 U. S. 838
(1986) ("Congress perceived a need to restrain the unfair
competition fostered by the tax laws"). Since Congress concluded
that investors reaping tax-exempt income from passive sources would
not be in competition with commercial businesses, it excluded from
tax the investment income realized by exempt organizations.
[
Footnote 13]
The exemption for social clubs rests on a totally different
premise. Social clubs are exempted from tax not as a means of
conferring tax
advantages, but as a means of ensuring that
the 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. The Senate Report
accompanying the Tax Reform Act of 1969, 83 Stat. 536, explained
that that purpose does not justify a tax exemption for income
derived from investments:
"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 (or other benefits)
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 (or other benefits) to its
membership. . . . In such a case, the exemption is
Page 497 U. S. 163
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.
In the Tax Reform Act of 1969, Congress extended the tax on
"unrelated business income" to social clubs. As to these
organizations, however, Congress defined "unrelated business
taxable income" to include income derived from investments. Our
review of the present case must therefore be informed by two
central facts. First, Congress intended that the investment income
of social clubs should be subject to federal tax, and indeed
Congress devised a definition of "unrelated business taxable
income" with that purpose in mind. Second, the statutory scheme for
the taxation of social clubs was intended to achieve tax
neutrality, not to provide these clubs a tax advantage:
even the exemption for income derived from members' payments was
designed to ensure that members are not disadvantaged as compared
with persons who pursue recreation through private purchases rather
than through the medium of an organization.
III
Petitioner's principal argument is that it may deduct losses
incurred through sales to nonmembers without demonstrating that
these sales were motivated by an intent to profit. In the
alternative, petitioner contends (and the Tax Court agreed) that,
if the Code does impose a profit-motive requirement, then that
requirement has been satisfied in this case. We address these
arguments in turn.
A
We agree with the Commissioner and the Court of Appeals that
petitioner may use losses incurred in sales to nonmembers
Page 497 U. S. 164
to offset investment income only if those sales were motivated
by an intent to profit. The statute provides that, as to social
clubs,
"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)."
§ 512(a)(3)(A) (emphasis added). As petitioner concedes, the
italicized language limits deductions from unrelated business
income to expenses allowable as deductions under Chapter 1 of the
Code.
See Brief for Petitioner 21-22. In our view, the
deductions claimed in this case -- expenses for food, payroll, and
overhead in excess of gross receipts from nonmember sales -- are
allowable, if at all, only under § 162 of the Code.
See North
Ridge Country Club v. Commissioner, 877 F.2d 750, 753 (CA9
1989);
The Brook, Inc. v. Commissioner, 799 F.2d 833, 838
(CA2 1986). [
Footnote 14]
Section 162(a) provides a deduction for "all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business." Although the statute does not
expressly require that a "trade or business" must be carried on
with an intent to profit, this Court has ruled that a taxpayer's
activities fall within the scope of § 162 only if an intent to
profit has been shown.
See Commissioner v. Groetzinger,
480 U. S. 23,
480 U. S. 35
(1987) ("to be engaged in a [§ 162] trade or business, . . . the
taxpayer's primary purpose for engaging in the activity must be for
income or profit"). Thus, the losses that Portland Golf incurred in
selling food and drink to nonmembers will constitute "deductions
allowed by this chapter" only if the club's nonmember sales were
performed with an intent to profit. [
Footnote 15]
Page 497 U. S. 165
We see no basis for dispensing with the profit-motive
requirement in the present case. Indeed, such an exemption would be
in considerable tension with the statutory scheme devised by
Congress to govern the taxation of social clubs. Congress intended
that the investment income of social clubs (unlike the investment
income of most other exempt organizations) should be subject to the
same tax consequences as the investment income of any other
taxpayer. To allow such an offset for social clubs would run
counter to the principle of tax neutrality which underlies the
statutory scheme.
Petitioner concedes that "[g]enerally a profit motive is a
necessary factor in determining whether an activity is a trade or
business." Brief for Petitioner 23. Petitioner contends, however,
that, by including receipts from sales to nonmembers within §
512(a)(3)(A)'s definition of "unrelated business taxable income,"
the Code has defined nonmember sales as a "trade or business," and
has thereby obviated the need for an inquiry into the taxpayer's
intent to profit. We disagree. In our view, Congress' use of the
term "unrelated business taxable income" to describe all receipts
other than payments from the members hardly manifests an intent to
define as a "trade or business" activities otherwise outside the
scope of § 162. Petitioner's reading would render superfluous the
words "allowed by this chapter" in § 512(a)(3)(A): if each taxable
activity of a social club is "deemed" to be a trade or business,
then all of the expenses "directly connected" with those activities
would presumably be deductible. Moreover, Portland Golf's
interpretation ignores Congress' general intent to
Page 497 U. S. 166
tax the income of social clubs according to the same principles
applicable to other taxpayers. We therefore conclude that
petitioner may offset losses incurred in sales to nonmembers
against investment income only if its nonmember sales are motivated
by an intent to profit. [
Footnote 16]
B
Losses from Portland Golf's sales to nonmembers may be used to
offset investment income only if those activities were undertaken
with a profit motive -- that is, an intent to generate receipts in
excess of costs. The parties and the other courts in this case,
however, have taken divergent positions as to the range of expenses
that qualify as costs of the nonexempt activity and are to be
considered in determining whether petitioner acted with the
requisite profit motive. In the view of the Tax Court, petitioner's
profit motive was established by the fact that the club's receipts
from nonmember
Page 497 U. S. 167
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.
Although the Court of Appeals' opinion is not entirely clear on
this point,
see n. 8,
supra, that court seems to
have taken a middle ground. The Court of Appeals expressly rejected
the Tax Court's assertion that profit motive could be
established
Page 497 U. S. 168
by a showing that gross receipts exceeded variable costs; the
court insisted that
some portion of fixed costs must be
considered in determining intent to profit. The court appeared,
however, to leave open the possibility that Portland Golf could use
the gross-to-gross method in calculating its actual losses while
using some
other allocation method to demonstrate that its
sales to nonmembers were undertaken with a profit motive. [
Footnote 18]
We conclude that the Commissioner's position is the correct one.
Portland Golf's argument rests, as the Commissioner puts it, on an
"inherent contradiction." Brief for Respondent 44. Petitioner's
calculation of actual losses rests on the claim that a portion of
its fixed expenses is properly regarded as attributable to the
production of income from nonmember sales. Given this assertion, we
do not believe that these expenses can be ignored (or, more
accurately, attributed to petitioner's exempt activities) in
determining whether petitioner acted with the requisite intent to
profit. Essentially the same criticism applies to the Court of
Appeals' approach. That court required petitioner to include
some portion of fixed expenses in demonstrating its intent
to profit, but it left open the possibility that petitioner could
employ an allocation method different from that used in calculating
its actual losses. Under that approach, some of petitioner's fixed
expenses could be attributed to exempt functions in determining
intent to profit and to nonmember sales in establishing the club's
actual loss. This, like the rationale of the Tax Court, seems to us
to rest on an "inherent contradiction."
Petitioner's principal response is that § 162 requires an intent
to earn an economic profit, and that this is quite different from
an intent to earn
taxable income. Portland Golf emphasizes
that numerous provisions of the Code establish
Page 497 U. S. 169
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 accept petitioner's contention that § 162 requires only an
intent to earn an economic profit. We acknowledge, moreover, that
many Code provisions are designed to serve purposes (such as
encouragement of certain types of investment) other than the
accurate measurement of economic income. A taxpayer who takes
advantage of deductions or preferences of that kind may establish
an intent to profit even though he has no expectation of realizing
taxable income. [
Footnote
19] The fixed expenses that Portland Golf seeks to allocate
Page 497 U. S. 170
to its nonmember sales, however, are deductions of a different
kind. The Code does not state that fixed costs are allocable on a
gross-to-gross basis irrespective of economic reality. Rather,
petitioner's right to use the gross-to-gross method rests on the
club's assertion that this allocation formula reasonably identifies
those expenses that are "directly connected" to the nonmember
sales, § 512(a)(3)(A), and are "the ordinary and necessary expenses
paid or incurred" in selling food and drink to nonmembers,
see § 162(a). [
Footnote
20] Language such as this, it seems to us, reflects an attempt
to measure economic income -- not an effort to use the tax law to
serve ancillary purposes. Having calculated its actual losses on
the basis of the gross-to-gross formula, petitioner is therefore
foreclosed from attempting to demonstrate its intent to profit by
arguing that some other allocation method more accurately reflects
economic reality. [
Footnote
21]
Page 497 U. S. 171
IV
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.
It is so ordered.
[
Footnote 1]
Section 501(c)(7) grants an exemption from federal income tax
to
"[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."
[
Footnote 2]
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.
[
Footnote 3]
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.
[
Footnote 4]
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.
[
Footnote 5]
The following table shows petitioner's losses when fixed costs
are allocated using the gross=to-gross method:
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)
It is of interest to note that, if petitioner's fixed costs had
been allocated using an alternative formula, known as the "square
foot and hours of actual use" method,
see id. at 29, its
gross receipts exceeded the sum of variable and allocated fixed
costs for both years:
1980 1981
Gross income $ 84,422 $ 106,547
Variable expenses (61,821) (78,407)
Allocated fixed expenses ( 3,153) ( 4,666)
Net loss $ 19,448 $ 23,474
[
Footnote 6]
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).
[
Footnote 7]
The Tax Court stated that Portland Golf
"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).
[
Footnote 8]
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.
[
Footnote 9]
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).
[
Footnote 10]
Section 513(a) defines "unrelated trade or business" as
"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. . . ."
[
Footnote 11]
Section 512(a)(3)(B) defines "exempt function income" as
"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."
[
Footnote 12]
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.
[
Footnote 13]
See S.Rep. No. 2375, at 30-31; H.R.Rep. No. 2319, at
38.
[
Footnote 14]
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.
[
Footnote 15]
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.
[
Footnote 16]
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.
The general rule that losses incurred in a not-for-profit
activity may not be used to offset unrelated income rests on the
recognition that one who incurs expenses without an intent to
profit presumably derives some intrinsic pleasure or benefit from
the activity. The Code's limitation on deductibility (expenses may
be deducted up to, but not above, the gross income produced by the
activity) reflects the view that taxpayers should not be allowed to
deduct what are, in essence, personal expenses simply because the
activity in question generates some receipts. Just as an individual
taxpayer may not offset personal expenses against income from other
sources, a social club should not be allowed to deduct expenses
incurred for the benefit of the membership from unrelated business
income.
[
Footnote 17]
The parties stlpulated that the gross-to-gross formula was a
reasonable method of allocating fixed expenses. App. 17. In his
brief to this Court, however, the Commissioner states:
"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.
[
Footnote 18]
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.
[
Footnote 19]
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.
[
Footnote 20]
As stated earlier, § 512(a)(3)(A) limits deductions from
unrelated business taxable income to "deductions allowed by this
chapter." In the present case, petitioner may offset losses from
nonmember sales against investment income only if those losses are
deductible under § 162. That Code provision states:
"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.
[
Footnote 21]
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.
[
Footnote 22]
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.
Justice KENNEDY, with whom Justice O'CONNOR and Justice SCALIA
join, concurring in part and concurring in the judgment.
The Tax Court found that Portland Golf Club's nonmember activity
qualified as a trade or business under § 162(a) of the
Page 497 U. S. 172
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.
I join all but Parts III-B and IV of the Court's opinion. I
otherwise concur only in the judgment, because the Court decides a
significant issue that is unnecessary to our disposition of the
case, and, in my view, decides it the wrong way. When the Court of
Appeals instructed the Tax Court to consider the Club's indirect
costs, it did not specify how the Club should allocate these costs
between its member and nonmember activities. In particular, it left
open the possibility that the Club could use one allocation method
to calculate its expenses under § 162(a), while using some other
allocation method to demonstrate its profit motivation.
See
ante at
497 U. S. 160.
Although the Court purports to affirm the Court of Appeals, its
opinion eliminates this possibility, and thus works a dramatic
change in the remand order. The Court rules in Parts III-B and IV
that, if the Club uses the so-called gross-to-gross method to
allocate its fixed costs when computing its expenses, it must use
the same allocation method to prove its profit motivation. The Tax
Court and Court of Appeals, in my view, should have had the
opportunity to consider this issue in the first instance. Because
the Court has
Page 497 U. S. 173
reached the question, however, I must state my disagreement with
its conclusion.
A taxpayer's profit motive, in my view, cannot turn upon the
particular accounting method by which it reports its ordinary and
necessary expenses to the Internal Revenue Service (IRS). The Court
cites no authority for its novel rule, and we cannot adopt it
simply because we confront a hard case. Section 162(a)
provides:
"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.
A taxpayer often may choose from among different accounting
methods when computing its ordinary and necessary expenses under §
162(a). In this case, as stipulated by the IRS, the Club could have
allocated its fixed costs either by the gross-to-gross method or by
the so-called actual use method. Although the gross-to-gross method
showed a net loss for the relevant tax years, the actual use method
would have shown a net profit.
See ante at
497 U. S. 158,
n. 5. If profit motivation turns upon the allocation method
employed by the Club in filling out its tax forms, then the status
of the nonmember activity as a trade or business may lie within the
control of
Page 497 U. S. 174
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.
The Court's decision also departs from the traditional practice
of the courts and the IRS. Rather than relying on strict
consistency in accounting, the courts long have evaluated profit
motivation according to a variety of factors that indicate whether
the taxpayer acted in a manner characteristic of one engaged in a
trade or business.
See, e.g., Teitelbaum v. C.I.R., 294
F.2d 541, 545 (CA7 1961);
Patterson v. United States, 459
F.2d 487, 493-494, 198 Ct.Cl. 543 (1972);
see Boyle, What
is a Trade or Business?, 39 Tax Law. 737, 743-745 (1986); Lee, A
Blend of Old Wines in a New Wineskin: Section 183 and Beyond, 29
Tax L. Review 347, 390-447 (1974). In a regulation based on a wide
range of prior court decisions, the IRS itself has explained § 162
and profit motivation as follows:
"Deductions are allowable under section 162 for expenses of
carrying on activities which constitute a trade or business of the
taxpayer and under section 212 for expenses incurred in connection
with activities engaged in for the production or collection of
income or for the management, conservation, or maintenance of
property held for the production of income. Except as provided in
section 183 and [26 CFR] § 1.183-1 [which authorize individuals and
S-corporations to offset hobby losses], no deductions are allowable
for expenses incurred in connection with activities which are not
engaged in for profit. . . . The determination whether an activity
is engaged in for profit is to be made by reference to objective
standards, taking into account all of the facts and circumstances
of each case. Although a reasonable expectation of profit is not
required, the facts and circumstances
Page 497 U. S. 175
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).
The Court today limits this longstanding approach by pinning the
profit motive requirement to the accounting method that a taxpayer
uses to report its ordinary and necessary expenses under § 162(a).
Although the tax laws in general strive to reflect the true
economic income of a taxpayer, the IRS at times allows taxpayers to
use accounting methods that understate their income or overstate
their expenses. In this case, as the Court itself acknowledges, the
IRS stipulated that the Club could use the gross-to-gross
allocation method to calculate its expenses under § 162(a) even
though this method tends to exaggerate the percentage of fixed
costs attributable to the Club's nonmember sales.
See ante
at
497 U. S.
157-158, n. 4. Yet I see no basis for saying that, when
the Club took advantage of this unconditional stipulation, it
committed itself to the legal position that the gross-to-gross
method best reflects economic reality. Some inconsistency will
exist if the Club uses the gross-to-gross allocation method in
computing the expenses while using some other reasonable accounting
method to prove that it undertook the nonmember activity
Page 497 U. S. 176
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.