Section 277 Deduction Rules for Membership Organizations

Internal Revenue Code (IRC) Section 277 provides specific tax rules for certain membership-based organizations. The rule’s purpose is to create a clear financial distinction between an organization’s activities with its members and its dealings with non-members. It prevents a non-exempt membership organization from using losses generated by providing services to its members to lower the taxable income it earns from other sources, such as investments or business dealings with the public. This segregation ensures that income from non-member sources is taxed appropriately.

Organizations Subject to the Deduction Limitation

The deduction limitation rules in Section 277 apply to non-exempt membership organizations, which are groups operated primarily to provide goods, services, or other benefits to their members. Common examples include social clubs, such as country clubs or recreational groups, and business leagues that do not qualify for tax-exempt status. The rules also extend to other entities like certain cooperative housing corporations, whose primary focus is serving their membership base rather than generating profits for external shareholders.

The Internal Revenue Code exempts several types of organizations from this deduction limitation. The rule does not apply to:

• Organizations that are tax-exempt under other provisions, such as charitable organizations under Section 501(c)(3).
• Certain financial institutions, specifically those taxed under Subchapter H (relating to Real Estate Investment Trusts) or Subchapter L (relating to insurance companies).
• National securities exchanges.
• Certain news gathering agencies.

Calculating the Deduction Limitation

The principle of the Section 277 deduction limitation is that total deductions for providing services and goods to members cannot exceed the total income received from those members in a given tax year. To apply this rule, an organization must separate its income and expenses into two categories: membership and non-membership, which requires careful record-keeping.

Membership income includes all revenue derived directly from members. This encompasses periodic dues, special assessments, fees for using facilities like a golf course or swimming pool, and payments for goods or services sold to the membership. Any income not from members, such as interest earned on bank accounts, dividends, or revenue from renting facilities to the public, is considered non-membership income.

Once income is categorized, the organization must identify and allocate its expenses. Deductions for member activities include both direct and indirect costs. Direct costs are expenses like the cost of food for a members-only dinner. Indirect costs, like administrative salaries, rent, and utilities, must be allocated between member and non-member activities using a reasonable and consistent method, often based on factors like facility usage, staff time, or square footage.

To illustrate the calculation, consider a social club that generated $150,000 in member income and $50,000 from non-member rentals. The club incurred $160,000 in expenses for member services and $20,000 for non-member rentals. Under Section 277, the club can only deduct member service expenses up to its member income. Since member-related expenses ($160,000) exceed member income ($150,000), the deduction is limited to $150,000, and the remaining $10,000 is disallowed for the current year.

Treatment of Disallowed Deductions

When an organization’s deductions for member services exceed its income from members, the excess amount is not permanently lost. Section 277 allows these disallowed deductions to be carried forward to subsequent tax years. The disallowed amount is treated as a deduction attributable to furnishing services to members in the succeeding taxable year.

This means the excess deduction from the current year is added to the member-related deductions of the next year. For example, if a club has $10,000 in disallowed deductions in Year 1, that $10,000 is carried over and treated as a member-related expense in Year 2. This carryover has an indefinite life and can be carried forward for an unlimited number of years until it is fully utilized to offset future net income from member transactions.

Special Considerations for Homeowners Associations

Homeowners associations (HOAs) are subject to Section 277 rules if they file a standard corporate income tax return, Form 1120. This filing status treats them as non-exempt membership organizations, requiring the separation of membership and non-membership income and expenses. This can be complex as interest on reserve funds is considered non-membership income.

As an alternative, qualifying HOAs can elect to be treated as tax-exempt for their primary activities under IRC Section 528. This election is made annually by filing Form 1120-H. To qualify, an HOA must derive at least 60% of its gross income from members and spend at least 90% of its expenditures on managing association property.

By making the Section 528 election, an HOA’s exempt function income, which includes member dues and assessments, is not taxed. The organization is then taxed only on its net non-exempt function income, such as interest, dividends, or fees from non-members. This income is taxed at a flat rate of 30% (32% for timeshare associations). A consequence of this election is that the organization is not subject to the Section 277 deduction limitation.