What Is the Section 277 Carryover Deduction?
Understand the tax rule that lets membership organizations defer losses from member services by applying them as a deduction against future member income.
Section 277 of the Internal Revenue Code is a tax rule for certain non-exempt membership organizations. It limits the deductions an organization can claim for providing services and goods to its members. These deductions cannot exceed the income generated from members within a single tax year, preventing the organization from using non-member income to offset losses from serving its membership.
When member-related expenses are greater than member income, the resulting loss cannot be used to lower taxable income from other sources. Instead, this excess deduction amount is handled through the Section 277 carryover. This allows the loss to be carried to the next tax year as a deduction against future member income.
Organizations Subject to Section 277
Section 277 applies to nonexempt membership organizations operated primarily to furnish goods or services to members. This includes non-profit social clubs, business leagues, and similar groups that lack tax-exempt status under other code sections, like 501(c)(7). These organizations are structured as corporations and must file Form 1120, the U.S. Corporation Income Tax Return.
Homeowners associations (HOAs) are a common example of an organization affected by these rules. An HOA must file Form 1120 and is subject to Section 277 unless it makes an election under Section 528 of the Internal Revenue Code. Filing Form 1120-H allows an HOA to be taxed under different rules, which include a flat tax rate on non-exempt income and no ability to carry over net operating losses.
If an HOA or similar organization does not make the Section 528 election, it is taxed as a regular corporation using Form 1120 and becomes subject to Section 277. This requires the organization to track income and expenses based on whether they relate to members or non-members. This distinction is important because it can lead to a tax liability on non-member income even if the organization has a net loss overall.
Calculating the Deduction Limitation and Carryover
The calculation requires the segregation of income and expenses into two categories. The first category is member-related income, which includes dues, fees for services, and special assessments. The second category is non-member income, which includes investment interest, facility rentals to the public, or business conducted with non-members.
All expenses must also be allocated between these two categories. Member-related expenses include costs for maintaining member-only areas, salaries for staff serving members, and direct costs of member events. Expenses for generating non-member income, such as investment management fees, are allocated to the non-member category. Overhead expenses may need to be allocated between the two categories on a reasonable basis.
The limitation is applied after categorizing all finances. If member-related expenses exceed member income, the resulting net loss cannot be used to reduce taxable income from non-member activities. This disallowed amount is what becomes the Section 277 carryover deduction.
Consider a social club in its first year of operation (“Year 1”). The club generates $100,000 in income from member dues and fees, while its expenses for providing member services total $120,000. This creates a $20,000 loss from member activities. During the same year, the club earned $30,000 in interest from its bank accounts. The club cannot use the $20,000 member loss to offset the $30,000 of interest income. Therefore, the club reports $30,000 of taxable income, and the $20,000 loss is designated as the Section 277 carryover.
Applying the Carryover in Subsequent Tax Years
The Section 277 carryover is a deferred deduction, not a refund. It is treated as a member-related expense paid in the succeeding taxable year. An organization can use the carryover to reduce its member income in the next tax period. The carryover has an indefinite life and can be carried forward until it is fully used.
To continue the example, the social club enters its second year (“Year 2”) with the $20,000 carryover from Year 1. In Year 2, the club generates $150,000 in income from its members, and its member-related expenses are $110,000. Before applying the carryover, the club has a net income of $40,000 from member activities ($150,000 – $110,000).
The club can now apply the $20,000 carryover from Year 1, which is treated as an additional member-related deduction in Year 2. The club’s taxable income from member activities is reduced from $40,000 down to $20,000. If the club also earned non-member income in Year 2, that income would be added to this amount to determine the final taxable income for the year.
If the club’s member income in Year 2 was only $125,000 against $110,000 in expenses, its net member income would be $15,000. The club could use $15,000 of the carryover to reduce its member income to zero. The remaining $5,000 of the carryover would not be lost and would be carried forward to Year 3 or a subsequent year. This process continues until the entire carryover amount is used.