Are prepaid club dues deductible?

The Revenue Reconciliation Act of 1993 (RRA) completely eliminates the deduction for club does paid or incurred after Dec. 31, 1993. The repeal applies to dues paid to any club organized for business, pleasure, recreation or other social purposes (Sec. 274(a)(3)). Because of this new prohibition, many taxpayers who use their clubs for business entertainment have raised questions as to the types of organizations whose dues are subject to the new rules, as well as whether deductions will be permitted for club dues prepaid on or before Dec. 31, 1993.

What is a club?

The first question that must be answered is what constitutes a "club" for purposes of Sec. 274(a)(3)? The RRA Conference Report indicates only that the provision applies to "all" types of clubs, including business, social, athletic, luncheon, sporting, airline and hotel clubs. Given the limited legislative history and broad language found in the statute (which specifically includes clubs organized for "business" purposes), the scope of this provision may be wider than most taxpayers anticipate. The IRS has indicated informally that it will probably interpret the term "club" broadly, so as to include any organization in which membership is "voluntary." This may come as a surprise to many business and professional associations that have assumed that they are outside the scope of Sec. 274(a)(3). it is hoped that the Service will issue formal guidance in the near future to limit (or at least clarify) the applicability of this provision to business organizations whose activities have only incidental social aspects.

Prepayment for

cash-basis taxpayers

In general, a cash-basis taxpayer may deduct up to 12 months of prepaid expenses if certain tests under Rev. Rul. 79-229 are satisfied.

1. The prepayment must be a true prepayment, not simply a refundable deposit.

2. The payment must have a substantial business purpose separate and apart from generating an income tax deduction.

3. No material distortion of income may result from deducting the prepayment. (The courts have generally held that this test is satisfied if the substantial business purpose requirement is satisfied.)

The applicability of these rules to prepaid club dues is currently under consideration by the IRS. In the absence of specific guidance, there appears to be a reasonable basis for deducting a prepayment of club dues, provided the payment is in fact nonrefundable and a substantial business purpose exists for the prepayment. A valid business purpose might exist, for example, if a monetary discount is offered by the club for prepayments, or if other noncash incentives (e.g., guest passes, entitlement to additional services, pro shop discounts) are offered as an inducement to pay early. Assuming the preceding tests are met and a material distortion of income does not occur by reason of deducting the prepayment, a deduction for club dues prepaid by Dec. 31, 1993 appears to be permissible.

The deductible amount will, of course, be limited to the portion of the dues directly related to the furtherance of the taxpayer's trade or business. Moreover, the taxpayer must establish that more than 50% of club use is for business purposes and, further, must establish through proper documentation that the amount for which a deduction is claimed is directly related to the taxpayer's trade or business. Since the prepayment will occur prior to the actual use of the club for the following year, the deduction should presumably be based on the taxpayer's actual business use percentage for the year in which the dues are prepaid, or on a good faith estimate of the anticipated use for the next year. If all non-business use in the subsequent year will be charged by the taxpayer as compensation to employees or other persons who use the club for personal purposes, a deduction based on the full amount of the prepayment should be permitted. However, keep in mind that under Sec. 274, only 80% (50% for tax years beginning in 1994) of otherwise allowable entertainment-related expenses, including deductions for club dues (in 1993 only), may be deducted for tax purposes.

Prepayment for

accrual-basis taxpayers

An accrual-basis taxpayer is generally entitled to deduct an expense when the underlying liability is fixed and definite, and the amount is reasonably ascertainable, but not before "economic performance" has occurred. A liability is typically fixed at the earlier of the following dates: (1) when it is unconditionally due or (2) when performance has taken place by the other party. The first test is apparently satisfied when a liability is prepaid on a nonrefundable basis (GCM 38901).

"Economic performance," in the case of club dues, will generally occur with the passage of time (i.e., over the period during which the club's facilities and services arc made available). If a taxpayer is eligible to use the recurring item method under Sec. 461(h)(3) (and that method has been properly elected), economic performance will be deemed to have occurred during the tax year in which the liability initially accrues, provided the liability is fixed and determinable at year-end and economic performance actually occurs within 8 1/2 months after the end of that year. The recurring item election applies only to liabilities that are recurring in nature, and that either are not "material" or for which a current deduction results in a better matching against income to which the item relates.

If a taxpayer has not adopted the recurring item method or is ineligible (e.g., is a "tax shelter" entity), a deduction may still be claimed for prepayments of up to 3 1/2 months of club dues under Regs. Sec. 1.461-4(d)(6), provided the taxpayer reasonably expects economic performance to occur within 3 1/2 months after the date of the prepayment.

Applying these general principles to prepaid club dues, the critical issue will generally be whether the liability is fixed and definite at year-end. As noted, a liability generally becomes fixed when it is unconditionally due or when performance has taken place by the other party. If the club dues are not unconditionally due prior to the period to which the dues relate (which will frequently be the case), it should still be possible to "fix" the liability prior to year-end by prepaying the dues on a nonrefundable basis. An accrual-basis taxpayer should be able to deduct up to 8 1/2 months of 1994 dues under the recurring item exception, provided the amount is not material and is not treated as a prepaid expense in the taxpayer's accounting records. Taxpayers not eligible to use the recurring item exception should still be able to prepay and deduct 3 1/2 months of club dues prior to year-end under the special economic performance rule contained in Regs. Sec. 1.461-4(d)(6).

Fiscal-year taxpayers

The new prohibition against deductions for club dues applies to all amounts paid or incurred after Dec. 31, 1993. Fiscal-year entities will, therefore, be subject to the same cutoff date as calendar-year taxpayers, and should also arrange to prepay membership dues before Jan. 1, 1994, if appropriate. The criteria for prepayments by calendar-year taxpayers should also apply to fiscal-year companies. Consequently, deductible prepayments should not extend beyond Dec. 31, 1994 for cash-basis taxpayers, or beyond Sept. 15, 1994 for accrual-basis taxpayers using the recurring item method, even if the taxpayer uses a noncalendar tax year.

Risk of IRS challenge

As the foregoing discussion demonstrates, there appears to be a reasonable basis for deducting prepaid club dues as long as certain conditions are satisfied. However, deductions may still be subject to IRS challenge. For instance, thc Service may take the position that a prepayment is merely a refundable deposit, or that the business purpose for a particular prepayment is insufficient to support a tax deduction. The IRS may also take the position that a deduction for the prepayment in question will "materially distort" the taxpayer's income for the current year, or that the primary business use test cannot be satisfied until actual business use of the club occurs during the subsequent tax year.

While it appears that prepaid dues deductions can be supported in some situations, the ultimate resolution of these issues may remain in doubt until the Service takes an official stance.