PLR 1228014: IRS treats a rural telephone cooperative's stock-sale gain as patronage-sourced

Plain-English summary

A rural telephone cooperative planned to sell stock in a telecommunications service company and use the proceeds for construction projects serving its members. The cooperative had acquired and held the stock to obtain essential telecommunications services for its member-patrons, not as a standalone investment. The IRS ruled that the resulting capital gain would be patronage-sourced income and, if properly allocated to members, could be excluded from gross income as a true patronage dividend. The ruling applied the cooperative tax principles relevant to a rural telephone cooperative that might lose its exemption under IRC § 501(c)(12). It addressed only the described stock sale and the requested patronage treatment.

Ruling snapshot

• Question: Would gain from the cooperative's sale of telecommunications-company stock be patronage-sourced income?
• Outcome: Approved
• Key authorities: IRC §§ 501(c)(12), 1381, 1388; Treas. Reg. § 1.1382-3(c)(2)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201228014 Third Party Communication: None
Release Date: 7/13/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1381.02-00 ----------------------------, ID No. ----------
Telephone Number:
---------------------
-------------------------- Refer Reply To:
------------------------ CC:PSI:B05
------------------------------------------------- PLR-141816-11
---------------------- Date:
------------------ March 28, 2012

Legend

Taxpayer = --------------------------------------------------

State A = ------

Corp A = -----------------------------------

Corp B = ---------------------------------------------------------------

Corp C = ----------------------------

Corp D = ------------

E = ----------------------------------------

Dear --- ------------:

    This is in response to a request for a ruling dated September 30, 2011, submitted

on behalf of Taxpayer by your authorized representative. The ruling concerns the
application of cooperative tax law to a transaction described below.

    Taxpayer was incorporated in -------- pursuant to the State A Administrative

Code. Taxpayer is a rural telephone company operated on a cooperative, non-profit
basis for the mutual benefit of its members. It serves --------members/patrons
northwestern State A.
PLR-141816-11 2

     According to Taxpayer’s Amended Articles of Incorporation dated --------------------

--------------------------------------------------------------------------------------------------------------------:

     “[t]he purposes for which said corporation is formed are building,
     purchasing, and otherwise acquiring, equipping, maintaining, and
     operating telephone and broadband systems and furnishing telephone and
     broadband service or either in [Taxpayer] and neighboring townships,
     villages, and communities for the mutual benefit of its members, and doing
     any and all things necessary or incident thereto.”

   The “Code of Regulations of the [Taxpayer]” (i.e., “the Bylaws”) prescribe the

rights and responsibilities of the Taxpayer and its members.

     Article I. Requirement for Membership, Section 1 states that “any person, firm,

association, Company, limited liability company, limited liability partnership, or body
politic, or subdivision thereof may become a member of the [Taxpayer], hereinafter
called the Company” by complying with rules typical of cooperative organizations.

  Article II. Rights and Liabilities of the Company and the Members, Section 3

“Property Interest of Members” states the following:

     “Upon dissolution after (a) all debts and liabilities of the Company have
     been paid, (b) all capital furnished through patronage shall have been
     retired as provided in this code of regulation, and (c) the membership fees
     shall have been repaid, the remaining property and assets of the
     Company shall be distributed among members in proportion which the
     aggregate bears to the total patronage of such members and former
     members on the date of dissolution, unless otherwise provided by law.”

     Article III. Meeting of Members, Section 7, Voting at Meetings, states in part

that:

     “Each member shall be entitled to only one vote upon each matter
     submitted at a meeting of the members.”

     Article IV. Trustees, Section 1, General Powers, states that:

     “The business and affairs of the Company shall be managed by a board of
     --- trustees which shall exercise all powers of the Company except as are
     by law, Article of incorporation or this code of regulation conferred upon or
     reserved to the members.”

     Section 2, Election and Tenure of Office, states in part that:

PLR-141816-11 3

  “The trustees shall be elected by secret ballot at the annual meeting of the
  members by and from the members to serve until their successors shall
  have been elected and qualified.”

   Article VIII. Non-Profit Operation, describes the manner in which the Taxpayer

will operate with respect to its members.

  Section 1, Interest or Dividends on Capital Prohibited, states:

  “The Company shall at all times be operated on a mutual non-profit basis
  for the mutual benefit of its patrons. No interest or dividends shall be paid
  or payable by the Company on any capital furnished by its patrons.”

   Section 2, Patronage Capital in Connection with Furnishing Telecommunications,

Communications, Telephone and Information Services obligates its members/patrons to
furnish and the Taxpayer to account for on a cooperative basis to all its patrons “for all
amounts received and receivable from the furnishing of telecommunications,
communications and information services in excess of operative costs and expenses
properly chargeable against furnishing services.”

  Taxpayer received tax exemption from the Service on -------------------------, for

telephone and broadband services under section 501(c)(12)(A) of the Internal Revenue
Code. As telephone business has changed, fewer rural telephone cooperatives have
been able to satisfy the 85 percent income test prescribed by section 501(c)(12)(A).
Taxpayer believes it will not pass the 85 percent test for either tax years 2011 or 2012.

   In early 1980, American Telephone & Telegraph (AT&T) advised the independent

telephone industry of the prospective availability of a new telephone service to
subscribers. AT&T’s new system was known as a Data Base Administration System
(DBAS) and it enabled its customers to use the then recently developed Calling Card
Service (CSS), also known as Auto Bill Calling service (ABC). With that service, the
Taxpayer’s member/patrons would be able to make credit available, collect, or third-
party long distance calls with the assistance of an operator.

   While AT&T offered this service to the over 1,100 independent telephone

companies (including many rural telephone cooperatives like Taxpayer), the necessary
capital expenditure for each to participate would be prohibitive. At the same time it was
clear to small companies that they needed to offer the same type of services to their
subscribers enjoyed by customers of larger telephone companies. Therefore, the
smallest of the telephone companies formed Corp A allowing participation in the AT&T
system. Corp A followed many of the same principles as cooperatives such as
PLR-141816-11 4

governance by one-voter per member and distribution of margins based on member
participation.

  In --------------------Taxpayer purchased 1 share of Class A Voting Stock and -------

shares of Class B Non-voting Stock in Corp A. As part of the stock purchase, Taxpayer
agreed to use the services of Corp A’s Mechanized Calling Card Services data utilizing
a DBAS according to specifications of AT&T.

 In --------------------, Taxpayer signed Corp A’s “800 Services” – “Independent

Responsible Organization Agreement.”

 In ------------------, Taxpayer signed Corp A’s AT&T “Communications Standard

Agreement” for the provision of telecommunications services and facilities.

  In ----------------------, Taxpayer purchased an additional share of Class A Voting

Stock and ----- Shares of Class B Non-Voting Stock in Corp A.

   In -------------, Taxpayer singed Corp A/Local Exchange Carrier (LEC) Agreement

for Other Service Provider (OSP) billing and collection services.

  In -------, Taxpayer signed a variety of Corp A’s Master Service Agreements

which brought in MCI and Sprint service process.

  In ------------------Taxpayer paid $--------for Preferred Stock and Convertible

Debentures in Corp B, a new corporation formed by Corp A. Corp B was formed to
operate and manage a new and powerful “SS7” network to allow Taxpayer to meet its
members/patrons need for enhanced information services.

   In --------------------, it was announced that Corp B and Corp A were merging to

become Corp C. Taxpayer’s Corp B and Corp A stock certificates were replaced by
stock certificates of Corp C.

  In ----------------------, Corp C became a wholly-owned subsidiary of Corp D. That

transaction was followed by Taxpayer exchanging Holding Common Stock for ------------
shares of Corp D Common Stock.

   In -------------, Taxpayer received a letter from Corp D announcing that it had sold

their Communications Services Group Business to E. The last receipt for purchased
services made my Taxpayer from Corp D was received in --------------------.

   Because Corp D no longer provides Taxpayer with service, the Board of Trustees

has decided to sell all of the Corp D stock in various tranches and redeploy proceeds of
that sale to current telecommunications construction projects necessary to serve its
PLR-141816-11 5

members/patrons. The capital gain realized on the sale will be allocated based on
historic records maintained by Taxpayer on its member/patron service.

  Based on the foregoing, Taxpayer request a ruling that:

   The capital gain realized by the Taxpayer from the sale of Corp D stock

constitutes “patronage-sourced” income which if properly allocated to its
members/patrons will be excludable from gross income as a true patronage dividend.

   In the event a rural telephone cooperative such as Taxpayer loses its tax-exempt

status, section 501(c)(12) of the Code no longer applies until such time as the
cooperative again satisfies the requirements for exemption. During any taxable period,
the rules applicable to the telephone cooperative depend on the reasons why it failed its
exemption tests. If exemption was lost because the company failed to operate on a
cooperative basis, then it will be taxed under the same rules applicable to for-profit
corporations. Alternatively, if the cooperative becomes taxable because it failed the so-
called 85 percent income test imposed by section 501(c)(12), then the organization will
be taxed as a cooperative.

    While the requirements of subchapter C of the Code regarding corporate

distributions and adjustments and other provisions are generally applicable to
nonexempt cooperatives, these entities are distinguished from other types of
corporations by a specific body of tax law. The scheme of taxation for nonexempt
cooperatives was developed from the administrative pronouncements of the Service
and decision of the judiciary over a fifty-year period. These rules for tax treatment of
most nonexempt cooperatives and their patrons were finally codified with the enactment
subchapter T as part of the Revenue Act of 1962. Pub. L. No. 87-834 (H.R. 10650).

   With passage of subchapter T of the Code, the rules for deduction of patronage

dividends and the treatment of patronage dividends in the hands of a cooperative’s
patrons were defined. However, section 1381(a)(2)(c) states that subchapter T is not
applicable to organization engaged in furnishing electric energy, or providing telephone
service to persons in rural areas. According to the Senate Finance Committee Report
accompanying the 1962 Act, the intent of Congress was that nonexempt rural electric
and telephone cooperatives would continue to be treated as under “present law.”

   In its report accompanying the legislation, the Senate Finance Committee

described “present law” as follows:

  “Under present law patronage dividends paid by taxable cooperatives
  result in a reduction in the cooperative’s taxable income only if they are
  paid during the taxable year in which the patronage occurred or within the
  period in the next year elapsing before the prior year’s income tax return is

PLR-141816-11 6

   required to be filed (including any extensions of time granted).” S. Rep.
   No. 1881, 87th Cong., 1st Sess. 113 (1962).

    Under this earlier body of tax law applicable to nonexempt telephone

cooperatives, a cooperative may reduce its taxable income by any qualifying patronage
dividends paid to their members/patrons. Further, under pre-1962 cooperative rules,
the term “paid” means paid in cash or paid by notice of allocation. See also Rev. Rul.
83-135, 1983-2 C.B. 149 (A taxable cooperative not subject to the provisions of
subchapter T of the Code may exclude from gross income the patronage dividends paid
or allocated to its patrons in accordance with its by-laws).

    While subchapter T of the Code does not control the taxation of nonexempt

telephone cooperatives, its foundations rest upon pre-1962 cooperative tax law. As a
result, there are certain basic parallels between the tax treatment of nonexempt utility
cooperatives and treatment of other cooperative organizations under subchapter T.
Therefore, to extent that subchapter T reflects cooperative taxation as it existed prior to
1962, it is in instructive resolving certain issues facing rural telephone cooperatives.
This is because Congress stated that in enacting subchapter T it was merely codifying
the long common law history of cooperative taxation (with the exception of ensuring at
least one annual level of tax at the cooperative or patron level. See S. Rep. No. 1881,
87th Cong., 1st Sess. 113 (1962)) and, arguably, the case law post-enactment is merely
a continuation and refinement of the pre-enactment common law. This is particularly
true with respect to defining certain terms such as “operating on a cooperative basis”
and “patronage income.”

   Perhaps the most succinct definition of the term “cooperative” for Federal income

tax purposes was provided by the U.S. Tax Court in Puget Sound Plywood, Inc. v.
Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3. The Tax Court said:

   “Under the cooperative association form or organization, on the other
   hand, the worker-members of the association supply their own capital at
   their own risk; select their own management and supply their own
   direction for the enterprise, through worker meetings conducted on a
   democratic basis; and then themselves receive the fruits of their
   cooperative endeavors, through allocations of the same among
   themselves as co-workers, in proportion to the amounts of their active
   participation in the cooperative undertaking.”

 The Tax Court went on to describe three guiding principles at the core of

economic cooperative theory as:

   “(1) Subordination of capital, both as regards control over the cooperative
   undertaking, and as regards the ownership of the pecuniary benefits

PLR-141816-11 7

   arising therefrom; (2) democratic control by the worker-members
   themselves; and (3) the vesting in and allocation among the worker-
   members of all fruits and increases arising from their cooperative
   endeavor (i.e., the excess of operating revenues over the costs incurred in
   generating those revenues), in proportion to the worker-members’ active
   participation in the cooperative endeavor.” 44 T.C. at 308.

   The mechanism by which telephone cooperative achieve operation at cost is the

patronage dividend (or capital credit). Since the payment of patronage dividends (and
operation at cost) is so critical to achieving cooperative status as defined by Puget
Sound, it is important to analyze this issue.

   Rural telephone cooperatives perform a final accounting at year-end to determine

the net margin derived from their members’ patronage during the course of the year.
Then, the excess over cost collected from members is returned to them by a capital
credit allocation based on each member’s patronage. Those capital credits are typically
“paid” by allocations of capital credit certificates or notices of allocation, rather than in
cash. The capital credits retained form the foundation for the organization’s equity
capital.

  A true patronage dividend that may be excluded from the income of a rural

telephone cooperative must meet the three tests set forth in Farmers Cooperative Co. v.
Birmingham, 86 F, Supp 201 (N.D. Ia. 1949), and Pomeroy Cooperative Grain Co. v.
Commissioner, 31 T.C. 674 (1958), acq., AOD 1959-2 C.B. 6. Those tests are:

   1.     It must be made subject to a preexisting legal obligation;

   2.     the allocation must be made on the basis of patronage; and

   3.     the margins allocated must be derived from the profits generated from
          patrons’ dealings with the cooperative.

   Although the Code does not provide specific guidance as to what constitutes

patronage-sourced income for a nonexempt telephone cooperative, regulations and
rulings address the issues for cooperatives governed by subchapter T of the Code.
While not directly applicable to taxable utility cooperatives per se, arguably they reflect
the correct analysis with respect patronage income of cooperatives subject to pre-1962
law.

  The Senate Committee Report accompanying the cooperative provisions in the

Revenue Act of 1951 indicated that the Congress intended to tax “ordinary” (i.e., non-
farmer) cooperatives for:
PLR-141816-11 8

      “non-operating income…not derived from patronage, as for example in the
      case of interest or rental income, even if distributed to patrons on a pro
      rata basis.” S. Rep. No. 781, 82d Cong. 1st Sess. (1951).

   In response to that guidance of Congress, the Service promulgated regulations

distinguishing nonpatronage income from that which is patronage derived.

   Section 1388(a)(3) of the Code specifies that a patronage dividend must be

“determined by reference to the net earnings of the organization from business done
with or for its patrons.” That section further provides that the term “patronage dividend”
does not include any amount paid to a patron to the extent that such amount is out
earnings other than from business done with or for patrons. Further, it does not include
earnings from business done with or for other customers “to whom no amounts are
paid, or to whom smaller amounts are paid with respect to substantially identical
transactions.”

    In Rev. Rul. 69-576, 1969-2 C.B. 166, a nonexempt farmers’ cooperative

borrowed money from a bank for cooperatives (itself a cooperative) to finance the
acquisition of agricultural supplies for resale to its members. The bank for cooperatives
allocated and paid interest from its net earnings to the nonexempt farmers’ cooperative
which it in turn allocated to its members.

      In determining whether the allocation was from patronage sources the ruling

states:

      The classification of an item of income as from either patronage or
      nonpatronage sources is dependent on the relationship of the activity
      generating the income to the marketing, purchasing, or service activities of
      the cooperative. If the income is produced by a transaction which actually
      facilitates the accomplishment of the cooperative's marketing, purchasing,
      or service activities, the income is from patronage sources. However, if
      the transaction producing the income does not actually facilitate the
      accomplishment of these activities but merely enhances the overall
      profitability of the cooperative, being merely incidental to the association's
      cooperative operation, the income is from nonpatronage sources. Rev.
      Rul. 69-576 at 167.

      The ruling concluded that in as much as the income received by the nonexempt

cooperative from the bank for cooperatives resulted from a transaction that financed the
acquisition of agricultural supplies which were sold to its members, thereby directly
facilitating the accomplishment of the cooperative’s marketing, purchasing, or service
activities, the income was patronage sourced.
PLR-141816-11 9

      Section 1.1382-3(c)(2) of the Income Tax Regulations defines income from

sources other than patronage (nonpatronage income) to mean incidental income
derived from sources not directly related to the marketing, purchasing, or service
activities of the cooperative association such as income derived from lease of premises,
from investment in securities, or from the sale or exchange of capital assets.

   In St. Louis Bank for Cooperatives v. United States, 224 Ct. Cl. 289, 624 F.2d

1041 (Cl. Ct. 1980), the Court held that interest on demand deposits in farm credit
banks or on loans to brokerage funds received by St. Louis Bank for Cooperatives was
patronage sourced income. The Court stated that a particular item of income is
patronage sourced when the transactions involved are directly related to the marketing,
purchasing, or service activities of the cooperative association. 624 F.2d at 1045.

   In Twin County Grocers, Inc. v. United States, 2 Cl. Ct. 657 (1983), a nonexempt

cooperative was denied deductions for patronage dividends for interest on a certificate
of deposit bought from a nonpatron bank because the dividend income was not
patronage sourced. The Court held that the relation of income activity to the
cooperative’s business was too tenuous.

     Courts have ruled in several instances that income from corporations organized

by cooperatives to conduct activities related to the cooperative business is patronage
sourced. In Farmland Industries, Inc. v. Commissioner, 78 T.C.M. 846, 864 (1999),
acq., AOD 2001-03 (citing Cotter & Co. v. United States, 765 F.2d 1102, 1106 (1985);
Land O’Lakes, Inc. v. United States, 675 F.2d 988, 993 (8th Cir. 1982); Certified Grocers
of Cal., Ltd. v. Commissioner, 88 T.C. 238, 243 (1987); Illinois Grain Corp. v.
Commissioner, 87 T.C. 435, 459 (1986)), the taxpayer, a cooperative organized for the
purpose of providing petroleum products to its patrons, sought to have the proceeds
from the disposition of its stock in three subsidiaries classified as patronage-sourced
income. In reaching its decision, the Court stated that its task was to “determine
whether each of the gains and losses at issue was realized in a transaction that was
directly related to the cooperative enterprise, or in one which generated incidental
income that contributed to the overall profitability of the cooperative but did not actually
facilitate the accomplishment of the cooperative=s marketing, purchasing, or servicing
activities on behalf of its patrons.@ 78 T.C.M. at 870.

    In Land O’Lakes, Inc., supra., the Court held that dividends received by the

nonexempt cooperative from the St. Paul Bank for Cooperatives was patronage derived
and could be allocated to Land O’Lakes patrons as deductible patronage dividends.
The court noted that the taxpayer was required to acquire and hold the stock to obtain a
loan, the proceeds of which were used to finance cooperative activities on favorable
terms finding that the subject transaction was not significantly distinguishable from the
transaction in Rev. Rul. 69-576.
PLR-141816-11 10

     In the present case, Taxpayer purchased the stock which ultimately became

Corp D stock for the express purpose of gaining telecommunications services for its
members/patrons. Taxpayer had no choice but to participate in this way in order to
secure these services as it was too small to meet AT&T’s requirements to participate.
All of its transactions with Corp A, Corp B, Corp C, and Corp D were conducted to
obtain vital services for its member patrons. That continued for 20 years until Corp D
sold the unit rendering services to an unrelated party. All of Taxpayer’s relations with
the ever-changing service providers were conducted exclusively for the benefit of
Taxpayer’s members/patrons. Further, Taxpayer’s sale of the stock at issue is not
being done to merely enhance profitability but to provide capital for current
telecommunications construction projects necessary to serve its members/patrons.

   Accordingly, based solely on the foregoing we rule that:

   The capital gain realized by the Taxpayer from the sale of Corp D stock constitutes

“patronage-sourced” income which if properly allocated to its members/patrons will be
excludable from gross income as a true patronage dividend.

 This ruling is directed only to the taxpayer that requested it. Under section

6110(k)(3) of the Code it may not be used or cited as precedent. In accordance with a
power of attorney filed with the request, a copy of the ruling is being sent to your
authorized representative.

                                         Sincerely yours,

                                         /s/ Paul F. Handleman

                                         Paul F. Handleman
                                         Chief, Branch 5
                                         Office of the Associate Chief Counsel
                                         (Passthroughs & Special Industries)

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