Written determination 1246038: IRS denies exemption to a mutual ditch and irrigation company support organization

Plain-English summary

The IRS denied exemption under IRC § 501(c)(12) to a nonprofit support organization for mutual ditch and irrigation companies. The organization held an annual workshop, published a newsletter, and intended to conduct focus groups and lobbying, but it did not operate an irrigation system for its members. The IRS also found that the organization was not structured as a qualifying cooperative because only two of four membership classes could vote, voting rights were unequal, member interests were not tied to business with the organization, and records did not establish members' rights to retained funds. The organization also failed to show that at least 85 percent of its income came from qualifying members solely to meet losses and expenses.

Ruling snapshot

• Question: Did the support organization qualify for exemption under IRC § 501(c)(12) as a mutual ditch or irrigation company or a like organization?
• Outcome: Denied
• Key authorities: IRC §§ 501(a), 501(c)(3), 501(c)(12), and 6110; Treas. Reg. § 1.501(c)(12)-1(a); Rev. Ruls. 68-564, 72-36, and 81-109

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Number: 201246038 Contact Person:

Release Date: 11/16/2012
Identification Number:

Date: August 22, 2012
Contact Number:

Employer Identification Number:
Form Required To Be Filed:

Tax Years:

UIL: 501.12-01

Dear

This is our final determination that you do not qualify for exemption from Federal income tax
under Internal Revenue Code section 501(a) as an organization described in Code section
501(c)(12).

We made this determination for the following reason(s):

You are not organized and operated as a cooperative under I.R.C. § 501(c)(12). Your Articles
of Incorporation are not written to comply with I.R.C. § 501(c)(12), you are not democratically
controlled by your members, your members’ rights and interests are not determined in
proportion to their business with you, you retain funds in excess of expenses but do not
describe the use of this reserve, and you failed to provide adequate records to determine each
members’ rights and interest in the funds you maintain. Furthermore, you do not perform the
activities of a mutual ditch or irrigation company under I.R.C. § 501(c)(12). Finally, you failed to
show that 85 percent of your income is received from your members for the sole purpose of
meeting income and expenses. Based upon a review of the materials you submitted you are
not described in I.R.C. § 501(c)(12).

You must file Federal income tax returns on the form and for the years listed above within 30
days of this letter, unless you request an extension of time to file. File the returns in accordance
with their instructions, and do not send them to this office. Failure to file the returns timely may
result in a penalty.

We will make this letter and our proposed adverse determination letter available for public
inspection under Code section 6110, after deleting certain identifying information. Please read
the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the

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instructions in Notice 437. If you agree with our deletions, you do not need to take any further
action.

If you have any questions about this letter, please contact the person whose name and
telephone number are shown in the heading of this letter. If you have any questions about your
Federal income tax status and responsibilities, please contact IRS Customer Service at
1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933. The
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Enclosure

Notice 437
Redacted Proposed Adverse Determination Letter
Redacted Final Adverse Determination Letter

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: May 11, 2012 Contact Person:

Identification Number:

LEGEND:
You(r)/Applicant:
State:

Date 1:

Date 2:

Department:
x:

y:

Dear

We have considered your application for recognition of exemption from Federal income tax
under Internal Revenue Code § 501(a). Based on the information provided, we have concluded
that you do not qualify for exemption under I.R.C. § 501(c)(12). The basis for our conclusion is
set forth below.

I. FACTS

You were organized as a nonprofit corporation under the laws of State on Date 1. Your Articles
state that you are “organized exclusively for charitable, educational, and scientific purposes,
including, for such purposes, the making of distributions to organizations that qualify as exempt
organizations under” I.R.C. § 501(c)(3). Specifically, you were formed “to provide a means of
local representation on a statewide basis regarding policies and activities dealing with reservoir
storage and delivery within the [State].” You describe yourself as “a support organization for
mutual ditch and irrigation companies in [State].” You filed Form 1024, Application for
Recognition of Exemption under Section 501(a), on Date 2 for recognition as an I.R.C. §
501(c)(12) mutual ditch or irrigation company or “like” organization.

Activities

You hold one conference/workshop every year. The purpose of this two day workshop is to

increase awareness of dam and canal safety, construction, and technology. The first day is a
“field trip” to a dam or canal near the conference site. The second day is a workshop on topics

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such as dam engineering, construction, operation, maintenance, rehabilitation, and safety;
vegetation control; project management; and technological advances.

You publish a newsletter three to four times a year that includes stories about dam canal repair
and operation, maintenance tips, and grant applications deadlines.

You intend to conduct focus groups on various topics, including whether recreational users
should share the costs of dam operation and about how problems should be resolved with the
forest service. You provide no indication whether any focus groups have been conducted or are
planned for the future.

You also intend to perform some lobbying, but you fail to describe these activities.

Cooperative Structure

You have four membership classes: two voting classes and two non-voting. The voting classes
include individuals or associations that own or operate private, municipal, or county water
storage or delivery systems. Yearly membership dues for individuals are $x, which includes
attendance for one individual at the annual workshop and one vote. Yearly membership dues
for associations are $3x, which includes registration for three representatives and three votes.
Voting members establish policy by resolution, amend the Bylaws, and conduct other business
at the annual meeting.

The non-voting classes, called “affiliate members” and “sustaining affiliate members,” include
individuals or representatives from private firms, corporations, or agencies with an interest in
water storage and delivery systems. These members do not own or operate such systems.
Yearly membership dues for affiliate members are $2x, which includes attendance for one
individual at the annual workshop but no voting rights. Yearly dues for sustaining affiliate
members are $12x, which includes attendance for three and a booth for display of products at
the annual workshop but no voting rights.

Failure to pay membership dues results in the member, whether voting or non-voting, being
“dropped from the membership and the list of members.”

Currently, 100 percent of your income is from membership dues paid by all four membership
classes. You do not specify how much income is derived from each class. Additionally,
Department has agreed to contribute up to $y for expenses related to your annual workshop.
This amount will be paid directly to the annual workshop’s host. Your yearly expenses are
approximately half the amount received from membership dues. The rights and interests of
your members in your annual savings are not determined in proportion to their business with
you. You therefore do not keep the records necessary to determine at any time each member's
rights and interests in such savings, including assets acquired with the savings. Furthermore,
you do not intend to make distributions of surplus funds to your members.

Upon dissolution, you distribute any gains from the sale of an appreciated asset “for one or
more exempt purposes within the meaning of section 501(c)(3).”

II. LAW

I.R.C. § 501(c)(12) provides for the exemption of benevolent life insurance companies of a
purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone
companies, or like organizations, but only if 85 percent or more of the income consists of
amounts collected from members for the sole purpose of meeting losses and expenses.

Treas. Reg. § 1.501(c)(12)-1(a) states that an organization described in I.R.C. § 501(c)(12)
must receive at least 85 percent of its income from amounts collected from members for the
sole purposes of meeting losses and expenses. If an organization issues policies for stipulated
cash premiums, or if it requires advance deposits to cover the cost of the insurance and
maintains investments from which more than 15 percent of its income is derived, it is not entitled
to exemption. On the other hand, an organization may be entitled to exemption, although it
makes advance assessments for the sole purpose of meeting future losses and expenses,
provided that the balance of such assessments remaining on hand at the end of the year is
retained to meet losses and expenses or is returned to members.

Rev. Rul. 68-564, 1968-2 C.B. 221, determined that a mutual company, whose members were
the owners of river front property, formed to contract with the Federal Government to prevent
erosion of river banks qualified for exemption under I.R.C. § 501(c)(12) as a “like organization.”
The term “like organization” as used in this section applies to organizations that are similar to
any one of the types of organizations specified in that section. Therefore, the mutual company
was “like” a mutual ditch or irrigation company because the construction and maintenance of
improvements that protected the river banks from damage or destruction by erosion preserved
the usefulness of the members’ surrounding lands in the same way that the furnishing of water
by mutual ditch or irrigation companies enables their members to reclaim and preserve land for
useful purposes.

Rev. Rul. 72-36, 1972-1 C.B. 151, sets forth certain requirements cooperative companies must
meet for exemption under I.R.C. § 501(c)(12).

1. The rights and interests of the members in the savings of an organization should be
   determined in proportion to their business with the organization. The interests of
   members in the savings of the organization may be determined in proportion to either
   the value or the quantity of the services purchased from the organization, provided such
   basis is realistic in terms of actual cost of the services to the organization.

2. Funds retained in excess of those currently needed for such purposes as retiring
   indebtedness incurred in acquiring assets, expanding the services of the organization, or
   maintaining reserves for necessary purposes must be reasonable in light of the
   organization’s business needs. Whether there is an improper accumulation of funds
   depends upon the particular circumstances of each case.

3. The organization’s records must show each member's rights and interests in the funds it
   retains.

4. A member's rights and interest cannot be forfeited upon dissolution or termination.

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5. Upon dissolution, gains from the sale of an appreciated asset should be distributed to all
   persons who were members during the period which the asset was owned by the
   organization in proportion to the amount of business done by such members during that
   period, insofar as is practicable.

Rev. Rul. 81-109, 1981-1 C.B. 347, determined that a mutual ditch company that operated in a
traditional manner consistent with the provisions of a particular state statute may qualify for
exemption under I.R.C. § 501(c)(12) even though it does not satisfy the requirements of Rev.
Rul. 72-36, supra. The mutual ditch company in question was created in 1874 to maintain and
operate an irrigation system for the use and benefit of its members. Membership was obtained
through the purchase of stock that entitled the holder to certain water rights and the services of
the organization. The shares of stock were assessable to provide funds to operate and
maintain the irrigation system. If a member failed to pay the assessment, a lien was placed on
the stock that could be collected through a forced sale of the stock. The member's interest in the
organization would then be extinguished and the former member would have no claim on the
organization’s assets upon dissolution or otherwise. Furthermore, upon dissolution, only
current members would receive a distribution of the company’s gains. The mutual ditch
company’s operations were consistent with state law but not with Rev. Rul. 72-36, supra. The
Service noted that the organization was created prior to the enactment of the earliest tax
legislation pertaining to mutual ditch and irrigation companies and had continued to operate in a
traditional manner since that time. The lack of changes in the applicable federal law indicated
Congress’ intent that mutual ditch and irrigation companies operated in the manner and under
the circumstances described above would qualify for exemption under I.R.C. § 501(c)(12).

In Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), acqg. 1966-1 C.B. 3, the
Tax Court stated that an organization must meet certain common law requirements in order to
be a cooperative, which include: (1) democratic control of the organization by members; (2)
operation at cost for the benefit of the members; and (3) the subordination of capital.

In Lake Petersburg Association v. Commissioner, 33 T.C.M. (CCH) 259 (1974), the Tax Court
held, among other things, that the Lake Petersburg Association was not tax-exempt under I.R.C.
§§ 501(c)(4), (5), (6), (7), or (12). The Association was formed, in part, to own, construct,
maintain, and control a lake and its adjacent recreational facilities. The Service determined that
the Association had income tax deficiencies in the years spanning from 1962 to1967. As part of

its defense, the Association argued that it was exempt from taxation under I.R.C. § 501(a).
Specifically, the Association argued that it was exempt under I.R.C. § 501(c)(12) as an
organization like a mutual ditch or irrigation company. The court rejected this argument
because ‘“[t]he purpose and operation of these two types of organizations are clearly different.”

III. RATIONALE

An organization seeking exemption under I.R.C. § 501(c)(12) must satisfy three requirements.
First, it must be organized and operated as a cooperative (the “organizational and operational
tests”). Second, it must conduct activities described in I.R.C. § 501(c)(12) (the “activities test”).
Finally, it must derive at least 85 percent of its income from members solely for the sole purpose
of meeting expenses and losses (the “income source test”). The materials you submitted state
that you are seeking recognition as an I.R.C. § 501(c)(12) as a mutual ditch or irrigation
company or “like” organization. Based upon a review of your application, you are not described
in I.R.C. § 501(c)(12) as explained below.

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1. Organizational and Operational Test

An organization meets the requirements of the organizational and operational tests if it is
organized and operated under both the common law definition and the requirements of Rev.
Rul. 72-36, 1972-1 C.B. 151. Under the common law, a cooperative organization exhibits three
characteristics: (1) democratic control by the members; (2) operation at cost; and (3)
subordination of capital. Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 308 (1965),
acq. 1966-1 C.B. 3. Additionally, a cooperative organization must meet the five requirements of
Rev. Rul. 72-36, 1972-1 C.B. 151.

You do not meet the requirements of the organizational test. Your Articles are written to comply
with I.R.C. § 501(c)(3), not I.R.C. § 501(c)(12). As such, your Articles exhibit none of the
cooperative principles. Furthermore, your Articles do not contain any of the statements required
by Rev. Rul. 72-36.

You also do not meet the requirements of the operational test. You are not democratically
controlled by your members; only half of your membership classes have the right to vote, and,
of those classes, one receives more votes than the other. Additionally, you do not operate
according to the requirements of Rev. Rul. 72-36. First, your members’ rights and interests are
not determined in proportion to their business with you. Rather, membership dues are
determined based on the member’s commercial nature and ownership interest. Second, you
retain funds in excess of your expenses, but you do not indicate whether funds kept in excess of
those needed to meet current losses and expenses are kept solely to meet future losses and
expenses. Third, you fail to provide evidence of record keeping adequate to determine each
member's rights and interests in the funds retained. Fourth, members’ rights and interests may
be forfeited. Finally, upon dissolution, you distribute any gains from the sale of an appreciated
asset “for one or more exempt purposes within the meaning of section 501(c)(3)” rather than to
your members in proportion to the amount of business done by such members during the period
you owned that asset.

You would be relieved of the need to meet the last two requirements of Rev. Rul. 72-36 if you
were a mutual ditch company operated in the traditional manner consistent with the provisions
of State law. Rev. Rul. 81-109, 1981-1 C.B. 347. However, you are organized as a nonprofit
corporation under State law, not as a mutual ditch company. Therefore, you are neither
organized nor operated as an I.R.C. § 501(c)(12) organization.

2. Activities Test

Second, you do not perform the activities of a mutual ditch company or “like” organization under
I.R.C. § 501(c)(12). Rev. Rul. 81-109, 1981-1 C.B. 347, describes a “traditional” ditch and
irrigation company as an organization created to maintain and operate an irrigation system for
the use and benefit of its members. You “act as a support organization for mutual ditch and
irrigation companies in [State],” not as a mutual ditch and irrigation company itself. Thus, you do
not qualify as a mutual ditch or irrigation company under I.R.C. § 501(c)(12) because you do
not operate as such.

The term “like organizations” applies to organizations that are similar to any one of the types of
organizations specified in that section. See Lake Petersburg Assoc. v. Comm'r., 33 T.C.M.

(CCH) 259 (1974) (determining that a recreational lake association was not “like” a mutual ditch

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or irrigation company because “[t]he purposes and operation of these two types of organizations
[were] clearly different’). For example, Rev. Rul. 68-564, 1968-2 C.B. 221, determined that a
mutual company, whose members were the owner of a river front property, formed to contract
with the Federal Government to prevent erosion of river banks qualified for exemption as a “like
organization” under I.R.C. § 501(c)(3). This company was “like” mutual ditch or irrigation
company because the construction and maintenance of improvements that protect river banks
from damage or destruction by erosion preserves the usefulness of the members’ surrounding
lands in the same way that the furnishing of water by mutual ditch or irrigation companies
enables their members to reclaim and preserve land for useful purposes. However, your
activities are not like those of a mutual ditch or irrigation company. Therefore, you fail to meet
the requirements of the activities test under I.R.C. § 501(c)(12).

3. Income Source Test

Finally, you failed to show that 85 percent of your income is received from your members for the
sole purpose of meeting income and expenses. A “member’ is an individual who has the right
to elect the governing board of the cooperative and be involved in the operations of the
organization. Puget Sound Plywood, 44 T.C. at 308. Only two of your four membership classes
are “members” within the meaning of I.R.C. § 501(c)(12). You fail to state what percentage of
your income comes from each class. Furthermore, your funds may be retained for any purpose,
not for the sole purpose of meeting losses and expenses. Therefore, you fail to prove that you
meet the requirements of the income source test.

CONCLUSION

Based on the foregoing, you do not qualify as an I.R.C. § 501(c)(12) organization. You have the
right to file a protest if you believe this determination is incorrect. To protest, you must submit a
statement of your views and fully explain your reasoning. You must submit the statement,
signed by one of your officers, within 30 days from the date of this letter. We will consider your
statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including
accompanying documents, and, to the best of my knowledge and belief, the statement
contains all the relevant facts, and such facts are true, correct, and complete.

This declaration must be signed by an elected officer, a member of the board of
directors, or a trustee rather than an attorney or accountant.

You also have a right to request a conference to discuss your protest. This request should be
made when you file your protest statement. An attorney, certified public accountant, or an
individual enrolled to practice before the Internal Revenue Service may represent you. If you
want representation during the conference procedures, you must file a proper power of attorney,
Form 2848, Power of Attorney and Declaration of Representative, if you have not already done
so. For more information about representation, see Publication 947, Practice before the IRS
and Power of Attorney. All forms and publications mentioned in this letter can be found at
www.irs.gov, Forms and Publications.

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If you do not intend to protest this determination, you do not need to take any further action. If
we do not hear from you within 30 days, we will issue a final adverse determination letter. That
letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848 and any supporting documents to this address:

Internal Revenue Service
TE/GE (SE:T:EO:RA:T3)
1111 Constitution Ave, N.W.
Washington, DC 20224

You may also fax your statement using the fax number shown in the heading of this letter. If you
fax your statement, please call the person identified in the heading of this letter to confirm
that he or she received your fax.

If you have any questions, please contact the person whose name and telephone number are
shown in the heading of this letter.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations