Rural telephone cooperative's spectrum gain is patronage income

Plain-English summary

A taxable rural telephone cooperative used a wholly owned subsidiary to hold nonregulated telecommunications assets. The subsidiary bought wireless spectrum to support possible future services, but the cooperative later found the spectrum inadequate, expensive to build out, and subject to demanding FCC deadlines. It sold the spectrum to an unrelated party while considering a different spectrum purchase better suited to customer needs. The IRS found that both acquiring and selling the spectrum directly furthered the cooperative's telecommunications service rather than serving as a passive investment. It ruled that the consolidated group's gain was patronage-sourced income and therefore excludable under the cooperative tax rules applicable to taxable rural telephone cooperatives.

Ruling snapshot

• Question: Was the gain from selling cellular spectrum acquired for the cooperative's telecommunications services patronage-sourced income?
• Outcome: Approved, the gain qualifies as patronage-sourced and is excludable under applicable cooperative tax law
• Key authorities: IRC §§ 501(c)(12) and 1381 through 1388; Rev. Ruls. 69-576 and 74-160

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201507004 Third Party Communication: None
Release Date: 2/13/2015 Date of Communication: Not Applicable
Index Number: 1381.00-00
Person To Contact:
----------------------------, --------------------
Telephone Number:
-------------------------------------------- ----------------------
----------------------------------------------------------- Refer Reply To:
------------------------------ CC:PSI:5
------------------------------ PLR-120664-14
Date:
October 20, 2014
In Re: ---------------------------------------------------

Legend

Cooperative = ---------------------------------------------------------------

State A = ------------

State B = -------

Consolidated Subsidiary = -----------------------------------------------

Date = --------------------------

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

   This is in response to a request for a ruling dated May 15, 2014, submitted on

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

   Cooperative is a nonexempt rural cooperative telephone company that operates

on a cooperative basis. Cooperative was previously granted exemption as a rural
telephone company under section 501(c)(12) of the Internal Revenue Code but in
recent years it is no longer exempt.

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     Cooperative is the parent and agent of an affiliated group (“Taxpayer Group”),

which includes Consolidated Subsidiary. Consolidated Subsidiary is a corporation
organized in State A in ------- that is wholly owned by Cooperative. Taxpayer Group
files its tax return on a consolidated basis as provided in section 1501.

   Cooperative provides telecommunication services to rural customers in State A

and State B. Consolidated Subsidiary provides no services to customers. Its sole
function is to hold non-regulatory telecommunication assets for the benefit of
Cooperative and in furtherance of Cooperative’s telecommunication services. Entities
that provide regulated services, like telephone services, create subsidiaries to hold non-
regulated assets in an effort to comply with federal, state, and local regulations. The
separation of regulated and non-regulated assets by the creation of a subsidiary assists
telecommunications cooperatives in complying with such regulations.

    On or before -------, Cooperative’s management and board of directors identified

internal and external pressures that required a change in the business model of
providing telephone service to its customers. These pressures included shrinking plain-
old telephone service (“POTS”) access lines and declining access minutes of use, as
customers migrated to mobile cellular services. Competition from cellular providers
within the exchange area, and the loss of POTS lines, required investment in new
technologies for its customers, including additional spectrum to provide advanced
telecommunication services.

    In -------, Cooperative, through Consolidated Subsidiary, purchased the ----- MHz

spectrum at issue. At that time, Cooperative considered the use of spectrum in support
of future telecommunication services. As explained in more detail below, however,
Cooperative eventually determined that the spectrum did not meet its long-term
strategic objectives.

  Through Consolidated Subsidiary, Cooperative was forced to sell the spectrum

because of (i) unanticipated inadequacy of the spectrum, (ii) the onerous time
constraints and “build-out” requirements imposed by the Federal Communications
Commission (“FCC”), (iii) the anticipated large expense to implement and use the
spectrum, and (iv) the need to fund the potential purchase of spectrum that would be
more consistent with its strategic goals.

   Cooperative reviewed its business needs and determined that the spectrum was

inadequate to provide over ---Mbps fixed service to its customers. The speed of service
would be even less if a large number of customers were ultimately served. Moreover,
because the spectrum is granted by the FCC, it comes with regulatory requirements.
One such requirement is the obligation to build out the network and provide “substantial
service” by 2019. Cooperative expected the build-out of the associated network to be
very expensive.

PLR-120664-14 -3-

   Another factor in Cooperative’s decision to sell the spectrum is the possibility of

pursuing an upcoming ----- MHz auction that would better fit the projected demands of
customers and future customers. If Cooperative decides to pursue such spectrum, the
funds from the sale of the ----- MHz spectrum would be used to purchase the ------MHz
spectrum.

   As a result, on Date, Consolidated Subsidiary sold the spectrum at issue to an

unrelated third party. The ruling request concerns the treatment of the gain arising from
the sale of such spectrum.

  Section 501(c)(12) of the Code contemplates that rural cooperative telephone

companies may qualify as tax-exempt organizations. As the telephone business has
developed, however, very few rural telephone cooperatives now qualify for this
exemption; Cooperative falls into this category, and thus is a non-profit, but taxable,
cooperative corporation.

    Subchapter T of the Code, sections 1381-1388, provides the statutory scheme

for taxing most cooperatives. Rural telephone cooperatives, however, are not governed
by subchapter T, because of the exclusion provided by section 1381(a)(2)(C) for rural
telephone cooperatives. When Congress enacted subchapter T in 1962, Congress
excluded rural telephone cooperatives in order to avoid over-regulating them and,
presumably, to provide them with more flexible tax treatment because of the necessary
services they provided to under-served parts of the country. The underlying committee
reports stated that cooperative corporations engaged in providing telephone service to
persons in rural areas would continue to be treated the same as under prior law. See
H.R. Rep. No. 1447, 87th Cong., 2d Sess. 79, A127 (1962); S. Rep. No. 1881, 87th
Cong., 2d Sess. 113, 310 (1962); see also, Rev. Rul. 83-135, 1983-2 C.B. 149.

   Sections 1382 and 1388 of subchapter T placed new restrictions on the ability of

cooperatives to deduct patronage dividends that were allocated but not paid; in many
other ways, however, subchapter T codified the law that existed prior to 1962. Since its
enactment in 1962, most of the development in the law regarding the taxation of
cooperatives has occurred in cases under subchapter T. Thus while the cases and
rulings interpreting subchapter T may not control the taxation of rural telephone
cooperatives such as Cooperative, these authorities indicate the position of the Service
and the courts on many of the issues that do control the taxation of rural telephone
cooperatives.

    Cooperatives are a unique form of business entity, which are democratically

controlled by their patrons. In cooperatives, each member has one vote regardless of
how much capital he or she contributed. Cooperatives are required to allocate their net
margins from business done with or for their patrons back to such patrons in proportion
to their patronage. This return of patronage-sourced income is bound up with the basic
concept of a cooperative. Rather than using their net income to pay dividends to their
shareholders, as a regular corporation would, cooperatives pay patronage dividends to

PLR-120664-14 -4-

their members based on the amount of business that the member does with the
cooperative. Patronage dividends are thus effectively price rebates for member-
patrons. See CF Industries, Inc. v. Commissioner, 995 F.2d 101, 103 (7th Cir. 1993).

   The taxable income of a cooperative is calculated in much the same manner as

the taxable income of a taxable corporation, with one distinct difference: the income of a
cooperative that is attributable to business done with or for patrons is excluded from or
deducted from the income of the cooperative when such income is allocated to the
cooperative’s patrons. At the time this patronage-sourced income is allocated or (in the
case of cooperatives not subject to subchapter T) at the time it is distributed, the
cooperative’s patrons realize the income. Patronage-sourced income flows through the
cooperative and is taxed only once.

   In order for the amount realized from the proposed sale of the spectrum to be

deductible to Cooperative upon allocation, the amount must be patronage-sourced
income, i.e., income derived from business carried on with or for Cooperative’s patrons.
While neither the Code nor the regulations provide a clear definition of patronage-
sourced income, the courts have, in general, held that if the income at issue is produced
by a transaction which is directly related to the cooperative enterprise, such that the
transaction facilitates the cooperative’s marketing, purchasing or service activities, then
the income is deemed to be patronage income. Farmland Industries Industries v.
Commissioner, 78 T.C.M. 846, 864 (1999), acq., AOD 2001-003 (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).

  In Rev. Rul. 69-576, 1962-2 C.B. 166, the Service provided the following analysis

of what it means for income to be patronage sourced:

   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.

See also Rev. Rul. 74-160, 1974-1 C.B. 245 (ruling that interest income realized from
loans made by the taxpayer was patronage source, because the loans “actually
facilitated the accomplishment of taxpayer’s cooperative activities, in that [the loans]
enabled the taxpayer to obtain the necessary supplies for its operations.”)

PLR-120664-14 -5-

 The sale of the spectrum by Consolidated Subsidiary will generate income for

Cooperative.

   Cooperative actively participated in the formation of Consolidated Subsidiary to

insure that cellular service would be available to Coop’s customers.

   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, 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.

   Emphasizing the need to focus on the totality of the circumstances and to view

the business environment to which the income producing transaction is related, the Tax
Court analyzed the reasons behind both the organization of the subsidiaries and their
eventual disposition, Id. at 864, 865. First, it looked at whether the taxpayer’s
subsidiaries were organized to perform functions related to its cooperative enterprises.
The subsidiaries had been organized to explore for, produce, and transport crude oil.
The court determined that all of the subsidiaries were organized to perform functions
related to the taxpayer’s business and were not mere passive investments. Id. at 871.

   In other cases, the direct relationship between the purpose of a cooperative

business and its reasons for investing in a subsidiary were found to be dispositive on
the question of whether income received from the subsidiary was patronage sourced.
For example, in Astoria Plywood Corp. v. United States, 43 A.F.T.R. 2d 79-816, 79-1
USTC ¶ 9197 (D. Or. 1979), the court found that the income derived by a plywood and
veneer workers cooperative from the cancellation of a lease on a veneer plant was
patronage sourced, because the production of veneer was an integral part of the
cooperative’s business. In other words, the reason the cooperative leased the property
to begin with had nothing to do with investing in real estate and everything to do with
making veneer. Similarly, in Linnton Plywood Assoc. v. United States, 410 F.Supp.
1100 (D. Or. 1976), the court held that the dividends received by a plywood workers
cooperative from West Coast Adhesives, a glue supplier which the cooperative helped
to organize in order to supply its adhesive needs, were patronage-sourced income,
since glue is essential for the manufacture of plywood, and the arrangement to produce
the glue was reasonably related to the business done with or for the cooperative’s
patrons.

PLR-120664-14 -6-

   Cooperative’s investment in Consolidated Subsidiary and its purchase of the

spectrum was directly related to its cooperative business. Investing in a company in
order to provide wireless telephone service is directly related to the business of a rural
cooperative telephone company whose "reason for existence” is to provide telephone
service to its patrons.

    Cooperative’s sale of the spectrum through Consolidated Subsidiary is also

directly related to its cooperative business purpose.

    In CF Industries, Judge Posner noted in his opinion that the court was not aware

of any dramatic opportunities for tax avoidance by use of the cooperative form. 995
F.2d at 104. However, the court implied that a cooperative would be gaining an unfair
tax advantage for its members if it were investing in businesses unrelated to its
cooperative purpose and in effect running a mutual fund for its members on the side.
Id. Judge Posner indicated that one type of transaction would not pass the mutual fund
test: a temporary investment by a cooperative in securities. Id. Certainly, if Cooperative
had taken its members capital and purchased a diversified portfolio of public company
securities, there can be no doubt that the proceeds from such a portfolio should not and
would not be patronage sourced. But Cooperative did nothing of this sort. It was an
active participant through Consolidated Subsidiary in the purchase of the spectrum,
which was directly related to its cooperative telecommunication services.

   Accordingly based solely on the above, we rule that:

   1.    Taxpayer Group’s gain on Consolidated Subsidiary’s sale of cellular-

phone spectrum, which was purchased for the purpose of potentially expanding its
cellular-phone service to patrons of Cooperative, qualifies as patronage-sourced
income.

  2.     Taxpayer Group’s gain on sale of cellular-phone spectrum, which was

purchased and sold by Consolidated Subsidiary in furtherance of Cooperative’s
cooperative function, is patronage-sourced income and, therefore, excludable under
cooperative tax laws applicable to taxable rural telephone cooperatives.

PLR-120664-14 -7-

   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,



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