Rural telephone cooperative's spectrum gain is patronage income

Plain-English summary

A taxable rural telephone cooperative bought wireless spectrum intending to use it for expanded telecommunications services to members. It later determined that the spectrum was inadequate, costly to build out, and better used at a scale the cooperative could not provide, so it planned to sell the spectrum to an unrelated provider. The IRS applied the rule that income is patronage sourced when the underlying transaction directly facilitates the cooperative's marketing, purchasing, or service activities rather than merely improving overall profitability. The spectrum was acquired and sold for reasons directly connected to providing telecommunications services, not as a passive or unrelated investment. The IRS therefore ruled that the gain from the sale qualifies as patronage-sourced income.

Ruling snapshot

• Question: Is gain from selling unused cellular spectrum patronage-sourced income?
• Outcome: Approved.
• Key authorities: IRC §§ 1381 through 1388; Rev. Rul. 69-576; Farmland Industries v. Commissioner, 78 T.C.M. 846 (1999).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201515012 Third Party Communication: None
Release Date: 4/10/2015 Date of Communication: Not Applicable
Index Number: 1381.00-00
Person To Contact:
----------------------------, --------------------
Telephone Number:
--------------------------------------------------- ----------------------
--------------------------------------------------------- Refer Reply To:
----------------- CC:PSI:5
------------------------ PLR-126453-14
Date

                                                            December 16, 2014

In Re: -------------------------------------------

Legend

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

State A = -------

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

   This is in response to a request for a ruling dated February 11, 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 rural telephone cooperative organized in the State A in --------.

Since that time, it has provided telecommunication services to rural residents in its State
A exchanges.

  Cooperative has operated on a cooperative basis by returning net earnings to its

patrons on a patronage basis. In -------, Cooperative applied for and received tax
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exemption under I.R.C. § 501(c)(12). However, Cooperative lost its exempt status
under 501(c)(12) and has been filing as a taxable cooperative.

   Cooperative provides telecommunications services to rural customers in State A.

Its services include telecommunications exchange and local access services, long
distance services, internet services, video services, wireless communications, and
telecommunications equipment sales.

   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 mobile
telecommunication services.

   In -------, Cooperative purchased the spectrum at issue.         At such time,

Cooperative fully intended to use the spectrum in support of future telecommunication
services to its members. Cooperative saw the next generation demand for
communications services would be primarily wireless services.

   In -------, Cooperative determined that the spectrum did not meet its strategic

objectives. The spectrum had certain build-out requirements beginning in -------- for use
of the spectrum. The cashflow and other management requirements to complete the
build-out were not considered an effective use of Cooperative’s resources. The build-
out along with other considerations, listed below, led to the decision that the spectrum
should be sold.

    Cooperative was forced to sell the spectrum because of (i) unanticipated

inadequacy of the spectrum, (ii) the onerous time constraints on the use of such
spectrum, and (iii) the assessment that services provided over wireless spectrum
require a much larger scale than what Cooperative was capable of providing.
Specifically, Cooperative reviewed its business needs and determined that it had
insufficient ----- Mhz spectrum (---- Mhz) to provide over -- Mbps fixed service to
customers, and that speed would be less if a large number of customers were ultimately
served.

   In -------, Cooperative intends to sell its interest in the spectrum at issue to an

unrelated third party. The third party is capable of providing the necessary wireless
services to its cooperative members. The sale is pending FCC approval.

  Based on the forgoing, Cooperative request a ruling that:

PLR-126453-14 -3-

1. Cooperative’s gain on sale of cellular-phone non-utilized spectrum, which was
   purchased for the purpose of meeting existing patrons’ service demands and
   potentially expanding its cellular-phone service to new patrons of Cooperative,
   qualifies as patronage-sourced income.

   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
   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).
   PLR-126453-14 -4-

   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.”)

   The sale of the spectrum by Cooperative will generate income for Cooperative.

  Courts have ruled in several instances that income from corporations organized

by cooperatives to conduct activities related to the cooperative business is patronage
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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.

    Cooperative’s acquisition of the spectrum was directly related to its cooperative

purpose of providing telecommunications services. Cooperative’s sale of the spectrum
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.
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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 in the purchase of the spectrum, which was directly related to its
cooperative telecommunication services.

  Accordingly based solely on the above, we rule that:

  Cooperative’s gain on sale of cellular-phone non-utilized spectrum, which was

purchased for the purpose of meeting existing patrons’ service demands and potentially
expanding its cellular-phone service to new patrons of Cooperative, qualifies as
patronage-sourced income.

   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,



                                         Nicole Cimino
                                         Senior Technician Reviewer
                                         Office of the Associate Chief Counsel
                                         (Passthroughs & Special Industries)