Spectrum-sale income was patronage sourced

Plain-English summary

Several taxable rural telephone cooperatives formed a limited liability company to pool resources and improve telecommunications services for their members. The company bought wireless spectrum intending to support enhanced voice, data, internet, and backhaul services, but construction and operating costs prevented deployment. After spectrum values rose and the company determined it could not afford to use the licenses, it sold them. The IRS found that the investment and sale were directly related to the cooperative’s service business rather than a passive investment unrelated to its patrons. It ruled that the requesting cooperative’s share of the sale income was patronage sourced and could be excluded from gross income if properly allocated to member-patrons.

Ruling snapshot

• Question: Was the cooperative’s share of partnership income from the spectrum sale patronage-sourced income?
• Outcome: Approved
• Key authorities: IRC §§ 1381-1388; Rev. Rul. 69-576; Rev. Rul. 83-135

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201524004 Third Party Communication: None
Release Date: 6/12/2015 Date of Communication: Not Applicable
Index Number: 1381.00-00
Person To Contact:
---------------------------, -------------------
Telephone Number:
-------------------------------------------------- --------------------
-------------------------------------- Refer Reply To:
------------------------------ CC:PSI:5
------------------ PLR-130674-14
------------------------ Date:
February 10, 2015

Legend

COOP1 = ---------------------------------------------------------------
----------------------------------------------------------------------------------------

COOP2 = --------------------------------------------------------------
------------------------------------------------------------------

COOP3 = ---------------------------------------

Corp = -------

State A = ------

LLC = ---------------------------------------------------------------

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

   This is in response to a request for a ruling dated August 5, 2014, submitted on

behalf of COOP3 by your authorized representative. The ruling concerns the
application of cooperative tax law to the transaction described below.

  COOP1, COOP2, and COOP3 (the Cooperatives) are nonexempt rural

cooperative telephone companies that operate on a cooperative basis. Each
cooperative has less than ------ customers in its respective statutory exchange area (as

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defined by the State A Utilities Board). Each cooperative’s service area is significantly
rural and substantially agricultural. COOP1 has --------telephone access lines; COOP2
has ----- telephone access lines; and COOP3 has ----- telephone access lines. As
discussed below, each cooperative (consistent with its respective business goal) seeks
to provide its member-patrons with access to communications technology advances as
these advances become available and feasible for deployment.

   COOP1 was organized to (among other things): (i) furnish communication

services to its members at the lowest cost, (ii) contract for exchange service and toll
service and reciprocal telecommunications service with connecting lines with local
exchanges and long distance companies, and (iii) do and perform any and all acts and
things as necessary or convenient to accomplish any or all of the cooperative’s
objectives. Members are issued a certificate of membership, which is required in order
to receive communication services. No member of the association may own more than
one membership and each member shall be entitled to one vote at meetings of the
members of the association. COOP1’s articles of incorporation enumerate the manner
in which the directors are to “annually dispose of the earnings of the Association in
excess of its operating expenses.” The articles provide, among other things, that
“remaining net earnings shall be allocated to a revolving fund and shall be credited to
the account of each member ratable in proportion to the business he has done with the
Association during each year. Such credits are herein referred to a as ‘Deferred
Patronage Dividends’. Upon dissolution or liquidation, the assets of the Association
shall be applied first to pay liquidation expenses, then to pay Association obligations
and other Capital Credit Statements issued therefore, and the remainder of such assets
shall be distributed in the manner and order provided by law.

   COOP2 was organized to (among other things): (i) furnish, improve, and expand

telephone service to its members at the lowest possible cost consistent with the proper
maintenance of its telephone lines and other facilities, (ii) contract for exchange service
and toll service and reciprocal telecommunications service with connecting lines with
local exchanges and long distance companies, and (iii) do and perform any and all acts
and things as necessary or convenient to accomplish any or all of the cooperative’s
objectives. A member purchases a membership in the cooperative (at the issuing price)
and is eligible to receive telecommunication services. Each member may only own one
membership, which entitles him or her to one vote at all meetings of the association.
The cooperative’s articles of incorporation explain the manner in which “the directors
shall annually dispose of the earnings of the Association in excess of its operating
expenses.” “[R]emaining net earnings shall be allocated to a revolving fund and shall be
credited to the account of each member ratably in proportion to the business he has
done with the Association during the year. Such credits are herein referred to as
‘deferred patronage dividends’.” Upon dissolution or liquidation, the assets of the
association shall be applied first to pay liquidation expenses, next, to pay obligations to
general creditors, next to redeem preferred stock and pay accumulated dividends

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thereon, if any, and finally the remainder of the assets shall be distributed in the manner
and or of priority provided by law and the by-laws.

    COOP3 was organized to (among other things): (i) furnish, improve and expand

telecommunication services to its members and others at the lowest possible cost
consistent with the proper maintenance of its telephone lines and other facilities, (ii)
contract for exchange service and toll service and reciprocal telecommunications
service with connecting lines with local exchanges and long distance companies in such
manner as shall be deemed to be in COOP3’s best interest, and (iii) to do and perform
all acts and things, and to have and exercise any and all powers, as may be necessary
or convenient to accomplish any of all of the foregoing purposes, or as may be
permitted by the provisions of the laws under which COOP3 was formed, and to
exercise any of its powers anywhere. Coop3 members are composed of “any person,
firm, cooperative, corporation, limited liability company, partnership, limited liability
partnership, or body politic” who receive retail telecommunication services from the
cooperative at a premise within its established service area and the execution of a
membership application , agree to comply with and be bound by articles of incorporation
and bylaws and relevant rules – and accepted by majority vote of board of directors
(and are issued a certificate of membership at an issuing price). No member may own
more than one membership and each member entitled to one vote on each issue
presented for vote of the members of the cooperative. COOP3 is operated on a
cooperative nonprofit basis for the mutual benefit of its patrons (members). The
cooperatives articles of incorporation provide the manner in which the directors “shall
annually dispose of the earnings of the Cooperative in excess of its operating
expenses.” The cooperative’s articles of incorporation provide in relevant part that:

    The Cooperative shall allocate all remaining net earnings as provided in
    Section 2 below. [Section 2] In the furnishing of telecommunications
    service, the Cooperative’s operations shall be conducted so that all
    persons will through their patronage furnish capital for the Cooperative. In
    order to induce patronage and to assure that the Cooperative will operate
    on a nonprofit basis, the Cooperative is obligated to account on a
    patronage basis to all its patrons for all amounts received and receivable
    from the furnishing of telecommunications service in excess of operating
    costs and expenses at the moment of receipt by the Cooperative and
    received with the understanding that they are furnished by the patrons as
    capital. The Cooperative is obligated to pay by credits to a capital account
    for each patron all such amounts in excess of operating costs and
    expenses.

    In the event of dissolution or liquidation, after all outstanding indebtedness of the

cooperative shall have been paid, outstanding capital credits shall be retired without
priority on a pro rata basis before any payments are made on account of property rights
of its members.-----------------------------------------------------------------------------------------It is

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expressly understood that amounts paid for telecommunications services in excess of
the cost of service are furnished by members as capital and each member shall be
credited with the capital so furnished as provided in the Bylaws or Articles of
Incorporation.”

    The provision of telecommunication services by small, independent

telecommunication providers, such as the Cooperatives, to the relatively few customers
in a respective statutory exchange areas is costly, particularly the provision of switching,
calling features, broadband, IPTV, and call announcements. In an effort to provide their
respective customers with a broader range of telecommunication services of higher
quality delivered in a more efficient manner, the Cooperatives and similarly-situated
providers formed LLC. LLC enabled the providers to pool their respective resources and
provide furnish, improve and expand telecommunication services to their respective
customers at the lowest possible cost, which was consistent with each of the
Cooperatives respective goals. The partnership’s operating agreement provides in
relevant part that the “business of the Company shall…provide for switching
telecommunications traffic.” To that end, LLC enabled the participating providers to pool
their resources in securing a switch in which the partners could direct their respective
telecommunications traffic. The partnership agreement provides that each member
participate in the switch sharing agreement.

     In ------, in furtherance of LLC’s overall purpose, LLC executed an agreement

with --------------------------------------------------. and -----------------------------------------------------
---------, State A to purchase the State A --- License and State A --- License for ------------
and ------------, respectively. LLC purchased this spectrum in order to assist its members
in enhancing the telecommunications services that each member provides to member-
patrons; that is, it was intended that the spectrum acquisition would enable LLC’s
members to provide its member-patrons with enhanced voice, data, wireless internet,
and wireless backhaul. LLC did not purchase the spectrum for investment purposes; the
intention was to use the spectrum in order to enhance the telecommunication services
that each member provided to its respective member-patrons.

   LLC did not put the spectrum to use immediately because the construction costs

associated with its usage (e.g., tower construction and electronic equipment installation)
was approximately $----------. In addition to the construction-related costs, it was
estimated that on-going operational and management costs, such as paying customer
services representatives and fiber transport costs, would be approximately $------------
annually. Neither LLC nor its members had the financial wherewithal at the time the
spectrum was purchased to use the spectrum. LLC and its members, however, did
anticipate using the spectrum in the future to enhance their respective customers’
telecommunication services.

  Between ------ and ------ the spectrum market exploded due, in large part, to

advances in telecommunications technology which boosted spectrum’s value. In order

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to support the advances in technology, the key players in the telecommunications
marketplace sought available spectrum. In some instances, these players would consult
spectrum brokers in their respective searches for available spectrum.

    Corp learned of the licenses that LLC purchased in ------ – and Corp (ultimately)

made an offer, which LLC accepted. LLC purchased the spectrum in ------ with the
intent to use it; however, at the time, LLC could not use the spectrum because
construction costs were prohibitive. Importantly, the spectrum license required LLC to
complete its “build out” by -------------------------.

     Following the purchase, the costs associated with using the spectrum continued

to climb, as the spectrum market began to heat up. The key players in the
telecommunications industry were better positioned to use the spectrum and possessed
the financial wherewithal to bear the costs associated with using the spectrum. As the
costs associated with spectrum usage were ever-increasing, LLC determined in ------
that it would not be in a position to use the licenses and accepted Corp’s offer. On -------
------------------------, LLC sold the spectrum. As a result of the spectrum sale,COOP3,
received a distributive shares of partnership income relative to the sale. COOP3
submits that because the spectrum sale relates directly to its enterprise such distributive
shares constitutes patronage sourced income.

    Based on the foregoing, COOP3 requests a ruling that its distributive share of

partnership income from LLC’s Spectrum Sale constitutes patronage sourced income
and, if properly allocated to COOP3’s member-patrons, is excludable from COOP3’s
gross income in the tax year ending --------------------------.

  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; COOP3 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.

PLR-130674-14 -6-

   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 COOP3, 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).

   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 by COOP3 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:

PLR-130674-14 -7-

   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.”)

   Rev. Rul. 83-135, 1983-2 C.B. 149 provides that 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.

  Cooperatives became partners in LLC to insure that telecommunication services

would be available to the Cooperatives’ 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.

PLR-130674-14 -8-

   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.

   COOP3’s investment in LLC 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.
COOP3’s sale of the spectrum through LLC 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 COOP3
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 COOP3 did nothing of this sort. Rather COOP3
became a partner in LLC for the purpose of providing its patrons with advanced
telecommunication services.

  Accordingly based solely on the above, we rule that:

  COOP3’s distributive share of partnership income from LLC’s Spectrum Sale
  constitutes patronage sourced income and, if properly allocated to COOP3’s
  member-patrons, is excludable from COOP3’s gross income in the tax year
  ending --------------------------.

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

PLR-130674-14 -9-

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 R. Cimino
                                       Senior Technician Reviewer, Branch 5
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

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