Rural telephone cooperative's spectrum-sale gain is patronage-sourced income

Plain-English summary

A taxable rural telephone cooperative used a wholly owned subsidiary to buy wireless spectrum needed to offer advanced telecommunications services to its patrons. Another subsidiary used the spectrum to provide wireless service, but the cooperative later concluded that the spectrum was inadequate and that fiber better fit its long-term strategy. The spectrum-owning subsidiary then sold it to an unrelated buyer. The IRS focused on whether the purchase and sale actually furthered the cooperative's service activities or merely produced investment income. It concluded that both transactions were directly related to the cooperative's reason for existence, providing telephone service to patrons. The consolidated group's gain was therefore patronage-sourced income and excludable under the cooperative tax rules applicable to taxable rural telephone cooperatives.

Ruling snapshot

• Question: Is gain from selling spectrum acquired to serve the cooperative's telephone patrons patronage-sourced income?
• Outcome: approved
• Key authorities: IRC §§ 1381-1388; Rev. Ruls. 69-576, 74-160, and 83-135; Farmland Industries, Inc. v. Commissioner, 78 T.C.M. 846 (1999)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201704014 Third Party Communication: None
Release Date: 1/27/2017 Date of Communication: Not Applicable
Index Number: 1388.00-00, 1382.00-00
Person To Contact:
--------------------------------------- -----------------------------, ID No. -------------
-------------------------------- ------------------
-------------------------------------------- Telephone Number:
---------------------------- ----------------------
----------------- Refer Reply To:
---------------------------- CC:PSI:B05
In Re: PLR-126740-16
------------------------------------------- Date:
October 25, 2016

LEGEND:

Cooperative = ---------------------------------------------------------------------------------------------
--------------------------------------
Sub 1 = ---------------------------
Sub 2 = -------------------------------
Year 1 = -------
Year 2 = -------

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

   This letter responds to a request for a private letter ruling, dated August 23,

2016, submitted on behalf of Cooperative by its authorized representative, regarding the
application of cooperative tax law to the transaction described below.

  Cooperative is a nonexempt rural cooperative telephone company operating on a

cooperative basis. Cooperative’s bylaws require it to allocate patronage earnings
among its patrons on a patronage 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.

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

including Sub 1 and Sub 2. Sub 1 and Sub 2 are corporations 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. The

purpose of Sub 1 and Sub 2 is to hold nonregulatory telecommunication assets for the
benefit of Cooperative and in furtherance of Cooperative’s telecommunication services.
PLR-126740-16 2

Entities that provide regulated services, like telephone services, create subsidiaries to
hold nonregulated assets in an effort to comply with federal, state, and local regulations.
The separation of regulated and nonregulated assets by the creation of subsidiaries
assists telecommunications cooperatives in complying with such regulations.

    On or before Year 1, 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
telecommunications services.

   In Year 1, Cooperative, through Sub 1, purchased the additional spectrum. Sub

2 used the spectrum to provide wireless service to Cooperative members. Sub 1
received compensation from Sub 2 for use of the spectrum.

   Cooperative eventually determined that the spectrum did not meet its long-term

objectives because of unanticipated inadequacy of the spectrum together with fiber
options that had substantial bandwidth capacity that would be more consistent with its
strategic goals.

    In Year 2, Sub 1 sold the spectrum to an unrelated third party. This private letter

ruling request concerns the treatment of the gain arising from the sale of the 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, including Cooperative,
qualify for this exemption. Therefore, Cooperative 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 to avoid overregulating them and, presumably, to
provide them with more flexible tax treatment because of the necessary services they
provided to underserved 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-126740-16 3

   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. While the cases and rulings
interpreting subchapter T may not control the taxation of rural telephone cooperatives,
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 their 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 business 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 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 Cooperative upon allocation, the amount must be patronage-sourced
income, i.e., income derived from business done 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, Inc. v.
Commissioner, 78 T.C.M. 846, 864 (1999), acq., AOD 2001-003 (citing Cotter & Co. v.
United States, 765 F.2d 1102, 1106 (Fed. Cir. 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)).
PLR-126740-16 4

  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.”)

   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.

   The sale of the spectrum by Sub 1 will generate income for Cooperative.

  Cooperative purchased the spectrum through Sub 1 to insure that

telecommunication services would be available to Cooperative’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 a transaction that 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 864-65. First, it looked at whether the taxpayer’s
subsidiaries were organized to perform functions related to its cooperative enterprises.
PLR-126740-16 5

The subsidiaries had been organized to explore for, produce, and transport crude oil.
The Tax 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 that the cooperative helped to
organize in order to supply its adhesive needs, were patronage-sourced income
because glue is essential for the manufacture of plywood and because the arrangement
to produce the glue was reasonably related to the business done with or for the
cooperative’s patrons.

   Cooperative’s purchase of the spectrum through Sub 1 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 Sub 1 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. Rather Cooperative through Sub 1 purchased the spectrum for the purpose
of providing its patrons with advanced telecommunication services.
PLR-126740-16 6

    Accordingly based on the facts submitted and the representations made, we rule

that:

  1. Taxpayer Group’s gain on the sale by Sub 1 of the spectrum, which was

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

   2. Taxpayer Group’s gain on the sale of the spectrum, which was purchased and

sold by Sub 1 in furtherance of Cooperative’s cooperative function, is patronage
sourced income, and, therefore, excludable under cooperative tax laws applicable to
taxable rural telephone cooperatives.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the request for rulings, it is subject to verification on
examination.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                               Sincerely,



                                               THERESA M. MELCHIORRE
                                               Assistant to the Branch Chief, Branch 5
                                               Office of the Associate Chief Counsel
                                               (Passthroughs & Special Industries)

Enclosure:
Copy of this letter for § 6110 purposes