A nonprofit cooperative's conversion to a for-profit corporation qualifies as an "F" reorganization, and redeemed capital credits are ordinary income

Plain-English summary

A nonprofit cooperative corporation (with members instead of shareholders, and
"capital credit" accounts tracking each member's patronage) planned to convert
into a for-profit corporation. The steps: the cooperative dropped its assets
into a new corporation, cashed out inactive members' capital-credit balances,
and then merged into a newly formed for-profit corporation in which active
members received stock in proportion to their capital credits. The taxpayer
asked the IRS to rule on two discrete points. First, the IRS ruled that the
active members' exchange of their cooperative interests for stock qualifies as
a section 354(a) exchange, provided the overall deal qualifies as a "mere change
in form" reorganization under section 368(a)(1)(F). Second, it ruled that when
members' capital credits are redeemed for cash or stock, the amount is treated
as a redemption under Treasury Regulation section 1.61-5(b) and is included in
the members' gross income as ordinary income. The IRS expressed no opinion on
any other aspect of the deal.

Ruling snapshot

• Question: Does the cooperative-to-corporation conversion qualify for section 354/368(a)(1)(F) treatment, and how are redeemed capital credits taxed?
• Outcome: Approved (two favorable rulings; capital credits are ordinary income)
• Key authorities: IRC §§ 368(a)(1)(F), 354(a), 61; Treas. Reg. § 1.61-5(b)

Full text (IRS public release)

 Internal Revenue Service                                     Department of the Treasury
                                                              Washington, DC 20224

 Number: 202330006                                            Third Party Communication: None
 Release Date: 7/28/2023                                      Date of Communication: Not Applicable
 Index Number: 61.00-00, 368.00-00
                                                              Person To Contact:
 ----------------------------------------------               ----------------------------,
 ------------------------------------------------------       ID No. -----------------
 ------------------                                           Telephone Number:
 --------------------------------                             --------------------
                                                              Refer Reply To:
                                                              CC:CORP:2
                                                              PLR-119716-22
                                                              Date:
                                                              April 24, 2023




                                                    Legend

 Taxpayer              = ---------------------------------------------------------------------------------------
                         ---------------------------------------------------------------------------------------
                         --------------------------

 Newco LLC             = ---------------------------------------------------------------------------------------
                         -----------------------------

 Newco                 = ---------------------------------------------------------------------------------------
                         ----------------

 State A               = --------

 Year 1                = -------

 Services              = -------------------------------------

 Date 1                = -------------------------

 Date 2                = --------------------------

 Date 3                = --------------------------


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

This letter responds to your authorized representatives’ letter dated October 7, 2022, as
supplemented by subsequent information and documentation requesting rulings on
certain federal tax consequences of a series of transactions (the “Proposed
PLR-119716-22                                 2

Transaction,” as defined below). The material information submitted in that letter and
subsequent correspondence is summarized below.

This letter is issued pursuant to section 6.03(2) of Rev. Proc. 2022-1, 2022-1 I.R.B. 1,
regarding one or more significant issues under section 368 of the Internal Revenue
Code (the “Code”). The rulings contained in this letter only address one or more discrete
legal issues involved in the Proposed Transaction. This office expresses no opinion as
to any issue not specifically addressed by the rulings below.

The rulings contained in this letter are based upon facts and representations submitted
by the taxpayer and accompanied by a penalties of perjury statement executed by an
appropriate party. This office has not verified any of the material submitted in support of
the request for rulings. Verification of the information, representations, and other data
may be required as part of the audit process.

                                           Facts

Taxpayer is a nonprofit cooperative corporation organized under the laws of State A.
Taxpayer was formed in Year 1 and does not currently qualify as a tax-exempt
organization under section 501(c)(12). Taxpayer has no shareholders and no capital
stock. Taxpayer has one class of membership interests outstanding.

Under Taxpayer’s bylaws, Taxpayer must allocate to its members, on a patronage
basis, for all amounts received and receivable from the furnishing of Services in excess
of Taxpayer’s properly chargeable operating costs and expenses (“Patronage
Allocations”). Taxpayer also must treat the Patronage Allocations as capital furnished by
its members (a “capital credit,” which is credited to a member’s “capital credit account”).
Taxpayer may retire amounts from a member’s capital credit account at its discretion as
to the method, priority, and order of retirement.

A membership interest carries certain rights, depending on whether a member is in
active or inactive status. A member is considered active so long as the member
receives and pays for Services furnished by Taxpayer. A member becomes inactive
when it ceases receiving and paying for Services. Active members have the right to
elect Taxpayer’s board of directors on a one member, one vote basis and the right to
Taxpayer’s assets upon liquidation (following the satisfaction of debt and outstanding
capital credit balances). Active members have the right to be allocated capital credits.

Inactive members forfeit the right to vote, receive liquidation proceeds, and receive
allocations of capital credits. If a member has a zero balance in its capital credit account
when it becomes inactive, its membership interest in Taxpayer terminates. If a member
has a positive balance in its capital credit account when it becomes inactive, it retains its
membership interest in Taxpayer with the only right being to be redeemed of its capital
credit account.
PLR-119716-22                                3

                                 Proposed Transaction

For what are represented to be valid business reasons, Taxpayer proposes to engage
in the following steps, some of which have been completed (collectively, the “Proposed
Transaction”):

   (i)     On Date 1, Taxpayer formed a new, wholly-owned limited liability company
           (“Newco LLC”) that elected to be treated as a corporation for federal income
           tax purposes as of Date 2.

   (ii)    On Date 3, Taxpayer contributed all of its assets to Newco LLC in exchange
           for Newco LLC stock.

   (iii)   Taxpayer will redeem the entire balance of all of its inactive members’ capital
           credit accounts with cash (the “Redemption”). As a result of the Redemption,
           inactive members will cease having a membership interest in Taxpayer.

   (iv)    Taxpayer will merge with and into a newly formed for-profit corporation
           (“Newco”), with Newco surviving. In the merger, Taxpayer’s active members
           will exchange their interests in Taxpayer for stock in Newco in proportion to
           the balance of their capital credit accounts (the “Potential Reorganization”).

                                    Representations

(a) Provided that the exchange of active members’ interests, consisting of a
    membership interest and a capital credit account in Taxpayer, for Newco stock
    qualifies as an exchange pursuant to section 354(a), the Potential Reorganization
    will qualify as a reorganization under section 368(a)(1)(F).

(b) The capital credits qualify within the meaning of Treas. Reg. § 1.61-5(b) and are not
    with respect to capital assets as defined in section 1221 or property used in the
    trade or business within the meaning of section 1231.

(c) Some, but not all, members are or were entitled to claim as deductions, under either
    section 162 or section 212, the costs of the furnished Services.

                                         Rulings

(1) The exchange of active members’ interests in Taxpayer for Newco stock will qualify
    as an exchange under section 354(a) provided the Potential Reorganization
    otherwise qualifies as a reorganization under section 368(a)(1)(F).

(2) The exchange of capital credits, described in Treas. Reg. § 1.61-5(b)(1) and Treas.
    Reg. § 1.61-5(b)(1)(iii), for cash or Newco stock will be treated as a redemption or
    other disposition within the meaning of Treas. Reg. § 1.61-5(b)(2). Each member,
PLR-119716-22                                  4

      whose capital credits are described in the prior sentence, will include in gross
      income, as ordinary income, such amount as determined under Treas. Reg. § 1.61-
      5(b)(2).

                                          Caveats

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax treatment of the Proposed Transaction under any provision of the Code and
regulations or the tax treatment of any condition existing at the time of, or effects
resulting from, the Proposed Transaction that is not specifically covered by the above
rulings.

                                  Procedural Statements

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

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,


                                        __________________________
                                        Richard K. Passales
                                        Senior Counsel, Branch 4
                                        Office of Associate Chief Counsel (Corporate)




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