07 March 2018 IRS rules that rural telephone cooperative can exclude capital gain from cooperative income In PLR 201809005, the IRS has ruled that the gain on the sale of wireless service spectrum licenses by a rural telephone cooperative (which had formerly been recognized as tax-exempt under Section 501(c)(12)) constitutes "patronage-sourced income" excludable from the cooperative's income when properly allocated to the cooperative's patrons. "Cooperative" is a nonprofit rural telephone cooperative corporation that provides telecommunications services to rural customers. It is operated on a cooperative basis, and its bylaws require it to allocate patronage earnings among its patrons on a patronage basis. Cooperative had previously been granted a federal tax exemption as a rural telephone company under Section 501(c)(12), but it no longer has federal tax exempt status and is therefore treated as a taxable cooperative corporation. Cooperative wholly owns Sub 1, whose purpose is to hold nonregulatory telecommunication assets for Cooperative. This separation of regulated and nonregulated assets helps Cooperative comply with federal, state and local regulations applicable to telephone services. Recognizing their patrons' increasing use of mobile cellular services, Cooperative obtained licenses for advanced wireless service spectrum to provide cellular and other wireless services to patrons. Cooperative transferred one of these licenses to Sub 1, which used the license to provide wireless broadband services. Ultimately, Cooperative determined that it could not effectively utilize the spectrum and therefore decided to sell the licenses before they expired and became worthless. Cooperative and Sub 1 sold all the spectrum licenses to unrelated third parties at a gain. The IRS noted that Section 501(c)(12) exempts rural telephone cooperatives, but that, like Cooperative, very few rural telephone cooperatives have continued to qualify for the exemption as the telephone business has evolved. This is caused by the fact that, to retain tax exemption, 85% of a telephone cooperative's income must be collected for the sole purpose of meeting losses and expenses. Because many cooperatives have subsidiaries or other business ventures that generate income that the IRS does not consider to be "patronage-sourced income," these business ventures often cause the cooperative to fail the required test. The IRS explained that a cooperative is a unique form of business entity that is representatively controlled by its patrons. A cooperative's taxable income is calculated in a manner similar to that of taxable corporations, except that income of the cooperative that is attributable to business done with or for patrons (patronage-sourced income) is excluded from the cooperative's taxable income when such income is allocated to the cooperative's patrons. In this manner, patronage-sourced income that is allocated to the cooperative's patrons is only taxed once at the patron level. If a cooperative realizes a capital gain on the sale of a capital asset used in its business conducted with patrons, the cooperative must allocate the income to the persons who were patrons during the tax years that the capital asset was owned by the cooperative in proportion to the amount of business done with those patrons in those particular years. Within PLR 201809005, the IRS stated that, for the amount realized from the sale of the spectrum licenses to be deductible by Cooperative, the amount must be patronage-sourced income (i.e., income derived from business done with or for Cooperative's patrons). The IRS noted that, although there is no clear statutory or regulatory definition, courts have generally held that income is patronage-source income if it is produced by a transaction that is directly related to the cooperative enterprise. The IRS determined that Cooperative's acquisition of the spectrum licenses and the transfer of one license to Sub 1 were directly related to its cooperative business — concluding that providing wireless telephone services fits within Cooperative's purpose of providing telephone services to its patrons. Likewise, the IRS stated that the sale of the spectrum licenses by Cooperative and Sub 1 was directly related to its cooperative business purpose. Accordingly, the IRS ruled that both Cooperative's and Sub 1's gains on the sale of the spectrum licenses constitute patronage-sourced income such that, when allocated to Cooperative's patrons based on their patronage at the time that the licenses were owned, the gain would be excludable from Cooperative's gross income. Cooperative associations that do not qualify for exemption are treated the same as taxable corporations. The only differentiating feature under the tax law is that cooperatives can exclude patronage-sourced income so that it is not subject to double taxation. PLR 201809005 provides further guidance on distinguishing non-patronage and patronage-sourced income for nonprofit, nonexempt cooperatives and their wholly owned subsidiaries. The Internal Revenue Code does not provide a clear definition of patronage-sourced income. Rather, the definition has been established by the courts through rulings that patronage-sourced income is derived from transactions that directly relate to the cooperative's business, such that the taxable event facilitates the cooperative's activities. Essentially, the transaction must be in furtherance of the cooperative's business. The courts have further held that income produced by a taxable subsidiary that was created for the purpose of the cooperative's business can be deemed to be patronage-sourced income. This private letter ruling has solidified the analysis that assets used in the cooperative's business and sold by the cooperative and its wholly-owned subsidiary can be sourced to the patrons as long as the reason behind the transaction is directly related to the cooperative's business. This PLR supports the premise that a taxable subsidiary created to hold nonregulatory assets is still considered to be directly related to the nonprofit cooperative if it was created for the sole reason of holding assets related to the cooperative's business. If a cooperative's subsidiary has the same business purpose as the cooperative, then any gain upon the sale of its assets will likely be deemed to be patronage-sourced income. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg
Document ID: 2018-0516 | |||||||||||||||||||
