Rural telephone cooperative's gain on sale of a broadband partnership is patronage-sourced income

Plain-English summary

A rural telephone cooperative (now taxable, because it no longer meets the 85%
member-income test for exemption under § 501(c)(12)) had invested through a
subsidiary in a partnership that built and ran a regional fiber-optic broadband
network. The cooperative used that network to serve its members. When the
partnership was sold, the cooperative asked the IRS whether its share of the gain
counts as "patronage-sourced" income. That matters because a nonexempt telephone
cooperative can exclude patronage-sourced income from its taxable income when it
allocates that income back to members as patronage dividends (capital credits).
Applying the "directly related" test from cases like Farmland Industries, the IRS
concluded that because the partnership provided telecommunications service to the
cooperative's members, the portion of the gain allocable to members' use of the
network is patronage-sourced income. That member portion may be excluded from the
cooperative's consolidated gross income in the year of sale if properly allocated to
members. The IRS expressed no view on any other aspect of the transaction.

Ruling snapshot

• Question: Is a nonexempt rural telephone cooperative's gain from selling a broadband-network partnership interest patronage-sourced income excludable when allocated to members?
• Outcome: Approved (favorable ruling as to the member portion)
• Key authorities: IRC §§ 1381(a)(2)(C), 1382, 1388; Treas. Reg. §§ 1.1382-3, 1.1388-1; Farmland Industries v. Commissioner; Puget Sound Plywood v. Commissioner

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202214004 Third Party Communication: None
Release Date: 4/8/2022 Date of Communication: Not Applicable
Index Number: 1382.00-00, 1388.00-00
Person To Contact:
------------------------------------------------------- -------------------------, ID No. ----------------
------------------------------------------------------- Telephone Number:
----------------------------- --------------------
---------------------------- Refer Reply To:
------------------------------ CC:PSI:B05
PLR-114958-21
Date:
January 13, 2022

Re: -------------------------------------------------------

Legend

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

Consolidated Subsidiary = --------------------------------------------------------------

Partnership = ---------------------------------------

Limited Liability Company A = ----------------------------------------------------

Limited Liability Company B = ------------------------------------------

State A = --------

a = -------

b = -------

c = ---

d = -------

e = ---------------------
PLR-114958-21 2

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

   This is in response to a letter dated July 20, 2021, on behalf of Taxpayer by your

authorized representative requesting a ruling on the transaction described below.

   Taxpayer is a rural telephone cooperative that was incorporated in a, under State

A statutes. Taxpayer operates on a cooperative basis and was formed to bring
telephone service to rural regions of State A. Taxpayer's Bylaws require it to allocate
patronage earnings among its patrons (members) on a patronage basis. Taxpayer's
members are patrons that purchase retail telecommunications services from Taxpayer
or a subsidiary of Taxpayer. Purchasers of Taxpayer's services at wholesale, or
otherwise for resale, are not eligible for membership or patronage credits with respect to
such wholesale services.

   Taxpayer was previously granted exemption as a rural telephone cooperative

under section 501(c)(12) of the Internal Revenue Code (Code). At some point in its
history, Taxpayer was no longer able to receive 85 percent or more of its income from
members as required by the Code. As a result, Taxpayer now operates as a taxable
cooperative corporation.

   Taxpayer is the parent and agent of an affiliated group that files a consolidated

federal income tax return using a December 31 year end and the accrual method of
accounting. Taxpayer wholly owns Consolidated Subsidiary. To assist Taxpayer in
complying with applicable federal, state, and local regulations for telecommunication
service providers, Consolidated Subsidiary holds nonregulated telecommunication
assets for the benefit of Taxpayer and in furtherance of Taxpayer's telecommunication
services. Taxpayer provides a wide range of telecommunication services to its members
and non-member customers, both directly and through Consolidated Subsidiary.

   In b, Partnership was formed by c rural telephone companies (Founding

Partners). Partnership was created to build and operate a fiber optic cable (broadband)
network to transport data across the combined territories of Founding Partners. The
pooling of resources in Partnership enabled the Founding Partners to leverage and
combine their existing fiber optic networks into a broadband transport network they
could use to connect their local exchange networks to major cities and deliver
broadband telephone and internet services to customers in their respective service
areas.

     During Partnership's formation, Taxpayer acquired two separate equity interests

in Partnership. First, Consolidated Subsidiary acquired a direct equity interest in
Partnership. Second, Consolidated Subsidiary acquired an indirect equity interest in
Partnership through its membership in Limited Liability Company A, whereby Limited
Liability Company A acquired a direct equity interest in Partnership.
PLR-114958-21 3

    Upon Partnership's formation, Partnership contracted with Limited Liability

Company B to provide a full suite of broadband telecommunications network operating
services for Partnership's business. Following Partnership's formation, Partnership
developed and operated a regional broadband fiber optic network. Taxpayer used the
regional network to connect its local exchange network to major cities and deliver high
quality, cost affordable telecommunications services and products to its members and
other customers in its service area. Partnership's fiber network also provided transport
and internet services as a "carrier's carrier" to wholesale customers (i.e., other
communications companies providing telephone, internet, and similar services). The
day-to-day operations of Partnership were managed by Limited Liability Company B
since Partnership's inception.

    In d, Founding Partners entered an agreement to sell their respective equity

interests to Limited Liability Company B for an all-cash purchase price. The sale was
prompted by the change in ownership and control of Limited Liability Company B,
whereby the interests and objectives of Limited Liability Company B and Founding
Partners were no longer aligned. Following its change in ownership, Limited Liability
Company B also became interested in acquiring Partnership's network and integrating it
with Limited Liability Company B's network to offer current and potential customers a
unified service across the two companies' territories.

   The sale of Partnership to Limited Liability Company B consummated on e.

Following the sale, Consolidated Subsidiary received its share of sale proceeds in
exchange for its two separate interests in Partnership.

   Taxpayer plans to use the sale proceeds to build out its local exchange network,

improve services to its members and other customers, and focus on its core mission of
bringing state-of-the-art telecommunications services to homes and businesses in the
rural communities it serves.

  Based on the foregoing, Taxpayer requests a ruling that:

  Consolidated Subsidiary's gain from the sale of its equity interest in Partnership,
  and Consolidated Subsidiary's distributive share of partnership income from
  Limited Liability Company A's sale of its equity interest in Partnership, the
  proportion of these gains that are allocable to Taxpayer's members use of
  Partnership's network constitutes patronage-sourced income and, if that
  proportion of gain is properly allocated to Taxpayer's members, is excludable
  from Taxpayer's consolidated gross income in the tax year of the sale.

    In the event a rural telephone cooperative such as Taxpayer loses its tax-exempt

status, section 501(c)(12) no longer applies until such time as the cooperative again
satisfies the requirements for exemption. During any taxable period, the rules applicable
to the telephone cooperative depend on the reasons why it failed its exemption test. If
exemption was lost because the company failed to operate on a cooperative basis, then
PLR-114958-21 4

it will be taxed under the same rules applicable to for-profit corporations. Alternatively, if
the cooperative becomes taxable because it failed the so-called 85-percent-income test
imposed by section 501(c)(12), then the organization will be taxed as a cooperative.

    While the requirements of subchapter C of the Code regarding corporate

distributions and adjustments and other provisions are generally applicable to
nonexempt cooperatives, these entities are distinguished from other types of
corporations by a specific body of tax law. The scheme of taxation for nonexempt
cooperatives was developed from the administrative pronouncements of the Service
and decision of the judiciary over a fifty-year period. These rules for tax treatment of
most nonexempt cooperatives and their patrons were finally codified with the enactment
Subchapter T of the Code as part of the Revenue Act of 1962. Pub. L. No. 87-834 (H.R.
10650).

   With passage of Subchapter T, the rules for deduction of patronage dividends

and the treatment of patronage dividends in the hands of a cooperative's patrons were
defined. However, section 1381(a)(2)(C) of the Code states that Subchapter T is not
applicable to an organization engaged in furnishing electric energy, or providing
telephone service to persons in rural areas. According to the Senate Finance
Committee Report accompanying the 1962 Act, the intent of Congress was that
nonexempt rural electric and telephone cooperatives would continue to be treated as
under "present law."

   In its report accompanying the legislation, the Senate Finance Committee

described "present law" as follows:

   "Under present law patronage dividends paid by taxable cooperatives result
   in a reduction in the cooperative's taxable income only if they are paid during
   the taxable year in which the patronage occurred or within the period in the
   next year elapsing before the prior year's income tax return is required to
   be filed (including any extensions of time granted)." S. Rep. No. 1881, 87th
   Cong., 1st Sess. 113 (1962).

   Under this earlier body of tax law applicable to nonexempt telephone

cooperatives, a cooperative may reduce its taxable income by any qualifying patronage
dividends paid to their members/patrons. Further, under pre-1962 cooperative rules, the
term "paid" means paid in cash or paid by notice of allocation. See also Rev. Rul. 83-
135, 1983-2 C.B. 149 (A taxable cooperative not subject to the provisions of subchapter
T may exclude from gross income the patronage dividends paid or allocated to its
patrons in accordance with its by-laws).

   While Subchapter T does not control the taxation of nonexempt telephone

cooperatives, its foundations rest upon pre-1962 cooperative tax law. As a result, there
are certain basic parallels between the tax treatment of nonexempt utility cooperatives
and treatment of other cooperative organizations under Subchapter T. Therefore, to
PLR-114958-21 5

extent that Subchapter T reflects cooperative taxation as it existed prior to 1962, it is in
instructive resolving certain issues facing rural telephone cooperatives. This is because
Congress stated that in enacting Subchapter T it was merely codifying the long common
law history of cooperative taxation (with the exception of ensuring at least one annual
level of tax at the cooperative or patron level. See S. Rep. No. 1881, 87 th Cong., 1st
Sess. 113 (1962)) and, arguably, the case law post-enactment is merely a continuation
and refinement of the pre-enactment common law. This is particularly true with respect
to defining certain terms such as "operating on a cooperative basis" and "patronage
income."

   Perhaps the most succinct definition of the term "cooperative" for Federal income

tax purposes was provided by the U.S. Tax Court in Puget Sound Plywood, Inc. v.
Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3. The Tax Court said:

   "Under the cooperative association form or organization, on the other hand,
   the worker-members of the association supply their own capital at their own
   risk; select their own management and supply their own direction for the
   enterprise, through worker meetings conducted on a democratic basis; and
   then themselves receive the fruits of their cooperative endeavors, through
   allocations of the same among themselves as coworkers, in proportion to
   the amounts of their active participation in the cooperative undertaking."

The Tax Court went on to describe three guiding principles at the core of economic
cooperative theory as:

   "(1) Subordination of capital, both as regards control over the cooperative
   undertaking, and as regards the ownership of the pecuniary benefits arising
   therefrom; (2) democratic control by the worker-members themselves; and,
   (3) the vesting in and allocation among the worker-members of all fruits and
   increases arising from their cooperative endeavor (i.e., the excess of
   operating revenues over the costs incurred in generating those revenues),
   in proportion to the worker-members active participation in the cooperative
   endeavor." 44 T.C. at 308.

   The mechanism by which telephone cooperatives achieve operation at cost is the

patronage dividend (or capital credit). Since the payment of patronage dividends (and
operation at cost) is so critical to achieving cooperative status as defined by Puget
Sound, it is important to analyze this issue.

    Rural telephone cooperatives perform a final accounting at year-end to determine

the net margin derived from their members' patronage during the course of the year.
Then, the excess over cost collected from members is returned to them by a capital
credit allocation based on each member's patronage. Those capital credits are typically
"paid" by allocations of capital credit certificates or notices of allocation, rather than in
PLR-114958-21 6

cash. The capital credits retained form the foundation for the organization's equity
capital.

   A true patronage dividend that may be excluded from the income of a rural

telephone cooperative must meet the three tests set forth in Farmers Cooperative Co. v.
Birmingham, 86 F, Supp 201 (N.D. Ia. 1949), and Pomeroy Cooperative Grain Co. v.
Commissioner, 31 T.C. 674 (1958), acq., AOD 1959-2 C.B. 6. Those tests are:

   1. It must be made subject to a preexisting legal obligation;

   2. the allocation must be made on the basis of patronage; and

   3. the margins allocated must be derived from the profits generated from patrons'
   dealings with the cooperative.

    Although the Code does not provide specific guidance as to what constitutes

patronage-sourced income for a nonexempt telephone cooperative, regulations and
rulings address the issues for cooperatives governed by Subchapter T. While not
directly applicable to taxable utility cooperatives per se, arguably they reflect the correct
analysis with respect patronage income of cooperatives subject to pre-1962 law.

  The Senate Committee Report accompanying the cooperative provisions in the

Revenue Act of 1951 indicated that the Congress intended to tax "ordinary" (i.e., non-
farmer) cooperatives for:

   "non-operating income…not derived from patronage, as for example in the
   case of interest or rental income, even if distributed to patrons on a pro rata
   basis." S. Rep. No. 781, 82d Cong. 1st Sess. (1951).

    In response to that guidance of Congress, the Service promulgated regulations

distinguishing nonpatronage income from that which is patronage derived.

     Section 1388(a) of the Code defines the term "patronage dividend" as an amount

paid to a patron (1) on the basis of quantity or value of business done with or for such
patron, (2) under an obligation of such organization to pay such amount, which
obligation existed before the organization received the amount so paid, and (3) which is
determined by reference to the net earnings of the organization from business done with
or for its patrons. Such term does not include any amount paid to a patron to the extent
that (A) such amount is out of earnings other than from business done with or f or
patrons, or (B) such amount is out of earnings from business done with or for other
patrons to whom no amounts are paid, or to whom smaller amounts are paid, with
respect to substantially identical transactions. The (B) exception is further explained
under Section 1.1388-1(a)(2)(ii) of the Income Tax Regulations:
PLR-114958-21 7

   "An amount paid to a patron by a cooperative organization to the extent that
   such amount is paid out of earnings from business done with or for other
   patrons to whom no amounts are paid, or to whom smaller amounts are
   paid, with respect to substantially identical transactions. Thus, if a
   cooperative organization does not pay any patronage dividends to
   nonmembers, any portion of the amounts paid to members which is out of
   net earnings from patronage with nonmembers, and which would have been
   paid to the nonmembers if all patrons were treated alike, is not a patronage
   dividend."

    In Rev. Rul. 69-576, 1962-2 C.B. 166, the taxpayer (a nonexempt farmers'

cooperative) borrowed money from a bank for cooperatives to finance the acquisition of
agricultural supplies for resale to its members. At the close of the taxable year for the
bank, the bank determined its net earnings, which it then allocated to its patrons,
including the nonexempt farmers' cooperative, on a patronage basis. The patronage
allocations were based on the proportion of the total interest paid to it by each
cooperative during the taxable year. The nonexempt farmers' cooperative included the
patronage allocations received by it from the bank for cooperatives in its gross income
for the taxable year received under section 1385 of the Code. Under a preexisting
obligation the nonexempt farmers' cooperative then allocated and paid the
same amount it received from the bank for cooperatives to its own patrons. The Rev.
Rul. held that the allocation and payment of the amount by the nonexempt farmer's
cooperative to its own patrons qualified as a patronage dividend. The Rev. Rul. stated
that: "The classification of an item as from either patronage or non-patronage 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 servicing activities, the income is from patronage sources."

     In Farmland Industries, Inc. v. Commissioner, 78 T.C.M. 846, 864 (1999), acq.,

AOD 2001-03, 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, along with the income from the sale of its gas and soybean facilities, and
miscellaneous depreciable business assets classified as patronage source. In
articulating the "directly related" test for making the determination, the Court provides
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.
On the other hand, if the income is derived from a transaction that has no integral and
necessary linkage to the cooperative enterprise, such that it may fairly be said that the
income is merely incidental to the cooperative enterprise and does nothing more than
add to the overall profitability of the cooperative, then the income is deemed to be
nonpatronage income. The determination of whether income derived from a transaction
that is directly related to the cooperative enterprise, and, thus, is patronage income is a
determination that is necessarily fact intensive. In considering the relatedness of the
PLR-114958-21 8

income-producing transaction to the cooperative enterprise, it is important to focus on
the "totality of the circumstances" and to view the business environment to which the
income-producing transaction is related and not to view the transaction so narrowly as
to limit it only to its income-generating characteristic when such a characterization is not
consistent with the actual activity. The Court ruled that the sale of cooperative's assets
met the directly related test and therefore the resultant gains and losses were patronage
sourced.

   Section 1.1382-3(c)(3) of the Income Tax Regulations, provides that it is

necessary that the amount sought to be deducted be paid on a patronage basis in
proportion, insofar as is practicable, to the amount of business done by or for patrons
during the period to which such income is attributable. For example, if capital gains are
realized from the sale or exchange of capital assets acquired and disposed of during the
taxable year, income realized from such gains must be paid to patrons of such year in
proportion to the amount of business done by such patrons during the taxable year.
Similarly, if capital gains are realized by the association from the sale or exchange of
capital assets held for a period extending into more than one taxable year income
realized from such gains must be paid, insofar as is practicable, to the persons who
were patrons during the taxable years in which the asset was owned by the association
in proportion to the amount of business done by such patrons during such taxable
years.

   Based on consideration of Taxpayer's representations, since the Partnership was

used to provide telecommunication services to Taxpayer's members, the sale of these
investments satisfies the directly related test and the portion of gain that is allocable to
Taxpayer's members use of Partnership's network (member portion) of the gain is
patronage sourced income.

   Accordingly, the member portion of (1) gain from the sale of the equity interest in

Partnership and (2) distributive share of partnership income from Limited Liability
Company A's sale of its equity interest in Partnership constitutes patronage-sourced
income, which may be excluded from Taxpayer's consolidated gross income in the
taxable year of the sale if properly allocated to Taxpayer's members.

   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.

   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.
PLR-114958-21 9

   This ruling is directed only to the taxpayers that requested it. Section 6110(k)(3)

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

  In accordance with the power of attorney submitted with the ruling request, a

copy of this letter is being sent to your authorized representatives.

                                               Sincerely yours,




                                               Associate Chief Counsel
                                               (Passthroughs & Special Industries)


                                         By:        James A. Holmes________
                                               James A. Holmes
                                               Senior Counsel, Branch 5
                                               Office of Associate Chief Counsel
                                               (Passthroughs & Special Industries)

Enclosure
Copy for §6110 Purposes

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