A taxable rural telephone cooperative's cellular-network income is patronage-sourced income

Plain-English summary

A rural telephone cooperative that is now taxable (it once qualified for exemption under section 501(c)(12) but stopped meeting the 85%-member-income test) asked the IRS how to classify the income from its cellular-network investments. Cooperatives can effectively exclude "patronage-sourced" income (earnings from business done with their members) by paying it out as patronage dividends, but not "nonpatronage" income such as passive interest or rent. Over the years the cooperative invested in various rural and metropolitan cellular entities specifically to secure cellular service for its members and protect its core landline business. It had historically treated that cellular income as nonpatronage but, after review, concluded it was really patronage-sourced. Because taxable rural telephone cooperatives fall outside Subchapter T, the IRS applied the older common-law cooperative tax rules and the "directly related" test from Farmland Industries. It ruled that, to the extent the cellular income is attributable to securing cellular service for the cooperative's patrons, that income is patronage-sourced and may be excluded from the cooperative's income if properly allocated to its patrons.

Ruling snapshot

• Question: Is a taxable rural telephone cooperative's income from cellular (RSA/MSA) entities organized to provide cellular service to its members patronage-sourced income?
• Outcome: Approved (favorable ruling: income tied to securing patrons' cellular service is patronage-sourced).
• Key authorities: IRC §§ 1388(a), 1381(a)(2)(C); Treas. Reg. § 1.1388-1; Puget Sound Plywood, Inc. v. Commissioner; Farmland Industries, Inc. v. Commissioner; Rev. Rul. 69-576.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202224003 Third Party Communication: None
Release Date: 6/17/2022 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-119250-21
Date:
March 21, 2022

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

Legend

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

RSA A = ----------------------------------------------------------------

RSA B = -----------------------------------------------------

RSA C = -------------------------------------------------------------

MSA A = ----------------------------------------------------------------------

RSA Entity A = -----------------------------------------

RSA Entity B = ------------------------------

RSA Entity C = --------------------------------------

MSA Entity A = ----------------------------------------------
PLR-119250-21 2

Entity A = --------------

Entity B = ---------------

Entity C = ----------------------------------------------

Entity D = ----------------------------------

State A = ------------------

State B = ------------------

a = -------

b = --------

c = ------

d = ---

e = ---

f = ---

g = ---

h = ---

i = -------

j = ---------

k = --------

l = -------

m = -----------

n = ---

o = ---

p = -------
PLR-119250-21 3

q = ---

r = ---

s = ---

t = -------

u = ---

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

   This is in response to a letter dated September 10, 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 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 provides telecommunications and information services on a

cooperative basis to its members located in various counties of State A and State B. As
a taxable rural telephone cooperative, Taxpayer’s members elect a board of directors
on a one-member, one-vote basis. The business and affairs of Taxpayer are managed
by the board. Each year, Taxpayer allocates its net income among its members and
provides notice thereof to each member. Each year, the board determines the amount
of capital credits to be retired to members without financial detriment to Taxpayer.

   Taxpayer holds interests in certain cellular entities associated with Rural Service

Areas (RSAs) and Metropolitan Statistical Areas (MSAs). Taxpayer acquired interests
in RSA/MSA entities over the years through initial investment and several transactions.
The initial acquisition and subsequent transactions were effected to provide and
maintain cellular service to its customers.

   During the b, telephone companies began to provide cellular service. Taxpayer

recognized that if a competitor offered cellular services in its service areas, it would take
away Taxpayer’s existing customers and potentially leave Taxpayer with stranded
investment in the wireline infrastructure. To safeguard its core wireline business and
PLR-119250-21 4

offer the new cellular technology to its members, the Taxpayer decided to invest in new
cellular technologies as the opportunities arose.

   To develop its cellular service, Taxpayer needed to acquire spectrum through c

auctions. The c regulates the wireless industry primarily through wireless spectrum
management, a system developed in part to encourage development of wireless
technology. Providers access the country’s airwaves by acquiring a license to provide
services within a specific area. These geographic areas, defined at the smallest levels
by counties, range from one to two counties to the whole nation. The smallest license
areas are called Cellular Market Areas (CMAs) and are further defined by RSAs and
MSAs.

   To improve their chances of winning the auction, Incumbent Local Exchange

Carriers would form partnerships or other entities to submit a collective bid. Particularly
for Rural Local Exchange Carriers (RLECs), these RSA investments were necessary to
acquire spectrum to provide cellular service for members and customers.

    Taxpayer served customers located in three RSAs and one MSA, and has

participated in the RSA/MSA entities to serve those areas: Entity A, Entity B, Entity C,
and Entity D.

  In each RSA and MSA, a cellular corporation proposed a partnership with

RLECs, including Taxpayer, to bid and acquire cellular licenses. The RLECs and the
corporate partner believed that by bidding together, they would increase the odds of
winning a license. In addition, the corporate partner would handle all administrative
matters, financing, and management.

    As part of the plan for RSAs, the RLECs first formed an RSA entity, then the RSA

Entity and the corporate partner formed a separate entity (License Entity). Each RLEC
bid for a license, and the winner put the license into the License Entity. Initially, the
RSA Entity owned d percent of the License Entity, and Entity A owned e percent. If at
any time thereafter an owner in the License Entity sold some or all of its interest, the
other owners held a right of first refusal to purchase pro rata the interest sold.

    Each time an opportunity arose to purchase additional shares, Taxpayer

considered whether to find new management, attempt to manage the License Entity and
cellular system without the corporate partner, or sell its interest. Taxpayer believed that
the RLECs could not manage the License Entity and cellular system alone, but it did not
believe new management was an ideal result. Taxpayer wanted to keep the corporate
partner, but it wanted to avoid the corporate partner gaining too much of a controlling
interest over Taxpayer’s service area and its members.

   In RSA A, a corporate partner, Entity B, owned f percent and the remaining g

percent was split between RSA Entity A (h percent) and another corporate partner,
Entity A (d percent). In i, Entity B sold its entire share, and Taxpayer purchased it pro
PLR-119250-21 5

rata share. Thereafter, three RLECs sold their interests in RSA Entity A, and on each
occasion, Taxpayer purchased shares. Currently, Taxpayer holds j percent ownership
in RSA Entity A.

  RSA B was originally divided among four entities: Entity B, Entity A, Entity C, and

RSA Entity B. In the k and l, Entity B, Entity C, and two RLECs sold their shares, and
the Taxpayer purchased its pro rata share thereof. Currently, Taxpayer holds m percent
ownership in RSA Entity B.

   In RSA C, Entity B held n percent ownership and the remaining o percent

ownership was split between RSA Entity C (h percent) and Entity A (d percent). In the
early k, Entity B sold its shares to Entity A. In p, another RLEC sold its shares, and
Taxpayer purchased its pro rata share. Currently, Taxpayer holds q percent ownership
in RSA Entity C.

     Finally, the structure of ownership associated with MSA Entity A was different

from the RSA entities. Taxpayer held direct ownership of MSA Entity A. Entity B held r
percent, Taxpayer held f percent, and Entity D held f percent. In the early k, Taxpayer
increased its initial ownership stake from f percent to s percent when Entity D sold its
entire share and Entity B sold f percent. In t, Entity B planned to sell its u percent
ownership interest to Entity A, and Entity A offered to purchase Taxpayer’s s percent
ownership interest. Taxpayer declined Entity A’s offer and sought to exercise its right of
first refusal for the shares being sold by Entity B. Entity A would not accept being a
minority partner, and if it was not a majority owner, it would not manage the License
Entity. Taxpayer lacked the financial ability and expertise to manage MSA Entity A
alone. Therefore, Entity A purchased enough shares for h percent ownership, and
Taxpayer purchased enough shares to increase its ownership to d percent.

   In the past, Taxpayer characterized the income from RSA/MSA Entities as non-

patronage-sourced income. But in consultation with its legal and accounting with its
legal and accounting advisors, Taxpayer has determined that the transactions should,
more appropriately, be characterized as patronage-sourced income.

  Based on the foregoing, Taxpayer requests a ruling that:

  To the extent Cooperative’s income from RSA/MSA Entities, which were
  organized for the purpose of providing cellular service to its patrons, is
  attributable to securing cellular service for its patrons, such income is classified
  as patronage-sourced income.

    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-119250-21 6

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-119250-21 7

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 benef its 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-119250-21 8

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 for
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-119250-21 9

   “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-119250-21 10

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 1.1388-1(e) defines patron to include any person with whom or for whom

the cooperative association does business on a cooperative basis.

    Based on consideration of Taxpayer’s representations, Taxpayer’s members are

patrons of Taxpayer. Since the RSA/MSA Entities were used for the purpose of
securing cellular service for Taxpayer’s patrons, income from these investments
satisfies the directly related test. The portion of income that is allocable to Taxpayer’s
patrons’ use of the RSA/MSA Entities’ networks is directly related to securing cellular
service for Taxpayer’s patrons and is patronage sourced income, which may be
excluded from Taxpayer’s income if properly allocated to Taxpayer’s patrons.

    Accordingly, to the extent Taxpayer’s income from RSA/MSA Entities is

attributable to securing cellular service for its patrons, such income is classified as
patronage-sourced income.

   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.

   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.
PLR-119250-21 11

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

Enclosure
Copy for §6110 Purposes

cc: