Patron-use share of wireless divestiture income is patronage sourced

Plain-English summary

A taxable rural telephone cooperative used two consolidated subsidiaries to own a cellular partnership that served both patrons and nonpatron customers. The partnership and a subsidiary later sold substantially all of the wireless assets, and the cooperative planned to use the proceeds to expand its rural fiber-optic network. The cooperative asked whether both subsidiaries' distributive shares of the sale income were patronage sourced and excludable if properly allocated to patrons. The IRS applied the directly related test, which asks whether the income-producing transaction facilitated the cooperative's service activities rather than merely increasing overall profitability. It ruled that the portion of income allocable to patrons' use of the subsidiaries' networks was directly related to securing cellular service for those patrons. That portion qualified as patronage-sourced income and could be excluded if properly allocated to the cooperative's patrons.

Ruling snapshot

• Question: Does income from the subsidiaries' wireless-network divestitures qualify as patronage-sourced income?
• Outcome: Mixed, only the portion allocable to patrons' network use qualified
• Key authorities: IRC §§ 501(c)(12), 1381, 1385, and 1388; Treas. Reg. § 1.1388-1

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202326010                                              Third Party Communication: None
 Release Date: 6/30/2023                                        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-119498-22
                                                                Date:
                                                                April 05, 2023




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




Legend

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

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

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

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

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

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

Entity B = ----------------------------------------------------------
PLR-119498-22                               2


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

a = -------

b = ------------------

c = ---

d = ---

e = ----------------------

f = --------------------------

g = -----------------------

h = -----

i = -----------------

j = -----------------

k = -------

l = -------

m = -------

n = -----------------------

o = -------



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


       This is in response to a letter dated September 28, 2022, 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
PLR-119498-22                                3

patronage earnings among its patrons on a patronage basis. Taxpayer considers a
customer as any other entity with which the Taxpayer does business on a nonpatronage
basis.

       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 satisfy the requirement that it derive 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 A. Prior to b, Consolidated
Subsidiary A wholly owned Consolidated Subsidiary B. Effective b, Consolidated
Subsidiary B merged into Consolidated Subsidiary A, with Consolidated Subsidiary A as
the surviving corporation. At the time of this merger, Consolidated Subsidiary B owned c
percent of the partnership interests in Partnership, and an unrelated party owned the
remaining d percent of the partnership interests in Partnership.

        Consolidated Subsidiary A was Taxpayer’s sole subsidiary from e through f. On
the day after f, Consolidated Subsidiary C was formed as a wholly owned subsidiary of
Consolidated Subsidiary A. On g, Consolidated Subsidiary C acquired the d percent
minority partnership interest in Partnership from the unrelated party that owned it. As a
result, effective g, Taxpayer owned h percent of the partnership interests in Partnership
through its ownership of Consolidated Subsidiary A, which directly owned c percent of
Partnership, and its ownership of Consolidated Subsidiary C, which directly owned the
remaining d percent of Partnership.

      As the result of transactions occurring on i and j, substantially all assets of
Partnership, including related wireless licenses and equipment held by Consolidated
Subsidiary A that were used in Partnership’s business, were sold to unrelated parties.

        Taxpayer owns, operates, and maintains a fiber optic communications system in
rural regions of State A, that it uses to provide state-of-the-art telecommunications
services to homes and businesses in the rural communities it serves. Taxpayer’s
services include telecommunications exchange and local access services, long distance
services, internet services, video services, wireless communications, and
telecommunication equipment sales. Taxpayer provides these services to its patrons
and to customers with which the Taxpayer does business on a nonpatronage basis. As
a provider of telecommunication services, Taxpayer is subject to federal, state, and
local regulations. To assist Taxpayer in complying with applicable regulations,
Consolidated Subsidiary A holds nonregulated telecommunication assets for the benefit
of Taxpayer and in furtherance of Taxpayer’s telecommunication services.
PLR-119498-22                                 4

       In k, four telecommunication companies, including Taxpayer, formed Partnership
to serve rural State A communities. Partnership was formed to build a cellular network
and provide cellular telecommunication services and equipment to patrons and
customers with which the Taxpayer does business on a nonpatronage basis in rural
areas in State A. The pooling of resources in Partnership enabled the four partners to:
1) raise necessary capital to be awarded a cellular license, 2) share costs of developing,
operating, and maintaining a cellular network in rural regions of State A, 3) leverage the
partners’ combined purchasing power to get more favorable pricing terms on roaming
and telecommunications equipment for their patrons and non-patron customers, 4)
improve the quality, reliability, and affordability of the cellular services offered in their
respective service areas, and 5) develop new revenue generating services and products
using state-of-the-art technology, among other things.

       When Partnership was formed in k, Consolidated Subsidiary B and the other
three partners in Partnership, each acquired a d percent partnership interest in
Partnership. In l, Consolidated Subsidiary B purchased the partnership interests of two
other partners, increasing its ownership to c percent of Partnership. The remaining d
percent partnership interest in Partnership was owned by Entity A, a wholly owned
subsidiary of Entity B.

         In m, Consolidated Subsidiary A and Entity A decided to end their partnership
due to differences of opinion on operational matters. On n, Consolidated Subsidiary A
and Entity A entered into a purchase and sale agreement, whereby Entity A agreed to
sell its d percent partnership interest in Partnership to Consolidated Subsidiary C for an
all-cash purchase price. The sale closed on g. Following the sale, Taxpayer owned h
percent of Partnership through its ownership of Consolidated Subsidiary A, which
directly owned c percent of Partnership, and its ownership of Consolidated Subsidiary
C, which directly owned the remaining d percent of Partnership.

        During its existence, Partnership constructed and operated a wireless network in
rural regions of State A that grew to include telecommunications towers and related
wireless equipment and facilities at various other cellular service sites. Partnership also
operated retail stores. Taxpayer used the wireless network and retail stores to provide
cutting-edge wireless communication services and equipment to its patrons and to
customers with which the Taxpayer does business on a nonpatronage basis in its
service areas at competitive prices.

       In o, Taxpayer decided to exit the wireless business conducted through
Partnership and focus on its services delivered through fiber optic cable. This decision
was based on the belief that Taxpayer could not effectively compete with other major
wireless carriers. As a result, Taxpayer decided to divest Partnership’s wireless
business by selling substantially all of Partnership’s assets, including the wireless
licenses and equipment held by Consolidated Subsidiary A that Partnership used in its
business.
PLR-119498-22                                  5

        To effectuate the divestiture, four sale agreements were entered into with three
unrelated buyers. Following regulatory approval, the sale agreements were executed
on i and j. Taxpayer is using the proceeds from these divestiture transactions to build
out its fiber optic local exchange networks, to improve fiber-delivered services to its
patrons and other customers, and to focus on its core mission of bringing state-of-the-
art telecommunications services to businesses and residents in the rural communities it
serves.

       Based on the foregoing, Taxpayer requests a ruling that:

       1. Consolidated Subsidiary A’s distributive share of partnership income from
          Partnership’s sale of substantially all its assets resulting from three separate
          divestiture transactions, constitutes patronage-sourced income and, if
          properly allocated to Taxpayer’s patrons, is excludable from Taxpayer’s
          consolidated gross income in the tax year of the sale.

       2. Consolidated Subsidiary C’s distributive share of partnership income from
          Partnership’s sale of substantially all its assets resulting from a singular
          divestiture transaction, constitutes patronage-sourced income and, if properly
          allocated to Taxpayer’s patrons, is excludable from Cooperative’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
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
PLR-119498-22                                 6

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
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, 87th 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
PLR-119498-22                                 7

       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
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
PLR-119498-22                                 8

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:

       “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
PLR-119498-22                                 9

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
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, since Consolidated
Subsidiary A and Consolidated Subsidiary C were used for the purpose of securing
cellular service for Taxpayer’s patrons, income from these investments satisfies the
directly related test.

      Accordingly, the portion of Taxpayer’s income that is allocable to Taxpayer’s
patrons’ use of Consolidated Subsidiary A’s and Consolidated Subsidiary C’s networks
PLR-119498-22                                10

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.

       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.

      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


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