Tracking Legal Events involving Electric & Telephone Cooperatives

This extract from an Internal Revenue Publication discussing the ability of Coops to be exempt from income taxation neatly summarizes on of the major issues that could be catastrophic to Coop.

The purpose of an I.R.C. 501(c)(12) organization is to provide certain services to its members at the lowest possible cost.  To qualify for and maintain exemption under I.R.C. 501(c)(12), a cooperative must receive 85 percent or more of its income each year from members.  The income must be collected solely to meet the cooperative’s losses and expenses. . . .

After ratification of the Sixteenth Amendment, exemption from federal income taxes for mutual or cooperative insurance companies, ditch or irrigation companies, telephone companies and “like organizations” was first enacted in the Revenue Act of 1916, Pub. L. No. 64-271, ch. 462 § 11(a)(10), 39 Stat. 756, 767 (1916) (“1916 Statute”), reenacted in successive revenue acts, and in the 1939, 1954 and 1986 Internal Revenue Codes.  Electric cooperatives, which were not specifically listed in the 1916 Statute, but were recognized by the Service as “like organizations” in I.T. 1671, C.B. II-1, 158 (1923) and Rev. Rul. 67-265, 1967-2 C.B. 205, were added to I.R.C. 501(c)(12)(C) in 1980.

Before 1924, the statute limited cooperatives’ income to assessments, dues, and fees from members.  The Revenue Act of 1924, ch. 234, § 231(10), 43 Stat. 283 (1924), reduced the member-income requirement to 85 percent, allowing cooperatives to earn up to 15 percent of their income from nonmember sources. Congress intended to allow cooperatives to have other sources of income, such as interest on bank accounts, to pay for capital improvements, expansion, or to purchase real estate.  See 65 Cong. Rec. 71287129 (1924).  The 85 percent member-income test was intended to insure cooperatives continued serving members rather than placing their member-source income in investments, such as bonds or stocks, and becoming investment companies. See Cong. Rec. 3433 (1926). . . .

An organization must satisfy three requirements to qualify under I.R.C. 501(c)(12).  First, it must be organized and operated as a cooperative. Second, it must conduct activities described in I.R.C. 501(c)(12) and the regulations. Third, it must derive 85 percent or more of its income from members.  These three requirements can be categorized as: (1) the cooperative organizational and operational test; (2) the activities test; and (3) the income source test. . . .

A common requirement under I.R.C. 501(c)(12), I.R.C. 521 and Subchapter T is cooperative organization and operation. What is a cooperative? The term is not defined in I.R.C. 501(c)(12), I.R.C. 521, Subchapter T, or the regulations. Rather, the definition comes from the common law.

The Tax Court, in Puget Sound Plywood v. Commissioner, 44 T.C. 305, 307-308 (1965), acq.1966-1 C.B. 3, described a cooperative as comprised of members who sought “(1) [f]or themselves to own and manage the [organization], as distinguished from having it owned and managed by outside equity investors; and then (2) to have their [organization] turn back to the members the excess of the receipts from the store sales over the cost of the goods sold and the expenses of operation.”  This description identifies three basic principles or requirements: (1) democratic control by the members; (2) vesting in and allocating among the members all excess operating revenues over the expenses incurred to generate the revenues (i.e. operating at cost); and (3) subordination of capital.

These basic requirements apply to cooperatives described in section 501(c)(12) as well as those described in Subchapter T and I.R.C. 521.  They must be satisfied to qualify for and maintain exemption under I.R.C. 501(c)(12).

A. Democratic Control

This requirement assures that members participating in the cooperative endeavor remain in control of an I.R.C. 501(c)(12) cooperative.  A cooperative satisfies this by periodically holding democratically conducted meetings, with members, each with one vote, electing officers to operate the organization.

B. Operating at Cost

This requires that a cooperative return the excess of net operating revenues over its cost of operations to the member-patrons.  In other words, the cooperative must not operate either for profit or below cost.  The excess is usually called “savings” (rather than profit) because it is the amount not spent to obtain services (telephone, electricity, etc.) for member-patrons or to operate the cooperative.  A cooperative’s savings belong to its member-patrons, not the organization, and it must allocate the savings to its member-patrons in proportion to the amount of business it did with each.

C. Subordination of Capital

This requires that contributors of capital to the cooperative, in their status as equity owners, neither control the operations nor receive most of the pecuniary benefits of the cooperative’s operations.  That is, cooperatives are oriented to member-patrons.  This distinguishes the cooperative from the for-profit corporation, which is shareholder-oriented.  The idea behind this requirement is that members of a cooperative band together to share interest, risk, and burden to obtain services or benefits, whether water, telephone, electricity, etc., rather than simply invest as equity owners.

This requirement has two components.  First, members control an I.R.C. 501(c)(12) cooperative and own the savings or pecuniary benefits from its business, which stay with them rather than go to shareholders or equity investors.  Second, a cooperative must limit return on capital (e.g. dividends to shareholders) to insure savings or pecuniary benefits benefit member-patrons rather than shareholders. . . .

[Taken in part from General Survey of I.R.C. 501(c)(12) Cooperatives and Examination of Current Issues published by the Internal Revenue Service.  For a complete copy click here.]

This issue affects many Coops.