IRS written determination 201423027

Private letter rulings and published taxpayer determination letters. Native document type is retained separately; a determination letter is not labeled a private letter ruling. These taxpayer-specific releases cannot be used or cited as precedent under 26 USC 6110(k)(3); applicability and current legal force are not independently certified. Keep repeated UILC subjects attached to one actual numbered document.

TREASURY

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INTERNAL
ERNAL REVENUE S

SERVICE

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

Release Number: 201423027

Release Date: 6/6/2014

Date: March 13, 2014

UIL 501.12-03

Contact Person:

Identification Number:

Telephone Number:

Employer Identification Number:

Legend:

State =
Date =
☒
X =

Year =

Dear

We have considered your ruling request regarding the tax consequences relating to the
proposed transactions described below.

FACTS

You are an electric cooperative, formed as a cooperative, nonprofit, membership
corporation under the laws of State on Date. You are organized under your bylaws to operate
on a cooperative, nonprofit basis for the mutual benefit of your members. You are exempt from
federal income tax under § 501(c)(12) of the Internal Revenue Code ("Code"). In the past you
have satisfied, and you expect to continue to satisfy, the member income requirements for
exemption under § 501(c)(12).

You have approximately X current members. Your members are entitled to vote on all
☒
matters presented at meetings of the members, and all questions put to vote to the members
are generally decided by majority vote. Your governing board is composed of nine trustees, all
of whom are elected by the members at your annual meetings. Members elect the trustees on a
one member, one vote basis. In addition, a trustee may be removed and replaced by a majority
vote of the members upon a member initiated petition signed by the lesser of 10% or 400
members.

Pursuant to your bylaws, you are obligated to account to all of your members on a

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patronage basis for all amounts received and receivable from electric energy in excess of
operating costs and expenses properly chargeable against the furnishing of such services. You
are required to credit to a capital account all such amounts in excess of operating costs and
expenses for each member. You are obligated to maintain books and records reflecting the
amount of capital credited to each patron's account on an annual basis and to notify members
of the capital credited to their accounts within a reasonable time after the close of the fiscal
year.

Your bylaws provide that, in the event of your dissolution or liquidation, all of your
outstanding indebtedness will be paid first, and then outstanding capital credits of current and
former members will be retired, without priority, on a pro rata basis. The remaining property and
assets - representing your "net savings" account - will then be distributed among the members
and the former members in proportion to the patronage each bears to the total patronage of all
members during the seven years next preceding the date of filing of the certificate of dissolution.

Your bylaws also provide that, at any time prior to dissolution or liquidation, capital credited
to the members' accounts may be retired in full or in part if the Board determines that your
financial condition would not be impaired thereby. In the event of a capital credit retirement
occurring earlier than the time scheduled by the Board, the amount of the capital credit may be
discounted to present value in accordance with applicable accounting standards and as the
Board may determine to establish the amount to be received by the distribute in respect to such
early retirement.

The Board has adopted a policy for the regular assignment and retirement/payment of
capital credits ("Policy"). The Policy provides that, upon payment of discounted capital credits,
the difference between the discounted value paid and the stated value of the member's or
patron's capital account will be credited to an equity account in the name of the member or
patron to be held as retired capital. Thus your members retain a continuing property right in the
net savings for the difference between the stated value of the patronage allocation and any
discounted value that has been paid.

In Year you were sued by a group of former members ("Former Members") who allege that
you should immediately retire capital credits of a member once the member ceases taking
power from you and thus ceases to be your customer. You have negotiated a settlement
proposal with the Former Members ("Settlement Proposal"), which provides that, after off-setting
their bad debt, you will then discount to present value all capital credits of the Former Members
and pay out such capital credits over a defined period.

The parties have agreed that the rate of return of a competing electric utility within your
service area should be used as the capital credit discount/present value rate. The capital credits
allocated to the Former Members will be discounted on a ten-year basis, and then immediately
retired as a condition of the settlement. Pursuant to the Settlement Proposal, the Former
Members will receive their pro rata share of the discounted capital credit amount, less attorneys'
fees, administrative costs, and payment of compensation to the class representatives.

The discounted portion of the Former Members' redeemed capital credits - the difference
between the discounted amount and the original amount in the capital credit account - will be

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retained on your books as permanent equity and available for distribution to the members and
former members upon dissolution and liquidation as part of your net savings account. It will not
be reallocated to the capital credit accounts of current members.

You request the following rulings:

1\. The proposed transaction consisting of your (a) entering into a settlement agreement
consistent with the terms of the Settlement Proposal, (b) redeeming capital credits of the
Former Members at a discount rate pursuant to the terms thereof, and (c) transferring
the discounted portion to your permanent equity will not adversely affect your tax-exempt
status under § 501(c)(12).

2\. The discounted portion of the Former Members' redeemed capital credits will not be
included in your income for purposes of the 85 percent member income test under §
501(c)(12).

3\. The redemption of the capital credits of the Former Members pursuant to the Settlement
Proposal will constitute patronage dividends or patronage sourced income.

# LAW

Section 501(c)(12) of the Code provides for the exemption from federal income tax of
benevolent life insurance associations of a purely local character, mutual ditch or irrigation
companies, mutual or cooperative telephone companies, or like organizations, but only if 85
percent or more of the income consists of amounts collected from members for the sole purpose
of meeting losses and expenses.

Rev. Rul. 72-36, 1972-1 C.B. 151, describes certain basic characteristics an organization must
have in order to be a cooperative organization described in § 501(c)(12)(A). These
characteristics include the following: A cooperative must keep adequate records of each
member's rights and interest in the assets of the organization. A cooperative must not retain
more funds than it needs to meet current losses and expenses. The rights and interests of
members in the organization's savings must be determined in proportion to their business with
the organization. A member's rights and interests may not be forfeited upon the withdrawal or
termination of membership. Upon dissolution, gains from the liquidation of assets should be
distributed to all current and former members in proportion to the value or quantity of business
that each did with the cooperative over the years.

This ruling also addresses a situation involving forfeiture of a former member's rights and
interests where the bylaws provide for such action upon withdrawal from the cooperative or
termination. It states that even if forfeiture is permitted by the bylaws, the organization has not
operated on a cooperative basis and should not be recognized as tax-exempt.

In Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3, the
court stated that an organization must meet certain common law requirements in order to be a
cooperative. These common law requirements include: democratic control of the organization by
members, the organization operates at cost for the benefit of members, and the contributors of

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capital to the organization do not control or receive most of the pecuniary benefits of the
organization's operations (i.e. subordination of capital).

# DISCUSSION

Section 501(c)(12) of the Code provides for the federal tax exemption of cooperative
telephone companies or like organizations, including mutual or cooperative electric companies,
and other cooperative organizations not relevant here. While the term "cooperative" is not
defined in I.R.C. § 501(c)(12) or the regulations thereunder, a cooperative has been traditionally
and historically defined as a voluntary, membership business organization that is organized in
response to the economic needs of and to perform services for its members, and not to realize
monetary gains as a separate legal entity. A cooperative is organized and operated for the
benefit of and is democratically controlled by its members. See Puget Sound Plywood Inc., v.
Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3. Hence, to qualify for exemption under
I.R.C. § 501(c)(12), an organization must be a cooperative and organized and operated as
such. Puget Sound Plywood v. Commissioner describes the principles that are fundamental to
the organization and operation of cooperatives. They are: (1) democratic control by the
members, (2) operation at cost, and (3) subordination of capital. These principles apply to
organizations described in I.R.C. § 501(c)(12).

Democratic control requires that the cooperative be governed by members and on a one-
member, one-vote basis. Each member has a single vote regardless of the amount of business
he or she does with the organization. The issue of democratic control is a question of fact.

Operation at cost requires that the cooperative's net earnings or savings derived from
furnishing services in excess of costs and expenses be returned to its members in proportion to
the amount of business conducted with them. This principle ensures that a cooperative's net
savings from members are returned to members in proportion to the amount of business each
transacts with the cooperative. A cooperative satisfies this requirement by making annual
allocations of patronage to members.

Subordination of capital has two requirements. First, control of the cooperative and
ownership of the pecuniary benefits arising from the cooperative's business remains in the
hands of the members rather than with non-patron equity investors. Second, the returns on
equity investments must be limited. Hence, the net savings that accrue to the cooperative from
the business activities it transacts with its members will largely inure to the benefit of those
members rather than to its equity investors. The rationale for these limitations is to ensure that
the cooperative remains faithful to its purpose-providing services at the lowest possible prices
(or highest possible prices for a marketing cooperative) to its members and not to realize profits
for capital. If it were otherwise, the emphasis then would likely be on protection of returns of
equity capital rather than services to members, and this would destroy the basic purpose of
cooperatives. See Puget Sound Plywood Inc., v. Commissioner, 44 T.C. 305 (1965), acq. 1966-1
C.B. 3.

Rev. Rul. 72-36, supra, describes additional fundamental requirements for operation of
cooperatives described in I.R.C. § 501(c)(12). It requires that a member's rights and interest in
the assets of a cooperative cannot be forfeited upon termination of membership. It also requires

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that upon dissolution, a cooperative must distribute any gains from the sales of its assets to
those who were members during the period that the assets were owned.

## A. Redemption of Capital Credits at Discount

A fundamental tenet of cooperative operation is that the earnings of a cooperative are
allocated and ultimately distributed to its members based on the amount of business
(patronage) done with those members. The amount a cooperative member pays for the
cooperative's services less the cost of providing such services is allocated to the member. Thus,
the presumption is that the cooperative's services are provided at cost to the members. But it is
impractical for such a cooperative to return immediately all the amounts or earnings to its
members because the cooperative needs to have reserves in order to operate, meet
unexpected expenses, or to expand. These amounts or earnings are held by the cooperative for
a certain period of time as prescribed by cooperative bylaws and are allocated as capital credits
to accounts kept for each member. These capital credits are returned to the members or former
members when the cooperative redeems them (i.e., sends a check for the amount of the capital
credits) at the end of the prescribed time.

The primary issue raised by the transaction described in the Settlement Proposal is
whether it violates any of the cooperative requirements described Puget Sound Plywood, Inc., v.
Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3, and Rev. Rul. 72-36. The cooperative
principle of democratic control by members is satisfied because the redemption of capital credits
at discount will not affect member voting rights or governing rights. We also note that the
transaction described in the Settlement Proposal is consistent with the fiduciary duties of the
cooperative (and its board of directors and management) to former members, and their ability to
enforce their rights in the courts. See Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894
(1982). The cooperative principle of operating at cost is satisfied because the members' right to
receive the excess over the cost of electricity service (i.e. capital credits) is also not adversely
affected.

The cooperative principle of subordination of capital is satisfied because the transaction
described in the Settlement Proposal does not adversely affect the members' control and
ownership of the cooperative assets. The cooperative requirement that there is no forfeiture of
former members' rights to assets of the cooperative is not violated. Specifically, the terms of the
Settlement Proposal permit the Former Members to receive the present value of their capital
credit accounts at a date before dissolution and liquidation of the company. The discount rate is
in accordance with the prevailing market rate. Further, by discounting to present value, the
Former Members are not treated more favorably than current members.

## B. Transfer of Discount Portion of Capital Credits to Net Savings

Pursuant to the Policy, the difference between the discounted value paid to Former
Members and the value stated in the member's account will be credited to an equity account
within your net savings account in the name of that member. In accordance with your Bylaws,
the retired capital in the net savings account will be distributed to Former Members upon
dissolution prior to distributing any remaining amounts in the net savings account.

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Based on the facts presented, we do not believe that your establishment of this second
capital account for each member would create taxable income to you as a cooperative.
Analogizing to a corporate transaction, under §1032, a corporation will not recognize gain or
loss on the receipt of money or property in exchange for stock. Therefore, when a stockholder
contributes money in exchange for stock in the corporation, the corporation does not have
taxable income. Applied to a cooperative, so long as the member contributed money to the
cooperative in the capacity of a member, the cooperative would not have income.

It appears that, according to your Policy, you are simply transferring money already
received from members from one equity account to another equity account. As a result, it
appears that nothing has changed and you will not receive any income pursuant to the
transaction. The transfer of the discounted portion from the Former Members' capital credit
accounts to an equity account within the net savings account where their continuing equity
interest will be recorded is simply an organizational tool.

## C. Redemption of Capital Credits Constitute Patronage Dividends or Patronage Sourced Income

Regarding whether the redemption of capital credits are excluded from income as patronage
dividends or patronage sourced income, in Pomeroy Cooperative Grain Co. v. United States, 31
T.C. 674, 685-686 (1958), the U.S. Tax Court held that an allocation must represent true
patronage dividends to be given an exclusion from gross income. According to the court, three
prerequisites must be satisfied to exclude patronage dividends from gross income:

(1) The allocations must have been made under a pre-existing legal obligation, one which
existed when the patrons transacted their business with the cooperative.

(2) The allocations must have been made out of profits or income realized from transactions
with the particular patrons (members) for whose benefit the allocations were made, and
not out of profits or income realized from transactions with other persons or
organizations.

(3) The allocations must have been made equitably, so that profits realized from selling
merchandise or services to patrons, and profits from marketing products purchased from
patrons, were allocated ratably to the particular persons whose patronage created each
particular type of profit.

You maintain that the redemption of the Former Members' capital credit accounts qualify as
patronage dividends, excluded from gross income, because they will be made under a pre-
existing legal obligation, on the basis of patronage, and from profits derived from the patrons'
business dealings with you. Based on your representations, it appears that the requirements
set forth by the U.S. Tax Court in Pomeroy Cooperative Grain Co. v. United States, 31 T.C. 674,
685-686 (1958) have been satisfied, and we have found no contrary authority.

# RULING

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Accordingly, based on the foregoing facts and circumstances, we rule as follows:

1\. The transaction described in the Settlement Proposal, consisting of your (a) entering into a
settlement agreement, the terms of which are not yet finalized, but will be consistent with
the Settlement Proposal, (b) redeeming capital credits of the Former Members at a
discount/present day value rate pursuant to the terms thereof, and (c) transferring the
discounted portion to your permanent equity will not adversely affect your tax-exempt
status under Section 501(c)(12) of the Code.

2\. The discounted portion of the Former Members' redeemed capital credits will not be
included in your income for purposes of the 85 percent member income test under
Section 501(c)(12) of the Code.

3\. The redemption of the capital credits of the Former members pursuant to the Settlement
Proposal will constitute patronage dividends or patronage sourced income.

This ruling will be made available for public inspection under section 6110 of the Code after
certain deletions of identifying information are made. For details, see enclosed Notice 437,
Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make
available for public inspection is attached to Notice 437. If you disagree with our proposed
deletions, you should follow the instructions in Notice 437.

This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the
Code provides that it may not be used or cited by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that there
will be no material changes in these facts. This ruling does not address the applicability of any
section of the Code or regulations to the facts submitted other than with respect to the sections
described. Because it could help resolve questions concerning your federal income tax status,
this ruling should be kept in your permanent records.

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If you have any questions about this ruling, please contact the person whose name and
telephone number are shown in the heading of this letter.

In accordance with the Power of Attorney currently on file with the Internal Revenue Service,
we are sending a copy of this letter to your authorized representative.

Sincerely,
Mary J. Salins
Manager, Exempt Organizations
Technical Group 4

Enclosure
Notice 437