Cooperative-Subsidiary Consolidation Issues

Many cooperatives provide a range of services to their members.  Sometimes these services are provided through subsidiaries.  Each cooperative must choose the right mix of services to provide and customers to serve, along with the best corporate structure to provide them.  In a recent private letter ruling, a cooperative decided it was best to combine all services into the cooperative and to provide them on a cooperative basis.  The ruling discusses some of the tax considerations involved in such a transaction. 

Background Facts:

When it was originally formed, Cooperative was a Section 501(c)(12) cooperative that provided services to its members.  It eventually expanded its services by providing them through subsidiaries held by a wholly owned holding company (“Subsidiary 1”). 

For various reasons, Cooperative desired to consolidate all its services and its subsidiaries’ services into Cooperative.  It would do so by converting its subsidiaries that were Subchapter C corporations and a limited partnership into limited liability companies and thereafter electing classification as disregarded entities.  In addition, it merged a subsidiary into Subsidiary 1.  Ultimately, it liquidated Subsidiary 1 into Cooperative. 

Cooperative was concerned, however, that Subsidiary 1 might be subject to a Section 337(b)(2) gain upon its liquidating distribution of assets to Cooperative.  In addition, Cooperative was concerned that it would be subject to a gain if it satisfied the Member Income Test in subsequent years. 

Rulings and Rationale:

First, Cooperative was concerned that when Subsidiary 1 liquidated into Cooperative, it would trigger a Section 337(b)(2) gain – because the assets would be transferred from a taxable corporation to a tax-exempt entity. 

Under Section 337, normally no gain or loss is recognized by a corporate subsidiary when it liquidates and distributes property to its parent.  But when the parent is a tax-exempt organization, the non-recognition rule of Section 337 does not apply.  The regulations explain that when a taxable corporate subsidiary transfers all or substantially all its assets to a tax-exempt entity, the subsidiary must recognize gain or loss as if the assets were sold at their fair market value.  This could result in a substantial taxable gain when the assets are significantly depreciated.  (Notably, the rule also applies in many cases to the conversion of an entity from a taxable corporation into a tax-exempt entity.) 

For some purposes, a Section 501(c)(12) cooperative is treated as tax exempt, even when it fails the Member Income Test and files a Form 1120.  So Cooperative was understandably concerned that the liquidation would result in a gain under Section 337(b)(2), even if it failed the Member Income Test.  

Fortunately, the IRS ruled that for purposes of Section 337, Cooperative would not be considered a tax-exempt entity as long as it failed the Member Income Test (i.e., generated more than 15% non-member income).  Accordingly, Subsidiary 1 would not recognize a Section 337(b)(2) gain. 

Second, Cooperative wanted to be sure that if it later satisfied the Member Income Test, it would not trigger a conversation gain (i.e., by converting from taxable to tax exempt).  As noted above, when a taxable corporation converts to a tax-exempt entity, the regulations under Section 337 impose a Section 337(b)(2) gain. 

Fortunately the regulations under Section 337 provide an exception for Section 501(c)(12) cooperatives that switch between taxable and tax exempt due solely to the Member Income Test.  But an exception to the exception applies when a principal purpose was to avoid the conversion gain rules.

The IRS concluded that Cooperative would qualify under the exception for Section 501(c)(12) cooperatives, and that the anti-avoidance exception to the exception did not apply.  As a result, if Cooperative later satisfied the Member Income Test, it would not be subject to a Section 337(b)(2) conversation gain. 

When cooperatives are involved, there are many other considerations involved in undertaking a consolidation, merger, or other corporate transaction.  This ruling provides a discussion of only two issues.  Stay tuned to AHC’s Cooperative Law Blog for additional insight.