In the latest cooperative tax ruling, the Service ruled that a cooperative’s (“Cooperative”) gain on sale of stock in corporations that offered services to Cooperative’s members was patronage-sourced. The ruling was important to Cooperative because it expected to fail the Member Income Test of Section 501(c)(12), subjecting Cooperative to regular corporate income tax. The favorable ruling allowed Cooperative to avoid substantial taxes in the gain.
Cooperative provided telephone and broadband services to rural areas. It obtained tax-exempt status under Section 501(c)(12). It provided various additional services to its members through other cooperatives in which it owned stock (“Service Cooperatives”).
Throughout the years, Service Cooperatives had undergone mergers and created subsidiaries. Eventually Cooperative discontinued one of the Service Cooperative’s services. Upon discontinuing the service of that Service Cooperative, Cooperative decided to sell its stock. The proceeds from the sale would be used to fund current telecommunications construction projects for its members.
Tax Treatment Upon Sale of Service Cooperative’s Stock
Cooperative was rightfully concerned about the gain on sale of stock in Service Cooperative. While normally such a sale would not necessarily result in taxable income, Cooperative expected to fail the Member Income Test of Section 501(c)(12). During those years which Cooperative would fail the Member Income Test, Cooperative would be taxed as a taxable corporation. Yet because Cooperative continued to operate on a cooperative basis, it would nevertheless qualify as a taxable cooperative.
As a taxable cooperative providing telephone services to rural areas, Cooperative’s patronage-sourced income would become excludable from gross income (i.e., non-taxable). Cooperative wanted assurance from the Service that the gain on sale of stock in Service Cooperative would qualify as patronage-sourced income.
Was the Gain Considered Patronage-Sourced Income?
Whether income constitutes patronage-sourced income is a fact-intensive analysis. The Service looks at all facts surrounding the transaction that generated the income. Patronage-sourced income is income derived from business done with or for patrons. It does not include income generated merely to enhance the profitability of the cooperative. It generally does not include income derived from sources not directly related to the cooperative’s primary activities, such as income from lease of premises, investment in securities, or the sale or exchange of capital assets.
The Service’s Ruling
After reviewing several prior rulings and case law on the subject, the Service concluded that the gain was patronage-sourced income. In this case, Cooperative purchased stock in Service Cooperative for the purpose of obtaining vital services for its members. Furthermore, the proceeds from the sale would fund construction for projects to benefit its members. As a result, assuming Cooperative followed the rules for patronage dividends, the Service ruled that the gain would be excludable from gross income as a “true patronage dividend.”