Cooperatives May Offset Bad Debt With Capital Credit Balances
Like for-profit companies, cooperatives encounter bad debt of members and patrons. They can initiate collection efforts to pursue bad debts, but because their members are also their owners, debt collection can be a complicated endeavor. With regard to former members, a recent IRS private ruling discussed an alternative option for recovering outstanding balances.
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Cooperative is a Section 501(c)(12) electric cooperative that had a large number of former members with outstanding balances. The cooperative had previously offset these outstanding balances with the amount of capital credits retired each year on a non-accelerated basis. In other words, outstanding debts had been offset with retired capital credits as they were retired in accordance with Cooperative’s normal retirement cycle.
In addition, after members had been former members for seven years, Cooperative fully retired their capital credit account – by offsetting any outstanding debt and paying out the remaining capital credit balance.
Cooperative requested a ruling that would allow it to retire former members’ capital credit accounts, without waiting seven years, but only to the extent of any outstanding debt of such former member. Any remaining balance in the capital credit account would be retired in accordance with Cooperative’s normal retirement cycle. The offset would occur without applying a discount rate to the capital credit balance (i.e., former members receive full face value for the capital credits offset by debt).
All collection efforts would be discontinued for the amount of debt offset by capital credits. If the former member later pays any amount toward the satisfied debt, Cooperative would return that payment. The requested ruling would permit Cooperative to immediately settle outstanding debts with former members.
Does the Offsetting Program Comply with Federal Tax Law?
The primary questions were whether the offsetting program was consistent with cooperative principles, and whether it resulted in a forfeiture of member rights. The IRS began by discussing the Puget Sound cooperative principles: democratic control, subordination of capital, and operation at cost with return of net margins.
First, the offsetting program has no impact on democratic control, as members will continue to vote for directors. (Interestingly, the Service noted that Cooperative’s board of directors owes a fiduciary duty to former members, citing a federal Tax Court case.) Second, the program does not violate the principle of subordination of capital because it does not affect members’ control and ownership of Cooperative’s assets. Third, Cooperative would continue to operate at cost because former members would receive a full credit against outstanding debt in return for retirement of the same amount in capital credits.
Lastly, the program did not result in forfeiture of members’ rights because members’ rights to Cooperative’s assets were not impacted.
Accordingly, the IRS ruled that the offsetting program was consistent with cooperative principles and federal tax regulatory requirements.
The ruling is beneficial for a cooperative that seeks to implement an offsetting program similar to the one in the ruling. Interestingly, the cooperative at issue choose to offset outstanding debt with the full face value of capital credits. So, the ruling did not address the impact of discounting capital credits to present value. Some cooperatives with longer rotation periods would probably benefit from a ruling that addresses the impact of discounting in the context of offsetting outstanding debt.
Additional Note: This ruling obviously does not address the impact of a member’s bankruptcy.