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Rural Utility Cooperative Law Blog

IRS Scrutinizes Section 501(c)(12) Cooperatives

In its 2013 Workplan, the IRS reported a “high level” of incorrect reporting by Section 501(c)(12) cooperatives.  These errors primarily related to “miscalculation and misreporting” of member income percentages.

The IRS conducted a compliance check of Section 501(c)(12) cooperatives.  The compliance check involved questionnaires and examinations.  The IRS concluded that one-fourth of the cooperatives either (i) failed the Member Income Test or (ii) were not being operated on a cooperative or mutual basis.  Given the high number of irregularities, cooperatives would be well advised to review these two important requirements. 

To qualify for exemption under Section 501(c)(12), cooperatives must operate in accordance with cooperative principles.  In addition, 85 percent of their income must be “collected from members for the sole purpose of meeting losses and expenses.”

As a summary, to operate on a cooperative basis, cooperatives must satisfy the traditional cooperative principles:

  • subordination of capital,
  • democratic control, and
  • allocation and return of net margins based on patronage.

In addition, the IRS has established additional requirements that specifically apply to Section 501(c)(12) cooperatives.

The Member Income Test involves several other issues that must be considered.  These issues include, for example:

  • Is the definition of “income” under the Member Income Test the same as “income” under other section of the Tax Code?
  • What income is “collected from members”?
  • To what extent does the IRS’s guidance concerning patronage income apply?
  • When is income collected “for the sole purpose of meeting losses and expenses”?
  • Should income be calculated on the basis of gross income or gross receipts?
  • How should losses be treated?
  • Is netting of income and expenses permitted?
  • How should cooperatives treat the income of subsidiaries and related entities?

Section 501(c)(12) defines certain categories of income that are either excluded or reclassified for purposes of the Member Income Test.

In light of the IRS’s recent examinations and report, cooperatives exempt under Section 501(c)(12) should review their compliance with the tax laws.  Specifically, they should consider their cooperative operation and satisfaction of the Member Income Test.

Read AHC Cooperative Tax Briefs here


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