Who is entitled to vote as a cooperative member when a facility is composed of separately metered units? Does it matter whether residents of each unit are billed separately by the cooperative? Does the answer change when there are separate meters, but residents pay their pro rata portion to the facility’s owner, who remits payment to the cooperative?
Cooperative law attorneys often hear these questions from our cooperative clients. While the answer depends on the specific state laws in issue, several principles should be considered in determining who is a member.
Usually these questions arise in the context of voting and capital credits (or patronage dividends). But the answer can have tax implications as well.
The first step is to review applicable state law. Cooperatives are either organized under a cooperative enabling act (e.g., electric cooperative acts, telephone cooperative act, nonprofit cooperative act, agricultural cooperative act). These acts typically define who can qualify as a member, such as anyone who receives service and complies with the cooperative’s bylaws.
Some states allow cooperatives to be organized under the business corporations code, nonprofit corporations code, or even a limited liability act. To qualify as a cooperative in states without cooperative enabling acts, case law or other state-law sources should be reviewed to determine the requirements for cooperative operation, including the qualifications for membership.
The second step is to review the cooperative’s bylaws. Bylaws should define who is a member and establish the applicable qualifications. For instance, bylaws may require persons and businesses to sign a membership agreement before they can become members. In order for a person or business to qualify as a member, they would at a minimum need to comply with the bylaws’ prerequisites for membership.
In particular, the bylaws may address who is a member in the context of a multi-metered facility. For example, bylaws may define who is a member with reference to a meter, or with reference to who pays the invoice for a multi-metered facility.
The third step is to consider the impact of federal tax law. To qualify as a cooperative under federal tax law, cooperatives must satisfy the three fundamental cooperative principles. One of these three principles is democratic control, which requires members to vote (with limited exceptions) on a one-member-one-vote basis. In addition, utility cooperatives exempt under Section 501(c)(12) must obtain 85% of their income from members. So the determination of membership can have important consequences for federal income tax purposes.
According to guidance from the IRS, members are those who receive service from the cooperative and determine the governing body of the cooperative, usually by voting for the board of directors or board of trustees.
If customers do not receive the right to elect or otherwise determine the governing body of the cooperative, they will likely not qualify as members for federal tax purposes. For example, if customers are not members, revenue derived from such customers may not qualify for the 85% Member Income Test. Likewise, the IRS could question whether the cooperative fulfilled the cooperative principle of democratic control.
In one example, the IRS and a federal district court encountered struggled with this question in Modern Electric Water Co. v. U.S., 71A A.F.T.R.2d 93-3066 (1988), and in the resulting I.R.S. Action on Decision 1990-07. They considered how to classify payments made by non-member tenants (separately metered) for purposes of the Member Income Test.
In that case, the bylaws provided that only the owners of property were entitled to vote, whereas owners’ tenants were not entitled to vote. The Service concluded that payments from the tenants (as non-members) would not qualify as member income for purposes of the Member Income Test. The district court disagreed and ruled in favor of the cooperative. The Service issued an Action on Decision explaining why it disagreed with the district court, but it ultimately decided not to appeal this particular case.
It seems clear then that cooperatives should, at a minimum, review applicable federal and state laws, along with their bylaws and membership agreements, to determine whether their customers qualify as members. They should also consider whether certain persons or businesses that are not currently classified as members should be treated as members. This is especially true in the context of multi-metered facilities.