part7-64
- 7.25.12.1
Technical Overview - 7.25.12.2
Regulatory Overview - 7.25.12.3
Requirements for Exemption Under IRC 501(c)(12) - 7.25.12.4
Requirements for Benevolent Life Insurance Associations - 7.25.12.5
Requirements for Mutual Ditch, Irrigation, Cooperative Telephone
or Electric Companies, and “Like Organizations”
- 7.25.12.6
“Like Organizations”
- 7.25.12.7
Unrelated Business Income Tax - 7.25.12.8
The 85-Percent Member Income Test - 7.25.12.9
Current Issues
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IRC 501(c)(12) exempts the following organizations from federal income
tax:-
benevolent life insurance associations of a purely local character
-
mutual ditch or irrigation companies
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mutual or cooperative telephone companies
-
mutual or cooperative electric companies
-
“like organizations”
-
-
The phrase “of a purely local character”
applies
only to benevolent life insurance associations and organizations like them. -
To qualify for and maintain exemption under IRC 501(c)(12), all of the
organizations described in (1) above must receive 85 percent or more of their
income from members for the sole purpose of meeting losses and expenses each
year. -
Organizations that meet the requirements of IRC 501(c)(12) may apply
for exemption from federal income tax on Form 1024. -
Contributions to organizations that are exempt under IRC 501(c)(12)
are not deductible as charitable contributions on the donor’s income
tax return. -
For more information regarding examination issues, see IRM 4.76.20.
-
In 1916, Congress established exemption from federal income tax for
mutual ditch or irrigation companies, mutual or cooperative telephone companies,
and like organizations. 1916 Revenue Act, P.L. 64-271, sec. 11(a)(10), 39
Stat.766 (1916). -
In 1924, Congress extended exemption from federal income tax to benevolent
life insurance associations of a purely local character and reduced the member
income from 100 percent to 85 percent. Revenue Act of 1924, ch. 234, sec.
231(10), 43 Stat. 283 (1924). -
In passing the Miscellaneous Revenue Act of 1980, Congress added IRC
501(c)(12)(C), which specifically listed electric cooperatives as exempt under
this Code section for the first time and permitted them to exclude qualified
pole rentals from the 85-percent member income test. Miscellaneous Revenue
Act of 1980, P.L. 96-605, section 106(a), 94 Stat. 3523 (1980). -
In 1988, Congress permitted mutual or cooperative telephone and electric
companies to exclude income derived from the prepayment of a loan under sections
306A, 306B, or 311 of the Rural Electrification Act of 1936 from the 85-percent
member income test. Technical Miscellaneous Revenue Act of 1988, P.L. 100-647,
section 2003(a)(2)(C)(ii), 102 Stat. 3598 (1988). -
Effective for taxable years beginning after October 22, 2004, and before
January 1, 2007, Congress amended IRC 501(c)(12) to exclude income received
by a mutual or cooperative rural electric company from any open access transaction,
any nuclear decommissioning transaction, or any asset exchange or conversion
transaction, for purposes of determining whether such cooperative meets the
income test for tax-exempt status (i.e., 85 percent of income collected from
members of cooperatives for the sole purpose of meeting losses and expenses
of providing services to members). American Jobs Creation Act of 2004, P.L.
108-357, sections 319(a),(b), 118 Stat. 1470 (2004). -
Congress passed the Energy Policy Act of 2005, eff. Aug. 8, 2005, P.L.
109-58, Title XIII, Subtitle A, sections 1304(a),(b), 119 Stat. 997, eliminating
the January 1, 2007, sunset provision for treatment of income derived from
open access and nuclear decommissioning transactions and income from load
loss transactions, thereby making the income-exclusion provision described
above in paragraph (5) permanent.
-
State and federal agencies regulate mutual or cooperative telephone
or electric companies. Recordkeeping and reporting requirements vary.-
The Federal Communications Commission regulates and oversees interstate
and international communications by radio, television, wire, satellite, and
cable. More information is available at http://www.fcc.gov/aboutus.html. -
The Federal Energy Regulatory Commission (FERC) regulates interstate transmission
of electricity, natural gas, and oil. It reviews rates for wholesale sales,
examines proposed mergers and acquisitions, and seeks to ensure the integrity
of electrical power grids. More information is available at http://www.ferc.gov/default.asp. -
State public utility commissions regulate instate services and rates.
The National Association of Regulatory Utility Commissioners has links to
state regulators at http://www.naruc.org/displaycommon.cfm?an=7. -
The Department of Agriculture’s Rural Utilities Service (RUS) provides
financing for utility plants, expansion, and updating technology in rural
areas. More information is available at: http://www.usda.gov/rus/index2/aboutus.htm
The
RUS implementing regulations are in 7 CFR, Chapter 17, section 1710.
-
-
In order to qualify for exemption under IRC 501(c)(12), an organization
must:-
Meet the organizational and operational requirements that apply to one
of the types of organizations described in the Code, regulations derived thereof
and revenue rulings, and -
Receive 85 percent or more of its income from members for the sole purpose
of meeting losses and expenses.
-
-
The phrase “of a purely local character”
applies
only to benevolent life insurance associations and organizations that are
similar to them. An organization of purely local character is one that confines
its business activities to a particular community, place, or district, irrespective
of political subdivisions. Treas. Reg. 1.501(c)(12)-1(b). -
The organization must confine its operations to a single identifiable
locality. In 1928, the Court of Claims held that a reciprocal or interinsurance
exchange that operated in 27 states was not an organization of a purely local
character. Hardware Underwriters v. United States, 65
Ct. Cl. 267 (1928), cert. den., 278 US 645 (1928). -
An organization is not purely local in character if only the borders
of a state limit its activities. Treas. Reg. 1.501(c)(12)-1(b). A life insurance
organization that operated under a state permit that empowered it to do business
in any county within 75 miles of its home office, but also issued policies
to residents outside that area, did not qualify as an exempt organization.
Rev. Rul. 64-193, 1964-2 C.B. 151. -
The requirement that business activities must be purely local is satisfied
if members reside in the local area at the time of application. In 1983, the
Service ruled that a benevolent life insurance company that did not terminate
members’ life insurance coverage when they moved out of the local area
was tax-exempt. Rev. Rul. 83-43 1983-1 C.B.108.
-
Ditch and irrigation companies, telephone companies, electric companies,
and “like organizations”
that seek exemption under IRC
501(c)(12) must be organized and operated as mutual or cooperative organizations.
The terms “mutual”
and “cooperative”
have
no legal distinction for purposes of section 501(c)(12). The U.S. Tax Court
defined “cooperative”
as follows:
“A
cooperative is an organization established by individuals to provide themselves
with goods and services or to produce and dispose of the products of their
labor. The means of production and distribution are those owned in common
and the earnings revert to the members, not on the basis of their investment
in the enterprise, but in proportion to their patronage or personal participation
in it.”
Puget Sound Plywood, Inc. v. Commissioner
, 44 T.C. 305 (1966), acq. 1966-2 C.B. 6. -
The court described the organizational and operational cooperative principles
as follows:-
Democratic Control. The organization must periodically
hold democratically conducted meetings with members. Election of officers
must be on a one member, one vote basis. Meetings must have a quorum of members
in attendance or voting by proxy. -
Operation at Cost. The organization must allocate
all excess operating revenues (excess of revenue over expenses) among the
members. -
Subordination of Capital. The organization must
ensure that those who contribute capital neither control the operations nor
receive most of the pecuniary benefits. The organization will meet this requirement
by ensuring that the members control and own the savings or monetary benefits
rather than the shareholders or equity investors.
-
-
The Service sets out additional organizational and operational cooperative
requirements that an organization must meet for exemption under IRC 501(c)(12).
Rev. Rul. 72-36, 1972-1 C.B. 151. These requirements are:-
The organization must keep adequate records of each member’s rights
and interests in its assets. -
The organization must distribute any savings to members in proportion
to the amount of business done with them based on the “operation
at cost”
principle. -
The organization must not retain more funds than it needs to meet current
losses and expenses. -
The organization cannot forfeit a member’s right and interest in
the organization upon termination of membership. -
Upon dissolution, the organization must distribute the gains from the
sale of any appreciated assets to all persons who were members during the
period that the organization owned the assets, in proportion to the amount
of business done by the members during that period.
-
-
An association organized and operated on a cooperative basis to produce
and market the worker-members’ products and to allocate profits to the
worker-members was found to be exempt. Puget Sound Plywood,
Inc. v. Commissioner, supra. -
A mutual water company’s articles of organization required its
members, in the event of dissolution, to turn over their total interests without
charge to the local government. This requirement is consistent with the principles
of mutual operation and does not preclude exemption under IRC 501(c)(12).
Rev. Rul. 73-453, 1973-2 C.B. 185. -
In 1978, the Service announced that it would not follow the Ninth Circuit’s
decision in Peninsula Light Co., Inc. v. U.S., 552 F.2d
878 (9th Cir. 1977). The decision recognized an organization that never operated
on a patronage basis as exempt under IRC 501(c)(12). Its charter provided
each member with an equal share in the organization’s assets and, upon
dissolution, divided its assets equally among the current members. Rev. Rul.
78-238, 1978-1 C.B. 161. -
A mutual ditch company operated in a manner that was consistent with
the provisions of state law before Congress enacted legislation that provided
for exemption from federal income tax. It qualified for exemption even though
it did not satisfy all the requirements in Rev. Rul. 72-36. Since there were
no major changes in the applicable federal tax provisions in the intervening
years, the Service believed that Congress intended that mutual ditch and irrigation
companies that operate in such a manner would qualify for exemption. Rev.
Rul. 81-109, 1981-1 C.B. 347. -
The fact that all of its members may be exempt under IRC 501(c)(12)
does not alone qualify an organization for exemption. Consumers
Credit Rural Electric Cooperative Corp. v. Commissioner, 37 T.C. 136
(1961), aff’d on exemption issue, 319 F.2d 475
(6th Cir. 1963).
-
The Code provides that an organization may qualify for exemption from
federal income tax under IRC 501(c)(12) if it is “like”
a
benevolent life insurance association, a mutual ditch or irrigation company,
or a telephone or electric company. -
“Like organizations”
engage in activities
similar in nature to organizations listed in IRM 7.25.12.4 and IRM
7.25.12.5. Rev. Rul. 65-201, 1965-2 C.B. 170.
-
“Like”
Benevolent Life Insurance
Associations. An activity that is similar to providing life insurance
is providing cash benefit for burial and funeral expenses.
Thompson v. White River Burial Association, 178 F. 2d 954 (8th Cir.
1950). -
“Like”
Electric Cooperatives. Activities
or services that are similar to providing electricity to members include:-
water and sewer services (see Rev. Rul. 67-265, 1967-2 C.B. 205, updating and restating I.T. 1671, II-1 C.B. 158 (1923), and
Rev. Rul. 2002-54, 2002-2 C.B. 527) -
cable television service (see Rev. Rul. 83-170, 1983-2 C.B. 97)
-
natural gas service (see Rev. Rul. 2002-54, supra)
The rationale is
that these services are public utility-type services that have been traditionally
regulated by a state, political division, public utility commission, or other
similar body of a state, or an agency or instrumentality of the United States.
Such services also require extensive delivery infrastructure, the construction
of which necessitates large capital investment. See Rev. Rul. 2002-54, supra.
-
-
“Like”
Telephone Cooperatives. Activities
or services that are similar to providing telephone service include:-
a two-way radio service for the use of members (see Rev. Rul. 57-420,
1957-2 C.B. 308)
The rationale is that these services, like telephone service,
allow members to communicate with others. See Rev. Rul. 57-420, supra.
-
-
“Like”
Ditch and Irrigation Cooperatives.
An activity that is similar to providing ditch and irrigation services
is constructing and maintaining structures to prevent erosion of river banks.
Rev. Rul. 68-564, 1968-2 C.B. 221.
-
Providing bus services is an activity not exempt under IRC 501(c)(12).
Rev. Rul. 55-311, 1955-1 C.B. 72. -
Promoting automobile safety and furnishing road side and trip planning
services are activities not exempt under IRC 501(c)(12). New
Jersey Automobile Club v. United States, 181 F.Supp. 259 (Ct.Cl.1960), cert. den., 366 U.S. 964 (1961). -
Financing the purchase of appliances and equipment is an activity not
exempt under IRC 501(c)(12). Consumers Credit Rural Electric
Cooperative Corp. v. Commissioner, supra. -
Selling electrical materials, equipment, and supplies, and furnishing
equipment for manufacturing, repair, testing, and other services are not activities
exempt under IRC 501(c)(12). Rev. Rul. 65-201, 1965-2 C.B. 170. -
Selling tanked propane is not an activity exempt under IRC 501(c)(12).
Rev. Rul. 2002-54, 2002-2 C.B. 527.
-
IRC 511(a)(1) imposes a tax on unrelated business income earned by organizations
described in IRC 501(c)(12), except as described in (2) below. The criteria
to determine whether an activity conducted by a section 501(c)(12) organization
is an unrelated business are in section 511 et seq.
These criteria are whether the activity is a trade or business, whether it
is regularly carried on, and whether it is unrelated within the meaning of
IRC 513. -
Income earned by electric cooperatives from activities described in
IRC 501(c)(12)(H) is excluded from the definition of unrelated business taxable
income. See IRC 512(b)(18). -
Interest earned on debt-financed income is subject to tax under section
511. Southwest Tex. Elec. Coop. v. Commissioner, T.C.
Memo 1994-363 (1994).
-
A cooperative exempt under IRC 501(c)(12) must receive 85 percent or
more of its income from members. The 85-percent member income test requires
that the income be-
derived from members and
-
used to pay for services listed in IRC 501(c)(12)
Rev. Rul. 2002-55,
2002-2 C.B. 529; see Rev. Rul. 2002-54, supra, Treas. Reg. 1.501(c)(12)-1(a),
and Credit Rural Electric Cooperative Corp. v. Commissioner
, supra.
-
-
The 85-percent member income test is computed each tax year. If in any
year the member income falls below 85 percent of the total income received
that year, the organization is no longer exempt under IRC 501(c)(12) for that
tax year and must file a corporate tax return. Rev. Rul. 65-99, 1965-1 C.B.
242. -
When an organization uses the accrual method of accounting, it will
use the same method to compute the 85-percent member income test. Rev. Rul.
68-18, 1968-1 C.B. 271. -
Electric cooperatives do not have to subtract the cost of goods sold
from gross sales to calculate the 85-percent member income test. Prior to
1998, the Service’s position was that an electric cooperative must deduct
the cost of goods sold for purposes of calculating the 85-percent member income
test. See Rev. Rul. 80-86, 1980-1 C.B. 118. This position was proposed for
formal adoption in Prop. Treas. Reg. 1.501(c)(12)-2 (49 Fed. Reg. 1244, 1984).
The proposed regulation was withdrawn. See 58 Fed. Reg. 25587 (April 27, 1993).
Under the safe harbor guidelines, electric cooperatives may continue to use
the method they have consistently used in the past. Ann. 96-24, 1996 I.R.B.
35, (12)22.3(b). -
A benevolent life insurance company is not entitled to exemption if
it issues policies for stipulated cash premiums, or requires advance deposits
to cover the cost of the insurance and maintains investments from which it
gets more than 15 percent of its income. However, if an organization makes
advance assessments for the sole purpose of meeting future losses and expenses,
and retains the balance of the assessments remaining at the end of the year
to meet losses and expenses or returns it to members, it may be entitled to
exemption. Treas. Reg. 1.501(c)(12)-1(a). The Court of Claims has held that:
“…[T]he income of the association did not consist solely of assessments,
dues, and fees collected from members. It had income from large investments
in certificates of deposits and United States bonds, and this income, as stated,
was deposited and commingled with the general fund of the association in the
bank and used for paying expenses. It was income derived from investments.
Certainly there is at least a grave doubt as to whether the plaintiffs come
within the exemption, and it must be held that they are not entitled to be
exempted.”
Hardware Underwriters v. United States
, supra.
-
A cooperative must take income from all sources (except as provided
below) for computation under the 85-percent member income test, including
capital gains from the sale of assets where the gain arises from an incidental
disposition of assets upon dissolution. Mountain Water Co.
of La Crescenta v. Commissioner, 35 T.C. 418 (1960),
acquiescence on other issues, 1961-2 C.B. 5; Cate Ditch
Co. v. U.S., 194 F.Supp. 688 (D.Cal.1961). -
When an electric cooperative leases power facilities to a nonmember
power company, and the nonmember power company furnishes electric energy to
the cooperative members, the payments are not an “interchange
of power.”
Rather, they are rental payments that the cooperative must
include in income to determine whether it meets the 85-percent member income
requirement for exemption from federal tax. Rev. Rul. 65-174, 1965-2 C.B.
169. -
A government grant is not income and is treated as nonshareholder contribution
to capital. Hence, such a grant is not included as income for purposes of
computation under the 85-percent member income. In order to be treated as
a grant, the income:-
must become a permanent part of the transferee’s working capital
structure, -
may not be compensation, such as a direct payment for a specific, quantifiable
service provided for the transferor by the transferee, -
must be bargained for,
-
must result in benefit to the transferee in an amount commensurate with
its value, and -
must ordinarily, if not always, be used in or contribute to the production
of additional income and its value assured in that respect.
United States v. Chicago, Burlington & Quincy R.R., 412 U.S. 401
(1973); Rev. Rul. 93-16, 1993-8 C.B. 26.
-
-
Telephone cooperatives will apply the 85-percent income test without
taking into account any income received or accrued from:-
Another telephone company for the performance of communication services
involving the completion of long distance calls to, from, or between members
of the IRC 501(c)(12) telephone company. IRC 501(c)(12)(B)(i).Example:
In one year, a cooperative telephone company receives $85X from its members
for telephone calls, $15X interest income, and $20X in credits. Other long
distance telephone companies give the credits, under long distance interconnection
agreements, for the performance of communication services involving the completion
of long distance calls to, from, or between the cooperative members (whether
the credits may be offset, in whole or in part, by amounts due the other companies
under the interconnection agreements). The cooperative telephone company will
calculate the member income fraction without taking into account, either in
the numerator or the denominator, the $20X credits received from the other
telephone companies. Treas. Reg. 1.501(c)(12)-1(c); Rev. Rul. 81-291, 1981-2
C.B. 131. -
Qualified pole rentals. IRC 501(c)(12) (B)(ii).
-
The sale of display listings in a directory furnished to members of the
mutual or cooperative telephone company. IRC 501(c)(12)(B)(iii). -
The prepayment of a loan under section 306A, 306B, or 311 of the Rural
Electrification Act of 1936. IRC 501(c)(12)B(iv). -
Charging third parties such as inter-exchange carriers, local exchange
carriers, or other exchange carriers for billing and collecting intrastate,
interstate, or international revenues. FSA 199906034 (1999). This Field Service
Advice changed the Service’s position and reflected its acquiescence
to the U.S. Tax Courts decision in Golden Belt Telephone Association,
Inc. v. Commissioner, 108 T.C. 498 (1997). See AOD 1998-18 I.R.B. 4
(1998); see also, Notice 92-33, 1992-2 C.B. 363.
-
-
Electric cooperatives will apply the 85-percent income test without
taking into account any income received or accrued from:-
Qualified pole rentals. IRC 501(c)(12)(C)(i).
-
Nondiscriminatory open access transactions (other
than income received or accrued directly or indirectly from a member) such
as the provision or sale of electric energy transmission services or ancillary
services under an open access transmission tariff approved or accepted by
FERC, or under an independent transmission provider agreement approved or
accepted by FERC. See IRC 501(c)(12)(C)(ii),(iii). -
Nuclear decommissioning transactions. IRC 501(c)(12)(C)(iv).
The term “nuclear decommissioning transaction”
is defined
as any transfer into a trust, fund, or instrument established to pay any nuclear
decommissioning costs if the transfer is in connection with the transfer of
the cooperative’s interest in a nuclear power plant or nuclear power
plant unit, or any distribution from a trust, fund, or instrument established
to pay any nuclear decommissioning costs, or any earnings from a trust, fund,
or instrument established to pay any nuclear decommissioning costs. IRC 501(c)(12)(F). -
Asset exchange or conversion transactions. IRC 501(c)(12)(C)(v).
The term “asset exchange or conversion transaction”
means
any voluntary exchange or involuntary conversion of any property related to
generating, transmitting, distributing, or selling electric energy by a mutual
or cooperative electric company, the gain from which qualifies for deferred
recognition under IRC 1031 or IRC 1033, but only if the replacement property
acquired by the company constitutes property which is used or to be used for
generating, transmitting, distributing, or selling electric energy or natural
gas. IRC 501(c)(12)(G).
-
-
Members are those who have the rights to elect the governing board of
the cooperative and be involved in the operations of the organization. Many
kinds of entities and individuals may be members of organizations exempt under
IRC 501(c)(12). Government agencies may be members of IRC 501(c)(12) organizations.
Rev. Rul. 68-75, 1968-1 C.B. 169. An organization that is exempt under section
501(c)(12) may have members that are exempt under that section. See e.g., Consumers Credit Rural Electric Cooperative Corp. v. Commissioner
, supra. -
Below are some examples of types of member income or nonmember income
for purposes of the 85-percent member income test:-
Income from the sale and service of appliances to nonmembers who do not
purchase electricity from the cooperative is nonmember income, whether the
sale is made through a third party or subsidiary. Treas. Reg. 1.513-1(a),
(d). -
Interest income from the sale of an office building is nonmember income.
Rev. Rul. 65-99, 1965-2 C.B. 242.
-
-
Some current issues are described below.
-
Many cooperatives keep savings in reserve for improvements, expansion,
and unexpected expenses. They create capital credit accounts that show pro-rata
savings per member. When finances permit, cooperatives may redeem these accounts.
Some cooperatives have asked to redeem the accounts at a discount rather than
face value. Discounted redemption programs raise two issues:-
Whether the difference between the face value and the discounted amount
is income for purposes of the 85-percent member income test–
The
difference is treated as income for purposes of the 85-percent member income
test. -
Whether discount redemption programs violate any cooperative principles–
A
capital credit redemption program may jeopardize two cooperative principles:
(1) a member’s rights and interest in the assets of the cooperative
cannot be forfeited if his or her membership ends; and (2) on dissolution,
a cooperative must distribute any gains from the sale of its assets to all
members while the cooperative owned the assets. The Office of Exempt Organizations,
Rulings and Agreements, in coordination with the Office of Chief Counsel,
has issued multiple private letter rulings to the effect that an electric
cooperative’s program that creates capital accounts and retires capital
credit accounts at a discount does not violate cooperative principles.
-
-
Below is a list of activities that the Service has determined administratively
to be exempt under IRC 501(c)(12). See IRM 7.25.12.6.1, above.-
Telecommunications. Many telephone cooperatives
are offering new telecommunications services such as:
• wireless or
cellular phone services
• Internet access
• paging
•
home security monitoring
• medical alert and environmental monitoring
services
The rationale is that providing a communications capability to
members on a cooperative basis is an exempt activity similar to a two-way
radio system. See Rev. Rul. 57-420, 1957-2 C.B. 308. -
Direct Satellite Television. The Service has determined
that this service is an activity exempt under IRC 501(c)(12). The rationale
is that, like cable television, it is regulated to some extent by state governmental
units.
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