4.76.20  Local Benevolent Life Insurance Associations, Mutual Ditch or Irrigation Companies, Mutual or Cooperative Telephone or Electric Companies, and Like Organizations - IRC 501(c)(12)

4.76.20.1  (12-01-2006)
Overview

  1. IRC 501(c)(12) exempts from federal income tax benevolent life insurance associations and similar organizations of purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone and electric companies, or like organizations.

  2. The phrase "of local character" applies only to benevolent life insurance associations and similar organizations and not to other organizations specified in IRC 501(c)(12). Organizations that are similar to benevolent life insurance associations include burial and funeral benefit associations.

  3. Mutual ditch or irrigation companies, mutual or cooperative telephone companies, and like organizations are also exempt from federal income tax under IRC 501(c)(12). The Service has never distinguished between the terms "mutual" or "cooperative" for purposes of IRC 501(c)(12).

  4. The purpose of an IRC 501(c)(12) organization is to provide certain services to its members at the lowest possible cost. To qualify for and maintain exemption under IRC 501(c)(12), a cooperative must receive 85 percent or more of its income each year from members. The income must be collected solely to meet the cooperative's losses and expenses.

4.76.20.2  (12-01-2006)
Legislative History

  1. Even before ratification of the Sixteenth Amendment to the U.S. Constitution authorizing income tax, Congress provided exemption from federal excise taxes to cooperative companies and not-for-profit mutual benefit associations. After ratification, the Revenue Act of 1916, P.L. 64-271, Chapter 462, section 11(a)(10), 39 Stat. 756, 767 (1916), and successive revenue acts, exempted mutual or cooperative insurance companies, ditch or irrigation companies, telephone companies, and like organizations from federal income taxes. Electric cooperatives were not specifically listed in the 1916 Statute but were added to IRC 501(c)(12) in 1980.

  2. The Revenue Act of 1924, Chapter 234, section 231 (10), 43 Stat. 283 (1924), reduced the member-income requirement from 100 percent to 85 percent, allowing cooperatives to have other sources of income to pay for capital improvements, expansion or purchase real estate. The 85-percent member-income test was intended to ensure cooperatives continued serving members rather than placing their member-source income in investments, such as stocks or bonds, and becoming investment companies. See Cong. Rec. 3433 (1926).

  3. In 1980, P.L. 96–605 amended IRC 501(c)(12) to provide that the income derived by mutual or cooperative telephone and electric companies from qualified pole rentals will not be taken into the 85-percent member-income test calculation.

    1. "Qualified pole rentals" means any rental income from the right to use any pole (or other structure that supports wires) that is used by the cooperative in providing telephone or electric services to its member;

    2. Also, the use of the poles by the lessee must be limited to support wires for use in connection with the transmission of electricity, telephone, or other communications. In this connection, the term "rental" includes the sale of the right to use the pole;

    3. The law change also took out of the calculation any income from the sale of display listings in a directory furnished to the members of mutual or cooperative telephone companies;

    4. The law also amended IRC 513 by adding IRC 513(g), which provides that the term "unrelated trade or business" does not include engaging in qualified pole rentals.

  4. In 1988, P.L. 100-64 amended IRC 501(c)(12) to provide that income derived by mutual or cooperative telephone and electric companies from the prepayment of a loan under sections 306A, 306B or 311 of the Rural Electrification Act of 1936, effective January 1, 1987, would not be included in the calculation of the 85-percent member-income test.

  5. In 2004, P.L. 108-357 amended IRC 501(c)(12) to provide under IRC 501(c)(12)(C) that the following income received or accrued from mutual or cooperative electric companies will not be included in the calculation of the 85-percent member-income test:

    1. provision or sale of certain open access electric energy transmission or ancillary services;

    2. provision or sale of certain open access energy distribution or ancillary services;

    3. any nuclear decommissioning transaction; and

    4. any asset exchange or conversion transaction.
      This provision had a sunset provision of January 1, 2007, but the Energy Policy Tax Incentive Act of 2005 made the exclusion permanent.

4.76.20.3  (12-01-2006)
Requirements for Exemption under IRC 501(c)(12)

  1. An organization must satisfy three requirements to qualify under IRC 501(c)(12):

    1. It must be organized and operated as a cooperative.

    2. It must conduct activities described in IRC 501(c)(12) and the regulations.

    3. It must derive 85 percent or more of its income from members.

4.76.20.4  (12-01-2006)
Organizational and Operational Test - Basic Cooperative Principles

  1. The term "cooperative" is not defined in IRC 501(c)(12) or the regulations. Rather, the definition comes from common law.

  2. In Puget Sound Plywood v. Commissioner , 44 T.C. 305, 307-308 (1965), acq. 1966-1 C.B. 3, the Tax Court described a cooperative as an organization comprised of members who sought "(1) [f]or themselves to own and manage the [organization], as distinguished from having it owned and managed by outside equity investors; and then (2) to have their [organization] turn back to the members the excess of the receipts from the store sales over the cost of the goods sold and the expenses of operation."

  3. This description identifies three basic principles or requirements:

    • Democratic control by the members

    • Vesting in and allocating all excess operating revenues (over expenses incurred to generate the revenues) among the members, i.e., operating at cost

    • Subordination of capital.

  4. Democratic Control. This assures that members participating in the cooperative's endeavors remain in control of an IRC 501(c)(12) cooperative. A cooperative satisfies this requirement by periodically holding democratically conducted meetings with members, each with one vote, electing officers to operate the organization.

  5. Operating at Cost. This requires a cooperative to return excess operating revenues to its member-patrons. This means the cooperative must not operate either for profit or below cost. The excess is usually called "savings" rather than profit because it is the amount not spent to obtain services for members or to operate the cooperative. A cooperative's savings belong to its members, not the organization, and it must allocate the savings to its members in proportion to the amount of business it did with each.

  6. Subordination of Capital. This requires that those who contribute capital to the cooperative neither control the operations nor receive most of the pecuniary benefits of its operations. This principle distinguishes a cooperative from a for-profit corporation, which is shareholder-oriented. The theory behind this requirement is that members band together to share their interest, risk, and burden to obtain services or benefits rather than invest as equity owners. Subordination of capital has two components:

    1. Members control and own the savings or monetary benefits from the IRC 501(c)(12) cooperative that stay with them rather than going to shareholders or equity investors.

    2. The cooperative must limit its return on capital to ensure savings or monetary benefit go to its members rather than shareholders.

  7. Fundamentals.Rev. Rul. 72-36, 1972-1 C.B. 151, sets out organizational and operational requirements to ensure an IRC 501(c)(12) cooperative complies with certain fundamental principles:

    • The organization must keep adequate records of each member's rights and interest in the organization's 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 cooperative must not retain more funds than it needs to meet current losses and expenses (also based on the "operation at cost" principle).

    • The cooperative cannot forfeit a member's right and interest in the organization upon termination of membership.

    • Upon dissolution, the cooperative must distribute any gains from the sale of any appreciated asset to all who were members while the cooperative owned the asset in proportion to the amount of business done with each, so far as practical.

  8. IRC 501(c)(12) Cooperative Operations.Neither IRC 501(c)(12) nor the regulations issued thereunder define " member." However, the definitions for non-exempt cooperatives (IRC 521 farmers' cooperatives and Subchapter T cooperatives) apply because they parallel IRC 501(c)(12) cooperatives. Treas. Reg. section 1.1388-1(c)(3)(ii)(c) defines "member" as a person (individual, corporation, or cooperative) entitled to participate in the cooperative's management. Since a member usually gets services from the cooperative, he/she/it is also a patron. Treas. Reg. sections 1.1388-1(e) and 1.522-1(b)(2) define "patron" as any person, whether member or nonmember, with or for whom the cooperative does business on a cooperative basis.

4.76.20.5  (12-01-2006)
The Activities Test

  1. There are five categories of organizations that can qualify for exemption:

    • Benevolent life insurance associations

    • Ditch or irrigation companies

    • Telephone companies

    • Electric companies

    • Like organizations

  2. Benevolent Life Insurance Associations. This requirement of "purely local character" means the business is confined to a particular community, place, district, or locality, irrespective of political subdivision. An insurance association can conduct business in several political subdivisions such as counties if they constitute a locality or community.

    1. The locality restriction does not require it to terminate membership if a member moves out of the locality in which it operates. Rev. Rul. 83-43, 1983-1 C.B. 108.

    2. Rev. Rul. 64-193, 1964-2 C.B. 151, held that a "purely local character" did not include an insurance association doing business within a 75-mile radius of a home office that included three separate large metropolitan areas. The ruling reasoned that "purely local character" implies a single locality, not three large metropolitan areas.

  3. Mutual Ditch or Irrigation Activities. Mutual ditch or irrigation companies are cooperatives that operate a ditch or irrigation water system. The Code and regulations do not define ditch or irrigation, but the common meaning of both is to bring, channel, or control water to or away from land.

    1. Rev. Rul. 68-564, 1968-2 C.B. 221, held that constructing and maintaining structures or improvements to prevent erosion of riverbanks are activities like those of ditch or irrigation companies.

  4. Telephone and Electric Activities. IRC 501(c)(12)(A) expressly provides for exemption of cooperatives that provide telephone services. Telephone services include both local and long distance services. Electric cooperatives also are exempt under IRC 501(c)(12)(C). Rev. Rul. 67-265, 1967-2 C.B. 205.

  5. Like Organization Activities.

    1. Cable television services operating on a cooperative basis are like organizations described in IRC 501(c)(12). Rev. Rul. 67-265, 1967-2 C.B. 205, and Rev. Rul. 83-170, 1983-2 C.B. 97.

    2. The Eighth Circuit Court of Appeals held that providing burial and funeral benefits is within the definition of "like activities" similar to providing benevolent life insurance, Thompson v. White River Burial Association, 178 F.2d 954 (8th Cir. 1950).

  6. Not Like Organization Activities.

    1. Nonprofit automobile clubs furnishing travel and other services to members.New Jersey Automobile Clubv. United States , 181 F.Supp. 259 (Cl. Ct. 1960), cert. denied, 366 U.S. 964 (1961).

    2. Housing cooperatives. Rev. Rul. 65-201, 1965-2 C.B. 170.

    3. Providing electric services does not include financing purchases of electrical, water, or plumbing appliances. See Consumers Credit Rural Electric Coop. Corp.v.Commissioner, 37 T.C. 136, 143 (1961), aff'd F.2d 475 (6th Cir. 1963).

    4. Rev. Rul. 65-201, 1965-2 C.B. 170, held that neither selling electrical materials to members nor furnishing, repairing, or testing equipment is providing electric services or like activities within the meaning of IRC 501(c)(12).

    5. Rev. Rul. 2002-54, 2002-2 C.B. 528, held that distribution and sale of tanked propane by trucks is not a "like organization" activity under IRC 501(c)(12(A).

  7. If the organization has unrelated activities and they are not substantial, the income derived from these activities is subject to unrelated business income tax. An electric cooperative’s distribution and sale of tanked propane by trucks is unrelated to its exempt purpose, and income derived from such activity is subject to unrelated business income tax. However, if the activity is insubstantial, it would not jeopardize the exempt status of the electric cooperative under IRC 501(c)(12).

4.76.20.6  (12-01-2006)
The 85-Percent Member-Income Test

  1. Annual Testing. The 85-percent member-income test must be computed in each taxable year. A cooperative may fail the test one year but meet the test in a prior or subsequent year. Rev. Rul. 65-99, 1965-1 C.B. 242. The member-income test considers only income received or accrued in the annual accounting period. Rev. Rul. 68-18, 1968-1 C.B. 271. See also IRC 451(f) and IRC 166.

  2. Definition of Income

    1. IRC 501(c)(12) and the regulations do not define income. Rev. Rul. 74-362, 1974-2 C.B. 170, states that the term means "gross income" for purposes of the 85-percent member-income test. Rev. Rul. 80-86, 1980-1 C.B. 118, defined "gross income" as gross receipts less cost of goods sold, trade discounts, allowances of goods sold, and refunds on returned goods. It held that an exempt electric cooperative need not include income from its sales (at cost) of excess natural gas.

    2. Gross Receipts and Cost of Goods Sold. IRC 501(c)(12) cooperatives are not required to deduct the cost of goods sold from gross receipts to determine gross income for purposes of calculating the 85-percent member-income test. See instructions for Forms 990 and 990-EZ. IRC 501(c)(12) cooperatives that formed before 1998 may continue to deduct the cost of goods sold from gross receipts, provided they have consistently used this method in the past.

      Note:

      Prior to 1998, the Service maintained that in the sale of electricity, gross income means gross receipts with a deduction for cost of goods sold. Prop. Treas. Reg. section 1.501(c)(12)-2 (49 Fed. Reg. 1244 (Jan. 10, 1984)) articulated this position. However, the proposed regulations were withdrawn (58 Fed. Reg. 25587 (April 27, 1993)). Therefore, IRC 501(c)(12) cooperatives need not deduct the cost of goods sold from gross receipts, and this position is reflected in the instructions for Forms 990 and 990-EZ in the tax years 1998 and thereafter.

    3. No Netting. Gross income derived from a transaction with a third party cannot be offset by amounts owed to that third party. Rev. Rul. 65-174, 1965-2 C.B. 169; Rev. Rul. 74-362, 1974-2 C.B. 131, obsoleted in Rev. Rul. 81-291, 1981-2 C.B. 131.

    4. No Reductions. Rents, dividends, and interest must be included in gross income without reduction.

  3. Non-income Items. Many IRC 501(c)(12) cooperatives receive grants from state or federal agencies. A government grant is treated as a contribution to capital, which under IRC 118(a) is not income if it meets the following conditions from Rev. Rul. 93-16, 1993-1 C.B. 26:

    • The grant must become a permanent part of working capital;

    • The grant must not be compensation for specific quantifiable services;

    • The use of the grant is subject to conditions imposed by the grantee;

    • The grant must benefit the corporation commensurately with its value;

    • The grant must ordinarily be employed to generate additional income.

  4. Excluded Income.

    1. Qualified Pole Rentals. Many electric and telephone cooperatives rent their electric or telephone poles. For example, an electric cooperative may allow a telephone or cable television company to use its poles in return for rent. IRC 501(c)(12)(B)(ii) and (C)(i) specifically exclude qualified pole rental income from the member-income test computation.

    2. Billing and Collection Services of Telephone Cooperatives. IRC 501(c)(12)(B)(i) excludes "communication services " from the 85-percent member-income test. Many exempt telephone cooperatives administer billing and collection of fees for nonmember long-distance carriers that provide long-distance telephone service to their members. In Golden Belt Telephone Cooperative v. Commissioner, 108 T.C. 198 (1997), the Tax Court held that billing and collection are communication services because the Federal Communication Commission had interpreted the phrase to include them. The Service, in Action on Decision 1998-18 IRB 4, acquiesced in the result but disagreed with the court's reasoning. The Service reasoned that billing and collection are communication services excluded under IRC § 501(c)(12)(B)(i) because they are a step in completing long-distance telephone calls for members.

    3. Income Derived from Directory Listings. Many IRC 501(c)(12) telephone cooperatives sell display space in the telephone directories furnished to their members. IRC 501(c)(12)(B)(iii) excludes this income from the 85-percent member-income test.

  5. Member Income

    1. Member income has a two-prong test. First, it must be collected from the cooperative's members. Second, it must be paid for services described in IRC 501(c)(12). This analysis comes from IRC 501(c)(12)(A), which requires that member income be collected to meet losses and expenses from IRC 501(c)(12) activities. See also, Rev. Rul. 2002-54, 2002-2 C.B. 528.

    2. Cooperatives may have several types of members. In general, members are those entitled to participate in management of the cooperative and to share in patronage capital. Rev. Rul. 78-238, 1978-1 C.B. 161. If the cooperative has more than one type or class of "members," ascertain which are members (as defined in IRC 501(c)(12)). A municipal corporation may be a member or nonmember. Rev. Rul. 68-75, 1968-1 C.B 271. Generation and Transmission cooperatives (G&Ts) may have members that are not distribution cooperatives.

  6. Nonmember Income, for example, includes:

    • Interest from nonmember sources

    • Rental income

    • Installment sales of assets

    • Income from nonmember patrons

    • Dividend income from a wholly-owned for-profit entity that is not a cooperative and member. Rev. Rul. 2002-55, 2002-2 C.B. 529.

  7. Classifying Income as Member or Nonmember Income. Each transaction for which income is realized must be classified as member income, nonmember income, or excluded income. Member income is member-sourced and derived from activities conducted according to cooperative principles. IRC 501(c)(12); Rev. Rul. 72-36, 1972-1 C.B. 151; Rev. Rul. 78-238, 1978-1 C.B. 161; Rev. Rul. 80-86, 1980-1 C.B. 118; Rev. Rul. 2002-55, 2002-2 C.B. 529.

4.76.20.7  (12-01-2006)
General Examination Guidelines

  1. Analyze and verify all sources of income to determine the purpose for which income is derived from members.

  2. Determine whether 85 percent or more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses.

    1. Include gains from sales of property, interest on tax-exempt securities, and income from contracts entered into with the United States or any of its agencies.

    2. Exclude losses on sales of property and voluntary contributions which are in the nature of gifts.

    3. Exclude 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 its members in the case of a mutual or cooperative telephone company.

    4. Exclude income received or accrued from the sale of display listings in a directory furnished to members of a mutual or cooperative telephone company.

    5. Exclude income received or accrued from qualified pole rentals by a mutual or cooperative telephone or electric company.

    6. Exclude income IRC 501(c)(12) cooperatives realize from repayments at discount of loans borrowed from the federal Rural Utilities Service (RUS) (formerly Rural Electrification Administration) or other U.S. government loans only if the repayments were made before 1990. This exclusion lapsed after December 31, 1989. See Technical and Miscellaneous Revenue Act of 1988.

    7. Include any income realized from the repayments at discount of RUS loans made after 1989 for purposes of calculating the 85-percent member-income test.

      Note:

      In general, income includes the amount realized from the repayment of a loan at discount. This amount is usually the difference between the discounted amount and the face value of the loan. See IRC 61; see also Rev. Rul. 82-202, 1982-2 C.B. 35, and Rev. Rul. 91-31, 1991-1 C.B. 19.

    8. Exclude income of wholly-owned but separately established for-profit entity. Rev. Rul. 2002-55, 2002-2 C.B. 529.

    9. Exclude income received or accrued from the sale of electric energy transmission services or ancillary services if such services are provided on a nondiscriminatory open access basis under an open access transmission tariff (or under an independent transmission provider agreement) approved or accepted by the Federal Energy Regulatory Commission (FERC).

    10. Exclude income received or accrued from the sale of electric energy distribution services or ancillary services if such services are provided on a nondiscriminatory open access basis to distribute electric energy not owned by the mutual or cooperative electric company.

    11. Exclude income derived from nuclear decommissioning transactions (as defined in IRC 501(c)(12)(F)).

    12. Exclude income derived from any asset exchange or conversion transaction (as defined in IRC 501(c)(12)(G)).

  3. Determine purpose and necessity for any reserves held.

  4. Ascertain "reasonableness" of the reserves based on facts and circumstances.

4.76.20.8  (12-01-2006)
Examination Issues - Cooperative Principles

  1. Providing Multiple Services. Historically, exempt cooperatives engaged in only one activity, such as a telephone cooperative that provided local and long-distance telephone service. Recently, exempt cooperatives have expanded to include other services. For example, many telephone cooperatives now offer cellular (or wireless) telephone and internet services. In keeping with cooperative principles, the cooperative must equitably allocate costs or savings among its member-patrons of each service so savings or losses are returned to each member in direct proportion to his/her patronage. However, many exempt cooperatives have combined two or more services for allocation purposes. The organization can do this without violating the " operate at cost" requirement if it meets the following criteria:

    • Member-patrons of one service are also patrons of the other services in the allocation unit;

    • The articles of incorporation, bylaws, or written policies specifically detail all allocation units' composition and how savings or losses will be allocated in each unit;

    • The cooperative informs each allocation unit's members of the risk-sharing and benefits of combining different services into one allocation unit;

    • A majority of the cooperative's members agree to the grouping; and

    • The members periodically vote to affirm the agreement.

  2. Issuance of Non-Voting, Interest-Bearing Stock. To raise capital, some exempt cooperatives have sought the Service's permission to issue a class of stock that a) pays a dividend at a fixed or state regulated rate, b) does not allow the stockholder to directly or indirectly participate in the cooperative's savings, and c) does not give the stockholder voting rights.

    1. Although neither IRC 501(c)(12) nor the regulations prohibit it, such stock issuance may violate the "subordination of capital" principle (depending upon facts and circumstances).

    2. For example, an IRC 501(c)(12) telephone cooperative that issues 10,000 shares of stock at $1 par value with an annual interest rate of 8% and sells all shares would pay $80,000 in dividends annually to stockholders. Depending on its financial situation, the stock may raise doubt that the cooperative would return net savings to member-patrons by the services performed for them rather than distribute them to stockholders as a return on capital.

    3. Whether this occurred is a question of fact that an examiner would have to determine. Whether stock with different characteristics from the one described violates the "subordination of capital" principle is also a question of fact upon examination.

  3. State Laws. IRC 501(c)(12) and the regulations do not require a cooperative to organize under a state cooperative statute, but many states do have statutes that govern cooperatives described in IRC 501(c)(12). Although state statutes do not usually cause conflicts with cooperative principles, the examiner should review the governing instruments to determine if they satisfy a cooperative's organizational and operational requirements.

    1. Rev. Rul. 81-109, 1981-1 C.B. 347, resolved a conflict by holding that a mutual ditch organization qualified for exemption under IRC 501(c)(12) although it did not meet some cooperative requirements because it operated as required by state law.

    2. The revenue ruling noted that several state laws and practices governing cooperatives allowed them to operate in the manner described, but Congress has not amended IRC 501(c)(12) to provide that state laws should not govern in such a circumstance. Congressional inaction was interpreted as intent that state law should control if it conflicts with cooperative requirements.

4.76.20.9  (12-01-2006)
Examination Issues - Activities Test

  1. Telecommunication Services. Many exempt cooperatives have expanded to offer wireless or cellular services, internet access, paging services, home security monitoring, medical alert services, and environmental monitoring (energy consumption, temperatures, etc.). These services allow member-patrons to communicate with others by voice, writing, or other forms. The current EO position is that these services are types of communication services permitted under IRC 501(c)(12). See Rev. Rul. 57-420, 1957-2 C.B. 308.

  2. Direct Satellite Television Service. Paid television service has also changed. Many IRC 501(c)(12) cooperatives are beginning to offer direct satellite television to member-patrons.

    1. Rev. Rul. 83-170, 193-2 C.B. 97, held that a cooperative providing cable television to its members could qualify for exemption as a like organization under IRC 501(c)(12). It equated the term like with a public utility or public-utility type service. It compared cable television to public utilities and considered state law regulating cable television as an indication it is a public utility.

    2. The current EO position is that this rationale is applicable to direct satellite television service. Therefore, a cooperative that provides direct satellite television may qualify for exemption as a like organization under IRC 501(c)(12).

  3. Natural Gas. Many exempt electric cooperatives have begun providing natural gas to member-patrons, usually by pipeline. Rev. Rul. 67-265, 1967-2 C.B. 205, and Rev. Rul. 83-170, 193-2 C.B. 97, held the definition of like organization includes providing public-utility type services. However, the distribution and sale of tanked propane by trucks is not a "like organization" activity. Rev. Rul. 2002-54, 2002-2 C.B. 528.

4.76.20.10  (12-01-2006)
Examination Issues - The 85-Percent Member-Income Test

  1. Redemption of Accounts at Discount. Many IRC 501(c)(12) cooperatives, especially electric and telephone cooperatives, keep amounts of savings as reserves for improvements, business expansion, unexpected expenses, etc. The cooperative creates a capital credit account for each member-patron with the amount belonging to that member. Periodically, cooperatives make a distribution from the accounts (called a "redemption" or "retirement of capital credit accounts" ) to the member-patron. Many cooperatives want to redeem capital credit accounts at a discount of the face value by paying a portion of it to the member and crediting the difference to an equity account in that member's name.

    1. The discounted amount is not a patronage savings or dividend because it is not paid based on the amount of business done with the member-patron, but should the difference be included in computing the 85-percent member-income test?

    2. Under the tax benefit doctrine, a recovered item that produced an income tax benefit in a prior year must be included in income in the year it is recovered. However, an exempt cooperative will not usually receive a tax benefit by redeeming capital at a discount, because there has not been a related deduction, such as an offset to unrelated business income. If there was no tax benefit, there is no income. Therefore, the redemptions are ignored for purposes of the 85-percent member income test.

  2. Aggregating Gross Receipts of IRC 501(c)(12) Cooperatives and Their Subsidiaries. An exempt cooperative may engage in many different business activities through subsidiaries: 1) A subsidiary may provide IRC 501(c)(12) services to its parent's members that the parent does not provide; 2) It may carry on business with nonmembers on a non-cooperative basis; 3) It may conduct business activities unrelated to the parent's exempt purposes. The first activity listed will not adversely affect an IRC 501(c)(12) parent's exempt status and the parent continues to meet the 85-percent member-income test. However, the second and third activities may jeopardize the parent's exempt status. Parent-subsidiary activities raise the issue whether a subsidiary's gross income should be combined with its parent's to compute the 85-percent member-income test.

    1. Rev. Rul. 2002-55, 2002-2 C.B. 529, held that an IRC 501(c)(12) telephone cooperative that owned a separate for-profit entity that was not a cooperative and a member should not include the income of the for-profit entity in satisfying the 85-percent member-income test. However, any payment received from the for-profit entity will be included as nonmember income by the cooperative. This revenue ruling overrules TAM 1999908038.

  3. Interrelationship Among Unrelated Business Activities, the Activities Test, and the 85-Percent Member-Income Test. Some IRC 501(c)(12) cooperatives provide both IRC 501(c)(12) services and services not described in IRC 501(c)(12). For example, an exempt electric cooperative may also sell and service electric appliances. This raises issues of both exemption and unrelated business income tax (UBIT). The activities test, UBIT test, and the 85-percent member-income test must be applied separately to the activities and income of the exempt cooperative.

    1. IRC 511(a)(2) provides that organizations described in IRC 501(c) are subject to UBIT. Therefore, an IRC 501(c)(12) organization can conduct some unrelated activities but may jeopardize its exempt status if those activities are more than an insubstantial amount. Whether insubstantial or not is a matter of facts and circumstances.

    2. Even if an unrelated activity does not affect exemption, it may still be subject to UBIT under IRC 511. For example, an IRC 501(c)(12) electric cooperative’s distribution and sale of tanked propane is an unrelated activity. If substantial, the activity would jeopardize the cooperative’s exempt status. However, if insubstantial, the income derived the activity is subject to UBIT under IRC511. See Rev. Rul. 2002-54, 2002-2 C.B. 528.

4.76.20.11  (12-01-2006)
Examination Issues - Unrelated Business Taxable Income

  1. IRC 511 imposes a tax on the unrelated business taxable income of most IRC 501(c) organizations, including IRC 501(c)(12) cooperatives. Each item of an exempt cooperative's income must be included in computing the 85-percent member-income test. Unrelated taxable income is usually nonmember income for purposes of this test. Nonmember income, however, is not necessarily subject to UBIT. For example, interest income from an IRC 501(c)(12) telephone cooperative received from the bank, a member of the cooperative, though not member income for purposes of the 85-percent member-income test, would not be subject to UBIT because of the exception to UBIT for interest income.

  2. Advertising in Directories. Some types of "advertising" income are unrelated trade or business:

    1. Display advertisements (whether placed by members or nonmembers) are unrelated trade or business.

    2. Bold type listings. Payments for business listings in bold type ordinarily confer minimal commercial benefit and are not unrelated trade or business. IRC 513(c); Treas. Reg. sections 1.513-1(d)(2), 1.513-1(d)(4)(iv), 1.513-1(d)(4)(iv), Example (7); Rev. Rul. 74-38, 1974-1 C.B. 144; Rev. Rul. 76-93, 1976-1 C.B. 170.

  3. Debt-Financed Income. Income from debt-financed investments may be taxable under IRC 514(a) (e.g., arbitrage investments of RUS loan funds). Southwest Tex. Elec. Coop. v. Commissioner, T.C. Memo. 1994-363 (1994), aff'd 67 F.3d 87 (5th Cir. 1995); Kern County Elec. Pension Fund v. Commissioner, 96 T.C. 845 (1991), aff'd 988 F.2d 120 (9th Cir. 1993).

  4. Depreciation Recapture. IRC 1245 and IRC 1250 depreciation recapture rules override IRC 512(b)(5). Treas. Reg. section 1.1245-6(b); 1.1250-1(c)(2).

  5. Controlled Organizations. Payments from affiliated organizations or subsidiaries may be taxable under IRC 512(b)(13).

  6. Qualified Pole Rentals. Qualified pole rentals are not income from unrelated trade or business. IRC 513(g).

4.76.20.12  (12-01-2006)
Benevolent Life Insurance Companies

  1. In the case of benevolent life insurance companies, evaluate the policies issued to determine:

    1. Whether activities are confined to a territorial unit " purely local in character."

    2. Whether coverage includes life insurance benefits or burial and funeral benefits payable in cash.

    3. Whether coverage for sickness, accident or health benefits are in addition to death benefits.

    4. If premiums are payable as a result of assessments or if premiums are at established rates with policyholders subject to additional assessments and return of an unexpended balance.

  2. If the organization returns excess premiums to members, ascertain whether there is a preexisting obligation to do so, and whether returns are made on the basis of business done with the organization.

4.76.20.13  (12-01-2006)
Exempt Telephone Cooperatives

  1. Cooperatives provide telecommunications products and services in a rapidly changing industry by investing in technologies such as fiber optic cabling, digital switching equipment, enhanced network services (e.g., ISDN) to offer enhanced services (e.g., voice messaging systems), personal communications services (cellular and portable radio communications services for individuals and businesses), interactive video networks and information services.

  2. Cooperatives have been diversifying, venturing into satellite television service, and selling satellite reception equipment, even offering cable television service. Some cooperatives belong to the National Rural Telecommunications Cooperative (NRTC), which offers alternative television programming. Many of these satellite and cable television services are for-profit (noncooperative) businesses organized as divisions or subsidiaries of the cooperative.

  3. Under the Communications Act of 1934 (the Act), the Federal Communications Commission (FCC) regulates certain activities of telecommunication companies (including telephone cooperatives) engaged in interstate commerce. The Act, FCC, and ratemaking rules determine the source and nature of regulated and unregulated telecommunication, other goods and services offered by cooperatives. To provide the FCC with necessary ratemaking information, cooperatives must use a prescribed system of accounting called the "Uniform System of Accounts," or"USoA." This accounting system presents telephone companies' financial information in a specified format, identifying regulated and unregulated income, expense and capital expenditures, included or excluded from the ratebase.

  4. Many cooperatives' operations are financed by loans from Rural Utilities Service (RUS), Rural Telephone Bank, Bank for Cooperatives, Rural Telephone Finance Cooperative, and other federal agencies. RUS loans finance 70-90% of telephone plants. RUS requires cooperatives to follow FCC's USoA for their loans. 7 C.F.R. § 1770.11.

4.76.20.13.1  (12-01-2006)
Research Resources

  1. Federal Communication Commission. FCC's two main divisions affecting cooperatives are listed below. The examiner can find audit information at www.fcc.gov and follow the menu to the pertinent divisions.

    1. Pricing Policy Division (Wireline Competition Bureau). Administers the provisions of the Communications Act requiring that the charges, practices, classifications, and regulations of communications common carriers providing interstate and foreign services are just and reasonable.

    2. Investigation and Hearing Division (Enforcement Bureau). Responsible for common carrier audits and for suspected or alleged non-compliance by common carriers with various market-related requirements.

  2. Rural Utilities Service. The Technical Accounting and Auditing Staff oversees the accounting regulations by which the RUS loan recipient cooperatives must abide. The regulations and examples in bulletin form are available on the internet at www.usda.gov/rus/pasd .

4.76.20.13.2  (12-01-2006)
Overview - FCC Regulations and Telephone Cooperatives

  1. Traditional FCC ratemaking allows telephone companies to recover their allowable costs to provide regulated telecommunications service plus a reasonable rate of return on investment. M. Kellogg et al., Federal Telecommunications Law §§ 9.2, 9.8 (1992).

  2. When cooperatives' members converse with others on interstate or intrastate long-distance telephone calls, they use the facilities of their telephone cooperative (a local exchange carrier, "LEC" ) plus one or more interexchange carriers ("ICs" ) (such as AT&T) and another LEC. Each of these earns a return on investment and recovers the cost of providing long-distance service. The FCC, through its ratemaking authority, apportions the long-distance charges the end-user pays among them.

  3. Prior to its January 1, 1984, divestiture of local exchange subsidiaries, AT&T, Bell Operating Companies, and independent telephone companies (including cooperatives) participated in joint interstate rates. The local exchange carriers reported all long-distance charges for their members' calls to the pertinent Bell company. AT&T handled the long-distance settlements through the Bell company, which in turn remitted a share of the charges back to the local carrier. See generally, Rev. Rul. 74-362, 1974-2 C.B. 170.

  4. The FCC replaced this system with a system of tariffed access charges, setting forth rules for the charges that interexchange carriers (such as AT&T and end users, e.g., telephone cooperatives' members) paid for access to local carriers for interstate telephone service.

  5. Telephone companies incur two types of costs to provide long distance service. One varies with the number of access lines needed (non-traffic-sensitive), and the other varies with the traffic level (traffic-sensitive).

    1. Non-Traffic-Sensitive Costs. When cooperatives' members pick up the receiver and hear a dial tone, they can access both local and long-distance telephone service. The cost of accessing either one is non-traffic-sensitive because the cost does not vary with amount of usage. The FCC reasoned that a subscriber ("end user" ) who does not even place calls (local or long-distance) would still be willing to pay a flat fee for the right to do so. For the same reason, the FCC imposed a flat amount per line ("subscriber line charge" ) for the interstate portion of calls. As end users, cooperatives' members pay these subscriber line charges to their cooperative. For purposes of the 85-percent member-income test, revenue recorded in Account 5801, End User Revenue) isnot excluded under IRC 501(c)(12)(B)(i) because it is assessed directly upon the members as end users, not upon another telephone company (e.g., AT&T). Also, it is not unrelated taxable business income because it is collected from members for the sole purpose of meeting cooperatives' losses and expenses (i.e., certain non-traffic-sensitive costs).

    2. Traffic-Sensitive Costs.The FCC considered but rejected requiring that end users bear all local exchange carriers' (i.e., telephone cooperatives') costs to provide long-distance service, both traffic-sensitive and non-traffic-sensitive. Instead, the FCC decided that the LECs must recover their traffic-sensitive costs from interexchange carriers (e.g., AT&T) through access charges based upon amount of usage. The ICs pass these costs on to their subscribers (those who use their long distance carrier, e.g., AT&T) through toll charges for long-distance calls. To complete long distance calls, it utilizes the LECs' facilities and operators. LECs recover their long-distance traffic-sensitive costs through access charges the ICs pay for use of their facilities. Access revenues received or accrued from another telephone company involving the completion of long-distance calls to, from or between members of telephone cooperatives are excluded from the 85-percent test under IRC 501(c)(12)(B)(i).

4.76.20.13.3  (12-01-2006)
Billing and Collection

  1. Billing and collection (data processing, creating, mailing, and collecting invoices) were not considered communication services under IRC 501(c)(12)(B)(i). See Notice 92-33, 1992-2 C.B. 364. This is no longer the position of the Service. Income received by telephone cooperatives for performing billing and collection services for other telephone companies is excluded income for purposes of the 85-percent member-income test. Golden Belt Tel. Ass'n., Inc. v. Commissioner, 108 T.C. 498 (1997), acq. in result only, 1998-2 C.B.. AOD No. 1998-003, CCH para. 51, 217.

4.76.20.13.4  (12-01-2006)
State Regulations

  1. Many state public utility commissions (PUCs) regulate local telephone rates. Documents filed with state PUCs may reveal information useful in the audit of telephone cooperatives.

4.76.20.13.5  (12-01-2006)
Rural Utility Service ("RUS" ) Regulation of Telephone Cooperatives

  1. Many telephone cooperatives request RUS financing for new telecommunications plant construction and replacement or refinancing of new or existing plants. RUS only lends for construction of capital assets, not for maintenance or repairs. As a result, cooperatives have an economic incentive to classify disbursements as capital expenditures (as opposed to current expenses). After loan approval and promissory note execution, RUS becomes the first mortgage holder on all the cooperative's property. The cooperative deposits the RUS loan proceeds into a special trustee account and spends its own funds to construct the new plant. When construction is complete, RUS reviews and approves/disapproves the cooperative's documentation of construction expenditures. The cooperative can withdraw the approved amount from the trustee account and deposit the funds in its own cash accounts. The cooperative must reimburse the trustee account for any construction expenditure disallowed later.

  2. To ensure loan repayments, RUS requires telephone cooperatives to follow FCC's Uniform System of Accounting. Its audit procedures are published at 7 C.F.R. § 1770.10 et seq. and on its internet site. An RUS mortgage requires that the cooperative submit detailed annual financial reports to RUS, including certified audits and other reports, all of which are public information. If the cooperative does not comply with these (and other) requirements, RUS may declare the loan in default, suspend future lending, and exercise other remedies under the mortgage. RUS headquarters staff and field accountants review a cooperative's records, reports, and certified financial statements at least once every three years. Field accountants look at direct cost accumulation for plant construction as well as overhead allocations for construction, retirement, and maintenance and perform non-opinion audits of the cooperative's loan fund transactions. These RUS Field Reports also are public documents.

4.76.20.13.6  (12-01-2006)
The FCC/RUS Uniform Systems of Accounts ("USoA)"

  1. Overview. The FCC regulates certain activities of telecommunications companies (including telephone cooperatives) engaged in interstate commerce. In order to identify regulated and nonregulated income, expenses, and capital expenditures affecting the rate base, the FCC requires the companies/cooperatives to keep financial records according to its Uniform System of Accounting ("USoA" ) and to file annual financial reports. The USoA follows Generally Accepted Accounting Principles ("GAAP" ) in many instances.

  2. USoA Objectives. In general, regulated telecommunications companies recover their allowable costs to provide regulated goods and services and earn a return on investment. (Operating income and expense affecting the rate base are sometimes referred to as "above the line" and nonoperating income and expense as "below the line" ). The USoA separates regulated (operating income and expense) from nonregulated activities (non-operating income and expense). The purpose of this accounting separation is to prevent telecommunications companies from imposing costs and risks of nonregulated activities on the ratepayers (cooperative's members). Expense accounts are grouped by type (e.g., wages) and function (e.g., engineering expense). Examiners must be aware of differences among regulatory accounting, income tax accounting, and GAAP.

  3. Reporting to RUS. RUS also requires telephone cooperatives to keep detailed books as well as detailed financial information and reporting on cooperatives' activities such as corporate structure, reorganizations and acquisitions, investments in affiliated companies, extraordinary gains and losses. RUS requires cooperatives to follow the FCC's USoA with some modifications. Examiners will need to refer to publication of the USoA at 47 C.F.R. Part 32 and 7 C.F.R. § 1770.

  4. Classification of Telephone Companies. Reporting obligations vary with the revenues of the telephone company. Companies with regulated telecommunications revenues exceeding $100 million are Class A companies. All other companies are Class B companies. Almost all cooperatives are Class B companies. Accordingly, these guidelines cite the rules for Class B companies.

  5. Recordkeeping and Accounting Requirements. In accordance with FCC regulations, cooperatives must keep books of account, records, minute books, memoranda, etc., to support all entries and keep financial records "with sufficient particularity to show fully the facts pertaining to all entries" in the USoA and subsidiary records, as necessary. They must use the accrual method of accounting (as defined in GAAP), and regulated (defined in 47 C.F.R. § 32.9000) activities must be accounted for separately.

  6. Non-Regulated Activities. Non-regulated activities also must be accounted for separately. This separate accounting may provide useful information for the 85-percent test and/or UBIT. For rules on revenues from non-regulated activities, see § 32.4999(l). For example, cable TV and direct broadcast TV are not nonregulated activities.

  7. Assets and Expenses. There are two methods to account for assets and expenses:

    1. Dual Use. Where regulated activities and nonregulated activities use the same assets, cooperatives must maintain subsidiary records reflecting assets used and expenses incurred in each type of activity. Nonregulated activities involving dual use assets are reported as part of telephone company operations.

    2. No Dual Use. Where there is no dual use of assets, the cooperative must keep a separate set of books for its nonregulated activities.

  8. USoA Accounts for Telephone Cooperatives. FCC/RUS USoA accounts have four digits. The first digit in an account indicates the account classification (for example, an account beginning with " 5" is a revenue account). For RUS reporting, the RUS subaccounts are preceded by "REA." For example, the account for Cash - General Fund is REA 1120.11. All Accounts are set out in 47 C.F.R. Part 32.

  9. The telephone cooperative balance sheet accounts are:

    1120 - 1500 Current and Noncurrent Assets
    2001 - 2690 Telecommunications Plant in Service
    3100 - 3600 Depreciation and Amortization Reserves
    4010 - 4550 Liabilities and Stockholders' Equity (or patronage capital accounts

  10. The telephone cooperative income and expense accounts are:

    5000 - 5302 Operating Revenue
    6110 - 6790 Operating Expense
    7100 - 7990 Other Operating Revenues and Expenses (i.e., accounts for activities peripheral to the cooperative's main operations)

  11. Entities Covered by Financial Statements. A cooperative's financial statements must comply with SFAS No. 94, "Consolidation of All Majority-Owned Subsidiaries." If the cooperative owns a majority interest in one or more subsidiaries, it must prepare consolidated financial statements to include each subsidiary and supplementary schedules presenting a balance sheet and income statement. RUS Form 479 must be prepared on an unconsolidated basis. The RUS regulations contain sample financial statements (with accountants' notes) for a telephone cooperative.

  12. RUS Regulations on CPAs' Audits of RUS Borrowers. The CPAs must prepare and submit the following annual reports to RUS:

    1. Auditor's Report (on the cooperative's financial statements, including accountants' notes and statements of cash flows);

    2. Report on Compliance with Applicable Laws and Regulations (as required by SAS No. 63, "Compliance Auditing Applicable to Governmental Entities and Other Recipients of Governmental Financial Assistance," and Generally Accepted Government Auditing Standards (GAGAS));

    3. Report on Internal Controls;

    4. Management Letter, including disclosure of material transactions with related parties, e.g., officers and directors (these reports and the management letter are public documents),

    5. Sample Financial Statements. See 7 C.F.R. § 1773 Appendix B for sample financial statements, auditor's report, compliance report, and report on internal controls, and Appendix C for a sample management letter.

  13. There is insufficient space in these guidelines to explore all aspects of the USoA, GAAP, and GAGAS relevant to examination of cooperatives. Examiners should review the particular provisions relevant to their examination and contact the pertinent agency for questions:

    • FCC, Deputy Chief, Pricing Policy Division (Wireline Competition Bureau), at (202) 418-1520

    • FCC, Deputy Chief, Investigation and Hearing Division (Enforcement Bureau), at (202) 418-7450

    • RUS, Technical Accounting and Auditing Staff, at (202) 720-5227

4.76.20.13.7  (12-01-2006)
Examination Planning

  1. The examiner should consult the following for assistance in planning and conducting the examination:

    • State Public Utility Commissions. If one or more PUCs regulate the cooperative, contact the PUC(s) concerning the cooperative's filings and PUC orders.

    • Federal Communications Commission. Financial reports are filed with the FCC's Common Carrier Bureau, FCC, Washington, D.C. 20554. Contact telephone numbers are at IRM 4.76.20.13.6.

    • Rural Utilities Service. Contact telephone number is at IRM 4.76.20.13.6

4.76.20.13.8  (12-01-2006)
Requesting the Assistance of Specialists

  1. Assistance from Other Functions. If the examiner believes it is also necessary to examine an entity not under the jurisdiction of TE/GE Examination (e.g., a joint venture with another telephone company), he/she should request assistance from the function responsible for examining that entity as soon as he/she identifies the need.

    Note:

    EO Examiners should be aware that the Specialist Referral System (SRS) which may be accessed from the TE/GE website homepage automates the referral request process. Examiners can generate a referral request online which will automatically notify the appropriate Field Specialist Manager of the request. The manager can then assign an Examiner to the case at his/her discretion.


    The following Specialists are available for assistance:

  2. Utilities Industry Specialist/Media/Communications Industry Specialist. The Industry Specialists (including cable television and direct TV) can assist the examiner with the following:

    • identifying unique industry issues and Service position;

    • giving insight into the economic conditions of the industry;

    • describing accounting and business practices; and

    • suggesting examination procedures and computer programs that may have potential application.

  3. VEBA (Voluntary Employees' Beneficiary Association) Industry Specialist. The Industry Specialist can assist with examination of VEBAs.

  4. Computer Audit Specialist. If the services of a computer audit specialist are necessary, obtain a description of the cooperative's hardware, software (including accounting software), and formats of files and records.

  5. Engineer. All cooperative returns with assets of $10 million or more must be referred for engineering action. In examination of exempt and nonexempt cooperatives, the engineer is a valuable resource (e.g., tax exempt bonds, construction techniques, machinery and building design, repairs, depreciation, depletion and valuation of assets). The engineer should be involved in the early planning stages of the examination.

  6. Excise Tax Specialist. Examinations of cooperatives often raise excise tax issues which may require the use of an Excise Tax Specialist.

  7. Employee Plans The industry Specialist can assist with the examination of the pension and profit sharing plans of the cooperative.

4.76.20.13.9  (12-01-2006)
Initial Document Requests

  1. Obtain and review the documents listed below to gain a basic understanding of the cooperative's activities, income, expenses, capital structure, and related organizations:

    • Articles of incorporation (and all amendments);

    • Bylaws (and all amendments);

    • A list of the names and addresses of all subsidiaries and associated companies;

    • Names and addresses of all directors, trustees, and officers of the cooperative and of all subsidiaries and associated companies;

    • Minutes of meetings of board of directors and of all board committees;

    • Annual reports, financial statements (including statements of cash flow and accountants' notes), and tax returns for all subsidiaries and associated companies;

    • All reports filed with RUS (including but not limited to: RUS Form 479; audited financial statements, including statements of cash flow and accountants' notes); auditor's report, compliance report, report on internal controls and management letter;

    • RUS Field Reports on the cooperative (from RUS field accountants, field engineers, or general field representatives);

    • Any prepayment agreement(s) between the cooperative and RUS (concerning prepayment of RUS loans);

    • Any debt restructuring plan entered into between the cooperative and RUS;

    • Methods and Procedures Manual (procedures to record transactions);

    • A chart of accounts correlating general ledger accounts to USoA Accounts;

    • The cooperative's 85-percent test worksheets;

    • Patronage dividends;

    • An analysis of income and expense;

    • All reports and other filings with PUCs and PUC orders (if applicable);

    • Records of transactions with subscribers (as appropriate): applications for service, service orders, subscriber's record cards, toll tickets and toll settlements, subscriber's monthly bill, adjustment vouchers;

    • Subscriber's ledgers (ledgers, cards, or stubs), paystation accounting;

    • Control of subscriber's accounting (subscriber accounts grouped into control units), collection posting and reconciling cash collections, collection of delinquent accounts;

    • All agreements between the cooperative and any subsidiary or associated company;

    • Qualified employee retirement plans: the official plan and trust documents, any determination letters issued to qualified plans, records of employer and employee contributions, account balances or accrued benefits and employee compensation;

    • Non-qualified deferred compensation plans: employee benefit plans and related documents (e.g., trusts, insurance contracts, private letter rulings), records of employer and employee contributions and account balances or accrued benefits;

    • All other employee benefit plans: including accident and health plans, cafeteria plans and VEBAs, related documents (including any trust instruments);

    • All arrangements for compensation of directors (including qualified and nonqualified deferred compensation plans);

    • A schedule of all funded reserves (including any trusts or VEBAs for payment of welfare benefits or postretirement benefits);

    • Joint operating agreements, settlement agreements, cost-pooling agreements (see 47 C.F.R. § 32.14(e));

    • All documents concerning any waiver of any provision in the FCC's USoA or requested FCC approval of accounting for unusual items or contingent liabilities;

    • Forms 720 filed for the examination period;

    • A list of the names and addresses of all members;

    • Securities and Exchange Commission Forms 10-K filed by the cooperative (if applicable);

    • The method used to compute patronage dividends;

    • Workpapers used to support claimed patronage dividends;

    • Notification letters to all members on allocations of patronage dividends;

    • Newsletters and other communications to members;

    • Tax exempt bond information as necessary.

4.76.20.13.10  (12-01-2006)
Examination of Financial Statements and Reports to Regulatory Agencies

  1. Methods of Accounting. Although basic principles are the same, the accrual method of accounting RUS requires, income tax accounting, and GAAP diverge. When this occurs, income tax accounting rules control. Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979); Treas. Reg. section 1.446(e)-1; Rev. Rul. 90-38, 1990-1 C.B. 57; Rev. Proc. 92-20, 1992-1 C.B. 685. Many differences exist that affect timing of income and expense, gain and loss, and raising issues under IRC 61, 118, 451, 1001, 1231, and IRC 446 and 481 for changes in methods of accounting. They also may affect IRC 461 and 512 issues.

  2. IRC 451(f). Accrual basis telephone utilities must recognize income from furnishing telephone and other communications services to customers not later than the taxable year in which they provide the service. Utilities may not accrue income relying on when they bill customers. Adjustments to the cooperative's income may be necessary. For IRC 481(a) adjustments resulting from IRC 451(f), see P.L. 99-514 §§ 821(b)(2), (3) and 100-647 § 1008(h). S. Rep. No. 313, 99th Cong., 2d Sess., 1986-3 C.B. (Vol. 3) 120-121; H. Conf. Rep. No. 841, 99th Cong., 2d Sess., 1986-3 C.B. (Vol. 4) II-322-324. For prior law (cycle billing vs. budget billing), see Rev. Rul. 72-114, 1972-1 C.B. 124.

  3. Rate Increases. For financial accounting purposes, utilities report a permitted rate increase as revenue in the year in which the new rate order is issued. For income tax accounting, increased income is recognized when properly earned or accrued. Notify Headquarters of any instances in which the USoA differs from income tax accounting for:

    1. Reporting purposes (Forms 990 and 990-T) or

    2. Calculating member income in applying the 85-percent test.

  4. Statement of Cash Flows. Cooperatives' financial statements must include a statement of cash flows. FAS No. 95. The statement provides information on the cooperative's ability to generate positive cash flows, to pay patronage dividends and need to borrow funds. This statement may assist the examiner in assessing whether the cooperative operates according to cooperative principles (including the reasonableness of cash reserves).

  5. Cash Flows from Investing. Activities reflects the operations of subsidiaries. Analyze the statement of cash flow (or, if a condensed statement of cash flow is used, a more detailed cash flow statement). If appropriate, request the underlying workpapers.

4.76.20.13.11  (12-01-2006)
The 85-Percent Member-Income Test

  1. Effect of Accounting Methods. The differences in accounting methods among USoA, GAAP, and income tax that affect timing of income and expense, gain and loss, and raising issues may also affect the 85-percent test in IRC 501(c)(12).

  2. Exhibit 4.76.20-1. This exhibit illustrates the income tax treatment of certain USoA Accounts for purposes of applying the 85-Percent Test.

  3. Members. In general, subscribers served by the cooperative are members of the cooperative. These guidelines assume that all subscribers are members. Cooperatives must keep records of membership subscriptions. See the accounts for "Subscriptions to Memberships" and "Subscriptions to Members' Equity Certificates." The cooperative's subscription ledger should show the amounts due, paid, and owed for each subscriber. New members usually pay a membership fee, which is to a final bill or refunded in cash.

  4. Revenue Accounts. These Accounts are divided into five groups: 1) Local Network Service, 2) Network Access Services Revenues, 3) Long-Distance Network Services Revenues, 4) Miscellaneous Revenues, and 5) Uncollectible Revenues. Network Access Services Revenues and Long-Distance Network Services Revenues, combined, are the largest revenue sources for most cooperatives.

  5. Telecommunications Services. FCC determines the amount, type and source of cooperatives' revenue from regulated telecommunications services. Cooperatives must comply with the USoA, classifying and reporting revenues from regulated and unregulated services. See Exhibit 4.76.20-1 for accounts used to record income from these categories for telecommunications services.

  6. Telecommunications Accounts Receivable. Account 1180 includes all amounts billed to subscribers (local and long-distance service, member income, nonmember income, and excluded income). Also see accounts 1181, 5301, and 5302. Taxpayers must use the specific charge-off method in accounting for losses on bad debts. Accordingly, it may be necessary to adjust accrued income to compute member, nonmember, and excluded income. Review accounts 1190 and 1191.

  7. Income from Interest and Dividends. Review the following accounts:

    1. Cash accounts Cooperatives must invest cash in income-producing accounts and should give primary consideration to safety and liquidity. Trace earnings to the appropriate revenue accounts or other income accounts; ascertain whether earnings are member or nonmember, and trace to Form 990.

    2. Other Investment Funds Trace investment income attributable to these accounts to Form 990.

    3. Revenue Accounts. Analyze dividend and interest income accounts and accounts receivable as well as other non-operating income and expense accounts. Note that the account "Allowance for Funds Used During Construction" exists solely for regulatory purposes. Dividends received and receivable from affiliated companies are recorded in " Investments in Affiliated Companies."

    4. Interest Income from "Cushion of Credit Accounts. " Ascertain whether interest income from "cushion of credit accounts" is reported. If so, it is nonmember income. Cooperatives with RUS loans may deposit amounts in cushion of credit accounts at the U.S. Department of the Treasury. These accounts can only be used to pay principal and interest on RUS loans. If necessary, the examiner can request a transcript of RUS's loan receivable accounts for the cooperative and analyze deposits and accrued interest income applied to installments of principal and interest on RUS loans.

    5. Notes Receivable. Review accounts for amount, timing, and source of interest income.

  8. Forgiveness of Indebtedness Income from Reacquisition of Long-Term Debt. When cooperatives reacquire their debt prior to maturity, the face amount appears in "Reacquired Debt." For income tax purposes, discharge of indebtedness income is (nonmember) gross income in the taxable year realized unless TAMRA § 6203 applies. IRC 61(a)(12), 451, 501(c)(12)(B)(iv).

  9. Other Investment Income, Gain or Loss. Review accounts for gains and losses from foreign exchanges, nonregulated use of regulated facilities, disposition of land and certain property, and nonregulated net income.

  10. Premium Income. If a cooperative has bond financing (uncommon), it may have premium income. Cooperatives must maintain separate accounts for premium, discount, and expense for each class and series of long-term debt. See the account for "Premium on Long-Term Debt." Also see Treas. Reg. section 1.61-12.

  11. Rural Telephone Bank (RTB). RTB, an agency of the United States, provides cooperatives with financing to supplement REA loans. Cooperatives borrowing from RTB must purchase Class B stock. Class B stockholders may receive patronage dividends in the form of additional stock, par value of purchased stock, or stock received as a patronage refund. See accounts for "Investments in Nonaffiliated Companies," "Investments in Nonaffiliated Companies-Class B RTB Stock," "Investments in Nonaffiliated Companies-Class C RTB Stock," and "Other Margins."

  12. Gains and Losses on Disposition of Plant. Gains and losses from disposition or retirement of telecommunications plant and other assets are included in gross income in the taxable year realized and recognized. FCC/RUS USoA rules on plant accounting differ radically from income tax accounting in many ways such as acquisitions, retirements, depreciation reserves, adjusted basis and realization.

    1. Accounting for Telecommunications Plant. Telecommunications plant is the largest asset account on the balance sheet. For FCC/RUS reporting, plant and equipment are economic resources to be used to provide future service. Their cost must be rationally and systematically allocated to the future periods that benefit from these assets. Telecommunications plant includes plant in service, under construction, or held for future use and goodwill. Assets cover land, buildings, vehicles, office furniture, and equipment. Cooperatives must maintain detailed property records. The required records for jointly owned property must identify all joint owners. "Telecommunications Plant in Service - Classified" is the controlling account for subaccounts.

    2. Plant Accounts. Amounts in plant accounts may differ from income tax basis rules.

    3. Depreciation. Depreciation is generally computed on the straight line method over the service life of the property.

    4. Retirement of Telecommunications Plant. When plant is obsolete, abandoned, lost, or destroyed, the plant account is credited with the original cost of the retired item (whether or not the item is replaced).

    5. Transactions with Affiliated Companies. Transfers of assets between the cooperative and its affiliates must be booked according to special rules. These transactions may be treated differently and raise examination issues. See IRC 267, 482.

  13. Investments in Nonaffiliated Companies. Debt and equity investments are booked at acquisition cost. Separate records must be kept for each investment. A temporary decline in value is charged to "Other Capital." Permanent decline in value becomes a current period loss.

  14. Cable Television. Cable television activities conducted in a division of the cooperative are recorded in" Nonregulated Investments" and "Nonregulated Net Income. "

  15. Miscellaneous. Entries in the following accounts may reveal member, nonmember, or unrelated trade or business income:

    • Other Operating Income and Expense

    • Extraordinary Income Credits

    • Extraordinary Income Charges

    • Property Held for Sale or Lease

    • Nonregulated Operating Revenue

    • Nonregulated Investments

    • Nonoperating Plant

    • Nonoperating Margins

    • Carrier Billing and Collection Revenue

    • Land and Support Assets

    • General Purpose Computers

4.76.20.13.12  (12-01-2006)
Unrelated Business Taxable Income

  1. Some directory advertising revenues may raise unrelated business taxable income issues during the examination of telephone cooperatives. IRC 513(c); Treas. Reg. sections 1.513-1(d)(2), 1.513-1(d)(4)(iv), 1.513-1(d)(4)(iv), Example (7); Rev. Rul. 74-38, 1974-1 C.B. 144; Rev. Rul. 76-93, 1976-1 C.B. 17.

    • Display advertisements (whether placed by members or nonmembers) are unrelated trade or business.

    • Payments for business listings in bold type ordinarily confer minimal commercial benefit and are not unrelated trade or business.

4.76.20.13.13  (12-01-2006)
Cooperative Principle - Subordination of Capital (Patronage Account)

  1. Cooperatives must keep detailed records on names and addresses of members and a patronage capital ledger. Under cooperative principles, the excess of operating revenues over operating expenses for each year is considered capital furnished by member-patrons). The cooperative assigns such capital to members based on each year's margins:

    1. At the end of each year, revenue and expense from furnishing telecommunications and other services are closed into "Operating Margins" and "Non-Operating Margins" accounts. Patronage capital credits appear in "Other Margins." Note: These accounts cannot be used (unless adjusted) in the 85-percent test because they reflect net income from operations and because the income accounts do not uniformly parallel member/nonmember classifications in IRC 501(c)(12).

    2. The balance in the accounts is then transferred to the " Patronage Capital Assignable" account. Patronage capital is assigned to individual members on the basis of patronage, pursuant to the cooperative's bylaws.

    3. After the margins are allocated to members, this amount is transferred from "Patronage Capital Assignable" account to " Patrons' Capital Credits Assigned."

    4. When the board of directors authorizes the return of capital credits to member-patrons, the amount authorized is transferred to "Patronage Capital Payable."

    5. Forfeited membership fees appear in the"Members' Equity - Other" account. Ascertain whether forfeitures are treated consistently with Rev. Rul. 72-36, Q 4.

    6. The cooperative's CPAs must analyze patronage capital accounts and a sample of membership transactions.

    7. Cooperatives are not required to file Forms 1099 to report payments of patronage dividends. Treas. Reg. section 301.6044-2(b)(2)(iii).

4.76.20.13.14  (12-01-2006)
Package Audit Considerations - Excise Taxes

  1. Cooperatives are responsible for collecting and paying federal excise taxes on certain communications services. These guidelines summarize the communications tax. Consult an Excise Tax Specialist if additional assistance is needed. The following services are taxable:

    1. Local telephone service

    2. Toll (long-distance) telephone service

    3. Teletypewriter exchange service

  2. The tax rate is three percent on the total amount paid for the services. State or local taxes (but not gross receipts or gross earnings taxes) that are separately stated on the bill are not included in the tax base.

  3. A credit or refund may be allowed to the cooperative collecting the tax from members if it establishes that it repaid the amount collected to members or obtains the members' consent to the allowance of a credit or refund. In general, crediting members' patronage capital account has the same effect as refunding the overpaid tax to members. Rev. Rul. 68-206, 1968-1 C.B. 557, amplified Rev. Rul. 70-13, 1970-1 C.B. 273.

  4. The excise taxes on the use of certain large vehicles may also apply. See IRC 4481.

  5. Cooperatives must file Form 720 quarterly (reporting communications tax) and Form 2290 (reporting highway use tax). For exemption certificates, see IRC 4253(k).

4.76.20.14  (12-01-2006)
Nonexempt Telephone Cooperatives

  1. Overview. If it is necessary to prepare a Form 1120 for any years under examination, seek assistance from the Utilities Industry Specialist, the Farmers' Cooperatives Industry Specialist, and, as appropriate, the Media/Communications Industry Specialist or VEBA (Voluntary Employees' Beneficiary Association) Industry Specialist. Many aspects of the USoA not covered in these guidelines may be useful in preparing Form 1120.

  2. Patronage Deductions. Nonexempt cooperatives not subject to Subchapter T may exclude patronage dividends paid or allocated to patrons, according to their bylaws. Rev. Rul. 83-135, 1983-2 C.B. 149. The examiner will need information from the cooperative to analyze patronage and nonpatronage income and expense.

  3. IRC 277. Nonexempt telephone cooperatives are subject to IRC 277, a method of accounting (as defined in IRC 446). Treas. Reg. section 1.446-1(e)(2)(ii)(a); Concord Consumers Hous. Coop. v. Commissioner, 89 T.C. 105, 116 (1989); Rev. Rul. 90-38, 1990-1 C.B. 57.

4.76.20.15  (12-01-2006)
Exempt Rural Electric Cooperatives

  1. These guidelines offer suggestions on issues, documents, and techniques for examining rural electric cooperatives. They do not attempt to cover every issue that might arise in an examination. Examinations of generation and transmission cooperatives (G&Ts) and distribution and transmission cooperatives, for example, present different issues and are usually examined under the Team Examination Program. Further, the guidelines are not intended to require examiners to exhaustively review all areas described in examining every rural electric cooperative. Examiners should use their professional judgment to determine the scope and depth of each examination.

4.76.20.15.1  (12-01-2006)
Overview - Electric Utilities and Rural Electric Cooperatives

  1. Electric Utilities. Electric utilities (including rural electric cooperatives) were once monopolies. Now they confront many challenges, including increased competition from independent power producers and other electric utilities. Industry and government consumers demand electricity at the lowest cost, and, increasingly, if dissatisfied with rates from the local electric utility, they may build their own generating plants (and bypass the electric utility altogether) or purchase electricity from another electric utility. Changes in economics and technology are also challenges to electric utilities. It remains to be seen how much the internet will affect electric utilities as an industry.

  2. Trends. Industry analysts forecast several trends that will likely generate new accounting and tax questions:

    • Price competition among competing utilities

    • Mergers among electric utilities (including G&Ts)

    • Joint ventures between cooperatives and other utilities to own and operate power generation plants

    • Sharing of services

  3. Rural Electric Cooperatives. Rural electric cooperatives (cooperatives) provide electric power to members and other consumers. G&Ts construct and operate power plants (alone or in arrangements with other utilities) and sell electricity at wholesale to their member distribution cooperatives, which, in turn, sell electricity retail to consumers. Distribution cooperatives are members of G&T cooperatives. The distribution cooperatives purchase electricity from their G&Ts to furnish electricity to consumers. Each cooperative, in turn, may be a member of other cooperatives, including cooperative subsidiaries. To carry out their activities, G&Ts and distribution cooperatives acquire land and land rights (including easements, water and power rights, diversion rights, submersion rights). They own (or lease) and operate electric generating plant and transmission and distribution plant, office space, furniture, and equipment. (Some distribution cooperatives are not members of a G&T and purchase power from other sources.) Cooperatives also contract for fuel/power supply and operate power plants jointly with other utilities.

  4. Joint Ventures. G&Ts often join with other electric utilities to build and operate power generating stations. The joint venturers may own the station as tenants in common, operating the station and sharing its capacity and energy according to various operating agreements, station agreements, and load management agreements. These joint ventures may raise issues bearing on the 85-percent member-income test.

  5. Diversification. Cooperatives are diversifying, offering water management and sewage treatment, venturing into economic development, offering satellite television service, selling satellite reception equipment, and, less commonly, offering cable television service. Many cooperatives belong to the National Rural Telecommunications Cooperative (NRTC) which offers Rural TV programming via satellite. Many of the satellite and cable television services are for-profit (noncooperative) businesses.

4.76.20.15.2  (12-01-2006)
State and Federal Regulation of Electric Cooperatives

  1. Regulation of electricity rates differs from state to state. To ascertain if rates are regulated by the state governing the electric cooperative being examined, check with the state's public utility commission.

  2. Federal Energy Regulatory Commission (FERC) regulates the rates, terms, and condition of interstate wholesale electric power sales and transmission services. Certain G&Ts file annual reports with FERC (FERC Form 1). These reports are public information.

4.76.20.15.3  (12-01-2006)
Rural Utility Service ("RUS" ) Regulation of Electric Cooperatives

  1. Like telephone cooperatives, many electric cooperatives finance their utility plant through loans from or guaranteed by the Rural Utilities Service ("RUS," formerly known as "REA" ). G&Ts generally borrow from the Federal Financing Bank (FFB) or from private lenders with a RUS loan guaranty.

  2. Loans from RUS to electric cooperatives work in essentially the same way as those to telephone cooperatives. See IRM 4.76.20.13.5 for discussion.

  3. To ensure repayment of loans, RUS also requires electric cooperatives to follow its Uniform System of Accounts (USoA) and audit procedures. For electric cooperatives, the procedures are published at 7 C.F.R. § 1767.10 et seq. and on the RUS internet site.

  4. RUS holds a first mortgage on all the cooperative's property. The mortgage requires the cooperative to submit detailed annual financial reports to RUS, including certified audits and other reports, all of which are public information. If the cooperative does not comply with these (and other) requirements, RUS may declare the loan in default, suspend future lending, and exercise other remedies under the mortgage. RUS field accountants (sometimes referred to as general field representatives) review the loan fund records, reports, and financial statements of active borrowers at least once every three years. Field accountants look at direct cost accumulation for utility plant construction and overhead allocation among construction, retirement, and maintenance. The field accountants perform non-opinion audits of the cooperative's loan fund transactions. The RUS Field Reports are public documents.

4.76.20.15.4  (12-01-2006)
RUS Uniform System of Accounts for Electric Cooperatives ("USoA" )

  1. Reporting to RUS. RUS requires electric cooperatives to keep detailed financial information and reporting on activities. See discussion at IRM 4.76.20.13. The USoA is based on FERC's accounting system with some modifications. RUS's Uniform System of Accounts for electric cooperatives is published at 7 C.F.R. § 1767 and its Accounting Methods and Procedures (required of all borrowers) at 7 C.F.R. § 1767.15. RUS also publishes Accounting Interpretations on the USoA. The methods and procedures mandate the entries to book particular transactions and aid in understanding the proper accounting treatment of items. Many accounts and account numbers in the USoA remain unchanged from year to year, so these examination guidelines can generally be used year to year.

  2. Recordkeeping and Accounting Requirements. Cooperatives must keep books of account to support all entries and all supporting books, records, minute books, memoranda, etc. Cooperatives must use the accrual method of accounting (as defined in GAAP). Separate accounting records must be maintained for each power plant and any other utility department (e.g., gas or water). The USoA contains the following Accounts:

  3. Balance Sheet Accounts for Electric Cooperatives

    100-199 Assets and Other Debits
    200-299 Liabilities and Other Credits
    300-399 Plant Accounts
    433, 436-439 Retained Earnings Accounts

  4. Income and Expense Accounts

    400-432; 434-435 Income Accounts (Net Income)
    440-459 Revenue Accounts
    500-599 Production, Transmission, and Distribution Expenses
    900-949 Customer Accounts, Customer Service and Informational, Sales, General and Administrative Expenses

  5. Non-Balance Sheet Accounts. Most USoA non-balance sheet accounts are paired revenue and expense accounts. Income accounts (generally, the less significant accounts) combine revenue and expense into a single account. Certain non-balance sheet accounts show revenue and expense for transactions between different departments within the cooperative. Because there are numerous timing and permanent differences between RUS accounting and income tax accounting, it may be necessary to adjust the amounts shown on the financial statements when conducting an examination.

  6. Patronage Capital Accounts. Regarding closing operating and non-operating revenue and expense accounts into patronage capital accounts at the end of the fiscal year, see discussion at IRM 4.76.20.13.

  7. Contact. There is insufficient space in these guidelines to explore all aspects of the USoA, GAAP, and Generally Accepted Government Auditing Standards (GAGAS) relevant to examination of cooperatives. Examiners may contact RUS's Technical Accounting and Auditing Staff with questions at (202) 720-5227.

  8. Subsidiaries. A cooperative's financial statements must comply with FAS No. 94,"Consolidation of All Majority-Owned Subsidiaries." If the cooperative owns a majority interest in a subsidiary, the cooperative must prepare consolidated financial statements including the subsidiary, together with supplementary schedules presenting a balance sheet and income statement for each subsidiary. RUS Forms 7 and 12 must be prepared on an unconsolidated basis. The RUS regulations contain sample financial statements (with accountants' notes) for an electric cooperative.

  9. RUS Regulations on CPAs' Audits of RUS Borrowers. The CPAs must prepare and submit the following annual reports to RUS, which are public documents:

    • Auditor's report (financial statements, accountants' notes, and statements of cash flow)

    • Report on Compliance with Applicable Laws and Regulations

    • Report on internal controls

    • Management Letter (including disclosure of material transactions with related parties)

4.76.20.15.5  (12-01-2006)
Examination Planning

  1. The examiner should consult the following for assistance in planning and conducting the examination:

    • State Public Utility Commissions. If one or more PUCs regulate the cooperative, contact the PUC(s) concerning the cooperative's filings and PUC orders.

    • Federal Energy Regulatory Commission. Contact the Office of Chief Accountant at (202) 219-2600.

    • Rural Utilities Service. Contact the Director of the Program Accounting Services Division at (202) 720-9450.

4.76.20.15.6  (12-01-2006)
Initial Document Requests

  1. Request and review the documents listed below to gain a basic understanding of the electric cooperative's activities, capital structure, and related organizations.

  2. Documents to be requested from all electric cooperatives:

    • Articles of Incorporation (and all amendments)

    • Bylaws (and all amendments)

    • A list of the names and addresses of all subsidiaries and associated companies

    • Names and addresses of all directors, trustees and officers of the cooperative and of all subsidiaries and associated companies

    • Minutes of meetings of board of directors and of all board committees

    • Annual reports, financial statements (including statement of cash flows and accountants' notes) and tax returns for all subsidiaries and associated companies

    • RUS Forms 7 Financial and Statistical Report, Operating Report-Financial, Form 12

    • RUS Field Reports on the cooperative (from RUS field accountants, field engineers, or general field representatives)

    • Any debt restructuring plan entered into between the cooperative and RUS

    • Methods and Procedures Manual (procedures to record transactions)

    • A chart of accounts correlating general ledger accounts to USoA Accounts

    • The cooperative's 85-percent test worksheets

    • The cooperative's policy book on patronage capital and patronage dividends

    • An analysis of income and expense

    • An analysis of deferred credits and deferred debits with supporting documentation (this analysis is required in 7 C.F.R. § 1773)

    • All reports filed with RUS (including but not limited to: RUS Forms 7, 12; audited financial statements, including statement of cash flows and accountants' notes); auditor's report, compliance report, report on internal controls and management letter

    • All reports and other filings with PUCs and PUC orders (if applicable)

    • All agreements between the cooperative and any subsidiary or associated company

    • Qualified employee retirement plans: the official plan and trust documents, any determination letters issued to qualified plans, records of employer and employee contributions, account balances or accrued benefits and employee compensation

    • Nonqualified deferred compensation plans: employee benefit plans and related documents (e.g., trusts, insurance contracts, private letter rulings), records of employer and employee contributions and account balances or accrued benefits

    • All other employee benefit plans: including accident and health plans, cafeteria plans and VEBAs, related documents (including any trust instruments)

    • all arrangements for compensation of directors (including qualified and nonqualified deferred compensation plans)

  3. Newsletters and other communications to members should be requested from distribution cooperatives.

4.76.20.15.7  (12-01-2006)
Examination of Financial Statements and Reports to Regulatory Agencies

  1. Methods of Accounting. See discussion at IRM 4.76.20.13.10(1).

  2. IRC 451(f). Electric cooperatives on the accrual basis of accounting must recognize income from the sale of electricity to customers not later than the taxable year in which they provide it. Such electric cooperatives may not rely on the meter-reading or customer billing date when accruing income.

    1. Check whether the cooperative accrues all unbilled revenue associated with its purchased gas adjustment or deferred fuel adjustment.

    2. Check to ensure that such unbilled accruals are not netted against unbilled fuel costs to provide electricity.

    3. Look at the "Accrued Utility Revenue." Even when IRC 451(f) applies, RUS rules of accounting may allow the electric cooperative to choose whether or not to accrue estimated revenue for electricity sold but not billed as of the end of the taxable year. As a result, adjustments to the cooperative's income may be necessary for purposes of the 85-percent member-income test.

  3. Timing Differences Between RUS Accounting and Income Tax Accounting

    1. Distribution cooperatives generally use cycle billing or budget billing. Cycle billing is based on monthly meter reading and billing cycle. Budget billing is based on an annual projected budget; and customers are billed a level amount monthly with an annual adjustment reflecting actual electricity consumption. On billing methods, see Rev. Rul. 72-114, 1972-1 C.B. 124. Ascertain whether the cooperative accrues income consistently and in accordance with IRC 451(f).

    2. Accounts for "Memberships Issued," " Customer Advances for Construction," or "Donated Capital " may raise issues under the 85-percent test and IRC 118, 446, or 481. See Rev. Rul. 75-557, 1975-2 C.B. 33, clarified in Rev. Rul. 76-61, 1976-1 C.B. 12.

    3. Amounts in "Customer Deposits" usually represent security deposits for electricity. Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990); Rev. Proc. 91-31, 1991-1 C.B. 566; Rev. Rul. 72-519, 1972-2 C.B. 32.

    4. The "Accumulated Provision for Rate Refunds" and "Provision for Rate Refunds" accounts may also affect the timing of income, expense, gain, or loss.

4.76.20.15.8  (12-01-2006)
Margin Stabilization Plans

  1. In 1988, RUS (then REA) published proposed regulations for borrower rural electric cooperatives to gain approval for a "margin stabilization plan." If REA approved, the electric cooperatives could use accounting methods to defer certain current revenues or expenses to future periods. Under the proposed regulation, the electric cooperative submitted a private letter ruling (PLR) from IRS to REA that essentially deferred the cooperative's tax exempt status and operation as a cooperative under the tax law. REA's proposed regulation also provided that a cooperative could elect to implement a margin stabilization plan before receiving the PLR by submitting to REA a board of directors' resolution stating the cooperative was aware of and accepted responsibility for a potential adverse effect on its tax exempt status. REA required the cooperative to submit the resolution with substantiation of a formal PLR application to the Service.

  2. Subsequently, the REA/RUS modified the proposed regulation to require submission of a board of director's resolution stating that in lieu of a favorable PLR from the Service, margins would be allocated based upon current operating performance, absent any effects of a margin stabilization plan.

  3. RUS has placed a moratorium on approving margin stabilization plans since 1994. Electric cooperatives can elect to discontinue the plan they had implemented, but if they choose to do so, they must notify RUS and recognize income in the year of discontinuance. Otherwise, those electric cooperatives that implemented an REA-approved plan under the proposed procedures may continue to defer certain income and expenses to future periods.

  4. Electric cooperatives must maintain certain financial ratios or their RUS loans are in default. To meet the required ratios, some cooperatives under a margin stabilization plan average their margins. The cooperative selects a target margin by which income is to exceed expenses (usually the ratio required by RUS) and show it as income in financial statements and RUS reports, as opposed to the actual income and expense accrued that year. In a good year, the cooperative books the excess of income over expense as a deferred credit; in a bad year, the operating loss is booked as a deferred charge. GAAP allows this under certain conditions, as does RUS, if the cooperative meets certain requirements and discloses the plan in its financial statements.

  5. These plans raise issues with respect to the 85-percent test and Rev. Rul. 72-36. See EO Technical Instruction Program for FY 1994, " Current Issues Affecting Certain Cooperatives and Like Organizations Described Under IRC § 501(c)(12)."

  6. The Service's position is that the use of margin stabilization plans could result in erroneous calculations of member income for purposes of meeting the 85-percent member-income test. In the case of an electric cooperative company utilizing such plan, determine whether the organization has a Service ruling letter. If so, determine if the cooperative is following all of the letter's provisions. If it does not have a PLR issued by the Service, determine if:

    1. Income deferred under the margin stabilization program is being included in the calculation of the 85-percent member-income requirement in the year it is received or earned;

    2. Income or reserve deferred or set aside under the margin stabilization plan is being applied to future years' revenues within five years from the date such reserve is deferred or accumulated (This should serve to avoid an accumulation of unreasonable reserves. See Question 2 of Rev. Rul. 72-36, 1972-1 C.B. 151.);

    3. There is disclosure of the operation of the margin stabilization plan to member-patrons;

    4. Records are maintained for purposes of determining each member's rights and interests in the cooperative's assets, including reserves set aside under the margin stabilization plan (see Question 3 of Rev. Rul. 72-36, 1972-1 C.B. 151).

4.76.20.15.9  (12-01-2006)
The 85-Percent Member-Income Test and Unrelated Business Taxable Income

  1. See Exhibit 4.76.20-2, "Applying the 85-Percent Test: Analysis of RUS Uniform System of Accounts (Selected Revenue, Income, Expense and Balance Sheet Accounts)," which illustrates the income tax treatment of certain USoA Accounts.

  2. Operating Revenue from Sale of Electricity. The total amount of the electric operating revenue accounts is entered in "Operating Revenue." A cooperative's electricity customers vary: residential, commercial, industrial, agricultural, governmental consumers, or other public utilities. To verify meeting the annual 85-percent test and to check for possible unrelated trade or business, review accounts that classify sales to members/nonmembers. Compare information on members to those whom the cooperative supplies with electricity. For example, through accounts "Public Street/Highway Lighting" and "Other Sales to Public Authorities," ascertain whether a local, state, or federal government agency is a member of the cooperative. Ascertain if commercial customers are members or nonmembers. Review "Sales for Resale " and "Commercial and Industrial Sales" accounts for member/nonmember income.

  3. Accounts Receivable and Uncollectible. Review customer accounts for member/nonmember income: "Customer Accounts Receivable," "Customer Accounts Receivable-Electric," "Customer Accounts Receivable-Other," "Accumulated Provision for Uncollectible Customer Accounts-Credit," and " Uncollectible Accounts." Taxpayers must use the specific charge-off method in accounting for losses on bad debts. Utilities are not barred from charging off uncollectible accounts merely because they must continue to serve customers in arrears on their accounts. For the change in method of accounting from reserve to specific charge-off and IRC 481(a) adjustment, see P.L. 99-514 § 805(d)(2).

  4. Electricity Purchased for Resale.The account"Purchased Power" shows the cost of electricity purchased for resale and all net settlements for exchange of electricity (including economy power, off-peak power for on-peak power, and spinning reserve capacity). The cooperative must maintain records by months, showing the demands, demand charges, kilowatt-hours, and prices under each purchase contract and the charges and credits under each exchange or power pooling contract.

  5. Income from Interest and Dividends. Review the following accounts:

    1. Cash Accounts. Cooperatives must invest cash in income-producing accounts and should give primary consideration to safety and liquidity. Review the cash accounts, trace earnings to the appropriate revenue accounts or income accounts, ascertain whether earnings are member or nonmember, and trace to Form 990.

    2. National Utilities Cooperative Finance Corporation (CFC) . Many cooperatives also borrow from the CFC and pay a membership fee to join. As part of the financing, they execute a subscription agreement with the CFC to purchase interest-bearing capital term certificates. These transactions are booked in "Subscriptions to Capital Term Certificates-CFC, " "Other Long-Term Debt Subscriptions," " Interest and Dividends Receivable," "Interest and Dividend Income."

    3. Interest Income from "Cushion of Credit Accounts " . Ascertain whether interest income from "cushion of credit accounts" is reported. Cooperatives with RUS loans may deposit amounts into cushion of credit accounts at the U.S. Department of the Treasury. These accounts can only be used to pay principal and interest on RUS loans. When interest rates from other investments fall below the percentage paid by the U.S. Department of the Treasury, cooperatives often increase deposits to their cushion of credit accounts. If necessary, the examiner can request a transcript of RUS's loan receivable accounts to analyze deposits and accrued interest income applied to installments of principal and interest on RUS loans.

  6. Forgiveness of Indebtedness Income from Reacquisition of Long-Term Debt. Under the USoA, when cooperatives reacquire or redeem their debt, the difference between the amount paid upon reacquisition and the face value (with certain modifications) is booked to the " Unamortized Loss on Reacquired Debt" or the "Unamortized Gains on Reacquired Debt" account. In general, for income tax purposes, discharge of indebtedness income is nonmember gross income in the taxable year realized.

  7. Rental Income. Analyze "Rents Receivable Non-Operating Rental Income." Review "Electric Plant Leased to Others" and "Revenues from Electric Plant Leased to Others" accounts for source and amount of rental income for the 85-percent test and unrelated trade or business taxable income. Qualified pole rentals are recorded in "Rent from Electric Property."

  8. Gains and Losses. The USoA rules on plant accounting and realization differ from the income tax rules on adjusted basis and realization:

    1. Transfer of Electric Plant and Other Property. When an electric plant is transferred, the net (book cost less accumulated depreciation amount) minus the consideration received and sale expenses is credited to "Electric Plant Purchased or Sold." If it is a significant amount, it is closed into Deferred Gains from Disposition of Utility Plant or Deferred Losses from Sale of Utility Plant and usually amortized over five years.

    2. Income Tax Accounting. Gains and losses from disposition or retirement of utility plant and other assets is included in gross income in the taxable year realized and recognized. Review and reconcile activity in these accounts with income tax accounting rules.

  9. Transfer of Clean Air Act Allowances. The Clean Air Act Amendments of 1990 established a system to issue emission allowances for airborne pollutants, implemented by the Environmental Protection Agency. Electric utilities are issued emission allowances authorizing the emission of a specified amount of airborne pollutants by the utility during a specified calendar year or later period. Starting in 1993, unused allowances may be sold, traded, or held in inventory for use against emissions in future years. G&T cooperatives may have gains and losses from transfers of clean air allowances. Rev. Proc. 92-1, 1992-1 C.B. 503. USoA treatment may vary.

  10. Associated (Affiliated) Companies and Subsidiaries. These accounts may raise issues concerning the 85-percent test, operation as a cooperative, unrelated trade or business, and employment taxes.

    1. A cooperative may invest in an associated company embracing corporations, joint ventures, and funded deferred compensation plans. Cooperatives must keep accounts and records to accurately report transactions with subsidiaries. The results of subsidiaries' operations appear on the cooperative's balance sheet in the accounts"Investment in Subsidiary Companies," "Equity in Earnings of Subsidiary Companies," and " Unappropriated Undistributed Subsidiary."

    2. "Review Investment in Associated Companies," "Other Investments in Associated Organizations," " Temporary Cash Investments," "Notes Receivable from Associated Companies," "Notes Payable to Associated Companies," "Accounts Receivable from Associated Companies," " Accounts Payable to Associated Companies," "Advances from Associated Companies." These accounts show the book cost of investments in securities issued to each associated company or joint venture, any advancements, and accrued interest on any debt.

  11. Economic Development Loan Fund. Cooperatives are encouraged to participate in the Rural Economic Development Loan and Grant Program administered by the Rural Business-Cooperative Service. RUS provides interest-free loans or grants to cooperatives to promote rural economic development and job-creation projects through revolving loan funds and pass-through grants. Interest earned on rural economic development loans appears in " Interest and Dividends Receivable" and "Interest and Dividend Income" accounts. Analyze activity in these accounts in connection with the 85-percent test.

  12. Miscellaneous. Entries in the following accounts may reveal member, nonmember, or unrelated trade or business income:

    1. The accounts "Electric Plant Held for Future Use," "Nonutility Property" or "General Plant" (particularly "Communication Equipment" ) may suggest nonmember income and/or unrelated business such as industrial parks or noncooperative cable TV service.

    2. Sale of Nuclear Materials (as opposed to reuse). "Nuclear Materials Held for Sale" is debited for salvage value, and "Accumulated Provision for Amortization of Nuclear Fuel Assemblies" is credited. Any difference between salvage value and the amount realized is credited/debited to "Nuclear Fuel Expense. "

    3. Make Ready Charges Received from Cable Television Companies. The cooperative and a cable television company (an affiliate or an unrelated firm) may agree to place lines, attachments, or apparatus on the cooperative's poles for transmission of TV signals. To make the poles ready, the cooperative incurs labor and materials costs. Make ready charges may be booked in several ways: as a reimbursement, as contract work, or as reductions in expenses.

    4. Sales of Timber, Sand and Gravel. See " Miscellaneous Non-Operating Income."

4.76.20.15.10  (12-01-2006)
Cooperative Principle - Subordination of Capital (Patronage Account)

  1. Cooperatives must keep detailed records on names and addresses of members and a patronage capital ledger.

  2. The Patronage Capital Cycle. Cooperatives must operate on a cooperative, or nonprofit, basis. Each year, the excess of operating revenues over operating expenses is considered to be capital furnished by member-patrons. Such capital or margins is to be assigned to members on the basis of each year's margins. Cooperatives typically pay patronage dividends on a FIFO basis. Recordkeeping and procedures are basically the same as those of telephone cooperatives. See discussion at IRM 4.76.20.13.

4.76.20.16  (12-01-2006)
Nonexempt Electric Cooperatives

  1. Overview. If it is necessary to prepare a Form 1120 for any years under examination, the examiner may wish to seek assistance from the Utilities Industry Specialist, the Farmers' Cooperatives Industry Specialist (patronage deductions, IRC 277), the Media/Communications Industry Specialist, and the VEBA (Voluntary Employees' Beneficiary Association) Industry Specialist (IRC 501(c)(9), 419, 419A). Preparing Form 1120 in place of Form 990 may be somewhat complicated, particularly when the cooperative moves in and out of exempt status, files Form 990-T, and pays tax under IRC 511 (resulting in a credit on Form 1120).

  2. Patronage Deductions. Nonexempt cooperatives not subject to Subchapter T may exclude patronage dividends paid or allocated to patrons, according to their bylaws. The examiner will need information from the cooperative to analyze patronage and nonpatronage income and expense. See Form 8817, "Allocation of Patronage and Nonpatronage Income and Deductions (Subchapter T cooperatives)."

  3. IRC 277. Nonexempt electric cooperatives are subject to IRC 277, a method of accounting (as defined in IRC 446). Treas. Reg. section 1.446-1(e)(2)(ii)(a); Concord Consumers Hous. Coop. v. Commissioner, 89 T.C. 105, 116 (1989); Rev. Rul. 90-38, 1990-1 C.B. 57. Also see Form 8817.

Exhibit 4.76.20-1  (04-01-2003)
Applying the 85-Percent Test - Cooperative Telephone Companies

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Exhibit 4.76.20-2  (04-01-2003)
Applying the 85-Percent Test - Cooperative Electric Companies

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