CHAPTER NINETEEN
Other Categories of Tax-Exempt Organizations

Many categories of organizations are exempt from federal income tax in addition to those that are the subject of the previous chapters. The law as to these categories of entities is summarized in this chapter, in order of the accompanying Internal Revenue Code section provisions, followed by law summaries as to other types of exempt organizations.

§ 19.1 INSTRUMENTALITIES OF THE UNITED STATES

The federal income tax law references “[c]orporations organized under Act of Congress, if such corporations are instrumentalities of the United States and if it is specifically provided in this title [Internal Revenue Title] (or under such Act as amended and supplemented before…[July 18, 1984]) that such corporations are exempt from Federal income taxes.”1 This third criterion was added to the Internal Revenue Code in 1984 to stipulate that tax exemptions for United States instrumentalities must be specified in the Code or in a revenue act. Under prior law (and for pre-1984 instrumentalities), it was sufficient to have tax exemption provided in any act of Congress.

Organizations exempt from federal income tax as U.S. instrumentalities include the Federal Deposit Insurance Corporation, the Reconstruction Finance Corporation, Federal Land Banks, the Federal National Mortgage Association, Federal Reserve Banks, the Federal Savings and Loan Insurance Corporation, the Pennsylvania Avenue Development Corporation, and the Pension Benefit Guaranty Corporation.2

Federal credit unions organized and operated under the Federal Credit Union Act are instrumentalities of the United States3 and therefore are entitled to tax exemption under this body of law. These credit unions are included in a group exemption ruling4 issued to the National Credit Union Administration.5 Certain other credit unions that fail to qualify under this provision may secure tax exemption as nonstock mutual credit unions.6

In other illustrations, the Supreme Court held that the concept of a federal instrumentality includes army post exchanges7 and the American National Red Cross.8 While neither is directly controlled by the United States, both have an “unusual relationship” with the federal government, such as operation pursuant to a federal charter, federal government audit, involvement of a presidential appointee or government employees, and government funding or provision of services. Applying these criteria, a federal court found the U.S. Capital Historical Society to be a federal instrumentality, also finding that it performs an essential function for the federal government (with the result that the District of Columbia was held to lack the power to tax sales by the Historical Society).9 An organization that was created by Congress to coordinate, support, and facilitate programs of the federal government and state and local governments, along with other entities, in commemoration of a war was ruled to be an activity of the federal government and thus tax-exempt, with contributions to it deductible as charitable gifts.10

§ 19.2 TITLE-HOLDING CORPORATIONS

The title-holding corporation is an entity that serves one or more tax-exempt organizations. Its purpose, as the name indicates, is to function as a subsidiary organization, holding title to property that would otherwise be held by the parent exempt organization or organizations and remitting any net income from the property to the parent or parents. Originally designed to circumvent state law restrictions on the holding of property by nonprofit organizations, the title-holding company today is used to house the title to property in the subsidiary for the purpose of reducing the exposure to liability from use of the property by the parent entity, otherwise facilitate administration, and increase borrowing power.

Title-holding corporations are most useful where—for management and/or law reasons—it is deemed appropriate that the title to an item of property be held in the name of another (albeit related) organization. There is no limitation on the type of property whose title may be held by a title-holding corporation; it may be real property, such as an office building, or an item of personal property, such as capital equipment. As the IRS observed, the title-holding corporation is “by its nature responsive to the needs and purposes of its exempt parent which established it mainly to facilitate the administration of properties.”11 Wherever the administration of one or more organizations may be so served, the title-holding corporation is available as a useful tax planning mechanism.

Should the organization to which a tax-exempt title-holding corporation makes income distributions cease to qualify for tax exemption, the holding company would, in turn, lose its entitlement to tax exemption on this basis.12 Likewise, the sale of all of the stock of an exempt title-holding company to a private person would cause the organization to no longer qualify for tax-exempt status.13

(a) Single-Parent Organizations

The federal tax law references “[c]orporations organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, to an organization that itself is” tax-exempt.14 This is the single-parent title-holding organization. For this purpose, the term expenses includes a reasonable allowance for depreciation.15

In general, this type of organization cannot accumulate income.16 That is, as a general rule, its function is to transfer the entire amount of its income, less expenses, to a tax-exempt parent.17 If the organization is not specifically organized to do this, it cannot qualify as an exempt title-holding corporation.18 Moreover, if the entity does not operate in this fashion, it cannot constitute this type of exempt organization.19

Despite the general prohibition on income accumulation, however, a tax-exempt title-holding corporation may retain part of its income each year to apply to indebtedness on property to which it holds title.20 The transaction is treated as if the income had been transferred to the parent organization and that entity had used the income to make a capital contribution to the title-holding corporation, which, in turn, applied the contribution to the indebtedness.21

The IRS ruled that an organization formed as a subsidiary of a tax-exempt title-holding corporation, organized for the exclusive purpose of holding title to investment property that would otherwise be held by the parent, itself qualified as an exempt title-holding corporation, inasmuch as it collected the income from the property and transferred it to its parent (which was, of course, an exempt organization).22 In other words, an exempt title-holding organization can be the beneficiary of the functions of another exempt title-holding organization.

These organizations can be put to creative uses. In one instance, a tax-exempt title-holding corporation was utilized to hold and administer a scholarship and loan fund for a fraternity.23 In another case, a stock corporation organized and operated to hold title to a chapter house of a college fraternity was held to qualify as an exempt title-holding organization, even though the stock was owned by members of the fraternity.24 (Where, however, an exempt organization has no control over the title-holding organization, the latter cannot qualify for tax-exempt status.25)

While the renting of real estate generically is a business, the IRS determined that income from the rental of realty is a permissible source of income for tax-exempt title-holding corporations.26 That is, this rental activity is not an unrelated business. The rental of personal property (unless leased with realty), however, is treated as the conduct of an unrelated business.27 Thus, title-holding organizations engaging in business activity—other than rental of real property—may be denied or lose tax exemption.28

Consequently, the characterization of the nature of the property being rented can be determinative of an organization's status as a tax-exempt title-holding corporation. In one instance, a corporation that otherwise qualified for exemption as a title-holding entity held a leasehold interest in an office building, with all of its income derived from the subleasing of space in the building to the general public. Even though a leasehold of real property is generally classified as personal property, income derived from subleasing an office building was treated as income derived from the rental of real property.29 The IRS reasoned that this type of income is similarly treated as rental income from real property for purposes of qualification for exemption as a title-holding corporation,30 thereby concluding that the corporation was tax-exempt.31

A title-holding corporation that derives income from the rental of real property to the general public is not precluded from tax exemption. In one instance, a corporation held title to a building containing offices that were rented to the public. It collected the rents, paid the expenses incident to operation and maintenance of the building, and turned over the balance of the income to its exempt parent. The rents were not forms of unrelated business income, because there were no substantial services to the tenants.32 The IRS wrote that the “statutory language that requires them [tax-exempt title-holding corporations] to turn over the income from the property to an exempt organization contemplates that income will be received from parties other than the exempt organization for which they hold title.”33

A tax-exempt title-holding corporation may receive unrelated business taxable income in an amount up to 10 percent of its gross income for a tax year, where the unrelated income is incidentally derived from the holding of real property.34

A tax-exempt title-holding corporation is subject to the unrelated business income tax if one of its parent organizations is subject to that tax. In one instance, a title-holding entity with two parents, one subject to the tax, the other not, found itself in this position.35

Where a tax-exempt title-holding corporation holds title to property for the benefit of its parent exempt organization, the property is encumbered with a debt, and the property is not utilized for the exempt purposes of the parent organization, the title-holding corporation will be subject to the tax on unrelated debt-financed income.36

As noted, a title-holding corporation must, to be tax-exempt, not engage in any business other than that of holding title to property and collecting and remitting any resulting income to its parent organization.37 For example, an organization that held title to a building housing its exempt parent, maintained the property, and operated social facilities located in the building was held to not qualify for this tax exemption, because the social activities were “outside the scope of” those allowed to an exempt title-holding entity.38 Likewise, a title-holding corporation had its exempt status revoked because it operated a bar and buffet in the building it maintained.39

A title-holding corporation may file a consolidated return with a parent entity for a tax year. When this occurs and the title-holding entity pays net income to the parent, or would pay net income but for the fact that the expenses of collecting the income exceed its income, the title-holding corporation is deemed, for purposes of the unrelated business income tax, as being organized and operated for the same purposes as the parent, as well as its title-holding purposes.40

Generally, contributions to a title-holding corporation are not deductible as charitable gifts. Where a tax-exempt title-holding entity engages in a charitable activity, however, contributions to it for the express purpose of funding that activity are deductible as charitable gifts for federal income tax purposes.41 Indeed, if a title-holding corporation has a charitable organization as its parent and the corporation engages in one or more activities that the parent itself could undertake without loss of tax exemption, the title-holding entity itself may be eligible to be recognized as a charitable organization or can convert its basis for tax exemption from that as a title-holding organization to that of a charitable entity.42

It was the position of the IRS that a title-holding company is ineligible for tax exemption under these rules if it has multiple unrelated parents, inasmuch as that is evidence of a pooling of assets for an active corporate venture, not a mere holding of title.43 This matter was, however, resolved by legislation.44

(b) Multiple-Parent Organizations

The multiple-parent title-holding organization was added in 1986 to the categories of tax-exempt organizations.45 This is an otherwise eligible corporation or trust that is organized for the exclusive purposes of acquiring and holding title to real property, collecting income from the property, and remitting the entire amount of income from the property (less expenses) to one or more qualified tax-exempt organizations that are shareholders of the title-holding corporation or beneficiaries of the title-holding trust.46 For this purpose, the term real property does not include any interest as a tenant in common (or similar interest) and does not include any indirect interest; this requirement means that the title-holding entity must hold real property directly, rather than, for example, as a partner in a partnership.47 The term real property also includes any personal property that is leased under, or in connection with, a lease of real property, although this rule applies only if the rent attributable to the leasing of the personal property for a year does not exceed 15 percent of the total rent for the year attributable to both the real and personal property under the lease.48

Tax exemption under this category of organization is available only if the corporation or trust has no more than 35 shareholders or beneficiaries, and has only one class of stock or beneficial interest.49 Also, to be exempt as this type of title-holding organization, the corporation or trust must permit its shareholders or beneficiaries to (1) dismiss the corporation's or trust's investment adviser, following reasonable notice, on a vote of the shareholders or beneficiaries holding a majority of interest in the corporation or trust, and (2) terminate their interest in the corporation or trust by either (or both), as determined by the corporation or the trust, selling or exchanging their stock in the corporation or interest in the trust (subject to federal or state securities law) to any qualified organization as long as the sale or exchange does not increase the number of shareholders or beneficiaries in the corporation or trust to more than 35, or having their stock or interest redeemed by the corporation or trust after the shareholder or beneficiary has provided 90 days' notice to the corporation or trust.50

Organizations that are eligible to acquire or hold interests in this type of title-holding organization are charitable organizations;51 qualified pension, profit-sharing, or stock bonus plans;52 governmental plans;53 and governments and agencies and instrumentalities of them.54

For these purposes, a corporation that is a qualified subsidiary (wholly owned) of a tax-exempt multiple-parent title-holding organization is not treated as a separate organization.55 In this instance, all assets, liabilities, and items of income, deduction, and credit of the qualified subsidiary are treated as assets, liabilities, and like items of the title-holding organization.56 These rules allow a title-holding company to hold properties in separate corporations so as to limit liability with respect to each property.

This category of tax-exempt organization was, as noted, created in response to the position of the IRS that a title-holding company otherwise eligible for tax exemption under preexisting law57 cannot be tax-exempt if two or more of its parent organizations are unrelated. This body of law does not modify the preexisting law concerning the exempt status of single-parent or related-parent title-holding corporations.58

§ 19.3 LOCAL ASSOCIATIONS OF EMPLOYEES

Federal income tax law provides exemption for “local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational or recreational purposes.”59 The word local has the same meaning as is applicable with respect to certain benevolent organizations.60

A local association of employees can assume a variety of forms. For example, an association that operated a gasoline station on property owned by its members' employer qualified,61 as did an organization that engaged only in social and recreational activities that met the approval of the members' employer.62 By contrast, a local employees' association whose membership was limited to the employees of a particular employer and that operated a bus for the convenience of its members was denied recognition of tax exemption,63 as was an organization whose purpose was to pay lump-sum retirement benefits to its members or death benefits to their survivors.64 Employees can include retirees who were members of the association at the time of retirement.65 An exempt local association of employees may allow family and friends of its members to participate in the organization's recreational activities as long as those uses of the facilities are not so extensive as to deter the association from adhering to its primary function of providing means of recreation to its members.66

The IRS considered the tax status of an organization whose membership was limited to the employees of an employer in a particular municipality. The organization arranged with businesses to extend discounts to its members on their purchases of specified goods and services, and sold tickets to recreational and entertainment activities to them at a discount. Basing its position on the legislative history for this category of tax-exempt organization,67 the IRS dismissed the organization as merely a “cooperative buying service for members” and denied it tax exemption as an employees' association.68

The IRS took the position that a voluntary employees' beneficiary association69 that could not meet the 85 percent source-of-income test (repealed in 196970) could not qualify for tax exemption as an employees' association.71 Thus, the IRS does not follow a case holding that a cooperative electric company is exempt as an employees' association even though it met the requirements for exemption under the rules for certain benevolent and mutual organizations,72 except for the 85 percent source-of-income test.73

There is no statutory law or regulation standard concerning the qualification of members in the case of tax-exempt employees' associations. The IRS, however, informally applies the 90 percent threshold that is part of the law in the context of voluntary employees' beneficiary associations.74 Thus, a health club available only to salaried employees qualified as an exempt employees' association.75 If, however, the membership criteria are too exclusive, the organization may not qualify as a local employees' association because it may “not really [be] an association of employees at all.”76

§ 19.4 FRATERNAL ORGANIZATIONS

There are two general types of tax-exempt fraternal organizations: fraternal beneficiary societies and domestic fraternal societies.

(a) Fraternal Beneficiary Societies

Federal income tax law provides tax exemption for fraternal beneficiary societies, orders, or associations operating under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system and providing for the payment of life, sickness, accident, or other benefits to the members of the society, order, or association or their dependents.77 These are, collectively, fraternal beneficiary societies.78

A federal court of appeals wrote that a fraternal beneficiary society is an organization “whose members have adopted the same, or a very similar, calling, avocation, or profession, or who are working in unison to accomplish some worthy object, and who for that reason have banded themselves together as an association or society to aid and assist one another and to promote the common cause,” and these entities have been formed for the purpose of “promoting the social, moral, and intellectual welfare of the members of such associations, and their families, as well as for advancing their interests in other ways and in other respects.”79 On the basis of this definition, an organization of employees of a railroad company was denied tax exemption as a fraternal beneficiary society.80

Thus, an organization will not be classified as fraternal in nature for these purposes where the only common bond between the majority of its members is the fact of membership in the organization.81 Moreover, mere recitation of common ties and objectives in an organization's governing instrument is insufficient; there must be specific activities in implementation of the appropriate purposes.82

As noted, a fraternal beneficiary organization, to qualify for tax exemption, must operate under the lodge system or for the exclusive benefit of members that operate in that manner. The phrase operating under the lodge system means that an organization is “carrying on its activities under a form of organization that comprises local branches, chartered by a parent organization and largely self-governing, called lodges, chapters, or the like.”83 Therefore, an organization without a parent organization or subordinate branches does not operate under the lodge system and cannot qualify for tax exemption as a fraternal beneficiary society.84 (Moreover, this type of a mutual, self-interest type of organization that may otherwise qualify as an exempt fraternal beneficiary society cannot qualify as an exempt social welfare organization.85) Further, the parent and local organizations must be active; mere provision for them in governing instruments is insufficient.86 Notwithstanding this requirement, however, an organization that did not operate under the lodge system was granted exemption as a fraternal beneficiary society because it operated exclusively for the benefit of the members of a fraternal beneficiary society that itself operated under the lodge system, by providing life, sickness, and accident benefits to the members of the society or their dependents.87

Also, as noted, a tax-exempt fraternal beneficiary society must have an established system for the payment to its members or their dependents of life, sickness, accident, or other benefits. While not every member of a society need be covered by the benefits program,88 this type of coverage must be extended to a substantial number of members.89 A common way benefits are provided by an exempt fraternal beneficiary society is by means of insurance programs.90 According to a federal court of appeals, the term benefits in this context is not confined to insurance for members against personal risks such as disability or death but may also extend to insuring them against property loss.91 This decision overruled a lower court's determination that permissible benefits include only those insuring members against mishap to the person.92 The IRS concluded that the term other benefits embraces the provision of legal expenses to defend members accused of criminal, civil, or administrative misconduct arising in the course of their employment (by a fraternal beneficiary society composed of law enforcement officers93) and the operation by a fraternal beneficiary society of an orphanage for children of deceased members.94 The IRS ruled that whole life insurance constitutes a life benefit that fraternal domestic societies can provide to members, even though the policies contain investment features such as cash surrender value and policy loans.95

Consequently, a tax-exempt fraternal beneficiary organization must both operate under the lodge system and provide for the payment of benefits to members or their dependents—although one of these features does not have to predominate over the other.96 Both of these features, however, must be present in substantial form; neither may be a sham.97

As noted, the tax-exempt fraternal beneficiary society must be operated for the exclusive benefit of its members. Where benefits provided to others are incidental to the accomplishment of the society's exempt purpose, however, the organization's exemption will not be jeopardized. For example, a society that conducted an insurance operation for its members in all of the states was found not to have lost its exemption because it participated in a state-sponsored reinsurance pool that protected participating insurers from excessive losses on major medical health and accident insurance, since any benefit derived by other insurers from participation in the pooling arrangement was “incidental to” the society's exempt purpose.98 Similarly, the reinsurance of its policies is a fraternal beneficiary society's exempt function.99

A federal district court held that fraternal organizations that are otherwise tax-exempt that practice racial discrimination as to entry into membership may not be exempt.100 This holding was based on the fact that, unlike organizations that are exempt as social clubs or voluntary employees' beneficiary associations,101 the passive investment income of fraternal beneficiary organizations is not taxed; this the court found to be a governmental benefit warranting invocation of the Fifth Amendment.

Individuals' gifts to a domestic fraternal beneficiary organization are deductible where the gift is to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children and animals.102

(b) Domestic Fraternal Societies

Federal income tax law provides tax exemption for domestic fraternal societies, orders, or associations, operating under the lodge system, whose net earnings are devoted exclusively to religious, charitable, scientific, literary, educational, and fraternal purposes, and that do not provide for the payment of life, sickness, accident, or other benefits to their members.103 These are, collectively, domestic fraternal societies.

An organization not providing these benefits but otherwise qualifying as a fraternal beneficiary society104 qualifies as a tax-exempt domestic fraternal society. Thus, for example, a domestic fraternal beneficiary society of farmers, which met the fraternal beneficiary society rules except that it did not provide for the payment of the requisite benefits, although it did make its members eligible for favorable insurance rates, was denied classification as an exempt fraternal beneficiary society and was ruled to be an exempt domestic fraternal society.105 A social welfare organization,106 however, does not qualify for tax exemption under these rules.107

A domestic fraternal society meeting these basic requirements was organized to provide a fraternal framework for social contact among its members who were interested in the use of and the philosophy behind a method used in attempting to divine the future. The net income of the organization was used to provide instruction on the use of the method, supply information on the method to the public, and maintain a reference library—all charitable and educational uses. The IRS ruled that the organization qualified for tax exemption under these rules.108

The IRS ruled that an organization formed by a local lodge of a fraternal beneficiary society, both tax-exempt as domestic fraternal societies, to carry on the activities of the society in a particular geographical area, was itself exempt as a domestic fraternal society.109 Because the organization was chartered and supervised by the local lodge and was subject to the laws and edicts of the parent society, it was deemed to function as “part of the lodge system” of the fraternal society and hence qualify for exemption.

The IRS also ruled that an organization that did not conduct any fraternal activities and did not operate under the lodge system, but operated exclusively for the benefit of the members of certain related domestic fraternal societies operating under the lodge system, could not qualify as a tax-exempt domestic fraternal society.110 The rationale for this denial of exemption was that the tax law requirements for domestic fraternal societies lack the language in the tax rules for fraternal beneficiary societies providing exemption for an organization operating for the benefit of the members of a tax-exempt fraternity (a provision enacted to cover the separately organized insurance branches of a fraternal beneficiary society). The IRS likewise ruled that an organization operating a public tavern and conducting gaming did not qualify for this exemption, in that the only common bond among the ostensible membership was the membership itself; there was no lodge system or rituals.111

§ 19.5 BENEVOLENT OR MUTUAL ORGANIZATIONS

Federal income tax law references tax-exempt benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone companies, or like organizations.112 These are, collectively, benevolent or mutual organizations. In general, 85 percent or more of the income of these entities must consist of amounts collected from members for the sole purpose of meeting losses and expenses.113 As discussed later in this section, there are some exceptions to this rule in the case of mutual or cooperative telephone companies.114

(a) Local Life Insurance Associations

Thus, one type of organization described in these rules is the benevolent life insurance association of a purely local character. These associations basically operate to provide life insurance coverage to their members, albeit at cost because of the requirement that income be collected solely for the purpose of meeting losses and expenses. Organizations like benevolent life insurance associations include burial and funeral benefit associations that provide benefits in cash,115 but not in the form of services and supplies (although the latter type of organization may qualify for exemption as a mutual insurance company),116 and an organization furnishing light and water to its members on a cooperative basis.117 IRS rulings and court decisions provide examples of organizations considered not like benevolent life insurance associations.118

The phrase of a purely local character means “confined to a particular community, place, or district, irrespective, however, of political subdivisions,”119 that is, a single identifiable locality.120 This requirement does not mean that members of an otherwise qualifying benevolent life insurance association must continually reside in the local area to retain membership; it only means that persons applying for membership in the association must reside in the local geographic area at the time of application.121 An organization is not local in character where its activities are limited only by the borders of a state,122 although state lines are not controlling as to what constitutes a single locality. One organization lost its tax exemption as a benevolent life insurance association by advertising in four states.123 Another organization was denied tax exemption because it operated in 14 counties, as did another conducting its affairs in 32 counties, including three separate metropolitan trade centers.124

(b) Mutual Organizations

The other type of organization exempt from federal income tax by virtue of these rules encompasses mutual ditch or irrigation companies, mutual or cooperative telephone companies, and similar organizations. The IRS issued criteria as to cooperative operation in 1972.125 These organizations are commonly mutual or cooperative electric companies and water companies.126 Tax exemption was accorded an organization established to protect certain riverbanks against erosion,127 an organization that provided and maintained a two-way radio system for its members,128 an electric generation and transmission cooperative that sold and serviced electric appliances,129 an electric utility that provided Internet service to its members on a cooperative basis,130 and a mutual telephone exchange that provided telecommunications/broadband services to its members.131 The membership of cooperative companies need not be restricted to ultimate consumers,132 nonmembers may be charged a higher rate for service than members,133 and a government agency may be a member of a cooperative.134 The IRS, ruling that a cooperative organization furnishing cable television service to its members qualified for tax exemption as a like organization under these rules, observed that this category of tax exemption is applicable “only to those mutual or cooperative organizations that are engaged in activities similar in nature to the benevolent life insurance or public utility type of service or business customarily conducted by the specified organizations.”135 IRS rulings also, by contrast, provide examples of organizations considered not like mutual and cooperative organizations.136

A mutual ditch company, created in 1874, qualified for this tax exemption, even though it did not satisfy all of the IRS criteria at the time. The IRS gave consideration to the “historical context” in which these entities were created, in that they were operating in the manner under review at the time legislation providing for their exemption was adopted.137 (These requirements were modified accordingly.) In another instance, a court held that a mutual company did not have to credit or distribute its net gains on a patronage basis to maintain its exemption.138

As noted,139 the general rule is that all organizations, to be exempt from tax under these rules, must obtain at least 85 percent of their income from amounts collected from members for the sole purpose of meeting losses and expenses.140 This requirement is applied on the basis of annual accounting periods141 and by taking into account only income actually received each year.142 Income from all sources is taken into account, including capital gains from the sale of assets143 and investments.144 Amounts received as gifts or contributions are not regarded as income.145 In one instance, the IRS ruled that, where an electric cooperative leased power facilities to a nonmember power company that in turn sold power to the cooperative, the entire rental income was income from a nonmember for purposes of the 85-percent-of-income requirement, rather than an offset against the cost of acquiring power.146 In another case, an organization in good faith failed to elect the installment method of treating gain from the sale of real property, with the result that the receipt of the entire gain caused less than 85 percent of its income to be derived from its members; over the government's objection, a court allowed the organization to amend its annual information return to make the election and thus preserve its tax exemption.147

By contrast, the IRS determined that the income derived by an exempt electric cooperative from the annual sale of its excess fuel to a commercial pipeline company that was not a member of the cooperative was not to be taken into account in determining compliance with the 85-percent-of-income requirement, in that the excess fuel was sold at cost and thus gross income was not derived from the sales.148 A federal district court held that the 85-percent-of-income requirement was satisfied where income from tenants of members of a mutual water and electric company was considered member income; the IRS took the position that the tenants did not have any participation in the management of the company and thus could not be regarded as members.149 Court decisions provide examples of organizations that failed to meet the 85-percent-of-income requirement.150

Some exceptions to this 85-percent-of-income requirement are applicable in the case of mutual or cooperative telephone companies. One of these exceptions is that the requirement does not apply to income received or accrued from a nonmember telephone company for the performance of communication services that involve members of the mutual or cooperative telephone company.151 These services pertain to the completion of long-distance calls to, from, or between members of the company.152 This exception was legislated to supplant a ruling by the IRS holding that a cooperative telephone company, providing only local telephone service to its members but obtaining connecting long-distance service by agreement with a nonmember company, could not adjust its gross income by offsetting income from long-distance tolls collected by both companies against expenses for services rendered by the nonmember company to the cooperative's members, but had to include as part of its gross income all of the member and nonmember income from the long-distance service to determine whether member income met the 85-percent-of-income requirement.153 This statutory revision reflects the view that the performance of the “call-completion services” is a related activity and that the “payments” from another telephone company for the services should not disqualify otherwise eligible mutual or cooperative telephone cooperatives from this tax-exempt status.154

Another exception is that this requirement does not apply to income received or accrued from qualified pole rentals.155 A qualified pole rental is any rental of a utility pole (or other structure used to support wires) if the pole (or other structure) is used by the telephone or electric company to support one or more wires needed to provide telephone or electric services to its members and is used pursuant to the rental to support one or more additional wires for use in connection with the transmission by wire of electricity or of telephone or other communications.156 For this purpose, the word rental includes any sale of the right to use the pole (or other structure).157

There are two other exceptions. One exception is for income received or accrued from the sale of display listings in a directory furnished to the members of the mutual or cooperative telephone company.158 The other exception is for income received or accrued from the prepayment of certain loans.159

Exceptions are also available in the case of an exempt mutual or cooperative electric company,160 in that the 85-percent-of-income requirement does not apply in connection with income received or accrued from (1) qualified pole rentals; (2) the provision or sale of electric energy transmission services or ancillary services if these services are provided on a nondiscriminatory open access basis under an open access transmission tariff approved or accepted by the Federal Energy Regulatory Commission (FERC)161 or under an independent transmission provider agreement approved or accepted by the FERC (other than income received or accrued directly or indirectly from a member); (3) the provision or sale of electric energy distribution services or ancillary services if the services are provided on a nondiscriminatory open-access basis to distribute electric energy not owned by the mutual or cooperative electric company (a) to end users who are served by distribution facilities not owned by the company or any of its members (other than income received or accrued directly or indirectly from a member) or (b) generated by a generation facility not owned or leased by the company or any of its members and which is directly connected to distribution facilities owned by the company or any of its members (other than income received or accrued directly or indirectly from a member); (4) any nuclear decommissioning transaction;162 or (5) any asset exchange or conversion transaction.163

The income of a wholly owned subsidiary of a tax-exempt cooperative is not included for purposes of determining whether the exempt cooperative satisfies the 85-percent-member-income test.164 (This rule assumes that the subsidiary is recognized as an entity validly separate from the cooperative.165) Any payments a cooperative receives from its wholly owned subsidiary must, however, be included in the calculation of the member income test.

The IRS is of the opinion that an organization that meets all of the requirements for tax exemption under these rules except for the 85-percent-of-income test cannot qualify for exemption as a social welfare organization.166 Also, an organization carrying on two functions, one qualifying under the social club rules167 and the other under these rules, cannot qualify for exemption under either category.168

§ 19.6 CEMETERY COMPANIES

The federal income tax law exemption rules reference cemetery companies that are owned and operated exclusively for the benefit of their members and that are not operated for profit.169 This tax exemption also extends to a corporation chartered solely for the purpose of the disposal of bodies by burial or cremation; it may not engage in any business not necessarily incident to that purpose. Thus, there are three types of cemetery companies that may gain exemption under these rules.

According to the courts, a tax-exempt cemetery company is generally one that owns a cemetery, sells lots therein for burial purposes, and maintains these and the unsold lots in a state of repair and upkeep appropriate to a final resting place.170 With respect to the membership category of cemetery companies, its members are those who are its “lot owners who hold such lots for bona fide burial purposes and not for purpose of resale.”171 A mutual cemetery company that also engages in charitable activities, such as the burial of paupers, is regarded as operating in conformity with this rule.172 According to a court, an exempt cemetery company need not serve exclusively public interests but may be a family cemetery organization.173 Under certain circumstances, a cemetery company may be exempt even though it has private preferred stockholders.174 This category of exemption applies only to organizations providing for the burial or cremation of the remains of human bodies—not pets.175

An organization receiving and administering funds for the perpetual care of a nonprofit cemetery itself qualifies as a tax-exempt cemetery company.176 A nonprofit organization that provides for the perpetual care of a burial area in a community may also become so classified, even though it is not associated with a nonprofit cemetery.177

One of the requirements for tax exemption as a cemetery company is that the company may not be permitted by its charter to engage in any business not necessarily incident to its tax-exempt (burial) purposes.178 The IRS construed this requirement to extend to activities, thereby ruling, for example, that operation by a cemetery company of a mortuary will deprive the company of this exemption.179 Under this approach, the IRS also held that operation of a crematorium would likewise adversely affect the exemption,180 although this determination was withdrawn in view of modification of the exemption statute.181 A cemetery company may, however, sell monuments, markers, vaults, and flowers solely for use in the cemetery, where the sales proceeds are used for maintenance of the cemetery.182

No part of the net earnings of a tax-exempt cemetery company may inure to the benefit of any private shareholder or individual.183 The private inurement doctrine frequently is involved in the case of a newly organized cemetery company, in relation to payments to and other relationships with the organizers. The reasoning of the IRS is that (1) where a cemetery company acquires land at an indeterminable price, to be paid for on the basis of a percentage of the proceeds from the sale of individual lots from the tract, the vendor of the land has a continuing interest in the land; (2) any appreciation in value, whether it is due to the state of the market generally or to the cemetery's own efforts in undertaking capital improvements and the like, will result in a benefit to the vendor of the land; and (3) continuing participation in the earnings of the cemetery company will also ordinarily result in receipt by the vendor of a total price substantially in excess of the reasonable value of the land at the time of its sale to the cemetery company.184

Perhaps the most important issue in relation to these rules is one that emerged as many American cemeteries became transformed from noncommercial operations (such as by religious institutions and municipal governments) to commercial businesses. As part of that process, profit-oriented enterprises sought favorable tax consequences from bootstrap sales of assets to ostensibly tax-exempt cemetery companies. When this issue was first litigated, the courts were highly tolerant of these transactions,185 thereby generating substantial criticism. Subsequently, the courts began to scrutinize the substance of these transactions more carefully, concluding that some cemetery companies were causing private inurement of net earnings by the creation of equity interests.186 Thus, the IRS ruled that a nonprofit cemetery company that acquired land from a for-profit cemetery company, under an agreement providing payment to the former owners on the basis of a percentage of the sales price of each cemetery lot sold, was not a tax-exempt cemetery company, because the transferors acquired an equity interest in the cemetery company, which constituted private inurement.187

Another issue concerns the ability of a commercial cemetery to sequester funds in a perpetual care trust fund that would qualify as a tax-exempt cemetery company. The matter seemed to have been resolved when a court, enunciating an adjunct theory,188 held in 1975 that this type of tax exemption was available by reason of the fact that the fund, which rendered services normally provided by the cemetery company, had the same tax status as the cemetery company itself.189 The IRS had espoused this rationale earlier.190 Congress the next year, however, enacted a law providing a deduction for amounts distributed by perpetual care trust funds to taxable cemetery companies for the care and maintenance of gravesites.191 To qualify under this provision, the fund must be a trust established pursuant to local law by a taxable cemetery for the care and maintenance of the cemetery.192

Contributions to tax-exempt cemetery companies are deductible for federal income tax purposes.193 The contributions must be voluntary and made to or for the use of a nonprofit cemetery, the funds of which are irrevocably dedicated to the care of the cemetery as a whole. Contributions made to a cemetery company for the perpetual care of a particular lot or crypt are, however, not deductible.194 While bequests or gifts to exempt cemetery companies are generally not deductible for federal estate or gift tax purposes,195 a court allowed the estate tax deduction for a bequest to a public nonprofit cemetery because of its ostensible characteristics as a charitable entity.196 This decision was, however, reversed.197

§ 19.7 CREDIT UNIONS

The federal income tax law exemption rules reference credit unions without capital stock organized and operated for mutual purposes and without profit.198 As noted, federal credit unions organized and operated in accordance with the Federal Credit Union Act are tax-exempt as instrumentalities of the United States.199 Credit unions otherwise exempt from federal income tax generally are those chartered under state law,200 although in one instance the IRS recognized tax exemption under this body of law for the benefit of an organization formed by a group at a U.S. military base in a foreign country.201 In addition to being chartered under a state credit union law, however, a credit union, to qualify under these rules, must, as noted, operate without profit and for the mutual benefit of its members.202

The first credit union in the United States had its tax exemption recognized in 1935; the government attempted to revoke its exempt status in 1966, contending it was operating in a commercial manner. Courts found that the organization did not lose its exempt credit union status because it offered services such as checking accounts and real estate loans, and that the members of the credit union in fact had a common bond even though this commonality was not reduced to a written requirement.203 A federal court of appeals used the occasion of its decision in this case to define a credit union as a “democratically controlled, cooperative, nonprofit society organized for the purpose of encouraging thrift and self-reliance among its members by creating a source of credit at a fair and reasonable rate of interest in order to improve the economic and social conditions of its members.”204

This controversy continues to fester, with banks and other financial institutions contending that tax exemption for some or all credit unions should be repealed, because they are directly competing with these institutions by functioning in a commercial manner.205

§ 19.8 MUTUAL RESERVE FUNDS

Tax exemption is extended to certain mutual organizations organized before September 1, 1957.206 Prior to 1951, all savings and loan associations were exempt from taxation, as were the nonprofit corporations that insured these savings institutions. In that year, the tax exemption for savings and loan associations was repealed because Congress determined that the purpose of the exemption, which was to afford savings institutions that had no capital stock the benefit of an exemption so that a surplus could be accumulated to provide the depositors with greater security, was no longer applicable because the savings and loan industry had developed to the point where the ratio of capital account to total deposits was comparable to that of commercial banks.

Tax exemption for the insurers of these associations was, however, continued for those that were organized prior to September 1, 1951.207 In 1960, Congress extended the expiration date to September 1, 1957, to accommodate a particular organization, inasmuch as that entity had been organized at a time when the savings and loan associations were essentially not taxed, due to generous bad debt reserve provisions.208

In 1962, a nonprofit corporation was established by a state legislature for the purpose of insuring the accounts of depositors in savings and loan associations doing business in the state that were not insured by the Federal Savings and Loan Insurance Corporation (FSLIC). Legislation to extend the termination date was not enacted, in part because Congress did not want to discriminate (again) in favor of these financial institutions.209 (This nonaction on the part of Congress was challenged, with the U.S. Supreme Court holding that Congress did not function in an arbitrary and unconstitutional manner in declining to extend the exemption beyond 1957.210) Similar legislation to extend the cutoff period was considered but not enacted. Thereafter, one of the organizations that would have been benefited by the legislation attempted to secure a judicial determination that it was entitled to a deduction from its income for an addition to its loss reserves, but this was rejected on the ground that the deduction would be the equivalent of exemption of the income from tax—a result Congress had rejected.211

It is the position of the IRS that the only way that organizations providing insurance for shares or deposits can qualify for tax exemption is to satisfy the rules as to this category of exemption.212 This position is predicated on the rule of statutory construction that a specific statutory provision must prevail over more general provisions.213 Thus, for example, the type of organization that cannot satisfy the requirements for exemption of these mutual organizations (for example, because it was organized after 1957) cannot be exempt as a business league.214 Therefore, generally, credit unions cannot be categorized as exempt business leagues.215

§ 19.9 INSURANCE COMPANIES AND ASSOCIATIONS

A property and casualty insurance company generally is a taxable organization.216 The taxable income of a property and casualty insurance company is determined as the sum of its underwriting income and its investment income (including gains and other income items), reduced by allowable deductions.217

Nonetheless, federal law provides tax exemption for insurance companies218 other than life insurance companies (including interinsurers and reciprocal underwriters) if the gross receipts of the company for the tax year involved do not exceed $600,000 and more than 50 percent of the receipts consists of premiums.219 For a mutual insurance company to be exempt, however, its gross receipts for the tax year cannot exceed $150,000, and more than 35 percent of the receipts220 must consist of premiums. Exemption is available for mutual insurance companies only if no employee of the company or member of the employee's family is an employee of another company that is exempt under these rules.221

For purposes of determining gross receipts, the gross receipts of all members of a controlled group of corporations of which the company is a part are taken into account.222 This controlled group rule223 takes into account the gross receipts of foreign and tax-exempt corporations.224

The IRS is issuing rulings that organizations failed to qualify as tax-exempt insurance companies because they did not function as an insurance company in the first instance.225

§ 19.10 CROP OPERATIONS FINANCE CORPORATIONS

Federal income tax law provides tax exemption for corporations organized by an exempt farmers' cooperative or association226 or members of these organizations, for the purpose of financing the ordinary crop operations of the members or other producers, and operated in conjunction with this type of an association.227 The crop operations finance corporation may retain its exemption even though it issues capital stock, where certain statutory conditions are met, or it accumulates and maintains a reasonable reserve. A tax-exempt crop financing corporation may own all the stock of a business corporation without jeopardizing its exempt status.228

A court denied tax exemption under these rules to a crop financing corporation that was organized by fruit growers who were members of tax-exempt cooperatives, because the growers were not engaging in their activities in the capacity of members of the cooperatives.229

§ 19.11 VETERANS' ORGANIZATIONS

(a) General Rules

Federal income tax law provides tax exemption for a post or organization of past or present members of the armed forces of the United States, or an auxiliary unit or society of these entities, or a trust or foundation operated for these entities, where (1) it is organized in the United States or any of its possessions; (2) at least 75 percent of its members are past or present members of the U.S. armed forces, and substantially all of the other members are individuals who are cadets or spouses, widows, or widowers of these past or present members or of cadets; and (3) there is no private inurement.230 The IRS, from time to time, issues rulings as to whether organizations adhere to these membership requirements.231 Indeed, in one instance, the IRS revoked the exemption of an ostensible veterans' organization because it did not have a bona fide membership.232 Some veterans' groups may have exemption as social welfare organizations.233

Presumably, a veterans' organization, to qualify for tax exemption under these rules, must operate exclusively to (1) promote the social welfare of a community; (2) assist disabled and needy veterans and members of the U.S. armed forces and their dependents, and the widows, widowers, and orphans of deceased veterans; (3) provide entertainment, care, and assistance to hospitalized veterans or members of the U.S. armed forces; (4) carry on programs to perpetuate the memory of deceased veterans and members of the armed forces and comfort their survivors; (5) conduct programs for religious, charitable, scientific, literary, or educational purposes; (6) sponsor or participate in activities of a patriotic nature; (7) provide insurance benefits for their members or dependents thereof, or both; and/or (8) provide social and recreational activities for their members.234

Income derived from members of these organizations attributable to payments for life, accident, or health insurance with respect to the members or their dependents, where the net profits are set aside for charitable purposes, is exempt from the unrelated business income tax.235 The enactment of this general income tax exemption thus provides a category of organizations entitled to use the unrelated business income tax exemption.

The IRS, from time to time, issues rulings as to whether organizations qualify as tax-exempt veterans' organizations.236

A contribution to a post or organization of war veterans, or an auxiliary unit or society of, or trust or foundation for, any of these posts or organizations is deductible as a charitable gift, if the donee is organized in the United States or any of its possessions and none of its net earnings inures to the benefit of any private shareholder or individual.237

There is no federal tax law restriction on the extent of lobbying by veterans' organizations. This feature was characterized by the U.S. Supreme Court as a “subsidy” enacted by Congress as part of the nation's long-standing policy of compensating veterans for their contributions by providing them with numerous advantages.238 Presumably tax exemption for their organizations is likewise a subsidy, for those who have “been obliged to drop their own affairs and take up the burdens of the nation”239 and have subjected themselves to the “mental and physical hazards as well as the economic and family detriments which are peculiar to military service and which do not exist in normal life.”240 “This policy [of subsidization],” wrote the Court, “has ‘always been deemed to be legitimate.'”241

(b) Pre-1880 Organizations

In 1982, Congress established another category of tax-exempt veterans' organizations, which is available for any association organized before 1880, more than 75 percent of the members of which are present or past members of the U.S. armed forces, and a principal purpose of which is to provide insurance and other benefits to veterans or their dependents.242

§ 19.12 FARMERS' COOPERATIVES

An eligible farmers' cooperative organization is exempt from federal income taxation.243 These farmers' cooperatives are farmers', fruit growers', or like associations organized and operated on a cooperative basis for the purpose of (1) marketing the products of members or other producers and returning to them the proceeds of sales, less the necessary marketing expenses, on the basis of either the quantity or the value of the products furnished by them, or (2) purchasing supplies and equipment for the use of members or other persons and turning over the supplies and equipment to them at actual cost plus necessary expenses.244 A farmers' cooperative may pay dividends on its capital stock in certain circumstances,245 permit proxy voting by its shareholders,246 and maintain a reasonable reserve.247 The earnings of cooperatives are generally taxed to them or their patrons; these rules give tax-exempt farmers' cooperatives certain advantages in computing their tax that are not available to other cooperatives.248

Farmers' cooperatives came into being because of the economic fact that a farmer “sells his products in a producers' market and makes his purchases in a retail market.”249 Thus, a farmers' marketing cooperative markets farmers' products at a price nearer retail price and makes its purchases at wholesale rather than retail. A farmers' purchasing cooperative sells supplies and equipment to its patrons at a price that leaves a balance after expenses. The cooperative's net earnings or savings are distributed to the patrons on the basis of the amount of business transacted by them, in the form of patronage dividends. Patronage dividends are the profits of a cooperative that are rebated to its patrons pursuant to a preexisting obligation of the cooperative to do so; the rebate must be made in an equitable fashion on the basis of the quantity or value of business done with the cooperative.

Farmers' cooperatives are associations of individuals such as farmers, fruit growers, livestock growers, and operators of dairies. Illustrations of these organizations include associations operated to facilitate the artificial breeding of members' livestock,250 acquire and apportion the beneficial use of land for the grazing of members' livestock,251 furnish its members a place to market their farm products,252 process and market poultry for members and other producers,253 market farm-raised fish,254 operate a grain elevator and feed yard and process soybeans,255 purchase raw materials for processing into completed products before their transfer to patrons,256 and produce and market range grasses.257 The term like association is limited to associations that market agricultural products or purchase supplies and equipment for those engaged in producing agricultural products.258 Thus, the admission to membership of a substantial number of nonproducers in an otherwise tax-exempt producers' cooperative would destroy the association's exemption.259 This, in turn, raises questions as to what constitutes a farm260 and a farmer.261

The specific rules in this area of the federal tax law do not define these terms. These terms are, however, referenced elsewhere in the federal tax law.262 On the basis of these other definitions, the IRS concluded that these terms do not apply to forestry, so that a federated cooperative marketing newsprint and its member cooperatives supplying pulpwood cut from timber grown by the patron members did not qualify as tax-exempt farmers' cooperatives.263

Examples of organizations denied this category of tax exemption as not being like a farmers' cooperative include an association that maintained its patrons' orchards and harvested their crops,264 an association that marketed lumber for the independent lumber-producing companies that controlled it,265 an association that marketed building materials on a cooperative basis,266 an association of advertising agencies267 and one of garbage collectors,268 and a cooperative that processed and marketed brine shrimp cysts where the harvesting of the cysts occurred in a publicly owned lake.269 An organization may be recognized as a cooperative association under state law and still be denied this form of exemption.270

Other requirements must be met in order to achieve this category of tax exemption, including the requirements that the association be organized and operated on a cooperative basis,271 there be bona fide members,272 and (where appropriate) there be producers.273 A federal court of appeals held that a person who merely stores items in the cooperative's facilities but does not market any products or purchase any supplies from the cooperative is not a producer.274

To be tax-exempt as a farmers' cooperative, an organization must establish that it does not have any taxable income for its own account other than that reflected in an authorized reserve or surplus.275 An organization engaged in both marketing farm products and purchasing supplies and equipment is exempt as this type of cooperative if it meets the tax law requirements as to each of its functions.276 An organization cannot be exempt under these rules if it nets losses between the marketing function and the purchasing function.277

With respect to a farmers' cooperative that issues stock, for the cooperative to be tax-exempt substantially all of the capital stock must be owned by producers who market their products or purchase their supplies and equipment through the cooperative.278 Also, the farmers' cooperative must be able to demonstrate that the ownership of its capital stock has been restricted to participating shareholders “as far as possible.”279 While the phrase substantially all is not defined in the statute or regulations, it is the view of the IRS that, for this rule to be satisfied, at least 85 percent of the capital stock must be held by producers;280 a court held that a 91 percent holding satisfied the requirement281 and that neither a 78 percent nor a 72 percent holding met the requirement.282

Subsequently, a court agreed with the IRS's 85-percent-of-stock test “in concept,” emphasizing that the “favorable tax treatment offered cooperatives is intended to benefit the member producers, not the cooperative as a business entity.”283 A federal court of appeals twice concluded that the test is reasonable.284 This appellate court wrote that, inasmuch as this form of tax exemption is available “only to those cooperatives in which participation in the direction and decision making process of the cooperative is strictly limited to patrons,” of “primary importance, therefore, is a shareholder's right to vote.”285 Consequently, the court of appeals enunciated the rule that “if a producer who sufficiently patronizes a cooperative during the tax year to become entitled to a share of capital stock is actually entitled to vote that share at the annual shareholders' meeting following the close of that tax year, that producer should be counted as both a shareholder and as a patron for the tax year in which the right to vote the share accrued,” while “if a shareholder, by failing to patronize a cooperative, ceases to be entitled to own a share and thereby actually loses the right to vote at the annual shareholders' meeting following the close of the tax year, that shareholder should not be counted as a shareholder or patron for the tax year in which the right to the share was lost.”286

The law provides that tax exemption “shall not be denied any such association because it has capital stock…if substantially all such stock…is owned by producers who market their products or purchase their supplies and equipment through the association.”287 It is, as noted, the position of the IRS that at least 85 percent of capital stock must be held by producers to satisfy the substantially all test.288 This requirement has been upheld by the courts, with the courts agreeing that, as noted, a person who merely stores items in the cooperative's storage facilities but does not market any products or purchase any supplies from the cooperative is not a producer.289

The IRS issued guidelines290 to determine whether a patron is a producer patron of a tax-exempt farmers' cooperative for purposes of applying these stock ownership requirements. These guidelines, which were subsequently abandoned, stated that the qualifying stockholders will be persons who, during the cooperative's tax year, market through the cooperative more than 50 percent of their products, who purchase from the cooperative more than 50 percent of their products, or who purchase from the cooperative more than 50 percent of their supplies and equipment of the type handled by the cooperative. A person who did not meet this 50 percent requirement could nonetheless be considered a producer for purposes of the ownership requirements if certain facts and circumstances, as stated in a 1977 IRS ruling, were present.291 A court, however, voided the 50-percent-patronage requirement,292 causing the IRS to revoke the test293 and the ruling.294 Thus, stock owned by persons who transact any amount of current and active patronage with an exempt cooperative during the cooperative's tax year will be considered stock that is counted toward the stock ownership requirement. Moreover, a person who does not transact any patronage during the cooperative's tax year may still be considered a producer for these purposes if, on the basis of all the facts and circumstances, it is determined that the person was unable to transact any patronage during the year because (1) the person encountered a crop failure and had nothing to market; (2) sickness, disability, death, or other hardship prevented the person from transacting any patronage; or (3) the cooperative deals in items (such as farm machinery) that are not normally purchased on an annual basis.295

Still other requirements concern the nature of permissible activities of these tax-exempt cooperatives. With respect to marketing cooperatives, questions have been raised as to what constitutes marketing.296 The IRS has a long-standing policy of allowing exempt farmers' cooperatives, in connection with their marketing function, to manufacture or otherwise change the basic form of their members' products, as illustrated by the exempt farmers' cooperative that operated a cannery and facilities for drying fruit and a cooperative that operated a textile mill, both of which marketed the processed or unprocessed products of their member growers and distributed the proceeds to them on the basis of the quantity of product furnished, less a charge to cover the cost of processing.297 Subsequently, this policy was illustrated by an IRS ruling allowing qualification as an exempt farmers' cooperative of a cooperative association that, in connection with its marketing function, processed its members' agricultural products into alcohol.298

As to the tax-exempt purchasing cooperative, the issue may be what is encompassed by the term supplies and equipment.299 Business done for or with the federal government is disregarded in determining the right to this category of exemption.300 Because hedging is an activity that is incidental to the marketing function of an exempt farmers' cooperative, it may establish a commodity trading division to serve as a commodity broker to facilitate hedging transactions for its marketing patrons without adversely affecting its exemption.301

Tax exemption for a farmers' cooperative may not be denied because it has capital stock, if the dividend rate of the stock is fixed at a rate not to exceed the legal rate of interest in the state of incorporation or 8 percent annually, whichever is greater, on the value of the consideration for which the stock was issued, and if substantially all of the stock (other than nonvoting preferred stock, the owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the organization on dissolution or otherwise, beyond the fixed dividends) is owned by producers who market their products or purchase their supplies and equipment through the organization.302 It is the position of the IRS that this substantially all test can be satisfied only where at least 85 percent of the capital stock (other than the nonvoting preferred stock) is held by producers.303 This test was upheld by a federal court of appeals.304

A tax-exempt farmers' cooperative may establish and control a subsidiary corporation as long as the activities of the subsidiary are activities that the cooperative itself might engage in as an integral part of its operations without adversely affecting its exempt status.305 For this reason, the IRS ruled that a cooperative may establish and control a domestic international sales corporation.306

A rule that has generated considerable attention is the limitation on the purchasing of supplies and equipment for nonmembers and nonproducers to 15 percent of the value of all of the tax-exempt cooperative's purchase of supplies and equipment.307 By contrast, a marketing cooperative will generally not qualify for this exemption if it markets the goods of nonproducers.308 There are exceptions to the limitation on marketing nonproducer goods, however, which may be categorized into sideline,309 ingredient,310 and emergency311 purchases from nonproducers.

Still another requisite for qualification for this category of tax exemption is that any excess of gross receipts over expenses and payments to patrons (termed earnings) must be returned to the patrons in proportion to the amount of business done for them. The income and expenses for each function (primarily marketing and purchasing) must be accounted for separately.312 In computing earnings, the exempt cooperative must experience only necessary expenses associated with marketing and purchasing (frequently undertaken in different departments or branches), rather than for items such as the purchase of life insurance for members.313 Nonpatronage income may be allocated to the appropriate department of the cooperative.314

Also, a tax-exempt farmers' cooperative must treat its nonmember patrons the same as member patrons with respect to patronage dividends. There are several cases where an association was denied tax exemption under these rules because of this type of discrimination,315 as well as a number of instances where inequality among patrons was deemed to not be present.316

A discussion of the circumstances under which a federated farmers' cooperative (an association whose membership includes tax-exempt farmers' cooperative associations) may qualify for this form of exemption was the subject of an IRS ruling.317 Two revenue procedures set forth methods acceptable for a federated cooperative and its members to establish exemption (involving the look-through principle)318 and setting forth the general requirements in this regard.319

The federal tax law provisions for cooperatives generally320 operate to treat these organizations more like a conduit than a separate taxable business enterprise. The primary reason for this treatment is to avoid penalizing (by taxing) a group of persons for collectivizing their marketing or purchasing efforts in order to take advantage of economies of scale. The conduit treatment is derived from the ability of a cooperative to deduct from its taxable income patronage dividends paid. (A farmers' cooperative generally may deduct patronage dividends to the full extent of its net income and may also deduct, to a limited extent, dividends on common stock.)

A tax-exempt cooperative may make purchases and/or market goods in several product lines and/or several geographic areas. Many cooperatives of this type will calculate net income on an aggregate basis, netting gains from profitable products or geographic areas with losses from unprofitable ones, and thus pay patronage dividends based on the net income so computed. The position of the IRS is that a cooperative may not net gains and losses from different operations in any manner it chooses and that netting is not permitted unless it is equitable under the circumstances.321

§ 19.13 SHIPOWNERS' PROTECTION AND INDEMNITY ASSOCIATIONS

The federal tax law provides that “[t]here shall not be included in gross income the receipts of shipowners' mutual protection and indemnity associations not organized for profit, and no part of the net earnings of which inures to the benefit of any private shareholder; but such corporations shall be subject as other persons to the tax on their taxable income from interest, dividends, and rents.”322 This law, in essence, provides federal income tax exemption for the shipowners' protection and indemnity association.

The return of excess dues by a fishing vessel owners' association to its members was ruled by the IRS to not be inurement of earnings to the members; therefore, the dues paid to the association were not includable in its gross income.323 The amount paid by a member of a tax-exempt association of this type to its reserve fund to provide certain insurance protection was deemed deductible.324

§ 19.14 HOMEOWNERS' ASSOCIATIONS

For decades, tax-exempt homeowners' associations were treated as a form of exempt social welfare organization.325 It is common for these associations to be formed as part of the development of a real estate subdivision, a condominium project, or a cooperative housing project. These associations enable their members (usually individual homeowners) to act together in managing, maintaining, and improving areas where they live. The associations' purposes include the administration and enforcement of covenants for preserving the physical appearance of the development, the ownership and management of common areas (for example, sidewalks and parks), and the exterior maintenance of property owned by the members.

Originally, as noted, the IRS regarded homeowners' associations as tax-exempt social welfare organizations.326 The agency, however, concerned that the requisite community was not being served, issued a countervailing ruling in 1974.327 Most homeowners' associations found it difficult to meet the requirements of this policy change. The IRS also ruled that condominium management associations did not qualify for this category of exemption.328

Congress responded to this dilemma with an elective tax exemption provision for most of these associations.329 This provision is in the mode of the tax treatment of exempt social clubs330 and political organizations,331 in that only exempt function income escapes unrelated business income taxation.

To qualify as a tax-exempt homeowners' association, an organization must be a condominium332 management association or a residential real estate management association.333 Generally, membership in these associations is confined to the developers and the owners of the units, residences, or lots.334 Membership in either type of association is normally required as a condition of this ownership.335

A tax-exempt homeowners' association must meet certain requirements: (1) It must be organized and operated primarily to provide for the acquisition, construction, management, maintenance, and care of association property;336 (2) it must pass an income test, by which at least 60 percent of the association's gross income for a tax year consists of exempt function income;337 (3) it must pass an expenditure test, by which at least 90 percent of the annual expenditures of the association must be to acquire, construct, manage, maintain, and care for or improve its property;338 (4) no part of the association's net earnings may inure to the benefit of any private shareholder or individual;339 and (5) substantially all of the dwelling units in the condominium project or lots and buildings in a subdivision, development, or similar area must be used by individuals for residences.340 The acts of acquiring, constructing, or providing management, maintenance, and care of association property, and of rebating excess membership dues, fees, or assessments, do not constitute private inurement. Association property means not only property held by it but also property commonly held by its members, property within the association privately held by the members, and property owned by a governmental unit and used for the benefit of residents of the unit.341

In this context, exempt function income means any amount received as membership dues, fees, or assessments from persons who are members of the association, namely, owners of condominium housing units (in the case of a condominium management association) or owners of real property (in the case of a residential real estate management association).342 Taxable income includes investment income and payments by nonmembers for the use of the association's facilities, subject to a specific $100 deduction and deductions directly connected with the production of gross income (other than exempt function income).343 The taxable income of a qualified homeowners' association is taxable at the rate of 21 percent.344

The House version of the Tax Reform Act of 1969 would have applied the foregoing rules to cooperative housing corporations,345 but the 1969 act in its final form followed the Senate bill in not allowing the exemption for these corporations.346 Instead, the act clarified existing law to ensure that a cooperative housing corporation is entitled to a deduction for depreciation347 with respect to property it leases to a tenant-stockholder even though the tenant-stockholder may be entitled to depreciate his or her stock in the corporation to the extent that the stock is related to a proprietary lease or right of tenancy that is used by the tenant-stockholder in a trade or business or for the production of income.348

§ 19.15 HIGH-RISK INDIVIDUALS' HEALTH CARE COVERAGE ORGANIZATIONS

Tax-exempt status is available for a membership organization established by a state exclusively to provide coverage for medical care349 on a nonprofit basis to high-risk individuals through insurance issued by the organization or a health maintenance organization under an arrangement with the organization.350

The individuals, who must be residents of the state, must be—by reason of the existence or history of a medical condition—unable to acquire medical care coverage for the medical condition through insurance or from a health maintenance organization, or able to acquire the coverage only at a rate that is substantially in excess of the rate for the coverage through the membership organization.351 The composition of the membership in the organization must be specified by the state.352 For example, a state can mandate that all organizations that are subject to insurance regulation by the state must be members of the organization.353 The private inurement doctrine354 is applicable to this type of organization.355

§ 19.16 WORKERS' COMPENSATION REINSURANCE ORGANIZATIONS

Tax-exempt status under federal law is available for a membership organization established before June 1, 1996, by a state exclusively to reimburse its members for losses arising under workers' compensation acts.356

Tax exemption is also available to any organization (including a mutual insurance company) if it is created by state law and is organized and operated under state law exclusively to (1) provide workers' compensation insurance that is required by state law or with respect to which state law provides significant disincentives if the insurance is not purchased by an employer, and (2) provide related coverage that is incidental to workers' compensation insurance.357

(a) State-Sponsored Organizations

The state must require that the membership of the organization consist of all persons who issue insurance covering workers' compensation losses in the state, and all persons and governmental entities that self-insure against these losses. The organization must “operate as a nonprofit organization” by returning surplus income to its members or workers' compensation policyholders on a periodic basis and by reducing initial premiums in anticipation of investment income.358

(b) Certain Insurance Companies

The organization must provide workers' compensation insurance to any employer in the state (for employees in the state or temporarily assigned out of state) that seeks the insurance and meets other reasonable requirements.359 The state must make a financial commitment with respect to the organization, either by extending the full faith and credit of the state to the initial debt of the organization or by providing the organization its initial operating capital.360 The assets of the organization must revert to the state on dissolution, unless state law does not permit the dissolution of the organization.361 The majority of the board of directors or oversight body of the organization must be appointed by the chief executive officer or other executive branch official of the state, by the state legislature, or by both.362

§ 19.17 NATIONAL RAILROAD RETIREMENT INVESTMENT TRUST

Federal income tax law provides tax exemption for the National Railroad Retirement Investment Trust, which was established by enactment of the Railroad Retirement Act of 1974.363

§ 19.18 QUALIFIED HEALTH INSURANCE ISSUERS

Federal income tax law provides tax exemption for qualified nonprofit health insurance issuers.364 In general, this type of organization is one that has received a loan or grant under the Consumer Operated and Oriented Plan (CO-OP) program365 but only with respect to periods for which the issuer is in compliance with the requirements of that program366 and any agreement with respect to the loan or grant. In addition, to be exempt, the issuer must seek recognition of exemption from the IRS,367 be in compliance with the private inurement doctrine,368 not engage in legislative activities to a substantial extent,369 and not participate in or intervene in political campaigns on behalf of or in opposition to candidates for public office.370

The non–tax law aspects of the CO-OP program are administered by the Department of Health and Human Services, which has published a rule to implement the program.371 There is to be at least one CO-OP in every state in order to expand the number of health plans available in Affordable Insurance Exchanges. There may be funding for multiple CO-OPs in a state, if there is sufficient funding to foster the creation of a CO-OP in each state; $3.8 billion has been authorized for this program.

The executive summary of the rules states that individuals and small businesses will be able to purchase health insurance through the Exchanges (which the summary terms “state-based competitive marketplaces”). The summary states that the Exchanges will “offer Americans competition, choice, and clout…. Insurance companies will compete for business on a level playing field, driving down costs” and “[c]onsumers will have a choice of health plans to fit their needs.”

These rules set forth eligibility standards for the CO-OP program, establish terms for the loans, and provide basic standards that organizations must meet to participate in the program and become a CO-OP. A CO-OP will be expected to implement policies and procedures to ensure member control (by a majority) of the organization. The members will select a board of directors in a contested election. Each director must meet ethical, conflict-of-interest, and disclosure standards, “protecting against insurance industry involvement and interference.” A CO-OP will have to “operate with a strong consumer focus, including timeliness, responsiveness, and accountability to members.” These entities must “demonstrate financial viability and the ability to meet all other statutory, legal, or other requirements.” An organization that was an insurance issuer on July 16, 2009, is ineligible for this classification.

§ 19.19 QUALIFIED TUITION PROGRAMS

Tax-exempt status is accorded certain types of qualified tuition programs.372 States may be the sponsors of college savings plans or may offer prepaid tuition plans. Eligible private institutions of higher education may offer the second type of qualified tuition programs.

(a) State-Sponsored Programs

State-sponsored tuition programs include programs established and maintained by a state (or an agency or instrumentality of a state) under which individuals may (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to the waiver or payment of qualified higher education expenses of the beneficiary or (2) make contributions to an account that is established for the sole purpose of meeting qualified higher education expenses of the designated beneficiary of the account.373 The phrase qualified higher education expenses means tuition, fees, and outlays for books, supplies, and equipment (including computer or peripheral equipment, computer software, and Internet access and related services) required for the enrollment or attendance at a college, university, or certain vocational schools.374

This type of program must provide that purchases or contributions may be made only in cash.375 Contributors and beneficiaries are not allowed to direct any investments made on their behalf by the program.376 The program is required to maintain a separate accounting for each designated beneficiary.377 A specified individual must be designated as the beneficiary at the commencement of participation in a qualified tuition program (that is, when contributions are first made to purchase an interest in the program), unless interests in the program are purchased by a state or local government or a tax-exempt charitable organization as part of a scholarship program operated by the government or charity under which beneficiaries to be named in the future will receive the interests as scholarships.378 A transfer of credits (or other amounts) from one account benefiting one designated beneficiary to another account benefiting a different beneficiary is considered a distribution (as is a change in the designated beneficiary of an interest in a qualified tuition program) unless the beneficiaries are members of the same family.379

Earnings on an account may be refunded to a contributor or beneficiary, but the state or instrumentality must impose a more than de minimis monetary penalty unless the refund is used for qualified higher education expenses of the beneficiary, made on account of the death or disability of the beneficiary, or made on account of a scholarship received by the designated beneficiary to the extent the amount refunded does not exceed the amount of the scholarship used for higher education expenses.380 These programs may not allow any interest in the program or any portion of it to be used as security for a loan.381

A program cannot be treated as a qualified tuition program unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.382

(b) Educational Institution–Sponsored Programs

Pursuant to this body of law as originally enacted, these tuition programs could be established and maintained only by a state or an agency or instrumentality of a state. Prepaid tuition plans, however, can be established and maintained by eligible educational institutions, including private institutions.383 In order for a tuition program of a private eligible educational institution to be a qualified tuition program, assets of the program must be held in a qualified trust.384 This is a trust that is organized in the United States for the exclusive benefit of designated beneficiaries, where its trustee is a bank or other person or entity that demonstrates that it will administer the trust in accordance with certain requirements; the assets of the trust may not be commingled with other property except in a common trust fund or common investment fund.385 The tuition program of a private educational institution must receive a determination from the IRS that the program meets these requirements.386

(c) Other Rules

Amounts from qualified tuition plans can be distributed, up to $10,000, for tuition incurred during a tax year in connection with the enrollment or attendance of a designated beneficiary at a public, private, or religious elementary or secondary school.387

In general, no amount is includable in the gross income of a designated beneficiary under a qualified tuition program or a contributor to the program on behalf of a designated beneficiary with respect to any distribution or earnings under the program.388 A contribution to a qualified tuition program on behalf of a designated beneficiary is not a taxable gift.389 A distribution under a qualified tuition program is includable in the gross income of the distributee in the manner as prescribed under the annuity taxation rules390 to the extent not excluded from gross income under other federal tax law.391 Thus, if matching-grant amounts are distributed to or on behalf of a beneficiary as part of a qualified tuition program, the matching grant amounts still may be excluded from the gross income of the beneficiary as a scholarship.392

An exclusion from gross income is provided, however, for distributions from qualified state tuition programs to the extent that the distribution is used to pay for qualified higher education expenses. This exclusion from gross income was extended to distribution from qualified tuition programs established and maintained by an entity other than a state (or agency or instrumentality of a state).393

In the case of a designated beneficiary who receives a refund of any higher education expenses, any distribution that was used to pay the refunded expenses is not subject to tax if the beneficiary recontributes the refunded amount to the qualified tuition program within 60 days of receiving the refund, only to the extent that the recontribution is not in excess of the refund.394

Amounts contributed to a qualified tuition program (and earnings on those amounts) are included in the contributor's estate for federal estate tax purposes in the event that the contributor dies before the amounts are distributed under the program.395

The IRS issues private letter rulings on an ongoing basis as to plans that do or do not qualify as qualified tuition programs.396 The IRS approved a prepaid tuition plan structured for participation by private colleges and universities throughout the United States; it is organized as a limited liability company,397 with the institutions functioning as members pursuant to a consortium agreement.398 The IRS subsequently ruled that, when an institution of higher education receives a distribution from the plan of proceeds reflecting a “tuition certificate” in consideration for the provision of educational services to a qualified beneficiary, the proceeds will not be unrelated business income399 to the institution.400

§ 19.20 ABLE PROGRAMS

One of the newest categories of tax-exempt organization, modeled somewhat on the state-sponsored qualified tuition program,401 is the ABLE Program.402 This is a program established and maintained by a state, or agency or instrumentality of a state, under which a person may make contributions for a tax year, for the benefit of an eligible individual, to an ABLE account that is established for the purpose of meeting the qualified disability expenses of the designated beneficiary of the account.403 A designated beneficiary may have only one ABLE account.404 A beneficiary is not required to be a resident of the state that established the account. An interest in an ABLE program may not be used as security for a loan.405

An eligible individual is an individual entitled to benefits based on blindness or disability under the Social Security Act, where the blindness or disability occurred before the date on which the individual attained age 26, or a disability certification406 with respect to the individual is filed with the IRS.407 A designated beneficiary in connection with an ABLE account established under a qualified ABLE program is the eligible individual who established an ABLE account and is the owner of the account.408 The term disability expenses means expenses related to the eligible individual's blindness or disability that are made for the benefit of an eligible individual who is the designated beneficiary, including expenses for education, housing, transportation, health, financial management services, and legal fees.409

Contributions to an ABLE account must be in the form of money.410 There is an annual per account funding limit equal to the annual gift tax exclusion.411 A qualified ABLE program must provide a separate accounting for each designated beneficiary.412 A beneficiary may, directly or indirectly, direct the investment of contributions to the program, and earnings thereon, no more than two times in any calendar year.413 Distributions from a qualified program are not includible in the beneficiary's gross income to the extent they do not exceed the amount of qualified disability expenses.414

Each officer or employee having control of the qualified ABLE program or their designee must make reports regarding the program to the IRS and to designated beneficiaries with respect to matters such as contributions, distributions, and the return of excess contributions.415 For research purposes, the IRS must make available to the public reports containing aggregate information, by diagnosis and other relevant characteristics, on contributions and distributions from qualified ABLE programs.416

§ 19.21 PROFESSIONAL SPORTS LEAGUES

Tax exemption is available for professional football leagues.417 This category of exemption exists to forestall a claim that an exempt football league's pension plan is a means of conferring private inurement to individuals.418 This addition to the law was enacted as part of a larger legislative package that facilitated a merger that created an “industry-wide” professional football league. This category of exemption has been extended to other categories of professional sports leagues.

§ 19.22 GOVERNMENTAL AND QUASI-GOVERNMENTAL ENTITIES

The concept of federal tax exemption extends to a variety of governmental and quasi-governmental entities. These entities range from the states to nonprofit organizations that have a unique relationship with one or more governmental departments, agencies, and/or instrumentalities. There are essentially four ways an organization can achieve tax exemption or its equivalent in this context: (1) by constituting a state or political subdivision of a state; (2) by reason of having its income excluded from federal income taxation, when the income is derived from the exercise of an essential governmental function and the income accrues to a state or a political subdivision of the state; (3) by reason of being an integral part of a state, city, or similar governmental entity; or (4) by classification as an instrumentality of a state.

(a) Intergovernmental Immunity

The states, the District of Columbia, and U.S. territories are, in a loose sense of the term, tax-exempt entities. This tax exemption does not derive from any specific provision in the federal tax statutory law, but rather is a consequence of the doctrine of intergovernmental immunity—the doctrine implicit in the U.S. Constitution that the federal government will not tax the states.

This tax exemption extends not only to the states as such but to component parts thereof: political subdivisions, instrumentalities, agencies, and the like. The general principle is that the “United States may not tax instrumentalities which a state may employ in the discharge of her essential governmental duties.”419

The constitutional law basis for this tax exemption is not unlimited; however, its scope has not been delineated. The position of the U.S. Supreme Court initially was that all “governmental” functions of a state were encompassed by the exemption and that only its “proprietary” activities could be taxed by the federal government.420 Subsequently, the Court ruled that Congress could tax any “source of revenue by whomsoever earned and not uniquely capable of being earned only by a State,” even though the tax “incidence falls also on a State.”421 Apparently, the uniquely capable test remains the standard.422

The IRS, though it had for some time been regularly issuing private letter rulings concerning organizations that do or do not qualify for tax exemption by reason of the intergovernmental immunity doctrine,423 has ceased doing so.424

(b) Income Exclusion Rule

Notwithstanding the existence of this constitutional law tax exemption, Congress in 1913 enacted a provision providing a statutory immunity from taxation in the form of an exclusion from gross income. In its relevant portions,425 this statutory immunity is available only for entities that exercise an essential governmental function, and where the income thereby generated accrues to a state or political subdivision of the state. The IRS has long maintained that, by enacting the statutory immunity, “Congress did not desire in any way to restrict a State's participation in enterprises which might be useful in carrying out those projects desirable from the standpoint of the State Government.”426 Thus, the IRS ruled that the income of an investment fund established by a state was excludable from gross income; even though more than one governmental entity participated in the fund, the requisite accrual was found.427 Likewise, the IRS held that the income of an organization formed, operated, and funded by one or more political subdivisions (or by a state and one or more political subdivisions) to pool their risks in lieu of purchasing insurance to cover their public liability, workers' compensation, or employees' health obligations was excluded from gross income, as long as private interests did not, except for incidental benefits to employees of the participating state and political subdivisions, participate in or benefit from the organization.428 Similarly, this status was accorded an integrated faculty group practice corporation, formed to deliver high-quality, cost-effective patient care, established by a state university and the state's teaching hospital facility to provide a more strategically, financially, and clinically integrated enterprise.429

As to the type of entity that can avail itself of the broader immunity, it appears that only a state or political subdivision of a state, and not a private corporation, may invoke this immunity, because only the former can perform an essential governmental function. The courts have reached this conclusion, albeit for a different reason—namely, on the theory that the interposition of a corporation operates to prevent the requisite accrual from taking place.430 These analyses, however, leave unanswered the question of whether a corporation, such as a nonprofit one, can qualify for federal tax purposes as a political subdivision. The answer to this question has several ramifications, not the least of which is the ability of this type of entity to incur debt the interest on which is excludable from the recipient's gross income.431

In its narrowest sense, the term political subdivision connotes a jurisdictional or geographical component of a state, such as counties, cities, and sewer districts. Perhaps a more realistic definition of the term was provided by a federal court of appeals: The term political subdivision is broad and comprehensive, and denotes any division of a state made by the proper authorities thereof, acting within their constitutional powers, for the purpose of carrying out a portion of these functions of the state that by long usage and the inherent necessities of government have always been regarded as public.432

The term political subdivision has been defined as denoting a division of a state or local governmental unit that is a municipal corporation or that has been delegated the right to exercise part of the sovereign power of the unit.433 Under that definition, a political subdivision of a state or local governmental unit may or may not include special assessment districts so created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school, harbor, port improvement, and similar districts and divisions of these units.434 The three generally acknowledged sovereign powers are the power to tax, the power of eminent domain, and the police power.435

An entity may nonetheless be a division of a state without being a political subdivision. In that determination, consideration is given to factors that indicate that it will be a governmental rather than a private entity. These factors include its public purposes and attributes, whether its assets or income will inure to private interests,436 and the degree of control by the state.437 For example, the IRS ruled that an association formed by state statute to fund no-fault compensation for certain medical procedures was not a political subdivision of the state because it was not delegated the right to exercise a sovereign power, yet was a division of the state because it was established for a “public purpose,” its plan was funded by the state, it was granted sovereign immunity, its board is appointed by the state's chief financial officer, and it is operated in accordance with a plan of operation approved by a department of the state.438 The IRS also ruled that an employee benefit fund, although it could not qualify for exemption as a social welfare organization (in part because it was not serving a community439), was an instrumentality of the state involved and its income derived from an essential governmental function, so that its income is excludible under this rule.440

These considerations take on greater coloration when applied in the context of organizations that are state-owned but have charitable organization counterparts, such as state schools, colleges, universities, hospitals, and libraries.441 Certainly these entities are generally exempt from tax; the tax exemption derives in part from the constitutional immunity accorded the revenue of integral units of states. The exemption may likewise be traced to this statutory immunity. Presumably, there is the requisite accrual; for example, the provision of education has been regarded as the exercise of an essential governmental function.442 By contrast, courts have held that, under certain circumstances, operation of a hospital is not an essential governmental function.443 There is no case that specifically holds that, for example, a state college or university is a political subdivision, although this conclusion may be reached by a process of negative implication.444 The IRS, however, asserted that a state university cannot qualify as a political subdivision because it fails to possess a substantial right to exercise the power to tax, the power of eminent domain, or the police power.445

The IRS issues private letter rulings on an ongoing basis as to organizations that do or do not qualify as political subdivisions.446

(c) Integral Parts of States

A third way for an organization to qualify for this type of tax-exempt status is to be an integral part of a state (or political subdivision of a state). Generally, income earned by an enterprise that is an integral part of a state (or political subdivision thereof) is not subject to federal income taxation in the absence of specific statutory authorization to tax that income. If an enterprise is deemed to be an integral part of a state (or political subdivision), that enterprise will not be treated as a separate entity for federal tax purposes. By contrast, when a state conducts an enterprise through a separate entity, the income of the entity may be excluded from gross income.447

The IRS ruled that a trust fund created by a state supreme court to hold amounts advanced to lawyers in the state by their clients was an integral part of the state.448 This ruling was based on the state court's creation of the fund and its ability to select and remove the fund's governing body, to control the fund's investments and expenditures, to monitor the fund's daily operation, and to abolish the fund.

In one case, a state formed a corporation to insure the customer accounts of state-chartered savings and loan associations. Under this entity's charter, the full faith and credit of the state was not pledged for the organization's operations. State officials selected only 3 of 11 directors. The trial court rejected the organization's claim of intergovernmental tax immunity because the state did not make any financial contribution to the entity and did not have a present interest in its income. Thus, it was held that the imposition of the federal income tax on this corporation would not burden the state. The U.S. Supreme Court, though it reversed the decision on other grounds, agreed with the lower court's analysis on this point.449

The rules as to whether an entity is a political subdivision, instrumentality, agency, or integral part of a state continue to become more inconsistent and confusing. A court of appeals evaluated the tax status of an organization established to receive advance payments of college tuition, invest the money, and ultimately make disbursements under a program that allows its beneficiaries to attend any of the state's public colleges and universities without further tuition cost. The appellate court, having found that the entity was an instrumentality of the state, concluded that it was also an integral part of the state, so that its investment income was not taxable.450 The court ruled that a state or political subdivision of a state is not a corporation for purposes of the federal corporate income tax.451 It wrote that the “broad constitutional immunity from federal taxation once thought to be enjoyed by states and their instrumentalities has been severely eroded by the passage of time.”452 As to the law concerning the exclusion from taxation of income accruing to the state, the court characterized the rules as “very old and somewhat cryptic.”453

An organization created in the aftermath of a major hurricane as a vehicle for property and casualty insurers to share insurance coverage for property owners unable to obtain coverage in the “voluntary” market was held to be an integral part of a state.454 The court considered the factors used in this context by the IRS to determine instrumentality status,455 and concluded that the organization “bears a much closer resemblance to being an integral part of the state than to being a private insurance company.”456 The court also noted the state's financial commitment to the enterprise. Overall, wrote the court, the “determinative test with respect to the financial arrangements” regarding this organization is “whether it is the [s]tate or the participating private insurance companies who ultimately may profit from its operations, and the undisputed evidence is that only the state may receive any financial benefit.”457

The check-the-box regulations support the position that an entity that is recognized as separate from a state (or political subdivision) for local law purposes may nonetheless be an integral part of that state (or political subdivision). These regulations state: “An entity formed under local law is not always recognized as a separate entity for federal tax purposes. For example, an organization wholly owned by a State is not recognized as a separate entity for federal tax purposes if it is an integral part of the State.”458

The policy of the IRS, in determining whether an enterprise is an integral part of a state, is to consider all the facts and circumstances, including the state's degree of control over the enterprise and the state's financial commitment to the enterprise. For example, a multiemployer insurance program established by a state, when the participants include the state and its political subdivisions, was held to be an integral part of the state because the state exerted significant control and influence over the program and the state made a substantial financial commitment to the program.459 Also, an entity established by legislation to educate the citizens of a state about a historical event was found to be an integral part of the state, because the state exerted significant control over and made a substantial financial commitment to the entity.460 Likewise, a nonprofit public corporation formed by a state legislature for the purpose of insuring the existence of an orderly market of types of insurance offered by two plans for state residents and businesses was held to be an integral part of the state because the entity was to be supervised and controlled by the state and the state was to exercise a significant degree of control over it.461

(d) State Instrumentalities

The IRS rarely issues rulings that an entity is tax-exempt by reason of being an instrumentality of a state.462 An entity can, however, have its income excluded from taxation because it exercises an essential governmental function and its income accrues to a state or political subdivision,463 and be classified as an instrumentality of a state for other purposes.464

The IRS takes the following factors into account in determining whether an entity is an instrumentality of one or more governmental units: whether the organization is used for a governmental purpose and performs a governmental function; whether performance of its function is on behalf of one or more states or political subdivisions; whether any private interests are involved or whether the states or political subdivisions have the power and interests of an owner; whether control and supervision of the organization are vested in a public authority or authorities; whether express or implied statutory or other authority is necessary for the creation and/or use of the organization, and whether this authority exists; and the degree of financial autonomy of the entity and the source of its operating expenses.465 The IRS used these criteria in ruling, for example, that a charter school did not qualify as a state instrumentality.466

(e) Related Considerations

Some governmental entities are tax-exempt because they have a clear counterpart in the conventional realm of tax-exempt organizations.467 Some organizations are exempt because they are instrumentalities of the federal government.468 A governmental unit can qualify as a public charity.469 Exempt organizations can be excused from the requirement of filing an annual information return if they can be classified as an affiliate of a governmental unit.470

This aspect of the law of tax-exempt organizations has become somewhat of a jumble, if only because of the variety and inconsistency of the nomenclature: a state, city, and similar governmental entity; political subdivision; governmental department, agency, and/or instrumentality; clear counterpart entity; governmental unit; and affiliate of a governmental unit.

§ 19.23 NATIVE AMERICAN TRIBES

Native American tribes generally are not taxable entities for federal income tax purposes.471 These tribes generally have governing instruments, a council, operational rules, a formal membership arrangement, and various governmental powers, such as the rights to levy taxes, enact ordinances, and maintain a police force. The assets of an Indian tribe are owned by the tribe as a community (rather than by the individual members), and the right to participate in the enjoyment of tribal property depends on continuing membership in the tribe.472

Any income earned by an unincorporated tribe (including that from gambling and other commercial business activities), regardless of the location of the business activities that produced the income (that is, whether on or off the tribe's reservation), is not subject to federal income tax.473 Tribal income not otherwise exempt from federal income tax is includable in the gross income of the Indian tribal member when distributed to, or constructively received by, the member.474

Native American tribal corporations organized under the Indian Reorganization Act of 1934475 share the same tax status as the Native American tribe and are not taxable on income from activities carried on within the boundaries of the reservation.476 Thus, any income earned by this type of corporation, regardless of the location of the business activities that produced the income, is not subject to federal income tax.477 Tribal corporations organized under the Oklahoma Welfare Act478 have the same tax status.479

A corporation organized by a Native American tribe under state law is not the same as a Native American tribal corporation organized under the Indian Reorganization Act and does not share the same tax status as the Native American tribe for federal income tax purposes. This type of corporation is subject to federal income tax on any income earned, regardless of the location of the income-producing activities.480

§ 19.24 OTHER CATEGORIES OF TAX-EXEMPT ORGANIZATIONS

There are several other types of organizations or entities that may be regarded as tax-exempt organizations in the broadest sense of the term.

Some organizations are tax-exempt as a matter of practice, not because of any specific grant of exemption but because of the ability to utilize sufficient deductions to effectively eliminate taxation. As noted, this is the principle on which the general tax exemption for cooperatives is premised.481 Likewise, a pooled income fund482 is generally a nontaxpaying entity because it is entitled to a deduction for distributions to beneficiaries and for long-term capital gain set aside.483 A charitable remainder trust484 is an organization that is exempt from federal income tax, although it has to pay a tax in years in which it has unrelated business taxable income.485 As discussed earlier, this approach also provides “tax exemption” for perpetual care trust funds operated in conjunction with taxable cemeteries.486

Other entities achieve federal income tax exemption because the law regards them as organizations that, while they may have to file tax returns, do not have taxable income but instead pass that liability on to others. It is this principle that operates to exempt partnerships,487 small business (“S”) corporations,488 and limited liability companies489 from federal income taxation.

§ 19.25 NONEXEMPT MEMBERSHIP ORGANIZATIONS

An organization can be a nonprofit entity without qualifying for tax exemption; an organization can be a nonprofit entity and not be tax-exempt even though it is eligible for exemption.490 That is, a nonprofit organization can be a taxable organization. It is possible for a taxable organization to, in fact, not pay taxes because its deductible expenses are equal to or exceed its gross income. Indeed, occasionally, the management of a tax-exempt organization contemplates forfeiture of its exemption,491 to avoid the regulatory requirements, believing that its expenses will offset its income.

Special rules apply, however, in situations where the nonprofit organization that is not exempt from federal income tax is a membership entity. Where this type of organization is operated primarily to furnish goods or services to its members, these rules allow deductions for a tax year attributable to the furnishing of services, insurance, goods, or other items of value to the organization's membership only to the extent of income derived during the year from members or transactions with members (including income derived during the year from institutes and trade shows that are primarily for the education of members492).493 If, in a tax year in these circumstances, deductions exceed income, the excess is treated as a deduction attributable to furnishing services, insurance, goods, or other items of value to members paid or incurred in the succeeding tax year.494

The purpose of these rules is to preclude a result earlier sanctioned by a federal court of appeals, which held that the investment income of a nonexempt water company could be offset by its losses in supplying water to its members.495 (Other courts, however, were not permitting this result.496) That is, the rules prevent a taxable membership organization from offsetting its business and investment income with deductions created by the provision of related services to members. Stated another way, these rules are designed to cause taxable membership organizations to allocate and confine their deductions to the corresponding sources of income.497 As a result, an organization that operated in a year at an overall loss may still have to pay tax if its unrelated business and investment activities produced net income. These rules are intended to deter the abandonment of tax-exempt status by membership organizations by entities that are serving their members at less than cost.498

The principal issue in this context pivots on the concept of membership income. The seminal court opinion on this point held that the term means only gross income received directly from an organization's members or transactions with members.499 In that case, the court addressed the issue of whether interest income earned on statutorily mandated cash reserves held by a taxable membership organization was income derived from members or transactions with members for these purposes. The court wrote that it found “nothing to indicate that Congress intended that phrase [income derived from members] to include all income from sources substantially related to the function of the organization.”500 Consequently, this court concluded that because the interest income at issue was not received from members or came to the organization in a transaction with members, the income constituted nonmembership income in this setting. Similarly, a court ruled that a taxable insurance trust could not deduct an expense incurred for insurance for its members inasmuch as it failed to convince the court that the gain realized from the sale of shares of stock was member income, which held that the income was not derived from its members or transactions with its members.501

NOTES

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.14.6.194