internal_revenue_service national_office technical_advice_memorandum date third party communication none date of communication not applicable tam-130828-06 index uil no case-mis no number release date ------------------------- taxpayer's name taxpayer's address taxpayer's identification no years involved date of conference --------------------------------------------- -------------------------- ------------------------------------- ---------------- --------------- ------------------ legend taxpayer promoter underlying instruments issuer issuer trustee primary trust holding trust p o certificate --------------------------------------------- --------------------------------------- ------------------------------------------------------------------------ ------------------------------------------------------------------------ --------------- ------------------------------------------------------------------------ ---------------- ------------------------------------------------------------------------ ---------------- --------------------------------- ----------------------- ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ---------------------------------------- tam-130828-06 i o certificate p unit t unit year year period date reference event series redemption date trust termination_date dollar_figurea dollar_figureb dollar_figurec dollar_figured dollar_figuree aa bb cc state e ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ 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------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ------------------------------------------------------------------------ ----------------------------------- ------------------------------------ ---------------------------------- issues i whether the underlying instruments should be characterized as debt or equity ii whether the p o certificates create multiple classes of ownership in the assets of the primary trust so that the primary trust should be classified as a business_entity under reg sec_301_7701-2 iii what are the consequences of treating the primary trust as a business_entity under sec_301_7701-4 iv whether the interest retained by taxpayer in the underlying instruments represents merely income rights conclusions the underlying instruments are characterized as equity the p o certificates create multiple classes of ownership interests in the assets of the primary trust so that the primary trust is classified as a business_entity under sec_301 the primary trust will initially be treated as a disregarded_entity and then treated as a partnership when taxpayer transfers the p o certificates to the promoter as a result of the partnership formation the transfer of the p o certificates to the promoter will be treated as constituting a transfer of a proportionate by value share in all of the primary trust’s partnership’s assets the interest retained by taxpayer in the underlying instruments does not represent merely income rights i ii iii iv taxpayer acquired through the promoter foreign bank notes paying a variable tam-130828-06 background on date the national_office issued tam original tam the assistant chief_counsel passthroughs and special industries requested that the original tam be revoked and reissued to delete certain incorrect language this tam is the result of that request the conclusions of the original tam are not altered facts rate of interest having no fixed maturity_date taxpayer dropped the notes into a_trust and in return taxpayer received two classes of trust certificates one certificate entitling the holder to all payments of income from the notes for the first bb years the other entitling the holder to payments of note principal plus the rights to later year income payments taxpayer retained the certificates embodying the rights to the first bb years of income and sold to the promoter the other certificates at the same time taxpayer and an affiliate of the promoter entered into a termination agreement which provided that the affiliate would pay taxpayer a portion of any principal payment the promoter received on the underlying instruments in the event of either a default or a repurchase of the underlying instruments by its issuer taxpayer treated the purchase_price of the entire note as its basis in the sold certificates on its year sec_1 and consolidated income_tax returns taxpayer reported capital_loss deductions on the sales of the certificates to the promoter taxpayer contends that the sale of the corpus of the notes and the effective retention of the right to income from those same notes was a means of achieving intermediate term cash_flow as well as adding negative duration to its asset portfolio in order to manage duration mismatches between assets and liabilities and this was not an effort to generate artificial tax losses the field however takes the position that the taxpayer is not entitled to the losses and seeks technical_advice as to whether taxpayer is justified in taking these deductions this transaction is described more fully below in computing a loss on the sale of the principal certificates to the promoter the the transaction during year and year taxpayer entered into three transactions with the promoter which the promoter characterized as selling off the back-end of a single or a series of the underlying instruments all three transactions are very similar in structure and therefore the same analysis below can be applied to all three transactions because of the similarity of the transactions the field has submitted a tam request with respect to only one of the three transactions which is described below taxpayer acquired a portfolio consisting of cc underlying instruments from or tam-130828-06 through the promoter during period the underlying instruments are labeled by their issuers as undated perpetual subordinated capital floating rate notes the terms of the underlying instruments are generally similar with some differences that are not material to our discussion such as differences in interest rates for the purposes of the following discussion underlying instrument will refer to all of the notes from a particular issuance and underlying instruments will collectively refer to all cc underlying instruments the underlying instruments have no fixed final maturity_date the principal_amount due will only be repaid in the event a an issuer is subject_to winding up and the issuer trustee recovers funds on behalf of the underlying instruments holders b an issuer exercises its option to purchase underlying instruments directly from the underlying instrument holders c an issuer purchases underlying instruments on the open market or d an issuer after a change in its local law becomes required to withhold taxes on payments made on the underlying instruments the underlying instruments are unsecured obligations of the issuers ranking pari passu without any preference as between such issuer and the holders of other similar undated perpetual subordinated capital floating rate notes issued by such issuer and are subordinate to senior creditors of the issuers payments of principal and income are subject_to the issuer being solvent at the time of payment and immediately thereafter if an issuer would be insolvent after payment of the income or principal payment such principal and income payments will not be required rather the amount of principal and income in respect of the underlying instruments will be used to meet the losses of the issuer in the event that an issuer goes through a winding up holders of the underlying securities will be treated as if they were the holders of a class of preference shares in the capital of the issuer having a preferential right to a return of assets in the winding up over the holders of all other classes of shares in the capital of the issuer the underlying instrument holders are entitled to receive interest from the issuers some of the underlying instruments pay interest semi-annually while others pay interest quarterly all of the underlying instruments bear an interest rate based upon libor london_interbank_offered_rate plus a set number of basis points in the event of the nonpayment of interest the underlying instrument holders have no recourse against an issuer so long as the issuer for such period has not paid dividends to its shareholders unpaid interest goes into arrears and becomes due in full on the earliest of i the date upon which a dividend is next paid on any class of share capital ii the date fixed for any repayment pursuant to certain conditions having to do with the repayment of the underlying instruments or iii the commencement of a winding up of the underlying instruments have a stated_interest component for purposes of this technical_advice_memorandum the terms income or income_interest will be used interchangeably with the term_interest no inference should be drawn from our use of one term or the other tam-130828-06 the issuer arrears of interest do not themselves bear interest in the event an issuer defaults on an interest payment the issuer trustee may bring a proceeding on the holders’ behalf in the issuer’s country of incorporation the underlying instruments do not convey to their holders any voting rights with respect to an issuer’s operations the underlying instruments however do entitle their holders to vote upon significant modifications to the terms of the underlying instruments whereas non-significant modifications may be approved by the issuer trustee without obtaining the approval of the underlying instrument holders the underlying instruments also entitle their holders to join with other holders to request the issuer trustee to institute proceedings to wind up the issuer in the event of default the issuer trustee is not required to take any_action against the issuer unless it is requested to do so either by an extraordinary resolution of the holders of the underlying instruments or by a written request of the holders of at least percent of the principal_amount of the underlying instruments then outstanding the holders of the underlying instruments do not have any remedy against an issuer other than the institution of proceedings for the winding up of the issuer on date taxpayer acquired a portfolio consisting of cc underlying instruments from or through the promoter on that same date taxpayer established the primary trust transferring to the primary trust its portfolio of underlying instruments each underlying instrument was deposited into a separate series or sub-account of the primary trust with each sub-account administered and accounted for separately from the other sub-accounts of the primary trust the series have been labeled series a-j in the submissions the trust agreement for the primary trust trust agreement states that taxpayer intends to treat the primary trust a delaware business_trust as a grantor_trust also on date the primary trust issued p o certificates and i o certificates to taxpayer p o certificates are certificates issued by the primary trust which represent the right to the underlying instrument at the termination of the trust i o certificates are certificates issued by the primary trust representing all interest payments on the underlying instrument prior to the termination of the trust the primary trust will terminate approximately years after its formation separate i o certificates and p o certificates were issued for each series in the primary trust in the technical_advice request submissions the i o certificates have been labeled i o certificates a- j and the p o certificates have been labeled p o certificates a-j for purposes of the following discussion i o certificate will refer to all of the i o certificates issued by a single series of the primary trust and i o certificates will refer collectively to all of the i o certificates issued by series a-j similarly p o certificate will refer to all of the p o certificates issued by a single series of the primary trust and p o certificates will refer collectively to all of the p o certificates issued by series a-j tam-130828-06 an i o certificate represents the right to receive payments from the trustee of the primary trust in an aggregate amount equal to the amount of interest received by the trust on account of the aggregate face_amount of the underlying instrument through the applicable series redemption date the series redemption date for a given i o certificate is separately_stated from the series redemption dates of the i o certificates for the other series in the primary trust each series redemption date for the primary trust is approximately bb years after the formation of the primary trust as long as at least one of the underlying instruments remains outstanding the primary trust will not terminate except on the trust termination_date which is approximately months after the last series redemption date otherwise the primary trust will terminate when there is no p o or i o certificate outstanding each p o certificate states that it evidences a fractional undivided beneficial_interest in the underlying instrument other than the right to receive interest actually paid on the underlying instrument during the restricted_period and any and all permitted_investments made in respect of amounts other than interest_paid during the restricted_period on date taxpayer sold the p o certificates to the promoter who simultaneously deposited the p o certificates into the holding trust and received in return a p unit and a t unit for each p o certificate deposited the p unit entitles the holder to instruct the trustee how to vote a corresponding p o certificate and to receive payments in amounts equal to all payments on the p o certificate other than the right to receive the amounts paid to the holder of the t unit the t unit entitles the holder to no rights with respect to the p o certificate other than the right to be paid certain amounts by the issuer upon the occurrence of a default or partial_redemption of the underlying instruments also on date and simultaneous with the creation of the primary and holding trusts and the sale of the p o certificates taxpayer entered into a termination agreement with an affiliate of the promoter for which taxpayer paid dollar_figurea per series covered for a total of dollar_figureb the termination agreement provides that in the event of a receipt of principal related to an underlying instrument prior to the trust termination_date the promoter’s affiliate agrees to pay taxpayer a portion of the amount received in the liquidation or redemption of the underlying instruments the amounts due to taxpayer are computed using a formula and schedules that are identical to those used to compute payments on the t units the amount of the portion of any principal payment that may be received with respect to an underlying instruments due to taxpayer under the termination agreement is the relevant market_value which decreases over time and is based upon a formula described in the allocation schedules attached to the agreement a separate allocation schedule is provided for each underlying instrument each schedule provides a list of percentages that apply on specific dates for a payment tam-130828-06 received between specified dates a linear interpolation based upon an agreed-upon formula basically straight_line allocation is used to determine the applicable allocation_ratio the relevant market_value is equal to applicable allocation_ratio x total principal received over time the applicable allocation_ratio which begins at roughly percent increases until it equals percent on the appropriate series redemption date at which time the rights under the termination agreement will expire taxpayer’s submission states that it considers the occurrence of reference events resulting in a principal payment as remote contingencies taxpayer also stated that without the termination agreement the parties would either not have undertaken the transaction or the pricing on the transaction would have been materially different the promoter’s promotional materials state that the p units may be sold by the promoter but that it will retain the t units to hedge its obligation to taxpayer under the termination agreement each p unit represents the right to all principal received with respect to a particular underlying instrument minus the amount owed to the holder of the t unit over time the portion of the principal payment retained by the p unit holder increases until on the applicable series redemption date the p unit holder is entitled to retain percent of any principal payments taxpayer claims that the transfer of the p o certificates to the promoter was a sale of the entire principal portion of the underlying instruments that results in a dollar_figurec loss for tax purposes taxpayer argues that this loss arises because as it contends it is required by case law to allocate percent of its dollar_figured basis in the underlying instruments to the p o certificates and percent of its basis to the retained i o certificates to date taxpayer represents that it continues to hold all the i o certificates there have been no defaults or call events or other reference events with respect to the underlying instruments law and analysis i the underlying instruments constitute equity interests in the issuer under code sec_385 the secretary_of_the_treasury is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an ainterest in a corporation is to be treated as stock or indebtedness or as in part stock and in part indebtedness sec_385 sets forth some of the factors that the regulations take into account in determining whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists these factors include the following whether there is a written unconditional promise a to pay on demand or on a specified date a sum certain in money in return for an adequate_consideration in money_or_money's_worth and b to pay a fixed rate of interest whether there is subordination to or preference over any indebtedness of the corporation the ratio of tam-130828-06 debt to equity of the corporation whether there is convertibility into the stock of the corporation and the relationship between holdings of stock in the corporation and holdings of the interest in question proposed_regulations under code sec_385 were issued on date which set forth the factors to be considered in determining whether an instrument was stock or debt final regulations under sec_385 were then issued in date with a delayed effective date that was extended several times the final regulations however were withdrawn in t d 1983_2_cb_69 there currently are no regulations under sec_385 notice_94_47 1994_1_cb_357 provides that the characterization of an instrument as debt for federal_income_tax purposes depends on the terms of the instrument and all surrounding facts and circumstances among the factors that may be considered in making such a determination are whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity_date that is in the reasonably foreseeable future whether holders possess the right to enforce the payment of principal and interest whether the rights of the holders of the instrument are subordinate to rights of general creditors whether the instruments give the holders the right to participate in the management of the issuer whether the issuer is thinly capitalized whether there is identity between holders of the instruments and stockholders of the issuer the label placed upon the instrument by the parties and whether the instrument is intended to be treated as debt or equity for non-tax purposes including regulatory rating agency or financial_accounting purposes the weight given to any factor depends upon all of the facts and circumstances 326_us_521 the various factors listed in notice_94_47 are aids in answering the ultimate question whether the investment analyzed in terms of its economic reality constitutes risk capital entirely subject_to the fortunes of the corporate venture or represents a strict debtor-creditor relationship 398_f2d_694 3rd cir the important issue is whether there was genuine intention to create a debt with a reasonable expectation of repayment and did that intention comport with the economic reality of creating a debtor-creditor relationship 61_tc_367 under code sec_385 the characterization as of the time of issuance by the issuer as to whether an interest in a corporation is stock or indebtedness is binding on the issuer and on all holders of such interest but is not binding on the secretary_of_the_treasury although this provision mandates that both the holder and the issuer treat the financial_instrument consistently for u s income_tax purposes this mandate does not affect how one or both of the parties treat it for purposes of foreign law consequently it does not prohibit inconsistent treatment or reporting of the instrument under the laws of the united_states and a foreign jurisdiction tam-130828-06 in the instant case an application of sec_385 is not compelled nor violated in substance the perpetual securities are equity no other code or regulation section requires the holder of an interest in a by the treatment of these instruments under foreign law the issuer a foreign_entity treated the underlying instruments as debt for financial_accounting purposes moreover the issuer’s reference to the underlying instruments in the prospectus as notes indicates that it considers them debt for foreign financial purposes there is no indication that the issuer files a u s tax_return and or reports income gain loss or takes any deduction with regard to these notes on its or a related entity’s u s tax_return the purchasers and the holders of the underlying instruments have reported them as equity for u s tax purposes any resulting inconsistent treatment with respect to the underlying instruments is due to the way it is reported in foreign countries not to the way it is reported in the u s accordingly sec_385 is neither implicated nor violated here corporation to treat that interest as it is characterized by the issuer we must therefore determine whether the underlying instruments in substance are debt or equity by applying a traditional debt equity analysis the prospectus pursuant to which the underlying instruments are issued shows the following facts concerning the underlying instruments that weigh in favor of a finding of equity they have no fixed maturity_date they are unsecured they are not payable upon default of payment of interest or principal they are subordinated to the issuer s senior creditors which it defines broadly to include trade creditors the rights to payment of interest and principal are conditional upon the issuer being solvent at the time of payment and immediately thereafter the holders have no remedy for nonpayment of interest so long as no dividend has been paid or declared in respect of any class of issuer’s share capital in the event of the winding up of the issuer the holders of the underlying instruments will for purpose only of calculating the amounts payable be treated as if they were the holders of preference shares in the issuer’s capital and the prospectus provides that no payment of interest or principal can be accelerated or paid before its due_date the following facts weigh in favor of a finding of debt if and when the issuer redeems the underlying instruments it will pay if it will not become insolvent as a result of such payment percent of their principal_amount interest is payable biannually on an annual rate of ¼ percent above libor and the holders of the underlying instruments have no right in the management of the issuer nor do they have a right to elect directors to the issuer s board_of directors one of the most important of the factors is the provision for a fixed or tam-130828-06 ascertainable time when the purported creditor is unconditionally entitled to require payment of the principal where there is an absence of an unconditional right to demand payment the investor has embarked upon the corporate adventure and has assumed its risks this factor ie absence of a maturity_date alone is not determinative however when coupled with the other factors listed above which weigh in favor of a finding of equity leads us to conclude that the taxpayer’s investment in the underlying securities is at the risk of the issuer’s business and therefore the underlying securities resemble equity more than debt ii p o certificates create multiple classes of ownership in the assets of the primary trust and therefore the primary trust is a business_entity under sec_301_7701-2 an analysis of whether multiple classes of ownership interests exist depends upon a determination of the rights and obligations attached to the ownership of the two types of certificates ie the i o and p o certificates in identifying these rights and obligations we have considered the rights and obligations of taxpayer and the promoter including its affiliates provided under the termination agreement for the facts and reasons set forth below we conclude that the termination agreement is an integral part of the formation of the primary trust partnership and therefore the rights and obligations created by the agreement are relevant in determining the rights and obligations attached to the ownership of the i o and p o certificates a the termination agreement is an integral part of the formation of the primary trust partnership in support of its position that the termination agreement is a separate transaction taxpayer asserts that the termination agreement was supported by adequate separately bargained-for consideration the affiliate although related to the promoter is an entity separate from the promoter the termination agreement expressly states that the promoter is not guaranteeing the affiliate’s performance under the agreement the affiliate was not a party to the sale of the p o certificates or to either of the trust agreements the affiliate was not obligated to enter into the termination agreement and the promoter was not obligated to enter into a termination or similar agreement by reason of its purchase of the p o certificates or its participation in either of the trusts we find however that the following facts compel a conclusion that the termination agreement should be included as part of the transaction under which the primary trust partnership was formed a the termination agreement appears to have been executed simultaneously with the rest of the transactions b the termination agreement was executed by the taxpayer and the promoter’s affiliate the parties to the tam-130828-06 agreement c the payments under the termination agreement are identical to those due to the promoter as holder of the t units d the termination agreement specifically references and adopts the terminology of the holding trust and e the promoter’s write up states that the t units are to serve as a hedge of its obligation on the termination agreement pursuant to the termination agreement in the event of receipt of any principal redemption payment on an underlying instrument prior to its series redemption date the promoter’s affiliate must pay to taxpayer the relevant market_value the relevant market_value is determined based upon a self-amortizing allocation_ratio that distributes the principal redemption payment between the promoter and taxpayer under the termination agreement taxpayer receives a decreasing portion of any principal redemption payment the longer the note is outstanding and ultimately at the series redemption date taxpayer will not receive any of the principal redemption payment it is important to note that up to the day before the series redemption date taxpayer is still entitled to receive at least some small amount of any principal redemption payment thus to the extent of any substantive principal rights in the underlying instruments they have been divided between taxpayer as holder of the i o certificates and the promoter as holder initially of the p o certificates and later as holder of the t units through the operation of the termination agreement moreover without the termination agreement any call event would render worthless the taxpayer’s i o certificates with regard to the taxpayer who owns the right to the payment of income its entering into the transaction would not make economic sense without the rights afforded to it by the termination agreement taxpayer readily admits that it would not have engaged in the transaction as structured and priced without the termination agreement taxpayer asserts that the termination agreement is a separate insurance_policy which it purchased for small consideration from the affiliate of the promoter taxpayer claims that the affiliate has no interest economic or otherwise in the underlying instruments we conclude however that the termination agreement is not like an insurance_policy here the termination agreement actually creates the rights to receive payments in the event of either default or a repurchase of the underlying instruments by its issuer instead of merely insuring that the principal payments will be made without the termination agreement the taxpayer would have no rights to payments in the case of one of these events for which even another party could provide a guarantee taxpayer also claims that it has no recourse against the promoter or the transferred p o certificates which are held in the holding trust and therefore it could not have retained any rights in the principal of the underlying instruments the fact that the taxpayer’s recourse upon the occurrence of either a default or partial_redemption of the underlying instruments is against a wholly-owned subsidiary of the promoter does tam-130828-06 not change the fact that this as part of the formation of the primary trust partnership effectively served to protect the taxpayer’s rights to the value of its future income payments we conclude that under the termination agreement the taxpayer effectively has received rights to principal redemption payments in connection with setting up the primary trust partnership accordingly we believe that the termination agreement is not a separate transaction but is an integral part of the formation of the primary trust partnership b the primary trust is a business_entity sec_301_7701-4 of the procedure and administration regulations provides in part that an investment_trust that has multiple classes of ownership interests is ordinarily classified as a business_entity under sec_301_7701-2 an investment_trust that has multiple classes of ownership_interest however is classified as a_trust for tax purposes if there is no power under the trust agreement to vary the investment of the certificate holders and the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership_interest is incidental to that purpose in the instant case there are two classes of certificates holders of i o certificates are entitled to all scheduled and unscheduled payments of interest until their certificates are retired and a declining percentage of any unscheduled payments of principal while their certificates are outstanding holders of p o certificates receive payments of interest only after the i o certificates have been retired and receive an increasing percentage of any unscheduled payments of any principal redemption payments while the i o certificates are outstanding there are no subordination rights as between the two certificates the allocation of unscheduled payments is based upon a formula set forth in the termination agreement that applies whether the principal redemption payment is made due to an event of default or a repurchase of the underlying instruments by its issuer as a result in the event of a shortfall in payment of part or all of the underlying instruments due to an event of default the amount of the shortfall will reduce the distribution on both certificates ownership in the primary trust the certificates effectively separate current income rights on the underlying instruments from a portion of the right to appreciation on the value of the underlying instruments similar to the circumstance described in example of sec_301_7701-4 in addition the termination agreement provides taxpayer protection from the risk that an underlying instrument will be prepaid this type of protection is similar to that described as call protection in example of section in light of these facts the two classes of certificates represent different classes of tam-130828-06 c the primary trust thus serves to create investment interests with respect to the underlying instruments that differ significantly from direct investment in the underlying instruments as a result the existence of multiple classes is not incidental to any purpose of the trust to facilitate direct investment in the assets of the primary trust and therefore the trust is classified as a business_entity under sec_301_7701-2 iii the primary trust will be treated as a partnership and the transfer of interests will be treated as a transfer of a proportionate by value share of the trust’s assets based on the default classification rules of sec_301_7701-3 the primary trust as a business_entity will be disregarded for the period in which it has one owner and will be treated as a partnership for the periods in which it has multiple owners in addition we conclude that through retention of income rights coupled with the termination agreement benefits_and_burdens_of_ownership associated with the principal interest in the underlying instruments continue to reside with the taxpayer even after taxpayer has transferred the p o certificates to the promoter the identity of a partner for federal tax purposes is not dependent on legal_title rather it is dependent on an analysis of the benefits_and_burdens_of_ownership see eg 73_tc_676 acq 1980_2_cb_2 dummy_corporation held partnership_interest as nominee for true partner because benefits associated with the principal of the underlying instruments flow to taxpayer we conclude that this right to a portion of the principal of the underlying instruments actually serves to define the nature of taxpayer’s partnership_interest because the primary trust is treated as a business_entity the transfer of the interest to the second owner should be analyzed in accordance with the holding of situation one of revrul_99_5 that ruling describes the federal tax consequences when a single member limited_liability_company that is disregarded becomes an entity with more than one owner that is then classified as a partnership where the primary trust is treated as a business_entity then by definition it has to be a single member business_entity when it is formed by the taxpayer when the p o certificates are transferred away by the taxpayer a partnership is created such that the primary trust has been effectively converted into a partnership situation one of the ruling addresses a fact pattern where a transfers a portion of the ownership_interest in the disregarded_entity to b for consideration the ruling concludes that in such a situation the disregarded_entity is converted to a partnership when the new member b purchases an interest in the disregarded_entity from the owner a b’s purchase of percent of a’s ownership interests in the llc is treated as the purchase of a percent interest in each of the llc’s assets which are treated as held directly by a for federal tax purposes immediately thereafter a and b are treated tam-130828-06 as contributing their respective interests in those assets to a partnership in exchange for ownership interests in the partnership under sec_1001 a recognizes gain_or_loss from the deemed sale of the percent interest in each asset of the llc to b under sec_721 no gain_or_loss is recognized by a or b as a result of the contribution of their separately held assets to the partnership the present transaction falls within situation one of the ruling when interests are transferred away from taxpayer it is equivalent to the sale to b in the ruling accordingly taxpayer is treated as disposing of an appropriate proportion of the underlying assets in a sec_1001 transaction taxpayer is treated as if it disposed of some but not all of the right to principal payments on the underlying instrument as well as the rights to later year income payments thus the taxpayer is treated as retaining the rights to the first bb years of income with regard to the underlying instruments as well as some but not all of the rights to any principal redemption payment of these instruments where the underlying assets consist of dollar_figured worth of the underlying instruments and taxpayer receives dollar_figurec in consideration taxpayer is treated as transferring a aa interest in the undivided underlying instruments rights to principal and interest payments that portion transferred having a basis equal to the dollar_figurec amount taxpayer received as consideration to the extent that taxpayer has a fair_market_value basis in the underlying instruments it will recognize no gain_or_loss on the deemed sale iv taxpayer retained not merely the rights to payment of income taxpayer’s primary argument to avoid basis allocation between the interest retained and the interest sold is that it retained merely an income_interest and therefore it must allocate its entire basis to the disposed of p o certificates according to the taxpayer the p o certificates represent the entire_interest in the right to principal redemption payments of the underlying instruments because taxpayer allocated its entire basis to the p o certificates taxpayer claimed capital losses in both year sec_1 and when it sold the p o certificates to the promoter in support of its position taxpayer cites 356_us_260 311_us_112 and 472_f2d_867 6th cir taxpayer interprets these cases as standing for the proposition that an income component is not a property right separate from the stripped corpus and therefore basis cannot be allocated between the corpus and the income component because we have concluded that taxpayer has retained not only the rights to future income but also rights to principal redemption payments we therefore do not reach the question of whether the mere right to future income payments constitutes an income_interest and if so whether basis should be allocated to it these cases however are easily distinguishable from the present case in tam-130828-06 horst a father who owned a bond attempted to transfer taxable interest_income to his son by detaching a negotiable interest coupon before the maturity_date and giving it to his son who ultimately collected the interest payment the court held that the father was the owner of the coupons notwithstanding his assignment of the interest and his son’s ultimate receipt of the cash paid as interest in p g lake inc a corporate taxpayer paid off a debt owed to its corporate president through assigning an oil_payment right to him and it reported that disposition as a capital-gain-producing transaction the oil_payment right entitled the holder to payment of dollar_figure out of a portion of oil revenues due to the corporation plus an additional per year on the unpaid balance the supreme court held that the corporate taxpayer was the owner of the oil_payment notwithstanding its assignment of the interest and the corporate president’s ultimate receipt of cash finally in estate of stranahan the taxpayer sold the right to future dividend income to his son in an attempt to accelerate income to the taxable_year of the sale so as to offset a large unused interest_deduction the taxpayer claimed the entire amount_realized as ordinary_income without any basis recovery the court upheld the taxpayer's characterization of the transaction and treated the sale of dividend rights as generating ordinary_income in the year_of_sale assignment of future income since we have concluded that both the interest retained and the interest disposed of by the taxpayer were property instead of income interests taxpayer cannot look to those cases to support its position therefore p g lake horst and estate of stranahan are not relevant to the basis allocation issue of our case termination rights through the termination agreement these termination rights actually create rights to receive principal redemption payments upon the occurrence of a reference event without the termination agreement taxpayer would have no rights to payments in the case of a reference event upon which he could have another party guarantee payment all three cases involved an income_interest resulting from the taxpayer’s as we pointed out in our analysis of issue ii above the taxpayer had we conclude that taxpayer has retained both a the right to future income payments for the next bb years and b through its continuing interest in any principal redemption payments wasting rights with regard to any principal payments on the underlying instruments because taxpayer has retained the right to future income payments as well as a continuing interest in any principal redemption payments in the formation of the primary trust partnership the taxpayer has retained a principal interest in the underlying instruments accordingly taxpayer must allocate a portion of his basis in the underlying instruments to the retained interests and a portion of his basis to interests sold to the promoter see sec_1_61-6 when a part of a larger property is sold the basis of the entire property is equitably apportioned tam-130828-06 among the parts 118_f2d_462 5th cir taxpayer who sold an interest in a leasehold and reserved an oil_payment must allocate basis between the interest and the reserved payment in proportion to their fair market values at the time of the sale 10_bta_961 taxpayer must allocate its basis where it retains the timber rights to land that the taxpayer sells along with the rights to any turpentine produced from the timber caveats no opinion is expressed herein as to any other issues that were raised in the a copy of this technical_advice_memorandum is to be given to the taxpayer s sec_6110 of the code provides that it may not be used or cited as precedent incoming technical_advice request or that may be raised based on the facts of this case specifically the service is not ruling on whether a retained right to payment of income would constitute a mere income_interest to which no basis would be allocated and the sale of the p o certificates can be characterized as a lending transaction furthermore for purposes of this advice only we have accepted that the taxpayer sold to the promoter only a part interest in the underlying instruments rather than selling the whole interest in the underlying instruments consequently we are not expressing any opinion as to whether the transaction would be treated as a sale by the taxpayer of a whole interest in the underlying instruments with the taxpayer acquiring the income_interest as an additional_amount realized ie an addition to the purchase_price see 46_tc_363


internal_revenue_service number release date index number ------------------------ --------------------------------------------- -------------------- ----------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ------------------------ id no ------------- telephone number --------------------- refer reply to cc psi b01 plr-140069-05 date date ---------------------------- -------------------------- legend x --------------------------------------------------- y ---------------------------------------------------- country date date dear ------------ ------------------------- ------------------------- ----------- this is in response to a letter dated date requesting an extension of time under sec_301_9100-3 of the procedure and administration regulations to file an election to treat y as an entity disregarded as separate from its owner for federal tax purposes under sec_301_7701-3 facts according to the information submitted and representations made within the request x is the ultimate owner of an affiliated_group of entities among this affiliated_group is y which is an entity that was formed under the laws of country on date x acquired y x timely made a sec_338 election relating to its acquisition of y due to inadvertence a form_8832 entity classification election to treat y as an entity disregarded as separate from its owner effective date was not filed plr-140069-05 law and analysis sec_301_7701-3 provides guidance on the classification of a foreign eligible_entity for federal tax purposes generally unless the entity makes an election to be treated otherwise a foreign eligible_entity is treated as an association_taxable_as_a_corporation if all members have limited_liability if a foreign eligible_entity has only one owner it may elect to be treated as a disregarded_entity pursuant to the rules in sec_301_7701-3 if a foreign eligible_entity has more than one owner it may elect to be treated as a partnership pursuant to the rules in sec_301_7701-3 sec_301_7701-3 further provides that an entity classification election must be filed on form_8832 entity classification election and can be effective up to days prior to the date the form is filed or up to months after the date on which the form is filed sec_301_7701-3 provides that an election made under sec_301_7701-3 will be effective on the date specified by the entity on form_8832 or on the date filed if no date is specified on the election form the effective date specified on form_8832 cannot be more than days prior to the date on which the election is filed and cannot be more than months after the date on which the election is filed if a purchasing_corporation makes an election under sec_338 regarding an acquired subsidiary an election under sec_301_7701-3 for the acquired subsidiary can be effective no earlier than the day after the acquisition_date within the meaning of sec_338 under sec_301_9100-1 the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than six months except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as including an election with a deadline prescribed by a regulation published in the federal_register sec_301_9100-1 through provide the standards the commissioner will use to determine whether to grant an extension of time to make an election sec_301_9100-2 provides automatic extensions of time for making certain elections sec_301_9100-3 provides extensions of time for making elections that do not meet the requirements of sec_301_9100-2 requests for relief under sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that granting relief will not prejudice the interests of the government sec_301_9100-3 plr-140069-05 conclusion based solely upon the information submitted we conclude that the requirements of sec_301_9100-1 and sec_301_9100-3 have been satisfied as a result an extension of days from the date of this letter is granted to elect to treat y as disregarded as an entity separate from its owner for federal tax purposes effective date the entity classification election should be made by filing form_8832 with the appropriate service_center a copy of this letter should be attached to the form_8832 a copy is enclosed for that purpose concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter except as expressly provided herein no opinion is expressed or implied this ruling is directed only to the taxpayer s requesting it sec_6110 of the internal_revenue_code provides that it may not be used or cited as precedent in accordance with the power_of_attorney on file with this office a copy of this sincerely letter will be sent to your authorized representative enclosures copy of this letter copy for sec_6110 purposes william p o’shea associate chief_counsel passthroughs and special industries


number release date index number ------------------------- ---------------------------------------------- ------------------------------------- ----------------------------------- - department of the treasury washington dc third party communication none date of communication not applicable_person to contact ---------------------------- id no ----------- telephone number --------------------- refer reply to cc psi b05 plr-141524-04 date date legend taxpayer ---------------------------------------------------------------------- state a ------------------ --------------------------- b c f g e d brand name geographic area trade mark ------------- ----------------- ---------------- --------------- ------ ------- ------------------------ ------------------------------------ ---------- this is in response to a request for a ruling dated date submitted on plr-141524-04 dear ----------------- behalf of taxpayer by its authorized representative the ruling concerns the conversion of taxpayer to a corporation operating_on_a_cooperative_basis within the meaning of subchapter_t of the internal_revenue_code as explained below premium quality b under the brand name and other c through a franchise network of established b producers covering most of geographic area additionally taxpayer sells b purchased from its franchise network directly to certain customers from d taxpayer has intended to operate on a cooperative basis for the benefit of its franchise- patron the taxpayer engages in its business by franchising certain rights with respect to the production and marketing of b and c to franchisees pursuant to a franchise agreement individually entered into by and between each franchisee and the taxpayer the b and c covered by the franchise agreements are those produced by f fed the ------- --------------------------------------------------------------------------------------feed supplement and marketed under the ------------------------------------------------------------------------- the terms of this agreement recognize the franchisee’s ability to produce and distribute the product in a specified territory and the taxpayer’s ability to advertise and promote the product taxpayer is a state a corporation formed in g that markets and distributes under the terms of the franchise agreements the taxpayer has granted each franchisee the right to produce sell and distribute the b known as brand name or any other trademark or trade_name approved by the taxpayer in the territory specified in the particular franchise agreement the initial term of a franchisee’s rights under the agreement is --------- years with options specified in the agreement for renewal the franchise agreement also covers the terms by which franchisees are required to purchase the ------------------------------feed additive or other feed supplements under the trade mark or other name the taxpayer currently has a contract with a feed manufacturer to produce and sell the taxpayer’s ------------ feed additive and other feed supplements to the franchisees at pricing negotiated by the taxpayer franchisees are also required to purchase packing supplies and promotional materials bearing the brand name trade names at sizes and according to package designs specified by the taxpayer from approved manufacturers at pricing negotiated by the taxpayer in consideration of the advertising promotion publicity research quality control and other services provided by the taxpayer franchisees pay the taxpayer a ------------- --------- fee based on the franchisee’s net sales of brand name b and c net sales for this purpose is the franchisee’s sales volume less returns at the then current wholesale price suggested by the taxpayer for the franchisee’s region the --------------- plr-141524-04 ------------------------------------------------------------------------------------------------------------------- - --------- fees are incurred by the franchisee as of the date the franchisee sells the b or c to an unrelated party the taxpayer recognizes ------------------------ fees as revenue upon delivery of the c by the franchisee to the customer under the terms of the franchise agreements the taxpayer is obligated to spend the ---------------------------------- ----------------------------------------------------------------------------------------------------------fees on advertising promotion and publicity of the brand name b and c within each of the franchise territories the taxpayer operates a franchise territory repurchased in ------- geographically within one state the taxpayer purchases b and c from franchisees producing b in neighboring territories and re-sells the products to wholesalers at prevailing market prices the taxpayer does not charge the supplying franchisees a --------------------------- ----------------------------------------------------------------------------------------------------------------- fee on these purchases the taxpayer funds its advertising promotion and publicity costs in this repurchased territory through the gross margin earned on these direct product sales and proportionate funding as needed from ------------------------ fees received from all franchisees the taxpayer believes continued operation of this repurchased territory benefits all franchisees by maintaining a national market and source of supply to taxpayer’s customers operating both within and without the repurchased territory the taxpayer also consolidates the sale of b and c on behalf of its franchisees for sales to retail outlets on u s military installations the u s government requested a single source of supply of brand name products rather than having each military installation purchase directly from the franchisee distributing c in the territory in which the military installation is located the taxpayer purchases b and c from the franchisee producing b in the franchise territory in which the military installation is located and re- sells the products to the applicable u s military procurement office at prevailing market prices the franchisee responsible for the territory in which the military installation is located delivers the c directly to the military installation the taxpayer collects ------------ ------------------------ fees from the franchisees on the same basis as described above on these sales to the u s military to cover the taxpayer’s advertising promotion and publicity activities in the respective franchise territories the taxpayer has a contract with a feed manufacturer to supply the taxpayer’s proprietary feed supplements to its franchisees the manufacturer’s services include procurement blending packaging warehousing and distribution of the taxpayer’s proprietary feed supplement to franchisees the manufacturer also provides franchisees with technical services relating to the implementation of the taxpayer’s ------ ---------------------------feed program the franchisees purchase the feed products directly from the manufacturer at pricing negotiated by the taxpayer ---------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------------- plr-141524-04 the taxpayer has contracts with approved manufacturers of brand name packaging materials to supply packaging materials to its franchisees the franchisees purchase the packaging materials directly from the manufacturers at pricing negotiated by the taxpayer --------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------- the taxpayer also purchases promotional materials eg small kitchen ware pens golf balls apparel items etc and re-sells them to the franchisees these promotional materials are used by the franchisees in retail promotion programs targeted to the consumer plan of reclassification to cooperative operation and business_purpose taxpayer has operated since g as a subchapter_c_corporation without any major changes to its corporate structure on ------------------- the taxpayer’s shareholders voted to approve a plan of reclassification to make certain adjustments to its capital structure and approve amendments to the taxpayer’s articles of incorporation and bylaws in order to qualify the taxpayer as operating_on_a_cooperative_basis within the meaning of sec_1381 of the code the majority of the voting shares were owned by franchisees of the franchisees who were shareholders all were eligible to vote and of the franchisees that voted all voted for the plan of reclassification for about two years prior to the approval of the plan of reclassification on ----------- ------- the board_of directors evaluated alternative entity structures the goal of this evaluation was selection of an entity that would vest the financial benefits of the taxpayer’s operations in the hands of the franchisees in the months leading up to the adoption of the plan of reclassification the board_of directors determined that the cooperative form of operation would be most consistent with this stated goal at a meeting in early attended by the taxpayer’s board_of directors and substantially_all of the franchisees representing a majority of the shareholders entitled to vote the franchisees finalized their deliberations on whether to recommend proceeding with conversion to the cooperative form of operation the franchisees concluded that the taxpayer and its franchisees would gain substantial economic and operational benefit by operating the taxpayer’s business as a cooperative as classified under and for the purposes of sec_1381 of the code as amended the franchisees recommended the plan of reclassification be presented to the shareholders and was approved by the shareholders on ------------------- the business_purpose of the taxpayer’s reclassification as a cooperative included the following identified economic and operational business benefits better opportunity for the taxpayer acting on behalf of its franchisees to introduce new products throughout the network plr-141524-04 better enables the franchisee patrons to coordinate production and distribution schedules better enables the franchisee patrons to manage and coordinate national customer accounts by sharing the benefits derived on a cooperative basis enables the franchisee patrons to democratically control who their fellow franchisees are in an era of industry consolidation to associate only producers achieving high standards with their trademarked product increases the franchisee patrons’ commitment to the cooperative and its products through the operation at cost principle and formalizes a one-man one-vote concept of a cooperative consistent with the operations of the franchisees’ democratically managed franchisee association the franchisee association is an independent organization controlled by the franchisees its purpose has been to represent the franchisee group in dealing on a collective basis with the taxpayer for example the franchisee association might negotiate any proposed revisions to the terms of the franchise agreement on behalf of the franchisees the taxpayer expects the franchisee association to have less of a direct role in the future given the franchisees’ democratic control of the taxpayer resulting from its conversion to cooperative status the b production industry has been experiencing consolidation and the franchisees have a strong interest in controlling who their fellow franchisees are there are instances where certain producers have not maintained high standards evidenced by continual occupational health and safety issues environmental concerns and problems complying with local ordinances it would cause very detrimental consequences for the business of the franchisees and the taxpayer if a rogue producer became a franchisee in the case where a rogue producer attempted to acquire a franchise the franchisees through their board_of directors must approve all those applying for membership and would prevent a potential acquirer not meeting high standards from becoming a member of the taxpayer without the assurance that their membership would be approved the benefits of such membership being substantial a potential acquirer would be less likely to seek to acquire a franchise thus the cooperative principle of democratic control will help the franchisees ensure that only producers achieving high standards become franchisees and members of the taxpayer the plan of reclassification became effective on ------------------- it made certain adjustments to the taxpayer’s capital structure and approved amendments to the taxpayer’s articles of incorporation and bylaws in order to qualify the taxpayer as operating_on_a_cooperative_basis within the meaning of sec_1381 of the code the changes to the capital structure authorized a single class of voting common_stock under the plan of reclassification all outstanding shares of capital stock on ----- plr-141524-04 --------------------were converted into non-voting common_stock this conversion eliminated any voting shares in the hand of non-franchisee shareholders and also eliminated all voting shares with the exception of one share of membership voting common_stock held by each franchisee-member the amendments to the taxpayer’s articles of incorporation and bylaws govern the taxpayer’s operations on a cooperative basis under the plan of reclassification non-member shareholders a shareholder who does not have a current franchise agreement in effect by and between the franchisee and the taxpayer will have each share of common_stock held on the effective date of the reclassification converted into one share of non-voting common_stock member shareholders a shareholder who has a current franchise agreement in effect by and between the franchisee and the taxpayer will have each share of common_stock held on the effective date of the reclassification converted into one share of non-voting common_stock and will receive solely one share of voting common such evidencing the franchisee’s membership in the taxpayer non-voting common_stock the taxpayer’s plan of reclassification designated a total of e shares of the corporation’s authorized stock as non-voting common_stock dollar_figure-------par value per share the holders of the non-voting stock shall not be permitted or entitled to vote on any matters presented to the stockholders of the taxpayer during the taxpayer’s first fiscal_year operating as a cooperative under the code dividends shall accrue at the rate of four percent per annum of the par_value of the non-voting stock and be paid_by the last day of such fiscal_year out of funds legally available therefore thereafter the holders of non-voting stock have no right to any dividends dividends shall be paid on each share of non-voting stock only when and if declared by the taxpayer’s board_of directors provided however that such dividend shall not exceed eight percent per annum of the par_value of the non-voting stock as of date the taxpayer had - --------------shares of non-voting common_stock issued and outstanding voting common_stock the taxpayer’s plan of reclassification designated a total of ------shares of the taxpayer’s authorized stock as voting common_stock dollar_figure----------par value per share holders of voting_stock shall be entitled to vote on all matters submitted to a vote of shareholders of the taxpayer each holder of voting_stock shall be entitled to one vote for each share of voting_stock held by such holders of voting_stock no person or entity shall hold more than one share of voting_stock the holders of voting_stock are not entitled to receive dividends but will receive patronage refunds as of date the taxpayer had-----shares of voting common_stock issued and outstanding reclassification in cooperative organization and operation plr-141524-04 under the plan of reclassification the articles of incorporation and bylaws were amended to ensure for each member shareholder of the cooperative may exercise its vote in the nomination and election of all board_of directors and in any other matter of business that requires member shareholder approval as provided in the articles bylaws and under state law voting_stock will be issued only to persons or entitles who or which meet the requirements to be classified as a member shareholder as set forth in the bylaw and approved as a member shareholder by the board member shareholders must execute a membership agreement by and between the member shareholder and the taxpayer the requirements to be classified as a member shareholder contained in the bylaws of membership agreement specify that the person or entity must be a franchisee under the terms of an executed franchise agreement with the taxpayer under the plan of reclassification the bylaws were amended to ensure that the cooperative is governed by democratic control in which each member shareholder of the cooperative has one vote including for the election of the members of the board_of directors regardless of the size of its investment or the amount of business it does with the cooperative actual voting power is complete and unrestricted the board_of directors possesses the right to decide matters pertaining to the management of the cooperative’s business_enterprise under the plan of reclassification the bylaws were amended to ensure that all member shareholders of the cooperative are patrons of the cooperative and the cooperative conducts substantially_all of its business with or for its member shareholder and non-member patrons non-member patrons are franchisees of the taxpayer who are a party to a franchise agreement and a non-member patron agreement with the taxpayer non-member patrons must be affiliates of member shareholders section dollar_figure of the taxpayer’s bylaws restricts ownership of voting_stock to only one share of voting_stock held within an affiliated_group as defined in the bylaws the requirements to be classified as a non-member patron contained in the bylaws and non-member patron agreement specify that the person or entity must be a franchisee under the terms of an executed franchise agreement with the taxpayer under the plan of reclassification the articles of incorporation and bylaws were amended to ensure that the taxpayer operates on a service at cost_basis with respect to its member shareholders and non-member patrons the taxpayer distributes its net_earnings to its member shareholders and non-member patrons of the cooperative in proportion to the amount of business conducted with or for its patrons under the plan of reclassification the articles of incorporation and bylaws were amended to ensure that amounts received from or on behalf of member shareholder and non-member patrons in excess of cost of service belong to those patrons and the cooperative is obligated to return such amounts to the plr-141524-04 patrons as patronage refunds the bylaws provide discretion to the board_of directors in setting aside funds for reasonable reserves for necessary purposes for the taxpayer such reasonable reserves will first be set_aside from net_earnings from other than business done with or for member shareholders and non-member patrons if there are no net_earnings upon such business or if such net_earnings are insufficient to provide funds for reasonable reserves for necessary purposes for the taxpayer reasonable reserves may be set_aside and paid from the net_earnings on business done with or for member shareholder and non-member patrons in the reasonable reserves are set_aside from the net_earnings on business done with or for member shareholder and non-member patrons the taxpayer will maintain adequate_records to apportion such reasonably reserves to member shareholders and non-member patrons based upon the value of business done with the taxpayer by the member shareholder and non-member patron during such fiscal_year under the plan of reclassification the bylaws were amended to provide that any patronage net_earnings are allocated based upon factors determined by the board_of directors as related to the value of business done with the taxpayer and distributed to the member shareholders and non-member patrons within the payment period set forth in sec_1382 of the code the factors to be used in determining such allocation shall be announced by the board_of directors to the member shareholders and non-member patrons at least thirty days prior to the start of the fiscal_year except in the first fiscal_year that the board_of directors shall make such determination of the basis of such allocations beginning date no later than forty-five days after the commencement of such fiscal_year the net_earnings to be distributed annually shall be distributed in accordance with such separate allocation units or pools as may established by the board_of directors and on the basis of the value of business done with or for the member shareholders and non-member patrons on or before date the board_of directors announced to the member shareholders and non- member patrons that a single allocation unit or patronage pool would be utilized to account to patrons for its first fiscal_year ended date and any patronage net_earnings to be allocated will be allocated on the basis of ------------- --------- fees earned from each member shareholder and non-member patron in proportion to all ------------------------ fees earned by the taxpayer for said fiscal_year under the plan of reclassification the bylaws were amended to provide that the cooperative is prohibited from making payments of interest and dividends on any equity_capital held by its member shareholders and non-member patrons in the form of written notices of allocation under the plan of reclassification the bylaws were amended to provide that if any loss if sustained by the taxpayer for any fiscal_year in any allocation unit the corporation may at the discretion of the board_of directors carry such loss plr-141524-04 forward to subsequent years within such allocation unit or apportion such loss among the member shareholders and non-member patrons participating in such allocation unit on a cooperative basis and recoup the amount due from each member shareholder and non-member patron by offsetting it in whole or in part against patronage due such person in future years or against written notices of allocation of such person under the plan of reclassification in operating in compliance with the amendments to the bylaws the taxpayer will maintain books_and_records such that at the end of each fiscal_year the amount of capital accumulated as a result of patronage is clearly reflected and may be credited to the member shareholder’s and non-member patron’s account under the plan of reclassification the bylaws were amended to provide the member shareholder’s and non-member patrons participating in the cooperative consent that the amount of any distributions made to them which are made in qualified written notices of allocation and are received by them will be taken into account at their stated dollar amounts in the manner provided in sec_1385 of the code in the taxable_year in which such qualified written notices of allocation are received by the member shareholder or non-member patron under the plan of reclassification the bylaws were amended to provide that in the event of withdrawal retirement death or expulsion or other termination of the membership of a member shareholder or non-member patron any voting_stock held by such member shareholder will be forfeited and cancelled and the taxpayer shall pay such person or entity an amount per share in cash equal to the par_value of such share of voting_stock plus the stated_value in cash of the amount of any written notices of allocation held by such person or entity and the additional capital amount_paid for or with respect to such voting_stock if any such payments in the sole discretion of the board_of directors may be extended such that redemption of written notices of allocation will be paid at such times as such written notices of allocation would otherwise be paid in the ordinary course or make any or all payments with an unsecured five year promissory note of the taxpayer providing for interest at the rate of five year u s treasury notes further each member shareholder expressly has agreed that in the event of termination the value of a member’s voting_stock prior to dissolution merger or consolidation of the taxpayer will be the par_value plus the additional capital amount_paid for such stock if any as well as the stated_value of any written notices of allocation issued to such member shareholder the member shareholder will not be entitled to be paid anything else for the value of its voting_stock or other membership rights under the plan of reclassification the articles of incorporation were amended to provide that upon any liquidation dissolution or winding up of the taxpayer liquidation event any remaining assets and funds of the taxpayer after plr-141524-04 payment of all debts redemption of outstanding non-voting common_stock at par_value redemption of outstanding written notices of allocation at their stated amount and redemption of voting common_stock at par_value plus any paid-in capital with respect to such stock will be distributed to member shareholders and non-member patrons on the basis of the value of the business done with the taxpayer during the------fiscal years immediately preceding the liquidation event as shown on the records of the taxpayer or if a shorter period the period over which the member shareholder held voting_stock or the non-member patron did business with the taxpayer as applicable statement of law sec_1381 of the code provides that subchapter_t shall apply to any corporation operating_on_a_cooperative_basis with certain exception not here relevant sec_1_1381-1 of the regulations states that subchapter_t of the code applies to any corporation operating_on_a_cooperative_basis and allocating amounts to patrons on the basis of business done with or for patrons in 44_tc_305 acq c b three principles are described as fundamental to cooperative operation subordination of capital democratic control by the members and operation at cost the vesting in and allocation among the members of all fruits and increases arising from their cooperative endeavor subordination of capital requires that control of the cooperative and ownership of the pecuniary benefits arising from the cooperative’s business remains in the hands of the member patrons of the cooperative rather than with nonpatron equity investors in the cooperative the purpose of this limitation is to insure that the gains that accrue to the cooperative from the business that it transacts with its patrons will largely or completely inure to the benefit of those patrons rather than to its stockholders to be operating_on_a_cooperative_basis a cooperative must limit the financial return with respect to its equity_capital puget sound t c pincite stated differently a cooperative may not be operated for the purpose of paying a return on equity investments democratic control of the cooperative as envisioned in puget sound pincite is typically achieved by voting on a one-member one-vote basis the principle of democratic control was further discussed in 462_f2d_259 5th cir in which the court noted that sec_521 regarding exempt_cooperatives contemplates that the stock will be owned by the patrons of the cooperative that section envision s the exempt association organized according to a model of a widely-based participatory democracy in which all the members are able to plr-141524-04 exercise a franchise of equal strength each member must have a single vote regardless of the size of its investment or the amount of business it does with the corporation the requirement of operation at cost is met if the cooperative’s net_earnings or savings are distributed to the cooperative’s patrons in proportion to the amount of business conducted with them this requirement relates to the proportionate vesting in and allocation among the worker-members of all fruits and increases from their cooperative endeavor is achieved through statutes bylaws and contractual arrangements between the association and its members whereby the elected officers of the associations are required to make periodic allocations of the same among the members in proportion to their active_participation as workers puget sound pincite revrul_70_481 1970_2_cb_170 holds that a corporation supplying services to its members at cost and making distributions to each member based on the value of business done with each member was operating_on_a_cooperative_basis within the meaning of sec_1381 of the code revrul_72_36 1972_1_cb_151 states that in accordance with fundamental cooperative principles the rights and interests of the members in the savings of a cooperative should be determined in proportion to their business with the cooperative with respect to liquidating distributions the service has stated that the cooperative principle of operation at cost requires that a cooperative’s articles of incorporation or bylaws obligate the cooperative to distribute its remaining assets upon liquidation to both its current and former members in proportion to the value or quantity of business that each did with the cooperative over some reasonable number of years sec_1382 of the code provides in part that in determining the taxable_income of a cooperative there shall not be taken into account amounts paid during the payment period for the taxable_year as patronage_dividends to the extent paid in money qualified written notices of allocation or other_property with respect to patronage occurring during such taxable_year sec_1382 of the code and sec_1_1381-2 of the regulations provide in pertinent part that there is allowed as deduction from the gross_income of any cooperative to which part of subchapter_t applies amounts paid to patrons during the payment period for the taxable_year as patronage_dividends to the extent that such amounts are paid in money qualified written notices of allocation or other_property other than nonqualified written notices of allocation sec_1388 of the code defines the term nonqualified written notices of allocation as meaning a written_notice_of_allocation other than a qualified_written_notice_of_allocation or a qualified_check that is not cashed on or before the day after the close of the payment period for the taxable_year plr-141524-04 sec_1382 of the code provides in part that the payment period for any taxable_year is the period beginning with the first day of such taxable_year and ending with the fifteenth day of the ninth month following the close of such year sec_1388 of the code provides that the term patronage_dividend means an amount_paid to a patron by a cooperative on the basis of the quantity or value of business done with or done for such patron sec_1388 provides that a patronage_dividend is an amount_paid under an obligation that must have existed before the cooperative received the amount so paid sec_1388 of the code provides that patronage_dividend means an amount_paid to a patron that is determined by reference to the net_earnings of the corporation from business done with or for its patrons that section further provides that patronage_dividend does not include any amount_paid to a patron to the extent that such amount is out of earnings other than from business done with or for patrons sec_1_1382-3 of the regulations states that income derived from sources other than patronage means incidental income derived from sources not directly related to the marketing purchasing or service activities of the cooperative association subordination of capital subordination of capital requires that control of the cooperative and ownership of the pecuniary benefits arising from the cooperative’s business remain in the hands of the member patrons of the cooperative rather than with non-patron equity investors in the cooperative the purpose of the limitation is to insure that the gain that accrues to the cooperative from the business that it transacts with its patrons will largely or completely inure to the benefit of those patrons rather than to its stockholders to be operating_on_a_cooperative_basis a cooperative must limit the financial return with respect to its equity_capital puget sound t c pincite stated differently a cooperative may not be operated for the purpose of paying a return on equity investments numerous provisions of the taxpayer’s articles of incorporation and bylaws ensure that it will meet the requirement of subordination of capital taxpayer’s articles of incorporation and bylaws both have provisions that mandate that it operate on a cooperative basis for the benefit of its member shareholders to ensure that control of taxpayer remains in the hands of its member shareholders its bylaws also mandate that each of its member shareholders shall have one and only one vote on any matter subject_to voting of the member shareholder and unless otherwise provided the vote of the majority shall control member shareholders must also be parties to a franchise agreement with the taxpayer further the taxpayer’s bylaws prohibit payment of dividends on any equity_capital furnished by its member shareholder and non-member patrons with exception on the par_value of outstanding non-voting common_stock during taxpayer’s first fiscal_year operating as a cooperative under the code dividends shall accrue at the rate of four percent per annum of the par_value of the non-voting plr-141524-04 stock and be paid_by the last day of such fiscal_year out of funds legally available therefore estimated to be dollar_figure------------out of dollar_figure-----million of patronage taxable_income for the first year of operation thereafter the holders of non-voting stock have no right to any dividends dividends shall be paid on each share of non-voting stock only when and if declared by the taxpayer’s board_of directors provided however that such dividend shall not exceed eight percent per annum of the par_value of the non-voting stock further the bylaws obligate the cooperative to return all benefits arising from business combined with or for its member shareholders of non-member patrons excluding any earnings distributed as dividends on non-voting stock to those whose participation gave rise to the benefits pursuant to section c of the taxpayer’s bylaws the board_of directors have obligated the taxpayer to account to non-member patrons for all of the patronage activities with the corporation by such non-member patron in the same manner share and share alike with member shareholders participating in the same activity a non-member patron must be a party to a franchise agreement and non-member patron agreement with the corporation and not be in default thereunder in addition to the mandate to operate on a cooperative basis the articles specifically provide that member shareholders and non-member patrons shall be entitled to any net_proceeds that are distributed after dissolution upon the basis of the value of the business done with the corporation by the member shareholder or non-member patron thus the taxpayer’s articles of incorporation and bylaws satisfy the subordination of capital requirement for cooperative operation democratic control democratic control of the cooperative as envisioned in puget sound pincite is typically achieved by voting on a one-member one-vote basis the principle of democratic control was further discussed in 462_f2d_259 in which the court noted pincite that sec_521 regarding exempt_cooperatives contemplates that the stock will be owned by the patrons of the cooperative that section envision s the exempt association organized according to a model of widely-based participatory democracy in which all the members are able to exercise a franchise of equal strength each member must have a single vote regardless of the size of its investment or the amount of business it does with the organization the taxpayer’s bylaws provide that each member shareholder shall be entitled to one and only one vote on all members of business that require member approval as prescribed by the taxpayer’s bylaws only member shareholders can hold voting_stock and all member shareholders must be franchises thus the bylaws satisfy the democratic control requirement for cooperative operation operation at cost plr-141524-04 the requirement of operation at cost is met if the cooperative’s net_earnings or savings are distributed to the cooperative’s patrons in proportion to the amount of business conducted with them this requirement relates to the proportionate vesting in and allocation among the worker-members of all fruits and increases from their cooperative endeavor is achieved through statutes bylaws and contractual arrangements between the association and its members whereby the elected officers of the association are required to make periodic allocations of the same among the members in proportion to their active_participation as workers puget sound at p the taxpayer operates on a service at cost_basis with respect to its member shareholders and non-member patrons who are its only patrons franchisees the taxpayer’s articles of incorporation and bylaws ensure that the net_earnings or savings are distributed to the member shareholders and non-member patrons in proportion to the value of business done with the corporation by the member shareholder and non-member patrons during said fiscal_year and amounts so allocated shall be distributed within the payment period set forth in sec_1382 of the code moreover in carrying out the purpose and effect of sections dollar_figure and dollar_figure of the taxpayer’s bylaws the taxpayer will account on a patronage basis to all member shareholders and non- member patrons for amounts collected from such patrons in excess of the cost of service make payment of all amounts collected in excess of cost from member shareholders and non-member patrons in the form of patronage_dividends and allocated on a dollar value basis maintain books_and_records such that at the end of each fiscal_year the amount of capital furnished by patronage is clearly reflected and may be credited to the member shareholder’s and non-member patron’s account in respect of any loss sustained by the taxpayer for any fiscal_year in any allocation unit the corporation may at the discretion of the board_of directors carry such loss forward to subsequent years within such allocation unit or apportion such loss among the member shareholders and non-member patrons participating in such allocation unit on a cooperative basis and recoup the amount due from each member shareholder and non-member patron by offsetting it in whole or in part against patronage due such person in future years or against written notices of allocation of such person finally the articles of incorporation mandate that upon dissolution or liquidation of the organization any remaining net assets and funds of the plr-141524-04 taxpayer will be distributed to member shareholders and non-member patrons on the basis of their historic participation in the cooperative generally computed on the basis of the value of the business done with the cooperative during the immediately preceding ten fiscal years thus the articles of incorporation and bylaws satisfy the operation at cost requirement for cooperative operation liquidating distributions the taxpayer’s articles of incorporation provide that upon any liquidation dissolution or winding up of the taxpayer liquidation event any remaining assets and funds of the taxpayer after payment of all debts redemption of outstanding non-voting common_stock at par_value redemption of outstanding written notices of allocation at their stated amount redemption of voting common_stock at par_value plus any paid-in capital with respect to such stock will be distributed to member shareholders and non-member patrons on the basis of the value of the business done with the taxpayer during the -----fiscal years immediately preceding the liquidation event as shown on the records of the corporation or if a shorter period the period over which the member shareholder held voting_stock or the non-member patron did business with the corporation as applicable the taxpayer’s bylaws further provide that in the event of withdrawal death or expulsion or other termination of the membership of a member shareholder or non-member patron any voting_stock held by such member shareholder will be forfeited and cancelled and the taxpayer shall pay such person or entity an amount per share in cash equal to the par_value of such share of voting_stock plus the stated_value in cash of the amount of any written notices of allocation held by such person or entity and the additional capital amount_paid for or with respect to such voting_stock if any further each member shareholder expressly has agreed that in the event of termination the value of a member’s voting_stock prior to dissolution merger or consolidation of the taxpayer will be the par_value plus the additional capital amount_paid for such stock if any as well as the stated_value of any written notices of allocation issued to such member shareholder the member shareholder will not be entitled to be paid anything else for the value of its voting_stock or other membership rights as such the intent of the taxpayer’s bylaws as approved by the shareholders in adopting the plan of reclassification is that current member shareholders and non-member patrons will receive a distribution of the remaining assets and funds of the taxpayer on the basis of the value of business done with the taxpayer over the period of their historic participation in the cooperative the bylaws contemplate that member shareholders and non- plr-141524-04 member patrons that withdraw retire or otherwise terminate their membership or non-member patron status will receive the full value of their equity_interest in the cooperative at the effective time of the terminating event each member shareholder and non-member patron has expressly agreed to those provisions under the terms of their executed membership agreement or non-member patron agreement on the effective date of the plan of reclassification all of the taxpayer’s franchisees were received into membership or non-member patron status upon their express agreement and upon the condition that the value of their equity_interest and membership rights prior to dissolution merger or consolidation of the corporation is limited to the value of their equity_interest on the date of their membership termination and will not be entitled to be paid anything else for the value of their equity_interest or membership rights as part of their approval of the plan of reclassification adopting cooperative status the franchisee shareholders with full knowledge disclosure and opportunity for objection approved these provisions as part of their approval of the restated articles of incorporation and bylaws all of the taxpayer’s member shareholders and non-member patrons are required to be franchisees of the taxpayer each with a geographically defined franchise territory all of the territories within -------------------------have been fully subscribed and the taxpayer anticipates a very stable group of franchisees with immaterial changes from year to year in the identity of franchisees or their respective proportion of business with the taxpayer termination or withdrawals of particular franchisees are anticipated to be a rare occurrence generally most franchise agreements are held by incorporated entities and thus such member shareholders and non-member patrons would be unaffected by the death or retirement of any particular individual past experience indicates that there is about one transfer of a franchise every three or four years often to an entity that already holds another franchise the board_of directors must approve the acquisition of a franchise such approval not be unreasonably withhold and would reject an acquisition where there was evidence that the acquirer’s ability to run the business would be impaired such as in an acquisition heavily leveraged with debt in the case where a corporate franchisee is acquired the existing franchise and membership agreements would likely remain unchanged as the member shareholder or non-member patron remains the same in the case of an asset acquisition a new franchise and membership agreements would be executed with the new member shareholder or non-member patron as such it is anticipated all of the franchisees will remain the same from year to year in view of the foregoing the taxpayer’s liquidation distribution provisions contained in the articles of incorporation satisfy the equitable allocation and operation at cost requirement for cooperative operation plr-141524-04 accordingly based solely on the foregoing we rule that the taxpayer is a corporation operating_on_a_cooperative_basis within the meaning of sec_1381 of the internal_revenue_code this ruling is directed only to the taxpayer that requested it under sec_6110 k of the code it may not be used or cited as precedent in accordance with a power_of_attorney filed with the request a copy of the ruling is being sent to your authorized representatives cc walter h woo senior technician reviewer branch office of the assistant chief_counsel passthroughs and special industries sincerely yours