Death and Taxes: These Two Certainties of Life Also Apply to Expansion into BroadbandSeptember 2018 -
Death and taxes could, indeed, be the only certainties we face in life. Still, there are many ways to structure a broadband operation that can impact an entity’s tax liability. Similarly, the potential “death” or sale of either a successful or unsuccessful broadband venture can have a significant impact on a cooperative’s membership and ongoing operations. Both of these issues should be seriously considered up-front – before or during the feasibility study stage – by getting input from multiple perspectives and asking the right – and some tough – questions.
Matthew Hale, credit supervisor in CoBank’s Denver office, spoke with Bill Miller, CPA, a tax partner with the firm of Bolinger, Segars, Gilbert & Moss, LLP to get a perspective on the accounting, tax and other issues that surround both creation of a broadband venture and an exit strategy.
Matthew Hale: Why is it important for an electric distribution cooperative to partner with its accounting firm when considering new business structures for broadband?
Bill Miller: Having a well-rounded view that incorporates multiple perspectives – financial, legal, engineering, as well as tax and accounting – is key to finding an effective structure for the cooperative. Each of these disciplines will look at a broadband business structure from a different angle.
For example, legal counsel will look at cooperative operations from the state level and accounting/tax professionals, such as myself, will take a cooperative tax view, which might add a layer to the consideration or maybe even take away a layer of consideration.
I generally advise clients to get everybody in a room or on a conference call so that all the different perspectives get out on the table and are considered at the same time. It’s the most effective approach to finding a solution, having a discussion and creating a perspective that considers the project from all angles. This type of all-inclusive, well-rounded approach provides the client’s management team and board with a sense of confidence that the new venture will be created in consistency with their goals and objectives.
MH: What are the positives and negatives of establishing a subsidiary corporation when considering a new business opportunity in broadband?
BM: The basis of any business structure should be the membership – how you want members to benefit from the project. The answer to this question will drive the legal structure and the tax structure of the project. If the goal is to provide an additional service for members, as well as for non-members, and the way members benefit is through cost-sharing and through a source of unallocated retained equity, a for-profit and taxable subsidiary corporation provides these benefits. Both legal and tax separation are also achieved. Tax separation is important because the IRS will not attribute the activities of the subsidiary corporation to the parent cooperative as long as a valid business reason exists.
Cost sharing is generally achieved through the use of intercompany agreements, such as a management services agreement. When the agreement is structured at cost, it allows the cooperative flexibility in staffing without creating, in general, unrelated business income. If the bylaws of the cooperative are modified accordingly to retain the net after tax earnings of the subsidiary as a source of retained unallocated equity, then cash distributions out of the equity of the subsidiary corporation, generally in the form of a corporate dividend, provides the cooperative a source of cash flow that can be used to assist the electric operations. Examples include using cash dividend distributions for construction, repayment of debt and for retiring patronage capital credits. Return of invested capital, such as amounts invested to capitalize the subsidiary corporation, does not generate non-member income for the electric cooperative’s 85-15 Test. A corporate dividend distribution out of the earnings of the subsidiary corporation does, however, result in non-member income for purposes of the 85/15 test. Although income for purposes of the 85/15 test, corporate dividends are excluded from the definition of unrelated business income, except to the extent the investment is debt financed. Therefore, so-called double taxation on the earnings of the subsidiary corporation can be limited.
By virtue of its structure, a subsidiary corporation will have federal and state corporate income tax return filings and will be subject to the corporate income tax at the applicable rates. Additionally, sales tax exemptions that may apply to the electric cooperative often do not apply to purchases used in or made by a subsidiary corporation. In addition to these anticipated results, a negative to establishing a subsidiary corporation is the effect inter-company transactions may have on the parent cooperative’s 85/15 test calculation and the potential for unrelated business taxable income. For example, if a management service agreement is built to generate a profit, it will generate non-member income for the 85/15 test for the amount of the total cost of the agreement and unrelated business taxable income. With the potential for unrelated business taxable income, the feasibility studies need to factor in unrelated business income tax. Therefore, we generally recommend that a cooperative should establish those types of agreements at cost.
Another consideration is the lease of fiber to the subsidiary corporation. Most of the feasibility studies we have seen consider the inter-company lease of the fiber as either related or excluded from unrelated business taxable income as a “qualified pole rental.” Rents meeting the definition of qualified pole rental income are excluded from the 85/15 test and from unrelated business taxable income. However, with few exceptions, inter-company loans and leases result in both non-member income and unrelated business income tax considerations. Therefore, analysis should be done to determine if the fiber leases involved are governed by the “qualified pole rental” rules or are governed by the inter-company transaction rules.
In general, the negatives for the cooperative would be non-member income and unrelated business income tax issues of inter-company related transactions, which could generate tax issues and effect the 85/15 test.
Having a well-rounded view that incorporates multiple perspectives—financial, legal, and engineering, as well as tax and accounting—is very important.
MH: What are the positives and negatives of keeping the broadband business within the co-op as a separate division?
BM: This goes back to the primary question of how members should benefit from the project. Subsidiary corporations are all about separation – both legal and tax. But when creating a division, typically the answer is that we not only want members to have access to a service, we also want them to benefit from additional patronage earnings. Achieving that as a so-called “like organization activity,” which is exempt from federal income taxes under Section 501(c)(12) of the Internal Revenue Code, is key.
Offering the service through a division implies an understanding and preference for the co-op model and reflects the members’ desire to maintain that structure. Additionally, a divisional structure provides no legal or tax separation, which may allow for simplification of the overall accounting and tax structure. Please note, however, that the use of a so-called disregarded entity may be used for legal separation but continue to be treated as a division for tax purposes.
Further, it eliminates inter-company transactions for purposes of the 85/15 test and the unrelated business income tax calculations. Therefore, any fees from one division to another division or any management services agreements from one division to another division are eliminated, unlike what happens in the case of a taxable subsidiary corporation.
The main negative is what happens if the amount of non-member sales exceeds the non-member income threshold for passing or failing the 85/15 test. Accordingly, the co-op should consider an exit strategy and determine the point in time it makes sense to move to a taxable subsidiary corporation structure.
The basis of any business structure should be the membership—how you want members to benefit from the project.
There is also the fair and equitable allocation issue and associated governance related issues. For example, unless the patrons buying the service of an electric division and a broadband division are substantially the same, a cooperative should allocate patronage capital on a divisional basis. A related issue is if the patrons will be members only or both members and non-members. Services provided on a patronage basis qualify as a “like organization activity” and are related to the cooperative’s exempt purposes. Services provided on a nonpatronage basis, are generally not related. The bylaws should be modified accordingly.
Another related decision is who the members of the cooperative should be - electric only patrons or purchasers of all services? If it’s electric only, governance remains the same. If it’s purchasers of all services, then governance will change. These decisions are neither pro nor con. They simply have to be made.
In summary, if a co-op decides to go down the divisional route, its management and board has to take a hard look at bylaws and ask questions: Who do we want our members to be? Who do we want our patrons to be? What do we want to do with any non-patronage sales?
MH: What level of financial planning should be conducted on a material investment such as broadband and is it necessary to utilize the services of a CPA?
BM: To put it in context, one of the differences between the recent expansion by electric cooperatives into broadband versus the diversification and expansion in the late 1990s is the amount of financial analysis that is being conducted.
In the late 1990s, there was a big push for diversification with the thought that if a cooperative didn’t diversify, its business model was going to be significantly different. Therefore, a number of cooperatives expanded into areas that were core or non-core to their primary business of electric energy. Regardless of the type of service, there wasn’t nearly the level of financial planning and analysis and exit strategy development as there is today.
Cooperatives that hire firms which specialize in analyzing markets and preparing feasibility studies for broadband could consider utilizing a CPA firm or tax consultant to look at those studies to ensure they’re considering the appropriate accounting and tax issues.
For example, some financial models include income taxes; some do not. The ones that don’t are still being promoted as taxable subsidiary corporations, which is one area where a CPA or tax consultant could provide value. Such analysis could result in revised income tax calculations and resulting cash flow forecasts. It could also identify potential income tax implications on inter-company transactions because those aren’t always reflected in the feasibility studies.
MH: How should a cooperative account for contributions in aid to construction (CIAC) on a broadband project? Do they do anything different than they would for electric plant? Does it make a difference if the business is a division or a subsidiary of the cooperative?
BM: The accounting treatment may vary based on whether or not the broadband activity is regulated or non-regulated. If regulated, CIAC contributions for a broadband project should be treated the same way as for electric plant. If non-regulated, then the accounting treatment will likely vary based on the terms and conditions surrounding the CIAC, including service contracts. Because of potential differences between the accounting for CIAC between regulated and non-regulated operations, a cooperative’s audit firm should be consulted. Depending on how the auditor advises you to record CIAC, there likely will be differences between book and tax accounting.
Under federal tax law, CIAC is considered prepayment for a service and is, therefore, income for tax purposes. This holds true whether the CIAC is received from regulated or non-regulated operations. To illustrate the potential for book and tax differences, assume the operations are regulated and a portion of the business is operated on a taxable basis through a subsidiary corporation. For regulatory accounting purposes, the CIAC is a reduction in the depreciable cost of the plant, and therefore, you have less book depreciation expense. For tax purposes, CIAC is considered income in the year of receipt but increases the depreciable tax basis of the asset. The ability to claim and accelerate tax depreciation on a corporate income tax return will help minimize the timing and cash flow differences that occur between the date received and estimated depreciable life.
If received by a division of the cooperative, CIAC is considered for the 85/15 test because it is a tax basis calculation. If received from a member – who must have both a right to vote and right to receive patronage capital for the underlying services – for an exempt activity, then it is generally considered to be “member” income. If received from a non-member, regardless of the tax-exempt nature of the service, then it is “non-member” income. If the CIAC is associated with an unrelated business or received by a taxable subsidiary corporation, then it is taxable income and the ability to claim and accelerate tax depreciation is important.
MH: What are the considerations when receiving a grant or other forms of government or state funding for a broadband project?
BM: In general, up through 2017, a government grant that was received by a cooperative for the purpose of providing a public benefit and for the construction of an asset was considered under tax law to be a non-shareholder contribution of equity and not taxable income. Grant proceeds were generally excluded from the 85/15 test.
The Tax Cuts and Jobs Act amended Section 118 of the Internal Revenue Code upon which the exclusion was based. Amended Section 118 now excludes government grants from income of a grant recipient only if the government is a shareholder in the organization, which can create issues for the cooperative business structure. As the Internal Revenue Code exists today, it appears as though government grants are no longer excluded from tax basis income as a non-shareholder contribution of equity. Therefore, the main consideration today is to involve your tax advisor on any receipt of federal or state grants and have them determine the impact such grants will have, first and foremost, on the 85/15 test. Revisit income tax calculations of a subsidiary corporation as these could also change. Also track any potential legislative fixes to either Section 118 or Section 501(c)(12).
This is a very important step. When feasibility studies were conducted for most projects one or two years ago, the old set of tax rules would have applied and updates may be needed for the new rules.
MH: Does either option – subsidiary or division – offer an easier exit strategy if the cooperative elects to sell its broadband business?
BM: An exit strategy could be a couple of things. One, what if we think we know the structure we want today but we might want to modify that structure.
It’s easier to flow a business downstream rather than to try to reverse and flow it upstream. Unwinding a corporate subsidiary structure by moving to and operating as a division of the cooperative can be done, but doing so is generally more cumbersome and costlier. For example, the liquidation and dissolution of a subsidiary corporation may result in taxable gain to the subsidiary if the exempt cooperative parent will conduct the business operations of the subsidiary corporation on a tax-exempt basis. In other words, the cost to operating on a tax-exempt basis in the future is a potential income tax liability today. The same tax consideration generally does not exist when a business activity flows from a tax-exempt cooperative to a taxable subsidiary corporation.
Cooperatives that hire firms which specialize in preparing feasibility studies for broadband should consider utilizing a tax consultant to look at those studies to ensure they’re considering the appropriate accounting and tax issues.
If you have a subsidiary corporation and want to exit what has become an unsuccessful venture, the members are most likely going to be on the hook for the debt. This is true in either a subsidiary corporation or cooperative divisional structure. If it’s a subsidiary corporation, there’s some separation. But in the end, if the business is not successful and must be sold, that debt is ultimately going to be on the books of the cooperative.
That’s one aspect that doesn’t change and that should be considered in the feasibility study. A critically important consideration is the impact a potentially unsuccessful broadband operation and assumption of its debt would have on rates. If it’s a division, it’s already there. But if it’s a subsidiary, that’s a scenario that often isn’t – but should be – seriously considered. A related consideration is how any loss will be be recovered from the members. Bylaws should be modified accordingly and before the loss is incurred.
If the broadband business is successful, the tax implications and planning opportunities between the divisional and subsidiary corporation approaches will vary. Therefore, the structure of a potential sale will potentially be different, and a tax consultant can provide a general overview of the potential implications and options. Key questions in considering a sale are: What are the pros and cons? How is it going to work? What happens in case of a loss and what happens to the debt? What happens to a potential gain and what is the tax impact? These responses might drive a particular structure, or an idea that when we get to that point, there might be multiple ways to structure a sale.
These types of questions are examples of the difference between the current environment and the diversification that took place in the 1990s. In the late 1990s, the potential for failure wasn’t readily considered. Today, co-op bylaws should have provisions not for just allocating patronage capital but also for what to do in the event of a loss.
NRECA members can receive a comprehensive memo on the issues discussed here free of charge by emailing NRECA’s Ty Thompson.
Bill Miller, CPA, is a tax partner with the accounting firm of Bolinger, Segars, Gilbert and Moss in Lubbock, Texas. He began his career with the firm in 1992 and holds an accounting degree from the University of Texas at Austin. Bill is in charge of the firm’s utility and cooperative tax practice. The goal of his department is to provide tax and consulting services to the firm’s exempt and non-exempt utility cooperative audit clients, including related subsidiary companies. His responsibilities include tax research, tax planning, advising on entity selection for new business ventures and tax return preparation. Bill also assists his clients in complying with cooperative principles and structuring plans to allocate and redeem patronage capital. Bill is active in the National Society of Accountants of Cooperatives. He currently serves as a national director and president and also as a director of the Electric Cooperative Chapter.
This interview was originally published in Broadband Partnerships: A Key to High-Speed Success for Rural Electric Co-Ops.
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