LEGAL CORNER
Government purchasing
co-ops operate tax free
By Donald A. Frederick
Program Leader for Law,
Policy & Governance;
USDA Rural Development
donald.frederick@wdc.usda.gov
tate and local governments
that see opportunities
to hold down costs by
procuring goods and services
through a cooperative
should gain assurance from a recent
Internal Revenue Service (IRS) administrative
determination. While no
Subchapter T tax issues are involved,
the decision highlights another Internal
Revenue Code (Code) section helpful to
public institutions which organize a
separate entity to engage in joint purchasing
activities.
Code Sec. 115 provides that gross
income for federal income tax purposes
does not include income accruing to a
state or territory, or any political subdivision
thereof, which is derived from a
“...public utility or the exercise of any
essential governmental function.” This
provision gives state and local governments
the flexibility to create separate
entities to perform essential services
without incurring federal income tax
liability on earnings that are (1) generated
by those entities and (2) retained
within the public sector.
In Private Letter Ruling 200610001
(released March 10, 2006), the IRS
determined that income earned by a
nonprofit corporation, formed by public
school districts for the purpose of cooperatively
purchasing supplies, is not taxable
income under Code section 115.
Case facts
Two school districts formed a nonprofit
corporation for the sole purpose of
purchasing goods and services for public
school districts and other members. The
ruling points out that “Through cooperative
purchasing power, Taxpayer enables
its members to purchase a range of
goods and services at reduced prices.”
The ruling doesn’t discuss who
became members of the association, its
governance structure or its previous tax
history. But as the basis for submitting its
request for a ruling that it is entitled to
tax-free status, the purchasing association
amended its articles of incorporation to
provide that its members must be public
school districts or other government
entities that meet the requirements of
Code Sec. 115. In its request, the entity
identified current members that did not
meet this test and promised to terminate
those memberships by a specified date.
The article amendments also provide
that the entity may not issue shares of
stock nor declare or pay dividends. Also,
while reasonable compensation can be
paid to individuals for services rendered,
no part of net earnings may inure to the
benefit of any director, officer or other
individual. In the event of dissolution,
any remaining assets after liabilities are
paid will go only to member governmental
units on the basis of the prior three
years’ patronage.
IRS decision
In granting favorable tax treatment,
IRS held that the entity meets both
requirements to qualify for Sec. 115 tax
status. First, IRS notes that its only
function is to procure goods and services
at more competitive prices for its
members. IRS found this to meet the
test of performing an essential governmental
function within the meaning of
Code Sec. 115(1).
Second, IRS notes Code Sec. 115
also requires that any income must
accrue to a state or political subdivision
thereof. IRS finds that “...income
accrues to its members through the procurement
of goods and services for its
members.” It also points out that upon
dissolution, assets remaining after liabilities
are satisfied can be distributed only
to qualified members on a pro rata basis
and earnings cannot be distributed to
private persons. Under these conditions,
the entity’s income also meets the test of
accruing only to states and political subdivisions
thereof.
IRS concludes that so long as the
entity operates as represented and cleans
up its membership rolls by the date
promised, it will be eligible for Code
Sec. 115 tax treatment on that date.
