Business structure considerations for diversified activities.

Several alternative forms of business structure are available to an electric cooperative interested in developing diversified businesses. The optimal form of involvement will vary depending on each particular cooperative's legal considerations, along with its financial and operating situation, and potential funding sources. Cooperatives' choice of business structure for diversified operations is also a policy - and political - issue: investor-owned utilities and other non-cooperative businesses are routinely advancing their "level playing field" rhetoric as a ruse to force cooperatives to accept state law changes that allow cooperatives to enter competitive fields only as a for-profit corporation.

This article discusses legal, organizational, tax, accounting, benefits, and other regulatory implications of various forms of business structure. Cooperatives should determine which model best fits the needs of particular situations, and should endeavor to assure that state law allows cooperatives to compete as cooperatives and through any other appropriate business structure.

Options include the following:

* Organize as a division of the electric cooperative

* Create a subsidiary of the electric cooperative as either a for-profit or a not-for-profit entity, or a limited liability company (LLC)

* Execute a management or limited services contract (e.g., billing, meter reading) with another service provider - an approach that does not necessarily require establishment of a new organization.

* Participate in the establishment of a nonaffiliated legal entity, that is, one that is not majority-owned by the electric cooperative, but which may be initially sponsored by the cooperative or other organizations. Depending on the laws of the state, this entity can be a (1) new cooperative, (2) not-for-profit corporation, or (3) for-profit corporation.

* Establish an outsourcing/franchisee relationship by contracting with a non-affiliated entity (for example, AT&T or Enron or America On-Line) that would provide certain services to co-op customers on a turn-key basis.

Each option has its own inherent strengths and weaknesses. Within each organizational structure, the following areas will be evaluated:

Corporate Veil

The concept of "corporate veil" refers to the legal separation of a corporation from its owners. In a corporation, an owner's liability is generally limited to the investment made in the enterprise. This consideration becomes a concern mainly in the event the electric cooperative has determined a need to create a new company, and then has to decide if the new company should be a subsidiary or a separate corporation. A prime consideration in determining a form of organization for the new enterprise is the financial insulation of the electric cooperative's existing members' equity in cooperative from potential financial losses from diversified operations.

Governance 

Some business structures may be governed by the traditional electric cooperative board. For others, however, there may be legal or regulatory restrictions that require the cooperative to establish an alternative board structure for the diversification entity.

Impact on the Electric Cooperative's Financial Status

One factor that needs to be considered is which type of organization is the most advantageous for the electric cooperative.

Rural Utilities Service (RUS) Controls

RUS has extensive regulatory authority to control its electric cooperative borrowers and to monitor activities that might affect the ability of a borrower to repay federal loans. The extent of regulatory oversight will vary depending on which form of organization is selected.

Considerations from Other Lenders

Many electric cooperatives borrow some or all of their debt from private lenders, rather than from RUS. Debt from these private lenders - such as CFC, CoBank, banks, and other sources - may implicate additional or different considerations on the electric cooperative and its diversified operations for particular business structures.

Capitalization 

Depending on the structure or involvement chosen by the electric cooperative, a certain amount of funds may be required from the cooperative in connection with the diversification endeavor. It is expected that the least amount of funds would be required in the case where the electric cooperative merely assists local residents in forming a diversified entity but has no other involvement with the new entity. Under more intensive organizational options, costs will vary. However, a portion of the start-up costs may be reimbursable from loan or grant funds at a later date. It is likely, however, that some cash investment by the electric cooperative will be necessary.

Control of Diversified Enterprise

Under several of the organization structures, the electric cooperative may wish to exercise substantial control over the operations of the diversified enterprise. This is especially the case when the cooperative is involved in funding the project. Other issues to evaluate in control of the diversified activity are quality control (of product and customer service) and access to customer data.

Income Tax Implications

This will explain tax management strategies, including implications for retention of tax-exempt status.

Administrative Costs 

The additional costs of record-keeping, business taxes, etc., associated with a diversified enterprise can be somewhat reduced if the new enterprise is organized as a division of the electric cooperative. Administrative savings attendant to the division form of organization are not, however, likely to be substantial compared with other legal organizational structures. Many record-keeping costs and business taxes will apply regardless of the form of legal organization chosen for the diversified enterprise.

Option 1: Division of the Electric Cooperative

Corporate Veil: From a legal standpoint, organizing the diversified enterprise as a division allows the equity of the rural electric cooperative to be used for the collateral of the diversified business. The equity of members in the electric cooperative would be fully at risk for both margins and losses incurred by the diversified enterprise.

Governance: Because the diversification activity is operated as a division of the electric cooperative, the electric cooperative's board will oversee the diversification endeavor, as it would any other operation of the electric cooperative. While traditionally the electric cooperative's board of directors has been comprised solely of member-consumers. the IRS has recently ruled in a private letter ruling that an electric cooperative can elect outside directors. This authorization would enable the electric cooperative to obtain the service of outside directors with specific expertise relevant to various diversified enterprises, if the cooperative desired.

Impact on the Electric Cooperative's Financial Status: When using a division of the electric cooperative as the diversified entity, income and losses of the division will be included by RUS in the electric cooperative's Times Interest Earned Ratio (TIER) and Debt Service Coverage (DSC) ratio calculations.

RUS Controls: RUS exercises substantial control over the operations of electric cooperative borrowers including, for example, approval of significant sales; purchase, and operation and maintenance contracts; additions to the system; and issuance of secured debt. RUS has the legal right to exercise controls over the actions of a diversified entity that is a division of a borrower electric cooperative. RUS' rights are provided in the rural electric cooperative's mortgage and loan contracts. It cannot be determined at the outset what degree of control RUS will choose to exercise.

Considerations from Other Lenders: Earning ratios of the electric cooperative include the non-electric divisions' revenues and expenses. Lenders have some rights to exercise control over operations.

Capitalization: Start-up funds will be required to establish a diversified entity as a division of the electric cooperative. Lenders to the diversified business would likely require at least a release of lien on diversification assets by the existing lenders to the cooperative. A joint mortgage on all the assets of the electric and diversification assets would be another alternative.

Control of a Diversified Enterprise: Control is maximized by using the division of the electric cooperative because the cooperative's board of directors also fully controls the operations of the diversified enterprise.

Income Tax Implications: Under a division structure, the income of the diversified enterprise must be considered in the 85% member income test of the rural electric cooperative.

State Law Considerations: Existing state laws for the organization of electric cooperatives may restrict the types of businesses in which the cooperative can directly engage. Moreover, state or federal laws to restructure the electric industry could restrict the services that a "wireco" would be allowed to offer. Some restructuring laws could require formation of separate companies for provision of some services.

Option 2: Subsidiary of the Electric Cooperative and Limited Liability Company

Corporate Veil: Organization of a subsidiary should provide adequate insulation if steps are taken to ensure that the "corporate veil" is not "pierced" by lack of observance of corporate formalities at the subsidiary level. Excessively close arrangements (related to management and control) between a parent and its subsidiary increase the likelihood that the subsidiary will be viewed by courts as merely an agent or instrumentality of the parent. Steps that the electric cooperative can take to help ensure that the corporate veil between the parent and the subsidiary remains intact include the following:

* All or a majority of the subsidiary's board members are different from the parent's board of directors.

* If the subsidiary uses the parent's or rural electric cooperative's personnel, time is accounted for separately, and the subsidiary is charged for use of parent personnel at market rates.

* The subsidiary is charged market rent if it uses the parent's or rural electric cooperative's facilities.

Governance: The parent electric cooperative, which owns the stock in a subsidiary corporation, is entitled to elect the subsidiary's board of directors. In an LLC, the electric cooperative in essence assumes a role like that of a general partner in a legal partnership, directly overseeing the governance and management of the diversified business enterprise.

Impact on the Electric Cooperative's Financial Status: In the case of an electric cooperative thin creates a diversified enterprise as a subsidiary, RUS currently holds that the income and losses of a subsidiary of the cooperative should be included in the calculation of that cooperative's TIER and Debt Service Coverage (DSC) ratios. This is RUS' interpretation of the accounting rules of the Financial Accounting Standards Board. RUS' position should be taken into consideration before choosing the subsidiary structure for the diversified enterprise.

RUS Controls: Organizing the diversified enterprise as a separate legal entity, either as a subsidiary or as any nonaffiliated form of legal organization (such as a new cooperative, not-for-profit corporation, or for-profit) would avoid RUS' authority to control those diversified operations directly.

Considerations from Other Lenders: The electric cooperative's earnings ratios, for mortgage compliance, would include the income or losses of any form of subsidiary. For a stock subsidiary, the subsidiary dividends would be limited by a lender until earnings ratios have been achieved on a historic basis. Likewise, if the subsidiary were organized as a limited liability company or a legal partnership, distributions from the subsidiary to the electric cooperative would be limited by a lender until earnings ratios have been achieved on a historic basis. Special considerations might apply to more complex organizational structures, such as a for-profit subsidiary that is owned by a not-for-profit subsidiary of the electric cooperative. ln that scenario, lenders might find it preferable to lend the majority of the financing directly to the entity generating the cash flow because stock dividends alone would generally be insufficient to service the debt.

Capitalization: If the cooperative determines that a new entity is necessary, then a substantial amount of funds will be needed. Depending on the structure of the new entity, loan or guaranteed funds may be available for most, or at least a majority, of the project costs. The ability and willingness of the electric cooperative to guarantee the loans or grants for the project could increase the amount of funds available to new diversification entities.

Control of a Diversified Enterprise: A substantial amount of control is possible if the cooperative organizes the diversified enterprise as a subsidiary, because the cooperative would own the enterprise. As the owner, the rural electric cooperative elects the diversified enterprise's board of directors.

Income Tax Implications: The National Office of the IRS has recently ruled in a technical advice memorandum that the gross receipts of a for-profit subsidiary of a utility cooperative must be considered non-member income for purposes of the utility cooperative's member income test for tax exemption. Tax law requires that a utility cooperative must annually derive at least 85% of its income from members. If the IRS technical advice is upheld, it will be very difficult for an electric cooperative which owns a for-profit subsidiary to remain tax exempt.

Training materials issued by the IRS state that a tax-exempt electric cooperative may own a not-for-profit subsidiary, so long as: (1) the subsidiary engages in utility-like services and ancillary activities which themselves would qualify for tax-exempt status, and (2) the subsidiary is operated on a cooperative basis.

The gross receipts of an LLC would be considered non-member income in the electric cooperative's 85% member income test. If the parent electric cooperative, nonetheless, met the 85% member income test, the income of the LLC would be subject to the unrelated business income tax (UBIT).

Option 3: Contract for Management Services

Corporate Veil: The electric cooperative would be at risk for actions taken on behalf of the diversified entity. Although some reduction of the risk could be achieved through contract limitations and "non-recourse" language, it is unlikely they will substantially reduce the risk.

Governance: Provided that the management duties were carried out directly by the electric cooperative, the board of the electric cooperative would be responsible for implementation of the agreement.

Impact on the Electric Cooperative's Financial Status: If the electric cooperative manages the diversified company, the financial results of that diversified company should not affect the electric cooperative's books. To ensure this separation, different bank accounts and accounting records should be maintained for the electric and the diversified companies. However, the income from the management fees would impact the co-op's financial statements.

RUS Controls: Other than possibly approving the contract between the electric and the diversified entities, it is not expected that RUS would have any direct control of your rural electric cooperative's involvement in the diversified entity under the management contract scenario. The RUS may become involved, however, if the agency determined that the contract would somehow impact its collateral at the rural electric cooperative.

Considerations from Other Lenders: Any lending required to enable implementation of the agreement would be directly to the electric cooperative or its subsidiary, and considerations would be as discussed in above sections.

Capitalization: This structure will probably require a minimal amount of funds from the cooperative. The cooperative can probably utilize its current employees to meet the contract requirements; most of the costs would then be required for staff training.

Control of a Diversified Enterprise: Under a management contract, the cooperative would have the degree of control agreed to in the contract. The level of control varies depending on the requirements of the diversified enterprise, the cooperative, and other parties (as specified in the contract terms negotiated between them).

Income Tax Implications: There should be no impact on the tax-exempt status of the rural electric cooperative in the case of a management contract, unless the management fees, when combined with other nonmember income, are greater than 15% of the electric cooperative's total income. While the tax-exempt status of the electric cooperative may be unaffected by management fees, the IRS may consider management service fees derived from a diversified enterprise to be unrelated business income to the electric cooperative, which is subject to the unrelated business income tax (UBIT). The unrelated business income tax applies to electric cooperatives, even though they are otherwise tax-exempt. The expenses associated with providing the management services would be deductible from management service fees when computing unrelated business income tax liability - so actual income taxes payable would be expected to be minimal.

Option 4: Non-Affiliated Entity

Corporate Veil: A non-affiliated legal entity - one that the cooperative may participate in founding but which is not owned by the cooperative - provides a high-level of legal insulation. However, it is imperative that the cooperative and the non-affiliated entity each comply strictly with the particular corporate formalities required of each under state law. Failure to adhere to such formalities could enable a court to "pierce the corporate veil," with the new entity being viewed as merely an agent of the cooperative, thus exposing the cooperative's treasury to claims made against the new entity. Provided the formalities are observed, a nonaffiliated legal entity provides a high level of financial insulation. However, the rural electric cooperative could be subject to some financial risk if it has executed a management contract with the nonaffiliated company.

Governance: The stockholders of a for-profit corporation elect the corporation's board of directors. The members of a separate cooperative elect that cooperative's board of directors. In the case of a not-for-profit, non-cooperative corporation, state law and the articles of incorporation will specify the composition and election procedures of the governing board.

Impact on the Electric Cooperative's Financial Status: The income and losses of the nonaffiliated diversified enterprise would not be included in the electric cooperative's TIER and DSC ratio calculations.

RUS Controls: RUS would have virtually no control over a nonaffiliated entity, unless the electric cooperative executes a management contract with the non-affiliate.

Considerations from Other Lenders: Any lending required by the electric cooperative to enable implementation of the agreement would be loaned directly to the electric cooperative or its subsidiary, and considerations would be as discussed in above sections.

Capitalization: The level of capitalization would be determined by the rural electric cooperative's level of involvement with the nonaffiliated entity.

Control of a Diversified Enterprise: The electric cooperative exercises very little control when a nonaffiliated entity is created. The cooperative neither owns the diversified enterprise nor elects its board. The cooperative's lack of control over the nonaffiliated entity can be mitigated by contract. For example, in a management contract where the electric cooperative agrees to manage the diversified enterprise, the contract should clearly establish the level of control. Certain limitations could be made at the request of your cooperative (for liability purposes) or by the entity (because of lender requirements, insurance requirements, etc.),

Income Tax Implications: Depending on the services provided, a diversified entity organized as a cooperative could qualify for tax-exempt status under the same classification of exemption as electric cooperatives. For-profit and not-for-profit corporations would generally be fully taxable entities, although under certain circumstances, a not-for-profit corporation might qualify for tax-exempt status under IRC Section 501(c)(4) as a social welfare organization. As a practical matter, a taxable rural electric cooperative is unlikely to incur significant income tax liability because its taxable income should normally be minimal. The projected tax liability of for-profit diversified businesses will, of course, depend on the extent of taxable income that the new entity expects to receive.

Option 5: Outsourcing/Franchisee Relationships

Corporate Veil: The distinction between the cooperative and a nonaffiliated contractual business partner provides a high level of legal insulation. Allocation of liability will be based on the terms negotiated in the contract.

Governance: The allocation of responsibility in these situations would be governed in part by contract and the division of labor between the franchisor/outsource company and the electric cooperative. The board of the electric cooperative would be responsible for actions undertaken by the electric cooperative and any affiliates to implement a joint venture or any delivery of services by the electric cooperative or its affiliates. However, the outside company (and its board) would be principally responsible for actions undertaken by that company and its agents.

Impact on the Electric Cooperative's Financial Status: The income and losses of the diversified enterprise would not be included in the electric cooperative's TIER and DSC ratio calculations.

RUS Controls: RUS would have virtually no control over the contractual business partner, except in those cases where RUS chooses to use its discretionary contract review/approval authority to force certain changes in contract terms. Even in these situations, however, RUS' power would likely not extend beyond the contract terms into any aspect of the business partner's daily operations.

Considerations from Other Lenders: Any lending required by the electric cooperative itself to enable implementation of the agreement would be loaned directly to the electric cooperative or its subsidiary, and considerations would be as discussed in above sections. Lending required by the franchisor/outsource company would have no effect on the electric cooperative's lender requirements.

Capitalization: The level of capitalization required of the electric cooperative would be negotiated as a contract term with the business partner.

Control of a Diversified Enterprise: The contractual business partner would retain sole control over virtually all aspects of the diversified company's operation, such as quality control. The cooperative could attempt to establish some initial operational standards for the diversified business during contract negotiations by prescribing certain benchmark contract terms. The cooperative's ability to initially require such standards and to enforce such standards on a daily basis would be limited by the cooperative's negotiating power relative to the prospective business partner.

Income Tax Implications: The taxable status of the diversified enterprise will depend on the business structure and tax status of the contractual business partner that owns the diversified business. The contractual business partner will be responsible for any taxes that are due from the diversified company.

GLOSSARY FOR SUBSIDIARIES AND NONAFFILIATED ENTITIES

If a cooperative determines that it wants to form a new legal business entity - either a subsidiary or a nonaffiliated entity - to carry out certain diversification functions, there are several alternative types of business organization types that the cooperative could choose to form. Each of these business types has legal and tax advantages and disadvantages. In evaluating the most appropriate fit for a cooperative's particular needs, the cooperative's board and management should consult qualified local legal and tax counsel. Here are some very basic characteristics of alternative business forms:

Cooperative

A cooperative is a legal entity (a corporation or association) wherein each member has an equal share in the governance of the entity: one member, one vote. Margins above the costs of operating the business are allocated to members based on patronage and refunded to members over time as capital credits. Members are not liable for the debts of the cooperative beyond the capital they have invested. Cooperatives may be organized on either a for-profit or not-for-profit basis.

Corporation

A corporation is a business association that is authorized by the state to be a legal entity that exists separately from its creators and shareholders. The corporate business form insulates a corporation's shareholders or members from the legal liabilities of the corporation. A corporation may be either a for-profit or a not-for-profit entity.

A not-for-profit corporation is one formed for some charitable or benevolent purpose authorized by state law. A not-for-profit corporation operates for some social or business purpose other than accumulation of profits for shareholders.

A for-profit corporation is an investor-owned legal entity with voting rights weights based on voting stock ownership. Corporate strategies should maximize monetary return to shareholders, and the value of a stockholder's ownership of the company increases as the value of the company increases. Ownership in the corporation can generally be bought or sold on an open market. Shareholders are not liable for the debts of the corporation beyond the capital they have invested. Taxable corporations are taxed once at the corporate level and again as personal income on distribution of dividends to individual shareholders.

Legal Partnership

A legal partnership is an extension of the partners. It does not insulate the partners from the legal and financial liabilities of the partnership. The partners remain liable for all debts of the partnership. The partnership is not liable for income taxes; instead, each partner pays taxes on the partnership's income that is attributable to that partner.

Limited Liability Company

A relatively new form of business structure in most jurisdictions, a limited liability company, or LLC, combines the limited liability advantages of a corporation and the income tax advantages of a partnership. In an LLC (or limited liability partnership - LLP), the partners are not liable for the company's debts, and income taxes are due only from the individual partners (rather than from the company and the partners).

Joint venture

A joint venture is a limited purpose legal entity that allows two or more distinct companies to join forces to accomplish a task that would be substantially more difficult without the synergies gained from the partners' joint efforts. None of the partners obtains any financial interest in any other partner through the mechanism of the joint venture. For example, an electric cooperative forms a joint venture with a home security company to offer and deliver home security monitoring in the cooperative's territory (an area not presently served by the home security company). The cooperative possesses goodwill with the area's consumers and substantial customer market data - data that the home security company does not have. The home security company has substantial experience in its field - experience that it might take the cooperative significant time and money to develop on its own. By joining forces, the joint venture gains from the expertise of each partner without divulging trade secrets or otherwise merging the two partners.

Alliance

An alliance is not a legal entity, but is some form of loose, coordinated endeavor. An alliance may be accomplished through a contractual arrangement, vendor-vendee relationship, or franchise relationship.

Greg Wortham is association counsel for the National Rural Electric Cooperative Association in Arlington, Virginia, where his work focuses an the changing electric industry and the response of consumer-owned electric cooperatives to those changes. Prior to joining NRECA in 1995, Mr. Wortham practiced corporate and regulatory law for four years at two Washington, D.C., law firms: Atlanta-based Sutherland, Asbil & Brennan and Los Angeles-based Paul, Hastings, Janofsky & Walker.

Mr. Wortham graduated magna cum laude from Rice University with majors in political science and policy studies. He earned his law degree with honors from The University of Texas. Mr. Wortham also holds a masters degree from the Lyndon B. Johnson School of Public Affairs at The University of Texas.