Southwest Texas Electrical Cooperative, Inc. v. Commissioner

The Southwest Texas Electrical Cooperative, Inc. (co-op) (plaintiff) was a tax-exempt organization. The co-op qualified for an approximately $5 million loan from the Rural Electrification Administration. The purpose of the loan was to help the co-op expand and upgrade its facilities. Under the conditions of the loan, the co-op could draw down funds only to reimburse the co-op for already-incurred construction expenses. Over the course of about two years, the co-op drew down approximately $2.5 million of the loan and used the proceeds to reimburse itself for construction costs. At this point, the co-op decided to self-fund continued construction to avoid incurring additional debt on its accounting books. Three years later, just before the co-op’s ability to draw down the remainder of the loan was set to expire, the co-op drew down the remaining $2.5 million, which it placed in its general fund. A few weeks later, the co-op purchased approximately $2.5 million in United States Treasury notes. The interest the co-op had to pay on its loan was 5 percent, whereas the Treasury notes paid the co-op 9 percent interest. The co-op did not pay any tax on its interest income from the Treasury notes. The Internal Revenue Service (IRS) (defendant) assessed a deficiency against the co-op, arguing that the interest income was unrelated business taxable income (UBTI), notwithstanding the co-op’s tax-exempt status. The co-op challenged the deficiency in the United States Tax Court. The Tax Court ruled in favor of the IRS, and the co-op appealed.