Business structure considerations for diversified activities.

• Author: Wortham, Gregory L.

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...