My last article post described two of the tax related benefits that an entity may receive if it is properly characterized as an “instrumentality” of a state or political subdivision for federal income tax purposes.  It also described the six factors that the IRS takes into consideration when determining whether or not an entity is properly characterized as an instrumentality.  However, the lifeline given by the IRS in Rev. Rul. 57-128, 1957-1 C.B. 311, does not explicitly state how many of the six factors must be met before an entity will qualify as an instrumentality.   Thus, a perplexed entity may need to utilize the “Phone-A-Friend” option to obtain some insight in this regard.  I suggest the call be made to the Sixth Circuit Court of Appeals (“Sixth Circuit”).

The Sixth Circuit addressed this question in State of Michigan and Michigan Education Trust v. United States, 40 F.3d 817 (6th Cir. 1994).  In this case, the Sixth Circuit held that meeting five of the six factors set forth in 57-128 is sufficient for an entity to qualify as an instrumentality of a state or political subdivision.  The subject entity in this case was the Michigan Education Trust (“MET”), a state agency that was established to collect advance payments for college tuition.  The MET was tasked with investing the advance payments and then distributing them to the appropriate beneficiary when the beneficiary attended college.

The specific issue in the MET case was whether the MET had to pay federal income tax on the investment earnings it made each year.  As discussed in my prior blog post, Section 115 of the Internal Revenue Code of 1986, as amended, exempts from federal income tax any income accruing to an instrumentality that results from either an essential governmental function or public utility function.  Accordingly, the MET argued for both instrumentality status and a decision that it was providing an essential governmental service.  The Sixth Circuit delivered in both regards.

With respect to the instrumentality issue, the Sixth Circuit determined that the MET satisfied the first five factors set forth in 57-128.  However, with respect to the sixth factor, the one requiring that the subject entity’s financial autonomy be limited, the Sixth Circuit was not sure that the MET satisfied this factor.  For example, the Sixth Circuit discussed how the goal of the State of Michigan and the MET was for the MET to be financially self-sufficient.  In addition, the Sixth Circuit pointed out that the State of Michigan was not legally bound to subsidize any deficits the MET incurred.  However, the Sixth Circuit then reasoned that if the MET was not able to provide what it had contractually obligated itself to do (i.e., make sufficient tuition payments on behalf of the beneficiaries), the State of Michigan would be under enormous pressure to make up the shortfall.  After pointing out these facts, the Sixth Circuit stated that this “may not be enough to satisfy the sixth criterion”, but that looking at the six factors together, “on balance they militate in favor of a conclusion” that the MET was an instrumentality of the State of Michigan.   In other words, meeting five of the six factors set forth in 57-128 is sufficient in the opinion of the Sixth Circuit to qualify as an instrumentality.

Furthermore, although the IRS has not specifically stated what minimum number of factors described in 57-128 it believes must be met in order for an entity to be properly characterized as an instrumentality of a state or political subdivision, it has implied that not all six factors must be satisfied.  For example, the IRS issued numerous PLRs in the 1980s and 1990s that concluded that an entity qualified as an instrumentality of a state or political subdivision because the entity met “substantially all of the factors” listed in 57-128.   (See, e.g., PLRs 9624013, 9524028, 9403025, 9320043, 8233021, 8222072, 8111032).  In addition, in most of these PLRs, the IRS did not specifically discuss the financial autonomy factor.  Thus, these PLRs clearly imply that not all of the six factors must be met.  Furthermore, in PLR 7821037, the IRS held that an entity qualified as an instrumentality of a state because the entity met “a majority of the tests” set forth in 57-128.  It appears in PLR 7821037 that the subject entity only met four of the six criterion set forth in 57-128.

With all of that background knowledge, you should be able to answer the following question- for $75,000:

How many of the six factors set forth in 57-128 will an entity need to satisfy  in order to qualify as an instrumentality of a state or political subdivision for federal income tax purposes?

(a)  all six factors

(b)  one of six factors

(c)  five of the six factors

(d)  two of six factors

The best answer is...

C