Probably not as many people as want to be a millionaire.  However, being an instrumentality can also have lucrative benefits, without having to answer increasingly difficult trivia questions or having to deal with Regis Philbin.  For example, entities qualifying as “instrumentalities” for federal income tax purposes obtain two significant tax benefits.  First, instrumentalities may issue tax-exempt bonds under Section 103 of the Internal Revenue Code of 1986, as amended (the “Code”).  Second, Section 115 of the Code exempts from federal income tax any income of an instrumentality that results from either an essential governmental function or public utility function.

Now that everyone is convinced that they too want to be an instrumentality, you are probably wondering how to go about it.  Luckily, the IRS has provided you a lifeline (i.e., a roadmap).

Rev. Rul. 57-128, 1957-1 C.B. 311 sets forth six factors that are taken into consideration when determining whether an entity is an instrumentality of one or more states or political subdivisions for federal income tax purposes.  The following factors are relevant:

(1) Whether the entity is used for a governmental purpose and performs a governmental function?

In order to determine whether this factor is met, it will be necessary to review the entity’s authorizing legislation, if any, and governing documents.  If either the entity’s authorizing legislation or the entity’s governing documents permit the entity to delegate, assign or outsource its primary function(s) to private persons or entities, this factor may not be met.

(2) Whether the entity’s performance of its function is on behalf of one or more states or political subdivisions?

This factor will likely be met if the subject entity is relieving the state or political subdivision of a function that it would otherwise be required (either explicitly or from a practical standpoint) to perform.

(3) Whether there are any private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner?

When determining whether this factor has been met, the IRS seems to focus on who receives the subject entity’s assets upon its liquidation.  Thus, it is helpful if the subject entity’s governing documents affirmatively state that upon its liquidation, the subject entity’s assets will be distributed to the affiliated state or political subdivision.   In addition, this factor is more likely to be met if the entity’s governing documents also state that none of the entity’s assets or earnings will inure to a private individual or entity.

(4) Whether control and supervision of the entity is vested in a public authority or authorities?

When determining whether this factor is met, the IRS seems to focus on who sits on the subject entity’s board (or equivalent governing body).  The ideal make-up of the subject entity’s board would be representatives from the affiliated state or political subdivision.  In addition, it is also helpful if the affiliated state or political subdivision is required to approve significant decisions made by the subject entity.

(5) Whether express or implied statutory or other authority is necessary for the creation and/or use of such an instrumentality, and whether such authority exists?

When determining whether this factor is met, the authorizing legislation for the subject entity, if any, will need to be reviewed.

(6) The degree of the entity’s financial autonomy and the source of the entity’s operating expenses.

Restrictions or requirements placed on the subject entity that are helpful in meeting this factor are: (a) that the subject entity is required to report frequently to the affiliated state or political subdivision as to its financial condition or is required to be audited by the affiliated state or political subdivision;  (b) the subject entity is required to receive approval from the affiliated state or political subdivision before incurring a significant amount of debt or making large expenditures, or must have its annual budget approved by the affiliated state or political subdivision; (c) the subject entity’s ability to spend its funds is limited by statute; and (d)  the subject entity receives most of its funds from the affiliated state or political subdivision.

The lifeline given by the IRS in Rev. Rul. 57-128 is very helpful.  However, it does not indicate how many of the six factors must be met in order for an entity to be characterized as an instrumentality for federal income tax purposes.  That issue will be addressed in the next episode of “Who Wants to Be an Instrumentality?”  Stay tuned.