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    Internal Revenue Service
 Revenue Ruling

Rev. Rul. 77-261

1977-2 C.B. 45

Section 115 -- State and Municipal Income
 Section 6012 -- Filing Requirements 

Caution: Clarified by Rev. Rul. 78-316 

IRS Headnote

Income of State investment fund. Income from a fund, established under a
written declaration of trust by a State, for the temporary investment of
cash balances of the State and its political subdivisions, which purchase
units of participation and have an unrestricted right of withdrawal, is
excludible from gross income; however, the fund is classified as a
corporation and must file a Federal income tax return. 

Full Text

Rev. Rul. 77-261 

Advice has been requested whether under the circumstances described below
the income of an investment fund established by State X is excludible from
gross income and whether the fund will be required to file a Federal income
tax return. 

In the normal course of their operations, State X and its political
subdivisions would receive and hold substantial amounts of cash revenues in
excess of the funds needed to meet current expenses. In order to obtain a
yield on these cash balances, the State and its political subdivisions
would invest them in any one of a number of legal investments. 

In 1975, to enable the State treasurer to create an effective mechanism for
the management of these cash balances, the State legislature of State X
enacted a statute enabling the State treasurer to establish, with the
advice of an investment advisory counsel, one or more combined investment
funds for the purpose of investing funds of State X and its political
subdivisions. The statute authorizes the State treasurer to sell
participation units in any such combined investment fund to State X and its
political subdivisions, and the statute specifically makes such
participation units legal investments for State X and its political
subdivisions. 

The State treasurer proposes to establish the investment fund under State X
law by a written declaration of trust. The fund is specifically designated
as an instrumentality of State X. The fund will be managed by its trustee,
the State treasurer, who will have complete and exclusive control over the
management, conduct, and operation of the fund, including the power to vary
the fund's investments. 

The investment objective of the investment fund will be to seek as high a
level of current income as will be consistent with the preservation of
capital and liquidity. The fund will seek to achieve this objective by
investing and reinvesting exclusively in high-grade money market
instruments. 

The net income of the investment fund will be determined at the close of
business on each business day. All the net income of the fund so determined
will be allocated among and accrue to State X and its political
subdivisions at the time of such determination in proportion to the number
of units then held by each participant. Each participant will be entitled
to withdraw any amount from its account in the fund at any time. 

Section 115(1) of the Internal Revenue Code of 1954 provides that gross
income does not include income accruing to a State or a political
subdivision thereof derived from the exercise of any essential governmental
function or from a public utility. 

Section 6012(a)(2) of the Code provides that returns with respect to income
taxes under subtitle A shall be made by every corporation subject to
taxation under subtitle A. 

Section 1.6012-2(a)(1) of the Income Tax Regulations provides that every
corporation, as defined in section 7701(a)(3) of the Code, subject to
taxation under subtitle A (except charitable and other organizations with
unrelated business income and certain foreign corporations) shall make a
return of income regardless of whether it has taxable income or regardless
of the amount of its gross income. 

Section 301.7701-4(c) of the regulations provides, in part, that an
investment trust of the type commonly known as a management trust is an
association, and a trust of the type commonly known as a fixed investment
trust is an association if there is power under the trust agreement to vary
the investment of the certificate holders. 

A comprehensive interpretation of section 115(1) of the Code is set forth
in G.C.M. 14407, XIV-1 C.B. 103 (1935), as superseded by Rev. Rul. 71-131,
1971-1 C.B. 28, in discussing the corresponding section of a prior statute
(section 116(d) of the Revenue Act of 1934). It is indicated therein that
the predecessor section of what is now section 115(1) of the Code was
intended to refer, not to the income of a State or municipality resulting
from its own direct participation in industry, but rather to that part of
the income of a corporation engaged in the operation of a public utility or
the performance of some governmental function that accrued to a State or
municipality. It was pointed out that it may be assumed that Congress did
not desire in any way to restrict a State's participation in enterprises
that might be useful in carrying out those projects desirable from the
standpoint of the State government which, on a broad consideration of the
question, may be the function of the sovereign to conduct. 

The investment fund in the instant situation is a separate entity of the
type discussed above. The investment of positive cash balances by a State
or political subdivision thereof in order to receive some yield on the
funds until needed to meet expenses is a necessary incident of the power of
the State or political subdivision to collect taxes and other revenues for
use in meeting governmental expenses. The investment of funds by a State or
political subdivision in an investment fund of the kind involved in this
case constitutes the exercise of an essential governmental function for
purposes of section 115(1) of the Code. 

Section 115(1) of the Code does not provide that the income in question
must accrue only to a State or a single political subdivision of a State
The accrual to a number of political subdivisions of a State as well as to
that State itself is therefore not inconsistent with the statute. Since the
participating political subdivisions and State X have an unrestricted right
to receive in their own right their proportionate share of the investment
fund's income as it is earned, the fund's income accrues to them within the
meaning of section 115(1). 

Accordingly, the income of the investment fund derived from the operations
as described above is excludible from gross income under section 115(1) of
the Code. However, pursuant to section 6012(a)(2) and the underlying
regulations, the investment fund, being classified as a corporation that is
subject to taxation under subtitle A, will be required to file a Federal
income tax return each year.