INCOME TAX TREATMENT OF

COOPERATIVES: Patronage Refunds

and other Income Issues

Cooperative Information Report 44, Part 2

2005 Edition

Donald A. Frederick
Abstract

INCOME TAX TREATMENT OF COOPERATIVES:

Patronage Refunds and other Income Issues

2005 Edition

Donald A. Frederick, Program Leader

Law, Policy & Governance

Cooperative tax rules are a logical combination of the unique

attributes of a cooperative and the income tax scheme in the

Internal Revenue Code. The single tax principle is applied to

earnings from business conducted on a cooperative basis in

recognition of the unique relationship between the members and

their cooperative associations. Cooperatives have been granted

a certain degree of flexibility in their financial and tax planning

and should exercise their options effectively to maximize benefits

for members.

Key words: Cooperative, equity, income, patronage, per-unit

retain, tax

Cooperative Information Report 44, Part 2

April 2005
 This report does not represent official policy of the U.S. 1

Department of Agriculture, the Internal Revenue Service, the U.S.

Department of the Treasury, or any other government agency. This

publication is presented only to provide information to persons

interested in the tax treatment of cooperatives.

3

Preface1

The patronage refund is an important concept distinguishing

cooperatives from other forms of doing business. It is the vehicle

by which cooperatives return earnings to users based on the

amount of business conducted with the cooperative, rather than

to investors on the basis of equity owned.

Patronage refunds permit cooperatives to operate as typical

businesses, earning income in excess of expenses, while still

operating "at cost." By permitting cooperatives to retain a portion

of the margins designated as patronage refunds, members

provide needed equity without having to write checks to the

association.

Application of the single tax principle to patronage refunds

reflects the unique nature of the patronage refund, whether the

distribution is paid in cash or retained for investment. Single

taxation is helpful to accumulation of capital from members since

it partially compensates for the lack of liquidity of cooperative

equity.

This report contains three chapters, which are part of a larger

project on income taxation of cooperatives. Chapter 4 explains

the Internal Revenue Code definition of a patronage refund.

Chapter 5 reviews the rules for distinguishing patronage sourced

income that can be distributed tax-free to patrons from

nonpatronage sourced income that is subject to double taxation.

Chapter 6 explores other issues that have arisen in the context of

ascertaining the proper tax treatment of distributions from

cooperatives to patrons as patronage refunds and patronagebased pass-throughs of deductions and credits.
 Farmer cooperatives with section 521 tax status also qualify for 2

single taxation of dividends on capital stock and distributions of

nonpatronage income to patrons on the basis of patronage.

4

Highlights

Since 1962, the Internal Revenue Code has contained a

specific definition of a patronage refund. Generally, distributions

of earnings by cooperatives must conform to that definition to

qualify for single tax treatment.

Patronage refunds are amounts paid to patrons by a

cooperative on the basis of quantity or value of business done

with or for such patrons, under a preexisting obligation, based on

net earnings from business with or for patrons. Earnings on

patronage business are refunded to patrons based on the level

of business they do each year with the cooperative. Generally,

only earnings on patronage activity qualify for single tax

treatment.2

The problem that has caused the most difficulty in

administering the patronage refund provisions of the Code is

differentiating patronage from nonpatronage business. Two tests

have evolved for making the distinction. Both are based on the

same Treasury Department regulation, and they sometimes

suggest conflicting results.

One test classifies income as patronage-sourced if the

activities producing that income are directly related to, or actually

facilitate, business conducted on a cooperative basis. Income

merely incidental to cooperative business is nonpatronagesourced. The other test categorizes income from certain

sources--lease of premises, investment in securities, and the sale

of capital assets--as automatically nonpatronage-sourced.

Cooperatives have favored application of the directly related

test in distinguishing patronage from nonpatronage business.

The Internal Revenue Service has used the nature-of-the-income

test when one of the types of income listed in the regulation as

nonpatronage-sourced is under consideration. The courts have

shown a preference for the directly related standard.
5

Cooperatives with complex organizational structures or

financial arrangements confront several technical issues in

classifying income for tax purposes. Different groups of patrons

may use different services provided by the cooperative,

presenting problems of how to allocate funds available for

distribution as patronage refunds among those patron groups.

Patronage may not always occur in the same year that the

resulting income is realized, producing timing differences. And

the use of third-party agents has raised questions about whether

certain business is really with or for patrons.

A parallel issue to income classification is the proper

allocation of expenses between patronage and nonpatronage

business. An expense allocated to nonpatronage business

reduces nonpatronage earnings and in the process increases

patronage earnings eligible for single tax treatment.

The American Jobs Creation Act of 2004 created new

benefits for cooperatives and their patrons. Cooperatives are

allowed to both claim and pass-through to patrons a special

deduction for the applicable portion of the cooperative's qualified

production activities income. Cooperatives are also given the

option to claim at the cooperative level, or pass through to

patrons, the small producer ethanol credit and the new low sulfur

diesel fuel production credit.
6

Contents

Page

Chapter 4. Code Definition of a Patronage Refund . . . . . 9

An Amount Paid to a Patron . . . . . . . . . . . . . . . . . . . . . . . . 11

By a Cooperative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

On the Basis of Quantity or Value of Business

Done With or For Such Patron . . . . . . . . . . . . . . . . . . . 12

Under a Preexisting Legal Obligation . . . . . . . . . . . . . . . . . 12

How Established . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Preexisting Requirement . . . . . . . . . . . . . . . . . . . . . . . . 16

Board Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Patronage or Nonpatronage Allocation . . . . . . . . . . 17

Allocations Among Different Groups of Patrons . . . 19

Based on Net Earnings From Business

With or for Patrons . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Income Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Year Patronage Occurred . . . . . . . . . . . . . . . . . . . . . . . 23

Chapter 5. Patronage and Nonpatronage Business . . . 27

Significance of Classifying Business Sources . . . . . . . . . . . 27

Tests Applied to Classify Business . . . . . . . . . . . . . . . . . . . 29

Regulatory Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Directly Related/Actually Facilitates Test . . . . . . . . . . . . 32

Nature-of-the-Income Test . . . . . . . . . . . . . . . . . . . . . . 35

Taxpayer's Burden of Proof . . . . . . . . . . . . . . . . . . . . . . . . 38
7

Rental Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Income From Sale of Assets . . . . . . . . . . . . . . . . . . . . . . . . 50

Depreciation Recapture . . . . . . . . . . . . . . . . . . . . . . . . . 50

Special Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Farmland Industries Case . . . . . . . . . . . . . . . . . . . . . . . 55

Subsequent Rulings . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

Income From Other Events . . . . . . . . . . . . . . . . . . . . . . . . . 66

Change in Accounting Method . . . . . . . . . . . . . . . . . . . 66

CCC Storage Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Judicial Settlements . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Partnership and LLC Earnings . . . . . . . . . . . . . . . . . . . 70

Pension Fund Reversions . . . . . . . . . . . . . . . . . . . . . . . 80

Chapter 6. Other Income Issues . . . . . . . . . . . . . . . . . . . 82

Simultaneous Patronage and Nonpatronage Operations . . 82

Multiple Service Cooperatives . . . . . . . . . . . . . . . . . . . . . . . 84

Equitable Allocation Among Patron Groups . . . . . . . . . . . . 86

Matching Patronage and Allocation - Tracing . . . . . . . . . . . 90

Unequal Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

Use of Third-Party Agents . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
8

Export Entity Earnings... . . . . . . . . . . . . . . . . . . . . . . . . . 104

Domestic International Sales Corporation . . . . . . . . . . 104

Foreign Sales Corporation . . . . . . . . . . . . . . . . . . . . . 105

Extraterritorial Income Exclusion . . . . . . . . . . . . . . . . . 106

Qualified Production Activities Income Deduction . . . . . . . 108

Cooperative Pass-through Provision . . . . . . . . . . . . . . 111

Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

Dividend Allocation Rule Repeal . . . . . . . . . . . . . . . . . . . . 112

Declaratory Judgement Relief . . . . . . . . . . . . . . . . . . . . . . 118

Marketing Includes Value-Added Processing

Involving Animals . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

Small Ethanol Producer Credit, Co-op Pass-through . . . . 119

Small Low Sulfur Diesel Fuel Producer Credit,

Co-op Pass-through . . . . . . . . . . . . . . . . . . . . . . . . . . 120
 CF Industries, Inc. v. Commissioner, 995 F.2d 101 (7th Cir. 1993),

3

modifying 62 T.C.M. (CCH) 1249 (1991). 

 Patronage dividend in the Code. 4

 Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat. 960, 1045-1052 5

(1962). Subchapter T is codified at I.R.C. §§ 1381-1388.

9

CHAPTER 4

CODE DEFINITION OF A

PATRONAGE REFUND

The principal difference between cooperatives and other

business forms is the patronage refund system--allocating earnings

to users on the basis of use, rather than to investors on the basis of

investment. The Federal income tax treatment of patronage 3

refunds, a single tax liability at either the recipient or cooperative

level, reflects public policy recognition of the unique nature of

cooperatives and the patronage refund.

A specific definition of a patronage refund was added to the 4

Internal Revenue Code (Code) with enactment of the Revenue Act

of 1962, as part of the new subchapter T. Codified at Code 5

section 1388(a), the definition reads as follows:

(a) Patronage Dividend - For purposes of this

subchapter, the term "patronage dividend" means an

amount paid to a patron by an organization to which part

I of this subchapter applies -

(1) on the basis of quantity or value of business

done with or for such patron,

(2) under an obligation of such organization to pay

such amount, which obligation existed before the

organization received the amount so paid, and

(3) which is determined by reference to the net

earnings of the organization from business done with

or for its patrons.
 The Revenue Act of 1951 used the phrase "patronage dividends,

6

refunds, and rebates to patrons with respect to their patronage...." ch.

521, 65 Stat. 492. The phrase was adopted without change when

recodified as part of § 522 of the I.R.C. of 1954. 68A Stat. 178. When

§ 522 was repealed and replaced by subchapter T as part of the Revenue

Act of 1962, the single term "patronage dividend" was adopted. 76 Stat.

1049.

 T.D. 2737, 20 Treasury Decisions, Internal Revenue 441 (1918). 7

 "Report on Terminology," in Proceedings of the Section of

8

Corporation, Banking and Mercantile Law, American Bar Association,

cited in Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201, 217

(N.D. Iowa 1949), 1949-2 U.S.T.C. (CCH) ¶ 9400.

10

Such term does not include any amount paid to a

patron to the extent that (A) such amount is out of earnings

other than business done with or for patrons, or (B) such

amount is out of earnings from business done with or for

other patrons to whom no amounts are paid, or to whom

smaller amounts are paid, with respect to substantially

identical transactions.

The Code uses the term "patronage dividend" to describe net

margins from business done with or for patrons that are allocated

to patrons on a patronage basis. "Patronage dividend" was first

introduced into the Code by the Revenue Act of 1951. The term

6

had been used before, however, as a synonym for patronage

refund.7

The origin of the term patronage dividend is unclear. In 1948,

A. Ladru Jensen wrote that "'patronage dividend' originated more

from historical accident than from any analogy to stock dividends

of ordinary business corporations, and that the usage of the phrase

has contributed to misunderstanding."8

"Patronage refund" rather than "patronage dividend" is used in

this report in accord with general cooperative preferences and to

avoid confusion with dividends paid to patrons on their capital

stock.
 I.R.C. § 1388(a) and Treas. Reg. § 1.1388-1(a)(1). 9

 Treas. Reg. § 1.1388-1(e).

10

 Farmer cooperatives with § 521 tax status must treat all persons 11

who do business with the cooperative as patrons, whether or not they

are members. Treas. Reg. § 1.521-1(a)(1). This rule, and other

requirements to utilize § 521 tax status, will be discussed in a

subsequent report in this series. 

 Priv. Ltr. Rul. 8104118 (Oct. 30, 1980).

12

11

The following subsections examine each of the key elements

in the Code's section 1388(a) definition of the patronage refund.

AN AMOUNT PAID TO A PATRON

A patronage refund is "an amount paid to a patron." A 9

cooperative-patron relationship must exist between the cooperative

and the recipient of a patronage refund.

While the Code does not define patron, the applicable

regulation defines a patron as "any person with or for whom the

cooperative association does business on a cooperative basis,

whether a member or a non-member of the cooperative...."10

As explained in Chapter 1, a patron is anyone who has a legal

right to share in the cooperative's margins on a pro rata patronage

basis. A cooperative may choose to only do business with

members on a patronage basis, or it may treat both members and

nonmembers as patrons.11

A person who deals with the cooperative but receives no

refund is not a patron. In the typical situation the nonpatron has

no right to receive patronage refunds. A nonpatron may also be a

person who has a right to receive patronage refunds but refuses to

accept them or waives the right to receive them.12
 I.R.C. § 1388(a) and Treas. Reg. § 1.1388-1(a)(1). 13

 The terms "cooperative" and "operating on a cooperative basis" 14

are not defined in the Code or the regulations.

12

BY A COOPERATIVE

A payment may only be treated as a patronage refund for

purposes of subchapter T if it is paid "by an organization to which

part I of this subchapter applies." Thus, a payment with all the 13

characteristics of a patronage refund will not qualify as a

patronage refund unless the paying organization meets subchapter

T requirements of operating on a cooperative basis.

14

ON THE BASIS OF QUANTITY OR VALUE OF BUSINESS

DONE WITH OR FOR SUCH PATRON

The "quantity" measure is generally thought of in physical

terms, for example, bushels delivered as a proportion of all bushels

handled by the cooperative. The "value" measure is related to

dollar volume rather than physical volume.

The two measures will not necessarily yield identical refunds

to individual patrons, but Code section 1388(a)(1) gives

cooperatives the option to use either method. And as it is

permissible to use either volume or value, it is presumably

possible to use a combination of both.

The "with or for" term in Code section 1388(a)(1) provides

flexibility, recognizing the variety of relationships a cooperative

may have with its patrons.

UNDER A PREEXISTING LEGAL OBLIGATION

The requirement that patronage refunds be made pursuant to

a "preexisting legal obligation" to qualify for single tax treatment
See, e.g., Peoples Gin Co. v. Commissioner, 118 F.2d 72 (5th Cir.

15

1941); Farmers Cooperative Co. v. Birmingham, 86 F.Supp. 201, 230-

231 (N.D. Iowa 1949), 1949-2 U.S.T.C. (CCH) ¶ 9400.

 Union Fishermen's Cooperative Packing Co. v. Earle, 121 F.Supp. 16

373, 377-378 (D. Ore. 1954), 1954-1 U.S.T.C. (CCH) ¶ 9366.

 American Box Shook Export Ass'n v. Commissioner, 156 F.2d 17

629, 631 (9th Cir. 1946), 1946-2 U.S.T.C. (CCH) ¶ 9314, aff'g 4 T.C.

758 (1945).

Farmers Union State Exchange v. Commissioner, 30 B.T.A. 1051 18

(1934). The cooperative charter said margins would be distributed

according to bylaws, but bylaws were not introduced into evidence and

may not have been adopted, so deduction was denied.

 Petaluma Co-operative Creamery v. Commissioner, 52 T.C. 457

19

(1969). This case concerned tax years 1958 and 1959, which predated

enactment of subchapter T.

 Colony Farms Cooperative Dairy, Inc. v. Commissioner, 17 T.C. 20

688, 692 (1951).

 Treas. Reg. § 1.1388-1(a)(1)(ii). 21

13

was established long before enactment of subchapter T. The 15

obligation has to have substance. In one case the court said a

"moral obligation" to make returns was insufficient to justify the

exclusion. In another, an "understanding" that such returns 16

would be made was held deficient.17

Obligations requiring further action to make them binding

upon the cooperative are not sufficient. If the obligation is not 18

established until a declaration is made by the cooperative, the

obligation to return net margins is not effective. An "existing 19

legal" obligation is required.20

Code section 1388(a)(2) only requires a preexisting obligation.

The regulations describe the obligation as being a "valid

enforceable written obligation." Thus the regulations appear to

21

have added a requirement that in addition to having a legal status

(valid and enforceable), the obligation must be in writing. It also
Id.

22

 Treas. Reg. § 1.1388-1(a)(1). 23

 Fountain City Co-op Creamery Ass'n v. Commissioner, 172 F.2d 24

666 (7th Cir. 1949), aff'g, 9 T.C. 1077 (1947).

 Treas. Reg. § 1.1388-1(a)(1) and Rev. Rul. 83-135, 1983-2 C.B. 25

149. Bylaw provisions are noted in Land O'Lakes, Inc. v. United States,

675 F.2d 983 (8th Cir. 1982), aff'g in part, rev'g in part, 470 F.Supp.

238 (D. Minn. 1979); Smith and Wiggins Gin, Inc. v. Commissioner,

341 F.2d 341 (5th Cir. 1965) aff'g, 37 T.C. 861 (1962); and Priv. Ltr.

Rul. 8118012 (Jan. 18, 1981). Charter or articles of incorporation

provisions are noted in Mississippi Chemical Co. v. United States, 197

F. Supp. 490 (S.D. Miss. 1961), aff'd, 326 F.2d 569 (5th Cir. 1964).

 Donald A. Frederick, Sample Legal Documents for Cooperatives,

26

RBS Cooperative Information Report No. 40 (USDA 1990).

14

must be an obligation "of such organization to the patron to pay

such amount."22

How Established

A valid enforceable written obligation may be established in

several ways.

A State law, such as the statute under which the cooperative is

incorporated, may require refund payments. Mere statutory 23

direction for the directors to allocate net margins annually,

however, may not make the margins deductible. An actual

allocation and distribution may still be required. In Fountain City

Co-op Creamery Ass'n v. Commissioner, the patronage refund

deduction was disallowed because the directors allocated net

margins to reserves rather than making cash or stock distributions

to patrons as contemplated by the statute.24

The cooperative's articles of incorporation or bylaws may also

place a sufficiently enforceable obligation on the cooperative to

pay patronage refunds.25

A typical bylaw provision creating such an obligation is found

in Sample Legal Documents for Cooperatives:

26
 Land O'Lakes, Inc. v. United States, 675 F.2d 988 (8thCir. 1982),

27

1982-1 U.S.T.C. (CCH) ¶ 9326, aff'g in part, rev'g in part, 470 F. Supp.

238 (D. Minn. 1979), 1979-1 U.S.T.C. (CCH) ¶ 9380. In the agreement,

an "agent buyer" purchased supplies from the cooperative and

distributed them to farmers. The cooperative, by agreement with the

agent buyers, paid patronage refunds directly to farmer patrons under

cooperative bylaws obligating it to make such payments.

15

ARTICLE . OPERATION AT COST AND MEMBERS'

CAPITAL

Section 1. Operation at Cost. The association shall at all

times be operated on a cooperative service-at-cost basis for

the mutual benefit of its member patrons.

Section 2. Margin Allocation. In order to induce patronage and to assure that this association will operate on a

service-at-cost basis in all its transactions with its

members, the association is obligated to account on a

patronage basis to all member patrons on an annual basis

for all amounts received from business conducted with

members on a patronage basis, over and above the cost of

providing such services, making reasonable additions to

reserves, and redeeming capital credits. Such allocation

shall be on the basis of the volume (dollar value) of product marketed through (purchased from) the association.

The association is hereby obligated to pay all such

amounts to the patrons in cash or by credits to a capital

account of each member patron.

The binding nature of an obligation established in the bylaws

is not necessarily extinguished by payment arrangements between

a cooperative, third parties, and ultimate patron recipients.

27
 Treas. Reg. § 1.1388-1(a)(1). A marketing agreement was found 28

to establish the necessary obligation in Sumner Rhubarb Growers' Ass'n

v. Commissioner, 10 T.C.M. 465, 474 (1951). See also, Western

Colorado Producers Corp. v. Commissioner, 1 T.C.M. 697 (1943).

 I.R.C. § 1388(a)(2) and Treas. Reg. § 1.1388-1(a)(1)(ii). 29

See the discussion of Tax Logic and Cooperatives in chapter 2. 30

 Peoples Gin Co. v. Commissioner, 118 F.2d 72 (5th Cir. 1941),

31

1941-1 U.S.T.C. (CCH) ¶ 9318, aff'g, 41 B.T.A. 343 (1940).

16

A written contract between the patron and cooperative may

also establish the required obligation.28

Preexisting Requirement

The Code requires that the obligation must have "existed

before the organization received the amount so paid...."29

Before enactment of subchapter T, exclusion or deduction for

patronage refunds was based on the status of income as generated

by the cooperative always belonging to patrons, not the

cooperative business entity. The obligation, the legal mechanism

30

guaranteeing that the income was the patron's, not the

cooperative's, had to exist before the income was first received by

the cooperative. Otherwise, it necessarily became the cooperative's and the right to exclude or deduct it from the cooperative's

own corporate income was lost.

Two cases involving the same cooperative illustrate what is

meant by "preexisting." The cooperative adopted a bylaw creating

an obligation to return margins to patrons during the middle of its

fiscal year. The Internal Revenue Service (the Service or IRS)

challenged the cooperative's patronage refund deduction for that

same year. The court upheld the Service on the grounds that when

the income was received by the cooperative, there was no

obligation to make refunds to the patrons. When the Service 31

questioned the cooperative's patronage refund deductions for a
 Peoples Gin Co. v. Commissioner, 2 T.C.M. 325 (1943). 32

 For summaries of concepts involved, see Farmers Cooperative 33

Co. v. Birmingham, 86 F. Supp. 201 (N.D. Iowa 1949), 1949-2 U.S.T.C.

(CCH) ¶ 9400, and United States v. Mississippi Chemical Co., 326 F.2d

569 (5th Cir. 1964), 1964-1 U.S.T.C. (CCH) ¶ 9181, aff'g, 197 F. Supp.

490 (S.D. Miss. 1961), 1961-1 U.S.T.C. (CCH) ¶ 9277.

 James Baarda, Cooperative Principles and Statutes: Legal

34

Descriptions of Unique Enterprises, ACS Research Report No. 54

(USDA 1986).

17

subsequent tax year, the court held for the cooperative. It found

the bylaw created a timely obligation for the following tax years.

32

Bythe time subchapter T was enacted in 1962, the requirement

that the legal obligation be "preexisting" was well established.33

Board Discretion

The cooperative, normally through its board of directors, may

have discretion to distribute some portion of patronage margins as

dividends on capital or to add some portion to reserves. This

discretion may reduce the amounts of earnings allocated to patrons

on a patronage basis. The issue presented by these circumstances

is whether patronage refunds that may be reduced at the

cooperative's discretion (the board's discretion), but are not

actually reduced, are paid under a legally enforceable obligation.

Patronage or Nonpatronage Allocation

A cooperative may have discretion to allocate some portion of

earnings on business with or for patrons on a nonpatronage basis.

The portion allocated on a nonpatronage basis cannot qualify as

patronage refunds. The issue is whether those amounts allocated

on a patronage basis are distributed under a legal obligation to do

so given the cooperative's discretion not to make such payments.

Although most cooperatives that issue stock do not pay

dividends, most are statutorily able to do so within limits. For 34

example, the bylaws may permit the board of directors to pay
 United States v. Mississippi Chemical Co., 326 F.2d 569, 571 (5th

35

Cir. 1964), 1964-1 U.S.T.C. (CCH) ¶ 9181, aff'g, 197 F. Supp. 490

(S.D. Miss. 1961), 1961-1 U.S.T.C. (CCH) ¶ 9277. See also, Farmers

Union Co-op of Guide Rock, Neb. v. Commissioner, wherein the Court

said, "Where a portion of such earnings are usable to pay dividends on

capital stock without reference to patronage by stockholders, there

exists a situation containing the feature of private profit from the

enterprise. Such being the situation here, we must conclude that this

balance of income over outgo in 1928 was a gain subject to taxation

under the Sixteenth Amendment." 90 F.2d 488, 492, 1937-2 U.S.T.C.

(CCH) ¶ 9360, aff'g 33 B.T.A. 225 (1935).

 Midland Cooperative Wholesale v. Commissioner, 44 B.T.A. 824

36

(1941). Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201

(N.D. Iowa 1949), 1949-2 U.S.T.C. (CCH) ¶ 9400, discussed the Iowa

reserve statute at some length and decided the limited right to establish

reserves did not destroy the cooperative's obligation to pay patronage

refunds. The obligation extended to all refunds actually paid.

18

dividends on capital stock up to a stated percentage, with the

remaining earnings allocated to patrons on a patronage basis.

A number of decisions predating subchapter T held that if the

board of directors had discretion to pay a part of the cooperative's

net margins as dividends on capital stock, "the legally enforceable

obligation to pay patronage refunds is destroyed to the extent that

discretion to divert exists." In other words, if the cooperative 35

board had the authority to declare a dividend on stock of up to 8

percent, the level of earnings necessary to pay a dividend at that

rate was ineligible for patronage refund treatment, even if the

board declared a smaller stock dividend or no stock dividend at all.

Other decisions discussed situations in which, typically by

State law, cooperatives could add a certain percentage of each

year's net margins to reserves. In those cases involving reserves,

the courts generally did not express the same concern as to the

effect of such diversions on the legal obligation to pay patronage

refunds.36

In a decision involving both issues, the court said discretion to

add funds to reserves did not affect the preexisting legal
 United Cooperatives, Inc. v. Commissioner, 4 T.C. 93 (1944), 37

acq., 1945 C.B. 6.

 Rev. Rul. 69-621, 1969-2 C.B. 167. 38

 The Tax Court, in an opinion written in 1972, adopted the old rule 39

that discretion to pay a stock dividend destroys the obligation to pay a

patronage refund to the extent that discretion to divert exists. Union

Equity Cooperative Exchange v. Commissioner, 58 T.C. 397, 414-415

(1972), aff'd, 481 F.2d 812 (10th Cir. 1973), 1973-2 U.S.T.C. (CCH) ¶

9534, cert. denied, 414 U.S. 1028 (1973). The Tax Court opinion fails

to mention Rev. Rul. 69-621. The court may have been influenced by

the fact that this case dealt with tax years 1963 and 1964, which were

before Rev. Rul. 69-621 was issued. The 10th Circuit opinion does not

mention the issue.

 I.R.C. § 1388(a), Treas. Reg. § 1.1388-1(a)(2)(ii). 40

19

obligation, but discretion to pay dividends on stock destroyed the

obligation to the extent discretion existed.37

In Revenue Ruling 69-621, IRS held that the amount available

for distribution as a patronage refund is computed by deducting

only the actual amount paid in stock dividends, not the amount

that could have been paid, from patronage-sourced income.38

Since the announcement of Revenue Ruling 69-621, discretion

to pay stock dividends has not been an issue of contention between

IRS and cooperatives.39

Allocations Among Different Groups of Patrons

Subchapter T provides that amounts paid to patrons can't be

patronage refunds if different amounts are paid "with respect to

substantially identical transactions."40

This doesn't apply, however, when different amounts are paid

to patrons of different services. IRS has generally accepted the

practices of cooperatives with respect to different groups of

patrons, except where the board of directors has some discretion

to use margins of a profitable service to offset losses on an

unprofitable service.
 Priv. Ltr. Rul. 8521003 (Jan. 25, 1985).

41

 Consolidated Omnibus Budget Reconciliation Act of 1985, Pub. 42

L. No. 99-272, § 13210, 100 Stat. 82 (1985). This legislation will be

discussed in detail in Chapter 13 of these reports on how cooperatives

treat losses for tax purposes.

 I.R.C. § 1388(a)(3) and Treas. Reg. § 1.1388-1(a)(1)(iii).

43

 Treas. Reg. § 1.1388-1(a)(1). 44

 I.R.C. § 1388(a). Slightly modified language is found in Treas. 45

Reg. § 1.1388-1(a)(2)(i).

20

In a 1985 private letter ruling, IRS relied in part on the older

decisions on dividend payment discretion to disallow the entire

patronage refund deduction claimed by a cooperative that netted

gains and losses on patronage business. This ruling was reversed

41

by enactment of section 13210 of the Budget Reconciliation Act

of 1985.42

BASED ON NET EARNINGS FROM BUSINESS

WITH OR FOR PATRONS

Patronage refunds are "determined by reference to the net

earnings of the organization from business done with or for its

patrons."43

The regulations describe "net earnings" as including "the

excess of amounts retained (or assessed) by the organization to

cover expenses or other items over the amount of expenses or

other items."44

The Code sets out two further limitations. First, a patronage

refund may not include "any amount paid to a patron to the extent

that...such amount is out of earnings other than from business done

with or for patrons...."45

Second, a payment will not be recognized as a patronage

refund to the extent such amount is paid "out of earnings from

business done with or for other patrons to whom no amounts are
 I.R.C. § 1388(a) and Treas. Reg. § 1.1388-1(a)(2)(ii). 46

 Miller v. Commissioner, 65 T.C. 612 (1975) (payments for

47

packing services); Producers Livestock Marketing Ass'n of Salt Lake

City v. Commissioner, 45 B.T.A. 325 (1941) (regular payments to cover

various expenses).

21

paid, or to whom smaller amounts are paid, with respect to

substantially identical transactions."46

Thus, each year a cooperative must determine what portion of

income is from business done with orfor patrons and what portion

of expenses is properly allocable to such patronage business. The

amount of income on patronage business less allocated expenses

is the amount the cooperative may distribute as patronage refunds.

Finally, it must divide the level of earnings that qualify as

patronage refunds among its various patrons during the tax year

under consideration.

Income Sources

The first step in calculating net margins is identifying income.

Principles used to determine whether a cooperative's revenues

should be classified as income or not follow principles similar to

those applied to noncooperative corporations.

A cooperative'sincome maycome from almost as wide a range

of sources as that for any noncooperative corporation. Typically,

the primary source of income is from sale of patrons' goods in raw

or processed form in the case of marketing cooperatives and the

sale of supplies, equipment, or services to farmer-patrons in the

case of supply or service cooperatives.

Most cooperatives also have other kinds of income. Examples

include fees for services provided, gains from dealings in 47

property (frequently sale of a cooperative asset at a gain), interest

income, rentals of real property or equipment, royalties, and

dividend income. These sources can, under appropriate

circumstances, be an integral part of the cooperative's operation
 "In the case of a corporation, gross income does not include any 48

contribution to the capital of the taxpayer." I.R.C. § 118(a).

 "[I]f a corporation requires additional funds for conducting its

49

business and obtains such funds through voluntary pro rata payments by

its shareholders, the amounts so received being credited to its surplus

account or to a special account, such amounts do not constitute income,

although there is no increase in the outstanding shares of stock of the

corporation. In such a case the payments are in the nature of

assessments upon, and represent an additional price paid for, the shares

of stock held by the individual shareholders, and will be treated as an

addition to and as a part of the operating capital of the company."

Treas. Reg. § 1.118-1.

 "[T]he exclusion does not apply to any money or property 50

transferred to the corporation in consideration for goods or services

rendered, or to subsidies paid for the purposes of inducing the taxpayer

to limit production." Treas. Reg. § 1.118-1.

 United Grocers, Ltd. v. United States, 308 F.2d 634 (9th Cir.

51

1962), aff'g, 186 F. Supp. 724 (N.D. Cal. 1960).

22

depending on what the cooperative does for patrons and how its

business is conducted.

Not all funds received by a cooperative are income. For

example, contributions of capital to any corporation, including a

cooperative, are not income. This includes payments made pro 48

rata on the basis of shares of stock owned that do not increase the

outstanding shares of stock.49

As a general rule, payments received in exchange for goods or

services from a corporation are income to the corporation, not

contributions to its capital. Whether dues or fees paid by patrons 50

to a cooperative are compensation for services or contributions to

capital requires analysis of the facts involved.

For example, in United Grocers, Ltd. v. United States, a retail 51

grocers' association assessed monthly charges to each member.

Originally called "dues," they were later referred to as "contributions to capital."
Id. at 640.

52

23

The payments were not made directly for the purchase of

goods or services, but solely to qualify a member to share in

patronage refunds. The court said it was obvious the purpose of

the payments was to obtain merchandise and services at the lowest

possible prices. It was also reasonable to assume no member

would continue to make the monthly payments unless a patronage

refund was forthcoming.

Neither was there an investment motive in the payments.

Members received no equivalent equity interest in the cooperative

and no greater right to share in the cooperative on liquidation.

Any member who withdrew before liquidation forfeited any right

to share in the property of the cooperative. The court said, "While

the acquisition of an increased equity or interest in the corporation

is not a requisite of a capital contribution, the presence or absence

of such interest has a bearing upon the motive of the person

making the payment."52

The court found no single fact to be decisive, but the

arrangement as a whole required that the payments be treated as

payments for services from the cooperative. Given all circumstances, the monthly payments were income to the cooperative, not

contributions to its capital.

Year Patronage Occurred

Cooperatives usually receive income and incur expenses on a

more or less continuous basis. Taxable years, however, are

divided into discrete time periods. Income received in one year

may be derived from business with patrons of a prior year, and the

cooperative must determine what allocation principles to apply.

This is a common occurrence among manufacturing and

processing cooperatives and cooperatives that operate in a

federated system. For example, a cooperative that processes fruits

into juices might take delivery of a crop and process it into a
 I.R.C. § 1382(f).

53

 Treas. Reg. § 1.1382-6. 54

24

canned or frozen product in one year, and then store it before

selling the product well into the subsequent year.

Or a local cooperative that sells farm supplies might buy some

fertilizer from a federated regional cooperative to which it belongs

and resell that fertilizer to its farmer-members, all in 1993. The

local cooperative probablywould not collect any patronage refund

resulting from its purchase from the regional until 1994. And the

farmer-members probably would not receive their pro rata share

of the patronage refund from the regional to the local until they

receive their refund from their local in 1995.

The Code recognizes this timing problem. Section 1382(f)

provides:

If any portion of the earnings from business done with

or for patrons is includible in the organization's gross

income for a taxable year after the taxable year during

which the patronage occurred, then...the patronage shall,

to the extent provided in regulations..., be considered to

have occurred during the taxable year of the organization

during which such earnings are includible in gross

income.53

The applicable regulation, after restating the Code provision,

adds: "Thus, if the cooperative organization pays these earnings

out as patronage dividends during the payment period for the

taxable year for which the earnings are includible in its gross

income, it will be allowed a deduction for such payments under

section 1382(b)(1)...."54

In other words, section 1382(f) provides that where a

cooperative has earnings from patron business in a year

subsequent to the year the underlying business took place, the

patronage shall be considered to have occurred in the same year
 Kingfisher Cooperative Elevator Association v. Commissioner,

55

84 T.C. 600 (1985). This case is discussed in more detail in the section

in Chapter 6 of this report on "tracing."

 Rev. Rul. 79-45, 1979-1 C.B. 284, and Priv. Ltr. Rul. 8023023 56

(Feb. 28, 1980).

 Rev. Rul. 74-84, 1974-1 C.B. 244. 57

 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894 (1982). 58

 I.R.C. § 631(a). 59

Rev. Rul. 71-439, 1971-2 C.B. 321, and Rev. Rul. 74-24, 1974-1 60

C.B. 244, describe workers' cooperatives owning standing timber from

which the cooperative manufactured wood products.

 Priv. Ltr. Rul. 7926068 (Mar. 29, 1979).

61

25

the earnings are included in income. This permits the cooperative

to distribute the earnings to patrons as patronage refunds and claim

the appropriate tax treatment.

The ability of a local cooperative to treat patronage refunds

from a federated cooperative as patronage-sourced income in the

year the refund is received was established in Kingfisher

Cooperative Elevator Association v. Commissioner.

55

Section 1382(f) also applies to earnings increases realized in

tax years after the underlying business event. The change in

earnings may be due to changes in inventory valuation method,56

depreciation recapture, or gain on the sale of a capital asset. 57 58

Where the Code assigns the year of recognition, income occurs

in that year. Under special Code provisions, timber owners may

elect to treat cutting as a sale or exchange. Although 59

appreciation may have occurred over a period of time, gain is

recognized in the harvest year if a cooperative owner so elects.60

IRS has also applied Section 1382(f) when a cooperative

managed a loss by redeeming nonqualified written notices of

allocation during the 81⁄2-month period following the tax year. In

a 1979 private letter ruling, the cooperative suffered a loss during 61

the taxable year. It placed each patron's share of the loss in an

account receivable. During the 81⁄2 month payment period that
 Rev. Rul. 74-327, 1974-2 C.B. 173. 62

26

followed the tax year, the cooperative canceled the accounts

receivable due from patrons by redeeming the nonqualified

equities at less than face value. The transaction was held to relate

to patronage during the taxable year in which the loss occurred.

In contrast, when the applicable tax law provides that an

adjustment increases income in the years the underlying

transactions took place, IRS may refuse to apply section 1382(f).

If the 81⁄2 month payment period has expired, patronage refund tax

treatment may be denied.

Revenue Ruling 74-327 held income resulting from the 62

adjustments to depreciation was includible in the cooperative's

gross income for the years the incorrect amount of depreciation

was claimed. IRS said the fact the amount of depreciation claimed

in the prior years was overstated and the overstatement was not

discovered until after the returns had been filed for those years did

not result in income includible in a later year. Thus, section

1382(f) was not applicable to assign the added income from

adjustment to the year the error was discovered and corrected.
 I.R.C. § 521. Under § 521, farmer cooperatives that meet certain 63

organizational and operational tests may, in addition to patronage

refunds, also deduct dividends paid on stock and nonpatronage income

distributed to patrons on a patronage basis. Section 521 is discussed in

detail in Part 4 of these reports.

27

CHAPTER 5

PATRONAGE AND NONPATRONAGE BUSINESS

Patronage refunds must be derived out of earnings on business

done with or for patrons.

Characterizing business or income as patronage or

nonpatronage sourced can be approached in two ways. The first

distinction deals with how a cooperative treats those with whom

it transacts business. For example, if a cooperative purchases

products from nonmembers who are not entitled to patronage

refunds, the income generated from reselling such products is from

nonpatronage sources because the cooperative is not dealing with

nonmembers on a cooperative basis. The difference in the status

of the persons served by the cooperative is clearly established, so

this distinction has generated little legal controversy.

The second means of distinguishing patronage and

nonpatronage income is based on the nature of the transaction or

operation that generates the income. For example, a cooperative

may earn income from the investment of cash reserves.

Determining whether income from certain sources, with traits not

always associated with operating income, is patronage or

nonpatronage sourced has been the subject of much controversy

between cooperatives and IRS.

SIGNIFICANCE OF CLASSIFYING BUSINESS SOURCES

Whether income is patronage or nonpatronage sourced is

primarily a concern of cooperatives that do not qualify for section

521 tax status. It is an issue of limited importance to section 521 63

cooperatives.
 I.R.C. § 521(b)(1) requires a qualifying cooperative to return

64

earnings from marketing products to "members or other producers" and

providing supplies to "members and other persons." The regulations are

more specific, stating: "...patronage dividends must be paid to all

producers on the same basis...." Treas. Reg. § 1.521-1(a)(1).

 I.R.C. § 1381(a)(1) and § 1382(c)(2)(A). Treas. Reg. § 1.1382-

65

3(c).

 The Eighth Circuit Court of Appeals put it this way, 66

"...cooperatives that do qualify under section 521 are allowed not only

the ordinary deductions for patronage dividends and qualified per-unit

retain allocations, but also deductions for capital stock dividends and

patron-age dividends derived from nonpatronage business....A

nonexempt cooperative, by contrast, operates as a hybrid; only its

patronage income enjoys this kind of treatment." Farm Service Co-op

v. Commissioner, 619 F.2d 718, 727 (8th Cir. 1980).

28

To qualify for section 521 tax status a cooperative may not

discriminate between member and nonmember patrons.64

Members and nonmembers alike are entitled to share, on a pro rata

basis, earnings distributed as patronage refunds.

The patronage/nonpatronage distinction is also of less concern

to section 521 cooperatives because they can deduct both

patronage and nonpatronage income allocated to patrons on a

patronage basis. A section 521 cooperative will add non- 65

patronage income to patronage income and allocate total earnings

as patronage refunds to everyone it serves, members and nonmembers alike. It can then deduct all earnings distributed as

patronage refunds, regardless of whether the earnings came from

patronage or nonpatronage sources.

For cooperatives without section 521 status, only patronagesourced income qualifies for single tax treatment. Nonpatronage

income is subject to regular corporate double tax treatment.66

Distinguishing patronage and nonpatronage business is

significant for another reason. Cooperatives engaged in both

patronage and nonpatronage business must separate both income
 Farm Service Co-op v. Commissioner, 619 F.2d 718, 723-727 (8th 67

Cir. 1980); Certified Grocers of California, Ltd. v. Commissioner, 88

T.C. 238 (1987). 

 1963-1 C.B. 109. 68

Id.

69

 I.R.C. § 1388(a)(3). 70

29

and expenses related to each type of business. This requires the 67

cooperative to maintain adequate records in order to properly

allocate income and expense items between patronage business

and nonpatronage business. This complicates the cooperative's

accounting system and the computation of its tax liability.

Revenue Ruling 63-58 provides an example of how this 68

requirement works. The ruling discusses a cooperative that both

stores and markets grain, and that only pays patronage refunds to

its members. The ruling states that where cooperatives distribute

earnings:

...only to member patrons, ...it is essential (to) keep

permanent records to show business done with

nonmembers and that done with members. Where, for

example, 20 per cent of the bushels delivered for storage

and 60 per cent of the bushels delivered for marketing are

attributable to transactions with members, only 20 per cent

of the income from storage may be combined with 60 per

cent of the income from marketing and the aggregate net

profit may be distributed to the members ratably....

69

TESTS APPLIED TO CLASSIFY BUSINESS

The primary legal authority for distinguishing patronagesourced from nonpatronage-sourced business is the Code

definition of a patronage refund, which is "an amount paid to a

patron...which is determined by reference to the net earnings of the

organization from business done with or for its patrons."70
 I.R.C. § 1388(a).

71

 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 451 (1986). 72

30

Further, a patronage refund "does not include any amount paid

to a patron to the extent that (A) such amount is out of earnings

other than business done with or for patrons...."71

The phrase "done with or for patrons" provides the basis for

tests applied to classify specific business practices or sources of

income as patronage sourced or nonpatronage sourced. The Code

gives no further explanation of patronage or nonpatronage

business, and "the legislative history of the subchapter T

provisions is not helpful."72

The variety of circumstances in which patronage business must

be distinguished from nonpatronage business has led to the

formulation of two general "tests." One line of thought

emphasizes the kind of income (such as interest or capital gain).

The other focuses on the nature of the transaction generating the

income in relation to the cooperative's overall business purposes.

As the issues have developed by IRS rulings and court

decisions, a trend has emerged toward application of underlying

principles and economic and business realities to facts at hand, and

away from classifications based on simple terms applied to the

transaction or type of income. This trend is especially evident in

judicial opinions.

Regulatory Rules

One reason cooperatives and IRS have difficulty in this area is

the somewhat ambiguous wording of the relevant regulations. The

regulations do not define patronage income, but Treas. Reg. §

1.1382-3(c)(2), does define nonpatronage income as:

...incidental income derived from sources not directly

related to marketing, purchasing, or service activities of

the cooperative association. For example, income derived
 Action on Decision 2001-03 (2001), acquiescing in Farmland 73

Industries v. Commissioner, T.C. Memo 1999-388.

 T.D. 6014, 1953-1 C.B. 110, 115, published as Treas. Reg. § 74

29.101(12)-3(d).

 Revenue Act of 1951, Pub. L. No. 183, § 314, 65 Stat. 452, 491- 75

493 (1951), reprinted in U.S. Code Cong. & Admin. Serv. 308, 371-

372.

31

from the lease of premises, from investment in securities,

and from the sale or exchange of capital assets, constitutes

income derived from sources other than patronage.

The two sentences quoted above may be somewhat selfcontradictory. The first sentence presents a "directly related" test,

which suggests looking at the nature of the transaction and the

economic reality of the situation. If income is generated by

transactions directly related to marketing, purchasing, or service

activities of a cooperative for its patrons, then it is patronage

income.

The second sentence lists three specific examples of income--

rent, returns on investments, and gains from the sale of assets--as

nonpatronage income. For a considerable period of time, the

Service read the second sentence as conclusively establishing that

income from these three sources is per se nonpatronage income.

Cooperatives countered that the “directly related” test should be

applied to determine the patronage or nonpatronage nature of all

income. After numerous court battles led to a series of decisions

adopting the cooperative position, the Service has agreed to accept

the “directly related” test as the proper standard for determining

whether cooperative income is from patronage or nonpatronage

sources.73

The regulation language in question was adopted in 1953, in 74

response to 1951 legislation which required section 521 farmer

cooperatives for the first time to allocate income set aside in

reserves to avoid corporate tax. The fundamental requirement 75
See, e.g., Fertile Cooperative Dairy Ass'n v. Huston, 119 F.2d 274 76

(8th Cir. 1941), aff'g, 33 F. Supp. 712 (N.D. Iowa 1940); Western

Colorado Producers Cooperative v. Commissioner, 1 T.C.M. (CCH)

697, 702 (1943).

 Treas. Reg. § 1.1382-3(c)(3). 77

Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 451 (1986). 78

32

for section 521 status is nondiscrimination between member and

nonmember patrons. Prior to 1951, in a number of court cases the

Commissioner challenged the allocation practices of tax exempt

cooperatives as inconsistent with this nondiscrimination

requirement for exemption. Subsection (3) of the current 76

regulation , which follows the definition in subsection (2), 77

indicates this regulation was adopted to deal primarily with

allocation of nonoperating income.

The historical background of the regulation suggests that the

primary intent was to deal with nondiscriminatory allocations by

exempt cooperatives. However, as the Tax Court has said, "it

appears to be generally accepted that this definitional attempt is of

equal application to both exempt and nonexempt cooperatives."78

The next sections discuss the two types of tests used to

distinguish patronage- and nonpatronage-sourced income and how

IRS and the courts have handled situations where the two

approaches conflict.

Directly Related/Actually Facilitates Test

This test for distinguishing patronage- and nonpatronagesourced income looks to the transaction or activity generating the

income and asks whether it is "directly related to" or "actually

facilitates" the cooperative's overall business purpose.

The "directly related" test is based on Treas. Reg. § 1.1382-

3(c)(2), which states, in part: "'Income derived from sources other

than patronage' means incidental income derived from sources not

directly related to the marketing, purchasing, or service activities
Rev. Rul. 74-160, 1974-1 C.B. 246; Rev. Rul. 75-228, 1975-1 79

C.B. 278; Astoria Plywood Corp. v. United States, 1979-1 U.S.T.C.

(CCH) ¶ 9197 (D. Ore. 1979).

 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 463 (1986). 80

 Astoria Plywood Corp. v. United States, 1979-1 U.S.T.C. (CCH) 81

¶ 9197 (D. Ore. 1979).

 Rev. Rul. 69-576, 1969-2 C.B. 166. 82

33

of the cooperative association." Conversely, income directly

related to the cooperative's activities is patronage-sourced

income.79

The directly related test first identifies the cooperative's

activities with respect to marketing, purchasing, or services

performed for patrons. "The same activities that may be directly

related to the cooperative enterprise in one case may not be so

directly related in another case." For example, a workers'

80

cooperative lease of a plywood plant for its own use is directly

related to the cooperative's business. Such a plant, however, may 81

not be directly related to another cooperative's marketing,

purchasing, or service activities. The activity meets the directly

related test if it relates to business done with or for patrons.

The "actually facilitates" language is credited to Revenue

Ruling 69-576. This ruling concerned a cooperative that 82

borrowed money from a Bank for Cooperatives to finance the

acquisition of supplies for resale to its members. After the close

of its fiscal year, the Bank for Cooperatives determined its net

margin and paid the borrower/cooperative a patronage refund

based on its ratable share of the bank's margin. In holding the

patronage refund paid bythe Bank for Cooperatives was patronage

sourced income to the cooperative, the Service stated:

The classification of an item of income as from either

patronage or nonpatronage sources is dependent on the

relationship of the activity generating the income to the

marketing, purchasing, or service activities of the
Id. at 167.

83

 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 452 (1986). 84

34

cooperative. If the income is produced by a transaction

which actually facilitates the accomplishment of the

cooperative's marketing, purchasing, or service activities,

the income is from patronage sources. However, if the

transaction producing the income does not actually

facilitate the accomplishment of these activities but merely

enhances the overall profitability of the cooperative

operations, being merely incidental to the association's

cooperative operation, the income is from nonpatronage

sources.83

The "actually facilitates" concept enunciated in Revenue

Ruling 69-576 has been called the "touchstone or common thread"

running through cases and rulings "which enables them to be

reconciled" with the regulations, at times facially inconsistent.84

In Illinois Grain Corp. v. Commissioner, the Tax Court, after

reviewing the analysis of patronage sourced versus nonpatronage

sourced income in a number of prior cases, concluded the

characterization in Revenue Ruling 69-576 was correct. The court

stated:

As the cases make clear, such a determination is necessarily fact-intensive. Income derived by a cooperative

from its various business activities may indeed be so

closely intertwined and inseparable from the main

cooperative effort that it may be properly characterized as

directly related to, and inseparable from the cooperative's

principal business activity, and thus can be found to

'actually facilitate' the accomplishment of the cooperative's

business purpose. On the other hand, it is equally possible

that a cooperative may undertake business activities which,

while profitable, have no integral and necessary linkage to
Id. at 459.

85

 Cotter and Co. v. United States, 765 F.2d 1102 (Fed. Cir. 1985),

86

1985-2 U.S.T.C. (CCH) ¶ 9487, rev'g, 6 Ct. Cl. 219 (1984), 1984-2

U.S.T.C. (CCH) ¶ 9773.

 765 F.2d at 1106. 87

See, e.g., Certified Grocers of California, Ltd. v. Commissioner,

88

88 T.C. 238 (1987), wherein the cooperative had widely fluctuating and

substantial needs for cash reserves as it made purchases for its patrons.

 Treas. Reg. § 1.1382-3(c)(2). The list is not without some 89

foundation. A report of the Senate Finance Committee on the 1951

35

the cooperative enterprise, so that it may fairly be said that

the income from such activities does nothing more than

add to the taxpayer's overall profitability. It all depends on

the facts of each case.85

Patronage sourced income results from activities integrally

intertwined with the cooperative's functions in a business context,

as opposed to activities that merely produce incidental profits.

86

Analysis should focus on the "totality of the circumstances" to

determine how the activity is related to the cooperative's principle

business. This includes the facts surrounding the generation of 87

income. For example, income generated from temporary excess

cash is judged in the context of the cooperative's cash needs and

the fluctuation of those needs as it conducts business on behalf of

patrons. Excess cash and its temporary use to generate income

may be part of the business in which the cooperative is engaged.88

Nature-of-the-Income Test

Treas. Reg. § 1.1382-3(c)(2), which provides the directly

related test, also gives three specific examples of income derived

from sources other than patronage: "Income derived from the lease

of premises, from investment in securities, or from the sale or

exchange of capital assets."89
amendment to section 101(12) of the 1939 Code gave a somewhat

similar list. It stated: "At the present time...nonoperating income such

as interest, dividends, rents, and capital gains and also the income from

certain business done with the United States Government or its

agencies, is taxable to the ordinary cooperative even when allocated to

the accounts of patrons, but are tax-free to the exempt cooperative

whether or not allocated." S. Rep. No. 781, 82nd Cong., 1st Sess. 20,

21 (1951), reprinted in 1951 U.S. Code Cong. & Admin. Serv. 1989.

 "The government contends that all capital gains are not patronage 90

source income and that it is unnecessary to consider whether the lease

cancellation payment and [the cooperative's] income fromthe sale of the

machines are otherwise directly related to the cooperative's activities

because both are capital gains." Astoria Plywood Corp. v. United

States, 1979-1 U.S.T.C. (CCH) ¶ 9197, at 86,348-49 (D. Ore. 1979).

 An investigation of the underlying reasons for a transaction was 91

commenced despite the regulations, for example, in Astoria Plywood

Corp. v. United States, where the court said, "In my view capital gains

may be patronage source income. In each instance, it depends on

whether the income is 'directly related' to [the cooperative's] activities."

1979-1 U.S.T.C. (CCH) ¶ 9197, at 86,349 (D. Ore. 1979). Similarly,

Certified Grocers of California, Ltd. v. Commissioner, noted "it is clear

that interest income earned by cooperatives is, in some circumstances,

patronage sourced income," 88 T.C. 238, 243 (1987), citing Cotter and

Co. v. United States, 765 F.2d 1102, 1107 (Fed. Cir. 1985), and Illinois

Grain Corp. v. Commissioner, 87 T.C. 435, 459-460 (1986).

36

Efforts have sometimes been made to apply these three

examples as tests without regard to the underlying facts or the

relation to the cooperative's patronage activities. In this approach,

if income falls in any of the three categories, it is considered

income from a nonpatronage source without considering whether

it may meet a "directly related" or "actually facilitates" test.90

The approach that any income falling in a category noted in

one of the regulatory examples needs no further analysis to

determine its patronage or nonpatronage character has not been

generally accepted. The Tax Court has said, "in spite of the 91

apparently clear language of the regulation, however, the law, as
 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 451 (1986). 92

 87 T.C. at 463. 93

 87 T.C. at 463, quoting Associated Milk Producers, Inc. v. 94

Commissioner, 68 T.C. 729, 736 (1977).

 Rev. Rul. 73-497, 1973-2 C.B. 314. 95

 St. Louis Bank for Cooperatives v. United States, 624 F.2d 1041, 96

1050-51 (Cl. Ct. 1980).

37

it has developed, shows that the language does not always mean

what it literally says. Both the [IRS] and the courts have played a

hand in this evolution of the law...."92

At times, the courts have been openly hostile to IRS attempts

to narrowly interpret this regulation. The Tax Court rejected

attempts by IRS to remove income generated by money

management practices (interest income) as "any other business

enterprise would have done," from patronage-sourced treatment.93

The court quoted another Tax Court decision that said, "We

consider [IRS's] position herein not only contrary to the [law], but

conceptually strained and lacking any fundamental policy support;

in short, an unwarranted tinkering with the tax structure applicable

to cooperatives."94

The Court of Claims was similarly harsh on IRS's literal

interpretation of Treas. Reg. § 1.1382-3(c)(2). In Revenue Ruling

73-497, IRS relied on the regulatory examples to classify interest

income earned by a Bank for Cooperatives as nonpatronagesourced. The interest income came from temporary investments 95

of surplus funds and on bonds the bank was required to buy to

comply with Farm Credit Administration liquidity requirements.

In St. Louis Bank for Cooperatives v. United States, the Claims

Court found Revenue Ruling 73-497 to be "inherently

defective....The ruling reiterates the language of the regulation, is

conclusory in content, and of little persuasive value."96
 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 459 (1986);

97

Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 238, 244

(1987).

 Certified Grocers, 88 T.C. at 244 (1987). 98

See, for example, Astoria Plywood Corp. v. United States, 1979-1 99

U.S.T.C. (CCH) ¶ 9197 (D. Ore. 1979); Washington-Oregon Shippers

Cooperative, Inc. v. Commissioner, 52 T.C.M. (CCH) 1406 (1987);

Thwaites Terrace Home Owners Corp. v. Commissioner, 72 T.C.M.

(CCH) 578.

 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 100

238, 245 (1987).

38

TAXPAYER’S BURDEN OF PROOF

Analysis of the patronage- or nonpatronage-sourced nature of

a particular business activity is "necessarily fact-intensive."97

Cooperatives wishing to establish the patronage nature of a

particular activity have the burden of proof to establish the facts

necessary to prove IRS's determination incorrect. Income has 98

been found nonpatronage-sourced when the cooperative fails to

show the necessary connection between the activity generating the

income and the principal business of the cooperative conducted

with or for its patrons. As the Tax Court has said: 99

Although we realize that cooperatives such as

petitioner need cash to operate, the record in this case does

not allow us to determine whether the funds that earned the

interest income in issue were needed for use in petitioner's

cooperative activity. The record does not disclose, for

example, the amount of funds that earned the interest, the

term for which the funds were placed, petitioner's needs

for the funds, and when those needs were expected to

occur. [footnote omitted] Lacking such facts, we must

hold that petitioner has failed to prove that respondent

erred in determining that the remaining interest income

was nonpatronage-sourced.100
 Treas. Reg. § 1.1382-3(c)(2). 101

39

On the other hand, most situations in which the patronage or

nonpatronage nature of the income was disputed and in which the

cooperative's position prevailed resulted from careful explanation

of the activity and its relation to the cooperative's business.

Examples of these situations are found in the following sections

on specific items of income or activities.

RENTAL INCOME

The first example of nonpatronage income listed in the

regulation is "income derived from the lease of premises." Two 101

significant court decisions included a discussion of the status of

rental income, and both found it patronage-sourced. Both cases

eschewed a literal application of the regulatory example in favor

of an analysis weighing the totality of the facts.

In Cotter and Company v. United States, a hardware

cooperative with a growing business built additional warehouse

space to meet its current and anticipated future needs. It leased the

excess space built to accommodate future growth. The U.S. Court

of Appeals for the Federal Circuit, in a reversal of a Claims Court

decision, found:

The rental income earned through the leasing out of

temporary excess space is also patronage sourced. The

stipulated facts clearly show that renting temporarily

excess space was only a minor component of taxpayer's

plan for making certain that Cotter had sufficient

warehouse and manufacturing space.... It is clear from the

undisputed facts that Cotter did not go into the warehouse

rental business, seeking to enhance corporate profits while

hiding behind its label as a cooperative. Indeed, Cotter

occasionallymust lease space from others as well. Rather,
 Cotter and Co. v. United States, 765 F.2d 1102, 1109-1110, (Fed. 102

Cir. 1985), rev'g, 6 Ct. Cl. 219 (1984). While the IRS Chief Counsel's

Office did not recommend an appeal of the Cotter decision, it did

express disagreement with the outcome. Action on Decision 1986-032

(June 23, 1986).

 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 461-462 103

(1986). IRS accepted the court's decision that the barge rental income

was patronage sourced. Action on Decision 1990-027 (Sept. 24, 1990).

40

Cotter implemented a reasonable plan to secure the

warehousing of its goods at the lowest cost to its patrons;

the result is a primary function of Cotter's.102

In Illinois Grain Corp. v. Commissioner, a grain marketing

cooperative involved in moving members' grain by barge sublet

two of its barges to another barge transportation cooperative of

which it was a member-patron. The Tax Court looked at the

totality of the facts and determined rental income received from

subletting the barges was patronage sourced. The court concluded:

We are satisfied that petitioner's leasing and subleasing

of barges to its transportation cooperative was not an

'investment' in such barges, intended to produce merely

passive rental income, but was ... clearly linked to

petitioner's principal cooperative enterprise, and was not

entered into as an independent and unrelated profit-making

activity. We accordingly hold that the barge rentals which

petitioner derived in the year in issue were patronage

sourced income, within the rational of Rev. Rul. 69-576,

and consistent with the philosophy expressed in the Cotter

case.

103

INVESTMENT INCOME

The second example of income identified as nonpatronagesourced in Treas. Reg. § 1.1382-3(c)(2) is income "from
See, e.g., Tech. Adv. Mem. 9236001 (May 20, 1992).

104

 Rev. Rul. 73-497, 1973-2 C.B. 134. 105

 Rev. Rul. 74-160, 1974-1 C.B. 246. 106

41

investment in securities." This encompasses both interest earned

on funds loaned out by cooperatives and dividends received on

equity investments held by cooperatives.

Interest

A cooperative may make loans for various reasons, and earn

interest on the amounts loaned. Whether interest income should

be classified as from patronage or nonpatronage sources has

proven a difficult issue to resolve.

As a general rule, if the loan enables the borrower to perform

some service for the cooperative, the interest is likely to be

characterized as patronage-sourced income. The cooperative has

been able to meet its burden of establishing the loan was directly

related to its cooperative activity.104

Cooperatives have been less successful in meeting the "directly

related to" and "actually facilitates" standard where the loan is to

entities without other business connections to the cooperative.

The first decision in this area, Revenue Ruling 73-497,105

applied Treas. Reg. § 1.1382-3(c)(2) literally to deny patronage

sourced income status to interest income earned by a Bank for

Cooperatives on temporary placements of surplus funds and on

bonds purchased to comply with liquidity requirements imposed

by the Farm Credit Administration. This ruling ignored Revenue

Ruling 69-576 and the "directly related to" and "actually

facilitates" tests.

In Revenue Ruling 74-160, a plywood workers' cooperative 106

made loans to its chief supplier. The supplier needed the loans to

finance equipment necessary to carry out its business operations

for the cooperative. This time IRS relied on Revenue Ruling 69-

576 and held the loans to purchase equipment facilitated the
 St. Louis Bank for Cooperatives v. United States, 624 F.2d 1041 107

(Ct. Cl. 1979), 1980-2 U.S.T.C. (CCH) ¶ 9509, rev'g in part, aff'g in

part, 1979-2 U.S.T.C. (CCH) ¶ 9576.

 624 F.2d at 1052-53. 108

42

accomplishment of the cooperative's activities by enabling the

cooperative to obtain needed supplies for its operations. Without

making the loans, the cooperative would have been unable to

procure the necessary supplies. Thus, income generated as a result

of the loans was found to be "directly related" to the cooperative's

activities.

Court decisions analyzing the patronage/nonpatronage

character of interest income have uniformly adopted some form of

the directly related test. An early court case dealt with the money

management activities of a Farm Credit System institution. In St.

Louis Bank for Cooperatives v. United States, the bank 107

sometimes generated surplus funds from the sale of bonds that

temporarily exceeded the needs of its member-borrowers. These

funds were invested first with other Farm Credit System

institutions and, if no one in the system needed the funds, with

brokerage houses that sold Farm Credit System bonds.

The bank also realized interest income on Federal bonds held

to meet Farm Credit System liquidity rules. These rules required

the bank to keep invested cash equal to between 20 and 25 percent

of its capital stock.

The U.S. Court of Claims disavowed the strict literal

interpretation of Revenue Ruling 73-497 in favor of the other

rulings previously cited. Looking at the totality of the facts, the

court found the interest income earned on the investment of the

temporary surplus funds and on bonds held to meet the liquidity

requirement to be "directly related" to the services the cooperative

bank provided its members and "patronage sourced" for tax

purposes.108
 TwinCounty Grocers, Inc. v. United States, 2 Cl. Ct. 657 (1983). 109

 Cotter and Co. v. United States, 765 F.2d 1102, (Fed. Cir. 1985),

110

1985-2 U.S.T.C. (CCH) ¶ 9487, rev'g, 6 Ct. Cl. 219 (1984), 1984-2

U.S.T.C. (CCH) ¶ 9773.

 Cotter and Co. v. United States, 6 Cl. Ct. 219, 230 (1984). 111

43

In Twin County Grocers, Inc. v. United States, the U.S. 109

Court of Claims also applied the "directly related" test. The court

rejected the argument that all interest income was "directly

related" to a cooperative's business activity because that income

reduced the need for the cooperative to borrow other funds. The

court found that prudent money management, absent a showing

that it was directly tied to the marketing, purchasing, or service

activities of the cooperative, was merely an incidental method of

enhancing overall profitability. The cooperative's interest income

was held to be from nonpatronage sources.

The watershed case on this issue, Cotter &Company v. United

States, involved a wholesale hardware cooperative that had wide 110

seasonal fluctuations in its business. Suppliers often required

payment before Cotter could resell merchandise; so Cotter needed

temporary cash surpluses available to pay suppliers. Cotter

invested its temporary cash surpluses in short-term paper and

claimed the interest generated as patronage sourced income.

The Court of Claims had both St. Louis Bank and Twin County

Grocers to consider in deciding this case. Cotter attempted to

distinguish Twin County Grocers on the basis that that cooperative

failed to show any close connection between the accumulation of

surplus funds and its business activity. The Claims Court,

however, sided with IRS. The court stated that for interest income

to be patronage sourced "the cooperative must establish a

connection between the transaction that produced the income and

the basic services it rendered." This decision appeared to limit 111

St. Louis Bank to situations involving financial service

cooperatives.
 Cotter and Co. v. United States, 765 F.2d 1102, 1110 (Fed. Cir.

112

1985), rev'g 6 Cl. Ct. 219 (1984).

 Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 460 (1986).

113

While the Service did not appeal this decision, it later announced its

nonacquiescence in the outcome, A.O.D.-1990-027 (Sept. 24, 1990).

44

But on appeal, the U.S. Court of Appeals for the Federal

Circuit reversed the Claims Court. Placing substantial reliance on

St. Louis Bank, the court said that in determining the status of

interest income one should not look at the transaction in a vacuum,

but rather should consider "the income-generating transaction in

its relation to all the activity undertaken to fulfill a cooperative

function...." It found the money management activity of Cotter 112

directly related to its overall function and held the interest income

in dispute patronage sourced income.

In Illinois Grain Corp. v. Commissioner, the Tax Court

adopted the approach of the appellate court in Cotter. A grain

marketing cooperative established that it operated in a volatile

market in competition with large worldwide firms and that it

needed surplus funds for flexibility to deal with fluctuations in the

marketplace. The court found the short-term placement of these

surplus funds to be "inseparably intertwined with the overall

conduct of its cooperative enterprise, and the interest income

which it earned was therefore patronage sourced...."113

The next time the Tax Court considered this issue, the court

made it clear cooperatives need to prove a nexus between their

business operations and the investment creating the interest

income. In Washington-Oregon Shippers Cooperative, Inc. v.

Commissioner, a freight forwarding cooperative purchased

certificates of deposit with excess operating funds and claimed the

interest as patronage-sourced income. The court failed to find "the

integral and necessary linkage between petitioner's money

management activities and its overall conduct of its cooperative

enterprise such as we found in Illinois Grain. We conclude that

petitioner's money management activities did nothing more than
 Washington-Oregon Shippers Cooperative, Inc. v. Commis- 114

sioner, 52 T.C.M. (CCH) 1406 (1987). The cooperative had also made

loans to encourage construction of a freight terminal used by the

cooperative in its business and to encourage expansion into new

territory. Income received on these notes was conceded to be

patronage-sourced income.

 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 115

238 (1987).

 Dundee Citrus Growers Ass'n v. Commissioner, 62 T.C.M. 116

(CCH) 879 (1991).

45

add...to its overall profitability." The interest was found to be 114

from nonpatronage sources.

In Certified Grocers of California v, Commissioner, the Tax 115

Court found interest earned on the temporary investment of funds

borrowed to finance construction of a warehouse was income from

patronage sources. But as in Washington-Oregon Shippers

Cooperative, interest earned on the investment of general surplus

funds was nonpatronage income.

Dundee Citrus Growers Association v. Commissioner116

involved a citrus marketing association that used a pooling system

to equitably distribute earnings to members from the sale of a crop

whose price might fluctuate substantially during the marketing

year. Rather than make distributions to members during the

season, and risk overpaying some members, the cooperative

invested proceeds from sales of product and paid members after a

pool was substantially sold and could be closed. Some of the

loans were to a federated cooperative in which this cooperative

held membership.

IRS argued the cooperative could have made preclosing

distributions instead of accumulating surplus cash which resulted

in the challenged interest. Therefore the investments did not

actually facilitate the cooperative's operation, and the income was

nonpatronage sourced.

The court noted, however, the volatile nature of the industry,

the difficulty in recovering over-advances, and the benefits of
Id. at 885.

117

CF Industries v. Commissioner, 62 T.C.M. (CCH) 1249 (1991). 118

 The court in Washington-Oregon Shippers Cooperative said it 119

was "troubled by the rather long term involved" in 90-day T-bills, but

didn't decide the case on that basis. 52 T.C.M. (CCH) 1406 (1987).

 CF Industries v. Commissioner, 955 F.2d 101 (7th Cir. 1993),

120

aff'g as modified, 62 T.C.M. (CCH) 1249 (1991).

Id. at 104.

121

46

lowering the borrowing costs of the federated cooperative. Given

these circumstances, the court concluded the cooperative acted

prudently, and "maintenance of the temporary excess of incoming

funds over outgoing expenses is both integral to and necessary to

petitioner's cooperative functions."117

In CF Industries v. Commissioner, the Tax Court focused on 118

the length of maturity of the investment instrument. Testimony

indicated CF operated in a volatile market and was unable to

forecast accurately its cash needs for more than 30 days. On this

basis, the U.S. Tax Court said only interest on investments with

maturities of 30 days or less would qualify as patronage sourced.119

On appeal, the U.S. Court of Appeals for the 7th Circuit first

found that the Tax Court’s 30-day rule made no sense and

discarded the length-of-maturity test. The appellate court found 120

that CF needed a cash reserve to operate its business and earning

interest on that reserve was prudent cash management for the

benefit of its member-patrons. It held all of the interest income

under review was patronage sourced because "...the earnings on

the money in the cash-management account are generated by the

bona fide business dealings of the cooperative, as a producer and

seller of fertilizers, with or on behalf of its member-customers.

CF is not running a mutual fund for its members on the side."121

These cases suggest that determining whether interest income

is patronage-sourced is a fact-intensive process. While the nature

of the investment vehicle is not determinative, the longer its

maturity the more closely a court is likely to look at the reason for
 Tech. Adv. Mem. 9208004 (October 31, 1991).

122

 Tech. Adv. Mem. 9211001 (September 23, 1991); Tech. Adv. 123

Mem. 9236001 (May 20, 1992).

47

the investment. Cooperatives seeking patronage-sourced status

must show that the invested funds are directly related to their

overall business operation, and not just surplus money invested to

enhance overall firm profitability.

In 1992, between the Tax Court and 7th Circuit opinions in the

CF case, the Service issued three rulings that referred to the nature

of the lender in determining the nature of interest earned. In the

first, a wholesale supply cooperative was primarily financed with

funds provided by its members. It invested these funds in

certificates of deposit and a money market fund. The Service

found that while the investments were prudent money

management strategies, the interest income realized was

nonpatronage sourced. The Service noted that the funds were

placed with third-party financial institutions and not with its own

patrons. As nothing in the facts demonstrated that the income in

question came from the actual sale of goods and services to its

patrons or to others on behalf of its patrons, it must be considered

nonpatronage sourced income.122

Two rulings issued shortly thereafter involved co-ops that

marketed products on behalf of their members. Both sold their

members’ production to a noncooperative firm for processing and

marketing. As part of the overall arrangement, the co-ops loaned

money to the noncooperative firm to fund the processing of

member product and received interest on those funds from the

firm. In both instances, the Service found that the interest resulted

from a transaction required to secure a market for members’

products and held the interest income realized by the cooperatives

was patronage sourced.123
 Action on Decision 2001-03 (2001), acquiescing in Farmland 124

Industries v. Commissioner, T.C. Memo 1999-388.

 Treas. Reg. § 1.1382-3(c)(2). 125

 Land O'Lakes, Inc. v. United States, 675 F.2d 988 (8th Cir.

126

1982), aff'g in part, rev'g in part, 470 F.Supp. 238 (D. Minn. 1979).

48

IRS has agreed to abandon its position that interest income is

per se nonpatronage sourced. However, it has not issued any 124

rulings concerning interest income since the CF decision, so it is

not clear whether that opinion has led the Service to a more

flexible interpretation of the “directly related” test or not. 

Dividends

Dividends received on equity investments, like interest on

loaned funds, fall within the general topic of income "from

investment in securities" listed as an example of nonpatronage

sourced income in the regulation. Once again, the courts have 125

looked beyond the narrow confines of the regulatory examples and

found dividend income is patronage sourced when the equity

position is acquired to facilitate the cooperative's business

purpose. As with interest income, the cooperative has the burden

of showing the direct relationship between the investment activity

and cooperative operations.

In Land O'Lakes, Inc. v. United States, a cooperative was 126

required to purchase stock in a Bank for Cooperatives as a

condition of borrowing funds from the bank. This is a common

provision in the cooperative banking system, analogous to

requirements for capital contributions of members to their

marketing, supply, or service cooperative. While the cooperative

could have obtained loans elsewhere, such loans would have been

on less favorable terms.

IRS challenged the cooperative's attempt to treat the dividends

received on the Bank for Cooperative's stock as patronage income.

The court turned back the challenge, holding "because the
 675 F.2d at 933. A similar situation was not challenged by IRS 127

in M.F.A. Central Cooperative v. Bookwalter, 427 F.2d 1341 (8th Cir.

1970), rev'g, 286 F. Supp. 956 (E.D. Mo. 1968).

 Tech. Adv. Mem.9211001 (September 23, 1991).

128

 Tech. Adv. Mem. 9236001 (May 20, 1992).

129

 Land O'Lakes, Inc. v. United States, 675 F.2d 988 (8th Cir.

130

1982), aff'g in part, rev'g in part, 470 F.Supp. 238 (D. Minn. 1979).

 Linnton Plywood Association v. UnitedStates, 410 F.Supp. 1100 131

(D.C. Ore. 1976).

49

transactions actually facilitated the cooperative's activities by

providing financing on terms favorable to the cooperative, the

income from the bank stock was from a patronage source...."127

In subsequent administrative rulings, the Service has said that

dividends from a bank for cooperatives are patronage sourced,128

even when the funds were borrowed to reloan them to a

noncooperative partner in a joint venture.

129

Land O'Lakes also discussed the cooperative's ownership of 130

a chain of convenience stores that marketed both patron and

nonpatron products at retail. The cooperative argued that all

dividends received from the chain of stores was patronage sourced

income as all sales facilitated the movement of patron product.

The court, however, required the cooperative to accept IRS's

method of allocating dividends received between patronage and

nonpatronage status because the cooperative could not prove that

all the sales actually facilitated movement of patron products.

Stock dividends have also been held to be patronage sourced

income when holding the stock is a requirement for obtaining

needed services. In Linnton Plywood Association v. United

States, two plywood worker cooperatives shared ownership of 131

a glue factory. The cooperatives received dividends on capital

stock in the factory. The court said glue is essential to the

manufacture of plywood, and the cooperatives' arrangement to
Id. at 1108. 132

 Treas. Reg. § 1.1382-3(c)(2). 133

 I.R.C. § 1221. With certain limitations, the four exceptions listed 134

in § 1221 are basically (1) inventory, (2) depreciable business property

and real estate used in a trade or business, (3) intellectual property in the

hands of the creator, and (4) accounts receivable.

 I.R.C. § 1231. 135

50

produce glue through a supplier which they owned "is reasonably

related to the business done with or for its patrons."132

INCOME FROM SALE OF ASSETS

The final specific example of nonpatronage sourced income

given by the regulation is income from the "sale or exchange of

capital assets." The term "capital asset" is defined quite broadly 133

in the Code to include all property held by a taxpayer (regardless

of how long it is held and whether or not it is connected with a

trade or business) unless it falls within four specific exceptions.134

While I.R.C. section1221(a)(2) expressly excludes depreciable

business property and real estate used in a trade or business from

the definition of capital assets, I.R.C. section 1231 provides that

if depreciable business property and real estate used in the trade or

business are held for more than one year and the net result from

the disposition of these items in a year is a gain, that gain is a

capital gain for tax purposes.135

Depreciation Recapture

Gain or loss from the sale of capital assets often requires

recognition of how much the asset has been depreciated at the time

of sale or exchange. Some gain from sale or exchange of

depreciable property may be a "recapture" of income not

recognized during the life of the asset because of the depreciation

methods used. If a cooperative has reduced its income by
 I.R.C. § 1245. 136

 Rev. Rul. 74-84, 1974-1 C.B. 244, 245. See also, Priv. Ltr. Rul.

137

8952019 (September 28, 1989).

St. Louis Bank for Cooperatives v. United States, 1979-2 138

U.S.T.C. (CCH) ¶ 9576, at 88,098 (Ct. Cl. 1979).

 I.R.C. § 1221(2). Treas. Reg. § 1.1221-1(b) reads, in part, 139

"Property used in the trade or business of a taxpayer of a character

which is subject to the allowance for depreciation provided in section

51

depreciation during the life of a depreciable asset, some income

from sale or exchange of the capital asset may be ordinary income

and some may be gain from sale or exchange of a capital asset.136

Revenue Ruling 74-84 concerned a sale in which a cooperative

recognized both ordinary income under the recapture rules of Code

section 1245 and gain on the sale of a capital asset under Code

section 1231. The Service said:

That portion of the gain from the sale of machinery

treated as ordinary income under section 1245 of the Code

is considered patronage sourced income because, in effect,

the taxpayer is merely recapturing income that otherwise

would have been available for distribution as a patronage

dividend. That portion of the gain treated under section

1231 as gain from the sale of a capital asset held for more

than six months is considered income derived from

sources other than patronage and, thus, does not give rise

to a deduction to the cooperative when distributed to its

patrons.137

In St. Louis Bank for Cooperatives v. United States, the 138

Court of Claims (Trial Division) determined the Service had

misclassified an automobile used in business as a capital asset. It

found the automobile fell under the exclusion for property used in

a trade or business subject to depreciation under I.R.C. section

1221(2). The judge refused the Service's request to mecha- 139
167 and real property used in the trade or business of a taxpayer is

excluded from the term 'capital asset.'"

I.R.C. § 167(a)(2) authorizes a depreciation deduction for wear and

tear "of property used in the trade or business." Automobiles can be

depreciated to the extent they are used for business, as opposed to

personal, activities. 

 Rev. Rul. 74-84, 1974-1 C.B. 244. 140

 St. Louis Bank for Cooperatives v. United States, 624 F.2d 1041, 141

1054 (Ct. Cl. 1980), 1980-2 U.S.T.C. (CCH) ¶ 9509, rev'g in part, aff'g

in part, 1979-2 U.S.T.C. (CCH) ¶ 9576 (Ct. Cl. 1979).

 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894, 900

142

(1982).

52

nically apply the regulatory example to classify the gain as

nonpatronage-sourced income. The judge, however, did find that

the sale was an isolated transaction not integrally related to the

supplying of credit, and on that basis held the gain was

nonpatronage-sourced income.

A three-judge panel of the Court of Claims reversed the trial

judge's finding. The panel observed that the automobile was used

solely for bank business. Over the years it had been depreciated,

and the depreciation expense had been treated as a patronage

expense that offset patronage-sourced income and reduced

patronage refunds paid to members. The gain on the sale was

recapture of depreciation, pursuant to Code section 1245.

The panel noted the Service, in Revenue Ruling 74-84, held 140

depreciation recapture was patronage-sourced income when the

cooperative was merely recapturing income that otherwise would

have been available for distribution as a patronage refund. The

panel found it "would be anomalous to treat the gain upon the sale

of the automobile resulting from the recapture of excess

depreciation as nonpatronage sourced when the depreciation itself

was treated as patronage sourced."141

In Lamesa Cooperative Gin v. Commissioner, the Service

conceded that recapture of depreciation on trailers, tractors, and

manufacturing equipment was patronage sourced income.142
 Astoria Plywood Corp. v. United States, 1979-1 U.S.T.C. (CCH) 143

¶ 9197, at 86,349 (D. Ore. 1979).

53

Astoria Plywood Corp. v. United States involved a firm that

converted from noncooperative to cooperative status. It was not

able to use patronage income treatment for the recapture of

depreciation taken before the business became a cooperative. The

court said: "This income reflects the appreciation in value of the

machines over the costs Astoria had already recovered through

depreciation and is not directly related to the activities of the

cooperative."143

Special Rules

Transactions not formally sales of property may be so treated

under the Code in certain circumstances.

For example, Section 631(a) of the Code provides that the

owner of standing timber may elect to treat the cutting of that

timber as a sale or exchange of the timber. In Revenue Ruling 71-

439, a workers' cooperative was engaged in the manufacture and

sale of wood products. The cooperative owned the standing

timber that served as the raw material for its wood products

business. When the cooperative made the election to treat the

cutting of timber as a sale or exchange, it realized gain from the

sale of a capital asset. The Service sanctioned patronage sourced

income treatment of that gain, saying:

The gain recognized by the instant taxpayer pursuant

to a section 631(a) election represents the unrealized

appreciation in value of timber cut during the year which,

in the absence of an election under section 631(a) of the

Code, would have been reflected in the taxpayer's ordinary

income from the sale of wood products and be included in

amounts available for patronage dividend distribution.

The election permits an earlier recognition at capital gains

rates of an amount that ultimately may be realized by the
 Rev. Rul. 71-439, 1971-2 C.B. 321, 322. Followed in Rev. Rul.

144

74-24, 1974-1 C.B. 244, and Stevenson Co-Ply, Inc. v. Commissioner,

76 T.C. 637 (1981).

 I.R.C. § 1241. 145

 The lease was property used in the trade or business under Treas. 146

Reg. § 1.1231-1.

 Rev. Rul. 74-160, 1974-1 C.B. 245, 246. 147

 Astoria Plywood Corp. v. United States, 1979-1 U.S.T.C. (CCH) 148

¶ 9197, at 86,349 (D. Ore. 1979). The court had juststated "In my view,

54

taxpayer when the finished products of its timber is sold.

The actual realization of the appreciation in value of the

standing timber (when the finished product is sold) is

brought about through the cooperative efforts of the

members. Accordingly...it is held that the gain recognized

by the taxpayer pursuant to an election under section

631(a) of the Code is income from a patronage source.144

A capital asset may also be created by tax law. An example,

the Code provides that amounts received from cancellation of a

lease shall be considered amounts received in exchange for the

lease. If the lease covers capital assets used in the co-op's 145

business, and the co-op accepts a payment to cancel the lease, the

income received is treated, for tax purposes, as income from the

sale of a capital asset.146

In Rev. Rul. 74-160, the Service ruled income from the

cancellation of a lease on a veneer plant operated by a plywood

workers' cooperative was nonpatronage-sourced income. The

Service relied on the literal wording of the capital assets example

provided in Treas. Reg. 1.1382-3(c)(2).

147

A contrary conclusion was reached by the U.S. District Court

in Oregon a few years later on identical facts. The court applied

the "directly related" test and found the capital gain was patronagesourced income "because it is directly related to its cooperative

activities."148
capital gains may be patronage sourced income. In each instance, it

depends on whether the income is 'directly related' to [the cooperative's]

activities." Id.

 Tech. Adv. Mem. 8815001 (Nov. 3, 1987).

149

 Rev. Rul. 69-576, 1969-2 C.B. 166. 150

55

Farmland Industries Case

In late 1987, the IRS focused cooperative attention on the

status of the sale of an asset with the issuance of a controversial

ruling, Technical Advice Memorandum (TAM) 8815001. This 149

ruling concerned numerous transactions by Farmland Industries,

a regional federated farm supply and marketing cooperative that at

the time was the largest cooperative in the country.

By far the largest transaction involved the sale by Farmland of

all of the stock in a wholly owned subsidiary, Terra Resources.

The subsidiary had been formed to supply Farmland with crude oil

that Farmland used to manufacture refined petroleum products

which were sold primarily to its local cooperative members. In the

early 1980s, Farmland suffered substantial operating losses during

a downturn in the agricultural economy. In 1983, Farmland, under

severe pressure from the Wichita Bank for Cooperatives to reduce

its debt load and increase liquidity, sold all the stock in Terra

Resources.

Farmland realized a substantial gain on that sale. On its tax

return, Farmland treated the gain as patronage-sourced income and

sought to offset the gain with operating losses on its patronage

operations.

TAM 8815001 said the gain on the Terra Resources stock sale

is income from a nonpatronage source. The Service cited both

Treas. Reg. § 1.1382-3(c)(2) and Revenue Ruling 69-576 and 150

then said:

Under certain circumstances, income producing

transactions included in the list of examples of
 Tech. Adv. Mem. 8815001 at 5 (Nov. 3, 1987).

151

See, the discussion in part 5 of these reports of Farm Service 152

Cooperative v. Commissioner, 619 F. 2d 718 (8th Cir. 1980), and

related rulings establishing a general prohibition on cooperatives netting

nonpatronage earnings with patronage losses.

56

nonpatronage source income (in the Treas. Reg.) may still

be categorized as income derived from patronage sources

by meeting the “directly related” test. However, Taxpayer

sold its stock in Subsidiary in order to ease the financial

burdens Subsidiary was imposing on Taxpayer....Although

Taxpayer may have made a sound business decision in

selling Subsidiary's stock, the income resulting from this

sale merely enhanced Taxpayer's profitability and therefore

is not income derived from sources directly related to

Taxpayer's cooperative functions.

151

The IRS disallowed Farmland’s netting of its patronagesourced operating losses against the gain on the sale of stock,

which it called “nonpatronage.”152

The TAM also concerned losses suffered by the cooperative on

the disposition of its stock in two other ventures, (1) a corporation

organized to make collective purchases of Mexican crude oil in

large volume and (2) a crude oil pipeline company. The Service

held that the losses on stock in these two companies were

patronage-sourced as those activities were directly related to the

cooperative's business operations.

A third group of transactions concerned the disposition of socalled section 1231 property, real estate and depreciable property

used in Farmland’s business operations, which resulted in gains

for Farmland. Farmland claimed virtually all of the gains on these

transactions were patronage sourced and ordinary income. The

Service determined that the depreciation recapture was entitled to

be treated as patronage sourced ordinary income under I.R.C.

section 1245. Any additional gain was a capital gain under I.R.C.
 Corn Products Refining Co. v. Commissioner, 350 U.S. 46 153

(1955).

 Arkansas Best v. Commissioner, 800 F.2d 215 (8th Cir. 1986),

154

cert. granted 480 U.S. 930 (1987).

 Arkansas Best v. Commissioner, 485 U.S. 212 (1988). 155

57

section 1231 and therefore nonpatronage sourced under Treas.

Reg. § 1.1382-3(c)(2).

The issue was complicated by a contemporaneous dispute

between the business community as a whole and the Service over

the status of the so-called "Corn Products" doctrine. In Corn

Products Refining Co. v. Commissioner, the Supreme Court 153

held that assets not within the then five exclusions to the section

1221 definition of "capital asset" were nonetheless to be treated as

ordinary assets if they were acquired as an integral and necessary

part of the taxpayer's business. As each of the transactions

discussed in TAM 8815001 concerned the disposition of stock or

property acquired by the cooperative for a business purpose,

Farmland had a cogent argument that, under Corn Products, they

were not “capital assets" and thus not covered by the example in

Treas. Reg. § 1.1382-3(c)(2).

At the time TAM 8815001 was released, the Supreme Court

had granted certiorari in Arkansas Best v. Commissioner, which 154

had rejected the business purpose test of Corn Products and taken

a literal reading of Code section 1221 to require all capital stock

to be treated as a capital asset. Later in 1988, the Supreme Court

affirmed the appellate court decision in Arkansas Best.

155

In the meantime, Farmland had asked IRS to reconsider its

apparently inconsistent finding in TAM 8815001 that gains on the

disposition of stock in Terra Resources were patronage-sourced

and losses on the disposition of the stock in the Mexican oil

purchasing and domestic pipeline ventures were nonpatrongesourced. In mid-1989, the Service responded with TAM 8941001.

Citing Arkansas Best, the Service now said that the stock
 Tech. Adv. Mem. 8941001 (June 14, 1989). This eliminated the 156

inconsistent treatment in TAM 8815001 of the gains (nonpatronage) and

losses (patronage).

 In the 100th Congress, H.R. 4542 (May 5, 1988), and S. 2669 157

(July 29, 1988); in the 101st Congress, H.R. 2353 (May 16, 1989), and

S. 1273 (June 23, 1989); and in the 102nd Congress, H.R. 2360 (May

15, 1991), and S. 1522 (July 22, 1991).

 H.R. 1931 (Apr. 29, 1993) and S. 545 (Mar. 10, 1993).

158

58

Farmland sold in all three transactions were capital assets under

I.R.C. section 1221. The Service dismissed arguments by the

cooperative that the "directly related" and "actually facilitates"

standards called for patronage sourced income treatment. Placing

greater emphasis on Treas. Reg. § 1.1382-3(c)(2), the Service now

determined both the gains and losses were from sources other than

patronage.156

The cooperative community responded to these rulings by

developing draft legislation to permit cooperatives to elect

ordinary patronage-sourced treatment for gain or loss from the sale

or other disposition of any asset, provided the asset had been used

to facilitate the conduct of business done with or for patrons.157

The Treasury Department expressed reservations about two

aspects of the bills: (1) the elective factor that lets a cooperative

choose patronage or nonpatronage income treatment of assets used

to facilitate business with or for patrons, and (2) the retroactive

application of the election.

In 1992, a scaled-back version of the industry proposal,

prospective only and limited to farmer cooperatives, passed both

houses of Congress as part of the proposed Revenue Act of 1992.

However, President Bush vetoed the bill.

Legislation based on the provisions in the Revenue Act of

1992 was introduced in the 103rd Congress. The bills applied

only to farmer cooperatives and made the election prospective

only. However, the steam was running out of the legislative 158

initiative and Farmland was forced to pursue its position in the

courts.
 Rev. Rul. 74-84, 1974-1 C.B. 244. 159

59

In 1995, the case was tried in the U.S. Tax Court. The primary

issue was straightforward.

Farmland argued that the classification of gains or losses as

patronage or nonpatronage sourced depends on the factual

relationship between the activity producing the gain or loss and the

operations of the cooperative. This is true whether the gains and

losses are capital or ordinary in nature. The cooperative asserted

that if the activity is directly related to, or facilitates the

cooperative’s marketing, purchasing or service activities on behalf

of its patrons, the gains and losses it produces should be treated as

patronage sourced. Farmland cited the numerous cases and rulings

on the application of that test discussed in the preceding

subsections on dividend, rental, and interest income. It asked the

Court to reject the per se rules espoused by the IRS under which

capital gains and losses are always classified as nonpatronage.

The Service countered, with regard to the disposition of stock

in the three ventures, that under Arkansas Best capital stock is

always a capital asset and under Treas. Reg. § 1.1382-3(c)(2) the

disposition of a capital asset is always nonpatronage sourced.

Concerning the Section 1231 property, the Service relied on Rev.

Rul. 74-84 to establish that the gain on the sale of a physical 159

assets used in a trade or business, to the extent that it exceeded the

recapture of depreciation, is a gain on the sale of a capital asset

and, under the same regulation, per se nonpatronage sourced. IRS

also attacked the “directly related” test as overly simplistic and

asserted Farmland ownership interests in various business ventures

under review were strictly “investments.”

Four years later, a decision was issued favorable to the

cooperative on essentially all fronts. The court began it opinion

with an exhaustive discussion of the history of Farmland Industries

and a thorough review of the earlier cases on the income items

mentioned in the regulation. After summarizing the cases, the

court said, “Neither this nor any other court has ever held that
 Farmland Industries v. Commissioner, T.C. Memo 1999-388 160

(Nov. 29, 1999), 78 T.C.M. (CCH) 846.

Id. 161

60

rents, dividends or interest income, or capital gains are

nonpatronage based upon a per se rule found in section 1.1382-

3(c)(2)... (citations omitted).”160

The court then held:

...we decline to abandon the directly related test that

has been used by this and other courts to distinguish

patronage from nonpatronage items and to adopt

respondent’s per se nonpatronage rule for capital gains and

losses. Accordingly, in this case our task is to determine

whether each of the gains and losses at issue was realized

in a transaction that was directly related to the cooperative

enterprise, or in one which generated incidental income

that contributed to the overall profitability of the

cooperative but did not actually facilitate the accomplishment of the cooperative’s marketing, purchasing, or

service activities on behalf of its patrons.161

The Tax Court concluded by applying the directlyrelated/actually facilitates test to six different kinds of gains and

losses, finding in each instance that the gains and losses were

patronage, notwithstanding their character as capital:

 ! A capital gain from the sale of the stock of Terra

Resources

 ! A capital loss on stock in Mex-Am Crude Corp., a

company formed by Farmland and eight other refiners to

purchase Mexican oil

 ! A capital loss on the sale of stock in Seaway Pipeline Inc.,

a corporation formed by Farmland and others to build and

operate a pipeline to transport crude oil
61

 ! Net Section 1231 gain from the sale of a natural gas

products plant in Texas, the proceeds of which were

reinvested in other gas plants

 ! Net Section 1231 gain from the sale of its soybean

processing business as part of the formation of Ag

Processing Inc.

 ! Net Section 1231 gain from the sale of approximately 525

miscellaneous assets (including tractors and other vehicles,

livestock, buildings, office furniture and office equipment)

For Farmland, the key holding in the case was the treatment of

the gain on the sale of its stock in Terra Resources since that issue

involved, by far, the most money. But for most cooperatives, the

holding that section 1231 gains and losses realized on assets sold

in their trade or business may be patronage is probably of greater

significance. It is not common for cooperatives to sell stock in

companies that are directly related to their patronage business and,

when they do, it is usually at a loss as part of a decision to exit

from an unprofitable line of business.

In 2000, the IRS chose not to appeal the Tax Court decision.

In March, 2001, the Service announced it acquiescence in the

Farmland decision. The Service released an action on decision

setting out its new position:

...the Service will view the examples of nonpatronage

income in the regulations as instructive, but not

controlling. It will look at the facts and circumstances to

determine if each item of income or loss is patronage or

nonpatronage sourced. The nonpatronage or patronage

character of every item of income or loss will be

determined by the relationship of the activity producing the

income or loss to the cooperative’s business of serving its

patrons. Only where the activity generating the income or

loss is directly related to the cooperative business, in the
 Action on Decision 2001-03 (2001), acquiescing in Farmland 162

Industries v. Commissioner, T.C. Memo 1999-388.

Id.

163

62

sense that it is an integral part of that business, will the

income or loss be considered patronage sourced.162

Then the Service indicates it may take a restrictive view when

applying the “directly related” test:

Interest earned on an investment will be considered

nonpatronage income, but interest earned on funds retained

for a true cooperative business purpose will be considered

patronage income. Income produced by property held for

rental purposes will be considered nonpatronage income,

but income produced by rental property will be considered

patronage income in those unusual situations where the

property was held to facilitate business conducted for the

benefit of patrons. Gains or losses from the sale or

exchange of a capital assets will be considered

nonptaronge sourced where the asset was not used for a

cooperative business purpose, but will be considered

patronage sourced where the asset actually facilitated the

cooperative business.163

Subsequent Rulings

In the period immediately following the Farmland decision,

the IRS has issued a number of letter rulings favorable to

cooperatives involving the patronage/nonpatronage nature of gain

on the sale of assets.

Five private letter rulings issued to rural telephone

cooperatives approved the treatment of capital gains on the sale of

stock as patronage sourced income. In each of these rulings, a

rural telephone cooperative (“RTC”) joined with other small
Priv. Ltr. Rul. 200152035 (Oct. 2, 2001) and Priv. Ltr. Rul.

164

200404003 (Oct. 10, 2003), the RTC’s purpose was to secure cellular

service for its members; Priv. Ltr. Rul. 200206044 (Nov. 9, 2001) and

Priv. Ltr. Rul. 200314002 (Dec. 4, 2002), the RTC’s purpose was to

secure access to calling card services for its members; Priv. Ltr. Rul.

200239029 (June 19, 2002), the RTC’s purpose was to secure access to

digital PCS cellular service for its members.

In Priv. Ltr. Rul. 200404003 (Oct. 10, 2003), the RTC had also

purchased two licensesto provide PCS service to its patrons. However,

it later concluded that developing the infrastructure to provide PCS

service was not economically feasible. The RTC sold the licenses and

the Service permitted the RTC to treat the gain on the sale of the

licenses as patronage sourced even though it never placed the assets in

service to its patrons.

Code § 501(c)(12) contemplates that rural cooperative telephone

companies (“RTC’s”) may qualify as tax-exempt organizations.

However, most RTC’s, including the ones in these letter rulings, don’t

meet the statutory prerequisites for tax exempt status. The rulings

describe them as “non-profit, but taxable, cooperative corporations.”

Such RTC’s are also not governed by Subchapter T because of the

exclusion provided in Code § 1382(a)(2)(C). While these RTC’s are

technically to be treated the same for tax purposes as they were before

enactment of Subchapter T, cases and rulings interpreting Subchapter

T are usually applied to them. And likewise, rulings dealing with both

rural telephone and electric cooperatives may be of direct relevance to

Subchapter T cooperatives.

63

telephone companies to invest in and thus gain access to new

technologies that would enable them to provide cutting-edge

services to their member-patrons. In each instance, (1) the RTC 164

achieved its purpose of obtaining the new service for its members,

(2) the company started by the RTC and other small telephone

companies was engulfed in the rapid consolidation that occurred

in the tele-communications industry and merged into a large

national publicly traded entity, and (3) the RTC wound up with

stock in the publicly traded company, which was inconsistent with

its mission, so it sold the stock at a gain and used the proceeds to

improve services to member-patrons.
 Farmland Industries v. Commissioner, 78 T.C.M. (CCH) 846, 165

864 (1999), other cites omitted.

 Rev. Rul. 69-576, 1962-2 C.B. 166; Rev. Rul. 74-160, 1974-1 166

C.B. 245.

 Priv. Ltr. Rul. 200252027 (undated, but released Dec. 27, 2002).

167

64

The IRS analysis is similar in all five determinations. First, the

Service notes that while neither the Code nor the regulations

provide a clear definition of “patronage sourced income,” it cites

Farmland Industries and other decisions for the proposition that

the courts have, in general, held that “...if the income at issue is

produced by a transaction which is directly related to the

cooperative enterprise, such that the transaction facilitates the

cooperative’s marketing, purchasing, or service activities, then the

income is deemed to be patronage income.”165

Next the Service cites its earlier rulings, Rev. Rul. 69-576 and

Rev. Rul. 74-160, which first espoused the “directly related”

test. Then it cites several cases, again starting with Farmland 166

Industries, which held “...that income from corporations organized

by cooperatives to conduct activities related to the cooperative

business is patronage sourced.”

It concludes by finding, in each instance, that the investment

by the RTC in the original company was made to provide modern

telephone service to its patrons and therefore is directly related to

the business of a cooperative whose “raison d’etre is to provide

telephone service to its patrons.”

Another IRS ruling concludes that most of the gain realized by

a cooperative in the process of liquidation from the sale of

substantially all of its assets was patronage-sourced. The 167

cooperative was a wholesaler and distributor of natural food and

related products, which its members (retailers, supermarkets,

individual buying clubs, and cooperative retailers) resold to

customers. Apparently the venture was in the vanguard of the

health food movement and did quite well while it was a niche

market. However, the market expanded and large food industry
65

firms entered it. Thisresulted in increased availability of products,

greater competition, and lower pricing.

The members concluded they simply didn’t need the

cooperative any more and decided to liquidate through a sale to a

publicly held food wholesaler while the cooperative still had

value. The assets sold included trade receivables; inventories;

land, property and equipment (including a fleet of trucks);

customer lists, their trade name, and other intangible assets. All

of these assets were used exclusively in the cooperative’s

wholesale and distribution activities.

Pursuant to a bylaw covering allocation of a substantial gain

or loss, the cooperative intended to distribute any gain on the sale

of these assets to member and nonmember patrons based on the

amount of business each did from the inception of the cooperative

through the date of final sale. It asked the Service to rule that such

gain was patronage sourced so the funds could be excluded from

the cooperative’s gross income when distributed to the patrons.

The Service summarized Revenue Ruling 69-576 and the Tax

Court opinion in Farmland Industries, and concluded the

cooperative could treat any gain as patronage sourced.

Three other items in this ruling are of interest. First, the

Service cited Treas. Reg. § 1.1382-3(c)(3) for the proposition that

the gain must be allocated (as this cooperative intended) “on a

patronage basis in proportion, insofar as is practicable, to the

business done by or for patrons during the period to which such

income is attributable.” This regulation concerns distributions of

nonpatronage income that a section 521 farmer cooperative wishes

to deduct, while the ruling concerns a subchapter T cooperative

allocation of patronage-sourced income. Whether it could be used

to compel a subchapter T cooperative to allocate patronage

sourced capital gains on this basis is unclear.

Second, the cooperative also sold a wholly owned subsidiary

that was formed to loan funds to member retail customers for

expansion or relocation. The cooperative didn’t attempt to have

the gain on this sale classified as patronage-sourced The service

just noted in passing that, unlike the other assets being sold, the
See I.R.C. § 481. 168

 Rev. Rul. 79-45, 1979-1 C.B. 284. 169

66

subsidiary operations were not directly related to cooperative

operations.

Third, the company was originally formed as a not for profit

corporation and later converted to a cooperative corporation. No

mention is made of the fact that none of the gain would be

allocated to customers during this time period.

The Farmland Industries decision has gone a long way toward

clearing the air over the proper test to determine if the income

items listed in Treas. Reg. 1.1382-3(c)(2) are patronage or

nonpatronage sourced. In all likelihood, cooperatives and the

Service will continue to disagree over whether specific lease

payments, interest and dividends received, and gains and losses on

the sale of capital assets are directly related to a cooperative’s core

business operations on behalf of its member-patrons. But

cooperatives no longer have to overcome an IRS position that such

items are per se nonpatronage in nature.

INCOME FROM OTHER EVENTS

Disputes have arisen over the patronage or nonpatronage status

ofincome created from events not specificallymentioned in Treas.

Reg. § 1.1382-3(c)(2). Some of these situations are discussed in

this section.

Change in Accounting Method

A change in accounting method may result in an adjustment to

income in the year of change. Revenue Ruling 79-45 168 169

describes a cooperative changing from the last-in, first-out

inventory method to the first-in, first-out method, using lower of

cost or market. The change resulted in a positive adjustment to

income in the year of change.
 For further discussion of I.R.C. § 1382(f), see the section of 170

chapter 4 titled "Year Patronage Occurred," supra, pp. 23-26.

67

Without further describing the cooperative's operation or the

nature of the inventory, the Service said the adjustment resulted in

patronage sourced income. The Service reasoned that had the new

method of inventory valuation been used in earlier years, patrons

of those years would have been entitled to larger patronage

refunds, reflecting the results of using the new valuation methods.

Section 1382(f) was applied to the income, so that the

patronage to which the income related was considered to have

occurred in the year of adjustment. The cooperative requested,

and was granted, permission to allocate the earnings to patrons of

the prior years.

170

CCC Storage Fees

At times in the past, under certain price support programs

administered by the USDA Commodity Credit Corporation

(CCC), loans were made to producers with the producer's crop

serving as collateral for the loan. The producer had the option, for

a specified period, to repay the loan and reclaim the crop. If the

producer didn’t exercise the option, the producer "defaulted" on

the loan. The producer kept the loaned funds, and CCC took title

to the crop.

Cooperatives frequently stored crops under CCC programs,

both for the farmer before default and for CCC after default. CCC

customarily paid the storage fees to the cooperative from the time

the crop entered the program until it was either reclaimed, or

default occurs and CCC subsequently moved or disposed of the

crop. While the farmer held title to the crop, the storage fees were

deducted from the loan proceeds.

In the 1950's, some cooperatives were claiming that all CCC

payments derived from handling and storing grain produced by

patrons were patronage-sourced income. IRS agents were

disallowing attempts to deduct patronage refunds to the extent they
Pomeroy Cooperative Grain Co. v. Commissioner, 31 T.C. 674

171

(1958), rev'd in part, aff'd in part, 288 F.2d 326 (8th Cir. 1961); See

also, Minburn Cooperative Elevator v. Commissioner, 18 T.C.M.

(CCH) 93 (1959).

 Rev. Rul. 59-107, 1959-1 C.B. 20. 172

 43 T.C. 836 (1965), acq., 1966-1 C.B. 2.

173

 Rev. Rul. 70-25, 1970-1 C.B. 17. 174

68

were based on earnings from storage that occurred after the

producer defaulted on the loan and title to the grain was

transferred to CCC.

The U.S. Tax Court sided with the Service. In Pomeroy

Cooperative Grain Co. v. Commissioner, the court classified 171

Government storage payments to a cooperative as patronage or

nonpatronage sourced income depending on whether the grower

still owned the grain. Before loan default, the farmer patron held

title to the grain, and storage income received by the cooperative

was characterized as patronage-sourced. After default, ownership

resided in the CCC, and storage income was nonpatronage

sourced.

IRS adopted the ownership test in Rev. Rul. 59-107. The 172

validity of the standard was upheld in Juniata Farmers

Cooperative v. Commissioner.

173

Revenue Ruling 70-25 described cooperative income 174

received from CCC for crop storage under a "reseal" program.

Under the reseal program, farmers obtained a CCC price support

loan by pledging the crop and storing it with a cooperative during

the period of the loan. The program provided for an automatic

extension of the loan for 12 months if the farmer did not satisfy

the obligation by the original maturity date.

Under the program, CCC was solely liable for handling and

storage charges for the 12 month extended period even though title

to the grain remained with the farmer-producer. Revenue Ruling

70-25 held that the handling and storage charges paid to the

cooperative association under the reseal program by CCC, for
 Caldwell Sugars Co-op Inc. v. United States, 692 F. Supp. 659 175

(E.D. La. 1988), 88-2 U.S.T.C. (CCH) ¶ 9509.

 692 F. Supp. at 662. 176

 Rev. Rul. 89-97, 1989-2 C.B. 217. 177

 Priv. Ltr. Rul. (EIN 75-0235810), Mar. 8, 1976.

178

69

which CCC was solely liable, was income to the cooperative

association derived from business done with or for the United

States or any of its agencies and was income derived from

nonpatronage sources.

The status of storage payments before default under a reseal

program was reviewed by a Federal District Court in Caldwell

Sugars Co-op Inc. v. United States. The court discussed Rev. 175

Rul. 59-107 and Rev. Rul. 70-25 and concluded Rev. Rul. 70-25

was illogical and incorrect. The court viewed the extension of

time to redeem the crop under the reseal aspect of the program as

irrelevant. The true test was ownership of the crop. The court

stated, "...(I)f the property stored belongs to the farmer, the income

derived from such storage is income derived from that farmer, and

therefore patronage income. Where the property stored is the

property of the Government, then the income yielded by such

storage is income yielded from doing business with the

Government" and nonpatronage sourced.176

Shortly thereafter IRS issued RevenueRuling 89-97. While

177

this ruling did not mention Caldwell Sugars, it adopted the

holding of the case and revoked Revenue Ruling 70-25.

Judicial Settlements

In two private letter rulings concerning amounts received as

settlements from a lawsuit filed under Federal antitrust laws, IRS

has taken a middle-of-the-road position toward the tax status of the

money received. In the first, the cooperative was permitted to 178

treat the portion of the amount received that covered actual

damages claimed as patronage sourced. Money received in excess
 Priv. Ltr. Rul. 8340012 (June 24, 1983).

179

 Astoria Plywood Corp. v. United States, 1979-1 U.S.T.C. (CCH) 180

¶ 9197 (D. Ore. 1979).

70

of the amount actually claimed was classified as nonpatronage

sourced income.

In the second, the cooperative was granted patronage income 179

treatment of the compensatory damages paid as part of the

settlement of the case, but had to treat interest paid as part of the

settlement as nonpatronage income.

In a Tax Court case, income from a judgment against a party

who wrongfully removed the cooperative's property was not

patronage sourced income when the event took place before the

organization was a cooperative.180

Partnership and LLC Earnings

Farmers and other business people form cooperatives to

provide themselves with goods and services they either can’t

afford on their own, or can obtain more efficiently through a group

effort. Sometimes these cooperatives find themselves in the same

position, their members want them to provide goods and services

they can’t develop on their own or can obtain more efficiently

through a group effort with other cooperatives or with

noncooperative firms. These collaborative efforts among two or

more businesses are commonly referred to by the general term

“joint venture.”

Historically, if two or more cooperatives wanted to form a

joint venture, they usually organized the entity (called a federated

cooperative) under a State cooperative law and paid taxes pursuant

to Subchapter T. The federated allocates its earnings to its local

cooperative member-patrons on the basis of business done with

the federated. The locals then combine the patronage refunds they

receive from the federated with operating income for the year and

allocate the total to their member-patrons as patronage refunds.
 The IRS ruling first recognizing the “directly related” test 181

involved the federated banks for cooperatives system, Rev. Rul. 69-576,

1969-2 C.B. 166.

71

As these federated systems have traditionally consisted entirely of

patrons and their cooperatives, and limited their operations to

serving the needs on the member-patrons of the local cooperatives,

few questions have arisen over the patronage nature of the income

passed down through the system.181

If a cooperative entered into a joint venture with a

noncooperative firm, it frequently formed a partnership with that

firm. For example, a farm supply cooperative owned a plant that

processed a raw material into a valuable agricultural input, which

the cooperative then sold to its patrons. The cooperative proposed

entering into a partnership with a non-cooperative corporation

with a reliable supply of the raw product.

Under the partnership agreement, the cooperative would sell

an interest in the plant to the corporation. The partnership would

acquire substantially all its raw material from the corporation and

sell substantially all the processed product to the cooperative. The

cooperative would then resell substantially all of the input to its

patrons.

In response to a request from the cooperative, the Service ruled

that any income arising from product sales to patrons was

patronage-sourced, whether received individually by the

cooperative, or in its capacity as a partner. IRS observed:

In this situation, Coop is buying the (processed input)

from a supplier that it partially owns: the partnership.

When Coop sells this product to its patrons, those sales are

"with" its patrons within the meaning of section 1388(a) of

the Code. Accordingly, any net margin from these sales

that is returned to the patrons is eligible for the patronage

dividend deduction because the Coop is, in essence,

rebating to the patron a portion of the cost of goods

purchased. Similarly, when Coop receives its distributive
 Priv. Ltr. Rul. 9033006 (May 14, 1990).

182

 T.D. 8697 (Dec. 17, 1996); Treas. Reg. § 301.7701-1 to §

183

301.7701-3.

72

share of partnership operating income, the portion of that

income that is attributable to Coop's sales to its patrons is

akin to a rebate of the cost of the (input) purchased by

Coop for resale to its patrons and, when ultimately

returned to the patrons, is a rebate of the cost of their

purchases of the (input).182

One of the impacts the Treasury Department’s adoption of the

“check-the-box” regulations had on cooperatives was the rapid 183

rise of the limited liability company (LLC) as the preferred vehicle

for organizing joint ventures both among cooperatives and

between cooperatives and noncooperative firms. Since the LLC

was a relatively new business structure and the Internal Revenue

Code doesn't contain any rules specifically covering it,

cooperatives were concerned about how IRS might treat

distributions of LLC earnings to cooperatives who participated in

an LLC.

In two sets of letter rulings issued in 1998, IRS said that if the

business activity of the LLC "is directly related to" and "actually

facilitates" operations conducted on a cooperative basis, earnings

distributed to cooperative members of the LLC are patronagesourced income. While LLC distributions are taxable income to

a cooperative, the amount of the distributions can be deducted if

passed through to the cooperative members as a patronage refund.

Subsequent rulings have also applied the “directly related” test in

a manner that is allowing cooperatives to form alliances that help

them stay competitive and still serve their members’ needs on a

patronage basis.

Significant differences existed in the way the LLC’s discussed

in these rulings are organized and operated. The facts and specific

findings of the rulings are discussed below.
 Priv. Ltr. Ruls. 9827042 and 9827043 (April 8, 1998).

184

73

Nonagricultural Purchasing Cooperatives. The first rulings

were issued in response to inquiries from two health care

purchasing cooperatives who provided various services to their

members, including the negotiation of contracts with suppliers of

products and services used by their members. These contracts 184

allow members to obtain products and services that they need in

their businesses at less cost and on more favorable terms than each

member would likely receive negotiating on its own. Only

cooperative members have access to these contracts. Members

typicallyplace orders directlywith the suppliers, the suppliers ship

directly to the co-op members and bill them directly, and the

members pay the suppliers directly.

Each co-op's group purchasing program is a separate allocation

unit funded by supplier-paid "administrative fees" under the terms

of their contracts with the co-op. The fees are related to the

amount of purchases the members of each co-op makes with each

vendor. These fees have exceeded the related expenses of the coops, with the excess being allocated to the co-ops' members as

patronage refunds. Both associations have received IRS Private

Letter Rulings recognizing their status as cooperatives.

The two cooperatives formed an LLC to negotiate such

contracts on behalf of both co-ops and their members. The two

co-ops are the LLC's only members. Their objectives are to

combine their market power to arrange better contracts for their

members and reduce costs by eliminating duplication in their

administrative offices. Co-op members will continue to deal

directly with suppliers, but now under the terms of contracts

negotiated by the LLC rather than the co-ops.

The cooperatives will not pool or otherwise use

"administrative fees" to finance the LLC. Rather, the "fees" will

continue to be the property of the co-ops based on the respective

purchases of their patrons. The flow of "administrative fees" to
74

the co-ops and then to participating patrons as patronage refunds

will continue essentially unchanged.

To finance the LLC, each month each member will write a

check to the LLC for its share of the previous month's expenses,

computed on the basis of their respective patrons' usage of the

LLC the previous year.

The two co-ops formed a second LLC to perform group

purchasing functions previously conducted by one of them on a

nonpatronage basis. This second LLC (LLC-2) is expected to do

a considerably smaller volume of business than the first LLC

(LLC-1). LLC-1 will provide administrative and management

services to LLC-2. All administrative fees collected on purchases

made on a nonpatronage basis through LLC-2 will remain the

property of LLC-2, and any distributions to the co-ops based on

business generated through LLC-2 will be treated as nonpatronage

income.

The IRS issued four findings favorable to the cooperatives:

1. Participation in these LLCs will not affect their status

as corporations "operating on a cooperative basis."

2. The "administrative fees" they receive from the

vendors related to purchases by their patrons will

continue to be patronage-sourced income.

 3. The payments they make to the first LLC to cover its

expenses will be patronage-sourced expenses.

4. When the first LLC realizes income or loss from

activities related to the group purchasing contracts

accessed by patrons of the cooperatives, it will be

patronage-sourced gain or loss when distributed to the

cooperatives.

IRS also found, as expected, that any gain or loss passing

through to the cooperatives from business conducted through

LLC-2 will be nonmember nonpatronage-sourced income.
 Priv. Ltr. Ruls. 9846022 and 9846027 (August 17, 1998).

185

75

Local Farm Supply Cooperatives. Later in the year, rulings

were issued in response to inquiries from two local agricultural

supply cooperatives who provide their patrons with petroleum

products, feed, chemicals, seed and fertilizer, all on a cooperative

basis. Faced with aging facilities and equipment, the two 185

cooperatives formed an LLC to conduct their agronomy

operations. The LLC is located midway between their respective

locations. The LLC has leased a new fertilizer plant and

purchased modern equipment to apply the product it sells onto

patrons' farmland.

At first, the LLC acted as the agent of the cooperatives; all

sales to their farmer patrons of products and services provided by

the LLC were funneled through the cooperatives.

However, this proved to be administratively burdensome. The

co-ops wanted to make the LLC a principal, selling products and

service directly to their patrons. In an unusual arrangement, each

farmer-member of one of the cooperatives was also made a

member of the other cooperative. When a farmer purchased

fertilizer from the LLC, half of the purchase was attributed to each

of the co-ops. The LLC split its earnings between the two

cooperatives on a 50/50 basis.

Each year the cooperatives will receive their respective shares

of the LLC's earnings and report such income under partnership

rules. Each will allocate this income to its patrons in proportion

to the amount of business each patron has conducted during the

year with the LLC.

The IRS determined that allocations of LLC earnings to its coop members would be patronage-sourced income under

Subchapter T. IRS agreed to "look through" the LLC to its

cooperative owners and their relationships with their patrons. It

found a preexisting legal obligation on the part of the cooperatives

to allocate LLC earnings as patronage refunds. It also found the

LLC operations are directly related to and actually facilitate the co-
 Priv. Ltr. Rul. 199920034 (Feb. 24, 1999).

186

76

ops' supply and service functions. Therefore, it concluded the

allocations of LLC earnings by the cooperatives to their members

are eligible for the patronage refund deduction.

Agricultural Processing and Marketing Venture involving

Cooperative and Noncooperative Firms. The next letter ruling

was issued to an agricultural processing and marketing cooperative

that felt its long term viability was threatened by the consolidation

and globalization occurring in the industry in which it operated.

The cooperative was offered the opportunity to join an LLC owned

by two noncooperative firms in the industry. The LLC had three

times the product volume of the cooperative and, according to the

letter ruling, was “a very successful processor and marketer” with

“an excellent management team and record of financial

success.”186

The cooperative would transfer its physical assets and some

cash to the LLC. It would purchase its members’ production at

market price and sell the product to the LLC for processing and

marketing. The cooperative’s voting and financial interest in the

LLC will be commensurate with the anticipated share of all

product delivered to LLC that it will provide (about 28%). The

cooperative’s share of the LLC earnings will be allocated to its

members on the basis of how much product each member delivers

to the cooperative each year.

The IRS applied the “directly related” test and found that the

cooperative’ share of the LLC operating income attributable to the

processing and marketing of its members’ product is income from

patronage sources. This ruling is significant in that it is the first to

involve processing and marketing and the first involving an LLC

with both cooperative and noncooperative members.

Large, Regional Farm Supply Cooperatives. The next link

in the chain strengthening cooperatives through joint ventures was
 Priv. Ltr. Rul. 200123033 (June 8, 2001). The structure of the 187

entire operation is quite detailed and beyond the scope of this report.

The Service treated the venture essentially as if it was a single LLC

owned by three cooperatives.

Id.

188

77

a ruling covering an LLC formed by three large, regional farm

supply cooperatives to combine their wholesale agronomy (plant

food and crop protection) operations. Manufacturing and retail 187

operations are to remain separate. The LLC is to act as a principal,

buying agronomy products from the three regionals and others and

reselling the products to the local cooperative members of the

three regionals and others.

The LLC was structured so that each of its three cooperative

members received a fixed percentage of the earnings. To ensure

the local cooperative member-owners received their allocation of

LLC earnings on the basis of patronage, each local that belonged

to any of the three regionals was offered the opportunity to join all

three regionals (which most did). Then they receive a patronage

refund from all three regionals based on the amount of agronomy

products they purchased from the LLC.

After summarizing the rulings and cases establishing the

“directly related” test, the Service noted that:

LLC was formed and is and will be operated to allow

Coop 1, Coop 2, and Coop 3 to better serve their members

and participating patrons by obtaining economies of scale,

elimination of duplication, the ability to achieve

operational efficiencies byworking together, and reducing

costs without sacrificing service. (The Co-ops) anticipate

significant cost savings and efficiencies. These savings

will flow through to members and participating patrons in

the form of lower prices for...products or increased

patronage dividends. LLC is directly related to and

actually facilitates the accomplishment of the cooperative

mission of (The Co-ops).188
 Priv. Ltr. Rul. 200244013 (July 25, 2002).

189

78

The Service then held that each regional’s distributive share of

the profits and losses of the LLC on sales of agronomy products to

local cooperative members and participating patrons of the

regionals was patronage sourced. It also said that use of the LLC

for wholesale operations would not alter the established patronagesourced status of earnings each regional generates for itself on its

manufacturing and retail operations.

The Service concluded by stating that two potential items of

income for the LLC would be nonpatronage sourced, (1) income

on LLC sales to persons who were not members or participating

patrons of the regionals and (2) income on any business activity of

the LLC that would be nonpatronage in nature if conducted by one

of the regionals. The regionals had not asked for patronage

treatment of either of these income items.

Limited Partnership of Two Large Marketing Cooperatives. While LLC’s are often the structure of choice in forming

new joint ventures, and some partnerships have reorganized as

LLC’s, some partnerships still exist. Since LLC’s are taxed as

partnerships, rulings concerning one should provide guidance to

owners of the other.

This ruling concerned a change in the operations of an existing

limited partnership (LP) formed by two cooperatives to slaughter

and process livestock and to market and sell processed meat.189

One partner was a smaller, new-generation cooperative that only

accepts a fixed number of cows from its farmer-members and

transfers them all to LP for processing and marketing. The other

partner was a large, regional cooperative that purchased cows from

members and nonmembers in sufficient quantity to meet LP’s need

for livestock beyond that supplied by the first cooperative.

To improve efficiency and reduce costs, the two partners

agreed to shift the regional cooperative’s cattle-buying function to

the LP. Thus the cooperative’s members would be selling their
79

livestock directly to the LP. The regional’s share of LP earnings

on the handling of member cattle would be allocated on a

patronage basis to those members who sold cattle to LP.

The Service again displayed an understanding of how

cooperatives need to function to stay competitive. It said:

Coop is attempting to best serve its members in the

changing economic climate. The increased efficiency

realized through the transfer of the buying function will

increase LP’s profitability and, concomitantly, Coop’s

patronage sourced earnings and patronage dividends. ...

Coop’s ability to determine and distribute its (livestock)

marketing margins to its members will not be adversely

affected, since LP will continue to maintain the required

records to insure that such margins are properly allocated

and distributed to Coop’s members.

* * *

Under these circumstances, Coop’s activities through

LP are directly related to and actually facilitate, the

accomplishment of Coop’s cooperative mission.

* * *

Coop’s profits realized from its (livestock) marketing

activities will remain patronage sourced income after Coop

has transferred its (livestock) acquisition activities to LP.

Coop’s profits from its (livestock) marketing activities are

to be allocated and distributed on a patronage basis to

Coop’s members based upon the (livestock) purchased

from Coop’s members by LP on behalf of Coop. Coop’s

(processed meat) marketing profits attributable to LP’s

purchase of (livestock) from nonmembers attributable to
Id.

190

 Rev. Rul. 74-84, 1974-1 C.B. 245. 191

80

Coop will continue to be taxable as nonmembers

income.190

These letter rulings suggest that cooperatives and the Service

have reached a common ground on the status of earnings returned

from joint ventures organized as noncooperative firms to their

cooperative members and partners. If the venture’s operations are

directly related to and actually facilitate activities conducted by the

cooperative on a patronage basis, then earnings and losses

distributed by the venture to the cooperative can qualify as

patronage-sourced. But earnings not directly attributable to

providing services to cooperative members and nonmember

patrons will be treated as nonpatronage income.

Pension Fund Reversions

One of the trends in employee benefit programs is to change

from a defined benefit pension plan to a defined contribution plan.

If the defined benefit plan is overfunded at the time it is

terminated, a cooperative may realize taxable income on any funds

that revert to it after other plan termination obligations are

satisfied.

The service has consistently compared these transactions to the

sale of Code section 1245 depreciable property. Rev. Rul. 74-84191

held that gain on the sale of a piece of machinery that is

recapturing depreciation is patronage-sourced income, while

additional gain is nonpatronage-sourced. Citing Rev. Rul. 74-84,

the Service has said that the portion of the excess funds reverting

to the cooperative attributable to excess company contributions

deducted in prior years can be treated as patronage-sourced

income. However, that part of the excess funds attributable to

“superior investment performance” by the plan “...is not patronage
 Tech. Adv. Mem. 9208004 (Oct. 31, 1991); see also, Priv. Ltr.

192

Rul. 8520003 (Jan. 11, 1985); Priv. Ltr. Rul. 8752008 (Dec. 24, 1987);

Priv. Ltr. Rul. 8827027 (April 7, 1988).

81

source income since it is incidental income not directly related to

the marketing, purchasing, or service activities for the benefit of

(Cooperative’s) members.”192
 American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118

193

Stat. 1418 (2004).

 Treas. Reg. § 1.1388-1(e).

194

82

CHAPTER 6

OTHER INCOME ISSUES

This chapter is something of a catch-all. It discusses several

situations that pose challenges in determining the proper

accounting and tax treatment of cooperative financial results in the

patronage refund area. It also looks at other issues in determining

taxable income, including new tax planning options provided by

the American Jobs Creation Act of 2004.193

SIMULTANEOUS PATRONAGE AND

NONPATRONAGE OPERATIONS

Income that a cooperative generates in providing marketing,

supplies, or services may not be entirely attributable to patronage

income if the cooperative conducts that business with or for

persons who aren't patrons of the cooperative.

While "patron" is not defined in the Code, it is defined in the

regulations as "any person with whom or for whom the

cooperative association does business on a cooperative basis,

whether a member or a nonmember of the cooperative association,

and whether an individual, a trust, estate, partnership, company,

corporation, or cooperative association."194

Thus, any time a cooperative conducts business with someone

on a noncooperative basis, that activity is nonpatronage business

and the resulting earnings are not eligible for tax treatment as

patronage refunds.

It is common for cooperatives to provide like services to

members and nonmembers, but only make patronage refund
 Rev. Rul. 74-160, 1974-1 C.B. 245, 246. 195

 Caldwell Sugars Co-op Inc. v. United States, 692 F. Supp. 659

196

(E.D. La. 1988), 88-2 U.S.T.C. (CCH) ¶ 9509.

83

distributions to members. Cooperatives that conduct both patronage and nonpatronage business must be diligent in separating

patronage and nonpatronage earnings.

For example, in Revenue Ruling 74-160 the Service ruled

interest income from loans made to a supplier, under

circumstances permitting it to be classified as patronage-sourced

income, cannot be allocated solely as patronage-sourced net

margins if part of that income is attributable to business with

nonmembers on a nonpatronage basis. The Service said:

...to the extent such income is allocable to the member

patrons on the basis of business done with or for those

patrons, the income is patronage sourced income that may

be distributed as patronage dividends. However, to the

extent the interest income is allocable to nonmember

business it constitutes nonpatronage sourced income that

must be taken into account in computing the Federal

income tax of taxpayer (cooperative).195

In Caldwell Sugars Co-op Inc. v. United States, the 196

association did 87.555 percent of its business with member

patrons and the remainder with nonpatrons. The cooperative was

entitled to claim 87.555 percent of its income as patronage

sourced.

A cooperative may not make spurious adjustments to its usual

method for calculating patronage and nonpatronage sourced

income, especially when it shifts business from nonpatronage to

patronage sources. A workers' cooperative that distributed net

margins only to members was not permitted to arbitrarily multiply

hours worked by members by 40 percent. The result was "to

distribute to the member workers income of the [cooperative] that
 Rev. Rul. 74-20, 1974-1 C.B. 242, 243. 197

 Priv. Ltr. Rul. 8104118 (Oct. 30, 1980).

198

See, e.g., Pomeroy Cooperative Grain Co. v. Commissioner, 288

199

F.2d 326 (8th Cir. 1961), 1961-1 U.S.T.C. (CCH) ¶ 9316, rev'g in part,

aff'g in part, 31 T.C. 674 (1958) (handling, storage, conditioning grain

by a grain marketing cooperative); Priv. Ltr. Rul. 7729062 (no date,

1977) (fertilizer supply cooperative dividing its operation into nitrogen

products and mixed products); Priv. Ltr. Rul. 7819019 (Feb. 7, 1978)

(two types of marketing arrangements for the same commodity); and

Priv. Ltr. Rul. 8531002 (Feb. 28, 1985) (different kinds of supplies).

84

is attributable in part to net earnings from the efforts of the

nonmember workers."197

The cooperative's membership may decide not to conduct

some or all of its business with the cooperative on a patronage

basis. Access to the patronage refund deduction is an option, not

a mandatory step for associations otherwise operating on a

cooperative basis. The earnings from nonpatronage business are

taxed at the corporate level. If the earnings are distributed at a

later date, they are subject to a second income tax at the recipient

level.

Individual members also may choose to "waive" their

patronage refund. The cooperative "will not be dealing with these

producers on a patronage basis, [and] the net earnings from these

transactions will not be available for distribution as patronage

dividends but must be included in [the cooperative's] taxable

income."198

MULTIPLE SERVICE COOPERATIVES

Cooperatives can face complicated allocation decisions when

providing more than one service to patrons. Differences in

services range from those that are essentially integral parts of the

same service, such as storage in a grain marketing operation, to 199

services that are quite distinct, as in the case of a cooperative that
See, e.g., Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 200

201 (N.D. Iowa 1949), 1949-2 U.S.T.C. (CCH) ¶ 9400; Juniata Farmers

Cooperative v. Commissioner, 43 T.C. 836 (1965), acq., 1966-1 C.B. 1;

and Pomeroy Cooperative Grain Co. v. Commissioner, 288 F.2d 326

(8th Cir. 1961), 1961-1 U.S.T.C. (CCH) ¶ 9316, rev'g in part, aff'g in

part, 31 T.C. 674 (1958).

85

markets farmers' commodities and purchases supplies for farm

production input. In some instances, the same set of services is 200

provided to essentially the same group of patrons. In others, the

cooperative may deal with different, although somewhat

overlapping, sets of patrons.

Several factors make allocation decisions in multiple service

cooperatives challenging. The cooperative may deal with one

group of patrons with respect to one service, and a different group

with respect to another service. Net margins attributable to each

service will usually differ. Patrons of one service may use the

cooperative to a different degree than patrons using another

service.

Multiple service cooperatives have two basic options in

allocating margins, although numerous modifications are used.

First, a cooperative may combine the financial results of all

operations to determine net margins available for distribution.

These margins are then allocated to patrons based on business

done with the cooperative without regard to which services were

used by each patron.

On the other hand, the cooperative can segregate its services

and calculate net margins separately, assigning gross income and

expenses almost as if a different cooperative provided each

service. Net margins are then allocated to patrons of each unit in

proportion to business done with each unit.

It is probable that the two allocation methods will yield a

different patronage refund for a patron doing the same amount of

business with the cooperative.
 The Consolidated Omnibus Budget Reconciliation Act of 1985 201

added a new Subsection (j) to Section 1388 of the Code. Cooperatives

are given the option to offset patronage losses attributable to one or

more allocation units (whether such units are functional, divisional,

departmental, geographic, or otherwise) against patronage earnings in

one or more other allocation units. Pub. L. 99-272, § 13210, 100 Stat.

82 (1985). This provision is discussed in detail in Part 5 of this series,

Handling of Losses.

86

Except for a technical amendment covering the netting of

earnings and losses among allocation units, the Code doesn't 201

specifically address multiple service cooperatives and their

methods of calculating and allocating net margins.

EQUITABLE ALLOCATION AMONG

PATRON GROUPS

Code section 1388(a), in defining "patronage dividend

(refund)," provides the term "does not include any amount paid to

a patron to the extent that...(B) such amount is out of earnings

from business done with or for other patrons to whom no amounts

are paid, or to whom smaller amounts are paid, with respect to

substantially identical transactions."

This language had been implemented through an "equitable

allocation" concept, suggesting patronage refunds be equitably

distributed among the patrons who have transacted business with

the cooperative. Courts that have discussed equitable allocation

have approved the concept in principle, but have not accepted it as

a precise accounting requirement limiting the flexibility of

cooperatives and their user-owners to agree on various methods of

allocation among groups.

In Pomeroy Cooperative Grain Company v. Commissioner,

decided just before subchapter T adoption, the Eighth Circuit

Court of Appeals addressed an "equitable allocation" argument

involving a grain marketing cooperative that also generated
 Pomeroy Cooperative Grain Co. v. Commissioner, 288 F.2d 326

202

(8th Cir. 1961) rev'g in part, aff'g in part, 31 T.C. 674 (1958).

 288 F.2d at 332. 203

 288 F.2d at 333 (quoting Farmers Cooperative v. Birmingham, 204

86 F. Supp. 201, 213 (N.D. Iowa 1949), 1949-2 U.S.T.C. (CCH) ¶

9400). The District Court did suggest that the equitable allocation

principle required that marketing and supply margins should be kept

separate. 31 T.C. 674, 686 (1958). Upon review, the Eighth Circuit

Court of Appeals said, "it is not entirely clear just what standards the

Tax Court intended to apply by [this] requirement." 288 F.2d at 329 (8th

Cir. 1961).

87

income from storing members' grain. IRS argued that allocating 202

grain storage income to grain marketing patrons in proportion to

their grain marketing activities violated the equitable allocation

principle.

The court said, there "is some doubt whether the

Commissioner has sufficient standing to object to the taxpayer's

method of allocating what would normally be income excludable

to the taxpayer among its member-patrons in a manner apparently

acceptable to such members as an equitable distribution of

profits."203

After discussing the close connection between marketing and

storage activities, the court rejected IRS's argument that allocating

the net margins from the two activities to one allocation unit was

inequitable. The court asserted:

...from a revenue standpoint, the Commissioner should

be more concerned with the total exclusions allowable on

membership business profits rather than the means by

which such profits are divided among the qualified

members. As stated in the Birmingham case..."the crucial

question involved in determining the taxability of

patronage dividends is whether they constitute income to

the cooperative, or to the patron, or to both."204
 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894 (1982). 205

 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213 (1980).

206

88

In Lamesa Cooperative Gin v. Commissioner, the coopera- 205

tive primarily performed marketing services for its patrons but also

purchased small quantities of farm supplies that it resold to

patrons approximately at cost. The cooperative based its

allocation of patronage refunds solely on the patronage of its

marketing operation. The Tax Court approved the cooperative's

policy of combining the financial results of these distinct activities

and making a single distribution based only on marketing

patronage, noting that neither the operation-at-cost principle nor

the concept of equitable allocation required any particular

accounting method.

Recent decisions have addressed the equitable allocation issue

when one or more units within a cooperative suffer a loss. While

handling of losses is the subject of Part 5 of these reports, a brief

discussion of the issue is presented here.

Treatment of losses by multiple service cooperatives can

present a difficult situation, especially where different groups of

patrons use distinct services of the cooperative that generate vastly

different financial results. The Service has argued that combining

such divergent results is inequitable.

Courts have not interpreted the equitable allocation rule as

strictly prohibiting such combination of margins and losses among

different groups of patrons. In Ford-Iroquois FS, Inc. v.

Commissioner, the cooperative carried operating losses on 206

supply and grain marketing functions forward to offset earnings on

supply operations in a later year, pursuant to Code section 172.

The method of handling losses did not impose losses directly on

patrons of the loss units in proportion to their business done with

the cooperative.

IRS argued that the operation at cost and equitable allocation

concepts require that the losses be charged to the patrons whose
 Priv. Ltr. Rul. 8521003 (Jan. 25, 1985). This ruling described an 207

interesting fact situation and applied several rather strict rules to the

situation in addition to the equitable allocation principle. In response

to this ruling, legislation was enacted permitting cooperatives to net

margins and losses among units. The Consolidated Omnibus Budget

Reconciliation Act of 1985, Pub. L. 99-272, § 13210, 100 Stat. 82

(1985).

89

business produced the losses. The court disagreed with IRS, and

permitted the cooperative's method of carrying the losses forward

and assigning them to different functions and patrons. The court

referred to the substantial overlap in members using both supply

and marketing functions and the fact that members found the

allocation to be acceptable to support its decision.

In a 1985 private letter ruling, IRS put forward some specific

criteria for the equitable allocation of cooperative losses:

Whether a cooperative is allocating its losses (i.e.

costs) in an equitable manner is a question of fact to be

answered according to the circumstances of each case. In

this regard we believe that there is evidence of inequity in

the netting of losses attributable to one group of patrons

with the gains of another group when they deal in wholly

different commodities, are geographically separated, and

have no knowledge that risk sharing to this degree is

taking place.

On the other hand, there is evidence of equity in the

netting of losses between groups of patrons when the

patrons of one department are often the patrons of others,

the commodities involved are similar, geographical

separation is limited, and the various patrons of the

department are adequately informed of the risk sharing

arrangement before the loss transaction occurs.207

One factor frequently mentioned in equitable allocation

decisions, at least in recent ones, is the role members play in
 Examples include Juniata Farmers Cooperative v. Commissioner,

208

43 T.C. 836, 841 (1965), acq., 1966-1 C.B. 1 (The cooperative's

"method of allocation is a fair and equitable one, fully acceptable to its

patrons."); and Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213,

1222 (1980) (With respect to losses carried forward to a new set of

patrons, "the allocation of losses among a cooperative's past, continuing

and future members is properly the concern of the membership and the

board of directors"), quoted with approval in Lamesa Cooperative Gin

v. Commissioner, 78 T.C. 894, 905 (1982).

90

deciding what is "equitable." The courts have given great weight

to the members choosing, as owners and users, the method for

distributing benefits and risks of cooperative operations.

208

Cooperatives consider a number of factors when determining

how the activities within the organization are to be divided for

accounting, financial analysis, and allocation purposes.

Management practices may suggest that units be divided into

relatively narrow activities so that performance can be monitored.

On the other hand, the difficulties of accounting separately for

many closely related activities, especially if allocation decisions

will be tied to them, may push the leadership toward bundling the

results of different activities. Member views on the degree that

they want to share the risks with users of other services are also an

important consideration.

MATCHING PATRONAGE AND ALLOCATION -

TRACING

A cooperative may receive income in a year subsequent to the

year in which the patronage activity occurred that generated the

income. Code section 1382(f) applies to this situation. This

provision states:

If any portion of the earnings from business done with

or for patrons is includible in the organization's gross
 Treas. Reg. § 1.1382-6. 209

See Rev. Rul. 69-576, 1969-2 C.B. 166; Rev. Rul. 70-249, 1970- 210

1 C.B. 181.

 Rev. Rul. 79-45, 1979-1 C.B. 284. 211

91

income for a taxable year after the taxable year during

which the patronage occurred, then...the patronage

(income) shall, to the extent provided in the regulations...,

be considered to have occurred during the taxable year of

the organization during which such earnings are includible

in gross income.

The applicable regulation, after restating the Code provision,

adds: "Thus, if the cooperative organization pays these earnings

out as patronage dividends during the payment period for the

taxable year for which the earnings are includible in its gross

income, it will be allowed a deduction for such payments under

section 1382(b)(1)...."209

For some time, both the Service and cooperatives generally

interpreted this language to mean income realized in one year from

a prior year's patronage was allocable to patrons of the year of

receipt on the basis of business done during the year of receipt.

210

In Revenue Ruling 79-45, the IRS shifted its position. A 211

change in a cooperative's inventory accounting method caused a

positive adjustment in the cooperative's income in the year of

change. The cooperative requested, and was granted, permission

to allocate the gain to patrons of the cooperative during the 3 years

in which the old inventory accounting method was used, the

patrons whose business with the co-op resulted in the adjustment.

The Service went on to state that not only was the cooperative

permitted to distribute the gain to patrons of the years it was

earned, the cooperative was required to do so. IRS said:

The payment of a patronage dividend that is based on

income subject to the treatment of section 1382(f) of the
 1979-1 C.B. at 285.

212

 Tech. Adv. Mem. 8023023 (Feb. 28, 1980).

213

 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894 (1982).

214

92

Code necessitates a tracing of the allocation of this income

to patrons that may no longer be members of the cooperative because it was their business with the cooperative

that resulted in this income. In situations where that

income is related to business done with patrons over an

extensive period of time, the payment of a patronage

dividend with respect to this income should be made in

proportion, in so far as practicable, to the amount of

business done by or for such patrons during the period to

which such income is attributable.212

Following Revenue Ruling 79-45, the Service denied patronage refund treatment to a local cooperative that distributed a

refund from a federated cooperative to its patrons of the year of

receipt rather than to patrons of the year the underlying business

transactions occurred.213

Farmer cooperatives were greatly distressed over this ruling.

Local cooperatives that were member patrons of federated supply

and marketing associations faced an extreme administrative

burden if required to trace and allocate every refund from the

federated cooperatives back to the specific members' business that

generated those margins. And in the early 1980's, IRS auditors

began challenging the tax returns of numerous local cooperatives

over the tracing issue. Shortly thereafter, however, two court

decisions checked IRS's efforts in enforcing stringent tracing

requirements.

Lamesa Cooperative Gin v. Commissioner concerned a 214

cooperative that sold equipment in 1974 on which it had deducted

depreciation in prior years. All the gain from the sale of the

equipment was reported on Lamesa's 1974 tax return as ordinary

income underCode section 1245. In determining the amount to be
 78 T.C. at 903. 215

 Kingfisher Cooperative Elevator Association v. Commissioner,

216

84 T.C. 600 (1985). 

93

paid as patronage refunds, the cooperative allocated all this gain

to its patrons during the 1974 taxable year in proportion to their

patronage during that year.

IRS denied the patronage refund deduction, asserting that the

concepts of operation at cost and equitable allocation required the

cooperative to allocate the gain in proportion to patronage that

occurred during the years in which the equipment was depreciated.

The Tax Court in Lamesa disagreed with the Service and

upheld the cooperative's allocation to current year patrons only,

thus entitling the cooperative to deduct the entire amount of the

gain. The court reasoned as follows:

The requirement of 'equitable allocation' should not be

seen as a strict accounting requirement but only as a

general principle to prevent inequitable treatment to some

patrons at the expense of others. As a principle of equity,

the overall scheme of allocation should be examined,

including the practicalities of making allocations, the

democratic nature of cooperatives, and the extent of

patronage to the cooperative by nonmembers who have no

say over how patronage dividends are distributed.215

The Tax Court dealt with the applicability of tracing to

federated cooperatives in Kingfisher Cooperative Elevator

Association v. Commissioner. Kingfisher, a local cooperative, 216

belonged to four federated marketing, supply, and finance

cooperatives. Kingfisher included patronage refunds received

from the federated cooperatives in its gross income in the year of

receipt. In computing its patronage refunds for its memberpatrons, Kingfisher allocated net income to its patrons according

to their patronage during that year. Prior year's patronage activi-
 I.R.C. § 1388(a) and Treas. Reg. § 1.1388-1(a)(2)(ii). 217

 Rev. Rul. 75-110, 1975-1 C.B. 167, relating to qualification for 218

§ 521;see also Rev. Rul. 66-98, 1966-1 C.B. 200 in which a cooperative

94

ties were not taken into account. Kingfisher's allocation was

adopted by its board of directors and ratified annually by its

members.

The Tax Court, following Lamesa Cooperative Gin, held that

Kingfisher's allocation method was equitable. The court was

impressed by the stability of Kingfisher's membership, the

practical difficulties of tracing the allocations, and the approval of

the method by its members.

The tracing issue has not been raised in IRS audits of

cooperatives since the decisions in Lamesa and Kingfisher.

UNEQUAL ALLOCATIONS

The Code states a patronage refund cannot include any amount

paid "out of earnings from business done with or for other patrons

to whom no amounts are paid, or to whom smaller amounts are

paid, with respect to substantially identical transactions."217

Situations exist, however, in which a cooperative may have

legitimate reasons to treat patrons who appear to be dealing with

the cooperative on a "substantially identical" manner differently.

If the cooperative does treat them differently, it has the burden of

proving it falls within the scope of the equitable allocation rule.

Some characteristics of a transaction between cooperative and

patron may distinguish one patron's dealing with the cooperative

from another patron. For example, the product delivered may be

subject to variation in quality, justifying differential treatment in

calculating and returning patronage refunds. An example is a

bonus program giving higher returns in the form of premium

payments to producers who deliver higher quality milk to a milk

marketing cooperative.218
formed by department stores to purchase accounts receivable required

different "hold backs" for losses based on past loss record.

 Rev. Rul. 74-567, 1974-2 C.B. 174. 219

 Rev. Rul. 66-98, 1966-1 C.B. 200, 201-202. 220

 Rev. Rul. 55-141, 1955-1 C.B. 337. Allocations of less than $1 221

and all cents in excess of whole dollar amounts were set aside in a fund

to defray recordkeeping expenses. See also Priv. Ltr. Rul. 9049026

(Sept. 10, 1990) (nondistribution of patronage refund below unspecified

de minimis level approved).

95

A marketing cooperative may use its members' product in

different ways, and treat patrons according to the use made of the

product. For example, a grain marketing cooperative sold

debentures to members to finance a feed manufacturing facility.

The debentures carried rights to deliver grain to the feed plant.

The cooperative was permitted to calculate and allocate margins

on grain delivered to the feed mill differently than grain delivered

and sold under the regular grain marketing program.219

The Service has permitted variations in patron treatment if

based on market factors prevailing when product is delivered to or

sold by the cooperative. Revenue Ruling 66-98 described a

cooperative formed by department stores to purchase their

accounts receivable. The discount charged was based on current

market discount rates that varied during the year. The ruling held

cooperative operation of a finance corporation did not require it to

purchase accounts receivable "on a basis different from that on

which such receivables would customarily be acquired by a

comparable commercial institution."220

Small allocations can cause considerable bookkeeping

expense. In response, the Service has permitted cooperatives to

eliminate small allocations, technically resulting in inequitable

treatment. Likewise, a cooperative with a very small patronage 221
 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894, 907- 222

910.

 Smith & Wiggins Gin, Inc. v. Commissioner, 341 F.2d 341 (5th

223

Cir. 1965).

 Iberia Sugar Cooperative, Inc. v. United States, 480 F.2d 548

224

(5th Cir. 1973), 1973-1 U.S.T.C. (CCH) ¶ 9465, aff'g, 360 F. Supp. 967

(W.D. La. 1972).

96

sideline function may allocate margins earned from the function

on the basis of its primary patronage business.222

Section 1388(a) and the requirement that patrons be treated

equally with respect to substantially identical transactions have

caused problems for cooperatives with farm owners as members

that also market the production of the tenants of the members. In

Smith & Wiggins Gin, Inc. v. Commissioner, the cooperative 223

ginned cotton delivered by both members and tenants of members.

When the patronage refunds of the members were computed, each

member was credited not only with the cotton which the member

grew and brought to the gin but also with that of the member's

tenants. The refund was made to the member and not to the

tenants. The court denied patronage refund deductions for the

amounts based on cotton delivered by the tenants. The court

reasoned the tenants, not the member/landlords, were the proper

"patrons" for such distributions.

A similar result was reached in Iberia Sugar Cooperative, Inc.

v. United States. In this case the cooperative contended that 224

because its bylaws and marketing agreements with members

required members to deliver all of the crop, including the

nonmember tenants' shares of the crop, the business was transacted

only with members. The court disagreed stating patronage

refunds, to be deductible, cannot be paid out of earnings based on

the production of nonmembersto whom no amounts are paid with

respect to substantially identical transactions. The court held

refunds paid to members based on product grown by tenants were

out of nonpatronage income.
 Mississippi Valley Portland Cement Co. v. United States, 408 225

F.2d 827 (5th Cir. 1969), cert. denied, 395 U.S. 944 (1969), aff'g 280 F.

Supp. 393 (S.D. Miss. 1967).

 408 F.2d at 834. 226

 Land O'Lakes, Inc. v. United States, 675 F.2d 988 (8th Cir.

227

1982), aff'g in part, rev'g in part, 470 F. Supp. 238 (D. Minn. 1979).

97

USE OF THIRD-PARTY AGENTS

Another interesting line of cases involves the tax status of

payments to member-patrons who have assigned their right to do

business with the cooperative to third parties.

In Mississippi Valley Portland Cement Co. v. United States,

225

a small group of investors formed an alleged cooperative to

manufacture cement. The investors purchased stock in the

cooperative, which gave them rights to purchase quantities of

cement from the cooperative. These rights were assigned to a

common sales agent that resold the cement to the general public.

Earnings of the manufacturer were returned to its members on the

basis of stock ownership. The association claimed a patronage

refund deduction on its income tax return.

The court found the distributions were not made out of

earnings from "business with or for patrons" and therefore not

excludable from the corporation's taxable income. The court cited

two factors as particularly important. First, the record showed the

business was operated "not to supply its shareholders with cement

at a reduced cost but to supply them with a return on their invested

capital."226

Second, the owners lacked the common business interest of

true member-patrons of a real manufacturing cooperative.

In Land O'Lakes, Inc. v. United States, the cooperative, in an

227

"agent-buyer" arrangement, sold supplies to independent

companies, which resold the supplies to farmer members of the

cooperative. The agents entered into contracts with the

cooperative under which the patronage refunds, normally payable
 Mississippi Chemical Corp. v. Commissioner, 86 T.C. 627

228

(1986).

98

to the agents, were paid directly to the farmer-customers of the

agents.

The court noted that the Land O'Lakes bylaws created the

necessary preexisting obligation to make patronage refunds to the

members, and the members had consented to include the refunds

in their taxable income. The court acknowledged that an argument

could be made that the agents, not the farmers, were the patrons of

Land O'Lakes. The court observed, however, that the Code

section 1388(c)(1)(B) definition of a qualified written notice of

allocation provides for consent from the "distributee." The court

held "distributee" has a broader meaning than "patron,"

encompassing the members of Land O'Lakes. Since the members

would recognize the tax obligation, the refunds paid to the farmercustomers under the agent-buyer agreements were properly

deductible by Land O'Lakes as patronage refunds.

In Mississippi Chemical Corp. v. Commissioner, several 228

members of a fertilizer manufacturing cooperative formed a

separate corporation to buy and sell fertilizer. The corporation

also became a member of the cooperative.

The corporation assigned its rights to buy fertilizer from the

cooperative to third parties, two of whom were members of the

cooperative and onewho was a nonmember. The assignees agreed

to assign back to the corporation any patronage refunds they might

receive as a result of the purchases from the cooperative.

The cooperative, which paid patronage refunds only to

members, distributed earnings on all sales under the assignments

to the corporation pursuant to its status as a member of the

cooperative.

The court held that when the corporation's right to purchase

fertilizer was assigned to another member of the cooperative, the

distribution paid to the corporation qualified as a patronage refund.

But when the right to purchase fertilizer was assigned to a

nonmember, the cooperative could not deduct the payment as a
 Treas. Reg. § 1.1388-1(a)(1)(iii), and the explanation below

229

subsection (iii).

99

patronage refund. And the payments could not be deducted as an

agreed-upon refund of purchase price either.

The court also noted that, after the tax year in question, the

cooperative amended its bylaws to permit payment of patronage

refunds to nonshareholders. This suggests the court would have

permitted deductibility of all distributions to the corporation, had

all the assignees been patrons of the cooperative. This, in turn,

highlights the important distinction between a member and a

patron for tax purposes.

EXPENSES

Two factors jointly determine net margins--gross income and

business expenses, including dividends and taxes. Patronage

refunds are based on the net earnings of the cooperative, computed

only after taking expenses into account.229

There are no special rules on computing total expenses for

cooperatives. Cooperatives are entitled to the same operating

expense deductions as noncooperative firms in similar lines of

business.

But special situations do arise for cooperatives in allocating

expenses to different classifications of business activity.

Cooperatives that calculate net margins for separate units within

the cooperative must allocate expenses to the appropriate units to

determine net margins for each unit.

Cooperatives with patronage and nonpatronage income must

also allocate expenses between the business activities generating

the two classifications of income so that patronage-sourced

earnings can be computed for distribution as deductible patronage

refunds. As stated by the Tax Court:
 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 230

238, 246 (1987).

 88 T.C. 238. Patron grocery stores purchased from a wholesale 231

food supply cooperative. The patrons were required to maintain cash

deposit balances with the cooperative in proportion to the amount of

purchases made from the cooperative.

 Priv. Ltr. Rul. 8531002 at 6 (Feb. 28, 1985).

232

 Priv. Ltr. Rul. 9238010 (June 16, 1992).

233

100

...expenses must be assigned to the type of income to

which they apply and may not be arbitrarily assigned to

reduce one type of income or the other.

The first step in determining whether an item of

expense is nonpatronage sourced is to establish how the

expense arises. If the expense is incurred with respect to

business done with or for patrons, it is patronage

sourced.230

The rule is applied in the same way as the rules for

determining if income is from patronage or nonpatronage sources.

For example, interest expenses paid to patrons for their deposits in

the cooperative are patronage sourced expenses, as is interest on

commercial borrowing done as a necessary part of the cooperative's business with or for its patrons.231

The Service has held that administrative expenses and interest

costs associated with collection of late payment fees from patrons

are patronage-sourced expenses and can be offset against income

from patronage sources "in accordance with generally acceptable

accounting principles."232

IRS has also permitted a marketing cooperative to treat

payments made to settle a private civil antitrust lawsuit as

patronage sourced expenses for purposes of determining net

patronage earnings available for allocation as patronage refunds.233

But interest expenses associated with funds a cooperative

borrows to redeem per-unit retain certificates early, at less than
 Priv. Ltr. Rul. 8033070 (May 22, 1980).

234

 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 235

238, 247 (1987).

 I.R.C. §§ 1382(b) and 1388(a). 236

101

face value, have been characterized as nonpatronage expenses by

IRS. The IRS considers the income generated from redemption at

less than face value to be nonpatronage sourced; thus any expenses

arising from that activity are likewise nonpatronage in nature.

234

As a general rule, cooperatives may not use patronage-sourced

expenses to reduce income from nonpatronage sources.

The cooperative in Certified Grocers of California, Ltd. v.

Commissioner argued its surplus funds, which it used to earn

interest from bank instruments, could have been utilized to reduce

its debt used to finance operations that generated patronagesourced income. This would have reduced interest expense

properly allocated to patronage operations. Therefore, the

cooperative asserted it should be allowed to set off interest

expenses incurred on patronage operations against interest income

earned on the bank instruments.

The Tax Court found the argument:

...entirely speculative and unconvincing. There is

nothing in this record to show to what extent, if any, [the

cooperative] could have used the excess cash which it

temporarily had in its hands, from time to time, for the

reduction of other indebtedness on which it was obligated,

consistent with maintaining the liquidity necessary for the

operation of its business. In any event, it was not done.

[The cooperative] chose the manner in which it operated

its business, and it must abide the tax results flowing from

those choices.235

Subchapter T prohibits the payment of patronage refunds out

of income from nonpatronage sources. Reducing nonpatronage 236
 This result is noted in Des Moines County Farm Service Co. v. 237

United States, 448 F.2d 776 (8th Cir. 1971), 1971-2 U.S.T.C. (CCH) ¶

9665, aff'g, 324 F. Supp. 1216 (S.D. Iowa), 1971-1 U.S.T.C. (CCH) ¶

9200; Farm Service Cooperative v. Commissioner, 619 F.2d 718 (8th

Cir. 1980), 1980-1 U.S.T.C. (CCH) ¶ 9352, rev'g, 70 T.C. 145 (1978);

and Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 238

(1987).

 Rev. Rul. 74-161, 1974-1 C.B. 247. This is distinguished from 238

a tax imposed on the total net earnings from all operations, which the

Service has said must be allocated to both patronage- and nonpatronagesourced income. Rev. Rul. 82-76, 1982-1 C.B. 118.

 An early Board of Tax Appeals decision, Farmers Union 239

Cooperative Exchange v. Commissioner, 42 B.T.A. 1200 (1940), noted

this position, basing its decision, in part, on A.R.R. 6967, III-1 C.B. 287

(1924), superseded by Rev. Rul. 68-228, 1968-1 C.B. 385, modified by

102

sourced income by patronage sourced expenses would evade this

principle by increasing net margins available for distribution as

patronage refunds under the single tax rule for patronage refunds.

This would then decrease the nonpatronage-sourced income

otherwise fully taxable at the cooperative level, at least for

nonsection 521 cooperatives.237

A cooperative that operates on a patronage basis with respect

to members and on a nonpatronage basis with respect to nonmembers may find some expenses should be assigned to only one

group or the other. For instance, a State may impose an income

tax on the net margins derived from nonmember, nonpatronage

business but not on net margins from the patronage business if

returned to members on a patronage basis. In such a case, earnings

from business done with members must be segregated from

nonmember business earnings. The income tax is then assessed

only against nonmember earnings. Member earnings distributed

as patronage refunds are not affected by the tax.238

Similarly, Federal income taxes paid on nonpatronage income

are not applied to reduce patronage refunds payable to patrons

with whom the cooperative did business on a cooperative basis.

239
Rev. Rul. 72-602, 1972-2 C.B. 510.

 A.R.R. 6967, III-1 C.B. 287 (1924), superseded by Rev. Rul.

240

68-228, 1968-1 C.B. 385, modified by Rev. Rul. 72-602, 1972-2 C.B.

510. See also Valparaiso Grain & Lumber Co. v. Commissioner, 44

B.T.A. 125 (1941), for statement of this presumption.

 Union Equity Cooperative Exchange v. Commissioner, 58 T.C. 241

397 (1972), aff'd, 481 F.2d 812 (10th Cir. 1973), 1973-2 U.S.T.C.

(CCH) ¶ 9534, cert. denied, 414 U.S. 1028 (1973).

Land O'Lakes, Inc. v. United States, 675 F.2d 988 (8th Cir. 242

1982), 1982-1 U.S.T.C. (CCH) ¶ 9326, aff'g in part, rev'g in part, 470

F. Supp. 238 (D. Minn. 1979), 1979-1 U.S.T.C. (CCH) ¶ 9380.

103

Certain presumptions may affect the allocation of expenses, or

at least the need to calculate them separately. An early IRS ruling

established a presumption that for patronage and nonpatronage

business involving the same activity, the patron and nonpatron

portions of a cooperative's business were equally profitable.240

While that presumption is rebuttable, the burden of proof falls on

the cooperative.241

In Land O'Lakes, Inc. v. United States, a cooperative 242

operated retail outlets that sold both member product and

nonmember goods. All income from the store was designated

income from patronage sources, with no profit allocated to

nonpatronage-sourced income. Reversing a U.S. District Court

decision, the Eighth Circuit Court of Appeals disagreed with

designating all the income as patronage sourced.

The appellate court ruled the cooperative failed to produce

sufficient evidence to overcome the presumption that sales for

member and nonmember marketing were equally profitable. The

cooperative did not produce sales records for the year in question

(1963). And while the cooperative did introduce into evidence a

week long study performed in 1970 which based its cost allocation

on observation of labor costs, the appellate court found the

analysis flawed and of doubtful validity. As a result, the presumed

correctness of IRS's assessment was not overcome.
 Rev. Rul. 54-297, 1954-2 C.B. 132. 243

American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118

244

Stat. 1418.

 Revenue Act of 1971, Pub. L. No. 92-178, § 501, 85 Stat. 497; 245

26 U.S.C. §§ 991-999.

104

Some expenses cannot be assigned solely to patronage or

nonpatronage activity. Instead, they are "organization wide" in

their impact. These expenses or payments may not be used to

selectively reduce patronage or nonpatronage sourced income but

must be applied proportionately to reduce both. For example,

amortization of a facility is apportioned between patronage and

nonpatronage business to apply proper deduction to net margins

available for payment as patronage refunds.243

EXPORT ENTITY EARNINGS

The Federal government has a long history of lending public

policy support to efforts of United States companies to increase

sales of their products in foreign countries. For many years, tax

incentives were one of the tools used to promote exports. The

value of these incentives to cooperatives, and other businesses,

were limited by their complexity and constant challenges by other

nations to their legality under international trade rules. The

American Jobs Creation Act of 2004 reduced U.S. reliance on 244

this approach to stimulate domestic economic activity.

Domestic International Sales Corporation

The Revenue Act of 1971 authorized the creation of taxfavored Domestic International Sales Corporations (DISC). A 245

properly organized and operated DISC is a nontaxable entity.

DISC earnings, whether distributed as cash or retained by the

DISC, are taxable income to the shareholders. The tax advantage
 Rev. Rul. 73-247, 1973-1 C.B. 294. 246

 Rev. Rul. 75-228, 1975-1 C.B. 278. 247

 Deficit Reduction Act of 1984, Pub. L. 98-369, §§ 801-805, 98 248

Stat. 494, 985-1003; 26 U.S.C. §§ 921-927. Although DISC's were not

abolished by the 1984 Act, their benefits were limited and an interest

charge for tax-deferred amounts was imposed on DISC shareholders.

105

is that shareholders can defer some of their tax liability on

earnings allocations from the DISC.

While the DISC statute was not cooperative user friendly, IRS

took a positive attitude toward cooperative use of DISC’s. In a

brief ruling, it said that a section 521 farmers’ cooperative could

organize and operate a DISC as a wholly owned subsidiary

without jeopardizing its section 521 status.

246

The Service also took a favorable position on the character of

DISC income distributed to its cooperative owner. A fruit

processing and marketing cooperative organized a wholly owned

DISC to handle its export sales. The cooperative paid a

commission to the DISC for its sales, and received back a

distribution of one-half of any earnings realized by the DISC.

Neither the cooperative nor the DISC handled fruit for

nonmembers of the cooperative. The Service held the distribution

from the DISC to the cooperative was patronage sourced income

because it was produced by a transaction directly related to

marketing patrons' products.247

Foreign Sales Corporation

DISC’s proved difficult to operate and drew constant criticism

from other nations as a violation of the prohibition on export

subsidies in the General Agreement on Tariffs and Trade. The

Deficit Reduction Act of 1984 created the Foreign Sales

Corporation (“FSC”) as a substitute for the DISC.248

A FSC was a corporation organized and operated in another

countrythat marketed goods produced in the United States in other
 26 U.S.C. § 923(a)(4) and § 925(f), both of which were repealed 249

by § 2 of the Foreign Sales Corporation Repeal and Extraterritorial

Income Exclusion Act of 2000. 

 Foreign Sales Corporation Repeal and Extraterritorial Income 250

Exclusion Act of 2000, Pub. L. No. 106-519, 114 Stat. 2423-2435,

codified at 26 U.S.C. §§ 941-943.

106

countries. Under this export incentive scheme, a percentage of an

FSC’s income earned from the sale of qualified export property

was exempt from U.S. tax.

Special rules for cooperatives provided that so-called

“exempt” foreign trade income could be retained at the

cooperative level tax free, while “nonexempt” foreign trade

income was taxable to the cooperative but deductible if allocated

to patrons on a patronage basis. Thus the legislation 249

presupposed that FSC income was patronage-sourced.

Extraterritorial Income Exclusion

In 1999, the World Trade Organization (WTO), at the request

of the European Union, ruled that the FSC regime was not in

compliance with WTO obligations. Congress responded by

repealing the FSC rules found in Code sections 921-927 and

replacing them with a general exclusion from the gross income of

U.S. companies for “extraterritorial income (ETI).”250

The new scheme eliminated the need for a foreign company to

handle the export arrangements. Qualifying foreign trade income

was simply excluded from gross income of the exporting entity.

As the tax-favored ETI was excluded from income, sole

proprietorships and owners of passthrough entities (partnerships,

LLC’s, and S corporations) could benefit directly from the

exclusion. To make sure cooperatives and their patrons were not

disadvantaged under the newest scheme, two special rules were

included in the law.
 26 U.S.C. § 941(b)(2).

251

 26 U.S.C. § 943(g). 252

 American Jobs Creation Act of 2004, Pub. L. No. 108-357, 253

§ 101, 118 Stat. 1423.

Id. at § 101(d). 254

Id. at § 101(f). 255

107

First, similar to the rules for FSC, qualifying ETI could be

retained at the cooperative level tax free. But in a change from 251

FSC, qualifying ETI could be passed through to patrons as either

patronage refunds or per-unit capital retains that could also be

excluded from the patrons’ gross income. Thus ETI was even 252

more beneficial than regular patronage-sourced income as it could

be distributed directly to patrons free from any Federal income

taxation.

The European Union immediately challenged the ETI regime

in the WTO. In January 2002, the WTO Appellate Body found the

ETI regime also constituted a prohibited export subsidy under the

relevant trade agreements.

The ETI exclusion was repealed, for transactions after

December 31, 2004, by the American Jobs Creation Act of

2004. This included the language allowing agricultural and 253

horticultural marketing cooperatives to pass ETI benefits through

to their patrons. Transition rules provide cooperatives and other

taxpayers with 80 percent of their otherwise-available ETI benefits

for transactions during 2005 and 60 percent of their otherwiseavailable ETI benefits for transactions during 2006. Transition 254

relief is also available for income realized under certain contracts

in effect on September 17, 2003.255
Id. at § 102. The Qualified Production Activities Income 256

deduction created by this provision is codified as a new § 199 of the

Internal Revenue Code, 26 U.S.C. § 199.

 I.R.C. § 199(a). 257

 I.R.C. § 199(c)(1).

258

108

QUALIFIED PRODUCTION ACTIVITIES

INCOME DEDUCTION

To compensate United States manufacturing companies for the

loss of export tax relief and encourage domestic economic growth,

the American Jobs Creation Act of 2004 provides a new, phasedin deduction from taxable income for a portion of "qualified

production activities income" (QPAI) generated by businesses,

including cooperatives. Unlike the ETI regime, the QPAI 256

deduction is available to all taxpayers deriving income from

qualified domestic production activities, whether or not they are

exporters. The new deduction can be as much as three percent of

QPAI for tax years beginning in 2005-2006, six percent for 2007-

2009, and nine percent for 2010 and later.257

QPAI generally is equal to the excess (if any) of a taxpayer's

domestic production gross receipts for the taxable year, over the

sum of:

(1) the cost of goods sold that are allocable to such receipts,

(2) other deductions, expenses, or losses directly allocable to

such receipts, and

(3) a ratable portion of other deductions, expenses, and losses

that are not directly allocable to such receipts or another

class of income.258

"Domestic production gross receipts" meansthe gross receipts

of a taxpayer which are derived from any lease, rental, sale,

exchange, or other disposition of:
 I.R.C. § 199(c)(4)(A). 259

 I.R.C. § 199(c)(4)(B)(i). This exception is discussed at some 260

length in a footnote to the Conference Report on the American Jobs

Creation Act of 2004, H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess.

at 272, n.27.

 I.R.C. § 199(c)(4)(B)(ii). This exception is also discussed in a

261

lengthy footnote to the Conference Report at 272-273, n.28.

 I.R.C. § 199(c)(5).

262

 H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess. at 274. 263

109

(1) qualifying production property which was manufactured,

produced, grown, or extracted in whole or in significant

part by the taxpayer within the United States,

(2) any qualifying film produced by the taxpayer, or

(3) electricity, natural gas, or potable water produced by the

taxpayer in the United States.259

The provision defining "domestic production gross income"

also includes two specific exceptions--activities that will not

produce QPAI--of interest to cooperatives. The first is the sale of

food or beverages at retail. The second is the transmission or 260

distribution of electricity, natural gas, or potable water.261

"Qualifying production property" consists of:

(1) tangible personal property

(2) any computer software, and

(3) certain sound recordings (records, tapes, CD's, etc.).262

The Conference Report provides further clarification on the

intent of Congress in determining QPAI for agricultural and

horticultural cooperatives. First, it states that income derived from

the manufacturing, production, growth or extraction in whole or

significant part of any agricultural or horticultural product by a

cooperative, or from the marketing of agricultural or horticultural

products by a cooperative, may be included in the co-op's QPAI.263
 H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess. at 274, n.33. 264

 H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess. at 271, n.25. 265

110

A note to the Conference Report says that the term "agricultural or

horticultural product" includes "fertilizer, diesel fuel, and other

supplies used in agricultural or horticultural production that are

manufactured, produced, grown or extracted by the cooperative."264

Second, it discusses how the handling, processing, and

marketing of agricultural products are to be treated under this

regime, stating:

Domestic production gross receipts include gross

receipts of a taxpayer derived from any sale, exchange, or

other disposition of agricultural products with respect to

which taxpayer performs storage, handling, or other

processing activities (other than transportation activities)

within the United States, provided such products are

consumed in connection with, or incorporated into, the

manufacturing, production, growth, or extraction of

qualifying production property (whether or not by the

taxpayer).

265

In summary, the range of income that can qualify is broad,

including most taxable income realized on manufacturing,

producing, growing, and extracting goods in the United States.

Rules of special interest to cooperatives provide that:

! Income from food processing (but not retail operations) is

included,

! Income from storing and handling (but not transporting)

agricultural products that are used in manufacturing,

producing, or growing other goods is included, and

! Income from the production (but not the transmission or

distribution) of electricity, natural gas, or potable water is

also included.
 I.R.C. § 199(a)(1).

266

 I.R.C. § 199(b). 267

 I.R.C. § 199(d)(3)(A). 268

Id.

269

 I.R.C. § 199(d)(3)(B)(i).

270

 I.R.C. § 199(d)(3)(B)(ii). 271

111

Two limitations apply to this deduction. First, the deduction

that may be claimed is the lesser of QPAI or taxable income for

the year. So if a cooperative or other taxpayer loses money on 266

other activities, that could reduce or eliminate this deduction.

Second, the QPAI deduction may not exceed 50 percent of the

W-2 wages paid by the taxpayer for the year.

267

Cooperative Pass-through Provision

Another provision of Code sec. 199 is particularly helpful to

agricultural and horticultural cooperatives. It provides that patrons

of agricultural and horticultural cooperatives can take a deduction

on their tax returns for QPAI allocated to them as part of a

qualified patronage refund or qualified per-unit retain. The 268

amount each patron can deduct must be computed by the

cooperative and a written notice must be provided each patron

explaining the computation.269

One special rule provides a cooperative may not take a

patronage refund deduction for amounts passed through to patrons

that can be deducted by those patrons. As this amount is already 270

eligible at the cooperative level for the QPAI deduction, this

language merelymakes it clear cooperatives can't deduct the same

amount twice.

A second special rule states that any qualifying activity of

patrons who market agricultural or horticultural products through

a cooperative may be attributed to that cooperative for purposes of

computing its QPAI deduction.271
 American Jobs Creation Act of 2004, Pub. L. No. 108-357, 272

§ 312, 118 Stat. 1467.

 Rev. Rul. 68-228, 1968-1 C.B. 385. Rev. Rul. 68-228 is not so 273

much a new IRS position as it is a modern restatement of A.R.R. 6967,

III-1 C.B. 287 (1924), cited with approval in Valparaiso Grain &

Lumber Co. v. Commissioner, 44 B.T.A. 125 (1941).

112

Example

This example illustrates how the deduction and the passthrough might work at a typical agricultural or horticultural

cooperative. Assume Co-op C has $100,000 of QPAI. Also

assume it is a tax year beginning in 2005 or 2006, so the available

deduction is 3 percent of QPAI, or $3,000.

Co-op C allocates the $100,000 to its member-patrons as a

qualified patronage refund. It is allowed to deduct the $3,000 in

QPAI under the new law and the remaining $97,000 as a

traditional patronage refund. Thus the result is the same for the

cooperative as it was before the new law was enacted, the entire

$100,000 is deductible.

Now assume Patron P does 10 percent of the business with Coop C in the tax year. Patron P receives a patronage refund of

$10,000 in QPAI, all of which is taxable income to Patron P.

However, under the new law Patron P can deduct the applicable

percentage of QPAI (3 percent in 2006), or $300. The value of

this benefit will increase significantly when the QPAI deduction

increases to 6 percent in 2007 and again to 9 percent in 2010.

DIVIDEND ALLOCATION RULE REPEAL

Until repealed by the American Jobs Creation Act of 2004,272

the dividend allocation rule (DAR) acted as an impediment to

equity accumulation by cooperatives. The DAR was an administrative interpretation of subchapter T by the Service, enunciated in

Revenue Ruling 68-228. A cooperative distributed patronage 273
 Treas. Reg. §1.1388-1(a).

274

113

refunds to its members but not to nonmembers with whom it did

business. Its bylaws provided that payments of capital stock

dividends first come out of net earnings from nonmember

(nonpatronage) business. Any capital stock dividends that

remained unsatisfied were to be paid out of net earnings from

member patronage.

The IRS disallowed part of the cooperative’s patronage refund

deduction. After citing several subsections of the regulatory

definition of patronage dividend, the Service said: 274

To qualify as a patronage dividend...an amount

paid...to a patron by a cooperative organization must be

determined by reference to the net earnings from business

done with or for the patrons. The net income of the

cooperative organization must be reduced by dividends

paid on capital stock or other proprietary interest.

Furthermore, the amount paid to members cannot be paid

out of earnings derived from nonmember business.

To permit a cooperative to pay dividends on its capital

stock solely out of earnings derived from nonmember

business would have the effect of permitting a cooperative

to deduct amounts distributed to its members out of the

earnings from nonmember business under the guise of

patronage dividends.

* * *

Accordingly, to the extent that payment of capital stock

dividends is charged against net earnings from nonmember

business instead of being charged ratably against all net

earnings thereby increasing the amount paid to member

patrons, such increase does not qualify as a patronage divi-
 Rev. Rul. 68-228, 1968-1 C.B. 385. 275

 Farmer cooperatives with section 521 tax status can deduct both

276

patronage-based distributions of nonpatronage income and dividends

paid on capital stock. Thus, the DAR is primarily a concern of other

cooperatives. 

 Priv. Ltr. Rul. 8547039 (August 27, 1985); Priv. Ltr. Rul.

277

9852012 (September 24, 1998).

114

dend and therefore is not deductible in arriving at taxable

income under section 1382(b) of the Code.275

Thus, the DAR provided that if a co-op has both patronage and

nonpatronage sourced income, and it pays dividends on its capital

stock, then the funds to pay those dividends must come

proportionately from both patronage and nonpatronage income.

For example, if a cooperative does 80 percent of its business with

patrons and 20 percent with nonpatrons, $.80 of every $1.00 paid

out as dividends on stock must come from patronage income and

only $.20 can come from nonpatronage income.

Cooperatives that generate nonpatronage earnings and pay

dividends on stock usually prefer to pay all of their stock

dividends out of nonpatronage income (at least to the extent they

earn sufficient nonpatronage income to cover their dividend

obligation). Since these earnings are subject to double taxation 276

regardless of how they are distributed, distributing them on the

basis of stock owned has no adverse tax impact on the cooperative.

And it leaves a larger pool of patronage earnings to be distributed

to patrons as tax-deductible patronage refunds.

Attempts by cooperatives to convince the Service to limit the

application of the DAR were unsuccessful.277

Furthermore, the courts consistently held that a nonsection 521

cooperative that deals with nonmember patrons on a noncooperative basis may not reduce the nonpatronage sourced income by

the entire amount paid as dividends on capital stock. Such a

cooperative must apportion the amount paid as dividends on
 Des Moines County Farm Service Co. v. United States, 448 F.2d 278

776 (8th Cir. 1971), aff'g, 324 F. Supp. 1216 (S.D. Iowa); Union Equity

Cooperative Exchange v. Commissioner, 481 F.2d 812 (10th Cir. 1973),

cert. denied, 414 U.S. 1028, aff'g, 58 T.C. 397 (1972); FCX, Inc. v.

United States, 531 F.2d 515 (Ct. Cl. 1976).

115

capital ratably between earnings on member and nonmember

business.278

For a considerable time, the DAR was not an important issue

for cooperatives. They tended to do most of their business with

member-patrons and frequently did not pay any return on their

capital stock. However, recently market forces have driven

cooperatives to become larger and more integrated to remain

viable in many of the industries where they participate. This has

led some cooperatives to solicit more business with or for

nonmembers on a nonpatronage basis. And they are also turning

to members and nonmembers for direct financing when their needs

for equity capital can no longer be met by retained patronagebased earnings.

Persons making a direct investment in a cooperative, especially

nonmembers, expect to receive at least a market rate of return on

their investment. When a cooperative has both significant

earnings on nonpatronage business and a substantial dividend

obligation to meet, the DAR could be a serious additional cost of

carrying that additional financing.

The following example illustrates the impact of the DAR:

Facts: Cooperative A earns $1000 in a given year. Eightypercent ($800) is patronage-sourced and 20 percent ($200) is

nonpatronage-sourced. The cooperative pays dividends on its

capital stock totaling $125 per year.

Under the DAR: Assuming Cooperative A is in the 34% tax

bracket, it would owe a corporate income tax of $68 on its
116

nonpatronage sourced income ($200 x .34), leaving $132 in taxpaid nonpatronage-sourced earnings.

Under the DAR, $100 of the stock dividend would have to be

paid out of patronage-sourced income ($125 x .8), reducing the

amount that can be allocated to patrons as patronage refunds and

excluded from tax at the cooperative level to $700 ($800-$100).

This $100 is now subject to corporate income taxation at the

cooperative level because it is distributed on the basis of

investment rather than patronage. As Cooperative A is in the 34%

tax bracket, it would owe an additional corporate income tax of

$34 ($100 x .34). The cooperative’s total tax liability is $102 ($68

on its nonpatronage earnings + this $34 on patronage earnings).

The “triple” tax: Cooperatives described the DAR as

imposing an unfair “triple tax” on the relevant part of their

income. Using the example above, that triple tax is computed as

follows:

1. The cooperative pays $68.00 ($200 x .34) in tax on its

nonpatronage-sourced earnings.

2. The investors will pay a tax on the dividends they

receive at their personal marginal tax rates. Assuming they are

in the 25% tax bracket, this tax would total $31.25 ($125 x

.25).

3. The cooperative pays $34.00 ($100 x .34) in tax on its

patronage-sourced income distributed on the basis of

investment, not patronage.

DAR repeal: Without the DAR, Cooperative A pays the $125

stock dividend with its $132 of tax-paid nonpatronage-sourced

earnings. This allows the entire $800 of patronage-sourced

earnings to be distributed as patronage refunds and excluded from

taxable income at the cooperative level.

Now Cooperative A is taxed the same on its stock dividends

as a regular corporation. The co-op owes tax on its nonpatronage

earnings used to pay the dividends. The investors will pay a

second tax on the dividends they receive, just as they would on
 The Taxpayer Refund and Relief Act of 1999, H.R. 2488, 106th 279

Cong, 1st Sess., § 1335.

American Jobs Creation Act of 2004, § 312, Pub. L. No. 108- 280

357, 118 Stat. 1467 (codified at 26 U.S.C. § 1388(a)). See also, H.R.

Conf. Rept. No. 755, 108th Cong., 2d Sess. at 318-319.

117

dividends from a non-cooperative corporation. But elimination of

the third tax on patronage earnings reduces the cooperative’s tax

liability from $102 to $68, creating a tax savings of $34 over

current law.

In 1998, cooperatives began a concerted effort to enact

legislation overturning the DAR. For example, appropriate

language was included in the proposed Taxpayer Refund and

Relief Act of 1999 that passed both houses of Congress, but was 279

vetoed for other reasons by President Clinton.

In 2004, cooperatives secured repeal of the DAR. The

American Jobs Creation Act of 2004 adds a new paragraph to

Code sec. 1388(a). It states that--to the extent provided in a

cooperative's articles, bylaws, or a contract between the

cooperative and its patrons--net earnings available for distribution

as patronage refunds shall not be reduced by dividends on capital

stock or other proprietary capital interests.

280

The provision is not self-executing. To take advantage of this

change, the new law requires cooperatives to have appropriate

language authorizing them to pay stock dividends out of

nonpatronage income in their articles of incorporation, bylaws, or

marketing contracts with their members and other patrons.

Cooperatives that pay dividends on equity capital will want to

review their organizational documents to make sure they include

such a provision.
 American Jobs Creation Act of 2004, § 317, Pub. L. No. 108- 281

357, 118 Stat. 1470 (codified at 26 U.S.C. § 7428(a)(1)(D)). See also,

H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess. at 363.

 I.R.C. § 521(b)(1).

282

 This position was not the subject of a published ruling. Rather, 283

it was a position stated by IRS staff at meetings with representatives of

cooperatives involved in this type of value-added marketing activity

who had hoped to receive a letter of exemption under § 521.

118

DECLARATORY JUDGMENT RELIEF

Farmer cooperatives who want access to the special tax

deductions permitted under Internal Revenue Code section 521

and other benefits that come with section 521 status, must apply

for and receive approval from IRS. In the past, the only ways a

cooperative could get a court to review a rejection of its

application was claim a deduction IRS said they weren't entitled

to, or pay some tax they didn't think they owed and then sue for a

refund.

The American Jobs Creation Act of 2004 amends Code sec.

7428(a)(1) to enable a farmer cooperative to seek judicial review

of the denial without first creating a tax controversy or being

subject to immediate tax liability.281

MARKETING INCLUDES VALUE-ADDED

PROCESSING INVOLVING ANIMALS

One ofthe activities that allows a farmer cooperative to qualify

for section 521 tax statusis to engage in "...marketing the products

of members or other producers." IRS interpreted this language 282

to include value-added processing involving a mechanical process

(converting corn to ethanol) but not a biological process (feeding

corn to hens and selling eggs and chickens).283

The American Jobs Creation Act of 2004 adds a new

subsection (k) to Code sec. 1388 to make it clear that under both
American Jobs Creation Act of 2004, § 316, Pub. L. No. 108- 284

357, 118 Stat. 1469 (codified at 26 U.S.C. § 1388(k)). See also, H.R.

Conf. Rept. No. 755, 108th Cong., 2d Sess. at 362.

 I.R.C. § 40(b)(4)(A). 285

 I.R.C. § 40(g)(1).

286

 I.R.C. § 40(b)(4)(C). 287

American Jobs Creation Act of 2004, § 313, Pub. L. No. 108- 288

357, 118 Stat. 1467 (codified at 26 U.S.C. § 40(g)(6)). See also, H.R.

Conf. Rept. No. 755, 108th Cong., 2d Sess. at 517-518.

119

section 521 and regular cooperative tax rules, marketing products

of members and other producers includes feeding products of

members and other producer to cattle, hogs, fish, chickens, or

other animals and selling the resulting animals or animal

products.284

SMALL ETHANOL PRODUCER CREDIT,

CO-OP PASS-THROUGH

Section 40 of the Code provides a 10-cents-per-gallon tax

credit for each gallon of ethanol produced and sold by so-called

small ethanol producers, including cooperatives. These are 285

companies whose production capacity does not exceed 30 million

gallons of ethanol per year. The credit can be claimed on 286

production of up to 15 million gallons of ethanol per year.

287

The American Jobs Creation Act of 2004 allows cooperatives

to choose to pass some or all of the small ethanol producer credit

through to their patrons. The credit is to be apportioned among

patrons on the basis of the quantity or value of business done with

or for such patrons during the tax year. Any credit not passed

through to patrons is treated as a general business credit by the

cooperative.288
 American Jobs Creation Act of 2004, § 339, Pub. L. No. 108- 289

357, 118 Stat. 1481 (codified at 26 U.S.C. § 45H). See also, H.R. Conf.

Rept. No. 755, 108th Cong., 2d Sess. at 538-539.

 I.R.C. § 45H(b)(1).

290

 I.R.C. § 45H(c)(1).

291

 I.R.C. § 45H(b)(2).

292

 H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess. at 313. 293

I.R.C. § 45H(g). 294

120

SMALL LOW SULFUR DIESEL FUEL PRODUCER

CREDIT, CO-OP PASS-THROUGH

The American Jobs Creation Act of 2004 created a new 5-

cents-per-gallon tax credit to small petroleum refiners who must

incur capital costs complying with the Environmental Protection

Agency's rules limiting the sulfur content of diesel fuel. Eligible

289

refiners may claim the credit until they have recovered 25 percent

of such costs.290

For these purposes a small refiner is one that employs not more

than 1,500 persons directly in refining and has less than 205,000

barrels per day (average) of total refining capacity. The credit 291

is reduced for refiners with a capacity between 155,000 and

205,000 barrels per day. The conferee's report states that when 292

capacity "differs substantially" from average daily output of

refined product, capacity should be measured by reference to

average daily output.293

Cooperatives may also choose to pass some or all of this credit

through to their patrons. As with the small ethanol producer

credit, any pass-through is to be apportioned among patrons on the

basis of patronage and any credit not passed through to patrons is

treated as a general business credit by the cooperative.294