INCOME TAX TREATMENT OF

COOPERATIVES: Distributions, Retains,

Redemptions, and Patrons’ Taxation

Cooperative Information Report 44, Part 3

2005 Edition

Donald A. Frederick
Abstract

INCOME TAX TREATMENT OF COOPERATIVES:

Distributions, Retains, Redemptions and Patrons’ Taxation

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 3

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 correlation between cooperative finance and taxation

involves several elements of the cooperative/patron relationship.

Earnings are allocated to patrons on the basis of the amount of

business they do with the cooperative, not to investors on the

basis of equity ownership. Tax law recognizes that cooperative

margins are allocated directly to patrons and permits

cooperatives to pass through those earnings to patrons much as

a partnership passes through its earnings to its partners.

To accommodate the unique association between a

cooperative and its patrons, the Internal Revenue Code (Code)

has special and sometimes complex rules creating a single tax on

cooperative margins. Part II of this series described the

patronage refund, the basic vehicle for cooperatives to distribute

margins to patrons and for patrons to provide equity capital--

through retained patronage refunds--to their cooperative. This

report examines the additional elements of the cooperative/patron

relationship. It covers how patronage refunds are distributed to

patrons, how the per-unit retain operates as another tool of equity

accumulation for marketing cooperatives, the operation and tax

treatment of methods cooperatives use to redeem outstanding

equity, and looks specifically at how various patronage financing

developments are taxed at the patron level.
4

Highlights

The linchpin of cooperative equity accumulation is the

patronage refund. A patronage refund is a distribution from a

cooperative to a patron, based on the amount of business done

with or for that patron, out of net earnings from business with or

for all patrons. The payment can be made in money or as a

distribution of equity or debt capital in the cooperative.

The Internal Revenue Code (Code) provides that if timely

payment is made, the underlying earnings of the cooperative are

only subject to a single Federal income tax. If the patronage

refund is "qualified" according to procedures in the Code, the tax

obligation is immediately passed through to the patrons. If the

refund is "nonqualified," the tax obligation falls on the cooperative

until the equity is redeemed. Then the tax burden passes

through to the patron.

Marketing cooperatives have another method of distributing

funds and accumulating patronage-based capital that also

qualifies for single tax treatment. The per-unit retain is a

distribution based on the volume or value of product marketed

through the cooperative by the patron. Per-unit retains can be

issued as capital certificates, permitting the cooperative to retain

the underlying funds as equity and debt financing. Retains are

taxed much like patronage refunds, including the option to issue

qualified or nonqualified retain certificates.

Although equity accumulation is one of the biggest challenges

facing cooperatives, each year many associations redeem part of

their patronage-based capital. Equity redemption frequently

focuses on the oldest allocations in the cooperative. Redeeming

the oldest equities, particularly those of persons no longer

patronizing the cooperative, implements the cooperative principle

that financing should come from persons currently benefitting

from the cooperative's services. Tax consequences for the

cooperative and the patron at the time of redemption are

determined by the nature of the allocation and whether the

redemption is for the full face amount of the original equity

distribution.

With few exceptions--notably when members purchase

nondepreciable personal and household goods from their

cooperative--the earnings on all cooperative business activity are
5

subject to Federal income taxation. Ultimately, if not immediately,

that tax burden falls on the patron. The timing and extent of that

tax burden depend on the way those earnings are distributed.

Some cooperative distributions from nonpatronage sources and

patronage-based funds not distributed according to specific rules

in the Code may be taxable to the patron even though a tax was

already paid by the cooperative.

The American Jobs Creation Act of 2004 created a new tax

pass-through deduction and two pass-through energy-related

credits that give cooperatives new flexibility in allocating tax

benefits between the cooperative and its patrons.

The characteristics of payments from a patron to a

cooperative are important in determining if they are deductible

business expenses or nondeductible contributions to capital.
6

Contents

Page

Chapter 7. Patronage Refund Distributions . . . . . . . . . . 11

Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Code Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Taxation in General . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Refund Distribution Basics . . . . . . . . . . . . . . . . . . . . . . . . . 16

Actual Payment to Patrons . . . . . . . . . . . . . . . . . . . . . . 17

Payment Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Timing Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Income Received in a Subsequent Year . . . . . . . . . 23

Federated Cooperatives . . . . . . . . . . . . . . . . . . . . . 24

Pooling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Accounting Method Adjustments . . . . . . . . . . . . . . . 25

Qualified Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Payment in Money or Other Property . . . . . . . . . . . . . . . . . 26

Written Notice of Allocation . . . . . . . . . . . . . . . . . . . . . . . . . 27

Character . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Qualified Written Notice of Allocation . . . . . . . . . . . . . . . . . 31

Redeemable Notice . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Qualification Based on Patron Consent . . . . . . . . . . . . . 34

Written Consent . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Bylaw Consent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

Qualified Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Effective Consent Period . . . . . . . . . . . . . . . . . . . . . . . . 41

Written Consent . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
7

Bylaw Consent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

Qualified Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Deceased Patron's Estate . . . . . . . . . . . . . . . . . . . . 44

The 20-Percent in Money Requirement . . . . . . . . . . . . . 45

Basis of Calculation . . . . . . . . . . . . . . . . . . . . . . . . . 46

Prohibited Payment Forms . . . . . . . . . . . . . . . . . . . 46

Patron's Discretion . . . . . . . . . . . . . . . . . . . . . . . . . 48

Nonqualified Written Notice of Allocation . . . . . . . . . . . . . . 51

Chapter 8. Per-Unit Retain Allocations . . . . . . . . . . . . . . 54

What Is a Per-Unit Retain? . . . . . . . . . . . . . . . . . . . . . . . . . 54

How Per-Unit Retains Are Used . . . . . . . . . . . . . . . . . . 55

Comparison with Patronage Refunds . . . . . . . . . . . . . . 56

Historical Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

Legislative and Regulatory Background . . . . . . . . . . . . . . . 61

Code Definition of a Per-Unit Retain . . . . . . . . . . . . . . . . . . 67

Advances and Per-Unit Retains Paid in Cash . . . . . . . . . . . 70

Per-Unit Retain Certificates . . . . . . . . . . . . . . . . . . . . . . . . . 73

Qualified Per-Unit Retain Certificates . . . . . . . . . . . . . . 75

No Cash Payment Required . . . . . . . . . . . . . . . . . . 77

Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

Qualification Based On Written Agreement . . . . . . . 78

Qualification Based On Bylaw Provision . . . . . . . . . 80

Nonqualified Per-Unit Retain Certificates . . . . . . . . . . . 82

Payment of Per-Unit Retains . . . . . . . . . . . . . . . . . . . . . . . . 83

Payment Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Pooling and Statutory Payment Period . . . . . . . . . . . . . 85
8

Chapter 9. Redemption of Patronage Equity . . . . . . . . . 88

Role of Equity Redemption in Cooperative Finance . . . . . . 88

Tax Treatment of Equity Redemption . . . . . . . . . . . . . . . . . 90

Redemption of Qualified Patronage Equity . . . . . . . . . . 90

Redemption of Nonqualified Patronage Equity . . . . . . . 91

Tax Computation Upon Redemption of

 Nonqualified Equity . . . . . . . . . . . . . . . . . . . . . . . . . . 95

Redemption Year Alternative . . . . . . . . . . . . . . . . . . 96

Prior Year Alternative . . . . . . . . . . . . . . . . . . . . . . . 97

Examples of Nonqualified Redemptions . . . . . . . . . . . . 98

General Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

Change in the Applicable Tax Rate . . . . . . . . . . . . 100

Higher Marginal Tax Rate in Redemption Year . . . 102

Lower Margins or Loss in Redemption Year . . . . . 104

Redemption at Less Than Face Value, for Reasons

 Other Than Loss Recoupment . . . . . . . . . . . . . . . . . . . 107

Cods Sec. 311... . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

The Tax Benefit Rule . . . . . . . . . . . . . . . . . . . . . . . . . 109

Gold Kist Decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Other Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

Chapter 10. Taxation of Patrons . . . . . . . . . . . . . . . . . . 122

Inclusions in Gross Income . . . . . . . . . . . . . . . . . . . . . . . . 124

Exclusion for Personal, Living, or Family Items . . . . . . 124

Exclusion for Adjustment to Basis of

 Depreciable Property . . . . . . . . . . . . . . . . . . . . . . . . 126

Related Patronage Refunds . . . . . . . . . . . . . . . . . 127

Basis Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . 128

When Exclusion Not Available . . . . . . . . . . . . . . . . 130

Taxable Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

Payment Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
9

Money or Other Property . . . . . . . . . . . . . . . . . . . . . . . 135

 Qualified Written Notices and Per-Unit Retains . . . . . . 135

Nonqualified Written Notices and Per-Unit Retains . . . 136

Redemption at Greater Than Face Value . . . . . . . . . . . . . 139

Redemption at Less Than Face Value . . . . . . . . . . . . . . . 142

Sale or Exchange of Equity Interests . . . . . . . . . . . . . . . . 148

Transfer of Rights to Patronize a Cooperative . . . . . . . . . 149

Taxation of Direct Investments . . . . . . . . . . . . . . . . . . . . . 151

Income Not Based on Patronage . . . . . . . . . . . . . . . . . . . 151

Income From Nonpatronage Sources . . . . . . . . . . . . . 152

Not Paid on Patronage Basis . . . . . . . . . . . . . . . . . . . 154

Dividends on Capital Stock . . . . . . . . . . . . . . . . . . . . . 154

Amounts Not Deductible by Cooperative . . . . . . . . . . . 154

Pass-Through Deduction and Credits . . . . . . . . . . . . . . . . 155

Qualified Production Activities Income Deduction . . . . 155

Energy Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

Patron Payments to a Cooperative . . . . . . . . . . . . . . . . . . 157

Contributions to Capital . . . . . . . . . . . . . . . . . . . . . . . . 157

Payments to Cover Operating Losses . . . . . . . . . . . . . 162
10
 The term "patronage refund" (rather than "patronage dividend" as 2

used in the Internal Revenue Code) 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. §§ 1381-1388.

3

11

CHAPTER 7

PATRONAGE REFUND DISTRIBUTIONS

After a cooperative determines its earnings and reviews its

capital needs, it must decide the amount and form of patronage

refunds to be distributed to its patrons. Generally, a cooperative 2

pays the patronage refund in two forms--in money or with a

document representing an equity or debt interest in the

cooperative.

Timely distributions of patronage refunds in money

automatically qualify for single taxation. To likewise qualify for

single tax treatment, the noncash payment document must comply

with the Internal Revenue Code (Code) requirements to be a

"written notice of allocation."

Cooperatives can place the tax obligation for refunds issued as

written notices of allocation on either the cooperative or the

patrons. But whatever method of allocation is chosen, it is subject

to the basic public policy underlying the enactment of subchapter

T of the Code, a single tax is immediately due on the underlying 3

cooperative margins.

Some Code requirements relating to the distribution of

patronage refunds are mandatory in whatever form paid. Other

constraints apply to specific distribution methods. This chapter

describes the forms in which patronage refunds may be paid to

qualify for cooperative tax treatment and the tax collection method

applicable to each form.
 Donald A. Frederick, Income Tax Treatment of Cooperatives: 4

Patronage Refunds, RBS Cooperative Information Report 44, Part 2

(USDA 2005), pp. 9-26.

 The other three distributions are redemptions of nonqualified 5

written notices of allocation, qualified per-unit retain allocations, and

redemptions of nonqualified per-unit retain allocations. Each is

discussed in later chapters of this report.

12

TAX TREATMENT

Alternative tax treatments are often an important factor in

determining the form of a patronage refund, so taxation will be

discussed before the technical aspects of the refund options.

Code Provisions

Code section 1388(a) defines a patronage refund. Rulings and

cases interpreting this definition are covered in Chapter 4 of these

reports. In summary, a patronage refund is an amount paid to a 4

patron by a cooperative on the basis of the quantity or value of

business done with or for such patron. The payment must be made

pursuant to a legal obligation that existed before the transaction

occurred that produced the margin being refunded. The payment

must also be based on net earnings of the cooperative from

business with of for patrons.

The basic rules governing taxation of patronage refunds are in

Code sections 1382(a) and 1382(b)(1). Section 1382(a) states

single tax treatment of payments from a cooperative to its patrons

is only available for distributions described in section 1382(b).

In determining the taxable income of a cooperative, section

1382(b) provides "...there shall not be taken into account amounts

paid during the payment period for the taxable year" in four

specific circumstances. The first is the subject of this chapter and 5

is set forth in Code section 1382(b)(1) as follows:
 I.R.C. § 1382(d).

6

 I.R.C. § 1388(b).

7

 I.R.C. § 1388(c).

8

 I.R.C. § 1388(d).

9

 I.R.C. § 1388(e).

10

 Treas. Reg. § 1.1382-2(b)(1). 11

 I.R.C. § 1385(a)(1), Treas. Reg. § 1.1385-1(a). The tax treatment 12

of patrons is discussed in chapter 10 of this report.

13

...patronage dividends (as defined in section 1388(a)),

to the extent paid in money, qualified written notices of

allocation (as defined in section 1388(c)), or other property

(except nonqualified written notices of allocation (as

defined in section 1388(d)) with respect to patronage

occurring during such taxable year.

As section 1382(b)(1) suggests, several other Code definitions

bear directly on the proper distribution of patronage refunds.

These include the payment period, written notice of allocation, 6 7

qualified written notice of allocation, nonqualified written notice 8

of allocation, and determining the amount paid or received. 9 10

Taxation in General

Patronage refunds fall into one of three categories: money or

other property, qualified written notices of allocation, and

nonqualified written notices of allocation. This section explains

an important difference between the tax treatment of nonqualified

written notices of allocation and other forms of patronage refunds.

This is a key consideration in deciding how the patronage refund

allocation should be structured.

Payments in money or other property are deductible by the

cooperative in the year the underlying patronage business occurs.11

The payments are included in the gross income of the patron

recipients in the year of receipt. Money is valued at face value. 12
 I.R.C. § 1388(e)(1), Treas. Reg. § 1.1382-2(b)(1). 13

 Treas. Reg. § 1.1382-2(b)(1). 14

 I.R.C. § 1385(a)(1), Treas. Reg. § 1.1385-1(a).

15

 I.R.C. § 1388(e)(2), Treas. Reg. § 1.1382-2(b)(1). 16

14

Property is valued at its fair market value.13

Patronage refunds paid in the form of qualified written notices

of allocation are taxed essentially as cash. Qualified written

notices of allocation are deductible by the cooperative in the

taxable year the underlying patronage business occurs. The 14

payments are included in the gross income of the patron recipients

in the year of receipt. Qualified written notices of allocation are 15

taken into account at their stated dollar amount.16

Example A illustrates the tax consequences of a patronage

refund paid in cash, other property, or as a qualified written notice

 

Example A. Patronage Refund Paid in Cash, Other Property,

or Qualified Written Notice Of Allocation

Cooperative Patron

Income $1,000

Expenses Income

 Crop $600 Crop $600

 Other $300

 Total $900

Margin $100 Refund $100

Taxable Income 0 Taxable Income $700

 
15

of allocation. Assume a marketing cooperative pays one producer

$600 for a crop, incurs $300 in additional business expenses for

processing and marketing the crop, and sells it for $1,000.

Any business is allowed to deduct the payment to the patron

for the crop ($600) and other expenses ($300). A cooperative may

also deduct the margin earned when it sells the producer's crop

($100), provided the cooperative returns the margin to the patron

as a patronage refund paid in cash, other property, or a qualified

written notice of allocation. This leaves the cooperative with no

taxable income on its business conducted on a cooperative basis.

The patron includes the $600 crop payment and the $100

patronage refund in gross income, for a total taxable income of

$700. The patron must include the entire $100 patronage refund

in gross income, even if part was paid as a qualified written notice

of allocation.

Example B illustrates the same situation, only the patronage

refund is paid as a nonqualified written notice of allocation.

 

Example B. Patronage Refund Paid as a Nonqualified Written

Notice Of Allocation

Cooperative Patron

Income $1,000

Expenses Income

 Crop $600 Crop $600

 Other $300

 Total $900

Margin $100 Refund $100

Taxable Income $100 Taxable Income $600

 
 I.R.C. § 1382(b)(2), Treas. Reg. § 1.1382-2(c).

17

 I.R.C. § 1385(c), Treas. Reg. § 1.1385-1(b).

18

16

When a noncash patronage refund payment is made using a

nonqualified written notice of allocation, the current obligation to

pay tax on the underlying margin remains with the cooperative.

The cooperative is allowed the $900 in normal business

deductions, including the $600 deduction for the payment to the

patron for the crop. But the $100 margin is taxable income to the

cooperative in the year the patronage occurs.

The patron includes the $600 payment for the crop in gross

income. The patron has no immediate tax liability, however, for

the value of the nonqualified allocation.

When the cooperative redeems the nonqualified written notice

of allocation, the tax obligation is transferred to the patron. The

cooperative is allowed to deduct the value of the money or other

property distributed to the patron. And the patron includes the 17

value of the money or property received in gross income in the

year of receipt.

18

Therefore, in the year the cooperative redeems the $100

patronage refund issued as a nonqualified written notice of

allocation, the cooperative claims a $100 deduction from gross

income and the patron includes the $100 payment in gross income.

The use of nonqualified allocations places a temporary tax

obligation on the cooperative and postpones any tax obligation for

the patron until the patron receives cash or other property to

redeem the nonqualified allocation.

REFUND DISTRIBUTION BASICS

This section details the fundamental requirements that must be

met to protect access to single tax treatment for patronage refunds.

While the rules may seem cumbersome at times, it should be

remembered that a series of court decisions had permitted
 Caswell's Estate v. Commissioner, 211 F.2d 693 (9th Cir. 1954),

19

rev'g, 17 T.C. 1190 (1952); Commissioner v. Carpenter, 219 F.2d 635

(5th Cir. 1955), aff'g, 20 T.C. 603 (1953), acq. 1958-1 C.B. 4; Long

Poultry Farms, Inc. v. Commissioner, 249 F.2d 726 (4th Cir. 1957),

rev'g, 27 T.C. 985 (1957). These cases are discussed in chapter 3 of

these reports, Donald A. Frederick, Income Tax Treatment of

Cooperatives: Background, RBS Cooperative Information Report 44,

Part 1 (USDA 2005) pp. 119-121.

 Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat. 960 (1962), 20

reprinted in 1962-3 C.B. III.

 S. Rep. No. 1881, 87th Cong., 2nd Sess. 111 (1962), reprinted in 21

1962-3 C.B. 703, and 1962 U.S. Code Cong. & Admin. News 3304,

3414-3415; S. Rep. No. 1707, 89th Cong., 2nd Sess. (1966), reprinted

in 1622-2 C.B. 1055, 1108 and 1966 U.S. Code Cong. & Admin. News

4446, 4515.

 I.R.C. § 1388(a). The provision covering deductibility of 22

patronage refunds also requires that they be "paid." I.R.C. § 1382(b).

 Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). 23

17

cooperatives and patrons to avoid the current single tax obligation

which Congress had intended to create under the Revenue Act of

1951. Subchapter T of the Code was enacted as part of the 19

Revenue Act of 1962 to make sure the single tax due was

20

collected on a current basis.

21

Actual Payment to Patrons

The first rule in establishing tax deductibility at the

cooperative level is that an actual payment must be made to the

patrons. This requirement is based on the Code definition of a

patronage refund as "an amount paid to a patron by (a

cooperative)..." This requirement has two parts, the first is 22

"actual payment" and the second is the payment must be made to

a "patron."

The first condition, actual payment, is addressed in Seiners

Association v. Commissioner. Seiners Association didn't distri- 23
 The time periods within which cooperatives can distribute

24

patronage refunds, called "payment periods," are discussed in a

subsequent section of this chapter.

 Rev. Rul. 55-141, 1955-1 C.B. 337. 25

 Treas. Reg. § 1.1382-2(b)(1). 26

 1968-2 C.B. 373. 27

18

bute the cash portion of its patronage refunds within the

permissible time period for tax deductibility. Rather, patrons had 24

the right to withdraw the cash portion of their refund before the

expiration of the payment period. The cooperative argued that this

constituted constructive receipt sufficient to satisfy the Code

requirements. The U.S. Tax Court disagreed, holding an actual

payment must occur for a distribution of money to be deductible

as a patronage refund.

A cooperative may meet its payment obligation by mailing the

money or written notice of allocation to the last known address of

the refund recipient. Such refunds are considered paid on the date

they normally would be received by the recipients, including any

distributions returned when the addressee cannot be located by

postal authorities and held by the cooperative subject to the

rightful owner's claim.25

The second condition requires that the patronage refunds be

paid to "patrons." Under most circumstances, a cooperative 26

should have little difficulty determining to whom the patronage

refund is paid. Patronage refunds are paid to patrons whose

business with the cooperative produced the margin being returned.

Sometimes payment to patrons will be impossible or

impractical. This following discussion reviews how cooperatives

have handled some of those situations.

Occasionally, a cooperative may find it impossible to locate

patrons to whom refunds are owed. Many States have so-called

escheat laws that require such unclaimed funds be paid to the

State. In Revenue Ruling 68-423, a section 521 cooperative, 27

having ceased operations some years before, attempted to make a
 A section 521 cooperative is permitted to deduct patronage-based 28

allocations of nonpatronage income under I.R.C. § 1382(c). Special

rules for section 521 cooperatives will be discussed in a later report in

this series.

 Rev. Rul. 73-93, 1973-1 C.B. 292. 29

 This dispute first arose over whether Land O'Lakes, Inc., was 30

entitled to section 521 tax status. The first District Court opinion held

the cooperative was eligible for section 521 status. Land O'Lakes, Inc.

v. United States, 362 F. Supp. 1253 (D. Minn. 1973), 1973-2 U.S.T.C.

¶ 9644. This finding was reversed, 514 F.2d 134 (8th Cir. 1975),

1975-1 U.S.T.C. ¶ 9431, cert. denied, 423 U.S. 926. The case was

remanded to the District Court to determine issues resulting from the

cooperative's non-section 521 status. The District Court found the

agent-buyer arrangement permissible, and this determination was

19

cash distribution of nonpatronage income in a bank account to

former patrons as part of its final liquidation. Under the State's 28

escheat law, the cooperative was obligated to turn the funds over

to the state at the time of liquidation.

The IRS permitted the cooperative to deduct the payments,

even though the funds were paid to the State and not the patrons.

IRS noted payment was made to the State within the applicable

payment period for such distributions. It said the State's escheat

law was "custodial" in nature, meaning the rightful owners of the

unclaimed property (cash) paid to the State by the cooperative

could obtain this money by presenting evidence of ownership.

The same logic appears to apply to unclaimed patronage refunds

paid to the State under escheat.

In some circumstances, payment may be made to a patron's

successor in interest, such as the estate of a deceased individual

patron or a successor in interest of a corporate or partnership 29

patron.

Another example of payment to someone other than the patron

occurs when an intermediary is imposed between the cooperative

and the person whom the cooperative wishes to treat as its patron.

In Land O'Lakes, Inc. v. United States, part of the cooperative's 30
affirmed. Land O'Lakes, Inc. v. United States, 470 F. Supp. 238 (D.

Minn. 1979), 1979-1 U.S.T.C. ¶ 9380, aff'd in part, rev'd in part, 675

F.2d 988 (8th Cir. 1982), 1982-1 U.S.T.C. ¶ 9326.

 Land O'Lakes, Inc. v. United States, 362 F. Supp. 1253, 1261 (D. 31

Minn. 1973).

20

business consisted of selling agricultural supplies to agent-buyers

who resold the supplies to members and other patrons. The agentbuyer, a nonmember-nonproducer, was used in geographical areas

where the cooperative had no member-cooperatives or company

stores. The agent-buyer executed a contract with the cooperative

to agreeing to provide the cooperative with all invoices based on

sales of supplies to producers.

At the end of each year, the cooperative distributed patronage

refunds directly to producers who purchased supplies from the

agent-buyer as reflected by the invoices. The cooperative treated

the agent-buyer as an agent of the farmer producers. The courts

ultimately concurred with this treatment. While several decisions

emanated from this litigation, the original U.S. District Court

opinion addresses this issue most succinctly:

Plaintiff's reliance on agency principles to support its

argument that the agent-buyer was acting in a fiduciary

capacity on behalf of the producer-customers appears to be

a strained legal position, but the Court believes the

contract between Land O'Lakes and the agent-buyers was

a permissible arrangement and not violative of the statute.

The evidence established that the use of the agent-buyer

was necessitated by a lack of other facilities to adequately

provide for the supply needs of the producer-customers.

The government has not made any showing that the agentbuyers breached the contract or acted in any manner

contrary to the intended purpose of the arrangement to

supplement the lack of supply outlets for the benefit of the

producer-customers.

31
 Land O'Lakes, Inc. v. United States, 675 F.2d 988, 991 (8th Cir.

32

1982).

 I.R.C. § 1382(b).

33

 I.R.C. § 1382(d).

34

21

The final opinion in this case found Code support for Land

O'Lakes' position. The court noted that Code section 1388(c)(1)

defines a qualified written notice of allocation as a notice which

the "distributee" consents to include in his own income. The court

interpreted the word "distributee" to be broader than "patron," and

concluded that the refunds paid directly to the farmer-customers

pursuant to the agent-buyer agreements were properly deductible

by Land O'Lakes as patronage refunds.32

Payment Period

A cooperative's ability to deduct patronage refunds is

conditioned not onlyon actual payment to patrons but also on such

payments being made within a certain time period.

The Code requires cooperative payment of patronage refunds

to take place "during the payment period for the taxable year."33

The "payment period" for payment of patronage refunds "is the

period beginning with the first day of such taxable year and ending

with the fifteenth day of the ninth month following the close of

such year." This encompasses the cooperative's taxable year plus 34

the following 81⁄2 months. For example, a cooperative on a

calendar-year tax year has until September 15th of the following

year to distribute its patronage refunds.

Although refunds to patrons may be made before the end of a

cooperative's taxable year, in most cases it is impossible to

complete the process by the last day of the taxable year. The

cooperative's financial results for the year have to be computed

before the actual margin available as a patronage refund can be

determined. The Code, therefore, allows cooperatives a grace

period following their taxable year to complete the payment
 I.R.C. § 6072(d).

35

Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). The payment 36

period ended August 15. Payments on August 18 of one year and

September 18 the next failed to qualify for cooperative tax treatment.

 58 T.C. 949 (1972). 37

22

process. However, payment maynot be delayed beyond the period

established by the Code.

The payment period is coordinated with the tax return filing

deadline for cooperatives. Generally, qualifying cooperatives have

81⁄2 months following the end of the taxable year to file their

income tax returns. This provides time for cooperatives to 35

compute, allocate, and distribute their patronage refunds before

finalizing their tax return for the year.

If a refund is not paid to patrons during the permitted payment

period to which the refund relates, the payment no longer qualifies

for cooperative single tax treatment. The U.S. Tax Court held that

a refund that met all the other requirements of the Code, but was

paid 3 days late, was not deductible.36

If the cooperative's actions regarding patronage refunds during

the payment period fail to qualify as a "payment," subsequent

actions can't retroactively cause such distributions to become

acceptable. In Seiners Association v. Commissioner, the 37

cooperative provided its patrons with financial statements during

the payment period. The statements contained figures from which

a patron could calculate the refunds due assuming the patron kept

all records of transactions with the cooperative for the year. After

the payment period expired, the cooperative distributed cash and

written notices of allocation.

The Tax Court held (1) the actions taken during the payment

period did not qualify as payment in cash or as written notices of

allocation and (2) the cooperative's subsequent actions could not

correct deficiencies occurring during the payment period. The

court said a cooperative must meet "very definite rules to deduct
Id. at 955.

38

 Priv. Ltr. Rul. 8604011 (October 25, 1985).

39

 I.R.C. § 1382(b)(1). 40

 For example, Priv. Ltr. Rul. 7936017 (May 31, 1979).

41

23

patronage (refunds) from its taxable income."38

A cooperative's patronage refund payments may be made

within the payment period and qualify as patronage refunds for the

taxable year even though the cooperative lost its cooperative

character as of the last day of its taxable year. IRS permitted a

cooperative that converted to a noncooperative corporation and

terminated its taxable year upon the conversion to deduct

patronage refunds paid to former patrons after the conversion, but

before the expiration of the payment period.39

Timing Problems

The Code includes the general rule that a patronage refund

deduction must be based on patronage occurring during the tax

year the deduction is claimed. In several instances, a cooperative 40

may not be able to make a final determination of its margins until

well after the end of the payment period for the year the patron

conducted the business that generated the margin. The coop must

determine the tax year the patronage occurred because patronage

refunds can only be paid in the payment period for that year.

Income Received in a Subsequent Year

Cooperatives may receive income based on patronage which

took place in prior years. A patron may deliver product to a

marketing cooperative in one year. The cooperative processes and

stores the product and doesn't sell the processed product until the

following year. While patronage occurred in the tax year delivery

was made, the income generated from that patronage is not created

until a subsequent year. A similar result may arise when the

patron and cooperative have different tax years.

41
 I.R.C. § 1382(f) and Treas. Reg. § 1.1382-6. See, e.g., Priv. Ltr.

42

Rul. 7951127 (Sept. 24, 1979) (income realized by a § 521 cooperative

from the sale of a capital asset on the installment basis); Priv. Ltr.

Rul. 8142166 (July 24, 1981) (raw product delivered in one year is

processed and the finished goods sold in a subsequent year).

 Kingfisher Cooperative Elevator Ass'n. v. Commissioner, 84 T.C. 43

600 (1985).

24

Code section 1382(f) recognizes this timing difference by

assigning patronage to the taxable yearthat income is created. The

cooperative recognizes the income for tax purposes in the year of

receipt. The margin on that business qualifies for single tax

treatment if allocated and distributed in an appropriate manner

within the payment period for the year of receipt.

42

Federated Cooperatives

A common situation leading to receipt of income by a

cooperative in years following its dealings with patrons occurs

when the cooperative is part of a federated system. A local

cooperative may deliver patrons' products to a federated

cooperative for further processing and marketing. A period of one

or more years commonly passes before the local receives a

patronage refund based on that business from the federated.

The U.S. Tax Court, citing section 1382(f), held that a local

cooperative may include a patronage refund from a federated in

gross income in the year of receipt and pass the amount received

through to patrons of that year as a deductible patronage refund.43

Pooling

If a cooperative markets under a pooling arrangement and the

pool isn't closed until a tax year (or several tax years) following

the patrons' delivery of product into the pool, the calculation of

patronage refunds must await the final accounting for that pool.

The Code has a special provision dealing specifically with

products marketed under a pooling arrangement. Section 1382(e)

recognizes the timing problem inherent in pooling by assigning all
 I.R.C. § 1382(e)(1) and Treas. Reg. § 1.1382-5. The regulation 44

contains a simple example illustrating this point.

 Treas. Reg. § 1.1382-5. 45

 Rev. Rul. 74-327, 1974-2 C.B. 173. 46

 I.R.C. § 1382(f), Treas. Reg. § 1.1382-6. 47

25

patronage to "the taxable year in which the pool closes." The 44

regulations provide that the circumstances of each case will be

considered in determining when a pool is closed, but generally the

procedures of the cooperative will be followed.45

Accounting Method Adjustments

The requirement that patronage refunds be paid during the

statutory payment period may cause hardship to cooperatives

whose accounting methods are adjusted in years following the

taxable year. The determinative factor is the tax year in which

income is recognized.

Patronage-sourced income may be created in one tax year, but

not refunded to patrons within the payment period for that tax year

because the income wasn't recognized in time to make payments.

In that case, any subsequent payment of refunds based on that

income may not qualify as payment during the payment period.

In Rev. Rul. 74-327 an IRS audit conducted in 1973 resulted 46

in a disallowance of a portion of the depreciation claimed by a

cooperative in 1970 and 1971. IRS held the income resulting from

adjustments to depreciation was correctly included in the

cooperative's gross income for the years under examination.

While noting Code section 1382(f), IRS found it inapplicable.

If income relating to a cooperative's patronage during one tax

year is recognized as patronage income in a subsequent tax year,

the payment period for the subsequent tax year applies.47
 Qualified checks are defined at I.R.C. § 1388(c)(4). They are 48

discussed in more detail later in this chapter.

 I.R.C. § 1382(d).

49

See Priv. Ltr. Rul. 7728030, (no date), 1977. 50

 Treas. Reg. §§ 1382-2(b)(1), 1.1388-1(c)(1)(ii). 51

 Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). 52

26

Qualified Checks

Patronage refunds paid in qualified checks also raise a timing 48

consideration. The Code says a qualified check issued during the

payment period is to be treated as an amount paid in money during

that payment period if it is "endorsed and cashed" on or before the

90th day after the period closes. Tax treatment of a qualified 49

check depends on whether the recipient cashes it, a fact that may

not be known until after the payment period ends. A cooperative

that issues qualified checks may have to file its income tax return

as much as 90 days before it knows whether some payments are

qualified or nonqualified.50

PAYMENT IN MONEY OR OTHER PROPERTY

Most cooperatives pay at least some of their patronage refunds

in "money." The term "money" covers cash, regular bank checks,

and "qualified checks." Payment of patronage refunds in money 51

requires more than a right to receive payment from the

cooperative. It requires actual payment.52

Patronage refunds may also be paid in the form of property.

While this is not a usual form of payment, it may give the

cooperative a mechanism to satisfy its patronage refund

obligations without a cash drain on the cooperative or requiring

patrons to take an equity interest in the cooperative.

When patronage refunds are paid in property, the value of the

property determines the amount of the cooperative's deduction and
 I.R.C. § 1388(e)(1); see also, Treas. Reg. § 1.1382-2(b)(1). 53

 Priv. Ltr. Rul. 7738016 (June 22, 1977).

54

 For description of such practices, see Farmers Cooperative Co. v. 55

Birmingham, 86 F. Supp. 201 (N.D. Iowa 1949); and Farmers

Cooperative Co. v. Commissioner, 288 F.2d 315 (8th Cir. 1961), rev'g,

33 T.C. 266 (1959).

 Rev. Rul. 55-66, 1955-1 C.B. 282. 56

27

the patron's income. The Code states that property shall be taken

into account at its fair market value.53

In one instance, a cooperative was acquired by another

corporation. In its last taxable year prior to merger, the co-op

became obligated to pay patronage refunds to patrons. It paid the

refunds partly in money and partly in shares of stock of the

acquiring corporation. The acquiring corporation's stock was

valued at par value in computing the patronage refund deduction.54

WRITTEN NOTICE OF ALLOCATION

Payment of patronage refunds with a document evidencing an

equity or debt interest in the cooperative rather than payment in

cash was a recognized practice before the formal definition of a

written notice of allocation appeared in Subchapter T in 1962.55

Payment through such a written notice was considered

payment in money to the patron, followed by either reinvestment

in the cooperative's capital or a loan to the cooperative.56

Written notices of allocation permit cooperatives to combine

the payment of refunds with other financing objectives. Patrons

receive these notices as a return based on proportion of business

done with their cooperative. They represent the culmination of a

patronage relationship between the cooperative and patron. At the

same time, written notices of allocation are a means of acquiring

patron financing through capital contributions in proportion to use

of the cooperative's services.
 Treas. Reg. § 1.1388-1(b).

57

 I.R.C. § 1388(b).

58

 Treas. Reg. § 1.1388-1(b).

59

28

These notices are an important determinant in taxable events.

They represent payments to patrons by the cooperative, the receipt

of income by patrons, the cooperative's receipt of capital contributions, and capital investments by patrons.

The following sections describe the character of written

notices of allocation, the form they may or must take, their

contents, and how they are distributed.

Character

A written notice of allocation is a disclosure to each patron of

that patron's patronage payment. Treasury Department regulations

provide that the notice shall report the entire "stated dollar amount

allocated [to the patron] on the books of the cooperative."57

A written notice of allocation usually evidences a contribution

to the cooperative's equity capital. It is not restricted, however, to

equity. This notice can represent a loan to the cooperative. The

Code definition of a written notice of allocation includes the term

"certificate of indebtedness."58

Form

These notices of allocation must be in writing. A mere credit

to a patron's account on the cooperative's books, without written

disclosure to the patron, does not qualify.59

The cooperative must issue a written notice of allocation to

each patron receiving a patronage refund (unless the patronage

refund is to be paid entirely in money). The Code lists documents

that may qualify as written notices of allocation including "capital
 I.R.C. § 1388(b) and Treas. Reg. § 1.1388-1(b).

60

 Priv. Ltr. Rul. 8138144 (June 26, 1981).

61

 Preferred stockwith these characteristicswas described in Agway 62

Inc. v. United States, 524 F.2d 1194 (Ct. Cl. 1975), 1975-2 U.S.T.C. ¶

9777, a pre-subchapter T situation, thus not a "written notice of

allocation."

See Priv. Ltr. Rul. 8505001 (May 15, 1984) where the cooperative 63

issued two classes of common stock. The class issued as a written

notice of allocation was nonvoting.

 I.R.C. § 1388(b) and Treas. Reg. § 1.1388-1(b). 64

29

stock, revolving fund certificate, retain certificate, certificate of

indebtedness, letter of advice, or other written notice."60

If capital stock is part of a written notice of allocation, it is

usually issued as some form of preferred stock. Common stock 61

usually certifies membership. Its issuance is unrelated to the

amount of business conducted with the cooperative. Preferred

stock issued as a written notice of allocation can have all the

attributes of ordinary preferred stock, including transferability,

right to dividends on capital stock, and preferences of various

kinds. Cooperatives may use a special class of common stock 62

rather than preferred stock as part of a written notice of

allocation.63

The Code doesn't elaborate further on the form of a written

notice of allocation. However, certain information must be

included in a written notice of allocation regardless of its form.

Contents

The Code states a written notice of allocation must disclose to

the recipient "the stated dollar amount allocated to him by the

organization and the portion thereof, if any, which constitutes a

patronage [refund]." This awkward language is usually applied 64

by cooperatives so that the notice reports: (1) the total patronage

refund allocated to the patron, (2) the amount returned at the time
 Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). 65

30

of the allocation in the form of money or other property, and (3)

the amount retained as a contribution to capital (1 less 2).

The written notice can't be presented in a manner that requires

the recipient to compute the payment amount. In Seiners

Association v. Commissioner, each member received a receipt or 65

invoice at the time it purchased supplies from the cooperative.

The patronage refund due each member could be calculated by

multiplying the member's total purchases for the year by a

percentage factorset forth in the cooperative's financial statements

issued at the annual meeting following the taxable year. The

financial statements reported the cooperative's earnings for the

year, the total amount available for "members' rebates," and the

percentage factor upon which individual rebates could be

calculated.

Members, who kept all of their purchase records for the year,

could determine their allocable patronage refund by multiplying

the percentage figure given in the financial statements by the

amount of their purchases. However, the financial statements

distributed at the annual meetings did not by themselves contain

sufficient information for the members to compute their allocable

shares.

The court ruled the combination of financial statements and

receipts provided by the cooperative did not constitute a written

notice of allocation. The court stated:

Even assuming that the members kept adequate

records, they would still have been put to the task of

making correct calculations to determine the allocable

stated dollar amount. Therefore it is obvious that on their

face these documents did not reveal a stated dollar amount.

The available documents showed no individual dollar

amounts whatsoever. Clearly the type of instrument

intended by Congress as sufficient to meet the
Id. at 957.

66

 I.R.C. § 1388(b) and Treas. Reg. § 1.1388-1(b).

67

 Treas. Reg. § 1.1388-1(b).

68

 Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). 69

See I.R.C. § 1388(c)(1)(A) and Treas. Reg. § 1.1388-1(c)(2). 70

31

requirements of a written notice of allocation is that notice

which petitioner sent out after the close of the payment

periods.66

The written notice of allocation must disclose to the patron the

portion of the allocation, if any, which constitutes a patronage

refund. If the notice partly represents an allocation of a 67

patronage refund eligible for single tax treatment and partly a

distribution of cooperative income not qualifying for a patronage

refund deduction, the patron must be informed of that fact in the

notice. The portion constituting a patronage refund may be

disclosed either as a stated dollar amount or a percentage of the

face amount of the written notice of allocation.68

Distribution

Just as the money portion of a patronage refund must be

"paid," so written notices of allocation must be distributed to

patrons entitled to receive them. Most are distributed by mail.

The process must assure that all portions of a written notice of

allocation are actually distributed.69

QUALIFIED WRITTEN NOTICE OF ALLOCATION

A "qualified" written notice of allocation is a special kind of

notice. Notices are qualified in two ways. One way is based on

redemption rights assigned to the written notice of allocation by

the cooperative when issued. The other is to have the recipient 70
See I.R.C. § 1388(c)(1)(B) and Treas. Reg. § 1.1388-1(c)(3). 71

 I.R.C. § 1388(c)(1). 72

 I.R.C. § 1388(e)(2). 73

 I.R.C. § 1388(c)(1)(A). 74

32

consent to include the stated dollar amount of the notice in gross

income for tax purposes in the year of receipt. In either case, at

71

least 20 percent of the patronage refund reported by the written

notice must be paid in money or by qualified check.72

If a written notice is "qualified," then the portion of the

patronage refund retained by the cooperative is taxed essentially

the same as a cash distribution. The retained funds are deductible

by the cooperative in the taxable year the underlying margin was

earned. Both the cash distribution and the retained funds must be

included in gross income of the recipient in the year of receipt.

For purposes of determining the dollar amounts paid by the

cooperative and received by patrons, a qualified written notice of

allocation "shall be taken into account at its stated dollar

amount." Both the deduction taken by the cooperative and the 73

income received by patrons are based on the stated dollar amount

of the notice.

Redeemable Notice

One method of qualifying a written notice of allocation is

based on the document's redemption characteristics. The Code

defines a qualified written notice in redeemable form as:

(A) written notice of allocation which may be

redeemed in cash at its stated dollar amount at any time

within a period beginning on the date such written notice

of allocation is paid and ending not earlier than 90 days

from such date, but only if the distributee receives written

notice of the right of redemption at the time he receives

such written notice of allocation...74
 I.R.C. § 1388(c)(1)(A) and Treas. Reg. § 1.1388-1(c)(2). 75

 I.R.C. § 1388(c)(1)(A). The cooperative may, if it wishes, give 76

patrons a longer time period in which to exercise the redemption option.

 I.R.C. § 1388(c)(1)(A) and Treas. Reg. § 1.1388-1(c)(2). 77

 Treas. Reg. § 1.1388-1(c)(2). 78

 I.R.C. § 1382(b)(1). 79

 I.R.C. § 1388(c)(1). 80

33

A written notice relying on redemption rights for qualification

must be redeemable in cash at its stated dollar amount. The 75

cooperative must stand ready to give the patron full cash payment

of the stated dollar amount at any time during the appropriate

payment period. That period begins on the date the written notice

is "paid" (distributed to the patron) and continues for 90 days.76

If a patron chooses not to redeem the notice during the

specified time period, the cooperative may redeem the notice as it

would any other written notice of allocation. The patron's choice

not to redeem does not destroy the notice's qualified status.

The recipient of a redeemable written notice of allocation must

also receive written notification of the right to redeem it in cash.

The notification and the written notice of allocation must be

separate documents but may be given simultaneously to each

patron. Publishing the notification in a newspaper or posting it 77

at the cooperative's place of business is not sufficient.78

A cooperative can deduct the full face value of a redeemable

qualified written notice of allocation, provided at least 20 percent 79

of the entire patronage refund was paid in cash when the

redeemable notice as distributed. If the patron does not seek

80

redemption during the given redemption period, the cooperative

has no further cash outlay until redeeming the written notice of

allocation at some later date.
 I.R.C. § 1388(c)(1)(B) and Treas. Reg. § 1.1388-1(c)(3). 81

 I.R.C. § 1388(c)(2)(A) and Treas. Reg. § 1.1388-1(c)(3)(i).

82

 I.R.C. § 1388(c)(2)(B) and Treas. Reg. § 1.1388-1(c)(3)(ii). 83

 I.R.C. § 1388(c)(2)(C) and Treas. Reg. § 1.1388-1(c)(3)(iii).

84

See Independent Cooperative Milk Producers Ass'n v. 85

Commissioner, 76 T.C. 1001 (1981).

 I.R.C. § 1388(c)(2)(A) and Treas. Reg. § 1.1388-1(c)(3)(i).

86

 Treas. Reg. § 1.1388-1(c)(3)(i).

87

See Treas. Reg. § 1.61-5(d)(2)(ii) and Independent Cooperative 88

Milk Producers Ass'n v. Commissioner, 76 T.C. 1001, 1016, n. 25

(1981).

34

Qualification Based on Patron Consent

A second way to qualify a written notice of allocation requires

the distributee to consent to include the stated dollar amount of the

allocation in gross income in the year received."81

The patron consent requirement is satisfied through a written

consent agreement, a bylaw provision, or the distributee 82 83

endorsing and cashing a qualified check. These are the only 84

permissible means for obtaining patron consent.85

Written Consent

One way to obtain patron consent is through a written statement, signed by the distributee, and furnished to the cooperative.86

No specific form or words are needed as long as the document

"clearly discloses the terms of the consent."87

The regulations provide a general consent form for per-unit

retains which can be used for written notices of allocation with

appropriate changes in the instrument's description. The sample

88

language reads:

I agree that, for purposes of determining the amount I

have received from this cooperative in payment for my

goods, I shall treat the face amount of any per-unit retain
 Treas. Reg. § 1.61-5(d)(2)(ii). 89

 Priv. Ltr. Rul. 8023018 (Feb. 27, 1980). This ruling focused on 90

bylaw provisions whose terminology did not correspond exactly to the

names given the written notices of allocation.

 Treas. Reg. § 1.1388-1(c)(3)(i).

91

 Priv. Ltr. Rul. 8023018 (Feb. 27, 1980) and Priv. Ltr. Rul.

92

8850027 (Sept. 16, 1988).

 Independent Cooperative Milk ProducersAss'n v. Commissioner,

93

76 T.C. 1001 (1981). The bylaw consent was not effective standing

35

certificates issued to me on or after as representing a cash distribution which I have constructively

received and which I have reinvested in the cooperative.89

A written consent may refer to written notices of allocation

generally without being precise as to the name of the document.

The Service approved a consent provision in a membership

agreement that said:

The producer agrees the amount of any allocation with

respect to his patronage occurring after October 1, 1963,

indicated in written notice of allocation received by him

from the Association, will be reported by him to the

Director of Internal Revenue as income in the taxable year

in which the notice of allocation is received.90

According to the regulations, written consent may be on "a

signed invoice, sales slip, delivery ticket, marketing agreement, or

other document, on which appears the appropriate consent." A 91

membership agreement containing a required consent provision in

express terms is also effective.92

However, a signed membership agreement in which the

member agrees to abide by the cooperative's "rules and

regulations" will not make a bylaw provision effective as a written

consent. Similarly, an endorsed patronage refund check may 93
alone because a copy of the provision was not provided to members.

Id. at 1014, n.20. 94

 Compare with bylaw consent which applies only to members. 95

 Such as when a cooperative deals with nonmembers on a 96

patronage basis (eliminating the membership agreement option).

 I.R.C. § 1388(c)(2)(B) and Treas. Reg. § 1.1388-1(c)(3)(ii). 97

 Sometimes referred as consent by membership, as in Treas. Reg. 98

§ 1.1388-1(c)(3)(ii).

 I.R.C. § 1388(c)(2)(B)(i).

99

 I.R.C. § 1388(c)(1)(B). 100

36

provide written consent, but only if it contains "express terms by

which the signer" gives consent.94

Written consent is effective for anyone signing the consent

document. It doesn't depend on membership in the cooperative.95

The cooperative should choose the most appropriate document

based on convenience and its method of operation. In some

circumstances, a separate document whose only content is a

consent provision may be the only appropriate means.

96

Bylaw Consent

Another way of obtaining patron consent to qualify a written

notice of allocation is through a cooperative bylaw provision.97

Bylaw consent differs from written consent in that bylaws are not 98

documents signed by members. As a result, the formalities for

bylaw consent are devised to insure that consent is an informed

consent despite the absence of a signature. The bylaw provision

must meet certain requirements as to form and applies only to

cooperative members who have been properly notified.

A consent provision in the bylaws must provide "that

membership in the organization constitutes such consent" and 99

that the recipient agrees to take the distribution "into account at its

stated dollar amount...." The regulations provide an example of 100

an appropriate bylaw consent provision. It states:
 Treas. Reg. § 1.1388-1(c)(3)(ii)(b).

101

 Priv. Ltr. Rul. 8023018 (Feb. 27, 1980).

102

 I.R.C. § 1388(c)(2)(B). 103

 Treas. Reg. § 1.1388-1(c)(3)(ii)(c).

104

 Treas. Reg. § 1.1388-1(c)(3)(ii)(a).

105

37

Each person who hereafter applies for and is accepted

to membership in this cooperative and each member of this

cooperative on the effective date of this bylaw who

continues as a member after such date shall, by such act

alone, consent that the amount of any distributions with

respect to his patronage occurring after....., which are made

in written notices of allocation (as defined in 26 U.S.C.

1388) and which are received by him from the cooperative,

will be taken into account by him at their stated dollar

amounts in the manner provided in 26 U.S.C. 1385(a) in

the taxable year in which such written notices of allocation

are received by him.

101

The sample provision doesn't name a particular document to

serve as the written notice of allocation. Under this language, any

written instrument otherwise conforming to the Code requirements

can suffice. If a bylaw consent provision adopts more specific

terminology, the instrument issued must conform to the bylaw

provision.102

Bylaw consent is effective for current members at the time the

provision is adopted and for members who join a cooperative with

a consent provision in place. "Member means a person who is 103

entitled to participate in the management of the cooperative

organization."104

A bylaw consent provision applies only to members.

105

Cooperatives must use one of the two other consent methods for

qualifying written notices with respect to nonmember patrons.

Being a member of a cooperative with a consent provision in

its bylaws does not, by itself, meet the Code requirement for by-
 I.R.C. § 1388(c)(2)(B)(ii); Treas. Reg. 1.1388-1(c)(3)(ii)(a).

106

 Treas. Reg. § 1.1388-1(c)(3)(ii)(a).

107

Id.

108

Id.

109

Id.

110

Id.

111

 Independent Cooperative Milk Producers Ass'n v. Commissioner,

112

76 T.C. 1001 (1981).

Id. at 1015. 113

38

law consent. Members at the time the bylaw is adopted, and

persons who become members later, must receive "a written

notification and copy of such bylaw...."106

This notice must inform patrons that the bylaw has been

adopted and state its tax significance. Both notification and a 107

copy of the bylaw must be given to each member or prospective

member. A written notice and bylaw can't be merely published 108

in a newspaper or posted at the cooperative's place of business.109

The notice and bylaw can be mailed; and a member or

prospective member is "presumed to have received" the notice and

bylaw if they are sent to the last known address by "ordinary

mail." For prospective members, both documents must be 110

received prior to obtaining membership for consent to be

effective.111

Whether a cooperative uses written or bylaw consent, it must

meet all requirements to make the consent effective. In Independent Cooperative Milk Producers Ass'n v. Commissioner, the 112

Tax Court did not allow one signed document that lacked the

express consent provision (marketing agreement) to incorporate

another document (bylaws) that contained the necessary consent

language. The court believed explicit reference to the patron's

consent on the face of the writing "is best suited to achieve the

certainty the statute was intended to produce."113
 Citing Treas. Reg. § 1.1388-1(c)(3)(i).

114

 Independent Cooperative Milk Producers Ass'n v. Commissioner,

115

76 T.C. 1001, 1017 (1981).

 I.R.C. § 1388(c)(4). 116

 I.R.C. § 1388(c)(4). 117

 Treas. Reg. § 1.1388-1(c)(3)(iii)(b). 118

39

The Tax Court also looked to the regulations which indicate

the signature and consent must appear in the same document and 114

concluded that the specificity of all Code consent require-ments

suggests a strict approach requiring "unambiguous, affirmative

acts of consent...."115

Qualified Check

A third means of qualifying written notices of allocation is to

issue a "qualified check," defined by the Code as:

...a check (or other instrument which is redeemable in

money) which is paid as a part of a patronage [refund]... on

which there is clearly imprinted a statement that the

endorsement and cashing of the check (or other

instrument) constitutes consent of the payee to include in

his gross income, as provided in the Federal income tax

laws, the stated dollar amount of the written notice of

allocation which is a part of the patronage [refund] or

payment of which such qualified check is also a part.

116

A check must meet requirements as to its form, the payment it

represents, the recipient, and the consent statement to be

"qualified." And this type of consent is effective only if the

recipient takes specific action.

The instrument must be in the form of a check or "other

instrument which is redeemable in money." It doesn't have to be 117

an ordinary check payable through the banking system. It can be

an instrument redeemable in money by the cooperative.118
 I.R.C. § 1388(c)(4). 119

 I.R.C. § 1388(c)(4); Treas. Reg. §§ 1.1388-1(c)(3)(iii)(a) and (b). 120

 Treas. Reg. § 1.1388-1(c)(3)(iii)(a). 121

 I.R.C. § 1388(c)(4). 122

Id.

123

 I.R.C. § 1388(c)(2)(C). 124

Id.

125

 Treas. Reg. § 1.1388-1(c)(3)(iii)(a). Compare with redeemable 126

written notices of allocation, where the redeemable period must extend

for at least 90 days. I.R.C. § 1388(c)(1)(A).

 Treas. Reg. § 1.1388-1(c)(3)(iii)(a). 127

40

A qualified check must be paid as part of a patronage refund.119

Section 521 cooperatives may also use qualified checks to

distribute nonpatronage sourced income. Consent obtained by 120

means of a qualified check relates only to those written notices of

allocation which are part of the same patronage refund or payment

as the qualified check.121

Finally, the consent language for a qualified check must be

"clearly imprinted" on the check itself. The consent form may 122

not be a loose enclosure mailed or delivered to the patron, nor may

the consent be attached to the check. The recipient of a 123

qualified check gives consent by "endorsing and cashing" the

check.124

A qualified check must be endorsed and cashed "on or before

the 90th day after the close of the payment period for the taxable

year of the organization for which such patronage dividend or

payment is paid." The cooperative may set an earlier deadline 125

for endorsing and cashing the qualified check.126

A qualified check is presumed to have been endorsed and

cashed within the 90-day period if the earliest bank endorsement

is dated no later than 3 days after the end of the 90-day period

(excluding Saturdays, Sundays, and legal holidays)."127
 I.R.C. § 1388(c)(3)(A)(i). Thus written consent can apply 128

retroactively to cover patronage that occurred from the beginning of the

cooperative's tax year until the consent became effective. 

 Treas. Reg. § 1.1388-1(c)(3)(i).

129

 I.R.C. §§ 1388(c)(3)(A)(i) and 1388(c)(3)(B), and Treas. Reg. § 130

1.1388-1(c)(3)(i).

 I.R.C. § 1382(e), cited in I.R.C. § 1388(c)(3)(A)(i).

131

 Treas. Reg. § 1.1388-1(c)(3)(i).

132

41

Effective Consent Period

For qualified written notices of allocation based on consent,

qualification applies only to patronage that occurs while the

consent is effective. The consent period is different for written

consent, bylaw consent, and qualified check consent. For consent

based on a writing or a bylaw provision, it is necessary to consider

the initial effective date, duration of the consent period, and

conditions for revocation.

Written Consent

Written consent is effective for all patronage occurring during

the cooperative's taxable year in which the consent is given,128

unless it specifically provides to the contrary. The written 129

consent remains in effect for "all subsequent years of the

organization" until revoked.130

The applicable tax year in which patronage is considered to

have occurred may follow the year in which the patron conducted

business with the cooperative. In pooling arrangements, for

example, patronage is treated as having occurred during the

taxable year in which the pool closes. A written consent made 131

any time before the end of the cooperative's taxable year during

which the pool closes "shall be effective with respect to all

patronage under that pool."132
 I.R.C. § 1388(c)(3)(B)(i).

133

Id.

134

 Treas. Reg. § 1.1388-1(c)(3)(i).

135

Id.

136

Id.

137

 I.R.C. § 1388(c)(3)(A)(i) and Treas. Reg. § 1.1388-1(c)(3)(i).

138

 I.R.C. § 1388(c)(3)(B)(i) and Treas. Reg. § 1.1388-1(c)(3)(i).

139

 I.R.C. § 1388(c)(3)(B)(i).

140

 Treas. Reg. § 1.1388-1(c)(3)(i).

141

42

Written consent can be revoked only by "the distributee."133

The revocation must be in writing, signed by the patron, and 134 135

is effective only when filed with the cooperative.136

Written consent can be revoked at any time. A consent that

cannot be revoked will not "qualify" a patronage-based

distribution. Absent revocation, a patron's written consent 137

remains in effect for all taxable years subsequent to the year in

which such consent is given.138

Revocation of written consent doesn't take effect immediately

upon patron signature and delivery to the cooperative. The written

consent remains in force for all patronage conducted up to the

close of the cooperative's taxable year in which the revocation is

filed. Thus, a cooperative using written consent can predict its

139

tax position regarding patronage refunds for the taxable year.

In a pooling arrangement, revocation of written consent is not

effective for any pool "to which the distributee has been a patron

before such revocation." Written consent remains in effect for 140

any pools in which the patron participated prior to revocation.141

Bylaw Consent

Unlike written consent, bylaw consent cannot be retroactive to

the beginning ofthe cooperative's tax year. Bylaw consent applies

only to patronage occurring after a patron has received written no-
 "A consent...shall be effective only with respect to patronage 142

occurring after the patron has received a copy of the bylaw and the

prerequisite notice and while he is a member of the organization."

Treas. Reg. § 1.1388-1(c)(3)(ii)(a).

 I.R.C. § 1382(e).

143

 I.R.C. § 1388(c)(3)(A)(ii). 144

 Treas. Reg. § 1.1388-1(c)(3)(ii)(a).

145

 I.R.C. § 1388(c)(3)(A)(ii). 146

 I.R.C. § 1388(c)(3)(B)(ii) and Treas. Reg. § 1.1388-1(c)(3)(ii)(a) 147

 Treas. Reg. § 1.1388-1(c)(3)(ii)(a).

148

43

tification of the adoption of the bylaw provision, a copy of the

bylaw, and has attained member status in the cooperative.142

The Code provision on pooling arrangements, which assigns 143

patronage to the year the pool closes, does not apply to bylaw

consent situations. In pooling arrangements, bylaw consent 144

applies only to patronage that occurs after notification and bylaw

copy are received, even though for income and distribution

purposes patronage occurs in the year the pool closes.145

Bylaw consent remains in force so long as the patron remains

a member of the cooperative and the bylaws contain the required

consent provision. Bylaw consent ends once the distributee 146

"ceases to be a member" of the cooperative or the cooperative's

bylaws "cease to contain" the required consent provision.147

In pooling situations, bylaw consent no longer is effective

"with respect to any patronage under a pool after the patron ceases

to be a member of the cooperative organization or after the bylaw

provision is repealed by the organization."148

Qualified Check

Consent by qualified check applies to all patronage represented

by the written notice of allocation to which the qualified check

relates. Consent is effective upon endorsement and cashing of the
 Treas. Reg. § 1.1388-1(c)(3)(iii)(a). 149

 I.R.C. § 1388(d), and Treas. Reg. § 1.1388-1(d).

150

 Treas. Reg. § 1.1388-1(c)(3)(iii)(c)(Example 2).

151

 1973-1 C.B. 292. 152

Id.

153

44

check within 90 days after the close of the cooperative's payment

period. No opportunity to revoke exists after this occurs. 149

If an otherwise qualified check is not endorsed and cashed

within the permissible period, the distribution becomes a

nonqualified written notice of allocation. The regulations 150

provide that if the patron then cashes the check, the action is

treated as a redemption of a nonqualified written notice of

allocation.151

Deceased Patron's Estate

The death of a patron raises special concerns about the

continuing effectiveness of that patron's consent. Written notices

of allocation may be distributed to the estate of a deceased patron.

In Revenue Ruling 73-93, the Service addressed the issue of 152

whether bylaw consent, applicable to a deceased member while

alive, was sufficient to qualify a written notice of allocation paid

to the deceased member's estate. IRS found that the member's

consent was still effective for business conducted with the

cooperative during the part of the year prior to the patron's death,

and the portion of the written notice covering that time period was

qualified.

However, the member's consent did not cover business

conducted on behalf of the estate after the member's death.

Written notices of allocation relating to business with the estate

itself would only be qualified if the required consent was

specifically granted by the estate. If the estate is to qualify under

bylaw consent, the estate must follow normal procedures for

membership, including receipt of a bylaw consent provision and

formal membership in the cooperative.153
 I.R.C. § 1388(c)(1). 154

 Rev. Rul. 65-221, 1965-2 C.B. 320; S. Rep. No. 1881, 87th

155

Cong., 2d Sess. (1962), reprinted in 1962-3 C.B. 707, 818 and 1962

U.S. Code Cong. & Admin. News 3304, 3415-3416. A minimum tax

rate of 20 percent was included in the Internal Revenue Code of 1954,

§1, 68A Stat. 5 (1954), and remained unchanged until reduced to 14

percent in 1964.

 Treas. Reg. § 1.1388-1(c)(1). 156

45

The 20-Percent in Money Requirement

Another requirement to qualify a written notice of allocation

is that at least 20 percent of the total patronage refund must be

"paid in money or by qualified check."154

This requirement was enacted as part of Subchapter T to

ensure that cooperatives provided patrons with sufficient cash to

pay the first bracket tax bill on qualified allocations immediately

taxable to the patrons.155

"Payment in money" can be made in cash or by a bank

check. If the patron has consented to include the entire 156

allocation in taxable income, by either a written agreement or

bylaw consent, a regular check is sufficient. However, if consent

has not been attained, the 20 percent payment must be by

"qualified check" as defined in Code section 1388(c)(4) and

discussed previously.

Some cooperatives with a written consent or bylaw consent

program nonetheless make the "money" payment by a check that

meets the requirements of a qualified check. Then, if other

consent methods are found invalid for any reason, they can fall

back on the qualified check option to substantiate its patronage

refund deductions.

The Service has held that the payment in money must be made

at the same time the patron receives the written notice of

allocation. IRS reasoned that if the cash payment were made

before or afterreceipt, the patron could face the same problems the
 Priv. Ltr. Rul. 7746080 (August 22, 1977).

157

 Treas. Reg. § 1.1388-1(c)(1). 158

Id.

159

 Treas. Reg. § 1.1388-1(c)(1). 160

 Rev. Rul. 65-221, 1965-2 C.B. 320, 320-321. 161

46

20-percent payment in money requirement was intended to eliminate.157

Basis of Calculation

The 20 percent calculation is based on the total dollar amount

of the written notice of allocation. This includes, in the case of a

section 521 cooperative, any nonpatronage-sourced income

distributed on a patronage basis.

Any portion paid in nonqualified written notices of allocation

"may be disregarded" in determining the 20 percent amount. In 158

an example provided in the regulations, cooperative A paid a 159

patronage refund of $100 in the form of a nonqualified written

notice of allocation with a stated dollar amount of $50, a written

notice with a stated dollar amount of $40, and money in the

amount of $10. The written notice with a stated dollar amount of

$40 would constitute a qualified written notice if all other

requirements under section 1388(c) are met. The $10 payment in

money accompanying the $40 written notice satisfies the 20-

percent-payment-in-money requirement.

Prohibited Payment Forms

The regulations, on their face, prohibit certain noncash

payments in lieu of money.

Offsetting a Debt. A credit by a cooperative against amounts

a patron owes it, in lieu of payment to the patron, doesn't satisfy

the "paid in money" requirement. Revenue Ruling 65-221 states

160

this is because the patron "does not have the opportunity to use the

money he is entitled to have made available to him from the

cooperative to pay his taxes."161
 Treas. Reg. § 1.1388-1(c)(1). 162

Id.

163

 Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). 164

47

Paying Membership Fee. Cooperatives and prospective

members may find it convenient to apply patronage refunds due

nonmember patrons toward the cost of membership stock or a

membership certificate. The patron isn't required to make an

initial payment for membership, yet gains the benefits of

membership in the course of time.

There is no prohibition against this practice. However,

amounts applied towards membership costs cannot reduce the

money portion paid in connection with written notices of

allocation below the 20 percent requirement for qualification. As

noted in the regulations, payment in money does not include "a

credit against the purchase price of a share of stock or of a

membership in such organization."162

Documents Redeemable by the Cooperative. The regulations

also provide payment in money does not include a document

redeemable by the cooperative for money.163

Constructive receipt. Although not specifically mentioned in

the regulations, the payment in money requirement also is not met

through "constructive receipt," whereby a patron has the right to

collect the money at any time after its availability is "declared."

In Seiners Association v. Commissioner, the U.S. Tax Court 164

found that allowing constructive receipt would completely negate

the 20 percent money payment rule. Money not actually received

cannot be applied towards the patron's tax liability that results

from recognizing the full value of the qualified written notice as

taxable income. In addition, the words of the statute calling for

payment in the form of "money" (or qualified check) are not

compatible with the constructive receipt concept. The court noted

that there is "little room for doubt that when a statute requires a
Id. at 959.

165

 Rev. Rul. 65-128, 1965-1 C.B. 432. 166

 Rev. Rul. 65-221, 1965-2 C.B. 320. 167

48

distribution of money its requirements cannot be met by the

application of the constructive receipt doctrine."165

Patrons’ Discretion

The above discussion suggests that a check drawn on a bank

is the only acceptable noncash method of meeting the 20 percentin-money requirement. However, the Service has been more

flexible and permitted noncash distributions to satisfy the payment

in money requirement where the patron had the option to receive

a cash or bank check payment, but voluntarily agreed to direct the

funds elsewhere.

In the first ruling in this area, the Service allowed an 166

arrangement where the patron, by contract with the cooperative,

agreed to apply the entire patronage refund, including the 25

percent otherwise paid in a qualified check, against an annual

minimum payment owed by the patron to the cooperative for

equipment purchased under a conditional sales contract.

In a second ruling released in 1965, the IRS discussed the 167

authority of a patron to direct the cooperative to make the payment

in money to a third party. Three situations were presented:

(1) The bylaws of cooperative X said it could deduct from

patronage refunds otherwise payable to a member an annual

amount for dues to a farmers' educational organization. Before

the cooperative could deduct the amount for dues, the member

had to authorize the "check-off" in writing.

(2) Cooperative Y had a similar bylaw provision except it

automatically paid the dues unless the member notified the

cooperative in writing that it did not want the funds deducted.

(3) Cooperative Z's bylaws provided simply for check-off

of dues to a farmers' education organization. The members
Id. at 321.

168

 Priv. Ltr. Rul. 7850073 (Sept. 18, 1978).

169

49

were not given authorization either to deduct the dues or to

discontinue the deduction. If a member did not want dues

deducted, the only alternative was withdrawal from

membership in the cooperative.

IRS said that in the cases of both cooperative X and

cooperative Y, the member makes the election as to the deduction

from their patronage refund. Consequently, the amounts applied

to the educational organization's dues by both cooperatives would

satisfy the 20 percent "paid in money" requirement. The dues

check-off by cooperative Z, however, could not be treated as a

patronage refund "paid in money" because the payments were not

made at the option of the individual member for whom the dues

were paid. The Service stated:

...where the disposition of the money the patron is

entitled to receive from the cooperative is beyond the

control of the cooperative, a payment by the cooperative to

a third party at the option of the patron can be treated as a

payment in money to the patron. The cooperative, in

effect, has made the money available to the patron and is

simply following his authorization as to payment.168

The importance of patron choice also was emphasized in a

subsequent letter ruling. Here, a supply cooperative met its

169

payment in money requirement by having the funds credited to

each patron's account. The credit could be used by the patron to

purchase merchandise within 81⁄2 months after the close of the

cooperative's fiscal year. Checks were sent to the patrons for any

unused credits before the end of the 81⁄2-month period. The

patrons also had the option to request the cooperative to send them
Id.

170

 Priv. Ltr. Rul. 8006112 (Nov. 20, 1979).

171

 Priv. Ltr. Rul. 200226037 (March 28, 2002).

172

50

 the remaining part of their patronage refund in money rather than

establish a credit.

The ruling outlines the general rule in the regulation against

crediting accounts in lieu of actual cash payment. However,

relying on Revenue Ruling 65-221, IRS stated:

...where the patron has the option of receiving the

money he is entitled to receive from the cooperative, in

cash, rather than as a credit to his account with the

cooperative; the cooperative, in effect, has made the

money available to the patron and is simply following his

authorization in regard to payment, whether such

authorization is given either actively or passively.170

In another instance, a wholesale hardware cooperative had a

policy whereby when a membership was terminated and the

member was indebted to the cooperative, returns of retained

refunds could be applied against the debt. The cooperative

proposed a bylaw change in which the cash portion of qualified

written notices of allocation could be applied against the debt

unless timely request for payment of an amount equal to 20

percent of the total allocation in cash was made by the member.

The Service approved the cooperative's bylaw change. The

payment in money requirement was met because the patron could

receive cash upon request.171

A more recent letter ruling has reinforced the guidelines set out

above. In this instance, members of a cooperative of health care 172

providers paid annual dues to help finance their cooperative. Many

of the members also belonged to, and paid dues to, a tax-exempt

organization that provided information and educational services to

the health care community.
Id.

173

51

The cooperative wished to amend its bylaws to provide that (1)

it could apply the entire cash portion of the patronage refunds

owed to the members against the dues owed by that member and

(2) if any cash patronage refund was still owed to a member who

was also a member of the exempt organization, that amount could

be transferred from the cooperative to the exempt organization in

payment of the member’s dues to the exempt organization.

However, the bylaw amendment will also provide that cooperative

members may request that 20 percent of their total patronage

refund be paid in cash and the cooperative will honor that request.

IRS summarized previous decisions on the issues and

concluded:

The rulings applying the “20% cash requirement” in

set-off and assignment situations involving patronage

dividends focus on whether money has been “made

available” to the patron. If the patron has the option to

receive cash, but does not exercise that option and rather

allows its patronage dividends to be applied to amounts

that the patron owes the cooperative or to a third party, the

patron will be treated as having received a “payment in

money” as that term is used in Section 1388(c)(1) of the

code [citations omitted]. If the patron does not have the

option to receive the 20% cash, and the patronage dividend

is automatically applied to amounts the patron owes the

cooperative or to a third party, then the 20% cash

requirement is not met [citations omitted].173

NONQUALIFIED WRITTEN NOTICE OF ALLOCATION

The Code uses the term "nonqualified written notice of

allocation" to cover two documents, a written notice of allocation
 I.R.C. § 1388(d) and Treas. Reg. § 1.1388-1(d).

174

 Priv. Ltr. Rul. 8138144 (June 26, 1981).

175

 I.R.C. §§ 1382(b)(2) and 1385(c). Redemption of patronage 176

equity is discussed in another chapter.

 Priv. Ltr. Rul. 7728030, (no date), 1977. 177

 Priv. Ltr. Rul. 7825095 (March 27, 1978). The Service approved 178

the cooperative's proposal to retroactively reclassify the written notices

of allocation from qualified to nonqualified status and to deduct

52

that does not meet the requirements for qualified status set out in

Code section 1388(c) and a qualified check that is not cashed

within 90 days after the close of the payment period.174

A nonqualified written notice of allocation can be in any form

allowable for a written notice of allocation. For example, a

cooperative may pay all its patronage refunds as nonqualified

written notices of allocation in the form of preferred stock.175

Nonqualified notices must comply with the general

requirements covering all written notices of allocation, or else

single tax treatment is forfeited. The unique aspect of

nonqualified notices is the method by which single tax treatment

is achieved.

When a nonqualified notice is issued, the cooperative is not

entitled to an immediate deduction from gross income and the

patron recipient is not required to include as income in the year

received the stated dollar amount of the allocation. Instead,

deduction by the cooperative and income recognition by the patron

take place in the taxable year in which the nonqualified notice is

redeemed. Therefore, single tax treatment for both the 176

cooperative and patron is finalized in the taxable year of

redemption.

A written notice of allocation will acquire nonqualified status

if the payment in money is not included with the notice at the time

of distribution, the payment is less than 20 percent of the 177

amount of the patronage refund, or the proper patron consent is not

attained.178
payments to patrons in redemption of the notices.

 Treas. Reg. § 1.1388-1(c)(1). 179

 Priv. Ltr. Rul. 8142166 (July 24, 1981).

180

53

Sometimes written notices of allocation inadvertently attain

nonqualified status. But issuing a nonqualified notice might also

reflect the members' preference for the cooperative to assume the

tax liability attributable to the allocation in the year of issue, while

deferring the patron's tax burden until the time of redemption.

Cooperatives have considerable flexibility to issue patronage

refunds as a combination of cash, qualified written notices of

allocation, and nonqualified written notices of allocation. The

only limit is that at least 20 percent of a qualified allocation

package be paid in money.

The regulations include an example in which a cooperative

pays a patronage refund of $100 consisting of a $50 nonqualified

written notice of allocation, a $40 qualified written notice of

allocation, and $10 in money. The $40 written notice of allocation

was qualified because the $10 payment in money is at least 20

percent of the total allocation package comprised of the qualified

notice and the payment in money.179

The Service has also approved a patronage refund distribution

scheme using only cash and nonqualified written notices of

allocation.180
 The formal Code term "per-unit retain allocation" is often 181

shortened to "per-unit retain" or "per-unit retains."

 I.R.C. §§ 1382(b)(3)-(4). 182

 The payment period may last longer in situations where the 183

cooperative has a pool remaining open over more than one taxable year.

See discussion under "Pooling and Statutory Payment Period" in this

chapter.

54

CHAPTER 8

PER-UNIT RETAIN ALLOCATIONS

The traditional tool of cooperative finance, both to return

earnings to members and to acquire equity capital, is the patronage

refund. However, a second patronage-based financing mechanism,

the per-unit retain allocation, is an important source of capital for

certain marketing cooperatives.

WHAT IS A PER-UNIT RETAIN?

A per-unit retain allocation is a distribution by a cooperative 181

to a patron based on the quantity of products, measured by

physical volume or dollar value, marketed through the cooperative

by the patron.

Per-unit retains can be distributed in money, certificates, or

other property and receive single tax treatment as long as 182

payment or allocation occurs during the cooperative's taxable year

or within 81⁄2 months after the close of the taxable year.

183

A cooperative's authority to issue per-unit retains usually

appears in the association's bylaws, the member marketing

agreement, or both.
See Neely & Hulbert, Legal Phases of Farmer Cooperatives,

184

FCS Information 100 (USDA 1976), at 443. The authors comment that

use of "the term'retains'is unfortunate because it carries the connotation

that the cooperative is 'withholding' money or funds from its patrons--

perhaps arbitrarily. This, of course, is not the case. These funds are

provided by patrons under specific agreements with the cooperative and

are, in fact, capital investments."

 Riverfront Groves v. Commissioner, 60 T.C. 435 (1973); Priv. 185

Ltr. Rul. 8033070 (May 22, 1980).

 Priv. Ltr. Rul. 8023018 (Feb. 27, 1980).

186

See Independent Cooperative Milk Producers Ass'n v. Commis- 187

sioner, 76 T.C. 1001 (1981).

55

How Per-Unit Retains Are Used

The primary role of per-unit retains is to generate membercontributed capital. In a typical transaction, a cooperative markets

a certain number of units of a patron's product resulting in a given

price per-unit. Under the marketing agreement between the

cooperative and the patron, the cooperative deducts a fixed amount

of money per-unit of product marketed from the check it sends the

patron for sales proceeds as a patron equity or debt interest in the

cooperative. The patron receives a per-unit retain certificate

evidencing the particular interest. The certificate's stated value is

the amount invested in the cooperative.184

Capital generated from per-unit retain certificates might be

used to replenish a cooperative's working capital, targeted for 185

general capitalization uses, or used as a reserve for a special

186

purpose. An example of the latter would be withholding a fixed

amount each month to establish a reserve fund for guaranteeing

payments to patrons in case a buyer fails to pay for product

delivered.187

Cooperatives often use the funds generated from per-unit

retain certificates to redeem certificates issued previously. This

enables a cooperative to revolve capital accounts so that patron

investment is more nearly related to current patronage or use.
 The term "patronage refund" rather than the Code term 188

"patronage dividend" is used in this series of reports in accord with

general cooperative preferences and to avoid confusion with dividends

paid to patrons on their capital stock.

56

Cooperatives withmarketing operationsmay use both per-unit

retains and patronage refunds in their financial plan. When

members deliver products, the cooperative may deduct a per-unit

retain from the cash advance it pays to the members. After the

fiscal year end (or, if a pool is involved, when the pool closes), the

cooperative calculates the appropriate net margins and pays each

patron a patronage refund (in cash or noncash allocations) based

on the amount of product that patron delivered.

Per-unit retains also can be paid in money or in certificates

which are redeemed shortly after issuance. This is really a device

for making cash payments to patrons rather than a means of

financing the cooperative. Since per-unit retains are not tied to a

cooperative's earnings, they can be paid to patrons before the end

of the tax year.

Cash per-unit retains are predominantly used by cooperatives

that market member products on a pooled basis and don't close

their pools until after the end of the taxable year in which the

product was delivered. Patronage refunds can't be distributed until

the pool is closed and the related margins determined, so per-unit

retains give the association a method of making a cash payment to

the members, related to use, and eligible for single tax treatment.

Comparison with Patronage Refunds

It is important to recognize the similarities and differences

between per-unit retains and patronage refunds.188

First, the similarities. Per-unit retains, like patronage refunds,

base a patron's capital investment in the cooperative on the extent

each patron uses the cooperative's services. Assuming Code

requirements are followed, both payment forms are eligible for

single tax treatment--tax liability at either the cooperative or
 I.R.C. 1388(c)(1). 189

 I.R.C. § 1388(f).

190

57

patron level, but not both. And both methods generally are used

in conjunction with capital financing plans such as a revolving

fund or base capital plan.

Several key distinctions should also be noted. The calculation

of per-unit retains is not tied to the cooperative's net earnings from

business done with or for its patrons as is the case with patronage

refunds. Instead, per-unit retains are based on the physical volume

or dollar value of product marketed for each patron without regard

to net earnings. This non-linkage with earnings gives cooperatives

the ability to raise equity in years with low earnings or even losses

and the flexibility to make per-unit retain allocations before the

end of the fiscal year.

Single tax treatment of per-unit retain allocations is only

available for transactions made as part of a cooperative's

marketing operations. In contrast, subchapter T tax treatment is

available for patronage refunds based on any marketing, supply, or

service activity of a cooperative.

Another difference is that single tax treatment of per-unit

retains issued as qualified certificates doesn't require that some

portion of the allocation be paid in money. At least 20 percent of

a qualified patronage refund distribution must be paid in cash or

qualified check.189

The contentious issue of whether a refund is from patronageor nonpatronage-sourced earnings doesn't arise when considering

per-unit retains. A per-unit retain allocation, by definition, can

only involve funds derived from marketing a patron's products.190

This activity is generally accepted as patronage in nature.

HISTORICAL BACKGROUND

Little is known of the exact origin of per-unit retain financing

by cooperatives. Experienced cooperative advisers indicated that
 Silveria v. Associated Milk Producers, 219 P. 461, 63 Cal. App. 191

572 (1923). Members successfully sued their cooperative to secure

refunds of per-unit retains collected for capital accumulation because

the marketing agreement between the cooperative and its members only

authorized deductions to cover transportation and other marketing

expenses.

 Reinert v. California Almond Growers Exchange, 63 P.2d 1114, 192

1117 (Cal. App. 1936)(unreported in California); rev'd, 70 P.2d 190, 9

C.2d 181 (1937). The California Almond Growers Exchange is

currently called Blue Diamond Growers.

58

the system just evolved as a natural method of financing a

cooperative marketing operation.

A review of some of the earlier court decisions involving

cooperative finance indicates per-unit retains were used early in

the development of the marketing cooperative system. In 191

Reinert v. California Almond Growers Exchange, the court

described an early per-unit retain similar to those in use today:

In view of the fact that the Exchange was a nonprofit,

nonstock corporation it did not have funds available from

the sale of capital stock to be used for working capital and

to acquire a plant in which to conduct its operations. To

provide working capital from which to make advances to

growers before sale of their nuts and for supplies, the

reserve for working capital, also known as the suspense

account, was established some time prior to 1919. From

the amount described as net proceeds to the grower on the

annual pool closing statements a further deduction was

made, representing a stated percentage of the grower's net

proceeds, usually 5 per cent., and held out by the

Exchange, and credited to its reserve for working capital.

This reserve was placed on the revolving fund basis, the

amounts held out in future years being used in part to

repay to growers the contributions of prior years to the

account.192
 Burley Tobacco Growers' Co-op Ass'n v. Tipton, 11 S.W.2d 119, 193

227 Ky. 297 (1928); Burley Tobacco Growers' Co-op Ass'n et al. v.

Brown, 17 S.W. 2d 1002, 229 Ky. 696 (1929).

The Bingham Co-operative Marketing Act, adopted in Kentucky in

1922, is sometimes referred to as the "Standard Act" because it served

as the model for similar laws adopted in many other States. Baarda,

State Incorporation Statutes for Farmer Cooperatives, ACS

Cooperative Information Report 30 (USDA 1982), p. 3.

See, e.g., Boyle et al. v. Pasco Growers' Ass'n, 17 P.2d 6, 170 194

Wash. 516 (1932).

 A predecessor to the Rural Business\ Cooperative Service. 195

 H. Hulbert, Griffin, and Gardner, Methods of Financing Farmer 196

Cooperatives, FCS General Report 32 (USDA 1957) pp. 14-16. The

study found this method of acquiring capital was insignificant for farm

supply cooperatives. 

 H. Hulbert, Griffin, and Gardner, Revolving Fund Method of

197

Financing Farmer Cooperatives, FCS General Report 41 (USDA 1958)

p. 8.

Id. at p. 19.

198

59

Per-unit retains (frequently called "deductions" in the earlier

years) were authorized by the historically important Bingham

Act and other State cooperative laws.

193 194

A detailed study by USDA's Farmer Cooperative Service of 195

financial data for association fiscal years ending in 1954 revealed

per-unit retain financing was widely used well before Subchapter

T was enacted in 1962. Of the $847 million in equity capital

reported by the 1,157 farmer cooperatives supplying data to the

study, 10 percent had been acquired through per-unit retains. For

marketing associations only, the figure was 18 percent.196

A follow-up report disclosed the responding cooperatives

reported $489 million of their equity, or 58 percent, was revolving

fund capital. For all cooperatives, 17 percent of revolving fund 197

capital was acquired through per-unit retains. The percentage

increased to 23 percent for local marketing associations and 26

percent for marketing regionals.198
Id. at p. 37. Of these 157 cooperatives, 152 were marketing. 199

 Griffin, A Financial Profile of Farmer Cooperatives in the 200

United States, FCS Research Report 23 (USDA 1972) at p. 23 (Table

14).

Id. at p. 24 (Table 15). 201

 Royer, Wissman and Kraenzle, Farmer Cooperatives' Financial 202

Profile, 1987, ACS Research Report 91 (USDA 1990) at p. 17 (Table

9).

60

Per-unit retains were used extensively in California. The

questionnaires from a 1952 survey of California cooperatives by

the Department of Agricultural Economics of the University of

California (Davis) were made available to USDA for tabulation,

using the same methods as USDA's 1954 survey. Of the 157

California cooperatives providing data that had an equity

redemption program, 68.4 percent of their revolving fund capital

had been acquired by per-unit retains.

199

USDA studies conducted after enactment of Subchapter T

document the continued importance of per-unit retain financing.

For 1970, marketing cooperatives reported that 35.9 percent of

their allocated equity had been acquired by per-unit retains. This

amounted to nearly $460 million.200

Reliance on per-unit retains varied among commodity groups.

Two out of every 3 dollars of patronage-sourced equity in fruit and

vegetable cooperatives came from per-unit retains. The

percentages for other crops included rice (nearly 50 percent),

poultry (38 percent), dairy (26 percent), cotton (13 percent), and

grain and soybeans (1 percent).201

The latest USDA study, covering 1987, found that while the

number of marketing cooperatives using per-unit retains fell from

229 in 1976 to 190 in 1987, the amount of new financing provided

from per-unit retains increased from $125 million in 1976 to $190

million in 1987. Thus, for many marketing associations per-unit 202

retains are an integral part of their capital accumulation program.
 Revenue Act of 1951, ch. 521, §314, 65 Stat. 452, 491-493 203

(1951). This law is discussed in Chapter 3 of these reports, Donald A.

Frederick, Income Tax Treatment of Cooperatives: Background,

Cooperative Information Report 44, Part 1 (USDA 2005) pp. 116-119.

 Rev. Rul. 54-10, 1954-1 C.B. 24. 204

 Rev. Rul. 54-244, 1954-1 C.B. 104. For a thorough discussion 205

of whether payments from patrons to a cooperative are taxable payments

for goods and services received or nontaxable contributions to capital,

see United Grocers, Ltd. v. United States, 308 F.2d 634 (9th Cir. 1962),

aff'g 186 F. Supp. 724 (N.D. Calif. 1960).

61

LEGISLATIVE AND REGULATORY BACKGROUND

In view of the extensive regulatory, judicial, and legislative

history of the tax treatment of patronage refunds, it seems difficult

to believe that little consideration was given to per-unit retains

until the 1960s. The Revenue Act of 1951 made no mention of

them.203

In 1954, the U.S. Treasury Department (Treasury) issued two

administrative rulings that acknowledged per-unit type retains.

Rev. Rul. 54-10 set out the IRS's policy regarding the tax

treatment of patrons who received noncash allocations from

cooperatives. The Service noted that while the term patronage

refund "does not include amounts without reference to earnings of

the association," the rules in the regulation applied "to all

allocations made by a cooperative association in document

form."204

In a one-paragraph decision, Rev. Rul. 54-244, a cooperative

had retained a portion of sales proceeds due patrons and issued

stock with a par value equal to the amount of funds retained. The

patrons had reported the face amount of the stock received as part

of their income in each year the stock was distributed. The

Service held the value of the stock did not represent "earnings and

profits of the association."205

In 1958, Treasury issued new regulations to implement the

cooperative provisions of the Code as recodified by the Revenue
 Internal Revenue Code of 1954, 68A Stat. 3, 177-178 (1954).

206

 Treas. Reg. § 1.522-1(b)(4)(ii), published as T.D. 6301, 1958-2 207

C.B. 197, 247. See also Example 1 of this regulation, which

immediately follows the quoted definition.

 Hulbert and Mischler, Legal Phases of Farmer Cooperatives,

208

FCS Bulletin 10 (USDA 1958) at pp. 120-123.

Id. at p. 209. 209

Id. at p. 214. 210

62

Act of 1954. The definition of "patronage dividends, rebates, 206

and refunds" specifically excluded "Amounts allocated...by the

association for products of members or other patrons to the extent

such amounts are fixed without reference to the earnings of the

cooperative association."207

The 1958 version of USDA's Legal Phases of Farmer

Cooperatives only briefly describes the nature of "deductions"

from sales proceeds returned to producers and the legal authority

for cooperatives to use them to raise capital. In discussing tax

208

law, the statement is made that the only difference between the tax

treatment of noncooperative and cooperative corporations is that

cooperatives may exclude from gross income "true patronage

refunds," ignoring deductions used as retains.

209

The 1958 USDA report's one paragraph on the tax treatment

of retains states:

Amounts authorized by members to be deducted from

sales proceeds in the case of a marketing cooperative or to

be added to the cost of purchases made for the express

purpose of being used by the cooperative as capital also are

not taxable to the cooperative. This is because money

furnished to any corporation for capital purposes is not

income to the corporation (cites omitted).210
 Pub. L. No. 87-834, 76 Stat. 960 (1962), reprinted in 1962-3 211

C.B. III.

 The judicial and administrative decisions that defeated the intent 212

of Congress to create a single current tax in the Revenue Act of 1951

are discussed in Chapter 3 of these reports, Donald A. Frederick,

Income Tax Treatment of Cooperatives: Background, RBS Cooperative

Information Report 44, Part 1 (USDA 2005) at pp. 119-122.

 These recollections are supported by language in the Senate

213

Report accompanying the Foreign Investors Tax Act of 1966, which

included statutory language on tax treatment of per-unit retains. The

report states, "...because the per-unit retain certificates issued by cooperatives may have a fair market value considerably less than their face

amount...some have raised questions as to whether they may be considered as paid out by the cooperatives and whether the patrons can be

required to include them in their gross income." S. Rep. No. 1707, 89th

Cong., 2d Sess., reprinted in 1966 U.S. Cong. & Admin. News 4446,

4515.

63

The Revenue Act of 1962, which introduced subchapter T 211

and the present system of cooperative taxation, also didn't mention

per-unit retain allocations. It focused on written notices of

allocation without, however, casting any particular hindrances in

the way of per-unit retain type distributions to patrons.

Some knowledgeable cooperative tax practitioners have

suggested in informal conversations that this was an inadvertent

omission in the original version of Subchapter T. When

Subchapter T was drafted, the Treasury Department was only

concerned about making sure a current tax was paid on patronage

refunds.212

The new provisions were, by their terms, only applicable to

patronage refunds. Cooperative tax experts recall certain

cooperative advisers at the time suggesting that because per-unit

retains were not covered by subchapter T, patrons receiving

"qualified" retains could still avoid tax on the theory the retains

had no fair market value when issued and thus were not taxable

income.213
 30 FR 6349-50 (May 6, 1965).

214

 XIV Legal-Tax Memorandum No. 5, National Council of Farmer 215

Cooperatives (May 6, 1965).

 Treas. Reg. § 1.61-5(d)-(h), published as T.D. 6855, 30 FR 216

13134-36 (Oct. 15, 1965).

 XIV Legal-Tax Memorandum No. 11, National Council of

217

Farmer Cooperatives (Oct. 15, 1965).

 Pub. L. No. 89-809, tit. II, § 211(a)-(f), 80 Stat. 1539, 1580-1584 218

(1966).

 S. Rep. No. 1707, 89th Cong., 2d Sess., reprinted in 1966 U.S. 219

Cong. & Admin. News 4446, 4515.

64

Because of this gap in coverage, Treasury amended Treas. Reg.

section 1.61-5 to include rules for the deductibility of per-unit

retain certificates by cooperative associations as well as their

treatment as income by patrons. Proposed rules were published in

May 1965.214

Cooperatives found several deficiencies in these proposed

rules, notably the lack of recognition of bylaw consent to "qualify"

per-unit retain certificates and unmanageable effective dates.

215

Treasury published its final rule that October. The final rule 216

included most of the changes suggested by cooperatives, but the

test for distinguishing qualified and nonqualified per-unit retains

was still considered unclear.

217

In 1966, subchapter T was revised to include comprehensive

coverage of per-unit retain distributions. These changes,

appearing in the Foreign Investors Tax Act of 1966, amended

Code sections 1382, 1383, 1385, and 1388 of subchapter T and the

information reporting rules for co-ops in Code section 6044.218

The Senate report accompanying this act noted that Treasury's

1965 regulations "provided for the income tax treatment of perunit retain certificates in a manner that is substantially parallel to

the treatment prescribed in the Revenue Act of 1962 with respect

to patronage (refunds)."219
Id.

220

 S. Rep. No. 1707, 89th Cong. 2d Sess. 70,reprinted in 1966 U.S. 221

Code Cong. & Admin. News 4446, 4515-4516.

65

Treasury's authority to tax per-unit retains at the patron level

was still being questioned, even after the 1965 regulations were

promulgated. The 1966 amendments clarified both the authority 220

of Treasury to collect a single current tax on per-unit retains and

answered cooperative questions about the treatment of qualified

and nonqualified retains.

The Senate report to the Foreign Investors Tax Act of 1966

summarized the amendments to subchapter T as follows:

The bill amends present law to provide tax treatment

with respect to per-unit retain certificates which parallels,

in general, the tax treatment applicable with respect to

patronage dividends. Providing essentially the same

treatment for per-unit retain certificates means, generally,

that they are to be treated as income to the patron in the

year in which the certificates are issued, if the patrons give

their consent in writing to the inclusion of the face amount

of these certificates in their income or if there is a

provision in the bylaws or charter of the cooperative

indicating that membership in the cooperative represents

consent to such treatment. Under the amendment, the

cooperative is permitted to take a deduction in arriving at

gross income for a per-unit retain certificate when issued,

only when the certificate qualifies for the treatment

specified above at that time in the hands of the patron.

Otherwise, the amount involved is deductible by the

cooperative only at the time the certificate is redeemed.221

The 1966 amendments to the Code brought per-unit retain

financing within subchapter T coverage by providing for the

imposition of income taxes at either the cooperative or patron
 S. Rep. No. 1707, 89 Cong., 2d Sess. 70, reprinted in 1966 U.S. 222

Code Cong. & Admin. News 4446, 4515.

 Pub. L. No. 89-809, tit. II, § 211(d), 80 Stat. 1584, codified at 223

I.R.C. § 6044.

 I.R.C. § 1382(b)(1). 224

 Pub. L. No. 89-809, 80 Stat. 1539, at tit. II, § 211(a)(2) (1966), 225

codified at I.R.C. § 1382(b)(3).

66

level. And per-unit retains were to be taxable at face value, even

if the fair market value was considerably less. The 1966 222

changes also required cooperatives to provide return information

on per-unit retain allocations comparable to that already required

for patronage refunds.223

Just as amendments were enacted to correct an oversight

during the original drafting of subchapter T in 1966, a further

amendment was needed in 1969 to remedy a deficiency in the

1966 amendments. The 1962 Act authorized cooperatives to

deduct patronage refunds paid in "money, qualified written notices

of allocation...or other property...." However, the 1966 224

amendment only permitted the deduction of per-unit retain

allocations paid in "qualified per-unit retain certificates...."225

The Senate report accompanying the 1969 amendment

explained that cooperatives that marketed products on a pooling

basis were having trouble making cash payments to patrons during

the 81⁄2 month payment period following the end of their taxable

year. As the pool might not be closed during that period, and net

earnings on a pool can't be determined until it is closed, patronage

refunds couldn't be made.

While per-unit retain payments could be made during this

time, the Code only authorized the deduction of such retains paid

in qualified noncash form. Congress saw "no reason why a

cooperative should be able to deduct per unit retain allocations

paid as qualified certificates during the 81⁄2 month period following
 S. Rep. No. 552, 91st Cong., 1st Sess. (1969), reprinted in 1969 226

U.S. Code Cong. & Admin. News 2027, 2331-2332.

 Tax Reform Act of 1969, Pub. L. 91-172, § 911, 83 Stat. 487, 227

722 (1969), reprinted in 1969-3 C.B. 10, 154.

 In amending the Code in 1966 to include per-unit retain tax 228

treatment, the Senate Finance Committee acknowledged Treas. Reg. §

1.61-5 (as amended by T.D. 6855, 30 FR 13134, Oct. 15, 1965) and

noted on p. 4515 of its report:

By adopting this amendment, your committee does not intend to

reflect on the validity of the regulations recently issued by the

Treasury Department with respect to per-unit retain certificates..."

S. Rep. No. 1707 (on H.R. 13103), 89th Cong., 2d Sess. 70,

reprinted in 1966 U.S. Code Cong. & Admin. News 4446, 4515.

67

the close of the taxable year, but not per unit retain allocations

paid in money during the same period."226

The 1969 amendment of subchapter T made it clear cooperatives could deduct cash per-unit retain allocations under the same

rules as qualified per-unit retain certificates.227

The regulations pertaining to subchapter T haven't been

rewritten to reflect the 1966 and 1969 Code changes relating to

per-unit retains, so per-unit retains are not expressly covered in

Treas. Reg. §§ 1.1381-1 through 1.1388-1. However, where the

Code provides parallel treatment for patronage refunds and perunit retains, the subchapter T regulations should be one source of

guidance even though per-unit retains are not specifically

referenced. And Treas. Reg. § 1.61-5 with its coverage of per-unit

retain certificates, while predating official Code recognition of

per-unit retains in 1966, has never been revoked or superseded.228

CODE DEFINITION OF A PER-UNIT RETAIN

Code section 1388(f) defines "per-unit retain allocation" as any

allocation by a cooperative "to a patron with respect to products

marketed for him, the amount of which is fixed without reference
 I.R.C. § 1388(f).

229

 I.R.C. § 1388(f). I.R.C. § 1381(a) provides that section 521 230

farmers' cooperatives and other corporations "operating on a cooperative

basis" are eligible for tax treatment under subchapter T. Chapter 2 of

this series of reports discusses what it means to be "operating on a

cooperative basis." Donald A. Frederick, Income Tax Treatment of

Cooperatives: Background, Cooperative Information Report 44, Part 1

(USDA 2005) pp. 41-54.

 Treas. Reg. § 1.1388-1(e) defines "patron" as "any person with

231

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."

The issue of distinguishing a patron from a member is discussed in

Chapter 1 of these reports, Donald A. Frederick, Income Tax Treatment

of Cooperatives: Background,Cooperative Information Report 44, Part

1 (USDA 2005) p. 15.

 I.R.C. § 1388(f). By "agreement," the Code means some form of 232

agreement among the members of a cooperative generally, such as a

bylaw provision, as to the measure or formula to be used. This concept

should be distinguished from "obtaining agreement" from patrons to

take into account as income the stated value of qualified per-unit retain

certificates required under I.R.C. § 1388(h)(2).

68

to the net earnings of the organization pursuant to an agreement

between the organization and the patron."229

This definition contains several parts. First, an association

making per-unit retain allocations must meet the Code's

requirements as a subchapter T cooperative organization.230

Second, the allocation must be made to patrons pursuant to

231

an agreement between the cooperative and the patron.232

Third, the calculation of the per-unit retain is not tied to the

cooperative's net earnings. This requirement distinguishes per-unit

retain allocations from written notices of allocation. The basis for

computing per-unit retains is apparently left to agreement between

the patron and the cooperative. Normally, a per-unit retain is
 I.R.C. § 1388(f). The Code's specific use of the word "marketed" 233

indicates per-unit retain allocations made with reference to

nonmarketing activities of a cooperative don't qualify for single tax

treatment.

 Rev. Rul. 68-236, 1968-1 C.B. 382. This revenue ruling was 234

prepared for the guidance of cooperative organizations and their patrons

in the treatment of per-unit retains for Federal income tax purposes.

 Farm Service Cooperative v. Commissioner, 619 F.2d 718, 725, 235

n. 17 (8th Cir. 1980), 1980-1 U.S.T.C. ¶ 9352, rev'g, 70 T.C. 145

(1978). The court in Farm Service noted the similarity of patronage

refunds to per-unit retains in supporting its refusal to allow patronage

sourced losses to offset nonpatronage sourced income when payments

were made in per-unit retain allocations rather than patronage refund

allocations.

See Priv. Ltr. Rul. 8447038 (Aug. 20, 1984) where the Service 236

approved the issuance of both qualified and nonqualified per-unit retain

certificates.

 Farm Service Cooperative v. Commissioner, 619 F.2d 718 at 726

237

(8th Cir. 1980), 1980-1 U.S.T.C. 9352, rev'g, 70 T.C. 145 (1978);

noting H. Rept. 91-413, 91st Cong., 1st Sess. (1969), reprinted in 1969

69

based on the quantity or value of products "marketed" for the 233

patron.

Per-unit retains usually take the form of a deduction of money

from a payment to the patron for products sold (in raw or

processed form) by the cooperative. The "per-unit" designation

often refers to cents or dollars per bushel of grain, per hundredweight of milk, per box of fruit or some other unit of quantity of

product marketed by the cooperative. Whether a per-unit retain

meets the Code requirements is a question of fact.234

Despite various distinctions, the parallelism in the tax

treatment of patronage refunds and per-unit retains has been

characterized as "striking." Principles that apply to patronage 235

refunds generally also apply to per-unit retains. However, the 236

statutory provisions for per-unit retains and patronage refunds are

distinct and do reflect the differences in their character.

237
U.S. Code Cong. & Admin. News 1645, 1821.

See Senate Finance Committee Technical Explanation, Pub. L. 238

89-809 (1966). The Committee, in adopting the 1966 changes, noted

that the new law provided "tax treatment with respect to per-unit retain

certificates which parallels, in general, the tax treatment applicable with

respect to patronage dividends." S. Rep. No. 1707 (on H.R. 13103), 89th

Cong., 2d Sess. 70, 1966 U.S. Code Cong. & Admin. News 4446, 4515-

4516.

 I.R.C. § 1382(b).

239

 I.R.C. § 1382(b)(3). 240

 I.R.C. § 1382(b)(4). Redemptions can be in the form of money 241

or other property (except per-unit retain certificates).

70

Subchapter T tax treatment of per-unit retain allocations

follows the same basic principles first established for written

notices of allocation, taking into account the differences in form

between the two equity instruments and the option to make cash

per-unit retain allocations prior to pool closing.238

The tax treatment of per-unit retains to cooperatives is set out

in Code section 1382(b). Section 1382 authorizes cooperatives to

treat "as a deduction in arriving at gross income" per-unit retains 239

distributed in money, qualified certificates, or other property.240

Treatment similar to that accorded patronage refunds also applies

to cooperative payments used to redeem nonqualified per-unit

retain certificates.241

ADVANCES AND PER-UNIT RETAINS PAID IN CASH

Marketing cooperatives frequently make an initial cash

payment to their producers when product is delivered. This is

especially true of pooling cooperatives. A final payment or

patronage refund may not be made for some time. The accounting

and tax consequences of this payment, and any periodic payments

that may be made before the final payment, depend on whether the
 Tax Reform Act of 1969, Pub. L. 91-172, § 911, 83 Stat. 487, 242

722 (1969), reprinted in 1969-3 C.B. 10, 154.

 Rev. Rul. 67-633, 1967-2 C.B. 299. 243

 Rev. Rul. 69-67, 1969-1 C.B. 142. 244

 S. Rept. No. 91-552, 91st Cong., 1st Sess. (1969), reprinted in 245

1969 U.S. Code Cong. & Admin. News 2027, 2331-2332. The effective

date for this provision is October 9, 1969.

71

preliminary payments are considered a cash advance or a cash perunit retain.

Priorto the 1969 amendment to subchapter T authorizing cash

per-unit retains, the Service issued two rulings that involved the 242

treatment of cash advances paid by pooling cooperatives. In Rev.

Rul. 67-333, the Service concluded that cash advances are

deductible by the cooperative as a cost of products sold in the

same year they are considered income to the members.

243

In Rev. Rul. 69-67, the Service modified Rev. Rul. 67-333 to

make it clear that cash advances must be capitalized as part of

inventory (cost of goods sold). Cash advances were only

deductible to the extent that inventory in the pool was sold by the

end of the tax year. For example, if 70 percent of the inventory 244

from the pool was sold by the end of the year, then 70 percent of

the cash advances were deductible in that year. Additional

deductions were permitted in subsequent years in proportion to the

extent that pool inventory was sold off.

Subchapter T was amended in 1969 so that per-unit retains

allocated to patrons in cash or other property could receive the

same single tax treatment as per-unit retains issued as qualified

certificates. Section 1382 of the Code provides, in part:

245

(b) In determining the taxable income of an

organization to which this part applies, there shall not be

taken into account amounts paid during the payment

period for the taxable year--
 I.R.C. §1382(b)(3).

246

 Tech. Adv. Mem. 8005012 (Oct. 29, 1979); Priv. Ltr. Rul.

247

8540056 (July 8, 1985); Priv. Ltr. Rul. 8838018 (June 23, 1988).

 Tech. Adv. Mem. 8005012 (Oct. 29, 1979); Priv. Ltr. Rul.

248

8838018 (June 23, 1988).

72

...(3) as per-unit retain allocations..., to the extent paid in

money, qualified per-unit retain certificates..., or other

property...with respect to marketing occurring during such

taxable year....

246

The Service has taken the position that cash payments made

during the 81⁄2 months of the payment period after the close of the

tax year are fully deductible per-unit retains paid in money, but 247

such payments during the tax year are cash advances that must be

capitalized under Rev. Rul. 69-67.248

Another interpretation of this Code language is that it clearly

states a cooperative shall not include per-unit retains paid in

money in determining taxable income. Thus, a marketing

cooperative that makes an initial payment to a patron for product

delivered appears to have some flexibility in how it treats that

payment for tax purposes. If it chooses cash advance treatment,

the payments are capitalized as cost of goods sold. If it chooses

cash per-unit retain treatment, the entire amount is deductible if

paid anytime during the payment period.

In some situations, flexibility may also exist as to the year that

the deduction may be taken. For example, it appears that cash

payments for product delivered in one year, but made during the

first 81⁄2 months of the following year, may be considered (1)

advances in the second year, (2) per-unit retains paid in money

relating back to the first year, or (3) per-unit retains paid during

the second year, depending on how the cooperative chooses to

characterize them.
 I.R.C. § 1388(g). 249

 Treas. Reg. §1.61-5(g). 250

 I.R.C. § 1388(g) and Treas. Reg. § 1.61-5(g). 251

Id.

252

73

PER-UNIT RETAIN CERTIFICATES

Most per-unit retains collected by cooperatives are treated as

equity or debt. The funds are retained by the cooperative and the

patrons receive written certificates as evidence of their individual

capital contributions.

Code Section 1388(g) defines a retain certificate as "any

written notice which discloses to the recipient the stated dollar

amount of a per-unit retain allocation to him by the

organization."249

The regulations to Code section 61 are more specific,

providing:

...the term "per-unit retain certificate" means any

capital stock, revolving fund certificate, retain certificate,

certificate of indebtedness, letter of advice, or other written

notice--

(1) Which is issued to a patron with respect to

products marketed for such patron;

(2) Which discloses to the patron the stated dollar

amount allocated to him on the books of the

cooperative association; and

(3) The stated dollar amount of which is fixed

without reference to net earnings.250

A per-unit retain certificate must be a "written notice" issued

to the patron. No particular form of written statement is

251

required. Written notices found adequate have included 252
In Independent Cooperative Milk Producers Ass'n v. Commis- 253

sioner, 76 T.C. 1001 (1981), the court notes a cooperative issued what

it simply called "certificate of retains."

 Priv. Ltr. Rul. 8846030 (Aug. 22, 1988), describes a cooperative 254

issuing one class of common stock for qualified per-unit retain

certificates and another class of common stock for nonqualified per-unit

retain certificates.

 Riverfront Groves, Inc. v. Commissioner, 60 T.C. 435 (1973). 255

 Tech. Adv. Mem. 8023018 (Feb. 27, 1980). The bylaws in this 256

ruling also permitted the issuance of debt certificates.

 I.R.C. § 1388(g) and Treas. Reg. 1.61-5(g). The regulations for 257

Subchapter T, in discussing what is required for disclosing the stated

dollar amount of written notices of allocation, note that "a mere credit

to the account of a patron on the books of the organization without

disclosure to the patron, is not a written notice of allocation." Treas.

Reg. § 1.1388-1(b). This rule is also applicable to per-unit retain

certificates.

 Rev. Rul. 68-236, 1968-1 C.B. 382. 258

74

certificates of retain, common stock, revolving fund 253 254

certificates, and equity capital retain certificates. 255 256

The Code and regulations also require that the certificate

disclose to the recipient "the stated dollar amount" of the

allocation to the patron by the cooperative.257

In Revenue Ruling 68-236, IRS described how some 258

cooperatives issue a preliminary statement which indicates the

amount of the per-unit retain for that particular transaction. It

might be issued on a receipt at the time the goods are delivered, or

it might appear on the voucher accompanying a check given as

initial payment for goods delivered. A more formal statement is

issued later showing the total amount of per-unit retains for a

specific time period.

The Service said both sets of documents meet the technical

definition of a per-unit retain certificate. The written statement

uniformly treated by the parties as the per-unit retain certificate
Id.

259

 Seiners Ass'n v. Commissioner, 58 T.C. 949, 957-958 (1972).

260

Although this case dealt with written notices of allocation, it referred to

Rev. Rul. 68-236 to support the finding of a need for specific disclosure

of the amount retained.

See I.R.C. § 1388(b), which defines written notice of allocation 261

as "any capital stock, revolving fund certificate, retain certificate,

certificate of indebtedness, letter of advice, or other written notice,

which discloses to the recipient the stated dollar amount allocated to

him by the organization and the portion thereof, if any, which

constitutes a patronage dividend." (emphasis added)

See discussion under "Pooling and Statutory Payment Period" in 262

this chapter.

75

will be treated as the certificate for tax purposes. While some 259

degree of informality is tolerated, in Seiner Association v.

Commissioner the Tax Court made it clear that any notice, whether

a per-unit retain certificate or a written notice of allocation, must

disclose the amount of the allocation.260

Because both written notices of allocation and per-unit retain

certificates are issued under a variety of names, it is important to

look beyond the specific name of the instrument to establish its

true character. For example, a "retain certificate" could be a

patronage refund in the form of a written notice of allocation

rather than a per-unit retain certificate.

261

Cooperatives differ in the timing ofthe distribution of per-unit

retain certificates. Certificates may be issued when patrons deliver

their product; or might not be issued until the cooperative sells the

product. In pooling arrangements, some time may elapse before

the cooperative issues the certificates.262

Qualified Per-Unit Retain Certificates

Once a per-unitretain certificate has been established, the next

question is whether the certificate is qualified or nonqualified. As

is the case with written notices of allocation, the qualified/
I.R.C. § 1388(h)(1), referring to the I.R.C. § 1385(a) rule on 263

amounts includible in patron's gross income.

 I.R.C. § 1388(h)(2). This provision refers to "obtaining agree- 264

ment" for a qualified per-unit retain certificate. I.R.C. § 1388(c)(2) uses

the term "obtaining consent" for qualifying written notices of allocation.

While the Code language varies slightly, the procedures outlined under

both Code sections are nearly identical except for inclusion of the

qualified check option as a form of consent for qualified written notices

of allocation [see I.R.C. § 1388(c)(2)(C)].

 I.R.C. §§ 1388(h)(1) and 1388(e)(2). 265

 60 T.C. 435 (1973). 266

76

nonqualified characterization is important because it determines

when a cooperative can deduct the allocated amount of the

certificate from income.

The Code defines a "qualified per-unit retain certificate" as a

certificate which the distributee agrees, through prescribed methods, to include in taxable income "at its stated dollar amount."263

Patron agreement is obtained by one of two methods: (1)

individual written agreement or (2) an appropriate bylaw

provision. Issues in obtaining agreement are discussed later in

264

this subsection.

As with any per-unit retain certificate, the Code requires that

qualified certificates be accounted for at their "stated dollar

amount." This is true even if the certificates are worth

265

considerably less than face value.

In Riverfront Groves, Inc. v. Commissioner, the U.S. Tax 266

Court ruled that certain per-unit retain certificates be appraised at

their face value even though their worth in real terms was much

less. The court explained:

These per-unit retain certificates have no fair market

value outside of the citrus industry. They cannot be

utilized as security for normal commercial, or banking

transactions, or loans, and they are redeemable by the

issuing cooperative solely at the discretion of the board of
 Riverfront Groves, Inc. v. Commissioner, 60 T.C. 435, 437 267

(1973).

Id. at 441.

268

 A written notice of allocation is not "qualified" unless it is 269

distributed as part of a patronage refund with 20 percent or more of the

patronage refund paid in money or by qualified check. I.R.C. §

1388(c)(1).

77

directors. Petitioner has never received any cash payments

from [the cooperative] in redemption ofthe certificates. In

fact, redemptions of similar certificates have not been

made by the cooperative for at least 10 years.

267

The court based its decision on the following rationale:

...this deduction is premised on the consent of the

patron to include in his income at their face amount the

qualified allocations distributed by the cooperative. It is

this voluntary consent of the patron which Congress in

enacting subchapter Tbelieved to be sufficient to establish

the necessary elements to tax the patron on the noncash

distributions.

268

No Cash Payment Required

One distinction between qualified per-unit retain certificates

and qualified written notices of allocation is that no minimum cash

payment has to accompany the distribution of qualified per-unit

retain certificates. The money or qualified check requirement 269

for qualified written notices of allocation was imposed in part to

assist the patron in paying the income tax on the allocation. This

requirement was not considered necessary or practical for qualified

per-unit retain certificates. As noted in the House Report

accompanying the Tax Reform Act of 1969:

With respect to per-unit retains, this requirement is not

imposed since retains are not determined with respect to
 H.R. Rep. No. 413, 91st Cong., 1st Sess., reprinted in 1969 U.S. 270

Code Cong. & Admin. News 1645, 1821.

 I.R.C. § 1382(b)(3). 271

 I.R.C. § 1385(a)(3). 272

 I.R.C. § 1388(h)(1). 273

 I.R.C. § 1388(h)(2)(A) and Treas. Reg. § 1.61-5(d)(2). 274

 For an explanation of the requirements for obtaining "consent in 275

writing" for qualified written notices of allocation, see I.R.C. §

78

profits, and if the requirement were imposed, many

cooperatives would merely increase by 20 percent the

amount of the retain, and return the increase as a cash

payment in satisfaction of the requirement.270

Tax Treatment

The tax consequences that arise from distribution of qualified

per-unit retain certificates parallel those for qualified written

notices of allocation. The cooperative can deduct from gross

income in the taxable year of issuance payments made in the form

of qualified per-unit retain certificates while patrons must 271

include the stated certificate amount in gross income.

272

Qualification Based On Written Agreement

As mentioned previously, a qualified per-unit retain certificate

requires that the patron agree to include as income the certificate's

stated dollar amount. Code section 1388(h)(2) specifies two 273

methods for satisfying this requirement.

One method is to have the patron agree in writing to include

the certificate's stated dollar amount in gross income for income

tax purposes. A common practice among marketing cooper- 274

atives that obtain agreement by written consent is to include the

patron agreement provision in their membership or marketing

agreement with each patron. Obtaining written agreement from

the patron in this manner parallels the Code's written consent

procedures for qualifying written notices of allocation.275
1388(c)(2)(A) and Treas. Reg. § 1.1388-1(c)(3).

 Treas. Reg. § 1.61-5(d)(2)(ii). 276

 I.R.C. § 1388(h)(3)(A)(i).

277

Id.

278

79

The written agreement with the patron doesn't have to follow

any special form so long as there is adequate disclosure to the

patron about treating the certificate's stated dollar amount as

income. The regulations provide the following example:

I agree that, for purposes of determining the amount I

have received from this cooperative in payment for my

goods, I shall treat the face amount of any [qualified] perunit retain certificates issued to me on or after 

as representing a cash distribution which I have constructively received and which I have reinvested in the

cooperative. [bracketed language added]. 276

A cooperative can obtain the written agreement from the

patron any time during the taxable year. Once obtained, the

agreement applies to all products marketed by the patron during

the taxable year in which the agreement was made unless another

period is specifically provided for. This includes products 277

marketed by the cooperative during the taxable year but before the

agreement was executed. Once signed, a written agreement

remains in effect, unless revoked, for "all subsequent taxable years

of the organization."278

Cooperatives which solely rely on individual written

agreements to qualify per-unit retain certificates run the risk of not

obtaining agreements from all their patrons. If this should happen,

the cooperative is limited to deducting only those amounts

evidenced by certificates distributed to patrons who did sign such

agreements.
 I.R.C. § 1388(h)(3)(B)(i).

279

Id.

280

Id.

281

Id.

282

 I.R.C. § 1388(h)(2)(B)(i).

283

 I.R.C. § 1388(h)(2)(B)(ii). 284

 I.R.C. § 1388(h)(2)(B). 285

 In one ruling, IRS took a somewhat lenient position. In Tech. 286

Adv. Mem. 8023018 (Feb. 27, 1980), the Service said "certificate of

equity" in the bylaws was broad enough to include certificates that were

issued as "equity capital retain certificates."

80

Patrons can revoke at anytime their written agreements to treat

their per-unit retain certificates as income in the year received.279

Such a revocation must be in writing. A revocation is not neces- 280

sarily effective immediately. Once filed with the cooperative, a

revocation becomes effective on the first day of the following

taxable year. In pooling arrangements, the revocation does not 281

apply "to anyproducts which were delivered to the organization by

the distributee before such revocation."282

Qualification Based On Bylaw Provision

The other method specified in the Code for obtaining patron

agreement is through a bylaw provision that says "membership in

the organization constitutes such agreement."283

For the bylaw consent to take effect, the member must receive

written notification of the particular provision and a copy of the

bylaw. Note that consent through bylaw is operative only for 284

members of the cooperative, and not nonmember patrons.285

The bylaw language should clearly identify the applicable

instrument(s) to which the patron's consent applies. This is

286

particularly important for cooperatives that distribute more than

one type of instrument.
 Treas. Reg. § 1.1388-1(c)(3)(ii)(b).

287

 I.R.C. § 1388(h)(2)(B)(ii). 288

 Treas. Reg. § 1.1388-1(c)(3)(ii)(a).

289

81

The regulations don't include a sample bylaw provision for

qualified per-unit retain certificates as is done for qualified written

notices of allocation. Such a provision might read: 287

Each person who hereafter applies for and is accepted

as a member in this cooperative and each member of this

cooperative on the effective date of this bylaw who

continues as a member after such date shall, by such act

alone, consent that the amount of any per-unit retain

allocations with respect to his patronage occurring after 

 , which are made in qualified per-unit retain

certificates (as defined in 26 U.S.C. 1388(h)) and which

are received by him from the cooperative, will be taken

into account by him at their stated dollar amounts in the

manner provided in 26 U.S.C. 1385(a) in the taxable year

in which such per-unit retain certificates are received by

him.

Written notification of the adoption of this bylaw, a

statement of its significance, and a copy of the provision

shall be given separately to each member and prospective

member before becoming a member of the association.

For a bylaw consent to be effective, the Code requires that the

cooperative provide members with both written notification and a

copy of the bylaw. While the regulations don't contain specific 288

notification instructions for qualifying per-unit retain certificates,

the procedures for qualifying written notices of allocation are 289

considered applicable to qualified per-unit retain certificates.

The cooperative's written communication should make the

member aware of the bylaw and the significance of the consent.
Id.

290

 I.R.C. § 1388(h)(3)(B)(ii). 291

Id.

292

 I.R.C. § 1388(i).

293

 I.R.C. § 1382(b). 294

 I.R.C. § 1385(a).

295

82

Each member should be notified individually and not through a

notice posted at the association or published in a newspaper.290

Patron consent through a bylaw provision doesn't qualify

certificates relating to products delivered after the recipient ceases

to be a member of the association. In addition, it doesn't apply 291

to products delivered after the requisite language is stricken from

the bylaw.292

Nonqualified Per-Unit Retain Certificates

The Code defines a nonqualified per-unit retain certificate as

"a per-unit retain certificate which is not" a qualified certificate.293

Nonqualified certificates have many of the characteristics of

qualified ones. Like a qualified per-unit retain certificate, a

nonqualified certificate is a written notice which discloses to the

patron the stated dollar amount of a noncash allocation. It is based

on products marketed without reference to net earnings.

The key distinction is that a nonqualified certificate doesn't

include the requisite patron agreement to account for the

certificate's stated dollar amount as income when issued.

The tax treatment of nonqualified per-unit retain certificates is

comparable to the treatment of nonqualified written notices of

allocation. In the taxable year of issue, the cooperative doesn't

exclude the stated dollar amount of the nonqualified per-unit retain

certi-ficate from income. And the patron doesn't include the 294

stated dollar amount of the certificate as income at the time of

receipt.

295
 I.R.C. § 1382(b)(4). 296

 I.R.C. § 1382(b).

297

 I.R.C. § 1385(c).

298

 Priv. Ltr. Rul. 8447038 (Aug. 20, 1984).

299

 I.R.C. § 1382(b). The payment also affects the liability of a

300

recipient to take the per-unit retain allocation into account for tax

purposes. Riverfront Groves, Inc. v. Commissioner, 60 T.C. 435

(1973).

 I.R.C. § 1382(b)(3). 301

83

Only in the taxable year in which nonqualified per-unit

certificates are redeemed, can a cooperative reduce its gross

income by the amount of the redemption payout to certificate

holders. Amounts paid in redemption of nonqualified per-unit 296

retain certificates are "treated as a deduction in arriving at gross

income" by the cooperative.297

The patron recipient must include the redemption amount paid

by the cooperative as income in the taxable year received. This 298

finalizes the incidence of taxation for both.

The Service has concluded that a cooperative may issue both

qualified and nonqualified per-unit retain certificates in the same

year. Due to the dissimilar tax treatment between qualified and 299

nonqualified per-unit retain certificates, a cooperative issuing both

types of allocations should make it clear to patrons that consent

applies only to certificates designated as "qualified per-unit retain

certificates" by the board of directors.

PAYMENT OF PER-UNIT RETAINS

Per-unit retain allocations, regardless of the form in which

distributed, must be "paid" to patrons. And to be deductible 300

from a cooperative's gross income, per-unit retains distributed in

money, qualified per-unit retain certificates, or other property must

be paid "during the payment period for the taxable year during

which the marketing occurred." Similarly, nonqualified per-unit 301
 I.R.C. § 1382(b)(4). 302

 I.R.C. § 1382(d) and Treas. Reg. § 1.1382-4. 303

 Farm Service Cooperative v. Commissioner, 619 F.2d 718 (8th

304

Cir. 1980), 1980-1 U.S.T.C. ¶ 9352, rev'g, 70 T.C. 145 (1978). Cash

per-unit retains were paid when the grower delivered the product.

 Pub. L. No. 91-172, 83 Stat. 487, (1969), in 1969-3 C.B. 10. 305

See Priv. Ltr. Rul. 8838018 (June 23, 1988).

306

84

retain certificates must be issued "during the payment period for

the taxable year during which the marketing occurred."302

Payment Period

The "payment period" is the time interval in which per-unit

retains must be allocated to receive single tax treatment. Like that

for patronage refunds, the "payment period" for per-unit retains

begins on the first day of the taxable year and extends for 201⁄2

months, ending on the 15th day of the 9th month following the

close of the taxable year. For example, if a cooperative operates 303

on a calendartax year, the "payment period" extends from January

1 of the taxable year through September 15 of the following year.

Cooperatives may use more of the payment period in making

allocations as per-unit retains than as patronage refunds. Per-unit

retains can be paid anytime during the 12 month taxable year as

well as during the 81⁄2-month interval following the taxable year.

304

Patronage refunds can't be paid until after the cooperative's tax

year closes because they are based upon earnings for the year from

patronage business.

Prior to statutory recognition of cash per-unit retains in the Tax

Reform Act of 1969, it was questionable whether cash payments 305

made after the taxable year could relate back and affect gross

income for that taxable year. With the 1969 Code change,

however, cash payments made during the period following the

taxable year can relate back to the taxable year's marketing and are

deductible as per-unit retains in the taxable year.

306
See Wile, Taxation of Farmers' Cooperatives and their Patrons,

307

18 University of Southern California School of Law Tax Institute 449

(1966). The author notes:

The pooling system is frequently combined with the use of

capital or per unit retains. Where commodities require a longer

period of time for processing and sale or are to be stored and

sold at higher prices when the product supply is lower, the pool

may close long after the growers' delivery of their products to

the cooperative. Id. at 457-458.

 I.R.C. § 1382(e)(2). 308

 Code § 1382(e)(1) provides "patronage" shall be treated as 309

occurring in the taxable year the pool closes. Thus patronage refunds

for longstanding pools can only be paid during the payment period for

the year the pool closes.

85

Pooling and Statutory Payment Period

The marketing of products pooled on a seasonal or crop year

basis will not always coincide with a particular tax year or the 81⁄2

month period that follows. Pools may stay open for longer than

one year because the delivered crops need more time for

processing or marketing, or because storage might be desired until

themarket is more favorable. Growers, who contribute to pools, 307

need funds in the interim to pay expenses and finance new crops.

The Code recognizes the potential timing problems if multiyear marketing wasn't given appropriate treatment. Section

1382(e)(2) provides that "the marketing of products shall be

treated as occurring during any of the taxable years in which the

pool is open."308

This gives cooperatives some flexibility in timing per-unit

retain allocations under a multi-year pooling arrangement. Under

section 1382(e)(2), "marketing" must occur in just one of the years

the pool is open. This marketing activity is then attributed to all

other open pool years, resulting in a payment period for per-unit

retains extending for the life of the pool and the 81⁄2 months

immediately following the taxable year that the pool closes.309
 Farm Service Cooperative v. Commissioner, 619 F.2d 718 (8th

310

cir. 1980), rev'g, 70 T.C. 145 (1978). As stated by the U.S. Court of

Appeals for the Eighth Circuit:

We hold, then, that subchapter T requires a nonexempt

cooperative to segregate its patronage and nonpatronage

accounts in calculating its gross income, at least in those cases

where grower payments or per-unit retain allocations contribute to net operating losses in patronage activities. Id. at 726-

727.

See Priv. Ltr. Rul. 8005012 (Oct. 29, 1979). Here, the Service 311

determined that cash payments made during the 8 1⁄2 month period after

the taxable year ended were not patronage refunds because the pool was

still open. The Service then held that these cash proceeds, which were

distributed within four to six weeks after the close of the taxable year,

qualified as per-unit retains.

 Treas. Reg. § 1.1382-5 provides another example where 312

patronage is considered to have occurred in the taxable year in which

86

For example, if a pool is open for 2 years, the cooperative can

distribute per-unit retains at any time within the 2-year period as

well as during the 8 1⁄2-month period that immediately follows the

taxable year in which the pool closes.

Assigning per-unit retains paid in subsequent years to the

earliest taxable year of the pool may create a pool loss for the first

year which is carried over and offsets pool profits in subsequent

years in which the pool is open. When such a loss occurs, it must

be segregated from nonpatronage gains and carried back or

forward separately as the case may be.310

The flexibility provided under section 1382(e)(2) for pooling

arrangements involving per-unit retains contrasts with section

1382(e)(1) covering pooling that relates to patronage refunds.

Under section 1382(e)(1), the patronage is treated as occurring in

the taxable year in which the pool closes. If a pool closes 2 311

years after delivery of the product, the patronage is considered to

have taken place in the second year. This is true even if the

patron's business with the co-op took place during the first year.

312
the pool closes: 

Example. Farmer A delivers to the X Cooperative 100 bushels

of wheat on August 15, 1963, at which time he receives a 'per

bushel' advance. (Both farmer A and the X Cooperative file returns

on a calendar year basis.) On October 15, 1963 farmer A receives

an additional "per bushel" payment. The pool sells some of its

wheat in 1963 and the remainder in January of 1964. The pool is

closed on February 15, 1964. For purposes of section 1382(b), A's

patronage is considered as occurring in 1964.

 Treas. Reg. § 1.1382-5. 313

 Priv. Ltr. Rul. 8005012 (Oct. 29, 1979).

314

87

Sometimes an important issue in pooling situations is

determining the year in which the pool, for tax purposes, closes.

The regulations provide that "The determination of when a pool is

closed will be made on the basis of the facts and circumstances in

each case, but generally the practices and operations of the

cooperative organization shall control."313

This regulation was written before the Code was amended to

cover per-unit retains, but appears generally applicable to per-unit

retains because it is designed to cover products "marketed under

pooling arrangements" pursuant to I.R.C. § 1382(b).

To avoid keeping a pool open into the next fiscal year,

cooperatives sometimes close a pool just prior to the end of the

first fiscal year, and sell the remaining inventory to the next year's

pool. However, in at least one instance the Service refused to

recognize a cooperative's closing of a pool and selling forward of

the remaining inventory. The Service looked to Treas. Reg. §

1.1382-5 and determined that a pool was not closed based on the

facts that the marketing cooperative retained title and risk of loss

of a substantial amount of the goods in the pool.314
88

CHAPTER 9

REDEMPTION OF PATRONAGE EQUITY

Several preceding chapters have focused on tax issues raised

by the distribution of written notices of allocation and per-unit

retain certificates. This chapter looks at the consequences of the

subsequent redemption of patronage equity. The financial and

legal underpinnings of equity redemption are explained. Then key

tax considerations and options are discussed.

The primary factor in analyzing the tax implications of a

redemption of patronage equity is whether the written notice of

allocation or per-unit retain certificate is qualified or nonqualified.

Another factor is whether the redemption payout equals the

equity's stated value when issued. For example, the redemption of

a qualified written notice of allocation for less than face value may

require special tax computations by both the cooperative and the

holder of the notice to reflect changed circumstances from the time

the equity was issued.

ROLE OF EQUITY REDEMPTION

IN COOPERATIVE FINANCE

The regular redemption of patron equity is unique to

cooperatives. While other corporations occasionally "buy-back"

shares, only cooperatives return equityto investors on a systematic

basis. This is somewhat ironic, in view of the difficulty

cooperatives have attracting equity. But it is consistent with the

equitable concept that since current patrons benefit from service

provided by the cooperative, they should also be responsible for

capitalizing it.

Equity redemption is defined as returning equity to members

and other patrons who have previously invested it, in the form of

cash or other property. Over the years, patrons build up allocated
 Some equity redemption plans are briefly discussed in chapter 2 315

of these reports. For a thorough explanation of cooperative equity

redemption, see D. Cobia, et al., Equity Redemption: Issues and

Alternatives for Farmer Cooperatives, ACS Research Report No. 23

(USDA 1982).

 For a report of current cooperative equity redemption practices, 316

see Rathbone and Wissman, Equity Redemption and Member Equity

Allocation Practices of Agricultural Cooperatives, ACS Research

Report No. 124 (USDA 1993).

89

equity from retained patronage refunds and per-unit capital retains.

Equity redemption programs provide cooperatives with a

mechanism to keep a balance between each member's use of the

cooperative's services and that member's share of the responsibility

to provide equity capital.

While several methods are used to redeem equity, the most

315

common plan is to redeem oldest equity outstanding first and work

forward toward more current equities. If, each year, a cooperative

redeems the equity issued in the earliest year it has equity

outstanding, it is said to have a "systematic" redemption program.

For example, if a cooperative is on a 7-year revolving cycle,

patronage equities issued in 2005 would be redeemed for cash in

2012. Current patrons would be furnishing equity on the basis of

a 7-year moving average of the use they made of the cooperative.

Former members would be relieved of their burden of financing

the association 7 years after they ceased patronizing it.

Some cooperatives redeem equity on a base capital method.

Each member is assigned responsibility for providing a specific

amount of equity capital, based on use of the cooperative's

services. While more equity is collected from under-invested

members, equity is redeemed for over-invested members.

A cooperative that retains patronage refunds and/or collects

per-unit retains and also redeems allocated patronage equity on a

systematic basis has a way to continually acquire equity while

placing the primary responsibility for financing the association on

current patrons, in proportion to the extent of their patronage.316
 Priv. Ltr. Rul. 7926068 (March 29, 1979), quoting Marker v. 317

Scotts Bluff County, 289 N.W. 534, 537 (1939).

 Priv. Ltr. Rul. 7926068 (March 29, 1979), citing Stoller v. State, 318

105 N.W.2d 852 (1960).

 This statement assumes redemption payment is for the full face 319

amount of the equity.

 I.R.C. § 1382(b)(1) and Treas. Reg. § 1.1382-2(b)(1). Qualified 320

written notices of allocation are treated "as an item of gross income and

90

TAX TREATMENT OF EQUITY REDEMPTION

The term "redemption" is not defined in subchapter T of the

Code or the Treasury Regulations (regulations). One private letter

ruling characterized redemption as "the act of buying back or

repurchasing" something which may be accomplished in a 317

number of different ways, including "repurchase, cancellation,

repayment, or any other action otherwise satisfying one's

obligations."318

Redemption of patronage equity, like its issuance, signifies a

form of payment by the cooperative to the patron. However, it is

important to view the issuance and redemption acts as separate and

distinct events for purposes of tax treatment.

As indicated in earlier chapters on patronage refunds and perunit retains, tax consequences at the time of redemption, for both

the cooperative and its patrons, depends on whether the equity was

originally issued in qualified or nonqualified form.

Redemption of Qualified Patronage Equity

When qualified written notices of allocation or qualified perunit retain certificates are redeemed, the cooperative and the

patron recipients generally do not make any adjustments to income

in the taxable year of redemption.319

The cooperative deducted the stated value of qualified written

notices of allocation or qualified per-unit retain certificates 320 321
as a deduction therefrom." I.R.C. § 1382(b). See also I.R.C. §

1382(c)(2)(A), specifically permitting § 521 farmer cooperatives to

deduct qualified written notices of allocation representing nonpatronage

earnings distributed to patrons on a patronage basis.

 I.R.C. § 1382(b)(3) and Treas. Reg. § 1.61-5(d). Qualified per321

unit retain certificates are treated "as a deduction in arriving at gross

income." I.R.C. § 1382(b).

 I.R.C. § 1385(a).

322

 I.R.C. § 1388(d) defines "nonqualified written notice of allo- 323

cation" as "...a written notice of allocation which is not described in

subsection (c) [i.e., a qualified written notice of allocation] or a

qualified check which is not cashed on or before the 90th day after the

close of the payment period for the taxable year for which the

distribution of which it is a part is paid."

A per-unit retain certificate is nonqualified if the cooperative 324

fails to meet the necessary requirementsfor obtaining patron agreement.

See I.R.C. § 1388(i).

For financial accounting purposes it may be appropriate for 325

patrons to account for the value of the certificates as a receivable in the

year issued. This matter may be relevant for corporate patrons who

91

from gross income in the taxable year of issue. Patron recipients

include the face value of the qualified equity in gross income in

the taxable year received. As a result, single tax treatment for 322

the cooperative and patrons was finalized at the time the qualified

equity was issued.

Redemption of Nonqualified Patronage Equity

The tax treatment of nonqualified written notices of

allocation and nonqualified per-unit retain certificates is not 323 324

finalized at the time of initial distribution. In the year of issue,

cooperatives must include the stated value of the nonqualified

written notices or nonqualified per-unit retain certificates in gross

income. Patrons don't account for the stated value of the

nonqualified equity at the time of issue for tax purposes.325
report on audited financial statements and it indicates that the book

treatment and tax treatment of accounting for patronage equity

certificates are not necessarily the same.

 I.R.C. § 1382(b)(2) for redemption of nonqualified written 326

notices of allocation; I.R.C. § 1382(b)(4) for redemption of nonqualified

per-unit retain certificates.

 I.R.C. §1382(b). 327

 I.R.C. § 1385(c)(2)(C). 328

 I.R.C. §§ 1382(b)(2), 1382(b)(4), and 1382(c)(2)(B). 329

 I.R.C. § 1388(e). See also Treas. Reg. § 1.1382-2(c) which states 330

in part: "In determining the amount paid which is allowable as a

deduction under this paragraph, property...shall be taken into account at

its fair market value when paid."

See Priv. Ltr. Rul. 7926068 (March 29, 1979), wherein IRS 331

interpreted "amounts paid...in other property" to include the cancellation

of accounts receivable, issued to patrons to recover an operating loss.

See, also, Rev. Rul. 81-103, 1981-1 C.B. 447.

92

In the year of redemption, however, the cooperative can deduct

from income the value of payments in money or other property to

patron recipients to redeem nonqualified allocations. Payments 326

to redeem nonqualified written notices of allocation are treated by

the cooperative "in the same manner as an item of gross income

and as a deduction therefrom," while amounts paid in redemption

of nonqualified per-unit retain certificates are "treated as a

deduction in arriving at gross income."327

Patrons must recognize as ordinary income the amount of the

redemption payment in the tax year the funds or property are

received. Single tax treatment is thus finalized at the time of 328

redemption, with the tax obligation placed on the patron.

To be deductible by a cooperative, payments in redemption of

nonqualified equity must be made "in money or other property."329

Payment in "other property" is accounted for at fair market

value.330

While "other property" is not defined by the Code, issuance 331
 I.R.C. §§ 1382(b)(2) and 1382(c)(2)(B). 332

 I.R.C. § 1382(b)(4). 333

 In Rev. Rul. 81-103, 1981-1 C.B. 447, the redemption of 334

nonqual-ified written notices by crediting account receivables was

evidenced by "clearly identified book entries and notification to its

patrons."

 In Priv. Ltr. Rul. 7926068 (Mar. 29, 1979), the cooperative had

335

"properly notified its patrons at each of the steps involved in the

transaction" including "the redemption of previously issued

nonqualified written notices of allocation." See also Rev. Rul. 70-407,

1970-2 C.B. 52, wherein IRS emphasized the use of written notices to

patrons in approving cancellation of equity credits representing

qualified written notice of allocation to recover an operating loss.

 Priv. Ltr. Rul. 7925101 (March 23, 1979). Recall, however, a

336

cooperative will not receive a deduction if the new issue of written

notices are used to redeem previously issued nonqualified written

notices. I.R.C. § 1382(b)(2). 

93

of new written notices of allocation to redeem outstanding

nonqualified written notices of allocation is not permitted.332

Similarly, new per-unit retain certificates may not be issued to

redeem other nonqualified per-unit retain certificates.333

If all or part of the redemption payment is in a noncash form,

cooperative recordsshould reflect the payment and patrons should

receive tangible evidence of the redemption. No specific form

334

of notification is mandated, although some written notice is

probably required.335

The issuance of new nonqualified written notices of allocation

in the same year that outstanding nonqualified notices are

redeemed doesn't affect the tax treatment of either issue. In

determining total tax liability, a cooperative must account for both

transactions. This concept should apply as well to nonqualified 336

per-unit retain certificates issued in the same year that other

nonqualified per-unit retain certificates are redeemed.

A cooperative's ability to useCode section 1383 is not affected

by subsequent adjustments to its underlying net margins which
 Priv. Ltr. Rul. 8540051 (July 3, 1985), and Priv. Ltr. Rul.

337

8540056 (July 8, 1985). Nonqualified written notices of allocation

issued without regard to a I.R.C. § 481 adjustment caused by change in

pool accounting methods.

 Priv. Ltr. Rul. 8613017 (Dec. 23, 1985).

338

 Priv. Ltr. Rul. 8846030 (Aug. 22, 1988).

339

 Priv. Ltr. Rul. 7728030 (no date), 1977.

340

94

were the basis for the original issue of nonqualified written notices

of allocation.337

Corporate reorganizations may also take place without

impacting the tax status of nonqualified equity. In one instance,

a cooperative issued nonqualified written notices of allocation to

patrons of a particular division. When the division was spun off

as a separate cooperative, the nonqualified allocations were

transferred to the new cooperative as part of a tax-free

reorganization under Code section 368(a)(1)(D). IRS held the

nonqualifieds would be deductible when redeemed by the new

cooperative, just as they would have been had the reorganization

not occurred.338

And in a tax-free reorganization in which nonqualified per-unit

retain certificates were exchanged for a class of stock, a

cooperative was allowed to treat redemption of the stock as

redemption of the original nonqualified per-unit retain

certificates.339

Typically, nonqualified written notices of allocation or

nonqualified per-unit retain certificates are issued some time prior

to the taxable year of redemption. However, redemption may

quickly follow the time of issue, even within the payment period

of the same taxable year.

For example, a cooperative with a taxable year ending on June

30, can take a deduction based on redemption of nonqualified

written notices of allocation and per-unit retain certificates so long

as the issue and redemption take place by March 15 of the

following year. Or, a cooperative may simply distribute cash 340
 I.R.C. § 1381(b)(1). 341

 I.R.C. § 1382(b)(3). 342

 Treas. Reg. § 1.1382-2(c). A separate regulation, § 1.1382-3(d),

343

pertaining specifically to section 521 cooperatives, contains the same

rule. Although these regulations only mention nonqualified written

notices of allocation, the same rule would appear applicable to the

redemption of nonqualified per-unit retain certificates. 

95

patronage refunds or per-unit retains. Cooperatives may

341 342

choose to do this if the objective is to return income to patrons

instead of providing equity capital to the cooperative.

One technical rule must be followed. Both nonqualified

written notices of allocation and nonqualified per-unit retain

certificates may be redeemed within the payment period of 2

different tax years. The payment period extension of one tax year

81⁄2 months into the following tax year causes the overlap.

If this occurs, a cooperative must take the redemption-based

deduction in the first taxable year. The regulation includes this

example: "[I]f a cooperative which reports its income on a

calendar year basis pays an amount in redemption of a

nonqualified written notice of allocation on January 15, 1966, it

will be allowed a deduction for such amount only for its 1965

taxable year."343

Tax Computation Upon Redemption of

Nonqualified Equity

Nonqualified written notices of allocation and per-unit retain

certificates may be redeemed years after original issue. Yet, the

single tax principle cannot be finalized in the redemption year by

a simple "reversal" of the tax burden between the recipient and

cooperative. It wouldn't be feasible to reopen the tax returns of all

the patron recipients for the year in which the nonqualified paper

was issued.
 I.R.C. § 1383. 344

 I.R.C. § 1385(c). The tax treatment of patrons is discussed in 345

chapter 10.

 I.R.C. § 1383(a)(1); Treas. Reg. § 1.1383-1(a)(1)(i).

346

96

Cooperatives and patron recipients recognize all tax

adjustments brought about byredemption of nonqualified paper in

the year of redemption. The applicable rules are found in Code

section 1383. It deals exclusively with the tax computations where

a cooperative redeems nonqualified written notices of allocation

and nonqualified per-unit retain certificates.344

Section 1383(a) contains a general statement that allows

cooperatives to deduct redemptions of nonqualified patronage

equities in the year of redemption. It then provides two methods

for a cooperative to use in computing the deductible amount and

specifically states the tax due is the lesser of the two amounts.

The following analysis discusses the two methods and provides

examples to illustrate when each is advantageous.

Patrons include payments in redemption of nonqualified

equities in taxable income in the year of receipt, regardless of the

method the cooperative uses to determine its tax adjustment.345

Redemption Year Alternative

Under the first method, the cooperative takes a regular

deduction for amounts "paid in redemption" of nonqualified

equities. The redemption amount is treated as a deduction under 346

the relevant Code section 1382 provision:

! Section 1382(b)(2) for regular nonqualified written notices

of allocation,

! Section 1382(b)(4) for nonqualified per-unit retain certificates, or

! Section 1382(c)(2)(B) for nonqualified written notices of

allocation representing patronage-based distributions of

nonpatronage income by a section-521 farmer cooperative.
 I.R.C. § 1383(a)(2) and Treas. Reg. § 1.1383-1(b)(1). The phrase 347

"year or years" is used because a cooperative may, in its current taxable

year, redeem nonqualified equities issued in more than one previous

year. The singular term "year" is used in this section to simplify the

explanation.

 Treas. Reg. § 1.1383-1(b)(3). 348

 I.R.C. § 1383(a)(2)(B); Treas. Reg. § 1.1383-1(a)(1)(ii). 349

 Treas. Reg. § 1.1383-1(b)(3). 350

97

Prior Year Alternative

The alternative method for calculating tax on redemption of

nonqualified equity involves redoing certain calculations for the

year(s) the nonqualifieds were issued and using the results to

adjust the cooperative's tax deemed paid in the year of redemption.

Under the prior years alternative, a cooperative first recalculates the amount of tax for the prior year or years.

347

The regulations provide that the first step in determining the

change in tax for the prior taxable year is to determine the amount

of tax paid in that prior year. As the base figure, take the tax

reported on the cooperative's applicable tax return, add any tax

assessed (or collected without assessment) as deficiencies, and

then subtract the amount of any rebates paid by IRS to the

cooperative. This step produces the actual tax liability of the 348

cooperative for the year the nonqualified equities were issued.

The cooperative next computes the aggregate decrease in tax

for the prior taxable yearthat results from treating the nonqualified

written notices of allocation and/or nonqualified per-unit retain

certificates issued during that year as if they had been issued in

qualified form. In calculating the decrease in tax for the prior 349

taxable year, appropriate adjustment is made to "any item which

is dependent upon the amount of gross income or taxable income

(such as charitable contributions, net operating losses, the foreign

tax credit, and dividends received credit)."350

Finally, the cooperative subtracts any decrease in taxes caused

by treating the nonqualified notices as qualified in the year of
 I.R.C. § 1383(a)(2), Treas. Reg. § 1.1383-1(a)(ii).

351

 The same analysis would be valid if the cooperative had issued 352

nonqualified per-unit retain certificates, either exclusively or in

combination with nonqualified written notices of allocation.

98

allocation from otherwise taxable income in the year of

redemption.351

Examples of Nonqualified Redemptions

A numerical model will illustrate how the various

computations work and how a cooperative determines which of

the two methods results in the least tax.

General Model

As illustrated in Example 1, assume that in 2003 Cooperative

A had $20,000 in margins and the entire amount was distributed

to member-patrons as nonqualified written notices of allocation.352

The $20,000 is reported as taxable income in 2003 by Cooperative

A. Cooperative A was in the 15-percent tax bracket in 2003, so

the total tax due was $3,000.

In 2010, Cooperative A has margins of $30,000. This amount

is also distributed entirely to patrons as nonqualified notices. In

addition, Cooperative A redeems the nonpatronage notices distributed in 2003.

Under the redemption year alternative, Cooperative A starts

its tax computation by first recognizing the $30,000 in margins

distributed an nonqualified notices as taxable income. Then, it

deducts the $20,000 paid in redemption of the 2003 nonqualified

notices, leaving net taxable income for 2010 of $10,000. At the 15

percent tax rate, the tax due is $1,500.

Under the prior year alternative, Cooperative A recomputes

its taxable income for 2003 assuming it had distributed the

$20,000 margin for that year as qualified written notices of allo-
99

EXAMPLE 1: GENERAL MODEL

a) Redemption Year Alternative

2003

Net Margin 20,000

Nonqualified Allocations 20,000

Taxable Income 20,000

Tax Due (15% x 20,000) 3,000

2010

Net Margin 30,000

Nonqualified Allocations 30,000

Redemption of Nonqualifieds from 1988 (20,000)

Taxable Income 10,000

Tax Due (15% x 10,000) 1,500

b) Prior Year Alternative

2003 (recomputed)

Net Margin 20,000

Assume Payment as Qualified Allocations (20,000)

Taxable Income 0

Tax with Recomputation 0

Tax Paid in 2003 3,000

Tax Savings from Recomputation 3,000

2010

Net Margin 30,000

Nonqualified Allocations 30,000

Taxable Income 30,000

Unadjusted Tax (15% x 30,000) 4,500

Tax Savings from Recomputation (3,000)

Tax Due 1,500
 To keep the example simple, the assumption is made that there

353

are no adjustments to other items dependent on the amount of gross or

taxable income.

 Treas. Reg. § 1.1383-1(a)(3). 354

100

cation. The entire $20,000 patronage refund is now deductible and

the tax savings for 2003 is $3,000. Cooperative A next figures

353

the tax on its $30,000 in taxable income for 2010. At the 15-

percent rate, the tax is $4,500. Finally, it subtracts the tax it would

have saved using qualified notices in 2003 ($3,000) from the tax

otherwise due in 2010 ($4,500), and arrives at tax due in 2010 of

$1,500.

Under these or similar facts (no change in the applicable tax

rate and margins in the year of redemption at least equal to those

in the year of issuance), both methods produce the same result.

The regulations provide that when this happens, the tax shall be

computed under the simpler redemption year method and other

parts of section 1383 shall be disregarded.354

Change in the Applicable Tax Rate

Assume the same facts in Example 1, except that in 2008 a

change in tax rates became effective so that the minimum

corporate rate was increased from 15 percent to 20 percent.

As reflected in Example 2, under the redemption year

alternative, the 20 percent rate would be applied to Cooperative

A's otherwise taxable income for 2010 ($30,000) less the

deduction for redemption of the 2004 nonqualified notices

($20,000). The tax due would be $2,000 ($10,000 x .20).

Under the prior year alternative, the recomputation ofthe 2004

tax would reflect the tax rate in effect in that year. The deduction

would still be $3,000 ($20,000 x .15). However, now the

cooperative's unadjusted tax for 2010 is $6,000 ($30,000 x .20).

The tax due under this method is $3,000 ($6,000 - $3,000).

Thus, other things being comparable, if the applicable tax rate

in the year of redemption is higher than in the year of distribution,

then the redemption year method will be more favorable to the 
101

EXAMPLE 2: INCREASE IN TAX RATE FROM

15% TO 20% IN YEAR OF REDEMPTION

a) Redemption Year Alternative

2003

Net Margin 20,000

Nonqualified Allocations 20,000

Taxable Income 20,000

Tax Due (15% x 20,000) 3,000

2010

Net Margin 30,000

Nonqualified Allocations 30,000 

Redemption of Nonqualifieds from 1988 (20,000) 

Taxable Income 10,000

Tax Due (20% x 10,000) 2,000

b) Prior Year Alternative

2003 (recomputed)

Net Margin 20,000

Assume Payment as Qualified Allocations (20,000)

Taxable Income 0

Tax with Recomputation 0

Tax Paid in 1988 3,000

Tax Savings from Recomputation 3,000

2010

Net Margin 30,000

Nonqualified Allocations 30,000 

Taxable Income 30,000

Unadjusted Tax (20% x 30,000) 6,000

Tax Savings from Recomputation (3,000)

Tax Due 3,000
 This example reflects the corporate income tax rates in effect for

355

2004: 15 percent on the first $50,000 of taxable income; 25 percent on

taxable income from $50,001 to $75,000; and 34 percent on taxable

income above $75,000. I.R.C. § 11.

102

cooperative. If the applicable rate is lower in the year of

redemption, then the prior year method will be more favorable.

Higher Marginal Tax Rate in Redemption Year

With the progressive nature of the income tax rate structure, a

similar result to Example 2 occurs if the cooperative's margins are

such that it is in a higher marginal tax bracket in the year of

redemption.

Example 3 assumes the same facts as in Example 1, including

the actual tax rates, except that in 2010 Cooperative A has margins

of $100,000. Again, all of the margin is distributed to patrons as

nonqualified written notices of allocation.

Under the redemption year alternative, Cooperative A would

deduct the $20,000 paid in redemption of the 2003 nonqualified

notices from its otherwise taxable income of $100,000. The tax

due on the resulting $80,000 in taxable income would be $15,450

[($50,000 x .15) + ($25,000 x .25) + ($5,000 x .34)].355

Under the prior year method, the adjustment for redemption of

the2003 nonqualified notices is still the amount of tax that would

have been saved had qualified notices been issued in 2003, or

$3,000 ($20,000 x .15). When this is subtracted from the

cooperative's unadjusted tax obligation of $22,250 [($50,000 x

.15) + ($25,000 x .25) + ($25,000 x .34)], the tax due is $19,250.

Thus, the result of the cooperative being in a higher tax bracket

because of higher earnings in the year of redemption is the same

as a tax rate increase. Other things being comparable, the redemption year method will be more favorable to the cooperative.
103

EXAMPLE 3: HIGHER MARGINS IN YEAR OF

REDEMPTION

a) Redemption Year Alternative

2003

Net Margin 20,000

Nonqualified Allocations 20,000

Taxable Income 20,000

Tax Due (15% x 20,000) 3,000

2010

Net Margin 100,000

Nonqualified Allocations 100,000

Redemption of Nonqualifieds from 1988 (20,000)

Taxable Income 80,000

Tax Due

 (15% on first 50,000) 7,500

 (25% on next 25,000) 6,250

 (34% on final 5,000) 1,700 15,450

b) Prior Year Alternative

2003

Net Margin 20,000

Assume Payment as Qualified Allocations (20,000)

Taxable Income 0

Tax with Recomputation 0

Tax Paid in 1998 3,000

Tax Savings from Recomputation 3,000

2010

Net Margin 100,000

Nonqualified Allocations 100,000

Taxable Income 100,000
104

Unadjusted Tax

 (15% on first 50,000) 7,500

 (25% on next 25,000) 6,250

 (34% on final 25,000) 8,500 22,250

Tax Savings from Recomputation ( 3,000)

Tax Due 19,250

Lower Margins or Loss in Redemption Year

As shown in Example 4, if margins in the year of redemption

are substantially lower than in the year nonqualified notices being

redeemed were issued and thus the cooperative is subject to a

lower marginal tax rate, the prior year method is more favorable.

This advantage might be made even more significant by a special

rule permitting cooperatives to recapture tax paid in the year of

issuance that might otherwise be lost under the computation

methods.

Assume the same basic facts as in Example 3, only reverse the

margins so that Cooperative A earned $100,000 in 2003 and only

$20,000 in 2010. All margins are again distributed as nonqualified

allocations.

Under the redemption year method, deduction of the $100,000

paid in redemption of 2003 nonqualified notices from the $20,000

in otherwise taxable income for 2010 would yield a tax loss of

($80,000). The only benefit would be a savings of the $3,000 in

taxes otherwise due on the $20,000 in 2010 margins ($20,000 x

.15).

Under the prior year method, the cooperative would have a

potential deduction of $22,250, the savings by treating the

nonqualified notices issued in 2003 as qualified notices for that

year. The tax obligation, without adjustment, for 2010 would be

only $3,000 ($20,000 x .15).

Access to the tax loss carryback or carryover provided in Code

section 172 to use the ($80,000) loss generated under the

redemption year method is apparently precluded. The regulations

provide that the prior year alternative in Code section 1383(a)(2)
105

EXAMPLE 4: LOWER MARGINS OR A LOSS

IN YEAR OF REDEMPTION

a) Redemption Year Alternative

2003 

Net Margin 100,000

Nonqualified Allocations 100,000

Taxable Income 100,000

Tax Due

 (15% on first 50,000) 7,500

 (25% on next 25,000) 6,250

 (34% on final 5,000 8,500 22,250

2010

Net Margin 20,000

Nonqualified Allocations 20,000

Redemption of Nonqualifieds from 1988 (100,000)

Taxable Income (80,000)

Tax Due 0

b) Prior Year Alternative

2003

Net Margin 100,000

Assume Payment as Qualified Allocations (100,000)

Taxable Income 0

Tax with Recomputation 0

Actual Tax Paid 22,250

Tax Savings from Recomputation 22,250

2010

Net Margin 20,000

Nonqualified Allocations 20,000

Taxable Income 20,000

Unadjusted Tax (15% x 20,000) 3,000
 Treas. Reg. § 1.1383-1(a)(3). 

356

 Treas. Reg. § 1.1383-1(a)(2). 357

 I.R.C. § 1383(b)(3). This does not prevent a cooperative from 358

deducting, in the year of redemption, the value of nonqualified

distributions made in a year a refund or credit is claimed under §

1383(b)(1). Priv. Ltr. Rul. 7925101 (March 23, 1979).

 I.R.C. § 1383(b)(1). See also Treas. Reg. § 1.1383-1(c).

359

Id.

360

106

Tax Savings from Recomputation (22,250)

Tax Credit 19,250

must be used "when a credit or refund would be allowable for the

taxable year under section 1383(b)(1)."356

If a cooperative uses the prior year alternative in section

1383(a)(2), then redemption deductions available under sections

1382(b) or 1382(c) cannot be used in calculating taxable income

or loss for that year, "including the computation of any net

operating loss carryback or carryover."357

The tax calculated under the prior year alternative relates back

to the year the nonqualified paper was first issued. The tax impact

triggered by redemption, however, is confined to the taxable year

in which redemption takes place. The Code emphasizes the

relation back concept and the limited use of the prior year method

when it states that a deduction based on section 1383(a)(2) "shall

not be taken into account for any purposes of (subchapter T) other

than for purposes of this section."358

The special rule applies here. Code section 1383(b)(1) provides that if the decrease in tax determined under the prior year

alternative exceeds the redemption year tax computed without the

deduction, then the excess amount "shall be considered to be a

payment of tax on the last day prescribed by law for the payment

of tax for the taxable year." The excess is then "refunded or 359

credited in the same manner as if it were an overpayment for such

taxable year...."360
 Treas. Reg. § 1.1383-1(d).

361

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 362

Handling of Losses, Cooperative Information Report 44, Part 5 (USDA

2005), pp. 43-54.

See infra pp. 142-148. 363

107

In the example, Cooperative A would be entitled to a refund or

credit for 2010 of $19,250, the difference between the recovery of

2003 taxes ($22,250) and the tax otherwise due on margins for

2010 ($3,000). The tax adjustment for using the prior year alternative is returned to the taxpayer as if it were a tax deposited in the

year the return is filed for the year of redemption and no interest

is recovered, regardless of how old the certificates are. 

An additional, more complex example of the application of

Code section 1383 is provided in the regulations.

361

REDEMPTION AT LESS THAN FACE VALUE, FOR

REASONS OTHER THAN LOSS RECOUPMENT

While cooperatives normally redeem written notices of

allocation and per-unit retain certificates at face value, this is not

always the case. Cooperatives have, from time to time, redeemed

outstanding patronage-based equities at less than face value for

two general reasons. The first is to recoup losses. The IRS has

given cooperatives considerable flexibility in redeeming equities

for less than face value in these instances. Rulings and

determinations that discuss handling of losses at the cooperative

level are covered in Part 5 of these reports. As a redemption at 362

less than face value always creates a loss for the patrons, tax

treatment at the patron level is reported later in this chapter.363

The second reason equities are redeemed at less than face

value is as part of an ongoing capital management strategy. Early

redemption may be implemented, for example, to sever financial
 Priv. Ltr. Rul. 8015048 (Dec. 31, 1979); Tech. Adv. Mem. 364

9249005 (Dec. 4, 1992). For a discussion of the practical and legal

reasons to terminate memberships of former patrons, see Donald A.

Frederick, Keeping Cooperative Membership Rolls Current, ACS

Cooperative Information Report 37 (USDA 1991).

 Priv. Ltr. Rul. 8225100 (Mar. 25, 1982).

365

 Priv. Ltr. Rul. 7840010 (June 22, 1978), Priv. Ltr. Rul. 8031041 366

(May 8, 1980), Priv. Ltr. Rul. 8033070 (May 22, 1980), among others.

 Priv. Ltr. Rul. 7410291300A (Oct. 29, 1974).

367

 I.R.C. § 311(a). 368

108

relations with an inactive or terminated member, as part of a 364

financial restructuring, or to convey some cash to the members 365

as rapidly as possible. This section of these reports looks at the 366

Service’s rather restrictive approach to redemptions as less than

face value that are part of capital management, and the court

reactions thereto.

Code Sec. 311

The Service’s first examination of the tax consequences at the

cooperative level involved a co-op that wished to both simplify its

capital structure by eliminating a class of capital credits that

represented older retained qualified patronage refunds and get

some cash into the hands of the retired or otherwise inactive

patrons who held most of that paper. The cooperative proposed to

do so at a steep discount, $.20 cents per $1.00 of face value. IRS

held the cooperative need not recognize a gain as a result of the

proposed redemption.367

The Service found the redemption of qualified equity was

governed by Code sec. 311(a). Sec. 311(a) provides a corporation

doesn't recognize gain or loss on a distribution of (1) its stock or

rights to acquire its stock or (2) property that hasn't increased in

value.368
 I.R.C. § 317(a). 369

 Treas. Reg. § 1.311-1(a).

370

 Pasco Packing Ass’n v. U.S., 1957-2 USTC (CCH) 58,049 (So. 371

D. Fla. 1957); Atwood Grain and Supply Co. v. Commissioner, 60 TC

412 (1973). 

 Priv. Ltr. Rul. 7743054 (July 28, 1977).

372

109

The rationale for this approach is as follows. The term

"property," as used in this part of the Code, includes money.369

The term "distribution with respect to its stock" includes

distributions made in redemption of stock (other than distributions

in complete or partial liquidation). Finally, the term "stock" as 370

used in the Code is considered broad enough to include equity

interests not specifically called stock, such as the many terms

cooperatives use to refer to retained patronage allocations.371

Thus, under Code section 311(a), money paid by a cooperative in

redemption of patronage-based equities is a distribution of

property with respect to its stock that doesn't produce a gain or

loss to a cooperative for tax purposes.

The Tax Benefit Rule

In a short time, IRS reversed its position. A second

cooperative, that also planned to redeem old paper representing

retained qualified patronage refunds for 20 cents on the dollar,

asked for a similar determination that it would not recognize a

gain for tax purposes on the transactions. This time the Service

said the co-op would have to recognize gain to the extent that

previously claimed patronage refund deductions exceeded the

amounts paid in redemption of the old equities. The Service

asserted that the "tax benefit rule," a tool of judicial interpretation

not found in the Code, prevailed over section 311.372

The tax benefit rule provides that recovery of an item which

produced an income tax benefit in a prior year must be added to
See, e.g., Twitchco Inc. v. United States, 348 F. Supp. 330 (M.D. 373

Ala. 1972); Hillsboro National Bank v. Commissioner, 460 U.S. 370

(1983).

 Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931); Putnam

374

National Bank v. Commissioner, 50 F.2d 158 (1931); Commissioner v.

Liberty Bank & Trust Co., 59 F.2d 320, 325 (1932).

 I.R.C. § 111(a). 375

110

income in the year of recovery. The tax benefit rule has been in 373

force in one form or another almost since enactment of the 16th

Amendment and the decision to levy the income tax on an annual

accounting basis. It was immediately recognized that some

transactions would take 1 or more tax years to complete. When a

taxpayer was able to deduct something in one year and recover the

amount deducted in a subsequent year, the courts said taxpayer

had to include the recovered amount in income in the year of

recovery.374

A common example involves a seemingly uncollectible debt.

The debtor may believe the debt is uncollectible and legitimately

deduct it in one year. However, if it is repaid in a later year, the

repayment must be included in income in the year of repayment.

Sometimes this results in an unfair tax obligation. The

taxpayer may not have had any tax liability in the year the

deduction was taken, so it didn't produce a tax savings. However,

if the taxpayer had taxable income in the year of recoupment, a tax

would be due on the repayment amount.

In 1942, the predecessor to current Code sec. 111 was enacted

to protect taxpayers in this situation. Section 111 states that a

taxpayer need not include in gross income "income attributable to

the recovery during the taxable year of any amount deducted in

any prior taxable year to the extent such amount did not reduce the

amount of tax" owed in the prior year. Thus, while Congress 375

didn't specifically codify the tax benefit rule, it implicitly

recognized it and limited its applicability to the amount of tax

savings realized in the earlier year.
 Putoma Corp. v. Commissioner, 66 T.C. 652, 664 n.10 (1976), 376

aff'd, 601 F.2d 734 (5th Cir. 1979).

 Priv. Ltr. Rul. 7743054 (July 28, 1977).

377

111

Today, the tax benefit rule is characterized as one of inclusion

and exclusion. "Recovery of an item previously deducted must be

included in income; that portion of the recovery not resulting in a

prior tax benefit is excluded."376

Where a co-op redeems qualified patronage equity at less than

face value, the tax benefit rule says the co-op obtains an income

tax benefit because the deduction for full value in the year of issue

is not offset by the same amount of payment at redemption.

IRS said that a cooperative's cash redemption of qualified

equity credits for less than face value: 

...is distinguishable from the situation in which a corporation redeems its stock as described in section 311 of

the Code...[For qualified patronage based equities the] full

face amount of the equity credits was either excluded from

income or deducted from income in accordance with the

provisions of Subchapter T of the Code when they were

issued. The cooperative now plans to distribute only a

fraction of the face value of these equity credits to its

patrons.

In this situation the tax benefit rule prevails over the

provisions of section 311 of the Code. The tax benefit rule

is of judicial origin, and is not expressly stated in the

Code. The rule requires that if an amount is deducted from

gross income in one taxable year and provides a tax benefit

to the taxpayer in that year, and the amount is recovered in

a later year, the recoverymust be included in income in the

later year (citation omitted).

It is also apparent that the tax benefit rule acts as an

override of specific statutory non-recognition provisions

(citation omitted). 377
 Tech. Adv. Mem. 7840010 (June 22, 1978).

378

 Priv. Ltr. Rul. 8033070 (May 22, 1980).

379

112

The Service issued subsequent letter rulings also applying the

tax benefit rule to find a cooperative that redeems patronage-based

equity at less than face value must recognize a gain, in the year of

redemption, for the difference between the deductions taken in the

year(s) of issuance and the amount of the distribution in

redemption.

The first involved a Section 521 farmer cooperative that

redeemed qualified written notices of allocation at a discount in

response to patron requests for cash before the equities would be

redeemed under the co-op’s eight-yearrevolving cycle. The co-op

accepted the applicability of the tax benefit rule and included the

discounted amount as income in the year discounted.

IRS then refused to permit the cooperative to deduct the

amounts paid out to patrons at the time of redemption under either

of two theories advocated by the cooperative. First, even though 378

the amounts were paid on the basis of patronage, IRS said they

were not “patronage dividends” deductible under Code sec.

1382(b). Second, the amounts were not “earnings” and thus did

not qualify for the deduction available for an amount paid on a

patronage basis with respect to nonpatronage sourced earnings

during the taxable year under Code sec. 1382(c). So the cooperative had to pay tax on the amount of its gain.

The next ruling also concerned a cooperative (without section

521 tax status) that conceded that the gain was taxable income.

379

The Service agreed with the request of this cooperative to treat the

gain as nonpatronage income, retain the net amount of such

income as permanent capital in an unallocated reserve, and assign

interest and tax expenses related to the early redemption at less

than face value entirely to the resulting nonpatronage income.

This allowed the cooperative to distribute all of its patronagesourced income as deductible patronage refunds.
 Priv. Ltr. Rul. 8225100 (March 25, 1982).

380

 Tech. Adv. Mem. 9249005 (Dec. 4, 1992).

381

113

In 1981, a federated marketing cooperative came up with a

novel attempt to circumvent the tax benefit rule. It argued the 380

patrons who agreed to take less than full value for their retained

qualified written notices of allocation were making a tax-free gift

to their cooperative. The Service found no intent to make such a

gift and, again applying the tax benefit rule, said the cooperative

must recognize the gain as income.

Gold Kist Decision

At the time under consideration, Gold Kist was a large farmer

cooperative that had provided a variety of goods and services to

farmers in the Southeast for several decades. For many years,

Gold Kist allocated the bulk of its margins to members as

qualified patronage refunds. Gold Kist traditionally redeemed

outstanding retains at face value under a regular revolving cycle

(usually about 20 years) or upon the death of the holder of the

retains.

Gold Kist also regularly honored requests by producers who

terminated their membership in Gold Kist to promptly redeem that

person’s retains. However, to make sure remaining patrons

weren’t disadvantaged, Gold Kist reduced the amount it paid to

former members choosing this option to the present value of the

retains.

Gold Kist did not report as income the difference between the

face value of the retains and the discounted amount paid to

patrons. The Service challenged Gold Kist on this issue. In 1992,

after a period of negotiation, IRS issued a technical advise

memorandum again applying the tax benefit rule. It said a

cooperative must recognize as taxable income the difference

between the stated dollar amount of qualified written notices of

allocation and a lesser amount paid to redeem the notices.381
 Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983). 382

 460 U.S. at 383. 383

 The synopsis of Gold Kist's position is based on Pinney L. Allen, 384

Timothy J. Paeden & Ben E. Muraskin, New Opportunities for

114

The IRS assessed deficiencies against the cooperative for three

open tax years. Gold Kist sued in the U.S. Tax Court to void those

assessments.

The positions of the parties reflected the arguments discussed

in the previous subsection of this report. The Service argued that

the cooperative realized a tax benefit when it deducted the face

value of the qualified retains when issued and, under the tax

benefit rule, loses that benefit when the retains are cancelled.

Gold Kist raised two arguments. First, it said that the tax

benefit rule did not apply in this case. Gold Kist relied on the U.S.

Supreme Court's interpretation of the tax benefit rule in Hillsboro

National Bank v. Commissioner. In Hillsboro, the Court stated: 382

Not everyunforeseen event will require the taxpayer to

report income in the amount of his earlier deduction. On

the contrary, the tax benefit rule will "cancel out" an earlier

deduction only when a careful examination shows that the

later event is indeed fundamentally inconsistent with the

premise on which the deduction was initially based.

(emphasis added)383

Gold Kist asserted that the transaction creating the patronage

refund deduction at the cooperative level was completed when the

allocation was made and the patron consented to include the

amount of any retained allocation in its income. As subchapter T

didn't require that any amount ever be paid out in redemption of

the retained allocation, there could not be a "fundamental

inconsistency" between the original patronage refund distribution

and the later redemption of the retained portion at less than face

value.384
Cooperatives Regarding the Redemption of Equity, XLX The

Cooperative Accountant 3-7 (Fall 1997).

 Gold Kist v. Commissioner, 104 T.C. 696 (1995), rev'd, 110 F.3d

385

769 (11th Cir. 1997).

 104 T.C. at 715. 

386

 104 T.C. at 719. Some cooperative advisers are upset over this 387

finding, as it may call into question the applicability of other tax rules

covering "stock" to retained cooperative equity. They feel the court

could have merely relied on the tax benefit rule to justify its holding.

As the 11th Circuit didn't find it necessary to address this finding, it

remains unclarified at this time.

115

Second, Gold Kist resurrected the position first accepted and

then discarded by the Service in the 1970s, that this redemption of

equity was a distribution with respect to stock that should not be

recognized for tax purposes under Code sec. § 311.

The Tax Court rejected both arguments. First, it held that 385

the purpose of Subchapter T is to ensure that someone pays a tax

on patronage earnings. When a cooperative redeems a qualified

patronage refund for less than face value and treats the residual as

unallocated equity, the retained portion is no longer a patronage

refund.

The Tax Court relied on the tax benefit rule. It concluded that

“...the redemption of qualified written notices of allocation at less

than their stated amounts is fundamentally inconsistent with the

deduction of notices at their stated amounts and that the difference

represents an amount which no longer qualifies as a patronage

refund.”386

Second, the Tax Court found that since Gold Kist’s written

notices of allocation were not issued as formal shares of stock,

they “are not stock for purposes of section 311 and that section

311(a) therefore does not apply. Consequently, we need not

address whether section 311 overrides the tax benefit rule.”387
 Gold Kist v. Commissioner, 110 F.3d 769 (11th Cir. 1997),

388

rev’g., 104 T.C. 696 (1995).

 110 F.3rd at 773. 389

116

Gold Kist appealed this decision. The U.S. Court of Appeals

for the 11th Circuit reversed the Tax Court and relieved Gold Kist

of any tax liability on the transactions under review.388

The Court of Appeals found that the original distribution of the

patronage refund and its constructive receipt by the patrons is a

single, completed transaction. The voluntary reinvestment of the

funds and their ultimate redemption for less than face value is a

second, unrelated transaction. The court summarized:

So, as the structure and legislative history of

Subchapter T make clear, Gold Kist's deduction is

premised on its patrons' consent to include the stated

amount of the written notice in gross income. We cannot

say that Gold Kist's redemption of qualified written notices

of allocation for less than their stated amounts is

fundamentally inconsistent with this premise. A tax year

1987 deduction, for example, is not initially premised on

a commitment by Gold Kist to pay in real dollars the stated

value ofthe qualified written notice of allocation; payment

twenty years later of that amount is simply not the

equivalent of the 1987 stated value.389

As this determination decided the case for Gold Kist, the court

did not address the Code sec. 311 issue.

The Service decided not to appeal the 11th Circuit decision.

However, IRS has also not embraced it. In a subsequent letter

ruling, the Service, in finding a requesting organization would be

“operating on a cooperative basis,” noted that the organizational

documents provided, “...a withdrawing member may have its

retained patronage allocation redeemed for amounts agreeable to

the Cooperative and the withdrawing member in full satisfaction
 Priv. Ltr. Rul. 200224017 (March 15, 2002).

390

 Priv. Ltr. Rul. 200414019 (Dec. 15, 2003).

391

 The marginal tax rate for many individuals was reduced to 25 392

percent, beginning with 2003, under the Jobs and Growth Tax Relief

Reconciliation Act of 2003, Pub. L. No. 108-27, § 105(a), 117 Stat. 752,

117

of the claim.” The Service then said, “Any discount would be

includable in theCooperative’s non-patronage income pursuant to

the tax benefit rule.”390

A later ruling involved a cooperative in bankruptcy that was

liquidating all of its assets to satisfy the claims of its creditors.

The cooperative’s equity was now worthless, but under bankruptcy

law, would not be canceled. The Service restated its belief in the

tax benefit rule but distinguished this situation from that of Gold

Kist, saying:

...Coop should not recognize any gain or loss with

respect to the patronage equity. In situations in which a

cooperative has redeemed its patronage equity from its

patronage equity holders at a discount, the Service position

is that the cooperative must recognize income in an

amount equal to the discount under the tax benefit rule.

However,Coop herein will not be cancelling the patronage

equity. Coop will not be recovering for itself the amount

it previously deducted, since all amounts will be paid to

Coop’s creditors in partial settlement of the amount due

Coop’s creditors.391

Persons interested in learning more about the implications of

the Gold Kist decision might want to work through the following

example. It illustrates why the Service is not pleased.

Assume Cooperative C has a marginal tax rate of 34% and

Patron P a marginal tax rate of 25%. These are the basic rates

applied to middle-income taxpayers at the time this report was

written.392
755 (current version at 26 U.S.C. § 1(i)(2)).

118

Year of Allocation. In 2005, C paid a patronage refund of

$100 to P, consisting of $20 in cash and a qualified written

notice of allocation for $80, which was credited to P's equity

account in C.

• C acquired $80 of equity and had no tax liability on

this $100 in margins.

 • P received $20 in cash.

• P included the entire patronage refund in taxable income, so P had a tax liability of $25 ($100 x .25).

 • P acquired an ownership interest of $80 in C equity.

Year of Redemption at Less Than Face Value, IRS Method. In 2009, C redeems P's 2005 equity allocation at $.50 on

the dollar.

 • C reduces its member equity account by $80.

 • C pays $40 in cash to P.

• C recognizes the $40 of canceled equity as taxable

income and pays a federal income tax of $13.60 on it

($40 x .34).

• The remaining $26.40 is accounted for as unallocated

equity.

 • P receives $40 in cash from Cooperative C.

 • P deducts the face value of the canceled equity, $40,

from othertaxable income and realizes a tax savings of

$10.00 ($40 x .25). Thus P has received a total of

$50.00 for equity with a former book value of $80.00.

Year of Redemption, Gold Kist Method. In 2009, C redeems

P's 2005 equity allocation at $.50 on the dollar.

 • C reduces its member equity account by $80. C pays

$40 to P.

• C does not have to recognize the $40 of canceled

equity as taxable income and therefore pays no
119

additional federal income tax. This leaves $40 to be

accounted for as unallocated equity.

 • Patron tax treatment is the same. P receives $40 in

cash. P deducts the face value of the canceled equity,

$40, from other taxable income and realizes a tax

savings of $10.00 ($40 x .25). P still receives a total of

$50.00 for equity with a former book value of $80.00.

Now that the facts are laid out, the real issue is: Where did the

money go? The following summary 2 shows who received what

under both the IRS and Gold Kist approaches. This illustrates why

this decision is favorable to cooperatives and upsetting to IRS.

Where Did the Money Go?

IRS Method:

C $26.40 in unallocated equity

P $45.00 cash

2005: $ -5.00 ($25 in taxes less $20 cash

received)

2009: $50.00 ($40 cash from C and $10.00

tax reduction)

IRS $28.60 cash

2005: $25.00 (P's tax on entire $100

qualified allocation)

2009: $3.60 (C's tax of $13.60 less P's

$10.00 deduction)

 

 $100.00
120

Gold Kist Method:

C $40.00 in unallocated equity

P $45.00 cash Same as IRS method

IRS $15.00 cash (P's 2005 tax of $25.00 less P's 2005

 deduction of $10.00)

 

$100.00

Thus, no tax is paid on the $40 now held by C as unallocated

equity. P has received a total of $60 in cash from C and paid a

total tax of $15.00.

The more equity canceled, the less money IRS ultimately

receives. If the entire $80 in retained equity is canceled, P

receives a tax deduction in 2009 of $20.00. C would now have

$80 of tax-free unallocated equity. P would have $15.00 ($20 cash

received in 2005, less $25 tax obligation in 2005, plus $20.00 tax

deduction in 2009) and IRS only $5.00.

While it would appear from these numbers that redeeming

qualified allocations at a discount is a good idea, it is a decision

that, in reality, should be approached cautiously. Any program to

redeem written notices of allocation at less than face has broader

implications.

Members are generally willing to invest in their cooperative

because they expect it will use the money to provide them services

and, when it no longer needs the money, return it to them.

Redemptions at less than face value turn members' money into the

cooperative's money. It undermines member-patron ties to and

confidence in their cooperative and conflicts with the cooperative

principle of member ownership and control. While the Gold Kist

method may be a tempting apple, consider whether a bite could be

poisonous to your cooperative.
 Tech. Adv. Mem. 7840010 (June 22, 1978) dealt with qualified 393

written notices of allocation; Priv. Ltr. Rul. 8033070 (May 22, 1980)

covered qualified per-unit retain certificates. See also, Priv. Ltr. Rul.

200224017 (March 15, 2002).

Tech. Adv. Mem. 7840010, (June 22, 1978). The Service relied,

394

in part, on I.R.C. § 911(b) definition of "earned income" as well as

definition of "earnings" appearing in Black's Law Dictionary.

 Priv. Ltr. Rul. 7840010 (June 22, 1978).

395

121

Other Issues

The Service has taken other positions that may complicate

redeeming patronage-sourced equities at less than face value. For

one thing, it considers such income to be nonpatronage-sourced

income to the cooperative.393

For another, IRS asserts that a section 521 cooperative may not

deduct the allocation of such nonpatronage-sourced income to

patrons on a patronage basis. Code section 1382(c)(2)(A) permits

a section 521 cooperative to deduct amounts paid on a patronage

basis with respect to nonpatronage sourced "earnings." The

Service has said amounts realized as a result of a discounting

procedure are not "earnings" and therefore are not deductible.

394

Instead ofsection 1382(c) earnings, IRS characterized the income

as "amounts recovered which were previously deducted against

'earnings' of another taxable year."395
See, e.g., Rev. Rul. 70-249, 1970-1 C.B. 181 (concerns proper 396

year to include certain per-unit retains from the regional to the local in

the local's taxable income).

 While the terms "member" and "patron" are sometimes used 397

interchangeably, there is an important distinction between them for tax

purposes. A member is allowed to vote on issues presented to the

membership. A patron is any person, member or nonmember, with

whom the cooperative does business on a cooperative basis. Treas. Reg.

§ 1.1388-1(e).

 Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat. 960 (1962), 398

reprinted in 1962-3 C.B. III.

122

CHAPTER 10

TAXATION OF PATRONS

While most administrative and judicial law on taxation focuses

on the cooperative, the patron is an equally important element of

the equation. A patron is usually perceived as an individual

dealing with his or her local cooperative. However, if that local

cooperative is part of a federated system, the local is a patron of

the federated cooperative and must deal with the tax laws as they

apply to both cooperatives and patrons.396

Patrons, if they are also members, not only share in the 397

earnings of a cooperative but also have ultimate control, as the

user-owners, of the method used by their cooperative to allocate

those earnings (and losses). Thus, any analysis of cooperative

taxation must also consider the taxation of patrons.

Subchapter T generally imposes a single current tax obligation

on cooperative margins. Whether the cooperative or the patrons

assumes this tax obligation for a given payment generally depends

on a mutual arrangement on how to recognize the income for tax

purposes. This gives cooperative members valuable flexibility in

planning the tax consequences of their business transactions.

Before 1962, when rules clarifying cooperative and patron

taxation were established in subchapter T, patron treatment of 398

refunds or other payments from the cooperative was not always
 Treas. Reg. § 1.1385-1 provides explanation and examples. 399

 An exception for consumer goods is discussed beginning on the 400

next page.

See infra pp. 142-148 401

123

consistent with the tax treatment ofthese distributionstaken by the

cooperative. Code section 1385, titled "Amounts Includible in

Patron's Gross Income," was added to the Code as part of

subchapter T. Section 1385 provides specific rules on the taxation

of income received by patrons based on the cooperative-patron

relationship.399

Generally, when patrons receive taxable distributions of

earnings from a cooperative, they are included in the patrons' gross

income along with other income received in the course of farming

or other business operations. Patrons recognize the income in 400

the tax year it is received from the cooperative.

Cooperative distributions to patrons may be in the form of

money, property, or noncash allocations of equity or debt in the

cooperative, evidenced by written notices of allocation or per-unit

retain certificates. The tax consequences to the patron of any

distribution of written notices of allocation and retain certificates

when received, and later when redeemed, depends primarily upon

whether the notices or certificates are "qualified" or "nonqualified"

distributions.

Written notices of allocation and per-unit retain certificates

may be redeemed by the cooperative for less than or more than

face value. Holders may be able to sell or exchange them,

although this isn't common.

Patrons may incur losses in connection with patronage

distributions from a cooperative. Such losses are recognized for

tax purposes in a number of situations.

401

In addition to receiving distributions from it, members and

patrons sometimes make payments to their cooperative. The

potential tax effects of patron payments to a cooperative depends

on the nature and purpose of the payment.
"Patronage refund" rather than "patronage dividend," the term in 402

the Code, 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. § 1385(a)(1) and Treas. Reg. § 1.1385-1(a)(1). 403

 I.R.C. § 1385(a)(2) and Treas. Reg. § 1.1385-1(a)(2). 404

 I.R.C. § 1385(a)(3). While § 1385 doesn't mention per-unit 405

retains paid in cash, they undoubtedly are also taxable income to the

recipient in the tax year received. While the regulations for section

1385 don't mention per-unit retains, their inclusion in patrons' gross

income is supported by Treas. Reg. § 1.61-5(a).

124

INCLUSIONS IN GROSS INCOME

Code section 1385 begins with a general rule that for tax

purposes patrons must include in gross income:

(1) patronage refunds paid in money, qualified written 402

notices of allocation, and other property (but not nonqualified

written notices of allocation),403

(2) patronage-based distributions of nonpatronage income

from a section 521 cooperative paid in money, qualified written

notices of allocation, or other property (but not nonqualified

written notices), and 404

(3) per-unit retains paid in qualified per-unit retain certificates.405

Subchapter T only covers amounts received from the

cooperative based on the cooperative-patron relationship. Other

kinds of income are covered by rules not specific to cooperatives.

Exclusion for Personal, Living, and Family Items

Code section 1385(b) provides that in two instances the

amount of any patronage refund and any amount received on re-
 As the Code doesn't mention per-unit retains in this section, no 406

exclusions are available for per-unit retain distributions.

 I.R.C. § 1385(b)(2). 407

 Treas. Reg. § 1.1385-1(c)(1)(i).

408

 Treas. Reg. § 1.1385-1(c)(1)(ii). 409

 I.R.C. § 212. "In the case of an individual, there shall be allowed 410

as a deduction all the ordinary and necessary expenses paid or incurred

during the year (1) for the production or collection of income; (2) for

the management, conservation, or maintenance of property held for the

production of income ...." Id.

 Treas. Reg. § 1.1385-1(c)(1)(ii). 411

125

demption, sale, or other disposition of a nonqualified written

notice of allocation isn't included in a patron's gross income.406

One is when the distribution is "attributable to personal, living,

or family items." The regulations describe personal, living, or 407

family items in terms of the tax status of the item purchased. A

patron doesn't include as income patronage refunds "received with

respect to the purchase ofsupplies, equipment, or services, which

are not used in the trade or business and the cost of which is not

deductible under section 212."408

Similarly excluded are amounts received in redemption of

nonqualified written notices of allocation which were received as

a patronage refund with respect to the purchase of supplies,

equipment, or services not used in a trade or business and the cost

of which was not deductible under Code section 212.409

Code section 212 allows individuals to deduct expenses

incurred in the "production of income." If a patron can't deduct 410

the expense of supplies, equipment, or services obtained from a

cooperative under section 212, then patronage refunds received

from a cooperative "with respect to" such purchases are not

income to the patron.411
 I.R.C. § 1385(b)(1). 412

 Treas. Reg. § 1.1385-1(c)(1). 413

 Treas. Reg. § 1.1385-1(c)(2). 414

 Treas. Reg. § 1.1385-1(c)(2)(i).

415

Id.

416

126

Exclusion for Adjustment to Basis

of Depreciable Property

Patrons may also exclude from gross income patronage refunds

and amounts received in redemption of nonqualified written

notices of allocation "properly taken into account as an adjustment

to basis of property." Regulations say this exclusion covers

412

patronage refunds distributed with respect to the marketing or

purchasing of a capital asset (as defined in section 1221) or

business property depreciable for tax purposes under Code section

167.413

In this case, the patronage refund or payment in redemption of

a nonqualified allocation should be treated as an adjustment to the

basis of the property or asset rather than as ordinary income by the

patron. The adjustment is effective as of the first day of the 414

taxable year in which the distribution is received. To the extent 415

that the amount received exceeds the adjusted basis of the

property, it shall be considered ordinary income.416

The primary beneficiaries of the "adjustment to basis" rule are

patrons who purchase from their cooperative property used in their

business and depreciable under Code section 167. The principal

kind of depreciable property is permanent and tangible such as

buildings (but not the land), office furniture and machines, and

farm machinery. Normally, a taxpayer can't deduct the total cost

of such items in the year of purchase, but rather must depreciate

the cost over a number of years.

The regulations provide that Code section 167 property

includes all farm buildings (except the residence of the owner),

machinery, and physical property (except land). Livestock
 Treas. Reg. § 1.167(a)(6)(b).

417

 Treas. Reg. § 1.1385-1(c)(1)(i).

418

 Treas. Reg. § 1.1385-1(c)(1)(ii). 419

 Treas. Reg. §§ 1.1385-1(c)(1)(i) and (c)(1)(ii). 420

 Treas. Reg. § 1.1385-1(c)(1)(i). The Code definition of 421

"patronage dividend" appears at I.R.C. § 1388(a).

 Treas. Reg. § 1.1385-1(c)(1)(i) only applies to patronage refunds 422

described in Treas. Reg. § 1.1385-1(a)(1). Refund or redemption

amounts paid by I.R.C. § 521 cooperatives and derived from U.S.

Government or nonpatronage sourced income are described in Treas.

Reg. § 1.1385-1(a)(2).

127

acquired for work, breeding, and dairy purposes may, under certain

conditions, also be section 167 property.417

Related Patronage Refunds

Amountsreceived by patrons which are excludible from gross

income if used as basis adjustment are (1) cash and qualified

noncash patronage refunds and (2) amounts received upon 418

redemption, sale, or other disposition of a nonqualified written

notice of allocation to the extent treated as ordinary income.419

The portion of a patronage refund or redemption amount that

a patron can apply to basis and exclude from gross income is

limited to amounts "received with respect to the marketing or

purchasing" of the property whose basis is adjusted.420

The refund portion must qualify as a "patronage dividend" as

defined in the Code. It cannot include any portion of a section 421

521 cooperative refund or redemption amount that was derived

from U.S. Government or nonpatronage sourced income.422

Patrons need to establish what portion of the amount received

from the cooperative relates to the eligible property. The determination may be based on the patron's own records or the notices

received from the cooperative. These examples illustrate how to

make the proper calculation. 
 Treas. Reg. § 1.1385-1(c)(2)(i).

423

128

Example 1. Patron A receives a qualified written notice of

allocation totaling $100 from a cooperative. Patron A's only

business with the cooperative during the cooperative's taxable year

was the purchase of property eligible for basis adjustment. The

entire $100 received by Patron A can be applied to basis

adjustment if otherwise qualified.

Example 2. Assume a similar situation to Example 1, except

the cooperative notifies patron A that $80 of the payment qualifies

as a refund from patronage sources, while $20 is from

nonpatronage sources. Patron A has $80 available for basis

adjustment and exclusion. The remainder must be included in

gross income and cannot be used to adjust eligible property basis.

Example 3. Patron B receives $100 in patronage refunds from

the cooperative, all of which is from patronage sources. During

the cooperative's taxable year, patron B purchased $1,000 in

supplies and equipment from the cooperative, $200 of which was

properly eligible for basis adjustment. Patron B applies only the

allocable portion of the refund, which is $20 (200/1000 x 100), to

the eligible property basis adjustment.

Basis Adjustment

The regulations provide that if a patron purchases eligible

assets or property from the cooperative and owns the asset or

property any time during the taxable year in which the amount is

received, the adjustment to the property's basis occurs "as of the

first day of the taxable year in which such amount is received."423

This important rule frees patrons, who purchase a covered item in

one year and receive the related patronage refund the following

year, from having to file an amended return for the previous year

to adjust their depreciation deduction.

The following example, based on the regs, illustrates this

timing issue. More complex examples, including some dealing
 Treas. Reg. § 1.1385-1(c)(3). 424

129

 with redemptions of nonqualified written notices of allocation and

other aspects of basis adjustment, are found in the regulations.

424

Example 4. On July 1, 2004, a cooperative patron purchases

an implement for use in her farming business for $2,900. The

implement has an estimated useful life of 3 years and an estimated

salvage value of $200, which the patron chooses to take into

account in computing depreciation. She files her income tax

returns on a calendar-year basis. For 2004, she claims

depreciation of $450 pursuant to her use of the straight-line

method of depreciation at the rate of $900 per year.

On July 1, 2005, the cooperative pays a patronage refund to the

patron of $300 in cash regarding her purchase of the farm

implement. She will adjust the basis of the implement and

compute her depreciation deduction for 2005 (and subsequent

taxable years) as follows:

Cost of farm implement, July 1, 2004 2,900

 Less:

Salvage value 200

Depreciation for 2004 (6 months) 450

Adjustment as of Jan. 1, 2005 for

 cash patronage dividend 300 950

Basis for depreciation for remaining

 2 1⁄2 years of estimated life 1,950

Depreciation deduction for 2005 ($1,950 divided

by the 21⁄2 years of remaining life) 700
 Treas. Reg. § 1.1385-1(c)(2)(i).

425

 Treas. Reg. § 1.1385-1(c)(2)(ii). 426

 Treas. Reg. §§ 1.1385-1(c)(2)(ii)(a) and (b).

427

 Treas. Reg. § 1.1385-1(c)(2)(iii).

428

 Treas. Reg. § 1.1385-1(c)(2)(iv). 429

130

When Exclusion Not Available

A patron's application of patronage refunds or redemption

amounts to property basis is a substitute for recognizing it as gross

income. This exclusion isn't available in all circumstances.

For example, the distribution from the cooperative may exceed

the property's adjusted basis. In this case, the amount of the

distribution is first applied to basis. To the extent the distribution

exceeds the adjusted basis, it is ordinary income to the patron.425

Another example is when a patron has sold or otherwise

disposed of the property before the taxable year in which the

patron receives the distribution. This usually occurs where the

distribution is in redemption of a nonqualified written notice of

allocation. In such cases, the basis adjustment is not used and the

amounts received are "included in gross income as ordinary

income."426

The regulations also describe special rules for situations

involving losses deductible under Code section 165 on long-term

capital assets no longer owned by the taxpayer.427

A patron, who markets eligible property through a cooperative,

may receive patronage refunds based on that sale in the same

taxable year as the property was sold. In that case, the distribution

is treated as additional proceeds from the sale of that property.428

Finally, if a patron receiving a patronage refund or proceeds

from the disposition of nonqualified written notices of allocation

is unable to identify the related property, basis adjustment isn't

available and the patron must treat the distribution as ordinary

income.429
 I.R.C. § 1385(a)(1). 430

 I.R.C. § 1385(a)(2). 431

 I.R.C. § 1385(a)(3). 432

 I.R.C. § 1385(a). At one time, IRS said cooperatives had to 433

"trace" margins back to the specific transactions that generated them

and allocate the margin to the patrons of that year. Rev. Rul. 79-45,

1971-1 C.B. 284. The IRS position was rejected in Lamesa Cooperative

Gin v. Commissioner, 78 T.C. 894 (1982) and Kingfisher Cooperative

Elevator Association v. Commissioner, 84 T.C. 600 (1985). For a

discussion of "tracing," see Donald A. Frederick, Income Tax Treatment

of Cooperatives: Patronage Refunds, Cooperative Information Report

44, Part 2 (USDA 2005), pp. 90-94.

See, e.g., Tech. Adv. Mem. 7936017 (May 31, 1979).

434

 Treas. Reg. § 1.1385-1(a).

435

131

Taxable Year

Code section 1385 designates the taxable year in which a

patron must include patronage refunds, amounts received as

430

nonpatronage distributions from a section-521 cooperative, and 431

per-unit retains in gross income. Generally, such amounts are

432

included in patron income in the taxable year received.433

Patrons frequently receive taxable distributions from cooperatives in a tax year subsequent to the time the related transactions

took place. These four examples illustrate how this may occur:

1. The cooperative and patron have different tax years,

resulting in different years for income recognition.434

2. Cooperatives usually distribute patronage refunds or perunit retain allocations during the eight and one-half month period

after the cooperative's tax year, as provided in Code section

1382(d). The year payment is received by patrons, which may

follow the tax year in which the cooperative took its deduction, is

the year the patron recognizes the distribution for tax purposes.435

If the cooperative fails to make payments within the payment

period and thereby loses its deduction, patrons must still include
Id.

436

 I.R.C. § 1385(c).

437

 In this situation the local association is a "cooperative" for tax 438

purposes when dealing with its patrons and a "patron" itself when

dealing with the federated cooperative. The local cooperative includes

cash payments and qualified patronage refunds and per-unit retains

received from the federated cooperative in gross income in the year of

receipt. These amounts are then deductible by the local if passed on to

its patrons as cash or qualified distributions within the payment period

for the year of receipt of the local.

 Rev. Rul. 70-249, 1970-1 C.B. 181, applying I.R.C. § 1382(f) and 439

Treas. Reg. § 1.1382-6.

132

the amount received in gross income in the year of receipt.

436

3. Cooperatives frequently redeem nonqualified written notices

of allocation and nonqualified per-unit retain certificates several

year after issuance. These payments are taxable income to patrons

in the year of receipt.

437

4. Cooperative payments may also be treated as occurring in a

subsequent tax year when they are from a local cooperative

belonging to a federated system. Because each cooperative in the

system has its own tax year and payment period, the actual income

from the patron's initial transaction with its local cooperative may

not be recognized for some time.

For example, a local marketing cooperative might receive

product from a patron in year one. In that same year, the local

cooperative delivers the product to a federated cooperative for

further processing and sale. The local receives a patronage refund

or per-unit retain from the federated in year two, based on business

done with or for its patrons in year one.438

The Code provides that the local can make patronage refunds

during the payment period of year two based on the amounts

received from the federated. Local patrons will likely receive 439

their appropriate share of the federated cooperative's earnings in

patrons' tax year three.
 Tech. Adv. Mem. 7936017 (May 31, 1979).

440

 Rev. Rul. 71-430, 1971-2 C.B. 219. 441

 Priv. Ltr. Rul. 8004074 (Oct. 31, 1979).

442

 Treas. Reg. § 1.451-1(a).

443

133

IRS has said that patrons who receive such payments in a year

subsequent to the year the underlying transaction took place may

not "accelerate" the recognition of an expected distribution. A

patron may not "accrue an estimated patronage refund" in order to

recognize it as income in a tax year prior to the time the

cooperative issues the refund.440

Patrons receive other kinds of payments from their cooperative

for which subchapter T provides no special timing rules. In these

instances, general tax principles apply.

Marketing cooperatives frequently make partial payments to

producers for product delivered at or shortly after delivery. After

the end of the its fiscal year, the cooperative determines net

margins allocable to each patron and pays them during the

cooperative's payment period. Questions have arisen as to the

correct year for the patron to include the advance payment in

taxable income.

As a general rule, the advance is considered a partial payment

for product delivered and must be treated by patrons as income

from the sale of product in the year received. "The grower is not

to defer the accounting for the payments until the year in which the

final settlement is made with him by the association for his entire

crop...."441

Similarly, a patron can't postpone the tax liability on an

advance to a subsequent tax year by simply having the cooperative

postpone payment. If the patron could have received the advance

in the first year, IRS has applied the doctrine of constructive

receipt to require the patron to include it in income for the first

year. This is consistent with the cash receipts and disburse442

ments method of accounting that requires amounts to be included

in gross income when actually or constructively received.443
 Priv. Ltr. Rul. 8004074 (Oct. 31, 1979). 444

 Treas. Reg. § 1.1385-1(d)(3). Thus, if a patron on a calendar tax 445

year receives a qualified check in November of one year and cashed it

in January of the following year, for tax purposes the amount received

is income to the patron in the first year.

 I.R.C. § 1385(a)(1) and Treas. Reg. § 1.1385-1(a)(1). 446

 I.R.C. § 1385(a)(2) and Treas. Reg. § 1.1385-1(a)(2). 447

 I.R.C. § 1385(a)(3). See also Treas. Reg. § 1.61-5(f)(1)(i).

448

Although the Code doesn't specifically mention cash per-unit retain

134

If the patron hasn't met all the conditions for securing a right

to payment, no income has been received for tax purposes. In a

letter ruling, one of several options under the cooperative's

marketing program permitted patrons to defer making a pricing

decision until the year following harvest and delivery of grain to

the cooperative. No advance was payable until the patron made

the pricing decision. IRS said constructive receipt did not apply

and no current tax liability resulted for deferring payment until the

second year.

444

The regulations discuss one other issue concerning the year

patrons include amounts received from cooperatives in income.

Patrons must recognize payments by qualified check in the taxable

year received, if the check is endorsed and cashed on or before the

90th day following the close of the payment period for the cooperative's taxable year in which the relevant patronage occurred.445

PAYMENT FORM

Section 1385 of subchapter T lists specific forms of

cooperative payments that must be included in gross income by

patrons. These include patronage refunds and patronage-based 446

distributions of nonpatronage income by section-521

cooperatives paid in money, qualified written notices of 447

allocation, or other property, and per-unit retain allocations paid

as qualified per-unit retain certificates.448
distributions, the same rules undoubtedly apply.

 I.R.C. § 1385(c)(1), Treas. Reg. § 1.1385-1(b) (nonqualified 449

written notices of allocation), and Treas. Reg. § 1.61-5(f)(1)(ii)

(nonqualified per-unit retain certificates).

 Treas. Reg. §§ 1382-2(b)(1), 1.1388-1(c)(1)(ii). 450

 Treas. Reg. § 1.1385-1(d)(1). For an example involving the 451

stock of a successor noncooperative company being issued as a

patronage refund allocation to the patrons of a predecessor cooperative

and its valuation, see Priv. Ltr. Rul. 8617040 (Jan. 24, 1986) and Priv.

Ltr. Rul. 8638054 (June 24, 1986).

 I.R.C. § 1385(a)(1). 452

 I.R.C. § 1385(a)(3). 453

135

Patrons must also recognize as income all amounts received in

redemption of nonqualified written notices of allocation and

nonqualified per-unit retain certificates.449

For other kinds of income received by the patron from the

cooperative, subchapter T provides no special rules and general

tax principles therefore apply.

Money or Other Property

The term "money" includes cash, negotiable bank checks, and

qualified checks.

450

The term "other property" includes payments of merchandise

or other property in kind. Payments made in property are

accounted for by the patron at the property's fair market value

when received.451

Qualified Written Notices and Per-Unit Retains

Code section 1385(a) provides that patrons must include the

amount of any patronage refunds distributed in cash or as qualified

written notices of allocation and qualified per-unit retain 452

certificates in gross income in the taxable year received. 453
 I.R.C. § 1388(c)(1) and Treas. Reg. § 1.1385-1(d)(2) for 454

qualified written notices of allocation, I.R.C. § 1388(h)(1) for qualified

per-unit retain certificates. Similarly for "certificates of indebtedness,"

James W. Salley, Inc. v. United States, 1976-1 U.S.T.C. ¶ 9443 (W.D.

La. 1976).

 I.R.C. § 1385(c)(2) and Treas. Reg. § 1.1385-1(b).

455

See Priv. Ltr. Rul. 7926068 (Mar. 29, 1979) where IRS permitted 456

a cooperative to offset accounts receivable, established to allocate a

loss, against outstanding nonqualified written notices of allocation.

 I.R.C. § 1385(c)(1)(A)(i).

457

136

Qualified notices and certificates are valued by patrons at their

"stated dollar amount."454

Patrons recognize the income in the tax year they receive the

qualified allocation(s). Subsequent redemption of the notice or

certificate is not a taxable event for the patron as long as the

redemption payment is for the face amount. Redemptions for less

than, or in excess of, the face value are discussed later in this

chapter.

Nonqualified Written Notices and Per-Unit Retains

Patrons who receive nonqualified written notices of allocation

or nonqualified per-unit retain certificates recognize no income at

the time of issuance. The single tax obligation is transferred from

the cooperative to the patron when the nonqualified equity is

redeemed by the cooperative.455

If the redemption payment is applied against a debt owed by

the patron to the cooperative, the patron receives property (and

thus income) to the extent of debt satisfaction.456

Code section 1385(c) includes basis and gain rules by which

patrons determine the income they must recognize from the

redemption of nonqualified written notices of allocation paid as

patronage refunds, patronage-based distributions of nonpatron- 457
 I.R.C. § 1385(c)(1)(A)(ii). 458

 I.R.C. § 1385(c)(1)(B). 459

 I.R.C. § 1385(c)(2)(A) and Treas. Reg. § 1.1385-1(b)(3). 460

 I.R.C. § 1385(c)(2)(B) and Treas. Reg. § 1.1385-1(b)(3). The 461

basis is not increased to the fair market value as of the date of death.

 I.R.C. § 1385(c)(2)(C). 462

Id.

463

 Treas. Reg. § 1.1385-1(b)(1). 464

Id.

465

137

age earnings bya section-521 farmer cooperative, and nonquali- 458

fied per-unit retain certificates.459

The first step in determining a patron's taxable income when

nonqualified written notices of allocation and nonqualified perunit retain certificates are redeemed is to establish the patron's

basis in that property. The basis of these equities in the hands of

the patron is zero. The assignment of basis is statutory and the 460

equity's fair market value has no tax effect at either issuance or

redemption. The Code also provides that if such equities are

acquired from a decedent, the basis of the heirshall be the basis in

the hands of the decedent.461

Second, the amount of taxable income must be determined.

The realized gain upon redemption is the amount received which

exceeds basis. In most situations, the basis of a nonqualified 462

written notice of allocation or nonqualified per-unit retain certificate is zero; so patrons will realize taxable income for the full

amount paid in redemption.

Third, the nature of the income must be established. The Code

states the amount received by the patron, up to the stated dollar

amount of the nonqualified written notice or per-unit retains being

redeemed, shall "be considered as ordinary income," that is,

463

"gain from the sale or exchange of property which is not a capital

asset." Treatment as ordinary income applies to the original 464

patron recipient and subsequent holders.

465
Id.

466

Id.

467

138

The redemption, sale, or other disposition of nonqualified

written notices of allocation or nonqualified per-unit retain

certificates may result in a gain that exceeds their stated face

value. Excess amounts "will be treated under the applicable

provisions of the Code." For instance, the regulations say 466

amounts received in excess of a nonqualified written notice's

stated dollar amount should be treated as interest by the recipient

if the amounts "in effect, constitute interest."467

The following example from the regulations illustrates the tax

treatment of nonqualified allocations by patrons.

Example. A, a farmer, receives a patronage dividend

from the X Cooperative, in the form of a nonqualified

written notice of allocation, which is attributable to the

sale of his crop to that cooperative organization. The

stated dollar amount of the nonqualified written notice of

allocation is $100. The basis of the written notice of

allocation in the hands of A is zero and he must report any

amount up to $100 received by him on its redemption,

sale, or other disposition, as ordinary income. If A gives

the written notice of allocation to his son B, B takes A's

(the donor's) basis which is zero, and any gain up to $100

which B later realizes on its redemption, sale, or other

disposition is ordinary income. Similarly, if A dies before

realizing any gain on the nonqualified written notice of

allocation, B, his legatee, has a zero basis for such written

notice of allocation and any gain up to $100 which he then

realizes on its redemption, sale, or other disposition is also

ordinary income. Such gain is income in respect of a dece-
 Treas. Reg. § 1.1385-1(b)(4). Examples from the regulations 468

were written only for written notices of allocation and don't specifically

include per-unit retain certificates. However, principles involved are

the same, as should be the results.

See Agway, Inc. v. United States, 524 F.2d 1194 (Ct. Cl. 1975),

469

and Agway, Inc. v. United States, 1981-2 U.S.T.C. ¶ 9700 (Ct. Cl.

1981), aff'd 696 F.2d 1367 (Fed. Cir. 1982).

 Treas. Reg. § 1.1385-1(b)(1). For example, this regulation states 470

"amounts received in redemption of a nonqualified written notice of

allocation which are in excess of the stated dollar amount of such

written notice of allocation and which, in effect, constitute interest shall

be treated by the recipient as interest."

 In this protracted litigation, the Service actually raised the same 471

issue twice. The first case involved stock a cooperative, that was

139

dent within the meaning of section 691(a) and section

1.691(a)-1.468

REDEMPTION AT GREATER THAN FACE VALUE

Cooperative payments in redemption of retained patronage

refunds or per-unit retain certificates may exceed the face value of

the notice or certificate. Although the whole payment to patrons 469

may be termed "redemption" and paid simultaneously, any amount

in excess of the notice or certificate redeemed is not a true

redemption. Rather, it is a payment that falls into some other

category for tax purposes.

The regulations provide that if a patron receives an excess

payment, the distribution is divided into two parts. Amounts

received up to the notice or certificate's face value are ordinary

income. The excess is then treated "under applicable provisions

of the Code."470

The tax classification of excess paid at the time of redemption

can turn on the facts of the situation. In Agway, Inc. v. United

States, a federated cooperative issued preferred stock to a 471
subsequently merged into Agway, received from being a member of yet

another cooperative in 1957. This stock was redeemed for a premium

in 1960. Agway, Inc. v. United States, 524 F.2d 1194 (Ct. Cl. 1975),

1975-2 U.S.T.C. ¶ 9777.

The second case involved stock the predecessor cooperative

received in 1960 that was redeemed in 1962. Agway, Inc. v. United

States, 1981-2 U.S.T.C. ¶ 9700 (Ct. Cl. 1981), aff'd 696 F.2d 1367 (Fed.

Cir. 1982). IRS justified the repeat litigation of the grounds that a

regulation issued in 1959 supported its position and if not controlling in

the first case because it could not be applied retroactively, it was

controlling in the second case. The courts held the regulation wasn't

applicable to this situation and decided both cases on other grounds for

the cooperative.

140

member cooperative as part of a patronage refund in one year and

redeemed it in a later year for an amount greater than its face

value. IRS argued the amount received above face value was

essentially a dividend and should be taxable to the patron-recipient

as ordinary income. The cooperative asserted that the premium

was a long-term capital gain.

The court said the hallmarks of a dividend are pro rata

distribution of earnings and profits and no change in basic

shareholder relationships. The cooperative's bylaws provided

retained equities were to be "retired in the order in which they

have been received." The court found the premium payments,

based on the amount of the underlying equity redemption, did not

meet the "pro rata distribution" test.

As the members of the federated cooperative received different

distributions of preferred stock each year depending on the

proportion of business each did with the federated that year, a

redemption of that stock issued in a prior year would not be in the

same proportion as the total equity investment of each member in

the federated.

The only way a distribution could be "pro rata" would be if

every stockholder received the same number of shares in each year

at issue. Consequently, the court ruled the excess over face value
 The court in Agway relied on other decisions that addressed the 472

basic character of patronage refunds paid during that time, such as

Tomlinson v. Massey, 308 F.2d 168 (5th Cir. 1962), 1962-2 U.S.T.C. ¶

9730; and Raley v. United States, 491 F.2d 136 (5th Cir. 1974), 1974-1

U.S.T.C. ¶ 9300.

 Priv. Ltr. Rul. 8846030 (Aug. 22, 1988).

473

141

was not a dividend on capital stock, but rather a long-term capital

gain for the recipient.472

Good accounting practice would suggest cooperatives clearly

identify payment in redemption and payment in excess of

redemption so patron recipients can treat each portion

appropriately for tax purposes. This is particularly true when part

of the payment is a redemption of a qualified written notice of

allocation or a qualified per-unit retain certificate upon which

patrons had previously been taxed.

The Service has said no gain or loss need be recognized if the

payment is part of a tax-free reorganization. In a letter ruling, a

cooperative proposed to restructure its capital to allocate

accumulated nonpatronage income to its members. The cooperative would issue various classes of capital stock in exchange for

members' current holding of common voting stock, per-unit retain

certificates, and a proportionate share of the surplus built from

nonpatronage sourced income.

Even though the members received additional value in the

form of a more direct interest in the nonpatronage earnings

retained by their cooperative, the ruling held "no gain or loss will

be recognized by the members" as the transactions were a

"recapitalization" under Code section 368(a)(1)(E), a reorganization that does not trigger a gain or loss under Code section

354(a)(1).473
See supra pp. 107-121. 474

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 475

Handling of Losses, RBS Cooperative Information Report 44, Part 5

(USDA 2005), pp. 43-54.

 Rev. Rul. 70-64, 1970-1 C.B. 36, suspended by Notice 87-68, 476

1987-2 C.B. 378.

142

REDEMPTION AT LESS THAN FACE VALUE

While redemptions of outstanding patronage equity for more

than face value is preferable from the patron’s perspective, there

are many more rulings dealing with redemptions by the

cooperative of retained patronage equity for less than face value.

As discussed elsewhere in these reports, the IRS position is

somewhat different toward cooperatives who redeem equity at less

than face value depending on whether the redemption is part of a

capital restructuring or to recover a loss from the patrons whose 474

business generated the loss. Regardless of the motive of the 475

cooperative in redeeming equity for less than face value, the

impact on patrons is the same: the value of their investment has

been reduced.

In fact, the landmark IRS ruling doesn't even mention why 476

the equity was redeemed forless than face value. It merely reports

a cooperative issued qualified written notices of allocation to

patrons in 1963, which the patrons properly included as ordinary

income. Then, in 1968, it redeemed them at less than the stated

dollar amount.

The Service stated matter-of-factly that the patron had suffered

a loss in 1968. The question addressed was whether the loss was

an ordinary or a capital loss. IRS said:

The transaction that gave rise to the issuance of the

notice of allocation arose in the ordinary course of

taxpayer's trade or business. Accordingly, the loss

incurred by the taxpayer upon redemption of the qualified
Id.

477

 Rev. Rul. 70-407, 1970-2 C.B. 52. 478

 Priv. Ltr. Rul. 7804083 (Oct. 28, 1977).

479

143

written notice of allocation is an ordinary loss deductible

for 1968 under the provisions of section 165 of the Code.

See Corn Products Refining Company v. Commissioner,

350 U.S. 46 (1955). [other citations omitted] The loss is

measured by the difference between the stated amount

included in income in 1963 and the amount received upon

redemption.477

IRS expanded on this holding in Revenue Ruling 70-407.478

It presented facts wherein a cotton marketing cooperative suffered

a loss when it made cash advances to patrons that proved to be

excessive because of an unanticipated decline in the price of

cotton. In the following yearthe cooperative recovered the loss by

offsetting each patron's pro rata share against book credits

representing retained qualified written notices of allocation. The

Service said:

! The patrons are entitled to an ordinary loss, equal to the

value of the credits canceled, under Code section 165(a).

! As to those patrons who lacked sufficient book credits to

cover their share of the loss, it can be offset against future

patronage allocations. The full amount of the patronage

allocation should be included in the patron's gross income

pursuant to Code sec. 1385, and then the allocated loss

reported as a deduction.

Even greater flexibility was approved in a letter ruling to a

section 521 cooperative with three departments: a supply function,

a grain marketing program that handled both sunflowers and

soybeans, and a cotton ginning and marketing program. The 479

cooperative suffered a loss in one year on its sunflower marketing.
 Priv. Ltr. Rul. 8624019 (March 10, 1986).

480

144

The cooperative prorated the loss among sunflower patrons.

It proposed offsetting the loss first against any grain department

book credits of each patron. Next, any remaining loss would be

offset against each patron's cotton and supply department credits.

Any loss still not recouped would be recognized as an account

receivable and collected from future grain, cotton, or supply

department patronage refunds or any other normal method of

collecting accounts receivable.

Citing Revenue Ruling 70-407, IRS said the patrons could

treat any offset of book credits or future patronage allocations as

an ordinary loss under Code section 165(a). It also said recovering

the loss in this manner would not adversely impact the

cooperative's section 521 status.

Similarly, in a letter ruling involving a bank that qualified as

a Subchapter T cooperative, IRS said:

To the extent a member/patron has previously

recognized income with respect to qualified written notice

of allocation pursuant to section 1385(a) of the Code, the

member/patron may take an ordinary loss under section

165(a) for the year that the notice of cancellation is

received.480

The IRS point of emphasis is recovering the loss, on a pro rata

basis, from the patrons whose business generated the loss. It

doesn't require that the business producing the equity that is

canceled be related to the loss. Canceling equity is simply a

convenient alternative, acceptable to the Service, to having the

patrons write checks to the cooperative for their shares of the loss.

It makes good sense as the funds conveyed by checks from the

patrons could have come from any source of income available to

the patrons.
Priv. Ltr. Rul. 7950064 (Sept. 14, 1979); Priv. Ltr. Rul. 8812019 481

(Dec. 16, 1987); Priv. Ltr. Rul. 8952019 (Sept. 28, 1989).

 Corn Products Refining Co. v. Commissioner, 350 U.S. 46 482

(1955).

145

These rulings dealt with equity accumulated as retained

qualified written notices of allocation. Patrons have likewise been

allowed to claim an operating loss under Code section 165(a)

when patronage losses are recouped by canceling equity

representing qualified per-unit capital retains.

481

All of the rulings discussed in this subsection concern

qualified patronage allocations. From a tax standpoint, holders of

nonqualified written notices of allocation or nonqualified per-unit

retain certificates lose nothing if redemption is for less than face

value. The patron’s basis in nonqualified notices or certificates is

zero, so gain is realized only for amounts received at redemption.

Because the patron recognized no income when the nonqualified

equity was issued, the patron has no loss for tax purposes if the

equity is cancelled and taxable income to the extent of any cash

received if the nonqualified allocation is redeemed for something

less than face value.

One cloud hangs over this favorable tax treatment for patrons.

Revenue Ruling 70-64 cited the U.S. Supreme Court decision in

Corn Products Refining Co. v. Commissioner. For over 30 482

years, Corn Products had been construed to permit ordinary

income (and loss) treatment for certain business-motivated

transactions in stock and other capital assets. Because patrons

acquire equity in a cooperative as part of their on-going business

relationship with it, the tie-in between the case and ordinary loss

treatment for patrons when equity is canceled or redeemed at less

than face value appeared beneficial to patrons.

However, in 1986, the U.S. Court of Appeals for the Eighth

Circuit reinterpreted Corn Products. It said that capital stock (not

held by a dealer or otherwise within the exceptions listed in Code
 Arkansas Best v. Commissioner, 800 F.2d 215 (8th Cir. 1986).

483

 Notice 87-68, 1987-2 C.B. 378. 484

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

 Notice 87-68, 1987-2 C.B. 378. 486

 Priv. Ltr. Rul. 8952019 (Sept. 28, 1989).

487

146

section 1221) is always a capital asset, regardless of the taxpayer's

business motivation in acquiring or holding the stock.483

IRS responded to theEighthCircuit decision by suspending its

published revenue rulings that relied on the so-called Corn

Products doctrine, pending Supreme Court review in Arkansas

Best. Revenue Ruling 70-64 was one of three rulings 484

specifically listed in Notice 87-68.

In March of 1988, the U.S. Supreme Court affirmed the Eighth

Circuit opinion in Arkansas Best. Under this decision, all 485

property not specifically excluded under Code section 1221 is a

"capital asset" for tax purposes and the gain or loss on the sale of

such assets, regardless of the motive for their purchase or

disposition, is a capital and not an ordinary gain or loss.

To date, the rulings mentioned in Notice 87-68, including

Revenue Ruling 70-64, have not been revoked but remain

temporarily suspended. It is also noteworthy that the notice itself

concluded, "No inference is intended as to whether the result

reached in any suspended ruling would be correct using another

rationale."486

When IRS next addressed this issue, it continued to permit

patrons to take an ordinary loss deduction when qualified

patronage equities are redeemed at less than face value. It 487

mentioned Code section 1221's definition of "capital asset," but

then relied on Revenue Ruling 70-407, which was not mentioned

in Notice 87-68.

A second cloud over the ordinary loss treatment for patrons

when qualified patronage equities are redeemed at less than face
 Gold Kist v. Commissioner, 110 F.3d 769 (11th Cir. 1997),

488

rev’g, 104 T.C. 696 (1995).

 104 T.C. 696, 708 (1995) n.20. 489

Farming -- Specific Income Issues and Farm Cooperatives,

490

Market Segment Specialization Program training document No. 3147-

114, Department of the Treasury, Internal Revenue Service (1997), p.

6-2.

147

value is the decision in Gold Kist v. Commissioner. Favorable 488

treatment for patrons was part of an overall taxing scheme which

required cooperatives that redeemed qualified equities at less than

face value (and had deducted the value of the allocations when

made) to include the difference between face value and cash paid

out in gross income in the year of redemption. Gold Kist holds

that the cooperative need not include the difference in taxable

income, thus permitting the cooperative to transfer the retained

portion of the cancelled qualified equities to a tax-free unallocated

reserve. The Tax Court opinion in the Gold Kist case raises the

issue of whether patrons are entitled to ordinary loss treatment

when they receive less than face value for their qualified retained

allocations and then specifically declines to address it.489

Now that the cooperative's duty to include the value of the

canceled equity in income has been questioned, whether the

Service will challenge the ability of patrons to claim an ordinary

loss is unclear. However, to date the Service has not done so and

at least one IRS training manual provides that a discounted

redemption “...gives rise to an ordinary loss to the farmer in the

amount of the discount. See Rev. Rul. 70-407, 1970-2 C.B. 52.”490

In summary, when a qualified written notice of allocation or

per-unit retain certificate is redeemed at less than face value or

cancelled altogether, patron holders can claim an ordinary loss to

the extent they had previously recognized the qualified allocation

as income under Code sec. 165(a). The amount of the loss is the

difference between the equity’s stated value and the amount

received.
See, e.g., Rev. Rul. 70-407, 1970-2 C.B. 52; Priv. Ltr. Rul.

491

8624019 (March 10, 1986); Priv. Ltr. Rul. 8812019 (December 16,

1987).

 Tech. Adv. Mem. 8432010 (April 27, 1984).

492

148

The loss is recognized in the tax year the redemption occurs.

This offsets the patron’s previous recognition of the face amount

of the qualified equity as ordinary income in the year received.491

SALE OR EXCHANGE OF EQUITY INTERESTS

Under some circumstances a member or patron may have an

interest in a cooperative that can be sold or exchanged to others.

The tax issues to be considered when a holder sells or exchanges

a written notice of allocation or per-unit retain certificate are: (1)

the effect on the seller when the sale or exchange is made, and (2)

the effect on the purchaser when the cooperative redeems the

notice or certificate.

IRS dealt with both issues in a letter ruling. Shortly after

492

issuance, cooperative members sold qualified written notices of

allocation to an unrelated third party at less than face value. Soon

thereafter the members purchased similar certificates from another

patron, also for less than face value. The members reported their

loss on the sale of their written notices as an ordinary loss. When

the certificates purchased by the members were redeemed by the

cooperative, the members treated these certificates as a capital

asset eligible for long-term capital gain treatment.

The Service disallowed the members' loss deduction for the

sale of their written notices of allocation on the ground that no

actual loss was incurred. The mere exchange of one interest for a

similar interest was not sufficient to generate a tax loss as the

members had exactly what they had before the transactions,

qualified allocation certificates from the same cooperative issued

in the same year.
Id. The U.S. Tax Court, in dealing with transactions that 493

occurred before the enactment of subchapter T, reached the same

conclusion in Greenvine Corp. v. Commissioner, 40 T.C. 926 (1963).

 Rev. Rul. 77-168, 1977-1 C.B. 248. Holding period and

494

termination of base under the California Agric. Code are discussed in

Rev. Rul. 73-416, 1973-2 C.B. 304. See also Rev. Rul. 72-384, 1972-2

C.B. 479, modifying Rev. Rul. 70-644, 1970-2 C.B. 167; and Rev. Rul.

73-429, 1973-2 C.B. 205, clarifyingRev. Rul. 70-644, 1970-2 C.B. 167.

 I.R.C. § 1221. 495

 I.R.C. § 1221. See Rev. Rul. 70-644, 1970-2 C.B. 167 and Rev. 496

Rul. 65-228, 1965-2 C.B. 43.

149

IRS determined that the gain on the sale of the written notices

by a third party subsequent holder (the difference between the

discounted purchase price and the amount paid to the holder by the

cooperative at the time of redemption) was a capital gain. This

was true regardless of whether the holder was a member of the

cooperative, because the certificates were not acquired in the

ordinary course of a trade or business, but rather as an

investment.493

TRANSFER OF RIGHTS TO PATRONIZE

A COOPERATIVE

In some situations, the right to patronize a cooperative is a

valued asset in itself. When patronage rights are limited, the right

to patronize is often tied to some equity ownership or capital

contribution. An example of limited patronage rights is the

issuance of milk bases by dairy cooperatives.

A milk base has been described in one revenue ruling as "an

intangible right permitting the [patron] the opportunity to sell a

designated amount of milk at a premium price pursuant to a

program designed to alleviate the ill effects of seasonal

fluctuations on the supply of milk." A milk base is an intangible

494

property right that qualifies as a capital asset if held by a 495

taxpayer who is not a dealer in milk bases.496
 Rev. Rul. 77-168, 1977-1 C.B. 248. 497

 Treas. Reg. § 1.1012-1(c)(1). 498

 Rev. Rul. 77-168, 1977-1 C.B. 248, discussing Treas. Reg. § 499

1.1012-1(c)(1). One other comment on milk bases. In Revenue Ruling

65-228, the Service ruled that since a milk base has a life of indefinite

duration, payments are capitalized and not subject to amortization or

depreciation under Code section 167.Rev. Rul. 65-228, 1965-2 C.B. 43.

150

Revenue Ruling 77-168 addresses the issue of determining 497

the cost of a milk base when it has been allocated to or purchased

by patrons over time. Patrons received their initial milk base

allocations according to their past supply record.

In subsequent years, patrons could purchase additional milk

base in varying quantities and prices, normally from other dairy

farmers who no longer had a need for some or all of the milk base

they owned. When patrons transferred bases, the cooperative updated its records to reflect the total number of pounds each patron

was entitled to deliver. Certificates issued by the cooperative to

the base purchaser didn't identify the specific base acquired.

A patron sold some milk base when the price of the base was

deflated. The patron computed the tax basis of the milk base sold

by assigning to it the weighted average cost of the total milk base

acquired over the years.

The Service likened the sale of milk base to the sale of some

stock shares from a larger lot of shares which had been purchased

at different times and prices. In stock transactions, if the particular

shares sold cannot be linked to the purchase of the same shares,

the stock sold or transferred must be charged against the earliest

of such shares purchased to determine the cost or other basis of the

stock.498

Relying on this analogy to stock transactions, the Service ruled

the patron could not use the weighted average method in

determining gain or loss from the sale of the milk base. Instead,

the patron had to use the "first in, first out" method as described in

the regulations for stock sales.499
 Rev. Rul. 65-241, 1965-2 C.B. 44. 500

 The exception is the nonpatronage sourced income passed to 501

patrons by an I.R.C. § 521 cooperative. Section 521 is discussed in

detail in Part 4 of these reports.

151

TAXATION OF DIRECT INVESTMENTS

When a member makes a direct purchase of a share of

common voting membership stock in a cooperative (or purchases

a membership in a nonstock cooperative), IRS treats that

transaction as it would any direct investment in a noncooperative

firm. The purchase has no immediate tax effect.

For example, in Revenue Ruling 65-241, a farmers'

cooperative was denied a deduction for the cost of the Class C

stock it was required to buy to borrow from a bank for

cooperatives. The cooperative had attempted to treat the purchase

as either a business expense under Code section 162 or as interest

under Code section 163. IRS also stated that whether such stock

would be considered a capital asset if disposed of by the

cooperative for a gain or loss would depend upon the facts of each

case.

500

INCOME NOT BASED ON PATRONAGE

In analyzing the taxation of cooperative patrons, the primary

focusis on payments resulting from patronage business: advances,

patronage refunds, and per-unit retain allocations. Members and

other patrons, however, may receive payments from a cooperative

which are not based on patronage-related business.

For the most part, any payment a member or patron receives

from a cooperative which is not based on patronage is treated the

same as a payment from a noncooperative source. The single tax

principle of subchapter T applies only to the distribution of income

from the patronage relationship.501
 The issue of distinguishing patronage and nonpatronage income 502

and their tax treatment at the cooperative level is the subject of Chapter

5 of these reports. See Donald A. Frederick, Income Tax Treatment of

Cooperatives: Patronage Refunds, Cooperative Information Report 44,

Part 2 (USDA 2005).

 I.R.C. § 1382(c)(2). 503

 I.R.C. § 1385(a)(2) and Treas. Reg. § 1.1385-1(a)(2). 504

152

There are several ways a patron may receive a payment from

a cooperative that is outside the patronage relationship. They may

receive paymentsthat, although paid to them in proportion to their

business with the cooperative, don't qualify as patronage refunds

because the underlying income wasn't directly related to that

business. Payments to patrons may be in proportions not related

to their patronage business with the cooperative. Or patrons may

collect dividends based on capital stock ownership in the

cooperative or other dividend-like distributions.

Income From Nonpatronage Sources

Income from nonpatronage sources is sometimes distributed to

patrons in proportion to the amount of patronage business

conducted with the cooperative.502

Frequently, each patron receives a single payment consisting

of two parts--a true patronage refund and a distribution of

nonpatronage sourced income. It is important that the supporting

documentation properly distinguish the two types of payments.

Otherwise, the failure to provide the patrons with a proper written

notice of allocation or per-unit retain certificate may jeopardize the

subchapter T tax status of the patronage-sourced distribution.

Section 521 cooperatives are allowed to deduct distributions

of nonpatronage income to patrons that are made on a patronage

basis. Patrons must include such distributions in their gross 503

income in the taxable year received in the same manner as their

patronage refund.504
 Tech. Adv. Mem. 8031057 (April 29, 1980).

505

 Priv. Ltr. Rul. 8547039 (August 27, 1985).

506

153

The Service has looked at the correct way for patrons of nonsection 521 cooperatives to treat patronage-based distributions of

nonpatronage income on two occasions and reached apparently

conflicting conclusions.

Letter ruling 8031057 concerned a federated cooperative

without section 521 status and a member cooperative with it.505

The federated cooperative distributed nonpatronage earnings (after

taxes) to its members on the basis of the patronage purchases for

the prior 3 years. The member cooperative claimed the distribution was a dividend and therefore eligible for the 85 percent

dividends received deduction under Code section 243(a)(1).

However, IRS determined that a dividend had to be a

distribution in accordance with the equity interests of the members

in a cooperative. A distribution based on patronage, not total

equity investment, could not be a dividend and therefore didn't

qualify for the 85 percent dividends received deduction. IRS

decided the distribution was "other income" and noted that the

local cooperative with section 521 status could have avoided

taxation by including the distribution in total income refunded to

members as a patronage refund.

Letter ruling 8547039 appears to have been drafted to correct

a perceived error in the previous ruling. It began by citing the 506

definition of a dividend in Code section 316 as "any distribution

of property made by a corporation to its stockholders out of its

earnings and profits." It then noted several cases that held a

dividend may be distributed to stockholders on some basis other

than equity holdings. IRS stated that such distributions out of

earnings on nonpatronage business were dividends. If the

recipients were corporations, they were entitled to claim the 85

percent dividends received deduction under Code section 243.
 This ability to pay dividends is subject to rate of return

507

restrictions found in various laws affecting cooperatives. These include

state incorporation statutes for cooperatives, the Capper-Volstead Act

(7 U.S.C. § 291), and § 521(b)(2) of the Internal Revenue Code.

 Treas. Reg. § 1.1385-1(a).

508

154

Not Paid on Patronage Basis

Members and patrons may receive payments from a cooperative which are not based on the amount of business they transacted

with the cooperative. Examples would be a cooperative making

an interest payment on a loan provided by a patron or director fees

paid a patron-director as compensation for time spent on

cooperative business. These payments don't qualify for subchapter

T treatment because they are made without regard to the amount

of cooperative business done with or for patrons.

Dividends on Capital Stock

Cooperatives may pay dividends on capital stock. No Code 507

provision specifically addresses patron receipt of dividends on

capital stock from cooperatives. They are treated by the patron the

same as a dividend distribution from any other corporation.

Amounts Not Deductible by Cooperative

The single tax principle ultimately places the tax incidence of

patronage refunds and per-unit retains on the final recipient and

not the cooperative. But this applies only if payments are

distributed according to subchapter T rules. Just because a

distribution to a patron is taxable to the cooperative doesn't make

it automatically deductible by the patron-recipient.

For example, if a cooperative fails to make a distribution

within the proper payment period outlined in subchapter T, then

the payment must be included in gross income by the cooperative

and the patron recipient.508
 American Jobs Creation Act of 2004, Pub. L. 108-357, § 102, 509

118 Stat. 1418. The development and application to cooperatives of the

QPAI deduction is discussed at Donald A. Frederick, Income Tax

Treatment of Cooperatives: Patronage Refunds and other Income

Issues, RBS Cooperative Information Report 44, Part 2 (USDA 2005),

pp. 108-112.

 I.R.C. § 199(d)(3)(A). 510

Id.

511

155

PASS-THROUGH DEDUCTION AND CREDITS

The American Jobs Creation Act of 2004 provides new

flexibility to agricultural and horticultural cooperatives in

allocating a major new tax deduction and two energy productionbased credits between the cooperative entity and its patrons.

Qualified Production Activities Income Deduction

The American Jobs Creation Act of 2004 added a new sec. 199

to the Code. This section allows businesses to deduct so-called

Qualified Production Activities Income (QPAI).509

Among other things, Code sec. 199 allows patrons of

agricultural and horticultural cooperatives to 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 amount each

510

patron can deduct must be computed by the cooperative and a

written notice must be provided each patron explaining the

computation.511

An example, also included in Chapter 6 of these reports,

illustrates how the deduction and the pass-through 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
 The credits are described at Donald A. Frederick, Income Tax 512

Treatment of Cooperatives: Patronage Refunds and other Income

Issues, RBS Cooperative Information Report 44, Part 2 (USDA 2005),

pp. 119-120.

 American Jobs Creation Act of 2004, § 313, Pub. L. 108-357, 513

118 Stat. 1467-1468 (codified at 26 U.S.C. § 40(g)(6)).

 American Jobs Creation Act of 2004, § 339(a), Pub. L. 108-357, 514

118 Stat. 1481-1484 (codified at 26 U.S.C. § 45H(g)).

156

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.

For tax planning purposes, it is important to remember that this

a deduction and not a credit. Tax credits, such as the energyrelated credits discussed below, can be used dollar-for-dollar to

offset taxes due. Deductions can only be used to reduce taxable

income, so their value depends on each taxpayer's tax bracket.

Energy Credits

The American Jobs Creation Act of 2004 authorizes

cooperatives to choose to pass some or all of two energy-based tax

credits through to their patrons. The first is the small ethanol 512

producer credit and the second is the small low-sulfur diesel fuel

513

producer credit.

514

In each instance, any credit that is passed through to patrons

must be apportioned among patrons on the basis of the quantity or

value of business done with or for such patrons during the tax
 I.R.C. § 162. 515

 Priv. Ltr. Rul. 8723018 (March 5, 1987).

516

157

year. Any credit not passed through to patrons is treated as a

general business credit by the cooperative.

PATRON PAYMENTS TO A COOPERATIVE

Cooperative taxation from the patron's perspective usually

focuses on income passing from cooperative to patron. However,

members and other patrons maymake payments to the cooperative

as well. Generally, patron payments to cooperatives are for (1)

payment for products or services received from the cooperative or

(2) contributions to capital. A patron payment to the cooperative

may or may not be deductible.

Patrons can generally deduct ordinary and necessary business

expenses incurred in the conduct of their business. On the other 515

hand, Code section 263 disallows deductions for amounts paid for

the acquisition or creation of a capital asset. For a cost to be

capitalized undersection 263, the payment must create or enhance

what is essentially a separate and distinct property interest.

Contributions to Capital

Members and other patrons contribute to their cooperative's

capital by payment of membership fees or dues, purchase of

membership or other classes of stock, and patronage-based

capitalization.

An example of a capital investment in a cooperative that is an

acquisition of capital rather than an ordinary and necessary

business expense is a one time membership fee. IRS has said that

such a fee, used to capitalize the cooperative, creates a "separate

and distinct capital asset" and the payor/member may not deduct

any part of the fee under Code section 162.516
 United Grocers, Ltd. v. United States, 308 F.2d 634 (9th Cir.

517

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

 United Grocers v. United States, 186 F. Supp. at 737. 518

158

Contributions to cooperative capital by members and other

patrons often serve as a pre-condition for using the cooperative.

The compulsory nature of these contributions has been used to

support the view that such payments should be expenses rather

than contributions to capital for tax purposes. The courts have

dealt with this issue on several occasions, not always with

consistent results.

In United Grocers v. United States, a case predating 517

subchapter T, a grocery supply cooperative argued that various

monthly payments required from its members for them to do

business with the cooperative were nontaxable contributions to

capital. IRS claimed the payments were for goods and services

rendered and should be taxed as ordinary income to the co-op.

The Ninth Circuit Court of Appeals held that the determinant

as to whether a payment to a cooperative was a contribution to

capital or ordinary income was the intent of the patron making the

payment. The court found that the only reason members paid the

fees was because the fees were required to obtain merchandise and

services at the lowest possible price; the members had no true

investment motive. Therefore the cooperative had to treat the

payments as ordinary income.

While United Grocers didn't deal specifically with the tax

impact on patrons, the district court noted that evidence offered by

the government indicated that members deducted the payments to

the cooperative as business expenses on their own income tax

returns. The district court, however, struck that evidence from the

record and disregarded it as not properly admissible on the issue

of the cooperative's claims.

518

In a letter ruling issued after United Grocers, the Service held

that periodic paymentsmay be considered contributions to capital.

The ruling described a taxi cooperative whose members purchased
 Priv. Ltr. Rul. 8129050 (Apr. 22, 1981).

519

 The banks for cooperatives have replaced this interest-override 520

method of financing with a loan-based capital plan. However, the same

factors are likely to apply in determining the tax consequences to

patrons of capitalizing the banks.

 Rev. Rul. 65-241, 1965-2 C.B. 44, 45. 521

 M.F.A. Central Cooperative v. Bookwalter, 286 F. Supp. 956

522

(E.D. Mo. 1968).

159

one share of stock at a fixed price and made periodic payments

based on use of the cooperative. IRS ruled these periodic

payments were contributions to capital, stating "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 ofthe company." This ruling didn't address 519

the tax consequences to members making such payments.

An interesting line of cases developed in the late 1960's

concerning the proper treatment by member-patrons of payments

made to banks for cooperatives for class C stock. At the time,

member-borrowers from the banks were required to purchase class

C stock in an amount equal to 15 percent of the interest payable on

the loan each quarter.520

In Revenue Ruling 65-241, IRS stated that:

...costs incurred by cooperatives in purchasing class C

stock are not deductible either as a business expense under

section 162 or as interest under section 163 of the Internal

Revenue Code of 1954. Whether such stock will be

considered a capital asset upon subsequent disposition by

a farmers' cooperative will depend upon the facts in the

particular case.521

In M.F.A. Central Cooperative v. Bookwalter, a Federal 522

district court determined that the stock was of no use or benefit to
 Mississippi Chemical Corp. v. United States, 69-1 U.S.T.C. ¶

523

9266 (S.D. Miss. 1969).

 Penn Yan Agway Cooperative v. United States, 417 F.2d 1372 524

(Ct. Cl. 1969). The U.S. Court of Claims opinion in Penn Yan Agway

Cooperative v. United States is dated November 14, 1969. The U.S.

Court of Appeals (Eighth Circuit) decision in M.F.A. Central

Cooperative v. Bookwalter followed shortly thereafter on June 8, 1970.

160

the member-cooperative. It paid no dividend and conveyed no

rights to the cooperative. The court found that interest was a term

of art meaning an amount one contracted to pay for the use of

borrowed funds. These payments weren't deductible as interest

payments because they didn't meet the court's strict interpretation

of interest. However, the stock was purchased only because it was

a precondition to borrowing from the bank. So the cost was

deductible as an ordinary and necessary business expense.

In Mississippi Chemical Corp. v. United States, decided in 523

February 1969, a U.S. District Court in Mississippi reasoned that

any charge required as a precedent to a loan of money is interest.

The court held that although the Class C stock cost $100 a share,

it had only a nominal value of $1 per share. The $99 difference

was deductible as interest by the purchasing cooperative member.

In Penn Yan Agway Cooperative v. United States, decided

524

in November 1969, the United States Court of Claims noted

M.F.A. Central Cooperative v. Bookwalter, but reached the same

conclusion as the court in Mississippi Chemical. This court held

the interest override payments were deductible on the grounds that

they were measured as a percentage of the interest payable on the

outstanding loan obligation to the bank.

After Penn Yan Agway, the U.S. Court of Appeals for the

Eighth Circuit reviewed the earlier decision in M.F.A. Central

Cooperative v. Bookwalter. In June 1970, the appellate court

affirmed the finding of the district court that the payments for the

class C stock weren't deductible as interest but reversed the

original finding that the payments were deductible as necessary
 M.F.A. Central Cooperative v. Bookwalter, 427 F.2d 1341 525

(1970), aff'g in part, rev'g in part, M.F.A. Central Cooperative v.

Bookwalter, 286 F. Supp. 956 (E.D. Mo. 1968).

 Mississippi Chemical Corp. v. United States, 70-2 U.S.T.C. ¶

526

9601 (5th Cir. 1970), aff'g 69-1 U.S.T.C. ¶ 9266 (S.D. Miss. 1969).

 United States v. Mississippi Chemical Corp., 401 U.S. 908

527

(1971).

 United States v. Mississippi Chemical Corp., 405 U.S. 298

528

(1972).

 69 Stat. 655, 12 U.S.C. § 1134. 529

 405 U.S. at 305, 312. 530

Id. at 312.

531

161

and ordinary business expenses. The Eighth Circuit found the 525

class C stock had substantial value and must be treated as a capital

asset by the purchaser-cooperative.

In September 1970, the U.S. Court of Appeals for the Fifth

Circuit reviewed of the district court holding in Mississippi

Chemical Corp. The Fifth Circuit affirmed the district court's

determination that most payments for class C stock were

deductible as interest expense.526

In a rare venture into cooperative taxation, the U.S. Supreme

Court decided to review the Fifth Circuit opinion in United States

v. Mississippi Chemical Corp. In an opinion long on history of 527

the Farm Credit System and short on analysis of tax law, a

unanimous Supreme Court accepted the IRS position that the class

C stock acquired by cooperatives to borrow from banks for

cooperatives is a capital asset under Code section 1221. The 528

Court held the class C stock had substantial valued derived from

attributes other than marketability.

The Court also noted that Congress, in the Farm Credit Act of

1955, required co-op borrowersto purchase "stock" on a quarterly

basis as part of a scheme to retire government investments in the 529

Farm Credit System. If Congress had meant for the quarterly

530

payments to be interest, it could have called them interest.531
 Tech. Adv. Mem. 9128007 (March 28, 1991). In an earlier letter 532

ruling that found a proposed cooperative venture would be operating on

a cooperative basis, IRS said that payments to the cooperative to cover

annual operating deficits were also deductible by the members as

ordinary and necessary business expenses. Priv. Ltr. Rul. 8850027

(Sept. 16, 1988).

162

Payments to Cover Operating Losses

Members and patrons may make direct payments to their

cooperative to cover operating losses. For instance, a grain

marketing company was a member of a cooperative that

transported and stored grain. In 1982, cooperative began suffering

losses because some of its charges were subject to government

control and couldn’t be raised to reflect changes in the

marketplace. Instead, the cooperative began monthly assessments

of its members to recover its losses.

The member-patron deducted these assessments as ordinary

and necessary expenses under Code sec. 162. A revenue agent

proposed that these deductions be disallowed and that the

member-patron be required to treat the expenditures as

contributions to capital under Treas. Reg. 1.263(a)-1 and 1.263(a)-

2, increasing the member’s basis in its stock in the cooperative.

The Service sided with the member, holding the prompt and

patronage-based assessments to cover operating losses were not

capital expenditures or investments within the meaning of Reg.

1.263(a)-2(f), but rather were deductible by the patron as ordinary

and necessary business expenses under Code sec. 162(a).532