INCOME TAX TREATMENT OF

COOPERATIVES: Handling of Losses

Cooperative Information Report 44, Part 5

2005 Edition

Donald A. Frederick
Abstract

INCOME TAX TREATMENT OF COOPERATIVES:

Handling of Losses

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, loss, tax

Cooperative Information Report 44, Part 5

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

As with other businesses, cooperative financial results are

computed on a yearly basis, consistent with generally accepted

accounting practices. Even highly successful cooperatives can

report a loss during one of these years. Cooperatives can learn

to weather financial storms better if they know their options and

plan ahead for possible losses.

Handling losses has been a longstanding, contentious issue

between cooperatives and the Internal Revenue Service (IRS).

In 1986, amendments to the Internal Revenue Code resolved

some of the uncertainties in combining patronage-sourced gains

and losses for tax purposes. But many other issues remain.

Handling a loss can be one of the most difficult tasks for

cooperative leaders. Cooperatives anticipating or actually facing

a loss should consult with professional advisers who understand

the options available and can provide a disinterested assessment

of the likely outcome of choosing particular options.
4

Highlights

This report provides a general, comprehensive summary of

the issues and rules applicable to cooperatives faced with losses.

It begins with an explanation of how cooperatives can suffer

losses. Examples illustrate loss situations arising from operations, disposition of assets, and those related to accounting rules.

For many years, the IRS resisted the idea that a cooperative

could suffer a loss for tax purposes. IRS asserted that since

cooperatives "operate at cost," they couldn't have a loss. Since

cooperatives distribute margins in good years to patrons based

on patronage and are allowed a deduction for the distributions,

IRS said they should issue negative patronage refunds in loss

years and collect from each patron his or her pro rata share of

the loss. The courts, however, rejected the IRS position and now

the premise that cooperatives can have losses for tax purposes

is generally accepted.

The next dispute was over the degree of flexibility available to

cooperatives in recouping a loss. IRS insisted the loss had to be

recovered from the specific patrons whose business generated

the loss. Methods approved included direct billing, canceling

equity, and establishing accounts receivable that could be offset

against funds due the patrons. However, cooperatives insisted

that members had more options, including allocating the losses

to patrons of the same business activity in other years and

allocating the losses to patrons of other activities. The courts

again have generally supported the cooperative position. And in

1986, amendments to the Internal Revenue Code (Code)

established rules that, if followed, give cooperatives significant

latitude in combining patronage-sourced gains and losses.

Other issues continue to fester. The courts have thus far

rebuffed efforts of cooperatives to combine patronage and

nonpatronage gains and losses for tax purposes. While the

courts have generally barred IRS from applying Code sec. 277

to Subchapter T agricultural cooperatives, IRS maintains that it

pertains to other cooperative organizations. And a judicial

decision holding a cooperative that redeemed qualified retained

patronage distributions at less than face value (creating a loss for

tax purposes for its patrons) did not have to report its "gain" as

income at the time of redemption is being rejected by IRS.
5

Contents

Page

Chapter 13. Handling of Losses . . . . . . . . . . . . . . . . . . . . . 7

Losses on Direct Investments . . . . . . . . . . . . . . . . . . . . . . . . 8

Losses Related to Accounting Methods . . . . . . . . . . . . . . . 13

Book v. Tax Accounting . . . . . . . . . . . . . . . . . . . . . . . . . 13

Changes in Tax Year or Accounting Method . . . . . . . . . 16

Losses on Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Losses in the Supply Function . . . . . . . . . . . . . . . . . . . . 17

Losses in the Marketing Function . . . . . . . . . . . . . . . . . 20

Startup Situations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Showing an Operating Loss for Tax Purposes . . . . . . . . . . 24

Introduction to Code Sec. 172 . . . . . . . . . . . . . . . . . . . . 25

Early Indications Support Co-op Losses . . . . . . . . . . . . 26

IRS's Operation-at-Cost Principle . . . . . . . . . . . . . . . . . 29

The Courts Speak . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

The Section 521 Rulings . . . . . . . . . . . . . . . . . . . . . . . . 36

Handling a Patronage-Sourced Loss . . . . . . . . . . . . . . . . . 38

Recouping Pro Rata From Patrons Whose

 Business Generated the Loss . . . . . . . . . . . . . . . . . . . . . 40

Direct Billing and Reimbursement . . . . . . . . . . . . . . . . . 41

Canceling Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Establishing Accounts Receivable and Collecting

 Them By Cancelling Equities . . . . . . . . . . . . . . . . . . . 44

Nonqualified Allocations . . . . . . . . . . . . . . . . . . . . . 44

Qualified Allocations . . . . . . . . . . . . . . . . . . . . . . . . 46
6

Loss Allocation Based on Retained

 Patronage Equity . . . . . . . . . . . . . . . . . . . . . . . . . 49

Absorbing Loss at Co-op Level After

 Reasonable Recoupment Effort . . . . . . . . . . . . . . 51

The Farmland Industries Liquidation Rulings . . . . . . 52

Document Language Issues . . . . . . . . . . . . . . . . . . 54

Recovering a Patronage-Sourced Loss From Patrons

 of the Same Activity, but Different Years . . . . . . . . . . . . . 57

Carry Forward and Carry Back under Code Sec. 172 . . 57

Unallocated Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . 61

Recovering a Patronage-Sourced Loss From

 Patrons of Other Activities . . . . . . . . . . . . . . . . . . . . . . . . 64

IRS Objections to Netting . . . . . . . . . . . . . . . . . . . . . . . 64

Gold Kist Letter Ruling . . . . . . . . . . . . . . . . . . . . . . . . . 72

A Legislative Solution . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Option to Net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Notice Requirement . . . . . . . . . . . . . . . . . . . . . . . . . 75

Section 521 Status . . . . . . . . . . . . . . . . . . . . . . . . . 76

Effective Dates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

No Effect on Treatment of Nonpatronage Losses . . 77

Nonpatronage Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

Section 521 Cooperatives . . . . . . . . . . . . . . . . . . . . . . . 78

Non-section 521 Cooperatives, Netting

 Nonpatronage Losses with Patronage Earnings . . . . . 80

Non-section 521 Cooperatives, Netting

 Nonpatronage Earnings with Patronage Losses . . . . . 84

Section 277 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

Subchapter T Agricultural Cooperatives . . . . . . . . . . . . 91

Other Cooperatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Housing Cooperatives . . . . . . . . . . . . . . . . . . . . . . . 97

Rural Electric Cooperatives . . . . . . . . . . . . . . . . . . 101

Farm Credit Institutions . . . . . . . . . . . . . . . . . . . . . 102
 Notably IRC § 165 (provides a deduction of losses) and § 172

2

(authorizes net operating loss carrybacks and carryovers).

 IRC § 1388(j), Consolidated Omnibus Budget Reconciliation Act 3

of 1985, Pub. L. 99-272, § 13210, 100 Stat. 82, 323-324 (1986). This

provision is discussed infra pp. 74-77.

 IRC § 1382(g)(2).

4

7

CHAPTER 13

HANDLING OF LOSSES

It seems ironic indeed that cooperatives may face more

difficult income tax problems in years when they suffer a loss than

in years in which they generate net income. This, however, is

frequently the case.

Part of the difficulty in handling losses is business related.

Cooperative leaders may be under considerable pressure to handle

a traumatic situation, usually with little or no clear guidance from

incorporation statutes, cooperative bylaws, or precedence.

Several alternative actions may be available, each with some

positive and negative consequences. Portions of this chapter

discuss how cooperatives can generate losses and the options for

dealing with them. Hopefully, this will encourage cooperative

leaders and advisers to anticipate potential losses and plan to

handle them before the stresses actually occur.

Another factor that complicates handling cooperative losses is

the lack of direction in the Internal Revenue Code (Code) and

Treasury Department regulations (regulations). While the Code

has provisions on the general treatment of losses by corporations

and individuals, the only references to losses in Subchapter T are 2

relatively recent language dealing with netting of patronage gains

and losses and a definition of "completed crop pool method of 3

accounting" that recognizes an individual crop-year pool may have

a loss.4
 Treas. Reg. § 1.1383-1(a)(2), § 1.1383-1(b)(3), and § 1.1383-1(d).

5

 Treas. Reg. § 1.1385-1(c)(2)(ii)(b).

6

 Treas. Reg. § 1.1385-1(e).

7

 "Subchapter T says nothing about the appropriate treatment of net 8

operating losses,...." Farm Service Cooperative v. Commissioner, 619

F.2d 718, 723 (8th Cir. 1980).

 The impact of the loss is cushioned by the fact that non-corporate

9

taxpayers can deduct up to $3,000 in capital losses from ordinary

8

The regulations mention cooperative losses when discussing

redemption of nonqualified written notices of allocation, and the 5

distribution of patronage refunds related to the disposition of a

capital asset. The regulations also refer to the possibility of a loss

6

at the patron level related to the redemption of a patronage

distribution from a cooperative. But nowhere is guidance 7

provided to cooperatives in reporting common losses for tax

purposes. Thus most ground rules for handling cooperative losses 8

have developed through court decisions and Internal Revenue

Service (IRS or the Service) administrative rulings.

LOSSES ON DIRECT INVESTMENTS

As indicated throughout these reports, one way cooperatives

acquire equity is through direct investment by their memberpatrons. These contributions of capital are usually made to gain

access to goods and services for the patron’s business or personal

life, rather than to make money off the efforts of others. They are

usually represented by shares of stock or other representations of

membership interests. And they are at-risk investments that can

lose some or all of their value.

In many instances, the required direct investment to join a

cooperative is relatively small, $100 or less. If the organization

fails and that money is lost, it is not worth the cost to challenge

any IRS finding as to the nature of the loss. However, occa- 9
taxable income each year under Code § 1211(b). 

 Thus, while Cenex was itself a large federated farm supply

10

cooperative, in this instance it was a member-patron of another

federated cooperative.

Most of this equity was obtained as the result of a direct purchase 11

of an equity interest in ECI, and a small amount as a retained patronage

refund allocation. The courts did not indicate whether they would have

reached a different conclusion if most of the canceled equity had been

qualified written notices of allocation.

 It is frequently important from a tax perspective whether a loss is 12

classified as an “ordinary” or a “capital” loss. As a general rule,

“ordinary” losses can be deducted from ordinary income in the year the

loss is realized. IRC § 165(a). “Capital” losses can (must) be offset

against capital gains. IRC §§ 165(f), 1211(a).

Cenex only contested the IRS position that the loss was a capital

loss, not an ordinary loss. Cenex was willing to accept nonpatronage

status for the loss. The Cenex board had adopted a policy of allocating

only 90 percent of patronage-sourced earning each year to the members,

placing 10 percent of annual patronage earnings in an unallocated

reserve, and paying tax on that amount at the cooperative level. Cenex

was willing to have the loss on the ECI stock classified as a

nonpatronage ordinary loss as it could then carry that loss back and

forward to offset, for tax purposes, its operating earnings in other years

9

sionally a large sum is lost and the way it is classified for tax

purposes can involve substantial amounts of money.

In 1975, Cenex Inc., a predecessor to today’s CHS Inc.,

together with eight other regional cooperatives, formed what

became known as EnergyCooperative, Inc. (ECI), to purchase and

operate a petroleum refinery. The venture's objective was to 10

obtain access to an assured supply of petroleum products for the

cooperatives' producer members. It failed and dissolved in

bankruptcy.

Cenex claimed a substantial ordinary tax loss deduction for the

amount of its unrecoverable investment in ECI, under Code sec.

165(a). After an audit, IRS determined that the loss was a capital 11

loss, deductible only in accordance with Code sec. 165(f).

12
on patronage business that were not allocated on the basis of patronage.

 Cenex v. United States, 38 Fed.Cl. 331, 338-339 (1997), aff'd, 156 13

F.3d 1377 (Fed. Cir. 1998); cert. denied, 525 U.S. 1146 (1999). The

court herein noted that it had earlier held, on essentially the same facts,

that the loss on the sale of stock purchased to secure a “source of

supply” of petroleum products did come within the “inventory”

exception, Circle K Corp. v. United States, 23 Cl.Ct. 665, 672 (1991).

The court now said it could no longer accept the rationale of that

decision. 38 Fed.Cl. at 339, n.5.

Before the U.S. Supreme Court ruled in Arkansas Best that stock,

even when purchased for a business purpose, is always a capital asset

unless specifically excluded from that classification under Code § 1221,

a cooperative had prevailed on essentially the same facts. FS Services

v. United States, 413 F.2d 548 (Ct. Cl. 1969) (Stock purchased in oil

refiner to alleviate petroleum product supply procurement problems was

not a “capital asset” and loss on sale of stock after product shortage

ended is “ordinary loss”). 

10

Cenex paid the assessment and then sued for a refund. It

asserted that because the investment was made to guarantee a

source of inventory for its farm supply operations, ECI stock

comes within the "inventory" exception to the Code section 1221

definition of "capital asset." The court disagreed, finding the

cooperative:

...might indeed have been motivated to acquire stock

in an oil refinery by its desire to secure a source of

inventory. But through that stock purchase, plaintiff did

more than secure a supply of petroleum; plaintiff became

the owner of a refining company. ... 

Unless the taxpayer in question is a dealer in securities,

an ownership interest in a corporation cannot fit within

even a strained interpretation of the term “inventory.” ...

(P)laintiff's loss on its investment in the ECI stock is

properly subject to capital-asset treatment under § 1221.13
 Cenex v. United States, 156 F.3d 1377, 1381 (Fed. Cir. 1998),

14

aff’g, 38 Fed.Cl. 331 (1997); cert. denied, 525 U.S. 1146 (1999)

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 15

Patronage Refunds, Cooperative Information Report 44, Part 2 (USDA

2005) pp. 55-62.

 Farmland Industries v. Commissioner, T.C. Memo 1999-388 16

(Nov. 29, 1999), 78 T.C.M. (CCH) 846. Farmland acquired the stock

of three smaller companies to secure access to an assured supply of

crude oil for its refinery operations. When forced to sell the stock to

cover other operating losses in later years, Farmland realized a

11

On appeal, the U.S. Court of Appeals for the Federal Circuit

affirmed the trial court, saying:

The ECI stock transaction is more akin to vertical

integration than it is to an inventory substitute. If CENEX

were to produce petroleum products itself, it would not be

able to classify its refinery operation as inventory; once

petroleum products were produced, they would be

considered inventory and other assets would have to meet

the requirements of section 1221 to escape classification as

capital assets. Allowing CENEX to declare its refinery

operation an ordinary asset simply because it owns stock

would circumvent Congress’ intent in creating only the

five exclusions of section 1221. Perhaps excluding stock

of an inventory supplier from the definition of “capital

asset” is good policy, but we prefer to leave this decision

to Congress.14

A lengthy discussion of a series of IRS rulings and a court

decision concerning disputes between Farmland Industries and the

Service over the tax status of gains and losses on the disposition

of stock owned by Farmland in various other entities is found in

Part 2 of these reports. The Tax Court ultimately decided that 15

gains and losses on the stock sales were patronage-sourced capital

gains and losses.16
substantial gain on one sale and had modest losses on the other two.

Farmland was primarily concerned with establishing that the large

gain was “patronage” rather than “nonpatronage” sourced. Farmland

first applied the small losses on the disposition of the other two blocks

of stock to offset part of the gain. Then, as part of a negotiated

settlement with the Service on numerous tax issues, Farmland was

allowed to offset the remainder of the gain, on a pro rata basis, with

patronage and nonpatronage losses realized in a number of petroleum

“pools.” Apparently the Service felt this was an “equitable” use of the

gain in this instance. This aspect of the case was not in the decision and

therefore is not precedent for allowing the netting of a patronagesourced capital gain with ordinary patronage and nonpatronage sourced

losses in future disputes.

 Action on Decision 2001-03 (2001), acquiescing in Farmland 17

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

 Arkansas Best v. Commissioner, 485 U.S. 212 (1988). 18

12

When IRS announced its acquiescence in the Farmland

decision, it issued an Action on Decision abandoning its position

that gains and losses on certain transactions listed in Treas. Reg.

1.1382-3(c)(2), including the sale or exchange of capital assets, are

per se nonpatronage sourced. More specifically, it said, “Gains or

losses from the sale or exchange of a capital asset will be

considered nonpatronage sourced where the asset was not used for

a cooperative business purpose, but will be considered patronage

sourced where the asset actually facilitates the cooperative

business.”17

As to the losses involved in this case, Farmland was willing to

have them classified as patronage and capital because it had a

corresponding large gain to offset with the losses. When other

cooperatives are confronted with future losses on the sale of direct

investments, they may not have a ready source of capital gains, let

alone patronage-sourced capital gains. So, in light of the Arkansas

Best decision holding stock purchased by anyone other than 18

securities dealers is a capital asset, they may have trouble claiming

a tax benefit from the loss.
 Rev. Rul. 74-274, 1974-1 C.B. 247. 19

Id. at 248.

20

13

LOSSES RELATED TO ACCOUNTING METHODS

Special situations arise periodically under standard accounting

procedures that also produce losses for cooperatives. These can be

contentious with the Service as they may appear to be more the

result of creative bookkeeping than legitimate losses. But the need

to use consistent accounting methods, even when they produce

unusual results, makes these losses valid for tax purposes.

Sometimes disputes arise over events which produce a

different patronage refund calculation under generally accepted

accounting rules than under the applicable tax rules. Problems

occur when the accounting patronage refund is greater than the one

computed under tax rules and the cooperative attempts to deduct

the higher number on its "books," producing a loss for tax

purposes.

Book v. Tax Accounting

In 1974, the Service addressed the "book" versus "tax" issue.19

The cooperative in question used straight line depreciation for

book purposes and accelerated depreciation for tax purposes. It

had a larger depreciation expense under the tax rules and thus a

smaller margin available for distribution as a patronage refund

than under the book rules.

The IRS cited the definition of a "patronage dividend" in Code

sec. 1388(a). It interpreted the phrase "net earnings of the

organization from business done with or for its patrons" to mean

only net earnings "from patronage business reported for Federal

income tax purposes." It said that the cooperative could not 20

claim a patronage refund deduction for the amount of a

distribution that exceeds net earnings reported for Federal income

tax purposes.
 Associated Milk Producers v. Commissioner, 68 T.C. 729 (1977). 21

Id. at 741.

22

Id., n. 8. 23

14

The validity of the Service's position was questioned by the

U.S. Tax Court in Associated Milk Producers (AMPI) v.

Commissioner. In 1960, Rochester Dairy (a part of AMPI when 21

the litigation occurred) wrote-down the value of a building it

owned to reflect its obsolescence, but didn't attempt to deduct it on

its 1960 tax return.

In 1961, it sold the building and deducted the loss on its tax

return. But the loss had already been recorded on the cooperative's

books in 1960, so in 1961 its "book" income exceeded its "tax"

income. The cooperative paid a patronage refund on "book" and

claimed the difference between "book" and "tax" income as a tax

"loss" for 1961 to be carried forward to subsequent years. The

Service, relying on Revenue Ruling 74-274, denied the loss carry

forward because it resulted from claiming a patronage refund

deduction that exceeded net income from patronage business

reported for Federal income tax purposes.

The court allowed AMPI to carry the 1961 tax loss forward.

It noted that the 1961 patronage refund did not exceed 1961

"book" income and resulted "from merely a timing difference in

connection with the reporting of the loss on the building." In a 22

footnote, the court said that while Revenue Ruling 74-274 didn't

apply to tax year 1961, "we have serious doubts as to its

correctness even as an interpretation of sec. 1388."23

In a later case, the Tax Court reviewed various issues

involving a cooperative whose book income was greater than its

taxable income. Among other things, it did not include taxexempt income in taxable income and it claimed larger deductions

for tax purposes than for book purposes. The cooperative issued

patronage refunds based on book income and reported the differ-
 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 24

238 (1987).

Id. at 250.

25

 Priv. Ltr. Rul. 8248048 (August 30, 1982).

26

15

ence as a loss. The court recognized this as a valid loss for tax

purposes.24

The court didn't discuss the matter in detail, saying that the

IRS "herein now appears to concede that a cooperative may have

a net operating loss...and that it can be caused by the payment of

patronage (refunds) based upon book income which exceeds

taxable income from patronage."25

In 1991, the Service prepared a number of proposed coordinated issues papers concerning cooperatives, including one on the

"book" v. "tax" issue. The paper noted that the AMPI and

Certified Grocers decisions had created some doubt as to IRS's

position and its willingness to defend the issue. The paper

concluded that the Service stands behind Revenue Ruling 74-274

and that the use of "book" earnings to compute a patronage refund

deduction is not available to cooperatives.

In a written statement dated June 8, 1992, the National Council

of Farmer Cooperatives (NCFC) attempted to persuade IRS that

patronage refunds could be based on "book" earnings. Since that

time the issue has festered but IRS has not challenged cooperatives

that have used "book" consistently.

Cooperatives may have both tax and book losses in the same

year, but the amounts may differ because they are calculated

differently. In one instance, the differences between the book and

tax losses were due to amounts accrued for lawsuits, fixed asset

valuation, and unfunded pension plans that were deducted for

book purposes but not for tax purposes because the liability had

not become fixed and determinable. IRS noted the difference but

didn't discuss it.

26
 Ford-Iroquois FS v. Commissioner, 74 T.C. 1213 (1980).

27

 Tech. Adv. Mem. 8043019 (July 24, 1980).

28

 Priv. Ltr. Rul. 8540051 (July 3, 1985); Priv. Ltr. Rul. 8540056 29

(July 8, 1985).

 Rev. Rul. 79-45, 1979-1 C.B. 284. 30

16

Changes in Tax Year or Accounting Method

A cooperative may incur a loss because it is reporting results

for tax purposes for a period less than a full year. A short taxable

year may result from adjusting the tax years of the participants in

a merger or from changing the tax year of a single cooperative 27

for any reason acceptable to IRS.28

A cooperative may incur a loss from changes in accounting

methods from one year to another, losses indirectly related to

operations but not necessarily reflecting economic loss for the year

in which the loss is recognized. For example, letter rulings29

describe a cooperative that changed the method of closing its

marketing pools from the "net realizable value" method to closing

each pool in the year all the products in the pool are finally sold.

The change resulted in a Code sec. 481 negative adjustment.

The cooperative took the full amount of the adjustment into

account in the year of change, resulting in a substantial loss for

that year. The rulings compared that accounting change with a

change from LIFO method of valuing ending inventory to the

FIFO method described in a revenue ruling that resulted in a 30

gain. IRS cited a statement therein that the adjustment described

"facilitates a cooperative's ability to pass through gains or losses"

and said the losses in this instance should be treated in a similar

fashion.

LOSSES ON OPERATIONS

Cooperatives generally provide two types of services to their

member-users. They sell them supplies and business services and
 AICPA Audit and Accounting Guide, Audits of Agricultural 31

Producers and Agricultural Cooperatives, § 10.16 (Am. Inst. of Certified

Pub. Accountants 1987, with conforming changes as of May 1, 1996)

p. 44.

Ibid.

32

See, e.g., Priv. Ltr. Rul. 8248048 (Aug. 30, 1982).

33

17

market products produced by members. These operations are

often called "functions."

Cooperatives may provide services in only one or in both

functions. For example, a cooperative may only market wheat for

its members, only sell farm supplies, or do marketing and supply

functions.

When computing their financial results for the year,

cooperatives that operate both functions will usually account

separately for revenues and costs of each function. A co-op may 31

also provide more than one service within a function. For

example, it may sell diesel fuel, seed, and crop protectants to its

farmer-members. The cooperative would usually account

separately for the results of each department within a function.32

Determining the extent of margins and losses on a line-ofbusiness basis is critical to evaluating current operations and

planning for the cooperative's future. It also has important tax

implications. The next two subsections explain how losses can

occur within each function. Later, more complex issues such as

combining the financial results for tax purposes of a department or

function that generates a margin with one suffering a loss, called

"netting," will be discussed.

Losses in the Supply Function

Cooperatives that manufacture or purchase and resell supplies

and equipment can suffer a loss just like any similar

noncooperative firm: e.g.; from competitive pressures on prices,

orders not arriving on time, strikes, uncollectible accounts, etc.33
18

Local supply cooperatives that typically purchase in bulk and

resell in small lots to individuals can be hit by any of these

conditions. However, they commonly suffer a loss when the retail

price of a major product they handle falls after they have

purchased a large quantity but before they can resell it to their

patrons. They are compelled to resell the product at a loss to meet

competition and maintain member loyalty.

Example 1. Cooperative Loss Caused by Price Decline

in Supplies Purchased for Resale

Expected (1 million units)

Purchase Price ($0.85/unit) $850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Product Sales Proceeds ($1.10/unit) 1,100,000 

Net Margins $50,000 

Actual (1 million units)

Purchase price ($0.85/unit) $850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Product Sales Proceeds ($1.00/unit) 1,000,000 

Net Loss ($50,000) 

Example 1 illustrates how a decline in the market price of a

product purchased for resale to members can generate a loss. The

cooperative paid $.85 per unit for an item with the expectation the
19

article could be resold to patrons for $1.10 per unit, covering costs

and generating a net margin to be distributed as patronage refunds.

When it could only sell the item for $1.00 per unit, a net loss

occurred.

A modest shortfall in the anticipated price of the product, from

$1.10 to $1.00, turned a reasonable potential margin into a significant loss. In today's highly competitive markets, where profit

margins are thin in good times, this is a perfectly plausible event.

Supply cooperatives can also suffer losses when patrons

simply don't buy as much product as anticipated. For example, a

cooperative might make an advance purchase of seed corn to meet

normal member demand during the spring. However, unusually

wet weather may prevent members from getting into their fields

during the planting season for corn. As a result, they switch some

of their acreage to other crops that can be planted later, such as

soybeans, and purchase less seed corn than anticipated.

In Example 2, the cooperative experienced no price changes

for the product supplied and had no operating cost changes. A 20-

percent shortfall in deliveries to patrons was sufficient to cause the

cooperative's total costs to considerably exceed its total proceeds.

Example 2. Cooperative Loss Caused by 20-Percent

Shortfall in Orders for Supplies Furnished Patrons

Expected (1 million units)

Purchase Price ($0.85/unit) $850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Product Sales Proceeds ($1.10/unit) 1,100,000 

Net Margins $50,000 
See, e.g., Priv. Ltr. Rul. 9202026 (Oct. 11, 1991)(high processing

34

costs and interest expenses, erosion of commercial markets,

uncollectible accounts).

 Priv. Ltr. Rul. 8842018 (July 22, 1988).

35

 Tech. Adv. Mem. 9128007 (March 28, 1991).

36

20

Actual (800,000 units)

Purchase Price (1,000,000 units at $0.85/unit) $850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Product Sales Proceeds ($1.10/unit) 880,000 

Net Loss ($170,000) 

Unfortunately for cooperatives caught in this situation, they

may actually suffer additional pressure on prices and costs. If

competitors also have too much supply resulting from the

depressed demand, market conditions may force down prices.

And if that product remains in inventory, variable costs may

actually rise. Thus supply cooperatives should plan their

purchases carefully to avoid this predicament, if possible.

Losses in the Marketing Function

Marketing cooperatives also can suffer operating losses for a

variety of reasons. A primary buyer may file for bankruptcy and 34

be unable to pay for products already delivered. A Government 35

regulator may keep prices the cooperative can charge for its

services so low the cooperative can't cover its expenses.36

More typical is the cooperative trapped by fluctuations in the

markets in which it sells patrons' products. A cooperative may

purchase these products at a cost reflecting the current market
 Rev. Rul. 70-407, 1970-2 C.B. 52 (cash advances to patrons 37

proved to be excessive because of unanticipated decline in the price of

cotton); Priv. Ltr. Rul. 8248034 (Aug. 30, 1982)(sharp decreases in

market prices of commodities subsequent to cooperative's entering into

fixed-price contracts with its members); Priv. Ltr. Rul 7926068 (March

29, 1979)(cotton processing cooperative suffered a loss resulting from

a sudden decline in the price of denim).

21

price to producers at the time of delivery to the cooperative, or

make advances to patrons based on that price. The price paid or

advance is established with an expectation that the commodity or

product(s) made from the commodity can be sold at a price

sufficient to cover those payments and all other costs. If the actual

proceeds are less than anticipated, a loss can result.37

In Example 3, the cooperative made advances of $0.85 per unit

anticipating the product could be sold for $1.10 per unit, cover

costs, and generating a net margin to be distributed as patronage

refunds. When prices fell to $1.00 per unit, however, a net loss

occurred.

Example 3. Cooperative Loss Caused by Price Decline

of Product to be Marketed

Expected (1 million units)

Product Sales Proceeds ($1.10/unit) $1,100,000 

Advances Paid to Patrons ($0.85/unit) 850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Net Margins $50,000 
22

Actual (1 million units)

Product Sales Proceeds ($1.00/unit) $1,000,000 

Advances Paid to Patrons ($0.85/unit) 850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Net Loss ($50,000) 

Market factors other than price changes may affect a

cooperative's ability to generate enough income to cover costs and

advances to patrons. Marketing cooperatives depend on deliveries

by patrons. Fluctuations in patronage may lead to cooperative

losses, whether the fluctuation is an excess or deficiency.

For instance, patrons may deliver more product than a

cooperative can market at prices adequate to cover grower

payments and its operating costs. Overproduction is frequently

accompanied by a general market price decline, so the conditions

work together to compound the problem.

A shortfall in anticipated product delivery may also induce

losses, especially if prices don’t rise enough to cover the revenue

decline. A product shortage can be particularly troublesome if the

cooperative has contracted to deliver product to a buyer at a fixed

price and, in a time of rising prices, is forced to obtain substitute

product in the open market.

The cooperative in Example 4 had a 30-percent shortfall in

deliveries from patrons that resulted in a loss. This simplified

example doesn't deal with price changes for product bought or

sold, but does reflect changes in variable costs.
 Tech. Adv. Mem. 8245082 (Dec. 31, 1981); Priv. Ltr. Rul.

38

9202026 (Oct. 11, 1991).

23

Example 4. Cooperative Loss Caused by 30-Percent

Delivery Shortfall

Expected (1 million units)

Product Sales Proceeds ($1.10/unit) $1,100,000 

Advances Paid to Patrons ($0.85/unit) 850,000 

Operating Costs

Variable Costs ($0.05/unit) 50,000 

Fixed Costs 150,000 

Total Costs 1,050,000 

Net Margins $50,000 

Actual (700,000 units)

Product Sales Proceeds ($1.10/unit) $770,000 

Advances Paid to Patrons ($0.85/unit) 595,000 

Operating Costs

Variable Costs ($0.05/unit) 35,000 

Fixed Costs 150,000 

Total Costs 780,000 

Net Loss ($10,000) 

Startup Situations

Forming a new cooperative, or entering a new line of business,

forces members to incur costs before the cooperative generates

much, if any, income. While the members may realize an

immediate benefit from the new service, it may be some time

before the cooperative realizes positive financial results. Persons 38

starting a new cooperative must provide sufficient capital to cover

these early losses and develop a financial and tax plan to recoup

them as swiftly and efficiently as possible.
 James R. Baarda, Cooperative Principles and Statutes: Legal

39

Descriptions of Unique Enterprises, ACS Research Report No. 54, at

18-20 (USDA 1986).

 IRC § 172. 40

24

In summary, numerous factors may lead to operating losses for

both marketing and supply cooperatives, particularly if they can’t

adequately adjust their prices received for supplies provided, or

payments to patrons for products delivered, to reflect changes in

market conditions. A cooperative is vulnerable to operating losses

just like any other businesses in similar situations.

SHOWING AN OPERATING LOSS

FOR TAX PURPOSES

A sign in numerous small retail establishments reads, "This

business is a nonprofit organization. We didn’t intend it to be that

way, that’s just how things worked out."

Cooperatives are often referred to as "nonprofit" businesses

that "operate at cost." Many State cooperative incorporation laws

use the term "nonprofit" to describe organizations they cover.39

The terminology was often written into those laws decades ago, to

emphasize that cooperatives are not operated to generate profits

for themselves, but rather to provide goods and services to

members at the lowest possible cost. They describe the

relationship between cooperatives and their members, not a formal

accounting and tax principle.

Nonetheless, in the 1970s, IRS devised an "operation at cost"

theory it applied to determine cooperatives could not have a loss

for tax purposes on operations conducted on a cooperative basis.

Much of the resulting controversy focused on the ability of

cooperatives to use Code sec. 172.40
 IRC § 172(a). 41

 IRC § 172(c). 42

 IRC § 172(b)(1)(A). For tax years beginning before August 6,

43

1997, the loss can be carried back for three years and carried forward

for 15 years. Net operating losses that occurred in tax years ending in

2001 and 2002 can be carried back for 5 years.

 IRC § 172(b)(2).

44

 IRC § 172(b)(3).

45

25

Introduction to Code Sec. 172

Code sec. 172 permits most taxpayers to deduct in the current

tax year an eligible net operating loss suffered in another tax

year. A net operating loss is defined as the amount by which 41

allowable deductions exceeds gross income.42

For tax years beginning after August 5, 1997, a net operating

loss may be carried back and deducted against taxable income in

the 2 years before the loss year and then carried forward and

applied against taxable income for up to 20 years after the loss

year. Generally, the loss is to be used in the earliest tax year it 43

can be applied.44

However, a taxpayer may forgo the carry back period and use

the loss exclusively in the years following the loss year. Such an 45

election might be beneficial when the taxpayer expects higher

marginal tax rates to apply to its taxable income in the next few

years than applied in the most recent years. This flexibility to use

a net operating loss to offset taxable income paid in prior years

(and generate a refund) and/or in future years (and avoid a tax

liability) is a valuable tax planning tool.

The Service hasn't questioned the ability of cooperatives to

generate losses on nonpatronage activity or to carry them back and

forward to offset otherwise taxable nonpatronage-sourced earnings

in other years.

However, the Service has questioned whether a cooperative

can even have a net operating loss on patronage activity and barred
 Revenue Act of 1951, ch. 521, § 314, 65 Stat. 452, 491-491 46

(1951).

 For a discussion of the cooperative provisions in the Revenue Act 47

of 1951, see Donald A. Frederick, Income Tax Treatment of

Cooperatives: Background, RBS Cooperative Information Report 44,

Part 1 (USDA 2005) pp. 116-119.

26

the use of patronage-sourced losses to offset nonpatronage

earnings. Cooperatives claimed that when expenses exceeded

income, they had a net operating loss and attempted to carry it

back or forward.

IRS countered that since a cooperative operates at cost, it could

not generate a "net operating loss" and use it to reduce taxes due

in other years. IRS would disallow the claimed net operating loss

deduction and tell the cooperative to recoup the loss from the

patrons whose business created the loss.

Early Indications Support Co-op Losses

Prior to the 1970s, handling of losses by cooperatives received

little attention. Exempt cooperatives were truly exempt from

taxation and nonexempt cooperatives were taxed just as other

corporations, except they were permitted to treat income allocated

to the accounts of member-patrons as discounts or rebates.

The Revenue Act of 1951 terminated the true "tax exempt" 46

status of certain farmer cooperatives and included a provision to

insure that cooperative earnings would be currently taxable either

to the cooperative or to its patrons. The cooperative provisions 47

originated as a Senate amendment to the House bill. The Senate

Finance Committee report acknowledged a cooperative could have

a loss, stating:

It is to be noted that in computing (under Section 122

of the Code) the net operating loss deduction provided by

Section 23(s) of the Code [Section 172 of the 1954 Code],

not only will the amounts allowable as deductions under
 S. Rep. No. 781 (Supp. 2), 82nd Cong., 1st Sess. (1951) p. 29,

48

reprinted at 1951-2 C.B. 565.

 Marion M. Winkler, Treatment of Losses of Farmer Cooperatives,

49

The Cooperative Accountant, Fall 1971, at 8, 12.

See, e.g., references to cooperatives suffering losses in the 50

regulations on redemption of nonqualified written notices or allocation,

Treas. Reg. § 1.1383-1(a)(2), § 1.1383-1(b)(3), and § 1.1383-1(d); and

the distribution of patronage refunds related to the disposition of a

capital asset, Treas. Reg. § 1.1385-1(c)(2)(ii)(b).

 Rev. Rul. 65-106, 1965-1 C.B. 126. 51

See also, Letter Ruling 6503036020A (March 3, 1965).

52

27

Section 101(12)(B)(i) and (ii) of the Code as amended by

the bill be taken into account but such computation will

also reflect the patronage dividends, refunds, and rebates

made by the cooperative which are taken into account in

computing net income. [emphasis added]48

During the 1950s and 1960s, it apparently was general practice

for cooperatives to net losses both within a function and between

functions and to make patronage refund distributions of the

remainder. If an association suffered an overall loss, even though

one or more operation(s) might have margins, no patronage

refunds were paid. This mutual risk-sharing was accepted by

member-patrons.49

Until the early 1970s, the IRS gave at least passive acceptance

to the idea that a cooperative could have a loss. In Revenue 50

Ruling 65-106, the Service said that a net operating loss could be

carried back or forward under Code section 172 without

necessarily reducing the earnings of the cooperative available for

patronage refunds in the year to which the loss may be carried.51

The ruling indicated that if the cooperative had a legal obligation

to reduce future patronage refunds to recapture the loss, such as a

bylaw or provision in a contract between the cooperative and its

members to that effect, that obligation would control.52
 Rev. Rul. 67-128, 1967-1 C.B. 147. For an explanation of the 53

special rules in § 521, including those pertaining to patronage-based

allocations of nonpatronage income and losses, see Donald A.

Frederick, Income Tax Treatment of Cooperative: Internal Revenue

Code Section 521, RBS Cooperative Information Report 44, Part 4

(USDA 2005) pp. 102-108.

 Rev. Rul. 70-328, 1970-1 C.B. 5. This ruling held a cooperative 54

couldn't claim an investment tax credit (ITC) in a year it has an

operating loss. Rev. Rul. 85-126, 1985-2 C.B. 5, revoked this ruling and

said that under current law a cooperative may have unused ITC for carry

back and carryover purposes “in a year during which it has a net

operating loss.”

 Rev. Rul. 70-420, 1970-2 C.B. 64, revoked by Rev. Rul.74-377, 55

1974-2 C.B. 274. 

28

Revenue Ruling 67-128 concerned a cooperative with section

521 status that marketed both vegetables and grain. It accounted

for the income and expenses of each department separately. It

realized nonpatronage gains and losses on these lines of business.

The Service approved a plan to allocate the nonpatronage income

and losses to the patrons of the department to which they relate,

rather than to all patrons, "provided that the allocation is not

discriminatory among patrons similarly situated."53

Revenue Ruling 70-328 discussed a cooperative’s treatment of

an unused investment tax credit during a “taxable year its

operations resulted in a net operating loss as defined in section

172(c) of the Code.”54

Revenue Ruling 70-420 examined whether a cooperative that

earned 600x dollars onmember business and "sustained a net loss"

of 500x dollars under a contract with a foreign government had a

net operating loss for tax purposes. IRS said the cooperative had

to net the results of the two and had a single margin of 100x

dollars. The ruling seems to indicate that if the numbers had been

reversed so that the loss on the foreign contract exceeded member

earnings, the result would have been an overall net operating loss

of 100x.55
 Rev. Rul. 67-128, 1967-1 C.B. 147. 56

 Marion M. Winkler, Treatment of Losses of Farmer Cooperatives,

57

The Cooperative Accountant, Fall 1971, at 8, 12-13.

 TAXFAX, The Cooperative Accountant, Fall 1971, at 38. 58

29

This is consistent with language in Rev. Rul. 67-128 indicating

that allocation of losses by department is conditioned on its not

discriminating among similarly situated patrons. By implication,

the approach IRS preferred at the time was to allocate a loss in a

given department "to all patrons of the association."56

IRS's Operation-at-Cost Principle

Contemporaneous reports indicate that the IRS staff shocked

cooperative tax advisers during a presentation at the 1971 Annual

Meeting of the National Council of Farmer Cooperatives. They

announced that from now on (1) cooperatives were not to net

between functions and (2) losses were to recouped from the

patrons of the year that the loss was recognized.57

A summary of the session in TAXFAX reported:

Representatives of the IRS National Office participated

in the January meeting of the Legal, Tax and Accounting

Committee of the National Council of Farmer Cooperatives. In reporting on cooperative problems then under

consideration in the National Office, they dropped a "super

bomb" with respect to departmental losses of a multidepartmental operation.

Presume that one department earns $100 and the

second loses $40; the IRS representatives suggested that

the $40 loss should be assessed against patrons of the loss

department and patronage dividends of $100 should be

paid to patrons of the profitable department! This is

wholly contrary to the beliefs many of us have grown up

with over the years.

58
 Gerald A. Holmes, Cooperatives and Losses: An Historical 59

Perspective on Current Issues, The Cooperative Accountant, Winter

1975, at 2, 4.

 Rev. Rul. 69-67, 1969-1 C.B. 142. 60

 Ltr. Rul. 7207319410A (July 31, 1972).

61

Id. 62

30

A few years later, Gerald Holmes suggested, "The change in

the Service's position on losses may have evolved from its

philosophical definition of a cooperative. The axiom cited most

by the Service in recent years concerning cooperative losses is the

'cost principle.'"59

The operation-at-cost principle was first voiced by the Service

in a ruling that concerned inventory valuation, not losses. The

Service said:

One of the fundamental principles associated with a

farmers' cooperative is that it is operated at cost for its

patrons. This principle is usually evident when the net

earnings (net savings) resulting from the operation of the

cooperative from business done with or for its patrons are

returned by the cooperative to its patrons in proportion to

the amount of business done with or for each patron.60

After IRS announced its new position on losses in 1971, it

issued a letter ruling in 1972 that applied its operation-at-cost

principle to determine a cooperative could not net losses of its

marketing department with margins of its purchasing department.61

IRS cited Revenue Ruling 69-67 as the source of its position that

cooperatives must operate at cost with their patrons. It then stated,

"A corollary to this cost principle of operation is that any losses of

the cooperative operation attributable to excess advances or

undercharges to the patrons are recoverable from the patrons."62

The Service provided several options available to recoup the

loss:
Id. This ruling concerned a § 521 farmers cooperative. For the 63

application of the same rules to a non-section 521 wholesale grocery

cooperative, see Let. Rul. 7301319420A (Jan. 31, 1973). For

background, see Gen. Couns. Mem. 34,334 (Aug. 17, 1970).

 Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 729 64

(1977).

 In 1969, Rochester Dairy merged into AMPI, which was pursuing

65

the case as a successor in interest. 

31

1. Requiring direct reimbursement from the patrons whose

business generated the loss.

2. Establishing an account receivable due from each patron.

For accrual basis taxpayers, this recoups the loss for tax purposes.

3. Canceling outstanding credits in the patron's account with

the cooperative representing retained patronage refunds and perunit retains.

4. The Service acknowledged that recoupment through the

first three methods is not always feasible. It said a cooperative

may carry over the excess advances and undercharges to the next

year and treat them as a cost of operation to the department that

sustained the loss, provided it can show that this method of

recoupment doesn't result in inequitable treatment of the patrons

of that department in the subsequent year. IRS was emphatic,

however, that the cooperative did not have a Code sec. 172 loss for

the year in which the loss was sustained.63

The Courts Speak

The courts first addressed IRS's operation-at-cost principle in

Associated Milk Producers, Inc. v. Commissioner. From 1959 64

to 1961, Rochester Dairy reported deductions in excess of gross

income. The board of directors decided it would be inequitable 65

to charge the current losses against patrons' capital reserve

accounts. The directors were also concerned that reducing

member equities would anger patrons, resulting in a serious loss

of business to competing dairies.
 Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 729, 66

735 (1977).

32

The board decided the losses should be carried forward to

future profitable years. From 1962 through 1966, net income was

offset and patronage refund allocations eliminated until the entire

amount of the prior years' losses was recouped. For each of these

years, the cooperative claimed net operating loss carry forward

deductions pursuant to Code sec. 172. IRS disallowed the

deductions. 

The court described the IRS's argument:

Respondent's position in this case is not based on any

statutory exception to the loss carryover privilege, clearly

stated in section 172, but upon respondent's theoretical

perception of a cooperative as an exceptional entity which

by its nature cannot ordinarily have a net operating loss for

tax purposes. Respondent argues that the basic principle

of a cooperative is that it operates at cost (after patronage

dividend allocations) for its member-patrons. Pursuant to

this "cost" principle, respondent contends, in any year in

which expenses exceed gross income, this "loss" must be

recouped from the members who were patrons for that

period (i.e., the exact converse of a patronage dividend

allocation when income exceeds expenses), so that the

cooperative will then have operated at cost. The recovery

of the operating deficit from the current patrons would

thus eliminate any net operating loss for tax purposes.66

The court rejected the argument as a reason to restrict the use

of section 172 by cooperatives. It stated:

We consider respondent's position herein not only

contrary to the express provisions of section 172, but

conceptually strained and lacking any fundamental policy

support; in short, an unwarranted tinkering with the tax
Id. at 736.

67

 In 1972, the cooperative also suffered a loss in the broiler pool,

68

which was totally offset against nonpatronage income.

33

structure applicable to cooperatives. The deductions

claimed are clearly authorized by section 172. There is

nothing within that section or the regulations thereunder

which indicates that the net operating loss deduction is not

applicable in the case of a cooperative subject to

subchapter T. In fact, quite to the contrary, the utilization

of the net operating loss deduction by cooperatives is

clearly implicit in certain subsections of the Code and the

Income Tax Regulations, and in various of respondent's

rulings dealing with cooperatives.67

At the same time the Tax Court was considering the AMPI

case, a similar suit was before it involving Farm Service

Cooperative of Fayetteville, AR. Farm Service had four

accounting units: a broiler marketing pool, a turkey marketing

pool, a farm supply function, and a separate allocation unit for

nonpatronage activity. In 1971, broiler pool expenditures

exceeded receipts. The cooperative paid patronage refunds to

patrons of the turkey and supply units, offset all nonpatronage

income against the broiler pool loss, and carried the remaining

broiler pool loss back 3 years, charging it against an unallocated,

general reserve account.68

IRS disallowed the deductions based on offsets of the broiler

pool losses and told the cooperative to recover them from the

broiler pool reserve. The Court described the Service's approach

and its tax consequences:

Respondent views a cooperative as a sort of conduit

that can distribute patronage profits to its patrons and

thereby avoid paying tax on the profits. ...From this

observation, respondent carries the conduit approach
 Farm Service Cooperative v. Commissioner, 70 T.C. 145, 153

69

(1978), rev'd on other grounds, 619 F.2d 718 (8th Cir. 1980).

 70 T.C. at 152. 70

 70 T.C. at 154. 71

 "The Commissioner does not contest the proposition that a 72

cooperative can have a net operating loss, or that it can carry such losses

34

beyond the statutory framework and concludes that in a

loss year--in a year when patronage expenses exceed

patronage income--the only proper recourse is for the

cooperative to obtain capital contributions or refunds from

cooperative members, thereby running the cooperative on

a 'cost' principle.69

IRS said the implication of applying the operation-at-cost

principle is to conclude that cooperatives operate their patronage

activities without a profit motive. Lacking a profit motive,

deductions are not allowed under section 162, and "without

deductions under section 162, it is not possible for patronage

activities to incur net operating losses under section 172."70

The Tax Court rejected IRS's application of an operation-atcost principle and its suggested implications concerning Code sec.

162 deductions, reaffirming the court's opinion in Associated Milk

Producers:

[W]e conclude that cooperatives are entitled to net

operating loss deductions resulting from patronage

activities. Implicit in this conclusion, as it was in

Associated Milk Producers, is the conclusion that

patronage activities are carried on for a profit, hence

ordinary and necessary expenditures, unless otherwise

disallowed, are deductible by the cooperative under section

162.71

On appeal, the IRS did not pursue its operation-at-cost principle.72
forward and back as provided in IRC § 172." Farm Service Cooperative,

Inc. v. Commissioner, 619 F.2d 718, 724 (8th Cir. 1980).

The Court of Appeals reversed and remanded the Tax Court opinion

because it permitted the cooperative to offset the patronage sourced

losses against the nonpatronage income. "A nonexempt cooperative

simply may not use patronage losses to reduce its tax liability on

nonpatronage-sourced income. Taxpayer's accounting procedures

cannot supersede this statutory principle." 619 F.2d at 727.

 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213 (1980).

73

 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213, 1218 74

(1980).

35

The operation-at-cost principle was urged in a third Tax Court

case, following closely on the heels of Associated Milk 73

Producers and Farm Service. This cooperative incurred losses in

both its marketing and supply functions which it wanted to carry

forward and apply against future net margins.

IRS conceded that a cooperative can sustain net operating

losses and carry them back and forward under Code sec. 172. It

did note, however, that some former patrons had terminated their

memberships during the loss years. It now argued that the

operation-at-cost principle required the cooperative to recoup their

share of the losses directly from the terminating members. The

court reported the Service said:

...a cooperative's right to avail itself of section 172 for

losses incurred in business operations with cooperative

members is restricted by what are...certain fundamental

principles of cooperative operation, in particular the

concepts of equitable allocation and operation at cost. ...a

net operating loss may only be carried over to offset

income in other years of the same members whose

business produced the losses. Moreover, to the extent the

loss is attributable to business conducted with or on behalf

of members who terminate their membership, it is (the

IRS) view that the loss must be recovered currently.74
Id. at 1219, citing United Grocers, Ltd v. United States, 186 F.

75

Supp. 724, 733 (N.D. Cal. 1960).

Id. at 1222. 76

 Priv. Ltr. Rul. 7843060 (July 27, 1978); Priv. Ltr. Rul. 7852005 77

(August 31, 1978); Priv. Ltr. Rul. 7905125 (Nov. 6, 1978).

36

The Tax Court, as it did in Association Milk Producers and

Farm Service, declined to accept the implications of the operationat-cost principle for cooperative patronage losses. It did not reject

operation-at-cost as a valid cooperative characteristic. Rather, it

did not apply the concept rigidly to reach a required method of loss

handling. It said the "concept of operation at cost simply means

that a cooperative was organized for the purpose of rendering

economic services, without gain to itself, to shareholders or to

members who own and control it."75

The court said "The 'operation at cost' principle describes a

feature of a cooperative's relations with it members, not a codified

requirement of tax accounting. Accordingly, we reject [the

Commissioner's] argument that the principle of 'operation at cost'

absolutelybars a cooperative from carrying forward and deducting

losses allowable to its terminated members."76

The Section 521 Rulings

Each of the cases in the previous subsection involved a

nonsection 521 cooperative. As these cases were developing, an

interesting series of administrative rulings were handed down by

IRS concerning section 521 cooperatives.

In late 1978, IRS issued a series of letter rulings on

applications for section 521 status conditioning approval on

adoption of a bylaw provision reading: "In the event the

cooperative suffers a loss in any year the cooperative will trace the

deficit or loss to the patrons whose business gave rise to it and will

take whatever steps are necessary to recover such losses or deficits

from those patrons."77
 Tech. Adv. Mem. 8019003 (Nov. 20, 1979).

78

 Priv. Ltr. Rul. 8021073 (Feb. 28, 1980).

79

 Tech. Adv. Mem. 8316002 (Jan. 7, 1983) (also TAM's 8316003

80

through 8316018); Tech. Adv. Mem. 8316156 (Jan. 5, 1983). IRS also

allowed a section 521 cooperative to utilize the net operating loss

provisions of § 172 in Priv. Ltr. Rul. 8842018 (July 22, 1988) and Priv.

Ltr. Rul. 9021013 (Feb. 21, 1990).

 Tech. Adv. Mem. 8707005 (Nov. 7, 1986); Tech. Adv. Mem. 81

9128007 (March 28, 1991). The Service has also taken the position that

non-Subchapter T cooperatives must operate "at cost." See the

description of the government's brief and argument in Buckeye Power

v. U.S., 38 Fed. Cl. 154, 159 (1997) (rural electric cooperative exempt

under IRC § 510(c)(12)).

37

However, by late 1979 IRS had softened its position. In one

ruling, it said a cooperative with section 521 status did not have to

replace language giving the board discretion over handling a loss

with the provision quoted above. In another, it granted an

78

application for § 521 status on the condition a bylaw is adopted

reading: "...such loss will, to the extent practicable, be borne by

the patrons of the loss year on an equitable basis."79

By early 1983, IRS was permitting cooperatives to retain their

section 521 status that had disregarded conditional determinations

letters requiring bylaw language on tracing losses to the patrons

whose business gave rise to the losses. The Service said that while

it didn't acquiesce in Associated Milk Producers, it would permit

section 521 cooperatives to carry losses back and forward under

Code sec. 172.80

These cases and rulings establish that cooperatives can have a

net operating loss and carry a loss back and forward pursuant to

Code sec. 172. In spite of these decisions, the Service continues

to refer to its "operation at cost" theory as a fundamental

cooperative principle. And while these determinations establish 81

that a cooperative can have an operating loss for tax purposes, they

do little to clarify how that loss should be allocated among past,

present, and future members.
As mentioned previously, IRS hasn't questioned the ability of 82

cooperatives to generate losses on nonpatronage activity or to carry

those losses back and forward to offset otherwise taxable nonpatronagesourced earnings in other years. However, it has resisted cooperative

efforts to combine, or "net," patronage and nonpatronage gains and/or

losses. Issues involving nonpatronage gains and losses are discussed

near the conclusion of this chapter.

38

HANDLING A PATRONAGE-SOURCED LOSS

Once it is established that a cooperative has suffered a loss, the

tough issue becomes, "Who will absorb it?" Ultimately, in some

manner, the loss will be allocated to the members. The more

difficult questions are which members, and on what basis.

Regardless of what the courts have said about its "operation at

cost" theory, the Service's preference since at least 1972 has been

clear and consistent. IRS wants cooperatives to recoup patronagesourced losses from the specific patrons whose business generated

the losses, and in proportion to their patronage during the year that

the loss occurred. But even this seemingly straightforward 82

approach may become complicated in some instances, such as

when the loss results from an event that occurred over several

years or recovery from the patrons at the time is not feasible.

Cooperatives have countered that the members, not the IRS,

should determine what is fair and equitable. They say that they are

essentially risk-sharing ventures. They assert that if, for example,

cotton farmers and cattle ranchers want to be part of a diversified

cooperative and share the financial risks of marketing cotton and

supplying cattle feed, the decisions on the extent of risk-sharing

and how the risk is allocated among past, present and future users

should be theirs and IRS shouldn't tell them what they can and

can't do.

Cooperatives have attempted to achieve the maximum possible

flexibility in handling losses. As a general rule, the more

diversified the cooperative, the more flexibility it seeks.

Cooperatives often strive for the same ability to use Code sec. 172
See Gen. Couns. Mem. 37,751 (Nov. 21, 1978).

83

39

and to "net" the results of different operations as do their

noncooperative competitors. This has led to major confrontations

with the IRS, at least one of which was settled by Congress.

Both sides make liberal use of terms such as "equitable" and

"fair" to bolster their positions. For example, once "operation at

cost" was discredited by the courts, the Service sought to achieve

essentially the same result, require recoupment from the patrons

whose business led to the loss, by applying an "equitable

allocation" standard.83

The remainder of this chapter covers how this central

disagreement over what is an "equitable" allocation of losses has

played out in various factual situations. It is a difficult topic to

cover because several variables can apply. Factors affecting how

a loss may be handled include:

 ! Whether the loss is patronage or nonpatronage

sourced;

 ! Whether the loss is an operating loss or a nonoperating

loss;

 ! Whether the cooperative has sec. 521 tax status;

 ! Whether the cooperative provides only marketing or

supply services or has operations in both functions;

and

 ! How the cooperative wants to allocate the loss.

Because of the numerous variables involved, any approach to

describing cooperative losses will be somewhat arbitrary. This

chapter generally attempts to look at the options from the

perspective of a cooperative board of directors. Research suggests

three general approaches have been adopted:

 ! Recovering the loss from the patrons whose business

generated the loss, on a pro rata basis;

 ! Recovering the loss from patrons of the same

allocation unit, but from patrons of different years, by
 Rev. Rul. 70-64, 1970-1 C.B. 36. 84

 Rev. Rul. 70-407, 1970-2 C.B. 52. 85

 Tech. Adv. Mem. 7207319410A (July 31, 1972).

86

40

carrying the loss back or forward under Code sec. 172;

and

 ! Recovering some or all of the loss from patrons of

other allocation units, by netting the financial results of

the allocation units. Netting can involve combining

the patronage-sourced results of different allocation

units within the same function, netting between

functions (marketing and supply operations), and

netting patronage and nonpatronage results both within

and between functions.

The approaches will be discussed in the preceding order.

RECOUPING PRO RATA FROM PATRONS

WHOSE BUSINESS GENERATED THE LOSS

The IRS has a long-standing preference for cooperatives to

recoup patronage-sourced losses on a pro rata basis from the

patrons whose business generated the loss. In 1970, the Service

issued revenue rulings stating a cooperative could recover losses

by redeeming retained qualified written notices of allocation at

less than face value or canceling such retains outright. In one 84 85

of the earliest letter rulings released to the public, it specifically

approved three recovery methods: (1) direct payment, (2)

canceling retained patronage equities, and (3) accruing accounts

receivable.86

For a period after these ruling was issued, the Service

pressured cooperatives to force their patrons to write checks to

cover their share of any losses. Over time, the common practice

has evolved, with the Service’s blessing, of creating accounts

receivable from the patrons whose business generated the loss and
 Letter Ruling, Nov. 21, 1975. Members received an 8 1⁄2 percent

87

reduction in assessment owed if they made a single cash payment rather

than paying under the installment plan or offsetting certificates of

indebtedness previously issued by the cooperative.

 For an example of the difficulties a cooperative can encounter 88

when attempting to recoup a loss by direct assessment, see Plywood

Marketing Associates v. Astoria Plywood Corp., 16 Wash. App. 566,

41

collecting those accounts by canceling retained patronage equities

or withholding the amount due from subsequent payments by the

cooperative to the patrons.

After a brief discussion of the three methods, letter rulings

covering recoupment of losses by various types of cooperative and

equity allocations will be reviewed.

Direct Billing and Reimbursement

One loss recoupment method that has enjoyed consistent

acceptance by the Service is for the cooperative to assess and bill

each patron for his or her share of any loss and for the patrons to

promptly write checks to the cooperative to cover the shortfall.

The justification for this approach is that when a cooperative

generates a margin, it must allocate and distribute that margin

within 81⁄2 months of the end of the fiscal year to protect single tax

treatment for that margin. So when a loss occurs, it is logical that

it be allocated and recovered directly from the patrons also in a

short period of time.

An early IRS ruling gave patrons the option of making a onetime payment of the amount each owed the cooperative, paying in

monthly installments, or applying certificates of indebtedness due

shortly toward their assessments. The co-op was allowed to offer

an incentive to encourage payment in the manner most beneficial

to the cooperative, a lump sum cash payment of the assessment.87

Direct assessment, however, can be a member relations

disaster, evoking strong negative reactions from both current and

former members. The Tax Court has acknowledged this 88
558 P. 2d 283 (1976).

 Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 729 89

(1977).

Id. at 739.

90

 Tech. Adv. Mem. 9128007 (March 28, 1991); see also, Priv. Ltr.

91

Rul. 8850027 (Sept. 16, 1988).

Id. The cooperative computed operating losses on a monthly 92

basis and they were promptly covered by an assessment of the patrons.

42

situation. In AMPI, the Service argued a cooperative had to

recover losses from patrons of the years the losses occurred. IRS

said a cooperative could do this, where possible, by canceling

retained equities. But when a patron's equity account was

insufficient to cover its share of the loss, generally the case with

newer members, it had to seek cash reimbursement.89

The court responded:

...regardless of what might have been [the co-op's]

legal rights, we consider such a recoupment attempt highly

impractical for a cooperative operating in a competitive

environment, as was [the cooperative]. The impracticality

of such a step merely to preserve the 'cost' principle of

cooperative operation certainly calls into question the

sanctity with which [the IRS] views that principle."90

IRS permits members who pay a direct assessment to deduct

it under Code section 162(a) as an ordinary and necessary business

expense and does not require them, as suggested by a revenue

agent, to treat the payment as a contribution to capital merely

increasing the member's basis in its stock in the cooperative.91

While the impact at the cooperative level is a wash, an event

with no overall tax consequences, how that is determined depends

on the timing of the repayments. If repayments are made in the

same year as the loss, the cooperative includes them in income and

it has no net operating loss. If the repayments are for losses of a 92
 Letter Ruling, November 21, 1975.

93

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 94

Distributions, Retains, Redemptions, and Patrons’ Taxation, RBS

Cooperative Information Report 44, Part 3 (USDA 2005) pp. 107-121.

43

prior year, IRS suggests it be assumed the cooperative established

and collected an accrued receivable, even if it didn't actually do

so. The implications of setting up receivables are discussed in 93

the next portion of this report.

Canceling Equity

Over the years, if a cooperative has margins, members will

usually build up equity accounts reflecting retained patronage

refunds and per-unit retains. A second method of recouping a loss

from patrons is to cancel an amount of retained equity each has in

the cooperative that equals each patron's pro rata share of the loss.

The advantage of recouping losses in this manner is that the

members don't have to write checks to the cooperative. The

disadvantage is that it reduces the co-op's equity base and weakens

its balance sheet.

Part 3 of these reports contains a discussion of the Service’s

aggressive approach to compel cooperatives who cancel qualified

retained equities or redeem them at less than face value, for

business reasons other than the recoupment of losses, to include

the difference in taxable income under the tax benefit rule. IRS 94

has been more flexible when the equities are cancelled to recover

a loss.

Accounts Receivable

A third method of handling patronage losses approved by IRS

is for the cooperative to determine each patron's share of a loss and

then establish an account receivable from the patron for that

amount. Using accounts receivable gives the members flexibility
 TAXFAX, The Cooperative Accountant (Spring 1976) pp. 44, 45; 95

Priv. Ltr. Rul. 7804083 (Oct. 28, 1997); Priv. Ltr. Rul. 7937041 (June

13, 1979).

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

96

44

in paying off their obligations. Programs can be devised that make

recouping the loss less painful to the patrons than writing a check

to their cooperative. A disadvantage is that the cooperative

receives nothing but a receivable and has no immediate cash

inflow to pay its bills and maintain or improve services to

members.

Apparently IRS first envisioned accounts receivable as a tool

to recoup losses from patrons who lacked enough equity in their

cooperative to cover their pro rata share of losses. It suggested

cooperatives establish such accounts for these patrons to be

satisfied by direct payment or offsetting future patronage

allocations. However, a series of subsequent rulings provides 95

considerable flexibility in collecting accounts receivable

established to facilitate recovering losses.

Establishing Accounts Receivable and

Collecting Them by Cancelling Equities

Rulings issued over the years cover a variety of factual

situations wherein the cooperative has recouped losses from the

patrons whose business created the loss by establishing accounts

receivable and collected them by cancelling retained patronage

equities.

Nonqualified Allocations

When allocations are made in nonqualified form, the

cooperative is not permitted a tax deduction and the patrons have

no reportable income. Two of the earliest rulings on recouping

losses involved the cancellation of nonqualified allocations.

The first, a letter ruling involved a section 521 cotton 96

cooperative with two departments, a gin division and a cotton
 26 U.S.C. § 1382(b)(2). 97

 Rev. Rul. 81-103, 1981-1 C.B. 447. 98

45

division that operated a denim plant and sold raw cotton. The

cooperative closed its cotton pool each year by selling cotton

awaiting manufacture to the denim plant. A fall in the price of

denim resulted in a loss for the co-op.

The cooperative issued patronage refunds as non-qualified

written notices of allocation. The cooperative proposed to set up

accounts receivable and collect them by cancelling non-qualifieds

issued the previous year to cotton division patrons, the patrons

whose business generated the loss.

The Service noted that Code sec. 1382(b)(2) provides that a

cooperative need not include in its taxable income payments to

patrons of “money or other property...in redemption of a

nonqualified written notice of allocation.” It then said that what 97

the cooperative proposed would have the same result as if the

cooperative wrote checks to the patrons to redeem the nonqualified allocations and then the patrons wrote checks back to the

cooperative to settle their accounts receivable. As accounts

receivable have the attributes of “property, ” the cooperative can

use book entries to replicate paying cash to patrons to redeem last

year’s nonqualified allocations and patrons then paying off their

accounts receivable. The cooperative was allowed to deduct the

amounts of the nonqualified written notices redeemed to satisfy

the accounts receivable under Code sec. 1382(b)(2).

Revenue Ruling 81-103 expanded somewhat the finding of this

letter ruling. The Service provided an example of a redemption 98

of nonqualifieds involving a payment in cash and a notice that the

account receivable had been satisfied. In this instance, the

cooperative established an account receivable of $4 for a sample

patron to cover that patron’s share of losses in one year (1976),

issued that patron a nonqualified written notice of allocation for

$15 in the next year (1977), and redeemed that nonqualified

written notices of allocation by paying the patron $11 and
 Priv. Ltr. Rul. 8624019 (March 10, 1986).

99

46

notifying the patron that its $4 account receivable had been

satisfied in a subsequent year (1979).

The Service noted that for Federal income tax purposes, the

cooperative is treated as having paid the patron $15 in cash in

redemption of the nonqualified allocation. The cooperative is also

considered to have received $4 in cash to cover the amount of the

account receivable. Because the cooperative is an accrual basis

taxpayer, it has already taken the account receivable into income.

Therefore, satisfaction of the account receivable does not result in

income to the cooperative. It is entitled to a $15 deduction under

Code sec. 1382(b)(2).

Qualified Allocations

Qualified written notices of allocation and per-unit retain

certificates are deductible by the cooperative in the year to which

they relate and taxable income to the patrons in the year of receipt.

This has not, however, resulted in a substantially different

approach by the IRS when a cooperative cancels such equities to

recoup a loss.

In one letter ruling, a cooperative bank eligible for tax 99

treatment under Subchapter T distributed margins as patronage

refunds, partly in cash and the remainder as qualified written

notices of allocation. The bank anticipated a substantial patronagesourced loss in an upcoming year. The Service made certain

decisions consistent with earlier rulings, namely that:

! The cooperative might recover part of the loss by

cancelling part or all of its outstanding qualified written notices of

allocation for certain tax years. The bank’s patronage-sourced loss

in the upcoming year will be reduced by an amount equal to the

value of the cancelled qualified notices.

! To the extent patrons had reported the qualified allocations

when issued, they could take an ordinary loss deduction under

Code sec. 165(a) for the year that the notice of cancellation is

received.
 Farmer cooperatives battled the Service for nearly 3 decades 100

(approximately 1970-1997) to establish that § 277 did not apply to non521 cooperatives (see infra pp. 90-96). Code § 277 provides that social

clubs and other membership organizations, not exempt from taxation,

may carry losses forward, but not back, to offset income in future years.

From time to time individual cooperatives found it convenient to

concede the issue to IRS when they only wanted to carry losses forward

at the entity level, not back to earlier years, as is permitted under § 277.

 Priv. Ltr. Rul. 8812019 (Dec. 16, 1987).

101

 Priv. Ltr. Rul. 8952019 (Sept. 28, 1989).

102

47

! The cooperative could carry any patronage-sourced loss

remaining after the equity cancellations forward at the cooperative

level under Code sec. 277, to offset future patronage-sourced

income, provided the carry forward results in an equitable

allocation of the loss.100

Another ruling involved a section 521 marketing 101

cooperative that sustained significant losses is one year. It

apparently had a large group of inactive members. It proposed to

let each member decide whether an account receivable would be

set up and collected by cancelling qualified retains. This would

allow inactive members to get their capital out of the cooperative

but permit continuing members to leave theirs in if they so elect.

The Service said again that the cooperative could recover the

loss by cancelling qualified equities without adverse tax

consequences and the patrons could take an ordinary loss for the

value of the cancelled equities under Code sec. 165(a). In this

instance, since Code sec. 277 doesn’t apply to “exempt”

organizations, the Service let the cooperative carry the loss back

or forward pursuant to Code sec. 172.

Two rulings concerned the appropriate handling of losses by

cancelling qualified equity allocations of cooperatives approaching

liquidation.

In one instance, a vegetable processing and marketing 102

cooperative had both patronage and nonpatronage losses and

decided to liquidate. The cooperative proposed to establish
 Priv. Ltr. Rul. 9202026 (Oct. 11, 1991).

103

48

accounts receivable from its patrons to the extent of its patronagesourced losses and credit those accounts when it canceled qualified

per-unit retains previously allocated to those patrons.

The Service concluded:

! As an accrual basis taxpayer, the cooperative must recognize the accounts receivable in taxable income when established.

The income will be patronage-sourced because it is from the

patrons and is used to offset the patronage losses from prior years

that are the responsibility of the patrons.

! Once the loss carryover of the cooperative is reduced by

the establishment of the receivables, it will not have any further

income to recognize. The offset of the per-unit retain certificates

with the accounts receivable shouldn’t result in tax to the

cooperative since its net equity has not changed. It has merely

altered the form of its assets and liabilities.

! To the extent the patrons have included the value of the

qualified per-unit retains in income in prior years, theymay deduct

the value of that equity under Code sec. 165(a) in the year they

receive notice of cancellation.

! The cooperative may carry any remaining patronagesourced losses forward under Code sec. 277.

Another ruling, involving essentially the same facts as the 103

one above except this cooperative had section 521 tax status,

resulted in a similar determination by the Service. A vegetable

processing and marketing cooperative that had both patronage and

nonpatronage losses decided to liquidate. It proposed setting up

accounts receivable to recoup a patronage-sourced loss and

cancelling qualified per unit retains to recoup some of the loss.

The Service again said setting up accounts receivable will

create patronage-sourced income for the co-op, which can be

offset with the loss carryforwards. The transactions will have no

tax impact on the cooperative, except a reduction in available loss
 Priv. Ltr. Rul. 8233051 (May 19, 1982), based on Gen. Couns. 104

Mem. 38,885 (April 23, 1982).

49

carryforwards. Cancellation of the qualified per-unit retains by

crediting the accounts receivable will not result in income to the

cooperative.

Loss Allocation Based on Retained Patronage Equity

The flexibility the Service will allow a cooperative in

recovering a loss, if the association presents a well-reasoned

justification for its actions, is illustrated by letter ruling

8233051. The taxpayer was a federated cooperative with a 104

dozen grain marketing associations as members. After a successful

start-up, it suffered substantial operating losses. When an infusion

of capital became necessary, some members wanted to withdraw

and others wanted to continue.

IRS said the association was “operating on a cooperative

basis” under a plan whereby:

! The losses would be allocated to and collected only from

the continuing members,

! The losses would be allocated on the basis of each

member’s capital stock, all of which consisted of retained

patronage refunds, to the total shares of capital stock outstanding

in the cooperative, not recent patronage,

! The losses would be accounted for as an account receivable

from each continuing member, and

! Each continuing member could repay its receivable by any

of the following means, or a combination thereof; payments in

cash, the cancellation of stock received as a patronage refund or

otherwise, and application of the principal and accrued interest on

funds they had loaned to the cooperative.

IRS noted that the cooperative had shown that this plan

resulted from extensive discussion and negotiation among the

members, that State law did not authorize an assessment of

withdrawing members, and that the withdrawing members had

sufficient votes to block an assessment. It observed that the
See also, Priv. Ltr. Rul. 8812019 (Dec. 16, 1987).

105

 Priv. Ltr. Rul. 8248048 (August 30, 1982).

106

50

members agreed the losses resulted from the plan for rapid

expansion, so it wasn't equitable to allocate them on the basis of

any one year's patronage. Also, some members felt a factor in the

losses was the failure of other members to patronize the

cooperative. Using a recent patronage base would have penalized

thosememberswho supported the cooperative and rewarded those

who did not.

The Service determined:

! The cooperative could allocate the losses on the basis of

stock held rather than patronage,

! There is no tax consequence to cooperative from

establishing accounts receivable when they are established or

collected, except that the cooperative’s losses are reduced by the

amount assessed the continuing members,

! The cooperative can carry the losses allocated to

withdrawing members forward under Code sec. 277, and

! The continuing members are entitled to an ordinary loss

deduction under Code sec. 165(a) for the amount of their

assessment in the year their account receivable is established.

(Both the federated and its member-patron cooperatives all used

the accrual method of accounting).

This ruling is notable for the flexibility permitted the memberpatrons. Terminating members could get their capital out of the

cooperative while continuing members could leave theirs in to

finance future operations. The continuing members were then 105

allowed to choose from several options to satisfy their receivables.

Three months later, IRS issued another letter ruling that also 106

concerned a cooperative that couldn’t match a loss to specific

patronage transactions. A farm supply cooperative with both

individual and cooperative members sustained significant losses

for several years. Another cooperative agreed to purchase all of
 Priv. Ltr. Rul. 8248034 (August 30, 1982).

107

51

the assets and assume all of the liabilities of the failing

cooperative, after certain write-downs are made to the equity

accounts of the failing cooperative’s member equity accounts.

The failing cooperative intends to allocate the losses to its

member-patrons on the basis of each member’s pro rata share of

the cooperative’s total retained patronage equity. The cooperative

asserted that the losses were hard to allocate on the basis of

patronage as they were, in large measure, the result of uncollected

receivables, lawsuits, and general obsolescence of plant and

equipment. The write-downs would be applied, in order, to: (1)

qualified written notices, (2) nonqualified written notices, and (3)

unallocated retained earnings.

Again, the Service provided favorable rulings for the

cooperative. It approved the proposed allocation and collection

method. It said the transactions would have no tax consequences

to cooperative beyond reductions in itslosses otherwise reportable

by an amount equal to (i) the amount assessed and (ii) the

deduction allowable to the cooperative for the redemption of the

nonqualified allocations. Patrons can claim an ordinary business

loss under Code sec. 165(a)for the amount of qualified allocations

that are cancelled and can also claim a deduction for nonqualifieds

that are cancelled, but only after reporting the amount of cancelled

nonqualified allocations as income pursuant to Code sec. 1385.

Absorbing Loss at Co-op Level After

Reasonable Recoupment Effort

Another letter ruling concerned a marketing cooperative 107

with one primary line of business (the extraction of cotton seed oil

from cottonseed) that suffered a substantial loss in a minor line of

business (sunflower marketing) that threatened the continued

operation of the co-op. The cooperative’s leadership believed that

if it tried to recover this loss by an assessment against the

cottonseed-producing members, they would resign and the

cooperative would fail.
 The cooperative community owes a debt of gratitude to the 108

members, directors, and management of Farmland for their willingness

to share non-proprietary information about the issues they confronted

during their bankruptcy proceedings, so that others might learn from

their experiences. 

52

To ensure continued patronage, the cottonseed members and

the cooperative signed 5-year marketing agreements. Under its

terms, any margins earned during that time period would be offset

against each patron’s allocable portion of the losses, and any

unrecouped losses remaining after the agreements expired would

be absorbed by the cooperative.

The Service approved this arrangement. It said any

unrecouped losses remaining at the end of the 5 years would be

deductible at the cooperative level under Code sec. 165 in the year

the marketing agreements expire.

The Farmland Industries Liquidation Rulings

Farmland Industries operated as a major federated cooperative

providing farm supplies and marketing products for its local

cooperative and producer members. For many years, it earned

substantial margins on its patronage-sourced business with its

members and patrons. The cooperative allocated these earnings to

its patrons primarily as qualified written notices of allocation,

although a portion was issued as nonqualified written notices.

In the late 1990s, Farmland began incurring significant net

operating losses. A substantial portion of those losses were

attributable to business done with, or for, its member/patrons, and

the remainder were nonpatronage-sourced losses. As a result of

these losses and a resulting lack of liquidity, Farmland filed for

bankruptcy on May 31, 2002.108

As part of its reorganization, the cooperative sold all of its

assets and passed the proceeds through to its creditors. During the

process, Farmland submitted two requests for letter rulings to IRS

for clarification of the tax implications of parts of the

reorganization plan.
 Priv. Ltr. Rul. 200341017 (July 3, 2003).

109

 Rev. Rul. 70-407, 1970-2 C.B. 52. 110

 Priv. Ltr. Rul. 200414019 (Dec. 15, 2003).

111

 Gold Kist v. Commissioner, 110 F.3d 769 (11th Cir. 1997),

112

rev’g, 104 T.C. 696 (1995). See, Donald Frederick, Income Tax

Treatment of Cooperatives: Distributions, Retains, Redemptions, and

Patrons’ Taxation, RBS Cooperative Information Report 44, Part 3

(USDA 2005) pp. 113-120.

53

First, Farmland proposed to recover at least a portion of its

patronage-sourced losses from its member-patrons by cancelling

their qualified written notices of allocation. Apparently some

creditors were concerned that the equity cancellation would create

nonpatronage income subject to tax, thus reducing the amount of

funds available for distribution to creditors.

The Service said no, the cooperative should reduce its net

operating losses but would not otherwise recognize any taxable

income upon the cancellation of such patronage equity. It cited 109

Revenue Ruling 70-407 as recognizing this procedure, 110

cancelling member patronage equities to offset a net patronage

sourced loss.

The second letter ruling concerns outstanding patronage equity

remaining after the cancellations occur. Although the stock has 111

no value and its holders will not receive or retain any interest in

any property of the cooperative, the equity will remain

outstanding. Again, creditors wanted a clarification that having

the equity declared worthless but not cancelled would not trigger

a tax liability for the cooperative.

The Service took this opportunity to restate its disagreement

with the decision in the Gold Kist case, without forcing the 112

cooperative to take the value of the equity into income. First, it

stated:

In situations in which a cooperative has redeemed its

patronage equity from its patronage equity holders at a
 Priv. Ltr. Rul. 200414019 (Dec. 15, 2003).

113

Id.

114

54

discount, the Service position is that the cooperative must

recognize income in an amount equal to the discount under

the tax benefit rule. However, cooperative herein will not

be canceling the patronage equity. Coop will not be

recovering for itself the amount that it previously

deducted, since all amounts will be paid to Coop’s

creditors in partial settlement of the amount due Coop’s

creditors. Therefore, because the patronage equity will not

be cancelled or redeemed for less than face value, Coop

will not recognize any tax benefit income.113

The Service then determined:

Coop will not recognize any income if Coop’s

patronage equity holders do not receive consideration

equal to the face amount of their outstanding Coop

patronage equity issued as qualified written notices of

allocation, when Coop completely liquidates its assets to

pay its creditors and does not actually cancel its patronage

equities.114

Thus, the Service continues to advocate its position that the tax

benefit rule requires a cooperative that redeems qualified

patronage-based equity for less than face value to include the

amount of the discount in its taxable income. But it also isn’t

forcing the issue in situations where the cooperative is recovering

a loss from the patrons whose business created the loss.

Document Language Issues

A State Court decision illustrates the need for cooperatives to

understand the importance of language in related legal documents
 TruServ Corporation v. Bess Hardware and Sports, 346 Ill. App. 115

3d 194 (2004).

55

when recouping losses by cancelling equities. In 1999, TruServ, 115

a cooperative wholesale supplier of products and services to its

hardware retail store owners, suffered a substantial loss. On April

10, 2000, TruServ accepted the request of one of its members,

Bess Hardware and Sports, to terminate its Membership

Agreement. On that date, TruServ’s bylaws provided that:

Upon the effective date of the termination of a

Membership Agreement...all of this Corporation’s stock

owned by such stockholder...shall be deemed to be and

shall be and become the property of this Corporation; from

and after such date all rights and privileges incident to the

ownership of the shares...shall cease, except only the right

to receive the purchase price and a sum equal to any

dividends declared by unpaid at said date....

TruServ’s bylaws also required it to redeem all of a member’s

equity interests upon the termination of its membership, except

that if the funds of the Corporation legally available for such

purpose aren’t sufficient, the Corporation can delay redeeming the

equity until sufficient funds are legally available for that purpose.

On March 17, 2000, the board of directors learned that because

of the 1999 loss, the book value of it stock had fallen to $35.60,

while the par value was $100. The board unanimously adopted a

resolution placing a moratorium on all equity redemptions.

On August 28, 2000, TruServ’s board of directors passed a

second resolution creating a “Loss Allocation Plan” to allocate

the 1999 loss among its members. The Loss Allocation Plan

assigned a pro rata share of the loss to “each current TruServ

Stockholder” based upon the percentage each member’s retained

patronage refund account bears to such holdings of all members

(emphasis added). Under the plan, an account receivable would

be established for each member, who would satisfy the “loss
56

allocation account” by application of future patronage refunds. If

a member left the cooperative prior to satisfying its loss allocation

account, any unsatisfied portion would be offset against the

amount otherwise due the member for its retained equity. Even

though Bess’s membership had been terminated, the cooperative

allocated a portion of the loss to Bess.

In May, 2002, TruServ sued Bess Hardware to collect unpaid

charges for merchandise and services. Bess counterclaimed to

force TruServ to redeem its equity. Bess argued that the

moratorium was not legally adopted and that the loss allocation

plan did not apply to it as it was not a stockholder of TruServ

when the plan was adopted.

In an unreported decision, a County Court found in favor of

TruServ on its claim for unpaid merchandise and services. It held

for Bess on its claim that the loss allocation plan didn’t apply to

Bess. The court also held that Bess was entitled to offset what

TruServ owed Bess for its stock against what Bess owed TruServ

for goods and services. TruServ appealed.

A State Appellate Court upheld the validity of the moratorium

on the basis that applicable State law (Delaware) provides that a

corporation may not redeem its stock if the redemption would

cause an impairment of capital. As the aggregate par value of

TruServ’sstock exceeded its net assets, redemption would impair

its capital under Delaware law so the moratorium was appropriate

under the circumstances.

However, the court affirmed the lower court ruling that the

Loss Allocation Plan did not apply to Bess. It reasoned that under

TruServ’s bylaws, the date that a membership agreement is

terminated determines when a member ceases to be a TruServ

stockholder. Upon the effective date of the termination, the

terminated member’s stock becomes the property of TruServ. In

this case, Bess’s membership was terminated on April 10, 2000,

and Bess ceased being a stockholder in TruServ on April 10, 2000.

Since the language of the Loss Allocation Plan adopted by

TruServ on August 28, 2000, said it applied only to “current Tru-
 A general description of § 172 is provided supra pp. 25-26. 116

57

Serv stockholders,” the cooperative could not allocate a share of

the 1999 loss to Bess.

TruServ also argued to because Bess was a member in 1999

when the underlying loss occurred, it should be liable for a portion

of the loss. The Appellate Court found this argument unpersuasive where, as here, the loss allocation was made after the

membership was terminated.

This case should serve as a reminder to cooperative directors

and managers to make sure your bylaw provision on handling of

losses and any documents adopted to implement a plan to recoup

a loss are carefully crafted to reflect your intentions in

implementing a loss recovery strategy.

RECOVERING A PATRONAGE-SOURCED LOSS

FROM PATRONS OF THE SAME ACTIVITY,

BUT DIFFERENT YEARS

The Service clearly prefers that patronage-sourced losses be

absorbed by the patrons whose business generated the loss, on a

pro rata basis. The members, however, may prefer to spread the

burden over several years rather than absorb the entire loss in a

single year. If a cooperative has only one line of business, such as

marketing milk, this is the only alternative to direct recoupment.

But it is also a viable option for cooperatives with more than

one line of business, whether they be in the same or different

functions. This is usually accomplished by carrying the loss

forward or back to other taxable years under Code sec. 172.

Carry Forward and Carry Back under Code Sec. 172

Carrying the loss to other years eliminates the direct allocation

of the loss to individual patrons. The loss is carried over to

116
This is to be distinguished from situations where the loss is 117

allocated to patrons in the loss year and only an obligation to pay the

assessed loss is carried to following years. In this case an account

receivable is established and patronage refunds otherwise distributable

in money are applied to extinguish the patron's obligation. This does

not reduce the net margins available for distribution, but only affects the

distribution's form.

 Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 729

118

(1977).

Id. at 739.

119

58

other years at the cooperative level. It is offset against margins of

other years, resulting in reduced patronage refunds for patrons of

those years.

117

An example is found in the leading case of Associated Milk

Producers. The cooperative conducted a single line of business. 118

It received raw milk from its members and processed it into

various products, including pasteurized fluid milk, butter, and

dried milk powder. From 1959 to 1961, the cooperative's

deductions exceeded gross income. The board of directors

decided it would be inequitable to charge the current losses against

patrons' capital reserve accounts. The directors were also

concerned that reducing member equities would anger patrons,

resulting in a serious loss of business to competing dairies.

The board decided the losses should be carried forward to

future profitable years. From 1962 through 1966, the cooperative

claimed net operating loss carry forward deductions pursuant to

Code sec. 172. Net income was offset and patronage refund

allocations eliminated until all losses from 1959 through 1961

were recouped. As previously noted, the court found this a

permissible tax practice for cooperatives, stating "We fail to see

anylegitimate interest of (IRS) in the mechanics of (cooperative's)

allocation of losses among its past, current, and future memberpatrons."119

Even as IRS was litigating to prevent loss carryovers, it issued

an apparently conflicting letter ruling. The cooperative had two
 Priv. Ltr. Rul. 7804083 (Oct. 28, 1977). Shortly thereafter, the

120

Tax Court again rejected IRS's position that patronage sourced losses

had to be recovered from the specific patrons whose business created

them. Ford Iroquois FS v. Commissioner, 74 T.C. 1213 (1980). The

Ford Iroquois opinion is discussed in a subsequent section dealing with

recovering the loss from patrons of a different activity than the one

producing the loss.

See supra pp. 21-25. 121

59

marketing allocation units and a supply function, and suffered a

loss in one of the marketing units.

Without mentioning Code sec. 172, the Service stated "A

cooperative may also carry over such losses, to be treated as a cost

of operation in the unit that sustained the loss in the succeeding

year, if the cooperative can demonstrate that recoupment of the

loss in this manner does not create an inequitable burden on the

patrons of the succeeding year."120

After the AMPI decision and subsequent cases holding

cooperatives could have losses for tax purposes, the IRS 121

begrudgingly has allowed cooperatives to carry losses in one

activity back and forward to other tax years under Code sec. 172.

The first dispute to reach the Service involved a sugar

marketing cooperative that suffered an operating loss. The

revenue agent refused to let the cooperative carry the loss forward.

The cooperative appealed and the Appellate Division allowed

an operating loss carry forward, reduced by the loss attributable to

terminating members. The cooperative appealed again, asking to

carry the entire loss forward. Its bylaws gave the board of

directors the option of recouping a loss from current patrons or

carrying it forward as an operating expense of subsequent years.

The Director of IRS's Corporate Tax Division referred the

matter to the Office of General Counsel for review. After noting
 Associated Milk Producers Inc. v. Commissioner, 68 T.C. 729

122

(1977).

 Ford Iroquois F.S. v. Commissioner, 74 T.C. 1213 (1980).

123

 Gen. Couns. Mem. 39,170 (June 3, 1982). This cooperative and

124

the ones in the subsequent rulings mentioned in this subsection all had

§ 521 status. As mentioned in footnote 1 of this GCM, the Service had

by this time taken the position the § 277 applied to other cooperatives

and precluded them from using § 172. The Service's position on § 277

and its ultimate rejection by the courts is covered infra pp. 90-103.

 Tech. Adv. Mem. 8247011 (July 28, 1982).

125

 Priv. Ltr. Rul. 8540051 (July 3, 1985); Priv. Ltr. Rul. 8540056 126

(July 8, 1985).

60

the Tax Court opinions in AMPI and Ford Iroquois the 122 123

General Counsel sided with the cooperative on all counts,

suggesting:

1. The cooperative could use the net operating deduction

provided by Code sec. 172.

2. The cooperative could carry the loss of one allocation unit

back or forward to offset income of that same unit without tracing

the loss to any particular patrons. The memorandum mentioned

that the cooperative had a low member turnover rate and all

members were bound by long-term contracts. Thus carrying the

loss to other years as an operating expense would not be an

inequitable burden on patrons of those years.

3. The cooperative should not be required to recover from its

terminating members the losses generated by those members.

124

A letter ruling on the same facts and reaching the same

conclusions was issued shortly.125

The Service has permitted a cooperative to carry a loss to other

years and reduce patronage-sourced income from the same activity

that generated the loss under Code sec. 172 in several

circumstances. In one instance, the loss resulted from a change in

the method of closing pools. In another, the terminating 126

members of a cooperative with substantial losses had their equities
 Priv. Ltr. Rul. 8812019 (Dec. 16, 1987).

127

 Priv. Ltr. Rul. 9021013 (Feb. 21, 1990).

128

61

redeemed at a discount while continuing members exercised an

election not to have accounts receivable established for them but

rather to have the losses carried forward to other taxable years.

127

In another, a cooperative in dissolution was allowed to carry

forward net operating losses and offset them against nonpatronage

income from the sale of its office building and equipment.128

Unallocated Reserves

An unallocated reserve consists of funds held by a cooperative

that aren't allocated on the books to any particular patron. Income

placed in the unallocated reserve may come from patronage- or

nonpatronage-sourced business. Because the income generating

the unallocated reserves cannot qualify for deductibility as a

written notice of allocation or per-unit retain, these reserves are

frequently called "tax paid reserves."

As cooperatives without section 521 status can't deduct

nonpatronage income, they frequently place it into an unallocated

reserve and use that reserve, if necessary, to cover subsequent

nonpatronage losses. Patronage income (and nonpatronage

income of section 521 cooperatives) is usually allocated on a

patronage basis to maximize the benefits for patrons and to protect

access to single taxation on those earnings. However,

cooperatives occasionallywill put patronage-sourced income into

an unallocated reserve in good years to lessen the pain in loss

years, particularly those in cyclical industries. It helps them

recoup losses efficiently and removes the "cloud" that would

otherwise hang over present and future members. Without that

cushion, they might not receive patronage refunds for years to

come after a loss year or two.

Unallocated reserves are reduced by the amount of a loss much

like a noncooperative corporation reduces earned surplus or other
 I.R.C. § 521(b)(3).

129

 Treas. Reg. § 1.521-1(a)(3). 130

 Treas. Reg. § 1.521-1(c).

131

 Ltr. Rul. 6503036020A (March 3, 1965).

132

Id.

133

62

residual accounts in the case of a loss. The loss amount from the

income statement is transferred as a reduction of unallocated

reserve. No entries are made for individual patrons to reduce any

allocated equity interest they have in the cooperative in the form

of membership stock, written notices of allocation, or per-unit

retain certificates.

The question occasionally arises as to whether a section 521

cooperative can have an unallocated reserve. The Code provides

"(Section 521 status) shall not be denied...because there is

accumulated and maintained...a reserve required by State law or a

reasonable reserve for any necessary purpose."129

The regulations also say a section 521 cooperative can have a

reserve. They also state that to maintain this status, the 130

association "must establish that it has no taxable income for its

own account other than that reflected in a reserve or surplus

authorized in paragraph (a) of this section (emphasis added)."131

This suggests the only time a section 521 co-op can hold taxable

income is when it is placed in a required or a reasonable reserve.

One early letter ruling involved a cooperative that had section

521 tax status and suffered operating losses in years both before

and after enactment of Subchapter T. The cooperative's bylaws 132

said that if it suffered an operating loss, such loss shall be charged

against "reserves" to the extent they are available. The board

determines how the charge against "reserves" is allocated so that

the loss is "borne by the patrons on as equitable a basis as the

board of directors finds practicable."133

The IRS stated that whether the losses occurred before or after

enactment of Subchapter T, the net operating loss of a section 521

cooperative:
Id.

134

 Tech. Adv. Mem. 8015048 (Dec. 31, 1979).

135

63

...(I)s to be treated in the same manner as the net

operating loss of any other corporation under section 172

of the Code...(T)he method used by a particular

cooperative in handling a loss on its books will not affect

the treatment of the loss for Federal income tax purposes.

Thus, a loss incurred by a cooperative will not be

diminished merely because such a loss is charged against

a reserve for losses, or charged against revolving fund

accounts. The particular method employed to handle the

loss for book purposes will be governed by applicable

provisions in the cooperative's bylaws, charter, or

marketing agreements."134

Although not specifically stated in the ruling, apparently the

cooperative was allowed to carry the loss back to prior years and

offset it against unallocated and presumably taxable reserves from

earnings of patronage-sourced business in those years.

A later letter ruling concerned a section 521 cooperative with

declining membership. Terminating members were offered the 135

option of having their retained patronage equities redeemed ahead

of the normal revolving cycle at less than face value. The

difference between the face value and the amount paid was

assigned to an unallocated equity account.

When the cooperative began suffering losses, they were

applied against this unallocated equity. The Service found this an

acceptable method of handling the loss, provided (1) the account

could be allocated to current patrons on a patronage basis and (2)

the extent each patron's current losses offset against the account

did not exceed that patron's respective share.

Research has failed to uncover any rulings concerning

nonsection 521 cooperatives. However, the Chief Counsel has
 Gen. Couns. Mem. 34,334 (Aug. 17, 1970).

136

64

written that such a cooperative "may offset any deficit in operations by use of a reserve set up for such purpose."136

The tax consequences of reducing an unallocated reserve to

recoup a loss do not normally extend beyond the cooperative.

That is, the cooperative treats the loss as a noncooperative

corporate loss and does not recover the loss from patrons in a way

that impacts their tax obligation.

RECOVERING A PATRONAGE-SOURCED LOSS

FROM PATRONS OF OTHER ACTIVITIES

Cooperatives may serve different groups of members by

performing some services for one set and another service for

others, all on a patronage basis. A cooperative may establish

allocation units to calculate net margins for each activity.

For many years, conflicts existed between cooperatives and

IRS over the extent members who patronized different services

could share their risks by combining, or "netting," the financial

results of those allocation units for tax purposes. The conflicts

usually arose when one unit would have a margin and another a

loss in the same tax year. Much of this controversy was put to rest

by 1985 legislation permitting cooperatives to net the patronagesourced results of different allocation units, provided they

followed a set of rules in the legislation.

IRS Objections to Netting

IRS objected to cooperative netting even before enactment of

Subchapter T. A grain marketing cooperative with storage

capacity purchased member-patrons' grain before delivery to its

elevator. Other members delivered grain for storage, and paid fees

for this service, before selling the grain to the cooperative or
 Pomeroy Cooperative Grain Company v. Commissioner, 31 T.C. 137

674, 686 (1958); aff'd in part, rev'd in part, 288 F.2d 326 (8th Cir.

1961).

 Pomeroy Cooperative Grain Company v. Commissioner, 288

138

F.2d 326 (1961), rev'g in pertinent part, 31 T.C. 674, 686 (1958).

 288 F.2d at 332. 139

65

turning it over to CommodityCredit Corporation (CCC) under the

loan program. All grain storage and marketing earnings were

combined and allocated to patrons based on bushels marketed.

IRS denied the cooperative's patronage refund deduction on

the basis that is was unfair to those patrons who stored grain to

have a portion of the margin from this service allocated to patrons

who sold their grain to the cooperative before delivery. The Tax

Court agreed with the Service, finding such an allocation

conflicted with the requirement that to be deductible, a patronage

refund must be made equitably "to the particular patrons whose

patronage created each particular type of profit."137

On appeal the 8th Circuit, while affirming much of the Tax

Court opinion, reversed this holding. It stated: 138

There appears to be no requirement that a patronage

(refund) a member receives be based on the profit made on

his particular transaction. It appears to be sufficient if the

profits arising from member business are equitably

distributed among the members who have transacted

business with the cooperative.139

The court noted that the cooperative's grain marketing and

storage activity was an integrated business using the same

facilities. It also mentioned that passing back margins to each

member on their specific business would be a costly accounting

nightmare. Finally, the court rebuked the Service saying:
 288 F.2d at 333. 140

 Rev. Rul. 63-58, 1963-1 C.B. 109. 141

 Gen. Couns. Mem. 33,631 (Sept. 22, 1967).

142

 I.R.C. § 1388(a)(3). 143

 Pomeroy Cooperative Grain Co. v. Commissioner, 288 F.2d 326 144

(1961), rev'g in pertinent part, 31 T.C. 674 (1958); Juniata Farmers

Cooperative Ass'n, 43 T.C. 836 (1965), acq. in result, 1966-1 C.B. 2;

66

From a revenue standpoint, the commissioner should

be more concerned with the total exclusions allowable on

membership business profits rather than the means by

which such profits are divided among the qualified

members.

140

In 1963, the IRS adopted the position taken by the Eighth Circuit

Court of Appeals.141

Nonetheless, netting between allocation units was a major

issue for 20 years. A series of General Counsel Memoranda

drafted during this time illustrate how the Service wrestled with it.

The first responded to a proposed technical advice

memorandum concerning a section 521 cooperative that had

margins on its supply operations and losses on its marketing

activity. The bylaws required the cooperative to allocate margins

and losses to the patrons of the function that generated them.142

The Income Tax Division proposed to deny the cooperative's

entire patronage refund deduction for the year in question because

it didn't net. It relied on the Code definition of "patronage

dividend," which provides it must be computed on the basis of

"the net earnings of the organization" from business with patrons

(emphasis added).143

The Chief Counsel said that while his office had previously

approved the memorandum, it was now having second thoughts.

He noted cases and rulings holding cooperatives could

departmentalize operations to determine how patronage refunds

would be allocated. He concluded that while staff was literally 144
Rev. Rul. 67-128, 1967-1 C.B. 147.

 Gen. Couns. Mem. 33,795 (April 11, 1968).

145

 Rev. Rul. 67-253, 1967-2 C.B. 214. 146

67

reading the law properly, the cooperative's contention that it could

allocate margins and losses on a functional basis and still qualify

for the patronage refund deduction might be the better position.

Barely 6 months later, the Chief Counsel reversed his

position. This time, he was commenting on a proposed revenue 145

ruling concerning a section 521 cooperative that had margins on

its supply operations and losses on its marketing activity. The

bylaws required the cooperative to net margins and losses between

the functions and pay any remainder to the patrons of the function

with margins. The issue was whether netting was permissible

under Code sec. 521.

The proposed ruling, drafted by the Exempt Organizations

Division, would have approved this approach, perhaps reflecting

G.C.M. 33,631. However, in apparently unrelated litigation, the

Tax Court Division was taking the position that a section 521

cooperative could not net between functions.

The Chief Counsel sided with the litigation team, suggesting

this time that losses not be recouped from the margin of the other

function but rather from the patrons whose business occasioned

the loss. He cited Revenue Ruling 67-253, which said that to

qualify for section 521 status a cooperative had to maintain

separate records of income and expenses for its marketing and

purchasing departments and of the patrons' business with each

function.146

This was an active time for the issue of losses and

cooperatives. Congress was passing Code sec. 277, which says

that membership organizations not exempt from taxation may only

deduct expenses for providing services to members to the extent

of income derived from member payments for those services. Any

remaining deduction could be carried forward and offset against
 I.R.C. § 277. 147

Supra, pp. 19-21. 148

 Gen. Couns. Mem. 34,334 (Aug. 17, 1970).

149

68

income from member payments in the following year(s). The 147

applicability of sec. 277 to cooperatives is explored in detail in the

last section of this report. Also, the Service was developing its

position that a cooperative simply couldn't have a loss for tax

purposes.148

By now, everyone at IRS seemed to have an opinion on

netting. The next G.C.M. explained that the Income Tax Division

was asserting that netting at the functional level was mandatory

and the Exempt Organizations Division thought it was

permissible. Both had asked the Chief Counsel to reconsider the

position taken in G.C.M. 33,795 that it was prohibited. Although

a new Chief Counsel had been named, the office refused to alter

its position.149

The Chief Counsel buttressed his position with the view

emerging within the Service that cooperative principles required

that the organization operate "at cost" with each patron, not

necessarily on a transaction-by-transaction basis, but certainly over

the course of each tax year. He said that if a "loss" occurs, it is to

be recouped from those patrons whose business generated the loss.

He stated that this policy should apply to all cooperatives, whether

or not they had section 521 status. It would appear that this

position would argue as strongly against netting among allocation

units within a function as it did against netting between functions.

The next G.C.M. responded to a request from the Income Tax

Division to review proposed technical advice memoranda finding

cooperatives could not net margins and losses between functions

and had to recover losses from the patrons whose business

generated the losses. This conformed with the position set forth

in G.C.M. 34,334.

However, another new Chief Counsel took a slightly modified

approach. While he still said inter-functional netting was not
 Gen. Couns. Mem. 34,935 (July 3, 1972). Key elements of the 150

G.C.M. were published as Tech. Adv. Mem. 7207319410A (July 31,

1972).

See also, Ltr. Rul. 7729062 (no known date) (co-op permitted to 151

allocate any remaining margins to patrons of the unit that had earnings).

 Gen. Couns. Mem. 34,334 (Aug. 17, 1970). The methods of 152

recoupment, discussed throughout this chapter, were direct

reimbursement, setting up accounts receivable, canceling retained

patronage refunds and per-unit retains, and offsetting the deficit against

reserves set up for that purpose.

69

permitted, he suggested allowing a cooperative to carry over the

loss in one allocation unit to the same allocation unit as a cost of

operation for the next year, provided the carryover was equitable

treatment of the patrons of the succeeding year.

150

This G.C.M. is notable for the insight it provides into the

decision making process within IRS. First, it reports that in

August, 1971, the Regulations Policy Committee met to review

G.C.M. 34,344. The committee decided:

 1. Co-ops, whether they have section 521 status or not, cannot

net earnings of one function against losses of the other function.

 2. Co-ops, whether they have section 521 status or not, can

elect to net the results of different allocation units within a

function. If a cooperative wants to net within a function, it must

151

notify the Commissioner and any change in the netting plan would

require the Commissioner's approval.

3. Section 277 applies to cooperatives and should be

vigorously enforced.

A second meeting on May 11, 1972, concerned how netting

should be approached in litigation and involved several IRS

divisions. It was decided to follow the same course outlined

earlier. Netting between functions would be resisted. The court

would be urged to support the methods of recoupment set out in

G.C.M. 34,334. Also, the cooperative could carry the loss

152

forward in the same allocation unit as a cost of operation in the

succeeding year(s).
 Associated Milk Producers Inc. v. Commissioner, 68 T.C. 729

153

(1977); Farm Service Cooperative v. Commissioner, 70 T.C. 145

(1978).

 Gen. Couns. Mem. 37,578 (June 16, 1978).

154

 I.R.C. § 521(b)(1) and Treas. Reg. §§ 1.521-1(a)(1) and 1.521- 155

1(c).

 Tech. Adv. Mem. 7902004 (Sept. 27, 1978).

156

70

The relaxed position on carrying losses forward was dictated

by the firm IRS position that Code sec. 277 applied to

cooperatives. Since a carry-forward was specifically permitted

under sec. 277, IRS had to make it available to cooperatives.

The final G.C.M. in this series was issued after the Service's

operation-at-cost theory was rejected by the Tax Court. It said 153

that these cases were wrongly decided and the IRS should continue

to resist attempts by cooperatives to net between functions or

among allocation units within a function.154

The Chief Counsel relied heavily on his belief that a co-op had

to operate "at cost" and this meant losses had to be recouped from

the patrons whose business led to the loss. He also asserted that

permitting netting violated the requirement that a pre-existing

legal agreement cover all deductible patronage refunds.

This view was reflected in subsequent letter rulings. In one, a

section 521 cooperative with both marketing and purchasing

operations made patronage refund allocations based on each

patron's total dollar business with the association. IRS said that

the Code and regulations require each function to be treated as a

separate allocation unit.

155

The Service revoked the cooperative's section 521 status

because its allocation method didn't reflect the relative level of

margins earned by each function. It said, "A dual function cooperative does not qualify under section 521 of the Code if it fails to

turn back the proceeds of sales less expenses to the marketing

patrons, or fails to provide the purchasing patrons with the

supplies and equipment actual cost plus necessary expenses."156
 Tech. Adv. Mem. 8245082 (Dec. 31, 1981).

157

 Ford-Iroquois FS v. Commissioner, 74 T.C. 1213 (1980).

158

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

159

71

In a second ruling, a section 521 cooperative that operated

157

a feed mill began an egg marketing program to increase the

volume and reduce per-unit costs of its feed operation. The

current members agreed to this, knowing that the egg business

would lose money for several years and the feed division would

have to absorb those losses. Eventually the egg business became

profitable and paid back all the advances from the feed division.

The cooperative continued to divert all margins on egg

marketing to the feed division and patronage refunds were made

only on the basis of patronage with the feed division. The Service,

relying on the same arguments as the previous ruling, again found

the cooperative no longer qualified for section 521 status.

The courts, particularly the U.S. Tax Court, did not accept the

strictness of IRS's position against netting between patrons of

different activities. The Ford-Iroquois FS case concerned a 158

non-section 521 cooperative that operated both a grain storage and

marketing function and a farm supply function. The Tax Court

held that not only could the cooperative carry losses in its grain

operation forward under Code sec. 172, but it could, in subsequent

years, use those losses to offset income from its farm supply

operations. The court noted substantial overlap between the

marketing and supply function patrons and the regular reporting of

how the losses were being handled to the membership, suggesting

the members were aware of the allocation formula being used by

the cooperative and found it acceptable.

The Lamesa Cooperative Gin case involved a section 521 159

cooperative that performed primarilymarketing functions but also

purchased a small quantity of farm supplies that it resold to

patrons at approximately cost. Because its purchasing operation

was quite small compared with its marketing business, it didn't

keep separate accounts for its purchasing activities and allocated
Id. at 907. 160

Id. at 910.

161

 Tech. Adv. Mem. 8521003 (Jan. 25, 1985).

162

72

patronage refunds solely on the patronage of its marketing

operation.

During audit,IRS asked the cooperative to compute its margin

on farm supply operations for the year in question and then

disallowed that portion of its patronage refund deduction. The

court found this unjustified. It held that nothing in Code sec. 521

or the applicable regulations "explicitly refers to any separate

accounting requirement for cooperatives engaged in both

purchasing and marketing; all that is required is that the Code

requirements, including equitable allocation, be satisfied with

respect to each function."160

The court concluded:

This is not to say that the particular method of

allocation employed by petitioner would have been the

only proper way of allocating these gains. We hold merely

that petitioner's board of directors did not unjustly

discriminate against one group of patrons at the expense of

another group, given the practicalities of the allocation, the

substantial similarity in the identity of patrons over the

years, the absence of any indication that any of the patrons

complained about such allocations, and, with respect to the

profit from the purchase and resale of supplies, the de

minimis nature of the item.161

Gold Kist Letter Ruling

Any hope cooperatives had that IRS would permit greater

flexibility in handling losses was shattered in early 1985 by the

issuance of a letter ruling revoking the section 521 status of Gold

Kist Inc.162
73

Gold Kist divided its diverse operations into four major

"groups": 1) Poultry Group (poultry and egg marketing

departments); 2) Foods Group (fish and pork marketing

departments); 3) Marketing Group (cotton, pecan, peanut, grain,

soy and livestock marketing departments); and 4) Agriservices

(supply function). Gold Kist netted margins and losses among the

departments within a group. It also netted margins and losses

among the four groups, both within the marketing function and

between marketing groups and the Agriservices unit.

The Service raised three familiar objections to Gold Kist's

handling of losses:

 1. Code sec. 521 and the applicable regulations require that

marketing and purchasing functions be treated as separate

activities.

2. Patronage refund allocations must reflect an "equitable

allocation" of margins to members whose business created them.

IRS said evidence of equity in netting within a function can

include a showing that patrons of one unit are also patrons of the

other, geographical separation is limited, and patrons are informed

of the extent of the risk sharing before the loss transactions occur.

While no opinion was offered as to the propriety of Gold Kist's

netting among departments within a function, the Service said that

any netting among any of the four major groups failed the

equitable allocation test.

 3. IRS determined that the board of directors had sufficient

discretion to determine how margins and losses would be allocated

to destroy the preexisting legal obligation requirement in the

definition of deductible patronage refund at Code sec. 1388(a)(2).

The Service (a) revoked Gold Kist's section 521 status, (b)

disallowed any offsetting of losses in one group against gains in

another group (although it said these losses could be treated as an

operating cost in subsequent years within the group in which it

was sustained), and (c) disallowed the deduction of any patronage

refunds that the board had discretion to offset against losses in any

other department.
 Consolidated Omnibus Budget Reconciliation Act of 1985 163

(COBRA), Pub. L. No. 99-272, 100 Stat. 82, 323-324 (1986), § 13210,

codified as I.R.C. § 1388(j). For legislative history, see S. Rep. 146,

99th Cong., 1st Sess (1985), reprinted in 1986 U.S. Code Cong. &

Admin. News 42, 334-337.

 I.R.C. § 1388(j)(1). 164

74

A Legislative Solution

Gold Kist and other cooperatives determined they could not

accept IRS's position. They launched a lobbying effort that

resulted in legislative clarification of the rules for netting

patronage-sourced margins and losses among allocation units.

Most of the problems for cooperatives wishing to net

patronage-sourced margins and losses among different allocation

units were addressed and alleviated by the Consolidated Omnibus

Budget Reconciliation Act of 1985, adding section 1388(j) to

Subchapter T. The act clarifies Subchapter T to explain netting 163

options available to cooperatives and institutes a notice

requirement for cooperatives exercising their option to net

patronage gains and losses.

Option To Net

Paragraph (1) of section 1388(j) specifically provides that in

computing net earnings for purposes of the patronage refund

deduction, a cooperative has the option to offset patronage losses

attributable to one or more allocation units against margins earned

by another allocation unit. This is true whether the allocation units

are functional, divisional, departmental, geographic, or determined

on some other basis. Thus, a cooperative may net losses against

margins within the patronage operation, but is not required to do

so. For purposes of this provision, a patronage loss can include

losses carried back or forward to such year as well as losses arising

in a particular year.

164

Paragraph (2) makes clear that netting is also allowed after a

cooperative acquires the assets of another cooperative through the
 I.R.C. § 1388(j)(2). 165

 I.R.C. § 1388(j)(3). 166

 I.R.C. § 1388(j)(3)(A). 167

75

liquidation of a subsidiary or other reorganization, such as a

merger, described in Code sec. 381(a). The surviving cooperative

may compute its net earnings by offsetting losses of one or more

of its patronage allocation units against patronage earnings of the

acquired organization or by offsetting losses in one or more

patronage allocation units of the acquired organization against its

patronage earnings. However, the earnings which may be offset

in this manner are limited to earnings allocable to periods after the

date of acquisition.165

Notice Requirement

If a cooperative exercises its option to net margins and losses

for a particular tax year, paragraph 3 of section 1388(j) states that

the cooperative must provide its patrons a written notice that the

netting has occurred. This notice requirement was a necessary 166

part of obtaining Congressional approval of the legislation.

Congress wanted to be sure that patrons were advised of the

cooperative's netting practices.

The notice must be given within the payment period for

making patronage distributions for the year (within 81⁄2 months

after the close of such taxable year) and must state the following:

(1) that the cooperative has offset earnings and losses from one

or more of its allocation units and that such offset may have

affected the amount which is being distributed to its patrons,

(2) generally, the identity of the offsetting allocation units, and

(3) briefly, what rights, if any, the patrons have to additional

financial information about the cooperative under the terms of its

charter, articles of incorporation, bylaws, or under any provision

of the law.

167

Despite these disclosure requirements, a cooperative need not

reveal detailed or specific information about the earnings or losses
 I.R.C. § 1388(j)(3)(B). 168

 I.R.C. § 1388(j)(3)(C). 169

 I.R.C. § 521(b)(6).

170

 COBRA, Pub. L. No. 99-272, § 13210(c)(1), 100 Stat. 324 171

(1986). The subparts of the act concerning dates the new rules became

effective weren't codified.

 COBRA, § 13210(c)(2), 100 Stat. 324. 172

76

of its allocation units which it determines is commercially

sensitive and, if released, could put the organization at a

competitive disadvantage.168

In the event the Service determines that a cooperative failed to

provide sufficient written notice to its patrons, it may require the

cooperative to provide a revised written notice to the patrons

which does satisfy the requirements stated above. However, IRS

cannot disallow a patronage refund deduction, revoke a

cooperative's section 521 status, or impose any other penalty as a

result of the cooperative's failure to provide an adequate notice.169

Section 521 Status

A new provision is added to Code Sec. 521 making it clear that

should a section 521 cooperative exercise its option to net, its 521

status will not be jeopardized.170

Effective Dates

All of the provisions other than the notice requirements were

made effective retroactive to tax years beginning after December

31, 1962. This made sure the new permissive rules applied to 171

Gold Kist and similarly situated cooperatives that had netted

patronage-sourced margins and losses in a prior year. The notice

requirements became effective on the date of enactment of the law,

April 7, 1986.172
 COBRA, § 13210(c)(3), 100 Stat. 324. This language also was 173

not codified.

 Gen. Couns. Mem. 39,587 (Dec. 3, 1986).

174

77

No Effect on Treatment of Nonpatronage Losses

This legislation only deals with netting between and among

allocations units of a cooperative's patronage operation. It

specifically avoids the issue of netting patronage earnings and

nonpatronage losses, stating:

Nothing in the amendments made by this section shall

be construed to infer that a change in law is intended as to

whether any patronage earnings may or not be offset by

nonpatronage losses, and any determination of such issue

shall be made as if such amendments had not been

enacted.173

These amendments concluded the controversy over netting

patronage-sourced margins and losses among allocation units. The

Service quickly accepted the new law and its retroactive

application to interfunctional netting that occurred before

COBRA's enactment.174

It is a testament to all parties involved in drafting it that

research has not uncovered a single dispute in this area since its

enactment. The same cannot be said, however, for the situation

the Act sidestepped, the netting of patronage- and nonpatronagesourced margins and losses.

NONPATRONAGE ACTIVITY

One of the factors that determines how a loss is handled is

whether it is patronage or nonpatronage sourced. An entire

chapter in this series is devoted to distinguishing patronage and
 Donald A. Frederick, Income Tax Treatment of Cooperatives: 175

Patronage Refunds, Chapter 5, Cooperative Information Report 44, Part

2 (USDA 2005) p. 27.

 Tech. Adv. Mem. 8707005 (Nov. 7, 1986); Gen. Couns. Mem. 176

39,610 (March 5, 1987).

 Juniata Farmers Cooperative v. Commissioner, 43 T.C. 836

177

(1965), acq., 1966-1 C.B. 1, 2.

78

nonpatronage income. The same rationale for determining the 175

proper characterization for income also applies to losses. A loss

is patronage sourced if it results from a transaction directly related

to and actually facilitating the cooperative's patronage activity.

However, if the transaction producing the loss is incidental to

patronage activity, the loss is from nonpatronage sources.176

Section 521 Cooperatives

Netting patronage gains and losses with nonpatronage gains

and losses is seldom a contentious issue for section 521

cooperatives. As they must treat members and nonmembers alike

and can deduct patronage-based allocations of both, whether they

net or not generally has no tax consequences and has not been a

contentious issue in recent years. The few rulings in this area

involving section 521 cooperatives are summarized below.

The ground rules for section 521 treatment of nonpatronage

losses were established in the Juniata Farmers Cooperative

decision. Although the case dealt with the allocation of 177

nonpatronage income, it became the precedent for giving section

521 cooperatives flexibility in handling nonpatronage losses.

Juniata was a section 521 cooperative that marketed grain and

had feed and fertilizer supply operations. Like many local

cooperative elevators at the time, it realized substantial income

from storage fees paid by CCC for grain it accepted in lieu of

farmers repaying USDA loans. Such fees are nonpatronage

income.
 Rev. Rul. 67-128, 1967-1 C.B. 147. 178

 Ltr. Rul. 7202281240A (Feb. 28, 1972).

179

79

Juniata allocated the earnings on that nonpatronage income to

its grain marketing patrons on the basis of bushels of grain each

delivered to the cooperative. IRS disallowed Juniata's patronage

refund deduction and challenged its section 521 status on the

grounds that allocating these earnings only to grain patrons was

not equitable. IRS wanted them allocated to both the marketing

and supply function patrons.

The court found the Service's position without precedent or

merit. It noted that no perceivable revenue was at stake in this

matter, significant overlap existed between the marketing and

supply function patrons, and the patrons were regularly informed

of the allocation method used. Thus the court, over IRS objection,

ruled a section 521 cooperative could allocate nonpatronage

income only to patrons of the function that generated the income.

In a subsequent revenue ruling the IRS applied the Juniata

decision to a situation involving intra-functional netting. A 178

section 521 marketing cooperative had several departments,

including a vegetable marketing department and a grain marketing

department. When it had nonpatronage income or losses, they

were allocated to the department to which such income or losses

related, rather than to all patrons. IRS, citing Juniata, approved

this allocation method, provided it did not discriminate among

similarly situated patrons.

A letter ruling involved a section 521 cooperative that suffered

a loss on the sale of the stock representing ownership in a

subsidiary. In a subsequent year it realized a gain on the sale of

real estate. The requested ruling said: (1) the loss was a

nonpatronage capital loss and the gain was a nonpatronage capital

gain and (2) it could carry the nonpatronage loss forward and

offset a like amount of the gain for tax purposes.179

A later letter ruling concerned a section 521 cooperative in the

process of dissolution. It was permitted to carry forward a net
 Priv. Ltr. Rul. 9021013 (Feb. 21, 1990).

180

 Rev. Rul. 74-377, 1974-2 C.B. 274; Tech. Adv. Mem. 8707005 181

(Nov. 7, 1986); Gen. Couns. Mem. 39,610 (March 5, 1987).

 Rev. Rul. 70-420, 1970-2 C.B. 64, revoked by Rev. Rul. 74-377, 182

1974-2 C.B. 274.

80

operating loss and net it against nonpatronage income realized

from the sale of assets during the dissolution period.180

Non-section 521 Cooperatives, Netting

Nonpatronage Losses with Patronage Earnings

For non-section 521 cooperatives, the preferred approach of

the Service to handling losses on nonpatronage business is to carry

those losses back and forward under Code sec. 172 to offset

nonpatronage earnings in other years.

181

Some cooperatives don't object to this standard. They use a

nonpatronage loss to shield nonpatronage earnings in other years

from taxation.

However, instances arise when a cooperative prefers to net its

nonpatronage losses with patronage earnings. For example, it may

not want to pay out more in patronage refunds than its overall

book income. IRS opposes such netting as inconsistent with

"operating on a cooperative basis."

Two early rulings concerning the same facts, neither written

with total clarity, are a part of this controversy. The first, Revenue

Ruling 70-420, presents a simple example of a fertilizer supply 182

cooperative that had a margin of $600 on member sales and a loss

of $500 on nonmember sales. A cooperative had apparently asked

for permission to deduct the $600 patronage refund based on the

margin on its member business and to carry the nonmember loss

back to prior years under Code sec. 172. IRS said the loss should

be netted against member income, reducing the patronage refund

for the tax year to $100.
 Rev. Rul. 74-377, 1974-2 C.B. 274, revoking Rev. Rul. 70-420, 183

1970-2 C.B. 64.

Id.

184

 Farm Service Cooperative v. Commissioner, 619 F.2d 718 185

(1980), rev'g 70 T.C. 145 (1978).

81

The ruling caused confusion among cooperatives because it

didn't specify whether the nonmember loss was patronage or

nonpatronage sourced. In 1974, IRS revisited the issue. In a

second ruling on the same facts it clearly stated the nonmember

loss was a nonpatronage loss.183

The Service also changed its suggested tax treatment. It

phrased the issue as whether the cooperative must offset member

earnings with the loss sustained on nonmember, nonpatronage

transactions. It stated that "the amount of net earnings available

for distribution as patronage (refunds) is the entire ($600)

undiminished by the loss incurred with the nonmembers."

(emphasis added)

IRS then said, "If the taxpayer distributes the ($600) to

members as a patronage (refund), then the ($500) loss incurred

with the nonmember is a net operating loss" (emphasis added) and

may be carried back and forward to offset nonpatronage income in

other years.

184

The whole handling of losses issue was very contentious

during the following decade. As discussed previously, the Service

was aggressively pursuing its "operation-at-cost" theory to

challenge whether a cooperative could have a loss on patronage

operations. While the handling of nonpatronage losses seemed to

lay dormant until the mid-1980s, when another cooperative

attempted to net nonpatronage losses and patronage margins, it

was clearly on people's minds.

For example, while addressing other issues, the U.S. Court of

Appeals for the 8th Circuit commented on nonpatronage losses.

Farm Service Cooperative v. Commissioner is an important de- 185
 619 F.2d at 725, n. 16.

186

 For a thorough explanation of the cooperative perspective, see 187

Clifford R. Fulton, Relationship Netting Under Rev. Rul. 67-128: An

End to the Isolation of Nonpatron Loss, The Cooperative Accountant,

Summer 1986, at 55.

 Tech. Adv. Mem. 8707005 (Nov. 7, 1986). The length of time 188

the issue was under consideration is reflected in a General Counsel

Memorandum involving the same case which states the matter was

referred by the Director, Corporate Tax Division, in June 1984. Gen.

Couns. Mem. 39,610 (March 5, 1987).

82

cision on the issue of netting patronage losses and nonpatronage

earnings that is discussed later in this chapter. The court noted:

Fewer problems are presented when a cooperative

incurs a loss on its nonpatronage activities. The

Commissioner has held that, in such a case, a cooperative

need not reduce its patronage income to cover the loss.

Rev. Rul. 74-377, 1974-2 C.B. 274. No avoidance of tax

would result...; indeed, if the cooperative chose to offset

the loss with current patronage income, it would have to

forego the deduction for otherwise allowable patronage

(refunds). (emphasis added) 186

This opinion would seem to support the view of cooperatives

that Revenue Ruling 74-377 is permissive, giving cooperatives the

option to net nonpatronage losses with patronage margins or to

keep them separate and carry the nonpatronage losses back or

forward under Code sec. 172.187

However, when next faced with a cooperative attempting to

net nonpatronage losses and patronage earnings, the IRS, after

several years of deliberation, determined that such netting violated

the "universal" cooperative principle of operation at cost. IRS 188

acknowledged that the cooperative had followed this practice on

a consistent basis and the members were apparently cognizant of

it and supported it. Nonetheless, the Service said the association
Id.

189

 Certified Grocers of California, Ltd v. Commissioner, 88 T.C. 190

238 (1987).

Id. at 251 n.21. 191

83

had a pre-existing legal obligation to return all margins on

patronage business to the patrons. By reducing current patronage

refunds with the offset of nonpatronage losses, IRS said the

patrons were illegally underpaying themselves.

IRS added salt to the wound by pointing out that the netting

practice of the cooperative resulted in a smaller patronage refund

deduction than would have otherwise been available. However,

since the payment period for the year is dispute had expired, the

cooperative could not now claim the additional deduction.189

Shortly after the taxpayer received this ruling, the U.S. Tax

Court commented on the issue in Certified Grocers of California,

Ltd. v. Commissioner. Although the decision denied the 190

cooperative's attempt to offset nonpatronage income with

patronage expenses in a consolidated return, the court noted:

As the Court of Appeals intimated in Farm Service

Cooperatives, supra at 725, n. 16, the same rule would not

appear to apply where the facts are reversed. Thus, if a

cooperative has net income from patronage sources, even

after taking the special deductions provided by sections

1382 and 1383, there appears to be no reason why such

income may not be combined and netted with the income

or loss from nonpatronage sources, for tax purposes, at

least.191

As the courts have not directly addressed netting patronage

earning and nonpatronage losses, cooperatives that have legitimate

business reasons to do so may face uncertain consequences. If a

cooperative chooses to net nonpatronage losses against patronagesourced income, net margins otherwise available for distribution
 Rev. Rul. 74-377, 1974-2 C.B. 274. 192

 Tech. Adv. Mem. 7301319420A (Jan. 31, 1973).

193

84

as patronage refunds are reduced. The cooperative has no net loss

and can distribute the remaining net margin as patronage refunds

eligible for deduction under Subchapter T.

If a cooperative chooses not to reduce patronage income by

nonpatronage losses, it will have a net margin from which a

deduction may be taken upon payment of patronage refunds and

a nonpatronage-sourced net operating loss. The net operating loss

may be carried back and forward under Code sec. 172 to offset

past or future income from business done with persons to whom

the cooperative has no obligation to return patronage dividends.

Net margins available for allocation as patronage refunds are

unreduced by the loss and may be deducted in full under

subchapter T.192

Non-section 521 Cooperatives, Netting

Nonpatronage Earnings with Patronage Losses

Cooperatives with patronage and nonpatronage activities may

generate a profit on nonpatronage activities but incur a loss from

business with or for patrons. If a cooperative could net patronage

losses and nonpatronage earnings, it would reduce the amount of

tax it otherwise would owe on the nonpatronage income. This tax

consequence has caused IRS and, unfortunately from the

cooperative perspective, the courts to bar such offsets.

An early letter ruling concerned a wholesale grocery supply

cooperative that divided its operations into five geographic

divisions. Each division conducted both member-patronage and 193

nonmember-nonpatronage business. When one division suffered

a loss, the cooperative wanted to offset that loss against

nonpatronage income of the other divisions. IRS said the

cooperative had to keep its patronage and nonpatronage financial

results separate. It could net the nonpatronage portion of the loss
 Farm Service Cooperative v. Commissioner, 619 F.2d 718 (8th

194

Cir. 1980), rev'g, 70 T.C. 145 (1978).

 Associated Milk Producers v. Commissioner, 68 T.C. 729 195

(1977).

85

against nonpatronage income of the other divisions, but not the

patronage portion of the loss. That had to be recouped from the

patrons of the division with the loss.

The leading case on this issue is Farm Service Cooperative v.

Commissioner. The cooperative had four allocation units. The 194

"broiler pool" and the "turkey pool" were marketing units that

conducted all of their business with member-patrons. The "regular

pool" was a farm supply operation that did business with members

on a patronage basis and nonmembers on a commercial basis. The

"taxable pool" represented income from nonoperational sources,

such as gains on the sale of property, dividends on stock owned by

the association, and other incidental income that the cooperative

was willing to treat as nonpatronage sourced.

The cooperative incurred a loss in the "broiler pool" and

applied the loss to offset nonmember nonpatronage income of the

"regular pool" (supply function) and the nonpatronage income of

the "taxable pool."

The U.S. Tax Court, drawing heavily on its recent opinion in

Associated Milk Producers, found the cooperative did not, as 195

IRS asserted, have to recover its broiler pool loss from the broiler

pool patrons. It accepted the cooperative's argument that

subchapter T was silent on the appropriate treatment of net

operating losses and as it was a corporation it could aggregate

gains and losses of its various divisions just as other corporations

could. The Tax Court again rejected the Service's operation-atcost theory and said the cooperative's board could determine the

most equitable and appropriate method of allocating the broiler

pool loss, so long as it followed the association's bylaws. This in-
 Farm Service Cooperative v. Commissioner, 70 T.C. 145 (1978),

196

rev'd, 619 F.2d 718 (8th Cir. 1980).

 Farm Service Cooperative v. Commissioner, 619 F.2d 718 (8th

197

Cir. 1980), rev'g, 70 T.C. 145 (1978).

 619 F.2d at 727. 198

 619 F.2d at 724. 199

 619 F.2d at 727. 200

86

cluded offsetting the loss against otherwise taxable nonpatronage

earnings.196

The Tax Court decision was reversed by the U.S. Court of

Appeals for the 8th Circuit. The court accepted the IRS position 197

in the earlier letter ruling that subchapter T requires a cooperative

without section 521 status to separate its patronage and

nonpatronage accounts in calculating its gross income. It reviewed

the development of Subchapter T and concluded it "forbids (a

cooperative without section 521 status) to aggregate patronage

losses with its income from taxable activities."198

The court examined the tax consequences of netting patronage

losses with nonpatronage earnings and found the result is "to shift

the broiler pool losses from the broiler pool to [the cooperative]

itself and, more significantly, to the United States Treasury.... [The

cooperative] in this case is seeking to avoid taxation on income for

which no patronage dividend deduction is available."199

The court went on, "A (non-section 521) cooperative simply

may not use patronage losses to reduce its tax liability on

nonpatronage-sourced income. Taxpayer's accounting procedures

cannot supersede this statutory principle."200

The court also compared tax treatment of section 521

cooperatives with nonsection 521 cooperatives and concluded the

disparate tax treatment was significant. It said permitting netting

of patronage-sourced losses against nonpatronage income:

...would result in obliterating this statutory distinction.

If patronage losses could be used to offset nonpatronage-
Id.

201

 Priv. Ltr. Rul. 7937041 (June 13, 1979). Note that the Farm 202

Service opinion concerns a nonsection 521 cooperative.

87

sourced income, then a (nonsection 521) cooperative could

gain the tax advantages of a (section 521) cooperative

without meeting the qualifications set forth in IRC §

521(b). Not only would taxpayer itself gain the benefits of

(section 521 status)--notably, the exclusion of

nonpatronage-sourced income from taxation--but all other

cooperatives could do so as well. That is, any (nonsection

521) cooperative could avoid tax on nonpatronage-sourced

income by the simple expedient of operating at a loss on

its patronage activities.201

Farm Service Cooperative argued the abuse of the tax

treatment for patronage refunds would only occur if patronagesourced losses were incurred deliberately. The court, however,

said the distinction between deductions allowed section 521

cooperatives and other cooperatives do not turn on subjective

factors. The result reached depends only on subchapter T, not an

investigation of cooperative motivations.

Even while the Tax Court opinion in Farm Service was being

appealed, the Service continued to press its position

administratively. In a letter ruling to a cooperative applying for

section 521 status, IRS conditioned approval on the adoption of a

bylaw allocating any patronage losses to those patrons whose

business gave rise to the loss. Even though the issue was section

521 status, the IRS said that "...patronage sourced gains and losses

may not be netted with nonpatronage sourced gains and losses."202

In 1986, IRS issued two letter rulings that relied on the Farm

Service opinion to deny a cooperative's request to net patronage

losses and nonpatronage earnings. They also injected Code

section 277 into the discussion, holding that section 277 prevents

cooperatives from offsetting patronage losses against
 Tech. Adv. Mem. 8641003 (June 26, 1986), Tech. Adv. Mem. 203

8641005 (June 30, 1986). See also, Gen. Couns. Mem. 39,587 (Dec. 3,

1986).

 Buckeye Countrymark v. Commissioner, 103 T.C. 547 (1994), 204

acq., A.O.D. CC-1997-003 (May 2, 1997), noted 1997-1 C.B. 1. The

attempt by IRS to bring cooperatives under § 277 is detailed infra pp.

90-103.

 103 T.C. at 559-560. Legislative history of a law enacting 205

special rules for netting patronage income and losses reflects

congressional approval of this finding. The Senate Budget Committee

report expresses agreement with the 8th Circuit's holding in Farm

Service Cooperative "that a (non-section 521) cooperative could not

offset patronage losses against nonpatronage earnings." S. Rep. No. 146,

99th Cong., 1st Sess. (1985), reprinted in 1986 U.S.C.C.A.N. 43, 336.

See also, Priv. Ltr. Rul. 9326006 (March 16, 1993).

 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 206

238 (1987).

88

nonpatronage income and further that patronage losses may only

be carried forward to succeeding taxable years. While the 203

Service has accepted the Tax Court's rejection of its position that

Code sec. 277 applies to nonsection 521 cooperatives, the rule 204

that patronage losses can't be netted with nonpatronage income

remains firmly in place.205

A similar rule prohibits netting patronage-sourced expenses

against nonpatronage income. Certified Grocers of California v.

Commissioner concerned a grocery wholesale cooperative with 206

several noncooperative subsidiaries. The cooperative filed a

consolidated return including the results of its subsidiaries. The

earnings of the subsidiaries were nonpatronage income to the

cooperative.

The cooperative had substantial interest income and interest

expense. In its first determination, the court recognized that the

interest expense was patronage sourced but found the cooperative

failed to establish that the funds that earned the interest income

were so closely related to its primary cooperative activity to
 Treas. Reg. § 1.1502-80. 207

89

substantiate a finding that the interest income was patronage

sourced.

Under a stipulation agreed to by the parties, the court next

looked at whether the cooperative could offset patronage-sourced

interest expenses against nonpatronage-sourced interest income.

In its first discussion on netting patronage results with

nonpatronage earnings since Farm Service, the Tax Court decided

to follow the 8th Circuit.

The Tax Court held that cooperatives must determine their

patronage-sourced income separately from their nonpatronage

income, in order to properly compute their patronage refunds. As

part of this process, expenses must be assigned to the type of

income to which they apply. Therefore, nonpatronage income may

not be reduced by patronage expenses.

The court also looked at the impact of the cooperative's filing

a consolidated return with its noncooperative subsidiaries. The

court accepted with conviction the cooperative's position that it

could file such a consolidated return. However, it rejected the

premise that by using a consolidated return, the cooperative could

net a patronage loss against nonpatronage income.

In 1980, the cooperative paid a patronage refund based on

"book" income that exceeded its "taxable" income. On its

consolidated return, it attempted to offset the resulting tax loss

against nonpatronage income earned by the subsidiaries. The

court cited with approval a regulation providing that other tax law

applies to an affiliated group filing a consolidated return unless the

regulations say otherwise.207

Again following Farm Service, the Tax Court said that since

a cooperative can't net patronage losses and nonpatronage earnings

on a regular return, it can't net patronage losses with nonpatronage

income of subsidiaries in a consolidated return. However, it can

carry the patronage loss back and forward to other tax years under

Code sec. 172 "for application only against net income from
90

patronage in those years." The court also said it could carry

nonpatronage earnings and losses, whether from its own

operations or those of a subsidiary, to other years to offset against

other nonpatronage earnings from both sources in those years.

In summary, certain rules and guidelines govern the treatment

of losses where nonpatronage operations are involved:

1. Section 521 cooperatives can combine patronage and

nonpatronage income and losses and distribute the result as

deductible patronage refunds. Therefore, netting patronage and

nonpatronage results is usually not an issue for them.

 2. Non-section 521 cooperatives must separate patronage and

nonpatronage income and expenses when computing taxable

income.

3. Non-section 521 cooperatives may carry nonpatronage

losses back and forward to reduce taxable nonpatronage income in

other years under Code sec. 172. As the loss can be used to offset

otherwise taxable income in other years, this is generally an

acceptable strategy for cooperatives.

4. The Service opposes non-section 521 cooperatives netting

nonpatronage losses and patronage margins, even though under

this scenario the cooperative voluntarily forfeits the option to carry

those losses to other tax years and reduce taxable nonpatronage

income in those years. This reflects the Service's commitment to

its "operation-at-cost theory" which requires all losses be recouped

from the persons whose business generated the loss.

 5. Non-section 521 cooperatives may not net patronage losses

or expenses with nonpatronage income, as this would avoid the tax

otherwise due on the nonpatronage income at the cooperative

level.

SECTION 277

The Tax Reform Act of 1969 added a new provision, section

277, to the Internal Revenue Code. It states that a social club or

other membership organization that operates primarily to furnish
 I.R.C. § 277(a). 208

Id. See also, Tech. Adv. Mem. 8815001 (Nov. 3, 1987).

209

 H.R. Rep. 413, 91st Cong., 1st Sess (1969), reprinted in 1969 210

U.S. Code Cong. & Admin. News 1694, 1695; S. Rep. 552, 91st Cong.,

1st Sess (1969), reprinted in 1969 U.S. Code Cong. & Admin. News

2103. See, Concord Consumer Housing Cooperative v. Commissioner,

89 T.C. 105, 120-121 (1987).

 Gen. Couns. Mem. 34,334 (Aug. 17, 1970).

211

91

services or goods to its members, and is not exempt from taxation,

may only deduct costs associated with providing such services and

goods to members in an amount equal to the income derived from

transactions with its members. Section 277 also provides that 208

to the extent deductions from providing services and goods to

members exceed member income in any year, the difference can

be carried forward and deducted in the succeeding tax year. This

section also eliminates deductions relating to dividends received

by corporations to which it applies.209

Section 277 was enacted to reverse court decisions permitting

taxable membership organizations to escape taxation of

investment and nonmember income by offsetting it with losses

incurred in providing goods and services to members.

210

Subchapter T Agricultural Cooperatives

Because section 521 cooperatives are considered "exempt" by

terms of the Code, the application of section 277 to section 521

cooperatives was never an issue. But it was a contentious point

between nonsection 521 cooperatives and the IRS for many years.

IRS staff was quick to apply Code sec. 277 to cooperatives.

Shortly after enactment, theChief Counsel simplywrote, "Section

277 of the Code...applies to (nonsection 521) cooperative

associations."211

On August 20, 1971, the Service's Regulations Policy Committee decided "Section 277 should be applied to cooperatives and
 Gen. Couns. Mem. 34,935 (July 3, 1972).

212

 Farm Service Cooperative v. Commissioner, 70 T.C. 145 (1978),

213

rev'd on other grounds, 619 F.2d 718 (8th Cir. 1980). The Eighth

Circuit declined to address the section 277 issue. 619 F.2d 728, n.23.

 70 T.C. at 156-157. 214

 Priv. Ltr. Rul. 8233051 (May 19, 1982).

215

 Tech. Adv. Mem. 8247011 (July 28, 1982).

216

 Priv. Ltr. Rul. 8624019 (March 10, 1986); Tech. Adv. Mem. 217

8641003 (June 26, 1986); Priv. Ltr. Rul. 8641005 (June 30, 1986).

92

should be vigorously enforced." Yet, it was nearly 15 years

212

before the Service began to routinely apply section 277 to co-ops.

The first authoritative discussion of the applicability of section

277 to nonsection 521 cooperatives isin the Tax Court opinion in

Farm Service Cooperative. The Court held the Commissioner 213

did not meet his burden of proof that section 277 should apply to

cooperatives. However, it provided some analysis of the

substantive issue. The court stated that the purpose of enactment

was to attack "sham losses" intentionally generated in dealings

with members free of tax. It noted that IRS produced no evidence

that the cooperative loss under consideration was a sham.214

After the Tax Court's statement in Farm Service, private

rulings indicated a continuing but somewhat tentative effort to

apply section 277 to nonsection 521 cooperatives. A 1982 letter

ruling mentioned section 277 as a guide for carrying losses 215

forward when they aren't recouped from members in the loss year.

Another private ruling described how section 277 directs losses to

be carried forward. However, under the circumstances of the 216

case the ruling found carry forward under section 172 acceptable

and did not otherwise press the application of section 277.

In 1986, the IRS finally began to apply Code sec. 277 to

cooperatives aggressively. It used section 277 to support holdings

that (1) a cooperative could carry operating losses forward but not

back to offset taxable income in earlier years and (2) a cooperative

can't net patronage losses and nonpatronage earnings.217
 Washington-Oregon Shippers Cooperative, Inc. v. Commis- 218

sioner, 52 T.C.M. (CCH) 1406, 1413, n.13 (1987).

219 Tech. Adv. Mem. 8641005 (June 30, 1986). Neither the TAM

nor the court opinion explains why Fayette Landmark had substantial

taxable income from business with or for patrons. 

 Landmark v. United States, 25 Cl. Ct. 100 (1992). 220

93

In 1987, the Tax Court again discussed the applicability of

section 277 to cooperatives without deciding it. As in the Farm

Service case, the court noted doubt as to its applicability.218

Also in 1987, cooperatives decided to identify and fund a test

case to have the courts determine whether Code sec. 277 covered

nonsection 521 cooperatives. Buckeye Countrymark, the

successor to Fayette Landmark, a local grain marketing and farm

supply cooperative in Ohio, became the test vehicle.

In 1977, Fayette Landmark reported $85,275 in taxable income

from business with or for patrons. In 1980, it suffered operating

losses of $62,424 on business with or for patrons and attempted to

carry the loss back to offset taxable income in 1977.

An IRS agent auditing Fayette Landmark questioned the loss

carry back and requested technical advise from the IRS National

Office. The National Office response took the position that Code

sec. 277 applied and that the patronage-sourced loss could not be

carried back.219

As the cooperative had already received a refund based on an

amended 1977 tax return filed in 1981, IRS sent it a notice of

deficiency. The cooperative responded by initiating litigation in

the Tax Court. The only issue in the case was whether Code sec.

277 applied to Fayette Landmark, a nonsection 521 cooperative

covered by Subchapter T.

For unexplained reasons, the Tax Court took 6 years to issue

its decision. In the interim, another case involving Code sec. 277

was decided by the U.S. Claims Court. Landmark was a 220

federated cooperative whose members were local grain marketing

and supply cooperatives, also located in Ohio.
 25 Cl. Ct. at 108. 221

 Buckeye Countrymark v. Commissioner, 103 T.C. 547 (1994). 222

94

In tax year 1981, Landmark was allowed to claim (after

lengthy negotiations with IRS) an operating loss of more than $9.9

million on an investment in a failed petroleum refinery venture.

Landmark attempted to carry much of that loss back to tax years

1978-1980 to "free-up" investment tax credits previously claimed

in those years. Then it asked to carry the freed-up credits back to

offset taxable income at the cooperative level in 1975-1977.

Landmark initiated litigation in the Claims Court to recover

the funds represented by the unrealized credits. IRS countered

with two arguments. First, Code sec. 277 barred Landmark from

carrying the 1981 loss back to prior years to free-up the credits.

Second, if the credits were freed, Code sec. 46(h) required they be

passed through to Landmark's members rather than used to offset

taxable income at the cooperative level in earlier years.

The Claims Court rejected the Government's argument that

Code sec. 277 applies to Subchapter T cooperatives. However, it

also held that IRS was correct in asserting that the freed credits

could not be carried back at the cooperative level but rather must

be passed through to Landmark's patrons.

The court based its section 277 holding on fundamental

inconsistencies between that provision and Subchapter T. It said

Subchapter T provides a comprehensive taxing scheme for

cooperatives and superimposing the more generalized rules of

section 277 onto it would "produce results that extend from

legislative redundancy to a repeal by implication. These are not

results we can reasonably suppose Congress meant to achieve."221

The court concluded Landmark was entitled to carry back the

1981 net operating loss under Code sec. 172. However, no refund

of prior years' taxes was realized because it had to pass the freed

investment tax credits through to its members.

Finally, in late 1994, the Tax Court handed down its opinion

in Buckeye Countrymark v. Commissioner. While it never cited 222
 103 T.C. at 581-582. 223

95

the Claims Court opinion in Landmark, the Tax Court adopted

essentially the same logic. It based its ultimate finding upon an

analysis of cooperative taxation under Subchapter T and the

purposes and language of Code sec. 277, concluding:

As discussed in detail above, we find that the

provisions of section 277 conflict with the provisions of

subchapter T and the application of section 277 to

(nonsection 521) cooperatives would lead to absurd or

futile results. This is a strong indication that Congress did

not intend section 277 to be applied to (nonsection 521)

cooperatives. We also find that the arguments by (the

Service) in support of the position that section 277 applies

to (nonsection 521) cooperatives are flawed.

Accordingly, we hold that section 277 does not apply

to (nonsection 521) cooperatives subject to tax under

subchapter T and that (nonsection 521) cooperatives are

not "membership organizations" within the meaning of

section 277.223

While the lengthy opinion focuses on several arguments, one

is particularly noteworthy. The court looked at the underlying

policy for enacting Code sec. 277 and found:

Congress enacted section 277 to foreclose the

possibility that membership organizations could obtain an

unwarranted subsidy of their membership activities by

offsetting losses from those activities with investment or

other nonmembership income....However, as discussed

above, the rules of subchapter T forbid a (nonsection 521)

cooperative from using patronage losses to offset

nonpatronage income. [citations omitted] Thus,

irrespective of section 277, a (nonsection 521) cooperative
 103 T.C. at 570.

224

 Farm Service Cooperative v. Commissioner, 619 F.2d 718 (8th

225

Cir. 1980), rev'g, 70 T.C. 145 (1978).

 Occasionally, a cooperative whose only concerns were having its

226

losses recognized and carrying them forward, asked to be found subject

to § 277, Priv. Ltr. Rul. 8952019 (Sept. 28, 1989); or didn't object to

having § 277 applied, Priv. Ltr. Rul. 9314013 (Jan. 6, 1993). 

 AOD CC-1997-003 (May 2, 1997), noted 1997-1 C.B. 1.

227

96

is not entitled to use nonpatronage income to subsidize its

patronage activities.224

While this language was a disappointment to cooperatives that

disagreed with the Eighth Circuit's opinion in Farm Service, it

225

provided a rationale for the Tax Court to conclude in this case that

the policy concerns that led to enactment of Code sec. 277 would

not be served by applying section 277 to nonsection 521

cooperatives.

During the six years Buckeye Countrymark was under

consideration, the Service raised the Code sec. 277 issue in

numerous contexts. But IRS did not appeal the decision and 226

soon began conceding pending cases involving farmer

cooperatives where Code sec. 277 was at issue. Finally, in mid1997, it released an action on decision indicating acquiescence in

the Tax Court's decision, stating:

We will no longer take the position that (nonsection

521) cooperatives subject to subchapter T of the Code are

subject to the limitations of section 277 of the Code.

(Nonsection 521) cooperatives subject to subchapter T

may avail themselves of loss carry backs allowed by

section 172 of the Code.

227
 IRC § 216. 228

 Park Place v. Commissioner, 57 T.C. 767, 779 (1972). Also,

229

Concord Village v. Commissioner, 65 T.C. 142 (1975).

97

Other Cooperatives

While the Tax Court had the Buckeye Countrymark case under

consideration, IRS raised the issue of the applicability of Code sec.

277 to numerous other, non-farmer cooperatives. While the

Buckeye Countrymark decision essentially ended the need for

Subchapter T farmer cooperatives to concern themselves with

Code sec. 277, the Service wasn't totally throwing in the towel. It

drew a new distinction between cooperatives clearly subject to

Subchapter T and those it considered outside of that Code section,

either by specific legislative exception or its own administrative

determinations.

Housing Cooperatives

A key tax code provision for housing cooperatives is section

216, which states that owner-tenants of a housing cooperative are

to be treated, for tax purposes, as if they owned the real property

rather than stock in the cooperative. While Code sec. 216 offers 228

a framework for determining the tax treatment of housing

cooperative members, neither this nor any other Code language

specifically addresses taxation of housing cooperatives.

As early as 1972, the Tax Court had rejected an IRS position

that housing cooperatives couldn't deduct patronage refunds under

Subchapter T, stating:

We disagree with the Commissioner's assertion that

Subchapter T, section 1381, et seq., does not apply. Part

I of that subchapter applies to the taxable year of any

corporation operating on a cooperative basis after

December 31, 1962, and that necessarily includes a section

216 cooperative housing corporation. Sec. 1381(a)(2).

229
 Tech. Adv. Mem. 8532004 (April 17, 1985); Tech. Adv. Mem. 230

8532005 (April 17, 1985).

 Tax Reform Act of 1986, § 644(e), Pub. L. No. 99-514, 100 Stat. 231

2085, 2287 (1986). 

 The legislative language contained a specific statement that it

232

was not to be construed as a change in the tax law concerning the

applicability of § 277 to housing cooperatives. Tax Reform Act of

1986, § 644(e)(2)(B).

 Concord Consumers Housing Cooperative v. Commissioner, 89 233

T.C. 105 (1987).

 89 T.C. at 107, n.3. 234

98

In 1985, the IRS issued two letter rulings stating that housing

cooperatives were membership organizations within the meaning

of Code sec. 277. It then said that interest earned by the cooperatives on their reserve funds was not membership income and

therefore could not be used to offset membership losses for tax

purposes.230

The housing cooperatives involved in these rulings obtained

special legislative relief declaring the interest income was

membership income. While this solved the problem of the two 231

cooperatives it covered, it did not address the issue of the

applicability of Code sec. 277 to housing cooperatives.232

In 1987, the Tax Court decided a case involving a housing

cooperative that did not contest the applicability of Code sec. 277.

The cooperative's only argument was that interest earned on

certain reserve accounts was membership income under Code sec.

277. The court rejected the cooperative's position.233

The majority opinion didn't treat Concord as a Subchapter T

cooperative because it presented no evidence that it was. The

majority expressly stated "we leave to another day any exploration

of the possible interrelationship and full sweep of Sections 216,

277, and Subchapter T."234

But a concurring opinion, written by Judge Koener (and agreed

to by 6 other judges), cited Park Place and Concord Village for
 89 T.C. 125, 126-127. 235

 Rev. Rul. 90-36, 1990-1 C.B. 59. 236

 Trump Village Section 3 v. Commissioner, 69 T.C.M. (CCH) 237

2985 (1995).

99

the proposition that housing cooperatives were covered by

Subchapter T and said:

...those code provisions preempt other more general

code provisions which otherwise might be applicable....I

thus concur in the result reached by the majority here, as

long as it is clear, as I think it should be, that we are not

holding that the provisions of section 277 supersede the

provisions of subchapter T in a case where the latter

provisions apply. (court's emphasis)

235

Although the court didn't discuss the matter, the IRS issued a

revenue ruling, citing Concord Consumer Housing Cooperative,

that stated Code sec. 277 applied to limit the deductions of a

housing cooperative as defined in Code sec. 216(b)(1).

236

One week before Buckeye Countrymark went to trial, the first

of numerous cases concerning the applicability of Code sec. 277

to housing cooperatives was filed with the Tax Court. It involved

Trump Village, an 1800-unit housing cooperative in Brooklyn,

NY, named for Donald Trump's father, who was involved in its

original development.

The Trump Village litigation and the other housing cases were

assigned to the same judge handling the Buckeye Countrymark

case. Likewise, the original disputes languished for several years

and more cases were filed in the interim.

Finally, in June of 1995, several months after Buckeye

Countrymark, the Tax Court issued its opinion in Trump

Village. It didn't discuss Code sec. 216. Citing Buckeye 237

Countrymark, the court held that Code sec. 277 did not apply to

Trump Village because it was "operated on a cooperative basis"
 A.O.D. 1995-011 (Oct. 30, 1995).

238

 Thwaites Terrace House Owners Corp. v. Commissioner, 72 239

T.C.M. (CCH) 578 (1996).

100

within the meaning of Code sec. 1381(a)(2) and, as a Subchapter

T cooperative, is not subject to Code sec. 277. Implicit in the

decision is a finding that interest income Trump Village earned on

various reserve and escrow accounts was patronage sourced as the

court held it could be offset with operating expenses and losses

without discussing the issue.

In October, 1995, the Service issued an Action on Decision

acquiescing in the Trump Village decision. It still took an

aggressive attitude toward housing cooperatives, saying:

We will no longer take the position that cooperative

housing corporation subject to subchapter T of the Code

are subject to the limitation of section 277. We will

continue to assert in litigation that the limitations of

section 277 apply to cooperative housing corporations that

do not qualify as subchapter T cooperatives. In

considering whether subchapter T is applicable, we will

consider whether the cooperative housing corporation in

question has the three traditional characteristics of

cooperative operation essential to be “operating on a

cooperative basis.” Only where all three characteristics are

present, so that the housing corporation is a subchapter T

cooperative, will section 277 not be applied. Rev. Rul. 90-

36 will be modified to be consistent with our litigating

position.238

While Trump Village ignored Code sec. 216, a different Tax

Court judge, in a subsequent decision involving similar facts,

relied on it heavily. Noting that the parties had stipulated that 239

the taxpayer was a Code sec. 216 cooperative, the court cited Park

Place as creating at the least a presumption that a cooperative
 Of particular interest in the discussion of "operating on a 240

cooperative basis" is the court's outright rejection of the Service's

contention that Thwaites Terrace as not democratically controlled

because it both allowed proxy voting and used weighted voting based

on patronage, not one-member one-vote. 72 T.C.M. (CCH) at 581.

 Tech. Adv. Mem. 9214009 (Dec. 13, 1991).

241

101

meeting the tests of Code sec. 216 is also operating as a

cooperative for Subchapter T purposes. The court then followed

an independent analysis finding Thwaites Terrace was operating

as a cooperative with a legal conclusion that because it is subject

to Subchapter T, it is not covered by Code sec. 277.240

The court also addressed the nature of the interest income

leading to the litigation. It found that the issue of whether it was

patronage or nonpatronage sourced was in dispute and that the

cooperative had the burden of establishing it was derived from

activity directly related to its principal business purpose. As

Thwaites Terrace failed to introduce any evidence establishing the

income was patronage sourced, the court felt compelled to hold it

was nonpatronage sourced and could not be offset with patronagesourced losses.

Trump Village and Thwaites Terrace indicate that the Tax

Court, at least, is convinced that housing cooperatives are covered

by Subchapter T and are not subject to Code sec. 277.

Rural Electric Cooperatives

In a 1991 letter ruling, the IRS applied Code sec. 277 to a

"nonexempt" rural electric cooperative. The cooperative had 241

surrendered its exempt status under § 501(c)(12) when it entered

into a safe-harbor lease agreement to finance a new power plant.

Under the contract, the cooperative sold the power plant to a third

party for a down payment and a note. It then leased back the plant.

The cooperative filed a tax return claiming Code sec. 277

status and asserting that both the interest and rent were from

nonmember transactions. The co-op sold electricity to member
 Announcement 96-24, 1996-16 I.R.B. 30, 45. 242

 I.R.C. § 1381(a)(2)(c).

243

 Buckeye Power, Inc. v. United States, 38 Fed.Cl. 154 (1997). 244

 Tech. Adv. Mem. 9124004 (March 13, 1991).

245

102

 distribution cooperatives on a cooperative basis and nonmembers

on a for-profit basis.

IRS surprised the cooperative when, on audit, it took the

position that the "phantom" rent it paid had to be allocated

between member and nonmember income based on their relative

purchases of electricity. This reduced its "nonmember" expenses,

creating excess "nonmember" income which, under Code sec. 277,

could not be offset by the "member" portion of the rental expense.

Only after the agent challenged its treatment of the "phantom"

rent did the cooperative argue it was not subject to Code sec. 277.

In the letter ruling, the IRS national office affirmed the agent's

position on both the applicability of Code sec. 277 and the

treatment of the interest.

In 1996, the Service released proposed examination guidelines

for rural electric cooperatives. They included a statement that

nonexempt electric cooperatives are subject to Code sec. 277.242

As all rural electric and telephone cooperatives are expressly

excluded from Subchapter T coverage, they aren't specifically 243

covered by the cases holding Subchapter T takes precedence over

Code sec. 277. One case before the Court of Federal Claims might

have settled the issue. However, the court rejected the Service's

position that the cooperative was not entitled to exempt status

under Code sec. 501(c)(12). As a tax-exempt organization, 244

Buckeye Power was automatically excluded from the scope of

Code sec. 277 and the court never raised the issue in its opinion.

Farm Credit System Institutions

The Service also issued a letter ruling expressing the view that

Code sec. 277 applied to production credit associations, and that

as a result member losses could not be carried back.245
 Farm Credit Services of Northwest North Dakota, ACA, v. 246

Commissioner, 70 T.C.M. (CCH) 655 (1995).

Id. at 663.

247

103

This position was also rejected by the Tax Court. The 246

association attempted to carryback a net operating loss to offset

otherwise taxable income in previous years. IRS denied the loss

carryback on the basis that the association was subject to Code

sec. 277. The parties stipulated that the association was not a

Subchapter T cooperative (many such associations don't have a

pre-existing legal obligation to return earnings to patrons), so the

cases holding that a Subchapter T cooperative is not covered by

Code sec. 277 weren't applicable.

The court examined the purpose of Code sec. 277 and the

activities of the production credit association and concluded the

association "was not a membership organization for purposes of

section 277." The court found that all persons who did business 247

with the association were treated alike, so there was no use of

member losses to offset nonmember income. Furthermore,

everyone who applied for a loan was a nonmember and once the

loan was approved, they became members. Also, the losses

resulted from certain borrowers not making enough money

farming to repay them, not because members were given

preferential treatment over nonmembers. The court determined it

was improper to broaden the scope of Code sec. 277 to cover this

situation.

While the IRS may continue to raise the Code sec. 277 issue

in a cooperative context in the future, substantial precedent exists

to indicate it will be a difficult position to defend.
104