INCOME TAX TREATMENT OF

COOPERATIVES: Internal Revenue Code

Section 521

Cooperative Information Report 44, Part 4

2005 Edition

Donald A. Frederick
Abstract

INCOME TAX TREATMENT OF COOPERATIVES:

Internal Revenue Code Section 521

2005 Edition

Donald A. Frederick

Program Leader, Law, Policy & Governance

Cooperative tax rules are a logical combination of the unique

attributes of a cooperative and the income tax scheme in the

Internal Revenue Code. The single tax principle is applied to

earnings from business conducted on a cooperative basis in

recognition of the unique relationship between the members and

their cooperative associations. Cooperatives have been granted

a certain degree of flexibility in their financial and tax planning

and should exercise their options effectively to maximize benefits

for members.

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

retain, tax

Cooperative Information Report 44, Part 4

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

Agricultural marketing and supply cooperatives that have met

certain prescribed organizational and operational standards have

long enjoyed a special status under Federal income tax law. Until

1951, qualifying farmer cooperatives were truly exempt

organizations. Since then, they have been subject to income

taxation but able to take advantage of two deductions not

available to other cooperatives. They can deduct a limited

amount of dividends paid on capital stock and distributions of

nonpatronage income made to patrons on a patronage basis.

The rules to qualify for these deductions are found in Internal

Revenue Code section 521. As with any special tax status, the

prerequisites to use of section 521 are strictly construed against

the taxpayer. Restrictive rulings by the Internal Revenue Service

(IRS), when upheld by the courts, have made it increasingly

difficult for cooperatives to qualify for section 521 status. Even

otherwise eligible cooperatives may voluntarily relinquish section

521 status when the cost of compliance exceeds the benefits of

taking the two special deductions.

Although use of section 521 has fallen off in recent years,

special rules tied to it may make section 521 status appealing in

certain situations. For example, a limited exemption from Federal

securities regulation is attracting the attention of marketing

cooperatives that allow the transfer of delivery rights at more than

their original cost.
4

Highlights

This report contains two chapters in USDA's series on

Federal income taxation of cooperatives. Chapter 11 discusses

the requirements to attain section 521 status. Chapter 12

reviews the special tax deductions available to these cooperatives

and other tax and securities law treatments related to section 521

status.

Section 521 tax treatment reflects the Government’s intention

to support agriculture. A statutory exemption for qualifying farmer

cooperatives was enacted in the Revenue Act of 1916. Although

true exempt status was terminated in 1951, these associations

have access to deductions not available to other cooperatives or

noncooperative corporations. They may deduct (1) dividends

paid on capital stock and (2) distributions of nonpatronage

income to patrons made on a patronage basis.

Not all farmer cooperatives qualify for this tax treatment.

Section 521 status is only available to farmer cooperatives that

meet these organizational and operational tests:

1. Their primary activity must be to market the products of

members and other producers and/or purchase supplies and

other equipment for members and other persons.

2. They must pay patronage refunds to all patrons (members

and nonmembers alike) on the same basis.

3. Dividends on capital stock may not exceed the legal rate

of interest in the State of incorporation or 8 percent per year,

figured on the value of the consideration for which the stock was

issued, whichever is greater.

4. Substantially all voting stock (at least 85 percent) must be

owned by producers who have used the cooperative's services

during the past tax year.

5. Reserves must be required by State law or for a necessary

purpose.

6. The value of products marketed for members must exceed

that of products marketed for nonmembers.

7. The value of supplies and equipment sold to members

must exceed that of such products sold to nonmembers. Also,

the value of supplies and equipment sold to persons who are
5

neither members nor producers can't exceed 15 percent of the

cooperative's total sales of supplies and equipment.

8. In the event of dissolution, assets remaining after debts

are paid and equity redeemed must be paid to all patrons

(member and nonmember alike) on the basis of patronage.

To qualify for section 521 status, a farmer cooperative must

comply with all of these requirements. A cooperative with a

marketing and a farm supply function must meet these tests for

both.

While any corporation can claim general cooperative tax

treatment on its tax return, section 521 status must be applied for

and granted by IRS. The burden is on the cooperative to show

continuous compliance with the requirements. IRS may revoke

section 521 status at any time, retroactive to the time the

cooperative first failed to meet all of the prerequisites.

Other important tax and business issues are related to section

521. These cooperatives are eligible for limited additional tax

breaks. One benefit important to certain cooperatives is an

exemption from the registration and prospectus requirements of

the Securities Act of 1933 available only to section 521

cooperatives. Associations that promote agricultural interests

may qualify for true tax exempt status under Code section

501(c)(5). The Code also contains several other sections

providing special tax treatment for cooperatives that serve

farmers but are not eligible for section 521 status.
6

Contents

Page

Chapter 11. Section 521 Requirements . . . . . . . . . . . . . . 9

Underlying Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Requirements for Section 521 Status . . . . . . . . . . . . . . . . . 13

Farmers' Cooperative Described . . . . . . . . . . . . . . . . . . . . . 14

Statutory and Administrative Definitions . . . . . . . . . . . . 14

Like Associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Marketing for Members and Other Producers . . . . . . . . . . . 20

Marketing Described . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Value-Added Processing . . . . . . . . . . . . . . . . . . . . . 23

Biological v. Manufacturing Processing . . . . . . . . . . 24

Member Described . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Producer Described . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Landlords and Tenants . . . . . . . . . . . . . . . . . . . . . . 29

Purchaser-Reseller . . . . . . . . . . . . . . . . . . . . . . . . . 31

Agency Relationship . . . . . . . . . . . . . . . . . . . . . . . . 32

Multiple Owners . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

De Minimis Nonproducer Activity . . . . . . . . . . . . . . . 33

Exceptions Permitting Nonproducer Business . . . . . . . . 34

Emergency Purchases . . . . . . . . . . . . . . . . . . . . . . 35

Ingredient Purchases . . . . . . . . . . . . . . . . . . . . . . . . 37

Incidental Purchases . . . . . . . . . . . . . . . . . . . . . . . . 37

Necessary Marketing Expenses . . . . . . . . . . . . . . . . . . 43

Purchasing for Members and Other Persons . . . . . . . . . . . 44

Manufacturing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Household Items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7

Limits on Nonmember, Nonproducer Business . . . . . . . . . . 46

Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

Purchasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

Exchanges of Like Items and Disposition

 of Byproducts... . . . . . . . . . . . . . . . . . . . . . . . . 49

Use of Agents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

United States Government Business . . . . . . . . . . . . . . . . . . 52

Organizations Having Capital Stock . . . . . . . . . . . . . . . . . . 53

Limit on Stock Dividends . . . . . . . . . . . . . . . . . . . . . . . . 54

Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

Valuing Consideration . . . . . . . . . . . . . . . . . . . . . . . 55

Substantially All Test . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

The Current Patronage Requirement . . . . . . . . . . . 59

The 85 Percent Rule . . . . . . . . . . . . . . . . . . . . . . . . 61

The "Ability to Vote at the Next

 Annual Meeting" Test . . . . . . . . . . . . . . . . . . . . . 62

The Aborted 50-Percent-Current-Patronage Rule . . 66

Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Nonvoting Preferred Stock . . . . . . . . . . . . . . . . . . . . . . 72

Treating Members and Nonmembers Equally . . . . . . . . . . . 73

The General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

Dual-Function Cooperatives . . . . . . . . . . . . . . . . . . . . . 78

Nonpatronage Income . . . . . . . . . . . . . . . . . . . . . . . 80

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Exceptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Membership Investments and Fees . . . . . . . . . . . . . 82

Consent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

Small Refunds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

Returns on Nonqualified Allocations . . . . . . . . . . . . 84

Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
8

Other Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

Distributions Upon Dissolution . . . . . . . . . . . . . . . . . . . . 86

Federated Cooperatives and "Look Through" . . . . . . . . 87

Subsidiaries... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Access to Declaratory Judgments . . . . . . . . . . . . . . . . . 95

Chapter 12. Section 521 Tax Treatment . . . . . . . . . . . . . 97

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

Subject to Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Deduction for Dividends Paid on Capital Stock . . . . . . 100

Deduction for Patronage-Based Allocations

 of Nonpatronage Sourced Income . . . . . . . . . . . . . . 102

Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

U.S. Government Business . . . . . . . . . . . . . . . . . . 104

Other Nonpatronage Income . . . . . . . . . . . . . . . . 104

Paid on a Patronage Basis . . . . . . . . . . . . . . . . . . 105

Allocation Year . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

Capital Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

The Refund Payment . . . . . . . . . . . . . . . . . . . . . . . 107

Redemption of Nonqualified Written Notices

 of Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

Administrative Procedures . . . . . . . . . . . . . . . . . . . . . . . . 108

Obtaining Section 521 Status . . . . . . . . . . . . . . . . . . . 109

Maintaining 521 Status . . . . . . . . . . . . . . . . . . . . . . . . 110

Record Keeping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

Loss of Section 521 Status . . . . . . . . . . . . . . . . . . . . . 112

Other Issues Concerning Section 521 Status . . . . . . . . . . 113

Other Tax Consequences . . . . . . . . . . . . . . . . . . . . . . 113

Securities Law Consequences . . . . . . . . . . . . . . . . . . 114

Tax Exempt Agricultural Associations . . . . . . . . . . . . . 115

Other Cooperative Tax Exemptions . . . . . . . . . . . . . . . 120
 I.R.C. § 521. 2

 I.R.C. § 1382(c)(1). 3

 I.R.C. § 1382(c)(2). 4

See, Farmers Cooperative Co. v. Commissioner, 85 T.C. 601, 602, 5

(note 3) (1985); Union Equity Cooperative Exchange v. Commissioner,

58 T.C. 397, 408-411 (1972), aff’d, 481 F.2d 812 (10th Cir. 1973), cert.

denied, 414 U.S. 1028 (1973).

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 6

Background, RBS Cooperative Information Report 44, Part 1 (USDA,

2005), pp. 105-118.

9

CHAPTER 11

SECTION 521 REQUIREMENTS

Farmer cooperatives meeting organizational and operational

requirements detailed in Internal Revenue Code (Code) section

521 are given two special deductions in addition to those 2

subchapter T affords all corporations operating on a cooperative

basis. Section 521 cooperatives may deduct dividends paid on

capital stock and patronage-based distributions of nonpatronage 3

income.4

While the Code refers to qualifying cooperatives as "exempt,"

this is a misnomer. Section 521 cooperatives must generally

follow the rules and pay the same taxes applicable to other

cooperatives, except for the two special deductions. Because

5

these cooperatives are not truly "exempt," the term is avoided in

these reports.

A discussion of the legislative and regulatory history leading

to current Code section 521 is provided in Chapter 3. A review 6

of that material might be useful in understanding Chapters 11 and

12.

Section 521 has two parts. Section 521(a) provides that a

farmers' cooperative described in section 521(b)(1) shall be

exempt from taxation except as otherwise provided in part I of
 Most notably I.R.C. § 1382(c).

7

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 8

Background, RBS Cooperative Information Report 44, Part 1 (USDA

2005), pp. 113-116.

10

Subchapter T and shall be considered an organization exempt from

income taxes for purposes of any other law which refers to taxexempt organizations.

Subsection 521(b) contains the organizational and operational

rules a cooperative must meet to be eligible for section 521 status.

Requirements for section 521 tax treatment are strict, and unless

each is satisfied a cooperative may not be a "section 521"

cooperative. This chapter explains each of these tests.

While any corporation can claim subchapter T status when

filing its tax return, prior approval of the Internal Revenue Service

(IRS or the Service) is necessary to claim the benefits of section

521. Chapter 12 explains the procedural requirements of applying

for and maintaining section 521 status.

The tax rules specifically applicable to section 521

cooperatives are found in subchapter T. These are also covered

7

in Chapter 12.

UNDERLYING POLICY

This special tax treatment is only available to farmer

cooperatives. As indicated in Chapter 3, a statutory exemption for

farmer cooperatives dates back to the Revenue Act of 1916. The

current rules have remained virtually unchanged since the Revenue

Act of 1926.8

Prior to and during the Depression, farmers were under severe

economic pressure. The farmer cooperative movement was

enjoying a period of rapid growth. Farmers turned to cooperatives

as a means of survival. Congress was sympathetic to the farmers'

plight and strong public policy support existed for their
 Co-operative Grain & Supply Co. v. Commissioner, 407 F.2d 9

1158, 1162-63 (8th Cir. 1969), rev'g 26 T.C.M. 593 (1967).

11

cooperatives. As the court explained in Co-operative Grain &

Supply Co. v. Commissioner:

The history of the development of farm cooperatives

shows that they were organized primarily for the purpose

of helping individual farmers to better their bargaining

position in the sale of their products and the purchase of

their supplies (citations omitted). In granting favorable tax

treatment to certain farmer cooperatives Congress

recognized their contribution to the agricultural

community. Justification for bestowing upon them tax

exempt status is based upon the policy that a strong and

prosperous agriculture is necessary for the national welfare

(citations omitted).9

Randolph Paul, in an article published shortly after he

completed service as General Counsel to the Treasury and tax

adviser to the Secretary of the Treasury, discussed several reasons

justifying limited special treatment of certain farmer cooperatives.

These included:

1. The national welfare depends on a strong and prosperous

agriculture.

2. Individual farmers are at a great economic disadvantage

when negotiating with buyers of farm products. Cooperatives help

balance the marketplace.

3. Farmers have a limited ability to supply capital to their

cooperative at any one time. The exemption helps cooperatives to

build capital over time.

4. The exemption is strictly limited and narrowly circumscribed.

5. The benefit to farmers is much larger than the harm to

competing for-profit organizations.
 Randolph E. Paul, The Justifiability of the Policy of Exempting 10

Farmers' Marketing and Purchasing Cooperative Organizations from

Federal Income Taxes, 29 Minn. L. Rev. 343 (1945). At the time this

article was written, farmer cooperatives meeting the tests currently

codified in I.R.C. § 521(b) were totally exempt from Federal income

taxation. The benefit of "exempt" status was reduced in 1951 when the

exemption was replaced with the deductions for stock dividends and

nonpatronage income distributed on a patronage basis.

 Treas. Reg. § 1.521-1(c).

11

Rev. Rul. 68-496, 1968-2 C.B. 251. See also Fruit Growers' 12

Supply Co. v. Commissioner, 56 F.2d 90, 91 (9th Cir. 1932), aff'g 21

B.T.A. 315 (1930).

 The importance of properly written documents is seen throughout 13

this report. Any cooperative wishing to qualify for section 521 should

review all relevant documents carefully.

12

6. The earnings are taxable income to the farmer-patrons, so

they don't escape taxation.10

So the fact that section 521 tax treatment is limited to certain

agricultural cooperatives reflects the desire of Congress to help

farmers. It is based on economic and social concerns, not strictly

tax policy.

An organization must satisfy a number of requirements to

qualify as a section 521 cooperative. Qualification is judged by

actual operation. The applicable TreasuryRegulation (regulation)

states "An association to be entitled to exemption must not only be

organized but actually operated in the manner and for the purposes

specified in section 521."11

The IRS has determined that a cooperative whose articles of

incorporation grant it powers which, if exercised, would disqualify

it, nevertheless retains its section 521 status so long as it meets

qualification criteria in its actual operations. This is not to say 12

that a cooperative's operations will be the sole criteria for section

521 qualification absent any consideration of articles of

incorporation and bylaws.

13
 I.R.C. § 521(b)(1) and Treas. Reg. § 1.521-1(a)(1). 14

 I.R.C. § 521(b)(1)(A) and Treas. Reg. § 1.521-1(a)(1). 15

 I.R.C. § 521(b)(1)(B) and Treas. Reg. § 1.521-1(b).

16

 I.R.C. § 521(b)(1) and Treas. Reg. § 1.521-1(a)(1). 17

 I.R.C. § 521(b)(2) and Treas. Reg. § 1.521-1(a)(2). 18

 I.R.C. § 521(b)(2) and Treas. Reg. § 1.521-1(a)(2). 19

 I.R.C. § 521(b)(3) and Treas. Reg. § 1.521-1(a)(3). 20

 I.R.C. § 521(b)(4) and Treas. Reg. §§ 1.521-1(a)(3) and 1.521- 21

1(b).

13

REQUIREMENTS FOR SECTION 521 STATUS

Code sections 521(b)(1)-(4) contain several rules an organization must comply with to qualify for the special deductions

accorded section 521 cooperatives:

1. The organization must be a farmers' cooperative.14

2. It must market the products of members and other producers or purchase supplies and other equipment for members and 15

other persons.16

3. Margins must be returned to all patrons (members and

nonmembers alike) on a patronage basis.

17

4. Dividends on capital stock may not exceed the legal rate of

interest in the State of incorporation or 8 percent per year,

whichever is greater.18

5. Substantially all (85 percent) voting stock must be owned

by producers who use the cooperative's services.19

6. Reserves must be required by State law or for a necessary

purpose.20

7. The value of marketing and purchasing transactions with

members must exceed that of such transactions with nonmembers.

Also, purchasing for persons who are neither members nor

producers can't exceed 15 percent of total purchasing activity.21
 I.R.C. § 521(b)(1).

22

 Treas. Reg. § 1.521-1(a)(1) (marketing associations) and § 1.521- 23

1(b) (supply associations). Regulations implementing I.R.C. § 521 were

issued as T.D. 6301, 1958-2 C.B. 197, 242-245 and amended to reflect

changes made by the Revenue Act of 1962 by T.D. 6643, 1963-1 C.B.

148, 168-169.

 Treas. Reg. § 1.521-1(d).

24

14

A cooperative must comply with each of these rules to qualify

for section 521 status. The first part of this report explains how

the IRS and the courts have interpreted them.

FARMERS' COOPERATIVE DESCRIBED

The first requirement for a cooperative to qualify for section

521 tax treatment is that its members be engaged in farming. The

Code states that the only entities eligible for section 521 status are

"farmers’, fruit growers', or like associations organized and

operated on a cooperative basis...."22

Statutory and Administrative Definitions

Neither Code section 521 nor the applicable regulations define

"farmer." The only example mentioned in Code section 521 is a

fruit grower. The section 521 regulations expand the list of

examples to include livestock growers and dairymen. The 23

regulations also state "cooperative organizations engaged in

occupations dissimilar from those of farmers, fruit growers, and

the like, are not exempt."24

However, other regulations offer guidance as to the meaning

of "farmer" in a tax context. The Service has referred to these

definitions in limiting section 521 status to associations of

traditional farmers.
 Treas. Reg. § 1.61-4(d), cited in Rev. Rul. 73-570, 1973-2 C.B. 25

195 and Rev. Rul. 84-81, 1984-1 C.B. 135.

 Treas. Reg. § 1.175-3, cited in Rev. Rul. 73-570, 1973-2 C.B. 195 26

and Rev. Rul. 84-81, 1984-1 C.B. 135. Most of this regulatory language

was published in T.D. 6235, 1957-1 C.B. 98, 101. References to fish

farming were added by T.D. 6649, 1963-1 C.B. 49. An even more

extensive list of examples of agricultural activities is found in the

regulatory definition of "land used in farming" in Treas. Reg. § 1.175-4.

Treas. Reg. § 1.180-1, cited in Rev. Rul. 84-81, 1984-1 C.B. 135. 27

See also I.R.C. § 464(e)(1) for a similar definition of "farming,"

likewise cited in Rev. Rul. 84-81.

15

Code section 61 provides the general definition of gross

income. Under regulations associated with that section, a farm 25

is defined in the ordinarily accepted sense and includes livestock,

dairy, poultry, fruit, and truck farms, as well as plantations and

ranches. These regulations refer to those interpreting Code section

175 for more detailed rules to apply to determine whether an

activity is farming.

Code section 175 provides for the deduction of soil and water

conservation expenditures by a taxpayer engaged in the business

of farming. Associated regulations state "the term 'farm' is used in

its ordinary, accepted sense and includes stock, dairy, poultry, fish,

fruit, and truck farms, and also plantations, ranches, ranges, and

orchards."26

Section 180 of the Code provides for deduction of

expenditures by farmers for fertilizer. The regulations state "land

used in farming" means land used "for the production of crops,

fruits, or other agricultural products or for the sustenance of

livestock....The principles stated in §§ 1.175-3 and 1.175-4 are

equally applicable under this section in determining whether the

taxpayer is engaged in the business of farming...."27

Fishermen. Fishermen use cooperatives for marketing,

supply, and service purposes. IRS has stated that whether

fishermen qualify as farmers for section 521 purposes depends

upon how the fish are grown. Raising fish on privately owned
 Rev. Rul. 55-611, 1955-2 C.B. 270. Similarly, an organization 28

formed to promote the commercial fishing industry cannot qualify for

exempt status under I.R.C. § 501(c)(5) applying to agricultural

organizations. Rev. Rul. 75-287, 1975-2 C.B. 211, citing Rev. Rul.

55-611.

 Rev. Rul. 64-246, 1964-2 C.B. 154. The production of fish on 29

privately owned fish farms is also an agricultural activity under I.R.C.

§ 501(c)(5). Rev. Rul. 74-488, 1974-2 C.B. 166.

 Treas. Reg. § 1.175-3. 30

 Rev. Rul. 73-308, 1973-2 C.B. 193; Rev. Rul. 73-570, 1973-2 31

C.B. 194.

16

farms has been found to be an agricultural activity, while

commercial fishing in open waters is not.

A cooperative formed to purchase supplies for marine

fishermen and oyster growers was denied section 521 status, even

though under applicable State law the term "agricultural products"

includes fish and salt water seafood and the cooperative qualifies

as an agricultural cooperative under State law.28

However, an association engaged in cooperatively marketing

fish produced by its members and other patrons in privately owned

waters was found to be eligible for section 521 status. IRS

determined "farm-raised fish" are farm products and distinguished

Revenue Ruling 55-611 on the basis that those persons weren't

raising their fish on farms.29

These decisions are consistent with regulation 1.175-3, which

states "a fish farm is an area where fish are grown and raised, as

opposed to merely caught and harvested; that is, an area where

they are artificially fed, protected, cared for, etc."30

Tree farming. The Service has taken a firm position that

growing timber and other forestry activities are not farming for

section 521 purposes. Access to section 521 was denied

cooperatives engaged in marketing building materials produced by

members and a federated cooperative marketing newsprint and 31

its member cooperatives supplying pulpwood cut from timber
 Rev. Rul. 84-81, 1984-1 C.B. 135. 32

 Treas. Reg. § 1.175-3 provides in part that "A taxpayer engaged 33

in forestry or the growing of timber is not thereby engaged in the

business of farming." This language is incorporated by reference in

Treas. Reg. § 1.180-1(b). See also I.R.C. § 464(e)(1) which states in

part that "trees (other than trees bearing fruits or nuts) shall not be

treated as an agricultural or horticultural commodity." (farming

syndicate).

 Rev. Rul. 67-429, 1967-2 C.B. 218, superseding Gen. Couns. 34

Mem. 22,364, 1941-1 C.B. 296.

 Rev. Rul. 75-5, 1975-1 C.B. 166. 35

 Cooperative Central Exchange v. Commissioner, 27 B.T.A. 17 36

(1932).

 Garden Homes Co. v. Commissioner, 64 F.2d 593, 596 (7th Cir.

37

1933), rev'g 26 B.T.A. 441 (1932).

 National Outdoor Advertising Bureau, Inc. v. Helvering, 89 F.2d 38

878 (2d Cir. 1937).

 Sunset Scavenger Co. v. Commissioner, 84 F.2d 453 (9th Cir.

39

1936).

17

grown on members' land. These rulings draw heavily on 32

regulatory and statutory language stating forestry or the growing

of timber is not a farming activity for tax purposes.33

Grazing. IRS has approved section 521 status for an association of cattle ranchers who leased grazing land cooperatively to

provide feed for their livestock. It also approved a cooperative 34

formed by grazing landownersto market their range grass to cattle

raisers.

35

Other activities not farming. Early cases denied section 521

status to a federated cooperative whose membership included

consumer cooperatives, cooperative publishing houses, and a

cooperative bank; a housing cooperative; a cooperative whose

36 37

members were advertisers who procured billboard space and a 38

garbage collector cooperative.39
 Revenue Act of 1916, ch. 463, § 11(a) Eleventh, 39 Stat. 756, 767 40

(1916).

 I.T. 1312, I-1 C.B. 263 (1922). 41

 Revenue Act of 1926, ch. 27, § 231(12), 44 Stat. 9, 40 (1926).

42

 Garden Homes Co. v. Commissioner, 64 F.2d 593 (7th Cir. 1933).

43

 Sunset Scavenger Co. v. Commissioner, 84 F.2d 453 (9th Cir.

44

1936).

18

Thus "farmers" as used in section 521 has the traditional

meaning. It encompasses persons who raise food and fiber from

the soil and tend to animals.

Like Associations

The phrase "farmers', fruit growers', or like association(s)" has

continuously been used to describe "exempt" farmer cooperatives

since the Revenue Act of 1916.40

In 1922, the Treasury Department said: "In framing the Statute,

Congress appears to have had in mind agricultural, fruit growing,

and similar occupations. Under the doctrine of ejusdem generis

the term 'like association'should be confined to pursuits similar to

farming and fruit growing."41

The current language "farmer', fruit growers' and like

associations organized and operated on a cooperative basis..." was

enacted as part of the Revenue Act of 1926. Certain nonfarmer 42

cooperatives have sought to have the courts expand the scope of

"like associations" to include all cooperatives, not just farmer

associations. They have been unsuccessful.

In Garden Homes Co. v. Commissioner, the court relied on 43

I.T. 1312 to deny "exempt" status to a housing corporation that

leased dwellings to tenant stockholders. Another U.S. Circuit

Court of Appeals similarly rejected "exempt" status for a

cooperative of garbage collectors.44
 Rev. Rul. 73-308, 1973-2 C.B. 193. 45

Id. at 194.

46

 Treas. Reg. § 1.521-1(d).

47

 Section 521 is more restrictive in its application than subchapter 48

T. Regular cooperative tax treatment is available to section 521

cooperatives and to any other corporation operating on a cooperative

basis (with certain listed exceptions). I.R.C. § 1381(a). Thus,

disqualification from access to section 521 does not deny a taxpayer

single tax treatment as a cooperative. It only deprives a firm of the

additional deductions for stock dividends and nonpatronage income

19

Revenue Ruling 73-308 concerned an organization marketing 45

building materials on a cooperative basis. After quoting Code

section 521(b)(1), the Service said:

It is a well recognized rule of statutory construction

that where general words follow the enumeration of

particular classes of persons or things, the general words

will be construed as applicable only to persons or things of

the same general nature or class of those specifically

enumerated. Applying this rule to the statute under

consideration, it follows that the term 'like association' by

reason of its association with the word 'farmers' and 'fruit

growers' must be modified and limited by those words. In

harmony with this rule of statutory construction, it is

evident that section 521 of the Code and its predecessors

were designed to exempt from Federal income tax

cooperative organizations organized and operated for the

purpose of marketing the products of farmers, fruit

growers, or other engaged in like occupations."46

IRS then noted section 1.521-1(d) of the regulations provides

that "cooperative organizations engaged in occupations dissimilar

from those of farmers, fruit growers, and the like, are not

exempt." IRS denied section 521 status but indicated it might 47

qualify as a cooperative for Subchapter T purposes.48
distributed on a patronage basis that are only available to section 521's.

 Rev. Rul. 73-570, 1973-2 C.B. 194. 49

 Treas. Reg. § 1.61-4(d).

50

 Treas. Reg. § 1.175-3. 51

 I.R.C. § 521(b)(1)(A) and Treas. Reg. § 1.521-1(a)(1). 52

20

Shortly thereafter, Treasury issued another Revenue Ruling

updating and restating I.T. 1312 to reflect current statutes and

regulations. Using the example of a cooperative formed to sell 49

the products of independent lumber producing companies, it again

determined that "like association" means similar to farming and

fruit growing. It cited section 1.61-4(d) of the regulations as

defining "'farm' in the ordinarily accepted sense" (examples

omitted) and section 1.175-3, which states "a taxpayer engaged 50

in forestry or the growing of timber is not thereby engaged in the

business of farming."51

In summary, "like associations" means farmer associations, not

all cooperative associations. Thus, only farmer cooperatives can

qualify for section 521 tax treatment.

MARKETING FOR MEMBERS AND

OTHER PRODUCERS

To qualify for section 521 tax status, a farmers' cooperative

must be engaged in one of two specific activities. The first is

"marketing the products of members and other producers, and

turning back to them the proceeds of sale, less the necessary

marketing expenses, on the basis of either the quantity or the value

of the products furnished by them...."52

Questions have arisen as to the meaning of "marketing,"

"member," and "producer," and over the proper expenses to deduct

from sales proceeds.
 Rev. Rul. 66-108, 1966-1 C.B. 154. 53

Id.

54

21

Marketing Described

The Service discussed the meaning of "marketing" in Revenue

Ruling 66-108. This ruling involved the section 521 eligibility

53

of a cooperative organized and operated solely to maintain and

care for its patrons' orchards and to harvest their crops. In determining whether such activity constituted marketing, the Service

said:

The term "marketing" as used in section 521(b)(1) of

the Code includes the sale of farm products by a farmers'

cooperative for its patrons and other activities necessary in

the sale of such products, such as processing, packing,

shipping, etc. Grove caretaking and harvesting are farming

activities, but they do not involve the sale or the processing

for sale of agricultural products. Therefore, they do not

constitute "marketing" as that term is used in section 521

of the Code.54

While the cooperative did not receive the desired determination in Revenue Ruling 66-108, other cooperatives have been

more successful byestablishing a direct relationship between their

activity and "marketing" as defined in that ruling. In Revenue

Ruling 67-430 the Service found a cooperative formed to operate

a farmers' market was qualified for section 521 status. IRS said:

Revenue Ruling 66-108 (cite omitted) defines

"marketing" as used in section 521 of the Code to include

not only the sale of farm products by a farmers'

cooperative for its patrons but other activity necessary to

the sale of such products. This definition is broad enough

to include all activities which are an integral part of the
 Rev. Rul. 67-430, 1967-2 C.B. 220, supersedes I.T. 2720, XII-2 55

C.B. 71 (1933).

 Tech. Adv. Mem. 8705091 (Nov. 7, 1986).

56

 Rev. Rul. 71-100, 1971-1 C.B. 159. 57

22

marketing function. Therefore, a cooperative may be

exempt under section 521 of the code without actually

handling the sale of a product.55

While the Service has stated that "'marketing' includes all

activities that are integral to the marketing function," other 56

rulings illustrate the need to establish the direct connection to

marketing. Revenue Ruling 71-100 involved a cooperative that

57

marketed grain for a number of years. Then, it leased its elevator

and other equipment to a noncooperative corporation. The

members began selling their grain to the lessee and the

cooperative's sole source of income became rental payments from

the lessee. While the members benefitted by receiving higher

prices for their grain and patronage refunds from the rental based

on grain delivered to the lessee, IRS still denied section 521 status

to the cooperative. It said the cooperative was actually engaged in

a rental operation and did not market the products of its members

or other producers as contemplated by Code section 521.

In another instance, a section 521 marketing cooperative was

establishing a commodity trading division to serve as a commodity

broker and to facilitate hedging transactions for it marketing

patrons. The cooperative showed this new service would enable

patrons to obtain higher prices and more secure profits from their

farming operations. IRS, in finding the activity did not jeopardize

this cooperative's 521 status, said:

The proposed hedging transactions do not, in and of

themselves, constitute marketing since the vast majority of

hedging transactions are not intended to be consummated
 Rev. Rul. 76-298, 1976 C.B. 180. The Service noted the proposed 58

hedging would be done exclusively with current and active patrons.

 Treas. Reg. § 1.521-1(a)(1). 59

 Rev. Rul. 77-384, 1977-2 C.B. 198, restating Mim. 3886, X-2 60

C.B. 164 (1931).

 Rev. Rul. 81-96, 1981-1 C.B. 360. See also, Tech. Adv. Mem. 61

8705091 (Nov. 7, 1986) (“‘Marketing’ as used in section 521(b)(1)

includes activities necessary to the sale of producers’ products, such as

processing, packing, and shipping of these products.”)

23

by delivery. However, hedging may be an activity that is

incidental to the marketing function of the taxpayer. It is

a method of guaranteeing that the producer will be

protected from downward price shifts in the case of

products that are marketed through the taxpayer.58

Value-Added Processing

IRS has also acknowledged that value-added processing is part

of "marketing" for section 521 purposes. The applicable regulations begin with a statement that “...cooperative dairy companies

which are engaged in collecting milk and disposing of it or the

products thereof...” and returning margins to patrons on the basis

of patronage are eligible for section 521 tax status (emphasis

added).

59

Revenue Ruling 77-384 refers to the Service’s "long standing

position of allowing associations, in connection with their

marketing function, to manufacture or to otherwise change the

basic form of their members' products." In Revenue Ruling 77- 60

384, IRS said both the canning and drying activities of a fruit

marketing association and the textile mill activity of a cotton

marketing cooperative are permissible under section 521. IRS has

also stated that a cooperative that processes its members'

agricultural products into alcohol meets the requirements of

section 521.61

In 1969, Congress briefly considered eliminating single tax

treatment of cooperative earning generated by value-adding
 115 Cong. Rec. 37056-37062 (1969).

62

 115 Cong. Rec. 37057 (1969). 63

 115 Cong. Rec. 37058 (1969). 64

 115 Cong. Rec. 37064 (1969). 65

24

activity. During debate on the Tax Reform Act of 1969, Senator 62

Abraham Ribicoff introduced an amendment to Code sec. 1382

that would have limited the patronage refund deduction to earnings

from what he described as activities “directly related” to “the basic

agency activities of marketing and purchasing.”63

Senator Ribicoff seemed at least as concerned about

cooperatives manufacturing farm supplies as he was adding value

to products they marketed. On the marketing side, he indicated

that under his amendment cooperatives could deduct earnings

from making frozen concentrated fruit juice, baling cotton, and

canning peaches, but not from the manufacture of the can or box.

 On the supply side, cooperatives would be able to continue to

deduct earnings from reselling fertilizer and petroleum products

they bought in bulk but not earnings realized on manufacturing

fertilizer or drilling for and refining crude oil. The Ribicoff 64

amendment was rejected on a vote of 81-11.65

Biological v. Manufacturing Processing

In the mid-1990s, IRS began challenging certain requests for

determination letters approving a cooperative’s access to section

521 tax status. These associations were organizing by growers of

basic commodities to increase their income. Their plan was to add

value to the grain they produced by feeding it to animals owned on

a cooperative basis and selling livestock and livestock products.

The challenged marketing plans included feeding corn to hogs and

marketing the hogs, feeding soybeans to tilapia (a fish) and

marketing the fish, and feeding corn to hens and marketing both

eggs and chicken.

The Service took the position that producers were not using

these associations to market grain they produced, but rather to
 Rev. Rul. 75-5, 1975-1 C.B. 166. 66

See, e.g., S. 2498, 105th Cong., 2d Sess. § 1 (1998); H.R. 1469, 67

106th Cong., 1st Sess. § 1 (1999); S. 312, 107th Cong., 1st Sess. § 9

(2001); H.R. 2347, 107th Cong., 1st Sess. § 9 (2001); S. 665, 108th

Cong., 1st Sess. § 9 (2003); S. 1637, 108th Cong, 1st Sess. § 307

(2003).

 American Jobs Creation Act of 2004, § 316, Pub. L. No. 108-357, 68

118 Stat. 1469 (codified at 26 U.S.C. § 1388(k)). See also, H.R. Conf.

Rept. No. 755, 108th Cong., 2nd Sess. at 362.

25

market a totally different agricultural product. IRS said that

feeding a commodity to an animal involved a biological process,

as opposed to a mechanical process, and would not be considered

processing for purposes of section 521.

Cooperatives responded that, for tax purposes, this is no

different than changing corn to ethanol or cotton to cloth.

Cooperatives relied particularly on Revenue Ruling 75-5, in which

the Service had found that a farmers’ cooperative formed to

produce and market range grasses by grazing its own herd of

breeder cattle on the land qualifies for section 521 tax status.

66

Cooperatives decided to seek a legislative clarification of the

issue. Several bills introduced in successive Congresses, beginning in 1998, included a provision to make it clear that for

purposes of section 521, the marketing of the products of members

or other producers shall include feeding such products to animals

and selling the resulting animals or animal products.67

In 2004, cooperatives achieved their objective. The American

Jobs Creation Act of 2004 created a new I.R. Code subsection

1388(k). It provides that marketing products of members or other

producers includes feeding those products to cattle, hogs, fish,

chickens, or other animals and selling the resulting animals or

animal products.68
 Treas. Reg. § 1.521-1(a)(3). 69

See infra pp. 57-71. 70

 I.R.C. § 521(b)(1)(A). 71

 Revenue Act of 1926, ch. 27, § 231(12), 44 Stat. 9, 40-41 (1926), 72

noted in Tech. Adv. Mem. 8048018 (Aug. 27, 1980).

 S. Rep. No. 52, 69 Cong., 1st. Sess. 23, 24 (1926):

73

 The existing law, strictly construed, allows exemption

only to those farmers', fruit-growers', or like associations

which act as sales or purchasing agents for producer

members which return to such members the entire proceeds

of their operations, except necessary sales or purchasing

expenses. However, in order that any such association, not

operated for profit, and which is a true cooperative

association, shall get the benefit of this exemption, the

26

Member Described

The regulations say, "Anyone who shares in the profits of a

farmers' cooperative marketing association, and is entitled to

participate in the management of the association, must be regarded

as a member of such association within the meaning of section

521."69

Thus a member is, generally, someone who receives a payment

out of cooperative earnings and has a vote at membership

meetings. Member status hasn't been an issue in interpreting

eligibility in Code section 521(b)(1). However, it has been

contentious in applying the "substantially all" test in Code section

521(b)(2). A detailed description of membership in that context

is provided later in this report.

70

Producer Described

Code section 521 states a qualifying cooperative may engage

in marketing the farm products of "members or other producers."71

The term "or other producers" was added by the Revenue Act of

1926 following prior administrative practice.

72 73
Treasury Department in its regulations has construed the

existing law with great liberality, enlarging the term

"member" to mean any producer whether or not a member,

...

 The committee amendment exempts not only

associations acting as sales or purchasing agents but any

association organized and operated on a cooperative basis,

and specifically includes other producers as well as

member producers.

 Limited exceptions to this rule are explained in a subsequent 74

section of this report, pp. 27-38.

 Dr. P. Phillips Cooperative v. Commissioner, 17 T.C. 1002 75

(1951); Farmers Cooperative Creamery Ass'n of Cresco, Iowa v. United

States, 1981-1 U.S.T.C. (CCH) ¶ 9457 (N.D. Iowa 1981); Land

O'Lakes, Inc. v. United States, 514 F.2d 134 (8th Cir. 1975), cert.

denied, 423 U.S. 926 (1975), rev'g 362 F. Supp. 1253 (D. Minn. 1973);

Rev. Rul. 69-222, 1969-1 C.B. 161; Rev. Rul. 75-4, 1975-1 C.B. 165;

Tech. Adv. Mem. 8025168 (March 27, 1980); and Tech. Adv. Mem.

8047006 (July 29, 1980).

27

The phrase "member or other producers" means all products

marketed by a section 521 cooperative must be provided by the

farmer producer of that product. A marketing cooperative 74

generally will not qualify for section 521 if it markets goods for a

nonproducer, even when that nonproducer is a member. After it

75

is established that the product being produced and handled by the

cooperative is a farm product, it is still necessary to be sure the

cooperative patrons (members and nonmembers) are producers of

that product.

Revenue Ruling 67-422 provides that:

...a person is a producer if, as an owner or tenant, he

bears the risks of production, cultivates, operates, or

manages a farm for gain or profit--in short, if he is engaged

in the trade or business of farming," and a person "who

merely purchases a ripe crop at harvest would not be a pro-
 Rev. Rul. 67-422, 1967-2 C.B. 217, 218. 76

Id. See infra notes 78-79 and accompanying text.

77

 Farmers Cooperative Creamery Association of Cresco, Iowa v. 78

United States, 1981-1 U.S.T.C. (CCH) ¶ 9457 (N.D. Iowa 1981).

Id. at 87,322. 79

 Rev. Rul. 67-422, 1967-2 C.B. 217, 218. 80

 Rev. Rul. 72-589, 1972-2 C.B. 282. 81

28

ducer...since he fails to take the risks and responsibilities

of the owner of a growing crop.76

Examples in Revenue Ruling 67-422 make it clear an outside

occupation unrelated to farming will not disqualify a person as a

producer. Under the right facts, an insurance agent and a

physician can be producers.

77

On the other hand, a creamery that purchased milk from

producers did not qualify as a "producer" for purposes of section

521. In Farmers Cooperative Creamery Association, the court

78

reasoned that a creamery was not a producer because it did not

manage or operate a farm, and that while there are risks involved

in processing cheese from raw milk, "those particular risks are not

contemplated by the term producer" as used in section 521(b)(1).79

The farmers' form of business structure and the size of the

farming operation are generally not relevant. A partnership or

corporation can be a farmer member just as a sole proprietor.

Another example in Revenue Ruling 67-422 said that a profit

making corporation which manufactures fertilizer and maintains

land devoted to raising farm products for sale at a profit is a

producer.80

However, the Service has said that a shareholder of a farming

corporation is not, in the capacity of shareholder alone, a producer.

The corporation, as owner or tenant, bears the risk and

responsibilities of a growing crop and therefore is the producer.81
See James R. Baarda, State Cooperative Incorporation Statutes 82

for Farmer Cooperatives, ACS Cooperative Information Report 30

(USDA 1982) and James R. Baarda, Cooperative Principles and

Statutes: Legal Descriptions of Unique Enterprises, ACS Research

Report 54 (USDA 1986).

 Farmers Cooperative Creamery Ass'n v. Commissioner, 21 B.T.A. 83

265, 268 (1930).

 Rev. Rul. 67-422, 1967-2 C.B. 217. 84

29

Landlords and Tenants

The issue is commonly raised in analyzing landlord-tenant

relationships. These relations are often noted in cooperative

incorporation statute provisions on membership. A typical

provision is: "Any person, firm, partnership, corporation, or

association, including both landlords and tenantsin share tenancy,

who is a producer of agricultural products...may become a member

of the association."82

An early Board of Tax Appeal decision set the stage for how

the landlord-tenant situation would be treated. The case involved

the status of a farm owner whose farm was operated by a tenant on

a crop-sharing basis. The court held the owner was entitled to

producer status, reasoning:

He risks his capital, furnishes seed and takes his

chances on profits in much the same manner as he would

were he to hire the work done for wages. The fact that he

receives a cropshare of produce...is persuasive that he is

actually engaged in farming and is a producer of farm

products.83

In Revenue Ruling 67-422, IRS adopted a test focusing on 84

how the landlord and tenant are compensated. It said, "A person

who receives a rental (either in cash or in kind) which is based upon farm production is engaged in the trade or business of farming,

and hence is a producer. Generally, a person who receives a fixed
Id. at 218. Presumably, a landlord who receives rent based on the 85

land’s production bears the risk of production because his only remedy

is to look to the crop produced. In contrast, a landlord who receives a

fixed rent or other fixed compensation without reference to crop

production bears no risk of production because such a landlord may

look to the tenant’s other income and assets to satisfy the rental

obligation.

30

rental or other fixed compensation (without reference to

production) is not a producer."85

Several examples in Revenue Ruling 67-422 illustrate this

distinction:

(1) A land owner leases his land to a tenant farmer for a

specified number of years. Under the terms of the lease agreement

the tenant farmer agrees to farm the land and pay the land owner

a rental based on a certain fixed percentage of the farm crops

produced. The tenant farmer has the option of paying the land

owner in farm crops or their equivalent value in cash. Both the

landowner and the tenant farmer qualify as producers.

(2) A stockbroker owns pasture land which he rents to a dairy

farmer who uses the land to graze his dairy cattle. The dairy

farmer pays the stockbroker a periodic fixed rental fee. The rental

activity by the stockbroker does not qualify him as a producer.

(3) An insurance agent is engaged in the business of raising

and selling chickens on a part-time basis. He qualifies as a

producer.

(4) A physician, actively engaged in carrying on a medical

practice, is also engaged in the business of operating a dairy farm

through a manager. The manager is paid a fixed salary and has

authorityto make most managerial decisions for his principal. The

physician qualifies as a producer. The manager's employment

does not qualify him as a producer.

(5) The facts are the same as example (4) except that the

manager and the physician entered into a partnership arrangement

for the operation of the farm pursuant to which the manager
Id.

86

 Rev. Rul. 67-152, 1967-2 C.B. 147,superseding I.T. 3853, 1947-1 87

C.B. 42.

 Dr. P. Phillips Cooperative v. Commissioner, 17 T.C. 1002 88

(1951).

31

receives a percentage of the net profit of the farm rather than a

salary. Both the manager and the physician qualify as producers.

(6) A profit-making corporation which manufactures fertilizer

also maintains land devoted to raising farm products for sale at a

profit. The corporation qualifies as a producer.

86

Purchaser-Reseller

In other situations, a direct connection must be established

between the person whose status is in question and production for

that person to be a farmer/producer.

The purchaser of a crop does not become, as the new owner,

its producer. Under some circumstances a member may purchase 87

the product at some point during the production process and act as

its producer for the remainder of its production cycle. Where the

member is in a real sense the producer of that crop, the member

will qualify as a farmer/producer.

Dr. P. Phillips Cooperative v. Commissioner concerned 88

cooperative members who occasionally purchased an entire ontree crop from the grove owner. The court noted that where the

on-tree crop was purchased long before harvest, the member might

have taken some of the risks and responsibilities of a grower. The

court, however, found that in a couple of instances the fruit was

purchased at or after harvest. Even though the members were

clearly producers, the court revoked the association's "exempt"

status because some of the fruit was marketed by members in their

role as reseller rather than as producer.
 Rev. Rul. 55-496, 1955-2 C.B. 268. 89

In accord, Tech. Adv. Mem. 8750002 (July 23, 1987).

90

 Priv. Ltr. Rul. 9310031 (Dec. 15, 1992).

91

32

Agency Relationship

If the purchaser is legally obligated to account to the actual

producer for proceeds received from its sale through the

cooperative, the products delivered to the cooperative by the

purchaser may be deemed to be products of a producer. In

Revenue Ruling 55-496, some members marketed fruit for 89

nonmember producers as well as their own fruit through the

association. Such fruit was handled by the member for the actual

producers under a written agency agreement providing that all

proceeds of the fruit marketed, less only actual expenses incurred

in connection therewith, were to be paid to the actual producers.

About 20 percent of the value of all products marketed by the

association during the taxable year were produced by

nonmembers.

Prior to marketing any fruit offered by a member on an agency

basis, the cooperative required the member to sign a contract

promising that all fruit delivered to the cooperative on account of

other producers was the actual property of such producers and the

agent member would return to the producers proceeds of sales of

their fruit, less necessary expenses. The contract also provided

that the agent member would furnish the association with a written

authorization from each nonmember producer showing his right to

represent such producer. In this instance, the Service permitted

the cooperative to maintain its section 521 status.

90

The Service has also permitted a section 521 cooperative to

purchase product from nonproducer-agents acting on behalf of

producers when the agents were another section 521 cooperative

and a nonprofit organization that promotes collective marketing of

farm products and markets for its members as their agent.91
Farmers Cooperative Creamery Ass'n of Cresco, Iowa v. United 92

States, 1981-1 U.S.T.C. (CCH) ¶ 9457 (N.D. Iowa 1981).

 Land O'Lakes,Inc. v. United States, 514 F.2d 134 (8th Cir. 1975),

93

cert. denied, 423 U.S. 926, rev'g 362 F. Supp. 1253 (D. Minn. 1973).

 Rev. Rul. 58-483, 1958-2 C.B. 277. 94

 Tech. Adv. Mem., December 29, 1975.

95

33

On the other hand, a processor of products not accounting to

farmer producers for amounts received is not a producer. This 92

is true even where the processor is wholly owned by the

cooperative that treats it as a patron.93

Multiple Owners

Ownership interests in an agricultural product may be shared

by multiple participants in its production. Ownership interest,

along with a requisite degree of risk sharing, may make all owners

producers of agricultural products.

In Revenue Ruling 58-483, the Service found that both 94

contract poultry growers and feed dealers who furnished poultry

and all necessary supplies to the growers were producers for

section 521 purposes. IRS noted that they divided the net profit

from poultry sales and the parties otherwise operated as tenants in

common, with each having an undivided interest in the poultry.

De Minimis Nonproducer Activity

A strict application of the rule barring marketing for

nonproducers occurred in a 1975 letter ruling. In a few

95

instances, member producers who delivered grain to a cooperative

grain warehouse requested that negotiable warehouse receipts be

issued to nonmember-nonproducers such as charitable institutions

or family members. Title to the grain transferred to the recipient

and upon marketing the cooperative paid them the sales proceeds.

Though the total amount of such marketing was 0.001 percent of

total sales, IRS said the cooperative marketed for nonproducers

and could not qualify for section 521.
 Tech. Adv. Mem. 8048018 (August 27, 1980).

96

 Tech. Adv. Mem. 8626002 (March 4, 1986).

97

 Producers Produce Co. v. Crooks, 2 F. Supp. 969 (W.D. Mo. 98

1932).

34

Subsequent letter rulings have taken a more flexible approach,

although they do not define an exception to the general rule. In

one, the Service "looked through" nonproducer suppliers to the

ultimate producers to determine the cooperative could maintain

section 521 status. In another, the cooperative purchased a small 96

amount of farm products from nonproducers for processing and

resale. IRS determined that the nonproducer purchases "were not

significant (less than 1.5 percent of product handled), they assisted

other farmer cooperatives and their own organization in meeting

government requirements, and [the cooperative] stopped the

practice when it was suggested that such purchases could

jeopardize its exempt status." The cooperative's section 521 97

status was not revoked.

Exceptions Permitting Nonproducer Business

For a long time, the rule against marketing nonproducer items

has been interpreted to permit such activity on a limited, justifiable

basis. Producers' Produce Co. v. Crooks involved a poultry and 98

egg marketing cooperative that met all requirements for exempt

status. However, members occasionally were unable to provide all

the goods the cooperative had contracted to deliver within a

certain time. In those instances the cooperative purchased product

from nonmember producers and dealers to fulfill its contracts.

The cooperative did not realize any profit on this business. The

court found such contracts were necessary to successfully market

members' production and held:

Plaintiff made such purchases not with the idea of an

investment or profit, but with the sole object of meeting a
Id. at 970.

99

 Rev. Rul. 69-222, 1969-1 C.B. 161. The nexus between this 100

ruling and Producers' Produce Co. v. Crooks is discussed in Tech. Adv.

Mem. 8705091 (Nov. 7, 1986).

Id. See also, Rev. Rul. 76-388, 1976-2 C.B. 180 and Priv. Ltr.

101

Rul. 9034043 (purchases from foreign countries permitted).

35

contract obligation. Under these circumstances, there

would be no reason for depriving the plaintiff of the

exemption.99

Three exceptions to the prohibition on purchasing nonproducer

goods for processing and/or resale are now accepted. They are

emergency purchases, ingredient purchases, and incidental

purchases.

Emergency Purchases

IRS adopted the emergency purchases exception in Revenue

Ruling 69-222. A fruit marketing cooperative was unable to 100

meet reasonable contract obligations to deliver a minimum level

of product because a freeze greatly reduced member production.

The association purchased fruit from nonproducers to meet its

commitments under the contracts. The Service found that

"emergency purchases...made for the sole purpose of meeting preexisting contractual commitments to facilitate dealings with

member patrons and not for any purpose of investment or profit"

will not adversely affect the cooperative's section 521 status.

101

The Service issued a series of three letter rulings to a

processing cooperative faced with greatly reduced member

production for both 1990 and 1991 caused by unusually heavy and

extended rains and related pestilence. The cooperative had preexisting marketing contracts for reasonable amounts of product

based on production estimates of a nonprofit association providing

agronomic services to the industry. Relying on Revenue Ruling

69-222, the Service permitted the cooperative to make purchases
 Priv. Ltr. Rul. 9034043 (May 29, 1990); Priv. Ltr. Rul. 9132038 102

(May 13, 1991).

 Priv. Ltr. Rul. 9309012 (Dec. 1, 1992).

103

 Tech. Adv. Mem. 8047006 (July 29, 1980). A dairy cooperative 104

that made nonproducer purchases to cover contract commitments nearly

every month for a three-year period found not to be making

"emergency" purchases.

 Tech. Adv. Mem. 7812004 (Oct. 31, 1977).

105

36

from foreign nonproducer sources to fulfill its contracts without

jeopardizing its Section 521 status in both years.

102

IRS also allowed the cooperative to receive a drawback of

import duties paid on the replacement raw product for refined

product subsequently exported by the cooperative over the next

three years. The cooperative accounted for the duty refunds as a

partial recovery of previous marketing expenses and allocated the

refunds to the patrons originally charged with the import duty

expense in 1990 and 1991.103

The emergency purchases exception will only be available if

conditions show the purchase is made in a bona fide emergency.

If the cooperative is aware its contracted commitments exceed the

normal production of its members, purchases from nonproducers

cannot be considered "emergency" purchases. Frequent resort to

nonproducer purchases may be an indication the cooperative is

making nonemergency purchases.104

The Service requires a preexisting contractual commitment to

substantiate an emergency purchase. This is true even if the crop

failure is due to a Presidentially declared natural disaster. A co-op

described in a letter ruling processed and marketed cottonseed. 105

Although it had no preexisting orders for its product, the co-op

purchased from a nonproducer (a nonexempt cooperative) so it

would not face a five-month period of fixed plant overhead costs

and possible loss of established markets. The purchases were not

considered emergency purchases because the cooperative had no

contract to deliver product, and its section 521 status was revoked.
 Rev. Rul. 75-4, 1975-1 C.B. 165. 106

Id. See also Tech. Adv. Mem. 8705091 (Nov. 7, 1986).

107

 The early name for the United States Tax Court.

108

 Eugene Fruit Growers v. Commissioner, 37 B.T.A. 993 (1938). 109

37

Ingredient Purchases

When cooperatives process patrons' products, they may require

other ingredients to produce the end product. Ingredient purchases

may be made from nonproducers without violating section 521

restrictions on marketing nonproducer products.

Ingredients are materials used by a cooperative to transform its

patrons' farm product into another marketable form. For example,

a cooperative that produces ice cream from patrons' cream must

obtain sugar and flavoring necessary for ice cream production.

IRS has said that even though those ingredients are not purchased

from producers of agricultural products, their purchase does not

endanger the processing cooperative's section 521 status.

106

However, ingredients necessary to put agricultural products of

patrons into marketable or changed form may not include farm

products of the kind supplied by patrons. In Revenue Ruling 75-4,

the ice cream manufacturing cooperative also indicated an intent

to purchase cream from nonproducers. As this was a product

furnished by member-producers, the Service said its purchase from

nonmembers could not be called an ingredient purchase. If it

marketed ice cream products from cream purchased from

nonproducers, it would lose its section 521 status.

107

Incidental Purchases

In certain situations marketing cooperatives may make limited

"incidental" purchases of nonproducer goods for resale to facilitate

their marketing of member products. The incidental purchases exception was accepted by the Board of Tax Appeals in Eugene 108

Fruit Growers v. Commissioner.

109

An exception for incidental nonproducer activity was first

advocated by a cooperative that sold a small amount of supplies to
 The Revenue Act of 1921, ch. 136, § 231(11), 42 Stat. 227, 253

110

(1921).

 Fruit Growers' Supply Co. v. Commissioner, 56 F.2d 90 (9th Cir.

111

1932), aff'g 21 B.T.A. 315 (1930). Current law permits cooperatives

with section 521 status to do up to 15 percent of their farm supply

business with persons who are neither members nor producers. See

supra p. 13.

 The Revenue Act of 1921, ch. 136, § 231(11), 42 Stat. 227, 253

112

(1921).

 Burr Creamery Corp. v. Commissioner, 62 F.2d 407, 410 (9th

113

Cir. 1932), aff'g 23 B.T.A. 1007, cert. denied, 289 U.S. 730 (1933).

38

nonproducers. During the years at issue, the applicable law--the

Revenue Act of 1921--only mentioned an exemption for

cooperatives "purchasing supplies and equipment for the use of

members...." The cooperative's argument was unsuccessful. 110 111

The concept of an incidental purchases exception was

incorporated in the arguments of a dairy marketing cooperative

whose exemption was revoked for purchasing nonmember

products and reselling them to compliment the marketing of

member milk. The years in question were also controlled by the

Revenue Act of 1921, which also provided exempt status to a

cooperative "organized and operated as sales agent for the purpose

of marketing the products of members...."112

The same court that rendered the opinion in Fruit Growers'

Supply didn't flatly refuse to consider an incidental purchases

exception this time. It ruled against the cooperative because it

found the sales to outsiders to be "commercially desirable" rather

than "absolutely necessary" to meet competition in the sale of

members' products.113

Eugene Fruit Growers Association marketed fruits, vegetables,

and nuts on a cooperative basis. The cooperative also engaged in

several "commercial activities" IRS said exceeded permissible

conduct for an exempt cooperative. The cooperative had purchased an ice cream factory adjoining its cannery. The plant's

refrigeration equipment was used to refrigerate association
 Eugene Fruit Growers Association v. Commissioner, 37 B.T.A. 114

993, 1001 (1938).

S. Rep. No. 52, 69th Cong., 1st Sess., 23-24, cited at 37 B.T.A. 115

1003. For a discussion of the early legislative history leading to current

I.R.C. § 521, see Donald A. Frederick, Income Tax Treatment of

Cooperatives: Background, RBS Cooperative Information Report 44,

Part 1 (USDA 2005), pp. 113-116.

 37 B.T.A. 1001. Identical statutory language is found today in 116

I.R.C. § 521(b)(1).

39

products. The cooperative continued that facility's ice and ice

cream businesses to reduce the refrigeration costs of its members.

To make more effective use of the cannery machine shop, some

custom work was done on a commercial basis.

The cooperative separated the modest earning of the

commercial activity from its primary cooperative functions and

paid tax on the former. Nonetheless, IRS challenged the

cooperative's tax exempt status.

The court ruled for the co-op, stating, "...these 'commercial

departments' were purely incidental to petitioners' principal

purpose. They were conducted, not for their own sake, but as an

adjunct and supplement to the cooperative marketing of farm

products."114

The court took particular note of tax code changes enacted as

part of the Revenue Act of 1926 and continued in the applicable

law at the time of the events under review, the Revenue Act of

1932. It cited legislative history wherein Congress approved the

liberal interpretations of earlier law. The court noted: 115

...there is no statutory requirement that petitioner be

engaged "exclusively" in cooperative marketing, as there

was in some of the provisions construed by (earlier)

decisions, but merely that it be "organized and operated on

a cooperative basis (a) for the purpose of marketing the

products of members...." We believe petitioner falls

clearly within that definition.116
 Rev. Proc. 67-37, 1967-2 C.B. 668. 117

Id.

118

Id.

119

Id.

120

 Land O'Lakes, Inc. v. United States, 362 F. Supp. 1253 (D. Minn. 121

1973).

40

In Revenue Procedure 67-37, IRS established audit 117

guidelines for determining the effect of retail sales of

nonproducers' products on a cooperative's section 521 status. The

Service said a 521 cooperative could resell products acquired from

nonproducers "...as a necessary supplement or sideline to the

efficient retail marketing of products for its producer patrons."118

The ruling includes an example of a dairy cooperative that would

find it difficult to market its patrons' milk products at retail unless

it also offered nonproducer products such as fruit juice and eggs.

Revenue Procedure 67-37 creates a safe harbor for incidental

sales of nonproducer items. Auditors are to disregard such sales

where the dollar volume of such sales does not exceed 5 percent

of the cooperative's total retail sales. IRS based the figure on its

"audit experience," concluding sales below 5 percent "...are not

indicative of a separate profit motive." Where the sales of 119

nonproducer sideline items exceed 5 percent, a "facts and

circumstances" test is applied to determine if the sales are a

necessary supplement to efficiently marketing producer goods.

120

Revenue Procedure 67-37 was interpreted in Land O'Lakes,

Inc. v. United States. Land O'Lakes operated a chain of 121

convenience stores that sold dairy products of member-producers

and non-dairy items purchased from proprietary firms. It also sold

both producer and nonproducer goods at wholesale.

Nonproducer items amounted to 17 percent of Land O'Lakes

total retail sales. Nonetheless, the court held that the retail

nonproducer sales did not jeopardize the cooperative's section 521

status. It found the purpose of such sales was to enhance the sales

of producer items (by attracting more customers to the stores) and
Id. at 1257. 122

Id. at 1258-59. 123

 Land O'Lakes, Inc. v. United States, 514 F.2d 134, 137 (8th Cir.

124

1975), rev'g 362 F. Supp. 1253 (D. Minn. 1973), cert. denied, 423 U.S.

926 (1975).

 Rev. Rul. 76-233, 1976-1 C.B. 173. 125

 Tech. Adv. Mem. 8705091 (Nov. 7, 1986).

126

41

therefore met the test of being "incidental to the effective

marketing of producer goods."122

The court also held Land O'Lakes marketing of nonproducer

goods at wholesale was permissible under Code section 521. The

court was not persuaded by the Government's attempt to establish

a bright line between retail and wholesale marketing. It noted that

such sales totaled only 3.4 percent of the cooperative's wholesale

business and were otherwise incidental to the marketing of

producer goods.

123

The court's ultimate finding, that Land O'Lakes was entitled to

section 521 tax treatment, was overturned on appeal. However,

the appellate court opinion only dealt with IRS challenges to the

cooperative’s purchasing activities and its payment of patronage

refunds to the nonproducer furnishing the goods resold at

wholesale.

124

IRS has continued to take a restrictive view of the incidental

purchases exception. For example, a cotton marketing cooperative

lost its section 521 status when it purchased a wool processing

company. While the acquisition was made pursuant to a plan to

stabilize the cooperative's future by diversifying its business

activity, IRS said it did not qualify as an incidental activity

because it wasn't necessary to market member producers' cotton.125

In 1986, IRS established tests to determine whether

126

marketing nonproducer products is incidental to the marketing of

producer products:

1. The marketing of nonproducer products must be necessary

to market producer products.
Id.

127

 Rev. Rul. 76-388, 1976-2 C.B. 180. The nonproducer business 128

involved purchases of sideline products and emergency purchases.

 Land O'Lakes, Inc. v. United States, 514 F.2d 134, 139-140 (8th 129

Cir. 1975), rev'g 362 F. Supp. 1253 (D. Minn. 1973), cert. denied, 423

U.S. 926 (1975). 

42

2. The amount of nonproducer products sold must be

insubstantial in relation to the amount of producer products

measured, in part, by the relative level of gross receipts realized on

each activity.

3. The marketing of nonproducer products must not generate

substantial receipts or substantial profits. Substantial is measured

by looking at the receipts and profits of the cooperative's

competitors who are not exempt from taxation.

Relying on this standard, IRS revoked the cooperative's section

521 status because it resold relatively small amounts of processed

products it purchased from major customers for its member

products. IRS noted that some of the sales occurred at the

wholesale level, an activity it has never approved. It also

determined the cooperative failed to show that handling

nonproducer items was essential to the marketing of producer

products or that it was incidental in amount.127

A concluding tax planning note. The Service has determined

that when nonproducer items are purchased for a fixed price, the

nonproducers are not eligible to be patrons of the cooperative.

Therefore, the cooperative need not pay patronage refunds to them.

"Profits attributable to these transactions will be nonpatronage

sourced earnings subject to section 521(b)(4) of the Code."128

In Land O'Lakesthe court was even more forceful, holding the

cooperative forfeited section 521 status by paying patronage

refunds to a nonproducer subsidiary.129
 I.R.C. § 521(b)(1)(A). 130

 Treas. Reg. § 1.521-1(a)(1). 131

 Rev. Rul. 55-558, 1955-2 C.B. 270. 132

 Rev. Rul. 76-233, 1976-1 C.B. 173. 133

43

Necessary Marketing Expenses

Code section 521 provides that eligible cooperatives must

return to marketing patrons the proceeds from selling their

products, "less the necessary marketing expenses,...." While the 130

regulations don’t explain the phrase, they do substitute "operating"

for "marketing" when discussing the Code provision.131

Revenue Ruling 55-558 concerned a vegetable marketing 132

cooperative with only five high-volume producer-members. In

view of the impact the loss of a member’s volume would have on

the cooperative, it purchased a life insurance policy on the life of

each member, named itself the beneficiary, and paid the premiums.

The Service determined the insurance premiums were not a

"marketing" expense and therefore the association was not turning

back to its members and other producers the proceeds of sales less

necessary marketing expenses. Section 521 status was denied.

IRS explained its interpretation of "necessary marketing

expenses" in more detail in Revenue Ruling 76-233. A 133

marketing cooperative of cotton producers incurred consulting and

legal expenses in acquiring a wool processing company. The

purchase was part of a plan to broaden its economic base beyond

the marketing of cotton. The Service said:

Necessary marketing expenditures include expenses,

necessary to prepare a product for its final sale, incurred

from the time the product is turned over to the cooperative

by the producer. Expenses such as grading, packing,

crating, processing, canning, drying, freezing, evaporating,

and wrapping, qualify as necessary marketing expenses.

However, expenses not connected with the marketing of
Id. at 174.

134

 I.R.C. § 521(b)(1)(B). Research has not disclosed a ruling or 135

decision discussing "necessary expenses" in the context of providing

supplies. Presumably, IRS would argue they have to be connected to

the supply function just as "necessary marketing expenses" must be

connected to the marketing function under Rev. Rul. 76-233, 1976-1

C.B. 173.

 Limits on nonmember and nonproducer business are addressed 136

infra, pp. 33-38.

44

the products of the members and other producers do not

qualify as necessary marketing expenses within the

meaning of section 521(b)(1) of the Code.134

The Service found that these consulting and legal fees were not

"necessary marketing expenses." Because the payments reduced

the amounts of patronage refunds (sales proceeds less

expenditures) paid to the producers, IRS revoked the association’s

section 521 status. As any other payment reduces the funds

available for patronage refunds, a farmers’ marketing cooperative

may jeopardize its section 521 status whenever it incurs expenses

not connected to its marketing activity.

PURCHASING FOR MEMBERS

AND OTHER PERSONS

The second permissible activity for a section 521 cooperative

is "purchasing supplies and equipment for the use of members and

other persons, and turning over such supplies and equipment to

them at actual cost, less necessary expenses." It should be 135

noted that being able to provide supplies to members and other

"persons" gives a cooperative more leeway than in its marketing

function, where business can only be conducted for members and

other "producers."136
Id. Unfortunately, the term "purchasing" is often used when

137

discussing both marketing and supply functions. In the marketing

context, it is used when a cooperative purchases product "from"

someone, often nonmembers and/or nonproducers. In the supply

context, it is used when a cooperative purchases supplies and equipment

"for" someone, whether a member, nonmember or nonproducer.

 Rev. Rul. 69-417, 1969-2 C.B. 132, 133. For a discussion of the 138

so-called Ribicoff amendment to deny cooperatives a patronage refund

deduction for earnings on manufacturing farm supplies, see pp. 24-25

of this report.

45

Manufacturing

Code section 521 talks of eligible associations "purchasing"

supplies and equipment for the use of members and other

persons. This is probably because at the time this language was

137

first developed, cooperatives lacked the resources and expertise to

manufacture farm supplies.

Over the years, farmers have pooled their capital and acquired

fertilizer plants, petroleum refineries, feed mills, and other major

facilities to produce their own farm inputs. IRS has recognized

this change in the way cooperatives meet member needs and

determined that "Where a farmers' cooperative purchasing

association manufactures products supplied to the farmer patrons,

such manufacture represents a part of the purchasing activity of the

association."138

Household Items

Code section 521 focuses on business relationships, the

marketing of farm products and purchasing of farm supplies and

equipment. In a farm setting, differentiating business and

household items purchased by producers from their cooperative

would be very difficult.

A regulatory provision eliminates possible controversy in this

area. It states: "The term 'supplies and equipment' as used in
 Treas. Reg. § 1.521-1(b).

139

 Treas. Reg. 1.521-1(c) states "An association engaged both in 140

marketing farm products and in purchasing supplies and equipment is

exempt if as to each of its functions it meets the requirements of the

Code."

46

section 521 includes groceries and all other goods and

merchandise used by farmers in the operation and maintenance of

a farm or farmer's household."139

This permits farmer-members to use their cooperative to

purchase food and other household items for resale to them

without jeopardizing its section 521 status. This can be an

especially valuable service in sparsely populated areas that might

not attract commercial grocery, drug, or hardware stores. It also

means the cooperative includes sales of these items when

computing its member, nonmember producer, and nonmember

nonproducer supply activity when checking its compliance with

limitations on nonmember business.

LIMITS ON NONMEMBER,

NONPRODUCER BUSINESS

While section 521 cooperatives are permitted to do significant

business with nonmembers and nonproducers, the Code contains

specific limits on such activity. If a cooperative engages in both

marketing and purchasing, the regulations state it must meet all

Code requirements applicable to each function to qualify for

section 521 status.

140

The regulations also provide that "Anyone who shares in the

profits of a farmers' cooperative marketing association, and is

entitled to participate in the management of the association, must

be regarded as a member of such association within the meaning
 Treas. Reg. § 1.521-1(a)(3). This definition is made applicable 141

to supply cooperatives by Treas. Reg. § 1.521-1(b).

 I.R.C. § 521(b)(4) and Treas. Reg. § 1.521-1(a)(3). 142

 Rev. Rul. 67-152, 1967-2 C.B. 147,superseding I.T. 3853, 1947- 143

1 C.B. 42.

 Tech. Adv. Mem. 8115011 (Dec. 18, 1980).

144

47

of section 521." Thus, a cooperative counts as a member anyone 141

who has a legal right to receive patronage refunds and to vote in

cooperative affairs.

Marketing

The value of products marketed for members must exceed the

value of products marketed for nonmembers. This test has not 142

been controversial, but a few questions have arisen concerning its

application.

In one instance, a cooperative marketed fruit that was both

produced by members and purchased by them on the open market.

During the years in question, the value of fruit purchased by the

members and marketed through the association exceeded the value

of fruit marketed by the association that was grown or otherwise

produced by the members. IRS stated that "member" products

means products grown or otherwise produced by a member. Since

products purchased were considered nonmember business, the

association was in violation of the majority member business rule

and not eligible for section 521 status.

143

When one cooperative performs a mere administrative

function for other cooperatives, IRS has stated the activities don't

constitute marketing under section 521(b)(4). In a 1980 letter

ruling, three cooperatives combined grain shipments to take 144

advantage of lower carlot rail rates. Commercial practice required

that a single bill of lading be prepared in one cooperative's name

and a single check issued. One cooperative received payment for

all grain shipped by the three cooperatives and then wrote checks
 Rev. Rul. 55-496, 1955-2 C.B. 268; Priv. Ltr. Rul. 9310031 (Dec. 145

15, 1992).

 I.R.C. § 521(b)(4) and Treas. Reg. § 1.521-1(b).

146

Id. The limitations on marketing and purchasing for nonmem- 147

bers were first codified in the Revenue Act of 1926, ch. 27, § 231(12),

44 Stat. 9, 40-41 (1926).

 One cooperative did argue, unsuccessfully, that the term 148

"supplies," as used in section 521(b)(4), does not include grain and feed

48

to the other cooperatives for their portion of the payment. The

Service held this arrangement did not constitute marketing and the

cooperative need not include the amount shipped by the others

with whom it cooperated in its computation of nonmember

business.

Under some circumstances a member, acting as an agent, may

deliver another producer's product to the cooperative for

marketing. The Service has determined that as long as

nonmember producers are treated as patrons under the agency

agreement, the association is eligible for section 521 status. But

the product delivered is counted as nonmember business.145

Purchasing

Two limits apply to cooperative procurement of supplies for

nonmembers:

 1. The value of supplies and equipment purchased for

members must exceed the value of such items purchased for

nonmembers, and 146

 2. The value of supplies and equipment purchased for

persons who are neither members nor producers may not exceed

15 percent of the value of all purchases.147

Most of the questions about these rules have concerned

distinguishing producers from nonproducers for purposes of the

15-percent limitation on sales to persons who are neither members

nor producers. Sales to those who have no connection to 148
purchased by a cooperative for resale to member and nonmember

patrons. Farmers Union Cooperative Ass'n, Fairbury, Neb. v.

Commissioner, 44 B.T.A. 34 (1941).

Central Co-operative Oil Ass'n v. Commissioner, 32 B.T.A. 359

149

(1935); Farmers Union Cooperative Oil Co. v. Commissioner, 38 B.T.A.

64 (1938).

 Cooperative Central Exchange v. Commissioner, 27 B.T.A. 17 150

(1932).

 Rev. Rul. 67-223, 1967-2 C.B. 214. 151

 Rev. Rul. 54-12, 1954-1 C.B. 93. 152

49

farming must clearly be considered nonmember, nonproducer

sales. Examples include direct sales of petroleum products to the

public and sales by a federated cooperative to a member 149

consumer cooperative whose patrons were consumers.

150

IRS has stated that supplies sold to a farmer member, if used

for a nonfarm purpose, must also be treated as nonmember,

nonproducer business. Revenue Ruling 67-223 concerned a 151

cooperative that sold gasoline to a member who was both a farmer

and the owner of a trucking business. The member used the

gasoline in both businesses. IRS noted that the purpose of Code

section 521 is to assist farmers and other producers in their

agricultural activities as producers. It permitted the cooperative to

maintain its section 521 status, but required it to treat the

purchases of gasoline for the member's use in his nonfarming

business as purchases made for persons who are neither members

nor producers for purposes of the 15-percent limit.

Exchanges of Like Items and Disposition of Byproducts

A series of three IRS revenue rulings addresses common

situations in manufacturing farm supplies--exchanges of like

products with nonmember nonproducers and the disposition of

byproducts--in the context of the 15-percent limit on nonmember,

nonproducer business. Revenue Ruling 54-12 described a 152

cooperative that operated a petroleum refinery to provide light
Id.

153

 Rev. Rul. 67-346, 1967-2 C.B. 216. 154

Id. at 217. 155

 Rev. Rul. 69-417, 1969-2 C.B. 132. 156

50

petroleum products required by its farmer members. The refining

process also produced heavy fuel oils and distillates farmer patrons

couldn't use.

At times, the cooperative exchanged light petroleum products

for like products of other refineries, strictly to reduce

transportation costs for both firms. It regularly sold the heavy

byproducts on the open market to businesses, such as railroads and

steel mills, that could use them. The Service, without any real

analysis, found that both the exchanges of like products and the

sales of byproducts not usable by farmer patrons could be

disregarded in "determining whether the value of purchases made

for persons who were neither members nor producers exceeded 15

percent of the value of all its purchases."153

Revenue Ruling 67-346 concerned a cooperative that 154

exchanged a byproduct from its farm supply manufacturing

operations that patrons could not use for an unlike product of a

nonmember nonproducer its patrons could use. IRS said, "Such an

exchange is in effect a sale by the cooperative of its products with

the proceeds from the sale being used to acquire a different

product for resale to the patrons of the cooperative."155

The Service required the cooperative to count the value of the

byproducts exchanged against the 15-percent limit on nonmember,

nonproducer business. It distinguished Revenue Ruling 54-12 on

the basis that that ruling concerned the exchange of like products

for the sole purpose of providing savings in transportation costs.

In Revenue Ruling 69-417, IRS reviewed its findings in 156

Revenue Ruling 54-12. It modified the earlier ruling, making it

consistent with Revenue Ruling 67-346. The sale of byproducts

to nonmember nonproducers must be counted against the 15-

percent limit. However, the value of like products exchanged with
 Land O'Lakes, Inc. v. United States, 514 F.2d 134 (8th Cir.

157

1975), rev'g 362 F. Supp. 1253 (D. Minn. 1973), cert. denied, 423 U.S.

926 (1975).

Id. at 139.

158

51

nonmember nonproducers to save transportation costs would

remain outside the scope of the limitation.

Use of Agents

A purchasing cooperative may sell supplies to an agent acting

for producers rather than directly to producers. If the relationship

is not found to involve a true agent, the sales will be treated as

nonmember, nonproducer business.

In Land O'Lakes v. United States the cooperative sold farm 157

supplies (feed, seed, fertilizer) at wholesale to a number of retail

agricultural supply stores. The stores were not members of the

cooperative. They, in turn, sold the supplies to their farmer

customers. By agreement between the stores and the cooperative,

the retail store was designated an agent for the farmers who

purchased the inputs. The agreement said the retail store would

pass all patronage refunds from the cooperative on to farmer

purchasers. The cooperative argued that the retail stores were

agents for the ultimate farmer-purchasers and the sales should

count as producer business for purposes of section 521(b)(4).

The Eighth Circuit Court of Appeals found the arrangement

did not make farmer producers the purchasers rather than the

nonproducer retail store. It said the cooperative sold its supplies

unconditionally to the retail stores without knowing the identity of

those who would receive the supplies as the stores' principals. The

risks of loss remained with the retail store. The store remained

free to set the retail price on its sales to customers and would gain

the profit or bear the loss incident to the sale. The court found

"The agent-buyer device must be disregarded as a legal fiction."158

The court then upheld IRS's denial of section 521 status for

Land O'Lakes because including these items in the value of sup-
 I.R.C. § 521(b)(5). See also Treas. Reg. § 1.521-1(c).

159

52

plies sold to nonmembers and nonproducers pushed such business

by the cooperative over the permissible 15 percent.

UNITED STATES GOVERNMENT BUSINESS

The Code contains one additional rule pertaining to the

business operations of a section 521 cooperative. Code section

521(b)(5) provides "Business done for the United States or any of

its agencies shall be disregarded in determining" whether a

cooperative is eligible for section 521 status. A cooperative may

159

do business, of either a marketing or purchasing nature, for or with

the United States and not jeopardize its section 521 status. It may

also disregard the value of such business when determining the

percentage requirements of section 521(b)(4).

However, IRS has cautioned that a cooperative cannot be

operated primarily to do business with or for the United States or

one of its agencies. Revenue Ruling 65-5 concerned a cooperative

that purchased grain from Commodity Credit Corporation (CCC)

for use in both its supply and marketing activity. After

acknowledging that section 521(b)(5) allowed the cooperative to

disregard business with CCC in determining the percentage

requirements under section 521(b)(4), the Service said:

...(T)hat provision should not be construed to mean

that there is no limit on the amount of business a

cooperative may do with the United States....(T)he farmers'

cooperative in question will not jeopardize its exemption

because of business done for or with the United States or

an agency thereof...provided the organization continues to

engage in marketing or purchasing activities for its patrons

to the extent that it may properly be characterized as a far-
 Rev. Rul. 65-5, 1965-1 C.B. 244. 160

53

mers' cooperative within the meaning of that term as

defined in section 521 of the code.160

ORGANIZATIONS HAVING CAPITAL STOCK

A cooperative that meets the business conduct requirements of

being a farmers' marketing or purchasing organization has only

partially established its eligibility for section 521 status. It must

also comply with certain additional organizational and operational

requirements.

Cooperatives that issue capital stock must comply with two

tests tied to that stock. First, the dividend rate on its stock may not

exceed 8 percent per year or the legal rate of interest in the State

of incorporation, whichever is greater. Second, substantially all

voting stock must be owned by producers who market products or

purchase supplies through the association.

These requirements exemplify the influence of cooperative

principles over the tax law. They reflect the belief that cooperative

members should own, control, and receive the benefits of

cooperation. The limit on return on equity is to discourage

attempts to operate the cooperative to generate earnings for

investors, rather than to provide services and patronage refunds to

its members. The limit on nonuser ownership of voting stock

means member-users will always control a section 521

cooperative.

Research has not uncovered a definite explanation of why

these limits only apply to cooperatives that issue stock. One

possible answer is that nonstock associations were presumed not

to pay a return on equity and therefore nonusers would have no

interest in acquiring any voting interest. Early commentary

suggests that if nonstock cooperatives did pay a return on equity,
 George J. Waas and Daniel G. White, Application of the Federal 161

Income Tax Statutes to Farmers' Cooperatives, Farm Credit Administration Bulletin No. 53, ¶ 521 (USDA 1942) p. 128.

 I.R.C. § 521 (b)(2) and Treas. Reg. § 1.521-1(a)(2)(I). 162

 These developments are outlined in Donald A. Frederick, Income 163

Tax Treatment of Cooperatives: Background, RBS Cooperative Information Report 44, Part 1 (USDA 2005) pp. 110-111.

 South Carolina Produce Ass'n v. Commissioner, 50 F.2d 742 (4th 164

Cir. 1931), aff'g 19 B.T.A. (1930) (Exemption lost for paying a dividend

of 10 percent during tax years 1923 and 1924, when the regulatory limit

was 8 percent).

54

"the rate limitation applies to the interest paid or accrued on

whatever form of capital shares exists."161

Limit on Stock Dividends

The Code provides that section 521 status shall not be denied

a farmers' cooperative:

...because it has capital stock, if the dividend rate of

such stock is fixed at not to exceed the legal rate of interest

in the State of incorporation or 8 percent per annum,

whichever is greater, on the value of the consideration for

which the stock was issued.162

The Revenue Act of 1916 and its successor tax laws in effect

until 1925 made no mention of cooperative stock or dividends on

equity. However, a series of administrative decisions by the

Treasury Department between 1920 and 1924 authorized the

issuance of capital stock and established the parameters on

permissible returns. These regulations were found to be valid 163

and enforceable. The Revenue Act of 1926 contained the first

164

Code provision on dividends, the same as is now found in section

521.
 I.R.C. § 521(b)(2).

165

 Farmers Mutual Cooperative Creamery of Sioux Center, Iowa v. 166

Commissioner, 33 B.T.A. 117 (1935).

55

Rate of Return

The limit on the dividend rate, with its "whichever is greater"

provision, is interpreted in a straightforward manner. If the legal

rate of interest in the State of incorporation is greater than 8

percent, a cooperative can pay dividends at that rate with-out

jeopardizing its section 521 status. If the legal limit on interest in

the State is less than 8 percent, a section 521 cooperative can pay

a return on capital of up to 8 percent without jeopardizing its

section 521 status. The Code refers only to capital stock, so all

classes of stock are included, whether common or preferred.

Valuing Consideration

Rate limits on capital stock are applied to "the value of

consideration for which the stock was issued." This value has 165

been questioned in a few instances.

The value of consideration at original issue is the amount the

member paid for the stock (and not the par value, if there is a

difference). Certain stock transactions subsequent to original issue

may draw into question the value of consideration against which

a rate can be applied.

In Farmers Mutual Cooperative Creamery of Sioux Center,

Iowa v. Commissioner, members purchased capital stock that 166

paid an annual dividend of 8 percent and received patronage

refunds on their proportional share of the association's margins.

The association had substantial dealings with and for nonmember

producers. While nonmember producers received the same

payments for product as members, they did not receive patronage

refunds. (The court found this fact alone justified revocation of

exempt status.) Earnings on nonmember business were placed

into a reserve and additional stock allocations were made to

members from this reserve. While the members paid nothing for

this stock, it also returned an annual dividend of 8 percent.
Id. at 125.

167

 Laura Farmers Cooperative Elevator Co. v. United States, 273 F.

168

Supp. 1019 (S.D. Ill. 1967).

56

By the tax year in question, $27,140 of the outstanding capital

stock of $45,680 had been issued as stock dividends from the

reserve of earnings from nonmember business. The court held the

value of the consideration for which the stock was issued was the

amount each member paid for stock, which was often less than

half the book value of the stock in that member's account. As all

of the stock paid an 8 percent dividend, members were receiving

a return from 12 to 18 percent on the amount they had actually

invested in the cooperative. The court found this barred the

cooperative from exempt status.

167

In another situation, a general business corporation, which had

conducted its business on a partially (unspecified) cooperative

basis, reorganized as a cooperative. As part of the conversion, the

firm replaced the common stock of the former corporation with

one class of dividend-paying preferred stock. A second class of

preferred stock was issued to shareholder-members to capitalize

the earned surplus accumulated by the old corporation. This stock

also paid dividends.

The court held the cooperative had received no consideration

for the second preferred stock. It had, instead, simply changed the

structure of the reorganized corporation's capital account. When

the dividends on the two classes of stock were combined and

compared to the amount the members had paid for the old

corporation's common stock (now the first class of preferred in the

cooperative), the dividend rate greatly exceeded the allowable

limit of 8 percent of the value of the consideration. The

cooperative was held ineligible for section 521 status.

168

Shortly after the Laura Farmers opinion, the Service also

expressed the view that when stock dividends are made for no

additional consideration, the maximum annual dividend rate of the

cooperative, if it is to establish section 521 status, may not exceed
 Rev. Rul. 68-169, 1968-1 C.B. 286. 169

 Etter Grain Co. v. United States, 331 F. Supp. 283 (N.D. Tex. 170

1971), aff'd, 462 F.2d 259 (5th Cir. 1972).

 The new organization failed to qualify as a cooperative for a

171

number of reasons.

 Etter Grain Co. v. United States, 331 F. Supp. 283, 286 (N.D. 172

Tex. 1971), aff'd, 462 F.2d 259 (5th Cir. 1972).

57

the permissible percentage of the consideration paid for the

original stock.169

A second example of the value of consideration question in a

reorganization was addressed in Etter Grain. A noncooperative 170

business was allegedly converted into a cooperative. As part of 171

the reorganization, the former owners of the business had its assets

appraised. They exchanged their stock in the old company for

dividend-paying preferred stock in the cooperative. They assigned

this new stock a par value far above their investment in the old

firm, to capture its appreciation for themselves. The court said:

The question of valuation would not be present if, as

an example, a new cooperative corporation was formed

and each stockholder invested cash for his preferred

shares. But here, where stock is exchanged, the value to

be used for Sec. 521 purposes is the investment value of

each stockholder in the old corporation, not its reevaluation as was used by [the cooperative] in this case....

To hold otherwise, would only open another door or afford

another device and method for operating a co-op for the

advantage of the stockholders rather than the memberproducers.

172

Substantially All Test

The section 521 requirement that ties use, ownership, and

control together is the requirement that "substantially all" stock
 I.R.C. § 521(b)(2).

173

 Tech. Adv. Mem. 7814002 (June 29, 1977). The Service notes, 174

however, that if dividends can be paid on the basis of some equity

ownership, though not capital stock, the test may be applicable.

 Treas. Reg. § 1.521-1(a)(2). See Rev. Rul. 67-204, 1967-1 C.B. 175

149.

58

evidencing membership be owned by producers who use the

cooperative. The Code provides:

Exemption shall not be denied any such association

because it has capital stock...if substantially all such stock

(other than nonvoting preferred stock...) is owned by

producers who market their products or purchase their

supplies and equipment through the association.173

The "substantially all" rule applies only to cooperatives with

capital stock. "Membership" cooperatives having no capital stock

are not subject to the test.174

"Substantially all" is not defined in the Code or regulations.

However, inclusion ofthe modifier "substantially" indicates some

stock may be owned by persons who are not producers marketing

products and purchasing supplies through the cooperative.

The regulations require that any ownership of capital stock by

nonproducers at the time the cooperative applies for section 521

status be justified and that ownership "has been restricted as far as

possible to such actual producers."175

The regulations give examples where nonproducer stock

ownership is permitted:

If by statutory requirement all officers of an association

must be shareholders, the ownership of a share of stock by

a nonproducer to qualify him as an officer will not destroy

the association's exemption. Likewise, if a shareholder for

any reason ceases to be a producer and the association is
 Treas. Reg. § 1.521-1(a)(2). 176

 I.R.C. § 521(b)(2) and Treas. Reg. § 1.521-1(a)(2). 177

 Revenue Act of 1926, ch. 27 § 231(12), 44 Stat. 9, 40 (1926).

178

For a summary of early rulings that are the foundation for the

"substantially all" requirement, see, Donald A. Frederick, Income Tax

Treatment of Cooperatives: Background, RBS Cooperative Information

Report 44, Part 1 (USDA 2005) p. 110-111. See also, Gen. Couns.

Mem. 33,981 (Nov. 20, 1968).

59

unable, because of a constitutional restriction or

prohibition or other reason beyond the control of the

association, to purchase or retire the stock of such

nonproducer, the fact that under such circumstances a

small amount of the outstanding capital stock is owned by

shareholders who are no longer producers will not destroy

the exemption.176

They do not, however, offer guidance as to the issues that

became contentious in this area, (1) how do you identify

"producers who market their products or purchase their supplies

and equipment through the association," and (2) how do you

measure "substantially?"

The Current Patronage Requirement

Section 521 requires that substantially all voting stock must be

owned by "producers who market their products or purchase their

supplies and equipment through the association." Although this 177

language has been part of the Code since 1926, it was not 178

presented to the courts for interpretation until the late 1960s.

In 1960, Co-Operative Grain & Supply Co., a grain marketing

and farm supply cooperative in Roseland, Nebraska, applied for

section 521 status. The district director denied the request on

several grounds, including a determination that about 16 percent

of the cooperative’s stock was "in the hands of owners who are
 Co-operative Grain & Supply Co. v. Commissioner, 26 T.C.M. 179

(CCH) 593, T.C. Memo 1967-132 (1967).

Id.

180

 Co-operative Grain & Supply Co. v. Commissioner, 407 F.2d 181

1158, 1164 (8th Cir. 1969), aff’g 26 T.C.M. (CCH) 593, T.C. Memo

1967-132 (1967).

60

neither marketing or purchasing through the association." He 179

issued a notice of deficiency for taxes allegedly due and the

cooperative sued in U.S. Tax Court.

The court found that substantially all, if not all, of the

cooperative’s shareholders were agricultural producers. However,

it also determined that the cooperative was obligated to prove that

"Substantially all of petitioner’s shareholders were active

producers, that is--producers who marketed their products or

purchased their supplies and equipment through the

association."180

The court ruled that since the cooperative made no attempt to

show that its shareholder-producers were active patrons during the

years at issue, it failed to meet the requirements of Code section

521(b)(2) and thus failed to show it qualified for section 521

status.

The cooperative appealed to the Eighth Circuit Court of

Appeals. That court reviewed the underlying policy for special tax

treatment, to improve the plight of farmers, and found this cannot

occur unless the farmers patronize the association. The court

concluded "substantially all of the shareholder-producers are

required to market their products and purchase their supplies

through the taxpayer on a current basis. That is our holding."181

While the 8th Circuit adopted the general position of the Tax

Court, neither opinion provided guidance to cooperatives as to

how much flexibility they had under the "substantially all" rule.

The appellate court took two steps to remedy this. First, it noted

IRS had asserted its national office had an ongoing project to pub-
Id.

182

Id. at 1165. 183

Co-operative Grain and SupplyCo. v. Commissioner, 32 T.C.M. 184

(CCH) 795, 798 (1973), on remand from 407 F.2d 1158 (8th Cir. 1969).

 Farmers Cooperative Creamery Ass'n v. Commissioner, 21 185

B.T.A. 265 (1930).

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

186

(1969).

 Rev. Rul. 73-248, 1973-1 C.B. 295. This ruling was noted in the 187

Tax Court’s opinion on remand in Cooperative Grain & Supply Co.

The court declined to decide what percentage is sufficient, but held that

61

lish guidelines in this area. It urged the Service to issue

appropriate administrative determinations.

182

Second, the court ordered the case remanded to the Tax Court

to give the cooperative an opportunity to produce additional

evidence that it satisfied the current patronage test.183

On remand, the Tax Court interpreted "current" to mean

"...actual yearly participation." It held "substantially all" 184

shareholders must market products or purchase supplies through

the cooperative each year. A mere continuing business

relationship is not sufficient. If a shareholder does not patronize

the cooperative during the year, the shareholder may not be

counted as a patron for purposes of meeting the "substantially all"

requirement for that year.

The 85-Percent Rule

Several early decisions addressed the adequacy of a specific

percentage of stock ownership by producers, presented by the facts

at hand, but formulated no general quantitative measure. Ninetyone percent was held to be "substantially all", but 72 percent 185

was not.186

In 1973, IRS said for the first time that at least 85 percent of

capital stock must be held by producers to meet the "substantially

all" test.187
78 percent fell short. Co-operative Grain and Supply Co. v.

Commissioner, 32 T.C.M. (CCH) 795, 797-798 n.4 (1973), on remand

from 407 F.2d 1158 (8th Cir. 1969).

 West Central Cooperative v. United States, 607 F. Supp. 1 (N.D. 188

Iowa 1983), aff'd, 758 F.2d 1269 (8th Cir. 1985).

 Farmers Cooperative Co. v. Commissioner, 85 T.C. 601 (1985), 189

aff’d on this issue, remanded on other issues, 822 F.2d 774 (8th Cir.

1987)(84.78 percent insufficient).

62

In 1974, 83.75 percent of the member-shareholders of West

Central Cooperative in Ralston, Iowa, marketed some of their

products or purchased some of their supplies through the

cooperative. In 1978, the Service retroactively revoked the

cooperative’s section 521 status and accessed additional taxes for

fiscal year 1974. The cooperative paid the assessment and sued

for a refund in Federal District Court. The court determined that

the 85-percent rule established in Revenue Ruling 73-248 was

"reasonable and in keeping with the congressional mandate

embodied in the language of § 521(b)(3)."188

The 85 percent figure has been applied strictly in a subsequent

case, and appears to be the established measure. 189

The "Ability-to-Vote-at-the-Next-Annual-Meeting" Test

If the current patronage test is applied too literally, it creates a

dilemma for cooperatives. They have no way of determining how

many members, and which specific members, will patronize the

cooperative until after the end of the tax year.

At the same time IRS was challenging West Central

Cooperative, it was also questioning the section 521 status of

Farmers Cooperative Company, a grain marketing and supply

cooperative in Platte Center, Nebraska. In 1982, the district

director revoked the cooperative’s section 521 status for all years

after 1976 on the grounds that it had not sufficiently limited the

ownership of its common stock to active producersto comply with

the "substantially all" rule. The cooperative filed a petition for

redetermination with the Tax Court.
 Farmers Cooperative Co. v. Commissioner, 85 T.C. 601 (1985), 190

remanded, 822 F.2d 774 (8th Cir. 1987). The court noted that since an

appeal of this opinion would go to the 8th Circuit, it was bound by that

court’s opinion in West Central Cooperative. Regardless, it stated that

it also found the 85-percent test an appropriate measure for interpreting

"substantially all." 85 T.C. at 613.

Id. at 614-615. 191

63

During litigation, IRS argued that the current patronage

requirement meant a section 521 cooperative had to do whatever

was necessary to make sure at least 85 percent of its shareholders

during the year did business with the cooperative. The cooperative

asserted that it should be allowed to count as current shareholders

nonmembers who patronized the association during the year and

were entitled to, but had not by the end of the year, received their

share of membership stock. It also said it should be able to

disregard members who failed to patronize the association as its

bylaws provided only producers who do business with the

association each year may own common stock.

The Tax Court generally accepted the Service’s arguments.

First, it held that a cooperative whose annual shareholder

patronage hit a peak of 84.75 percent was not in compliance with

Section 521(b)(2). The court did not permit the cooperative to 190

count, as shareholders, producers who began patronizing the

cooperative during the tax year but did not receive their stock

certificates until after the end of that year. The cooperative was,

however, required to count former patrons whose voting stock had

not been redeemed by the end of the year. The court did suggest

that a "facts and circumstances" approach would be appropriate to

temper possible harsh results from a strict application of the 85-

percent rule, as, for example, a cooperative that had 90 percent of

its shareholders patronize it for 3 successive years and then saw

that figure drop to 84.75 percent for one year.

191

The cooperative appealed. In 1986, IRS issued a letter ruling

that applied a "facts and circumstances" test to justify finding that
 Tech. Adv. Mem. 8626002 (March 4, 1986).

192

 85 T.C. at 604 (note 4) (emphasis added). 193

 Tech. Adv. Mem. 8626002 at 4. 194

 Brief for Appellant at 11-13, 822 F.2d 774 (8th Cir. 1987).

195

64

although another cooperative did not meet the 85-percent rule, its

section 521 status should not be revoked.192

In its litigation against Farmers Cooperative Company, the

Service consistently argued that anyone holding a share of stock

was a shareholder under Code section 521(b)(2), although the

association’s articles of incorporation and bylaws provided that

"only producers of agricultural products...who do business with the

cooperative annually, may own the common stock of the

cooperative." Yet in Technical Advice Memorandum 8626002, 193

it applied a "facts and circumstances" test to disregard

shareholders who ceased farming or moved from the area because

they were no longer entitled to own stock in the cooperative.194

Although Technical Advice Memoranda cannot be cited as

precedent, the Farmers Cooperative Company quoted extensively

from this ruling in its brief to the 8th Circuit and argued to the

court that this letter ruling states the law applicable to this specific

issue. There is no public record of whether this reference 195

carried any weight with the court. However, the Service’s

inconsistency may have played a part in subsequent decisions

favorable to Farmers Cooperative Company and to section 521

cooperatives in general.

In its review, the 8th Circuit Court of Appeals had to

determine the status of two groups: (1) producers who began

patronizing the cooperative during the tax year but did not receive

their stock certificates until the following year, and (2)

shareholders who did not patronize the cooperative during the year

in question.

The cooperative asked the court to look beyond the actual

shareholder lists. It argued that new producer patrons should be

considered stockholders because they were automatically entitled
 Farmers Cooperative Company v. Commissioner, 822 F.2d 774, 196

777-778 (8th Cir. 1987).

Id. at 778.

197

Id.

198

65

to a share of stock when they first used the cooperative’s services,

although the stock certificate was not presented until the annual

meeting following the year of initial patronage. The cooperative

also claimed inactive shareholders should not be counted because

its articles and bylawsstated that only producers who did business

with the cooperative on an annual basis could own common

stock.196

IRS responded that the shareholder list on the last day of the

tax year is the only appropriate basis for determining the

cooperative’s shareholder group. Because new patrons had not

received their shares of stock, the Service said they should not be

included in the calculation. The Service then argued that

shareholders who were inactive during the year but still held their

common stock at year-end should be counted in establishing the

total number of shareholders.

197

The court disregarded the nuances of corporate law involving

stock ownership raised by both parties. It stated that accepting the

cooperative’s contentions would result in perpetual compliance

even if no action was taken to make sure nonpatrons were indeed

denied membership rights. It also noted that compliance with the

Service’s position, forcing the cooperative to revoke shareholder

status before the end of the year (and thus before it knew for sure

whether the patron would conduct any business that year) was a

practical impossibility.198

The court devised its own method for applying the current

patronage requirement. It said the purpose of the limitation was

to restrict section 521 benefits to cooperatives organized and

operated for the benefit of patrons as patrons and not for the

benefit of investors. It explained that a share of common stock in
Id. (note) 6.

199

 822 F.2d at 779. 200

 I.R.C. § 521(b)(2).

201

66

a cooperative is virtually worthless as an investment vehicle.199

Thus the key determinate is not the actual ownership of the share

of stock but the control, via the vote it symbolizes, over the

direction and decision-making process of the cooperative.

The court concluded:

...although the right to vote may accrue or be lost

during the tax year, it is normally exercised only at the

annual shareholders’ meeting that is ordinarily held several

months after the close of the tax year.

Thus, we hold that, for purposes of applying the 85%

test, the relevant consideration is whether the right to vote

has actually accrued or been terminated by the time of the

annual shareholders’ meeting following the close of the tax

year.

200

Thus, the proper test to determine if a person is a "member" for

purposes of the "substantially all" requirement is whether that

person has the right to vote at the annual stockholders' meeting

following the close of the taxable year. A cooperative may count

new patrons during the year who are actually entitled to vote at the

subsequent annual meeting. And it can disregard inactive patrons

only if their voting right has been terminated before that meeting.

The Aborted 50-Percent-Current-Patronage Rule

The "substantially all" rule requires that ownership of voting

stock be limited to "producers who market their products or

purchase their supplies and equipment through the association."201

The test requires a cooperative to determine if each stockholder

member markets through or purchases from the cooperative.

Although this seems to be an easy determination, the second IRS
 Co-operative Grain & Supply Co. v. Commissioner, 407 F.2d 202

1158, 1164 (note 10) (8th Cir. 1969),remanding 26 T.C.M. 593 (1967).

Id. On remand, the Tax Court found the cooperative did not

203

comply with the substantially all requirement without addressing the

issue of the amount of business each member did with the association.

Co-operative Grain & Supply Co. v. Commissioner, 32 T.C.M. (CCH)

795 (1973).

 Rev. Proc. 73-39, 1973-2 C.B. 502,revoked by Rev. Proc. 90-29, 204

1990-1 C.B. 533.

67

administrative action in 1973 interpreting "substantially all" cast

compliance in doubt for many cooperatives. The rule was eventually rejected by the Tax Court and revoked by the Service.

IRS raised the issue of the amount of product that must be sold

or supplies purchased through a cooperative by each patron in Cooperative Grain & Supply Co. v. Commissioner. The court noted

that, in his brief, the Commissioner "assumes that substantially all

of the shareholder-producers must market substantially all of their

products and purchase substantially all of their supplies through

the cooperative (court's emphasis)."202

The court refrained from discussing the issue as it wasn't

before it on appeal, but suggested "imposition of the standard

proposed here by the Commissioner could produce impractical and

perhaps oppressive results. We believe the Tax Court, on remand,

should resolve this issue, if it becomes an issue, by application of

a reasonable and realistic standard."203

In Revenue Procedure 73-39 , the Service said stockholder- 204

members, to be considered current and active patrons, must market

more than 50 percent of the farm products they produce through

the cooperative or purchase more than 50 percent of their supplies

and equipment of the type handled by the cooperative from the

cooperative. The only exceptions were for persons who were

unable to comply because of a disaster such as a crop failure or

serious injury or if the cooperative dealt in high-priced items, like

farm machinery, not normally purchased each year.
Rev. Rul. 77-440, 1977-2 C.B. 199. Similar facts were described

205

in Tech. Adv. Mem. 7745007 (June 28, 1977).

 West Central Cooperative v. United States, 607 F. Supp. 1, 2-3 206

(note 2) (N.D. Iowa 1983), aff'd, 758 F.2d 1269 (8th Cir. 1985).

68

Revenue Ruling 77-440 elaborated on qualifications for 205

active patronage, exploring the 50-percent marketing or supply

rule. IRS described four "categories" of farmers, indicating in

which categories the cooperative would be required to remove the

farmers from its membership rolls to meet the requirements of

section 521(b)(2).

In West Central Cooperative, the association argued that the

50-percent-of-production-and-purchases rule was unreasonable.

The court responded by counting as patrons any shareholder who

had done "some" business with the cooperative. As the

cooperative was still short of the required 85 percent current

patronage figure, the court did not address the legitimacy of

Revenue Procedure 73-39.206

In Farmers Cooperative Company, the Service's proportion of

business measure for counting stockholders as patrons was

specifically rejected. In its initial decision, the Tax Court was not

required to decide the proportion of business rule because it found,

like the court in West Central Cooperative, that even without this

rule the cooperative was still short of the required 85-percent

current patronage. Nonetheless, the court commented:

We note that consideration of this area is fraught with

many difficulties and problems. Does [the Service]

contemplate that cooperatives will keep track of shareholders' transactions outside the cooperative in order to

police the 50 percent test of Rev. Proc. 73-39, 1973-1 C.B.

502? Would cooperatives effectively serve their congressionally intended purpose if patrons were required by con-
 Farmers Cooperative Co. v. Commissioner, 85 T.C. 601, 617 207

(note 11) (1985), remanded, 822 F.2d 774 (8th Cir. 1987).

 Farmers Cooperative Co. v. Commissioner, 822 F.2d 774, 781 208

(8th Cir. 1987), remanding 85 T.C. 601 (1985).

 Farmers Cooperative Co. v. Commissioner, 89 T.C. 682, 685 209

(1987), on remand from 822 F.2d 774 (8th Cir. 1987).

69

tract to transact a minimum amount of business with the

cooperative?207

As noted previously, the Eighth Circuit, on appeal, expanded

the category of shareholders the cooperative could count as current

patrons. This meant that for one of the two years under review,

the cooperative did qualifyfor section 521 status if the 50-percentcurrent-patronage rule was invalid. The appeals court remanded

the case back to the Tax Court for review of the IRS requirement,

noting its observations in Cooperative Grain & Supply.

208

On remand, the Tax Court surveyed legislative history of the

"substantially all" provision. It concluded:

Petitioner’s records reflect the amount of marketing or

purchasing business transacted by each patron with

petitioner each year, but not the amount of a patron’s total

marketing or purchasing business with or from all entities

or sources for the same year. It would be impossible for

petitioner to determine from its records whether any patron

met the 50-percent test.209

We are at a loss to understand [the IRS's] concern

about the percentage or amount of their total business

activity that each member or patron conducts with each

cooperative. We are unable to perceive, and [IRS] has not

suggested, any evil that may arise from patrons or members belonging to many cooperatives or only conducting a
Id. at 687.

210

 Action on Decision CC-1988-018 (August 8, 1988). "We accept

211

the holding of the Tax Court that patrons currently transacting any

amount of business with an exempt cooperative will be counted as

active 'producers' in determining if 'substantially all' the cooperative's

stock 'is owned by producers who market their products or purchase

their supplies and equipment' through the cooperative within the

meaning of section 521(b)(2). Rev. Proc. 73-39 is being revoked at the

time this A.O.D. is issued." Formal acquiescence at 1988-2 C.B. 1.

 Gen. Couns. Mem. 39819 (July 7, 1989).

212

 Rev. Proc. 90-29, 1990-1 C.B. 533, revoking Rev. Proc. 73-39, 213

1973-2 C.B. 502. The exceptions for persons faced with a disaster or

who patronized a cooperative for an item not normally purchased on an

annual basis were retained. 

 Rev. Rul. 90-42, 1990-1 C.B. 117, revoking Rev. Rul. 77-440, 214

1977-2 C.B. 199.

70

small portion of their total business activity with a

cooperative."210

The Tax Court said any producer transacting any amount of

business with the cooperative may be considered a currently active

patron for purposes of the "substantially all" test. The Service

acquiesced in that decision.211

The IRS Chief Counsel's Office examined the implication of

Farmers Cooperative Co. and recommended revocation of

Revenue Procedure 73-39 and RevenueRuling 77-440. However,

it noted that the "facts and circumstances" exception contained in

Revenue Procedure 73-39 served a useful purpose and

recommended the announcement revoking Revenue Procedure

73-39 preserve that exception.212

The Chief Counsel's recommendations were adopted. Both

Revenue Procedure 73-39 and Revenue Ruling 77-440 were

213 214

revoked.

The issue now seems settled. If 85 percent of the voting rights

at the annual membership meeting are held by producers who did
 Rev. Rul. 67-204, 1967-1 C.B. 149. 215

 Farmers Cooperative Co. v. Commissioner, 822 F.2d 774, 780- 216

781 (8th Cir. 1987); Tech. Adv. Mem. 8205013 (Oct. 29, 1981) (2-year

grace period without patronage unacceptable); Tech. Adv. Mem.

8252002 (March 25, 1980). For a discussion of other problems caused

71

some marketing or purchasing through the cooperative during the

previous tax year, the "substantially all" test is satisfied.

Compliance

These cases and rulings place an obligation on section 521

cooperatives to make sure that at least 85 percent of the persons

entitled to vote at each annual meeting conducted some business

with the cooperative during the previous tax year. Due diligence

is required both when voting stock is issued and after each tax year

is concluded. 

Capital stock may be in the hands of nonproducers because the

cooperative did not determine for itself the producer status of

those to whom it issued capital stock. A cooperative must take

active steps to avoid placing capital stock in the hands of

nonproducers. It is not sufficient to automatically issue capital

stock to all who patronize the cooperative with instructions that

the certificate should be returned if the recipient is not actively

engaged in farming.215

Cooperatives must also monitor the continued qualification of

current holders of membership stock and purge from membership

those who no longer qualify. Two events require action. The

cooperative must terminate the memberships of persons who no

longer (1) are producers of agricultural products or (2) use the

cooperative.

To monitor "use," a cooperative must know who its members

are, who patronizes the cooperative, and analyze membership and

patronage data to determine who qualifies or does not qualify for

ownership of voting stock. It must also establish and enforce

procedures for purging membership rolls of those who do not

qualify.216
by inactive memberships and guidance in purging membership rolls of

inactive patrons, see Donald A. Frederick, Keeping Cooperative

Membership Rolls Current, ACS Cooperative Information Report No.

37 (USDA 1989).

 I.R.C. § 521(b)(2). See also, Treas. Reg. § 1.521-1(a)(2). 217

 Gen. Couns. Mem. 33,981 (Nov. 20, 1968).

218

Id.

219

72

Nonvoting Preferred Stock

The Code specifically provides that the requirement that

"substantially all" stock be owned by producers who patronize the

cooperative does not apply to "nonvoting preferred stock, the

owners of which are not entitled or permitted to participate,

directly or indirectly, in the profits of the association, upon

dissolution or otherwise, beyond the fixed dividends."217

This language was discussed in General Counsel

Memorandum 33,981. It examines the legislative history 218

leading up to enactment of the Revenue Act of 1926, including the

language cited earlier. In his analysis, the Chief Counsel took the

position that the limited exception was made to the "substantially

all" test so that a section 521 cooperative could issue preferred

stock as a part of an appropriate financing program.

While not stating what constitutes an appropriate financing

program, the memorandum cautions that "Permitting a cooperative

to issue an unlimited amount of nonvoting stock upon which

dividends are paid to nonproducers could result in payment by the

cooperative of a too substantial part of its profits to persons who

are not patrons." While there are no specific guidelines as to 219

how much nonvoting stock nonproducers may own, IRS staff has

noted that a section 521 cooperative that distributes too large a

percentage of its earnings as stock dividends, rather than patronage

refunds, is presumably no longer operating on a cooperative basis.
See, e.g., Priv. Ltr. Rul. 8025168 (March 27, 1980); Priv. Ltr.

220

Rul. 8419060 (Feb. 8, 1984).

 I.R.C. § 521(b)(1)(A). 221

 I.R.C. § 521(b)(1)(B). 222

73

TREATING MEMBERS AND

NONMEMBERS EQUALLY

Embedded in the Code description of a cooperative eligible for

section 521 status is a requirement that business with members

and nonmembers must be conducted on a cooperative basis. In

practice, this means that while other cooperatives need only make

patronage refund allocations and distributions to members, section

521's must make them to nonmember users as well, and on the

same basis as they are made to members. This section discusses 220

this requirement for equal treatment and notes several limited

exceptions.

The General Rule

Code section 521 requires equal treatment of member and

nonmember users in both marketing and supply operations. It

provides a section 521 cooperative may be engaged in:

(A) "(M)arketing the products of members and other

producers, and turning back to them the proceeds of sales, less the

necessary marketing expenses, on the basis of either the quantity

or the value of the products furnished by them," or 221

(B) "(P)urchasing supplies and equipment for the use of members and other persons, and turning over such supplies and

equipment to them at actual cost, plus necessary expenses."222

The applicable regulation is more specific:

If the proceeds of the business are distributed in any

other way than on such a proportional basis, the associ-
 Treas. Reg. § 1.521-1(a)(1). 223

 Revenue Act of 1926, ch. 27, § 231(12), 44 Stat. 4, 40-41 (1926). 224

For additional citations and a description of the legislative history of

this rule, see Donald A. Frederick, Income Tax Treatment of

Cooperatives: Background, Cooperative Information Report 44, Part 1

(USDA 2005) pp. 109-114.

See, e.g., Producers' Creamery Co. v. United States, 55 F.2d 104, 225

105-106 (5th Cir. 1932); Farmers' Mutual Cooperative Creamery of

Sioux Center, Iowa v. Commissioner, 33 B.T.A. 117, 123 (1935);

Farmers Union Co-op Co. of Guide Rock, Neb. v. Commissioner, 90

F.2d 488, 493 (8th Cir. 1937), aff'g 33 B.T.A. 225 (1935); Farmers

Cooperative Co. of Wahoo v. United States, 23 F. Supp. 123, 127 (Ct.

Cl. 1938).

See, e.g., Tech. Adv. Mem. 9114002 (No. 27, 1990).

226

 Council Bluffs Grape Growers Ass'n v. Commissioner, 44 B.T.A. 227

152 (1941). 

74

ation does not meet the requirements of the Code and is

not exempt. In other words, nonmember patrons must be

treated the same as members insofar as the distribution of

patronage dividends is concerned. Thus, if products are

marketed for nonmember producers, the proceeds of the

sale, less necessary operating expenses, must be returned

to the patrons from the sale of whose goods such proceeds

result, whether or not such patrons are members of the

association.223

The rule requiring equal treatment was first codified in section

231(12) of the Revenue Act of 1926 and has been in effect

224

continuously since that time. Once adopted, the rule was

consistently applied by the courts and is now generally accepted. 225

One way cooperatives have violated this rule is to charge or

pay similar initial amounts to both members and nonmembers, but

deny nonmembers any right to share in net margins by receiving

patronage refunds. In Council Bluffs Grape Growers Ass'n,

226 227

a section 521 cooperative marketed fruit for both member and
 I.R.C. § 521(b)(4). The right of section 521 cooperatives to 228

establish reserves is discussed in a subsequent section of this chapter.

 Fertile Co-operative Dairy Ass'n v. Huston, 119 F.2d 274, 277 229

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

Id. See also Farmers' Mutual Cooperative Creamery of Sioux 230

Center, Iowa v. Commissioner, 33 B.T.A. 117 (1935); Council Bluffs

Grape Growers Ass'n v. Commissioner, 44 B.T.A. 152, 155 (1941);

Rev. Rul. 69-431, 1969-2 C.B. 133, 134.

 Producers' Creamery Co. v. United States, 55 F.2d 104 (5th Cir.

231

1932).

 Rev. Rul. 69-431, 1969-2 C.B. 133. 232

75

nonmember producers. The bylaws provided that margins would

be withheld from all patrons for a period of 5 years and placed in

a working capital reserve. Members (but not nonmembers) were

issued certificates for their proportional share of the margin, which

said they would be paid off with margins earned 5 years after

issuance.

The cooperative argued that members and nonmembers were

treated equally in that neither got an immediate patronage refund.

The court disagreed, finding the cooperative had no purpose or

intent to return to nonmembers at any time any part of the earnings

from the sale of their products. The Service's denial of Section

521 status was upheld.

A section 521 cooperative may maintain a reserve "for any

necessary purpose." However, the Code's permission to 228

establish a reserve for any necessary purpose is "not intended as a

waiver in any respect of that equality of treatment which is part of

the necessary foundation" for section 521 status. The reserve 229

must be organized and operated in a manner that does not

discriminate against nonmembers.

230

The rule could also be violated if the cooperative makes an

unequal payment such as a "bonus" only to members.

231

Members and nonmembers must be treated alike regarding

income from sources other than patronage. This requirement 232
 Rev. Rul. 69-417, 1969-2 C.B. 132. 233

 Rev. Rul. 67-346, 1967-2 C.B. 216. 234

 Packers and Stockyards Act, 7 U.S.C. § 207(f). 235

 Rev. Rul. 73-59, 1973-1 C.B. 292. 236

 Eugene Fruit Growers v. Commissioner, 37 B.T.A. 993, 1002 237

(1938).

76

includes nonmember nonproducers for whom the cooperative

provides supplies and other equipment. Thus, if a cooperative 233

exchanges a byproduct it produces for an unlike product processed

by a nonmember nonproducer, the exchange is considered a sale

of the byproduct to the nonmember nonproducer and that person

is entitled to share in the net earnings of the cooperative on the

same basis as all other patrons of the cooperative.234

Under some circumstances, it may be impossible to treat

members and nonmembers alike. For example, the Packers and

Stockyards Act (P&SA) prohibits the payment of patronage

refunds to nonmembers. In such cases, the cooperative must

235

either not deal with nonmembers or not seek section 521

qualification.

One cooperative tried to avoid the P&SA problem by paying

amounts equal to a patronage refund into a "patronage refund

suspense reserve" for nonmembers. Even though it would have

been possible at a later time to refund the amounts to nonmember

patrons, the Service said there was no existing obligation to do so

at the time amounts were deposited into the reserve, and in fact

Federal law prohibited payment at that time. Section 521 status

was denied.236

Many cooperatives do not market or purchase for nonmembers. If a section 521 cooperative only conducts business with or

for members, the issue of treating members and nonmembers alike

is not relevant. The cooperative is not required to have in place a

mechanism for sharing patronage refunds with nonmembers.

237

Equality of treatment requirements do not apply where

permissible purchases of items to supplement marketing activity
 Rev. Rul. 76-388, 1976-2 C.B. 180, 181. 238

Id. 239

 Rev. Rul. 75-110, 1975-1 C.B. 167. 240

 I.R.C. § 521(b)(1).

241

77

are made from nonmember nonproducers who do not qualify as

patrons. Such circumstances may occur when a cooperative makes

sideline product purchases and emergency purchases from

nonmember nonproducers.

In Revenue Ruling 76-388, the Service said a patron bears the

risk of loss from dealings with the cooperative, but nonmember

nonproducers from whom sideline and emergency purchases are

made at a fixed price bear no such risk. These commercial

transactions do not involve "utilization of the cooperative

function." Nonmember nonproducers selling sideline and 238

emergency products to the cooperative do not attain "patron status"

and patronage dividends need not be paid to them.239

Cooperatives need not treat all patrons exactly the same. For

example, a cooperative may determine patronage refund

allocations based on quality of product, rewarding those patrons

who deliver a higher quality product to the cooperative. In

Revenue Ruling 75-110, a milk marketing co-op proposed to 240

adopt a quality bonus program to provide economic incentive for

its members to produce higher quality milk. The payment was a

premium above the Federal milk marketing order base price,

directly attributable to providing a higher quality of milk.

The Service said the bonus plan was a permissible method of

allocating income among the producer-members with which the

cooperative did business and would have no adverse effect on the

cooperative's section 521 status. It stated:

Under the stated facts, the...bonus program meets the

overall standard of the above sections of the Code in that 241

members similarly situated are treated equally. The quality

standards established by the program represent a reason-
 Rev. Rul. 75-110, 1975-1 C.B. 167, 168. 242

 Priv. Ltr. Rul. 9006024 (Nov. 9, 1989).

243

 I.R.C. § 521(b)(1)(A) and (B). 244

 Treas. Reg. § 1.521-1(c).

245

 Rev. Rul. 67-253, 1967-2 C.B. 214. 246

78

able method of differentiating between milk of varying

quality and are equally applicable to all the members of the

[cooperative].242

IRS also permitted a cooperative, for sound business purposes,

to make larger advance payments to patrons who delivered their

product early in the marketing year. The program was open to all

patrons (member and nonmember) and the final payment to

patrons was adjusted so the total price per ton paid to all patrons

(adjusted for quality) was the same.243

Dual-Function Cooperatives

Code section 521(b)(1) describes separately the marketing and

purchasing functions of eligible cooperatives. The regulations 244

also note a distinction between these two activities, stating, "An

association engaged both in marketing farm products and in

purchasing supplies and equipment is exempt if as to each of its

functions it meets the requirements of the Code."245

IRS has asserted for a number of years that each function's

activity must be separately accounted for and allocated to patrons

of the respective function, almost as if two cooperatives exist.246

In one letter ruling, a cooperative with both purchasing and

marketing activity allocated patronage refunds on the basis of the

association's overall net margin. In one year, purchasing

constituted about 20 percent of the cooperative's sales but

generated nearly 50 percent of the margin.

The Service stated section 521 cooperatives "...must deal at

cost, not below or above cost, with the patrons of each
 Tech. Adv. Mem. 7902004 (Sept. 27, 1978).

247

 For other instances where IRS determines margins of each 248

function must be returned to the patrons of that function, see, Priv. Ltr.

Rul. 8025168 (March 27, 1980) and Tech. Adv. Mem. 8245082 (Dec.

31, 1981). The concept of equitable allocation of financial results

between patrons of different functions will be explored in more detail

in a section of a later report in this series covering handling of losses

and netting losses and gains between functions.

 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894 (1982). 249

 Treas. Reg. § 1.521-1(c).

250

 Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894, 907

251

(1982).

79

function....distributions must accurately reflect each patron's

dealings with each function." The Service found the cooperative 247

did not qualify for section 521 status because the patrons of the

purchasing department were not getting their fair share of

patronage refunds and therefore not receiving supplies and

equipment at cost plus necessary expenses as required by Code

section 521(b)(1).248

The courts have been less demanding than the Service in

requiring strict separation of marketing and supply activities. For

example, in Lamesa Cooperative Gin v. Commissioner a 249

cooperative engaged primarily in marketing carried on a small

supply function. It did not wish to set up a separate accounting

system for the supply function, preferring instead to allocate its net

margins as part of the primary marketing function.

The Tax Court held such a practice was permissible under the

circumstances. It pointed out that "nothing in (the regulations)

250

explicitly refers to any separate accounting requirement for

cooperatives engaged in both purchasing and marketing." The 251

court said it is obviously easier to determine if the allocation is fair

to patrons of both functions if separate accounts are maintained,

but the failure to account separately should not automatically

cause a patronage deduction to be disallowed. Facts the court
Id. at 910.

252

 I.R.C. § 1382(c)(2). The unique tax treatment of section 521

253

cooperatives is covered in Chapter 12, supra.

 Juniata Farmers Cooperative v. Commissioner, 43 T.C. 836

254

(1965), acq. 1966-1 C.B. 1.

80

cited in upholding the cooperative's method of allocation included

significant overlap between patrons of the two functions, the small

amount of purchasing done, and the membership's total acceptance

of the system.252

Nonpatronage Income

One of the two special deductions available to section 521

cooperatives is for earnings derived from business with the United

States or from other nonpatronage sources distributed to patrons

on a patronage basis. The proper allocation of nonpatronage 253

income among patrons of different functions is necessary to

qualify for the deduction.

Juniata Farmers Cooperative v. Commissioner involved an 254

interesting juxtaposition. Taxpayer was primarily a grain marketing cooperative with a modest farm supply business. The

cooperative kept records for each function and allocated margins

earned by each function separately to the patrons of that function.

In the tax years in question, a substantial portion of the

cooperative's income came from Commodity Credit Corporation

grain storage payments. The cooperative allocated this

nonpatronage sourced income to the patrons of the grain marketing

department on a patronage basis. IRS asserted that the cooperative

should have allocated a prorata share of this nonpatronage income

to the patrons of the purchasing department. The court summarily

dismissed IRS's contention and held the cooperative's allocation

fair and in compliance with section 521 requirements.

The Service subsequently stated that nonpatronage income and

nonpatronage losses may be allocated to patrons of a department

or departments to which the income or losses relate, rather than to
 Rev. Rul. 67-128, 1967-1 C.B. 147. The cooperative was 255

consistent in its practice and in each case could show that the particular

nonpatronage income or loss was related to the department or

departments to which it was allocated.

 Rev. Rul. 67-253, 1967-2 C.B. 214; Priv. Ltr. Rul. 8025168 256

(March 27, 1980).

81

all patrons of the cooperative, "provided that the allocation is not

discriminatory among patrons similarly situated."255

Expenses

In general, net margins to be allocated to patrons as patronage

refunds are determined by reducing revenues by expenses. A

section 521 cooperative that pays patronage refunds separately to

its marketing and purchasing patrons must calculate the net margin

for each function. Therefore, it must allocate its expenses (as well

as revenue) between the two functions.

The Service has stated that when a section 521 cooperative

allocates expenses to functions, it may not do so simply on the

basis of gross sales by function. It must offset operating and other

costs against the gross income of each function insofar as such

costs are identifiable charges against the income of that function.

Costs which cannot be reasonably identified as being attributable

to a particular function may be apportioned between the functions

on the basis of ordinarily accepted accounting principles.256

Exceptions

Section 521 cooperatives must make proportional allocations

of earnings to member and nonmember patrons. However, limited

variations on the equal treatment rule are permitted. These include

applying a patronage refund toward a nonmember's membership

investment, different forms of payment depending on consent,

separate treatment for small refunds, and adjustments for

nonqualified paper.
 Treas. Reg. § 1.521-1(a)(1). 257

Id. 258

 Treas. Reg. § 1.521-1(a)(1); Treas. Reg. § 1388-1(c)(1). 259

 For a brief description of base capital financing plans, see 260

Donald A. Frederick, Income Tax Treatment of Cooperatives:

Background, RBS Cooperative Information Report 44, Part 1 (USDA

2005) pp. 79-80. For a thorough discussion, see Robert C. Rathbone &

Donald R. Davidson, Base Capital Financing of Cooperatives, RBCDS

Cooperative Information Report 51 (USDA 1995).

 Priv. Ltr. Rul. 7925114 (March 23, 1979).

261

82

Membership Investments and Fees

Normally, to join a cooperative the applicant must purchase a

share of capital stock or, in the case of a nonstock cooperative, pay

a membership fee. A cooperative may give new members options

in meeting this financial obligation.

Nonmembers may meet this commitment with an up-front cash

payment. They may also have their patronage refunds applied

toward purchase of membership. The regulations provide this

does not violate the section 521 equal treatment requirement.257

However, they require permanent records that support the

underlying patronage refund allocation and the application of the

refund to satisfy the membership requirement. They also note 258

refunds applied toward membership are not "payment in money"

for purposes of meeting the 20-percent cash distribution

requirement to qualify written notices of allocation.259

To facilitate a base capital plan cooperative financing system,

unequal amounts of equity investment may be required each year

to achieve the desired proportion of equity contributed by each

patron. A cooperative on a base capital plan may adjust the cash 260

portion of patronage refunds on an individual basis to bring each

patron's equity contribution in line with that required under its

plan.261

In Revenue Ruling 69-52, all members of the cooperative paid

an annual membership fee. An amount up to the annual member-
 Rev. Rul. 69-52, 1969-1 C.B. 161, superseding Gen. Couns. 262

Mem. 11,068, XII-1 C.B. 122 (1933).

 Treas. Reg. § 1.521-1(f).

263

 For requirements to qualify written notice of allocation, see 264

Donald A. Frederick, Income Tax Treatment of Cooperatives:

Distribution, Retains, Redemptions, and Patrons' Taxation, RBS

Cooperative Information Report 44, Part 3 (USDA 2005) pp. 31-51.

83

ship fee was withheld from patronage refunds otherwise due each

nonmember patron. The entire patronage dividend was withheld

if the patronage refund due a nonmember patron was less than the

annual membership fee.

IRS said this method of distributing patronage refunds was

permissible under section 521. "The requirement that nonmembers pay a reasonable annual fee is no more than a requirement

that those who avail themselves of the facilities offered by the

cooperative pay their share of the cost of the operations of the

organization."262

Consent

A section 521 cooperative may base some features of its

patronage refund distribution on each patron's consent decision.

A cooperative may make refund payments solely in nonqualified

written notices of allocation to patrons who do not give

qualification consent, but pay20 percent in cash and the remainder

in qualified written notices of allocation to patrons who do give

statutory consent.263

Small Refunds

If small amounts are due patrons, record-keeping requirements

become burdensome. Variances from the rule of equal treatment

are permitted.

A cooperative issuing qualified written notices of allocation is

generally required to pay at least 20 percent of the refund in

cash. The regulations provide that when the refund is for less 264

than $5, a section 521 cooperative may make the entire payment
 Treas. Reg. § 1.521-1(f).

265

 Rev. Rul. 66-152, 1966-1 C.B. 155. 266

 Rev. Rul. 55-141, 1955-1 C.B. 337. 267

 Tech. Adv. Mem. 8228008 (March 31, 1982).

268

84

as a nonqualified written notice of allocation, even though the

patron has consented to include the amount of the refund in

taxable income. Other consenting patrons receiving a refund of $5

or more must receive at least 20 percent in cash and the remainder

as a qualified written notice of allocation.265

The Service has also stated a section 521 cooperative may

make full payment in money or qualified check to patrons entitled

to patronage refunds of $10 or less, while patrons entitled to a

refund of $10 or more receive $10 or 20 percent of their refund in

cash, whichever is greater, thus eliminating the small written

notice of allocation. This is a permissible discrimination among

patrons.266

Also, again to reduce record-keeping costs, a section 521

cooperative may simply withhold refunds of less than one dollar,

and all cents in excess of even dollars due patrons. However, 267

except for the variations described in Revenue Ruling 55-141,

"administrative hardship" will not excuse strict adherence to

accounting and allocation rules.268

Returns on Nonqualified Allocations

Although not a usual practice, cooperatives may pay interest

or dividends on retained patronage refunds or per-unit retains.

Written notices of allocation or per-unit retain certificates may be

qualified or nonqualified depending on consent decisions by

recipients, and the tax imposed on the cooperative will differ

accordingly. The regulations permit a cooperative to pay a smaller

amount of interest or dividends on nonconsenting recipients' nonqualified written notices of allocation and per-unit capital retains.

The reduction in interest or dividends must be "reasonable in

relation to the fact that the association receives no tax benefit with
 Treas. Reg. § 1.521-1(f).

269

 I.R.C. § 521(b)(3).

270

 Treas. Reg. § 1.521-1(a)(3) for marketing cooperatives, made 271

applicable to supply cooperatives by Treas. Reg. § 1.521-1(b).

 Rev. Rul. 76-233, 1976-1 C.B. 173. 272

Id. at 174.

273

85

respect to such nonqualified written notices of allocation (or such

certificatesissued to nonqualifying patrons) until redeemed." If 269

reasonable, the difference will not violate the equality of treatment

requirement of section 521.

RESERVES

The Code provides that a section 521 cooperative may

accumulate and maintain "a reserve required by State law or a

reasonable reserve for any necessary purpose."270

The regulations give some examples of reserves considered to

be for a necessary purpose. They are "...to provide for the erection

of buildings and facilities required in business or for the purchase

and installation of machinery and equipment or to retire

indebtedness incurred for such purposes...."271

IRS has not questioned the authority of section 521

cooperatives to have reserves, but has attempted to limit how those

reserves are invested. Revenue Ruling 76-233 concerned a 272

cotton marketing cooperative that wanted to broaden its economic

base by purchasing a wool processing business. IRS said a section

521 cooperative may properly invest the reserves and incur

expenses incident to such investment without jeopardizing its

exempt status.

There are, however, limits on such investments. Investments

must be "...incidental to the conduct of [the cooperative's] business

on a cooperative basis. Investments...in noncooperative enterprises that are not merely incidental are inconsistent with" section

521 status. The Service said the cooperative in this example 273
 IRS staff has also questioned whether section 521 cooperatives, 274

and other cooperatives as well, can accumulate unallocated reserves.

See, e.g., Gen. Couns. Mem. 38,099 (Sept. 18, 1979).

 Fertile Co-operative Dairy Association v. Huston, 119 F.2d 274

275

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

 Rev. Rul. 69-431, 1969-2 C.B. 133. 276

86

would not qualify for section 521 status because the investment

was not made to facilitate marketing cotton for members and other

producers.

274

OTHER ISSUES

The Service has raised other issues questioning the right of

various farmer cooperatives to section 521 status. This section

discusses those items.

Distributions Upon Dissolution

At dissolution, a cooperative may have a residual available for

distribution after all obligations are paid and the equity is

redeemed. An early 8th Circuit opinion stated that a section 521

cooperative must establish a legal obligation and keep adequate

recordsto allocate and distribute that residual to all patrons whose

business contributed to the residual, not just to member patrons.275

In Revenue Ruling 69-431, the Service said that although the 276

Code does not specifically cover the participation rights of

stockholders in profits of a section 521 in the event of dissolution,

it does require all net earnings from marketing and purchasing be

returned to patrons on the basis of patronage. Such net earnings

available for distribution at the cooperative's dissolution must be

distributed to patrons on the basis of patronage rather than

stockholders on the basis of their stock ownership. Thus,

"although stockholders may share in the profits of an exempt
Id. at 134.

277

 This is a generally accepted definition. Rev. Rul. 69-651, 1969-2 278

C.B. 135. The literature may also refer to a "mixed" cooperative as one

with both individual farmers and other cooperatives as members.

Although research has not uncovered a ruling on point, it is likely that

a mixed cooperative would have to meet the same tests as a true

federated to qualify for section 521 status.

 I.T. 2000, III-1 C.B. 290 (1924); S.M. 2288, III-2 C.B. 233 279

(1924).

 Rev. Rul. 69-651, 1969-2 C.B. 135. 280

87

farmers' cooperative, they may do so only on the basis of their

patronage rather than on the basis of shares of stock that they may

own. Neither common nor preferred stockholders may participate

in the profits of an exempt farmers' cooperative, upon dissolution

or otherwise, beyond the fixed dividends."277

Federated Cooperatives and "Look Through"

A federated cooperative is one whose members are other

cooperatives rather than individual persons. Section 521 278

contains no specific reference to federated cooperatives, but

longstanding administrative practice has considered federated

cooperatives eligible for section 521 status.

279

IRS prescribed rules for the section 521 qualification of

federated cooperatives in Revenue Ruling 69-651. It applies 280

what the Service calls the principle of "looking through" the

member associations to the ultimate patrons in determining

eligibility of the federated for section 521 status. The ruling

states:

Farmers' cooperatives may join together to form a

federated cooperative to perform more efficient marketing

or purchasing functions on behalf of the patrons of the

member cooperatives. Since a federated serves the

interests of the patrons of its member cooperatives, it is
Id. 281

 Although the situations in the ruling involve purchasing 282

cooperatives, it states the conclusions are equally applicable to

marketing cooperatives. 

88

held that it is necessary to look to the patrons of the

member cooperatives to determine whether the federated

meets the requirements of section 521(b) of the Code. In

making that determination, the federated is considered to

be dealing directly with the patrons of its member

cooperatives. Likewise, in determining control of the

federated, it is held that it is necessary to consider the

composition of membership of the member

cooperatives.281

Rev. Rul. 69-651 illustrated the "look through" principle with

four sample situations:

282

1. When all members of the federated are section 521 cooperatives themselves, the federated will qualify for section 521 status.

2. When some of the members of the federated are not section

521 cooperatives and they pay patronage refunds only to their

members, even though they do business with members and

nonmembers, the federated does not qualify for section 521 status.

3. A federated with non-section 521 members must, in the

aggregate, comply with the limitations on nonmember,

nonproducer business applicable to section 521 cooperatives. The

ruling provides that the value of supplies the members of a

federated turn over to members must exceed that of supplies

turned over to nonmembers.

Also, the value of the federated's supplies its members turn

over to nonmember nonproducers may not exceed 15 percent of

the value of its supplies turned over to all supply customers by its

members. Asthe ruling also applies to marketing cooperatives, it

infersthat all products provided for marketingmust be from mem-
 Rev. Rul. 71-493, 1971-2 C.B. 240. 283

 Internal Revenue Bulletin, No. 1972-6 (Feb. 6, 1972).

284

 Rev. Rul. 72-50, 1972-1 C.B. 163. 285

89

bers or other producers and the value of member products marketed must exceed that of products marketed for nonmembers.

4. Substantially all (at least 85 percent) of the voting control

of the federated's members as a whole (indirect voting control of

the federated) must be held by producers who currently patronize

the federated's members.

The Service's "look through" theory produced controversy,

some confusion, and numerous additional administrative decisions

over the next few years. Rev. Rul. 69-651 was issued as a

prospective decision with an effective date of the federated's tax

year beginning on or after July 1, 1970. The first additional ruling

postponed the effective date for situation 2 through 4 to tax years

beginning on or after July 1, 1971. This postponement was 283

intended to give the Service time to develop compliance

guidelines for Rev. Rul. 69-651.

In early 1972, the Service published five rulings to clarify 284

Rev. Rul. 69-651. Their holdings are summarized below.

Revenue Ruling 72-50 -- The purchase from other commercial

sources and resale of farm supplies not available from the

federated by a non-section 521 member of a federated can be

disregarded in determining if the federated is eligible for section

521 status.

285

Revenue Ruling 72-51 -- A federated supply cooperative does

business with one nonmember, non-section 521 cooperative. It

knows all of its member cooperatives have section 521 status and

deal exclusively with producers. So long as its sales to the nonmember cooperative are less than 15 percent of total supply sales,

it need not do the "look through" calculations as it will clearly still

comply with the 15-percent limitation on nonmember,

nonproducer business. If the federated isn't sure of compliance

with the 15 percent limit, it may be able to look through the
 Rev. Rul. 72-51, 1972-1 C.B. 164. 286

 Rev. Rul. 72-52, 1972-1 C.B. 165. 287

 Rev. Proc. 72-16, 1972-1 C.B. 738. 288

 Rev. Proc. 72-17, 1972-2 C.B. 739. 289

 Rev. Rul. 73-138, 1973-1 C.B. 293. 290

90

nonmember to determine the level of purchases of its products

ultimately made by producers. But to do this, the nonmember

must be selling the supplies from the federated to both members

and nonmembers at cost plus necessary expenses.286

Revenue Ruling 72-52 -- A non-section 521 cooperative is a

member of a grain marketing federated with section 521 status.

The local cooperative receives grain from both its memberproducers and other nonmember producers. It sells grain to both

the federated and to other commercial buyers. In computing its

own compliance with the majority member business rule, the

federated will allocate grain received from this member according

to the same percentages as the member received grain from

members and nonmembers.

287

Rev. Proc. 72-16 -- This ruling sets out the information a

federated cooperative must compile and provide IRS to establish

and maintain section 521 status.

288

Rev. Proc. 72-17 -- Outlines three methods available to a

federated cooperative to establish and maintain its section 521

status when its taxable year differsfrom the taxable years of some

of its members.

289

Controversy over the "look through" rules continued,

particularly Revenue Procedure 72-17. In early 1973, IRS

suspended application of Situations 2 through 4 of Revenue

Ruling 69-651 until a restudy of Rev. Proc. 72-17 was

completed.290

In November 1973, the Service completed its consideration of

the "look through" theory. It provided an additional method for a

federated cooperative to treat members with tax years different

from its own. A federated was permitted to take the taxable year
 Rev. Proc. 73-38, 1973-2 C.B. 501. 291

 Rev. Rul. 73-568, 1973-2 C.B. 194. 292

 Rev. Rul. 69-651, 1969-2 C.B. 135 (situation 1).

293

 Rev. Rul. 84-81, 1984-1 C.B. 135. 294

 For a discussion of the IRS position concerning tree farmers and

295

section 521, see supra pp. 16-17.

91

of a member that ends within the federated's taxable year and

consider it the same as that of the federated.291

The Service also revoked Revenue Ruling 73-138, which had

suspended Revenue Ruling 69-651. This made Situations 2

through 4 in Revenue Ruling 69-651 applicable for all tax years

beginning on or after December 17, 1973, the date these

determinations appeared in the Internal Revenue Bulletin.292

The IRS position on "look through" has made it difficult for a

federated cooperative to use section 521. If all cooperative

members of a federated are section 521 cooperatives, and if the

federated deals with its member cooperatives on a cooperative

basis, the federated cooperative will qualify. Otherwise the 293

burdens of compliance discourage even trying to qualify.

Research has uncovered one additional ruling on federated

cooperatives and section 521. Revenue Ruling 84-81 discussed 294

a federated cooperative developed by persons who grew pine trees

and cut them into pulpwood. They formed local cooperatives to

market their pulpwood. The locals formed a federated cooperative

that bought pulpwood from its cooperative members and

processed it into newsprint. IRS said that because timber growers

are not "farmers" for purposes of section 521, the federated 295

cooperative could not qualify for section 521.

Subsidiaries

Although the issue isn't addressed in the Code or regulations,

farmer cooperatives can organize and use subsidiaries and still

qualify for section 521 treatment. However, IRS has consistently
 Rev. Rul. 69-575, 1969-2 C.B. 134. 296

Id., citing S. Rep. No. 52, 69th Cong., 1st Sess. (1939), reprinted 297

in 1939-1 C.B. (Part 2) 332, 350. See also Rev. Rul. 76-233, 1976-1

C.B. 173, 174 (cotton marketing cooperative began investment plan

including purchase of interest in wool processing company); Priv. Ltr.

Rul. 9547015 (August 24, 1995) (Subsidiary conducted business with

nonmembers on a nonpatronage basis).

92

said that the subsidiary may only carry out activities the parent

cooperative is allowed to conduct.

The IRS position was adopted in a series of rulings beginning

with Revenue Ruling 69-575. The Service offered two 296

examples of cooperative purchasing associations that created

subsidiaries to handle nonmember-nonproducer business. In the

first, the subsidiary paid patronage refunds to its patrons, but the

subsidiary's purchases for nonmember-nonproducers exceeded 15

percent of the combined purchasing business of the parent

cooperative and the subsidiary. In the second, the subsidiary's

purchases for nonmember-nonproducers were less than 15 percent

of the combined purchases for the subsidiary and the parent

cooperative, but no patronage refunds were paid to the patrons of

the subsidiary. Instead, all earnings of the subsidiary were treated

as taxable income and turned over to the parent cooperative as

nonpatronage income. The Service stated:

A farmers' cooperative association that is exempt under

section 521 of the Code may establish and control a

subsidiary corporation so long as the activities of the

subsidiary are activities that the cooperative itself might

engage in as an integral part of its operations without

affecting its exempt status. However, an exempt

cooperative may not utilize a subsidiary for the conduct of

operations on an ordinary profitmaking basis.

297

The Service then determined that neither cooperative was

entitled to section 521 status. In the first example, the operations
93

of the subsidiary couldn't have been conducted as an integral part

of the parent cooperative because such operations would have

violated the 15-percent limit on nonmember-nonproducer

purchasing business in Code section 521(b)(4). In the second, the

operations of the subsidiary also couldn't have been conducted as

an integral part of the parent cooperative because the subsidiary

paid no patronage dividends as required by section 1.521-1(a) of

the regulations.

Under Revenue Ruling 69-575, a subsidiary's operation may

jeopardize its parent cooperative's section 521 status in two ways.

First, limits placed on section 521 cooperatives regarding business

conducted with nonmembers and nonproducers may be violated if

the subsidiary's activities are attributed directly to the parent

cooperative. Second, the subsidiary may deal with its patrons on

a basis not permitted the parent if the parent dealt directly with

those patrons.

One farm supply cooperative tried a novel organizational

approach to avoid Revenue Ruling 69-575. The cooperative's

directors and officers, acting on instructions of the cooperative's

membership, established a separate supply association to handle

nonmember, nonproducer business. The supply association paid

patronage to all cooperative patrons. The cooperative's directors

were original incorporators and sole stockholders of the supply

association, each holding one share of common stock. If a

cooperative director ceased being a director, that stock was sold at

par value to the successor.

The supply association's purchases for nonmember,

nonproducers exceeded 15 percent of the combined purchases of

the cooperative and the supply association. IRS said "this

relationship...results in effective ownership and control by [the

cooperative] that is as significant as the ownership and control the

parent cooperative had over its subsidiary in Revenue Ruling

69-575.

Accordingly, all business conducted by [the supply

association], including nonmember-nonproducer business, will be
 Rev. Rul. 73-148, 1973-1 C.B. 294. The ability of the courts, 298

and presumably the Service, to "pierce through the shell of separate

corporate identity" and treat a cooperative and an affiliated firm "as a

single entity" for tax purposes was noted as early as Burr Creamery

Corp. v. Commissioner, 62 F.2d 407, 409 (9th Cir. 1932), cert. denied,

289 U.S. 730 (1933).

 Priv. Ltr. Rul. 9547015 and 9547016 (August 24, 1995). The 299

cooperative anticipated this outcome. In these same rulings it did

receive the findings it wanted, that the subsidiary could operate on a

cooperative basis and, if it did so, transfer to the cooperative as tax

deductible patronage refunds all of its earnings from processing and

marketing products supplied by the cooperative.

94

considered [the cooperative's] business."298

The Service treated the supply association as it would a true

subsidiary. Its business exceeded the 15-percent limit on

purchases for nonmember-nonproducers, so the cooperative was

denied section 521 status.

The Service reached a similar conclusion in two virtually

identical letter rulings concerning the acquisition of a food

processing firm by a cooperative marketing association with

section. 521 tax status. Before the acquisition, the firm had

purchased all of the product marketed by the cooperative on behalf

of its members. The acquired firm was reorganized as a wholly

owned subsidiary of the cooperative. The acquired firm had

conducted some business with nonproducers on a profit-making

basis and conducted some business with growers who were not

members of the acquiring cooperative on a nonpatronage basis.

The acquired firm intended to continue both business

arrangements. As both activities would disqualify the parent

cooperative from section. 521 status, the Service said that

conducting them through the subsidiary also caused the

cooperative to lose its section 521 status.

299

IRS did permit a section 521 cooperative to establish a wholly

owned Domestic International Sales Corporation (DISC). IRS

noted the DISC would perform foreign marketing functions that
 Rev. Rul. 73-248, 1973-1 C.B. 294. 300

 Rev. Rul. 75-388, 1975-2 C.B. 227. 301

95

the cooperative was already conducting as an integral part of its

operations without affecting its section 521 status.

300

Revenue Ruling 75-388 established that a subsidiary itself 301

may qualify for section 521 treatment, if the subsidiary meets

section 521 qualifications. The mere fact that its parent is a

section 521 cooperative does not convey that status to the

subsidiary. In this instance, the issue was whether substantially all

of the voting stock of a wholly owned subsidiary of a section 521

cooperative was owned by producers as required by Code section

521(b)(2). The Service said it was, because the subsidiary served

the interests of the cooperative members and since the cooperative

had section 521 status, its membership satisfied the control

requirements for the wholly owned subsidiary as well.

In summary, a section 521 cooperative may conduct business

through a subsidiary. But, for the cooperative to maintain its

section 521 status, the activities of the subsidiary must be

activities that the cooperative itself might engage in as an integral

part of its operations without jeopardizing section 521 status.

Access to Declaratory Judgments

Until recently, cooperatives were denied access to judicial

review of disputes regarding their initial or continuing

qualification to section 521 tax status until IRS asserted a tax

deficiency or a tax had been paid and a refund claim filed.

Available remedies were generally limited to filing a petition in

U.S. Tax Court for relief following a notice of deficiency or to

paying a tax and suing for a refund in a U.S. District Court or the

U.S. Court of Federal Claims. This could delay resolution of

disputed issues for several years.
 26 U.S.C. § 7428.

302

See, e.g., S. 2498, 105th Cong., 2d Sess. § 2 (1998); H.R. 1469, 303

106th Cong., 1st Sess. § 2 (1999); S. 312, 107th Cong., 1st Sess. § 10

(2001); H.R. 2347, 107th Cong., 1st Sess. § 10 (2001); S. 1637, 108th

Cong, 1st Sess. § 308 (2003).

American Jobs Creation Act of 2004, § 317, Pub. L. No. 108- 304

357, 118 Stat. 1470 (codified at 26 U.S.C. § 7428(a)(1)(D)). See also,

H.R. Conf. Rept. No. 755, 108th Cong., 2d Sess. at 363.

96

Code section 7428 provides that in other limited contexts,

declaratory judgment procedures are available. These permit a 302

taxpayer to seek judicial review of an IRS determination prior to

the issuance of a notice of deficiency and prior to the payment of

tax. Declaratory judgment relief is currently available to

organizations engaged in an actual controversy with the Service

over, among other things, their qualification as a religious,

charitable, or educational organization under Code section

501(c)(3) or a private foundation under Code section 509. So, for

example, when the IRS denies an organization’s application for

recognition as an exempt organization under Code section

501(c)(3), or fails to act on an application, or revokes or adversely

modifies its tax-exempt status, the organization can seek a

declaratory judgment regarding its tax-exempt status.

Legislation was introduced in several Congresses to extend

this same procedural option to cooperatives in a dispute with the

IRS over access to section 521 tax status.

303

In 2004, cooperatives achieved this objective. The American

Jobs Creation Act of 2004 created a new I.R. Code subparagraph

section 7428(a)(1)(D). It permits a cooperative, when its

application for Section 521 tax status is rejected, to seek judicial

review of the denial without first creating a tax controversy. Such

a case may be commenced in the U.S. Tax Court, the U.S. District

Court for the District of Columbia, or the U.S. Court of Federal

Claims. The court has jurisdiction to determine a cooperative’s

initial or continuing qualification as a farmers’ cooperative

described in Code section 521.304
 I.R.C. § 521(a). 305

 Treas. Reg. § 1.1381-2(a)(1). See also Independent Cooperative 306

Milk Producers Ass'n v. Commissioner, 76 T.C. 1001, 1008 (note 10)

(1981).

 Farmers Cooperative Company v. Commissioner, 85 T.C. 601, 307

602-603 (note 3) (1985). See also Certified Grocers of California, Ltd.

v. Commissioner, 88 T.C. 238, 249 (1987), where the Tax Court noted

that it was the Service, not the Code, that assigned the 501 status.

"Whatever the situation may be with respect to cooperatives exempt

under 521--whether [the Service] may decree that such cooperatives are

to be treated as exempt under section 501, the statute being silent, ... is

a matter which we may leave to another day and another case."

97

CHAPTER 12

SECTION 521 TAX TREATMENT

The Internal Revenue Code (Code) places section 521

cooperatives in a peculiar position. They are "exempt"

organizations subject to taxation. Code section 521(a) states:

A farmers' cooperative organization described in

subsection (b)(1) shall be exempt from taxation... except

as otherwise provided in part I of subchapter T (sec. 1381

and following)....(S)uch an organization shall be

considered an organization exempt from income taxes for

purposes of any law which refers to organizations exempt

from income taxes.305

At one point, the regulations go so far as to state a section 521

cooperative will "be considered as an organization exempt under

section 501." However, this statement has its limits. 306 307

Differences in the tax treatment of a section 521 cooperative and

a section 501 exempt organization are noted throughout this

chapter.
 At times, however, early courts seemed to impose taxation on 308

some impermissible activities without explicitly revoking the

organization's exempt status. In Fruit Growers' Supply Co. v.

Commissioner, 56 F.2d 90 (9th Cir. 1932), aff'g 21 B.T.A. 315 (1930),

income derived from selling surplus supplies to nonmembers constituted

taxable gain to the cooperative. In Central Co-operative Oil Ass'n v.

Commissioner, 32 B.T.A. 359 (1935), the cooperative was taxed on

income derived from patrons to whom no patronage refunds were made.

 Revenue Act of 1951, ch. 521, § 314, 65 Stat. 452, 491-493 309

(1951). For a detailed description of the legislative history leading up

to current Code section 521 and Subchapter T, see, Donald A.

Frederick, Income Tax Treatment of Cooperatives: Background, RBS

Cooperative Information Report 44, Part 1 (USDA 2005) pp. 83-129.

 This definition was designated § 101(12)(A) by the Revenue Act 310

of 1951. It was recodified as § 521 in the Internal Revenue Code of

1954.

 Codified as § 101(12)(B) in the Revenue Act of 1951 and 311

recodified as § 522(b)(1) in the Internal Revenue Code of 1954.

 Revenue Act of 1962, Pub. L. No. 87-834, § 17, 76 Stat. 960, 312

1045-1052 (1962).

98

BACKGROUND

Farmer cooperatives described in the current section 521 were,

until 1951, truly tax exempt organizations. The Revenue Act of 308

1951 retained the definition of a farmer cooperative previously 309

exempt from taxation. However, it ended the true tax exempt 310

status of these associations and replaced it with deductions for

stock dividends and patronage-based distributions of nonpatronage

income.311

Section 522 was repealed and replaced by Subchapter T (Code

secs. 1381-1388) in the Revenue Act of 1962. This explains 312

how tax rules for section 521 cooperatives were separated from the

description of such an association in the Code.

Code section 521 is merely descriptive of an association that

qualifies for section 521 status. It doesn't contain any tax rules.
 I.R.C. § 1382(c) and Treas. Reg. § 1.1382-3. 313

 I.R.C. § 1381(b).

314

 Treas. Reg. § 1.1381-2(a)(1). 315

See Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 316

729, 730 (note 2) (1978); Farmers Cooperative Co. v. Commissioner, 85

T.C. 601, 602 (note 3) (1985), remanded, 822 F.2d 774 (8th Cir. 1987).

99

The special tax treatment of section 521 cooperatives is set out in

Subchapter T.

The primary tax advantages of Section 521 cooperatives are

access to two deductions they may take in addition to those

available to all other Subchapter T cooperatives. They can deduct

dividends paid on capital stock, within limits, and nonpatronage

sourced income paid patrons on a patronage basis. In addition, 313

other tax and nontax laws are based on a cooperative's

qualification forsection 521, something cooperatives may need to

consider when making a decision to seek, maintain, or give up

section 521 status.

SUBJECT TO TAXATION

The anomaly of considering section 521 cooperatives as

exempt organizations is driven home by Code section 1381(b),

which provides such associations "shall be subject to the taxes

imposed by section 11 (corporate income taxes) or section 1201

(capital gains taxes)." The regulations state this includes both 314

normal tax and surtax, where applicable.315

The basic approach to section 521 cooperative taxation is

similar to that of other cooperatives. Gross income is reduced on

an item-by-item basis through the application of specific

deductions described in the Code. Income remaining is taxable to

the cooperative.316
 I.R.C. § 1382(c)(1) and Treas. Reg. § 1.1382-3(b).

317

 Treas. Reg. § 1.1382-3(b).

318

Id.

319

 I.R.C. § 1382(c)(1); Treas. Reg. § 1.1382-3(b). 320

 Treas. Reg. § 1.1382-3(b).

321

100

Deduction for Dividends Paid on Capital Stock

Cooperatives are free to compensate members for the use of

the capital they have in the cooperative by paying dividends on

capital stock. As with any corporation, dividends are typically

paid out of earnings on which the corporation has paid taxes.

The Code, however, provides special treatment for section 521

cooperatives. They are allowed to deduct "amounts paid during

the taxable year as dividends on capital stock."317

The regulations describe capital stock broadly as including

"common stock (whether voting or nonvoting), preferred stock, or

any other form of capital represented by capital retain certificates,

revolving fund certificates, letters of advice, or other evidence of

a proprietary interest in a cooperative association."318

The regulations also provide amounts paid as dividends on

capital are to be considered "as a deduction from the gross income

of a cooperative...."319

The proper time to recognize the deduction for dividends on

capital stock differs from that of patronage-based distributions.

The principle of "payment period" in which a cooperative may

deduct patronage refunds paid up to 81⁄2 months following the

close of its taxable year does not apply to dividends on capital

stock. Dividends on capital may only be deducted from gross

income for the year they are paid out. The regulations permit 320

actual or constructive payment.321

Because the date of payment determines the year in which a

deduction may be taken, IRS has said a cooperative may declare

a dividend in a year it is not qualified under section 521 and take
 Rev. Rul. 70-233, 1970-1 C.B. 180. 322

 Treas. Reg. § 1.1382-3(b). Code section 561 provides for the 323

deduction for certain dividends distributions by a personal holding

company and other types of businesses listed in Treas. Reg. § 1.561-

1(a).

 I.R.C. § 521(b)(2).

324

 For a discussion of the permissible rate of dividends on capital 325

stock, see supra pp. 54-57.

101

a deduction in the following year if it then qualifies for section 521

and makes payment of the dividend in that year.

322

The regulations contain three additional guidelines pertaining

to this deduction:

1. If the dividend is paid by a check bearing a payment

date within the taxable year and it is mailed in a manner to

reasonably assume it will arrive within the taxable year, a

presumption arises that payment occurred within that year.

2. The determination of whether a dividend has been paid

within a particular year is in no way dependent upon the

cooperative's method of keeping its financial records.

3. For other rules on deducting dividend payments, under

certain conditions, refer to Code section 561.323

The Subchapter T provision providing for the deduction of

dividends on capital stock by section 521 cooperatives does not

limit the rate of payment. However, to qualify for section 521

status, a cooperative may not pay a dividend that exceeds the legal

rate of interest in the State of incorporation or 8 percent per

annum, whichever is greater."324

Thus, to determine the maximum rate at which dividends can

be paid, a cooperative must look to both tax law and its own State

cooperative incorporation statute. The payment of dividends

above the permissible rate will result in the loss of section 521

status and all benefits thereof, not just the dividend payment

deduction.325
 I.R.C. § 1382(c)(2)(A) and Treas. Reg. § 1.1382-3(c).

326

Id.

327

 I.R.C. § 1382(c)(2)(B). 328

 Donald A. Frederick, Income Tax Treatment of Cooperatives: 329

Patronage Refunds, RBS Cooperative Information Report 44, Part 2

(USDA 2005) p. 27. This includes the definition of "income derived

from sources other than patronage" at Treas. Reg. § 1.1382-3(c)(2).

102

Deduction for Patronage-Based Allocations

of Nonpatronage Sourced Income

The Code provides a second special deduction for section 521

cooperatives. They may deduct "earnings...derived from business

done for the United States or any of its agencies or from sources

other than patronage" paid to patrons on a patronage basis. This 326

includes both direct payments in cash and qualified written notices

of allocation, as well as payments to redeem nonqualified 327

written notices issued to distribute earlier nonpatronage sourced

earnings.328

The requirement that most cooperatives distinguish patronage

and nonpatronage sourced income is the subject of Chapter 5 of

these reports. This is not a major issue with section 521 329

cooperatives. As both types of income are deductible when

allocated to patrons on the basis of patronage, for the most part

they simply combine the two and allocate them as other

cooperatives do their margins on patronage business.

Nevertheless, a section 521 cooperative must be careful in

handling its nonpatronage sourced income. It must be sure

nonpatronage sourced income is not generated from activities in

which the cooperative may not engage or somehow leads to

unequal treatment of patrons, either of which may destroy the

cooperative's section 521 tax status. It also needs to be sure the

underlying funds qualify for a deductible distribution.
 I.R.C. § 1382(c)(2)(A) in the case of refunds paid and I.R.C. § 330

1382(c)(2)(B) in the case of redemptions of nonqualified allocations.

 Tech. Adv. Mem. 7840010 (June 22, 1978).

331

 The cooperative also argued that such income was patronage 332

sourced. This approach was rejected by the Service.

 Tech. Adv. Mem. 7840010 (June 22, 1978).

333

103

Earnings

The distribution by the cooperative must be made "with

respect to its earnings...." If a cooperative receives income not 330

classified as "earnings," it cannot receive a deduction when the

money is distributed to patrons.

In one letter ruling, a section 521 cooperative had issued 331

qualified written notices of allocation in prior years as part of its

patronage refund distribution. Responding to patrons' requests, the

cooperative redeemed some of the nonqualified paper earlier than

it would have under its regular equity redemption schedule. It

redeemed this equity at a discount, paying only 50 percent of the

original patronage refund amount. The cooperative accounted for

the discounted amount as income and allocated it to current year's

patrons on a patronage basis. It claimed a deduction for

distribution of nonpatronage sourced income under Code section

1382(c).

332

The Service held the income generated by discounting the

equity certificates was not "earnings" for purposes of section 521

deductions. IRS said the amount realized must be recognized as

income under the tax benefit rule. However, it found that

classifying earnings as patronage or nonpatronage sourced

"presupposes a transaction which gives rise to an amount which

can legitimately be considered 'earnings.' It does not apply if the

amount realized isn't 'earnings' in the first place. The amounts

here in question are, in effect, merely amounts recovered which

were previously deducted against 'earnings' of another taxable

year." The co-op was not permitted to deduct the distribution of 333

income realized as a result of the discounted redemption.
 I.R.C. § 1382(c)(2)(A), incorporated by reference in I.R.C. § 334

1382(c)(2)(B). See also Treas. Reg. § 1.1382-3(c)(1).

See supra pp. 52-53. 335

 Rev. Rul. 76-388, 1976-2 C.B. 180, 181. 336

 Rev. Rul. 68-332, 1968-1 C.B. 383: Rev. Rul. 69-431, 1969-2 337

C.B. 133. See Treas. Reg. § 1.1382-3(c)(2) and the discussion of this

language in Donald A. Frederick, Income Tax Treatment of

Cooperatives: Patronage Refunds, RBS Cooperative Information

Report 44, Part 2 (USDA 2005) pp. 39-81.

104

U.S. Government Business

The Code specifically provides for the deduction of a proper

distribution of earnings "derived from business done for the

United States or any of its agencies." Cooperatives may engage 334

in numerous kinds of transactions with Government in which

income is generated. For example, a marketing cooperative may

store a commodity owned at some point by the Commodity Credit

Corporation (CCC) and receive income for the storage service.335

The storage function is business done for the Government and a

section 521 cooperative may deduct the income when distributed

to patrons on a patronage basis.

Other Nonpatronage Income

Section 521 cooperatives may have nonpatronage sourced

income from purchases of sideline products, ingredients, or

emergency purchases, if such purchases are otherwise permitted.

The Service has said that if nonmember-nonproducer suppliers

receive a fixed price for their products, a patronage relationship is

not established. "The profits attributable to these transactions will

be nonpatronage sourced earnings" and can be distributed to

patrons, subject to the limitations of Code section 521(b)(4).336

Nonpatronage income may also be realized from investments,

sales of assets, and other activities not directly related to or

actually facilitating the cooperative's patronage operations.

337

Such income may be generated as part of the cooperative's

ongoing business activity, such as a sale of property, or may be
See, e.g., Priv. Ltr. Rul. 8842018 (July 22, 1988).

338

 I.R.C. § 1382(c)(2)(A) in the case of refunds paid and I.R.C. § 339

1382(c)(2)(B) in the case of nonqualified written notices of allocation

redeemed. The regulations provide the amount to be deducted must "be

paid on a patronage basis in proportion, insofar as is practicable, to the

amount of business done by or for the patron during the period to which

such income is attributable." Treas. Reg. § 1.1382-3(c)(3).

 Rev. Rul. 69-431, 1969-2 C.B. 133. 340

Id. at 134.

341

105

generated upon the sale of property at the cooperative's

dissolution.338

Paid on a Patronage Basis

To be deductible, earnings from business done with the U.S.

Government or from other nonpatronage sources must be

distributed on a "patronage basis to patrons." Under some 339

circumstances a section 521 cooperative not only may, but must,

distribute nonpatronage sourced income to patrons. Failure to do

so will not simply cause loss of the deduction, it may cause the

cooperative to lose its status under section 521.

In Revenue Ruling 69-431 a cooperative's nonpatronage 340

income was placed in a reserve and paid to stockholders as an

increase in the value of their shares of stock when redeemed. IRS

said that "[S]ince an exempt farmers' cooperative is required to

operate for the benefit of its patrons, earnings from nonpatronage

sources (such as that derived from investments, the sale of assets,

and business done with or for the United States) must also be

distributed to the patrons on a patronage basis." The 341

cooperative was denied section 521 status.

A cooperative maintaining separate departments may allocate

nonpatronage income (and losses) to the departments to which

such income or losses are related and allocate the net earnings of

each department to the patrons of that department on a patronage

basis. IRS has said it is not necessary to allocate nonpatronage

income to all patrons of the cooperative "provided that the
 Rev. Rul. 67-128, 1967-1 C.B. 147. "In each case the association 342

is able to show that particular nonpatronage income or loss was related

to the department or departments to which allocated."

 Rev. Rul. 55-591, 1955-2 C.B. 553. 343

 Treas. Reg. § 1.1382-3(c)(3). 344

106

allocation is not discriminatory among patrons similarly

situated."342

Allocation Year

Generally, nonpatronage source income received in a taxable

year, and not related to a multiple year event such as appreciation

in value of a capital asset, must be allocated on a patronage basis

to patrons of that year. There may be exceptions under some

circumstances, as in the case where patronage patterns are highly

unusual for that year. Revenue Ruling 55-591 involved a grain 343

marketing cooperative that received substantial income from

Commodity Credit Corporation storage fees in a year in which

patronage was extremely low because of severe drought in its

service area. The Service allowed it to allocate this nonpatronage

source income on patronage of not only that year but the previous

4 years as well.

Capital Gains

The regulations recognize that in certain situations it may be

very difficult to allocate nonpatronage income precisely on a

patronage basis. They provide such payment must be on a

patronage basis, "insofar as is practicable."344

The example used to illustrate when this flexibility can apply

is capital gainsrealized from the sale or exchange of capital assets.

The regulations provide that if a capital asset is acquired and

disposed of within the same year, the income realized must be

apportioned among that year's patrons on a patronage basis. If the

assets is sold or exchanged in a tax year subsequent to the year of

acquisition, then any gain "must be paid, insofar as is practicable,
Id. See also Priv. Ltr. Rul. 8952042 (Sep. 29, 1989).

345

 Rev. Rul. 68-332, 1968-1 C.B. 383. 346

See also Priv. Ltr. Rul. 8819022 (Feb. 9, 1988).

347

 I.R.C. § 1382(c)(2). 348

 I.R.C. § 1382(c)(2) and Treas. Reg. § 1.1382-3(c)(1). 349

 I.R.C. § 1382(d) and Treas. Reg. § 1.1382-4. 350

107

to the persons who were patrons during the taxable years in which

the asset was owned by the association in proportion to the amount

of business done by such patrons during such taxable years."345

Another complicating element was introduced in Revenue

Ruling 68-322. A cooperative sold property and elected to 346

report the gain realized, for tax purposes, on the installment

method under Code section 453. The Service permitted the

cooperative to deduct the portion of the gain included in income

in each taxable year, provided that income is allocated and paid on

a patronage basis, insofar as is practicable, to the persons who

were patrons of the cooperative during the years it owned the

asset.347

The Refund Payment

The deduction for nonpatronage earnings distributed on a

patronage basis is only available for amounts actually "paid" to

patrons. Payment may be in money, qualified written notices of 348

allocation, or other property except nonqualified written notices of

allocation.

Section 521 cooperatives have the usual period of time to

allocate or distribute nonpatronage sourced income. It may be

paid out anytime "during the payment period for the taxable

year." The payment period stretches from the first day of the tax 349

year until 8 1⁄2 months after the close of that tax year.

350

Redemption of Nonqualified Written Notices of Allocation

When a section 521 cooperative has issued a nonqualified

written notice of allocation representing earnings from business
 I.R.C. § 1382(c)(2)(B) and Treas. Reg. § 1.1382-3(d).

351

Id.

352

 Treas. Reg. § 1.1382-3(d). 353

 This is comparable to the treatment accorded redemption of 354

patronage sourced nonqualified written notices under Treas. Reg. §

1.1382-2(c).

 Treas. Reg. § 1.521-1(e).

355

108

done with the U.S. Government or from other nonpatronage

sources, amounts paid to redeem it are deductible by the

cooperative. The redemption payment may be made in money 351

or other property except written notices of allocation.352

The regulations somewhat limit the flexibility of the

cooperative in determining the tax year that the deduction may be

taken. They provide that if the amount is paid during the payment

period of 2 or more years, it will be deductible only in the earliest

of those years. So, for example, if a cooperative is on a calendar 353

tax year and paid an amount to redeem nonqualified allocations of

nonpatronage income on January 15, 2005, it will be allowed a

deduction for such amount only for its 2004 tax year.

354

ADMINISTRATIVE PROCEDURES

Any corporation can assert a right to single tax treatment under

Subchapter T simply by claiming the deductions authorized by

Code section 1382(b) on its tax return. However, because section

521 cooperatives are treated as exempt organizations, section 521

status must be applied for and a letter of exemption received from

the Service. The regulations state, "An organization is not exempt

from taxation under this section merely because it claims that it

complies with the requirements prescribed therein."355

This section of the report discusses obtaining, maintaining, and

losing section 521 status.
Id.

356

 Rev. Proc. 84-46, 1984-1 C.B. 541. 357

See, e.g., Priv. Ltr. Rul. 9229011 (April 13, 1992).

358

Id.

359

109

Obtaining Section 521 Status

Application for section 521 status is made on Form 1028. The

regulations provide:

In order to establish its exemption every organization

claiming exemption under section 521 is required to file a

Form 1028. The Form 1028, executed in accordance with

the instructions on the form or issued therewith, should be

filed with the district director for the internal revenue

district in which is located the principle place of business

or principal office of the organization.356

The procedures to apply for section 521 status are set out in

Revenue Procedure 84-46. If the cooperative is found eligible

357

for section 521 status, IRS will issue a ruling or determination

letter granting access to section 521. A cooperative need not be

operational before applying for section 521 status. The Service

will issue a determination letter in advance of a cooperative

beginning its operations, provided the organizers show that the

association is organized and will be operated according to the

guidelines in section 521. Procedures to appeal an adverse

determination are also provided.

The Service may require changes in the cooperative's

organization and operation as a prerequisite to approving section

521 status. Sometimes this involves amending the bylaws.

358

Although section 521 status is usually only effective prospectively,

the Service has granted section 521 status on a retroactive basis.

359
 Rev. Proc. 72-16, 1972-1 C.B. 738; Rev. Proc. 72-17, 1972-1 360

C.B. 739; Rev. Proc. 73-38, 1973-2 C.B. 501; Rev. Rul. 72-50, 1972-1

C.B. 163; Rev. Rul. 72-51, 1972-1 C.B. 164; Rev. Rul. 72-52, 1972-1

C.B. 165; Rev. Rul. 73-568, 1973-2 C.B. 194.

 Rev. Proc. 2004-8, § 6.09, 2004-1 I.R.B. 248. 361

110

Special procedures and guidelines for federated cooperatives

applying for section 521 status are found in several Revenue

Rulings and Revenue Procedures.360

IRS charges a user fee to apply for section 521 status. In

recent years, the Service has reviewed its fee schedule annually

and published its charges for the year in Internal Revenue Bulletin

No. 1 for that year. For 2004, the user fee structure for section 521

applications appears in Revenue Procedure 2004-8. Persons 361

applying for section 521 status in later years should check the fee

schedule applicable at the time.

Maintaining 521 Status

Once a cooperative meets the requirements of section 521 and

receives a letter of exemption, no further filing is required to

maintain section 521 status. Section 521 status may be lost at any

time, however, if a cooperative no longer meets the section 521

requirements.

The key to maintaining section 521 status is to continue to

meet all qualifications. This responsibility falls on the

cooperative. The entire range of qualifications are subject to

continued maintenance. These include the specific percentages

given in section 521 on such things as stock ownership by

producers, nonmember business limits, nonproducer business

limits, and limits on dividends on capital stock. They also include

continuing to operate on a cooperative basis as required by

Subchapter T of the Code.
 Treas. Reg. § 1.521-1(a).

362

 Rev. Rul. 67-253, 1967-2 C.B. 214. 363

111

Record Keeping

Accurate records are crucial to proving continued compliance

with the requirements for section 521 status. The regulations

provide:

In order to show its cooperative nature and to establish

compliance with the requirement of the Code that the

proceeds of sales, less necessary expenses, be turned back

to all producers on the basis of either the quantity or the

value of the products furnished by them, it is necessary for

such an association to keep permanent records of the

business done both with members and nonmembers. The

Code does not require, however, that the association keep

ledger accounts with each producer selling through the

association. Any permanent records which show that the

association was operating during the taxable year on a

cooperative basis in the distribution of patronage dividends

to all producers will suffice.

362

To establish that it is actually operated according to section

521 requirements, a cooperative with marketing and purchasing

functions must maintain separate records of income and expenses

for its marketing and purchasing departments, as well as records

of business transacted with patrons of each department.363

Records may be needed for reasons other than those for which

they were initially kept. As an example, a cooperative's records

may show patronage for years in which gain in value of property

occurred. When property is sold, the gain is often allocated on the

basis of patronage during the years the cooperative owned the

property. Prior year's patronage records, although kept for the pur-
 Rev. Proc. 84-46, 1984-1 C.B. 541, 545 (Sec. 14).

364

 Etter Grain Company v. United States, 331 F. Supp. 283, 286

365

(N.D. Texas 1971), aff'd, Etter Grain Co. v. United States, 462 F.2d 259

(5th Cir. 1972).

 Tech. Adv. Mem. 8047006 (July 29, 1980).

366

112

pose of properly allocating margins during those years, may be the

basis for allocating the gain on the property sold later as well.

Loss of Section 521 Status

Section 521 status is a privilege granted by IRS. It can be

voluntarily relinquished by a cooperative. The Service can revoke

or modify the ruling or determination letter granting section 521

status.

364

Cooperatives voluntarily surrender their section 521 status

when they find the burdens of compliance outweigh the benefits.

For example, a grain marketing cooperative may, at one time, have

realized substantial income storing grain for the Commodity

Credit Corporation. As a section 521 cooperative, it could deduct

this nonpatronage income from its taxes if the margin was

allocated and distributed to patrons on the basis of patronage.

However, this business may have become much less important to

the cooperative. The record-keeping burdens and the loss of

capital from paying patronage refunds to nonmembers may now be

greater than the tax benefit realized, leading the association to

abandon section 521.

This status may be lost because the cooperative failed to

qualify from the beginning or it changed its structure or 365

operations so as to fail to qualify. For example, IRS has said that

a change in operation from marketing only for member-producers

to including nonproducers (outside the scope of the limited

exceptions to the rule barring such activity) is a change in method

of operation that can cause revocation of section 521 status.

366
 Rev. Proc. 84-46, 1984-1 C.B. 541, 545 (Sec. 14); Tech. Adv. 367

Mem. 8047006 (July 29, 1980) (applying earlier, but similar, rules to

those in Rev. Proc. 84-46); Tech. Adv. Mem. 9114002 (Nov. 27,

1990)(request for relief from retroactive application under I.R.C. §

7805(b) rejected).

 Etter Grain Co. v. United States, 462 F.2d 259 (5th Cir. 1972),

368

aff'g Etter Grain Co. v. United States, 331 F. Supp. 283 (N.D. Texas

1971).

 Tech. Adv. Mem. 9547015 (Aug. 24, 1995) and its companion 369

ruling Tech. Adv. Mem. 9547016 (Aug. 24, 1995).

113

Revocation may be retroactive to the time IRS believes the

association was first in violation of any of the requirements.

367

The revocation may be retroactive, and back taxes collected, even

though section 521 status was granted through the Service's

error.368

The loss of section 521 status doesn’t preclude an organization

from continuing to operate on a cooperative basis under

Subchapter T of the Code. If otherwise eligible, it will still be 369

allowed single tax treatment of its patronage refunds and per-unit

retains.

OTHER ISSUES CONCERNING

SECTION 521 STATUS

Other legal rights and responsibilities accrue to farmer

cooperatives that successfully apply for section 521 tax status.

Some of them are briefly described here.

Other Tax Consequences

A section 521 cooperative's quasi-exempt status impacts on

other aspects of the organization's business and tax practices. Two

restrictions are noted in the regulations. Provisions of section 243,

providing a credit for dividends received from a domestic
 Treas. Reg. § 1.1381-2(a)(1). More specifically, see I.R.C. § 370

246(a)(1) and Treas. Reg. § 1.246-1(b).

 Treas. Reg. § 1.1381-2(a)(1). 371

 I.R.C. § 3121(a)(16).

372

 I.R.C. § 3306(c)(10)(A). 373

 I.R.C. § 4421(2)(B). 374

 I.R.C. § 168(h)(2)(A)(ii). 375

 15 U.S.C. § 77c(a)(5)(B)(i). For a discussion of cooperative 376

status under Federal securities regulation, see, John Noakes, Chapter

114

corporation subject to taxation, are not applicable to dividends

received from a section 521 cooperative. Nor are provisions of 370

section 1501, relating to consolidated returns.

371

Section 521 cooperatives are sometimes specifically named as

sharing limited tax privileges with section 501(c) organizations.

If an employee is paid less than $100 in a calendar year, the wages

are not covered by the Federal Insurance Contributions Act.372

Likewise, if an employee is paid less than $50 in any calendar

quarter, the employee is not covered by the Federal

Unemployment Tax Act. Also, any drawing conducted by a 373

section 521 cooperative is excluded from taxes on wagering,

provided no part of the proceeds derived from selling tickets

benefits specific shareholders or individuals.374

In other instances, section 521 cooperatives are not treated as

exempt organizations. For example, under the accelerated cost

recovery systems described in Code section 168 "a cooperative

described in section 521" is not subject to rules for "tax exempt

entities."375

Securities Law Consequences

The Federal Securities Act of 1933 contains an exemption for

farmer cooperatives that qualify for section 521 treatment from its

registration and prospectus requirements covering the initial offer

and sale of securities.376
136, Agricultural Cooperative Securities, in Neil Harl, Agricultural

Law, Matthew-Bender: New York (1994).

 Conn. Gen. Stat. Ann. § 36b-21(a)(15). 377

 Ga. Code Ann. § 10-5-8(5).

378

 Miss. Code Ann. § 75-71-201(12). 379

115

State securities regulations, often called "blue sky laws," may

also rely on section 521 for identification of cooperatives eligible

for special treatment. For example, Connecticut and Georgia 377 378

bases their exemptions on section 521. Mississippi modifies its

379

restrictions on cooperatives having nonresident stockholders if the

cooperative qualifies as a section 521 association in addition to

meeting other listed requirements.

State treatment of cooperative securities varies widely. Many

State blue sky laws do not provide a State securities exemption for

section 521 cooperatives. However, they may have some form of

cooperative exemption based on a different standard. All section

521 cooperatives are urged to have their legal counsel check to see

if they are subject to State registration and prospectus

requirements.

And even if a cooperative qualifies for general exemptions

from registration at the Federal and State levels, cooperatives

offering and selling securities may incur liability under Federal

and State statutes for inadequate or misleading disclosure. As a

result, it is advisable for cooperatives to prepare and distribute an

appropriate disclosure document to potential purchasers of any

securities they do sell.

Tax Exempt Agricultural Associations

Cooperative members may form other organizations to

promote their common interests. If these organizations are

agricultural in nature, they may seek tax exemption under Code
 I.R.C. § 501(c)(5). The brief Code section provides an

380

exemption from taxes for "Labor, agricultural, or horticultural

organizations."

 I.R.C. § 501(g). 381

 Treas. Reg. § 1.501(c)(5)-1(a).

382

 Treas. Reg. § 1.501(c)(5)-1(b).

383

 Rev. Rul. 81-60, 1981-1 C.B. 335. 384

 Treas. Reg. § 1.501(c)(5)-1 was proposed January 21, 1956 and 385

adopted July 8, 1958 by T.D. 6301, 1958-2 C.B. 197, 203. 

116

section 501(c)(5). Code section 501(g) defines "agricultural" as 380

including "...the art or science of cultivating land, harvesting crops

or aquatic resources, or raising livestock."381

The regulations state the organizations contemplated for

exempt status under Code section 501©)(5) "are those which:

(1) Have no net earnings inuring to the benefit of any member,

and

(2) Have as their objects the betterment of the conditions of

those engaged in such pursuits, the improvement of the grade of

their products, and the development of a higher degree of

efficiency in their respective occupations."382

The regulations also provide these organizations are taxable on

their unrelated business income.383

While a section 501(c)(5) association can't pay out earnings to

members, if it should collect more in dues from its members than

it needs to cover its costs, IRS has said it can refund those excess

dues in the same proportion as they were received. The refunded

money must have come from dues income. The amounts returned

are considered a reduction in dues.384

The Service has issued several revenue rulings interpreting

eligibility for Code section 501(c)(5) status. The first series,

published during the time the regulations were being developed,385

were quite favorable for producers.

Some granted tax exempt status to associations formed to

educate producers on better methods of growing and marketing
 Rev. Rul. 55-230, 1955-1 C.B. 71 (Welsh ponies); Rev. Rul. 56- 386

245, 1956-1 C.B. 204 (fur-bearing animals).

 Rev. Rul. 54-282, 1954-2 C.B. 126. 387

 Rev. Rul. 57-466, 1957-2 C.B. 311. 388

 The Service relied on section 39.422-3 of Regulations 118 389

concerning taxation of unrelated business income. Regulations 118

were made applicable to the Internal Revenue Code of 1954 by T. D.

6091, 1954-2 C.B. 47.

 Rev. Rul. 66-105, 1966-1 C.B. 145. 390

117

their products. Others involved organizations more actively 386

engaged in the production and marketing process.

Revenue Ruling 54-282 discussed a corporation formed by 387

farm bureaus to test soil for farmers and other members of the

community (members and nonmembers of the farm bureaus) and

to educate community members on soil testing and conditioning.

The Service said this organization qualified for exemption.

Revenue Ruling 57-466 concerned an association organized 388

to provide a county-wide approach to improving and advancing

agriculture. Its charter also authorized it to market farm products

and provide farm supplies to producers. In addition to educational

activities furthering agriculture, the organization purchased

fertilizer and other supplies in bulk for resale to members and

other producers. The Service said the organization was eligible for

section 501(c)(5) tax exempt status but earnings on its farm supply

operations were subject to tax under the unrelated business income

provisions of Code section 511.389

Later rulings are more restrictive concerning the types of

conduct an agricultural association may engage in and still qualify

for tax exemption. An organization formed to carry out a

livestock improvement program and promote sales of livestock

also served as the sales agent for its members and operated a

livestock auction. IRS found its principal activity was marketing

livestock and determined it was not exempt under section

501(c)(5). The Service has also denied exempt status to other 390
 Rev. Rul. 72-391, 1972-2 C.B. 249. 391

 Rev. Rul. 74-195, 1974-1 C.B. 135. 392

 Rev. Rul. 70-372, 1970-2 C.B. 118. 393

 Rev. Rul. 74-518, 1974-2 C.B. 166. 394

118

agricultural associations that it felt were providing direct business

services to farmer-members, including arranging for transient farm

laborers and the management, grazing, and sale of cattle. 391 392

Two rulings dealt with associations that keep records for use

in improving milk production of member dairy herds. In the first,

the association provided a report on how each member's cows

compared with standards established by the State college of

agriculture only to the farmer member. In denying except status,

IRS said this activity did nothing to advance agriculture in general

as required by the regulations, but "simply relieve(d) the individual

farmer of work that he would either have to perform himself or

have performed for him."393

On the other hand, the Service found a similar organization

that takes part in the National Cooperative Dairy Herd

Improvement Program qualified for section 501(c)(5). The 394

ruling noted the information collected from individual dairy

producer members was used in a nationwide program to improve

milk production and the overall quality of dairy products. IRS

said:

Since the data from the testing is made available to all

dairy farmers for use in increasing production, the

association has as its objective the betterment of the

condition of those engaged in agricultural pursuits.

Members of the association receive individual benefits

when the computer center sends them the test results for

their cows. However, these benefits are incidental to the

objects of the program as a whole and are not inconsistent
 1974-2 C.B. 166, 167. The ruling is distinguished from Rev. 395

Rul. 70-372, 1970-2 C.B. 118.

 Rev. Rul. 74-488, 1974-2 C.B. 166. Relies on Rev. Rul. 64-246, 396

1964-2 C.B. 154, holding that farm-raised fish are farm products for

purposes of Code section 521. See supra pp. 9-10.

 Rev. Rul. 75-287, 1975-2 C.B. 211. Relies on Rev. Rul. 55-611, 397

1955-2 C.B. 270, holding an association that purchases supplies for

oystermen and fishermen is not eligible for section 521 status. In this

instance, since the fishermen were promoting a common business

interest, the Service noted the association would be eligible for tax

exempt status as a business league under I.R.C. § 501(c)(6).

 Rev. Rul. 76-399, 1976-2 C.B. 152. The ruling cited Rev. Rul.

398

74-118, 1974-1 C.B. 134, for the position that an organization of farm

wives that supports higher prices for farm products is exempt and

distinguished Rev. Rul. 66-105, 1966-1 C.B. 134 on the basis that the

association discussed in that ruling went beyond establishing price to

119

with those objectives. Accordingly, the association is

exempt....395

Two other rulings, concerning aquiculture, set standards that

parallel those for section 521 tax treatment. One concerned an

association that encouraged better production methods and the

overall interests of persons engaged in raising fish on private

ponds. The Service found this association qualified for a section

501(c)(5) exemption. But an association to promote the 396

commercial fishing industry was held not exempt.397

Two additional rulings involved associations that negotiated

with processors over the price to be paid members for their crops,

sometimes called bargaining associations. In one instance

bargaining was the organization’s only function. IRS noted the

organization performed no other activity that assisted the members

in selling their crops. The ruling held that by negotiating the price

of crops with processors, the organization’s objective was the

betterment of the conditions of the growers and producers.

Therefore, it was found eligible for section 501(c)(5) status.

398
acting as a sales agent.

 Rev. Rul. 77-153, 1977-1 C.B. 147. The ruling cites Rev. Rul.

399

74-195, 1974-1 C.B. 135, and Rev. Rul. 66-105, 1966-1 C.B. 145.

 Rev. Rul. 81-59, 1981-1 C.B. 334. 400

 I.R.C. § 501(c)(12) and Treas. Reg. § 1.501(c)(12)-1. 401

120

In the second ruling, livestock producers in a particular

geographic area were members of a national association that

negotiated with processors over selling prices and other terms of

trade with processors. The local group formed a corporation to

buy land and build a gathering and shipping facility to facilitate the

marketing of members' livestock under the national association's

negotiated contracts. The Service found that this went beyond

price negotiation to providing a service the farmers would

otherwise simply have to perform themselves and denied access to

section 501(c)(5) status.

399

The Service has approved section 501(c)(5) exempt status for

a local organization of farmers to promote more effective

agricultural pest control. Although the organization's primary

activity is to employ "scouts," who identify and count pests for

farmer members, it also makes its data available to all local

farmers through the local extension agent, farmers statewide

through a local university, and nationwide through USDA

programs. Thus, while the members receive individual benefits

from the data collected in their own fields, the organization is still

tax exempt because it shares its information for the overall

advancement of agriculture.400

Other Cooperative Tax Exemptions

"Mutual ditch or irrigation companies, mutual or cooperative

telephone companies, or like organizations" may qualify for

exemption under section 501(c)(12). The term "like 401
 Rev. Rul. 67-265, 1967-2 C.B. 205, restating and superseding 402

I.T. 1671, C.B. II-1, 158 (1923).

 Rev. Rul. 83-170, 1983-2 C.B. 97. 403

 Rev. Rul. 72-36, 1972-1 C.B. 151. 404

 I.R.C. § 501(c)(14)(A) and Treas. Reg. § 1.501(c)(14)-1. 405

 Rev. Rul. 69-282, 1969-1 C.B. 155, clarified by Rev. Rul. 72-37, 406

1972-1 C.B. 152.

 I.R.C. § 501(c)(15) and Treas. Reg. § 1.501(c)(15)-1. 407

 Rev. Rul. 74-196, 1974-1 C.B. 140. 408

121

association" includes rural electric and water cooperatives and 402

cable television cooperatives. IRS has said that while these 403

organizations are not subject to Subchapter T, they still must meet

basic requirements as cooperative organizations regarding interests

of members in net margins in proportion to business, reasonable

reserves, allocation of funds, treatment of members' interests and

member rights on dissolution.404

State-chartered "Credit unions without capital stock organized

and operated for mutual purposes and without profit" are exempt

under Code section 501(c)(14)(A). IRS has stated that in 405

addition to being State chartered, exempt credit unions must

operate without profit and for the mutual benefit of their

members.

406

Mutual insurance companies writing insurance at cost are tax

exempt under Code section 501(c)(15). The Service has said 407

such companies must also give members the right to choose

management, return premiums in excess of amounts needed to

cover losses and expenses to members, and provide for a common

equitable ownership of the assets by the members.

408

Crop financing corporations organized by section 521

cooperatives or their members, operated in conjunction with such

association, and meeting certain other tests consistent with section

521 cooperative tax status, are exempt under Code section
 I.R.C. § 501(c)(16) and Treas. Reg. § 1.501(c)(16)-1. The 409

Service’s rejection of one such corporations’s claim to exempt status

was upheld by the Tax Court on the basis that the corporation did not

prove it was “organized” by a section 521 cooperative or that

“substantially all” of its stock was owned by such association, or the

members thereof, both requirements for exempt status under §

501(c)(16). Growers Credit Corporation v. Commissioner, 33 T.C. 981

(1960).

 Rev. Rul. 78-434, 1978-2 C.B. 179. 410

 I.R.C. § 501(e) and Treas. Reg. § 1.501(e)-1. 411

 I.R.C. § 501(e)(1)(A) and Treas. Reg § 1.501(e)-1(c).

412

 HCSC-Laundry v. United States, 450 U.S. 1, 5-6 (1981), aff'g 413

624 F.2d 428 (3rd Cir. 1980). See also, Florida Hospital Trust Fund v.

Commissioner, 71 F.3d 808 (11th Cir. 1996); Tech. Adv. Mem.

9542002 (July 18, 1995).

 I.R.C. § 511(a). 414

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501(c)(16). The fact that such a corporation owns all of the 409

stock of another business corporation will not disqualify it from

exempt status.

410

Cooperative hospital service organizations are exempt under

Code section 501(e). These associations may only perform a 411

specific list of services spelled out in the Code. In one of the 412

rare instances of a cooperative tax case reaching the U.S. Supreme

Court, the Court determined that because such an association

provided linen and laundry service, admittedly "so essential to a

hospital's operation" but not on the list of permissible activities,

the association was not eligible for exempt status under section

501(e).

413

Even though a cooperative is classified as tax exempt, it can

still have a Federal income tax obligation. Code section 511

imposes a tax on the unrelated business taxable income of

organizations otherwise exempt. The unrelated business income 414

concept for exempt organizations is similar to nonpatronage

income of cooperatives. It is income that doesn’t qualify for

special tax treatment because it is generated by transactions that
 Tech. Adv. Mem. 9548001 (March 23, 1995).

415

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are merely incidental to the organization’s activity that is favored

under the Code.

For example, a credit union "exempt" under Code section

501(c)(14) realized income from the sale of credit life and

disability insurance policies to its member borrowers. The

policies provided that upon the death or disability of the borrower,

the insurer will repay the loan balance. The credit union collected

the premiums and received a commission on the premiums

collected and a fee for its related administrative services from the

insurer.

When IRS reviewed this arrangement, it stated that exempt

income must come from a trade or business that is "substantially

related to purposes for which exemption is granted" and "the

service from which the gross income is derived must contribute

importantly to the accomplishment of those purposes."415

IRS determined that the exempt purposes of a credit union

were to hold members’ funds on deposit and make loans to

members. It said the sale of insurance policies was not

substantially related to these functions and therefore the

compensation received from the insurance company was subject

to the tax imposed on unrelated business income.
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