t c memo united_states tax_court farmland industries inc petitioner v commissioner of internal revenue respondent docket no filed date herbert n beller juan d keller and norman h lane for petitioner alan m jacobson and davis l zoss for respondent memorandum findings_of_fact and opinion whalen judge respondent determined the following deficiencies in petitioner’s income_tax for the years in issue year ended deficiency date dollar_figure date big_number date big_number date big_number the sole issue for decision is whether the gains and losses that petitioner a nonexempt_cooperative realized from the disposition of certain property should be classified as patronage income for purposes of subchapter_t of the internal_revenue_code sections unless stated otherwise all section references are to the internal_revenue_code as in effect during the years in issue the gains and losses at issue are from the disposition of the stock of three corporations terra resources inc seaway pipeline inc and mex-am crude corp and from the disposition of certain property used in a trade_or_business as defined by sec_1231 findings_of_fact some of the facts have been stipulated and are so found the amended stipulation of facts filed by the parties and the exhibits attached thereto are incorporated herein by this reference petitioner is an agricultural_cooperative organized under the laws of the state of kansas references to petitioner are to farmland industries inc farmland to all predecessor corporations merged into farmland and to all subsidiaries affiliated with farmland unless the context suggests otherwise during the years in issue petitioner reported income and expenses on the basis of a fiscal_year ending august petitioner’s returns for fiscal years and were filed on forms u s_corporation income_tax return petitioner’s returns for fiscal years and were filed on forms 990-c farmers’ cooperative association income_tax return each of the returns was filed with respondent’s service_center in kansas city missouri at the time its petition was filed in this case petitioner's principal_place_of_business was kansas city missourl history and organization of petitioner farmland was founded in as the cooperative union oil co it was the successor to a missouri cooperative corporation called the union oil co which had been founded in by mr howard cowden its corporate name was changed to consumer’s cooperative association in and to farmland in mr cowden served as farmland’s president from the time of its incorporation until and as a member of - its board_of directors until he was a leader in the farmers’ cooperative movement and believed that farmers could improve their overall financial condition by combining their market power petitioner has operated continuously since as a farmers’ cooperative from to it was taxed as an exempt cooperative from to it was taxed as a nonexempt_cooperative under respondent’s administrative interpretations and practices then in effect see generally 86_fsupp_201 n d iowa since petitioner has been taxed as a nonexempt_cooperative under subchapter_t of the internal_revenue_code petitioner is a regional cooperative its members are local cooperative associations whose members are farmers and ranchers during the years in issue petitioner’s membership consisted of more than big_number local cooperatives which were located primarily in the midwest with the exception of petitioner’s president each member of its board_of directors during the years in issue was either a working farmer or a manager of a local cooperative petitioner’s articles of incorporation provide that its primary purpose is to engage in agricultural supply and marketing activities for the benefit of its patrons its - - bylaws require that net_income from cooperative activities be distributed to its patrons on a cooperative basis consistent with the provisions of subchapter_t historically petitioner’s overall approach has been to conduct business in the most economically advantageous fashion possible to maximize patronage_dividends the following chart shows petitioner’s patronage and nonpatronage income for tax years through nol’s and patronage fye patronage deductible income after nonpatronage income dividend deductions income dollar_figure -7 dollar_figure dollar_figure big_number dollar_figure -7 big_number big_number big_number big_number big_number big_number -7 big_number big_number big_number big_number big_number big_number ' petitioner reported nonpatronage taxable_income of dollar_figure on its original return the parties have stipulated that the correct amount is dollar_figure the deduction consisted of a patronage_dividend deduction of dollar_figure a net_operating_loss of dollar_figure carried forward from and a patronage loss of dollar_figure in respect of farmland agriservices a noncooperative subsidiary of petitioner which represented a carryover of net_operating_loss incurred by the company before its liquidation into petitioner petitioner carried back the nonpatronage loss to its taxable_year ending date and applied it against the nonpatronage income for that year portions of the nol were carried back and applied against nonpatronage income for taxable years ending date and petitioner’s consolidated operating results for fiscal years through are as follows fiscal_year net savings loss dollar_figure big_number big_number petitioner was organized for the primary purpose of supplying petroleum products such as gasoline kerosene motor oil lubricating oils and grease to its member_cooperatives for sale to their patrons petitioner originally purchased these products in a packaged or processed state from various suppliers and then resold them to its members during the 1930's and 1940's petitioner expanded its product lines to include additional refined petroleum products as well as feed seed fertilizer agricultural chemicals tires batteries and miscellaneous farm supplies petroleum and fertilizer have been petitioner’s two largest product lines by volume of sales since at least in petitioner formed a subsidiary called the cooperative finance agency to provide financing to local cooperatives petitioner also began a grocery business a cannery anda lumber mill to provide goods to its members many of petitioner’s nonpetroleum lines of business produced little or no profit and reguired large capital investments as a result petitioner’s expansion during - the 1930's and 1940's required petitioner to incur substantial debt in petitioner considered constructing a nitrogen plant to produce fertilizer however the company did not have sufficient cash to finance the construction the wichita bank for cooperatives wichita bank petitioner’s primary source of capital would not lend the required money to petitioner without the approval of the farm credit administration fca the fca was reluctant to approve a loan because petitioner lacked sufficient equity and permanent capital had too much outstanding debt and had a poor assets-to-liabilities ratio the fca also felt that the capital_investment reguired to construct the plant was too large given the anticipated return for that reason the fca suggested that petitioner sell assets and eliminate unprofitable product lines to reduce its debt despite its financial difficulties petitioner began constructing the nitrogen plant without obtaining complete financing for the project it undertook this project through a new wholly owned subsidiary called cooperative farm chemicals association the construction took place at a time when petitioner was experiencing poor financial returns nevertheless in the wichita bank agreed to lend petitioner the funds required to complete the plant on --- - the condition that petitioner raise cash through sales of common or preferred_stock certificates of indebtedness or assets the wichita bank also required petitioner to grant the wichita bank the right to examine petitioner’s books and have a bank representative attend meetings of petitioner’s board_of directors petitioner’s financial difficulties continued into petitioner took steps to cut costs and dispose_of assets and was ultimately able to complete the nitrogen plant by the nitrogen plant was operating profitably and the financial crisis had dissipated in petitioner formed a subsidiary called farmbest inc for the purpose of marketing food products of its members farmbest’s initial business consisted of slaughtering hogs and cattle and processing the meat into finished products in petitioner transferred its food marketing business to another subsidiary called farmland foods inc in petitioner acquired a grain marketing_cooperative called far-mar-co inc by the end of petitioner was one of the six largest industrial corporations in the united_states petitioner’s sales increased rapidly during the period from to petitioner’s expansion paralleled and reflected the overall expansion of the agricultural sector --- - of the economy during the 1970's petitioner’s management attributed these increases to changes in federal government policies which had the effect of encouraging agricultural cultivation to a general increase in demand for fertilizer and petroleum products and to petitioner’s increased investment in plant and equipment most notably fertilizer plants and facilities for the exploration for and production of crude_oil during this period petitioner raised the capital needed for expansion through debt financing primarily in the form of loans from the wichita bank and sales of subordinated securities petitioner also financed its expansion through leveraged leasing and occasionally through loans from commercial banks during this period petitioner was highly vulnerable to fluctuations in the prices of agricultural products oil production and refining activities a significant portion of petitioner’s business during the years in issue involved the supply of petroleum products to its members since petroleum products have accounted for the largest volume of petitioner’s total sales crude_oil was an essential raw material for all of the petroleum products sold by petitioner during the years in issue over the years petitioner has sought to improve -- - the economic efficiency of its petroleum business by controlling as many phases of the production process as possible this includes acquiring oil refineries crude_oil producing properties and related transportation systems mr cowden began encouraging petitioner’s board_of directors to establish an oil refinery as early as he believed that vertical integration in the petroleum business would be beneficial despite the fact that at least for some time during the 1930's petitioner was able to obtain favorably priced petroleum products on the open market mr cowden believed that the cooperative should vertically integrate its petroleum operations to enable it to compete with large companies in petitioner organized a subsidiary called the cooperative refinery association inc cra to construct and operate an oil refinery in phillipsburg kansas although cra was organized as a cooperative petitioner was at all times its only patron and owned all of its outstanding common_stock the phillipsburg refinery anda 70-mile network of pipeline were constructed during and the refinery officially opened in date although it did not commence production until at the time it opened the refinery was capable of processing big_number barrels of crude_oil per day petitioner purchased all of cra’s production for resale to its patrons on date petitioner’s board_of directors organized the cooperative pipeline association cpa as a wholly owned subsidiary cpa was organized to construct and operate a pipeline system to deliver crude_oil to the phillipsburg refinery the construction of the pipeline was to be financed primarily through the sale of preferred_stock in cpa to local cooperatives and their individual members cpa was merged into cra during petitioner’s fiscal_year ending date during its existence cpa transported oil exclusively to refineries owned by cra soon after the phillipsburg refinery opened petitioner had difficulty obtaining sufficient crude_oil to utilize the plant’s full production capacity under kansas proration statutes in effect at the time the wells connected to the refinery had an allowable output of big_number barrels per month or less than barrels per day in addition the standard oil co of indiana standard oil one of the primary crude_oil producers in the phillipsburg area refused to sell crude_oil to cra the kansas corporation commission also initially refused to increase the allowable output of wells in the phillipsburg area petitioner was forced to close the phillipsburg refinery for a short time due to a lack of supply of crude_oil in an effort to secure an adequate supply of crude_oil for the phillipsburg refinery mr cowden sought to have the u s department of justice investigate monopoly conditions in the oil industry mr cowden also instigated a mail-in campaign designed to encourage the governor of kansas to increase the maximum allowable output of wells connected to the refinery eventually standard oil agreed to supply crude_oil to the refinery with the exception of a brief shortage in petitioner was able to purchase an adequate amount of crude_oil from unrelated parties to utilize the entire production capacity of the phillipsburg refinery until the energy crisis of the 1970's however petitioner’s directors remained concerned about the possibility of shortages in date petitioner formed a wholly owned subsidiary called consumers oil production association copa to engage in oil exploration and drilling and to purchase existing oil wells petitioner’s directors believed that by controlling crude_oil production the company could maintain a consistent level of supply for its refinery and avoid reliance on suppliers who might be hostile toward petitioner by the end of copa held - interests in three producing oil wells located in rooks county kansas that were connected by pipeline to petitioner’s phillipsburg refinery copa sold all of the crude_oil it produced to cra petitioner continued to expand its petroleum-related activities throughout the 1940's in petitioner purchased a refinery in scottsbluff nebraska with a production capacity of big_number barrels per day by the end of its fiscal_year copa owned interests in producing oil wells petitioner’s management informed its members that cents of the cents in total savings per barrel created by its petroleum-related business was attributable to crude_oil production on date cra purchased the assets of the national oil refining co for approximately dollar_figure million these assets included a refinery located in coffeyville kansas approximately producing oil wells leasehold interests in more than big_number acres of undeveloped land and a network of pipelines by the end of copa and cra together owned interests in producing wells in copa was merged into cra which conducted all of petitioner’s oil exploration and production activities from the time of the merger until by the end of cra was extracting enough oil from its active wells to meet percent of its refineries’ needs throughout its existence cra obtained crude_oil from its own_production facilities from other entities owned by petitioner and from unrelated third parties cra refined this oil into finished petroleum products which it sold to petitioner for resale to its patrons cra and its subsidiaries also maintained inventories of crude_oil and refined petroleum products cra shipped finished products from its refineries directly to petitioner’s customers cra would generally send invoices to petitioner and petitioner would send invoices to its customers petitioner charged competitive market prices for the petroleum products it sold to its patrons petitioner’s management believed that its patrons would derive their benefits through the receipt of patronage refunds rather than through discount purchases petitioner’s management always intended to generate a net profit at the cooperative level without undercutting prevailing market prices from until mid-1992 petitioner was the largest interest holder ina refinery located in mcpherson kansas which was operated by the national cooperative refinery association ncra mr cowden was the first president of ncra and its other members were like petitioner regional -- - cooperatives petitioner consistently took delivery of its full share of the mcpherson refinery’s output for resale to its patrons during and the united_states experienced an energy crisis that caused major problems for petitioner and its patrons petitioner was unable to operate its refineries at full capacity due to the scarcity of crude_oil and increasing petroleum prices federal price controls on refined products also created a cost-price squeeze on petitioner’s operations during this time petitioner was able to produce less than percent of the crude_oil required by its refineries as a result of the shortages petitioner ceased selling refined petroleum products to nonmembers petitioner also developed an allocation system designed to ensure adequate distribution of fuel to its members despite these problems petitioner’s petroleum business in exceeded its performance in the previous year farmers experienced a general shortage of fertilizer during the energy crisis of the early 1970's this impaired government efforts to increase food production and combat price increases on date the arab oil producing countries implemented an embargo of crude_oil further intensifying the oil crisis on date - the federal government began mandatory allocations of crude_oil however the shortage began to decrease by the spring of in date following intensive lobbying by petitioner’s officers the federal government allocated to petitioner percent of its crude_oil needs through june of that year petitioner’s annual reports for and state that the company was able to adequately provide for the fuel needs of its member-patrons during those years prices of crude_oil changed very little from mid-1974 when the arab oil embargo ended until during that period the spot price for crude_oil was at or below the official selling_price for arabian gulf crude_oil the price of crude_oil increased rapidly in early due in large part to a political revolution in iran which cut off a substantial portion of the world’s crude_oil supply british petroleum one of petitioner’s primary suppliers had previously obtained a substantial portion of its crude_oil from iranian producers the iranian oil shortage forced british petroleum to reduce the amount of crude_oil it delivered to its customers including petitioner in date petitioner’s coffeyville refinery was operating below capacity on date petitioner was forced to limit its allocation of gasoline and other petroleum distillates to its member associations allocations for farm use remained at or near percent but little or no fuel was allocated for nonfarm uses petitioner’s officers and the managers of petitioner’s member associations then began lobbying the federal government for relief through a combination of efforts including government allocations and recertification of the coffeyville refinery to allow for increased allocations petitioner was able to adequately supply fuel for its members’ agricultural needs petitioner’s annual report for states that petitioner had begun searching for alternative sources of supply and had increased its oil exploration and production activities the oil shortage abated during the early 1980's and demand for petroleum products decreased petitioner’s scottsbluff and phillipsburg refineries were closed in when the capacity of its remaining refineries was deemed adequate to meet its members’ needs however the phillipsburg refinery was reopened in the mcpherson and coffeyville refineries have remained in continuous operation during the time petitioner has held interests in them -- - cra was merged into petitioner in date petitioner has owned and operated all of cra’s refineries since that time until it merged into petitioner cra always filed a separate federal_income_tax return after the merger petitioner maintained inventories of crude_oil and refined petroleum products from the beginning petitioner’s management has sought to vertically integrate its petroleum business in particular petitioner has sought to conduct its own exploration drilling and production of crude_oil and natural_gas refining and wholesale marketing of petroleum products and the associated gathering transportation and distribution of raw materials and refined petroleum products petitioner’s primary objectives in this regard were to secure a dependable and consistent supply of crude_oil for its refineries to provide its patrons with a full range of high guality petroleum products in an economically efficient manner to maximize the economic benefits to its patrons and to reduce its patrons’ dependence on profit-- seeking oil companies vertical integration in the petroleum production business creates several business risks oil exploration and production activities generally require substantial capital_investment with no guaranty that exploration will result in discovery of crude_oil deposits moreover even if a crude_oil deposit is discovered there is no guarantee that it will produce significant reserves there is also no guaranty that oil_and_gas reserves developed by other companies will be available for purchase at an affordable price petitioner’s directors were aware of the risks associated with petroleum exploration and production at the time they decided to enter into this activity from until petitioner explored for crude_oil and natural_gas through cra cra was also active in acquiring working properties and undeveloped reserves of crude_oil these activities were regularly described in petitioner’s annual reports by the volume of crude_oil processed in petitioners’ refineries had increased to over million barrels per year or approximately big_number barrels per day at the same time however the volume of crude_oil produced by petitioner was only approximately million barrels per year in petitioner’s annual report for its president and general manager mr homer young stated that petitioner had launched a program to increase its crude_oil production petitioner’s ultimate goal was to produce big_number barrels of crude_oil per day or approximately percent of its refineries’ daily requirements - - by the funds that petitioner invested in petroleum production and refining accounted for petitioner’s largest outlay of funds and predepreciation investment in plant and equipment crude_oil production and refining facilities represented percent of petitioner’s predepreciation investment compared to percent for fertilizer facilities and percent for all other facilities in date petitioner purchased most of the oil_and_gas_properties of the amax petroleum corp amax however despite the purchase of amax and additional capital expenditures petitioner’s crude_oil production at the end of was only approximately million barrels per year at the same time petitioner’s refineries were processing more than million barrels per year petitioner also sought to acquire crude_oil by exploring outside the united_states in date petitioner formed a wholly owned subsidiary called cracca libya inc cracca libya cracca libya thereafter joined other cooperatives and independent oil producers ina partnership called the eastern hemisphere group the group which was organized to explore for crude_oil in north africa in date the group participated in forming a private libyan corporation called the national --- - oil co of libya national oil to drill oil wells in libya however national oil was unable to secure drilling rights in petitioner dissolved cracca libya and formed a new subsidiary called cra international to cooperate with other oil companies in exploring for crude_oil and natural_gas in canada by petitioner owned domestic oil producing properties in kansas oklahoma texas louisiana and wyoming these properties produced for petitioner a combined average of approximately big_number barrels of crude_oil and million cubic feet of natural_gas per day petitioner was contractually obligated to sell some of this production to unrelated third parties petitioner used the remainder to supply its refineries or to exchange with other companies for crude_oil more readily accessible by its refineries such exchange transactions are common among oil companies petitioner was not able during the 1960's to achieve its goal of producing percent of the crude_oil processed in its refineries the capacity of petitioner’s refineries grew faster than its reserves of crude_oil in the late 1960's petitioner’s treasurer mr donald ewing met with an investment banker to determine how much money petitioner would have to invest in crude_oil production to achieve its - goal of percent self-sufficiency the banker determined that petitioner would have to invest dollar_figure million to achieve this goal at that time the total value of petitioner’s assets was only slightly in excess of dollar_figure million although its 50-percent self-sufficiency goal seemed to be unfeasible petitioner continued to engage in crude_oil production activities in an attempt to vertically integrate its petroleum-related business formation and operation of terra resources during petitioner’s management sought to increase its crude_oil production while limiting its expenditure of financial resources management’s objective was to increase the portion of cra’s crude_oil and natural_gas needs that it supplied through existing and new properties and thereby to increase its level of self- sufficiency while minimizing its commitment of capital at that time petitioner’s capital resources were already strained by the expansion of its nonpetroleum facilities to achieve its objective petitioner spun off cra’s crude_oil production assets into a new wholly owned subsidiary called terra resources inc terra petitioner’s management chose to organize terra as a commercial corporation and not as a cooperative in order to facilitate raising the capital necessary to fund additional - - oil and natural_gas exploration petitioner’s management also hoped to reduce petitioner’s oil exploration_costs to control more of the crude_oil processed in its refineries to stabilize its petroleum production_costs and to increase patronage refunds petitioner was required to seek outside capital because it had assumed a large amount of debt in the process of expanding its other business interests especially its fertilizer production facilities petitioner’s board_of directors approved the formation of terra during its february meeting later in petitioner’s board_of directors caused cra to transfer all of its crude_oil production properties and undeveloped acreage to terra but to retain its refineries and pipeline system petitioner’s management envisioned that terra would raise capital by periodically selling equity to the public but that petitioner would retain control of the enterprise by holding at least percent of its outstanding capital stock cra was also to retain the right_of_first_refusal to purchase all of the crude_oil produced by terra at the posted field price on or about date cra transferred all of its crude_oil and natural_gas production assets to terra on the same day petitioner transferred to terra its stock interest in cra international inc which was conducting -- - oil exploration and production activities both directly and through a joint_venture named cra international ltd the net_book_value of the assets transferred was dollar_figure in exchange terra issued big_number shares of common_stock to cra and big_number shares of common_stock to petitioner in addition terra assumed dollar_figure million of liabilities that petitioner had assumed incident to its purchase of amax in on date cra purchased an additional big_number shares of common_stock in terra for dollar_figure in cash at the time cra transferred its assets to terra terra and cra entered into a general conveyance assignment and transfer agreement the agreement identifies the properties transferred by cra to terra and the assets that were to remain in cra’ss possession the agreement also granted cra the prior call and option to purchase all uncommitted crude_oil and other liquid or liquefiable hydrocarbons that are produced and saved from the subject properties after the effective date and from all other oil_and_gas_properties hereafter acquired by terra or its wholly owned subsidiaries or its controlled affiliates at the posted field price or prices from time to time prevailing for the area in which such properties are located during its august meeting petitioner’s board_of directors approved the sale of big_number shares of - - terra stock to the public at a maximum price of dollar_figure per share the board_of directors resolved that the proceeds of this offering should be used for exploration and or purchase of oil properties and to retire a portion of the company’s previously incurred debt on the advice of petitioner’s investment bankers the stock offering was delayed until date terra’s prospectus which was released on date states that terra has paid no dividends to date and does not expect to do so in the foreseeable future although petitioner’s management had expected to receive approximately dollar_figure per share for the terra stock the offering price was only dollar_figure per share and the offering netted only dollar_figure million to terra after expenses terra used dollar_figure million of the proceeds of the initial offering to retire existing debt the remainder dollar_figure million was added to terra’s working_capital after the offering petitioner retained percent of terra’s outstanding capital stock and members of the public owned percent petitioner did not make any other public offering of terra stock although terra was formed primarily to raise outside capital to support petitioner’s oil_and_gas exploration activities very little capital was actually raised - - moreover terra’s operations presented a potential conflict of interest between petitioner and terra’s other share- holders petitioner preferred that terra use all of its earnings to finance additional crude_oil exploration activities however if the public shareholders were to receive a return on their investment some of those earnings would have to be distributed as dividends during the time that terra had minority shareholders it did not pay any dividends and petitioner did not intend that it do so in petitioner and cra purchased all of the publicly held capital stock in terra for dollar_figure per share this price was based on the appraised value of terra’s assets and on a fairness opinion prepared by smith barney co petitioner owned all of terra’s outstanding_stock from the date of the repurchase until date when it sold its entire_interest in the company petitioner maintained control_over terra from the time of its formation until most of terra’s directors were also officers or directors of petitioner terra’s president attended regular staff meetings held by petitioner’s vice president in charge of petroleum activities pursuant to resolutions adopted by petitioner’s board_of directors during its march -- p7 - date and october meetings terra’s employees were permitted to participate in petitioner’s employee incentive and investment savings plans retirement plans executive deferred_compensation plans and manage- ment performance plans petitioner intended terra to operate at a profit petitioner’s and terra’s management jointly prepared terra's proposed budgets one of petitioner’s vice presidents mr william rader also worked with each of terra’s operational units in developing separate budgets terra’s capital and operating budgets were considered for approval at annual budget meetings of petitioner’s board_of directors and senior management and ultimately were approved by petitioner’s board_of directors terra’s and petitioner’s management also jointly prepared business plans for approval by terra’s board_of directors petitioner charged fees for the administrative and other services it provided to terra and charged interest at the fair market rate when it lent money to terra petitioner did not file a consolidated federal_income_tax return with any of its subsidiaries including terra during any of the years in issue terra’s separate federal_income_tax returns were signed by officers or employees of terra terra maintained separate books_and_records to - - facilitate the preparation of its tax returns terra also prepared its own accounting_records which were subsegquently reviewed by employees of petitioner terra began to acquire and develop new properties and sources of crude_oil immediately after its formation this increased the volume of crude_oil available to cra’s refineries the crude_oil that was produced by terra that was not contractually committed to third parties its uncommitted production was made available to cra either for delivery to its refineries or for exchange with other oil companies in return for crude_oil more readily accessible by a cra refinery terra did not employ any personnel for marketing its uncommitted production employees of petitioner or cra arranged on terra’s behalf for the purchase and delivery of crude_oil to cra refineries for exchange with other oil companies and for the sale of uncommitted production not delivered to or exchanged for the benefit of cra throughout the 1970's petitioner consistently budgeted substantial amounts of money for its petroleum-- related business and crude_oil exploration operations however petitioner never reached its goal of producing percent of the crude_oil processed in its refineries in - - terra’s vice president of finance testified before a u s department of energy board terra is responsible to petitioner for the exploration development and production of as high a percentage as possible of the crude_oil and natural_gas needed as raw materials for petitioner’s refineries and fertilizer manufacturing plants terra’s specific goal over the next five years is to materially increase the percent of petitioner’s oil_and_gas raw material needs as it is now supplying between fiscal years and total expenditures_for the acquisition and development of new producing properties increased from dollar_figure annually to dollar_figure terra spent dollar_figure on the acquisition and development of production properties during the 6-month period ending date alone during its fiscal_year terra purchased producing properties for a total cost of dollar_figure this added approximately big_number barrels of crude_oil and big_number million cubic feet of natural_gas to terra’s reserves between fiscal years and terra’s production of crude_oil including its share of the production of cra international decreased from a high of big_number barrels in fiscal_year to a low of big_number barrels in fiscal_year before increasing again to big_number barrels in fiscal_year -- - between fiscal_year and date terra’s reserves including those held by a subsidiary and a joint_venture increased from big_number barrels of crude_oil and big_number million cubic feet of natural_gas to big_number barrels of crude_oil and big_number million cubic feet of natural_gas in mr rader became primarily responsible for petitioner’s petroleum operations from until mr rader held various positions with both terra and petitioner prior to mr rader’s employment terra focused primarily on acquiring established producing properties however mr rader believed that it was in petitioner’s best interest to combine all of its production activities into one company and to shift its emphasis and focus on exploring for new properties under mr rader’s direction terra hired a number of geologists geophysicists and other personnel needed for crude_oil exploration terra also expanded its operations into new geographical areas and began offshore exploration activities on date terra sold all of the common_stock it held in northern terra resources inc which owned oil producing assets in canada during terra also sold production assets located in north dakota - - terra obtained the funds necessary for capital expenditures from its own internal cash-flow terra always retained its profits for operating capital at the end of its fiscal_year terra’s balance_sheet showed retained earnings_of approximately dollar_figure million terra’s other source of funds was loans from petitioner and other affiliates by the end of the outstanding balance of the loans petitioner and other affiliates had made to terra was dollar_figure terra’s oil_and_gas acquisition and development_expenditures for through were as follows year expenditures in millions total from to terra consistently retained its full share of the uncommitted production of wells in which it held an ownership_interest and sought to acquire as much of the crude_oil held by its co-owners or subject_to contractual obligations as possible sales of uncommitted production to parties other than petitioner other than those incident to exchanges for cra’s benefit were - - unusual of the amount of crude_oil processed by the cra refineries the percentage that was produced by terra is petitioner’s self-sufficiency the self-sufficiency ratio for an integrated_oil_company is the ratio of the quantity of the crude_oil produced by the company to the quantity of crude_oil processed by its refineries at no time during its existence did terra and the other exploration subsidiaries meet petitioner’s goal of obtaining a 50-percent self-sufficiency ratio that is of producing percent of its refineries’ needs the volume of crude_oil processed at cra’s refineries and the volume of such crude_oil that was produced by terra from to were as follows crude processed at crude produced by cra refineries terra self--sufficiency year barrels per day barrels per day ratio big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure 'this does not include amounts refined at the ncra refinery of which petitioner was part owner petitioner’s goal of percent self-sufficiency did not represent an industry standard or have a particular economic motive the decline in self-sufficiency between - - and was caused by a combination of decreases in the amount of crude_oil terra produced and increases in the amount of oil cra processed because terra was contractually obligated to sell a portion of the crude_oil it produced to third parties petitioner’s true self-sufficiency was actually lower than the self-sufficiency ratios listed above true self- sufficiency refers to the percentage of crude_oil processed by cra that had been produced by terra and made available for processing in cra’s refineries the volume of crude_oil processed in cra’s refineries the volume of crude_oil produced by terra the percentage of terra’s crude_oil utilized in cra’s refineries the volume of terra's crude_oil used in cra’s refineries and petitioner’s true self- sufficiency from to are as follows crude crude amount of actual processed produced product crude used true self- year by cra by terra utilized by cra sufficiency big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number average big_number big_number big_number terra's crude_oil reserves totaled million barrels or dollar_figure years of production as of date on the same date petitioner's balance_sheet showed investment in oil_and_gas_properties of dollar_figure this constituted percent of petitioner's total investment in property plant and equipment at all relevant times terra's operating results assets and liabilities were included in petitioner's consolidated financial statements submitted to the securities_and_exchange_commission its member-patrons and its creditors each of petitioner's annual reports included a discussion of terra's operations however petitioner's consolidated financial statements did not disclose its interest in terra petitioner's and cra's separate and unconsolidated financial statements listed the terra stock in an asset account entitled investments in -- - subsidiaries during the period when members of the public held terra stock the interest of the public was reflected in the minority owners’ equity in subsidiaries section of petitioner’s consolidated balance_sheet and in the costs and expenses section of its consolidated statements of operations each prospectus and sec form 10-k filed by petitioner from until the date it sold terra included a detailed summary of petitioner's relationship with terra neither petitioner nor cra offered terra stock for sale in the ordinary course of its trade_or_business and neither ever recorded the terra stock in an account identified as a hedge hedging or inventory account petitioner never referred to the terra stock as a hedge against increases in the price of petroleum products although risk reduction was one of petitioner's reasons for forming terra prior to date neither petitioner nor cra sold any terra stock terra did not pay any dividends to petitioner prior to date terra's cash_flow was used exclusively to finance additional exploration and production activities other exploration and production activities petitioner and cra formed two other companies during the period from to for the purpose of exploring - - for crude_oil beginning in cra acguired in its own name interests in oil_and_gas_properties in texas montana louisiana nebraska oklahoma and wyoming on date these interests as well as federal leases were transferred to a newly formed company called cra oil exploration co on date cra purchased percent of the capital stock of cayman international co which was engaged in exploring for crude_oil in colombia south america cayman international co was later renamed farmland international energy corp fiec and began operating in the united_states fiec was merged into terra during petitioner's fiscal_year cra oil exploration co was merged into terra on or about date terra was the only subsidiary of petitioner engaged in oil_and_gas exploration from the date of this merger until when petitioner sold its interest in terra sale of terra sales of petitioner's petroleum-based products declined rapidly between and petitioner's refinery margins earnings from fertilizer sales and overall net_earnings also declined during this period as a result petitioner reported consolidated losses in -- - and for the first time in its history petitioner's management attributed the company's poor performance to the end of the energy crisis and resulting glut of oil worldwide over-production of grains high interest rates and the federal government's implementation of the payment-- in-kind program which caused a general decrease in the production of many agricultural commodities petitioner's members were also adversely affected by a general recession in the agricultural sector of the economy during this period petitioner's consolidated financial data regarding the company's farm supply operations for the period from to are as follows gross farm supply revenue dollar_figure dollar_figure dollar_figure dollar_figure farm supply operating savings total net savings’ interest_expense funded long-term debt fixed assets before big_number big_number big_number big_number depreciation ‘total net savings before income taxes patronage refunds and extraordinary items during the period from to petitioner's operating and capital needs were met primarily through a combination of bank financing on a floating-rate basis issuance of medium- and long-term subordinated debt and retained earnings including patronage_dividends not paid in cash during this period petitioner's loans from the -- - wichita bank were the largest in the national farm credit system as of date petitioner's consolidated loans from the wichita bank and commercial banks totaled over dollar_figure million as of the same date petitioner's outstanding subordinated debt certificates had reached an all-time high of approximately dollar_figure million prior to petitioner's loan agreements with the wichita bank contained covenants designed to ensure petitioner's continued solvency under these covenants petitioner was required to maintain a funded debt ratio subordinated debt instruments divided by total capitalization of no more than percent petitioner was also required to maintain a current ratio current_assets to current liabilities of at least in late the wichita bank took the position that more conservative ratios were necessary to ensure petitioner's financial stability in a loan agreement effective date petitioner agreed that by date its funded debt ratio would not exceed percent and that its current ratio would be at least shortly after adopting its budget for the fiscal_year which projected lower operating savings than had been realized in petitioner requested that the funded debt ratio agreed upon in the date loan agreement - - be increased to percent with a reduction to percent to be effective on date the wichita bank agreed to this change because the bank wanted to avoid a potential default and because it appeared unlikely that petitioner would quickly recover from its recent financial difficulties both petitioner and the wichita bank con- templated that when the loans were considered for renewal in date the maximum funded debt ratio for date would likely be reduced to percent by date petitioner's financial personnel were projecting a loss for fiscal_year of dollar_figure million compared to savings of dollar_figure million which had been projected when the budget was prepared for fiscal petitioner's financial personnel forecasted losses of dollar_figure million through date and savings of dollar_figure million for march through date at a date meeting between petitioner's representatives and officials of the wichita bank petitioner asked the wichita bank to consider changing the current ratio requirement in its loan agreements from to a flat amount of dollar_figure million in working_capital however the wichita bank refused to consider any changes in the current ratio requirement until petitioner made a long-range evaluation of other debt-reducing possibilities -- - including the possibility of selling major assets or business segments the wichita bank became increasingly concerned about petitioner’s financial situation throughout the early 1980's an internal memorandum of the wichita bank dated date states that farmland industries is experiencing serious financial difficulties a memorandum dated date states that petitioner’s vice president of finance mr robert ferguson informed a representative of the wichita bank that petitioner was having difficulty dealing with commercial banks mr earl knauss petitioner's chief financial officer was also reported to have stated that petitioner needed to develop financial contingency plans to avoid defaulting on its loans from the wichita bank on date mr ferguson told the wichita bank that the banking firm that previously handled petitioner's debt offerings had ceased doing so on date a vice president of the wichita bank proposed that the bank classify petitioner’s loan as a problem loan and suggested that petitioner consider selling assets and subsidiaries to raise cash and reduce its interest_expenses during a meeting of petitioner's board_of directors on october the board was informed that the al - estimated financial results for fiscal_year had been revised from savings of dollar_figure million to a loss of dollar_figure million during the same meeting mr david andra senior vice president of the wichita bank informed petitioner's board_of directors that the wichita bank had classified the company’s loan as a problem loan terra's president mr francis merelli also reported that terra was exploring the possibility of selling leasehold interests pursuant to authorization by petitioner's board_of directors to sell up to dollar_figure million of terra's reserves to raise cash in date the wichita bank proposed to change petitioner's loan covenant ratios effective date to require that the funded debt ratio would be no more than percent by date and no more than percent during the period from february through august petitioner resisted this proposal petitioner's financial difficulties continued into early in the year petitioner's board_of directors decided to sell the company's stock in terra to avoid default on the wichita bank loans and potential bankruptcy at a date meeting of representatives of the wichita bank and petitioner petitioner revealed that its projected loss for had increased to dollar_figure million furthermore mr knauss reported that the net_loss could - -- be as high as dollar_figure million due to unanticipated write- downs and other factors at that level of loss the funded debt ratio would have increased to percent mr knauss also advised officials of the wichita bank that petitioner's management had recommended selling a major asset to reduce debt at its meeting of february petitioner's board_of directors accepted mr knauss's recommendation to sell a major asset in view of this decision the wichita bank agreed to allow petitioner's funded debt ratio to remain pincite percent through date but insisted that it be reduced to percent by date the current ratio requirement was also relaxed for the period ending date to an absolute working_capital level of dollar_figure million petitioner's current ratio as of date wa sec_1 petitioner’s projected losses continued to increase throughout february and date an internal memorandum of the wichita bank dated date states that petitioner is firmly committed to selling assets to strengthen its operations another memorandum of the wichita bank prepared on the same day states that petitioner’s financial problems exceed the worst case projections a memorandum of the wichita bank dated - - date states that petitioner was planning a massive sale of assets to improve its overall financial condition without such a sale the wichita bank feared that petitioner would default on its loans before date by mid-date petitioner's loss estimate for had increased to between dollar_figure million and dollar_figure million a memorandum of the wichita bank dated date discussing a meeting between representatives of petitioner the wichita bank and the central bank for cooperatives states that the banks would work to avoid a default but the sale of terra was certainly more of a temporary cure than petitioner planned in the beginning on date petitioner’s current ratio wa sec_1 on the same date petitioner's funded debt ratio wa sec_63 percent at the time of petitioner's financial crisis petitioner's stock in terra was the only asset that could be sold quickly to pay down debt to the extent required by the wichita bank in the spring of petitioner's management and board_of directors concluded that selling the company's stock in terra was the only feasible course of action the board_of directors had never discussed selling the terra stock prior to petitioner's financial - crisis and petitioner would not have sold the stock if it had not experienced financial difficulties petitioner solicited bids for terra's stock in date petitioner required prospective buyers to purchase percent of terra's stock for cash and to agree to grant petitioner a call on terra's crude_oil production the pacific lighting corp plc submitted the highest bid for the terra stock in date petitioner agreed to sell the stock to plc for dollar_figure million plc regarded the sale price as reflecting the fair_market_value of terra's crude_oil reserves and other assets the price was established by evaluating the reserves projecting terra's production schedule years into the future and discounting the projected cash_flow to present_value petitioner's sale of terra stock was closed on date plc paid approximately percent of the purchase_price at closing and the balance on date petitioner distributed the cash it received from the sale to the wichita bank in partial payment of petitioner's outstanding loans this improved petitioner's overall financial health and benefited its balance_sheet and future years' profit and loss statements petitioner reported the gain from its sale of terra stock under the installment_method petitioner reported - - total gain of dollar_figure on its return for the taxable_year ending date dollar_figure on its return for the taxable_year ending date and dollar_figure on its return for the taxable_year ending date the gain reported for fiscal_year resulted from payments arising from various post-sale agreements between petitioner and plc petitioner did not report any gain from the sale on its return for the taxable_year ending date during the years in issue petitioner maintained a total of approximately allocation units for the purpose of calculating patronage refunds from its accounting_records of merchandise sold petitioner determined the member sales and nonmember sales attributable to each allocation unit petitioner defined a member sale as a sale of property or services to a person or entity entitled to receive patronage_dividends this includes sales to members associate members and certain nonmembers who are entitled to receive patronage_dividends under contractual arrangements petitioner defined a nonmember sale as a sale of property or services to a person or entity who is not entitled to receive patronage_dividends -- - in and petitioner’s bylaws required that patronage income be determined on the basis of taxable_income rather than book income the determination of patronage income was divided into five steps first the total sales for each allocation unit was determined second the ratios of member and nonmember sales to total merchandise sales for each allocation unit were determined third the gross savings for each unit was determined by subtracting the cost_of_goods_sold from total merchandise sales fourth the direct expenses for each allocation unit that did not enter into the cost_of_goods_sold computation such as marketing and warehousing were subtracted from gross savings to compute net savings before adjustments if the resulting figure was positive then it was reduced by the unit’s allocable portion of petitioner’s general and administrative expenses and the losses of units with negative net savings before adjustments the resulting figure constituted the net savings for the particular unit fifth the net savings for each unit were allocated between members and nonmembers by applying the ratios determined above in step two petitioner treated the entire gain realized on the sale of terra stock as ordinary_income petitioner a7 - allocated a portion of the gain to each of its four petroleum-related allocation units bulk petroleum farm fuels propane and lube oil and grease the portion of total gain allocable to each unit was determined by the ratio of gross savings allocable to such unit to the combined gross savings of all four units applying the patronage income computation formula described above petitioner reported all but approximately percent of the gain from the sale of terra stock as patronage income in and all but approximately percent as patronage income in all of the gain reported in was treated as patronage income on its return for the taxable_year ending date the gain reported as patronage income was entirely offset by current and unutilized prior years' losses from patronage operations part of the gain reported on petitioner's return for the taxable_year ending date was also offset by patronage losses several transactions took place between petitioner and terra prior to and in anticipation of the sale of terra stock on date terra paid a dollar_figure million dividend to petitioner on the same day petitioner paid dollar_figure million to the fourth national bank trust co in tulsa oklahoma in payment of a loan terra had previously -- - made to petitioner at the time of these transactions terra owed petitioner a total of dollar_figure million petitioner claimed a deduction pursuant to sec_243 equal to the entire amount of the cash dividend received from terra the date dividend was not intended to offset an increase in the price of crude_oil or natural_gas because the dividend was excluded from petitioner's income under sec_243 it did not enter into petitioner's calculation of patronage income for its fiscal_year in date terra paid another dividend trans-- ferring to petitioner its interest in the axom limited_partnership which was valued at dollar_figure petitioner received and reported as income an additional dollar_figure in dividends from terra during its tax_year it reported both of these dividends as patronage income petitioner reported the dividends it received with respect to all other stock as nonpatronage income petitioner did not sell its terra stock because of any increase or decrease in the market price of crude_oil or natural_gas or any contemporaneous purchase of crude_oil or natural_gas on the open market petitioner exercised its option to purchase crude_oil produced by terra several times between the date of the sale and the time of trial although the call option has benefited --- - petitioner terra has not been a desirable source of crude_oil since the sale when petitioner owned terra it had the right to purchase crude_oil at the posted field price regardless of whether other buyers would be willing to pay a higher price after the sale petitioner was forced to compete for the crude_oil and natural_gas terra produced petitioner was unable to purchase terra's oil_and_gas on several occasions due to the fact that other purchasers were willing to pay a premium over the posted field price petitioner has also encountered difficulty in arranging delivery of oil from terra further difficulties arose after terra sold some of its properties to unrelated third parties terra retained a call option for petitioner's benefit with regard to the oil produced at these properties which led to some confusion over deliveries seaway pipeline inc in date cra and six unrelated companies organized seaway pipeline inc seaway at the time of its organization all of seaway's shareholders were engaged in oil refining two of the other shareholders were regional cooperatives and four were for-profit corporations seaway was organized to construct and operate a pipeline and related terminal facilities for the - - transportation of crude_oil from freeport texas to cushing oklahoma pipelines owned by entities other than seaway connected the cushing oklahoma terminal with the refinery facilities of seaway's shareholders the pipeline was operated as a common carrier under federal_law the stockholders intended to use the pipeline to carry imported crude_oil part of the distance from freeport to their refineries at the time of construc- tion the shareholders expected that they would be the principal users of the pipeline and that nonshareholders would account for approximately percent of the pipeline's usage the total projected cost of the seaway pipeline was dollar_figure million approximately percent of the cost was to be financed by equity_capital contributed by the shareholders the remainder was to be financed through the sale of commercial paper and long-term debt through private placements by date seaway had issued long-term debt in the aggregate principal_amount of dollar_figure million pursuant to an agreement among the seaway shareholders dated date petitioner contributed dollar_figure to seaway as consideration for the issuance of seaway stock -- - petitioner owned percent of seaway's capital stock from the company's inception until its termination in to ensure payment of seaway's long-term debt its stockholders executed a throughput and deficiency agreement tda dated date under the terms of the tda each stockholder agreed to deliver sufficient crude_oil for transportation through the pipeline in proportion to its capital stock ownership so that revenues collected for the transportation would pay all operating_expenses of the pipeline and all principal and interest due on seaway’s outstanding debt in the event seaway experienced a cash deficiency the tda obligated each shareholder to pay seaway its proportionate share of the deficiency on the date any interest or principal payment was due or at the end of any 6-month accounting_period seaway and its shareholders treated these tda deficiency payments as prepaid transportation charges to be credited against actual charges when crude_oil was transported for the paying shareholder on its balance_sheet petitioner credited its tda deficiency payments to an account for prepaid_expense items and debited the payments to an expense account when it actually used the pipeline - - the seaway pipeline became operational on date petitioner used the pipeline to transport approxi- mately percent of the crude_oil processed at its coffeyville refinery which was connected to the cushing terminal by another pipeline owned by petitioner the seaway pipeline also gave petitioner access to foreign crude_oil needed to operate its refineries for financial_accounting purposes petitioner through cra recorded its seaway stock on its balance_sheet in an account labeled other investments neither petitioner nor cra recorded the seaway stock in an account identified as an inventory fixed assets hedge or hedging_account petitioner did not hold its stock in seaway for sale in the ordinary course of business and did not sell any seaway stock or receive any stock_dividends for financial reporting purposes petitioner’s share of seaway’s annual earnings or losses was reflected as adjustments to a balance_sheet asset account and a balance_sheet schedule entitled investments in equity and earnings_of and dividends received from affiliates and other persons---- a capital stock although seaway incurred operating losses in and it had sufficient pipeline transportation revenues and cash reserves in each of those years to pay - - its operating_expenses and service its debt however pipeline usage declined steadily from to seaway transported the following volumes of crude_oil during those years barrels of year crude transported big_number big_number big_number big_number big_number this decrease in pipeline usage caused seaway to experience a shortage of cash and forced the company to make cash calls pursuant to the tda between and petitioner's portion of the cash calls totaled dollar_figure of this amount approximately dollar_figure was ultimately applied to transportation charges for crude_oil transported through the pipeline on petitioner's behalf in seaway's board_of directors decided to sell the pipeline seaway later agreed to sell the pipeline to phillips petroleum phillips one of its shareholders for dollar_figure million phillips also agreed to purchase the port terminal facilities for dollar_figure million seaway sold the cushing terminal to amoco oil co for dollar_figure million petitioner’s annual report for describes the sale of the pipeline as follows -- -- during fiscal the seaway pipeline co sold its freeport tex to cushing okla crude_oil pipeline seaway was organized in the mid- 70s to transport foreign crude_oil from the texas gulf coast to midwest refineries farmland was a owner of the seaway facilities with less need for foreign crude_oil in the midwest the pipeline was no longer beneficial to farmland’s refining operations the sale of the pipeline was closed on date following the closing seaway's shareholders agreed to make short-term loans to seaway of up to dollar_figure million to cover operating_expenses pending dissolution seaway was to repay these loans with the proceeds of the sale of the terminal facilities in total the shareholders lent seaway dollar_figure petitioner's share of this loan was dollar_figure the sale of terminal facilities closed in july and date seaway ceased conducting business on date seaway used the proceeds from the sales of the pipeline and terminal facilities to repay its remaining debts to nonshareholders the full amount of the short-term loans made by the shareholders a portion of the shareholders' unapplied prepaid transportation charges and the shareholders' respective shares of the cost of oil remaining in the pipeline at the time it was sold on its federal_income_tax return petitioner reported an ordinary patronage loss from the seaway -- - transaction of dollar_figure this amount was calculated as follows estimated total amount received incident to liquidation dollar_figure unrecovered prepaid transportation advances dollar_figure inventory in pipeline big_number outstanding loan balance including accrued interest dollar_figure big_number cost of capital stock big_number total big_number net_loss reported big_number petitioner actually received dollar_figure upon the liquida-- tion of seaway because the final payments received in totaled dollar_figure rather that the amount originally estimated dollar_figure petitioner's amount received from the liquidation was calculated as follows inventory in pipeline dollar_figure outstanding loan balance including dollar_figure accrued interest big_number recovery_of unapplied prepaid transportation charges---1984 big_number recovery_of unapplied prepaid transportation charges--1985 big_number total amount received big_number in the subject notice_of_deficiency respondent determined that the portion of the net_loss attributable to the cost of seaway's capital stock dollar_figure is a nonpatronage capital_loss the notice describes this adjustment as follows -- - the loss realized on the sale of the seaway pipeline inc stock must be recognized as nonpatronage capital_loss and may not be offset by patronage income accordingly your non- patronage capital losses are increased by dollar_figure big_number the patronage ordinary_loss you reported is decreased by dollar_figure and the nonpatronage ordinary_loss you reported is decreased by dollar_figure in your fiscal_year ending date mex--am crude corp in an attempt to expand its access to crude_oil from sources outside the united_states petitioner became one of nine equal subscribers to the capital stock of the mex- am crude corp mex-am all of these subscribers were companies that engaged in refining crude_oil and required reliable access to adequate supplies of crude mex-am was incorporated on date it was organized to purchase oil in large volumes from petroleos mexicanos pemex on a collective basis for the benefit of its shareholders each of mex-am's shareholders was obligated to purchase a portion of the crude_oil mex-am acquired from pemex this obligation terminated if at any time a shareholder surrendered its stock for no consideration petitioner did not hold its mex-am stock for sale in the ordinary course of business for financial reporting purposes petitioner reported its stock in mex-am in an account on its balance_sheet labeled other investments - - petitioner never recorded its mex-am stock in an account identified as an inventory hedge or hedging_account petitioner never sold any mex-am stock and never received any dividends from mex--am supply conditions for crude_oil improved in late making it unnecessary for petitioner to obtain crude_oil from mex-am accordingly petitioner surrendered its stock in mex-am for no consideration thereby relieving itself of the obligation to purchase a portion of mex-am's crude_oil on its federal_income_tax return for petitioner reported an ordinary_loss of dollar_figure from the surrender of its mex-am stock petitioner treated dollar_figure of this amount as an ordinary patronage loss and dollar_figure as an ordinary nonpatronage loss in the notice_of_deficiency respondent recharacter- izes the loss as a nonpatronage capital_loss that cannot be offset by patronage income the notice_of_deficiency describes this adjustment as follows the loss realized on the surrender of the mex-am crude corporation stock must be recognized as non-patronage capital_loss and may not be offset by patronage income accordingly your non- patronage capital losses are increased by dollar_figure big_number the patronage ordinary_loss you reported is decreased by dollar_figure and the non- patronage ordinary_loss you reported is -- - decreased by dollar_figure in your fiscal_year ending date lamont gas processing plant for many years petitioner purchased propane and gasoline blending stocks from outside suppliers the guality of this fuel was often inconsistent and there was often an inadequate supply to meet the needs of petitioner's patrons to address these problems petitioner decided to manufacture propane and gasoline blending stock in petitioner purchased a natural_gas gathering system near lamont oklahoma to implement this plan after the purchase petitioner installed an absorption processing plant on the site the facility also included an extensive pipeline system which provided petitioner access to numerous natural_gas producing wells in petitioner added a cryogenic gas processing plant to its facilities at lamont which significantly enhanced the plant's efficiency we refer to the gathering system the absorption processing plant the pipeline system and the cryogenic plant collectively as the lamont gas plant in date petitioner sold the assets composing the lamont gas plant to union texas products corp for dollar_figure million the sale was an arm's-length_transaction petitioner used dollar_figure million of the proceeds to build and --- - expand similar gas gathering and processing plants in texas the balance of the proceeds was used to reduce petitioner's outside debt and free up funds for operating purposes petitioner’s annual report for describes the sale as follows farmland sold its gas products plant at lamont okla funds generated from the sale are being used to expand gas plants at mertzon and eldorado tex the lamont plant had been processing about million cubic feet of natural_gas per day kldorado-mertzon with a much larger pipeline gathering system processed million cubic feet per day in the expansion completed in date will boost capacity to million cubic feet per day in the annual report states that the sale took place to finance the expansion of the texas plants after feasi- bility studies pointed to advantages in expanding the mertzon texas natural_gas liguids plants on its federal_income_tax return for the year ending date petitioner reported a gain of dollar_figure from the sale of the lamont gas plant this gain comprised the following components amount_realized in excess of cost_basis dollar_figure sec_1245 recapture big_number straight-line_depreciation on sec_1250 property big_number total reported gain big_number -- - petitioner reported the entire gain from the sale of the lamont gas plant as ordinary patronage income in the subject notice_of_deficiency respondent reclassifies the portion of the gain representing the amount_realized in excess of cost_basis viz dollar_figure as nonpatronage capital_gain under sec_1231 respondent does not take issue with petitioner's treatment of the portion of the gain equal to depreciation_recapture under sec_1245 dollar_figure or the portion of the gain egual to the amount of straight-line_depreciation on sec_1250 property dollar_figure the notice_of_deficiency describes this adjustment as follows the sec_1231 gain realized on the sale of the lamont oklahoma gas plant must be recognized as non-patronage capital_gain and may not be offset by patronage losses accordingly your non-patronage capital_gains are increased by dollar_figure the patronage ordinary_income you reported is decreased by dollar_figure big_number and the non-patronage ordinary_income you reported is decreased by dollar_figure big_number in your fiscal_year ending date soybean processing facilities prior to date petitioner owned and operated three soybean processing facilities these facilities were located in sergeant bluff iowa st joseph missouri and van buren arkansas and are collectively referred to herein as the soybean facilities petitioner -- - used the soybean facilities to process soybeans purchased from its patrons into soy oil and soy meal petitioner sold most of the soy oil it produced to unrelated food processors for use in products such as margarine petitioner processed the soy meal it produced into formula livestock feed all of which it sold to its member_cooperatives boone valley and land o'lakes two other midwestern cooperatives also processed and marketed soy products during the years in issue boone valley processed soy meal into livestock feed using petitioner’s proprietary formulas and technical support boone valley’s feed production was marketed directly through petitioner boone valley is included ina list entitled subsidiaries and affiliates in petitioner’s annual report in some earlier reports boone valley is described as a subsidiary of petitioner and some of its member_cooperatives the record does not fully disclose the nature of the relationship of boone valley and petitioner during petitioner's fiscal_year consideration was given to consolidating the soybean operations of petitioner boone valley and land o'lakes under the terms of the plan petitioner was to sell its soybean -- - facilities to boone valley for dollar_figure million petitioner was then to purchase boone valley's hagle grove iowa feed mill for dollar_figure million and boone valley was to change its name to ag processing inc api petitioner land o'lakes and the former patrons of boone valley were to receive all of the equity in api the record does not disclose the consideration paid_by land o'lakes for its interest in api the soybean consolidation plan was effectuated in date petitioner's annual report for states that the consolidation of the three regional cooperatives into a single entity would eliminate some duplication of effort and create a stronger cooperative soy processing entity that will improve producers’ return petitioner estimated that the consolidation would provide additional savings of to cents per bushel for soybean farmers following the consolidation petitioner's patrons marketed soybeans through api api operated the soybean facilities and sold a substantial portion of its output to petitioner for resale to its member_cooperatives -- - on its federal_income_tax return for the year ending date petitioner reported a gain of dollar_figure from the sale of its soybean facilities to boone valley this gain was composed of the following components amount_realized in excess of cost_basis dollar_figure sec_1245 recapture big_number straight-line_depreciation on sec_1250 property big_number total reported gain big_number petitioner reported dollar_figure of the gain as patronage capital_gain under sec_1231 this amount consists of the portion of the gain equal to the amount_realized in excess of the cost_basis dollar_figure and the portion representing the straight-line_depreciation taken on sec_1250 property dollar_figure petitioner reported the portion of the gain representing sec_1245 recapture dollar_figure as ordinary patronage income in the subject notice_of_deficiency respondent reclassifies the portion of gain representing the amount_realized in excess of cost_basis dollar_figure as nonpatronage capital_gain respondent does not adjust petitioner's treatment of the portion of the gain representing sec_1245 recapture dollar_figure treated as ordinary patronage income or petitioner's treatment of the portion of the gain representing straight-line - -- depreciation taken on sec_1250 property dollar_figure treated as patronage capital_gain miscellaneous sec_1231 assets during the tax_year ending date petitioner sold in arm's-length transactions retired or otherwise_disposed_of approximately miscellaneous business_assets these included tractors and other vehicles livestock buildings office furniture and office equipment all of these assets were depreciable assets described in sec_1231 and had been used and disposed of in the ordinary course of petitioner's business activities on its federal_income_tax return for the year ending date petitioner reported a net gain of dollar_figure from the disposition of these assets this gain is comprised of the following components amount_realized in excess of cost_basis dollar_figure aggregate sec_1245 recapture big_number total reported gain big_number petitioner reported the portion of gain representing aggregate sec_1245 recapture dollar_figure as ordinary patronage income petitioner reported the portion of the gain representing the amount_realized in excess of cost_basis dollar_figure as patronage capital_gain under sec_1231 -- - in the subject notice_of_deficiency respondent reclassifies the portion of the gain representing the aggregate amount_realized in excess of cost_basis dollar_figure as nonpatronage capital_gain respondent does not adjust petitioner's treatment of the portion of the gain representing aggregate sec_1245 recapture as ordinary_income from patronage sources in describing the adjustments involving the gain realized from the sale of petitioner’s soybean facilities and the gain from the sale of the above miscellaneous sec_1231 assets the notice_of_deficiency states as follows the sec_1231 gain realized on the sale of the soybean processing facilities must be recognized and treated as non-patronage capital_gain and may not be offset by patronage losses accordingly your non- patronage capital_gains are increased by dollar_figure the patronage ordinary_income you reported is decreased by dollar_figure big_number and the non-patronage ordinary_income you reported is decreased by dollar_figure big_number in your fiscal_year ending date the increase in non-patronage capital_gains of dollar_figure determined in the notice consists of dollar_figure attributable to the sale of petitioner’s soybean facilities and dollar_figure attributable to the sale of miscellaneous assets - - opinion petitioner is a nonexempt_cooperative subject_to subchapter_t see generally 103_tc_547 for an overview of the taxation of nonexempt cooperatives under subchapter_t the principal issue in this case is whether the gains and losses that petitioner realized from the disposition of the property described above should be classified as patronage or nonpatronage gains and losses for purposes of subchapter_t the property at issue is petitioner’s stock in three corporations terra mex-am seaway and certain property used in a trade_or_business as defined by sec_1231 consisting of the assets of petitioner’s lamont gas plant its soybean processing facilities and miscellaneous business_assets the bulk of the deficiencies determined in the notice_of_deficiency is attributable to respondent’s reclassification of the gain from petitioner’s sale of the stock of terra the term patronage_dividend is defined by sec_1388 as follows a patronage_dividend --for purposes of this subchapter the term patronage_dividend means an amount_paid to a patron by an organization to which part i of this subchapter applies---- on the basis of quantity or value of business done with or for such patron -- - under an obligation of such organization to pay such amount which obligation existed before the organization received the amount_paid and which is determined by reference to the net_earnings of the organization from business done with or for its patrons such term does not include any amount_paid to a patron to the extent that a such amount is out of earnings other than from business done with or for patrons or b such amount is out of earnings from business done with or for other patrons to whom no amounts are paid or to whom smaller amounts are paid with respect to substantially identical transactions by patronage income we mean income derived from business done with or for patrons of the cooperative such that it can be included in computing the net_earnings from which a patronage_dividend can be paid sec_1388 by nonpatronage income we mean income that is derived other than from business done with or for patrons see sec_1388 petitioner argues that the classification of gains and losses as patronage or nonpatronage income depends on the factual relationship between the activity producing the gain_or_loss and the operations of the cooperative regardless whether the gains or losses are capital or ordinary in nature petitioner argues that if the activity producing the gain_or_loss is directly related to or facilitates the cooperative’s operations then the -- - gain_or_loss should be treated as patronage income petitioner asks the court to reject the per se rule espoused by respondent under which capital_gains_and_losses are always classified as nonpatronage in the event that the court adopts a per se rule for capital_gains_and_losses petitioner argues that the gains and losses from its disposition of the stock of terra seaway and mex--am are not subject_to such rule because they are ordinary gains and losses under the long-standing case law principles relating to ‘source of supply’ noncapital_asset ‘surrogacy’ and ‘hedging’ similarly petitioner argues that the gains from the disposition of the sec_1231 assets are noncapital’ assets by statutory definition under sec_1221 and are not subject_to respondent's per se rule finally petitioner argues that even if the gains from the sale of terra stock and the sec_1231 assets are classified as nonpatronage income such income can nevertheless be offset by petitioner's patronage losses which were true operating losses respondent argues that all of the gains and losses at issue in this case are capital in nature and must be automatically classified as nonpatronage under the per se rule prescribed by sec_1_1382-3 income_tax regs alternatively respondent argues that even if the court -- - does not adopt the per se rule for capital_gains_and_losses the gains and losses at issue must be classified as nonpatronage in either event respondent argues that the subject gains and losses cannot be combined with or netted against petitioner's patronage losses this and the other courts to have considered whether an item_of_income should be classified as patronage or nonpatronage have resolved the issue based upon the relationship of the transaction that generated the income to the marketing purchasing or service activities of the cooperative 995_f2d_101 7th cir modifying and affg tcmemo_1991_568 765_f2d_1102 fed cir 675_f2d_988 8th cir st louis bank for coops v united 624_f2d_1041 103_tc_547 88_tc_238 87_tc_435 dundee citrus growers association v commissioner tcmemo_1991_487 washington-oregon shippers coop inc v commissioner tcmemo_1987_32 twin country grocers inc v united_states cl_ct astoria plywood corp -- jo - v united_states aftr 2d ustc par d or 410_fsupp_1100 d or as appears from these cases if the income at issue is produced by a transaction which is directly related to the cooperative enterprise such that the transaction facilitates the cooperative's marketing purchasing or service activities then the income is deemed to be patronage income see eg cotter co v united_states supra pincite land o'lakes inc v united_states supra pincite certified grocers of cal ltd v commissioner supra pincite illinois grain corp v commissioner supra pincite on the other hand if the income is derived from a transaction that has no integral and necessary linkage to the cooperative enterprise such that it may fairly be said that the income is merely incidental to the cooperative enterprise and does nothing more than add to the overall profitability of the cooperative then the income is deemed to be nonpatronage income see eg cotter co v united_states supra pincite land o'lakes inc v united_states supra pincite certified grocers of cal ltd v commissioner supra pincite illinois grain corp v commissioner supra pincite - 7jl1- the determination of whether income derived by a cooperative from a transaction that is directly related to the cooperative enterprise and thus is patronage income is a determination that is necessarily fact intensive 88_tc_238 87_tc_435 washington--oregon shippers coop inc v commissioner tcmemo_1987_32 in considering the relatedness of the income-producing transaction to the cooperative enterprise it is important to focus on the totality of the circumstances and to view the business environment to which the income-producing transaction is related and not to view the transaction so narrowly as to limit it only to its income-generating characteristic when such a characterization is not consistent with the actual activity cotter co v united_states supra pincite- dundee citrus growers association v commissioner tcmemo_1991_487 the directly_related_test applied by the courts is traceable to published rulings issued by the commissioner such as revrul_69_576 1969_2_cb_166 and revrul_74_160 1974_1_cb_245 that interpreted patronage income broadly see cf indus inc v commissioner supra pincite illinois grain corp v commissioner supra pincite - j2 - cf land o'lakes inc v united_states supra pincite in revrul_69_576 supra the commissioner held that an amount received by the taxpayer a nonexempt_cooperative as a patronage_dividend from a bank for cooperatives should be considered patronage income in the taxpayer's hands the taxpayer cooperative became eligible to receive the patronage_dividend from the bank for cooperatives by reason of the fact that it had borrowed from the bank to finance the acquisition of agricultural supplies for resale to its members the commissioner reviewed sec_1_1382-3 income_tax regs and articulated the following test for classifying an item_of_income as patronage or nonpatronage income sec_1_1382-3 of the income_tax regulations defines the term income derived from sources other than patronage to mean incidental income derived from sources not directly related to the marketing purchasing or service activities of the cooperative association for example income derived from the lease of premises from investment in securities or from the sale_or_exchange of capital assets constitutes income derived from sources other than patronage the classification of an item_of_income as from either patronage or nonpatronage sources is dependent on the relationship of the activity generating the income to the marketing purchas-- ing or service activities of the cooperative if the income is produced by a transaction which actually facilitates the accomplishment of the cooperative's marketing purchasing or service activities the income is from patronage sources however if the transaction producing the income -- - does not actually facilitate the accomplishment of these activities but merely enhances the overall profitability of the cooperative being merely incidental to the association's cooperative operation the income is from nonpatronage sources accordingly inasmuch as the income received by the nonexempt_cooperative from the bank for cooperatives resulted from a transaction that financed the acquisition of agricultural supplies which were sold to its members thereby directly facilitating the accomplishment of the cooperative's purchasing activities it is held that the allocation and payment of this same amount by the nonexempt farmers' cooperative to its own patrons farmers qualifies as a patronage_dividend rev_rul supra similarly in revrul_74_160 1974_1_cb_245 the commissioner ruled that interest_income realized from loans made by the taxpayer a nonexempt_cooperative engaged in the manufacture and sale of plywood to the taxpayer's chief supplier was patronage income according to the ruling the loans were necessary in order to permit the supplier to finance equipment needed to carry on its business operations and without the loans the supplier would have been unable to supply the taxpayer thus the commissioner ruled that the interest_income paid_by the supplier to the taxpayer was classified as patronage income because it actually facilitated the accomplishment of taxpayer's cooperative activities in that it enabled the taxpayer to obtain necessary supplies for its operations - in effect the commissioner ruled that the patronage_dividend received by the taxpayer in revrul_69_516 supra and the interest_income received by the taxpayer in revrul_74_160 supra qualified for inclusion in the taxpayer’s net_earnings from business done with or for its patrons sec_1388 in neither case were patrons of the taxpayer cooperative directly involved in the transaction out of which the income arose compare revrul_73_497 1973_2_cb_18 in which the commissioner ruled that interest_paid to a bank for cooperatives by other farm credit banks did not qualify as patronage income because the payors were not patrons of the taxpayer this ruling has been criticized by the courts and it has not been followed see st louis bank for coops v united 624_f2d_1041 see also 765_f2d_1102 fed cir generally under the directly_related_test as applied by the courts transactions with third parties can qualify as business with or for patrons as long as the transaction is reasonably related to the business which the cooperative conducts with its patrons and benefits the patrons other than incidentally through the generation of extra income st louis bank for coops v united_states - j5 - f 2d pincite2 as the court said in twin county grocers inc v united_states cl_ct a common thread runs through each of the cases and rulings above summarized although the income at issue is generated by transactions between nonexempt cooperatives and nonpatrons it is deemed to be patronage sourced because those transactions facilitate the basic functions of the cooperative in some way other than simple money management or overall profitability in applying the directly related standard the courts have classified dividend income from a subsidiary of the cooperative as patronage income if the business of the subsidiary out of which the dividends are paid is reasonably related to the basic purpose of the cooperative for example in 410_fsupp_1100 d or the court held that dividends received by the taxpayer a workers' cooperative with respect to the capital stock it held in a glue manufacturing enterprise constituted patronage income the taxpayer in that case was engaged in the manufacture and sale of plywood and plywood products see id to secure a reliable supply of glue a material essential to the manufacture of plywood the taxpayer and another cooperative organized a glue manufacturing enterprise see id each cooperative owned percent of the capital stock of the glue manufacturer during - - the year the taxpayer received dividends from the glue manufacturer which it included in its net_earnings as patronage income see id in holding that the dividends were patronage income the court stated glue is essential to the manufacture of ply- wood and the arrangement which the taxpayer- cooperative made to produce its glue through a supplier which it and another plywood workers' cooperative organized is reasonably related to the business done with or for its patrons id cf revrul_74_160 supra interest_paid on loans made by taxpayer cooperative to its chief supplier held to be patronage income similarly in 675_f2d_988 8th cir the court considered the patronage classification of dividends received by the taxpayer a nonexempt_cooperative with respect to its stock in a bank for cooperatives the court noted that the taxpayer was required to acquire and hold the stock to obtain a loan the proceeds of which were used to finance cooperative activities on favorable terms see id pincite the court found that the subject transaction in which the taxpayer received the dividends was not significantly distinguishable from the transactions involved in revrul_69_576 supra and revrul_74_160 supra and held --- jj - that the dividends should be classified as patronage income id pincite according to the court because the transactions actually facilitated the cooperative’s activities by providing financing on terms favorable to the cooperative the income from the bank stock was from a patronage source and therefore was properly deductible as a patronage_dividend id in the same vein the commissioner ruled in revrul_75_228 1975_1_cb_278 that the dividends received by the taxpayer a farmers' cooperative from its wholly owned domestic international sales corp disc should be classified as patronage income the ruling formulates the directly_related_test to be used in classifying patronage and nonpatronage income as follows the classification of an item_of_income as from either patronage or nonpatronage sources is dependent upon the relationship of the activity generating the income to the marketing purchas-- ing or service activities of the cooperative thus if the income is produced by a transaction directly connected with marketing patrons' products the income is from patronage sources rev_rul supra 1975_1_cb_179 the ruling notes that the dividends_paid by the disc were from the selling commissions earned by the disc from selling the products of the taxpayer's patrons accordingly the ruling concludes that the dividend income --- - was produced by a transaction directly connected with marketing patrons' products the objective of distinguishing between patronage and nonpatronage income is bound up with the basic concept of a cooperative that is transforming the cooperative’s net_income into lower prices for its patrons 995_f2d_101 7th cir modifying and affg tcmemo_1991_568 in making this determination the courts have recognized that cooperatives should be permitted to take the action that is reasonably necessary under the circumstances without suffering the loss of benefits under subchapter_t as the court stated in cotter co v united_states f 2d pincite subchapter_t was also not enacted to require that a cooperative acting for its patrons function in an economically unreasonable manner or penalize it for acting reasonably the taxpayer in cotter co v united_states supra was a nonexempt_cooperative that purchased warehoused and distributed products for its members small independent hardware retailers see id the court agreed with the taxpayer that interest_income from short-term commercial paper and certificates of deposit purchased with temporarily unneeded funds was properly treated as - jq - patronage income according to the court by keeping short-term commercial paper the taxpayer was acting to retain its liquidity in order to prepay for goods at a discount and thus was acting as any reasonable business person id pincite the court compared the taxpayer’s actions to placing its funds in a bank account see id the court also agreed with the taxpayer that rental income from leasing temporarily excess warehouse space to tenants should be classified as patronage income the court noted that the warehouse space was rented only as part of the taxpayer’s plan to expand its space over its then-existing needs and not as apart of a separate warehouse rental business id pincite the court set forth the following guiding principle for application of the directly_related_test we agree with the claims_court that congress did not intend the term with or for patrons to be of unlimited scope so that all income produced by cooperatives that is passed through to patrons would be in essence income obtained for patrons and would therefore be considered patronage sourced cotter cl_ct pincite a cooperative cannot merely clothe its shareholders as patrons and its corporate dividends as patronage payments and retain the benefits of subchapter_t mississippi valley f 2d pincite but subchapter_t was also not enacted to require that a cooperative acting for its patrons function in an economically unreasonable manner or penalize it for acting reasonably consider- ing the income-generating transaction in its relation to all the activity undertaken to -- - fulfill a cooperative function will allow courts to distinguish from cooperative activity transactions which merely enhance overall profitability in a manner incidental to cooperative function such activity is not to receive the benefits of subchapter_t but other activity which does directly relate to cooperative function when considered in its actual business environment cannot properly be considered outside business done with or for patrons cotter’s transactions here were not merely to gain incidental profits they resulted from activities integrally intertwined with the cooperative’s functions the earnings cotter in this case produced and passed through to its members are patronage_dividends id pincite similarly in 87_tc_435 the court agreed that rental income from two barges that the taxpayer caused to be constructed leased from an insurance_company and subleased to a barge company constituted patronage income the court found that petitioner’s leasing and subleasing of barges to its transportation cooperative was not an ‘investment’ in such barges intended to produce merely passive rental income but was an integral part of its overall cooperative activity in moving its patrons’ grain to market id pincite in derogation of the directly_related_test described above respondent argues in this case that capital_gains_and_losses are always classified as non- patronage without consideration of the relatedness of the -- - transaction to the cooperative enterprise respondent argues that sec_1_1382-3 income_tax regs establishes this per se nonpatronage rule for capital_gains_and_losses the regulation provides as follows definition as used in this paragraph the term income derived from sources other than patronage means incidental income derived from sources not directly related to the marketing purchasing or service activities of the cooperative association for example income derived from the lease of premises from investment in securities or from the sale_or_exchange of capital assets constitutes income derived from sources other than patronage sec_1_1382-3 income_tax regs this regulation is expressly applicable only to exempt farmers'_cooperatives however the concept income derived from sources other than patronage is a concept applicable to both exempt and nonexempt cooperatives and the courts have applied the regulation to nonexempt cooperatives as well as to exempt_cooperatives see buckeye countrymark inc v commissioner t c pincite see also eg 995_f2d_101 7th cir modifying and affg tcmemo_1991_568 765_f2d_1102 fed cir 88_tc_238 ndollar_figure but see gold kist inc v commissioner t c - - ndollar_figure declining to apply sec_1_1382-3 income_tax regs to a nonexempt_cooperative revd on other grounds 110_f3d_769 11th cir sec_1_1382-3 income_tax regs defines nonpatronage income as incidental income derived from sources not directly related to the marketing purchasing or service activities of the cooperative association the regulation then gives three examples of nonpatronage income derived from the lease of premises from investment in securities and from the sale_or_exchange of capital assets see sec_1_1382-3 income_tax regs according to respondent by giving ‘income from the sale_or_exchange of capital assets’ as an example of non- patronage source income sec_1_1382-3 establishes a per se rule that the capital_gains_and_losses of a nonexempt_cooperative are to be classified as non- patronage source items we note that in considering this regulation the court in cf indus inc v commissioner supra pincite described it as hopelessly equivocal neither this nor any other court has ever held that rents dividends or interest_income or capital_gains are nonpatronage based upon a per se rule found in sec_1_1382-3 income_tax regs see eg ce indus inc v commissioner supra interest from short-term - - financial investments 765_f2d_1102 fed cir income from rental of excess warehouse space 675_f2d_988 8th cir dividends 87_tc_435 dividends and income from rental of barges dundee citrus growers association v commissioner tcmemo_1991_487 interest_income 410_fsupp_1100 d or in fact the premise of respondent's argument that sec_1_1382-3 income_tax regs requires income from the lease of premises from investment in securities and from the sale_or_exchange of capital assets to be treated as nonpatronage per se was rejected by this court in illinois grain corp v commissioner supra in that case the court noted that the apparently clear language of the regulation stating that income from the lease of premises from investment in securities or from the sale_or_exchange of capital assets are examples of nonpatronage income is language that under the law as it has developed does not always mean what it literally says id the court continued as follows thus in the case of interest both the courts and respondent have acknowledged that interest_income may have the quality of income - -- from patronage sources depending upon the circumstances 765_f2d_1102 fed cir st louis bank for coops v united 624_f2d_1041 revrul_74_160 1974_1_cb_245 dividend income has sometimes likewise been held to be patronage-sourced 675_f2d_988 8th cir 410_fsupp_1100 d ore revrul_75_228 1975_1_cb_278 rental income has also been held to be patronage-sourced on occasion cotter co v united_states supra revrul_63_58 1963_1_cb_109 semble and some capital_gains income has been held to be income from patronage sources under the circumstances presented in the particular case astoria plywood corp v united_states an unreported case d ore aftr 2d ustc par contra revrul_74_160 1974_1_cb_245 1d significantly in the last case cited above in response to the government’s argument that all capital_gains are not patronage source income the court stated in my view capital_gains may be patronage source income in each instance it depends on whether the income is ‘directly related’ to astoria's activities astoria plywood corp v united_states aftr 2d ustc par at big_number d or moreover the commissioner has twice ruled that in appropriate circumstances capital_gains can be classified as patronage income see revrul_74_24 1974_1_cb_244 revrul_71_439 1971_2_cb_321 hach of those rulings involves a nonexempt_cooperative engaged in the manufacture - - and sale of plywood and related wood products the taxpayer in each ruling owned standing timber which had appreciated in value and served as a source of raw material for the taxpayer's products the issue was whether the capital_gains recognized by each cooperative upon cutting the timber pursuant to an election under sec_631 could be classified as patronage income sec_631 a provides an election to certain taxpayers to treat as gain_or_loss from a sale_or_exchange under sec_1231 the difference between the actual cost or other basis of the timber cut during the year and its fair_market_value as standing timber see sec_1_631-1 income_tax regs in each ruling the commissioner took the position that the capital_gains recognized by the cooperative are properly classified as patronage income the classification of capital_gains realized pursuant to the election under sec_631 as patronage income was tacitly approved by this court in 76_tc_637 that case involved a dispute concerning the computation of the alternative_tax under sec_1201 with respect to sec_631 gains we held that for purposes of computing the alternative_tax a taxpayer 1s entitled to -- - reduce its sec_631 gains by the amounts distributed to its stockholder employees as patronage_dividends the capital_gains in revrul_74_24 supra and revrul_71_439 supra are similar to the capital_gain realized from the sale of terra stock in the instant case in both rulings the commissioner recognizes that the gain x represents the unrealized_appreciation in value of timber cut during the year revrul_74_24 supra revrul_71_439 supra both rulings make the point that the actual realization of the appreciation in the value of the standing timber would take place when the finished product is sold similarly the gain from the sale of petitioner's terra stock was attributable in large measure to apprecia-- tion in the value of the oil_and_gas reserves held by terra if petitioner had not been forced to sell the stock of terra the realization of the appreciation in terra’s oil_and_gas reserves would have taken place upon terra’s production and sale of oil_and_gas and would have been directly related to petitioner’s business of supplying petroleum products to its patrons respondent’s argument that capital_gains_and_losses must always be classified as nonpatronage income implies that there is no transaction out of which capital_gains or losses arise that can be directly related to the - - cooperative enterprise of a cooperative of course this argument 1s contrary to revrul_74_24 supra and revrul_71_439 supra in which the commissioner ruled that capital_gains recognized by a cooperative pursuant to an election under sec_631 are properly classified as patronage income see revrul_74_24 supra revrul_71_439 supra according to respondent under the per se rule set forth in sec_1_1382-3 all capital_gains_and_losses must be classified as nonpatronage this includes not only gains and losses realized from the sale_or_other_disposition of capital assets as defined by sec_1221 but also gains and losses from the sale or other disposi- tion of property_used_in_the_trade_or_business as defined by sec_1231 sec_1231 governs the tax consequences of gains and losses realized from the disposition of depreciable_property used in a trade_or_business generally the gains and losses from the sale_or_exchange of sec_1231 assets that are recognized during the taxable_year are netted together see sec_1231 tf the gains exceed the losses for the taxable_year then all of the gains and losses are treated as long-term_capital_gains and losses see sec_1231 if the - - losses exceed the gains for the taxable_year then all of the gains and losses are treated as ordinary gains and losses see sec_1231 respondent argues that any gain_or_loss that is treated as a capital_gain or loss under sec_1231 should be classified as from nonpatronage sources as a threshold matter respondent’s argument does not satisfactorily explain why assets that qualify as property_used_in_the_trade_or_business under sec_1231 are subject_to a per se rule under sec_1_1382-3 income_tax regs which is formulated in terms of income derived from sale_or_exchange of capital assets assets treated as property_used_in_the_trade_or_business as defined by sec_1231 are excluded from the definition of the term capital_asset sec_1221 see st louis bank for coops v united_states f 2d pincite where the court rejects the commissioner’s classification of gain from the sale of a car as nonpatronage income under sec_1_1382-3 income_tax regs and points out that the commissioner’s treatment was erroneous since the car was not a capital_asset under sec_1221 of the code respondent’s position is that if the sec_1231 gains and sec_1231 losses for the taxable_year are - - treated as long-term_capital_gains or long-term_capital_losses under sec_1231 by reason of the fact that the aggregate sec_1231 gains exceed the aggregate sec_1231 losses for the taxable_year then each sec_1231 gain and loss realized during the year is automatically deemed to be a nonpatronage item under the per se rule on the other hand if the sec_1231 gains and losses for the taxable_year are not treated as gains and losses from sales or exchanges of capital assets under sec_1231 by reason of the fact that the aggregate sec_1231 gains do not exceed the aggregate sec_1231 losses for the taxable_year then each sec_1231 gain and loss realized during the year is deemed to be a patronage item under the per se rule under respondent’s position therefore the patronage classification of gains and losses from the sale_or_exchange of property_used_in_the_trade_or_business is determined by the mathematical result of the netting process under sec_1231 it has nothing to do with whether the property or the transactions from which the gains or losses arose are related to the operations of the cooperative this is contrary to sec_1_1382-3 income_tax regs which formulates the distinction between patronage and nonpatronage in terms of whether the item is -- - incidental income derived from sources not directly related to the marketing purchasing or service activities of the cooperative association in the event that the aggregate sec_1231 gains exceed losses for the taxable_year respondent’s position is that the gain realized from the sale_or_exchange of each sec_1231 asset is automatically classified as nonpatronage except for the portion of the gain treated as ordinary_income under the recapture rules prescribed by sec_1245 according to respondent the portion of the gain recaptured under sec_1245 is considered patronage income because in effect the taxpayer is merely recapturing income that otherwise would have been available for distribution as a patronage_dividend revrul_74_ 1974_1_cb_244 according to respondent the same is true with respect to the portion of the gain recaptured under sec_1250 a logical inconsistency in respondent’s per se rule arises in the case of recapture under sec_1250 this is due to the fact that generally sec_1250 requires recapture only of additional_depreciation or depreciation in excess of straight-line_depreciation sec_1250 under respondent’s position the straight-line_depreciation taken on depreciable real_property held for more than --- - year would not be recaptured as ordinary_income under sec_1250 and accordingly would be treated as nonpatronage income despite the fact that it is no different than depreciation recaptured under sec_1245 respondent argues that the gain realized in excess of the portion recaptured as ordinary_income under sec_1245 or sec_1250 is nonpatronage income assuming that there is a net sec_1231 gain for the taxable_year respondent suggests that this portion of the gain is always attributable to appreciation in the value of the sec_1231 assets the invisible hand of the market place and can never be directly related to the activities of the cooperative respondent cites astoria plywood corp v united_states aftr 2d ustc par d or as authority for that position that case however involved an entity that had operated for years as a for-profit corporation before becoming a cooperative the machinery that was sold had been used and fully depreciated before the taxpayer became a cooperative and it was sold in the same year the taxpayer became a cooperative in that case there was no factual basis on which to conclude that the income from the sale of the machinery was related in any way to the cooperative activities of the taxpayer thus that case does not - -- support respondent’s argument that the realization of appreciation is always unrelated to the activities of a cooperative indeed contrary to respondent’s argument respondent’s own rulings suggest that appreciation in the value of an asset can be taken into account as patronage income as mentioned above in revrul_74_24 supra and revrul_71_439 supra the commissioner ruled that the capital_gain recognized pursuant to an election under sec_631 is patronage income in those rulings the gain represents the unrealized_appreciation in value of timber cut during the year revrul_74_24 supra pincite revrul_71_439 supra pincite furthermore under respondent’s own position sec_1231 gains attributable to appreciation in the value of the asset will be treated as patronage income if there is a net sec_1231 loss for the taxable_year according to respondent it is also proper to classify sec_1231 losses as from patronage sources respondent argues as follows the same rationale applies to sec_1231 losses and results in such losses being quite properly classified as patronage-sourced losses unless demonstrated otherwise sec_1231 losses occur when the amount_realized upon disposition of an asset is less than its basis as adjusted to reflect appreciation or other cost_recovery - - mechanism deductions the result for such a loss is that the cumulative effect of the business usage of the asset resulted in even greater degradation in its value than anticipated and provided by the depreciation or other cost_recovery mechanism which was utilized for the asset as with sec_1245 or sec_1250 recapture such a loss is logically patronage-sourced unless proved otherwise the same conclusion also results under the operating versus nonoperating focus of the provisions of subchapter_t since the loss is directly attributable to cooperative activities unless proven otherwise thus the classification of sec_1231 losses as patronage-sourced makes economic sense the flaw in respondent’s argument however is that the classification of sec_1231 gains and losses is based upon whether there is a net sec_1231 gain_or_loss for the taxable_year thus sec_1231 losses which respondent asserts are logically patronage-sourced will be treated as nonpatronage income under respondent’s position if there is a net sec_1231 gain for the taxable_year in light of the foregoing we decline to abandon the directly_related_test that has been used by this and other courts to distinguish patronage from nonpatronage items and to adopt respondent’s per se nonpatronage rule for capital_gains_and_losses accordingly in this case our task is to determine whether each of the gains and losses at issue was realized in a transaction that was directly related to the cooperative enterprise or in one which generated -- - incidental income that contributed to the overall profitability of the cooperative but did not actually facilitate the accomplishment of the cooperative’s marketing purchasing or service activities on behalf of its patrons see eg cotter co v united_states f 2d pincite this determination requires an examination of the factual relationship between the activity producing the gains or losses and the cooperative’s patronage activities respondent acknowledges that the directly_related_test as formulated in revrul_69_576 1969_2_cb_166 supra has been adopted and applied by the courts however respondent argues that the directly_related_test as applied by the courts is an overly simplistic approach to the question at hand respondent asks the court to apply a new 2-part test as we understand it respondent argues that the court should not only determine whether the transaction from which the subject income arose is directly related to the cooperative enterprise but it should also determine whether the type of income at issue is the customary operating income of the cooperative respondent formulates the test as follows the proper test focuses on identifying the regular everyday operating activities of the cooperative and the anticipated ordinary profits -- - therefrom and then determining whether the income or loss item in question was an unavoidable result of transaction which was an integrally necessary part of the regular course of those activities under respondent’s new test gain_or_loss from the sale of an asset could never be classified as patronage income unless the cooperative is in the trade_or_business of selling such assets we agree with respondent that the normal operating activities of a cooperative and the income realized therefrom should be taken into account in considering whether an item_of_income is patronage or nonpatronage however we do not believe that an item_of_income is automatically excluded from classification as patronage income if it does not match the customary operating income of the cooperative gain from the sale of terra stock and losses from the liquidation of seaway and the surrender of mex-am stock we disagree with respondent’s requested finding that the terra seaway and mex-am stock were investments from the facts discussed above it is evident that the business of each of the three corporations in issue terra seaway and mex-am was closely and directly related to petitioner’s cooperative business of supplying petroleum products to its patrons and that the formation and -- - operation of each of the three corporations facilitated petitioner’s cooperative enterprise in our view petitioner’s acquisition of the stock of terra seaway and mex-am was no more an investment than the taxpayer’s acquisition of the stock from which the taxpayer received dividends in 410_fsupp_1100 d or a case that respondent relies upon here no more of an investment than the stock of the bank for cooperatives that was involved in 675_f2d_988 8th cir and no more of an investment than the stock of the disc that was involved in revrul_75_228 1975_1_cb_278 the issue in those cases was whether dividends_paid on the stock should be classified as patronage income the issue here is whether income from the sale of such stock should be classified as patronage from patronage sources sale of terra stock petitioner formed terra to explore for and produce crude_oil and natural_gas for petitioner’s refineries which used the crude_oil to produce petroleum products that were sold to petitioner’s patrons petitioner sold its stock in terra during a time of financial distress to raise cash necessary to reduce its debt load and restore its financial stability at the time it sold its stock in terra - - petitioner was reacting to extreme economic distress petitioner was on the verge of bankruptcy caused by an agricultural recession and large debt to remain in business petitioner needed to reduce its interest_expense petitioner’s primary creditor the wichita bank required that it sell assets to reduce its debt load petitioner sold its terra stock because it was the only asset that could be sold guickly to raise substantial cash but it structured the sale to retain a call on the crude_oil produced by terra we cannot find that this transaction merely enhanced the overall profitability of the cooperative and was merely incidental to petitioner’s cooperative operation in our view the sale of terra was necessary for petitioner’s continued operation and thus it was directly related to petitioner’s cooperative enterprise and actually facilitated the accomplishment of those activities disposition of stock of seaway and mex-am we also find that the losses petitioner realized on the disposition of its capital stock in seaway and mex--am constitute patronage losses as with terra respondent mischaracterizes the business relationship between petitioner and both seaway and mex-am petitioner acquired its interests in seaway and mex-am in an effort to -- -- vertically integrate its petroleum production business the fact that seaway was a common carrier under federal_law and that there is no evidence that petitioner ever received crude_oil from mex-am does not convert petitioner’s interests in those entities to mere passive investments each corporation was organized to perform functions that were related to petitioner’s petroleum business petitioner’s holding of the stock of each corporation was directly related to petitioner’s petroleum business petitioner disposed of its interests in seaway and mex-am because changes in the crude_oil market made those interests unnecessary as with the sale of terra stock the losses realized are from transactions that are directly related to petitioner’s petroleum business as such we find that the losses realized are from patronage sources gains from the sale of sec_1231 assets during the years in issue petitioner disposed of three groups of assets which are described in sec_1231 as property_used_in_the_trade_or_business these include the lamont gas plant the soybean processing facilities and the miscellaneous sec_1231 assets collectively we refer to these assets as the sec_1231 assets lamont gas plant at the outset we note that petitioner reported the gain realized from its sale of the lamont gas plant in as ordinary_income in the subject notice_of_deficiency respondent recharacterized the gain as a capital_gain pursuant to sec_1231 petitioner does not take issue with respondent’s determination that the gain from the sale of the lamont gas plant is subject_to sec_1231 petitioner purchased operated and expanded the lamont gas plant as part of its main cooperative effort of producing petroleum-based goods for its patrons during the time petitioner owned the plant virtually all of the natural_gas liquids produced there were either sold to petitioner’s patrons or used in producing gasoline for sale to its patrons the sale of the lamont gas plant took place after feasibility studies suggested that advantages would be gained in expanding petitioner’s natural_gas liquids plants in texas the bulk of the proceeds of the sale of the lamont gas plant went to expanding the texas plants in order to enable petitioner to realize those advantages for the benefit of its patrons accordingly we find that the gain from the sale of the lamont gas plant was realized in a transaction that is directly related to petitioner’s cooperative enterprise and therefore is patronage income soybean processing facilities part of petitioner’s patronage activities during the years in issue included purchasing soybeans from its patrons and processing them into soy oil and soy meal petitioner sold the soy oil to unrelated food processors for use in products such as margarine and processed the soy meal into livestock feed which it sold to its members petitioner sold its soybean processing facilities as part of a plan to consolidate its soybean processing operations with those of boone valley and land o’ lakes the circumstances surrounding petitioner’s sale of the soybean facilities are similar to those surrounding the sale of the lamont gas plant petitioner sold its soybean facilities as part of a plan to make those operations more profitable for its patrons the consolidation plan was completed in four steps petitioner sold its soybean facilities to boone valley for dollar_figure million petitioner purchased boone valley’s eagle grove iowa feed mill for dollar_figure million boone valley changed its name to ag processing inc and the patrons of petitioner land o’lakes and the former boone valley received all of the equity_interest in ag processing inc the result of these transactions was a consolidation of petitioner’s soy processing capacity with that of land o’ lakes and boone valley petitioner agreed to the consolidation plan based on a study it had commissioned on methods of improving its soybean processing efficiency and maximizing savings to patrons ina letter to petitioner’s members printed in its annual report mr kenneth nielson petitioner’s president at the time and mr francis gwin chairman of petitioner’s board_of directors described the consolidation as follows the consolidation plan will be a good thing for farmers eliminating some of the duplication of efforts and creating a stronger cooperative soy processing entity to improve producers’ return petitioner’s annual report further describes the reasons for the consolidation as follows although its own plants are well-located geographically and operationally to compete with industry farmland took a leadership role in the unification study president ken nielson said the unification plan would eliminate duplication of some farmer-owned facilities and services and create a new organization of a size better able to compete to farmers' economic benefit at year end farmland’s soy operations joined those of land o’ lakes and boone valley in the newly unified boone valley cooperative processing association a new name is to be later selected headquartered in omaha neb the purpose of the consolidation plan was to serve patrons better petitioner entered into the transaction because it believed it could process its members’ soybeans less expensively after the consolidation as such we find that petitioner’s sale of the soybean facilities was directly related to its patronage activities of producing soybean products for its patrons miscellaneous sec_1231 assets in petitioner disposed of approximately miscellaneous depreciable assets used in its business these included tractors and other vehicles livestock buildings office furniture and office equipment the assets in question were miscellaneous depreciable assets used in the operation of petitioner’s business petitioner disposed of the assets in the ordinary course of business when they became obsolete or were no longer useful petitioner’s sales of the miscellaneous sec_1231 assets in this case is similar to the taxpayer’s sale of an automobile in st louis bank for coops v united 624_f2d_1041 in that case the taxpayer sold the automobile after it was fully depreciated and purchased a new one in holding that the gain on the sale of the automobile was patronage income the court stated the gain on the sale of the automobile was patronage-sourced because it was directly related to the plaintiff’s normal activities the automobile was one of three used in the plaintiff’s business and the cost of operating it including depreciation was treated as an expense of serving plaintiff’s patrons the sale of the car when it was no longer needed for plaintiff’s business was closely related to and stemmed from the prior use of the car depreciable assets used in a business were out and become obsolete and when that happens freguently they are sold or traded in for a replacement st louis bank for cooperatives v united_states f 2d pincite4 we believe that the sale of the miscellaneous assets in this case was closely related to and stemmed from their use in petitioner’s cooperative enterprise of providing petroleum products to its patrons accordingly we find that petitioner’s sales of the subject assets were directly related to its patronage activities of supplying products to and marketing products for its members we therefore find that the subject gain can be classified as from patronage sources a final note is necessary as mentioned above petitioner argues if we adopt respondent’s per se rule then the stock of terra seaway and am-mex were noncapital assets in its hands under case law ‘surrogacy’ ‘source of supply’ and ‘hedging’ principles and not subject_to the hedging regulations sec_1_1221-2 income_tax regs petitioner’s brief makes it clear that the court need not consider that argument if we do not adopt respondent’s per se rule accordingly we have not addressed that argument similarly as mentioned above petitioner argues if we hold that the gains from the sale of terra stock and the sec_1231 assets are nonpatronage items then those gains may nevertheless be offset by petitioner’s patronage losses we have not addressed that argument in light of the foregoing and to reflect previously determined issues decision will be entered under rule and an order will be issued denying respondent’s motion for summary_judgment