Download Introduction - National Council of Farmer Cooperatives

2003 LTA Subcommittee Reports
Distinguishing Between Patronage and Non-Patronage
Sourced Income Including Handling of Losses and Netting
Chair: Dan Schultz, PricewaterhouseCoopers
Vice Chair: Mike Meisenheimer, Kansas Farmers Service
I. Introduction and Summary
All the rulings issued this year reflect the apparent willingness of the IRS to allow
cooperatives to arrange and structure their organizations and operations to best achieve
the operating alliances and economies of scale they need to stay competitive in today’s
economy.
A. The Service continues to issue private letter rulings approving patronage treatment for
capital gains realized by cooperatives [Ltrs. 200252027 and 200314002].
B. A large agricultural cooperative was permitted to restructure the relationship between
its members and a marketing partnership the co-op belonged to without jeopardizing
the patronage character of its K-1 income from the partnership [Ltr. 200244013].
C. As disclosed in a co-op’s recent form 10-K filing with the SEC, the IRS exempt
organizations branch has issued an exemption letter granting section 521 exempt
status to a large agricultural marketing cooperative after it reduced its interest in a
processing and marketing subsidiary from 100% ownership to a noncontrol interest
under 50%. The subsidiary’s nonpatronage business with nonmembers was no longer
attributed up to the co-op after the change in control [ProFac Cooperative, Inc. form
10-K for fiscal year ended June 28, 2003].
D. Assessments collected by a membership organization taxable under section 277 from
its members to pay the principal on mortgage debt incurred by the organization to
acquire the land underlying its members’ mobile home units and common areas are
characterized by the Service as section 118 capital contributions excludable from the
organization’s gross income [Ltr. 200339002].
E. The IRS recently issued a private letter ruling allowing a cooperative to pass a net
operating loss through to its members by cancelling qualified patron equities. The
ruling specified that the co-op’s NOL is directly reduced and no income is recognized
[Ltr. 200341017].
F. The Service also published a revenue ruling this year allowing a membership
organization subject to section 277 (which category includes some nonexempt rural
utility cooperatives) to offset its nonmember losses against its member earnings [Rev.
Rul. 2003-73].
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II. Patronage and Non-Patronage Income Developments – Analysis
This section of our report will offer analysis and commentary on each of the new
developments in the patronage vs. nonpatronage category.
A. IRS ISSUES RULING THAT CAPITAL GAINS FROM COOPERATIVE’S
SALE OF ITS BUSINESS ASSETS IS PATRONAGE-SOURCED INCOME
Introduction
The IRS closed out 2002 with more good news for cooperatives with the release of Ltr.
2002520271 ruling that section 1231 gains from the disposition of trade or business assets
by a cooperative wholesaler and distributor of natural foods and health products
(SupplyCo) will be patronage-sourced income. The Service also approved a plan to
allocate the gains as patronage dividends to members based on their patronage of
SupplyCo over the life of the co-op.
Due to rapid growth in the market for natural foods and health products, the industry is
consolidating. As a small distributor SupplyCo has largely succeeded in its mission to
encourage the use of these products as a means to promote long-term health.
Consequently, SupplyCo is contemplating the sale of its business assets to a publicly-held
buyer followed by a distribution of the proceeds to its members.
The proposed sale is expected to generate large section 1231 gains. Ltr. 200252027 is in
response to SupplyCo’s request for a ruling on whether the section 1231 gains generated
by the sale of its assets constitute patronage-source income.
Background
SupplyCo is a non-exempt cooperative. Its members include retailers of natural foods
and health products, supermarkets, individual buying clubs and co-op retailers.
Approximately 95% of SupplyCo’s annual sales are to members on a patronage basis.
SupplyCo was organized as a cooperative for the purposes of providing its members
ready access to the natural foods and health product lines it carries; to encourage the
production and use of these products and other agricultural products; and to offer the best
value and service to its customers. At the time SupplyCo was formed, there was not a
high demand for the products it offered and retailers had difficulty acquiring these
products on a consistent basis.
SupplyCo owns a warehouse and office facility and leases another warehouse facility.
Both warehouse facilities are used exclusively for the warehousing and distribution of
products to members and non-members. The office facility is used exclusively for
administrative functions related to the operation of the cooperative. SupplyCo maintains
1
Ruling requested April 17, 2002; issued September 30, 2002; public release December 27, 2002.
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a fleet of trucks that are exclusively employed in the operation of the cooperative. In
addition, SupplyCo formed a wholly owned finance subsidiary for the purpose of loaning
funds to member retail customers for expansion or relocation. The finance subsidiary is
apparently not operated on a cooperative basis.
SupplyCo’s by-laws provide for the allocation and distribution of its adjusted net federal
taxable income from business done with members (Patronage Income). The bylaws give
SupplyCo’s Board of Directors the discretion to determine the allocation units used for
purposes of allocating the Patronage Income. To date, the Board has always elected to
include total patronage earnings in a single allocation unit.
However, SupplyCo’s bylaws also provide that if Patronage Income includes a
substantial gain or loss or extraordinary income or expense, such amount is excluded
from the allocation of ordinary earnings, which is based on each member’s share of
current year patronage. The substantial gain or loss or extraordinary income or expense
is to be allocated separately by the Board, at its sole discretion, to such members or class
of members to which such gain, loss, income or expense is attributable.
The increase in overall demand for natural foods and health products has created
additional competition among traditional suppliers within the industry as well as the
emergence of new and larger competitors. The additional competition has resulted in
lower costs for the products offered by SupplyCo. Greater price competition and
widespread availability of the products have reduced its members’ reliance on SupplyCo
as their source for these products.
The Transaction
With the growth and changes in the natural foods and health products industry, there is no
longer a compelling reason for SupplyCo to continue operating on a cooperative basis.
As a result, SupplyCo is contemplating a transaction whereby substantially all of its
assets would be sold to a single buyer, followed by a distribution of the proceeds to its
members.
The anticipated buyer is a publicly held natural foods wholesaler unrelated to SupplyCo.
The contemplated transaction is for SupplyCo to receive cash and marketable securities
in exchange for its assets plus the assumption of certain liabilities.
All of the assets included in the sale, other than the finance subsidiary stock, are used
exclusively in SupplyCo’s wholesale and distribution activities. The business assets
involved in the proposed sale include trade receivables, inventories and equipment
utilized in serving SupplyCo’s patrons. The proposed sale also includes intangible assets
such as customer lists, agreements with vendors, leases, trade names and other intangible
assets used in SupplyCo’s wholesale and distribution activities.
It is anticipated that the proposed sale will generate a substantial gain. For tax purposes
some of this gain will be ordinary income under Internal Revenue Code sections 1245
and 1250, with the remainder treated as capital gain under section 1231. This ruling
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deals exclusively with the question of whether the section 1231 capital gains generated in
the sale are patronage sourced.
SupplyCo’s Board of Directors believe, pursuant to the bylaws, that the gain resulting
from the sale of the business assets is a “substantial” gain which requires that, rather than
allocating the gain based on current year patronage, the gain should be allocated in an
equitable manner to the members it is attributable to. In this case, the Board proposes to
allocate the gain to members and non-members based on their business done with
SupplyCo since its formation.
Observation: The ability to allocate the gain based on business done with the
cooperative since inception indicates the allocation computation is not overly
burdensome, possibly due to a relatively stable membership base. Other cooperatives
should not infer from this ruling that the same methodology would be required in
situations where there is a much higher degree of difficulty in determining the level of
patronage by members over a long period of time. Regulation 1.1382-3(c)(3),2 which
provides guidance for allocating capital gains, and the relevant case law, clearly allow
for flexibility when an actual computation of patronage ratios for every year of the
cooperative’s existence, or every year of a capital asset’s life, proves to be
“impracticable.” The most complex and rigorous methodology may not necessarily lead
to the most equitable allocation. The overriding objective of both the IRS and the
cooperative is to achieve an equitable allocation of the gain among the cooperative’s
patrons.
IRS Analysis of Applicable Authorities
In the ruling, the Service follows a familiar path in analyzing the technical support for
defining patronage source income. After providing the statutory definition of a patronage
dividend,3 the ruling builds on the statutory foundation with the definition of “income
derived from sources other than patronage” found in the Regulations.4 The Service also
cites Rev. Rul. 69-576,5 which provides that the question of whether an item of income is
from a patronage source turns on, “the relationship of the activity generating the income
to the marketing, purchasing or service activities of the cooperative.”6
2
IRC Regulation Section 1.1382-3(c)(3) states with regard to patronage-based allocations to patrons that
“the amount sought to be deducted be paid on a patronage basis in proportion, insofar as is practicable, to
the amount of business done by or for patrons during the period to which such income is attributable. For
example, if capital gains are realized by the association from the sale or exchange of capital assets held for
a period extending into more than one taxable year income realized from such gains must be paid, insofar
as is practicable, to the persons who were patrons during the taxable years in which the asset was owned by
the association in proportion to the amount of business done by such patrons during such taxable years.”
3
IRC Section 1388(a).
4
IRC Regulation Section 1.1382-3(c)(2).
5
Rev. Rul. 69-576, 1969-2 C.B. 166.
6
Ibid.
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The Service then focuses on the “directly related” test and the Tax Court’s comment in
the Farmland Industries decision7 that its task was to “determine whether each of the
gains and losses at issue was realized in a transaction that was directly related to the
cooperative enterprise [patronage sourced income], or in one which generated incidental
income that contributed to the overall profitability of the cooperative’s marketing,
purchasing, or servicing activities on behalf of its patrons [nonpatronage sourced
income].”
Finally, after concluding that SupplyCo’s section 1231 gains are patronage sourced, the
IRS notes the requirement that in order for patronage income to be deducted from gross
income, it must be paid on a patronage basis in proportion, insofar as is practicable, to the
amount of business done by or for patrons during the period to which such income is
attributable.”8 The Service apparently agrees with SupplyCo that allocating all the
section 1231 gains in accordance with each member’s patronage over the life of the
cooperative satisfies the equitable allocation requirement.
Observation: The ruling does not directly address the character of the gain or loss on
sale of the finance subsidiary’s stock, other than to note that the stock is not used
exclusively in the cooperative’s wholesale and distribution activities, and is not being
allocated along with the rest of the patronage sourced gains. However, because
determining the patronage character of income is fact-intensive, it is possible that in this
and other cases the gain or loss on the sale of a subsidiary’s stock could qualify as
patronage sourced.
Rationale for the Ruling
The Service focuses on a common thread running through Rev. Rul. 69-576 and the
Farmland Industries opinion: In order for income of a particular activity to be patronage
sourced, the relationship of the specific activity must be analyzed in light of the
cooperative purpose of the entity. If the activity is directly related to and facilitates the
cooperative purpose of the entity, then the activity is patronage sourced. In this ruling,
the Service concludes that, except for the stock of the finance subsidiary, the business
assets being sold are directly related to SupplyCo’s wholesale and distribution business,
and actually facilitated the accomplishment of its cooperative activities. Accordingly, the
section 1231 gain allocable to SupplyCo’s member patrons is patronage sourced.
Other Tax Planning Ideas
7
Farmland Industries, 78 T.C.M. 846, 864 (1999), acq. AOD 2001-003. In this case the Service argued
that capital gain could never be considered patronage-source income pursuant to the language in Regulation
Section 1.1382-3(c)(2) which states that the definition of non-patronage income includes “ . . . income
derived from the lease of premises, from investments in securities, or from the sale or exchange of capital
assets, constitutes income derived from sources other than patronage.” The Court ruled that the
determination of whether capital gains were from sources other than patronage was not a per se
determination and instead the decision should be based on the totality of circumstances and whether the
asset sold is directly related to the cooperative activity and facilitates the overall cooperative purpose of the
entity.
8
Regulation Section 1.1382-3(c)(3).
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The following list is a sampling of other tax planning points to consider when structuring
the sale of a cooperative’s assets at a gain. Where a cooperative is dealing with a
significant gain, both the co-op and its members may be well-served to evaluate the tax
reduction and deferral opportunities available in the Internal Revenue Code. (Note: This
list is not intended as an all-inclusive survey of the issues and considerations important
to sales of assets by cooperatives. Cooperatives should consult their own professional
advisors when planning transactions).

A variety of tax deferral options are available to cooperatives disposing of all or a
portion of their assets. Where the sale involves substantial gains, the proceeds to
members may be significantly enhanced if a tax-free transaction is feasible (Note that
stock received in a tax-free exchange will generally take a “carryover” tax basis).
o The tax-free reorganization provisions of the Internal Revenue Code may
apply where, for example, the members exchange their equity in the
cooperative for stock in the acquiring company.
o The like-kind exchange rules may allow individual assets or groups of assets
to be exchanged tax-free for similar assets.
o Sale of an agricultural processing business to another co-op may be eligible
for tax deferral if the proceeds are reinvested in corporate securities. See
section 1042(g).
o For members, the tax-free disposition options noted above allow them to
convert their co-op equities into stock or securities of one or more other
corporations, possibly publicly-held. In the case of a major transaction,
careful tax planning can open the door to substantial tax savings for the
members. Some of the possibilities to consider include:

For older members, stock received for their co-op equity could be held
until death, allowing it to pass through their estate free of income tax
with a step up in tax basis to its fair market value on the date of death.

The stock received could also be used to make gifts as part of an
overall estate plan.

Tax deductions for gifts of stock to charity are measured by fair
market value and avoid capital gains taxes.

Members receiving stock in a tax-free transaction will be able to sell
the stock at capital gains rates. They will also have more flexibility in
choosing when to sell, which may be particularly helpful if they have
capital losses in their portfolio.
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B. TELEPHONE CO-OP RULINGS OFFER INSIGHTS FOR APPLYING THE
“DIRECTLY-RELATED” TEST TO CAPITAL GAINS ON STOCK SALES
There have now been four letter rulings issued to rural telephone cooperatives (RTCs)
released in the past two years allowing them to treat capital gains from investments in
new telecommunications technology ventures as patronage sourced income excludable
from the co-op’s taxable income when allocated as patronage dividends. We analyzed
the first of these rulings, Ltr. 200152035, in depth in our 2002 report. Since all of the
rulings deal with reasonably similar factual patterns, and each ruling has virtually the
same technical analysis, we decided to play back this common technical analysis here to
give our members the opportunity to focus on the rationale being used consistently by the
Service to apply the “directly related” test introduced in Rev. Rul. 69-576 and further
developed in a line of cases that culminated with the Farmland Industries case and the
IRS acquiescence to that decision. Therefore, the following technical analysis section is
excerpted directly from the most recent of the RTC rulings, Ltr. 200314002, and as noted
above, is virtually identical in each of the other three RTC rulings.
“The transaction that will generate income for Coop is comprised of two parts: the
original decision to participate in the organization Corp A and the currently
proposed sale of Holdings #3 stock. Both elements of the transaction are "directly
related" to Coop's cooperatives business and will facilitate Coop's ability to
provide communications services to its members.
Coop actively participated in the formation and funding of Corp A to insure that
its members would have the same type of "modern" services that would be
available to larger, nationally recognized telephone companies. Indeed, it had no
choice but to participate in that venture because it was too small to meet AT&T's
requirements for participation. All of its transactions with Corp A, from the
beginning of its participation in the company until the day it sold the final tranche
of Holdings #3 stock, were conducted exclusively for Coop's member patrons.
Courts have ruled in several instances that income from corporations organized by
cooperatives to conduct activities related to the cooperative business is patronage
sourced. In Farmland Industries, the taxpayer, a cooperative organized for the
purpose of providing petroleum products to its patrons, sought to have the
proceeds from the disposition of its stock in three subsidiaries classified as
patronage-sourced income. In reaching its decision the court stated that its task
was 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 servicing activities on behalf of its patrons," 78 T.C.M.
at 870.
Emphasizing the need "to focus on the 'totality of the circumstances' and to view
the business environment to which the income producing transaction is related,"
the Tax Court analyzed the reasons behind both the organization of the
subsidiaries and their eventual disposition, Id. at 864, 865. First, it looked at
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whether the taxpayer's subsidiaries were organized to perform functions related to
its cooperative enterprises. The subsidiaries had been organized to explore for,
produce, and transport crude oil. The court determined that all of the subsidiaries
were organized to perform functions related to the taxpayer's business and were
not mere passive investments. Id. at 87.
In other cases, the direct relationship between the purpose of a cooperative
business and its reasons for investing in a subsidiary were found to be dispositive
on the question of whether income received from the subsidiary was patronage
sourced. For example, in Astoria Plywood Corp. v. United States, 1979WL 1287
(D.Or.), the court found that the income derived by a plywood and veneer
workers' cooperative from the cancellation of a lease on a veneer plant was
patronage sourced, because the production of veneer was an integral part of the
cooperative's business. In other words, the reason the cooperative leased the
property to begin with had nothing to do with investing in real estate and
everything to do with making veneer. Similarly, in Linnton Plywood Assoc. v.
United States, 410 F.Supp. 1100 (D.Or. 1976), the court held that the dividends
received by a plywood workers' cooperative from West Coast Adhesives, a glue
supplier which the cooperative helped to organize in order to supply its adhesive
needs, were patronage-sourced income, since glue is essential for the manufacture
of plywood, and the arrangement to produce the glue was reasonably related to
the business done with or for the cooperative's patrons.
Coop's investment in Corp A was directly related to its cooperative business.
Investing in a company in order to provide modern telephone services is directly
related to the business of a cooperative whose raison d'etre is to provide
telephone service to its patrons.
In CF Industries, Judge Posner noted in his opinion that the court was "not aware
of any dramatic opportunities for tax avoidance by use of the cooperative form."
995 F.2d at 104. However, the court implied that a cooperative would be gaining
an unfair tax advantage for its members if it were investing in businesses
unrelated to its cooperative purpose and in effect "running a mutual fund for its
members on the side." Id. Judge Posner indicated that one type of transaction
would not pass the "mutual fund" test: a temporary investment by a cooperative in
securities. See id. Certainly, if Coop had taken its members' capital and purchased
a diversified portfolio of public company securities, there can be no doubt that the
proceeds from such a portfolio should not and would not be patronage sourced.
But Coop did nothing of this sort. It was an active participant in a venture, Corp
A, that was directly related to its cooperative telecommunication business. In fact,
investment in Corp A was only open to companies that were in the telephone
business. The Corp A investors were all rural telephone companies. Corp A was
not a passive investment of the type Judge Posner implies would be
impermissible. Corp A was organized much like a cooperative. Its members were
the smallest companies in the country. Each shareholder had only one vote on the
affairs of the company. Corp A's distribution of profits, if any, to its shareholders
was based approximately on a participation basis. For over a decade the
arrangement between Corp A and its shareholders was very successful and grew
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as more technology became available that could only be accessed through a larger
organization. However, following the merger of Holdings and Corp C in 1996, it
became apparent that the new company intended to depart from its original
purpose of serving the b small telephone companies. Following the statutorily
prescribed lock-out period for such an issuance, Coop obtained its new stock and
immediately proceeded with systematic liquidation of its minority interest which
resulted in capital gains.
Accordingly based solely on the above, we rule that the sale of the Holdings#3
stock will result in patronage sourced income, which may be excluded from
Coop's gross income when allocated to Coop's patrons. Because Coop does 100
percent of its telephone business with patrons on a cooperative basis no allocation
between patronage and nonpatronage is required.”
The consistent analysis used by the IRS in this series of RTC rulings offers helpful
guidance to cooperatives dealing with capital gains or other patronage v. nonpatronage
classification issues.
C. INCOME FROM AN AGRICULTURAL MARKETING PARTNERSHIP IS
PATRONAGE SOURCED TO CO-OP PARTNER
In Ltr. 2002440139 the IRS ruled that a large regional agricultural marketing
cooperative’s income from a limited partnership (“LP”) is patronage sourced, even if the
co-op’s members sell their livestock directly to the LP, bypassing the co-op. Prior to a
recent change in logistics, the co-op (“COOP”) maintained a procurement department to
coordinate the purchase of livestock from its members and non-members with its
deliveries to the LP for further processing and marketing. Years earlier when the LP was
formed, there was concern in the farmer cooperative community because of an IRS view
that only income from transactions directly between a cooperative and its patrons could
be counted as patronage source income. To achieve more certain tax results at the time
the LP was originally formed, COOP kept its procurement function in-house and
continued to purchase livestock direct from its members and non-members, but
immediately resold the cattle to LP. This tax issue has been put to sleep in recent years
on the supply side, where IRS letter rulings have been issued approving arrangements
that allow co-op members to purchase goods and services directly from LLC joint
ventures between supply cooperatives.10 In these supply side letter rulings, the co-ops’
income from their LLCs was determined to be patronage source to the extent derived
from business with co-op members. Now, this new ruling extends patronage income
treatment to marketing cooperatives whose members deliver directly to a joint venture
owned in part by the co-op.11
9
Requested April 5, 2002; issued July 25, 2002; public release November, 1, 2002.
See LTRs 9846022, 9846027, and 200123033.
11
An earlier private letter ruling, LTR 199920034, allowed patronage treatment for an agricultural
marketing cooperative’s income from its interest in a processing LLC, but in that case the co-op members
sold direct to the cooperative, which immediately resold to the LLC.
10
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Observation: In recent years the IRS has demonstrated that it understands most
cooperatives deal in highly competitive markets where size and efficiency are crucial to
survival. The Service has consistently shown its willingness to allow cooperatives to
enter into joint ventures and other alliances with cooperatives and non co-op partners
without sacrificing the patronage character of their earnings.
LP is in the business of buying live cattle, which it slaughters and processes into beef
products. LP is owned 71% by COOP and 29% by another livestock marketing
cooperative (“COOP2”). COOP2 provides cattle to LP in proportion to its ownership
share in LP, delivering all of its members’ production to LP. As a “closed cooperative”
COOP2 markets only for its members, and all its business is done on a patronage basis.
COOP accounts for its beef marketing operations in a single pool. Net income for the
beef pool is allocated between the portions attributable to member cattle and non-member
cattle. The member portion is allocated to the members participating in the beef pool as
patronage dividends and excluded from COOP’s taxable income, while non-member
income is retained and included in taxable income. Most of the beef pool’s earnings are
derived from its partnership interest in LP.
As described in great detail in Ltr. 200244013, COOP and LP were faced with
tremendous competitive pressures from globalization, the demand for more premium
products and other market factors that forced them to drive cost controls and efficiencies
to the next level. It was clear that LP needed to connect its procurement function more
directly to its processing and marketing functions. Having COOP buy its share of LP’s
livestock requirements first, immediately followed by a resale to LP, was a wasteful step
they could no longer afford. COOP and LP projected significant revenue growth and cost
savings from improved coordination and knowledge sharing, coupled with eliminating
multiple payment levels, and the ability to better centralize and streamline LP’s
operations. However, before committing to moving the procurement department into the
LP, COOP applied for a ruling that transferring its live cattle procurement function to LP
would not jeopardize the patronage character of the income it earns from its interest in
LP. The IRS national office agreed with COOP’s rationale and ruled in Ltr. 200244013
that income attributable to the LP’s business with members of COOP will continue to be
patronage source to COOP, even though COOP will no longer be taking title and
reselling the cattle delivered by its members and non-members to LP.
Observation: As is generally the case when cooperatives enter into joint ventures, their
objective is to protect and continue to grow their patronage dividend rate. The joint
venture is supposed to replace the co-op’s current earnings from dealing directly with its
patrons with greater earnings (hopefully) from its share of the joint venture’s income.
It’s reasonable that what qualifies as patronage sourced income in one form should
continue to qualify as patronage sourced even if it takes a different form. In both cases,
the cooperative is performing the same function for its members. It’s clear from this and
prior rulings on this topic that before the Service will rule favorably, it must be
comfortable that the proposed change will not compromise the ability of the cooperative
to properly compute and allocate patronage earnings to its members.
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The Ruling: The IRS stated its ruling as follows:
“Coop's profits realized from its b marketing activities will remain patronage sourced
income after Coop has transferred its b acquisition activities to LP. Coop's profits from its
b marketing activities are to be allocated and distributed on a patronage basis to Coop's
members based upon the b purchased from Coop's members by LP on behalf of Coop.
Coop's c marketing profits attributable to LP's purchase of b from nonmembers
attributable to Coop will continue to be taxable as nonmembers income.”
The IRS relied on the now-time honored “directly-related” test for classifying income as
patronage v. non-patronage sourced, citing St. Louis Bank for Cooperatives v. United
States, 624 F.2d 1041 (1980), and Revenue Ruling 69- 576, 1969-2 C.B. 166, which
provide that income is patronage sourced if it’s attributable to transactions that are
directly related to, and actually facilitate, the marketing, purchasing, or service activities
of the cooperative. The Service applied the directly-related test to the facts presented and
used the following rationale to draw its conclusion that COOP’s income from LP will be
patronage sourced:
“Coop is attempting to best serve its members in the changing economic climate. The
increased efficiency realized through the transfer of the buying function will increase
LP's profitability and, concomitantly, Coop's patronage sourced earnings and patronage
dividends. In addition, the closer relationship will better allow LP to institute aggressive
grid pricing programs in such a manner to maximize net margins and to match the supply
of high quality c to LP's demand for such finished c products. This will provide better
pricing for Coop's members and greater patronage dividends. Finally, the transfer of the
buying function will eliminate duplication of certain administrative activities, increase
operational efficiencies and profits, and help protect LP's market position in the highly
concentrated c packing marketplace. Coop's ability to determine and distribute its b
marketing margins to its members will not be adversely affected, since LP will continue
to maintain the required records to insure that such margins are properly allocated and
distributed to Coop's members.
In the proposed transaction, the cooperative is fulfilling its cooperative service activities
through its interest in a limited liability company [sic]. The cooperative's participation in
the partnership was due to the cooperative's need to react to changing and more
competitive market conditions and the need to better and more cost effectively serve its
members.
Under these circumstances, Coop's activities through LP are directly related to and
actually facilitate, the accomplishment of Coop's cooperative mission. Based upon the
foregoing, Coop's share of the LP income should be treated as patronage sourced, since
such income directly facilitates Coop in furnishing its b marketing services to its
members. The income should be allocated by Coop between and among (i) its members
and participating patrons and (ii) its non-members, based upon the b purchases made by
LP on behalf of Coop.”
48
Observation: This ruling represents some advancement in the state of the art in that,
unlike the supply side joint venture rulings (see footnote 2), the members of each
cooperative in the LP joint venture were not required to join the other cooperative. The
purpose of cross membership in the supply side joint ventures was to assure that all
business done by the joint venture was done for a patron of all the co-op owners, and
precluded an IRS argument that each co-op’s share of joint venture income should be
patronage sourced only to the extent of that co-op’s share of total joint venture income.
In the new ruling, COOP and COOP2 are not structured to make cross-membership a
workable approach, so it’s a sensible step forward that this ruling doesn’t look through
the partnership and try to attribute the source of LP’s income proportionately to its
partners, i.e., 29% of COOP’s income from LP being considered non-member income
attributable to COOP2’s members (and, 71% of COOP2’s income being treated as nonmember income attributable to COOP’s members). Instead, and consistent with its
holding in a prior letter ruling involving a marketing cooperative’s joint venture with a
non co-op (Ltr. 199920034), the IRS did not look behind the partnership interest, but
more appropriately treated the LP income as a replacement for COOP’s historic source
of patronage income. This is the sensible answer and gives cooperatives added flexibility
in a challenging competitive environment.
D. AGRICULTURAL MARKETING CO-OP QUALIFIES FOR SECTION 521
EXEMPTION AFTER RELINQUISHING CONTROL OF SUBSIDIARY
ProFac Cooperative filed its form 10-K for the fiscal year ended June 28, 2003 with the
SEC on September 26, 2003, and disclosed the following interesting news, as excerpted
from the financial statement footnotes –
“On June 11, 2003 the Cooperative received notification from the Internal Revenue
Service that effective August 19, 2002 the Cooperative qualified for tax exempt status
as a farmers' cooperative under Section 521 of the Internal Revenue Code. Exempt
cooperatives are permitted to reduce or avoid taxation through the use of special
deductions (such as dividends paid on its common and preferred stock). It is
anticipated that the Cooperative will use these special deductions and patronage
distributions to reduce taxable income to zero for periods after August 19, 2002.
Effective on August 19, 2002 the Board of Directors of the Cooperative amended its
By-laws to pay patronage distributions on a tax basis. Prior to this amendment the
Cooperative's patronage distributions were made on a financial statement basis. The
amendment was made to more closely connect the potential patronage distributions to
the cash flow of the Cooperative.”
ProFac is a fruit and vegetables marketing cooperative that prior to August 19, 2002,
owned 100% of its processing and marketing subsidiary, Agrilink Foods (recently
renamed Birdseye Foods). Agrilink processed and marketed not only all of ProFac’s
crops on a cooperative basis, but also processed and marketed non-ProFac crops on a
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nonpatronage for-profit basis. An agricultural marketing cooperative is not eligible for
exemption under section 521 if it does any marketing on a nonpatronage basis. Because
of its controlling interest in Agrilink, Agrilink’s nonpatronage processing and marketing
activities were attributed to ProFac and prevented it from qualifying for exempt status
under section 521 (see Rev. Ruls. 69-575 and 73-148). However, after a recapitalization
on August 19, 2002, ProFac’s interest in Agrilink was diluted below 50% and, while
ProFac continues to market its crops through Agrilink, and continues to hold a significant
equity position, it no longer holds the controlling interest. As a result, it’s apparent that
the IRS determined that Agrilink’s nonpatronage activities would no longer be attributed
to ProFac for purposes of determining section 521 eligibility and, accordingly, ProFac
was able to secure an exemption letter.
Also noteworthy is the disclosure that effective August 19, 2002, ProFac amended its
bylaws to provide that patronage dividends would be determined on a tax basis. Prior to
this amendment the Cooperative's patronage distributions were made on a financial
statement basis. As stated in the 10-K, this bylaw amendment was made to more closely
connect the potential patronage distributions to the cash flow of the Cooperative.
ProFac pays substantial preferred stock dividends each year. Prior to gaining section 521
exempt status, ProFac paid income taxes on the earnings allocated to pay these dividends.
Now, as a section 521 co-op, ProFac can avoid tax by deducting these preferred stock
dividends when paid, pursuant to section 1382(c)(1).
E. MEMBER ASSESSMENTS TO PAY MORTGAGE PRINCIPAL ARE
EXCLUDABLE FROM INCOME BY SECTION 277 ORGANIZATION
In Ltr. 200339002, The IRS allowed a nonprofit membership corporation taxed under
section 277 to treat a special assessment collected from its members as a capital
contribution excludable from its gross income under section 118(a) to the extent applied
to make principal payments on its mortgage debt.
The taxpayer corporation operates and maintains the common property of a mobile home
community for its members. Each member has one vote per lot. The members had been
renting the lots, common areas and infrastructure of the community from the developer,
and paid the taxpayer a small monthly fee to cover community maintenance costs.
According to the ruling, the developer decided to sell the leased property and the
members voted unanimously to have the corporation purchase it. The corporation
financed the purchase with a mortgage loan.
To provide the funds needed for the corporation to pay the mortgage, the members voted
unanimously to pay an additional special assessment throughout the term of the
mortgage. The special assessment will be used solely to pay down the mortgage. The
corporation will deduct the interest and real estate taxes associated with the purchased
property purchased.
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The IRS cited United Grocers Ltd. v. United States,308 F.2d 634 (9th Cir. 1962); and
Rev. Ruls. 75-371 and 74-563, for its rationale that the motive or intent of the person
making the contributions is the dominant factor in determining whether amounts received
by a corporation are contributions to capital and not payment for goods and services.
To apply this motive or intent test the Service looks to the three-factor test provided by
Board of Trade v. Commissioner, 106 T.C. 369 (1959), for establishing that the members
making payments have an investment motive and are not paying for goods or services.
The Board of Trade factors are: (1) whether the payment is earmarked for application to
a capital expenditure, (2) whether the persons making the payment are the owners of the
corporation's equity and the payment increases the corporation's equity capital, and (3)
whether the members have the opportunity to profit from their investment in the
corporation.
Applying these criteria in Ltr. 200339002, the IRS determined that to the extent the
special assessment payments are used to pay the principal portion of the mortgage, they
qualify as capital contributions. The Service, citing Eckstein v. United States,452 F.2d
1036 (Ct. Cl. 1971), noted that even though the purchase of the land relieved the
members of the obligation to pay rent to the developer, it does not believe this fact
prevents the special assessment payments from being classified as excludable capital
contributions.
III. Handling of Losses and Netting - Analysis
The forward progress made this year in terms of co-ops’ ability to efficiently utilize their
net operating losses is covered in more detail below.
A. SERVICE ALLOWS CO-OP TO TRANSFER PATRONAGE LOSSES TO ITS
MEMBERS
In Ltr. 200341017, the IRS held that an agricultural marketing and supply cooperative
“may utilize its patronage sourced loss by cancelling an equal amount of qualified notices
of allocation. Coop will not otherwise recognize any taxable income upon the
cancellation of such patronage equity.” The co-op proposed recovering both current year
losses and loss carryforwards from earlier years in this manner. The ruling gives no
indication as to how the cancellation amount was allocated among the members.
The cooperative issued a substantial amount of qualified notices of allocation as well as
nonqualified notices during prior profitable years, but fell on hard times in recent years,
and finally declared bankruptcy. The members’ equity is now believed to be worthless.
The co-op’s bylaws authorize it to net patronage income and loss from its various
allocation pools, subject to and in accordance with section 1388(j) and, subject to the
approval of the bankruptcy court, the co-op’s bylaws also authorize it to recover
patronage sourced losses by cancelling previously-issued patron equities. In approving
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this approach to utilizing losses, the Service noted that it allowed the same procedure in
Rev. Rul. 70-407, C.B. 1970-2, 52.
This decision is significant because it allows the co-op to avoid the alternative minimum
tax (AMT) 90% limit on the use of NOL carryovers. Co-ops had been concerned that if
cancelling equities caused income to be recognized by the co-op, using the NOL
carryforwards to offset this income could result in an AMT liability.
B. SECTION 277 ORGANIZATION ALLOWED TO NET NONMEMBER
LOSSES GAINST MEMBER INCOME
Rev. Rul. 2003-73, 2003-28 IRB 44, deals with a country club taxable under section 277.
The issues addressed in the ruling are (1) whether current year losses generated from
providing goods and services to members can be used to offset current year investment
income and income from providing goods and services to nonmembers, and (2) whether
current year losses from providing goods and services to nonmembers can be used to
offset current year income from providing goods and services to members. The ruling
concludes as follows –
“(1) A taxable social club's loss from transactions with members does not offset
nonmember income, but instead is carried forward to the next succeeding taxable year
as expenses incurred in providing goods and services to members.
(2) A taxable social club's loss from transactions with nonmembers is fully deductible
against both nonmember income and member income.”
This holding is consistent with the conclusion reached by the IRS in FSA 1999-1229
(March 25, 1999). While it is well established that section 277 is not applicable to
subchapter T cooperatives, Rev. Rul. 2003-73 would be helpful if the IRS ever tried to
dust off its old and hopefully forgotten argument that nonpatronage losses should not be
absorbed by patronage income.
According to the facts in the ruling, the club’s business with the public (nonmembers)
was substantial enough to be considered a trade or business. The Service also noted that,
“consistent with the analysis in Concord Consumers Housing Cooperative, the fact that
some or all of the principal generating A`s investment income came from members does
not cause the investment income to be treated as member income. As A`s investment
income is not otherwise derived from transactions with members, A`s investment income
is nonmember income for purposes of section 277.”
Daniel R. Schultz
October 10, 2003
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