(a)   

Introduction

Numerous cases and rulings have considered the proper classification of interest income earned from short-term investments of a cooperative's funds. Such income may be considered to be patronage-sourced income if the short-term investment is so closely intertwined with the cooperative function that it can be viewed as facilitating such function.⁴²⁸Ill. Grain Corp. v. Commissioner, 87 T.C. 435, 459–60 (1986), nonacq., 1990-2 C.B. 1. On the other hand, if the cooperative's investment of surplus funds more closely resembles a traditional investment of funds for profit, the income will likely not be viewed as having the requisite linkage to the cooperative function for classification as patronage-sourced income.⁴²⁹Id. at 452-53. The following examination of the authorities on this issue in chronological order will give the reader a good sense of the relationship required between the interest income and the cooperative's business. When advising a cooperative seeking to treat interest as patronage income, the key point is to analogize the client's situation to the cases holding interest income as patronage sourced and to distinguish the situation from the cases holding interest income as nonpatronage income.

The IRS has acknowledged in revenue rulings and private letter rulings that interest income of a cooperative can be characterized as patronage or nonpatronage income depending on the relationship of the interest-generating deposit to the cooperative's marketing, purchasing, or service function.⁴³⁰Compare Rev. Rul. 73-497 (interest derived by bank for cooperatives from government securities and from loans to other farm credit banks was nonpatronage income) with Rev. Rul. 74-160 (interest derived by nonexempt workers' cooperative on loans to its chief supplier was patronage income). See Ill. Grain Corp. v. Commissioner, 87 T.C. 435, 451 (1986), nonacq., 1990-2 C.B. 1 (stating that both courts and IRS have acknowledged that interest income may be patronage sourced depending on circumstances). Specifically regarding interest, the IRS position is that interest earned on an investment will be considered nonpatronage income, but interest earned on funds retained for a true cooperative business purpose will be considered patronage income. ⁴³¹See Farmland Indus., Inc. v. Commissioner, T.C. Memo 1999-388, acq., 2001-13 I.R.B. 920. The issue has also been considered in a line of Tax Court and federal district and circuit court cases.⁴³²E.g., C.F. Indus., Inc. v. Commissioner, 995 F.2d 101 (7th Cir. 1993), modifying & aff'g T.C. Memo 1991-568, petition for reh'g, 94-1 USTC ¶ 50,033 (7th Cir. 1993), on remand, T.C. Memo 1994-107; Cotter & Co. v. United States, 765 F.2d 1102 (Fed. Cir. 1985), rev'g 6 Cl. Ct. 219 (1984); St. Louis Bank for Coops. v. United States, 624 F.2d 1041 (Ct. Cl. 1980); Certified Grocers of Fla., Inc. v. Commissioner, 66-2 USTC ¶ 9493 (M.D. Fla. 1966); Ill. Grain Corp. v. Commissioner, 87 T.C. 435 (1986), nonacq., 1990-2 C.B. 1; Dundee Citrus Growers Ass'n v. Commissioner, T.C. Memo 1991-487; Wash.-Or. Shippers Coop., Inc. v. Commissioner, T.C. Memo 1987-32. The facts and rationales of the foregoing cases are discussed in the text below. In general, the courts have been more likely than the IRS to characterize a cooperative's interest income as patronage sourced. ⁴³³ E.g., PLR 200525010 (where cooperative invested in industrial loan corporation (ILC) for purpose of hedging against predicted loss of members and as strategy of attracting new members, interest received on certificates of deposit issued by ILC was not patronage sourced because investment in ILC was incidental to services provided by cooperative to its members and merely enhanced its overall profitability). In TAM 9208004, the IRS stated that “interest income earned by cooperatives is almost never patronage source income, since it is more often than not generated from transactions with third parties and not with or for patrons.” The facts of each case or ruling are critical to the outcome. In the typical analysis, the prior cases and rulings are summarized and the facts of the instant case are analogized to some and distinguished from others. The seminal cases and rulings are discussed below.

The most clear-cut example of patronage-sourced interest income is interest derived from a cooperative's transaction with a patron. For example, in a technical advice memorandum,⁴³⁴TAM 8641005. a cooperative marketed the products of its members and also sold supplies to them. Supplies were purchased by the members on open accounts. If the accounts were not paid timely, they were automatically converted to notes receivable on which interest was assessed and collected. The interest paid is income from the transaction of business with the members in pursuit of the cooperative function within the literal meaning of §1388(a)(1) and is therefore patronage sourced. In contrast to the technical advice memorandum, most cases and rulings concerned with the characterization of interest involve interest received from nonmembers such as suppliers and commercial banks.

(b)   

IRS Rulings

Rev. Rul. 68-423⁴³⁵1968-2 C.B. 373. concerned an exempt farmers cooperative that had ceased operation and was winding up its affairs. In its final tax year, the cooperative sold its assets and deposited the sales proceeds in commercial banks pending distribution to its patrons. Without analysis, the IRS stated that the interest income was not patronage sourced.⁴³⁶ Id. at 373-74. Interest income of a cooperative was also ruled to be nonpatronage sourced in Rev. Rul. 73-497.⁴³⁷1973-2 C.B. 314. The ruling concerned a nonexempt bank for cooperatives that derived income from loans made to its members, who were farmers cooperatives. In addition, the bank for cooperatives received interest income from owning government securities and from making short-term loans of its surplus funds to other farm credit banks. The IRS ruled that interest from the government securities was nonpatronage-sourced income because the interest was derived from an investment in securities within the meaning of Reg. §1.1382-3(c)(2).⁴³⁸Id. at 315. Reg. §1.1382-3(c)(2) provides that income derived from the lease of premises, investment in securities, or the sale or exchange of capital assets, constitutes nonpatronage income. The regulation literally applies to exempt farmers cooperatives, but courts and the IRS have consistently applied it to both exempt and nonexempt cooperatives. For further discussion on the question of whether the language of the regulation creates a per se rule that the three specified items are always nonpatronage sourced, see III.B.1.a., above. The IRS also ruled that the interest paid by the other farm credit banks was nonpatronage income because the banks were not entitled to receive patronage dividends and therefore were not dealt with on a patronage basis.⁴³⁹Id. at 315. In Rev. Rul. 73-497, the IRS did not cite Rev. Rul. 69-576⁴⁴⁰The facts and reasoning of Rev. Rul. 69-576 are discussed at III.B.1.a.(2), above. or discuss the relationship between the loans to other farm credit banks and the bank for cooperatives' service function.

In contrast, interest income of a nonexempt workers' cooperative was ruled to be patronage income in Rev. Rul. 74-160.⁴⁴¹In TAM 9236001, a cooperative had an agreement with a business corporation under which the corporation would process and market the products of the cooperative's members in return for a percentage commission and for certain financing provided by the cooperative to the corporation. The corporation agreed to pay the cooperative an amount designated as “additional interest” on funds provided by the cooperative. The IRS ruled that the interest from the corporation was analogous to the interest from the supplier in Rev. Rul. 74-160 and was therefore patronage sourced. Accord TAM 9211001. The cooperative, which manufactured and sold plywood, depended on raw materials provided by its chief supplier. Because the supplier was unable to obtain financing to purchase equipment needed to carry out its business operation, the cooperative loaned funds to the supplier for the purposes of purchasing the equipment. Without the loans, the supplier would not have been able to furnish the raw products required by the cooperative. Applying the test set forth in Rev. Rul. 69-576,⁴⁴²The facts and reasoning of Rev. Rul. 69-576 are discussed at III.B.1.a.(2), above. the IRS ruled that interest paid to the cooperative by the supplier was patronage income because the loans facilitated the accomplishment of the cooperative function by assuring an adequate supply of raw materials.

(c)   

St. Louis Bank for Coops. v. United States

The first case to consider the characterization of a cooperative's interest income was St. Louis Bank for Coops. v. United States,⁴⁴³624 F.2d 1041 (Ct. Cl. 1980). which involved a nonexempt cooperative bank that made loans to its member cooperatives. The bank's lending function required it to determine its surplus or deficit status on a daily basis. If the bank overestimated its members' borrowing needs, it had surplus funds on hand when it closed transactions. Conversely, the bank was in a deficit position when it underestimated the members' needs. The bank's position varied considerably on a daily basis. For example, in the tax years in question, its net daily deficit position averaged $5 million and $15 million, respectively. During the tax years in question, the bank's primary sources of funds for making loans was the sale of bonds with a six-month maturity and short-term borrowing from the Central Bank for Cooperatives, which served all banks for cooperatives. The bank attempted to avoid retaining surplus funds at the daily closing by selling the amount of bonds that would permit it to meet or be slightly short of its members' daily borrowing needs; however, the length of time between the issuance of bonds and the volatility of its members' borrowing needs made it difficult to predict accurately its cash needs from the sale of bonds. Depending on its closing position, the bank either borrowed or lent funds on a demand basis to the Central Bank for Cooperatives. The bank occasionally made short-term loans to the brokerage houses that sold its bonds. The question considered by the Court of Claims was whether the interest paid on loans to the Central Bank and brokerage houses was patronage or nonpatronage income. The government acknowledged that the bank's borrowing to correct a deficit position was directly related to its cooperative function but argued that the lending of surplus funds was a separate activity incidental to providing banking services to its patrons. Reiterating the test first articulated in Rev. Rul. 69-576,⁴⁴⁴The facts and reasoning of Rev. Rul. 69-576 are discussed at III.B.1.a.(2), above. the court stated that transactions with nonpatrons that facilitate the cooperative function may be considered business done “for” patrons within the meaning of §1388(a)(1) and Reg. §1.1382-3(c)(2).⁴⁴⁵624 F.2d at 307–08. The text of Reg. §1.1382-3(c)(2) and its use in interpreting §1388(a)(1) are discussed at III.B.1.a., above. The court concluded that the interest income was patronage sourced because the transactions generating the interest were “integrally intertwined” with the process of borrowing money to loan to cooperatives and the income derived from the management of surplus funds was directly related to the cooperative's services to its members.⁴⁴⁶624 F.2d at 308. The Court of Claims also held that interest income from Treasury and FNMA bonds was patronage sourced because the bonds were held to maintain a level of liquidity that allowed it to sell bonds and to borrow funds from secondary sources when necessary. Id. at 308–10.

(d)   

Twin Cnty. Grocers, Inc. v. United States

The character of interest income of a nonexempt retail food distribution cooperative was considered in Twin Cnty. Grocers, Inc. v. United States⁴⁴⁷2 Cl. Ct. 657 (1983). The cooperative served as a purchasing, warehousing, and distribution center for retail grocers and supermarkets in a geographic area. Believing it prudent to utilize temporary cash surpluses, the cooperative purchased short-term certificates of deposit from a commercial bank and derived interest therefrom. Relying on St. Louis Bank and Rev. Rul. 69-576, the cooperative claimed that the interest was patronage income because the interest reduced the need for the cooperative to borrow funds and pay interest when there was a deficit. According to the Claims Court, however, St. Louis Bank was distinguishable from the instant case based on the services provided by the two cooperatives. Money management was an integral function of the banking service cooperative in St. Louis Bank but was not part of the basic services provided by the purchasing cooperative in Twin Cnty. Grocers.⁴⁴⁸Id. at 660–61. Rev. Rul. 69-576 was also distinguishable. According to the court, the proper focus was the transaction or activity generating the interest rather than the use to which the interest was put.⁴⁴⁹Id. at 662. In the ruling, a purchasing cooperative borrowed funds from a cooperative bank and, at year's end, received a patronage dividend from the cooperative bank based on its pro rata borrowing. Thus, the income was derived from an activity that permitted the cooperative to engage in its purchasing function. In Twin Cnty. Grocers, the cooperative's purchase of certificates of deposit did not facilitate its purchasing function but rather was a means for investing periodic surpluses to increase its overall profitability that was incidental to the cooperative function.⁴⁵⁰Id.

(e)   

Cotter & Co. v. United States

In Cotter & Co. v. United States,⁴⁵¹765 F.2d 1102 (Fed. Cir. 1985), rev'g 6 Cl. Ct. 219 (1984). a nonexempt cooperative provided purchasing, warehousing, and distribution services to independent hardware retailers. Its cooperative function was to purchase goods at the lowest possible price by using large volume purchases and to warehouse and distribute the products at the lowest possible cost. The cooperative's business was seasonal in that it purchased the bulk of its goods in certain seasons and sold the goods to its members at a later date. Thus, the cooperative typically paid its suppliers some months before selling the goods to its members. The result was that the cooperative experienced deficits at certain times of the year and surpluses at other times. When there was a surplus, the cooperative applied the surplus to pay debts and prepay for supplies. With any remaining surplus, the cooperative purchased commercial paper and certificates of deposit with maturity dates of 43 days or less so that the funds remained accessible for purchases and other needs. The Federal Circuit approved the test set forth in Rev. Rul. 69-576 and analogized the instant case to St. Louis Bank. Viewing the interest-generating transactions in relation to all the activity undertaken to fulfill the cooperative function, the court held that such transactions were related to the cooperative's purchasing function and were not merely incidental investments designed to enhance the cooperative's overall profitability.⁴⁵²Id. at 1107.

(f)   

Ill. Grain Corp. v. Commissioner

Interest income of a nonexempt grain marketing cooperative was held to be patronage sourced in Ill. Grain Corp. v. Commissioner⁴⁵³87 T.C. 435 (1986), nonacq., 1990-2 C.B. 1. The cooperative's members were farmers cooperatives that purchased, stored, and marketed grain for their farmer members. In addition to marketing grain for member and nonmember patrons, the cooperative performed various other services for its members, including consulting services, business analyses, and hedging assistance. The money management required of the cooperative was based on the nature of the grain industry. The grain market is highly volatile, due to such factors as price competition, supply and demand, seasonal and cyclical factors, and the weather. Grain is purchased when harvested by the producer and marketed over the following 12-month period. Grain price fluctuations over the course of a year result in extreme changes in a grain company's capital requirements. A substantial increase in grain prices can result in significant cash demands on a company that necessitate short-term borrowing, whereas a substantial decrease in prices can reduce its capital needs and result in a temporary cash surplus. In order to survive the volatility, a grain company must have a flexible financial structure that allows it to maintain liquidity. The cooperative in Illinois Grain assessed its capital needs on a daily basis. Short-term cash shortages were covered by short-term loans from two banks with which the cooperative had ongoing banking relationships. When there was a temporary surplus, the cooperative repaid its short-term loans, if any, and then purchased short-term interest-bearing instruments such as commercial paper, certificates of deposit, and Treasury bills. The cooperative occasionally entered into repurchase agreements. Most of these short-term transactions were overnight or overweekend in duration. The cooperative could have obtained higher interest rates on longer term investments, but the need for daily assessment of its cash requirements necessitated short-term investment of the surplus funds.

The dispute in Illinois Grain arose when the IRS disallowed a patronage dividend deduction with respect to the interest from the cooperative's short-term debt instruments on the ground that the interest income was not patronage sourced. To resolve the issue, the Tax Court searched for a “touchstone or common thread” running through the case law and rulings that would reconcile their “facial inconsistency.” The Tax Court found the guiding principle in Rev. Rul. 69-576,⁴⁵⁴The facts and reasoning of Rev. Rul. 69-576 are discussed at III. B. 1. a., above. in which the IRS ruled that a patronage dividend received by a nonexempt farmers cooperative from a bank for cooperatives was patronage income because its business with the bank for cooperatives was directly related to, and facilitated, its cooperative function of purchasing supplies for its members. According to the Tax Court, the instant case was analogous to St. Louis Bank and Cotter, in which maintaining liquidity through prudent cash management was directly related to and actually facilitated the cooperative function.⁴⁵⁵87 T.C. at 455–59. Similarly in the instant case, the cooperative's money management was inseparably intertwined with the financing required to market its members' grain and therefore patronage sourced.⁴⁵⁶Id. at 459–60.

(g)   

Wash.-Or. Shippers Coop., Inc. v. Commissioner

Wash.-Or. Shippers Coop., Inc. v. Commissioner ⁴⁵⁷T.C. Memo 1987-32. considered the sources of interest income derived by a nonexempt cooperative that furnished shipping and distribution services for its member businesses. The cooperative combined partial truckloads of shipments and provided its members with the lowest possible freight rates. During the tax years in question, the cooperative derived income from several sources, including two promissory notes, a savings account, a 90-day Treasury bill, and two 90-day certificates of deposit. The cooperative received the first promissory note in connection with a loan to its manager to construct a terminal facility in Alaska for the use of the cooperative's members. The other promissory note related to a loan to a trucking company to induce the company to distribute freight in Alaska for the cooperative's patrons. The government conceded that interest paid on the two promissory notes was patronage income but argued that the additional interest was not patronage sourced. Citing Ill. Grain, the Tax Court stated that the test for distinguishing patronage and nonpatronage income was whether the income is so closely intertwined with, inseparable from, and directly related to the main cooperative activity that it facilitates the accomplishment of the cooperative's business purpose. The analysis required an examination of the circumstances surrounding the investments. The cooperative collected shipping rates from its members throughout the year based on application of various cost components. During the years in question, the estimated freight rates charged to the members exceeded the actual shipping costs to the cooperative, resulting in excess operating funds. When surplus funds accumulated in the cooperative's checking account, the manager periodically transferred funds to an interest-bearing savings account. As an alternative, surplus funds were occasionally used to purchase Treasury bills or certificates of deposit because the interest rates of these instruments were higher than the savings account rate. The interest income from the account and the instruments was used in the cooperative's shipping activities or refunded to its members at year's end as part of a patronage dividend.

The Tax Court distinguished the instant case from Ill. Grain in two principal respects. First, the freight shipping business is much more stable than the volatile grain marketing business considered in Ill. Grain, which meant that the cooperative's cash requirements did not fluctuate to the extreme extent described in Ill. Grain. In addition, the 90-day terms on the T-bills and CDs in the instant case were substantially longer than the overnight or overweekend terms secured by the cooperative in Ill. Grain. In the court's view, the 90-day transactions more closely resembled investments than temporary money management measures.⁴⁵⁸The Tax Court pointed out that its decision in Washington-Oregon Shippers should not be read to suggest that income from a 90-day instrument could never be directly related to a cooperative's business function within the meaning of Ill. Grain; however, the facts and circumstances surrounding the acquisition of such a “long-term” instrument should be closely scrutinized. The interest income from the savings account, T-bills, and CDs was nonpatronage income because it merely added to the cooperative's overall profitability rather than facilitating its cooperative function.

(h)   

Certified Grocers of Cal., Ltd. v. Commissioner

Certified Grocers of Cal., Ltd. v. Commissioner ⁴⁵⁹88 T.C. 238 (1987). involved a nonexempt cooperative composed of retail grocery stores and supermarkets. The cooperative purchased food and related items in large volume in order to secure to its patrons the price and term benefits available to volume purchasers. The cooperative's practice was to purchase and warehouse the food until it was purchased by its members. The cash it required to purchase inventory was derived from advance deposits of patrons and loans from banks. During a tax year at issue, the cooperative borrowed funds to construct a mechanized warehouse for use in its purchasing, warehousing, and distribution business. Because the total amount borrowed was not required initially, the cooperative deposited the temporarily unspent portion in interest-bearing accounts.

The Tax Court held that the interest from the accounts was patronage sourced.⁴⁶⁰Id. at 244. Unexplained was the fact that the cooperative had not reported the interest on the accounts as income on its tax return but had included the interest amount as being paid out to patrons as a deductible patronage dividend. The Tax Court sustained the denial of the deduction with respect to the interest income because the cooperative was not entitled to take an otherwise allowable patronage dividend deduction for funds that were not included in its gross income. Id. at 244–45. The opposite result was reached with respect to other interest derived from the short-term placement of the cooperative's excess funds. The burden is on the cooperative to demonstrate the direct relationship between the interest income and its cooperative function. In the instant case, the cooperative failed to establish the exact duration of the deposits, the amounts deposited, the needs for the funds, and when such needs were expected to occur. Thus, while the cooperative's need for cash to make its substantial volume purchases may have justified the retention of some cash on hand, the interest from the excess funds deposited was deemed to be nonpatronage sourced because of the cooperative's failure to make the “extensive showing of specific foreseeable needs for cash” that warranted the patronage characterization of interest income in Ill. Grain.⁴⁶¹Id. at 245, n. 14.

(i)   

Dundee Citrus Growers Ass'n v. Commissioner

Dundee Citrus Growers Ass'n v. Commissioner⁴⁶²T.C. Memo 1991-487. involved a nonexempt cooperative that furnished various services to citrus growers. The cooperative harvested, hauled, graded, packed, and marketed its members' fruit on a pooling basis. As each pool closed, the cooperative calculated the average net proceeds from sale of the fruit and distributed the proceeds to its members based on the average price. Dundee Citrus Growers was a member of two other cooperatives with which it did business, Seald Sweet and Citrus World. A portion of the choice fruit was sold to Seald Sweet, which marketed the fruit to retailers. The balance of Dundee's fruit was sold to Citrus World, which marketed citrus products and byproducts. When throughout the season payments from Seald Sweet exceeded Dundee's harvesting costs, Dundee loaned excess funds to Citrus World pursuant to its member reinvestment program (MRP). The MRP was advantageous to Citrus World and its members because it was a source of funds for Citrus World's operations and a means for members to invest excess cash temporarily. Because Citrus World's costs associated with the MRP were less than the typical administrative costs of commercial banks, Citrus World was able to pay its members a higher rate on their loans than the going commercial rate. Funds loaned under the MRP were subject to recall at any time without penalty by Dundee.⁴⁶³Citrus World would release the funds shortly after receiving a telephone request. When purchasing fruit from Dundee, Citrus World paid an advance allowance to cover harvesting and transportation expenses. Dundee deposited the advances in an interest-bearing money market account that automatically covered checks written on a noninterest-bearing account from which Dundee paid its operating expenses. The excess advances therefore earned interest until needed to cover expenses.

After reviewing the facts and holdings of Cotter, Ill. Grain, and Certified Grocers, the Tax Court in Dundee held that both types of interest earned by the investment of Dundee's temporary excess funds were patronage sourced. The key to the court's conclusions was Dundee's need to maintain liquidity due not only to the seasonal nature of the citrus business but also to the unpredictability of weather and other factors on each harvest. Pre-closing distributions could not be made under the pooling system because of the uncertainties and the resulting difficulty in estimating the average price. In addition, it was almost impossible for Dundee to recover overages mistakenly distributed to patrons because the patrons typically invested the amounts received into their own operations and could, if necessary, transact business with another cooperative the following year in order to prevent having the overage deducted from the next year's distributions.⁴⁶⁴The Tax Court noted that it was not reasonable to require Dundee to make pre-closing distributions in order to qualify temporarily invested funds as patronage income. The fact that “other somewhat incredible alternatives were available” did not require Dundee to act unreasonably in order to take advantage of the provisions of subchapter T. The court concluded that Dundee's primary purpose in placing the excess funds in the MRP and the money market account was not to invest the surplus funds but rather was “to find a temporary parking place consistent with safety and prudent money management.”

(j)   

CF Industries, Inc. v. Commissioner

CF Industries, Inc. v. Commissioner⁴⁶⁵T.C. Memo 1991-568, modified & aff'd, 995 F.2d 101 (7th Cir. 1993), modifying & aff'g petition for rehearing, 94-1 USTC ¶ 50,033 (7th Cir. 1993), on remand, T.C. Memo 1994-107. is another entry into the series of cases examining the treatment of interest income received by a cooperative. As in prior cases, the volatility and seasonal nature of the cooperative's business led the Tax Court to characterize interest income of a cooperative from the investment of its surplus funds as patronage income available for the payment of patronage dividends. A nonexempt cooperative manufactured and distributed fertilizer to its member cooperatives, which in turn sold the fertilizer to farmers and other cooperatives. The volatility of the fertilizer business due to changes in demand, supply, and price is caused by a variety of factors, including the worldwide markets and seasonal, cyclical, political, and weather factors. The cooperative in CF Industries employed a full-time cash manager to oversee its cash flow on a daily basis. Excess cash was placed in short-term instruments and cash shortages were met through short-term borrowing. Because of the cost of borrowing, the cash manager was charged with maintaining cash to meet current needs while minimizing short-term borrowing. The cooperative had a formal policy for making short-term investments that ranked safety of principal and liquidity as the primary considerations and the rate of return as the lowest priority. Investments were typically for terms of less than one month and maturity dates were staggered to ensure that funds would be available as needed to pay the cooperative's suppliers and other obligations.

In CF Industries, the government first argued that a direct interrelationship or connection must exist between the payor or source of the interest income and the cooperative's main business. For example, in St. Louis Bank, a bank for cooperatives earned patronage interest on short-term loans of surplus funds not immediately required for loans to its member cooperatives. The government in CF Industries contended that there was a direct interrelationship between the money management of the bank for cooperatives in St. Louis Bank and its cooperative function, which was to lend funds to its members. The government further argued that cases subsequent to St. Louis Bank, such as Cotter and Ill. Grain, were incorrectly decided because such an interrelationship was not present in those cases. Finally, the government broadly argued that money management activities cannot be directly related to a cooperative's business for purposes of subchapter T. ⁴⁶⁶ See also TAM 9208004 (interest of a nonexempt cooperative from the investment of its surplus funds in short-term certificates of deposit and money market accounts was nonpatronage income because the money management activities were not directly related to, and did not facilitate, the cooperative's purchasing function).

Rejecting all the arguments put forward by the IRS, the Tax Court stated that the case law was correct in that a cooperative's short-term placement of excess cash is simply prudent money management, and that the money management and resulting interest income was directly related to and intertwined with the cooperative's business; provided, however, that to qualify as patronage sourced the amount placed in short-term arrangements should be limited to that amount necessary to meet foreseeable cash needs and the amount must be reasonable in relation to the anticipated expenses payable by the cooperative. The Tax Court in CF Industries was affirmed by the Seventh Circuit, which upheld the validity of the existing case law and expressly declined to create a conflict with the Federal Circuit's decision in Cotter that might lead to Supreme Court review. ⁴⁶⁷In CF Industries, the IRS argued before the Tax Court for the application of a 30-day rule that would automatically characterize interest on instruments with maturity dates of more than 30 days as nonpatronage income. The Tax Court agreed to apply the 30-day rule because in the instant case the cooperative could estimate its cash inflows and outflows with reasonable certainty for not more than 30 days in advance. Although the IRS abandoned the 30-day rule on appeal, the Federal Circuit commented that the Tax Court's rationale for approving the 30-day rule made “no sense.” 995 F.2d at 103.

(k)   

Analysis of Authorities

In summary, the treatment of interest income of cooperatives has been addressed in several cases and rulings. The IRS can generally be expected to challenge a cooperative's treatment of interest as patronage-sourced income unless the interest is derived from a direct transaction with a patron or is very closely intertwined with the cooperative's business. In fact, the IRS has stated that interest income of a cooperative is almost never patronage income because the investment of idle funds with third parties is incidental to a cooperative's main function.⁴⁶⁸TAM 9208004. In contrast, the Tax Court and two U.S. Circuit Courts of Appeal have a broader, but not unlimited, idea of which activities are directly related to a cooperative enterprise.⁴⁶⁹C.F. Indus. v. Commissioner, T.C. Memo 1991–568, modified & aff'd, 995 F.2d 101 (7th Cir. 1993); Cotten & Co. v. United States, 765 F.2d 1102 (Fed. Cir. 1985). The cooperative has the burden of proving the necessary relationship between the interest-producing activity and the cooperative's marketing, purchasing, or service function.⁴⁷⁰Certified Grocers of Cal., Ltd. v. Commissioner, 88 T.C. 238, 244-45 (1987) (burden of proof not satisfied where cooperative failed to show the amount of funds deposited, the deposit terms, the cooperative's need for the funds, and when such need was expected to occur). Based on the case law, the presence of any of the following factors will enhance a cooperative's chances of convincing a court that interest income is patronage sourced:

Note: The business of agriculture is notoriously volatile due to its seasonal nature as well as to supply and demand, weather conditions, and world markets. If a cooperative that is directly or indirectly involved with agriculture can demonstrate a specific need to maintain accessible cash, then it will likely be successful in convincing a court that interest derived from the short-term investment of excess cash is patronage income. For example, the cooperative in Ill. Grain marketed grain and the cooperative in Dundee Citrus Growers marketed fruit. Both marketing cooperatives were required to maintain liquid funds because their expenses did not correspond in time with their cash inflow and therefore they were allowed to deduct interest from short-term investment of their surplus cash as patronage dividends. Similarly, in CF Industries a cooperative manufactured and sold fertilizer that was ultimately consumed by farmers. The fertilizer was manufactured during one part of the year and marketed during a different part of the year. Income from fertilizer sales was held until it was needed to pay suppliers during the manufacturing period, and the interest from temporary placement of its excess funds was held to be patronage sourced. Also, the cooperative in St. Louis Bank, another case decided in favor of the taxpayer, was indirectly involved with agriculture because it made loans to member farmers cooperatives. Cooperatives involved in sectors other than agriculture, however, may be less successful in establishing interest income as patronage sourced. The cooperative in Cotter provided purchasing, warehousing, and distribution services to hardware dealers and was able to demonstrate the requisite relationship because the timing of its purchases did not coincide with sales to members. In contrast, however, the cooperative in Twin Cities, which provided purchasing, warehousing, and distribution services to grocers, was not allowed to deduct interest from the short-term investment of its surplus funds. Similarly, in Washington-Oregon Shippers a cooperative that provided shipping and distribution services to its member businesses was required to treat interest on short-term instruments as nonpatronage sourced. The Tax Court expressly noted that the freight shipping business was more stable than the grain marketing business considered in Ill. Grain.

(a)   

In General

Income derived from the lease of premises is mentioned in Reg. §1.1382-3(c)(2) as an example of nonpatronage income. The IRS previously took the position that the regulation established a per se rule that all rental income received by cooperatives were nonpatronage sourced. Subsequently, the IRS announced that it would consider the examples of nonpatronage income in Reg. §1.1382-3(c)(2) as instructive but not controlling, and agreed to apply the directly-related test when classifying income as patronage sourced or nonpatronage sourced.⁴⁸⁶2001-13 I.R.B. 920. See AOD-CC-2001-03 (3/27/01). Specifically with regard to rental income, the IRS's position is that income produced by property held for rental purposes will be considered nonpatronage income, but income produced by rental property will be considered patronage income in those unusual situations where the property was held to facilitate business conducted for the benefit of patrons. ⁴⁸⁷ Id. Courts have consistently looked to the relationship between the cooperative's function and the rental activity. Thus, rental income may be characterized as patronage sourced or nonpatronage sourced, depending on the circumstances.

(b)   

Cotter & Co. v. United States

Cotter & Co. v. United States⁴⁸⁸765 F.2d 1102 (Fed. Cir. 1985), rev'g 6 Cl. Ct. 219 (1984). illustrates how different courts can apply the same standard to the same facts and reach different results. In Cotter, a nonexempt cooperative performed purchasing, warehousing, and distribution services for independent hardware retailers. Its cooperative function was to purchase goods at the lowest possible price by using large volume purchases and to warehouse and distribute the products at the lowest possible cost. The cooperative's business was seasonal in that it purchased the bulk of its goods in certain seasons and sold the goods to its members at a later date. The cooperative required substantial warehouse storage space due to the delay between its purchase of the merchandise and the sale of the merchandise to its patrons. Because it was experiencing rapid growth, the cooperative had a need for additional warehouse space to accommodate current and future anticipated requirements. Thus, the cooperative designed and built, or leased, warehouses with excess space for the anticipated future needs. Meanwhile, the cooperative leased the excess warehouse space to third parties.

Concerning whether the rental income in Cotter was patronage sourced or nonpatronage sourced, the Claims Court framed the issue as whether the rental of excess warehouse space facilitated the cooperative's basic purchasing and warehousing activities. According to the court, while the acquisition of excess warehouse space facilitated the operation of the cooperative's growing business, the rental of the excess space did not contribute to its central cooperative functions, but rather simply enhanced its overall profitability. Because the rental income was nonpatronage sourced, it could not be distributed to patrons as a patronage dividend.

Reversing the Claims Court's decision in Cotter, the Federal Circuit characterized the rental income as patronage sourced.⁴⁸⁹Id. at 1109–10. In reaching its conclusion, the circuit court emphasized the need to maintain excess capacity due to the uncertainty of the cooperative's current and future needs for warehouse space and that temporary rental of the excess space was a minor component of the cooperative's overall plan for its present and future warehouse requirements.⁴⁹⁰Id.

(c)   

Ill. Grain Corp. v. Commissioner

Ill. Grain Corp. v. Commissioner⁴⁹¹87 T.C. 435 (1986), nonacq., 1990-2 C.B. 1. involved a cooperative that purchased, distributed, and marketed grain and provided a variety of related services to its member and nonmember patrons. A key element of the cooperative's business was the transportation of grain from the cooperative's grain elevators to the market in New Orleans. Most of its grain was transported by a river barge system operating on the Mississippi and Illinois rivers. The river system utilized the economical river transportation to provide its patrons access to world markets. The availability of barges was essential to the cooperative's operation. To induce a barge company to commit more barges for shipping its grain, the cooperative entered into an arrangement by which barges were constructed and chartered to the cooperative, which in turn subchartered the barges to the barge company. The barge company and its successor thereafter used the barges to transport the cooperative's grain. By the tax year at issue, two barges remained in operation, from which the cooperative received approximately $13,000 in barge rentals from the barge company. For that year, the barge company that subchartered the barges carried about 1,200 barge loads of the cooperative's grain at a cost to the cooperative of $15 to $25 million. The cooperative considered the subchartered barges as part of its river system. The IRS challenged the treatment of the barge rentals as patronage income available for payment of a patronage dividend.

Applying the standard test, the Tax Court in Ill. Grain stated that the character of an income item depends on the relationship between the activity generating the income and the cooperative activities. The court did not view the barge leasing and subleasing as an investment in barges designed to provide passive rental income. Rather, because the cooperative relied so heavily on its river transportation system and the availability of sufficient barges, the leasing and subleasing of the barges was an integral part of the cooperative's grain marketing activity. Thus, the cooperative was entitled to treat the rental income as patronage income.

(d)   

Analysis

In Ill. Grain, the leasing of the barges directly facilitated the cooperative's function because the barges were used to transport its members' grain to market. The transportation of the grain was an essential component of the cooperative's services to its patrons. If the barge company had sufficient barge capacity to transport the grain, the cooperative almost certainly would not have purchased any barges.

In contrast, the relationship between the cooperative's rental of its excess space and its purchasing services in Cotter was tenuous. The excess space had never been used by the cooperative in its purchasing function, and its future use was uncertain. Thus, while it was prudent for the cooperative to lease the excess space, the leasing of the space did not facilitate the services it performed for its patrons.

Analogizing the treatment of rent with the treatment of interest income, Ill. Grain seems more like the cases holding that interest is patronage income.⁴⁹²The classification of interest income as patronage sourced or nonpatronage sourced is discussed at III.B.1.(b)(3), above. When interest earned on the investment of surplus funds was considered patronage sourced, money management was an integral aspect of a cooperative's services.⁴⁹³E.g., C.F. Indus., Inc. v. Commissioner, 995 F.2d 101 (7th Cir. 1993), modifying & aff'g T.C. Memo 1991-568, petition for reh'g, 94-1 USTC ¶ 50,033 (7th Cir. 1993), on remand, T.C. Memo 1994-107 (cooperative employed full-time cash manager to oversee its cash flow on daily basis); Cotter & Co. v. United States, 765 F.2d 1102 (Fed. Cir. 1985), rev'g 6 Cl. Ct. 219 (1984) (purchasing cooperative experienced deficits and surpluses); Certified Grocers of Cal., Ltd. v. Commissioner, 88 T.C. 238 (1987) (cooperative temporarily invested unused portion of cash from construction loan until needed in construction project); Ill. Grain Corp. v. Commissioner, 87 T.C. 435 (1986), nonacq., 1990-2 C.B. 1 (marketing cooperative covered temporary shortages by short-term borrowing and temporary surpluses with short-term investments); Dundee Citrus Growers Ass'n v. Commissioner, T.C. Memo 1991-487 (need for liquidity due to volatility of citrus business and to cooperative's inability to close pools and distribute the proceeds to members until last fruit of pool was sold). Having ready access to liquid funds was necessary to fulfill unpredictable cash needs, to respond to volatility of the business, or to accommodate suppliers. Similarly, the leasing of the barges in Ill. Grain was an integral part of the cooperative's grain marketing services. The Cotter case, on the other hand, is more analogous to the cases in which interest was considered nonpatronage income. In those cases, cooperatives engaged in prudent money management practices by investing idle or surplus funds, but the investments did not facilitate the services they provided.⁴⁹⁴E.g., Twin Cnty. Grocers, Inc. v. United States, 2 Cl. Ct. 657 (1983; Certified Grocers of Cal., Ltd. v. Commissioner, 88 T.C. 238 (1987); Wash.-Or. Shippers Coop., Inc. v. Commissioner, T.C. Memo 1987-32. In Cotter, as the Claims Court concluded, the lease of the cooperative's excess space enhanced its overall profitability but did not relate directly to its purchasing function.

The IRS approach to the treatment of rental income is illustrated by PLR 201105008. A cooperative owned a facility at which it conducted annual auctions to market the crops of its member farmers. The auction facility contained a large amount of storage space, which was needed to store crops pending their auction. Because the auctions were seasonal, the cooperative leased storage space in its facility to local businesses when auctions were not being conducted. The rental income represented a minimal part of the cooperative's gross income compared to the auction sales. According to the ruling, “the limited portion of the year in which the facilities are needed to fully carry out its services to its patrons creates a unique situation where off-season rental of the facilities is a prudent management decision resulting in a reasonable incidental income source that allows Coop to maintain the facilities in good condition for use by its patrons.” The rental income was nonpatronage income, however, because the leasing did not relate directly to the cooperative's marketing function but merely enhanced the cooperative's overall profitability.

The facts in PLR 201105008 were even stronger in the cooperative's favor than were the facts in Cotter. In Cotter, the cooperative leased excess space in a new facility that had never been used in the cooperative's purchasing function. The cooperative in the ruling leased space that it actually used each year in marketing its members' crops. In neither case, however, does the leasing activity itself directly relate to, or facilitate, the conduct of the cooperative's business.

(a)   

Farmland Indus., Inc. v. Commissioner

In Farmland Indus., Inc. v. Commissioner,⁵⁰¹T.C. Memo 1999-388, acq., 2001-13 I.R.B. 920. the Tax Court considered whether a nonexempt agricultural cooperative's gain from the sale of stock in three corporations was patronage income. As a regional cooperative, the cooperative's membership consisted of local cooperatives the members of which were individual farmers and ranchers. Originally, the cooperative's primary function was to supply petroleum products to its member-cooperatives, which in turn sold the products to their patrons. The cooperative subsequently diversified its business activities to include numerous product lines, a fertilizer plant, oil refineries, a pipeline system, and crude oil production. In 1969, the cooperative formed a for-profit subsidiary named Terra to engage in exploration and crude oil production. The cooperative planned to use Terra as a means to generate additional capital for further expansion through the sale of stock to the public. The sales of the cooperative's petroleum-based products experienced a rapid decline beginning in 1980. During this period, the cooperative met its operating and capital needs through bank financing, issuing subordinated debt, and retaining earnings. Its principal lender, a bank for cooperatives, became increasingly concerned about the cooperative's financial status and began making demands on the cooperative to reduce its debt ratio. To avoid a default and possible bankruptcy, the cooperative sold its Terra stock, which was its only asset that could be liquidated rapidly. The cooperative treated its gain from the sale of Terra stock as patronage-sourced income. In subsequent years, the cooperative continued to rely on Terra as a source of crude oil.

After a thorough review of the prior cases and rulings, the Tax Court rejected the IRS's position that Reg. §1.1382-3(c)(2) established a per se rule that all gains from investments are nonpatronage sourced⁵⁰²The Tax Court also rejected the IRS's proposed new two-part test, which would apply the directly-related test and also examine whether the receipts at issue are “customary operating income of the cooperative.” The Tax Court stated that whether receipts are customary operating income is a relevant, but not controlling, consideration. and focused on the relationship between the transaction producing the income and the cooperative's marketing, purchasing, or service function. According to the court, the acquisition of Terra stock was not an investment of the cooperative, but rather was closely and directly related to its function of supplying petroleum products to its patrons. The crude oil produced by Terra was processed in the cooperative's oil refineries to produce the petroleum products for its members. Moreover, the cooperative sold the Terra stock, at the request of its creditor, as the only means available to avert extreme financial distress. The court concluded that the gain from the sale of the Terra stock was patronage sourced because the sale was necessary for the cooperative's continued operation.⁵⁰³The cooperative in Farmland Indus. also had realized losses on the sale of stock in two other corporations. The two companies were acquired at a time when the cooperative was seeking to become self-sufficient through vertical integration. Thus, the holding of the stock in each corporation was directly related to the petroleum business. The companies were sold when changes in the crude oil market made the interest unnecessary. The Tax Court concluded that the losses incurred on the sale of the stock were patronage losses. See also PLR 200706002 (where nonexempt telephone cooperative was required to purchase stock in a bank in order to obtain a loan to conduct its activities, IRS applied Farmland Indus. and related cases applying subchapter T in determining that income from the sale of the stock was patronage sourced).

(b)   

IRS Acquiesces in Farmland Indus.

As noted above, the IRS previously took the position that gain from the sale of stock was always nonpatronage income by virtue of Reg. §1.1382-3(c)(2).⁵⁰⁴ E.g., TAM 8941001, TAM 8815001. In 2001, the IRS acquiesced in Farmland Indus., stating that it would consider the examples of nonpatronage income in Reg. §1.1382-3(c)(2) as instructive but not controlling.⁵⁰⁵Farmland Indus., Inc. v. Commissioner, T.C. Memo 1999-388, acq., 2001-13 I.R.B. 920. The IRS agreed to apply the directly-related test when classifying income as patronage sourced or nonpatronage sourced.⁵⁰⁶E.g., PLR 200252027 (where cooperative, wholesaler and distributor of product, desired to liquidate by selling all its assets and distributing proceeds to its members, gain from sale of stock of subsidiary corporation was nonpatronage sourced where subsidiary was established to lend funds to member retail customers for expansion or relocation). It was noted, however, that the IRS rejected any inference from Farmland Indus. that the underlying purpose for the sale may serve as the sole basis for characterizing gain or loss from the sale as patronage sourced. The IRS was likely referring in part to the sale of the Terra stock by the cooperative in Farmland Indus.. The Tax Court noted that Terra was integrally related to the cooperative's petroleum supply function, but seemed to emphasize that the sale of the Terra stock was necessary to avert a financial crisis. When a cooperative sells stock in a corporation, two factors may serve as the focus when applying the directly-related test: the cooperative's purpose for owning the stock and its purpose for selling the stock.⁵⁰⁷In PLR 200206044, the IRS stated that a transaction that generates gain from the sale of stock involves two parts: the original decision for owning the stock and the actual disposition of the stock. In the ruling, a telephone cooperative described in §501(c)(12) joined with other like cooperatives to form a corporation to provide certain telephone-related services in rural areas. The corporation subsequently merged with another company. The telephone cooperative did not agree with the direction in which the new company was moving because the company was expanding substantially beyond the cooperative's original purpose of serving small telephone cooperatives. In applying the directly-related test, the IRS ruled that both the initial investment and the sale of the stock were directly related to the cooperative's business purpose. In PLR 201010006, under similar circumstances, the IRS, again applying its acquisition/disposition analysis, stated that the transaction that will generate income for the taxpayer consists of two parts: the original decision to organize the enterprise — the equitable interest in which the taxpayer was selling — and the liquidation of that interest. The IRS ruled that both elements of the transaction were directly related to the taxpayer's cooperative business and facilitated the taxpayer's ability to provide communication services to its members. By participating in this venture, the taxpayer sought to insure that cellular service would be available on reasonable terms to the taxpayer's customers and to ensure that the taxpayer's wireline customers would not be adversely affected by other customers' migration to cellular. In liquidating its interest, the taxpayer acted on concerns that conflicts of interest might arise as a result of the nature of another entity that secured an interest in the enterprise. In Farmland Indus., the Tax Court examined both factors but may have emphasized the cooperative's reason for selling the subsidiary's stock, which was to use the proceeds to pay back its overdue loans.⁵⁰⁸Language in the Tax Court's opinion in Farmland Indus. may suggest that the court emphasized the reason for the sale of Terra rather than the reason for acquiring it. With regard to the other two subsidiaries, however, the Tax Court clearly addressed both the holding and sale of the stocks. Moreover, in the court's extensive examination of the facts of the case, several pages were devoted to Terra's formation and operation as well as its sale, which suggests that all the factors were relevant and taken into account. In PLR 200239029, the IRS stated that the Tax Court in Farmland Indus. had emphasized the need to consider the totality of the circumstances and had analyzed the reasons behind both the organization of the subsidiaries and their eventual disposition. From the acquiescence in Farmland Indus., the IRS appears to take the position that the purpose for selling the stock, standing alone, is an insufficient basis for classifying the gain from the sale as patronage sourced. For example, if the cooperative in Farmland Indus. had purchased stock in a corporation as an ordinary investment to enhance the cooperative's overall profitability and then sold the stock to satisfy its creditors, the IRS would probably have acquiesced in the directly-related test but not in the Tax Court's conclusion.

(c)   

IRS Applies Directly-Related Test

Since its acquiescence in Farmland Indus., the IRS has issued numerous private letter rulings concluding that gain from the sale of stock was patronage income to cooperatives under the directly-related test. In a series of rulings,⁵⁰⁹PLR 201123038, PLR 201010006, PLR 200907014, PLR 200627007, PLR 200404003, PLR 200314002, PLR 200229039, PLR 200206044, PLR 200152035. the IRS considered whether gain from the sale of stock was patronage-sourced income or nonpatronage-sourced income to rural telephone cooperatives.⁵¹⁰Rural telephone cooperatives described in §501(c)(12) are exempt from taxation if 85% or more of their income is collected from members for the sole purpose of meeting losses and expenses. §501(a), §501(c)(12)(A). A rural telephone cooperative that cannot satisfy the 85% test for any tax year is a nonexempt cooperative for such tax year. Neither exempt nor nonexempt rural telephone cooperatives are subject to subchapter T. §1381(a)(2)(A), §1381(a)(2)(C). Nonexempt rural telephone cooperatives are subject to the cooperative rules in effect immediately before the enactment of subchapter T in 1962. Because subchapter T was a codification of the existing rule with some changes, the principles developed under subchapter T are used in analyzing cooperative issues of nonexempt rural telephone cooperatives. The treatment of exempt telephone cooperatives described in §501(c)(12) and of nonexempt rural telephone cooperatives is discussed at II.D.1., and II.D.2., respectively. The cooperative had joined forces with other small rural telephone cooperatives to form a corporation to provide cellular service to its rural patrons. Subsequently, as part of the nationwide consolidation of cellular networks, the cellular corporation was sold to a large cellular company. The telephone cooperative received common stock in the large cellular company. The cooperative proposed to sell the newly acquired common stock and use the proceeds to meet its expansion needs. The IRS found that the telephone cooperative's investment in the cellular corporation was directly related to the cooperative's purpose of providing modern, high-quality telephone service to its members. Moreover, the sale of the stock would also be directly related to the cooperative's business because it was the natural conclusion of an enterprise designed to build a cellular network. Thus, the gain from the stock sale was patronage-sourced income to the cooperative.

Another series of private rulings involves the purchase of stock in the Rural Telephone Bank (RTB) by rural telephone cooperatives.⁵¹¹PLR 200743023, PLR 200736017, PLR 200724017, PLR 200714010, PLR 200713014, PLR 200706002. Established by federal law, the RTB was formed to provide a financing source for rural telephone cooperatives and other telecommunications companies. The RTB had three classes of stock. Class A stock was owned by ordinary investors. Class B stock was required to be purchased by borrowers in an amount equal to 5% of the amount borrowed. Borrowers were issued additional Class B stock as patronage refunds. When cooperatives repaid their loans, their Class B stock was converted to Class C stock. Borrowers were also allowed to purchase Class C stock. After Congress decided to liquidate the RTB, the company redeemed its stock from the various shareholders. The rulings address whether gain from the sale of the RTB stock by rural telephone cooperatives was patronage sourced or nonpatronage sourced. According to the IRS, the cooperatives were required to purchase Class B stock in the RTB in order to take advantage of the funding source that Congress provided. Thus, the purchase of the Class B stock was directly related to the cooperative's acquisition of capital to provide cooperative telephone services. The redemption of the stock was not subject to the cooperative's control. The IRS therefore ruled that gain from the sale of RTB stock was patronage sourced.⁵¹²Holders of Class C stock were eligible for a cash dividend as declared by RTB's board. Under the facts of PLR 200743023, voluntary purchases of Class C stock, as opposed to conversions from Class B stock, were “extremely rare because no borrower would want to invest in instruments that have no schedule of principal repayment.” The cooperative in the ruling did purchase some shares of Class C stock but never converted any Class B stock to Class C stock. Thus, all the Class C stock redeemed from the cooperative was voluntarily purchased. Without additional facts to explain why the cooperative purchased the Class C stock, it seems that the gain on the Class C stock would be nonpatronage income from an investment. Nevertheless, the IRS ruled that the gain on both the Class B and Class C stock was patronage sourced. In contrast, the rural telephone cooperative in PLR 200736017 repaid its loan from the RTB in full and converted all its Class B stock to Class C stock. The Class B stock paid no dividends. Thus, after repaying the indebtedness, it made sense for the cooperative to convert the B stock to C stock. In this case, there was a direct relationship between the conversion to Class C stock and the initial borrowing from the RTB, and the gain on the Class C stock was properly characterized as patronage sourced.

PLR 201103007 involved an exempt farmers cooperative that marketed the crops of its members. According to the ruling, the type of crops grown by its members were not planted, cultivated, and harvested unless there was an established market for the sale and processing of the crops. Previously, Corp B, primarily owned by Corp C, had purchased and processed the members' crops. When Corp C decided to sell its interest in Corp B, the cooperative realized that all the other interested bidders for Corp B were unlikely to continue to provide the essential market for its members' crops. To prevent losing the relationship with Corp B, the cooperative acquired all the outstanding stock of Corp B. The cooperative renamed the corporation Corp D and disposed of some unprofitable lines of business in order to make Corp D profitable in most years. After some years, Corp D began to struggle financially. Processing only a limited number of regional brands, Corp D's growth potential was limited, and it could not compete effectively with larger processors that handled national brand labels. To keep Corp D afloat, the cooperative caused Corp D to purchase Corp E, a processor of national brands. Both the cooperative and Corp D had to borrow significantly to finance the acquisition of Corp E, but it soon became apparent that additional capital was required. At that time, Corp D purchased and processed 90% of the crops marketed by the cooperative. Unable to raise additional funds and faced with losing its stable market, the cooperative accepted a cash infusion from a private equity firm and reorganized Corp D so that the equity firm controlled Corp D, renamed Corp A, from that point forward. As part of the restructuring, the cooperative negotiated a 10-year preferred supplier agreement that essentially continued the prior relationship between the cooperative and Corp D. Subsequently, the firm sold Corp A to an unrelated buyer, and the cooperative realized a gain on the sale of its interest in Corp A.

According to the IRS, the cooperative's initial purchase of Corp B was directly related to its cooperative marketing function because it continued the stable market for the crops of the members. The subsequent purchase of Corp E and the refinancing with the private equity firm were directed toward the same purpose. The sale of its Corp A stock was not within the cooperative's control because the decision was made by the controlling owner. Even after the sale of Corp A, the supplier agreement remained in effect to assure the cooperative of a steady market. Because the ownership of the processing corporation directly facilitated the cooperative's marketing function, the gain from the sale of the stock was patronage gain.

In PLR 202214004, the IRS applied the “directly-related test” in determining that gain recognized by a non-exempt rural telephone cooperative (taxpayer) from the sale of interests in a partnership through which telecommunication services were provided to the cooperative's members constituted patronage-sourced income. The partnership was formed by a group of rural telephone companies to build and operate a fiber optic broadband network. Through a wholly owned subsidiary, the taxpayer owned direct and indirect interests in the partnership. The taxpayer used the partnership’s regional network to connect its local exchange network to major cities and deliver high quality, affordable telecommunication services to its members and other customers. Following the sale, the taxpayer planned to use the sale proceeds received by its subsidiary to build out its local exchange network, improve services to its members and other customers, and otherwise further its mission of providing telecommunication services to homes and businesses in the rural communities it serves. Because the partnership was used to provide telecommunication services to taxpayer’s members, the IRS ruled that the sale satisfied the “directly-related test” and thus the gain recognized by the taxpayer’s subsidiary that was allocable to the taxpayer's members was patronage-sourced income excludable from the taxpayer's consolidated gross income.

(a)   

In General

Income derived from the sale or exchange of capital assets is mentioned in Reg. §1.1382-3(c)(2) as an example of nonpatronage income. While real and depreciable business properties are excluded from classification as capital assets,⁵¹³§1221(a)(2). gain from the sale or exchange of property used in a trade or business is treated as gain from the sale of a capital asset under §1231.⁵¹⁴§1231(a)(1), §1231(a)(3). If the §1231 gains for a tax year do not exceed the §1231 losses for the year, such gains and losses are not treated as gains from the sale or exchange of capital assets. §1231(a)(2). For purposes of §1231, property used in a trade or business includes depreciable property and real property, in either case used in a trade or business and held for more than one year.⁵¹⁵§1231(b)(1). The IRS previously took the position that Reg. §1.1382-3(c)(2) established a per se rule that all capital gain received by cooperatives were nonpatronage sourced. ⁵¹⁶Reg. §1.1382-3(c)(2) is discussed at III. B. 1. a.(1), above.

For example, Rev. Rul. 74-84⁵¹⁷Accord St. Louis Bank for Coops. v. United States, 624 F.2d 1041, 1053–54 (Ct. Cl. 1980) (gain from sale of automobile used in cooperative's business was patronage sourced where entire gain represented ordinary income from depreciation recapture under §1245); Astoria Plywood Corp. v. United States, 79-1 USTC ¶ 9197 (D. Ore. 1979) (where cooperative manufactured wood products, gain from sale of two machines used in its plywood plant, all of which represented appreciation in value of asset over costs already recovered as depreciation, was nonpatronage sourced). Relying on the rationale of Rev. Rul. 74-84, the IRS has ruled that, where a cooperative terminated a pension plan that was overfunded, the portion of the excess plan funds realized on the reversion that was attributable to excess cooperative contributions was patronage sourced, and the portion that was attributable to superior investment performance of the plan was nonpatronage sourced. TAM 9208004. involved a cooperative that manufactured wood products. The cooperative realized a gain on the sale of machinery that was used in the manufacturing process. The gain on the sale consisted of ordinary income from depreciation recapture under §1245 and capital gain from the sale of business property under §1231. The IRS noted that the depreciation deductions taken in years before the sale of the machinery had reduced the amount available for paying patronage dividends in such years. Thus, the depreciation recapture was patronage sourced because it represented income that otherwise would have been distributed as a patronage dividend. With respect to the capital gain, however, the IRS cited Reg. §1.1382-3(c)(2) and ruled that such gain was nonpatronage sourced without further discussion.

Subsequently, the IRS announced that it would consider the examples of nonpatronage income in Reg. §1.1382-3(c)(2) as instructive but not controlling, and agreed to apply the directly-related test when classifying income as patronage sourced or nonpatronage sourced.⁵¹⁸This change in policy was signaled by the IRS's acquiescence in Farmland Indus., Inc. v. Commissioner, T.C. Memo 1999-388, acq. 2001-13 I.R.B. 920, AOD 2001-03, I.R.B. 2001-13. Specifically concerning cooperative ownership of capital or business assets, the IRS's position is that gains or losses from the sale or exchange of property will be considered nonpatronage sourced if the asset was not used for a cooperative business purpose but will be considered patronage sourced if the asset actually facilitated the cooperative business.⁵¹⁹Rev. Rul. 69-576.

(b)   

Farmland Indus., Inc. v. Commissioner

In Farmland Indus., Inc. v. Commissioner,⁵²⁰T.C. Memo 1999-388, acq., AOD 2001-03, I.R.B. 2001-13. But see Astoria Plywood Corp. v. United States, 79-1 USTC ¶ 9197 (D. Ore. 1979) (where two machines were fully depreciated before organization became cooperative, gain from sale of machines representing appreciation in value was not directly related to cooperative purpose of making plywood and veneer, even though machines were used in plywood plant). the Tax Court examined the characterization of gains from the sale of property used in a trade or business within the meaning of §1231. The primary purpose of the cooperative in Farmland Indus. was to supply petroleum products to its member cooperatives. One of the cooperative's long-term goals was to reduce its dependence on third parties in the petroleum industry in order to achieve cost savings, reliability, and better quality products. As part of that effort, the cooperative acquired a gas plant consisting of a gathering system, an absorption processing plant, a pipeline system, and a cryogenic gas processing plant. The acquisition reduced its dependence on outside suppliers and provided access to numerous gas producing wells. The cryogenic plant increased the overall efficiency of the operation. During the cooperative's ownership of the gas plant, virtually all of the natural gas liquids produced at the plant were sold to patrons or used in processing gasoline for sale to patrons. The cooperative subsequently sold the plant assets to a larger processor. The sales proceeds were used by the cooperative primarily to expand gas plants at another location and also to cover loan payments and operating costs. The plant assets were subject to §1231 because they were depreciable personal property and real property, all used in the cooperative's trade or business and held for more than one year.⁵²¹§1231(b)(1). The amount received from the purchaser consisted of three categories of income: the amount realized in excess of cost basis and §1245 and §1250 depreciation recapture. The cooperative reported the entire gain as patronage sourced ordinary income. The IRS did not object to the cooperative's treatment of the depreciation recapture but argued that the amount realized in excess of cost basis was nonpatronage capital gain under §1231. The Tax Court determined that the gas plant was a part of the cooperative's main cooperative effort of producing petroleum products for its patrons and that the sales proceeds were used to expand similar features in another state. Thus, the long-term capital gain realized on the sale of the assets was patronage sourced.

Also considered in Farmland Indus. were soybean processing facilities used by the cooperative to process soy oil from soy beans purchased from its patrons. The cooperative sold the soybean processing facilities as part of a reorganization designed to combine the facilities with similar facilities of two other large cooperatives in order to achieve greater efficiency and cost savings. After all the steps were completed, the three cooperatives owned all the equity interest in a corporation, and the corporation owned their processing facilities. The Tax Court held that the gain from the sale of the soybean facilities was patronage sourced because the sale was undertaken to better serve its patrons by processing soy beans less expensively.⁵²²See also Astoria Plywood Corp. v. United States, 79-1 USTC ¶ 9197 (D. Ore. 1979) (where workers' cooperative leased veneer plant and production of veneer was integral part of cooperative's business, cancellation of lease payment from landlord was patronage sourced).

In its acquiescence to Farmland Indus., the IRS agreed to apply the directly-related test when classifying income as patronage sourced or nonpatronage sourced, subject to the caveat that the underlying purpose for a sale cannot serve as the sole basis for characterizing gain or loss from the sale as patronage sourced. When evaluating the character of gain from the sale of the gas plant, the Tax Court did consider the cooperative's reasons for purchasing and holding the plant and for selling the plant. In contrast, the Tax Court did not address the cooperative's reason for acquiring the soybean processing facilities. The soybean processing, however, was a legitimate sideline for the cooperative and the facilities aided that effort. Thus, the acquisition and holding of the facilities appears to be directly related to the cooperative's soybean processing business.

(c)   

IRS Applies Directly-Related Test

In several private letter rulings, the IRS has characterized gain from the sale of a cooperative's real or depreciable personal property as patronage income if the property was used in the cooperative's business and the sale facilitated the cooperative purposes. For example, PLR 200935019 ⁵²³Accord PLR 200842011 (sale of warehouse used in cooperative's business generated patronage income). involved a cooperative that purchased merchandise for its members, who were retailers in a particular line of business. In addition, the cooperative offered support services, such as advertising and training. To carry out its purchasing and other functions, the cooperative owned a large warehouse and distribution center and an office. Facing some uncertainty regarding its future, the cooperative sold its facility to an unrelated investment group and leased back the office and part of the warehouse space. The purposes of the sale were to improve operating efficiencies and to secure more flexibility in terms of its future operations. After considering a merger with another cooperative, the cooperative decided to liquidate after the lease term expired. Looking at the cooperative's reasons for owning and selling the property, the IRS noted that the property was used by the cooperative to facilitate the efficient distribution of products to its members, which related directly to the purchasing function. The sale of the property was motivated by financial concerns. The cooperative's directors believed the facility was too large and too costly in light of the present scope of the cooperative's operations. Thus, selling and leasing a portion of the property back would reduce expenses. Moreover, getting rid of the large, illiquid asset would facilitate either a future merger or termination and the proceeds were used to restore an underfunded pension plan. The IRS ruled that the gain from the sale of the property was patronage sourced because the acquisition, ownership, and sale of the property was directly related to the cooperative's business. Also, in several other private letter rulings the IRS has characterized gain from the sale of a rural telephone cooperative's spectrum as patronage-sourced income because the spectrum was directly related to cooperative's business of providing telephone service to patrons.^523.1PLR 201704014 (sale of cellular spectrum by rural cooperative telephone company's subsidiary in furtherance of cooperative's function was patronage-sourced income and excludable from gross income), PLR 201507004 (same), PLR 201524002 (cooperative's distributive share of partnership income from sale of spectrum constituted patronage-sourced income and, if properly allocated to cooperative's member-patrons, was excludable from gross income), PLR 201524003 (same), PLR 201524004 (same).

If all or part of a cooperative's gain from a property sale is recapture income relating to previous depreciation deductions, the income may be either patronage sourced or nonpatronage sourced. In Rev. Rul. 74-84,⁵²⁴1974-1 C.B. 244. the IRS ruled that ordinary income from depreciation recapture under §1245 was patronage sourced because it represented income that otherwise would have been distributed as a patronage dividend. When faced with the same issue in PLR 200916004, the IRS applied the directly-related test to characterize recapture income. The cooperative in the ruling was an electric cooperative that sold its interest in a nuclear power plant. All the gain on the sale of the plant was ordinary recapture income under §1245. The IRS ruled that the income was patronage sourced because the cooperative used the power plant to produce electric energy for sale to its members.

The directly-related test of Farmland Indus. applies to taxable exchanges as well as sales of business assets. PLR 200838008 involved a rural electric cooperative that produced and sold electric energy to its members. D owned several power plants that it used to generate energy. D constructed Project D, which included a hydroelectric generating plant with a dam, reservoir, dike, and spillway and related real property, structures, and equipment. Subsequently, as part of an arrangement among the state power authority and various electric cooperatives, the cooperative sold Project D to the state and entered into a power sales agreement under which it was required to operate and purchase all the electricity output of Project D. After some years, the state changed the arrangement by transferring all of Project D, plus a cash amount, back to the cooperative and releasing the cooperative from all its obligations under the power sales agreement. According to the IRS, the power sales agreement was an asset used by the cooperative in providing electricity to its members. When the cooperative exchanged Project D for the cancellation of the power sales agreement, the resulting gain was patronage sourced.

(d)   

Sale of Assets upon Liquidation

When a cooperative ceases doing business and sells its assets in liquidation, in general gain from the sale of assets directly related to the cooperative's business with and for its members will constitute patronage income, and gain from the sale of other assets will constitute nonpatronage income.⁵²⁵E.g., PLR 202014011 (member portion of net gain from sale of business assets that is directly related to amount of business done with or for patrons is patronage income), PLR 200652003 (gain on sale of operating assets, both real and personal, by liquidating cooperative was patronage-sourced income), PLR 200625021 (purchasing cooperative received patronage income on sale of its assets, including goodwill, workforce in place, geographical marketing rights, furniture, and equipment). For the proportionate allocation of liquidating proceeds of a cooperative, see II.B.1.d.(4), above. For example, PLR 200252027 involved a cooperative that operated as a wholesaler and distributor of a particular product and related products. Its members were retailers of the product, supermarkets, individual buying clubs, and cooperative retailers. When the cooperative was formed, the product was not widely available and the cooperative was the sole source of the product for its members. As time went by, the product became more widely available due to increased public awareness of the benefits of the product and to increased demand for the product. As a consequence, the cooperative's members no longer depended on the cooperative as their sole source of the product but were able to purchase the product from larger competitors at lower prices. As the result of this change in the industry, the cooperative proposed to sell all of its assets to a single buyer and distribute the proceeds to its members. The physical assets included land, property, warehouse and transportation equipment, and inventories used in the cooperative's wholesale and distribution activities. Also included in the sale were trade receivables, customer lists, trade name, goodwill, and agreements with vendors. In addition, the sale included stock in a subsidiary corporation that was formed for the purpose of lending funds to member retail customers for expansion or relocation. The proceeds were projected to be substantial, consisting of §1245, §1250, and §1231 gain. The IRS ruled the proceeds from the sale of all of the assets, except the subsidiary, were patronage sourced because the assets were directly related to the business of operating as a wholesaler and distributor of the product, and the sale facilitated the accomplishment of the cooperative activities. In contrast, the proceeds from the sale of the stock of the subsidiary were not patronage sourced because the activities of the subsidiary were not directly related to the cooperative function of wholesaling and distributing the product.

In PLR 200526012, the length of time between the cessation of business and the sale of assets caused a cooperative's gain from the sale of the assets to be characterized as nonpatronage-sourced income. The cooperative conducted auctions to market the crops of local farmers. The cooperative ceased doing business but retained its property for an unspecified number of years, in case its auction services were needed again. The facility would have been difficult to replace due to its highly specialized configuration. Finally, the cooperative decided to liquidate by selling its property. Most of the appreciation in the value of the property had occurred after the cooperative had closed. The IRS ruled that the gain resulting from the sale was not patronage sourced because the cooperative was not operating on a cooperative basis at the time of the sale. Thus, distributions of the proceeds to its members were not deductible by the cooperative as patronage dividends.

While the result in PLR 200526012 was unfavorable to the cooperative, the IRS reached a different conclusion on similar facts in PLR 201105008. The marketing cooperative in PLR 201105008 closed its crop auction house but retained the facility for an unspecified number of years to assess whether its services would be needed again. In addition, considerable time passed between the time when it decided to sell the facility and the actual sale. The property sold for substantially less than its appraised value because crop auction facilities were no longer in demand and the real estate market in general had declined. Thus, any gain from the sale was attributable to the period when the auctions were ongoing. The IRS ruled that the period between suspending the auctions and selling the property was a reasonable extended liquidation period. The cooperative was considered to be operating on a cooperative basis for purposes of the sale, and gain from the sale was patronage income.

(a)   

Use of Pass-Through Entities by Cooperatives

There are various reasons why a cooperative might choose to isolate all or part of its cooperative activities in another entity, such as a limited liability company (LLC) or a partnership. For example, two marketing cooperatives that deal with the same product may find it advantageous to combine their marketing activities in order to be more competitive, reduce costs, and increase efficiency. The cooperatives could reorganize and become one larger cooperative. An alternative to a reorganization is to combine their efforts in another entity. The new entity may be another cooperative or a for-profit corporation. One advantage of using a third entity is that each cooperative retains its separate identity, including its patrons and goodwill. The new entity may also limit the liability of the founding cooperatives from liability arising from the transferred function. If the new entity is performing a function previously performed by the cooperative, then distributions from the entity are normally patronage sourced to the same extent as if the activity were performed by the cooperative.

(b)   

Distributions from Cooperatives

In Rev. Rul. 69-576,⁵³³1969-2 C.B. 166. Accord TAMs 9236001, 9211001. the IRS considered a nonexempt agricultural cooperative that borrowed funds from a bank for cooperatives to finance the purchase of agricultural supplies. At the end of the tax year of the bank for cooperatives, the bank paid patronage dividends to its patron-borrowers based on the amount of interest that they paid on their loans. As a patron-borrower, the agricultural cooperative received a patronage dividend from the bank. The IRS ruled that the patronage dividend was patronage sourced because the borrowed funds directly facilitated the cooperative's purchasing function.

Another example of a patronage-sourced patronage dividend appears in PLR 200209024, which involves a cooperative of credit unions. The cooperative was formed to provide services to its members that would allow them to enter into the credit card business. Specifically, the cooperative provided the means by which the credit unions could offer credit cards to their members without incurring substantial new labor costs and arranged a service center to provide services related to insurance and maintenance of credit cards. At first, the cooperative used private collection agents to recover funds on delinquent credit card accounts. Subsequently, the cooperative's board of directors decided to perform collection services for its members. The cooperative formed a subsidiary to operate the collection service in order to isolate itself from potential liability under the Fair Debt Collection Practices Act. The subsidiary was organized as a single-member cooperative. The parent cooperative submits its members' requests to the subsidiary, which performs the collection services. The subsidiary then remits the net proceeds to the parent cooperative for distribution to its member credit unions. Any amounts retained by the subsidiary during the year are paid to the parent cooperative as patronage dividends. The parent cooperative then passes the amount received from the subsidiary to its members in proportion to their use of the collection services. The IRS ruled that the patronage dividends received by the parent cooperative from the subsidiary cooperative would be patronage sourced.

(c)   

Distributions from Limited Liability Companies

In PLR 9846027,⁵³⁴Accord PLR 9846027. See also PLR 200123033 (distributive shares of three cooperatives that formed an LLC to conduct their manufacturing and wholesale activities would be patronage sourced because use of the LLC allowed the cooperatives better to serve their members by achieving economies of scale to reduce costs); PLR 9827043 and PLR 9827042 (where two cooperatives formed an LLC to combine their group purchasing services, their distributive shares received from the LLC were patronage sourced). two agricultural supply cooperatives deemed it advisable to combine their efforts to save costs and replace their obsolete plants and equipment. Some of their products are purchased from third parties and some, like fertilizer, are produced by the cooperatives. The cooperatives formed an LLC within which to conduct their joint efforts. The LLC leased a modern fertilizer plant and has purchased modern equipment. The cooperatives plan to close their individual fertilizer plants. The two cooperatives proposed that the LLC will acquire products from manufacturers and distributors, provide its own storage, and operate the fertilizer plant. The products will be sold by the LLC to the members of the two cooperatives. When the LLC distributes their distributive shares of its income to the two cooperatives, they will in turn pay patronage dividends to their members based on the amount of business each transacted with the LLC. The IRS ruled that the distributive shares received by the two cooperatives from the LLC constitute patronage-sourced income to the cooperatives because the formation and use of the LLC facilitates the cooperatives' supply function by obtaining economies of scale and optimizing profits.

In PLR 199920034, a cooperative owned a processing facility at which it processed its members' produce and then marketed the products. Anticipating potential future changing economic conditions due to increased competition and uncertain price supports, the cooperative proposes to purchase an interest in an LLC. The LLC is a successful processor and marketer of the produce that the cooperative processes and markets. By realigning itself with the LLC, the cooperative can achieve a 28% cost savings. The cooperative will transfer its processing facility and an amount of cash to the LLC in exchange for a 26 to 30% interest in the LLC. The cooperative will have supply agreements with its members under which the members will deliver their produce to the cooperative and the cooperative will undertake to process and market the resulting products. The cooperative will also contract with the LLC to process and market its members' produce. The cooperative's distributive share of the LLC's earnings attributable to the marketing of the cooperative's members' produce will be distributed among the members based on the number of tons the member sells to the cooperative. The IRS ruled that the portion of the cooperative's distributive share of the LLC's income that is attributable to processing and marketing its members' produce will be patronage sourced.

(d)   

Distributions from Limited Partnerships

PLR 200244013 involves a limited partnership that had two general partners and two limited partners, one of which was a cooperative. Under an existing arrangement, the cooperative purchased livestock from its members and sold the livestock to the limited partnership. The limited partnership processed and marketed the product. The cooperative proposes to transfer its buying function to the limited partnership. The consolidation of the purchasing, processing, and marketing functions in the same entity would increase efficiency and reduce costs by eliminating the multiple payment levels. The cooperative will allocate its distributive share of the partnership's income to the cooperative's patrons on the basis of the value of the livestock purchased by the limited partnership. The IRS ruled that the cooperative's activities through the limited partnership will be directly related to and would facilitate the accomplishment of the cooperative's business. Thus, the cooperative's distributive share of partnership income will be patronage sourced.

(a)   

Reg. §1.1388-1(a)(1)

Although the term “net earnings” for purposes of §1388(a)(3) is not expressly defined in the Code, Reg. §1.1388-1(a)(1) provides guidance for determining a patronage dividend by reference to net earnings. In general, net earnings represent the excess of amounts retained or assessed by a cooperative to cover expenses or other items over the actual amount of such expenses or other items.⁵⁴⁶Reg. §1.1388-1(a)(1) (flush language). The treatment of dividends on capital stock in determining net earnings is discussed at III, B, 2, b, (2), below. Net earnings are not reduced by any federal income tax imposed on a cooperative.⁵⁴⁷Reg. §1.1388-1(a)(1) (flush language). See, e.g., Farmers Union Cooperative Exchange v. Commissioner, 42 B.T.A. 1200 (1940) (cooperative not required to deduct federal taxes and penalties from patronage income in determining a patronage dividend). If a state imposes an income tax on a cooperative's nonmember income but not on its member income, the sales tax is subtracted solely from the nonpatronage income. Rev. Rul. 74-161, 1974-1 C.B. 247. The amount of the sales tax does not reduce the net patronage income for purposes of computing net earnings from patronage sources. Id.

Net earnings under §1388(a)(3) is a federal income tax concept. Thus, the starting point for determining a cooperative's net earnings from patronage sources is its gross income from business done with or for its patrons. ⁵⁴⁸The determination of a cooperative's income from business done with or for patrons is discussed at III, B, 1, above. The determination of a cooperative's gross income for federal income tax purposes is discussed at IV, A, 1, below. Net earnings are then determined by subtracting the allowable deductions attributable to business done with or for patrons.⁵⁴⁹The deductions allowable in determining a cooperative's taxable income (other than the deductions for distributions to patrons under §1382) are discussed at IV, A, 2, below. The deductions from net earnings are determined with reference to a cooperative's taxable income rather than its book income.

(b)   

Allocation of Expenses

The issue of proper allocation of expenses arises when both patronage and nonpatronage income are received.⁵⁵⁰See, e.g., Land O'Lakes, Inc. v. United States, 675 F.2d 988 (8th Cir. 1982) (allocation of labor costs between patronage and nonpatronage-sourced income derived from operation of retail food store). Expenses that are attributable solely to one category of income are allocated entirely to that category.

Expenses attributable to both categories of income are allocated between the two categories in calculating a cooperative's net earnings.⁵⁵⁴Certified Grocers of Cal., Ltd. v. Commissioner, 88 T.C. 238 (1987).

(a)   

Distributions in Tax Years Beginning After October 22, 2004

For distributions in tax years beginning after October 22, 2004, a cooperative is not required to reduce its net earnings by dividends paid on capital stock to the extent that the cooperative's articles, bylaws, or other contract with patrons provide that the dividends are in addition to amounts otherwise payable to patrons from patronage sources.⁵⁵⁷ §1388(a) (flush language). The foregoing rule, added by the American Jobs Creation Act of 2004 (2004 AJCA),⁵⁵⁸Pub. L. No. 108-357, §312(a). was intended to reverse the prior rule that required ratable allocation of capital stock dividends to patronage and nonpatronage income even if the cooperative's governing documents provide otherwise.⁵⁵⁹ Reg. §1.1388-1(a)(1) is superseded for post-Oct. 22, 2004 distributions to the extent that it requires an allocation. Payment of a capital stock dividend will not reduce a patronage dividend deduction when the dividend allocation rule does not apply.⁵⁶⁰The legislative history accompanying the 2004 AJCA states that, to the extent that capital stock dividends are in addition to amounts payable as patronage dividends, Congress believed that the capital stock dividends are not being paid from earnings from patronage business. H.R. Rep. No. 548, 108th Cong., 2d Sess. pt. 1 (2004).

By eliminating the dividend allocation rule, Congress sought to assist cooperatives in raising operating capital by issuing capital stock. Under the dividend allocation rule, the deduction of part of a cooperative's capital stock dividends from its patronage-sourced income reduces a cooperative's deduction for patronage dividends and increases its taxable income.⁵⁶¹Des Moines County Farm Service Co. v. United States, 324 F. Supp. 1216, 1218 (S.D. Iowa 1971), aff'd per curiam, 448 F.2d 776 (8th Cir. 1971). The 2004 amendment was designed to enable cooperatives to raise equity capital by issuing capital stock without dividends paid on such stock causing the cooperative to be taxed on a portion of its patronage income.⁵⁶²H.R. Rep. No. 548, 108th Cong., 2d Sess. pt. 1 (2004). The National Cooperative Business Association lauded the elimination of the dividend allocation rule, stating that the rule unduly penalized cooperatives seeking to raise capital by issuing nonvoting preferred stock. National Cooperative Business Association News Release (10/11/04), reprinted at www.ncba.org/pubs_newsrel.cfm?nrid+106. A contrasting view was presented in Des Moines County Farm Service Co. v. United States, 324 F. Supp. 1216, 1220 (S.D. Iowa 1971), aff'd per curiam, 448 F.2d 776 (8th Cir. 1971), in which a federal district court stated that the dividend allocation rule produced an equitable result. Because business done with or for member and nonmember patrons was equally profitable, the court saw no logical basis to charge capital stock dividends solely against profits attributable to nonmember business.

Note: To avoid the dividend allocation rule, the governing documents of a cooperative with capital stock must provide that dividends are in addition to amounts otherwise payable to patrons from patronage sources during a tax year.

(b)   

Distributions in Tax Years Beginning On or Before October 22, 2004

A cooperative's net earnings are reduced by dividends paid on capital stock or other proprietary capital interests.⁵⁶³Reg. §1.1388-1(a)(1). The IRS applied the dividend allocation rule well before the enactment of subchapter T. A.R.R. 6967, C.B. III-1 (1924), superseded by Rev. Rul. 68-228, 1968-1 C.B. 385, modified on another issue, Rev. Rul. 72-602, 1972-2 C.B. 510, modified, Rev. Rul. 93-21, 1993-1 C.B. 188. See also Farmers Union Cooperative Exchange v. Commissioner, 42 B.T.A. 1200 (1940) (setting forth the IRS's method for the treatment of capital stock dividends). In most cases, taxpayers were not successful in challenging the dividend allocation rule. E.g., Des Moines County Farm Service Co. v. United States, 448 F.2d 776 (8th Cir. 1971); FCX, Inc. v. United States, 531 F.2d 515 (Ct. Cl. 1976); Union Equity Cooperative Exchange v. Commissioner, 58 T.C. 397 (1972); Valparaiso Grain & Lumber Co. v. Commissioner, 44 B.T.A. 125 (1941). But see Mississippi Chem. Corp. v. United States, 197 F. Supp. 490 (S.D. Miss. 1961), aff'd, 326 F.2d 569 (5th Cir. 1964). A distribution to a patron is not a patronage dividend if it is paid in redemption of capital stock. Reg. §1.1388-1(a)(2)(iii). For distributions in tax years beginning on or before October 22, 2004, the deduction of capital stock dividends from patronage-sourced income reduces the cooperative's deduction for patronage dividends and increases its taxable income.⁵⁶⁴Des Moines County Farm Service Co. v. United States, 324 F. Supp. 1216, 1218 (S.D. Iowa 1971), aff'd per curiam, 448 F.2d 776 (8th Cir. 1971). As discussed at III, B, 2, b, (2), (b), above, Congress amended §1388(a) for distributions after October 22, 2004, to permit a cooperative to avoid application of the dividend allocation rule by including appropriate language in its governing documents.

Under the dividend allocation rule, a cooperative must ratably allocate the dividends paid on capital stock between the patronage and nonpatronage income.

(a)   

Use of Allocation Units

The activities of a cooperative may be segregated into divisions, departments, or other allocation units based on factors such as function, geography, or products. The issue of netting patronage losses and gains arises when a cooperative engages in both marketing and purchasing functions or when a cooperative maintains discrete divisions within a single function. A cooperative may market grain and also purchase farm supplies for its patrons. Or, a cooperative may market grain, livestock, and vegetables and account separately for the different products. ⁵⁶⁶ E.g., Eugene Fruit Growers Ass'n v. Commissioner, 37 B.T.A. 998 (1938) (exempt farmers cooperative that marketed products of fruit, vegetable, and nut growers accounted for each product annually in separate pool). If the patrons of the multiple allocation units are identical, then no patron is disadvantaged by netting losses from one unit against earnings from another unit. If, however, the patrons of the allocation unit with a net loss are different from the patrons of the allocation unit with net earnings, then patrons from the profitable unit may feel that their distributions should not be affected by the losses from another unit.

In applying the netting procedure, the terms “patronage earnings” and “patronage losses” refer to earnings and losses derived from business done with or for patrons.⁵⁶⁷§1388(j)(4). Section 1388(j)(1) does not authorize netting between patronage and nonpatronage activities. Thus, a cooperative may not apply patronage losses against nonpatronage income in order to reduce the taxable nonpatronage income. ⁵⁶⁸ See Farm Serv. Coop. v. Commissioner, 619 F.2d 718 (8th Cir. 1980), rev'g 70 T.C. 145 (1978) (nonexempt cooperative could not offset taxable income with patronage-sourced losses); Certified Grocers v. Commissioner, 88 T.C. 238, 245–47 (1987) (nonpatronage-sourced interest income of nonexempt cooperative could not be offset by patronage-sourced interest expense for purposes of determining patronage dividend deduction); Thwaites Terrace House Owners Corp. v. Commissioner, T.C. Memo 1996-406 (nonexempt cooperative housing corporation could not offset nonpatronage interest income with patronage deductions). Similarly, a cooperative may not apply nonpatronage losses against patronage income.⁵⁶⁹E.g., TAM 8707005.

(b)   

Notice Requirements

Section 1388(j)(3) sets forth notice requirements that a cooperative must satisfy when netting patronage gains and losses from different allocation units in any tax year. On or before the 15th day of the ninth month following the close of the tax year, a cooperative using a netting procedure must provide a written notice to its patrons stating the following: ⁵⁷⁰§1388(j)(3)(A). The deadline for providing the notice may be extended if a cooperative is affected by federally declared disasters, significant fires (for which assistance is provided after November 15, 2021), or terroristic or military actions. §7508A(a), as amended by the Infrastructure Investment and Jobs Act, Pub. L. No. 117-58, §80504. See Reg. §301.7508A-1; Rev. Proc. 2018-58, §4.01; §6.32. See 627 T.M., Limitations Periods, Interest on Underpayments and Overpayments and Mitigation. The acts whose deadlines may be postponed are listed in Reg. §301.7508A-1(c), and in Tables, Charts and Lists (Federal), Postponements, Postponements Due to Combat Zone or Contingency Operation Service, Federally Declared Disasters, Significant Fires, or Terroristic or Military Actions.

A special rule protects against having to reveal sensitive commercial information in the notice of netting patronage gains and losses. When stating the identities of the offsetting allocation units, a cooperative may omit any detailed or specific data regarding earnings or losses of such allocation units that the organization determines would disclose sensitive commercial information that could either result in a competitive disadvantage to the cooperative or create a competitive advantage for a competitor.⁵⁷¹§1388(j)(3)(B).

The IRS is required to notify a cooperative that has failed to provide sufficient notice of the netting of patronage gains and losses.⁵⁷² §1388(j)(3)(C)(i). Upon receipt of the notification, the cooperative must issue a revised notice that satisfies the statutory requirements.⁵⁷³§1388(j)(3)(C)(ii). Any failure to give sufficient notice by an exempt farmers cooperative will not affect its exemption under §521.⁵⁷⁴§1388(j)(3)(C) (flush sentence).

(a)   

Requirements for Consent

(b)   

Application and Revocation

A written consent applies to all patronage of a consenting distributee during the tax year of the cooperative in which the consent is made. A cooperative does not have to obtain a written consent for every tax year.⁶³⁵§1388(c)(3)(A)(i). The written consent continues in effect for all subsequent years, unless it is revoked.⁶³⁶Reg. §1.1388-1(c)(3)(i). Written consent may be revoked at any time.⁶³⁷§1388(c)(3)(B)(i). Like a written consent, an effective revocation of a written consent must be in writing, signed by the patron, and furnished to the cooperative.⁶³⁸Reg. §1.1388-1(c)(3)(i). A revocation is effective with respect to patronage occurring on or after the close of the tax year of the cooperative during which the revocation is filed with the cooperative.⁶³⁹§1388(c)(3)(B)(i).

(c)   

Special Rule for Pooling Arrangements

When calculating a cooperative's deduction for patronage dividends and redemption of nonqualified notices of allocation, a special rule applies for determining the date of patronage in the case of pooling arrangements. When a cooperative employs a pooling arrangement, patronage is deemed to occur during the tax year in which the pool closes.⁶⁴⁰§1382(e)(1). The special rule for pooling arrangements also applies for purposes of determining the patronage to which a written consent applies. ⁶⁴¹§1388(c)(3)(A)(i), §1388(c)(3)(B)(i) (references to §1382(e)(1)). Thus, a written consent made at any time before the close of the tax year of the cooperative during which the pool closes is effective with respect to all patronage under that pool.⁶⁴²Reg. §1.1388-1(c)(3)(i). If a distributee subsequently revokes a written consent, the revocation is not effective for patronage with any pool in which the distributee participated before the revocation.⁶⁴³§1388(c)(3)(B)(i).

(a)   

Requirements for Consent

(b)   

Application and Revocation

A consent by membership is effective with respect to all patronage occurring after the distributee has received the requisite notification and copy of the bylaw.⁶⁵⁹§1388(c)(3)(A)(ii). A consent by membership is not effective with respect to any patronage occurring after the patron ceases to be a member of the cooperative or after repeal of the bylaw provision regarding consent. ⁶⁶⁰§1388(c)(3)(B)(ii).

Rev. Rul. 73-93⁶⁶¹1973-1 C.B. 292. illustrates the application of the provisions for consent by membership in the context of a deceased patron. Before his death, a patron had consented by membership to take into income the face amount of written notices of allocation issued to him by the cooperative. After the patron died, an administrator was appointed to administer his estate. The deceased member's consent was effective for a written notice of allocation sent to the estate with respect to business conducted for the portion of the year before his death.⁶⁶²Id. at 293. The consent of the deceased member was not effective, however, with respect to additional allocations. In order to deduct additional written notices of allocation, the cooperative must obtain the consent of the estate.⁶⁶³Id.

(c)   

Special Rule for Pooling Arrangements

When calculating a cooperative's deduction for patronage dividends and redemption of nonqualified notices of allocation, a special rule applies for determining the date of patronage in the case of pooling arrangements. When a cooperative employs a pooling arrangement, patronage is deemed to occur during the tax year in which the pool closes.⁶⁶⁴§1382(e)(1). The special rule for pooling arrangements does not apply when determining the occurrence of patronage for purposes of consent by membership.⁶⁶⁵§1388(c)(3)(A)(ii), (B)(ii) (references to §1382(e)(1)0. Thus, consent by membership of a participant in a pool is effective with respect to patronage occurring after the participant receives the requisite notification and bylaw copy and while the participant is a member of the cooperative.⁶⁶⁶Reg. §1.1388-1(c)(3)(ii)(a). Such consent is ineffective for patronage under a pool after the distributee ceases to be a member or after repeal of the bylaw. ⁶⁶⁷ Id.

(a)   

Requirements for Consent

The third form of consent is consent by qualified check. A distributee may consent to take the stated dollar amount of a written notice of allocation into gross income by endorsing and cashing a qualified check⁶⁶⁸The term “qualified check” is defined in §1388(c)(4) and discussed at III, D, below. under the following conditions:⁶⁶⁹§1388(c)(2)(C). The tax treatment of a patronage dividend paid by qualified check is illustrated by example in V, B, 2, a, below.

A qualified check is presumed to be endorsed and cashed within the 90-day period if the earliest bank endorsement appearing on the check bears a date no later than three days after the end of the 90-day period, excluding weekends and legal holidays.⁶⁷³Reg. §1.1388-1(c)(3)(iii)(a).

(b)   

Land O'Lakes, Inc. v. United States

Section 1388(c)(2) provides the three methods by which a “distributee” may give consent to take into account a written notice of allocation. The term “distributee” was construed in the context of consent by qualified check. Land O'Lakes, Inc. v. United States⁶⁷⁴675 F.2d 988, 82-1 USTC ¶ 9326 (8th Cir. 1982), aff'g in part and rev'g in part, 470 F. Supp. 238 (D. Minn. 1979), on remand from 514 F.2d 134 (8th Cir. 1975), cert. denied, 423 U.S. 926 (1975), rev'g and rem'g 362 F. Supp. 1253 (D. Minn. 1973). involved a cooperative that sold feed and fertilizer to its members or to independent dealers, called agent-buyers. The agent-buyers in turn sold the supplies to farmer-customers. Under a contract with the cooperative, the agent-buyers agreed that patronage dividends otherwise payable to the agent-buyers, as patrons of the cooperative, would be paid directly to the farmer-customers based on sales slips forwarded to the cooperative by the agent-buyers. The IRS disallowed a deduction for patronage dividends paid by qualified check to the farmer-customers because, inter alia, the agent-buyers did not consent to include the payments in their income. According to the government, the term “distributee” as used in §1388(c)(2) refers to the patrons of a cooperative and therefore would require the agent-buyers, as patrons of the cooperative, to give their consent by one of the authorized methods. The Eighth Circuit adopted a broader construction of the term “distributee.” According to the court, the purpose of subchapter T is to ensure that patronage income is taxed at the distributee level if the cooperative deducts a distribution. The statutory intent is fulfilled if the farmer-customers consent to include the patronage dividends in their income.⁶⁷⁵675 F.2d at 991. The court held that patronage dividends paid to the farmer-customers pursuant to the agent-buyer agreements were property deductible by the cooperative because the farmer-customers gave the required consent by endorsing and cashing their qualified checks.⁶⁷⁶Id.