PLR 200843016: Cooperative could add member checks back for § 199 calculation

Plain-English summary

An agricultural cooperative and its cooperative subsidiary processed and marketed members’ commodity deliveries through an annual closed pool. Members received periodic checks as advances on net proceeds and a final patronage dividend after year-end results were known. The checks were based on quantity delivered, arose under preexisting marketing agreements, did not depend on net earnings, and were paid within the statutory payment period. The IRS treated the checks as per-unit retain allocations paid in money under § 1382(b)(3). For the cooperative’s § 199 calculation, all net-proceeds payments and allocations, including those checks and patronage dividends, could be added back as provided by § 199(d)(3). The ruling also explained that inventory and cost-of-goods-sold adjustments must prevent a duplicate deduction.

Ruling snapshot

• Question: Could the cooperative treat its periodic commodity checks as cash per-unit retain allocations and add them back in computing its § 199 deduction?
• Outcome: Approved. The checks qualified under § 1382(b)(3), and all qualifying net-proceeds payments entered the § 199 computation.
• Key authorities: IRC §§ 199(d)(3), 1382, 1383, 1385, 1388(f); Treas. Reg. §§ 1.199-6, 1.1382-2, 1.1382-3

Full text (IRS public release)

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Internal Revenue Service Department of the Treasury
Washington, DC 20224

            Number: 200843016                                              [Third Party Communication:
            Release Date: 10/24/2008                                        Date of Communication: Month DD, YYYY]
                                                                             Person To Contact:
            Index Number: 1382.00-00, 199.06-00                              ----------------------------, ID No. -------------
                                                                             Telephone Number:
                                                                             ---------------------
            ----------------------------                                     Refer Reply To:
            -------------------------------------------------                CC:PSI:B05
            --------------------                                             PLR-114589-08
            -------------------                                              Date:
            --------------------                                             July 21, 2008
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              LEGEND:

              Coop                                =         ---------------------
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              Sub                                 =        ---------------------------------------

              State A                             =        -------------

              State B                             =        ------------

              States                              =         -----------------------------------------------------------------------
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              b                                   =        ------

              c                                   =        ------



              Dear ------------------:

                    This is in response to a request for ruling dated March 26, 2008, submitted by
              your authorized representative. The ruling concerns the interplay of the rules in
              subchapter T of the Internal Revenue Code (concerning the taxation of cooperatives

PLR-114589-08 2

and their patrons) and the calculation of the section 199 deduction for certain
cooperatives contained in section 199(d)(3).

     Coop is a nonexempt agricultural cooperative corporation organized and existing

under the laws of the State A. Sub is a wholly owned subsidiary of Coop and is a
nonexempt agricultural cooperative corporation organized and existing under the laws
of State B. Coop and Sub process and market b products for the b farmer members of
Coop. The members of Coop are b farmers in States who deliver their c to Coop.
Coop operates several plants and also transfers members’ c to Sub as needed for
processing in its plant. Coop represents that all intercompany transactions are properly
eliminated in the consolidated return. Sub also processes the c into a variety of
products and then markets those products. Coop and Sub have a ----------------------------
------------------------------------------------------------------------------------------------------year end.
At the end of each year, Coop and Sub compute their respective net proceeds. Sub
distributes the patronage income to its parent, Coop, for distribution to its members
along with Coop’s patronage income.

  The Coop’s Member Marketing Agreements and Bylaws clearly state that the

cooperative must distribute the net proceeds, but like many other c cooperatives around
the country, Coop and Sub have capitalized a portion of the net proceeds, known as the
“c Check,” into inventory.

   The Member Marketing Agreement states in Section 7 that all member b

products received by the cooperative may be mingled with other members’ products
and pooled. The duration of the pools will be Coop’s fiscal year. Coop has consistently
used an annual pool beginning on ---------------- and ending on ------------------. The
Bylaws in Section 11.2 defines the “net proceeds” of the cooperative as “all net amounts
realized from the sale of [c] of members and from any other members’ patronage
sources.” None of the payments to the members are included in the “net proceeds”
computation. Section 11.2 of the Bylaws also sets the pre-existing legal obligation of
the cooperative to pay the members their proportionate share of the net proceeds based
on their deliveries of c.

   Coop makes payments to its patrons each year pursuant to the Member

Marketing Agreement and Bylaws, the terms of which provide, in substance, that it pays
the patrons its patronage source net proceeds computed on a book basis. Because c is
delivered daily throughout the year, the Marketing Agreement provides that the member
receives one or more advances following delivery and acceptance of the member’s c.
Coop has historically made payments to the members on or about the 5th and 20th of
each month for deliveries in the previous month for these advances. These payments
are also known as the “c Check”. This advance amount keeps the cooperative
competitive with non-cooperative c processors. But as the Member Marketing
Agreement and Bylaws clearly state, this amount is merely an advance on the ultimate
net proceeds due to the member under the Agreement and Bylaws.
PLR-114589-08 3

   At the end of the year, Coop distributes the remaining amount of net proceeds to

the patrons. As will be discussed below, for federal tax purposes, the advance
payments, or c Checks, are considered advances on the net proceeds and treated as
“per-unit retains paid in money.” The final payment is made after the audited financial
statements are approved by the Board of Directors for the remaining amount of the
actual net proceeds for the c marketed during the underlying fiscal year. The final
payment is considered a “patronage dividend” for federal income tax purposes, and
there is a requirement that at least 20 percent of the patronage dividend be paid in cash
and the remainder in qualified written notices of allocation for the full amount to be
deductible by the Coop and includible in the income of the patrons. Coop also uses
per-unit retains deducted from the members c Checks for capital purposes.

   As described in the Member Marketing Agreement, Coop operates, as many

marketing cooperatives around the country do, as a pooling cooperative. In general, a
pooling cooperative is a marketing cooperative that segregates the patronage product
received during the year into a pool. A pool opens as deliveries of a product are made,
and closes after all, or substantially all, of the product is sold or disposed of. In some
cases, a cooperative will leave the pool open into the next year, called the “open pool”
method. In other cases where sufficient information is available, the cooperative will
close the pool at its year end and sell the remaining patronage product in inventory
forward to the next year’s pool at the product’s value determined at the lower of cost or
market, called the “closed pool” method. The cooperative distributes the net proceeds
from the sale of each pool to the patrons generally in proportion to the volume of the
commodity delivered to the pool. Pooling is essentially a risk sharing device. Rather
than each patron separately selling his or her product for a market price at the time of
delivery, all patrons commingle their product and share the revenues and expenses of
processing and selling. In effect, each producer receives an average price.

    Coop’s pooling arrangement is such that a separate pool is opened with each

fiscal year. Coop is using the “closed pool” method in its financial statement and tax
return accounting. Coop has always capitalized into inventory the c Check payments.
Thus, the ending inventory includes the capitalized c Check amount adjusted for the
lower of cost or market. Effectively the cooperative is selling inventory forward to the
next year and measuring its year end profit at the lower of cost or market (LCM). This
means that the product on hand at the end of the year is sold forward to the next year’s
pool at the LCM and the next year’s pool will get any benefit or cost of a difference
between the LCM and the actual amount realized on the c products.

   Coop’s financial statements reflect the c Check payments to members as part of

the inventory cost of the cooperative and, therefore, only the final payment, or
patronage dividend, is reflected as part of the net income. The presentation on the tax
return is the same as the financial statements. Form 990-C (and the new Form 1120-C)
requires the cooperative to report per-unit retains paid in money in Schedule A (cost of
PLR-114589-08 4

goods sold). As will be discussed below, this does not change the fact that the full
amount of the c Check and patronage dividend are section 1382(b) payments and may
be deducted on the income tax return and may be added back for purposes of
computing the section 199 deduction.

    Nonexempt subchapter T cooperatives are permitted to exclude or deduct

distributions to their patrons that qualify as patronage dividends or per-unit retain
allocations, provided those distributions otherwise meet the requirements of subchapter
T of the Code.

   Section 1388(f) of the Code defines the term “per-unit retain allocation” to mean

“any allocation, by an organization to which Part I of this subchapter applies, to a patron
with respect to products marketed for him, the amount of which is fixed without
reference to net earnings of the organization pursuant to an agreement between the
organization and the patron.”

    Per-unit retain allocations (PURs) may be made in money, property or

certificates. Per-unit retain allocations paid in money (PURPIMs) and in property are
excludable or deductible under section 1382(b)(3) of the Code. Per-unit retain
allocations paid in certificates are deductible under section 1382(b)(3) if the certificates
are qualified. If the certificates are nonqualified, the cooperative is permitted a
deduction under 1382(b)(4) (or a tax benefit figured under section 1383) when the
certificates are later redeemed.

    Section 1388(a)(1) of the Code provides that the term “patronage dividend”

means an amount paid to a patron by a cooperative on the basis of the quantity or value
of business done with or done for such patron. Section 1388(a)(2) provides that a
“patronage dividend” is an amount paid “under an obligation” that must have existed
before the cooperative received the amount so paid. Section 1388(a)(3) provides that
“patronage dividend” means an amount paid to a patron that is determined by reference
to the net earnings of the cooperative from business done with or for its patrons. That
section further provides that a “patronage dividend” does not include any amount paid to
a patron to the extent that such amount is out of earnings other than from business
done with or for patrons. Section 1.1382-3(c)(2) of the Income Tax Regulations states
that income derived from sources other than patronage means incidental income
derived from sources not directly related to the marketing, purchasing, or service
activities of the cooperative association.

   Section 1382(a) of the Code provides that except as provided in section 1382(b),

the gross income of any cooperative shall be determined without any adjustment (as a
reduction in gross receipts, an increase in cost of goods sold, or otherwise) by reason of
any allocation or distribution to a patron out of net earnings or by reason of any amount
paid to a patron as per-unit retain allocations.
PLR-114589-08 5

    Section 1382(b)(1) of the Code provides, in part, that in determining the taxable

income of a cooperative there shall not be taken into account amounts paid during the
payment period for the taxable year as patronage dividends to the extent paid in money,
qualified written notices of allocation, or other property with respect to patronage
occurring during such taxable year.

    Section 1.1382-2(b)(1) provides, in part, that there is allowed as a deduction from

the gross income of any cooperative to which part I of subchapter T applies, amounts
paid to patrons during the payment period for the taxable year as patronage dividends
with respect to patronage occurring during such taxable year, but only to the extent that
such amounts are paid in money, qualified written notices of allocation, or other property
(other than nonqualified written notices of allocation). Section 1388(d) of the Code
defines the term “nonqualified written notices of allocation” as meaning a written notice
of allocation other than a qualified written notice of allocation, or a qualified check that is
not cashed on or before the 90th day after the close of the payment period for the
taxable year for which the distribution of which it is part is paid.

  Section 1382(b)(3) of the Code provides, in part, that in determining the taxable

income of a cooperative there shall not be taken into account amounts paid during the
payment period for the taxable year as per-unit retain allocations paid in money, other
property, or qualified certificates with respect to marketing occurring during such taxable
year.

   Section 1382(e) of the Code provides that for purposes of section 1382(b), in the

case of a pooling arrangement for marketing products, the patronage shall be treated as
occurring during the taxable year the pool closes, and the marketing of products shall
be treated as occurring during any taxable years the pool is open.

   Though section 1382 of the Code is awkwardly drafted, the flush language of

section 1382(b) clarifies what it means for an item not to be “taken into account.” It
states that, “for purposes of this title,” a patronage dividend is treated as “an item of
gross income and as a deduction therefrom,” and a per-unit retain allocation in money
or qualified certificates are treated as a “deduction in arriving at gross income.”

   Section 1382(d) of the Code provides, in part, that the payment period for any

taxable year is the period beginning with the first day of such taxable year and ending
with the fifteenth day of the ninth month following the close of such year.

    Thus, per-unit retain allocations paid in money or qualified certificates are

deductions in arriving at gross income if paid with respect to an open pool within the
payment period for the taxable year. Because patronage dividends paid in money and
qualified certificates are treated as deductions in arriving at gross income, Form 990-C
(and new form 1120-C) requires such dividends to be reported on Schedule H as a
deduction from gross income. Because a per-unit retain allocations paid in money or
PLR-114589-08 6

qualified certificates are treated as a “deduction in arriving at gross income” they are
reported on Schedule A of the Form 990-C which represents the cooperative’s cost of
goods sold. This does not change the fact that Coop is allowed a full deduction under
section 1382(b) of the Code for per-unit retains paid in money or qualified certificates.

   We note that to prevent a cooperative from deducting the per-unit retain

allocations made in money or qualified certificates for the second time when the
associated product is sold, the cost of goods sold mechanism associated with inventory
must be adjusted to reflect the deductions allowable under subchapter T. Specifically,
cooperatives need to include the PURs in inventory cost for purposes of making
inventory and section 263A of the Code computations and then adjust the ending
inventory and cost of goods sold to prevent double deduction of the PURs. The
adjustments can be made to either the inventory or the line item deduction for the
PURs. In other words, if the PURs are deducted on a deduction line in the
cooperative's tax return, they should be removed entirely from the ending inventory and
cost of goods sold computed for the tax year. Alternatively, if the PURs are not
deducted on a deduction line in the tax return, the PURs reflected in the ending
inventory should be removed and included in the cost of goods sold amount for that tax
year. This procedure will allow the cooperative to deduct the PURs once while also
preserving the integrity of its section 263A calculation.

    Under section 199(d)(3) of the Code, patrons that receive a qualified payment

from a specified agricultural and horticultural cooperatives are allowed a deduction for
an amount allocable to their portion of the qualified production activities income (QPAI)
of the organization received as a qualified patronage dividend or per-unit retain
allocation which is paid in qualified per-unit retain certificates. In particular, section
199(d)(3)(F) requires the cooperative to be engaged in the manufacturing, production,
growth, or extracted (MPGE) in whole or significant part of any agricultural or
horticultural product, or in the marketing of agricultural or horticultural products. Under
section 199(d)(3)(D), in the case of a cooperative engaged in the marketing agricultural
and horticultural products, the cooperative is treated as having MPGE in whole or
significant part any qualifying production property marketed by the cooperative that its
patrons have MPGE (this is known in the industry as the “cooperative attribution rule”).
In addition, section 199(d)(3)(A)(ii) requires the cooperative to designate the patron’s
portion of the income allocable to the QPAI of the organization in a written notice mailed
by the cooperative to its patrons no later than the 15th day of the ninth month following
the close of the tax year.

    Under section 1.199-6(c), for purposes of determining a cooperative’s section

199 deduction, the cooperative’s QPAI and taxable income are computed without taking
into account any deduction allowable under section 1382(b) or (c) of the Code (relating
to patronage dividends, per-unit retain allocations, and nonpatronage distributions).
PLR-114589-08 7

   An agricultural or horticultural cooperative is permitted to “pass-through” to its

patrons all or any portion of its section 199 deduction for the year provided it does so in
the manner and within the time limits set by section 199(d)(3) of the Code. When a
cooperative passes-through all or any portion of the section 199 deduction, the
cooperative remains entitled to claim the entire section 199 deduction of its return
(provided that it does not create or increase a patronage tax loss), but is required under
section 199(d)(3)(B) to reduce the deduction or exclusion it would otherwise claim under
section 1382(b) for per-unit retain allocations and patronage dividends.

   Section 1.199-6(l) provides: “No double counting. A qualified payment received

by a patron of a cooperative is not taken into account by the patron for purposes of
section 199.”

   Section 1.199-6(e) defines the term qualified payment to mean any amount of a

patronage dividend or per-unit retain allocation, as described in section 1385(a)(1) or (3)
of the Code received by the patron from a cooperative, that is attributable to the portion
of the cooperative’s QPAI, for which the cooperative is allowed a section 199 deduction.
For this purpose, patronage dividends and per-unit retain allocations include any
advances on patronage and per-unit retains paid in money during the taxable year.

  Section 1.199-6(k) provides that the final regulations are the exclusive method for

the cooperative and its patrons to compute the amount of the section 199 deduction.

    The effect of these sections is that the cooperative will compute the entire section

199 deduction at the cooperative level and that none of the distributions whether
patronage dividends or per-unit retain allocations received from the cooperative will be
eligible for section 199 in the patron’s hands. That is, the patron may not count the
qualified payment he receives from the cooperative in his own section 199 computation
whether or not the cooperative keeps or passes through the section 199 deduction.
Accordingly, the only way that a patron can claim a section 199 deduction for a qualified
payment received from a cooperative is for the cooperative to pass-through the section
199 amount in accordance with the provisions of 199(d)(3) of the Code and the
regulations thereunder.

   Coop’s c Checks qualify as per-unit retain allocations within the meaning of

section 1388(f) of the Code because they were distributed with respect to c that Coop
markets for its patrons, and by the fact that the patrons receive the payments based on
the quantity of c delivered; the c Checks are determined without reference to the Coop’s
net earnings; the c Checks were paid pursuant to a contract with the patrons
establishing the necessary pre-existing agreement and obligation; and the c Checks
were paid within the payment period of section 1382(d).

   Based on the foregoing, we rule as requested that:

PLR-114589-08 8

  Section 199(d)(3) of the Code allows certain payments from the
  cooperative to its patrons to be added back for purposes of computing the
  section 199 amount. Coop should include all “net proceeds” payments or
  allocations, including the c Check and patronage dividend, in its
  computation of the section 199 amount. Specifically, the c Check is
  considered a per-unit retain paid in money under section 1382(b)(3).

   This ruling is directed only to the taxpayer that requested it. Under section

6110(k)(3) of the Code it may not be used or cited as precedent. In accordance with a
power of attorney filed with the request, a copy of the ruling is being sent to your
authorized representative.

                                       Sincerely yours,

                                       Paul F. Handleman

                                       Paul F. Handleman
                                       Chief, Branch 5
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

cc:
~~~