PLR 200852022: A marketing cooperative's advance payments count toward its section 199 deduction

Plain-English summary

A farmer cooperative pays its members in stages across the year. There are advances near the end of each month, monthly settlement checks that true up the prior month, a thirteenth check that closes out the marketing year, and finally a patronage dividend representing the profit from the cooperative's own processing plants. The first three together are what this cooperative calls the commodity check.

For accounting purposes the cooperative buries the commodity check in inventory rather than showing it as a payment. It uses the closed pool method, so product left on hand at year end is sold forward into next year's pool at lower of cost or market. The result is that only the final patronage dividend shows up in net income, on the financial statements and on the tax return alike. On Form 1120-C, per-unit retains paid in money land in Schedule A, which is cost of goods sold, not on a deduction line.

That presentation raised the question. The section 199 domestic production deduction is computed at the cooperative level without regard to the subchapter T deductions, which means patronage dividends and per-unit retain allocations get added back before the deduction is figured. If the commodity check is sitting inside cost of goods sold instead of on a deduction line, is it still one of the payments that gets added back?

The Service ruled yes. The commodity check qualifies as a per-unit retain allocation under section 1388(f) and is a per-unit retain paid in money under section 1382(b)(3). It is paid with respect to commodity the cooperative markets for its patrons, it is measured by the quantity delivered rather than by the cooperative's net earnings, it is paid under a pre-existing contractual obligation, and it is paid within the section 1382(d) payment period. So the cooperative should include all net proceeds payments, the commodity check and the patronage dividend both, in computing its section 199 amount. Where a payment appears on the return does not change what it is.

The letter is unusually instructive for a private ruling and spends much of its length explaining the surrounding machinery. It walks through the pooling mechanics, explains why section 1382 is awkwardly drafted and what its flush language actually accomplishes, and it warns about a trap: if per-unit retains are capitalized into inventory and also deducted, they get deducted twice. The cure is to include them in inventory for section 263A purposes and then back them out of either the ending inventory or the deduction line, one or the other, so the deduction is taken once and the section 263A computation stays intact.

It also spells out the one-way street on the patron side. A patron may never count a qualified payment received from a cooperative in the patron's own section 199 computation. The only route to a patron-level deduction is for the cooperative to pass its section 199 amount through under section 199(d)(3), and if it does, the cooperative must reduce what it would otherwise deduct under section 1382(b).

This is a clean digital release rather than a scan, so no OCR correction was needed. Several drafting slips are kept verbatim as released: "Coop also owns operates several plants," "based on Coops patronage sourced net proceeds," "growth, or extracted (MPGE)," "in the case of a cooperative engaged in the marketing agricultural and horticultural products," and "the cooperative remains entitled to claim the entire section 199 deduction of its return." The commodity marketed, the cooperative's name, its state, its geographic area, its member count and its year end are behind IRS redaction and appear below as letters and dashes.

Ruling snapshot

• Question: Does a pooling cooperative include the advance and settlement payments it capitalizes into inventory, not just its patronage dividend, when computing the section 199 deduction?
• Outcome: approved. The commodity check is a per-unit retain paid in money under section 1382(b)(3), and the cooperative should include all net proceeds payments, commodity check and patronage dividend alike, in its section 199 computation.
• Key authorities: Code sections 199(d)(3), 199(d)(3)(A)(ii), 199(d)(3)(B), 199(d)(3)(D), 199(d)(3)(F), 263A, 1382(a), 1382(b), 1382(b)(1), 1382(b)(3), 1382(b)(4), 1382(d), 1382(e), 1383, 1385(a), 1388(a), 1388(d), 1388(f); Treas. Reg. sections 1.199-6(c), 1.199-6(e), 1.199-6(k), 1.199-6(l), 1.1382-2(b)(1), 1.1382-3(c)(2).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200852022 [Third Party Communication:
Release Date: 12/26/2008 Date of Communication: Month DD, YYYY] Index Number: 1382.00-00, 199.06-00 Person To Contact:
------------------- ----------------------------, ID No. --------------

------------------------------------------------------------ Telephone Number:

-------------------------------------------- Refer Reply To:
-------------------------------- CC:PSI:B05
-- PLR-124583-08
Date:
September 17, 2008

LEGEND:

Coop = ------------------------------------------------------------------------
---------------------------------------

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

Geographic Area = ---------------

b = ------

c = ------

d = ------------------

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

This is in response to a request for ruling dated May 28, 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 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. The members of Coop are b farmers in Geographic Area who deliver their c to Coop. The members enter into a Marketing Agreement with Coop under which they agree to deliver c in accordance with the Bylaws. Coop operates in accordance with its Articles of Incorporation and its Bylaws to process and market c and b products for its members. Members are located throughout the Geographic Area.

Coop has a d year end. At the end of each year Coop computes its net proceeds and distributes patronage income to its members.

Coop also owns operates several plants that process the c into value-added products and is a majority owner of another plant operated as an LLC. Those products are then marketed throughout the Geographic Area. Coop’s c marketing and value- added businesses work to fulfill Coop’s mission to maximize member returns.

All member c and b products received by Coop are commingled with other member’s products and pooled. The duration of the pools is the Coop’s fiscal year unless Coop chooses another period. Coop has consistently used an annual pool.

The Coop’s Marketing Agreements and Bylaws clearly state that the cooperative must distribute the net proceeds on a patronage basis, but like many other c cooperatives around the country, Coop has capitalized a portion of the net proceeds, known as the “c Check,” into inventory.

Net proceeds from marketing c and c products consist of four components, the first three of which is referred to by Coop as the c Check. The four components are: (1) Advances are made on or around the last day of the month based on the producer’s c pounds delivered during the first 15 days of the month; (2) monthly settlement checks are paid on or about the fifteenth day of the following month, representing the prior month’s actual net proceeds less advances; (3) the thirteenth check is a final settlement payment attributable to marketing c paid after the close of the year; (4) the patronage dividend representing profit from Coop’s manufacturing and processing operations. The first three components emanate from the c marketing element and the residual net proceeds represent the profit from manufacturing and processing of c into finished products from the plants.

All four components are paid to Coop’s members under the Bylaws and are based on Coops patronage sourced net proceeds. The computation of advances, settlement payments, and the thirteenth check are determined using Generally Accepted Accounting Principles. The final payment or patronage dividend is determined under a federal taxable income basis.

As further discussed later, the advances, the twelve monthly settlement checks and the thirteenth check together comprising the c Check are treated as per unit retains paid in money (PURPIMs) under federal tax law.

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 lower of cost or market (LCM), 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 co-mingle 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 LCM. Effectively the cooperative is selling inventory forward to the next year and measuring its year end profit at 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.

The financial statements for Coop 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 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.

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 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).

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 that 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 section 1.199-6 is 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 received from the cooperative in the patron’s 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:

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
Chief, Branch 5
Office of the Associate Chief Counsel
(Passthroughs & Special Industries)