PLR 1041004: The IRS classified a cooperative's grain payments as per-unit retain allocations

Plain-English summary

The IRS ruled that a farmers' cooperative's cash payments to members for grain marketed through the cooperative were per-unit retain allocations paid in money under IRC § 1382(b)(3) and § 1388(f). The cooperative could therefore disregard those payments when computing its own section 199 domestic production activities deduction, rather than treating them as ordinary purchase costs for that computation. The ruling also explains that the cooperative's members could not count those qualified payments in their own section 199 computations unless the cooperative passed through a portion of its deduction under section 199(d)(3). The conclusions were limited to grain marketed during the tax year and did not cover grain remaining in year-end inventory or payments to nonmembers and nonpatrons.

Ruling snapshot

• Question: Are the cooperative's cash grain payments to members per-unit retain allocations paid in money, and may they be disregarded in the cooperative's section 199 computation?
• Outcome: Approved
• Key authorities: IRC §§ 1382(b)(3), 1388(f), and 199(d)(3); Treas. Reg. §§ 1.199-6, 1.1382-3, and 1.1388-1; IRC § 6110(k)(3)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201041004 Third Party Communication: None
Release Date: 10/15/2010 Date of Communication: Not Applicable
Index Number: 1382.00-00, 199.06-00
Person To Contact:
------------------- ----------------------------, ID No. ----------
------------------------------------ Telephone Number:
------------------------------ ---------------------
------------------------------- Refer Reply To:
-------------------------------- CC:PSI:B05
PLR-104573-10
Date:
July 9, 2010

LEGEND:

Taxpayer = -------------------------------

State A = ------

Company B = ---------------------------------------------------------------------------------

Company C = ------------------------------------------------

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

  This is in response to a request for rulings dated January 27, 2010, submitted by

your authorized representative. The rulings concern 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).

  Taxpayer is a farmers’ cooperative organized under the State A Cooperative Law.

Taxpayer is a local grain marketing and farm supply cooperative. Taxpayer serves
farmers through a network of --- facilities located in a-------county area in State A.

     Taxpayer traces its history back to Company B, which was formed in -------. It

changed its name to Taxpayer in -------. Over the years, it has been involved in a series
of mergers with neighboring cooperatives. The current corporate entity resulted from a -
------- consolidation with Company C.
PLR-104573-10 2

     Taxpayer markets grain for its farmer members and for other patrons. During its

fiscal year ended -----------------------, Taxpayer’s grain sales were approximately $--------
million. Principal commodities marketed in ------- were corn ($-------million), soybeans
($-------million), and wheat ($-------million). Taxpayer also marketed a small amount of
oats ($---------). Taxpayer also provides its members and other patrons with a broad
range of supplies used in farming – including principally feed, agronomy products
(fertilizer, farm chemicals, seed), and energy products (propane, diesel fuel, gasoline,
etc.). During--------, Taxpayer’s farm supply sales totaled approximately $--------million.

  Taxpayer’s “members” include voting members and nonvoting members. Voting

members are producers (i.e., farmers) and farmers’ cooperatives that do business with
Taxpayer. Nonvoting members are other persons interested in doing business with
Taxpayer on a patronage basis. [Note: although Taxpayer calls one class nonvoting
“members,” they are in reality “patrons” within the meaning of section 1.1388-1(e) of the
Income Tax Regulations because “member” is defined in section 1.1388-1(c)(3)(ii)(c) to
mean a person who is entitled to participate in the management of the cooperative
organization]. On -----------------------, Taxpayer had --------voting members and ---
nonvoting members. Taxpayer pays patronage dividends to both voting and nonvoting
members. Taxpayer does not pay patronage dividends to nonmembers.

  Taxpayer is organized and operated on a cooperative basis. State A has a

special law for the incorporation of cooperative associations known as the “State A
Cooperative Law.” State A Revised Code, -------------------.

     The State A Cooperative Law provides that associations organized under the act

“shall be corporations that are deemed nonprofit because they are not organized for the
purpose of making a profit for themselves as such, or for the purpose of making a profit
for their members as such, but for their members as patrons.” Section ----------------------
--------------------------------------------------------------------------------------------------------------The
State A Cooperative Law provides that associations organized under the Law shall
distribute their earnings on a patronage basis:

    “(A) An association may pay dividends annually on its capital stock. All of
    its other net income from business with or for members and other eligible
    patrons, less reserves which shall be provided for in the bylaws or other
    written agreements, shall be distributed to its members and other eligible
    patrons on the basis of patronage as provided in the bylaws or other
    written agreements....” (Section -------------- -).

  Taxpayer’s Articles of Incorporation provide that “[t]he Association is a

corporation organized as a cooperative association under Chapter--------of the State A
Revised Code (the ‘[State A] Cooperative Law’).” Section 3.2.

    They then describe Taxpayer’s purpose:

PLR-104573-10 3

     “3.1 --------------. The primary purpose of the Association is to associate
     producers and others to provide them economic benefit through joint
     action in procuring supplies, services and equipment and in marketing
     products they produce. The specific purpose of the Association and the
     general nature of its business is to market grain, procure crop and
     livestock production inputs, distribute petroleum fuels, and to provide
     related services, supplies and equipment for its Members and other
     persons. The Association may engage in any other lawful business or
     activity for which an association may be organized under the [State A]
     Cooperative Law.” (Section 3.1).

   Taxpayer is organized with capital stock. It has one class of common stock and

four classes of preferred stock (Preferred, Class A Preferred, Class B Preferred and
Class C Preferred). Section 4.1.

  The common stock and the Class B Preferred Stock are membership stock.

Each has a par value of $10 per share and neither is entitled to receive dividends.
Sections 4.1, 4.5(C) and 4.5(E).

  Taxpayer has two classes of members – voting members and nonvoting

members. Voting Membership in limited to producers and farmers’ cooperatives.
Sections 4.2(A) and 5.1(A). For this purpose:

     “‘Producer’ means a person engaged in the production of agricultural
     products for the market, including lessor of property used for the
     production of agricultural products for the market who receive as rent part
     of the agricultural product. ‘Cooperative’ means a Producer-controlled
     entity that is operated on a cooperative basis.” (Article 4, Section 4.2(A)).

   Each voting member owns one share of common stock. Other persons who

interested in actively patronizing Taxpayer are eligible to be nonvoting members.
Section 5.1(B). Nonvoting members each own one share of Class B Preferred Stock.

  The Articles of Incorporation provide that only Voting Members are entitled to

vote and that each Voting Member has one vote:

     “5.3 VOTING. The Voting Members exercise all of the voting control of
     the Association. Each Voting Member is entitled to one vote on any
     matter submitted to a vote of the Members. Membership or ownership of
     capital stock or other equity interests in the Association does not
     otherwise confer upon the holder any voting rights in the Association.…”
     (Section 5.3).

     The other classes of preferred stock were created for specific purposes over the

years.
PLR-104573-10 4

   ·   The Preferred was used to finance Taxpayer in its early years. Only $----------
       of that stock remains outstanding.

   ·   Before it consolidated with Taxpayer, Company C paid a portion of its
       patronage dividends in letters of advice, some of which it later exchanged for
       preferred stock. In the consolidation, that preferred stock was converted into
       Class A Preferred. Currently, $------------of this stock remains outstanding.

   ·   The Class C Preferred has been used as for special purposes. Some
       preferred stock was issued to acquire a building, and other was issued to a
       joint venture partner. Currently, $------------of this stock is outstanding.

Each class has the right to a noncumulative dividends as determined by Taxpayer’s
Board of Directors, but not to exceed 8 percent in the case of the Preferred and Class A
Preferred and 10 percent in the case of the Class C Preferred. Section 4.5(A), (B) and
(D). As of -----------------------, the par value of the outstanding dividend-bearing
preferred shares was $-----------, and the maximum annual dividend payable on those
shares was $---------.

   Taxpayer is also authorized to issue Capital Credits, which are used as written

notices of allocation for patronage dividend purposes and provide the principal source of
capital used to finance its business. Section 4.4. At -----------------------, the stated dollar
amount of outstanding Capital Credits was $---------------.

    Taxpayer’s Articles of Incorporation provide that its net earnings will be

distributed on a cooperative basis as provided in its Bylaws:

   “4.9 ----------------------------------. The Net Margins (savings) of the
   Association in excess of Association Net Margins must be distributed
   annually to the Association’s Patrons as Patronage Refunds on the basis
   of Patronage Transactions. The calculation, allocation, and distribution of
   Net Margins must be defined and provided for in the Bylaws.” (Section
   4.9).

    Article 7 of Taxpayer’s Bylaws provides a detailed description of how Taxpayer

computes and pays patronage refunds. That computation begins with a determination
of net margins from all of Taxpayer’s business (patronage and nonpatronage) for the
fiscal year. Section 7.3. Then, Taxpayer is required to deduct (i) an amount (fixed at ---
--- percent of net margins) to be added to the capital reserve, (ii) the amount declared
by the Board of Directors as dividends on the preferred stock, and (iii) an amount
sufficient to pay Taxpayer’s taxes. Section 7.4(A)(1), (2) and (3). Amounts held back
are subtracted out of net margins from nonpatronage sources, and, only if
nonpatronage net margins are not sufficient, are they subtracted from net margins from
patronage sources. Section 7.4(A)(4) If earnings from nonpatronage sources exceed
the amounts required to be retained, then any excess nonpatronage earnings are set
PLR-104573-10 5

aside in the capital reserve. Section 7.4(A)(4). Taxpayer refers to the amounts required
to be retained for reserves, dividends and taxes as the “Association Net Margins.”

  Taxpayer’s Bylaws then provide:

  “(B) Patronage Refunds. The balance of Net Margins after deduction of
  the Association Net Margins shall be the Patrons Net Margins. The
  Patrons Net Margins belong to the Patrons and must be allocated to the
  Patrons on the basis of their Patronage Transactions. These allocated
  amounts are Patronage Refunds due and distributable to the Patrons as
  provided in these Bylaws….” (Section 7.4 (B)).

   This section of the Bylaws goes on to provide that Taxpayer may pay patronage

dividends based upon allocation units.

  “Patronage Refunds may be allocated on the basis of Patronage
  Transactions and the Net Margins that result from the operations of
  divisions or departments of the Association as the Board considers fair to
  the Patrons.” (Section 7.4(B)).

    Taxpayer allocates patronage dividends upon the basis of three allocation units –

one for marketing, one for supplies and one for corn sold to members for feed. Patrons
Net Margins attributable to the marketing allocation unit are allocated among members
marketing their grain through Taxpayer based upon bushels. Patrons Net Margins
attributable to the supplies allocation unit are allocated based upon dollars of supply
purchases. Patrons Net Margins attributable to the allocation unit for corn sold to
members for feed are allocated among members purchasing corn from Taxpayer based
upon bushels purchased from Taxpayer.

    Section 7.5(A) of the Bylaws authorizes Taxpayer to pay patronage dividends in

“cash, capital stock or Capital Credits (or any combination these)….” Patronage
dividends are normally paid in a combination of cash and Capital Credits. In the past,
the Capital Credits distributed by Taxpayer as part of its patronage dividends have been
“qualified written notices of allocation” as defined in subchapter T of the Code.

    In the event of dissolution, Article 7 of Taxpayer’s Articles of Incorporation

provides that assets will first be used to pay creditors. Amounts remaining are then
distributed first to the holders of the Preferred and Class A Preferred stock in an amount
equal to par value, second to the holders of Class C Preferred stock in an amount equal
to par value, and third to the holders of common stock, Class B Preferred stock and
Capital Credits in an amount equal to par value or stated dollar value. Any residual
assets then remaining will be shared by the members “on the basis of their respective
aggregate Patronage Transactions over the previous ten (10) years as shown by the
records of the Association.”
PLR-104573-10 6

    This ruling relates to Taxpayer’s grain marketing activities. Taxpayer operates ---

--- grain elevators located strategically across the territory it serves. It purchases grain
from its members at the elevators for marketing on a cooperative basis. From the
elevators grain can be shipped by truck or rail. Taxpayer also purchases some grain
from its members and others for sale directly to several large customers.

  Taxpayer sells grain to livestock producers for feed, to grain processors to be

used to produce ethanol, high-fructose corn sweetener and other products, to soybean
processors to be crushed and sold as soybean meal, oil and other further refined
products, and to others for resale, both domestically and in the export market.
Taxpayer also crushes some of the soybeans, and sells the resulting products (soybean
meal and oil).

   Taxpayer’s grain business consists of buying grain from members and others,

handling and storing the grain at its elevators, and then selling the grain to terminal
grain elevators, grain processors, feed lots, grain exporters and others.

     The issue in this ruling relates to the characterization for purposes of

subchapter T of the Code and section 199 of payments (referred to in this ruling as
“grain payments”) that Taxpayer makes to members when it acquires their grain for
marketing on a patronage basis. For purposes of this ruling, “grain payments” do not
include any amounts paid to persons not entitled to share in patronage dividends. In----
------, approximately ------percent of Taxpayer’s grain marketing was for persons not
entitled to share in patronage dividends. For purposes of this ruling, “grain payments”
also do not include patronage dividends paid to members with respect to grain
marketed for them.

   Taxpayer does not operate on a pooling basis. Thus, Taxpayer’s grain marketing

proceeds are not shared equally on the basis of patronage and distributed in the form of
harvest advances and progress payments with a final settlement after the pool closes
as they would be if Taxpayer pooled. Commodity price risk does not shift from
Taxpayer’s members to a pool at the time of harvest. Rather, that risk remains with
members until they decide to sell their grain to Taxpayer for marketing.

   Taxpayer pays each member a market price for his or her grain. What that

market price is depends upon where, when and how a member chooses to sell his or
her grain to Taxpayer. That market price is determined without regard to the actual net
proceeds from marketing grain. Payments are made in cash (by check) and occur
throughout the year as members sell grain to Taxpayer for marketing and are paid
pursuant to the terms of their grain contracts.

   After purchasing grain from members, Taxpayer then markets each member’s

grain along with the grain of all of its other members in the manner that it judges will
produce the best return. After year end, when net earnings for the year have been
PLR-104573-10 7

determined, Taxpayer pays a patronage dividend to its members with respect to the
grain they market through Taxpayer.

   Grain farmers historically have retained the decision of when and how to sell their

grain and to choose whether to sell their grain to a cooperative for marketing on a
patronage basis or to a commercial grain company. Farmers have a variety of
alternatives when they sell their grain to Taxpayer. The choices are similar to those
offered farmers by commercial grain companies, though commercial grain companies
do not market grain on a patronage basis and do not pay patronage dividends.

    The basic choices available to a farmer selling grain to Taxpayer for marketing

on a cooperative basis are: (i) to sell the grain for Taxpayer’s current cash bid price, (ii)
to sell the grain to Taxpayer using a forward contract, and (iii) to sell the grain to
Taxpayer using a deferred price or a deferred payment contract. Under each of these
basic choices, there are additional options available to farmers.

   One way for a member to sell grain to Taxpayer for marketing is to sell the grain

to Taxpayer and be paid the cash bid price. Many members sell grain to Taxpayer on
this basis.

    Typically a country elevator’s cash bid price for a commodity is the nearby

futures price in a specified reference market where the commodity is actively traded
(e.g., the Chicago Board of Trade or the Minneapolis Grain Exchange) plus or minus a
fixed spread (referred to as the “basis”) set from time to time by the elevator based upon
local market conditions. Thus, the cash bid price at a country elevator reflects the
condition of the overall market for grain (the futures price) and the condition of the local
market for grain (the basis). An elevator’s cash bid price changes during the course of
each day as the reference futures price fluctuates. It also changes (though not as often)
as the elevator adjusts the basis.

   The bid price schedule at country elevators changes from hour to hour and day

to day. A member can deliver and sell grain to Taxpayer at the cash bid price at the
time of harvest, delivering the grain directly from the field. However, it usually is not
advantageous for farmers to sell then since prices often are lowest at harvest. Many
farmers have the capacity to store grain on their farm and so can wait until later, when
they think that the cash bid price is right, to deliver and sell their grain to Taxpayer.
Other farmers deliver grain to Taxpayer for storage, not for immediate sale. The
farmers retain ownership of the grain in the elevator and pay storage fees to Taxpayer.
Later, when a farmer believes the cash bid price is right, he or she can sell the grain to
Taxpayer for marketing on a cooperative basis.

   A member has the option of entering into a forward contract to sell his or her

grain to Taxpayer. Forward contracts call for delivery of a specified quantity and quality
of grain, at a specified location, during a specified time period. Forward contracts can
PLR-104573-10 8

be entered into before the grain is planted, while it is growing or after harvest while the
grain is being stored on the farm or in an elevator.

   Forward contracts can be priced in a variety of ways. Many contracts provide for

a fixed price, sometimes referred to as a “flat” price. Farmers interested in entering into
a forward contract with Taxpayer can determine the fixed price Taxpayer is willing to
pay at any time at any of its locations for delivery at various times in the future from
Taxpayer’s bid schedules for grain for future delivery or by contacting Taxpayer.

    Typically a country elevator’s bid price for future delivery is determined in a

manner similar to the way the cash bid price is determined. However, when the bid
price is for future delivery, it is based upon the nearby futures price for the time
specified for delivery plus or minus the basis set by the country elevator for that delivery
month. The bid price for future delivery changes during the course of each day as the
specified reference price fluctuates. It also changes as the country elevator adjusts its
basis.

    Taxpayer’s published bid schedule lists only the current bid price and the new

crop bid price since those are the bids of interest to most of its members. If a member
is interested in a flat price bid for delivery in another month or for Taxpayer’s basis for
any month, he or she can contact Taxpayer.

   Taxpayer uses the same form for all forward contracts and customizes the

contract to reflect the terms of each agreement. Farmers also can enter into forward
contracts where the pricing is left open for future determination. For instance, the
contracts may fix the basis and leave the futures price open, to be determined based
upon the futures price at the time chosen by the farmer before a specified date in the
future. Alternatively, the contracts may specify the futures price and leave the basis
open, to be determined based upon the elevator’s basis for delivery during the future
month at the time chosen by the farmer before a specified date in the future. Some
cooperatives use contracts which specify a minimum price that will be paid for the
member’s grain, giving the farmer the option to fix the price before a specified date in
the future based upon a reference futures price, leaving open the possibility that a price
greater than the minimum price will be paid if futures prices go up.

    Members have the option to deliver grain to Taxpayer, leaving the determination

of the price partly or wholly open. Contracts of this sort are called by various names –
deferred price contracts, delayed price contracts, credit-sale contracts, etc. Under a
delayed price contract, ownership of the grain passes from the farmer to Taxpayer at
the time of delivery. Farmers are given the opportunity to wait until later to price the
grain. When the farmer chooses to price the contract, the cooperative’s then current bid
price is used to fill the open price term. Once the price is determined the member is
paid.
PLR-104573-10 9

   Some farmers prefer to sell their grain to Taxpayer on a deferred payment basis.

Grain sold on that basis might be delivered in October, the price set at that time, but
with payment to be made in January. Ownership of the grain passes to Taxpayer when
the grain is delivered.

    The variety of options available to farmers for selling their grain to Taxpayer and

other grain companies provide farmers with a great deal of flexibility. Farmers can lock
in prices for their crops (even before they are planted or while they are growing) at any
time if they think that the price is right by using flat price forward contracts. Some
farmers prefer to do so after they can estimate the costs of production to lock in a
reasonable margin. If a farmer is happy with the futures price, but not the basis, the
farmer can enter into a forward contract that leaves the basis open. If a farmer is happy
with the basis, but not the futures price, the farmer can enter into a forward contract that
leaves the futures price open. If a farmer wants the assurance of a minimum price, the
farmer can enter into a forward contract that specifies a minimum price, but leaves final
pricing open. Such a contract can result in a higher price if the futures price increases,
or a guaranteed minimum price (albeit somewhat lower than the farmer could otherwise
have obtained) if the futures price does not increase.

   If farmers think that the cash price is low at the time of harvest, they can harvest

and store their crops either on the farm (if they have on-farm storage) or at one of
Taxpayer’s elevators while waiting for the price to improve. They can then sell that
grain to Taxpayer when they think the price is right at the current cash bid price.
Alternatively, farmers can deliver the crops to Taxpayer at the time of harvest and enter
into a deferred price contract.

   These choices and others described above are available to all members

marketing their grain on a cooperative basis through Taxpayer. Because of these
choices, two neighbors that market the same quantity and quality of a particular kind of
grain through Taxpayer during any year will receive different grain payments depending
upon where, when and how they sell their grain to Taxpayer. However, they will each
receive the same patronage dividend.

   For the fiscal year ended -----------------------, Taxpayer made grain payments to

members of over $----million. Taxpayer has not yet paid patronage dividends to
members for that year, but anticipates that the grain patronage dividends will total
approximately $-----million. Patronage dividends will be paid in cash and qualified
written notices of allocation (Capital Credits).

    Taxpayer has treated grain payments made in cash to members as “purchases”

for tax purposes and reported them on Schedule A, Line 2 of its Form 1120-C.
Taxpayer has not reported the grain payments made in cash as “per-unit retain
allocations paid in money” and therefore has not reported them on Schedule A, Line 4b
of its Form 1120-C. Taxpayer has reported the patronage dividends paid to members in
PLR-104573-10 10

money and qualified written notices of allocation on Schedule H, lines 3a and 3b of its
Form 1120-C.

  Because of this reporting, grain payments paid in cash have entered into the

determination for tax purposes of Taxpayer’s cost of goods sold for tax purposes. As is
customary in the grain business, Taxpayer values its grain inventories at year end at
market for financial statement and tax purposes.

   Taxpayer did not add back grain payments in its section 199 computations for

prior years. Taxpayer did not pass any portion of its section 199 deduction through to
its members in prior years.

    Recent developments have caused Taxpayer to reconsider how it should treat its

grain payments for purposes of its section 199 computation. Taxpayer is seeking
confirmation that all grain payments to members should be classified as “per-unit retain
allocations paid in money.”

    Taxpayer plans to disregard grain payments made to members and other patrons

eligible to share in patronage dividends for purposes of computing its qualified
production activities income and its taxable income beginning with its ------------------------
tax return. Taxpayer also is considering passing through to members all or a portion of
its Section 199 deduction.

   Based on the foregoing, Taxpayer requests the following rulings:

   1. Grain payments to members constitute “per-unit retain allocations paid in
      money” within the meaning of section 1382(b)(3) of the Code.

   2. For purposes of computing its section 199 domestic production activities
      deduction, Taxpayer’s qualified production activities income and taxable
      income should, pursuant to section 199(d)(3)(C) of the Code, be computed
      without regard to any deduction for grain payments to members.

    Nonexempt subchapter T cooperatives are permitted to exclude or deduct

distributions to patrons that qualify as per-unit retain allocations or patronage dividends,
provided the distributions other 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 [subchapter T] 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 may be made in money, property or certificates. Per-

unit retain allocations paid in money and in property are excludable or deductible under
PLR-104573-10 11

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 section 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 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.

   Patronage dividends may be paid in money, property or written notices of

allocation. Patronage dividends paid in money and in property are excludable or
deductible under section 1382(b)(1) of the Code. Patronage dividends paid in written
notices of allocation are deductible under section 1382(b)(1) if the written notices of
allocation are qualified. If the notices are nonqualified, the cooperative is permitted a
deduction under section 1382(b)(2) (or a tax benefit figured under section 1383) when
the notices are later redeemed.

   Section 1388(b) of the Code provides that the term “written notice of allocation”

means any capital stock, revolving fund certificate, retain certificate, certificate of
indebtedness, letter of advice, or other written notice, which discloses to the recipient
the stated dollar amount allocated to him by the organization and the portion thereof, if
any, which constitutes a patronage dividend.

   For cooperatives that use pooling, Rev. Rul. 67-333, 1967-2 C.B. 299, provides

that pool advances are treated as per-unit retain allocations and the final pool payment,
made after net earnings have been determined, is treated as a patronage dividend.

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

from a specified agricultural or horticultural cooperative are allowed a deduction for an
amount allocable to their portion of 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 extraction 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
PLR-104573-10 12

marketing of agricultural and horticultural products, the cooperative is treated as having
manufactured, produced, grown, or extracted (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) of the regulations, 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 on its return, 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 199(d)(3)(A) of the Code provides that a cooperative passes through an

amount of its section 199 deduction by “identifying” such amount in a written notice
mailed to such person during the payment period described in section 1382(d).
Section 1382(d) provides that the payment period for a 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.

    Section 1.199-6(g) of the regulations provide that in order for a patron to qualify

for the section 199 deduction, section 1.199-6(a) requires that the cooperative identify in
a written notice the patron's portion of the section 199 deduction that is attributable to
the portion of the cooperative's QPAI for which the cooperative is allowed a section 199
deduction. This written notice must be mailed by the cooperative to its patrons no later
than the 15th day of the ninth month following the close of the taxable year. The
cooperative may use the same written notice, if any, that it uses to notify patrons of their
respective allocations of patronage dividends, or may use a separate timely written
notice(s) to comply with this section. The cooperative must report the amount of the
patron's section 199 deduction on Form 1099-PATR, “Taxable Distributions Received
From Cooperatives,” issued to the patron.

  While a cooperative is permitted to disregard per-unit retain allocations and

patronage dividends in its section 199 deduction, section 1.199-6(l) of the regulations
PLR-104573-10 13

provide 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) of the regulations 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.

   Taxpayer is a “specified agricultural or horticultural cooperative” within the

meaning of section 199(d)(3)(F) of the Code and section 1.199-6(f) of the regulations. It
is an organization “to which part I of subchapter T applies” (i.e., it is a nonexempt
cooperative to which subchapter T applies). It is engaged “in the marketing of
agricultural or horticultural products” (i.e., grain).

    As a specified agricultural or horticultural cooperative, Taxpayer is entitled to the

benefit of section 199(d)(3)(C) of the Code and section 1.199-6(c) of the regulations,
which permit such cooperatives to disregard deductions under section 1382(b) and (c)
for purposes of computing QPAI and taxable income for purposes of section 199.
Section 1382(b) provides deductions for per-unit retain allocations paid in money,
property and qualified per-unit retain certificates as well as for patronage dividends paid
in money, property and qualified written notices of allocation. It also provides for
deductions when nonqualified per-unit retain certificates and nonqualified written notices
of allocation are redeemed. As a specified agricultural or horticultural cooperative,
Taxpayer is entitled to the benefit of section 199(d)(3)(C) and section 1.199-6(c), which
permit such cooperatives to disregard deductions under section 1382(b) and (c) for
purposes of computing QPAI and taxable income for purposes of section 199. Section
1382(b) provides deductions for per-unit retain allocations paid in money, property and
qualified per-unit retain certificates as well as for patronage dividends paid in money,
property and qualified written notices of allocation. It also provides for deductions when
nonqualified per-unit retain certificates and nonqualified written notices of allocation are
redeemed.

   Taxpayer does not operate on a pooling basis. Taxpayer purchases grain from

patrons and markets that grain. The amount that each patron receives when he or she
sells grain to Taxpayer for marketing depends upon where, how, and when the patron
chooses to sell that grain to Taxpayer. Patrons are not required to deliver their grain to
Taxpayer. They are free to sell as little or as much of their grain to Taxpayer as they
choose.

   Members have a number of options for determining how and when sales are

made. As a result, two neighbors delivering the same amount of grain to Taxpayer
during any year will be paid different amounts for that grain depending upon where,
PLR-104573-10 14

when, and how they sell the grain to Taxpayer. However, all members share in
Taxpayer’s net earnings from grain operations in proportion to the number of bushels of
grain they market through Taxpayer. Those net earnings are distributed after the end of
each year in the form of patronage dividends paid in cash and qualified written notices
of allocation (revolving fund credits).

 The question presented by the ruling request is whether the grain payments

made by Taxpayer to members for grain qualify as per-unit retain allocations paid in
money within the meaning of section 1388(f) of the Code.

   Under section 199 of the Code and section 1.199-6 of the regulations, the

answer to this question determines who gets to include the grain payments in the
section 199 computation. If the grain payments to patrons are per-unit retain allocations
paid in money, then they should be added-back in Taxpayer’s section 199 computation
and not included in the patrons’ section 199 computations. If the grain payments to
patrons are not per-unit retain allocations paid in money, then they should not be
added-back in Taxpayer’s section 199 computation, but should be included in the
patrons’ section 199 computations. These results are the same whether Taxpayer
decides to keep or to pass-through all or a portion of its section 199 deduction.

    Until recently, grain marketing cooperatives like Taxpayer have never thought of

their grain payments as per-unit retain allocations paid in money. However, Taxpayer’s
grain payments appear to meet the definition of “per-unit retain allocations paid in
money” which are excludible or deductible under section 1382(b)(3) of the Code.

   The grain payments are made in cash so the “paid in money” requirement is

met.

     Taxpayer’s grain payments also meet all the requirements of the definition of

“per-unit retain allocation” contained in section 1388(f) of the Code, which 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 the net earnings of the organization
pursuant to an agreement between the organization and the patron.”

   First, Taxpayer’s grain payments to a member are paid “pursuant to an

agreement,” namely the particular agreement applicable to the method the member
uses to determine how and when his or her grain is sold to Taxpayer.

    Second, Taxpayer’s grain payments to a member are made “with respect to

products marketed for him,” namely, the grain delivered by the member or other patron
eligible to share in patronage dividends for marketing by Taxpayer. As described
above, Taxpayer markets the grain it acquires from members and other patrons, and
PLR-104573-10 15

members and other patrons share in Taxpayer’s net earnings from its marketing
activities in the form of patronage dividends.

   Third, the amount of the grain payments to each member “is fixed without

reference to the net earnings” of Taxpayer since, at the time the payments are made,
Taxpayer’s actual net earnings for the year are neither known nor determinable.

   While per-unit retains are often made on the basis of a specified amount per unit

of product marketed, what is important is that they not be made with respect to net
earnings. Rev. Rul. 68-236, 1968-2 C.B. 236, provides that “to constitute a per-unit
retain allocation, the allocation need not be made strictly on the basis of a specified
amount per-unit of product marketed provided it is made with respect to products
marketed for the patron and not with respect to the net earnings of the organization.
Whether an allocation meets the foregoing description will be a question of fact.”

   The fact that all members and other patrons eligible to share in patronage

dividends do not receive the same payments for their grain (i.e., that Taxpayer does not
pool) does not mean that grain payments should not be treated as per-unit retain
allocations paid in money. In Farm Service Cooperative v. Commissioner, 619 F. 2d
718 (8th Cir. 1980), the Eighth Circuit Court of Appeals characterized payments to Farm
Service’s poultry growers as per-unit retain allocations paid in money, even though they
were determined under a formula that resulted in some poultry growers receiving more
than others depending upon the efficiency of their operations and the market price of
chickens when they delivered their chickens to Farm Service. The Tax Court in Farm
Service Cooperative v. Commissioner, 70 T.C. 145, 147-148 (1978), described the
formula as follows:

  “The grower was paid by petitioner for growing chickens based on the
  delivery weight to the processing plant, less the weight of chickens
  condemned by the U.S. Department of Agriculture. The formula under
  which the grower was paid also took into account variable market rates for
  full grown chickens, and an efficiency factor that related the number of
  pounds of feed to the pounds of chickens produced. The efficiency factor
  was figured into the grower's compensation because Farm Service
  supplied all chicken feed. Under the contract provisions established with
  each of the growers, there was also a guaranteed minimum amount the
  grower would receive from the cooperative irrespective of wholesale
  market variations. For example, the contract in effect on July 1, 1968,
  provided that ‘In no event will the Grower Member receive less than 1.25
  cents per pound less U.S.D.A. condemnation.’ On its books, petitioner
  treated payments to its growers as a cost of production.”

PLR-104573-10 16

    Historically, Taxpayer has treated its grain payments as “purchases,” not as “per-

unit retain allocations paid in money.” However, how the payments have been reported
should not obscure what they really are.

  Whether or not Taxpayer is pooling is a moot issue for purpose of this ruling

because its grain payments meet the definition of “per-unit retain allocations paid in
money” in any event. Nothing in subchapter T of the Code limits the exclusion or
deduction for per-unit retain allocations to cooperatives with pools.

   Section 1.199-6(k) of the regulations 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 a cooperative such as Taxpayer 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 section
199(d)(3) of the Code and the regulations thereunder.

     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 grain is sold, the cost of goods sold mechanism associated with inventory
must be adjusted to reflect the deductions allowable under subchapter T of the Code.
Specifically, cooperatives need to include the per-unit retain allocations 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
per-unit retain allocations. The adjustments can be made to either the inventory or the
line item deduction for the per-unit retain allocations. In other words, if the per-unit
retain allocations 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 per-unit retain allocations are not deducted on a
deduction line in the tax return, the per-unit retain allocations 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 per-unit retain allocations
once while also preserving the integrity of its section 263A calculation.

    For reasons described above, Taxpayer’s crop payments to members meet the

definition of “per-unit retain allocations paid in money.” The per-unit retains must be
treated as such for all purposes of the Code and are reported in box 3 of Form 1099-
PLR-104573-10 17

PATR, “Taxable Distributions Received From Cooperatives.” If properly treated as per-
unit retain allocations paid in money, then Taxpayer will be entitled to disregard such
payments in determining the amount of its section 199 deduction.

  Accordingly, we rule as requested that:

 1. Grain payments to members constitute “per-unit retain allocations paid in

money” within the meaning of section 1382(b)(3) of the Code.

  2. For purposes of computing its section 199 domestic production activities

deduction, Taxpayer’s qualified production activities income and taxable income should,
pursuant to section 199(d)(3)(C) of the Code, be computed without regard to any
deduction for grain payments to members.

    The conclusions set forth in this ruling address only purchases that are per-unit

retain allocations paid in money as they relate to grain marketed by the cooperative
during the taxable year and does not apply to purchases of grain that remain in
inventory at year end. Nor are payments to nonmember/nonpatrons for their grain
classified as per-unit retain allocations paid in money, but are purchases that are used
in determining Taxpayer’s cost of goods sold for tax purposes. No opinion is expressed
or implied regarding the application of any other provision in the Code or regulations.

   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)