PLR 1046001: grain cooperative payments qualify as per-unit retain allocations for section 199

Plain-English summary

The IRS ruled that a grain cooperative's cash payments to members and other participating patrons for grain marketed through the cooperative are per-unit retain allocations paid in money. The payments were fixed under the applicable sales agreements without reference to the cooperative's net earnings. The ruling also says the cooperative may compute its section 199 domestic production activities deduction without regard to a deduction for those grain payments. The ruling explains that the cooperative should account for the payments consistently under subchapter T and adjust inventory and cost of goods sold calculations to avoid a double deduction. The conclusions apply to the described grain purchases during the taxable year and not to grain remaining in inventory at year end.

Ruling snapshot

• Question: Are the cooperative's cash grain payments per-unit retain allocations paid in money, and may they be disregarded in its section 199 computation?
• Outcome: Approved
• Key authorities: IRC §§ 1382, 1388, and 199; Treas. Reg. §§ 1.199-6 and 1.1382-3

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201046001 Third Party Communication: None
Release Date: 11/19/2010 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-107325-10
Date:
August 06, 2010

LEGEND:

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

State A = ------

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

  This is in response to a request for rulings dated February 12, 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 State A Cooperative Law.

Taxpayer is a local grain marketing and farm supply cooperative. It is headquartered in
State A. It serves farmers through a network of --- facilities located in a ------county area
in State A. Taxpayer was formed in ------- as a result of the merger of ------- State A
cooperatives – ------------------------------------------------------------------------------------------------
---------------------. In -------, ----------------------------------------------- merged into Taxpayer.
Effective --------------------------, -------------------------------- merged into Taxpayer.

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

fiscal year ending -------------------------------, Taxpayer’s grain sales were approximately
$-----------------. Principal commodities marketed in ------- were corn ($---------------),
soybeans ($---------------), and wheat ($-------------).

   Taxpayer provides a broad range of the farm supplies to its farmer members and

other patrons – including principally agronomy products (fertilizer, farm chemicals,
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seed), energy products (propane, diesel fuel, gasoline, etc.) and feed. During -------,
Taxpayer’s farm supply sales totaled approximately $-----------------.

  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 ----------------------, ---------- had --------voting members and -----
nonvoting members. Taxpayer pays patronage dividends to both voting and nonvoting
members (other participating patrons). 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 in State A Revised Code,
Chapter ------- (State A Cooperative Law). 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 ---------------. State A Cooperative Law provides that
cooperative associations 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 in Section 3.2 provide that “[t]he Association

is a corporation organized as a cooperative association under Chapter -------” of [State A
Cooperative Law].”

   The Articles of Incorporation describe Taxpayer’s purpose:

   “3.1 PURPOSE. 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

PLR-107325-10 3

  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 five
classes of preferred stock (Preferred, A Preferred, B Preferred, C Preferred and D
Preferred). Section 4.1. No shares of D Preferred are issued and outstanding.

   The common stock and the 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. Each voting member owns one share of common stock and each nonvoting
member owns one share of B Preferred. 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 lessors 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.” (Section 4.2(A)).

Other persons who are interested in actively patronizing Taxpayer are eligible to be
nonvoting members. Section 5.1(B).

  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 over the years to provide

capital to support the operations of Taxpayer (and its predecessors) and to fund special
projects. The dividend rights of each class of preferred stock are specified in the
Articles of Incorporation. Section 4.5. Preferred is entitled to a non-cumulative dividend
of not less than -- percent and not more than -- percent per annum. A Preferred is
entitled to a noncumulative dividend of not less than -- percent and not more than --
percent per annum. B Preferred is not entitled to dividends. C Preferred is issuable in
series, and each series is entitled to a cumulative or non-cumulative dividend not in
excess of --- percent per annum. There are no outstanding shares of D Preferred. As
PLR-107325-10 4

of ----------------------, the par value of the outstanding dividend-bearing preferred shares
was $---------, and the maximum annual dividend payable was $------------.

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

notices of allocation for patronage dividend purposes. Equity Credits provide a
significant source of capital used to finance Taxpayer’s business. Section 4.4. At -------
----------------------, the stated dollar amount of outstanding Equity Credits was $-------------
-----------------.

    Taxpayer’s Articles of Incorporation provide that Taxpayer’s net earnings shall be

distributed on a cooperative basis as provided in its Bylaws:

   “4.9 PATRONAGE REFUNDS. 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 before the beginning of the
year for reasonable reserves necessary to insure solvency and financial stability of the
association, (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 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)).

PLR-107325-10 5

   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 (Allocation Pools) as the
   Board considers fair to the Patrons.” (Section 7.4(B)).

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

feed, energy, agronomy and grain. Patrons Net Margins attributable to the grain
allocation unit are allocated among members marketing their grain through Taxpayer
based upon bushels. Patrons Net Margins attributable to the feed, energy and
agronomy allocation units are allocated among the members doing business with each
unit based upon their dollars of purchases from Taxpayer.

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

“cash, capital stock or in Equity Credits (or any combination of these)…” Patronage
dividends are normally paid in a combination of cash and Equity Credits. In the past,
the Equity 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 after creditors have been paid amounts remaining are to be distributed
first to the holders of Preferred and D Preferred stock in an amount equal to par value,
second to the holders of A Preferred stock in an amount equal to par value, third to the
holders of C Preferred in an amount equal to par value, and fourth to the holders of
common stock, B Preferred and Equity Credits in an amount equal to par value or
stated dollar value as the case may be. Any residual assets then remaining are then to
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.”

    The ruling request relates to Taxpayer’s grain marketing activities. Taxpayer

operates ------ grain elevators located strategically across the territory it serves.
Taxpayer 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.
Collectively, the elevators have the capacity to store approximately -------------bushels of
grain. Taxpayer also purchases some grain from its members and others for sale
directly to several large customers. That grain is delivered by members directly to
customers’ facilities.

  Taxpayer sells grain to livestock and poultry 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
PLR-107325-10 6

further refined products, and to others for resale, both domestically and in the export
market.

   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 eligible to share in patronage dividends
when it acquires their grain for marketing on a patronage basis. Thus, any payments to
persons not eligible to share in patronage dividends are not “grain payments” as that
term is used in the ruling request. In -------, approximately ---- percent of the grain
Taxpayer marketed was acquired from persons not entitled to share in patronage
dividends. For purposes of this ruling, the term “grain payments” also does not include
patronage dividends paid to members of Taxpayer 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 are 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
automatically shift from Taxpayer’s members to a pool at the time of harvest. Rather,
that risk remains with members until they sell their grain to Taxpayer for marketing.

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

price depends upon where, when and how a member chooses to sell his or her grain to
Taxpayer. Market price is determined without regard to the actual net proceeds realized
by Taxpayer from marketing the 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
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.
PLR-107325-10 7

    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.

   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 because 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. This is the most common way for members to sell their 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 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.

    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
PLR-107325-10 8

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.

   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. A farmer who believes that basis levels are
strong, but that future prices could improve might use this kind of pricing. 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. This kind of pricing would be used if
the futures price met the farmer’s objective, but he or she felt the basis would improve.
A somewhat more complicated form of contract that is offered by some cooperatives
leaves the basis open and places a floor under the futures price. If future prices go
down, the farmer is protected. If future prices go up the farmer can share in the
appreciation.

    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.

    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. The simplest way to do this is to enter into a fixed price purchase
contract.

    If a farmer is happy with the futures price, but not the basis, the farmer can enter

into a basis purchase contract. If a farmer is happy with the basis, but not the futures
price, the farmer can enter into a futures/cash purchase contract. If a farmer wants to
lock in a minimum futures price, but benefit in any strengthening of the futures price and
leave the basis open, the farmer can enter into a put/cash purchase contract.

   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.
PLR-107325-10 9

   Alternatively, farmers can deliver the crops and enter into a delayed purchase

contract, keeping the price open, but not having to bear the costs of storage.

   These choices 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 receive the same patronage
dividends.

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

members of over $--------------. Taxpayer paid patronage dividends to members with
respect to their grain of approximately $--------------. Patronage dividends were paid in
cash and qualified written notices of allocation (Equity Credits).

    In the past, 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
as a patronage dividend paid in 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 has not passed any portion of its section 199 deduction through
to 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 (QPAI) and its taxable income beginning with its --------------

------- tax return. Taxpayer may retain all of its section 199 deduction, pass-through all
of the deduction to members, or pass-through part and retain part of the deduction.

RULINGS REQUESTED
PLR-107325-10 10

    1. Grain payments to members and other participating patrons 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 QPAI 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 and other participating patrons.

    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
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 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
PLR-107325-10 11

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
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
PLR-107325-10 12

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
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, which it markets, and various farm
supplies, which it sells to members and other participating patrons).

   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)
PLR-107325-10 13

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

members and other participating patrons and markets that grain. The amount that each
member receives when he or she sells grain to Taxpayer for marketing depends upon
where, how, and when the member chooses to sell that grain to Taxpayer. Members
and other participating 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 and other participating patrons 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, when and how they sell the grain to Taxpayer.
However, all members and other participating patrons 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 capital).

   The question presented in Taxpayer’s ruling request is whether the grain

payments made by Taxpayer to patrons 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
PLR-107325-10 14

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.

  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 patron are paid “pursuant to an

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

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

products marketed for him,” namely, the grain delivered by the patron for marketing by
Taxpayer. As described above, Taxpayer markets the grain it acquires from patrons,
and 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 patron “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 participating patrons 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
PLR-107325-10 15

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.”

    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.
PLR-107325-10 16

    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 grain payments to members and other

participating patrons 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-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 and other participating patrons 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 QPAI 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 and other participating patrons.

   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. No opinion is expressed or implied regarding the application of
any other provision in the Code or regulations.
PLR-107325-10 17

   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)

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