PLR 1120008: grain payments treated as per-unit retains paid in money

Plain-English summary

The IRS considered whether a grain marketing cooperative's cash payments to members and other participating patrons were per-unit retain allocations paid in money. The ruling concluded that the payments met that definition because they were made under agreements, related to products marketed for the patrons, and were fixed without reference to the cooperative's net earnings. The cooperative could therefore disregard those payments when computing its section 199 deduction, subject to the ruling's limits and the requirement to avoid double deductions. Payments to nonmembers who were not eligible to share in patronage dividends remained purchases. The ruling did not apply to grain remaining in inventory at year end.

Ruling snapshot

• Question: Are the cooperative's grain payments per-unit retain allocations paid in money, and how are they treated for the section 199 deduction?
• Outcome: Approved.
• Key authorities: IRC §§ 1382, 1388, and 199; Treas. Reg. §§ 1.1382-3 and 1.199-6.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201120008 Third Party Communication: None
Release Date: 5/20/2011 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1382.00-00, 199.06-00 ----------------------------, ID No. ----------
Telephone Number:
---------------------
------------------- Refer Reply To:
------------------------ CC:PSI:B05
---------------------------- PLR-137140-10
------------------------------- Date:
------------------------------ February 15, 2011

LEGEND:

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

State A = ------

Area = ---------------------------------------------------

Dear ------------------

   This is in response to a request for rulings dated September 7, 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. Headquartered
in State A, Taxpayer serves farmers through a network of --------- facilities located in
Area.

     Taxpayer markets grain for its farmer members and for others. During its fiscal

year ended -------------------------(“-------”), Taxpayer’s grain sales totaled approximately $-
--------million. Taxpayer markets principally corn, soybeans and wheat. In addition,
Taxpayer provides its members and others with a broad range of supplies used in
farming – including principally agronomy products (fertilizer, farm chemicals, seed),
energy products (propane, diesel fuel, gasoline, fuel oil, etc.), feed and general farm
supplies. During -------, Taxpayer’s supply sales totaled approximately $--- million.
PLR-137140-10 2

    Taxpayer’s “members” must be producers (i.e., farmers) or cooperative

associations of producers who do business with Taxpayer. Taxpayer currently has
approximately --------members. Taxpayer pays patronage dividends to members and to
“other persons with whom the Association, by written agreement, does business on a
cooperative basis.” These “other persons” are referred to in this ruling as “other
participating patrons.” Taxpayer does not have any persons who qualify as participating
patrons at the present time. Taxpayer does not pay patronage dividends to other
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, Chapter -------.

    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 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 describe Taxpayer’s purpose as follows:

  “3.1 PURPOSE. The 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 that they produce. The primary purpose and general nature of its
  business shall be to market grain and to procure crop and livestock
  production inputs and related services, supplies and equipment for its
  Members and other persons.” Section 3.1.

   Taxpayer is organized with capital stock. Section 4.1. It has one class of

common stock and two classes of preferred stock (Class A Preferred and Class B
Preferred). Section 4.1.

  The common stock is membership stock. Sections 4.2 and 5.1. Only producers

and cooperative associations of producers are eligible to be members and to own
common stock. Section 4.2(a). For this purpose:
PLR-137140-10 3

   “‘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.” Section 4.2(a).

Each voting member must one at least one share of common stock. The common stock
has a par value of $5 per share. Section 4.1. Holders of common stock are not entitled
to receive dividends with respect to the shares. Section 4.5(c).

   The Articles of Incorporation provide that only members are entitled to vote and

that each member has one vote:

   “5.2 MEMBER VOTING. The Members shall be entitled to exercise all
   of the voting control of the Association. Each member of the Association
   shall be entitled to one vote in any matter submitted to a vote of the
   Members. Ownership of capital stock or other equity interests shall not
   otherwise confer upon the holder any other voting rights in the
   Association, except that affected stockholders shall be entitled to notice
   and participation in matters to be decided by the Members to the extent
   provided in the [State A] Cooperative Law. Absentee Votes may be cast
   as provided in the Bylaws.” Section 5.2.

     The remaining classes of stock, Class A Preferred and Class B Preferred, have a

par value of $100 per share and $5 per share, respectively. Section 4.1. Shares of
Class A Preferred may be issued in series and may bear either a noncumulative or
cumulative dividend not to exceed -- percent of par value per annum. Sections 4.3(b)
and 4.5(a). Holders of Class B Preferred shares are entitled to a noncumulative
dividend of not more than -- percent of par value per annum. Section 4.5(b).
Historically, this stock traces back to stock issued by Taxpayer and its predecessors to
provide capital needed for the business. The par values of the outstanding Class A
Preferred shares and Class B shares were $----------and $-----------, respectively, at ------
------------------------.

    Taxpayer’s Articles of Incorporation provide that its 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’ shall be distributed as
   ‘Patronage Refunds’ to ‘Patrons’ annually on the basis of ‘Patronage
   Transactions’ all as defined and provided for in the Bylaws.” Section 4.9.

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

Taxpayer computes and pays patronage refunds. Article Seven begins with the
following general statement:
PLR-137140-10 4

  “7.1 COOPERATIVE OPERATION. The Association shall be operated
  upon a cooperative basis. The Patrons of the Association are Members
  doing business with the Association on a cooperative basis, and other
  persons with whom the Association, by written agreement, does business
  on a cooperative basis. Each transaction conducted on a cooperative
  basis between the Association and a Patron shall be a Patronage
  Transaction and shall include as part of its terms each provision of the
  Articles and Bylaws, whether referred to in the transaction or not. Each
  Patron shall be entitled to Patronage Refunds as provided in these
  Bylaws.” Section 7.1.

   The computation of patronage refunds begins with a determination of net

margins from all of Taxpayer’s business (patronage and nonpatronage) for the fiscal
year. Section 7.2(a) and (b). Amounts deducted in that determination of net margins
include “additions to reserves and other charges (including the amount of income and
other taxes)…” Section 7.2(b). Then, Taxpayer is required to deduct (i) the amount
declared by the Board for dividends and (ii) the net margins attributable to sources other
than patronage transactions. Section 7.3(a)(1) and (2). Amounts held back for
dividends are subtracted out of net margins from nonpatronage sources to the extent
thereof. Section 7.3(a)(3). If earnings from nonpatronage sources exceed the amounts
required to be retained, then any excess nonpatronage earnings are also set aside in
the Capital Reserve. Section 7.3(a)(3). Taxpayer refers to the amounts required to be
retained for these purposes as the “Association Net Margins.” Section 7.3(a).

  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 shall belong and be allocated to the Patrons on the
  basis of their respective Patronage Transactions….” Section 7.3 (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 the Patrons’
  respective Patronage Transactions with and the Net Margins that resulted
  from the operations of such divisions or departments of the Association as
  the Board deem fair and equitable to the Patrons.” Section 7.3(b).

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

one for grain marketing and the second for supplies. Patrons Net Margins attributable
to the grain allocation unit are allocated among members and other participating patrons
marketing their grain through Taxpayer based upon bushels. Patrons Net Margins
attributable to the supplies unit are allocated among the members and other
participating patrons doing business with the unit based upon their dollars of purchases.
PLR-137140-10 5

    Section 7.4(a) of the Bylaws authorizes Taxpayer to pay patronage refunds “in

cash, capital stock or Capital Credits (or any combination thereof).…” Taxpayer
historically has paid its patronage dividends in a combination of cash and Capital
Credits. For 2010, Taxpayer paid its patronage dividend-----percent in cash and -------
percent in Capital Credits.

   Capital Credits are authorized in Taxpayer’s Articles of Incorporation and

described as follows:

   “4.4 CAPITAL CREDITS. The Association may issue scrip to be known
   as ‘Capital Credits’ representing ownership of a stated portion of the
   Association’s capital. Capital Credits shall be assigned a ‘Stated Value’
   equal to such stated portion of the Association’s capital. … Capital Credits
   may be issued as evidence of Patronage Refunds as defined and
   provided for in the Bylaws or as evidence of dividends on capital stock or
   for any other purpose for which an equity interest in the Association may
   be issued….” Section 4.4.

Dividends are not paid with respect to Capital Credits. Articles of Incorporation, Section
4.5(c).

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

provides that creditors shall first be paid. Any assets then remaining are to be
distributed: first to the holders of Class A Preferred stock an amount equal to the par
value of their shares, second to the holders of the Class B Preferred stock an amount
equal to par value of their shares, and third to the holders of common stock and Capital
Credits in an amount equal to par value of their shares and the stated value of their
Capital Credits. Any remaining property is then to be shared by the member patrons
“on the basis of their respective aggregate Patronage Transactions over the previous
ten (10) years as shown by the records of the Association.”

    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. The storage capacity of Taxpayer’s
grain elevators is approximately -----million bushels. Taxpayer also purchases some
grain from its members and others for sale directly to several large customers. In the
case of direct sales, the grain generally is delivered by members at Taxpayer’s direction
directly to the customers’ facilities and Taxpayer is not involved in handling the grain.

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

used to produce ethanol 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.
PLR-137140-10 6

   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. A small amount
of grain is sold by Taxpayer direct to customers.

    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 and other participating patrons
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. 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 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. What that

market price is depends upon where, when and how a member chooses to sell his or
her grain to 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, of course, commercial
grain companies do not market grain on a patronage basis and do not pay patronage
dividends.

  The market price paid for grain 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 and other participating
patrons with respect to the grain they market through Taxpayer.

    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.
PLR-137140-10 7

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

to Taxpayer and to be paid the cash bid price.

    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, the Minneapolis Grain Exchange of the Kansas City
Board of Trade) 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 prices are delivered prices at one of Taxpayer’s elevators for grain of

normal merchantable quality. Farmers are responsible for the costs of delivering the
grain to the elevator. Grain is tested when it is delivered. The grain price is subject to
adjustment if the grain is below normal quality standards, provided the grain is still of
acceptable quality.

   Grain prices constantly fluctuate. While basis does not fluctuate as dramatically

as the futures prices, it also is variable. As a result of changes in the markets, the bid
price schedule at country elevators changes from hour to hour and day to day. The bids
posted on Taxpayer’s website are updated twice a day.

    When a farmer sells grain to Taxpayer in a spot sale at the cash bid price, a grain

settlement document is produced, identifying the kind, amount and quality of the grain
delivered, the price per bushel, any applicable discounts or other charges and the net
amount due to the farmer. There is an adjustment for shrink (when grain is dried the
volume is reduced) and a charge for drying the grain. The farmer does not immediately
sell the grain, but rather stored the grain in one of Taxpayer’s elevators, and there is a
charge for storage.

   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. This is a 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
PLR-137140-10 8

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 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.

   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 futures 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 is used if the futures price
          meets the farmer’s objective, but he or she believes that the basis will
          improve.

    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.

   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
PLR-137140-10 9

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 the crops are planted or while the crops are
growing) at any time if they think that the price is right by using fixed 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 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 delayed price purchase contract, keeping the pricing open, less delayed price
fees.

   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 each receive the same
patronage dividend.

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

members and other participating patrons of approximately $--- million. Taxpayer paid
patronage dividends to members and other participating patrons with respect to that
year of approximately $-----million, of which approximately $-----million was paid with
respect to grain business.

    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 did not report grain payments made in cash as “per-unit retain
allocations paid in money” and therefore did not report them on Schedule A, Line 4b of
its Form 1120-C. Taxpayer reported the patronage dividends paid to members in
money and qualified written notices of allocation on Schedule H, lines 3a and 3b of its
Form 1120-C.
PLR-137140-10 10

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

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

  In prior years, Taxpayer has not added back grain payments in its section 199

domestic production activities deduction computations for prior years. Nor has it passed
any portion of its section 199 deduction through to members.

   Recent developments have caused Taxpayer to reconsider how it should treat

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

    Taxpayer plans to disregard grain payments made to members and other

participating patrons for purposes of its section 199 computation. Taxpayer does not
currently plan to make any change in the manner it accounts for inventories for tax
purposes. Thus, the timing of the deduction of its grain payments will not be changed,
but it does plan to treat grain payments deducted on its return as per-unit retains paid in
money for section 199 computation purposes. Taxpayer will make certain that it does
not exclude or deduct grain payments twice on its tax return and that it does not add
back grain payments twice in its section 199 computation. Taxpayer may retain all,
pass through all, or retain part and pass through part of its Section 199 deduction.

   Based on the foregoing, Taxpayer requests the following rulings:

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 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 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 otherwise meet the requirements of subchapter T of the Code.

   Section 1388(f) of the Code defines the term “per-unit retain allocation” to mean
   “any allocation, by an organization to which part I of [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.”
   PLR-137140-10 11

   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 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 qualified production activities income (QPAI) of the
   organization received as a qualified patronage dividend or per-unit retain allocation
   which is paid in qualified per-unit retain certificates. In particular, section 199(d)(3)(F)
   PLR-137140-10 12

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
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 provides 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.
PLR-137140-10 13

  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 its 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)
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 the grain. The amount that each
member or other participating patron receives when he or she sells grain to Taxpayer
for marketing depends upon where, how, and when the member or participating patron
chooses to sell that grain to Taxpayer.
PLR-137140-10 14

   Members and other participating patrons have a number of options for

determining how and when sales are made. As stated above, 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 marketing operations in proportion to the quantity of grains 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.

   The question presented in this ruling is whether the grain payments made by

Taxpayer to members and other participating 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 members and other participating
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 members’ and other
participating patrons’ section 199 computations. If the grain payments to members and
other participating 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 members’ and participating 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 member or other participating patron are

paid “pursuant to an agreement,” namely the particular agreement applicable to the
method the member or participating patron uses to determine how and when his or her
grain is sold to Taxpayer. Reporting grain payments as per-unit retain allocations paid
in money in box 3 of Form 1099-PATR demonstrates that Taxpayer and its patrons
agreed to treat grain payments as per-unit retain allocations paid in money.
PLR-137140-10 15

   Second, Taxpayer’s grain payments to a member or other participating patron

are made “with respect to products marketed for him,” namely, the grain delivered by
the member or other participating patron for marketing by Taxpayer. As described
above, Taxpayer markets the grain it acquires from members and other participating
patrons, and members and other participating 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 or other participating

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
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

PLR-137140-10 16

   cents per pound less U.S.D.A. condemnation.’ On its books, petitioner
   treated payments to its growers as a cost of production.”

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

allocations paid in money.” However, how the payments have been reported by
Taxpayer in prior years does not determine how the payments are treated prospectively
in this ruling.

  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.
PLR-137140-10 17

    For the 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. 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.

   We also note that payments to nonmembers who are not eligible to share in

patronage dividends (i.e., those with whom Taxpayer does not operate on a cooperative
basis with) do not constitute per-unit retains paid in money within the meaning of section
1382(b)(3) of the Code and, accordingly, are treated exclusively as purchases in the
cost of goods sold mechanism.

  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 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 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 grains 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.

   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)-