Supplier settlement is cooperative patronage income

Plain-English summary

A grocery-distribution cooperative settled litigation over alleged overcharges on products it had bought for resale to its member stores. The IRS concluded that the settlement arose directly from the cooperative’s purchasing activity for patrons and therefore was patronage-sourced income rather than incidental nonpatronage income. The cooperative’s longstanding bylaws created a preexisting obligation to distribute patronage earnings, and a later amendment gave its board flexibility for extraordinary events. The IRS approved allocating part of the settlement-related dividend through the general current-year pool and the remainder among affected current members based on the quantity or value of their business during the litigation period. Any portion attributable to former patrons who would receive no dividend would instead remain taxable income to the cooperative.

Ruling snapshot

• Question: Were the overcharge settlement proceeds patronage income, and could the cooperative allocate them using historical patronage?
• Outcome: Approved
• Key authorities: IRC §§ 1382(b), 1388(a); Treas. Reg. §§ 1.1382-3, 1.1388-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201545001 Third Party Communication: None
Release Date: 11/6/2015 Date of Communication: Not Applicable
Index Number: 1381.00-00
Person To Contact:
------------------- ----------------------------, ID No. --------------
------------------------------ ------------------
------------------------------------------------ Telephone Number:
------------------------------ ----------------------
------------------------------------- Refer Reply To:
CC:PSI:B05
PLR-103864-15
Date: August 3, 2015

LEGEND:

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

b = -----------------

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

  This is in response to a request for rulings dated January 13, 2015, submitted by

your authorized representatives.

    Taxpayer is a taxable wholesale distributor of grocery products to individual retail

grocery operators that operates on a cooperative basis, subject to Subchapter T of the
Internal Revenue Code. Taxpayer's business is almost exclusively done with its
cooperative members. In accordance with its bylaws, Taxpayer is annually obligated to
distribute its patronage earnings to its member/patrons. Historically, Taxpayer has paid
approximately ------- percent of its patronage dividend in the form of cash, with the
remainder being paid in the form of a qualified written notices of allocation, within the
meaning of section 1388(c)(1).

     Historically, Taxpayer purchased b for sale to its members as part of Taxpayer's

patronage business activities. In -------, Taxpayer filed a lawsuit against ---------- b
producers and related parties for ------------------------------------------------------------------------
------------- regarding Taxpayer b purchases that occurred from ------- through ------- (the
"litigation period"). During the litigation period, Taxpayer purchased approximately $-----

million of b.
PLR-103864-15 2

     In -------, Taxpayer entered into separate settlement agreements with individual

defendants and groups of defendants. In each settlement agreement, the defendant
paid or agreed to pay an agreed amount in settlement of any and all claims made in the
litigation and any potential claims related to, arising out of, based upon, or in any way
concerning the facts, matters, occurrences, allegations, transactions, conduct alleged,
or subject matter of the litigation. In aggregate, Taxpayer received approximately $-------
million settlement proceeds in settlement of the lawsuit.

    Settlement proceeds do not exceed the amount of Taxpayer’s claimed damages.

In fact, in the case of some of the defendants, the amount paid in the settlement was
reflective of the defendant's distressed financial condition.

    Section 3(a) of Article IX of Taxpayer's bylaws provides that Taxpayer is required

to annually distribute as patronage dividends an amount equal to Taxpayer's net
patronage sourced earnings. Although Taxpayer's bylaws allow Taxpayer to maintain
and allocate among pools, Taxpayer historically has maintained all of its patronage
business in a single patronage pool. The bylaws provide that Taxpayer is to distribute
its patronage dividend "in proportion to the quantity of business done with such patron
during such fiscal year."

   The gross receipt of the $-------million settlement proceeds is a significant amount

to Taxpayer and its patrons. Although the litigation was funded by the overall
membership, the settlement proceeds are directly attributable to overpriced b, the cost
of which was borne directly by Taxpayer’s patrons who purchased b over the ------------
year time period.

     Taxpayer's board determined that in order to fairly allocate the portion of its

patronage dividend attributable to the settlement proceeds, a portion (approximately ----
--------percent) should be allocated in Taxpayer's general patronage pool and the
remainder (approximately -------------percent) should be allocated to Taxpayer’s patrons
who purchased b during the litigation period. In addition, with respect to the portion to
be allocated to the b patrons, Taxpayer’s board believes that the allocation should take
into account patronage of the b patrons over the applicable time period.

     Although Taxpayer's historic bylaws allowed the utilization of various pools,

Taxpayer's historic bylaws provided that any allocation of the patronage dividend was to
be based upon current year quantity of business done. The historic bylaws failed to
authorize an allocation based upon either (i) the value of the business done with of for
the patron, or (ii) the quantity of business done for more than the current year. In order
to grant Taxpayer the flexibility to allocate the portion of Taxpayer's patronage dividend
attributable to the settlement proceeds, Taxpayer amended its bylaws prior to the end of
------- to allow the board flexibility in the allocation of the patronage dividend with respect
to the b settlement proceeds and similar circumstances. Section 3(a) of Article IX of the
bylaws was amended to add paragraph (ii), which provides as follows:
PLR-103864-15 3

         (ii)    In the event the Corporation realizes net earnings from an
  extraordinary event or transaction with respect to which the patronage sourced
  earnings are attributable to the current year and/or prior years ("Extraordinary
  Event") and a determination is made by the Board of Directors to be appropriate
  under the particular circumstances, the Board of Directors may distribute the
  Patronage with respect to the Extraordinary Event among the patrons based
  upon (A) the value of the business done by the respective patrons with the
  Corporation ("Value Based") (as opposed to Quantity Based), (B) distribute
  based on Quantity Based or (C) distribute based on a combination of Quantity
  Based and Value Based, as the Board determines appropriate. The Board of
  Directors may take into account applicable business conducted prior to the then
  current fiscal year, if appropriate.

   As defined, the patronage attributable to the settlement proceeds would

constitute an Extraordinary Event. Under Section 3(a)(ii) of Article IX of the bylaws,
Taxpayer’s board would determine the appropriate portion to be allocated pursuant to
such Section 3(a)(ii). As determined by Taxpayer’s board, the portion allocated under
Section 3(a)(ii) would be based upon either the quantity or value of business done
(which would take into account the past patronage during the litigation period) or a
combination of the two.

  Under Taxpayer's bylaws, Taxpayer only distributes patronage to its members.

Although Taxpayer's membership has generally remained fairly stable, changes in
membership have occurred from the beginning of the litigation period through the
present. To the extent that a portion of the settlement proceeds are attributable to
former patrons, for whom Taxpayer has no obligation to distribute such amounts as
patronage dividends, Taxpayer intends to retain such amount and treat such amount as
non-patronage income.

   On the basis of the foregoing information, Taxpayer requests the following

rulings:

  1.     The settlement proceeds constitute patronage sourced income pursuant to
         section 1388(a).

  2.     Pursuant to Section 3(a)(ii) of Article IX of its bylaws, Taxpayer may
         allocate among its members a portion of the patronage dividends
         attributable to the settlement proceeds to the general pool (based upon
         current year patronage) and the remainder to the members (the “b
         Members") that purchased b during the litigation period (based either upon
         the value of the business done by the b Members (taking into account the
         business done during the litigation period) or the quantity of the business

PLR-103864-15 4

         done by the b Members (taking into account the quantity of business done
         during the litigation period).

    Taxpayer, as a cooperative, is obligated to annually pay patronage dividends to

its patrons on the business done with or for its members. Taxpayer pays the patronage
dividend through a combination of cash and qualified written notices of allocation, which
are currently deductible in determining Taxpayer's taxable income in accordance with
section 1382(b). The settlement proceeds constitute patronage dividends because they
are directly related to Taxpayer’s patronage business activity with its patrons.

    Section 1388(a), in relevant part, provides that for purposes of this subchapter,

the term "patronage dividend" means an amount paid to a patron by an organization to
which part I of subchapter T applies: (1) on the basis of quantity or value of business
done with or for such patron, (2) under an obligation of such organization to pay such
amount, which obligation existed before the organization received the amount so paid,
and (3) which is determined by reference to the net earnings of the organization from
business done with or for its patrons. The term does not include any amount paid to a
patron to the extent that (A) such amount is out of earnings other than from business
done with or for patrons, or (B) such amount is out of earnings from business done with
or for other patrons to whom no amounts are paid, or to whom smaller amounts are
paid, with respect to substantially identical transactions

   As to the initial requested ruling, the focus of the analysis is whether the

settlement proceeds are attributable to "net earnings of the organization from business
done with or for its patrons."

  Neither the Code nor the regulations promulgated thereunder defines business

"done with or for" patrons. However, Reg. § 1.1382-3(c)(2) provides that:

  the term "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. For example, income derived
  from the lease of premises, from investment in securities, or from the sale or
  exchange of capital assets, constitutes income derived from sources other than
  patronage.

  In Rev. Rul.69-576, 1969-2 C.B. 166, the Service provided the following analysis

of what it means for income to be patronage sourced:

  The classification of an item of income as from either patronage or nonpatronage
  sources is dependent on the relationship of the activity generating the income to
  the marketing, purchasing, or service activities of the cooperative. If the income
  is produced by a transaction which actually facilitates the accomplishment of the
  cooperative's marketing, purchasing, or service activities, the income is from

PLR-103864-15 5

   patronage sources. However, if the transaction producing the income does not
   actually facilitate the accomplishment of these activities but merely enhances the
   overall profitability of the cooperative, being merely incidental to the association's
   cooperative operation, the income is from nonpatronage sources.

     See also Rev.Rul.74-160, 1974-1 C.B. 245, (ruling that interest income realized

on loans made by the taxpayer was patronage source, because the loans “actually
facilitated the accomplishment of taxpayer’s cooperative activities, in that [the loans]
enabled the taxpayer to obtain necessary supplies for its operations”).

     The settlement proceeds are with respect to damages incurred by Taxpayer for

excessive prices paid on b purchased by Taxpayer and resold by Taxpayer to its b
Members. Thus, the settlement proceeds are attributable to the b purchases that
Taxpayer made in order to supply its patrons. Pursuant to section 1388(a) and the
rulings cited above, the settlement proceeds directly relate to Taxpayer’s purchase of
products sold as part of its cooperative business and are not incidental income to
Taxpayer’s operation. Taxpayer's purchases of b to service its members led to
Taxpayer’s filing of the lawsuit and receipt of the settlement proceeds. Therefore, the
settlement proceeds constitute patronage sourced income that is directly related to and
facilitative of Taxpayer’s cooperative operation and not incidental to Taxpayer’s
cooperative operations.

    Taxpayer will only be allocating and paying a patronage dividend to its current

members. Thus, if and to the extent that a portion of the settlement proceeds are
attributable to the business done with or for former b Members to whom no patronage
dividend will be paid, such portion of the settlement proceeds will not be distributed to
the b Members. Instead, Taxpayer will report such amounts in its computation of its
taxable income.

   Under Section 3(a) of Article IX of Taxpayer's historic bylaws, Taxpayer is

required to allocate and distribute as a patronage dividend its income attributable to the
settlement proceeds. Although Taxpayer's historic bylaws allowed Taxpayer to create
multiple patronage pools, Taxpayer has historically only utilized one pool. Under
Taxpayer's historic bylaws, all patronage dividends are to be allocated among
Taxpayer's members based upon the quantity of business done by Taxpayer's
members in the most recent year.

    Section 1388(a)(1) provides that a patronage dividend may be allocated and paid

"on the basis of quantity or value of business done with or for such patron." Taxpayer's
historic bylaws limited Taxpayer’s board to allocating Taxpayer's patronage dividend
among its members based upon the relative quantity of business done by Taxpayer with
or for such members. Under the newly adopted provisions of Section 3(a)(ii) of Article
IX of the Taxpayer bylaws, the Board is allowed to allocate the portion of Taxpayer's
patronage dividend attributable to an Extraordinary Event either based upon value or
PLR-103864-15 6

based upon quantity, or a combination of both. In any of the three methods, the board
may take into account patronage activity that occurs prior to the most recent year.

   In the context of the patronage dividend attributable to the settlement proceeds,

the value of business done by a particular b Member relates to the business that such
member did with Taxpayer during the litigation period, as opposed to the business the
b Member did with Taxpayer in the most recent year. Thus, under an allocation based
upon the value of business done, the board will take into account the business
transacted during the litigation period.

     If the board determines to allocate the patronage based upon quantity, the

Taxpayer board will take into account the b Members' patronage during the litigation
period. Such allocation is most consistent with the economic realization of the income
attributable to the settlement proceeds. The Service has approved of taking into
account past patronage in allocating a cooperative's patronage dividend among its
patrons. In Revenue Ruling 74-84, 1974-1 C.B. 244, a cooperative recognized income
from depreciation recapture. After confirming that such income as patronage sourced
income, the Service approved the allocation of the patronage dividend attributable to the
depreciation recapture over the period in which the depreciation was claimed, thereby
tracing the depreciation recapture income to the years in which tax depreciation was
claimed in excess of the economic depreciation. Accordingly, Taxpayer board's
allocation of the patronage dividend based upon the b Members' patronage during the
litigation period would be appropriate.

  In accordance with section 1388(a)(2), in order for an amount putatively paid as a

patronage dividend to be deductible as a patronage dividend, the amount must be paid
under a preexisting legal obligation. Section 1.1388-1(a)(1) provides that:

   For the purpose of subdivision (ii) of this subparagraph, amounts paid by a
   cooperative organization are paid under a valid enforceable written obligation if
   such payments are required by State law or are paid pursuant to provisions of
   the bylaws, articles of incorporation, or other written contract, whereby the
   organization is obligated to make such payment.

The legal obligation must exist at the time when the participating member patrons
transact their business with the cooperative, and not pursuant to an obligation created
after the allocated amount was earned. See Pomeroy Cooperative Grain Company v.
Commissioner, 31 T.C. No. 674 (Dec. 31, 1958).

    Taxpayer's bylaws (both before and after the recent amendment through the

addition of Section 3(a)(ii)) create a preexisting legal obligation. Taxpayer is obligated
to distribute to its patrons all of its net earnings from the business done with or for its
members. This obligation has existed throughout Taxpayer's operation as a
cooperative. Thus, Taxpayer's legal obligation has existed throughout the period that
PLR-103864-15 7

Taxpayer realized and recognized the income attributable to the settlement proceeds.
Taxpayer's preexisting legal obligation is not altered by Taxpayer board's discretion to
utilize different pools in its allocation of its patronage dividends among its members.

    Likewise, the additional discretion granted to Taxpayer’s board as to the method

to allocate its patronage dividend among its members pursuant to the newly adopted
provisions of section 3(a)(ii) of Article IX of Taxpayer's bylaws does not alter or affect
Taxpayer's preexisting legal obligation – it simply allows Taxpayer the discretion to
allocate the patronage dividend among the members under a different approved method
under section 1388(a). Given the unusual circumstances involved with the nature of the
income related to the settlement proceeds, in that the settlement proceeds represent
income attributable to improper overcharges imposed on Taxpayer over a ------------
year time period that ended ------ years prior to the year of the receipt, the exercise of
the board's discretion in accordance with Taxpayer's bylaws is the appropriate
allocation of the patronage dividend. In addition, the exercise of discretion does not
undermine Taxpayer's preexisting legal obligation to pay its members the patronage
dividend, it only allows Taxpayer to allocate that patronage dividend to the members
that should receive such patronage dividend.

   The courts have recognized the key aspect of a cooperative, its board and its

membership in determining the appropriate allocation of patronage dividends among the
membership. In Kingfisher Coop. Elevator Assoc. v. Commissioner, 84 T.C. 600, 613-
14 (1995), Taxpayer, a subchapter T agricultural cooperative, was allocated patronage
dividends from several cooperatives in which it was a member. The dividends received
related to fiscal years other than the fiscal year in which Taxpayer reported such
income. Instead of determining that the dividend be allocated precisely in proportion to
the patronage that generated them, the Taxpayer’s Board of Directors employed an
accounting method that allocated all of the dividends based upon the patronage in the
year in which the dividends were taxable to it. The Service contended that the
Taxpapyer should allocate its patronage to its members based upon the years to which
the patronage dividends received by Kingfisher related. The Tax Court agreed with
Taxpayer, stating that "the allocation method chosen by its democratically elected Board
of Directors, ratified annually and employed consistently for many years, was equitable
and reasonable." Kingfisher, 84 T.C. at 614. Noting that a board of director’s "weighing
of the equity should be overturned by this Court only when the exercise of that
discretion appears to have been unreasonable," the Tax Court held that the
government’s proposed reallocation was not superior to Taxpayer's, particularly when it
appeared that Taxpayer’s "directors made a concerted effort to ensure that all members
were treated fairly." Id. at 617-18.

    The proposed allocation by Taxpayer's board under its recently adopted Section

3(a)(ii) of Article IX of its bylaws represents the concerted effort of Taxpayer’s board to
ensure that all members are treated fairly. The split of the settlement proceeds is
necessary to be fair, based upon the historic treatment of prior and significantly smaller
PLR-103864-15 8

settlement receipts and the fact that the overall membership provided support to the
litigation and the fact that the b Members disproportionately suffered from the price
fixing that gave rise to the settlement proceeds.

   Based on the foregoing, Taxpayer may allocate the settlement proceeds

pursuant to the recently adopted bylaw amendment and such allocation and distribution
of funds constitute a deductible patronage dividend under section 1382(b).

  Accordingly, based solely on the foregoing, we rule that:

  1.     The Settlement Proceeds constitute patronage sourced income pursuant
         to section 1388(a).

  2.     Pursuant to Section 3(a)(ii) of Article IX of its bylaws, Taxpayer may
         allocate among its members a portion of the patronage dividends
         attributable to the settlement proceeds to the general pool (based upon
         current year patronage) and the remainder to the b Members that
         purchased b during the litigation period (based either upon the value of the
         business done by the b Members (taking into account the business done
         during the litigation period) or the quantity of the business done by the b
         Members (taking into account the quantity of business done during the
         litigation period).

    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,



                                        NICOLE R. CIMINO
                                        Senior Technician Reviewer Branch 5
                                        Office of the Associate Chief Counsel
                                        (Passthroughs & Special Industries-)