Patronage dividends are excluded from REIT income tests

Plain-English summary

A timberland REIT borrowed under a credit agreement from cooperative lenders and received annual patronage dividends based on its borrowing activity. Those dividends were includible in the REIT's gross income under section 1385 but economically reduced its prior-year interest expense. The IRS concluded that excluding the patronage dividends from gross income solely for the REIT's 95 percent and 75 percent income tests was consistent with the tests' focus on passive income. The ruling did not decide whether the taxpayer otherwise qualified as a REIT or whether the credit agreement was a loan for federal tax purposes.

Ruling snapshot

• Question: Do cooperative-lender patronage dividends count as gross income for the REIT income tests?
• Outcome: No, they are excluded for the section 856(c)(2) and (c)(3) tests even though included in taxable gross income under section 1385
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(c)(5)(J), 1385, and 1388

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201602003 Third Party Communication: None
Release Date: 1/8/2016 Date of Communication: Not Applicable
Index Number: 856.01-00, 856.02-00
Person To Contact:
-------------- -------------, ID No. ----------------
------------------------------------------------ Telephone Number:
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-------------------------------------------- Refer Reply To:
------------------------------------- CC:FIP:B01
PLR-115789-15
Date:
October 13, 2015

LEGEND:

Taxpayer ----------------------------------------------------------

Initial Lenders ---------------------------------------------------------------------------------
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Administrative Agent ------------------

Lenders ---------------------------------------------------------------------------------
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Voting Participants ---------------------------------------------------------------------------------
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Date 1 --------------------------

Date 2 ---------------------------

A --------------

B -----------------

C ----------------

D ---
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Dear ------------:

  This is in reply to a letter dated April 30, 2015, requesting a ruling that the

patronage dividends described below do not constitute gross income to Taxpayer for
purposes of § 856(c)(2) or § 856(c)(3).

                                     FACTS

    Taxpayer is a domestic corporation whose common stock is publicly traded.

Taxpayer elected to be treated as a real estate investment trust (“REIT”) beginning with
its taxable year ending Date 1. Taxpayer is a calendar year taxpayer that uses an
overall accrual method of accounting. Taxpayer’s primary business is to own and
manage timberland properties.

  The Lenders are subchapter T (§§ 1381-1388) cooperatives owned by the

patrons who borrow from them. The Lenders make distributions to their patrons in the
form of “patronage dividends.” The amounts of patronage dividends are based on the
quantity or value of business done with the patron.

   Taxpayer entered into a seven year credit agreement dated Date 2, (the “Credit

Agreement”) with the Initial Lenders to borrow $A from the Initial Lenders. Prior to
closing the Credit Agreement, one of the Initial Lenders assigned $B of its commitment
under the Credit Agreement to the Administrative Agent and Administrative Agent
together with the Initial Lenders became the Lenders under the Credit Agreement.
Administrative Agent sold participating shares in its share of the loan under the Credit
Agreement to the Voting Participants in the cumulative amount of $C.

    Taxpayer receives annual patronage dividends from the Lenders (and not from

any Voting Participants), the terms of which are set by each Lender in its respective
bylaws and other relevant documents (the patronage dividends received specifically by
Taxpayer with respect to amounts borrowed under the Credit Agreement are
“Patronage Dividends”). The amount of any Patronage Dividend depends on the
amount borrowed and the time such amount is outstanding. Administrative Agent pays
part of its Patronage Dividends in the form of equity. Per its bylaws, Administrative
Agent targets D% of its total patronage dividends to be paid in equity until the target
equity percentage has been met by the patron (in this case the Taxpayer).

                             REPRESENTATIONS

    The following representations are made by Taxpayer:

PLR-115789-15 3

   (a)    Taxpayer has used the proceeds of the Credit Agreement to pay off a
          mortgage of an affiliate secured by real estate assets described in
          § 856(c)(4)(A).

   (b)    The Patronage Dividends will be patronage dividends within the meaning
          of § 1388(a) and will be included on the tax return of Taxpayer as gross
          income.

   (c)    For financial accounting purposes, Taxpayer will treat the Patronage
          Dividends as a reduction in the interest expense related to Borrowings
          under the Credit Agreement.

                              LAW AND ANALYSIS

    Section 856(c)(2) provides that in order for a corporation to qualify as a REIT, at

least 95 percent of the corporation's gross income (excluding gross income from
prohibited transactions) must be derived from sources that include dividends, interest,
rents from real property, and gain from the sale or other disposition of stock, securities,
and real property (other than property in which the corporation is a dealer).

   Section 856(c)(3) provides that in order for a corporation to qualify as a REIT, at

least 75 percent of the corporation's gross income (excluding gross income from
prohibited transactions) must be derived from rents from real property, interest on
obligations secured by real property, gain from the sale or other disposition of real
property (other than property in which the corporation is a dealer), dividends from REIT
stock and gain from the sale of REIT stock, abatements and refunds of taxes on real
property, income and gain derived from foreclosure property, commitment fees to make
loans secured by mortgages on real property or to purchase or lease real property, gain
from certain sales or other dispositions of real estate assets, and qualified temporary
investment income.

   Section 856(c)(5)(J) provides that to the extent necessary to carry out the

purposes of part II of subchapter M of the Code, the Secretary is authorized to
determine, solely for purposes of such part, (i) whether any item of income or gain
which does not otherwise qualify under §§ 856(c)(2) or (c)(3) may be considered as not
constituting gross income for purposes of §§ 856(c)(2) or (c)(3), or (ii) whether any item
of income or gain which otherwise constitutes gross income not qualifying under
§§ 856(c)(2) or (c)(3) may be considered as gross income which qualifies under
§§ 856(c)(2) or (c)(3).

    Section 301(a) provides that except as otherwise provided in chapter 1 of subtitle

A of the Code (which chapter includes §§ 301, 316, 317, 856, and 1388), a distribution
of property (as defined in § 317(a)) made by a corporation to a shareholder with respect
to its stock shall be treated in the manner provided in § 301(c).
PLR-115789-15 4

   Section 301(c) provides, in part, that in the case of a distribution to which

§ 301(a) applies, that portion of the distribution which is a dividend (as defined in § 316)
shall be included in gross income.

    Section 316(a) provides that for purposes of subtitle A (which subtitle includes

§§ 856 and 1388), the term “dividend” means any distribution of property made by a
corporation to its shareholders (1) out of its earnings and profits accumulated after
February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed
as of the close of the taxable year without diminution by reason of any distributions
made during the taxable year), without regard to the amount of the earnings and profits
at the time the distribution was made.

    Section 316(a) provides in the flush language that, except as otherwise provided

in subtitle A, every distribution is made out of earnings and profits to the extent thereof,
and from the most recently accumulated earnings and profits. It provides further that to
the extent that any distribution is, under any provision of subchapter C of chapter 1 of
subtitle A, treated as a distribution of property to which § 301 applies, such distribution
shall be treated as a distribution of property for purposes of this subsection.

     Section 1388(a) provides that, for purposes of subchapter T, 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. For this purpose, net earnings shall not be reduced by amounts paid
during the year as dividends on capital stock or other proprietary capital interests of the
organization to the extent that the articles of incorporation or bylaws of such
organization or other contract with patrons provide that such dividends are in addition to
amounts otherwise payable to patrons which are derived from business done with or for
patrons during the taxable year.

   Section 1388(a) further provides that the term patronage dividend 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.

    Section 1385(a)(1) provides, that, except as otherwise provided, each person

shall include in gross income the amount of any patronage dividend which is paid in
money, a qualified written notice of allocation, or other property (except a nonqualified
written notice of allocation), and which is received by him during the taxable year from
an organization described in § 1381(a).
PLR-115789-15 5

   The legislative history underlying the tax treatment of REITs indicates that a

central concern behind the gross income restrictions is that a REIT's gross income
should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th
Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, at 822-23 states, “[o]ne of the principal
purposes of your committee in imposing restrictions on types of income of a qualifying
real estate investment trust is to be sure the bulk of its income is from passive income
sources and not from the active conduct of a trade or business.”

    Patronage dividends paid by a subchapter T cooperative are a return of earnings

to its cooperative patrons based on the amount of business that the patron transacts
with the cooperative. The patronage dividends paid by a subchapter T financing
cooperative effectively reduce the costs that its patrons incur to borrow funds from the
cooperative. The amounts paid by Lenders as Patronage Dividends represent earnings
that the cooperatives are able to refund to Taxpayer based on the average amounts that
Taxpayer borrowed from Lenders during the prior year. Thus, while Taxpayer must
include Patronage Dividend income in its gross income under § 1385(a)(1), the
Patronage Dividends effectively reduce Taxpayer's interest expense paid during the
prior year. Under the facts of the instant case, exclusion of the Patronage Dividends
from gross income for purposes of §§ 856(c)(2) and (c)(3) does not interfere with
Congressional policy objectives in enacting the income tests under those provisions.

                                 CONCLUSION

   Accordingly, pursuant to § 856(c)(5)(J)(i), we conclude that the Patronage

Dividends included in Taxpayer's gross income under § 1385 are excluded from its
gross income for purposes of §§ 856(c)(2) and (c)(3).

    Except as specifically ruled upon above, no opinion is expressed concerning any

federal income tax consequences related to the facts herein under any other provisions
of the Code. Specifically, we do not rule whether Taxpayer qualifies as a REIT under
Part II of Subchapter M of Chapter 1 of the Code. Additionally, we are not ruling on the
tax treatment of the Credit Agreement and whether the agreement is a loan for federal
income tax purposes.

  This ruling is directed only to the taxpayer requesting it. Taxpayer should attach

a copy of this ruling to each tax return to which it applies. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.

  The rulings contained in this letter are based upon information and

representations submitted by the Taxpayer under a penalties of perjury statement
executed by an appropriate party. While this office has not verified any of the material
submitted in support of the request for rulings, it is subject to verification on
examination.
PLR-115789-15 6

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                               Sincerely,


                                               ___________________________
                                               Steven Harrison
                                               Chief, Branch 1
                                               Office of Associate Chief Counsel
                                               (Financial Institutions & Products)

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