Cooperative asset-sale gain qualifies for patronage dividend deduction

Plain-English summary

A cooperative sold substantially all of its operating assets and planned to liquidate. It proposed allocating a member portion of the gain using the average patronage-to-nonpatronage business ratio for the years with available records, then distributing that portion to active and inactive members based on historic participation. The IRS ruled that the member portion was directly related to patron business, constituted patronage income, and was eligible for the patronage dividend deduction; using the available-year data did not prevent the deduction.

Ruling snapshot

• Question: Is the member portion of gain from selling a cooperative business patronage income eligible for the section 1382(b)(1) patronage dividend deduction?
• Outcome: approved
• Key authorities: IRC §§ 1381, 1382(b)(1), 1388(a); Treas. Reg. § 1.1382-3(c)(3); Rev. Rul. 69-576; Farmland Industries, Inc. v. Commissioner

Full text (IRS public release)

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Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202014011 Third Party Communication: None
Release Date: 4/3/2020 Date of Communication: Not Applicable
Index Number: 1382.00-00, 1388.00-00
Person To Contact:
-------------------------------- -------------------------, ID No. -----------------
------------------------------ -----------------------------------------------------
------------------- Telephone Number:
------------------------------------- --------------------
Refer Reply To:
CC:PSI:B05
PLR-115110-19
Date:
December 19, 2019

Legend

Coop = ----------------------------------------------------------------------------------------------------------

Corporation A = --------------------------------------------------------

State A = ---------

X = ---------------

Y = ------

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

   This is in response to a letter dated June 25, 2019, submitted on behalf of Coop

by your authorized representative requesting a ruling on the transaction described
below.

   Coop represents the facts as follows. Coop is currently a corporation operating

on a cooperative basis under the laws of State A. Coop is operating on a cooperative
basis within the meaning of subchapter T of the Internal Revenue Code (Code). Coop
uses the calendar year for financial accounting and tax return reporting purposes.

     In --------, ----------------------- began a business to provide shared access to ---------

----------------------------------------------. In -------, that business was transferred to a wholly-
owned, for-profit subsidiary of a not-for-profit trade association, whose membership
consisted of federally and state-chartered credit unions. The subsidiary expanded the
PLR-115110-19 2

business and also developed a --------------------------------------- to allow-------------------------

-------------------------------------------------------.

   In -------, Coop incorporated under the laws of State A, organized as a

corporation operating on a cooperative basis, and subject to income taxation under
subchapter T of the Code. Following its incorporation, Coop purchased the business
from the for-profit subsidiary and offered ----------------- that were customers of the
business to become shareholder-members of the Coop.

     Coop’s purpose was to develop, maintain, and operate on a cooperative basis an

-------------------------------- network for -------------- transactions to make it possible for its
members, -------------------------------------------------------- located across the country, to
issue ---------------------------- to their members and thus to compete with -------- and other
--------------------------. Coop’s business activities included network administration,
network operations, and sales and product development. Coop did not engage in any
business activity not related its purpose.

     Coop’s objective was to serve -----------------, and its bylaws limited membership

to -----------------, -----------------owned subsidiaries, and associations of -----------------.
Coop was also authorized to do business with other persons (nonmembers) on a
nonpatronage basis. The other persons that chose to participate in the network on a
nonpatronage basis were ----------------- that chose not to become members of Coop.

     Coop operated successfully as a cooperative for many years. However, Coop

was a small, limited-service, niche-market company in an increasingly competitive -------
------------- industry. At the beginning of -------, Coop undertook a comprehensive
strategic analysis to review its options going forward, and the analysis identified several
factors that presented significant threats to Coop’s business. While this review was
underway, Corporation A expressed an interest in buying Coop’s business. Ultimately,
after careful review by Coop’s Board of Directors and after obtaining approval from
members, Coop made the decision to sell the business to Corporation A.

     Coop’s members unanimously approved the sale of Coop’s assets as an on-

going business to Corporation A, and the sale closed on -------------, -------. The agreed
purchase price was $X. The transaction was structured as an asset sale. With a few
specified exceptions, Corporation A bought all of Coop’s assets “real, personal or
mixed, tangible and intangible, of every kind and description, wherever located.” These
assets included all tangible personal property, all accounts receivable, all inventories, all
of the network service and license agreements with Coop’s members and other -----------
------- customers, other agreements related to the business, settlement accounts,
business records, all intangible rights and property (including the names “-------------------
---” and “------------”), and all goodwill and going concern value. Excluded assets
included cash, and cash equivalents and corporate (as opposed to business) records
such as minute books, tax returns, tax work papers, etc.
PLR-115110-19 3

   When approving the sale, Coop’s members also approved winding up and

liquidating Coop. Coop’s Bylaws create an obligation to distribute patronage earnings
to members on a patronage basis. In the case of asset gains, Coop’s Bylaws are silent
as to what period to use for measuring patronage. Coop’s Bylaws provide that upon
dissolution, after debts and obligations have been paid and allocated equities have
been retired, residual assets shall be shared by shareholders (including both active and
inactive members) based on historic participation.

    Coop plans to make distributions to persons who were members (shareholders),

both active and inactive, at the time of dissolution based on their historic participation in
Coop’s business. Coop has historically paid patronage dividends only to members.
Coop has determined Y percent of the gain from the sale to Corporation A is eligible for
distribution as a patronage dividend (the “Member Portion”). That percentage is the
average of the patronage/nonpatronage business ratios over the past --- years. Coop is
using --- years because the patronage/nonpatronage data for the first -- years of its
operations is no longer available. Coop believes that the period used is representative
of its business activities over its entire existence, and that the Member Portion would be
slightly higher if information from the earlier years was available. Coop plans to treat
the remainder as a non-deductible liquidating distribution.

   Based on the foregoing, Coop is requesting rulings that:

   1. The Member Portion of the net gain realized by Coop on the sale of
   substantially all of the assets of its cooperative business to Corporation A is net
   income from business done “with or for” patrons within the meaning of section
   1388(a)(3).

   2. Pursuant to section 1382(b)(1), Coop will be entitled to exclude or deduct as a
   “patronage dividend” a portion of the patronage-based distributions equal to the
   Member Portion of the net gain realized on the sale.

   Section 1381(a) provides the organizations to which part I of subchapter T

applies. Coop represents that it has been operating on a cooperative basis from its
incorporation and has filed federal income tax returns in accordance with its status as a
cooperative.

   Section 1382(b)(1) permits an organization to which part I of subchapter T

applies, in determining taxable income, to not take into account patronage dividends (as
defined in section 1388(a)) paid during the payment period for the taxable year.

   Section 1388(a) provides that 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
PLR-115110-19 4

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. Such
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.

    In Rev. Rul. 69-576, 1962-2 C.B. 166, the taxpayer (a nonexempt farmers'

cooperative) borrowed money from a bank for cooperatives to finance the acquisition of
agricultural supplies for resale to its members. At the close of the taxable year for the
bank, the bank determined its net earnings, which it then allocated to its patrons,
including the nonexempt farmers' cooperative, on a patronage basis. The patronage
allocations were based on the proportion of the total interest paid to it by each
cooperative during the taxable year. The nonexempt farmers' cooperative in the instant
case included the patronage allocations received by it from the bank for cooperatives in
its gross income for the taxable year received under section 1385 of the Code. Under a
preexisting obligation the nonexempt farmers' cooperative then allocated and paid the
same amount it received from the bank for cooperatives to its own patron. The Rev. Rul.
held that the allocation and payment of the amount by the nonexempt farmer's
cooperative to its own patrons qualified as a patronage dividend. The Rev. Rul. stated
that: “The classification of an item as from either patronage or non-patronage 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 servicing activities, the income is from patronage sources.”

     In Farmland Industries, Inc. v. Commissioner, 78 T.C.M. 846, 864 (1999), acq.,

AOD 2001-03, a cooperative organized for the purpose of providing petroleum products
to its patrons, sought to have the proceeds from the disposition of its stock in three
subsidiaries, along with the income from the sale of its gas and soybean facilities, and
miscellaneous depreciable business assets classified as patronage source. In
articulating the “directly related” test for making the determination, the Court provides
that if the income at issue is produced by a transaction which is directly related to the
cooperative enterprise, such that the transaction facilitates the cooperative’s marketing,
purchasing or service activities, then the income is deemed to be patronage income.
On the other hand, if the income is derived from a transaction that has no integral and
necessary linkage to the cooperative enterprise, such that it may fairly be said that the
income is merely incidental to the cooperative enterprise and does nothing more than
add to the overall profitability of the cooperative, then the income is deemed to be
nonpatronage income. The determination of whether income derived from a transaction
that is directly related to the cooperative enterprise, and, thus, is patronage income is a
determination that is necessarily fact intensive. In considering the relatedness of the
income-producing transaction to the cooperative enterprise, it is important to focus on
the “totality of the circumstances” and to view the business environment to which the
PLR-115110-19 5

income-producing transaction is related and not to view the transaction so narrowly as
to limit it only to its income-generating characteristic when such a characterization is not
consistent with the actual activity. The Court ruled that the sale of cooperative’s assets
met the directly related test and therefore the resultant gains and losses were patronage
sourced.

   Section 1.1382-3(c)(3) of the Income Tax Regulations, provides that it is

necessary that the amount sought to be deducted be paid on a patronage basis in
proportion, insofar as is practicable, to the amount of business done by or for patrons
during the period to which such income is attributable. For example, if capital gains are
realized from the sale or exchange of capital assets acquired and disposed of during the
taxable year, income realized from such gains must be paid to patrons of such year in
proportion to the amount of business done by such patrons during the taxable year.
Similarly, if capital gains are realized by the association from the sale or exchange of
capital assets held for a period extending into more than one taxable year income
realized from such gains must be paid, insofar as is practicable, to the persons who
were patrons during the taxable years in which the asset was owned by the association
in proportion to the amount of business done by such patrons during such taxable
years.

   Based on consideration of Coop’s representations, the Member Portion of the net

gain from the sale of its business assets is directly related to the amount of business
done with or for patrons. Taxpayer’s use of data from only X years, rather than for its
entire existence, will not affect Taxpayer’s ability to deduct the Member Portion paid to
the members. Accordingly, the Member Portion of the net gain from the sale of its
business assets to Corporation A is patronage income eligible for patronage dividend
deduction under subchapter T.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty 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.

   This ruling is directed only to the taxpayers that requested it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.
PLR-115110-19 6

  In accordance with the power of attorney submitted with the ruling request, a

copy of this letter is being sent to your authorized representative.

                                            Sincerely yours,



                                            James A. Holmes
                                            Senior Counsel, Branch 5
                                            Office of Associate Chief Counsel
                                            (Passthroughs & Special Industries)

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