Evolving Cooperative
Business Structures
Daniel R. Schultz
5th Annual Farmer Cooperative Conference
November 13-15, 2002
PwC
5th Annual Farmer Cooperative Conference
Spotlight On The IRS
The theme of this conference is the trend for farmer
cooperatives to form strategic alliances.
An important question to ask and answer is: Can we
count on the Internal Revenue Service to be “here to
help,” or will they make troubled times even more difficult
for cooperatives?
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Answer:
In recent years, the Service appears to understand the
competitive pressures cooperatives face and is allowing
them to enter into joint ventures and other strategic
alliances without sacrificing the tax benefits provided for
co-ops in Subchapter T of the Internal Revenue Code.
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Background –
The primary tax benefit for farmer cooperatives is the
ability to avoid tax on net earnings from patronage
business by taking the tax deduction for patronage
dividends provided in Subchapter T of the Internal
Revenue Code (IRC).
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Subchapter T doesn’t specify rules for joint ventures so
any strategic alliance by a farmer cooperative must be
carefully planned to assure its net income will continue to
qualify as patronage source earnings eligible for payout
by the cooperative as a tax-deductible patronage
dividend.
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Historical perspective on the IRS treatment of farmer
cooperatives –
• From the 1970’s into the early 1990’s the IRS was a
“misguided missile” launched against cooperatives.
• During this “dark ages” era the IRS national farmer
cooperative industry specialist pursued an aggressive
agenda to allow patronage dividend deductions only for
income from transactions directly with patrons.
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During the 1970’s and 1980’s the IRS argued that –
– Interest earned on temporary investments of
working capital by cooperatives should be taxable
nonpatronage income.
– Rental income from leasing out excess warehouse
space or excess barge capacity should be taxable
nonpatronage income.
– Capital gains on the sale of assets used by
cooperatives in patronage activities should be
taxable nonpatronage income.
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In a number of cases during this time the IRS refused to
give co-ops private letter rulings approving patronage
treatment for income to be received from proposed
partnership joint ventures.
Fortunately for cooperatives, with a few minor
exceptions, the Service lost all the court cases it brought
on these issues.
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– Cotter & Co. – interest on temporary investment of
working capital and rental income from excess
warehouse space was held to be patronage source
income for the True Value hardware cooperative.
– Illinois Grain – interest on working capital and rental
of excess barge capacity was held by the court to be
patronage source income.
– Farmland Industries – capital gains on sale of stock
and fixed assets directly related to patronage
business held to be patronage source income.
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These court decisions established that determining
whether a cooperative’s income is patronage sourced or
not requires a very fact-intensive inquiry into whether the
income is from transactions that are directly related to
and actually facilitate the cooperative’s patronage
business activity.
This directly related test applies regardless of the source
or form of the income. It applies whether or not the
income is from transactions directly with patrons.
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The directly related test as applied in the Cotter, Illinois
Grain and Farmland court decisions to define patronage
source income has its roots in the Service’s own ruling,
Revenue Ruling 69-576, which dates back to the early
days of Subchapter T.
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These landmark court victories for cooperatives led to
the dawn of a new “enlightened” era at the IRS [at least
when it comes to co-ops]
By the last half of the 1990’s the IRS finally folded its tent
and “downsized” its farmer cooperative industry program
The Farmland Industries Tax Court decision in 1999 was
the last nail in the coffin.
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During the past few years the IRS national office has
issued a series of private letter rulings to cooperatives
that allow patronage source treatment for income earned
by cooperatives from a variety of partnership and LLC
joint venture structures.
Three recent post-Farmland case private letter rulings
allow patronage source status to large capital gains from
investments that originated as corporate joint ventures
between cooperatives and non-coop partners.
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Two examples of recent cooperative LLC joint venture
rulings from the IRS illustrate what’s going on these
days:
1. Private letter ruling 199920034 deals with a sugar
refining cooperative that formed a refining and
marketing LLC joint venture with two larger non-coop
sugar refiners.
2. Private letter ruling 200123033 was issued for the
Agriliance LLC joint venture set up by Farmland, Land
O’ Lakes and CHS Cooperatives to jointly operate
their agronomy businesses on a cooperative basis.
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PLR 199920034
Co-op
Members
Sugar crop
LLC Income
26%
Member
sugar
Sugar
Co-op
Assets
26%
Open
Market
Sugar
NonCo-op
Sugar Refiners
Sugar
Assets
74%
LLC Income
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Refining
and
Marketing
LLC
74%
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PLR 200123033
FL
CHS
LOL
LLC
Agriliance LLC
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Summing Up –
The IRS seems to finally realize what we’ve all known all
along –
Farmer cooperatives are not a threat to drain the U.S.
Treasury with their tax deductions for patronage
dividends.
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Cooperatives can’t survive in today’s economy, which is
characterized by global competition and the heavy
capital requirements of the technological revolution,
unless they have the freedom to team up in LLC joint
ventures and other forms of strategic alliances with
other companies, both co-ops and non-cooperatives,
to access more capital and bigger markets.
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One thing most co-ops can’t afford is the tax increase
that would result if the LLC joint venture income that
replaces their income from direct sales is treated as
taxable nonpatronage income.
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Thankfully, the IRS seems to understand the competitive
disadvantages most cooperatives operate under and
has been playing a supportive role by granting
cooperatives patronage treatment for their LLC
income from properly structured joint ventures.
However, caution is still called for. The senior IRS
national office decision-makers have roots in the
“reign of terror” of the 1970’s and 1980’s, so
cooperatives and their advisors still have to tread
carefully when applying for private rulings for joint
ventures.
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