IRS Acquiesces in Cooperative Decision

The IRS has acquiesced in Farmland Industries, Inc., TC Memo 1999-338 (AOD CC 2001-03). Farmland Industries is a farmers' cooperative, but it is not small potatoes—last year it ranked number 161 in the Fortune 500 and the amount at issue totaled over $70 million in deficiencies.

The issue before the court was whether certain capital gain income was "patronage income" under subchapter T, the part of the Code that provides special rules for cooperatives. Cooperatives are generally formed as corporations. As a special deduction, they can deduct patronage dividends distributed (or at least allocated) to members in accordance with Sec. 1388. For the cooperative to get a deduction, it must pay the distribution from patronage income.

For most items of cooperative income, a cooperative can determine relatively easily whether it earned the item as part of patronage income, as most of a cooperative's income comes from the sale of patrons' produce to third parties or from the sale of supplies to patrons. However, on the sale of an asset that may have been used in the cooperative's business, the IRS has battled the courts over the standards for identifying whether the resulting income is patronage income.

In Farmland Industries, the Service argued for a bright-line distinction; if gain on the asset was ordinary, the cooperative could treat it as patronage income. The IRS based its position on Regs. Sec. 1.1382-3(c)(2), which states that "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." The Service proposed a mechanical test. For example, if the taxpayer sold depreciable real property at a gain, the IRS was prepared to treat as patronage income any gain characterized as ordinary because of recapture, while the remaining gain, which was not ordinary, was not treated as patronage income.

The taxpayer argued that whether gain or loss from the sale of an asset affected patronage income depended on the relationship between the activities producing the gain or loss and the cooperative's operations; as long as the activity producing the gain or loss is related directly to the cooperative's operations, the gain or loss should be treated as patronage income. In contrast to the Service's mechanical approach, the taxpayer's approach required a facts-and-circumstances analysis of each case.

The court agreed with the taxpayer, and the IRS has acquiesced. It will source any type of income as patronage income (even those mentioned in Regs. Sec. 1.1382-3(c)(2)), as long as the activity generating the income is an integral part of a cooperative's business. In Farmland Industries, the patronage-source income included gain from the purchase and sale of minority interests in other corporations, which might not normally generate such income. However, because the court found that each corporation was formed, operated and sold to facilitate the cooperative's business, the sale of the stock generated patronage income (or loss).

The one qualification by the Service in the acquiescence was that it disagreed with language in the opinion that suggested that gain on the sale of an asset was patronage-sourced solely because the proceeds of the sale were needed to preserve the cooperative's business. Absent a direct relationship (prior to the sale) between the asset and the cooperative's business, the IRS remains unwilling to treat the gain from the sale as patronage-sourced.

The Service has not been all that successful recently in winning cases involving subchapter T; see, e.g., Gold Kist, Inc., 110 F3d 769 (11th Cir. 1997) and CF Industries, Inc., 995 F2d 101 (7th Cir. 1993). However, Farmland Industries may be particularly suggestive of the direction courts could be going.

In Farmland Industries, the court rejected a mechanical test that the IRS attempted to impose on cooperatives. In the past, the Service asserted a number of rigid requirements in regard to a basic characteristic of cooperatives, operating on a "cooperative basis." Perhaps with its loss in Farmland Industries, the IRS will reexamine its positions on some other issues in the area of cooperatives, and soften some of the more inflexible positions it has taken in the past. Otherwise, the courts may step in to do so.

From David J. Shakow, J.D., LL.M., Washington, DC