IRS approves novel structure for cooperative of foreign members.

In Letter Ruling 200430028, the IRS took a flexible approach in deciding whether to treat an entity as a cooperative for tax purposes. The Service looked to the underlying structure of the business arrangement, rather than focusing on mechanical details, suggesting that it may be prepared to approach issues relating to the treatment of cooperatives flexibly in the future.

Background

In the ruling, growers proposed a novel structure to market their foreign-grown produce in the U.S. Three members, each a corporation in foreign country A, created a U.S. cooperative. Each member dealt exclusively with one of three crops that the cooperative would market in the U.S. A group of mostly unrelated growers (described as "primarily unrelated closely-held corporations whose farming activities are conducted in" A) own these three companies. For purposes of sales in the U.S., each grower will be a voting owner of one (and only one) of the cooperative's three member companies (the company whose crop is the grower's predominant crop). Any grower who produces more than one crop can be a nonvoting patron of the company that sold the crop the grower does not specialize in.

The growers market their produce in A through a single grower-owned company. That company will initially coordinate the allocation of crops between distribution in the U.S. and distribution in A, for which the growers will pay a fee. To the extent crops are allocated for U.S. distribution, each of the cooperative's three members will authorize its grower-shareholders to sell produce to the cooperative at an arm's-length price.

Division of earnings: The cooperative will market the produce and distribute its net earnings as patronage dividends to the three members, based on the business done with the cooperative by each member's respective grower-shareholders. Similarly, on liquidation, residual assets will be distributed based on patronage, to the extent practicable. Each cooperative member's capital contributions will be made in proportion to the anticipated patronage in the cooperative; it is intended that ownership will be maintained in alignment with sales.

The three member corporations are governed internally by rules similar to those that govern U.S. cooperatives. The shares of each are held only by growers; they do not plan to have nongrower investors. Annually, each member corporation is required to allocate to its growers (presumably including those who are shareholders of one of the other two members) the patronage dividend received from the cooperative, along with any nonpatronage earnings distributed. This allocation by the three members will be made in accordance with the patronage each grower has with the member, and any dividend distributions will be based on those allocations.

Issue

The question was whether this entity was "operating on a cooperative basis," within the meaning of Sec. 1381(a)(2) and, thus, could be treated as a cooperative under subchapter T. The IRS regularly starts this analysis by using the three-prong test enunciated in Puget Sound Plywood, Inc., 44 TC 305 (1965), acq., 1966-2 CB 3; i.e., is there:

1. Subordination of capital;

2. Democratic control; and

3. Operation at cost.

The ruling applies this test first to the cooperative. Subordination of capital requires that the profits from the enterprise and its control remain with patrons, rather than nonpatron investors. The IRS observed that the cooperative does not have nonpatron members, nor does it anticipate having them. The cooperative intends to operate on a cooperative basis going forward, and, on dissolution, its remaining assets, after the payment of its obligations, will go to patrons based on their patronage over a reasonable period. This satisfies the "subordination of capital" requirement. Each member has only one vote, which the Service considers a classic method of satisfying the "democratic control" requirement. Further, net earnings are distributed based on patronage, satisfying the "operation at cost" test.

"Look-through" technique: As was described, the three members do not patronize the cooperative; rather, their grower-shareholders sell produce to it. Instead of addressing directly whether patronage of the cooperative by its members' owners is consistent with cooperative principles, the ruling analyzes the three members' operations (although it does not explain why it is doing so). The IRS apparently feels it should "look through" the three members to see whether there is also a cooperative relationship among their patrons.

This is similar to the Service's treatment of a "federated cooperative" (i.e., a cooperative whose members are also cooperatives). Such a federated structure, consisting of U.S. cooperatives, has been permitted in the past by the IRS when each member of the federated cooperative is itself operating on a cooperative basis; see, e.g., Rev. Rul. 73-568. There, the IRS accepted a "look-through" principle in evaluating a federated cooperative and treated it as if it were serving the members' patrons directly. Similarly, in Sec. 199 (the manufacturing activities deduction), Congress "looks through" cooperatives to take into account their patrons' activities; see Sec. 199(d)(3) (B)(ii).

Analysis

The Service approaches the proper treatment of the structure in Letter Ruling 200430028 by implicitly asking whether the three members can be considered to operate on a cooperative basis. Apparently, if the answer to that question is "yes" then, in the IRS's view, cooperative treatment of the U.S. entity is warranted. The three members have only patron shareholders, which satisfies the Service that "subordination of capital" exists (although the ruling does not discuss how residual assets are treated on liquidation). Each member operates under a one-member, one-vote system, a structure that satisfies the "democratic control" test. The conclusion is apparently strengthened in the IRS's view by the fact that a grower that patronizes more than one of the three members is still limited to a single vote. As a result, each grower has only one vote, so the U.S. cooperative would satisfy the requirement for democratic control even if one were to treat its three members as if they were a single entity. "Operation at cost" is satisfied, because each member is required to allocate the patronage refunds received from the cooperative on a patronage basis once a year.

The members were not required to comply with Sec. 1388(c)(1)'s rule that an allocation is "qualified" only if at least 20% of the patronage dividend is made in cash. Apparently, in the Service's view, this requirement is not an element of operating on a cooperative basis. Having ascertained that the three members' operations satisfy the elements of cooperative operation, the Service concluded that the U.S. entity is itself operating on a cooperative basis.

"Base capital plan": One interesting aspect of the ruling is that it involves a cooperative whose members buy into a "base capital plan" from the start. As indicated above, subordination of capital is viewed as an essential part of cooperative organization. Subordination of capital means that the return of patron-investors is a function of their patronage, rather than their investment. However, one normal method for cooperatives to raise capital is a "base capital plan" In such an arrangement, members keep their capital accounts in line with their patronage.

Example: Cooperative B has two members, X and Y, each of which contributed half of B's capital. In 2004, X did 60% of the cooperative's patronage. A base capital plan might require X to leave more of its money in B, so that it holds 60% of B's capital. (Actual base capital plans may use a rolling average to fix the target capital for the cooperative.)

Such an arrangement makes it possible for patronage and capital investment to remain consistent, which reduces the significance of saying that there is subordination of capital. Nevertheless, the IRS has approved of such plans; see Letter Ruling 9237013, in which the IRS reasoned that the base capital plan was consistent with subordination of capital, using the following analysis:

Rather than creating a return on equity, the new capital plan encourages members to increase their business with the cooperative because as business and capital balances increase, so does the cash pay-outs of patronage earnings to members. Because patronage distributions of net earnings are based upon the patronage business done by the members with Corp P, the principle of subordination of capital is not violated.

This argument appears to rely on the fact that distributions are based ultimately on patronage, with the IRS accepting that capital invested could then follow the level of patronage. Letter Ruling 200430028 takes a small additional step, by allowing the cooperative to require an investment based on anticipated patronage as a prerequisite to joining.

NGCs

The close connection between investment and patronage is even stronger in so-called new generation cooperatives (NGCs). In NGCs, the capital does not build up over time; instead, potential patrons buy in to the cooperative, and their capital contribution dictates the amount of patronage they are authorized (and, indeed, required) to have. NGCs are clearly an established form of cooperative today; Letter Ruling 200430028 shows that the IRS should have no problem with that structure. Indeed, courts have decided cases involving NGCs with no indication that the IRS would attack the cooperative nature of those entities; see Bot, 118 TC 138 (2002), aff'd, 353 F3d 595 (8th Cir. 2003), and Fultz, TC Memo 2005-45 (both involving Minnesota Corn Processors before its acquisition by Archer Daniels Midland Co.).

FROM DAVID J. SHAKOW, J.D., LL.M., WASHINGTON, DC