Evolving Cooperative Business Structures

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Evolving Cooperative Business Structures

• Daniel R. Schultz
• 5th Annual Farmer Cooperative Conference
• November 13-15, 2002

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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?

PricewaterhouseCoopers
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5th Annual Farmer Cooperative Conference

• 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.

PricewaterhouseCoopers
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5th Annual Farmer Cooperative Conference

• 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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5th Annual Farmer Cooperative Conference

• Subchapter T doesnt 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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5th Annual Farmer Cooperative Conference

• Historical perspective on the IRS treatment of
  farmer cooperatives
• From the 1970s into the early 1990s 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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5th Annual Farmer Cooperative Conference

• During the 1970s and 1980s 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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5th Annual Farmer Cooperative Conference

• 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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5th Annual Farmer Cooperative Conference

• 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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5th Annual Farmer Cooperative Conference

• These court decisions established that
  determining whether a cooperatives 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 cooperatives
  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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5th Annual Farmer Cooperative Conference

• 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 Services own ruling, Revenue
  Ruling 69-576, which dates back to the early days
  of Subchapter T.

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5th Annual Farmer Cooperative Conference

• 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 1990s 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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5th Annual Farmer Cooperative Conference

• 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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5th Annual Farmer Cooperative Conference

• Two examples of recent cooperative LLC joint
  venture rulings from the IRS illustrate whats
  going on these days
• 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.
• 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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5th Annual Farmer Cooperative Conference

• PLR 199920034

LLC Income 26
Co-op Members
Sugar Co-op
Member sugar Assets 26
Sugar crop
Refining and Marketing LLC
Non- Co-op Sugar Refiners
Sugar Assets 74
Open Market
Sugar
LLC Income 74
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5th Annual Farmer Cooperative Conference

• PLR 200123033

FL
CHS
LOL
LLC
Agriliance LLC
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5th Annual Farmer Cooperative Conference

• Summing Up
• The IRS seems to finally realize what weve 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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5th Annual Farmer Cooperative Conference

• Cooperatives cant survive in todays 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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5th Annual Farmer Cooperative Conference

• One thing most co-ops cant 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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5th Annual Farmer Cooperative Conference

• 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 1970s and 1980s,
  so cooperatives and their advisors still have to
  tread carefully when applying for private rulings
  for joint ventures.

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