CHAPTER 13
HANDLING OF LOSSES
It seems ironic indeed that cooperatives may face more
difficult income tax problems in years when they suffer a loss
than in years in which they generate net income. This, however,
is frequently the case.
Part of the difficulty in handling losses is business related.
Cooperative leaders may be under considerable pressure to
handle a traumatic situation, usually with little or no clear
guidance from incorporation statutes, cooperative bylaws, or
precedence.
Several alternative actions may be available, each with some
positive and negative consequences. Portions of this chapter
discuss how cooperatives can generate losses and the options for
dealing with them. Hopefully, this will encourage cooperative
leaders and advisers to anticipate potential losses and plan to
handle them before the stresses actually occur.
Another factor that complicates handling cooperative losses
is the lack of direction in the Internal Revenue Code (Code) and
Treasury Department regulations (regulations). While the Code
has provisions on the general treatment of losses by corporations
and individuals,² the only references to losses in Subchapter T are
relatively recent language dealing with netting of patronage gains
and losses³ and a definition of “completed crop pool method of
accounting” that recognizes an individual crop-year pool may
have a loss.4
The regulations mention cooperative losses when discussing
redemption of nonqualified written notices of allocation, and the
distribution of patronage refunds related to the disposition of a
Technologies Online Portal Advance and Code.
E and with factor E.
Cooperative losses
is the lack of direction in the internal revenue code (code) and treasury department regulations (Regulations).
The Code has PROVISIONS
on the general treatment of losses
by corporations and individuals,
the only references to losses
in
Subchapter T
are relatively recent language dealing with
netting of patronage gains and losses
and
a definition of
“completed crop pool method of accounting”
that recognizes an individual crop-year pool may have a loss.
The regulations mention cooperative losses when discussing
redemption of nonqualified written notices of allocation,
and the
distribution of patronage refunds
related to the disposition of a
Compliance Officer: William P Washington
Jennifer R Holderman,
2 Notably I.R.C. § 165 (provides a deduction of losses) and § 172 (authorizes net operating loss carrybacks and carryovers).
3 I.R.C. § 1388(j ), Consolidated Omnibus Budget Reconciliation Act of 1985, Pub. L. 99-272, § 13210, 100 Stat. 82, 323-324 (1986). This provision is discussed at pp. 101-106.
4 * I.R.C. § 1382(g)(2).
5 Treas. Reg. § 1.1383-1(a)(2), § 1.1383-1 (b)(3), and § 1.1383-1(d).
capital asset. The regulations also refer to the possibility of a loss
at the patron level related to the redemption of a patronage
distribution from a cooperative.” But nowhere is guidance
provided to cooperatives in reporting common losses for tax
purposes. Thus most ground rules for handling cooperative
losses have developed through court decisions and Internal
Revenue Service (IRS or the Service) administrative rulings.
HOW COOPERATIVES HAVE LOSSES
Cooperatives, like other business entities, generally compute
their financial results on an annual basis. A loss occurs whenever
expenses assigned to a given tax year exceed revenues generated
during that year.
Cooperatives may experience a loss for several reasons, such
as operations that fail to cover expenses, dispositions of assets,
and changes in accounting procedures.
Losses on Operations
Cooperatives generally provide two types of services to their
member-users. They sell them supplies and business services and
market products produced by members. These operations are
often called “functions. “
Cooperatives may provide services in only one or in both
functions. For example, a cooperative may only market wheat for
its members, only sell farm supplies, or do marketing and supply
functions.
When computing their financial results for the year,
cooperatives that operate both functions will usually account
6 Treas. Reg. § 1.1385-1(c)(2)(ii)(b).
7 Treas. Reg. § 1.1385-1 (e).
8 “Subchapter T says nothing about the appropriate treatment of net
operating losses,…. ” Farm Service Cooperative v. Commissioner, 619
F.2d 718, 723 (8th Cir. 1980).
separately for revenues and costs of each function. A cooperative
may also provide more than one service within a function. For
example, it may sell diesel fuel, seed, and crop protectants to its
farmer-members. The cooperative would usually account
separately for the results of each department within a function.10
Determining the extent of margins and losses on a line-of-
business basis is critical to evaluating current operations and
planning for the cooperative’s future. It also has important tax
implications. The next two subsections explain how losses can
occur within each function. Later, more complex issues such as
combining the financial results for tax purposes of a department
or function that generates a margin with one suffering a loss,
called “netting,” will be discussed.
Losses in the Supply Function
Cooperatives that manufacture or purchase and resell
supplies and equipment can suffer a loss just like any similar
noncooperative firm: e.g.; from competitive pressures on prices,
orders not arriving on time, strikes, uncollectible accounts, etc.11
Local supply cooperatives that typically purchase in bulk and
resell in small lots to individuals can be hit by any of these
conditions. However, they commonly suffer a loss when the retail
price of a major product they handle falls after they have
purchased a large quantity but before they can resell it to their
patrons. They are compelled to resell the product at a loss to meet
competition and maintain member loyalty.
Example 1 illustrates how a decline in the market price of a
product purchased for resale to members can generate a loss. The
cooperative paid $.85 per unit for an item with the expectation the
article could be resold to patrons for $1.10 per unit, covering costs
and generating a net margin to be distributed as patronage
9 AICPA Audit and Accounting Guide, Audits of Agricultural
Producers and Agricultural Cooperatives, § 10.16 (Am. Inst. of Certified
Pub. Accountants 1987, with conforming changes as of May 1, 1996) p .
44.
10 Ibid.
11 See, e.g., Priv. Ltr. Rul. 8248048 (Aug. 30, 1982).
refunds. When it could only sell the item for $1.00 per unit, a net
loss occurred.
Example 1. Cooperative Loss Caused by Price Decline
in Supplies Purchased for Resale
Expected………………………..(1 million units)
Purchase Price ($0.85/unit) …………..$850,000
Operating Costs
Variable Costs ($0.05/unit) ……………50,000
Fixed Costs ………………………….150,000
Total Costs ………………………….1,050,000
Product Sales Proceeds ($1.10/unit)……. 1,100,000
Net Margins …………………………$50,000
Actual ……………………………..(1 million units)
Purchase price ($0.85/unit)………….. $850,000
Operating Costs
Variable Costs ($0.05/unit) 50,000
Fixed Costs 150,000
Total Costs 1,050,000
Product Sales Proceeds ($1.00/unit) 1,000,000
Net Loss ($50,000)
A modest shortfall in the anticipated price of the product,
from $ 1.10 to $1.00, turned a reasonable potential margin into a
4
significant loss. In today’s highly competitive markets, where
profit margins are thin in good times, this is a perfectly plausible
event.
Supply cooperatives can also suffer losses when patrons
simply don’t buy as much product as anticipated. For example,
a cooperative might make an advance purchase of seed corn to
meet normal member demand during the spring. However,
unusually wet weather may prevent members from getting into
their fields during the planting season for corn. As a result, they
switch some of their acreage to other crops that can be planted
later, such as soybeans, and purchase less seed corn than
anticipated.
In Example 2, where the cooperative experienced no price
changes for the product supplied and had no operating cost
changes. A 20-percent shortfall in deliveries to patrons was
sufficient to cause the cooperative’s total costs to considerably
exceed its total proceeds.
Example 2. Cooperative Loss Caused by 20-Percent
Shortfall in Orders for Supplies Furnished Patrons
Expected…………………………..(1 million units)
Purchase Price ($0.85/unit)………….$850,000
Operating Costs
Variable Costs ($0.05/unit)…………..50,000
Fixed Costs ………………………..150,000
Total Costs ………………………..1,050,000
Product Sales Proceeds ($1.10/unit) …..1,100,000
Net Margins ……………………….$50,000
Actual ………………………………………(800,000 units)
Purchase Price (1,000,000 units at $0.85/ unit) …..$850,000
Operating Costs
Variable Costs ($0.05/unit) 50,000
Fixed Costs 150,000
Total Costs 1,050,000
Product Sales Proceeds ($ 1.10/unit) 880,000
Net Loss ($170,000)
Unfortunately for cooperatives caught in this situation, they
may actually suffer additional pressure on prices and costs. If
competitors also have too much supply resulting from the
depressed demand, market conditions may force down prices.
And if that product remains in inventory, variable costs may
actually rise. Thus supply cooperatives should plan their
purchases carefully to avoid this predicament, if possible.
Losses in the Marketing Function
Marketing cooperatives also can suffer operating losses for a
variety of reasons.12 A primary buyer may file for bankruptcy and
be unable to pay for products already delivered.13 A Government
regulator may keep prices the cooperative can charge for its
services so low the cooperative can’t cover its expenses.14
More typical is the cooperative trapped by fluctuations in the
markets in which it sells patrons’ products. A cooperative may
purchase these products at a cost reflecting the current market
12 See, e.g. , Priv. Ltr. Rul. 9202026 (Oct. 11, 1991)(high processing
costs and interest expenses, erosion of commercial markets, uncollectible
accounts).
13 Priv. Ltr. Rul. 8842018 (July 22, 1988).
14 Tech. Adv. Mem. 9128007 (March 28, 1991).
price to producers at the time of delivery to the cooperative, or
make advances to patrons based on that price. The price paid or
advance is established with an expectation that the commodity or
product(s) made from the commodity can be sold at a price
sufficient to cover those payments and all other costs. If the
actual proceeds are less than anticipated, a loss can result.15
In Example 3, the cooperative made advances of $0.85 per
unit anticipating the product could be sold for $1.10 per unit,
cover costs, and generating a net margin to be distributed as
patronage refunds. When prices fell to $1.00 per unit, however,
a net loss occurred.
Example 3. Cooperative Loss Caused by Price Decline
of Product to be Marketed
Expected ………………………………….(1 million units)
Product Sales Proceeds .($1.10/unit)………… $1,100,000
Advances Paid to Patrons ($0.85/unit)………… 850,000
Operating Costs
Variable Costs ($0.05/unit) …………50,000
Fixed Costs………………………. 150,000
Total Costs………………………. 1,050,000
Net Margins………………………. 50,000
15 Rev. Rul. 70-407, 1970-2 С.В. 52 (cash advances to patrons proved
to be excessive because of unanticipated decline in the price of cotton);
Priv. Ltr. Rul. 8248034 (Aug. 30, 1982)(sharp decreases in market prices
of commodities subsequent to cooperative’s entering into fixed-price
contracts with its members); Priv. Ltr. Rul 7926068 (March 29,
1979)(cotton processing cooperative suffered a loss resulting from a
sudden decline in the price of denim).
Actual (1 million units)
Product Sales Proceeds ($1.00/unit) $1,000,000
Advances Paid to Patrons ($0.85/unit) 850,000
Operating Costs
Variable Costs ($0.05/unit)
Fixed Costs
Total Costs
Net Loss
50,000
150,000
1,050,000
($50,000)
Market factors other than price changes may affect a
cooperative’s ability to generate enough income to cover costs and
advances to patrons. Marketing cooperatives depend on
deliveries by patrons . Fluctuations in patronage may lead to
cooperative losses, whether the fluctuation is an excess or
deficiency.
For instance, patrons may deliver more product than a
cooperative can market at prices adequate to cover grower
payments and its operating costs. Overproduction is frequently
accompanied by a general market price decline, so the conditions
work together to compound the problem.
A shortfall in anticipated product delivery may also induce
losses, especially if prices don’t rise enough to cover the revenue
decline. A product shortage canbe particularly troublesome if the
cooperative has contracted to deliver product to a buyer at a fixed
price and, in a time of rising prices, is forced to obtain substitute
product in the open market.
The cooperative in Example 4 had a 30-percent shortfall in
deliveries from patrons that resulted in a loss. This simplified
example doesn’t deal with price changes for product bought or
sold, but does reflect changes in variable costs.
Example 4. Cooperative Loss Caused by 30-Percent
Delivery Shortfall
Expected ……………………..( 1 million units)
Product Sales Proceeds ($1.10/unit) $1,100,000
Advances Paid to Patrons ($0.85/unit) 850,000
Operating Costs
Variable Costs ($0.05/unit) 50,000
Fixed Costs 150,000
Total Costs $1,050,000
Net Margins $50,000
Actual …………………………………(700,000 units)
Product Sales Proceeds ($1.10/unit) ……….$770,000
Advances Paid to Patrons ($0.85/unit)……….595,000
Operating Costs
Variable Costs ($0.05/unit) ……………….35,000
Fixed Costs………………………………150,000
Total Costs ……………………………..780,000
Net Loss ………………………………..$10,000
Startup Situations
Forming a new cooperative, or entering a new line of
business, forces members to incur costs before the cooperative
generates much, if any, income. While the members may realize
an immediate benefit from the new service, it may be years before
Persons the cooperative realizes positive financial results.16
starting a new cooperative must provide sufficient capital to cover
these early losses and develop a financial and tax plan to recoup
them as swiftly and efficiently as possible.
In summary, numerous factors may lead to operating losses
for both marketing and supply cooperatives, particularly if they
can’t adequately adjust their prices received for supplies
provided, or payments to patrons for products delivered, to
reflect changes in market conditions. A cooperative is vulnerable
to operating losses just like any other businesses in similar
situations.
Losses on Disposition of Assets
Cooperatives can also suffer losses when disposing of assets.
This report will not attempt to decipher all of the complex rules
in this area, but two determinations that apply to cooperatives are
worth mentioning.
First, IRS has said that gains and losses on the sale of capital
stock are Code sec. 1221 capital gains and losses and therefore
nonpatronage sourced.¹” This controversy is discussed in detail
in an earlier report in this series.18
Second, a letter ruling addressed issues arising when a
cooperative suffered losses on the disposition of Code sec. 1231
property as part of a plan to withdraw from an unsuccessful
business.19 IRS said this was a patronage-sourced loss and
provided guidelines for handling the tax consequences
concerning property put to other uses by the cooperative, sold,
held for possible use as supplies or scrap, or simply abandoned.
16 Tech. Adv. Mem. 8245082 (Dec. 31, 1981); Priv. Ltr. Rul. 9292026
(Oct. 11, 1991) .
17 Tech. Adv. Mem. 8815001 (Nov. 3, 1987) and Tech. Adv. Mem.
8941001 (June 14, 1989)(same facts) .
18 Donald A. Frederick and John D. Reilly, Income Tax Treatment of
Cooperatives: Patronage Refunds, RBS Cooperative Information Report 44,
Part 2 (USDA 1993) pp. 42-44.
19 Priv. Ltr. Rul. 9213030 (Nov. 27, 1991).
Losses Related to Accounting Methods
Special situations arise periodically under standard
accounting procedures that also produce losses for cooperatives.
These can be contentious with the Service as they may appear to
be more the result of creative bookkeeping than legitimate losses.
But the need to use consistent accounting methods, even when
they produce unusual results, makes these losses valid for tax
purposes.
Sometimes disputes arise over events which produce a
different patronage refund calculation under generally accepted
accounting rules than under the applicable tax rules. Problems
occur when the accounting patronage refund is greater than the
one computed under tax rules and the cooperative attempts to
deduct the higher number on its “books,” producing a loss for tax
purposes.
Book v. Tax Accounting
In 1974, the Service addressed the “book” versus “tax” issue.20
The cooperative in question used straight line depreciation for
book purposes and accelerated depreciation for tax purposes. It
had a larger depreciation expense under the tax rules and thus a
smaller margin available for distribution as a patronage refund
than under the book rules.
The IRS cited the definition of a “patronage dividend” in
Code sec. 1388(a). It interpreted the phrase “net earnings of the
organization from business done with or for its patrons ” to mean
only net earnings “from patronage business reported for Federal
income tax purposes.”21 It said that the cooperative could not
claim a patronage refund deduction for the amount of a
distribution that exceeds net earnings reported for Federal income
tax purposes.
The validity of the Service’s position was questioned by the
U.S. Tax Court in Associated Milk Producers (AMPI) v.
20 Rev. Rul. 74-274, 1974-1 С.В. 247.
21 Id. at 248.
Commissioner.22 In 1960, Rochester Dairy (a part of AMPI when
the litigation occurred) wrote-down the value of a building it
owned to reflect its obsolescence, but didn’t attempt to deduct it
on its 1960 tax return.
In 1961, it sold the building and deducted the loss on its tax
return. But the loss had already been recorded on the
cooperative’s books in 1960, so in 1961 its “book” income exceeded
its “tax” income. The cooperative paid a patronage refund on
“book” and claimed the difference between “book” and “tax”
income as a tax “loss” for 1961 to be carried forward to subsequent
years. The Service, relying on Revenue Ruling 74-274, denied the
loss carry forward because it resulted from claiming a patronage
refund deduction that exceeded net income from patronage
business reported for Federal income tax purposes.
The court allowed AMPI to carry the 1961 tax loss forward.
It noted that the 1961 patronage refund did not exceed 1961
“book” income and resulted “from merely a timing difference in
connection with the reporting of the loss on the building. “23 In a
footnote, the court said that while Revenue Ruling 74-274 didn’t
apply to tax year 1961, “we have serious doubts as to its
correctness even as an interpretation of sec. 1388. “24
In a later case, the Tax Court reviewed various issues
involving a cooperative whose book income was greater than its
taxable income. Among other things, it did not include tax-
exempt income in taxable income and it claimed larger deductions
for tax purposes than for book purposes. The cooperative issued
patronage refunds based on book income and reported the
difference as a loss . The court recognized this as a valid loss for
tax purposes.25
The court didn’t discuss the matter in detail, saying that the
IRS “herein now appears to concede that a cooperative may have
a net operating loss…and that it can be caused by the payment of
22 Associated Milk Producers v. Commissioner, 68 T.C. 729 (1977).
23 Id. at 741.
24 Id. , n. 8.
25 Certified Grocers of California, Ltd. v. Commissioner, 88 T.C. 238
(1987).
patronage (refunds) based upon book income which exceeds
taxable income from patronage. “26
In 1991, the Service prepared a number of proposed
coordinated issues papers concerning cooperatives, including one
on the “book” v. “tax” issue. The paper noted that the AMPI and
Certified Grocers decisions had created some doubt as to IRS’s
position and its willingness to defend the issue. The paper
concluded that the Service stands behind Revenue Ruling 74-274
and that the use of “book” earnings to compute a patronage
refund deduction is not available to cooperatives.
In a written statement dated June 8, 1992, the National
Council of Farmer Cooperatives (NCFC) attempted to persuade
IRS that patronage refunds could be based on “book” earnings.
Since that time the issue has festered but IRS has not challenged
cooperatives that have used “book” consistently.
Cooperatives may have both tax and book losses in the same
year, but the amounts may differ because they are calculated
differently. In one instance, the differences between the book and
tax losses were due to amounts accrued for lawsuits, fixed asset
valuation, and unfunded pension plans that were deducted for
bookpurposes but not for tax purposes because the liability had
not become fixed and determinable. IRS noted the difference but
didn’tdiscuss it.27
Changes in Tax Year or Accounting Method
Acooperative may incur a loss because it is reporting results
for tax purposes for a period less than a full year. A short taxable
year may result from adjusting the tax years of the participants in
a merger28 or from changing the tax year of a single cooperative
for any reason acceptable to IRS.29
A cooperative may incur a loss from changes in accounting
methods from one year to another, losses indirectly related to
operations but not necessarily reflecting economic loss for the
26 Id. at 250.
27 Priv. Ltr. Rul. 8248048 (August 30, 1982).
28 Ford-Iroquois FS v. Commissioner, 74 T.C. 1213 (1980).
29 Tech. Adv. Mem. 8043019 (July 24, 1980).
year in which the loss is recognized. For example, letter rulings30
describe a cooperative that changed the method of closing its
marketing pools from the “net realizable value” method to closing
eachpool in the year all the products in the pool are finally sold.
The change resulted in a Code sec. 481 negative adjustment.
The cooperative took the full amount of the adjustment into
account in the year of change, resulting in a substantial loss for
that year. The rulings compared that accounting change with a
change from Lifo method of valuing ending inventory to the Fifo
method described in a revenue ruling³¹ that resulted in a gain.
IRS cited a statement therein that the adjustment described
“facilitates a cooperative’s ability to pass through gains or losses “
and said the losses in this instance should be treated in a similar
fashion.
SHOWING A LOSS FOR TAX PURPOSES
A sign in numerous small retail establishments reads, “This
business is a nonprofit organization. We didn’t intend it to be
that way, that’s just how things worked out. “
Cooperatives are often referred to as “nonprofit” businesses
that”operate at cost.” Many State cooperative incorporation laws
use the term “nonprofit” to describe organizations they cover.32
The terminology was often written into those laws decades ago,
to emphasize that cooperatives are not operated to generate
profits for themselves, but rather to provide goods and services
to members at the lowest possible cost. They describe the
relationship between cooperatives and their members, not a
formal accounting and tax principle.
Nonetheless, in the 1970s, IRS devised an “operation at cost”
theory it applied to determine cooperatives could not have a loss
30 Priv. Ltr. Rul. 8540051 (July 3, 1985); Priv. Ltr. Rul. 8540056 (July 8, 1985).
31 Rev. Rul. 79-45, 1979-1 С.В. 284.
- James R. Baarda, Cooperative Principles and Statutes: Legal
Descriptions of Unique Enterprises, ACS Research Report No. 54, at 18-20
(USDA 1986) .
for tax purposes on operations conducted on a cooperative basis.
Much of the resulting controversy focused on the ability of
cooperatives to use Code sec. 172.33
Introduction to Code Sec . 172
Code sec. 172permits most taxpayers to deduct in the current
tax year an eligible net operating loss suffered in another tax
year.34 A net operating loss is defined as the amount by which
allowable deductions exceeds gross income.35
For tax years beginning after August 5, 1997, a net operating
loss may be carried back and deducted against taxable income in
the 2 years before the loss year and then carried forward and
applied against taxable income for up to 20 years after the loss
year.36 Generally, the loss is to be used in the earliest tax year it
can be applied.37
However, a taxpayer may forgo the carry back period and
use the loss exclusively in the years following the loss year.38
Such an election might be beneficial when the taxpayer expects
higher marginal tax rates to apply to its taxable income in the next
few years than applied in the most recent years. This flexibility to
use a net operating loss to offset taxable income paid in prior
years (and generate a refund) and/or in future years (and avoid
a tax liability) is a valuable tax planning tool.
The Service hasn’t questioned the ability of cooperatives to
generate losses on nonpatronage activity or to carry them back
and forward to offset otherwise taxable nonpatronage-sourced
earnings in other years.
33 I.R.C. § 172.
34 I.R.C. § 172 (a).
35 I.R.C. § 172 (c).
36 I.R.C. § 172(b)(1)(A). For tax years beginning before August 6,
1997, the loss can be carried back for three years and carried forward for
15 years.
37 I.R.C. § 172 (b) (2).
38 I.R.C. § 172 (b) (3).
However, the Service has questioned whether a cooperative
can even have a net operating loss on patronage activity and
barred the use of patronage-sourced losses to offset nonpatronage
earnings. Cooperatives claimed that when expenses exceeded
income, they had a net operating loss and attempted to carry it
back or forward.
IRS countered that since a cooperative operates at cost, it
could not generate a “net operating loss” and use it to reduce taxes
due in other years. IRS would disallow the claimed net operating
loss deduction and tell the cooperative to recoup the loss from the
patrons whose business created the loss.
Early Indications Support Co-op Losses
Prior to the 1970s, handling of losses by cooperatives received
little attention. Exempt cooperatives were truly exempt from
taxation and nonexempt cooperatives were taxed just as other
corporations, except they were permitted to treat income allocated
to the accounts of member-patrons as discounts or rebates.
The Revenue Act of 195139 terminated the true “tax exempt”
status of certain farmer cooperatives and included a provision to
insure that cooperative earnings would be currently taxable either
to the cooperative or to its patrons. 40 The cooperative provisions
originated as a Senate amendment to the House bill. The Senate
Finance Committee report acknowledged a cooperative could
have a loss, stating:
It is to be noted that in computing (under Section
122 of the Code) the net operating loss deduction provided
by Section 23(s) of the Code [Section 172 of the 1954
Code], not only will the amounts allowable as
deductions under Section 101 (12)(B)(i) and (ii) of the
39 Revenue Act of 1951, ch. 521, § 314, 65 Stat. 452, 491-491 (1951) .
40 For a discussion of the cooperative provisions in the Revenue Act
of1951, see Donald A. Frederick and John D. Reilly, Income Tax Treatment
of Cooperatives: Background, RBS Cooperative Information Report 44, Part
1 (USDA 1993) pp. 85-88.
Code as amended by the bill be taken into account but
such computation will also reflect the patronage
dividends, refunds, and rebates made by the cooperative
which are taken into account in computing net income.
[emphasis added]41
During the 1950s and 1960s, it apparently was general
practice for cooperatives to net losses both within a function and
between functions and to make patronage refund distributions of
the remainder. If an association suffered an overall loss, even
though one or more operation(s) might have margins, no
patronage refunds were paid. This mutual risk-sharing was
accepted by member-patrons.42
Until the early 1970s, the IRS gave at least passive acceptance
to the idea that a cooperative could have a loss. 43 In Revenue
Ruling 65-106, the Service said that a net operating loss could be
carried back or forward under Code section 172 without
necessarily reducing the earnings of the cooperative available for
patronage refunds in the year to which the loss may be carried.44
The ruling indicated that if the cooperative had a legal obligation
to reduce future patronage refunds to recapture the loss, such as
a bylaw or provision in a contract between the cooperative and its
members to that effect, that obligation would control.45
Revenue Ruling 67-128 concerned a cooperative with section
521 status that marketed both vegetables and grain. It accounted
for the income and expenses of each department separately. It
41 S. Rep . No. 781 (Supp. 2), 82nd Cong., 1st Sess. (1951) p. 29,
reprinted at 1951-2 С.В. 565 .
42 Marion M. Winkler, Treatment of Losses of Farmer Cooperatives, The
Cooperative Accountant, Fall 1971, at 8, 12.
43 See, e.g. , references to cooperatives suffering losses in the
regulations on redemption of nonqualified written notices or allocation,
Treas. Reg. § 1.1383-1(a)(2), § 1.1383-1 (b)(3), and § 1.1383-1 (d); and the
distribution of patronage refunds related to the disposition of a capital
asset, Treas. Reg. § 1.1385-1(c)(2)(ii)(b).
44 Rev. Rul. 65-106, 1965-1 С.В. 126 .
45 See also, Letter Ruling 6503036020A (March 3, 1965).
realized unspecified nonpatronage gains and losses on these lines
of business . The Service approved a plan to allocate the
nonpatronage income and losses to the patrons of the department
to which they relate, rather than to all patrons, “provided that the
allocation is not discriminatory among patrons similarly
situated. ” 46
Revenue Ruling 70-328 discussed a cooperative’s treatment
of an unused investment tax credit during a “taxable year its
operations resulted in a net operating loss as defined in section
172(c) of the Code.”47
Revenue Ruling 70-420 examined whether a cooperative that
earned 600x dollars on member business and “sustained a net
loss” of 500x dollars under a contract with a foreign government
had a net operating loss for tax purposes. IRS said the
cooperative had to net the results of the two and had a single
margin of 100x dollars. The ruling seems to indicate that if the
numbers had been reversed so that the loss on the foreign contract
exceeded member earnings, the result would have been an overall
net operating loss of 100x.48
This is consistent with language in Rev. Rul. 67-128 indicating
that allocation of losses by department is conditioned on its not
discriminating among similarly situated patrons. By implication,
the approach IRS preferred at the time was to allocate a loss in a
given department “to all patrons of the association. “49
46 Rev. Rul. 67-128, 1967-1 С.В. 147. For an explanation of the
special rules in § 521 , including those pertaining to patronage-based
allocations of nonpatronage income and losses, see Donald A. Frederick,
Income Tax Treatment of Cooperative: Internal Revenue Code Section 521, RBS
Cooperative Information Report 44, Part 4 (USDA 1996).
47 Rev. Rul. 70-328, 1970-1 С.В. 5. This ruling held a cooperative
couldn’t claim an investment tax credit (ITC) in a year it has an
operating loss. Rev. Rul. 85-126, 1985-2 С.В. 5, revoked this ruling and
said that under current law a cooperative may have unused ITC for
carry back and carryover purposes ” in a year during which it has a net
operating loss.”
48 Rev. Rul. 70-420, 1970-2 С.В. 64, revoked by Rev. Rul.74-377, 1974-2
С.В. 274.
49 Rev. Rul. 67-128, 1967-1 С.В. 147.
IRS’s Operation-at-Cost Principle
Contemporaneous reports indicate that the IRS staff shocked
cooperative tax advisers during a presentation at the 1971 NCFC
Annual Meeting. They announced that from now on (1)
cooperatives were not to net between functions and (2) losses
were to recouped from the patrons of the year that the loss was
recognized.50
A summary of the session in TAXFAX reported:
Representatives of the IRS National Office
participated in the January meeting of the Legal, Tax and
Accounting Committee of the National Council of
Farmer Cooperatives. In reporting on cooperative
problems then under consideration in the National
Office, they dropped a “super bomb ” with respect to
departmental losses of a multi-departmental operation.
Presume that one department earns $ 100 and the
second loses $40; the IRS representatives suggested that
the $40 loss should be assessed against patrons of the
lossdepartment and patronage dividends of $100 should
be paid to patrons of the profitable department! This is
wholly contrary to the beliefs many of us have grown up
with over the years.51
A few years later, Gerald Holmes suggested, “The change in
the Service’s position on losses may have evolved from its
philosophical definition of a cooperative. The axiom cited most
by the Service in recent years concerning cooperative losses is the
‘cost principle.”’52
The operation-at-cost principle was first voiced by the Service
in a ruling that concerned inventory valuation, not losses. The
50 Marion M. Winkler, Treatment of Losses of Farmer Cooperatives, The
Cooperative Accountant, Fall 1971, at 8, 12-13.
51 TAXFAX, The Cooperative Accountant, Fall 1971, at 38.
52 Gerald A. Holmes, Cooperatives and Losses: An Historical Perspective
on Current Issues, The Cooperative Accountant, Winter 1975, at 2, 4.
Service said:
One of the fundamental principles associated with
a farmers’ cooperative is that it is operated at cost for its
patrons. This principle is usually evident when the net
earnings (net savings) resulting from the operation of the
cooperative from business done with or for its patrons
are returned by the cooperative to its patrons in
proportion to the amount of business done with or for
each patron. 53
After IRS announced its new position on losses in 1971 , it
issued a letter ruling in 1972 that applied its operation-at-cost
principle to determine a cooperative could not net losses of its
marketing department with margins of its purchasing
department.54 IRS cited Revenue Ruling 69-67 as the source of its
position that cooperatives must operate at cost with their patrons.
It then stated, “A corollary to this cost principle of operation is
that any losses of the cooperative operation attributable to excess
advances or undercharges to the patrons are recoverable from the
patrons. “55
The Service provided several options available to recoup the
loss:
- Requiring direct reimbursement from the patrons whose
business generated the loss. - Establishing an account receivable due from each patron.
For accrual basis taxpayers, this recoups the loss for tax purposes. - Canceling outstanding credits in the patron’s account with
the cooperative representing retained patronage refunds and per-
unit retains. - The Service acknowledged that recoupment through the
first three methods is not always feasible. It said a cooperative
may carry over the excess advances and undercharges to the next
year and treat them as a cost of operation to the department that
53 Rev. Rul. 69-67, 1969-1 С.В. 142.
54 Ltr. Rul. 7207319410A (July 31, 1972).
55 Id.
sustained the loss, provided it can show that this method of
recoupment doesn’t result in inequitable treatment of the patrons
of that department in the subsequent year. IRS was emphatic,
however, that the cooperative did not have a Code sec. 172 loss
for the year in which the loss was sustained.56
The Courts Speak
The courts first addressed IRS’s operation-at-cost principle in
Associated Milk Producers, Inc. v. Commissioner.57 From 1959 to
1961, Rochester Dairy reported deductions in excess of gross
income.58 The board of directors decided it would be inequitable
to charge the current losses against patrons’ capital reserve
accounts. The directors were also concerned that reducing
member equities would anger patrons, resulting in a serious loss
of business to competing dairies.
The board decided the losses should be carried forward to
future profitable years. From 1962 through 1966, net income was
offset and patronage refund allocations eliminated until the entire
amount of the prior years’ losses was recouped. For each of these
years, the cooperative claimed net operating loss carry forward
deductions pursuant to Code sec. 172. IRS disallowed the
deductions.
The court described the IRS’s argument:
Respondent’s position in this case is not based on
any statutory exception to the loss carryover privilege,
clearly stated in section 172, but upon respondent’s
theoretical perception of a cooperative as an exceptional
56 Id. This ruling concerned a § 521 farmers cooperative. For the
application of the same rules to a non-section 521 wholesale grocery
cooperative, see Let. Rul. 7301319420A (Jan. 31, 1973). For background,
see Gen. Couns. Mem. 34,334 (Aug. 17, 1970).
57 Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 729
(1977).
58 In 1969, Rochester Dairy merged into AMPI, which was pursuing
the case as a successor in interest.
entity which by its nature cannot ordinarily have a net
operating loss for tax purposes. Respondent argues that
the basic principle of a cooperative is that it operates at
cost (after patronage dividend allocations) for its
member-patrons. Pursuant to this “cost” principle,
respondent contends, in any year in which expenses
exceed gross income, this “loss ” must be recouped from
the members who were patrons for that period (i.e., the
exact converse of a patronage dividend allocation when
income exceeds expenses), so that the cooperative will
then have operated at cost. The recovery of the
operating deficit from the current patrons would thus
eliminate any net operating loss for tax purposes.59
The court rejected the argument as a reason to restrict the use
of section 172 by cooperatives. It stated:
We consider respondent’s position herein not only
contrary to the express provisions of section 172, but
conceptually strained and lacking any fundamental
policy support; in short, an unwarranted tinkering with
the tax structure applicable to cooperatives. The
deductions claimed are clearly authorized by section
- There is nothing within that section or the
regulations thereunder which indicates that the net
operating loss deduction is not applicable in the case of
a cooperative subject to subchapter T. In fact, quite to
the contrary, the utilization of the net operating loss
deduction by cooperatives is clearly implicit in certain
subsections of the Code and the Income Tax Regulations,
and in various of respondent’s rulings dealing with
cooperatives.60
59 Associated Milk Producers, Inc. v. Commissioner, 68 T.C. 729,735
(1977).
60 Id. at 736.
At the same time the Tax Court was considering the AMPI
case, a similar suit was before it involving Farm Service
Cooperative of Fayetteville, AR. Farm Service had four
accounting units: a broiler marketing pool, a turkey marketing
pool, a farm supply function, and a separate allocation unit for
nonpatronage activity. In 1971, broiler pool expenditures
exceeded receipts. The cooperative paid patronage refunds to
patrons of the turkey and supply units, offset all nonpatronage
income against the broiler pool loss, and carried the remaining
broiler pool loss back 3 years, charging it against an unallocated,
general reserve account.61
IRS disallowed the deductions based on offsets of the broiler
pool losses and told the cooperative to recover them from the
broiler pool reserve. The Court described the Service’s approach
and its tax consequences:
Respondent views a cooperative as a sort of conduit
that can distribute patronage profits to its patrons and
thereby avoid paying tax on the profits. …From this
observation, respondent carries the conduit approach
beyond the statutory framework and concludes that in
a loss year–in a year when patronage expenses exceed
patronage income–the only proper recourse is for the
cooperative to obtain capital contributions or refunds
from cooperative members, thereby running the
cooperative on a ‘cost’ principle.62
IRS said the implication of applying the operation-at-cost
principle is to conclude that cooperatives operate their patronage
activities without a profit motive. Lacking a profit motive,
deductions are not allowed under section 162, and “without
61 In 1972, the cooperative also suffered a loss in the broiler pool,
which was totally offset against nonpatronage income.
62 Farm Service Cooperative v. Commissioner, 70 T.C. 145, 153
(1978), rev’d on other grounds, 619 F.2d 718 (8th Cir. 1980).
deductions under section 162, it is not possible for patronage
activities to incur net operating losses under section 172. “63
The Tax Court rejected IRS’s application of an operation-at-
cost principle and its suggested implications concerning Code sec.
162 deductions, reaffirming the court’s opinion in Associated Milk
Producers:
[W]e conclude that cooperatives are entitled to net
operating loss deductions resulting from patronage
activities. Implicit in this conclusion, as it was in
Associated Milk Producers, is the conclusion that
patronage activities are carried on for a profit, hence
ordinary and necessary expenditures, unless otherwise
disallowed, are deductible by the cooperative under
section 162.64
On appeal, the IRS did not pursue its operation-at-cost principle.65
The operation-at-cost principle was urged in a third Tax
Court case,66 following closely on the heels of Associated Milk
Producers and Farm Service. This cooperative incurred losses in
both its marketing and supply functions which it wanted to carry
forward and apply against future net margins.
IRS conceded that a cooperative can sustain net operating
losses and carry them back and forward under Code sec. 172. It
did note, however, that some former patrons had terminated their
63 70 T.C. at 152.
64 70 T.C. at 154.
65 “The Commissioner does not contest the proposition that a
cooperative can have a net operating loss, or that it can carry such losses
forward and back as provided in I.R.C. § 172.” Farm Service
Cooperative, Inc. v. Commissioner, 619 F.2d 718, 724 (8th Cir. 1980).
The Court of Appeals reversed and remanded the Tax Court
opinion because it permitted the cooperative to offset the patronage
sourced losses against the nonpatronage income. “A nonexempt
cooperative simply may not use patronage losses to reduce its tax
liability on nonpatronage-sourced income. Taxpayer’s accounting
procedures cannot supersede this statutory principle. ” 619 F.2d at 727.
66 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213 (1980).
memberships during the loss years. It now argued that the
operation-at-cost principle required the cooperative to recoup
their share of the losses directly from the terminating members.
The court reported the Service said:
… a cooperative’s right to avail itself of section 172
for losses incurred in business operations with
cooperative members is restricted by what are…certain
fundamental principles of cooperative operation, in
particular the concepts of equitable allocation and
operation at cost. …a net operating loss may only be
carried over to offset income in other years of the same
members whose business produced the losses.
Moreover, to the extent the loss is attributable to
business conducted with or on behalf of members who
terminate their membership, it is (the IRS) view that the
loss must be recovered currently.67
The Tax Court, as it did in Association Milk Producers and Farm
Service, declined to accept the implications of the operation-at-cost
principle for cooperative patronage losses. It did not reject
operation-at-cost as a valid cooperative characteristic. Rather, it
did not apply the concept rigidly to reach a required method of
loss handling. It said the “concept of operation at cost simply
means that a cooperative was organized for the purpose of
rendering economic services, without gain to itself, to
shareholders or to members who own and control it. “68
The court concluded “The ‘ operation at cost’ principle
describes a feature of a cooperative’s relations with it members,
not a codified requirement of tax accounting. Accordingly, we
reject [the Commissioner’s] argument that the principle of ‘oper-
ation at cost’ absolutely bars a cooperative from carrying forward
and deducting losses allowable to its terminated members. “69
67 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213, 1218 (1980).
68 Id. at 1219, citing United Grocers, Ltd v. United States, 186 F.
Supp. 724, 733 (N.D. Cal. 1960).
69 Id. at 1222.
The Section 521 Rulings
Each of the cases in the previous subsection involved a
nonsection 521 cooperative. As these cases were developing, an
interesting series of administrative rulings were handed down by
IRS concerning section 521 cooperatives.
In late 1978, IRS issued a series of letter rulings on
applications for section 521 status conditioning approval on
adoption of a bylaw provision reading: “In the event the
cooperative suffers a loss in any year the cooperative will trace the
deficit or loss to the patrons whose business gave rise to it and
will take whatever steps are necessary to recover such losses or
deficits from those patrons. “70
However, by late 1979 IRS had softened its position. In one
ruling, it said a cooperative with section 521 status did not have
to replace language giving the board discretion over handling a
loss with the provision quoted above.71 In another, it granted an
application for § 521 status on the condition a bylaw is adopted
reading: ” …such loss will, to the extent practicable, be borne by
the patrons of the loss year on an equitable basis. “72
By early 1983, IRS was permitting cooperatives to retain their
section 521 status that had disregarded conditional
determinations letters requiring bylaw language on tracing losses
to the patrons whose business gave rise to the losses. The Service
said that while it didn’t acquiesce in Associated Milk Producers, it
would permit section 521 cooperatives to carry losses back and
forward under Code sec. 172.73
70 Priv. Ltr. Rul. 7843060 (July 27, 1978); Priv. Ltr. Rul. 7852005
(August 31, 1978); Priv. Ltr. Rul. 7905125 (Nov. 6, 1978).
71 Tech. Adv. Mem. 8019003 (Nov. 20, 1979).
72 Priv. Ltr. Rul. 8021073 (Feb. 28, 1980).
73 Tech. Adv. Mem. 8316002 (Jan. 7, 1983) (also TAM’s 8316003
through 8316018); Tech. Adv. Mem. 8316156 (Jan. 5, 1983). IRS also
allowed a section 521 cooperative to utilize the net operating loss
provisions of § 172 in Priv. Ltr. Rul. 8842018 (July 22, 1988) and Priv. Ltr.
Rul. 9021013 (Feb. 21, 1990).
These cases and rulings establish that cooperatives can have
a net operating loss and carry a loss back and forward pursuant
to Code sec. 172. In spite of these decisions, the Service continues
to refer to its “operation at cost” theory as a fundamental
cooperative principle.74 And while these determinations establish
that a cooperative can have an operating loss for tax purposes,
they do little to clarify how that loss should be allocated among
past, present, and future members.
HANDLING A PATRONAGE-SOURCED LOSS
Once it is established that a cooperative has suffered a loss,
the tough issue becomes, “Who will absorb it?” Ultimately, in
some manner, the loss will be allocated to the members. The
more difficult questions are which members, and on what basis .
Regardless of what the courts have said about its “operation
at cost” theory, the Service’s preference since at least 1972 has
been clear and consistent. IRS wants cooperatives to recoup
patronage-sourced losses from the specific patrons whose
business generated the losses, and in proportion to their
patronage during the year that the loss occurred.75 But even this
seemingly straightforward approach may become complicated in
some instances, such as when the loss results from an event that
occurred over several years or recovery from the patrons at the
time is not feasible.
74 Tech. Adv. Mem. 8707005 (Nov. 7, 1986); Tech. Adv. Mem.
9128007 ( March 28, 1991). The Service has also taken the position that
non-Subchapter T cooperatives must operate “at cost. ” See the description
of the government’s brief and argument in Buckeye Power v. U.S., 38 Fed.
Cl. 154, 159 (1997) (rural electric cooperative exempt under I.R.C. §
510(c)(12)).
75 As mentioned previously, IRS hasn’t questioned the ability of
cooperatives to generate losses on nonpatronage activity or to carry
those losses back and forward to offset otherwise taxable nonpatronage-
sourced earnings in other years. However, it has resisted cooperative
efforts to combine, or “net,” patronage and nonpatronage gains and/or
losses. Issues involving nonpatronage gains and losses are discussed
near the conclusion of this chapter.
Cooperatives have countered that the members, not the IRS,
should determine what is fair and equitable. They say that they
are essentially risk-sharing ventures. They assert that if, for
example, cotton farmers and cattle ranchers want to be part of a
diversified cooperative and share the financial risks of marketing
cotton and supplying cattle feed, the decisions on the extent of
risk-sharing and how the risk is allocated among past, present
and future users should be theirs and IRS shouldn’t tell them
what they can and can’t do.
Cooperatives have attempted to achieve the maximum
possible flexibility in handling losses. As a general rule, the more
diversified the cooperative, the more flexibility it seeks.
Cooperatives often strive for the same ability to use Code sec. 172
and to “net” the results of different operations as do their
noncooperative competitors. This has led to major confrontations
with the IRS, at least one of which was settled by Congress.
Both sides make liberal use of terms such as “equitable” and
“fair” to bolster their positions. For example, once “operation at
cost” was discredited by the courts, the Service sought to achieve
essentially the same result, require recoupment from the patrons
whose business led to the loss, by applying an “equitable
allocation ” standard.76
The remainder of this chapter covers how this central
disagreement over what is an “equitable” allocation of losses has
played out in various factual situations. It is a difficult topic to
cover because several variables can apply. Factors affecting how
a loss may be handled include:
whether the loss is patronage or nonpatronage sourced;
- whether the loss is an operating loss or a nonoperating
loss; - whether the cooperative has sec. 521 tax status;
- whether the cooperative provides only marketing or
supply services or has operations in both functions; and - how the cooperative wants to allocate the loss.
76 See Gen. Couns. Mem. 37,751 (Nov. 21, 1978).
Because of the numerous variables involved, any approach
to describing cooperative losses will be somewhat arbitrary. This
chapter generally attempts to look at the options from the
perspective of a cooperative board of directors. Research suggests
three general approaches have been adopted:
- recovering the loss from the patrons whose business
generated the loss, on a pro rata basis; - recovering the loss from patrons of the same allocation
unit, but from patrons of different years, by carrying the
loss back or forward under Code sec. 172; and - recovering some or all of the loss from patrons of other
allocation units, by netting the financial results of the
allocation units. Netting can involve combining the
patronage-sourced results of different allocation units
within the same function, netting between functions
(marketing and supply operations), and netting
patronage and nonpatronage results both within and
between functions.
The approaches will be discussed in the preceding order.
RECOUPING PRO RATA
The IRS has a long-standing preference for cooperatives to
recoup patronage-sourced losses on a pro rata basis from the
patrons whose business generated the loss. It has specifically
approved three recovery methods: (1) direct payment, (2)
canceling retained patronage equities, and (3) accruing accounts
receivable.77
Two or three methods may be used together. For example,
the cooperative may set up accounts receivable and have the
patrons pay them off by direct payment or cancellation of
outstanding equities.
77 Tech. Adv. Mem. 7207319410A (July 31, 1972).
sufficient retained patronage paper from grain marketing margins
in prior years to cover the loss, the cooperative could cancel such
paper from cotton marketing or supply purchases.88
Other rulings that permit cooperatives to recoup a loss by
canceling retained equities are discussed in the next two
subsections on accounts receivable and redeeming equities at less
than face value.
Accounts Receivable
A third method of handling patronage losses approved by
IRS is for the cooperative to determine each patron’s share of a
loss and then establish an account receivable from the patron for
that amount. Using accounts receivable gives the members
flexibility in paying off their obligations . Programs can be
devised that make recouping the loss less painful to the patrons
than writing a check to their cooperative. A disadvantage is that
the cooperative receives nothing but a receivable and has no
immediate cash inflow to pay its bills and maintain or improve
services to members .
Apparently IRS first envisioned accounts receivable as a tool
to recoup losses from patrons who lacked enough equity in their
cooperative to cover their pro rata share of losses. It suggested
cooperatives establish such accounts for these patrons to be
satisfied by direct payment or offsetting future patronage
allocations.89 However, a series of subsequent rulings have
provided considerable flexibility in collecting accounts receivable
established to facilitate recovering losses .
In a letter ruling, a cooperative was permitted to collect such
accounts by canceling outstanding nonqualified written notices of
allocation, issued in the year prior to the loss, and to treat the cancel-
lation as a redemption deductible under Code sec. 1382(b)(2).90
88 Priv. Ltr. Rul. 7804083 (Oct. 28, 1977) .
89 TAXFAX, The Cooperative Accountant (Spring 1976) pp. 44, 45;
Priv. Ltr. Rul. 7804083 (Oct. 28, 1997); Priv. Ltr. Rul. 7937041 (June 13,
1979).
90 Priv. Ltr. Rul. 7926068 (March 29, 1979.)
33In Revenue Ruling 81-103, the cooperative was permitted to
establish accounts receivable to cover losses in one year (1976),
pay out margins in the next year (1977) in nonqualified written
notices of allocation, and then collect the accounts receivable by
canceling the nonqualifieds in a subsequent year (1979).91
In 1982, the Service issued two letter rulings concerning
losses from complex situations that accumulated over several
years. IRS said that where it wasn’t possible to match a loss to
specific patronage transactions, a cooperative could establish
accounts receivable for its patrons and collect them by canceling
various forms of equity provided by those patrons–qualified
allocations, nonqualified allocations, and direct investments.92
Subsequent rulings have approved paying off accounts
receivable established to cover patronage sourced losses by
redeeming qualified per-unit retain certificates and preferred
and common stock.94
The flexibility the Service will allow a cooperative in
recovering a loss, if the association presents a well-reasoned
justification for its actions, is illustrated by letter ruling 8233051.95
The taxpayer was a federated cooperative with a dozen grain
marketing associations as members. After a successful start-up,
it expanded into risky export operations and suffered substantial
operating losses. When an infusion of capital became necessary,
some members wanted to withdraw and others wanted to
continue.
IRS said the association was ” operating on a cooperative
basis” under a plan whereby:
1) the losses would be allocated to and collected from only
the continuing members,
91 Rev. Rul. 81-103, 1981-1 С.В. 447.
92 Priv. Ltr. Rul. 8233051 (May 19, 1982); Priv. Ltr. Rul. 8248048
(August 30, 1982).
93 Priv. Ltr. Rul. 8952019 (Sept. 28, 1989); Priv. Ltr. Rul. 9202026
(Oct. 11, 1991).
94 Priv. Ltr. Rul. 9326006 (March 16, 1993).
95 Priv. Ltr. Rul. 8233051 (May 19, 1982), based on Gen. Couns. Mem.
38,885 (April 23, 1982) .
342) the losses would be allocated on the basis of each
continuing member’s capital stock in the cooperative, not recent
patronage,
3) the losses would be accounted for as an account receivable
from each continuing member, and
4) each continuing member could repay its receivable by any
of the following means, or a combination thereof: payment in
cash, cancellation of equity, or cancellation of principal and
accrued interest on loans the members had made to the
cooperative.
IRS noted that the cooperative had shown that this plan had
resulted from extensive discussion and negotiation among the
members, that State law did not authorize an assessment of
withdrawing members, and that the withdrawing members had
sufficient votes to block an assessment. It observed that the
members agreed the losses resulted from the plan for rapid
expansion, so it wasn’t equitable to allocate them on the basis of
any one year’s patronage. Also, some members felt a factor in the
losses was the failure of other members to patronize the
cooperative. Using a patronage base would have penalized those
members who supported the cooperative and rewarded those
who did not.
IRS also permitted the cooperative to carry forward any
losses not assessed against continuing members (under Code sec.
277, not sec. 172) and said continuing members may deduct the
assessments as an ordinary loss under Code sec. 165(a).%
This ruling is notable for the flexibility permitted the
member-patrons. Terminating members could get their capital
out of the cooperative while continuing members could leave
theirs in to finance future operations. ” The continuing members
were then allowed to choose from several options to satisfy their
receivables.
Three months later, the IRS again displayed a tolerance for
flexibility. It permitted a cooperative to sign agreements with
members providing that margins for the next 5 years would be
96 Id. 97 See also, Priv. Ltr. Rul. 8812019 (Dec. 16, 1987).
35used to offset each patron’s share of a prior year’s loss. Any
unamortized losses remaining at the end of the 5 years would be
absorbed by the cooperative and deductible at the cooperative
level under Code sec. 165.98
When using accounts receivable, a cooperative that is an
accrual basis taxpayer will, for tax purposes, recognize income
when the receivables are established . The accounts receivable will
be patronage-sourced income if the income is from patrons and is
used to offset patronage losses that are the responsibility of the
patrons. “
However, the cooperative can frequently offset that income
with the loss carry forwards that the receivables are established
to recoup. Thus, another wash situation may be created, with no
direct tax consequences for the cooperative.100 But the association
will have to consider the alternative tax net operating loss
deduction limit of 90 percent of any loss carryover and other
required adjustments in computing its alternative minimum
taxable income for the year.101
When the patrons pay off the receivables, the cooperative
doesn’t have to recognize the amounts received as income because
it has previously recognized the receivable.102
The Service permits accrual-basis patrons to deduct the
amount of the assessment as an ordinary loss under Code sec.
165(a) in the year the account receivable is established.103 Cash
basis patrons can claim the loss in the year the account is settled.
98 Priv. Ltr. Rul. 8248034 (Aug. 30, 1982).
99 Priv . Ltr. Rul. 8952019 (Sept. 28, 1989); Priv. Ltr. Rul. 9202026
(Oct. 11, 1991).
100 Rev. Rul. 81-103, 1981-1 С.В. 447; Priv. Ltr. Rul. 8233051 (May 19,
1982); Priv. Ltr. Rul. 8952019 (Sept. 28, 1989); Priv. Ltr. Rul. 9202026
(Oct. 11, 1991).
1987) .
101 I.R.C. § 56(a)(4) and § 56(d).
102 Priv. Ltr. Rul. (Nov. 21, 1975); Priv. Ltr. Rul. 8812019 (Dec. 16,
103 Priv. Ltr. Rul. 8233051 (May 19, 1982).
36Redeeming Equities at Less Than Face Value
The general issues of redeeming equity at less than face
value, and the tax consequences thereof, are discussed at the end
ofChapter 9 of this series of reports. 104 At the risk of redundancy,
the topic is revisited, primarily in response to a court decision that
calls into question the tax treatment of a cooperative that redeems
qualified patronage-based equities as reported in the earlier
report.105
A review of the applicable IRS rulings indicates cooperatives
redeem equity at less than face value for one or more of four
primary reasons:
1. To remove old equity from the books without seriously
depleting cash.106 This is sometimes done as part of a program to
remove former patrons from the membership rolls. 107
2. To get cash into the hands of current members as
promptly as possible. Members may be given the option to
redeem recently issued patronage-based equities before they
would be paid off during the regular revolving cycle. This is done
at a discount, usually reflecting the current value of the paper, to
protect the interests of members who leave their allocations in the
cooperative.108
104 Donald A. Frederick and John D. Reilly, Income Tax Treatment of
Cooperatives: Distribution, Retains, Redemptions and Patrons ‘ Taxation, RBS
Cooperative Information Report 44, Part 3 (USDA 1996), pp. 90-96, 113-
105 Gold Kist v. Commissioner, 110 F.3d 769 (11th Cir. 1997); rev’g,
104 T.C. 696 (1995). At the time Part 3 was written, Gold Kist had just
petitioned the Tax Court challenging IRS’s position. CIR 44, Part 3, p. 96.
106 Priv. Ltr. Rul. 7410291300A (Oct. 29, 1974); Priv. Ltr. Rul. 7743054
(July 28, 1977) .
107 See, Tech. Adv. Mem. 8015048 (Dec. 31, 1979). For a discussion
of the practical and legal reasons to terminate memberships of former
patrons, see Donald A. Frederick, Keeping Cooperative Membership Rolls
Current, ACS Cooperative Information Report 37 (USDA 1991).
108 Tech. Adv. Mem. 7840010 (June 22, 1978); Priv. Ltr. Rul. 8031041
(May 8, 1980); Priv. Ltr. Rul. 8033070 (May 22, 1980); Priv. Ltr. Rul.
8225100 (March 25, 1982); Priv. Ltr. Rul. 8812019 (Dec. 16, 1987); Tech.
373. To recoup a loss from the patrons whose business led to
the loss.109
4. To clear the books of old equity as part of an effort to
establish a systematic equity redemption program .
One advantage of this approach is that it conforms to the IRS
desire that the loss be allocated to the patrons whose business
generated it. A second advantage is a practical one. The patron
doesn’t have to make any cash outlays to the cooperative.
One disadvantage is that the cooperative doesn’t receive any
cash. Another is that redeeming part of its equity may have
negative consequences on its balance sheet. Also, patrons’
investments may be less commensurate with current use of its
services .
In this context, two distinct “losses” may be involved. The
redemption at less than face value may or may not be triggered by
a financial loss at the cooperative level. From the patron’s
perspective, a loss is always involved, regardless of the
motivation for the cooperative’s action.
Nonqualified Allocations
The rulings dealing with redemption of nonqualified
allocations involve recouping an operating loss. In each instance,
the cooperative allocated the loss to its patrons by establishing
accounts receivable from the patrons. It then recovered the loss
by offsetting the accounts receivable with the nonqualified
allocations.110
When allocations are made in nonqualified form, the
cooperative is not permitted a tax deduction and the patrons have
no reportable income. When the accounts receivable are offset
against the nonqualified equity, the Service assumes the
cooperative redeemed the nonqualified allocation in cash at face
Adv. Mem. 9249005 (Dec. 4, 1992).
109 See, e.g., Rev. Rul. 70-407, 1970-2 C.B. 52; Rev. Rul. 81-103, 1981-1
C.B. 447; Priv. Ltr. Rul. 8624019 (March 10, 1986); Priv. Ltr. Rul. 9202026
(Oct. 11, 1991).
110 Rev. Rul. 81-103, 1981-1 С.В. 447; Priv. Ltr. Rul. 7926068 (March
29, 1979); Priv. Ltr. Rul. 8248048 (August 30, 1982).
38value and the patron then paid money to the cooperative to settle
the account receivable. The cooperative is allowed a deduction
for the redemption of the nonqualified allocation under Code sec.
1382(b)(2).111
The patrons are entitled to an ordinary loss deduction under
Code sec. 165(a) for the amount of the assessment in the year the
account receivable is established . However, when the
nonqualified allocations are “redeemed” to collect the account
receivable, the patrons have taxable income as provided in Code
sec. 1385.112
This situation creates an overall wash at both the cooperative
and patron level. The cooperative realizes income when it issues
the nonqualifieds and a deduction when it redeems them. The
patrons have a deduction for an ordinary loss when the accounts
receivable are issued as “negative patronage refunds ” and income
when the nonqualifieds are redeemed to collect the accounts
receivable.
Qualified Allocations
For many years, recouping losses by canceling qualified
allocations was also treated as a wash, although a different path
was taken to reach that end, one reflecting the differing initial tax
implications when qualified allocations are distributed. However,
the recent Gold Kist opinion113 has challenged that result.
While it might be more logical to look first at the tax
consequences of redeeming equity at less than face value for the
cooperative, this discussion will focus first on the impact on
patrons. This is primarily because Gold Kist looks only at the
cooperative.
Patron Tax Treatment.
The basic rule for patrons was established even before
enactment of Subchapter T:
111 Rev. Rul. 81-103, 1981-1 С.B. 447; Priv. Ltr. Rul. 7926068 (March
29, 1979) .
112 Priv. Ltr. Rul. 8248048 (August 30, 1982).
113 Infra, note 146.
39• If the amount of the original allocation that the patron
included in taxable income in the year of distribution was
more than the amount of money the patron received at the
time of redemption, the difference was an ordinary loss in the
year of redemption.
• If the amount of the original allocation that the patron
included in taxable income in the year of distribution was
less than the amount of money the patron received at the
time of redemption, the difference was ordinary income in
the year of redemption.114
For example, assume patron “P” received a patronage refund
of $100 in 1950 and the entire refund was retained by the cooper-
ative as equity allocated to P. In 1956 the cooperative redeemed
that equity for $60. If P reported the $100 patronage refund as
income in 1950, then P could claim an ordinary loss in 1956 of $40
($100-$60). If P did not report the allocation in 1950, then P would
have to report the $60 payment as income in 1956 ($60-$0).
The same general scheme was applied to losses occurring
after enactment in 1962 of subchapter T. This treatment is
available regardless of the reason the cooperative redeems the
equity for less than face value. In fact, the landmark IRS ruling115
doesn’t even mention why the equity was redeemed for less than
face value. It merely reports a cooperative issued qualified
written notices of allocation to patrons in 1963 and redeemed
them in 1968 at less than the stated dollar amount .
The Service stated matter-of-factly that the patron had
suffered a loss. The question addressed was whether the loss was
an ordinary or a capital loss. IRS said:
The transaction that gave rise to the issuance of the
notice of allocation arose in the ordinary course of
taxpayer’s trade or business. Accordingly, the loss
incurred by the taxpayer upon redemption of the
114 Priv. Ltr. Rul. 8225100 (March 25, 1982).
115 Rev. Rul. 70-64, 1970-1 C.B. 36, suspended by Notice 87-68, 1987-2
С.В. 378 .
