Briefs of Case Law
The tax court in this case followed the prior year’s brief Oregon federal district court decision of Linnton Plywood Association v. United States, 236 F. Supp. 227 (D.C. Ore. 1964). At issue was whether worker cooperatives could claim Subchapter T tax exemption. The court discussed at length the history of worker cooperatives and the Rochdale Principles, followed by a significant excerpt of the plaintiff’s bylaws, concluding that the plywood business operated on a cooperative basis for the mutual welfare of its worker-members. The court held that a worker cooperative such as this one was a “non-exempt cooperative association” and may still exclude patronage dividends from its gross income under Subchapter T. The form of corporation was not determinative for such tax treatment; an organization qualified as a cooperative for tax purposes if it satisfied the three requirements identified by the Linnton Plywood court: that the dividend be made according to a pre-existing legal obligation; that the dividend come from profits derived from transactions with its patrons; and that the dividends are equitable.
The Puget Sound Plywood case became the leading case which the IRS relied on for the definition of “operating on a cooperative basis.” The court listed three “guiding principles”: “(1) Subordination of capital, both as regards control over the cooperative undertaking, and as regards the ownership of the pecuniary benefits arising therefrom; (2) democratic control by the worker-members themselves; and (3) the vesting in and the allocation among the worker-members of all fruits and increases arising from their cooperative endeavor (i.e., the excess of the operating revenues over the costs incurred in generating those revenues), in proportion to the worker-members’ active participation in the cooperative endeavor.” Subsequent Revenue Rulings emphasized that these principles were necessary to a determination that a business was operating on a cooperative basis.
This case established for the first time that a worker cooperative is entitled to exclude retained patronage dividends from gross income to the same extent as purchasing and marketing cooperatives. The court emphasized that the cooperative must meet three requirements in order to qualify for the Subchapter T exclusion: (1) the allocation must be made pursuant to a legal obligation existing when the patron transacted business with the cooperative. (2) The allocation must be made out of profits or income realized from transactions with its patrons. (3) The allocations must have been equitably made. 236 F. Supp. at 228.
Linnton Plywood and Multnomah Plywood were the two plaintiffs in this case. Linnton was an Oregon worker cooperative that both manufactured and marketed plywood; Multnomah was a plywood manufacturing plant. The two co-ops had both members and non-member employees. Both paid their non-member employees an hourly wage. Linnton paid its members a bimonthly advance on projected patronage dividends, while Multnomah paid its members an hourly wage that was 130% of the average non-member wage. To determine the portion of net earnings that would be distributed as patronage dividends (and excluded from its taxable corporate income per Subchapter T), Linnton multiplied the hours worked by its members by 150% and Multnomah by 130%. The Commissioner found that the use of weighted hours improperly inflated the co-ops’ patronage dividend exclusions. The Commissioner also found that Multnomah’s practice of deducting wages paid to its members as a business expense was improper.
1. Whether a worker cooperative with both members and non-member employees may use weighted hours in order to calculate its patronage dividend exclusion, reflecting the greater value of member work.
2. What factors a court will consider when evaluating whether the weighted hours formula is proper.
3. Whether wages paid to members may be deducted as a business expense.
4. Whether a cooperative’s dividends from a partially-owned supplier are net earnings subject to patronage dividend treatment.
HOLDINGS AND REASONING
1. A worker cooperative may weigh member hours of work more heavily when calculating its patronage dividend, as necessary to calculate the relative contributions of members and non-members to the co-op’s net earnings. The court reasoned that it would be a question of fact as to whether, and how much more valuable, are member hours.
2. The valuation of member work for the co-op must be reasonable. The determination of a co-op’s board of directors as to the weighting of member hours is entitled to “some weight” but not a presumption of reasonableness. The court found that in this case, the weighting factors were reasonable. Evidence showed that the plaintiffs’ members were more productive than non-members, had lower turnover rates and required less supervision. Additionally, the cooperatives were more productive than comparable non-cooperative plywood mills. “In my view, these greater contributions to net earnings by members result from the members’ incentive to make the cooperative more profitable because they, as owners, will be the direct beneficiaries of increased profitability.” 410 F. Supp. at 1107.
3. Subchapter T allows a cooperative to deduct “wage” payments to members as a business expense, as long as the wages to members and non-members are reasonable. The court found that this approach and the alternative (treating wage payments and year-end distributions as patronage dividend) are not significantly different and the tax is roughly the same. Either approach is permitted.
4. The court held that Multnomah properly included dividends from a glue manufacturer in its net earnings subject to patronage dividend treatment. “Glue is essential to the manufacture of plywood, and the arrangement which Multnomah made to produce its glue through a supplier which it and another plywood workers’ cooperative organized is reasonably related to the business done with or for its patrons.”
Cases Addressing What is Patronage-Sourced Income
In Cotter and Co. v. United States, 765 F.2d 1102 (Fed. Cir. 1985), the US Court of Appeals reversed a Claims Court ruling that income generated by Cotter and Co., a purchasing and distribution cooperative, through i) interest on short-term investment of surplus capital in commercial paper and Certificates of Deposit (CDs), and ii) leasing temporarily excess warehouse space were not done “with or for patrons,” and thus not exempt as “patronage dividends” under 26 U.S.C. Sec. 1388.
At issue was whether income derived from certain business activities can be classified as patronage dividends. Citing Rev.Rul. 69-576, 1969-2 C.B. 166, which provides the basic distinction between patronage and nonpatronage activities, the Court found that Cotter and Co.’s disputed income-generating activities were sufficiently related to its primary business function to be classified as patronage-sourced, and not incidental or “merely [to] enhance the overall profitability of the cooperative.”
Cotter and Company and Subsidiaries (Cotter), a cooperative operating pursuant to Subchapter T (26 U.S.C. Secs. 1381-1388) of the Internal Revenue Code, was a purchasing and distribution cooperative whose members were small independent hardware retailers. The cooperative pooled the resources of its members to purchase hardware inventory in bulk at much lower costs than could individual members, often warehousing the bulk supplies for many months before distributing them to member businesses. The facts established that the cooperative needed to retain large amounts of liquid capital, and reasonably anticipated a growth in needed warehouse capacity, due to the seasonal nature of the business. Based on these facts and the wider business environment that Cotter operated within, the short-term investment of surplus capital and the leasing of temporarily excess warehouse space were determined to be “integrally intertwined” with the primarily function of the cooperative to purchase and distribute hardware inventory at the lowest possible prices to its members. Therefore, income derived from those activities could be classified as patronage dividends and thus deducted from Cotter’s gross income.
This case is significant for further clarifying that the business activities of cooperatives should be considered “in [their] relation to all the activity undertaken to fulfill a cooperative function,” i.e. in the “totality of the circumstances,” when determining whether such activity is patronage- or nonpatronage-sourced. Note that the IRS has issued several publications suggesting that, in other contexts, rental income and income from interest on CDs are not classified as patronage source income (see 1990 LGM TL-86 on rental income; 1992 WL 801071 and 1998 WL 897686 (IRS LB) on interest income).
In St. Louis Bank for Cooperatives v. United States, 624 F.2d 1041, 224 Ct.Cl. 289 (1980) examined the issue of whether the following items of income qualified for distribution as patronage dividends:
(a) interest income from demand deposits in nonpatron farm credit system banks, or from short-term loans to several brokerage houses through repurchase agreements, received by plaintiff through its management of funds surplus to the daily needs of its patrons;
(b) interest income obtained from certain Federal bonds required to be held for liquidity purposes in support of its banking business; and
(c) a gain of $386 realized upon the sale of an automobile used as a pool car by plaintiff’s officers and staff.
Mississippi Valley Portland Cement Co. v. United States, 408 F.2d 827, 832 (5th Cir.), cert. denied, 395 U.S. 844, 89 S.Ct. 2015, 24 L.Ed.2d 462 (1969) considered the economic realities of transactions in concluding them nonpatronage sourced.
The issue in Land O’Lakes, Inc. v. United States, 675 F.2D 988 (8th Cir.1982) concern the deductibility of three different types of dividends paid by the cooperative: (1) dividends paid pursuant to certain agent-buyer agreements; (2) dividends paid from the profits of Bridgeman stores owned by the cooperative; and (3) dividends paid from income received by the cooperative from Class B common stock issued by the St. Paul Bank for Cooperatives.
Briefs of Administrative Rulings
A Note about IRS Private Letter Rulings: Sometimes, corporations or individuals want to know, in advance, if the IRS agrees with a particular way of dealing with a tax issue. To find out, they will send the IRS a request for guidance. Someone at the IRS Office of Chief Counsel will respond with a letter expressing the IRS’ legal opinion based on the specific set of facts provided by the requester. This response, called a Private Letter Ruling, binds the IRS and the requester to the interpretation of the law, but does not have any precedential effect or binding authority on anyone else. Nonetheless, PLRs offer great insight into the IRS’s current legal opinion on a particular issue.
IRS Private Letter Ruling 9313016
Section 1381 of the Internal Revenue Code (IRC) (26 U.S.C. § 1381) describes which organizations fall within the scope of Subchapter T, governing taxation of cooperatives. In this ruling, the IRS decided that a nonprofit, non-stock corporation “operat[es] on a cooperative basis,” under section 1381(a)(2) of the IRC.
Corp H owns and operates several restaurants and Corp H’s franchisees own and operate several restaurants in the United States. To increase economic efficiency, H and its independent franchisees created a nonprofit, non-stock corporation (Corp E) to assume purchasing functions for H and the franchisees.
Citing Puget Sound, Inc. v. Commissioner, 44 T.C. 305, 308 (1965), the IRS applied a three-factor test to determine whether the nonprofit corporation was indeed a cooperative. The three factors considered were, (1) democratic control, (2) subordination of capital, and (3) allocation of excess operating revenues in proportion to the patron’s participation in the cooperative endeavor.
Democratic control is achieved by a “one-member-one-vote” rule. In addition, control of the corporation must be held by members actively patronizing the cooperative. In the case of E, each franchisee, through its operating partner, is automatically a member of E, and H is a single member as well. Each member is entitled to one vote on any issue submitted to the members for a vote. As a non-stock corporation, E has no investor members who are not actively patronizing the cooperative. As a result, the IRS decided that E was democratically controlled.
Subordination of Capital
“Subordination of capital requires that the control of the cooperative and ownership of the pecuniary benefits arising from the cooperative’s business remain in the hands of the patrons of the cooperative. Subordination of capital requires an organization to limit the financial return made on its equity capital.” E’s bylaws provide that E is obligated to return all excess receipts arising from its operation to its patrons based on the amount of patronage done by each. Further, E is a nonprofit, non-stock membership corporation, without any stockholders to whom equity distributions could be made. Based upon these factors, the IRS concluded that E meets the subordination of capital requirement.
Allocation of excess revenues based on patronage
“Allocation of excess operating revenue means that a cooperative must return the excess of its revenue from business transacted with patrons over related costs to its patrons in proportion to their participation in the cooperative. Similarly, when a cooperative is liquidated, the accumulated earnings from patronage business must be distributed to patrons (including former patrons to the extent practicable on the basis of the amount of business done with the cooperative.”
E’s bylaws require that excess receipts be returned to the patrons at least annually on the basis of the amount of business done with E. In addition, E’s bylaws provides that upon dissolution or liquidation all of the net assets will be distributed to the patrons, both present and past, on a patronage basis, insofar as is practicable, based upon the amount of business done by or for the patron during the period to which the income distributed is attributable. Based on these representations, E allocates excess operating revenue as well as net losses to its patrons in proportion to their participation in the cooperative.
IRS Private Letter Ruling 9235011
In this letter ruling, the IRS declared as “operating on a cooperative basis,” and thus exempt under Subchapter T, a corporation that converted into a cooperative by separating out different aspects of its business operations.
Corporation H, incorporated under the General Corporation Law of a state, operated two primary businesses. First, it provided goods and services to its shareholders that they use in their businesses. Second, it developed new business ventures. H transferred all its business development activities to a subsidiary, L. H then distributed all shares of L to its shareholders in exchange for almost all of their shares in H. Shareholders kept exactly 5 shares of common stock in H, which would begin operating as a cooperative at that point. The existing shareholders became the initial members of the cooperative.
H, as a cooperative, would conduct group purchasing activities for its members, negotiate contracts with it’s members’ suppliers, and develop and maintain a communication service to inform and educate its members and their affiliates. H also offered two classes of Associate Membership, which would allow associate members to participate in H’s activities. Associate Members, however, would not own any common stock and would therefore not have a vote in any of H’s affairs. Associate Members were entitled to patronage dividends on the basis of the quantity or value of business they transacted through H. Finally, H was to be provided with management services from L, for which H would negotiate payment at arm’s length.
Based on these facts, the IRS determined that H would be operating on a cooperative basis because it would engage in democratic control, subordination of capital, and allocation of excess revenue on the basis of patronage.
For more on taxation of cooperatives, see Patronage & Tax