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Cooperative's Payments to Members Were Per-Unit Retain Allocations for Section 199 Purposes

(Parker Tax Publishing November 2019)

The Tax Court held that payments made in years 2006 through 2009 by an agricultural cooperative to its members for products it processed and marketed for the members constituted per-unit retain allocations paid in money and the cooperative therefore had to treat them as such in computing its domestic production activities deduction (DPAD) under Code Sec. 199. The court also found that the cooperative was not required to compute separate DPAD amounts for its patronage and nonpatronage activities, the cooperative's DPAD had to be allocated between its patronage and nonpatronage accounts, and the DPAD could not be used to create or increase a net operating loss. AG Processing, Inc. v. Comm'r, 153 T.C. No. 3 (2019).


AG Processing, Inc. (AGP) is a member-owned agricultural cooperative engaged in processing and marketing soybeans, grains, and related products. For federal income tax purposes, AGP is a nonexempt cooperative under Code Sec. 1381 through Code Sec. 1388 (i.e., a subchapter T cooperative). AGP is also a specified agricultural or horticultural cooperative as defined in Code Sec. 199(d)(3)(F).

Observation: For tax years beginning before January 1, 2018, taxpayers could take a deduction under Code Sec. 199 for a percentage of their income attributable to certain production activities that took place within the United States (i.e., domestic production activities). The Tax Cuts and Jobs Act of 2017 repealed this deduction, effective for tax years beginning after December 31, 2017.

AGP's principal business was processing soybeans purchased from members and nonmembers. AGP marketed grain and soybeans from members on a patronage basis and from nonmembers on a nonpatronage basis. Each soybean purchase was made at a fixed price without reference to AGP's net earnings under a soybean contract. The price of the soybean contract was set using the current market price per bushel with adjustments for locality and other factors. The soybean contracts did not specify the tax treatment of the soybean payments or otherwise characterize them. Member and nonmember soybean contracts had the same terms.

During 2006-2009, AGP made soybean and grain payments to its members and paid patronage dividends to its members. AGP also sold grain on a patronage basis to another cooperative of which it was a member and received payments from the cooperative. AGP initially reported the soybean and grain payments as purchases on its federal income tax returns. However, with the enactment of the domestic production activities deduction (DPAD) under Code Sec. 199 in 2005, questions arose as to the correct treatment of payments from cooperatives to patrons for products processed or marketed for them. In 2008, the IRS issued Chief Counsel Advice 200806011, in which it concluded that such payments constituted deductible per-unit retain allocations paid in money (PURPIMs) under subchapter T and for purposes of the cooperative's DPAD calculation. The IRS also issued private letter rulings (PLRs) to other subchapter T cooperatives concluding that payments to patrons for products processed and/or marketed by the cooperatives were PURPIMs.

In 2009, the IRS issued a PLR to AGP ruling that (1) AGP's soybean payments to its members constituted PURPIMs for purposes of Code Sec. 1382(b)(3); and (2) in computing its DPAD, AGP's qualified production activities income (QPAI) and taxable income should, under Code Sec. 199(d)(3)(C), be computed without regard to any deduction for the soybean payments. The PLR also stated that the PURPIMs had to be reported in Box 3 of Form 1099-PATR, Taxable Distributions Received From Cooperatives. AGP filed amended returns to report the payments as PURPIMs. In a notice of deficiency, the IRS determined that the payments did not qualify as PURPIMs and that AGP was required to compute two separate DPAD amounts--one for its patronage activities and one for its nonpatronage activities. As a result, the IRS determined deficiencies of $277,477, $10,855,409, and $763,742 for AGP's 2007-2009 tax years. AGP challenged the deficiencies in the Tax Court.

Under Code Sec. 1382(b)(3), a subchapter T cooperative can deduct PURPIMs paid during the payment period for the tax year, which is defined in Code Sec. 1382(d) as the 8-1/2 month period following the close of the tax year. Code Sec. 1388(f) defines a per-unit retain allocation as any allocation by a subchapter T cooperative to a patron with respect to products marketed for it, the amount of which is fixed without reference to the net earnings of the cooperative, pursuant to an "agreement" between the cooperative and the patron. Neither Code Sec. 1388(f) nor the regulations prescribe any particular form that the agreement must take or specific terms that the agreement must incorporate.

The IRS argued that the "agreement" in Code Sec. 1388(f) is an agreement between the cooperative and the patron allowing the cooperative to use a per-unit retain allocation system and that the parties must agree to treat payments as PURPIMs. In other words, the IRS argued that a cooperative and the patron must agree as to the tax treatment of the payments and that AGP and its patrons failed to do so. Additionally, the IRS argued that the soybean and grain payments were not PURPIMs because they were not designated as such on AGP's Forms 1099-PATR within the 8-1/2 month payment period. AGP countered that the "agreement" requirement in Code Sec. 1388(f) merely distinguished obligatory payments from voluntary ones. According to AGP, the soybean and grain contracts themselves, which established an obligatory payment, constituted the "agreement" under Code Sec. 1388(f). AGP further argued that the 8-1/2-month payment period specifies the time within which the cooperative must make the payment; it does not require the designation of the payment as a PURPIM.


The Tax Court held that AGP's payments to its members were PURPIMs under Code Sec. 1382(b)(3) and AGP was required to treat them as such in computing its DPAD under Code Sec. 199. The court further held that AGP was not required to compute separate DPAD amounts for its patronage and nonpatronage activities and that once computed, AGP's DPAD had to be allocated between AGP's patronage and nonpatronage accounts. Finally, the court held that AGP's DPAD could not be used to create or increase a net operating loss.

The court found that interpreting the term "agreement" in Code Sec. 1388(f) to require an agreement as to the tax treatment of the payments would render other uses of the term in subchapter T superfluous because those uses specified the manner and/or form of an agreement while Code Sec. 1388(f) does not. The court reasoned that if Congress wanted to specify the form of the agreement or additional criteria for the exclusion of PURPIMs from a cooperative's gross income, it knew how to do so. The court concluded that AGP's soybean and grain payments were made to patrons with respect to products AGP marketed for them, their amounts were determined not by reference to AGP's net earnings, and the terms were memorialized in the soybean and grain contracts. The court also found that the payments were made within the 8-1/2-month payment period in Code Sec. 1382(d) and therefore were properly disregarded in determining AGP's taxable income and in its computation of its DPAD.

Next, the court held that while a cooperative must separate its patronage and nonpatronage income and expenses in computing its own taxable income, it is not required to compute two separate taxable incomes for patronage and nonpatronage activities so as to compute separate DPADs for its patronage and nonpatronage activities. The court found that the purpose of distinguishing and separating patronage income from nonpatronage income is to ensure that patronage dividends are not paid out of earnings from business done with nonpatrons by virtue of applying patronage-specific deductions or expenses (or a loss created by such deductions or expenses) to nonpatronage income. Finally, the court held that AGP'S DPAD could not be used to create or increase an NOL because, under Code Sec. 172(d)(7), DPAD is not taken into account in computing an NOL and there is no exception where a consolidated group's DPAD exceeds its taxable income.

For a discussion of deductions for cooperatives, see Parker Tax ¶49,420. For a discussion of the domestic production activities deduction, see Parker Tax ¶96,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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