Taxation of Cooperatives and Their Patrons (Portfolio 744)

Be a trusted advisor to your clients with Bloomberg BNA Tax Portfolios. In this portfolio, Premier tax experts analyze the federal income tax treatment of cooperatives and patrons.

To view this Portfolio, take a free trial to Bloomberg BNA Tax & Accounting


This Portfolio is available with a subscription to Bloomberg BNA Tax & Accounting, a comprehensive research solution including over 500 Tax Management Portfolios, practice tools, primary sources and timely news.


Taxation of Cooperatives and Their Patrons, No. 744-3rd, analyzes the federal income tax treatment of cooperatives and patrons. A cooperative is a business format in which patrons of the cooperative join together to transact business collectively. The principle underlying the federal income tax treatment of cooperatives and their patrons is that earnings derived by a cooperative from transacting business with and for its patrons are taxed once at the patron level, rather than twice, at both the cooperative and patron levels. This tax treatment is accomplished by allowing cooperatives to deduct certain distributions and allocations made to their patrons. The rules governing the taxation of cooperatives and their patrons are contained in subchapter T of the Code, §§1381 through 1388. Exempt farmers cooperatives and most nonexempt cooperatives are subject to Subchapter T.
Part I of this Portfolio provides a brief history of the federal income tax treatment of cooperatives and summarizes the rules of subchapter T. Part II examines the basic characteristics that identify a cooperative subject to subchapter T. In general, a cooperative is democratically controlled by its members, the payment of dividends is restricted, and its net earnings are distributed or allocated to members on the basis of their patronage rather than their stock ownership. Part II also discusses the requirements for exemption as a farmers cooperative. Exempt farmers cooperatives must limit their activities to marketing the agricultural products of members or other producers and purchasing equipment and supplies for sale to members and other persons. Both marketing and purchasing functions must be conducted on a nonprofit basis. The transaction of business between an exempt farmers cooperative and nonmembers is limited, and all patrons, whether members or nonmembers, must be treated equally.
Distributions to patrons are made by cooperatives in the forms of cash, other property, written notices of allocation, and per-unit retain certificates. The tax consequences of distributions to patrons depend on the source of the distributed earnings and the format of the distribution. Nonexempt cooperatives are allowed to deduct payments from patronage sources in cash, other property, qualified notices of allocation, and qualified per-unit retain certificates. Such distributions are included in income by the patrons in the year of payment. Payments from patronage sources made in nonqualified notices of allocation and nonqualified per-unit retain certificates are taxed to the cooperative when earned and deducted by the cooperative and included in income by the patron when redeemed. Exempt farmers cooperatives are also allowed to deduct capital stock dividends and payments on a patronage basis to patrons from nonpatronage sources. The unique terms employed by subchapter T are defined in Part III. The tax treatment of cooperatives and patrons is examined in Parts IV and V, respectively.


Bloomberg BNA Portfolios are written by leading tax professionals who set the standard as leaders in their fields. The Taxation of Cooperatives and Their Patrons, No. 744-3rd portfolio was authored by the following attorneys.  


Carla Neeley Freitag,Esq.

Carla Neeley Freitag, Esq.'s focus is on several areas of tax law, including Federal taxation, estate planning, probate & trust administration, exempt organizations, and tax whistleblower law. Carla also serves as a consultant and author for Bloomberg BNA's Tax Management, Inc. She wrote or co-wrote several Tax Management Portfolios and numerous chapters in Tax Practice Series.

Most recently, Carla was a member of Amari & Theriac PA, a small law firm in Cocoa, Florida. There she represented many estate planning clients, preparing living trusts, irrevocable life insurance trusts, asset protection trusts, and charitable remainder trusts. She also filed exemption applications for new nonprofits and participated in several complex acquisitions involving the partnership tax laws.

Carla was also a law professor at Southern Methodist University College of Law in Dallas, Texas. She taught courses as diverse as the introductory estates and trusts class and the exempt organizations class in the graduate tax program. Carla also taught for one year at Southern Illinois University in Carbondale, Illinois. There her courses included wills and trusts, income taxation of estates and trusts, and partnership and corporate tax law.


Credentials / B.A., Duke University (magna cum laude 1974); J.D., University of Florida College of Law (with high honors 1976); LL.M. (in Taxation), University of Miami School of Law (1988); admitted to practice in Florida, Texas, and Georgia; member, American Bar Association; author, The Funding of Living Trusts (American Bar Association 2004); author of 462 T.M., Unrelated Business Income Tax, 465 T.M., Debt-Financed Income (Section 514), 539 T.M., Net Operating Losses — Concepts and Computations, 607 T.M., Farm and Ranch Expenses and Credits, 517 T.M., Educational Expenses and Credits; co-author of 863 and 521 T.M., Charitable Contributions: Income Tax Aspects; contributor to Tax Practice Series; Tax Management Distinguished Author.

Table of Contents

Detailed Analysis

I. Introduction

A. Cooperatives in General

B. Background

1. Early Statutory and Case Law

2. Subchapter T

3. Role of Legislative History in Construing Subchapter T

C. Introduction to Subchapter T

1. Rationale for Tax Treatment of Cooperatives

2. Exempt and Nonexempt Cooperatives

3. Treatment of Distributions

4. Scope of Portfolio

II. Applicability of Subchapter T

A. Overview

B. Operating “On a Cooperative Basis”

1. Characteristics of Cooperatives

a. In General

(1) Three Cooperative Principles

(2) Puget Sound Plywood, Inc. v. Comr.

(3) Trump Village, Section 3, Inc. v. Comr.

b. Subordination of Capital

c. Democratic Control

(1) Voting Rights Required

(a) One Vote Per Member

(b) No Democratic Control

(c) Relationship Between Subordination of Capital and Democratic Control

(2) Approved Voting Formats

(a) Basic Voting Format

(b) Voting by Proxy

(c) Voting by Written Ballot in Lieu of a Meeting

d. Proportionate Allocation of Profits

(1) Allocation Based on Patronage

(2) Investment vs. Patronage

(3) Examples of Proportionate Allocations

(4) Requirement Strictly Construed

2. Business with Nonmembers

a. Exempt Cooperatives

(1) Quantity of Nonmember Business

(2) Equal Treatment for Nonmembers

b. Nonexempt Cooperatives

(1) Quantity of Nonmember Business

(2) Equal Treatment Not Required

3. Substance Over Form

a. Labels Not Controlling

b. Statute of Organization Not Controlling

c. Member Participation

d. Mississippi Valley Portland Cement Co. v. U.S.

C. Cooperatives Subject to Subchapter T

1. Exempt Farmers' Cooperatives

a. Requirements for Exemption

(1) Farmers,' Fruit growers,' or Like Organizations

(a) Patrons Must Produce Agricultural Products

(b) Examples of Eligible Cooperatives

(c) Examples of Noneligible Cooperatives

(2) Organized and Operated on a Cooperative Basis

(3) Permitted Purposes

(a) Marketing Function

(i) Marketing and Incidental Activities

(A) In General

(B) Eugene Fruit Growers Ass'n v. Comr.

(C) IRS Authorities

(ii) Producers

(A) Producer Defined

(B) Farmers Coop. Creamery Ass'n v. U.S.

(iii) Permissible Purchases from Nonproducers

(A) Necessary Sideline Purchases

(B) Ingredient Purchases

(C) Emergency Purchases

(D) “Look Through” to Corporation's Membership

(E) Purchases from Producers' Agent

(b) Purchasing Function

(4) Nonprofit Requirement and Equal Treatment of Patrons

(a) Nonprofit Requirement

(b) Equal Treatment of Patrons

(i) All Patrons Treated Equally

(ii) Transactions with Nonpatrons

(iii) Crediting Patronage Dividends of Nonmembers

(iv) Separate Divisions or Functions

b. Additional Issues

(1) Capital Stock

(a) Fixed Dividend Rate

(i) Value of the Consideration

(ii) Etter Grain Co., Inc. v. U.S.

(b) Limited Ownership by Nonproducers

(i) Substantially All Requirement

(A) No Set Percentage

(B) Federated Cooperatives

(ii) Qualified Producers

(A) Quantity of Patronage

(B) Timing of Patronage

(C) Who Is a Shareholder?

(D) Bylaw Provisions for Termination of Shareholder Status

(2) Reserve

(a) Investment of Reserve

(b) Interrelationship Between Reserve and Exemption Requirements

(3) Transactions with Nonmembers

(a) Express Limitations

(b) Federated Cooperatives

(4) Business for the United States

(5) Subsidiaries

c. Procedural Matters

(1) Grant and Revocation of Exemption

(2) Declaratory Judgment

2. Nonexempt Cooperatives

a. Corporation Requirement

b. Not Limited to Agricultural Pursuits

D. Cooperatives Not Subject to Cooperative Rules

III. Terminology

A. Patron

1. Transaction of Business on a Cooperative Basis

2. Mississippi Valley Portland Cement Co. v. U.S.

3. Mississippi Chemical Corp. v. Comr.

4. MVP Cement and Mississippi Chemical Compared

B. Patronage Dividend

1. Business Done with or for Patrons

a. Test for Distinguishing Patronage Income from Nonpatronage Income

(1) Regs. 1.1382-3(c)(2)

(2) Rev. Rul. 69-576

(3) Farmland Indus., Inc. v. Comr.

(4) Directly-Related Test Prevails

b. Application of Test to Specific Receipts

(1) Marketing of Products

(2) Sales to Members

(3) Interest

(a) Introduction

(b) IRS Rulings

(c) St. Louis Bank for Cooperatives v. U.S.

(d) Twin County Grocers, Inc. v. U.S.

(e) Cotter & Co. v. U.S.

(f) Illinois Grain Corp. v. Comr.

(g) Washington-Oregon Shippers Cooperative, Inc. v. Comr.

(h) Certified Grocers of California, Ltd. v. Comr.

(i) Dundee Citrus Growers Ass'n v. Comr.

(j) CF Industries, Inc. v. Comr.

(k) Analysis of Authorities

(4) Dividends

(5) Rent

(a) In General

(b) Cotter & Co. v. U.S.

(c) Illinois Grain Corp. v. Comr.

(6) Gain from the Sale of Stock

(a) Farmland Industries, Inc. v. Comr.

(b) IRS Acquiesces in Farmland Industries

(7) Gain from the Sale of 1231 Property

(a) In General

(b) Farmland Industries, Inc. v. Comr.

(c) Sale of Assets upon Liquidation

(8) Payments from Commodity Credit Corporation

(9) Distributions from Pass-Through Entities

(a) Use of Pass-Through Entities by Cooperatives

(b) Distributions from Cooperatives

(c) Distributions from Limited Liability Companies

(d) Distributions from Limited Partnerships

c. Allocation

2. Determination By Reference to Net Earnings from Patronage Sources

a. “By Reference To”

b. Net Earnings

(1) In General

(a) Regs. 1.1388-1(a)(1)

(b) Allocation of Expenses

(2) Treatment of Dividends on Capital Stock

(a) Distributions in Tax Years Beginning On or Before October 22, 2004

(i) Reduction of Net Earnings

(ii) Background

(iii) Mississippi Chemical Corp. v. U.S.

(iv) Authorities Upholding Dividend Allocation Rule

(b) Distributions in Tax Years Beginning After October 22, 2004

(3) Optional Netting of Patronage Gains and Losses

(a) Use of Allocation Units

(b) Notice Requirements

(4) Netting After 381(a) Transactions

3. Allocation Based on Quantity or Value of Business

a. Allocation Methods

b. Multiple Cooperative Activities

4. Equitable Allocation Among Patrons

5. Preexisting Obligation of Payment

C. Written Notice of Allocation

1. Written Notice of Allocation Defined

a. Adequate Disclosure Required

b. Form of Issuance

2. Qualified Written Notice of Allocation

a. Requirements

b. Right of Redemption

c. Consent of Patron

(1) Consent in Writing

(a) Requirements for Consent

(i) Requirements of 1388 and Regulations

(ii) Independent Coop. Milk Producers Ass'n, Inc. v. Comr.

(b) Application and Revocation

(c) Special Rule for Pooling Arrangements

(2) Consent by Membership

(a) Requirements for Consent

(i) Requirements of 1388 and Regulations

(ii) Cases Applying Consent by Membership

(b) Application and Revocation

(c) Special Rule for Pooling Arrangements

(3) Consent by Qualified Check

(a) Requirements for Consent

(b) Land O'Lakes, Inc. v. U.S.

d. 20% Cash Requirement

(1) Purpose of Requirement

(2) Use of Cash Payment to Offset Patrons' Liabilities to Cooperative

(3) Payment to Patrons' Assignees

(4) Constructive Receipt Not Sufficient

3. Nonqualified Written Notice of Allocation

D. Qualified Check

E. Per-Unit Retain Certificate

1. Per-Unit Retain Certificate Defined

2. Qualified Per-Unit Retain Certificate

3. Nonqualified Per-Unit Retain Certificate

IV. Tax Treatment of Cooperatives

Introductory Material

A. Taxable Income - In General

1. Gross Income

a. In General

b. Cooperative as Nontaxable Intermediary or Trustee

(1) Seven-Up Co. v. Comr.

(2) Affiliated Foods, Inc. v. Comr.

(3) Park Place, Inc. v. Comr.

(4) Concord Village, Inc. v. Comr.

2. Deductions (Other than 1382 Deductions)

a. In General

b. Net Operating Losses

(1) Deduction of Net Operating Losses

(a) In General

(b) Segregation of Patronage and Nonpatronage Gains and Losses

(2) Section 277 Not Applicable

(3) Impact of 199 Deduction

c. Deduction for Cooperative's Income from U.S. Production Activities

(1) Section 199 in General

(2) Terminology of 199 Pertaining to Cooperatives

(a) Specified Agricultural or Horticultural Cooperative

(b) Qualified Payment

3. Calculation of Cooperative's Deduction

4. Pass-Through to Patrons

5. Examples

6. Credits

B. Deduction of Distributions from Patronage Sourced Income by All Cooperatives

1. Exclusion vs. Deduction

2. Categories of Deductible Distributions

a. Patronage Dividends

(1) Requirements for Deduction

(2) Redemption of Qualified Written Notices of Allocation

(a) No Consequences

(b) Redemption at Less Than Fair Market Value

b. Redemption of Nonqualified Notices of Allocation

c. Per-Unit Retain Allocations

(1) Requirements for Deduction

(2) Redemption of Qualified Per-Unit Retain Certificates

d. Redemption of Nonqualified Per-Unit Retain Certificates

3. Payment Issues

a. Payment Period

b. What Constitutes Payment?

c. Payment by Successor Organization

4. When Patronage Occurs

a. Significance of When Patronage Occurs

b. Marketing and Patronage in Pooling Arrangements

c. Earnings Received After Patronage Occurred

C. Deduction of Distributions from Nonpatronage Sourced Income

1. Dividends on Capital Stock

2. Distributions on a Patronage Basis from Nonpatronage Sourced Income

D. Computation of Tax Where Cooperative Redeems Nonqualified Written Notices of Allocation or Nonqualified Per-Unit Retain Certificates

1. Seven-Step Approach

2. Examples

E. Nondeductible Distributions

F. Reduction for 199 Deduction Passed Through to Patrons

V. Tax Treatment of Patrons

A. General Rule

1. Distributions Includible in Gross Income in Year of Receipt

2. Receipts Includible upon Redemption

B. Exclusions from Gross Income

C. Miscellaneous

1. Self-Employment Tax

2. Deduction of Taxes, Interest, and Business Depreciation by Tenant-Stockholders

3. Deduction for Cooperative's Income from U.S. Production Activities

VI. Alternative Minimum Tax Treatment

VII. Returns and Compliance

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Written Notices of Allocation

Worksheet 2 Written Notices of Allocation: Consent Bylaws and Form of Written Consent

Worksheet 3 Exempt Farmers’ Cooperatives and Nonexempt Cooperatives Quick Reference



Treasury Rulings: