RATABLE ALLOCATION OF DIVIDENDS AMONG ALL SOURCES OF INCOME REQUIRED

A nonexempt agricultural cooperative operating in accordance with subchapter T of the Internal Revenue Code requested a ruling that ordinary dividends paid to preferred stockholders could be paid from non-patronage source earnings without affecting the amount of the cooperatives patronage distributions to member patrons or its cooperative status.

The cooperative asserted that paying dividends from non-patronage source income would have no effect on its cooperative relationships with members and patronage income and expense items.

The cooperative had two classes of stock outstanding:

Common Stock: May only he owned by eligible members (who are generally agricultural producers), has voting rights, and no ordinary dividends are paid. Holders receive patronage rebates.

Preferred Stock: May be only issued to a common or participating stockholder, has no voting rights, no rights to dividends and no conversion rights. Is redeemed through a revolving redemption plan.

The cooperative proposed a reorganization plan wherein a new series of preferred stock (Class B preferred) would be offered to holders of the existing common or preferred stock for cash or through an exchange formula for existing preferred stock shares.

The Class B preferred would be transferable between existing preferred stockholders, subject to the approval of the ooperatives board of directors, would have no voting rights, would not be redeemed in any redemption plan other than at the death of the stockholder. Ordinary dividends on Class B preferred stock would be paid entirely from earnings from business not done on a patronage basis. Capital attributable to the Class B preferred stock would represent a portion of the cooperatives investment in non-patronage businesses.

In Letter Ruling 9852012 (September 24,1998) the Internal Revenue Service firmly rejected the cooperatives request, stating that to the extent that ordinary dividends are charged solely against net earnings from non-patronage sources instead of being charged ratably against all net earnings thereby increasing the amount paid to member patrons, such increase will not qualify as a patronage dividend and will not be deductible.

In the ruling, the IRS first discusses the concepts of operating on a cooperative basis and the definition of a patronage dividend. The IRS then rejected the cooperatives assertions regarding viewing non-member business as separate from patronage business, because the IRS treats an ordinary stock dividend as a distribution to investors in the entire cooperative business, not just the non-patronage portion.

The IRS went on to refer to:

  • Section 1.1388-1 of the Income Tax Regulations which requires net income available for distribution as patronage dividends to be reduced by dividends paid on capital stock.

  • Rev. Rul. 68-228, 1968-2 C.B.385 which required ratable allocation of ordinary dividends between patronage and non-patronage source income.

  • Des Moines County Farm Service Company v. United States, 324 F.Supp. 1216 (S.D. Iowa) [71-1 U.S.T.C. 92001, affd per curiam, 448 F.2d 812 (8th Cir. 1971) [71-1 U.S.T.C., 9665]which found that Treas. Reg. Section 1.1388-1(a)1 was a valid regulation and that ordinary dividends must be allocated ratable because the cooperatives equity capital supports both patronage and non-natronage activities.

  • Union Equity Co-op Exchange v. Commissioner, 58 T.C. 397 (1972), affd 481 F.2d 812 (10th Cir. 1973) [73-2 U.S.T.C., 9534], cert. den., 414 U.S. 1028 (1973) which concluded attributing ordinary dividends to only non-member earnings is an accounting fiction because the investors had invested in an undivided totality of the cooperatives assets.

  • FCX, Inc. v. United States, 531 F.2d 515 (Ct. Cl. 1976) [76-1 U.S.T.C. 92941] which concluded the regulations and cited cases requiring ratable allocation of ordinary dividends between patronage and non-patronage source income are correct.

    Michael D. McIntyre