Cooperative Must Separately Compute DPAD for Patronage and Nonpatronage Sourced Income (Parker's Federal Tax Bulletin: June 05, 2013)

In 2004, as part of the American Jobs Creation Act, Congress enacted Code Sec. 199, which phased in a new tax deduction related to qualified domestic production. That tax deduction, the domestic production activities deduction (DPAD), is available for a broad range of domestic manufacturing and production businesses, as well as companies engaged in activities not traditionally seen as manufacturing, such as agriculture. As a result, cooperatives may avail themselves of this deduction.

In CCM 20131802F, the IRS's Chief Counsel's Office was asked whether a Subchapter T cooperative could compute its DPAD by aggregating patronage and nonpatronage sourced activities. By aggregating such activities, the cooperative in CCM 20131802F ended up with a bigger deduction. Unfortunately for the taxpayer, the Chief Counsel's Office advised that, while Code Sec. 199 does not explicitly require cooperatives to perform separate DPAD calculations, it was indisputable that Code Sec. 199(d)(3) is a deduction against patronage sourced earnings only, and thus the taxpayer was required to compute separately the DPAD for patronage and nonpatronage sourced income.

Facts

The taxpayer in CCM 20131802F is a large Subchapter T cooperative that files a Form 1120C, U.S. Income Tax Return for Cooperative Associations. The taxpayer had both patronage gross receipts and nonpatronage gross receipts. Additionally, the taxpayer claimed a DPAD for patronage income and no DPAD for nonpatronage income. Although the taxpayer computed a number for both patronage and nonpatronage income for DPAD, the taxpayer did not perform two DPAD computations, one for patronage sourced activities and another for nonpatronage sourced activities. Instead, the taxpayer computed its DPAD by aggregating the patronage and nonpatronage sourced activities. The taxpayer's nonpatronage activities had a negative QPAI, which, if calculated separately from patronage activities, would have resulted in a DPAD of zero. By aggregating its patronage and nonpatronage activities, the taxpayer was able to turn half of its nonpatronage wages into additional DPAD.

Under Code Sec. 199(d)(3), any person who receives a qualified payment from a specified agricultural or horticultural cooperative is allowed for the tax year in which the payment is received a DPAD equal to the portion of the deduction allowed under Code Sec. 199(a) to the cooperative that is (1) allowed with respect to the portion of the qualified production activities income to which the payment is attributable, and (2) identified by the cooperative in a written notice mailed to such person during the payment period described in Code Sec. 1382(d).

In an email to an IRS revenue agent, the taxpayer stated it was aware that some taxpayers have taken the position that cooperatives should separately calculate DPAD for patronage and nonpatronage income. However, the taxpayer took the position that because it could found no basis in Code Sec. 199 or the related regulations that requires cooperative to perform two separate calculations, its position was correct, reasonable, and proper based on the law and regulations.

For the tax years at issue in CCM 20131802F, the DPAD was the lesser of 6 percent of taxable income or 6 percent of qualified production activities income (QPAI), limited to 50 percent of the W-2 wages.

OBSERVATION: For 2010 and later years, the DPAD is equal to 9 percent of the lesser of the taxpayer's QPAI or its taxable income. However, the amount of the deduction is limited to 50 percent of the W-2 wages paid by the taxpayer that were allocable to the taxpayer's domestic production gross receipts.

Farm Service Cooperative Decision

In analyzing the situation in CCM 20131802F, the Chief Counsel's Office looked to the Eighth Circuit's decision in Farm Service Cooperative v. Comm'r, 619 F.2d 718 (8th Cir. 1980). The taxpayer in that case was an agricultural cooperative whose business consisted of four kinds or pools of activities. Only the broiler (chicken) pool activity was at issue. During the 1971 and 1972 fiscal years, the broiler pool sustained significant losses. In 1972, the taxpayer's broiler pool's expenditures exceeded broiler receipts, and the taxpayer offset the entire amount of the broiler pool (patronage) deficit against its taxable (nonpatronage) income for the 1972 fiscal year. The IRS disagreed with the taxpayer's method of accounting, and argued that the taxpayer was required to pay tax on all income not allocated to patrons i.e., as a taxable cooperative, taxpayer was not allowed to use patron sourced losses to offset its taxable nonpatronage income.

The Eighth Circuit in Farm Service Cooperative noted that taxable cooperatives could allocate to their patrons and deduct from its taxable income only income arising from patronage activities, subject to additional conditions specified in Code Sec. 1388. Since a restriction on the scope of allowable deductions existed, taxable cooperatives, the court stated, had to separate patronage and nonpatronage sourced income. The IRS raised the position that it called the cooperative tax accounting principle expenses allocable solely to patronage activities could not be used to offset nonpatronage income. The taxpayer countered that its treatment of operating losses did in fact conform with the Internal Revenue Code, because Subchapter T makes no explicit rules about the appropriate treatment of net operating losses, and therefore the general rules of corporate taxation applied. The taxpayer argued that since C corporations were allowed to aggregate gains and losses from their different business units, the taxpayer should be allowed to do the same: Aggregate gains and losses from its patronage and nonpatronage activities.

The Tax Court agreed with the taxpayer and held that the taxpayer could allocate the broiler pool losses as it saw fit. The Tax Court relied on its decision in Associated Milk Producers, Inc. v. Comm'r, 68 T.C. 729 (1977). In Associated Milk Producers, the Tax Court held that a taxable cooperative could use the net loss carryover to reduce current patronage earnings by past operating losses. The Tax Court said the cooperative could carryover losses as it saw fit and determine whether its past, present, or future patrons should bear the loss.

The Eighth Circuit, however, distinguished the taxpayer of Farm Service Coooperative from the Associated Milk Producers case. The Eighth Circuit explained that Associated Milk Producers dealt with a vertical allocation of losses, which shifted the losses in time, but kept them within solely patronage business. In contrast, the Eighth Circuit said, Farm Service Cooperative contained a horizontal allocation problem, where the income and losses shifted between the patronage and nonpatronage portions of the business. The Eighth Circuit reinforced the supremacy of Subchapter T in separating patronage from nonpatronage business, holding that a taxable cooperative must segregate accounts when calculating gross income, at least in those cases where grower payments or per-unit retain allocations contribute to net operating losses in patronage activities, and stating that a taxpayer's accounting procedures cannot supersede this statutory principle.

Chief Counsel's Analysis

In CCM 20131802F, the Chief Counsel's Office noted that the taxpayer aggregated its patronage and nonpatronage business activities for the purpose of calculating its DPAD. The taxpayer's nonpatronage activities had a negative QPAI, which, if calculated separately from patronage activities, the Chief Counsel's Office said, would have resulted in a DPAD of zero. By aggregating its patronage and nonpatronage activities, the taxpayer was able to turn half of its nonpatronage wages into additional DPAD.

According to the Chief Cousel's Office, the taxpayer's method of calculation created a distortion of DPAD. While requiring a taxpayer to separate its DPAD calculations for patronage and nonpatronage activities leads to a far smaller total DPAD, aggregating the two gives a taxable cooperative a large advantage over a corporation. Taxable cooperatives are able to calculate their gross patronage sourced income for DPAD without deducting certain types of payments, e.g., per units retained paid in money (PURPIM), making their patronage sourced income higher than it would otherwise be. If, as the taxpayer argued, Congress intended there to be no distinction between cooperatives and other corporations under Code Sec. 199, then cooperatives should not be allowed to exclude these expenses as part of their cost of goods sold, the Chief Counsel's Office said.

Aggregating patronage and nonpatronage income, wages, and expenses represent a horizontal allocation of cooperative business, the Chief Counsel's Office stated, as discussed in Farm Service Cooperative. Similarly, the taxpayer is using patronage QPAI, in the form of non-deducted PURPIMs, to offset a negative nonpatronage QPAI. While Code Sec. 199 does not explicitly require cooperatives to perform separate DPAD calculations, the Chief Counsel's Office concluded that it was indisputable that Code Sec. 199(d)(3) is a deduction against patronage sourced earnings only. Further, the Chief Counsel's Office said it was indisputable that cooperatives cannot deduct W-2 wages from nonpatronage activities against patronage sourced income (or vice versa). Here, however, the Chief Counsel's Office noted, the taxpayer was doing indirectly what it could not do directly by using nonpatronage sourced W-2 wages to artificially increase the amount of the Code Sec. 199 deduction that is solely used against patronage income. Subchapter T has precedence over cooperatives, and therefore the Chief Counsel's Office concluded that the taxpayer had to perform separate DPAD calculations.

Staff Editor Parker Tax Publishing

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