Rev. Rul. 74-160

Advice has been requested whether, under the circumstances described below, (1) certain income received and losses sustained are patronage or nonpatronage sourced income or losses, and (2) whether a distribution of such income qualifies as a patronage dividend under section 1388(a) of the Internal Revenue Code of 1954.

The taxpayer, a nonexempt cooperative within the meaning of section 1381(a) of the Code, is engaged in the manufacture and sale of plywood. It is composed of both member and nonmember workers. Only member workers are entitled to receive patronage dividends. These patronage dividends are computed by the method set forth in Rev. Rul. 74-20, page 242.

During the taxable year the taxpayer made loans to its chief supplier in order to permit the supplier to finance equipment necessary to carry out its business operation. Without the loans the supplier would have been unable to supply the cooperative. The taxpayer realized interest income on these loans.

As a part of its business the taxpayer was the lessee and operator of a veneer plant for a number of years. During the taxable year the lease on the veneer plant was cancelled and the taxpayer received a payment as a result of cancellation of the lease. The veneer plant had an operating loss for the year.

Section 1.1382-3(c)(2) of the Income Tax Regulations defines the term "income derived from sources other than patronage" to mean incidental income from sources not directly related to the marketing, purchasing, or service activities of the cooperative association. For example income derived from the leases of premises, from investment and securities, or from the sale or exchange of capital assets, constitutes income derived from sources other than patronage.

Section 1388(a) of the Code provides that for the purpose of subchapter T of the Code, the term "patronage dividend" means an amount paid to a patron by an organization to which part I of subchapter T applies: (1) on the basis of quantity or value of business done with or for such patron, (2) under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount so paid, and (3) which is determined by reference to the net earnings of the organization from business done with or for its patrons. The term patronage dividend does not include any amount paid to a patron to the extent that (A) such amount is out of earnings other than from business done with or for its patrons, or (B) such amount is out of earnings from business done with or for other patrons to whom no amounts are paid, or to whom smaller amounts are paid, with respect to substantially identical transactions.

Rev. Rul. 69-576, 1969-2 C.B. 166, holds that the classification of an item of income as from either patronage or nonpatronage sources is dependent on the relationship of the activity generating the income to the cooperative. Therefore, if the income is produced by a transaction that actually facilitates the accomplishment of the cooperative's marketing, purchasing or service activities, the income is from patronage sources. However, if the income producing activity does not actually facilitate the accomplishment of the cooperative's marketing, purchasing or service activities but merely enhances the overall profitability of the cooperative, the income is from nonpatronage sources.

The loans to its chief supplier to purchase equipment actually facilitated the accomplishment of taxpayer's cooperative activities, in that it enabled the taxpayer to obtain necessary supplies for its operations. Without making the loans, the taxpayer would have been unable to obtain necessary supplies. As the taxpayer could deduct any loss suffered as a result of these loans, so also any income generated as a result of these loans should be treated as directly related to the taxpayer's activities. See Rev. Rul. 58-40, 1958-1 C.B. 275, compare Gulftex Drug Co., Inc., 29 T.C. 118 (1958), and the cases cited therein.

Accordingly, to the extent such income is allocable to the member patrons on the basis of business done with or for those patrons, the income is patronage sourced income that may be distributed as patronage dividends. However, to the extent the interest income is allocable to nonmember business it constitutes nonpatronage sourced income that must be taken into account in computing the Federal income tax of taxpayer. For an analogous calculation, see the method set forth in Rev. Rul. 74-20.

Section 1241 of the Code provides that amounts received for cancellation of a lease shall be considered as amounts received in exchange for such lease. In the instant case the taxpayer, as tenant, received payment as a result of a cancellation of a lease. The lease was property used in the trade or business within the meaning of section 1.1231-1 of the regulations. See Rev. Rul. 72-85, 1972-1 C.B. 234.

Accordingly, the payment received for cancellation of the lease is considered as an amount received for the sale of a capital asset which under section 1.1382-3(c)(2) of the regulations, is considered income derived from sources other than patronage.

The operating loss resulting from the operation of the veneer plant by the taxpayer is a loss from patronage sources to the extent it is allocable to the business done with or for worker members. The manufacture of veneer is an integral part of the taxpayer's cooperative function and thus any profit or loss resulting from the operation of such a plant results in patronage and nonpatronage sourced income or loss to be allocated in the same manner as the interest income considered above.