Rev. Rul. 74-20

Advice has been requested whether, under the circumstances described below, the taxpayer is using a proper method of computing amounts available for patronage distributions under section 1382 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 wood products. The taxpayer's work force is composed of 100 member workers and 15 nonmember workers.

Under the provisions of the taxpayer's by-laws, when computing the net income available for distribution as a patronage dividend, the taxpayer used a percentage equal to the adjusted hours worked by member workers during the fiscal year divided by the sum of actual hours worked by nonmember workers plus the adjusted hours worked by member workers. The adjusted hours of the member workers is the sum of their actual hours worked increased by 40 percent. Thus, for example, if the actual hours worked by member workers equaled 60 hours and actual hours worked by nonmember workers equaled 40 hours the equation before the adjustment would be 60/100 times net income. By adjusting the actual hours worked by the member workers by 40 percent the equation would be changed to 84/124 times net income since the total actual hours worked by members workers would be increased by 24 hours (60 times 40 percent) and the total hours worked by all workers would be correspondingly increased by 24 hours.

Section 1382(b)(1) of the Code provides that in determining the taxable income of an organization to which subchapter T, Part I of the Code applies, there shall not be taken into account amounts paid during the payment period for the taxable year as patronage dividends, to the extent paid in money, qualified written notices of allocation, or other property with respect to patronage occurring during such taxable year.

Section 1388(a) of the Code defines the term patronage dividend to mean an amount paid to a patron by an organization to which Part 1 of Subchapter T of the Code 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.

In the instant case, the increasing of the hours worked by the member workers by 40 percent is not a determination on the basis of either quantity or value but is solely an arbitrary determination. The result is to distribute to the member workers income of the taxpayer that is attributable in part to net earnings from the efforts of the nonmember workers. See Rev. Rul. 74-24, page 244.

Accordingly, in the instant case, patronage dividends computed by increasing the hours worked by member workers in determining the applicable percentage of net earnings available for patronage distributions do not qualify as patronage dividends to the extent that such distributions are from income attributable to nonmember workers and to that extent the taxpayer is not entitled to a deduction for such distributions under section 1382(b)(1) of the Code.

However, the taxpayer may elect to use the quantity method in calculating net earnings available for patronage dividends. This method is based on the number of hours worked and is illustrated as follows:

Assume members worked 3,000 hours and nonmembers worked 1,000 hours to produce net earnings of 8,000x dollars. To calculate the amount of net earnings attributable to member workers the calculation should read:

3,000 hours worked by members ------------ times $8,000x = $6,000x 4,000 total hours worked

$6,000x is the amount attributable to member efforts on the basis of quantity of work done.

The formula for determining the patronage dividend for an individual member when the quantity method is used is as follows:

number of hours worked by member ----------------------------------- times net earnings available total number of member hours worked for patronage distribution

Thus, if member A worked 500 hours of the 3,000 hours worked by all members, A's patronage dividend would be calculated as follows:

500 ----- times $6,000x = $1,000x amount of patronage dividend payable 3,000 to A.

The applicable percentage as calculated under the above method must be applied to all aspects of the taxpayer's operation so as to clearly reflect the income attributable to the member workers and nonmember workers. See Rev. Rul. 74-24, page 244, this Bulletin.