Rev. Rul. 54-10

SECTION 1. PURPOSE.

The purpose of this Revenue Ruling is to set forth the policy of the Service and to furnish instructions to the district directors and other employees concerned, with respect to the tax treatment in the hands of patrons, of amounts allocated in document form by cooperative associations.

SEC. 2. MEANING OF TERMS.

For the purpose of this Revenue Ruling the terms `cooperative association,' `patron,' `allocation,' and `patronage dividend' have the meaning ascribed to them in section 39.101(12)-2(b) of Regulations 118. As so defined the term `allocation' includes patronage dividends and other distributions made by a cooperative association in any manner whereby there is disclosed to the patron the dollar amount apportioned on the books of the association for the account of such patron. The term `patronage dividend' as defined does not include amounts allocated on a patronage basis in document form which are fixed without reference to earnings of the association. However, the rules set forth in section 6 herein, as to the tax treatment of amounts allocated in document form, apply not only to patronage dividends but to all allocations made by a cooperative association in document form.

SEC. 3. BACKGROUND.

.01 Treasury Decision 6014, approved May 29, 1953, C.B. 1953-1, 110, added section 29.22(a)-23 to Regulations 111 (now 39.22(a)-23 of Regulations 118), prescribing rules for the tax treatment as to patrons of allocations by cooperative associations. Section 39.22(a)-23(b)(1) of Regulations 118 sets forth the extent of taxability of amounts allocated to a patron on a patronage basis by a cooperative association with respect to products marketed for such patron, or with respect to supplies, equipment, or services the cost of which is deductible by the patron under section 23 of the Code. These regulations provide in part to the effect that if the allocation is in the form of capital stock, revolving fund certificates, certificates of indebtedness, letters of advice, retain certificates or similar documents, the amounts allocated shall be included in the computation of the gross income of the patron to the extent of the face amounts of such documents provided the allocation is made in fulfillment and satisfaction of a valid obligation of such association to the patron, which obligation was in existence prior to the receipt by the cooperative association of the amount allocated.

.02 These provisions as to the tax treatment of allocations in the hands of the patron where there is a contractual obligation involved do not represent a departure from rules previously in effect, but set forth in regulation form a policy of the Service which has been long established.

.03 The regulations also set forth rules for the treatment of an allocation in document form where the allocation was not made pursuant to a valid obligation of the association to the patron. Normally in such case amounts so allocated are included in the gross income of the patron to the extent of cash or merchandise received in redemption or satisfaction of the document for the year in which the cash or merchandise is received. An exception is where the document is a negotiable instrument, in which case the amount to be included in the gross income of the patron in the year of receipt is the fair market value of the document.

.04 The foregoing described treatment of allocations to patrons is consistent with the theory under which patronage dividends are treated by cooperative associations. A cooperative association may exclude from its gross income true patronage dividends when made pursuant to a prior agreement between the cooperative organization and its patrons. The justification for this treatment rests upon the fact that these patronage dividends represent either an additional consideration due the patron for goods sold through the association or a reduction in the purchase price of supplies or equipment purchased by the patron. The amounts which may be excluded as patronage dividends are not limited to the distributions made in cash but include amounts distributable but retained by the cooperative and distributed in forms other than cash. However, where a cooperative makes a distribution which it is not obligated to make under a preexisting agreement, it is not entitled to exclude such distribution from gross income even though the distribution is made on a patronage basis. Moreover, for taxable years beginning after December 31, 1951, in the case of exempt cooperatives and for all years in the case of cooperatives not exempt, any receipts of a cooperative association which it fails to allocate to its patrons must be included in the taxable income of the association to the same extent as in the case of commercial corporations generally. This is true of any amounts set up in a reserve account as well as net margins remaining after provision for reserves. It is also true of amounts which are considered to be in partial payment of produce, held back from patrons by a marketing cooperative, even though the association considers such amounts as fixed without reference to earnings.

.05 The theory under which a cooperative association may make an allocation in document form is that the patron by express contract or by doing business with the cooperative agrees to allow the association to retain funds to which the patron is entitled. Allocations other than cash or merchandise usually take the form of certificates denoting an investment in the capital of the association or of certificates of indebtedness by the cooperative. Where the document has been issued in accordance with a preexisting agreement, the form of the document is immaterial as to its taxability to the patron. It is considered that the patron has in effect received in money the face amount of the document and has either reinvested such amount in the capital of the association or allowed the association the use of the money. In either event there is justification for including the face amount of the document in the patron's gross income. This justification exists by reason of the preexisting legal obligation of the cooperative to distribute all of its net savings to its patrons each year and by the agreement between the cooperative and its patrons, which agreement is ordinarily set out in a marketing agreement or the association's charter, bylaws, or both, whereby the patrons agree to accept other than cash or merchandise for their share of the net savings.

.06 An important problem regarding the treatment of allocations in document form has arisen in those cases where an allocation has been made by a cooperative association but the patron has failed to report the entire face amount of the document on his return as income. Of particular concern is the treatment of amounts received in redemption of documents issued in prior years where the period of limitations has expired for the year of allocation. The issue in such cases is the basis of the document to be used by the patron upon redemption, sale, or other disposition.

.07 There are precedents for holding that when a taxpayer has failed to include in his return property which he receives and which represents income to him he cannot in a subsequent related transaction shift his position so as to establish a basis for such property in excess of the amount carried into income in the year of receipt. A close analogy to the case of unreported noncash distributions by a cooperative association is found in decisions in which a taxpayer receives shares of stock representing income in the year of receipt. An important case illustrating this principle is Continental Oil Company v. Jones , 177 Fed.(2d) 508, certiorari denied on the issue of duty of consistency 339 U.S. 931.

SEC. 4. STATEMENT OF POLICY.

In line with the decision in the Continental Oil Company case and other supporting cases the Service has adopted the following policy:

When a patron of a farmers' marketing or purchasing cooperative receives capital stock, revolving fund certificates, retain certificates, certificates of indebtedness, letters of advice, or similar documents representing an allocation to him pursuant to a preexisting contractual obligation, or in any case in which the dollar amount of such allocation to him is disclosed in any other manner, and the patron reports the face amount of such allocation, the basis upon redemption, sale or other disposition of the evidence of such allocation is the face amount. In any such case in which the cash or merchandise received by the patron is less than the face amount, the patron may establish a loss under applicable provisions of the Internal Revenue Code. On the other hand when a patron receives similar evidence of an allocation to him and reports less than the face amount of the certificate or other document, his basis will be limited to the amount reported in income in the year of receipt thereof. Upon redemption, sale or other disposition of the evidence of the allocation the excess amount over the amount reported will represent gross income to the patron in the year of such redemption, sale or other disposition.

SEC. 5. EXCEPTION TO GENERAL RULE.

Although the general rule just stated will apply in the great majority of cases where the patron has failed to report the entire face amount of an allocation in document form, there are situations in which an exception should be made. These are cases in which the period of limitations for the year of allocation has expired and before such expiration the Internal Revenue Service was on notice that the patron had included in his income an amount less than the face amount of his certificate or other evidence of allocation. As an example this notice might consist of information given in the patron's return from which the Service could have known that the patron received patronage dividends in document form and failed to include them in his gross income. In any such exceptional case the Service will not insist that there be included in income the amount by which the payment received in the year of redemption exceeds the amount reported in the year of allocation. However, in this type of case if the amount received upon redemption exceeds the face amount of the document, the excess would be included in income.

SEC. 6. COURSE OF ACTION.

.01 As a summary of the foregoing, the following rules should be used in determining the extent to which amounts allocated in document form by a cooperative association should be included in the computation of the patron's gross income.

1. Where an allocation was made pursuant to a preexisting agreement:

a. If the period of limitations has not expired for the patron's taxable year in which the allocation was made, the amount of the allocation should be included in the patron's gross income to the extent of the face amount of the documents.

b. If the period of limitations has expired for the patron's taxable year in which the allocation was made, the difference, if any, between the amount reported in the year of allocation and the amount received upon redemption, sale, or other disposition of the documents should be included in the patron's income for the taxable year in which the redemption, sale, or other disposition took place.

2. Where an allocation was made which was not in pursuance to a preexisting agreement and the document issued was not a negotiable instrument the amount received upon redemption, sale, or other disposition of the document should be included in gross income for the patron's taxable year in which received.

3. Where an allocation was made which was not in pursuance to a preexisting agreement and the document issued was a negotiable instrument:

a. If the period of limitations has not expired for the taxable year of the patron in which the allocation was made, the fair market value of the instrument should be included in the patron's gross income.

b. If the period of limitations has expired the difference between the amount reported in the year of allocation and the amount received upon surrender, sale, or other disposition of the instrument should be included in the patron's gross income.

.02 An exception to the rule stated in l.b. above will be recognized in any case in which the Internal Revenue Service had knowledge, prior to the expiration of the period of limitations, of the fact that the patron has included in his income in the year of allocation an amount less than the face amount of his certificate or other evidence of allocation. However, in any such case the Internal Revenue Service will be charged only with knowledge of the facts reflected in the taxpayer's return or discovered upon an investigation thereof.