PwC Evolving Cooperative Business Structures Daniel R. Schultz 5 th Annual Farmer Cooperative Conference November 13-15, 2002

5 th Annual Farmer Cooperative Conference Spotlight On The IRS The theme of this conference is the trend for farmer cooperatives to form strategic alliances. An important question to ask and answer is: Can we count on the Internal Revenue Service to be “here to help,” or will they make troubled times even more difficult for cooperatives? PricewaterhouseCoopers

5 th Annual Farmer Cooperative Conference Answer: In recent years, the Service appears to understand the competitive pressures cooperatives face and is allowing them to enter into joint ventures and other strategic alliances without sacrificing the tax benefits provided for co-ops in Subchapter T of the Internal Revenue Code. PricewaterhouseCoopers

4 5 th Annual Farmer Cooperative Conference Background – The primary tax benefit for farmer cooperatives is the ability to avoid tax on net earnings from patronage business by taking the tax deduction for patronage dividends provided in Subchapter T of the Internal Revenue Code (IRC).

PricewaterhouseCoopers 5 5 th Annual Farmer Cooperative Conference Subchapter T doesn’t specify rules for joint ventures so any strategic alliance by a farmer cooperative must be carefully planned to assure its net income will continue to qualify as patronage source earnings eligible for payout by the cooperative as a tax-deductible patronage dividend.

PricewaterhouseCoopers 6 5 th Annual Farmer Cooperative Conference Historical perspective on the IRS treatment of farmer cooperatives – From the 1970’s into the early 1990’s the IRS was a “misguided missile” launched against cooperatives. During this “dark ages” era the IRS national farmer cooperative industry specialist pursued an aggressive agenda to allow patronage dividend deductions only for income from transactions directly with patrons.

PricewaterhouseCoopers 7 5 th Annual Farmer Cooperative Conference During the 1970’s and 1980’s the IRS argued that – –Interest earned on temporary investments of working capital by cooperatives should be taxable nonpatronage income. –Rental income from leasing out excess warehouse space or excess barge capacity should be taxable nonpatronage income. –Capital gains on the sale of assets used by cooperatives in patronage activities should be taxable nonpatronage income.

PricewaterhouseCoopers 8 5 th Annual Farmer Cooperative Conference In a number of cases during this time the IRS refused to give co-ops private letter rulings approving patronage treatment for income to be received from proposed partnership joint ventures. Fortunately for cooperatives, with a few minor exceptions, the Service lost all the court cases it brought on these issues.

PricewaterhouseCoopers 9 5 th Annual Farmer Cooperative Conference –Cotter & Co. – interest on temporary investment of working capital and rental income from excess warehouse space was held to be patronage source income for the True Value hardware cooperative. –Illinois Grain – interest on working capital and rental of excess barge capacity was held by the court to be patronage source income. –Farmland Industries – capital gains on sale of stock and fixed assets directly related to patronage business held to be patronage source income.

PricewaterhouseCoopers 10 5 th Annual Farmer Cooperative Conference These court decisions established that determining whether a cooperative’s income is patronage sourced or not requires a very fact-intensive inquiry into whether the income is from transactions that are directly related to and actually facilitate the cooperative’s patronage business activity. This directly related test applies regardless of the source or form of the income. It applies whether or not the income is from transactions directly with patrons.

PricewaterhouseCoopers 11 5 th Annual Farmer Cooperative Conference The directly related test as applied in the Cotter, Illinois Grain and Farmland court decisions to define patronage source income has its roots in the Service’s own ruling, Revenue Ruling , which dates back to the early days of Subchapter T.

PricewaterhouseCoopers 12 5 th Annual Farmer Cooperative Conference These landmark court victories for cooperatives led to the dawn of a new “enlightened” era at the IRS [at least when it comes to co-ops] By the last half of the 1990’s the IRS finally folded its tent and “downsized” its farmer cooperative industry program The Farmland Industries Tax Court decision in 1999 was the last nail in the coffin.

PricewaterhouseCoopers 13 5 th Annual Farmer Cooperative Conference During the past few years the IRS national office has issued a series of private letter rulings to cooperatives that allow patronage source treatment for income earned by cooperatives from a variety of partnership and LLC joint venture structures. Three recent post-Farmland case private letter rulings allow patronage source status to large capital gains from investments that originated as corporate joint ventures between cooperatives and non-coop partners.

PricewaterhouseCoopers 14 5 th Annual Farmer Cooperative Conference Two examples of recent cooperative LLC joint venture rulings from the IRS illustrate what’s going on these days: 1.Private letter ruling deals with a sugar refining cooperative that formed a refining and marketing LLC joint venture with two larger non-coop sugar refiners. 2.Private letter ruling was issued for the Agriliance LLC joint venture set up by Farmland, Land O’ Lakes and CHS Cooperatives to jointly operate their agronomy businesses on a cooperative basis.

PricewaterhouseCoopers 15 5 th Annual Farmer Cooperative Conference PLR Co-op Members Non- Co-op Sugar Refiners Sugar Co-op Refining and Marketing LLC Sugar crop Member sugar Assets 26% Sugar Assets 74% LLC Income 26% Open Market Sugar LLC Income 74%

PricewaterhouseCoopers 16 5 th Annual Farmer Cooperative Conference PLR FLCHSLOL LLC Agriliance LLC

PricewaterhouseCoopers 17 5 th Annual Farmer Cooperative Conference Summing Up – The IRS seems to finally realize what we’ve all known all along – Farmer cooperatives are not a threat to drain the U.S. Treasury with their tax deductions for patronage dividends.

PricewaterhouseCoopers 18 5 th Annual Farmer Cooperative Conference Cooperatives can’t survive in today’s economy, which is characterized by global competition and the heavy capital requirements of the technological revolution, unless they have the freedom to team up in LLC joint ventures and other forms of strategic alliances with other companies, both co-ops and non-cooperatives, to access more capital and bigger markets.

PricewaterhouseCoopers 19 5 th Annual Farmer Cooperative Conference One thing most co-ops can’t afford is the tax increase that would result if the LLC joint venture income that replaces their income from direct sales is treated as taxable nonpatronage income.

PricewaterhouseCoopers 20 5 th Annual Farmer Cooperative Conference Thankfully, the IRS seems to understand the competitive disadvantages most cooperatives operate under and has been playing a supportive role by granting cooperatives patronage treatment for their LLC income from properly structured joint ventures. However, caution is still called for. The senior IRS national office decision-makers have roots in the “reign of terror” of the 1970’s and 1980’s, so cooperatives and their advisors still have to tread carefully when applying for private rulings for joint ventures.

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