University of Wisconsin Center for Cooperatives
Rural Cooperatives, September/October 1998, pp. 24-25.
Published by the Rural Business and Cooperative Development Service
IRS Rules Favorably on LLC Distributions to Cooperatives
Donald A. Frederick
Program Leader- Law, Policy, and Governance
Editor's Note: A background article discussing the emergence of the limited liability company as an option for organizing a rural business can be found in the July/August 1997 issue of Rural Cooperatives (pp. 36-39). This article is presented only to provide information to persons interested in the tax treatment of cooperatives; it does not represent official policy of the U.S. Department of Agriculture, the Internal Revenue Service, the U.S. Department of the Treasury or any other government agency.
Since the limited liability company (LLC) is a relatively new business structure and the Internal Revenue Code doesn't contain any rules specifically covering it, cooperatives have been concerned about how the Internal Revenue Service (IRS) might treat distributions of LLC earnings to cooperatives who participated in an LLC.
In two sets of letter rulings this year, IRS has said that if the business activity of the LLC "is directly related to" and "actually facilitates" operations conducted on a cooperative basis, earnings distributed to cooperative members of the LLC are patronage-sourced income. While LLC distributions are taxable income to a cooperative, the amount of the distributions can be deducted if passed through to the cooperative members as a patronage refund.
Significant differences exist in the way the LLCs discussed in these rulings are organized and operated. The facts and specific findings of the rulings are discussed below.
Complex, nonagricultural cooperatives
The first rulings were issued in response to inquiries from two cooperatives who provide various services to their members, including access to group purchasing contracts (Priv. Ltr. Ruls.9827042 and 9827043, April 8,1998).
These contracts, negotiated by cooperative staff, allow members to obtain products and services they need in their businesses at less cost and on more favorable terms than each member would likely receive negotiating on its own. Only cooperative members have access to these contracts. Members typically place orders directly with the suppliers, the suppliers ship directly to the co-op members and bill them directly, and the members pay the suppliers directly
Each co-op's group purchasing program is a separate allocation unit funded by "administrative fees" paid to it by suppliers under the terms of their contracts with the co-opt The fees are related to the amount of purchases the members of each co-op make with each vendor. Historically, these fees have exceeded the related expenses of the co-ops, with the excess being allocated to the co-ops' members as patronage refunds. Both associations have received IRS Private Letter Rulings recognizing their status as cooperatives.
The two cooperatives formed an LLC to negotiate such contracts on behalf of both co-ops and their members. The two coops are the LLC's only members. Their objectives are to combine their market power to arrange better contracts for their members and reduce costs by eliminating duplication in their administrative offices. Co-op members will continue to deal directly with suppliers, but now under the terms of contracts negotiated by the LLC rather than the co-ops.
The cooperatives will not pool or otherwise use "administrative fees" to finance the LLC. Rather, the "fees" will continue to be the property of the co-ops based on the respective purchases of their patrons. The flow of "administrative fees" to the co-ops and then to participating patrons as patronage refunds will continue essentially unchanged.
To finance the LLC, each member will write a check each month to the LLC for its share of the previous month's expenses, computed on the basis of their respective patrons' usage of the LLC the previous year.
The two co-ops formed a second LLC to perform group purchasing functions previously conducted by one of them on a nonpatronage basis. This second LLC (LLC-2) is expected to do a considerably smaller volume of business than the first LLC (LLC-1). LLC-1 will provide administrative and management services to LLC-2. All administrative fees collected on purchases made on a nonpatronage basis through LLC-2 will remain the property of LLC-2, and any distributions to the coops based on business generated through LLC-2 will be treated as nonpatronage income.
The IRS issued four findings favorable to the cooperatives:
IRS also found, as expected, that any gain or loss passing through to the cooperatives from business conducted through LLC-2 will be nonmember nonpatronage-sourced income.
Local farm supply cooperatives
These rulings were issued in response to inquiries from two local agricultural supply cooperatives who provide their patrons with petroleum products, feed, chemicals, seed and fertilizer, all on a cooperative basis (IRS file numbers 11014298 and 110146-98, August 17,1998).
Faced with aging facilities and equipment, the two co-ops formed an LLC to conduct their agronomy operations. The LLCis located midway between their respective locations. The LLC has leased a new fertilizer plant and purchased modern equipment to apply the product it sells onto patrons" farmland.
At first, the LLC acted as the agent of the co-ops; all sales to their farmer patrons of products and services provided by the LLC were funneled through the co-ops.
However, this proved to be administratively burdensome. The co-ops wanted to make the LLC a principal, selling products and service directly to their patrons. To be a customer of the LLC, a producer would have to be a member of one of the co-ops or sign a written consent agreeing to take patron refunds into taxable income (The ruling doesn't say whether the co-ops had section 521 status).
Each year the co-ops will receive their respective shares of the LLC's earnings and report such income under Subchapter K of the Internal Revenue Code. Each will allocate this income to its patrons in proportion to the amount of business each patron has conducted during the year with the LLC.
The IRS determined that allocations of LLC earnings to its co-op members would be patronage-sourced income under Subchapter T. IRS agreed to "look through" the LLC to its coop owners and their relationships with their patrons. It found a preexisting legal obligation on the part of the co-ops to allocate LLC earnings as patronage refunds. It also found that the LLC operations are directly related to and actually facilitate the co-ops' supply and service functions. Therefore, it concluded that the allocations of LLC earnings by the co-ops to their members are eligible for the patronage dividend deduction.
Not the last word
These letter rulings aren't likely to be the last word on how cooperatives can treat distributions of earnings from LLCs. For example, they don't discuss whether the IRS would reach the same conclusion if a noncooperative firm is a member of an LLC with a cooperative. Also, both sets of rulings concern purchasing cooperatives. It is not clear how IRS will react to various complex marketing and value-added processing ventures likely to be formed as LLCs.
However, the rulings suggest distributions to cooperatives from joint ventures organized as LLCs will be treated like similar distributions from partnerships, federated cooperatives, and general business corporations. If the LLC's operations are directly related to and actually facilitate activities conducted by the cooperative on a patronage basis, then earnings and losses distributed by the LLC to the cooperative can qualify as patronage-sourced. This will facilitate cooperative use of the LLC structure in organizing and operating joint ventures with other cooperatives, and perhaps noncooperative firms as well.
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