IRS Denies Patronage Dividend Deduction

By Hamang Patel and Craig Johnson | September 23, 2010
In a newly released internal IRS memorandum, the Internal Revenue Service denied a deduction for some (but not all) of the patronage dividends paid by an ethanol cooperative. This memorandum is notable for being the first time the IRS has opined on this issue in the ethanol industry.

The memorandum released on Aug. 6 was written by the IRS in connection with an IRS audit of an ethanol cooperative. The cooperative in the audit is a non-exempt cooperative taxed under Subchapter T of the federal tax code. Accordingly, the cooperative is taxed as a corporation, but can claim a deduction for patronage dividends.

The cooperative and each of its members entered into a typical marketing agreement where members would be required to deliver a set number of bushels of corn each year to the cooperative. Because the committed bushels were insufficient to meet the production requirements of the ethanol plant, the cooperative purchased additional bushels from both members and nonmembers. On audit, the IRS denied deductions for dividends from earnings attributable to those additional bushels.

IRS Position
The IRS based its denial on two primary reasons. First, the IRS concluded that the cooperative's income from the additional bushels were not patronage sourced. This conclusion was based on the IRS interpreting "patronage source income" to require such income to result from transactions that the cooperative was obligated to enter into (among other requirements). The IRS noted that the cooperative was not obligated to buy corn other than pursuant to the marketing agreements. In other words, the IRS claimed that only the income attributable to corn purchased pursuant to the marketing agreements could be patronage sourced. (While the IRS' interpretation of the definition of patronage source income is debatable, the cooperative apparently conceded the point in the course of the audit). This IRS conclusion was fatal to the deductibility of these dividends, because federal statutes allow a cooperative to deduct only those distributions paid out of patronage-sourced income.

Secondly, the IRS argued that the cooperative's distribution of earnings attributable to the additional bushels failed to meet the definition of a "patronage dividend." Federal statutes define a "patronage dividend" as a distribution which (among other requirements) is pursuant to an obligation of a cooperative to pay such amount. Moreover, this obligation to pay the distribution must be in existence prior to earning the amounts that is distributed. The IRS noted that while the cooperative's bylaws required that net income from patronage business be distributed at least annually, net income from nonpatronage business was distributable at the discretion of the board of directors. Although the relevance of this fact is debatable, the IRS held that this discretion was fatal to the deductibility of the distribution of earnings attributable to the additional bushels.

Interpreting the Memo
It should be noted that this IRS memorandum is merely an internal communication released in redacted form under public disclosure laws, and not an official pronouncement of law. Nonetheless, the memorandum tells us how the IRS currently views the deductibility of patronage distribution. For an ethanol cooperative, this memorandum suggests the cooperative do the following to reduce the risk of problems in an IRS audit:
>Corn Delivery Requirements: The IRS clearly stated that corn purchases by an ethanol cooperative other than pursuant to a marketing agreement cannot generate patronage source income, even if the corn is purchased from members. Thus, an ethanol cooperative should re-evaluate whether the corn delivery requirements are sufficient to satisfy the needs of the ethanol plant, and if not, consider raising the delivery requirements.

>Bylaws: The IRS clearly stated that if the bylaws give the board of directors discretion to declare dividends of patronage source income, then any such dividends may not be deductible. Thus, cooperatives should re-examine their bylaws to see whether an annual declaration of dividends is required (as compared to being merely permitted).

Hamang Patel is a partner at Michael Best & Friedrich LLP. Reach him at (608) 283-2278 or Craig Johnson is a member of the renewable energy, business and health care practice groups in the Madison office at Michael Best & Friedrich LLP. Reach him at (608) 257-3064 or