Farmer Co-ops Suggest Guidance to Ease Use of IC-DISCs

Pursuant to recent discussions, the National Council of Farmer Cooperatives (NCFC)¹ would like submit two draft forms of administrative guidance that would clarify and simplify the rules applicable to the use of Interest-Charge Domestic International Sales Corporations (IC-DISCs) by farmer cooperatives. You may recall we previously met and discussed these issues with you.

A growing overseas market for U.S. agricultural products has created significant interest by farmer cooperatives and their members, in creating and utilizing IC-DISCs to enhance their export sales. However, the intricacies of the combination of subchapter T of the Internal Revenue Code (dealing with cooperatives) and the rules governing IC-DISCs create some uncertainty regarding the income tax effects of certain contemplated structures. The guidance we propose would resolve these issues so members of farmer cooperatives -- like other farmers and other exporters -- can enjoy the benefits Congress contemplated in enacting and retaining IC-DISCs.

Over the years, Congress has enacted, and then repealed because of trade violation challenges, various tax provisions designed to promote the export of U.S. goods.² Nevertheless, Congress retained the IC-DISC rules and resisted "technical corrections" that would have increased the rate of tax applicable to IC-DISC dividends.³ Thus, it is clear Congress intended the IC-DISC regime to apply to small businesses, such as members of farmer cooperatives, who are attempting to engage in export markets. The draft guidance we propose would clarify the availability of IC-DISCs to farmers that are members of cooperatives and would provide the same treatment applicable to other farm and small business exporters.

Cooperative/IC-DISC structures generally would take one of two contemplated forms. Under one proposed structure, a farmer who is a member of a cooperative would form his or her own IC-DISC through which the farmer would transfer the farmer's produce (say, grain) to a cooperative. The farmer would pay any commissions to the IC-DISC and receive any related dividends. The cooperative would store the grain from the IC-DISC with other grain acquired from other member farmers, and sell a portion of this combined grain to foreign buyers. Revenue Ruling 77-484 (1977-2 CB. 289) indicates that the grain transferred by a farmer through an IC-DISC through this structure does not give rise to qualified export receipts if the farmer's grain is commingled with other grain acquired by the cooperative, and cannot be traced to the export sale.

Treasury and the IRS should revisit Revenue Ruling 77-484. The ruling was issued before Congress significantly amended the export sales rules in 1984, 2000, and 2004. It would seem to have very little continuing viability other than to deny benefits otherwise intended by Congress. The IC-DISC rules are intended to provide benefits for export sales. Under the facts of the ruling, most of the grain acquired by the cooperative was exported, yet none of the grain sales qualified for DISC treatment because the exported grain had been commingled with grain that was not exported. Farmer cooperatives commingle grain or similar agricultural products because such products are commodities and are fungible. No one ever would -- or could -- track individual kernels of grain to determine which farmers' kernels were exported and which kernels were not. A farmers' ability to claim IC-DISC benefits should not depend upon such an exact and otherwise meaningless accounting.

IC-DISC rules should treat commodities similar to the way buyers view the commodities and cooperatives account for the commodities -- as fungible goods. To require cooperatives to segregate physically and trace grain or other commodities designated for export would impose unnecessary business practices and costs on U.S. farmers. The attached draft revenue procedure would allow cooperatives in the situation described in Revenue Ruling 77-484 to reasonably allocate the fungible produce it received from its patrons between exported and domestic sales. The draft revenue procedure also provides a safe harbor for a reasonable allocation method. We believe the draft revenue procedure applies a common sense approach to a customary business practice without frustrating any tax policy concerns.

Under a second proposed cooperative/IC-DISC structure, the farmer members of a cooperative jointly would form an IC-DISC (generally, held through a partnership or trust). The cooperative would be the related supplier for the IC-DISC. Upon export, the cooperative would pay the IC-DISC its commission, and the IC-DISC would then distribute a dividend to the farmer members through the partnership or trust.

This structure avoids the commingling issue present in Revenue Ruling 77-484 because the exported produce is sold only through the IC-DISC. However, it is unclear whether and how the subchapter T rules apply in the computation of "combined taxable income" upon which the commission is determined under this structure. For instance, cooperatives are allowed deductions for certain distributions to its members. It would seem based on a reasonable reading of the statute that combined taxable income would be determined without taking these patronage dividends, per-unit retain allocations, and nonpatronage distributions into account. Treasury and IRS took a similar approach in Treasury regulation section 1.199-6(c) regarding the calculation of qualified production activities income for farmer cooperatives. Similar rules should apply to the calculation of combined taxable income for IC-DISC purposes.

In addition, the second arrangement creates two streams of taxable income for farmers -- one from the cooperative and another from the entity holding the IC-DISC. The tax accounting treatment for these two revenue streams at the farmer level should be clarified.

The attached proposed revenue ruling addresses these two issues. The proposed guidance would: (i) confirm how the cooperative should calculate combined taxable income and (ii) clarify how cooperative farmer-members should calculate and report their own taxable incomes under the second arrangement.

We believe our proposed guidance with respect to the uniquely cooperative issues identified above will go along way toward facilitating the use of IC-DISCs by farmer cooperatives, and benefit the millions of farmers who are members of cooperatives. It would treat farmer members the same as other small businesses owners who use IC-DISCs for their export sales. We would request that Treasury and the IRS publish both proposed forms of guidance to provide certainty with respect to the two IC-DISC structures that farmers may use.

We also believe that published guidance is in the government's best interests. Guidance would alleviate the administrative burdens of the IRS. With clear rules, taxpayers would not have the need to request private letter rulings from the IRS National Office and field agents would have an easier time examining related tax returns. In addition, the proposed guidance would clarify the proper treatment for farmers. Without such guidance, farmers receiving Forms 1099-DIV and 1099-PATR and filing Schedules B and F of Form 1040 may have different filing positions depending on the structure of their IC-DISC arrangements and their reading of the instructions for the tax forms.

Thank you for continued interest in this matter. We would be happy to meet with you to discuss these matters further. In the meantime, please contact Marlis Carson (mcarson@ncfc.org; 202-879-0825) with any questions, comments, etc.

Rev. Rul.2016-xx

Advice has been requested how a farmer cooperative described in section 1381(a)(2) and its patron members take into account certain transactions with a Domestic International Sales Corporation described in section 992.

The patron members of cooperative form a limited liability company ("LLC") that is treated as a partnership for Federal income tax purposes. LLC forms a Domestic International Sales Corporation ("DISC") that meets all the requirements of section 992.

The cooperative sells 75% of the grain received from its members to sources in the United States for $1,500x and 25% of the grain to sources outside the United States for $500x. The exported grain is indistinguishable from the grain sold in the United States. The export sales are made through the DISC as the commission agent of the cooperative; the cooperative is the related supplier to the DISC. The cooperative incurs $800x of selling, general and administrative expenses with respect to total sales for the taxable year, before taking into account any commissions that are paid to the DISC or any amounts that are distributed to its members. The cooperative will pay a commission to the DISC. The DISC will distribute the commission to the LLC. The cooperative will distribute all its income to its members as patronage dividends and per-unit retains.

Mr. A, an individual, is one farmer who is a member of both the cooperative and LLC. Mr. A transferred all his grain to the cooperative. Such grain constituted 10% of the total grain sold by the cooperative for the year. Mr. A incurred $72x of deductible growing expenses related to producing the grain that was transferred to the cooperative.

How will Mr. A calculate and report his income with respect to his production for the year?

Section 1.994-1 (c)(6) of the regulations provides, in part, that the combined taxable income of a DISC and its related supplier from the sale of export property is the excess of the gross receipts of the DISC from such sale over the total costs of the DISC and the related supplier which relate to such gross receipts.

Deemed or actual distributions from a DISC generally are treated as dividends to the DISC's shareholders to the extent of earnings and profits.

Section 1382(a) provides that except as provided in section 1382(b), the gross income of a cooperative shall be determined without any adjustment (as a reduction in gross receipts, an increase in cost of goods sold, or otherwise) by reason of any allocation or distribution to a patron out of the net earnings of such cooperative or by reason of any amount paid to a patron as a per-unit retain allocation.

Sections 1382(b) and (c) generally provide that in determining the taxable income of cooperative, certain distributions (relating to patronage dividends, per-unit retain allocations and nonpatronage distributions) are not be taken into account.

Similarly, section 1.199-6(c) of the regulations provides that for purposes of determining its section 199 deduction, a cooperative's qualified production activities income and taxable income are determined without taking into account any deduction allowed under section 1382(b) or (c).

Section 1.861-8 prescribes rules for the allocation and apportionment of deductions to properly determine taxable income for certain operative sections of the Internal Revenue Code, including DISC taxable income and dividends from a DISC.

Under these facts, Mr. A will receive a $15x qualified dividend as a result of his interest in LLC. He will receive a patronage dividend of $105x from the cooperative (10% of ($2,000x sales proceeds less $800x cooperative expenses and less $150x DISC commission)). Mr. A must allocate his growing expenses of $72x between the qualified dividend ($9x) and the patronage dividend ($63x). On his Schedule B for the taxable year, Mr. A will report the gross amount of the $15x dividend from his interest in LLC, and offset that amount on Schedule B with the $9x of allocable expenses, for a net dividend of $6x. On his Schedule F for the taxable year, Mr. A will include the patronage dividend of $105x as gross receipts for the year, and report the entire amount of $72x of deductible growing expenses. Mr. A will then reduce his total expenses on Schedule F by $9x, with an indication that his amount is being reported on Schedule B as a reduction of qualified dividends. Net income on Schedule F will be $42x for the year.

END

Section 1 . -- Purpose

This revenue procedure provides a safe harbor for purposes of determining the amount of qualified export receipts of a Domestic International Sales Corporation that is wholly owned (directly or indirectly) solely by patrons of a fanner cooperative described in section 1381(a)(2) with respect to sales of fungible agricultural products to such cooperative.

Section 2. -- Background

.01 The Domestic International Sales Corporation (DISC) provisions of sections 991 through 994 provide certain rules regarding the sale of export property.

.02 Section 993(a)(1)(A) and section 1.993-1(b) of the Income Tax Regulations defines "qualified export receipts" to include "gross receipts from the sale of export property." Section 993(c)(1)(B) of the Code provides that the term "export property" means property held primarily for sale, lease, or rental, in the ordinary course of trade or business, by, or to, a DISC, for direct use, consumption, or disposition outside the United States.

.03 Section 1.993-3(d)(1) of the regulations provides that export property (a) must be held primarily for the purpose of sale or lease in the ordinary course of a trade or business to a DISC, or to any other person, and (b) such sale or lease must be for direct use, consumption, or disposition outside the United States. Thus, property cannot qualify as export property unless it is sold or leased for direct use, consumption, or disposition outside the United States. Property is sold or leased for direct use, consumption, or disposition outside the United States if such sale or lease satisfies the destination test in section 1.993-3(d)(2).

.04 Section 1.993-3(d)(2) of the regulations provides, in part, that the destination test is satisfied with respect to property sold by a seller only if it is delivered by such seller in one of the ways described therein, including delivery within the United States to a purchaser if such property is ultimately delivered, directly used, or directly consumed outside the United States by the purchaser (or a subsequent purchaser).

.05 Section 993(f) provides, in part, that the term "gross receipts" means the total receipts from the sale of property held primarily for sale in the ordinary course of trade or business, and gross income from all other sources. In the case of commission on the sale of property, the amount taken into account for purposes of this part as gross receipts shall be the gross receipts on the sale of property on which such commission arose.

products of the cooperative acquired from all sources for the year that is stored in the facility.

(2) A cooperative may calculate the qualified portion of export sales by aggregating amounts from each storage facility that holds the same fungible agricultural products from which export sales were made during the year.

Section 5. -- Effective Date

This revenue procedure shall apply to taxable years beginning after the publication of the procedure in the Federal register.

Section 6. -- Effect on Other Documents

Revenue Ruling 77-484 is modified.

² These provisions include the general Domestic International Sales Corporation, the Foreign Sales Corporation, and Extraterritorial Income rules.

³ Compare sections 8 of H.R. 4195 and S. 2374, the "Tax Technical Corrections Act of 2007," (as introduced) to H.R. 4839, of the "Tax Technical Corrections Act of 2007," (as enacted into law).