Controlled groups and deductibility of patronage dividends.

• Author: Mansour, Michael

As a business develops and grows its operations, it may be in the best interest of the shareholders for the business's leaders to consider merging with or acquiring other potentially successful businesses (domestic and foreign) to further build its foundation. While merging with or acquiring other businesses can be financially rewarding, it can present many complex tax issues. The IRS Office of Chief Counsel (the OCC) issued Chief Counsel Advice (CCA) 201228035 to address specifically the tax treatment of patronage dividends among related parties and/or controlled groups.

Patronage dividends are defined as amounts that a cooperative pays to its patrons on the basis of quantity or value of business done with the patrons, determined under a preexisting obligation and by reference to the cooperative's net earnings from the business (Sec. 1388(a)). In the CCA, the issue was whether the related-party provisions of Secs. 267(a)(2) and (a)(3) apply to patronage dividends so that a cooperative may not deduct them until they are included in the patrons' gross income.

In the CCA, patronage dividends were paid to members of a consolidated group that had previously acquired several domestic and foreign subsidiaries, which, in turn, owned several subsidiaries. The acquired domestic and foreign corporations met the definition of a controlled group under Sec. 267(f).

The consolidated group's common parent (Parent Corporation) hired a consultant to implement a system to improve efficiency and reduce costs. The consultant advised Parent Corporation to transfer its assets and operations to Corporation B, a third-tier subsidiary of the parent and, thus, part of its consolidated group. Corporation B decided to redeem its shares and reissue them to the domestic and foreign corporations at 55% and 45%, respectively. The purpose of this was to remove Corporation B from Parent Corporation's consolidated group.

Corporation B then elected to be treated as a cooperative under subchapter T of the Internal Revenue Code. This resulted in the treatment of the domestic and foreign shareholders as patrons of Corporation B. Corporation B sold its services to its patrons. Corporation B's past tax returns disclosed that it charged more than its cost to provide services to its patrons. To compensate its patrons for this built-in profit, it issued patronage dividends to its shareholders (the domestic and foreign corporations). For several years, Corporation B took a deduction...