Section 1383: What Tax Practitioners Need to Know About Cooperatives

SMALL BUSINESS COOPERATIVE FORUM

By Steve Schroeder, CPA, MBA, Senior Tax Manager, Eide Bailly, LLP, Fargo, North Dakota

The 2017 Tax Cuts and Jobs Act mandates a 21% tax rate for the taxable income of all corporations, including cooperatives. As provided in Internal Revenue Code Section 15, fiscal year entities will calculate their income tax for the fiscal year ending in 2018 using a blended tax rate combining the new and old tax rates. For cooperatives that have paid income tax on patronage income and have made nonqualified allocations of patronage income or unit retains, the reduction in corporate tax rates provides an opportunity to reclaim some taxes that were paid in prior years.

The Revenue Act of 1962 (P.L. 87-834) substantially revised the income tax treatment of cooperatives and their patrons. The purpose of the cooperative provisions in the Revenue Act of 1962 was to ensure amounts earned by a cooperative in the course of its cooperative business activity were included in the taxable income of either the cooperative or the patron, subjecting cooperative earnings to a single level of tax. Section 1383 was included in the Revenue Act of 1962 and amended in 1966 to provide that if a cooperative paid tax on nonqualified allocations of patronage income or unit retains, the cooperative would receive a tax deduction worth as much as the tax originally paid when it redeemed those nonqualified items. For example, if a cooperative paid tax in 2000 on nonqualified patronage items at a 34% rate and those items are redeemed in 2018, it will receive a credit for that redemption based upon

the 34% tax rate originally paid and not the lower 2018 corporate tax rate. Many cooperatives use nonqualified patronage dividends and nonqualified unit retains as a way to replenish revolving capital. If those nonqualified items have been timely allocated to patrons, tax practitioners who serve cooperatives will have to understand and apply Section 1383 when those items are redeemed. This can be a complex calculation, even in a relatively simple case, and it can provide surprising benefits.

The tax treatment of nonqualified notices of allocation and nonqualified unit retains is straightforward. Nonqualified written notices of allocation and nonqualified unit-retains produce no current tax benefit for the issuing cooperative in the year issued. When a cooperative redeems them, it is entitled to deduct the lesser of the cash paid or the stated dollar amount of the item. If a notice is redeemed in property, the amount of the deduction is limited to the fair market value of the property. When a nonqualified notice is redeemed in the payment period for two or more taxable years, the cooperative must take the deduction in the earlier taxable year. For example, if a calendar year cooperative redeems a nonqualified unit retain on March 1, 2018, the redemption occurs during the payment period for calendar years ending December 31, 2017, and December 31, 2018. The cooperative must take the deduction on the tax return for the year ending December 31, 2017.

Section 1383 is an income tax computation that

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SECTION 1383

is unique to cooperatives. Subsection (a) provides the following: (a) General rule. − If, under section 1382(b)(2) or (4), or (c)(2)(B), a deduction is allowable to an organization for the taxable year for amounts paid in redemption of nonqualified written notices of allocation or nonqualified per-unit retain certificates, then the tax imposed by this chapter on such organization for the taxable year shall be the lesser of the following: (1) the tax for the taxable year computed with such deduction; or (2) an amount equal to –

(A) the tax for the taxable year computed without such deduction, minus

(B) the decrease in tax under this chapter for any prior taxable year (or years) which would result solely from treating such nonqualified written notices of allocation or nonqualified per-unit retain certificates as qualified written notices of allocation or qualified per-unit retain certificates (as the case may be).

Two points deserve emphasis under Section 1383. First, Section 1383(a) is a calculation of tax, not of taxable income. Second, Section 1383(a) is not an optional calculation. The section reads, “the tax imposed…shall (emphasis added) be the lesser of the following” and refers to two separate tax calculations.

In determining the decrease in tax for any prior tax year, Treasury Regulation Section 1.1383-1 requires tax attributes to be carried forward or back within the calculation. Treasury Regulation 1.1383-1(b) provides this recalculation rule: (b) Determination of decrease in tax for prior taxable years. (1) Prior taxable years.− The prior taxable year (or years) referred to in paragraph (a) of this section is the year (or years) within the payment period for which the nonqualified written notices of allocation were paid and, in addition, any other prior taxable year (or years) which is affected by the adjustment to income by reason of treating such nonqualified written notices of allocation as qualified written notices of allocation when paid.

The required recalculation rule creates several challenges. It requires practitioners to recalculate every item of income, deduction and tax credit for the current year without the deduction for currently redeemed nonqualified items, and the tax for all

prior affected years as though the nonqualified items had been redeemed (paid in cash) in the year issued. As a result, practitioners must often recalculate the tax for several years.

For example, assume a cooperative which allocates its income based on financial income has allocated $1,200,000 of nonqualified patronage income to its patrons in 2000. Due to accelerated depreciation, also assume that its taxable income was $1,000,000 in 2000. It had no tax credits and paid $340,000 of tax in 2000. In 2018 it redeemed the entire $1,200,000 of nonqualified allocated patronage issued in 2000. For this example, the deduction under Section 199A has been treated as distributed to patrons, the cooperative has consistently had $15,000 of charitable contributions each year, and has taken a $5,000 deduction under Section 179 each year. (See Appendix 1 for calculations.) As expected, the Section 1383 calculation would produce a total tax benefit of $156,000 (13% of $1,200,000), but the reduction in tax would be spread over three prior years (1998, 2000 and 2001). The deduction in 2000 creates a $200,000 NOL carryback to 1998 and $20,000 of carryover deductions (charitable contributions of $15,000 and Section 179 of $5,000) to 2001. The cooperative will report $252,000 of total tax on Line 28 of its Form 1120- C and a tax deposit of $408,000 on line 29h. The tax deposit is treated as a payment on the last day for the payment of tax for the year. If there is a calculation in 2019 for redeeming 2001 nonqualified items, that calculation should begin where the 2018 calculation ends to avoid double counting. See Section 1383(b)(3).

The 2017 instructions for Line 29h of Form 1120-C read as follows: “If the cooperative would pay less total tax by claiming the deduction for the redemption of nonqualified written notices of allocation or nonqualified per-unit retain certificates in the issue year versus the current tax year, refigure the tax for the years the nonqualified written notices or certificates were originally issued (deducting them in the issue year), then enter the amount of the reduction in the issue years’ taxes on this line. Attach a statement showing how the adjustment was figured. This adjustment is treated as a payment, and any amount that is more than the tax on line 28 will be refunded.”

The word “prior” in Section 1383(a)(2) prevents a circular Section 1383 benefit. Suppose in 2016 a cooperative redeemed a nonqualified notice of allocation from 2014, a year when there

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were charitable contributions. If the result of recalculating the 2014 taxable income is that the contribution is disallowed, the word “prior” in Section 1383(a)(2) would mean that the deduction should be considered for calculating 2015 taxable income, but it appears that it could not be used to reduce 2016 taxable income.

If redemption of a nonqualified item produces a tax benefit under Section 1383, that redemption may not be used for any other purpose. If a cooperative redeemed a nonqualified unit retain in 2018 and received a benefit by recomputing the tax for a prior year, it may not also deduct the redeemed nonqualified unit retain to compute a 2018 net operating loss.

When a cooperative redeems nonqualified notices of allocation or nonqualified unit retains from several years in the same year, it must make a single Section 1383 calculation for both redeemed amounts. Treasury Regulation Section 1.1383- 1(d) provides an example where a cooperative redeemed nonqualified notices for 1964 and 1965 in 1966. The regulation clearly says the cooperative may not use one method (recalculate prior year tax liability) for the 1964 notices and another method (current deduction) for the 1965 notices in 1966. Since a single calculation is mandated by Treas Regulation Section 1.1383-1(d), careful planning is required to obtain the maximum tax benefit from the redemption of several years of nonqualified notices of allocation in the same year.

Practitioners must research all relevant old and new tax rules and rates. Although payments made to patrons as unit retains or patronage dividends are not considered in calculating Qualified Production Activities Income and the Section 199 taxable income limitation, collateral adjustments for carryovers of tax attributes may change the domestic production activities deduction in the carryback year. Alternative minimum tax should also be considered and included in the calculation provided with the tax return if relevant. If there were tax credits, consideration needs to be given as to whether these credits carry over or are lost. Section 199A will apply to years after 2017.

Treasury Regulations promulgated under Section 1383 may create state tax issues not contemplated by practitioners. Treasury Regulation Section 1.1383-1(a)(2) reads as follows:

If the cooperative organization computes its tax for the taxable year under the provisions of section 1383(a)(2) and subparagraph (1)(ii) of this paragraph, then no deduction under section

1382(b)(2) or (c)(2)(B) shall be taken into account in computing taxable income or loss for the taxable year, including the computation of any net operating loss carryback or carryover. However, the amount of the deduction shall be taken into account in adjusting earnings and profits for the taxable year.

Since Federal taxable income is the beginning point for computing state tax liabilities in most states, removing the deduction for the redemption of nonqualified items could increase state taxable income. Section 1383 is titled “Computation of Tax” and only discusses tax calculations. Many states only allow adjustments for items specifically enumerated in state statute. A literal reading and application of Treasury Regulation Section 1.1383(a) (2) may create problems for reporting state income taxes if the federal taxable income shown on Form 1120-C does not include the deduction for nonqualified items paid. Since Section 1383 applies only to the federal tax calculation, practitioners will have to take care to avoid duplicate reporting of state taxable income.

At this time there is no prescribed format for a Section 1383 statement. A columnar presentation showing patronage and non-patronage income separately for each affected year may be helpful for calculating the current tax and prior benefit and may reduce IRS correspondence. Separate sections should show the results with and without the deduction for nonqualified items. (See the example in Appendix 1.) A copy of restated tax returns is not required by the regulations, so the statement format provided in Appendix 1 should be sufficiently detailed to support a claim for refund.

The use of nonqualified patronage dividends, nonqualified notices of allocation and nonqualified unit retains allows cooperatives to build capital and value without passing the tax burden to patrons. When cooperatives redeem these nonqualified items, tax practitioners need to maximize the value of those redemptions by reviewing current and prior year tax returns and applying the rules of Section 1383. The 2018 tax rate reduction should provide immediate cash benefits to cooperatives which take advantage of the rules of Section 1383. Practitioners should also consider whether Section 1383 applies any time nonqualified items are redeemed. Tax benefits will be maximized if timely written nonqualified notices are provided to patrons as a matter of course, just as notices are issued when cooperatives pay qualified patronage dividends or withhold qualified unit retains.

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