Controlled Groups and Deductibility of Patronage Dividends

By Michael Mansour, CPA, Woodland Hills, Calif.

Editor: Mark G. Cook, CPA, MBA

Corporations & Shareholders

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 during its fiscal year for dividends it paid 8½ months following the close of the fiscal year, while the related patrons included the dividend income on Parent Corporation’s consolidated return when received.

The OCC advised that the following points must be established to determine whether Secs. 267(a)(2) and (a)(3) applied: (1) whether Corporation B and its patrons were related parties within the meaning of Sec. 267(b); and (2) whether the matching principle applied to the patronage dividends paid by Corporation B to its patrons. The IRS exam team had confirmed that Corporation B and its patrons were members of the same controlled group, so they were deemed to be related parties for purposes of the analysis. Thus, the remaining issue was whether Corporation B needed to apply the matching principle of Secs. 267(a)(2) and (3) to patronage dividends paid to its domestic and foreign patrons, respectively.

For Sec. 267(a)(2) to apply, Corporation B and its related patrons must have established a method of accounting for the patronage dividends. Corporation B consistently applied the timing of its patronage dividends under Sec. 1382(a) by deducting them in a given tax year even though they were paid 8½ months after each year’s end. The related patrons consistently applied Sec. 1385(a) and included the patronage dividends in income in the year received. Therefore, the OCC concluded they had established a method of accounting.

The OCC then explained that the legislative history for Sec. 267 shows that Congress was concerned over unwarranted tax benefits that arise when related taxpayers have different methods of accounting that cause the allowance of a deduction with respect to an item without a corresponding inclusion in income in the same year. The patronage dividend rules in Secs. 1382 and 1385 caused this to happen in this case, so the OCC advised that Sec. 267(a)(2) and (a)(3) applied, and Corporation B could not deduct the patronage dividends until the year they were included in income by the patrons.

The OCC also noted that Regs. Sec. 1.267(a)-3(a) might prohibit Corporation B from deducting the patronage dividend to related foreign patrons until the fiscal year in which it was paid. However, the OCC stated that it did not have sufficient information to determine if any of the exceptions to this rule in Sec. 267(a)(3)(B) or Regs. Sec. 1.267(a)-3(c) might apply in Corporation B’s case.

The OCC advised that Corporation B would also be required to defer the deduction of the patronage dividends under an alternative analysis based on Sec. 267(f), which defers losses and deductions from certain transactions (i.e., intercompany sales) between members of a controlled group. Corporation B was deemed to be part of a controlled group under Sec. 267(f). According to the OCC, the patronage dividends were considered to be an intercompany sale among Corporation B and the domestic and foreign subsidiaries per Regs. Secs. 1.1502-13(b) and 1.267(f)-1(b)(1). Thus, Sec. 267(f) requires Corporation B to defer the deduction for patronage dividends paid to match it with the related patrons’ inclusion of the corresponding income.


Mark Cook is a partner at SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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