Real Estate Investment Trusts and Cooperatives’ Patronage Dividends
Some of the more interesting cooperative tax cases involve the interplay of cooperative tax law, such as Subchapter T or Section 501(c)(12), and other tax systems. One such other tax system – Subchapter M, involving Real Estate Investment Trusts (“REITs”) – was recently addressed by the Service in a private letter ruling.
Cooperative tax rulings involving other tax systems have been addressed in prior Cooperative Tax Briefs. For example:
Background on REITs
REITs are organizations that receive special tax treatment in exchange for operating in accordance with Subchapter M. There are two key requirements that emphasize the focus of REITs on passive and real estate income (“Income Tests”):
(i) REITs must earn at least 75 percent of their gross income from certain real estate activities (e.g., rents from real property, interest on mortgages, gain on real property transactions, etc.); and
(ii) REITs must earn at least 95 percent of its gross income from certain passive activities (e.g., dividends, interest, rents from real property, etc.).
If REITs follow these and other rules, including the requirement to distribute most of its gross income to owners, then they are generally not taxed at the REIT level.
In a recent ruling, a REIT asked how it should treat patronage dividends from a cooperative. Taxpayer was a publicly held REIT whose primary business was to own and manage timberlands for the production and sale of timber. To finance its operation, Taxpayer sought financing from farm cooperatives (“Cooperatives”), which provide financing to patrons and are subject to regulation by the Farm Credit Administration.
Each year, Cooperatives pay patronage dividends to their patrons, including Taxpayer. For book accounting purposes, Taxpayer reduces its interest expense by the amount of patronage dividends.
While Taxpayer recognized that patronage dividends it received from Cooperatives were includible in gross income, it questioned how it should treat those patronage dividends for the REIT Income Tests.
Patronage Dividends Excluded From REITs’ Income Tests
The Service concluded that patronage dividends from Cooperatives are excluded for purposes of applying the Income Tests under Subchapter M. To reach this conclusion, it first reviewed the objectives of rules under Subchapter M and recognized the Congressional intent that REITs’ income should consist of passive items. Without explicitly stating, it must have concluded that patronage dividends were analogous to passive income to justify exclusion from the Income Tests.
In addition, the Service noted that the patronage dividends arose from Taxpayer’s need to obtain financing for its timber (real estate) business. Moreover, patronage dividends can be seen as a return of earnings to patronage. As such, Taxpayer treated those patronage dividends as a reduction in interest expense. The Service therefore concluded that patronage dividends should be ignored for purposes of the REIT Income Tests.
To view this Cooperative Tax Brief in the traditional PDF format, click here.