                      T.C. Memo. 1999-388



                   UNITED STATES TAX COURT



           FARMLAND INDUSTRIES, INC., Petitioner v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11881-93.           Filed November 29, 1999.



     Herbert N. Beller, Juan D. Keller, and Norman H. Lane,

for petitioner.

     Alan M. Jacobson and Davis L. Zoss, for respondent.



           MEMORANDUM FINDINGS OF FACT AND OPINION

     WHALEN, Judge:   Respondent determined the following

deficiencies in petitioner’s income tax for the years in

issue:
                               - 2 -

                Year Ended             Deficiency
             August 31, 1982             $402,453
             August 31, 1983           32,312,944
             August 31, 1984           38,037,781
             August 31, 1986               21,569


     The sole issue for decision is whether the gains and

losses that petitioner, a nonexempt cooperative, realized

from the disposition of certain property should be

classified as patronage income for purposes of subchapter

T of the Internal Revenue Code (sections 1381-1388).

Unless stated otherwise, all section references are to the

Internal Revenue Code as in effect during the years in

issue.   The gains and losses at issue are from the

disposition of the stock of three corporations, Terra

Resources, Inc., Seaway Pipeline, Inc., and Mex-Am Crude

Corp., and from the disposition of certain property used

in a trade or business, as defined by section 1231(b).



                      FINDINGS OF FACT

     Some of the facts have been stipulated and are so

found.   The amended stipulation of facts filed by the

parties and the exhibits attached thereto are incorporated

herein by this reference.

     Petitioner is an agricultural cooperative organized

under the laws of the State of Kansas.      References to
                              - 3 -

petitioner are to Farmland Industries, Inc. (Farmland), to

all predecessor corporations merged into Farmland, and to

all subsidiaries affiliated with Farmland, unless the

context suggests otherwise.

     During the years in issue, petitioner reported income

and expenses on the basis of a fiscal year ending

August 31.    Petitioner’s returns for fiscal years 1982 and

1983 were filed on Forms 1120, U.S. Corporation Income Tax

Return.   Petitioner’s returns for fiscal years 1984 and

1986 were filed on Forms 990-C, Farmers’ Cooperative

Association Income Tax Return.    Each of the returns was

filed with respondent’s service center in Kansas City,

Missouri.    At the time its petition was filed in this case,

petitioner's principal place of business was Kansas City,

Missouri.


History and Organization of Petitioner

     Farmland was founded in 1931 as the Cooperative Union

Oil Co.   It was the successor to a Missouri cooperative

corporation called the Union Oil Co., which had been

founded in 1929 by Mr. Howard Cowden.    Its corporate name

was changed to Consumer’s Cooperative Association in 1935,

and to Farmland in 1966.

     Mr. Cowden served as Farmland’s president from the

time of its incorporation until 1961 and as a member of
                             - 4 -

its board of directors until 1963.    He was a leader in

the farmers’ cooperative movement and believed that

farmers could improve their overall financial condition

by combining their market power.

     Petitioner has operated continuously since 1931 as a

farmers’ cooperative.    From 1931 to 1947, it was taxed as

an exempt cooperative.    From 1947 to 1961, it was taxed as

a nonexempt cooperative under respondent’s administrative

interpretations and practices then in effect.    See

generally Farmers Coop. Co. v. Birmingham, 86 F. Supp. 201

(N.D. Iowa 1949).   Since 1962, petitioner has been taxed as

a nonexempt cooperative under subchapter T of the Internal

Revenue Code.

     Petitioner is a regional cooperative.    Its members are

local cooperative associations whose members are farmers

and ranchers.   During the years in issue, petitioner’s

membership consisted of more than 2,200 local cooperatives

which were located primarily in the Midwest.    With the

exception of petitioner’s president, each member of its

board of directors during the years in issue was either a

working farmer or a manager of a local cooperative.

     Petitioner’s articles of incorporation provide that

its primary purpose is to engage in agricultural supply and

marketing activities for the benefit of its patrons.    Its
                                      - 5 -

bylaws require that net income from cooperative activities

be distributed to its patrons on a cooperative basis

consistent with the provisions of subchapter T.

Historically, petitioner’s overall approach has been to

conduct business in the most economically advantageous

fashion possible to maximize patronage dividends.

        The following chart shows petitioner’s patronage and

nonpatronage income for tax years 1982 through 1986:

                                 NOL’s and        Patronage
  FYE         Patronage         Deductible      Income After    Nonpatronage
 8/31           Income            Dividend       Deductions          Income
                                                                 1
 1982       ($107,448,343)           --        ($107,448,343)     $13,013,621
 1983          28,048,015      ($28,048,015)          --             1,202,216
                             2
 1984         104,087,552     (103,945,724)          141,828        14,778,795
                                                                   3
 1985         (17,151,510)           --          (17,151,510)       (1,936,452)
                                                                 4
 1986          23,934,347      (24,361,501)         (427,154)     (29,700,543)


      1
        Petitioner reported nonpatronage taxable income of $12,416,037
on its original return. The parties have stipulated that the correct
amount is $13,013,621.
      2
        The deduction consisted of a patronage dividend deduction of
$20,945,131, a net operating loss of $82,436,819 carried forward from
1982, and a patronage loss of $563,774 in respect of Farmland
Agriservices, a noncooperative subsidiary of petitioner, which
represented a carryover of net operating loss incurred by the company
before its liquidation into petitioner.
      3
        Petitioner carried back the nonpatronage loss to its taxable
year ending August 31, 1982, and applied it against the nonpatronage
income for that year.
        4
        Portions of the NOL were carried back and applied against
nonpatronage income for taxable years ending August 31, 1983, and
1984.


        Petitioner’s consolidated operating results for fiscal

years 1984 through 1986 are as follows:
                              - 6 -

                Fiscal Year     Net Savings (Loss)
                    1984            $11,193,000
                    1985            (61,082,000)
                    1986           (152,228,000)


     Petitioner was organized for the primary purpose of

supplying petroleum products such as gasoline, kerosene,

motor oil, lubricating oils, and grease to its member

cooperatives for sale to their patrons.    Petitioner

originally purchased these products in a packaged or

processed state from various suppliers and then resold

them to its members.    During the 1930's and 1940's,

petitioner expanded its product lines to include additional

refined petroleum products as well as feed, seed,

fertilizer, agricultural chemicals, tires, batteries, and

miscellaneous farm supplies.    Petroleum and fertilizer have

been petitioner’s two largest product lines, by volume of

sales, since at least 1973.

     In 1942, petitioner formed a subsidiary called the

Cooperative Finance Agency to provide financing to local

cooperatives.    Petitioner also began a grocery business, a

cannery, and a lumber mill to provide goods to its members.

Many of petitioner’s nonpetroleum lines of business

produced little or no profit and required large capital

investments.    As a result, petitioner’s expansion during
                              - 7 -

the 1930's and 1940's required petitioner to incur

substantial debt.

     In 1952, petitioner considered constructing a nitrogen

plant to produce fertilizer.    However, the company did not

have sufficient cash to finance the construction.    The

Wichita Bank for Cooperatives (Wichita Bank), petitioner’s

primary source of capital, would not lend the required

money to petitioner without the approval of the Farm Credit

Administration (FCA).   The FCA was reluctant to approve a

loan because petitioner lacked sufficient equity and

permanent capital, had too much outstanding debt, and had

a poor assets-to-liabilities ratio.    The FCA also felt that

the capital investment required to construct the plant was

too large given the anticipated return.    For that reason,

the FCA suggested that petitioner sell assets and eliminate

unprofitable product lines to reduce its debt.

     Despite its financial difficulties, petitioner began

constructing the nitrogen plant without obtaining complete

financing for the project.    It undertook this project

through a new wholly owned subsidiary called Cooperative

Farm Chemicals Association.    The construction took place at

a time when petitioner was experiencing poor financial

returns.   Nevertheless, in 1953 the Wichita Bank agreed to

lend petitioner the funds required to complete the plant on
                             - 8 -

the condition that petitioner raise cash through sales of

common or preferred stock, certificates of indebtedness, or

assets.   The Wichita Bank also required petitioner to grant

the Wichita Bank the right to examine petitioner’s books

and have a bank representative attend meetings of

petitioner’s board of directors.

     Petitioner’s financial difficulties continued into

1954.    Petitioner took steps to cut costs and dispose of

assets and was ultimately able to complete the nitrogen

plant.    By 1957, the nitrogen plant was operating

profitably, and the financial crisis had dissipated.

     In 1957, petitioner formed a subsidiary called

Farmbest, Inc., for the purpose of marketing food products

of its members.   Farmbest’s initial business consisted of

slaughtering hogs and cattle and processing the meat into

finished products.   In 1970, petitioner transferred its

food marketing business to another subsidiary called

Farmland Foods, Inc.   In 1976, petitioner acquired a grain

marketing cooperative called Far-Mar-Co, Inc.

     By the end of 1957, petitioner was one of the six

largest industrial corporations in the United States.

Petitioner’s sales increased rapidly during the period from

1973 to 1980.   Petitioner’s expansion paralleled and

reflected the overall expansion of the agricultural sector
                            - 9 -

of the economy during the 1970's.   Petitioner’s management

attributed these increases to changes in Federal Government

policies which had the effect of encouraging agricultural

cultivation, to a general increase in demand for fertilizer

and petroleum products, and to petitioner’s increased

investment in plant and equipment, most notably fertilizer

plants and facilities for the exploration for and

production of crude oil.

     During this period, petitioner raised the capital

needed for expansion through debt financing, primarily in

the form of loans from the Wichita Bank and sales of

subordinated securities.   Petitioner also financed its

expansion through leveraged leasing and occasionally

through loans from commercial banks.   During this period,

petitioner was highly vulnerable to fluctuations in the

prices of agricultural products.


Oil Production and Refining Activities

     A significant portion of petitioner’s business during

the years in issue involved the supply of petroleum

products to its members.   Since 1973, petroleum products

have accounted for the largest volume of petitioner’s total

sales.   Crude oil was an essential raw material for all of

the petroleum products sold by petitioner during the years

in issue.   Over the years, petitioner has sought to improve
                            - 10 -

the economic efficiency of its petroleum business by

controlling as many phases of the production process as

possible.    This includes acquiring oil refineries, crude

oil producing properties, and related transportation

systems.

     Mr. Cowden began encouraging petitioner’s board of

directors to establish an oil refinery as early as 1931.

He believed that vertical integration in the petroleum

business would be beneficial despite the fact that, at

least for some time during the 1930's, petitioner was able

to obtain favorably priced petroleum products on the open

market.    Mr. Cowden believed that the cooperative should

vertically integrate its petroleum operations to enable it

to compete with large companies.

     In 1938, petitioner organized a subsidiary called the

Cooperative Refinery Association, Inc. (CRA) to construct

and operate an oil refinery in Phillipsburg, Kansas.

Although CRA was organized as a cooperative, petitioner

was at all times its only patron and owned all of its

outstanding common stock.    The Phillipsburg refinery and a

70-mile network of pipeline were constructed during 1938

and 1939.    The refinery officially opened in May 1940,

although it did not commence production until 1941.    At the

time it opened, the refinery was capable of processing
                           - 11 -

3,000 barrels of crude oil per day.   Petitioner purchased

all of CRA’s production for resale to its patrons.

     On March 1, 1939, petitioner’s board of directors

organized the Cooperative Pipeline Association (CPA) as a

wholly owned subsidiary.   CPA was organized to construct

and operate a pipeline system to deliver crude oil to the

Phillipsburg refinery.   The construction of the pipeline

was to be financed primarily through the sale of preferred

stock in CPA to local cooperatives and their individual

members.   CPA was merged into CRA during petitioner’s

fiscal year ending August 31, 1947.   During its existence,

CPA transported oil exclusively to refineries owned by CRA.

     Soon after the Phillipsburg refinery opened,

petitioner had difficulty obtaining sufficient crude oil to

utilize the plant’s full production capacity.   Under Kansas

proration statutes in effect at the time, the wells

connected to the refinery had an allowable output of 26,000

barrels per month, or less than 900 barrels per day.     In

addition, the Standard Oil Co. of Indiana (Standard Oil),

one of the primary crude oil producers in the Phillipsburg

area, refused to sell crude oil to CRA.   The Kansas

Corporation Commission also initially refused to increase

the allowable output of wells in the Phillipsburg area.
                             - 12 -

Petitioner was forced to close the Phillipsburg refinery

for a short time due to a lack of supply of crude oil.

     In an effort to secure an adequate supply of crude oil

for the Phillipsburg refinery, Mr. Cowden sought to have

the U.S. Department of Justice investigate monopoly

conditions in the oil industry.       Mr. Cowden also instigated

a mail-in campaign designed to encourage the Governor of

Kansas to increase the maximum allowable output of wells

connected to the refinery.    Eventually, Standard Oil agreed

to supply crude oil to the refinery.      With the exception of

a brief shortage in 1948, petitioner was able to purchase

an adequate amount of crude oil from unrelated parties to

utilize the entire production capacity of the Phillipsburg

refinery until the energy crisis of the 1970's.      However,

petitioner’s directors remained concerned about the

possibility of shortages.

     In September 1940, petitioner formed a wholly owned

subsidiary called Consumers Oil Production Association

(COPA) to engage in oil exploration and drilling, and to

purchase existing oil wells.    Petitioner’s directors

believed that by controlling crude oil production, the

company could maintain a consistent level of supply for its

refinery and avoid reliance on suppliers who might be

hostile toward petitioner.    By the end of 1940, COPA held
                           - 13 -

interests in three producing oil wells located in Rooks

County, Kansas, that were connected by pipeline to

petitioner’s Phillipsburg refinery.    COPA sold all of the

crude oil it produced to CRA.

     Petitioner continued to expand its petroleum-related

activities throughout the 1940's.    In 1941, petitioner

purchased a refinery in Scottsbluff, Nebraska, with a

production capacity of 1,500 barrels per day.    By the

end of its fiscal year 1943, COPA owned interests in 13

producing oil wells.   Petitioner’s management informed its

members that 41 cents of the 84 cents in total savings per

barrel created by its petroleum-related business was

attributable to crude oil production.

     On January 1, 1944, CRA purchased the assets of the

National Oil Refining Co. for approximately $3.9 million.

These assets included a refinery located in Coffeyville,

Kansas, approximately 269 producing oil wells, leasehold

interests in more than 8,000 acres of undeveloped land, and

a network of pipelines.   By the end of 1944, COPA and CRA

together owned interests in 293 producing wells.    In

1945, COPA was merged into CRA which conducted all of

petitioner’s oil exploration and production activities from

the time of the merger until 1970.    By the end of 1945, CRA
                           - 14 -

was extracting enough oil from its active wells to meet 18

percent of its refineries’ needs.

     Throughout its existence, CRA obtained crude oil from

its own production facilities, from other entities owned by

petitioner, and from unrelated third parties.    CRA refined

this oil into finished petroleum products which it sold to

petitioner for resale to its patrons.    CRA and its

subsidiaries also maintained inventories of crude oil and

refined petroleum products.   CRA shipped finished products

from its refineries directly to petitioner’s customers.

CRA would generally send invoices to petitioner, and

petitioner would send invoices to its customers.

Petitioner charged competitive market prices for the

petroleum products it sold to its patrons.    Petitioner’s

management believed that its patrons would derive their

benefits through the receipt of patronage refunds rather

than through discount purchases.    Petitioner’s management

always intended to generate a net profit at the cooperative

level without undercutting prevailing market prices.

     From 1943 until mid-1992, petitioner was the largest

interest holder in a refinery located in McPherson, Kansas,

which was operated by the National Cooperative Refinery

Association (NCRA).   Mr. Cowden was the first president of

NCRA, and its other members were, like petitioner, regional
                            - 15 -

cooperatives.    Petitioner consistently took delivery of its

full share of the McPherson refinery’s output for resale to

its patrons.

     During 1972 and 1973, the United States experienced an

energy crisis that caused major problems for petitioner and

its patrons.    Petitioner was unable to operate its

refineries at full capacity due to the scarcity of crude

oil and increasing petroleum prices.    Federal price

controls on refined products also created a cost-price

squeeze on petitioner’s operations.    During this time,

petitioner was able to produce less than 20 percent of

the crude oil required by its refineries.    As a result

of the shortages, petitioner ceased selling refined

petroleum products to nonmembers.    Petitioner also

developed an allocation system designed to ensure adequate

distribution of fuel to its members.    Despite these

problems, petitioner’s petroleum business in 1973 exceeded

its performance in the previous year.

     Farmers experienced a general shortage of fertilizer

during the energy crisis of the early 1970's.    This

impaired Government efforts to increase food production and

combat price increases.    On October 21, 1973, the Arab oil

producing countries implemented an embargo of crude oil,

further intensifying the oil crisis.    On January 15, 1974,
                            - 16 -

the Federal Government began mandatory allocations of crude

oil.    However, the shortage began to decrease by the spring

of 1974.    In April 1974, following intensive lobbying by

petitioner’s officers, the Federal Government allocated to

petitioner 100 percent of its crude oil needs through

June 30 of that year.    Petitioner’s annual reports for 1973

and 1974 state that the company was able to adequately

provide for the fuel needs of its member-patrons during

those years.

       Prices of crude oil changed very little from mid-1974

when the Arab oil embargo ended until 1979.    During that

period, the spot price for crude oil was at or below the

official selling price for Arabian Gulf crude oil.

       The price of crude oil increased rapidly in early 1979

due in large part to a political revolution in Iran which

cut off a substantial portion of the world’s crude oil

supply.    British Petroleum, one of petitioner’s primary

suppliers, had previously obtained a substantial portion

of its crude oil from Iranian producers.    The Iranian oil

shortage forced British Petroleum to reduce the amount of

crude oil it delivered to its customers, including

petitioner.

       In February 1979, petitioner’s Coffeyville refinery

was operating below capacity.    On March 1, 1979, petitioner
                           - 17 -

was forced to limit its allocation of gasoline and other

petroleum distillates to its member associations.

Allocations for farm use remained at or near 100 percent,

but little or no fuel was allocated for nonfarm uses.

Petitioner’s officers and the managers of petitioner’s

member associations then began lobbying the Federal

Government for relief.   Through a combination of efforts,

including Government allocations and recertification of the

Coffeyville refinery to allow for increased allocations,

petitioner was able to adequately supply fuel for its

members’ agricultural needs.   Petitioner’s annual report

for 1979 states that petitioner had begun searching for

alternative sources of supply, and had increased its oil

exploration and production activities.

     The oil shortage abated during the early 1980's and

demand for petroleum products decreased.   Petitioner’s

Scottsbluff and Phillipsburg refineries were closed in 1982

when the capacity of its remaining refineries was deemed

adequate to meet its members’ needs.   However, the

Phillipsburg refinery was reopened in 1984.   The McPherson

and Coffeyville refineries have remained in continuous

operation during the time petitioner has held interests in

them.
                           - 18 -

     CRA was merged into petitioner in July 1982.

Petitioner has owned and operated all of CRA’s refineries

since that time.   Until it merged into petitioner, CRA

always filed a separate Federal income tax return.     After

the merger, petitioner maintained inventories of crude

oil and refined petroleum products.

     From the beginning, petitioner’s management has sought

to vertically integrate its petroleum business.   In

particular, petitioner has sought to conduct its own

exploration, drilling, and production of crude oil and

natural gas, refining and wholesale marketing of petroleum

products, and the associated gathering, transportation,

and distribution of raw materials and refined petroleum

products.   Petitioner’s primary objectives in this regard

were to secure a dependable and consistent supply of crude

oil for its refineries, to provide its patrons with a full

range of high quality petroleum products in an economically

efficient manner, to maximize the economic benefits to its

patrons, and to reduce its patrons’ dependence on profit-

seeking oil companies.

     Vertical integration in the petroleum production

business creates several business risks.   Oil exploration

and production activities generally require substantial

capital investment with no guaranty that exploration will
                            - 19 -

result in discovery of crude oil deposits.     Moreover, even

if a crude oil deposit is discovered, there is no guarantee

that it will produce significant reserves.     There is also

no guaranty that oil and gas reserves developed by other

companies will be available for purchase at an affordable

price.    Petitioner’s directors were aware of the risks

associated with petroleum exploration and production at the

time they decided to enter into this activity.

     From 1945 until 1970, petitioner explored for crude

oil and natural gas through CRA.     CRA was also active in

acquiring working properties and undeveloped reserves of

crude oil.    These activities were regularly described in

petitioner’s annual reports.

     By 1963, the volume of crude oil processed in

petitioners’ refineries had increased to over 14 million

barrels per year, or approximately 40,000 barrels per day.

At the same time, however, the volume of crude oil produced

by petitioner was only approximately 2 million barrels per

year.    In petitioner’s annual report for 1963, its

president and general manager, Mr. Homer Young, stated that

petitioner had launched a program to increase its crude oil

production.    Petitioner’s ultimate goal was to produce

20,000 barrels of crude oil per day, or approximately 50

percent of its refineries’ daily requirements.
                           - 20 -

     By 1967, the funds that petitioner invested in

petroleum production and refining accounted for

petitioner’s largest outlay of funds and predepreciation

investment in plant and equipment.   Crude oil production

and refining facilities represented 44 percent of

petitioner’s predepreciation investment, compared to 42

percent for fertilizer facilities, and 14 percent for all

other facilities.

     In May 1967, petitioner purchased most of the oil and

gas properties of the AMAX Petroleum Corp. (AMAX).

However, despite the purchase of AMAX and additional

capital expenditures, petitioner’s crude oil production at

the end of 1968 was only approximately 5.6 million barrels

per year.   At the same time, petitioner’s refineries were

processing more than 17 million barrels per year.

     Petitioner also sought to acquire crude oil by

exploring outside the United States.   In December 1960,

petitioner formed a wholly owned subsidiary called Cracca

Libya, Inc. (Cracca Libya).   Cracca Libya thereafter joined

other cooperatives and independent oil producers in a

partnership called the Eastern Hemisphere Group (the

Group), which was organized to explore for crude oil in

North Africa.   In January 1962, the Group participated in

forming a private Libyan corporation called the National
                            - 21 -

Oil Co. of Libya (National Oil) to drill oil wells in

Libya.    However, National Oil was unable to secure drilling

rights.    In 1966, petitioner dissolved Cracca Libya and

formed a new subsidiary called CRA International to

cooperate with other oil companies in exploring for crude

oil and natural gas in Canada.

     By 1969, petitioner owned domestic oil producing

properties in Kansas, Oklahoma, Texas, Louisiana, and

Wyoming.    These properties produced for petitioner a

combined average of approximately 14,000 barrels of crude

oil and 33.5 million cubic feet of natural gas per day.

Petitioner was contractually obligated to sell some of this

production to unrelated third parties.    Petitioner used the

remainder to supply its refineries or to exchange with

other companies for crude oil more readily accessible by

its refineries.    Such exchange transactions are common

among oil companies.

     Petitioner was not able during the 1960's to achieve

its goal of producing 50 percent of the crude oil processed

in its refineries.    The capacity of petitioner’s refineries

grew faster than its reserves of crude oil.    In the late

1960's, petitioner’s treasurer, Mr. Donald Ewing, met with

an investment banker to determine how much money petitioner

would have to invest in crude oil production to achieve its
                           - 22 -

goal of 50 percent self-sufficiency.    The banker determined

that petitioner would have to invest $200 million to

achieve this goal.   At that time, the total value of

petitioner’s assets was only slightly in excess of $300

million.   Although its 50-percent self-sufficiency goal

seemed to be unfeasible, petitioner continued to engage in

crude oil production activities in an attempt to vertically

integrate its petroleum-related business.


Formation and Operation of Terra Resources

     During 1969, petitioner’s management sought to

increase its crude oil production while limiting its

expenditure of financial resources.    Management’s objective

was to increase the portion of CRA’s crude oil and natural

gas needs that it supplied through existing and new

properties and, thereby, to increase its level of self-

sufficiency while minimizing its commitment of capital.

At that time, petitioner’s capital resources were already

strained by the expansion of its nonpetroleum facilities.

To achieve its objective, petitioner spun off CRA’s crude

oil production assets into a new wholly owned subsidiary

called Terra Resources, Inc. (Terra).

     Petitioner’s management chose to organize Terra as a

commercial corporation and not as a cooperative in order to

facilitate raising the capital necessary to fund additional
                           - 23 -

oil and natural gas exploration.    Petitioner’s management

also hoped to reduce petitioner’s oil exploration costs, to

control more of the crude oil processed in its refineries,

to stabilize its petroleum production costs, and to

increase patronage refunds.   Petitioner was required to

seek outside capital because it had assumed a large amount

of debt in the process of expanding its other business

interests, especially its fertilizer production facilities.

     Petitioner’s board of directors approved the formation

of Terra during its February 4-5, 1970, meeting.    Later in

1970, petitioner’s board of directors caused CRA to

transfer all of its crude oil production properties and

undeveloped acreage to Terra, but to retain its refineries

and pipeline system.   Petitioner’s management envisioned

that Terra would raise capital by periodically selling

equity to the public, but that petitioner would retain

control of the enterprise by holding at least 51 percent

of its outstanding capital stock.    CRA was also to retain

the right of first refusal to purchase all of the crude oil

produced by Terra at the posted field price.

     On or about March 25, 1970, CRA transferred all of

its crude oil and natural gas production assets to Terra.

On the same day, petitioner transferred to Terra its stock

interest in CRA International, Inc., which was conducting
                            - 24 -

oil exploration and production activities, both directly

and through a joint venture named CRA International, Ltd.

The net book value of the assets transferred was

$31,143,589.   In exchange, Terra issued 2,693,015 shares

of common stock to CRA and 187,985 shares of common stock

to petitioner.   In addition, Terra assumed $11.6 million

of liabilities that petitioner had assumed incident to its

purchase of AMAX in 1967.

     On August 31, 1970, CRA purchased an additional 96,998

shares of common stock in Terra for $1,050,000 in cash.

At the time CRA transferred its assets to Terra, Terra and

CRA entered into a General Conveyance, Assignment, and

Transfer Agreement.   The agreement identifies the

properties transferred by CRA to Terra and the assets that

were to remain in CRA’s possession.   The agreement also

granted CRA:


     the prior call and option to purchase all
     uncommitted crude oil and other liquid or
     liquefiable hydrocarbons that are produced and
     saved from the Subject Properties after the
     Effective Date and from all other oil and gas
     properties hereafter acquired by [Terra] or its
     wholly owned subsidiaries or its controlled
     affiliates, at the posted field price or prices
     from time to time prevailing for the area in
     which such properties are located.


     During its August 24-25, 1971, meeting, petitioner’s

board of directors approved the sale of 800,000 shares of
                           - 25 -

Terra stock to the public at a maximum price of $17.50 per

share.   The board of directors resolved that the proceeds

of this offering should be used “for exploration and/or

purchase of oil properties” and to retire a portion of

the company’s previously incurred debt.   On the advice of

petitioner’s investment bankers, the stock offering was

delayed until February 1972.   Terra’s prospectus, which was

released on February 15, 1972, states that Terra “has paid

no dividends to date and does not expect to do so in the

foreseeable future.”

     Although petitioner’s management had expected to

receive approximately $16 per share for the Terra stock,

the offering price was only $12 per share, and the offering

netted only $4.2 million to Terra after expenses.   Terra

used $2.3 million of the proceeds of the initial offering

to retire existing debt.   The remainder, $1.9 million,

was added to Terra’s working capital.   After the offering,

petitioner retained 88.2 percent of Terra’s outstanding

capital stock and members of the public owned 11.8 percent.

Petitioner did not make any other public offering of Terra

stock.

     Although Terra was formed primarily to raise outside

capital to support petitioner’s oil and gas exploration

activities, very little capital was actually raised.
                           - 26 -

Moreover, Terra’s operations presented a potential conflict

of interest between petitioner and Terra’s other share-

holders.   Petitioner preferred that Terra use all of its

earnings to finance additional crude oil exploration

activities.   However, if the public shareholders were to

receive a return on their investment, some of those

earnings would have to be distributed as dividends.    During

the time that Terra had minority shareholders, it did not

pay any dividends, and petitioner did not intend that it do

so.

      In 1976, petitioner and CRA purchased all of the

publicly held capital stock in Terra for $31 per share.

This price was based on the appraised value of Terra’s

assets, and on a fairness opinion prepared by Smith, Barney

& Co.   Petitioner owned all of Terra’s outstanding stock

from the date of the repurchase until July 1983 when it

sold its entire interest in the company.

      Petitioner maintained control over Terra from the

time of its formation until 1983.   Most of Terra’s

directors were also officers or directors of petitioner.

Terra’s president attended regular staff meetings held

by petitioner’s vice president in charge of petroleum

activities.   Pursuant to resolutions adopted by

petitioner’s board of directors during its March 31-
                            - 27 -

April 1, 1970, and October 27-28, 1970, meetings, Terra’s

employees were permitted to participate in petitioner’s

employee incentive and investment savings plans, retirement

plans, executive deferred compensation plans, and manage-

ment performance plans.

     Petitioner intended Terra to operate at a profit.

Petitioner’s and Terra’s management jointly prepared

Terra's proposed budgets.   One of petitioner’s vice

presidents, Mr. William Rader, also worked with each of

Terra’s operational units in developing separate budgets.

Terra’s capital and operating budgets were considered for

approval at annual budget meetings of petitioner’s board of

directors and senior management and ultimately were

approved by petitioner’s board of directors.    Terra’s and

petitioner’s management also jointly prepared business

plans for approval by Terra’s board of directors.

Petitioner charged fees for the administrative and other

services it provided to Terra and charged interest at the

fair market rate when it lent money to Terra.

     Petitioner did not file a consolidated Federal income

tax return with any of its subsidiaries, including Terra,

during any of the years in issue.    Terra’s separate Federal

income tax returns were signed by officers or employees of

Terra.   Terra maintained separate books and records to
                           - 28 -

facilitate the preparation of its tax returns.   Terra

also prepared its own accounting records, which were

subsequently reviewed by employees of petitioner.

     Terra began to acquire and develop new properties

and sources of crude oil immediately after its formation.

This increased the volume of crude oil available to CRA’s

refineries.   The crude oil that was produced by Terra that

was not contractually committed to third parties (its

uncommitted production) was made available to CRA either

for delivery to its refineries or for exchange with other

oil companies in return for crude oil more readily

accessible by a CRA refinery.   Terra did not employ any

personnel for marketing its uncommitted production.

Employees of petitioner or CRA arranged on Terra’s behalf

for the purchase and delivery of crude oil to CRA

refineries, for exchange with other oil companies, and

for the sale of uncommitted production not delivered to

or exchanged for the benefit of CRA.

     Throughout the 1970's, petitioner consistently

budgeted substantial amounts of money for its petroleum-

related business and crude oil exploration operations.

However, petitioner never reached its goal of producing 50

percent of the crude oil processed in its refineries.    In
                            - 29 -

1978, Terra’s vice president of finance testified before a

U.S. Department of Energy board:


     Terra is responsible to [petitioner] for the
     exploration, development and production of as
     high a percentage as possible of the crude oil
     and natural gas needed as raw materials for
     [petitioner’s] refineries and fertilizer
     manufacturing plants. Terra’s specific goal
     over the next five years is to materially
     increase the 14 percent of [petitioner’s] oil
     and gas raw material needs as it is now
     supplying.


Between fiscal years 1971 and 1975, total expenditures for

the acquisition and development of new producing properties

increased from $3,239,601 annually to $13,694,678.    Terra

spent $13,403,739 on the acquisition and development of

production properties during the 6-month period ending

February 29, 1976, alone.   During its 1975 fiscal year,

Terra purchased producing properties for a total cost of

$29,098,615.   This added approximately 6,718,500 barrels of

crude oil and 16,123,700 million cubic feet of natural gas

to Terra’s reserves.   Between fiscal years 1971 and 1975,

Terra’s production of crude oil, including its share of the

production of CRA International, decreased from a high of

4,345,600 barrels in fiscal year 1971, to a low of

3,805,238 barrels in fiscal year 1973, before increasing

again to 4,070,748 barrels in fiscal year 1975.
                           - 30 -

     Between fiscal year 1971 and February 29, 1976,

Terra’s reserves, including those held by a subsidiary and

a joint venture, increased from 25,486,542 barrels of crude

oil and 92,050 million cubic feet of natural gas to

31,052,598 barrels of crude oil and 131,616 million cubic

feet of natural gas.

     In 1978, Mr. Rader became primarily responsible for

petitioner’s petroleum operations.   From 1978 until 1980,

Mr. Rader held various positions with both Terra and

petitioner.   Prior to Mr. Rader’s employment, Terra focused

primarily on acquiring established producing properties.

However, Mr. Rader believed that it was in petitioner’s

best interest to combine all of its production activities

into one company and to shift its emphasis and focus on

exploring for new properties.   Under Mr. Rader’s direction,

Terra hired a number of geologists, geophysicists, and

other personnel needed for crude oil exploration.   Terra

also expanded its operations into new geographical areas

and began offshore exploration activities.

     On September 1, 1977, Terra sold all of the common

stock it held in Northern Terra Resources, Inc., which

owned oil producing assets in Canada.   During 1977, Terra

also sold production assets located in North Dakota.
                            - 31 -

     Terra obtained the funds necessary for capital

expenditures from its own internal cash-flow.    Terra always

retained its profits for operating capital.    At the end of

its fiscal year 1982, Terra’s balance sheet showed retained

earnings of approximately $92 million.    Terra’s other

source of funds was loans from petitioner and other

affiliates.    By the end of 1981, the outstanding balance of

the loans petitioner and other affiliates had made to Terra

was $120,557,651.

     Terra’s oil and gas acquisition and development

expenditures for 1977 through 1982 were as follows:

         Year              Expenditures (in Millions)
         1977                         43.300
         1978                         54.900
         1979                         50.300
         1980                         75.700
         1981                         88.800
         1982                         85.628

              Total                  398.628


     From 1970 to 1983, Terra consistently retained its

full share of the uncommitted production of wells in which

it held an ownership interest and sought to acquire as much

of the crude oil held by its co-owners or subject to

contractual obligations as possible.     Sales of uncommitted

production to parties other than petitioner, other than

those incident to exchanges for CRA’s benefit, were
                                        - 32 -

unusual.       Of the amount of crude oil processed by the CRA

refineries, the percentage that was produced by Terra is

petitioner’s self-sufficiency.                  The self-sufficiency ratio

for an integrated oil company is the ratio of the quantity

of the crude oil produced by the company to the quantity of

crude oil processed by its refineries.

       At no time during its existence did Terra and the

other exploration subsidiaries meet petitioner’s goal of

obtaining a 50-percent self-sufficiency ratio, that is, of

producing 50 percent of its refineries’ needs.                            The volume

of crude oil processed at CRA’s refineries, and the volume

of such crude oil that was produced by Terra from 1971 to

1982 were as follows:

               Crude Processed at     Crude Produced By
                 CRA Refineries             Terra           Self-sufficiency
       Year    (Barrels per day)1     (Barrels per day)           Ratio

       1971         52,085                 11,904                 22.85
       1972         53,852                 11,555                 21.46
       1973         51,997                 10,425                 20.05
       1974         56,959                 11,033                 19.37
       1975         62,271                 11,312                 18.17
       1976         68,527                 13,249                 19.33
       1977         71,756                 13,455                 18.75
       1978         71,926                 12,636                 17.57
       1979         76,167                 11,597                 15.23
       1980         71,434                 10,937                 15.31
       1981         68,896                 10,310                 14.96
       1982         55,932                  9,984                 17.85

        1
          This does not include amounts refined at the NCRA refinery, of which petitioner
was part owner.



Petitioner’s goal of 50 percent self-sufficiency did not

represent an industry standard or have a particular

economic motive.             The decline in self-sufficiency between
                          - 33 -

1971 and 1982 was caused by a combination of decreases in

the amount of crude oil Terra produced and increases in the

amount of oil CRA processed.

     Because Terra was contractually obligated to sell a

portion of the crude oil it produced to third parties,

petitioner’s true self-sufficiency was actually lower than

the self-sufficiency ratios listed above.   True self-

sufficiency refers to the percentage of crude oil processed

by CRA that had been produced by Terra and made available

for processing in CRA’s refineries.   The volume of crude

oil processed in CRA’s refineries, the volume of crude oil

produced by Terra, the percentage of Terra’s crude oil

utilized in CRA’s refineries, the volume of Terra's crude

oil used in CRA’s refineries, and petitioner’s true self-

sufficiency from 1971 to 1982 are as follows:
                                    - 34 -


                Crude      Crude       Amount Of      Actual
             Processed   Produced        Product   Crude Used    True Self-
  Year        By CRA     By Terra       Utilized     By CRA     Sufficiency
  1971         52,085     11,904          40.80%       4,857        9.32%
  1972         53,852     11,555          51.80%       5,985       11.11%
  1973         51,997     10,425          43.50%       4,535        8.72%
  1974         56,959     11,033          65.20%       7,194       12.63%
  1975         62,271     11,312          70.20%       7,941       12.75%
  1976         68,527     13,249          56.00%       7,419       10.83%
  1977         71,756     13,455          67.00%       9,015       12.56%
  1978         71,926     12,636          69.00%       8,719       12.12%
  1979         76,167     11,597          72.00%       8,350       10.96%
  1980         71,434     10,937          87.00%       9,515       13.32%
  1981         68,896     10,310          97.00%      10,001       14.52%
  1982         55,932      9,984          96.00%       9,585       17.14%

 Average      62,446     11,632         67.96%       7,760        12.17%


     Terra's crude oil reserves totaled 22.3 million

barrels, or 6.12 years of production, as of August 31,

1982.      On the same date, petitioner's balance sheet showed

investment in oil and gas properties of $619,990,000.                   This

constituted 35 percent of petitioner's total investment in

property, plant, and equipment.

     At all relevant times, Terra's operating results,

assets, and liabilities were included in petitioner's

consolidated financial statements submitted to the

Securities and Exchange Commission, its member-patrons,

and its creditors.       Each of petitioner's annual reports

included a discussion of Terra's operations.                 However,

petitioner's consolidated financial statements did not

disclose its interest in Terra.              Petitioner's and CRA's

separate and unconsolidated financial statements listed the

Terra stock in an asset account entitled “Investments in
                            - 35 -

Subsidiaries”.   During the period when members of the

public held Terra stock, the interest of the public was

reflected in the “Minority Owners’ Equity in Subsidiaries”

section of petitioner’s consolidated balance sheet, and

in the “Costs and Expenses” section of its consolidated

statements of operations.   Each prospectus and SEC Form

10-K filed by petitioner from 1970 until the date it sold

Terra included a detailed summary of petitioner's

relationship with Terra.

     Neither petitioner nor CRA offered Terra stock for

sale in the ordinary course of its trade or business, and

neither ever recorded the Terra stock in an account

identified as a “hedge”, “hedging”, or “inventory” account.

Petitioner never referred to the Terra stock as a hedge

against increases in the price of petroleum products,

although risk reduction was one of petitioner's reasons for

forming Terra.   Prior to July 1983, neither petitioner nor

CRA sold any Terra stock.   Terra did not pay any dividends

to petitioner prior to May 1983.     Terra's cash flow was

used exclusively to finance additional exploration and

production activities.


Other Exploration and Production Activities

     Petitioner and CRA formed two other companies during

the period from 1970 to 1983 for the purpose of exploring
                            - 36 -

for crude oil.    Beginning in 1973, CRA acquired in its own

name interests in oil and gas properties in Texas, Montana,

Louisiana, Nebraska, Oklahoma, and Wyoming.    On March 1,

1976, these interests, as well as Federal leases, were

transferred to a newly formed company called CRA Oil

Exploration Co.

     On January 28, 1975, CRA purchased 90 percent of

the capital stock of Cayman International Co., which was

engaged in exploring for crude oil in Colombia, South

America.    Cayman International Co. was later renamed

Farmland International Energy Corp. (FIEC) and began

operating in the United States.

     FIEC was merged into Terra during petitioner's 1978

fiscal year.    CRA Oil Exploration Co. was merged into Terra

on or about May 1, 1980.    Terra was the only subsidiary of

petitioner engaged in oil and gas exploration from the date

of this merger until 1983 when petitioner sold its interest

in Terra.


Sale of Terra

     Sales of petitioner's petroleum-based products

declined rapidly between 1980 and 1983.    Petitioner's

refinery margins, earnings from fertilizer sales, and

overall net earnings also declined during this period.       As

a result, petitioner reported consolidated losses in 1982
                                - 37 -

and 1983 for the first time in its history.            Petitioner's

management attributed the company's poor performance to

the end of the energy crisis and resulting glut of oil,

worldwide over-production of grains, high interest rates,

and the Federal Government's implementation of the payment-

in-kind program, which caused a general decrease in the

production of many agricultural commodities.            Petitioner's

members were also adversely affected by a general recession

in the agricultural sector of the economy during this

period.    Petitioner's consolidated financial data regarding

the company's farm supply operations for the period from

1980 to 1983 are as follows:

                                 1980       1981        1982       1983
 Gross farm supply revenue     $2,725     $3,040      $2,775     $2,546
 Farm supply operating
                                  273        187          90            2
   savings
 Total net savings1               202         68        (32)      (138)
 Interest expense                  92        105         122        106
 Funded long-term debt            584        684         795        566
 Fixed assets before
                                1,410      1,655       1,787      1,149
   depreciation


      1
        Total net savings before income taxes, patronage refunds, and
extraordinary items.


      During the period from 1981 to 1983, petitioner's

operating and capital needs were met primarily through a

combination of bank financing on a floating-rate basis,

issuance of medium- and long-term subordinated debt, and

retained earnings, including patronage dividends not paid

in cash.    During this period, petitioner's loans from the
                           - 38 -

Wichita Bank were the largest in the national Farm Credit

System.   As of August 31, 1982, petitioner's consolidated

loans from the Wichita Bank and commercial banks totaled

over $500 million.   As of the same date, petitioner's

outstanding subordinated debt certificates had reached an

all-time high of approximately $428 million.

     Prior to 1982, petitioner's loan agreements with the

Wichita Bank contained covenants designed to ensure

petitioner's continued solvency.    Under these covenants,

petitioner was required to maintain a funded debt ratio

(subordinated debt instruments divided by total

capitalization) of no more than 65 percent.    Petitioner was

also required to maintain a current ratio (current assets

to current liabilities) of at least 1.15:1.    In late 1981,

the Wichita Bank took the position that more conservative

ratios were necessary to ensure petitioner's financial

stability.   In a loan agreement effective February 15,

1982, petitioner agreed that by August 31, 1982, its funded

debt ratio would not exceed 62.5 percent, and that its

current ratio would be at least 1.20:1.

     Shortly after adopting its budget for the 1982 fiscal

year, which projected lower operating savings than had been

realized in 1981, petitioner requested that the funded debt

ratio agreed upon in the February 15, 1982, loan agreement
                           - 39 -

be increased to 65 percent with a reduction to 61 percent

to be effective on August 31, 1983.   The Wichita Bank

agreed to this change because the bank wanted to avoid a

potential default, and because it appeared unlikely that

petitioner would quickly recover from its recent financial

difficulties.   Both petitioner and the Wichita Bank con-

templated that when the loans were considered for renewal

in February 1983, the maximum funded debt ratio for

August 31, 1983, would likely be reduced to 61 percent.

     By August 1982, petitioner's financial personnel were

projecting a loss for fiscal year 1982 of $35 million,

compared to savings of $46.4 million which had been

projected when the budget was prepared.   For fiscal 1983,

petitioner's financial personnel forecasted losses of $41

million through February 1983, and savings of $87 million

for March through August 1983.

     At a September 10, 1982, meeting between petitioner's

representatives and officials of the Wichita Bank,

petitioner asked the Wichita Bank to consider changing the

current ratio requirement in its loan agreements from

1.20:1 to a flat amount of $75 million in working capital.

However, the Wichita Bank refused to consider any changes

in the current ratio requirement until petitioner made a

long-range evaluation of other debt-reducing possibilities,
                           - 40 -

including the possibility of selling major assets or

business segments.

     The Wichita Bank became increasingly concerned about

petitioner’s financial situation throughout the early

1980's.   An internal memorandum of the Wichita Bank dated

September 2, 1982, states that “Farmland Industries is

experiencing serious financial difficulties.”   A memorandum

dated September 14, 1982, states that petitioner’s vice

president of finance, Mr. Robert Ferguson, informed a

representative of the Wichita Bank that petitioner was

having difficulty dealing with commercial banks.   Mr. Earl

Knauss, petitioner's chief financial officer, was also

reported to have stated that petitioner needed to develop

financial contingency plans to avoid defaulting on its

loans from the Wichita Bank.   On September 16, 1982,

Mr. Ferguson told the Wichita Bank that the banking firm

that previously handled petitioner's debt offerings had

ceased doing so.   On October 19, 1982, a vice president

of the Wichita Bank proposed that the bank classify

petitioner’s loan as a problem loan and suggested that

petitioner consider selling assets and subsidiaries to

raise cash and reduce its interest expenses.

     During a meeting of petitioner's board of directors

on October 25-27, 1982, the board was informed that the
                           - 41 -

estimated financial results for fiscal year 1983 had been

revised from savings of $46.4 million to a loss of $18.4

million.   During the same meeting, Mr. David Andra, senior

vice president of the Wichita Bank, informed petitioner's

board of directors that the Wichita Bank had classified the

company’s loan as a problem loan.    Terra's president,

Mr. Francis Merelli, also reported that Terra was exploring

the possibility of selling leasehold interests pursuant to

authorization by petitioner's board of directors to sell up

to $50 million of Terra's reserves to raise cash.

     In December 1982, the Wichita Bank proposed to change

petitioner's loan covenant ratios effective February 1983,

to require that the funded debt ratio would be no more than

62 percent by August 31, 1983, and no more than 64 percent

during the period from February 15 through August 31.

Petitioner resisted this proposal.

     Petitioner's financial difficulties continued into

1983.   Early in the year, petitioner's board of directors

decided to sell the company's stock in Terra to avoid

default on the Wichita Bank loans and potential bankruptcy.

At a January 28, 1983, meeting of representatives of the

Wichita Bank and petitioner, petitioner revealed that its

projected loss for 1983 had increased to $64.7 million.

Furthermore, Mr. Knauss reported that the net loss could
                           - 42 -

be as high as $98.7 million due to unanticipated write-

downs and other factors.   At that level of loss, the

funded debt ratio would have increased to 66.4 percent.

Mr. Knauss also advised officials of the Wichita Bank that

petitioner's management had recommended selling a major

asset to reduce debt.

     At its meeting of February 1-2, 1983, petitioner's

board of directors accepted Mr. Knauss's recommendation to

sell a major asset.   In view of this decision, the Wichita

Bank agreed to allow petitioner's funded debt ratio to

remain at 65 percent through August 31, 1983, but insisted

that it be reduced to 62 percent by September 1, 1983.     The

current ratio requirement was also relaxed for the period

ending August 31, 1983, to an absolute working capital

level of $75 million.   Petitioner's current ratio as of

February 28, 1983, was 1.17:1.

     Petitioner’s projected losses continued to increase

throughout February and March 1983.    An internal memorandum

of the Wichita Bank dated March 4, 1983, states that

petitioner “is firmly committed to selling assets to

strengthen [its] operations.”    Another memorandum of the

Wichita Bank prepared on the same day states that

petitioner’s financial problems “exceed the worst case

projections.”   A memorandum of the Wichita Bank dated
                           - 43 -

April 18, 1983, states that petitioner was planning a

massive sale of assets to improve its overall financial

condition.   Without such a sale, the Wichita Bank feared

that petitioner would default on its loans before

August 31, 1983.

     By mid-April 1983, petitioner's loss estimate for 1983

had increased to between $140 million and $154 million.       A

memorandum of the Wichita Bank dated April 25, 1983,

discussing a meeting between representatives of petitioner,

the Wichita Bank, and the Central Bank for Cooperatives,

states that the banks would work to avoid a default, but

“the sale of Terra * * * was certainly more of a temporary

cure than [petitioner] planned in the beginning.”   On

May 31, 1983, petitioner’s current ratio was 1.15:1.     On

the same date, petitioner's funded debt ratio was 63.8

percent.

     At the time of petitioner's 1982-83 financial crisis,

petitioner's stock in Terra was the only asset that could

be sold quickly to pay down debt to the extent required by

the Wichita Bank.   In the spring of 1983, petitioner's

management and board of directors concluded that selling

the company's stock in Terra was the only feasible course

of action.   The board of directors had never discussed

selling the Terra stock prior to petitioner's financial
                           - 44 -

crisis, and petitioner would not have sold the stock if it

had not experienced financial difficulties.

     Petitioner solicited bids for Terra's stock in May

1983.   Petitioner required prospective buyers to purchase

100 percent of Terra's stock for cash, and to agree to

grant petitioner a call on Terra's crude oil production.

     The Pacific Lighting Corp. (PLC) submitted the highest

bid for the Terra stock.   In June 1983, petitioner agreed

to sell the stock to PLC for $298.3 million.   PLC regarded

the sale price as reflecting the fair market value of

Terra's crude oil reserves and other assets.   The price was

established by evaluating the reserves, projecting Terra's

production schedule 20 years into the future, and

discounting the projected cash flow to present value.

     Petitioner's sale of Terra stock was closed on

July 28, 1983.   PLC paid approximately 50 percent of the

purchase price at closing, and the balance on September 1,

1983.   Petitioner distributed the cash it received from the

sale to the Wichita Bank in partial payment of petitioner's

outstanding loans.   This improved petitioner's overall

financial health and benefited its balance sheet and future

years' profit and loss statements.

     Petitioner reported the gain from its sale of Terra

stock under the installment method.   Petitioner reported
                           - 45 -

total gain of $118,896,624 on its return for the taxable

year ending August 31, 1983, $118,191,603 on its return for

the taxable year ending August 31, 1984, and $879,783 on

its return for the taxable year ending August 31, 1986.

The gain reported for fiscal year 1986 resulted from

payments arising from various post-sale agreements between

petitioner and PLC.   Petitioner did not report any gain

from the sale on its return for the taxable year ending

August 31, 1985.

     During the years in issue, petitioner maintained a

total of approximately 20 allocation units for the purpose

of calculating patronage refunds.     From its accounting

records of merchandise sold, petitioner determined the

member sales and nonmember sales attributable to each

allocation unit.   Petitioner defined a member sale as a

sale of property or services to a person or entity

entitled to receive patronage dividends.     This includes

sales to members, associate members, and certain

nonmembers who are entitled to receive patronage dividends

under contractual arrangements.     Petitioner defined a

nonmember sale as a sale of property or services to a

person or entity who is not entitled to receive patronage

dividends.
                            - 46 -

       In 1983 and 1984, petitioner’s bylaws required that

patronage income be determined on the basis of taxable

income rather than book income.      The determination of

patronage income was divided into five steps.      First,

the total sales for each allocation unit was determined.

Second, the ratios of member and nonmember sales to total

merchandise sales for each allocation unit were

determined.    Third, the gross savings for each unit was

determined by subtracting the cost of goods sold from

total merchandise sales.    Fourth, the direct expenses for

each allocation unit that did not enter into the cost of

goods sold computation, such as marketing and warehousing,

were subtracted from gross savings to compute “net savings

before adjustments”.    If the resulting figure was

positive, then it was reduced by the unit’s allocable

portion of petitioner’s general and administrative

expenses and the losses of units with negative net savings

before adjustments.    The resulting figure constituted the

net savings for the particular unit.      Fifth, the net

savings for each unit were allocated between members and

nonmembers by applying the ratios determined above in step

two.

       Petitioner treated the entire gain realized on the

sale of Terra stock as ordinary income.      Petitioner
                            - 47 -

allocated a portion of the gain to each of its four

petroleum-related allocation units (bulk petroleum, farm

fuels, propane, and lube oil and grease).    The portion of

total gain allocable to each unit was determined by the

ratio of gross savings allocable to such unit to the

combined gross savings of all four units.

     Applying the patronage income computation formula

described above, petitioner reported all but approximately

6 percent of the gain from the sale of Terra stock as

patronage income in 1983, and all but approximately 9

percent as patronage income in 1984.    All of the gain

reported in 1986 was treated as patronage income.    On its

return for the taxable year ending August 31, 1983, the

gain reported as patronage income was entirely offset by

current and unutilized prior years' losses from patronage

operations.    Part of the gain reported on petitioner's

return for the taxable year ending August 31, 1984, was

also offset by patronage losses.

     Several transactions took place between petitioner

and Terra prior to and in anticipation of the sale of

Terra stock.   On May 19, 1983, Terra paid a $20 million

dividend to petitioner.    On the same day, petitioner paid

$21 million to the Fourth National Bank & Trust Co. in

Tulsa, Oklahoma, in payment of a loan Terra had previously
                           - 48 -

made to petitioner.   At the time of these transactions,

Terra owed petitioner a total of $150 million.   Petitioner

claimed a deduction pursuant to section 243 equal to the

entire amount of the cash dividend received from Terra.

The May 1983 dividend was not intended to offset an

increase in the price of crude oil or natural gas.

Because the dividend was excluded from petitioner's income

under section 243, it did not enter into petitioner's

calculation of patronage income for its 1983 fiscal year.

     In July 1983, Terra paid another dividend, trans-

ferring to petitioner its interest in the Axom Limited

Partnership, which was valued at $4,797,890.   Petitioner

received and reported as income an additional $161,573 in

dividends from Terra during its 1983 tax year.   It

reported both of these dividends as patronage income.

Petitioner reported the dividends it received with respect

to all other stock as nonpatronage income.

     Petitioner did not sell its Terra stock because of

any increase or decrease in the market price of crude oil

or natural gas, or any contemporaneous purchase of crude

oil or natural gas on the open market.   Petitioner

exercised its option to purchase crude oil produced by

Terra several times between the date of the sale and the

time of trial.   Although the call option has benefited
                           - 49 -

petitioner, Terra has not been a desirable source of crude

oil since the sale.   When petitioner owned Terra, it had

the right to purchase crude oil at the posted field price

regardless of whether other buyers would be willing to pay

a higher price.   After the sale, petitioner was forced to

compete for the crude oil and natural gas Terra produced.

Petitioner was unable to purchase Terra's oil and gas on

several occasions due to the fact that other purchasers

were willing to pay a premium over the posted field price.

Petitioner has also encountered difficulty in arranging

delivery of oil from Terra.   Further difficulties arose

after Terra sold some of its properties to unrelated third

parties.   Terra retained a call option for petitioner's

benefit with regard to the oil produced at these

properties which led to some confusion over deliveries.


Seaway Pipeline, Inc.

     In July 1974, CRA and six unrelated companies

organized Seaway Pipeline, Inc. (Seaway).   At the time of

its organization, all of Seaway's shareholders were

engaged in oil refining.   Two of the other shareholders

were regional cooperatives, and four were for-profit

corporations.

     Seaway was organized to construct and operate a

pipeline and related terminal facilities for the
                            - 50 -

transportation of crude oil from Freeport, Texas, to

Cushing, Oklahoma.    Pipelines owned by entities other than

Seaway connected the Cushing, Oklahoma, terminal with the

refinery facilities of Seaway's shareholders.    The

pipeline was operated as a common carrier under Federal

law.   The stockholders intended to use the pipeline to

carry imported crude oil part of the distance from

Freeport to their refineries.    At the time of construc-

tion, the shareholders expected that they would be the

principal users of the pipeline, and that nonshareholders

would account for approximately 21 percent of the

pipeline's usage.

       The total projected cost of the Seaway pipeline was

$204.4 million.   Approximately 10 percent of the cost was

to be financed by equity capital contributed by the

shareholders.   The remainder was to be financed through

the sale of commercial paper and long-term debt through

private placements.    By December 31, 1977, Seaway had

issued long-term debt in the aggregate principal amount of

$167.6 million.

       Pursuant to an agreement among the Seaway shareholders

dated July 22, 1974, petitioner contributed $2,299,595 to

Seaway as consideration for the issuance of Seaway stock.
                           - 51 -

Petitioner owned 12 percent of Seaway's capital stock from

the company's inception until its termination in 1984.

     To ensure payment of Seaway's long-term debt, its

stockholders executed a Throughput and Deficiency Agreement

(TDA) dated February 12, 1975.   Under the terms of the TDA,

each stockholder agreed to deliver sufficient crude oil for

transportation through the pipeline, in proportion to its

capital stock ownership, so that revenues collected for the

transportation would pay all operating expenses of the

pipeline and all principal and interest due on Seaway’s

outstanding debt.   In the event Seaway experienced a cash

deficiency, the TDA obligated each shareholder to pay

Seaway its proportionate share of the deficiency on the

date any interest or principal payment was due, or at the

end of any 6-month accounting period.   Seaway and its

shareholders treated these TDA deficiency payments as

prepaid transportation charges, to be credited against

actual charges when crude oil was transported for the

paying shareholder.   On its balance sheet, petitioner

credited its TDA deficiency payments to an account for

prepaid expense items and debited the payments to an

expense account when it actually used the pipeline.
                           - 52 -

     The Seaway pipeline became operational on November 23,

1976.   Petitioner used the pipeline to transport approxi-

mately 50 percent of the crude oil processed at its

Coffeyville refinery, which was connected to the Cushing

terminal by another pipeline owned by petitioner.    The

Seaway pipeline also gave petitioner access to foreign

crude oil needed to operate its refineries.

     For financial accounting purposes, petitioner, through

CRA, recorded its Seaway stock on its balance sheet in an

account labeled “Other Investments”.   Neither petitioner

nor CRA recorded the Seaway stock in an account identified

as an “inventory”, “fixed assets”, “hedge”, or “hedging”

account.   Petitioner did not hold its stock in Seaway for

sale in the ordinary course of business and did not sell

any Seaway stock or receive any stock dividends.    For

financial reporting purposes, petitioner’s share of

Seaway’s annual earnings or losses was reflected as

adjustments to a balance sheet asset account and a balance

sheet schedule entitled “Investments in Equity and Earnings

of, and Dividends Received from Affiliates and Other

Persons--(A) Capital Stock”.

     Although Seaway incurred operating losses in 1976,

1977, and 1979, it had sufficient pipeline transportation

revenues and cash reserves in each of those years to pay
                            - 53 -

its operating expenses and service its debt.   However,

pipeline usage declined steadily from 1979 to 1983.    Seaway

transported the following volumes of crude oil during those

years:

                              Barrels of
                  Year     Crude Transported

                  1979         59,294,000
                  1980         37,015,000
                  1981         23,400,000
                  1982         10,817,000
                  1983         12,663,000


This decrease in pipeline usage caused Seaway to experience

a shortage of cash and forced the company to make cash

calls pursuant to the TDA between 1980 and 1983.

Petitioner's portion of the cash calls totaled $11,844,791.

Of this amount, approximately $1,327,427 was ultimately

applied to transportation charges for crude oil transported

through the pipeline on petitioner's behalf.

     In 1983, Seaway's board of directors decided to sell

the pipeline.   Seaway later agreed to sell the pipeline to

Phillips Petroleum (Phillips), one of its shareholders, for

$127.6 million.    Phillips also agreed to purchase the port

terminal facilities for $15 million.    Seaway sold the

Cushing terminal to Amoco Oil Co. for $10.2 million.

Petitioner’s annual report for 1984 describes the sale of

the pipeline as follows:
                            - 54 -

          During fiscal 1984, the Seaway Pipeline Co.
     sold its Freeport, Tex., to Cushing, Okla., crude
     oil pipeline. Seaway was organized in the mid-
     70s to transport foreign crude oil from the Texas
     Gulf Coast to Midwest refineries. Farmland was a
     12% owner of the Seaway facilities. With less
     need for foreign crude oil in the Midwest, the
     pipeline was no longer beneficial to Farmland’s
     refining operations.


     The sale of the pipeline was closed on May 1, 1984.

Following the closing, Seaway's shareholders agreed to make

short-term loans to Seaway of up to $15 million to cover

operating expenses pending dissolution.    Seaway was to

repay these loans with the proceeds of the sale of the

terminal facilities.    In total, the shareholders lent

Seaway $11,100,000.    Petitioner's share of this loan was

$1,332,000.

     The sale of terminal facilities closed in July and

August 1984.   Seaway ceased conducting business on

August 31, 1984.   Seaway used the proceeds from the sales

of the pipeline and terminal facilities to repay its

remaining debts to nonshareholders, the full amount of the

short-term loans made by the shareholders, a portion of the

shareholders' unapplied prepaid transportation charges, and

the shareholders' respective shares of the cost of oil

remaining in the pipeline at the time it was sold.

     On its 1984 Federal income tax return, petitioner

reported an ordinary patronage loss from the Seaway
                                   - 55 -

transaction of $11,042,128.          This amount was calculated as

follows:
     Estimated total amount
      received incident to
      liquidation                                           $3,498,052
     Unrecovered prepaid
      transportation advances          ($10,517,364)
     Inventory in pipeline                 (343,195)
     Outstanding loan balance
      (including accrued
      interest, $48,026)                  (1,380,026)
     Cost of capital stock                (2,299,595)
        Total                                             (14,540,180)

     Net loss reported                                    (11,042,128)


Petitioner actually received $3,582,062 upon the liquida-

tion of Seaway because the final payments received in 1985

totaled $358,350, rather that the amount originally

estimated, $274,340.      Petitioner's amount received from

the liquidation was calculated as follows:

           Inventory in pipeline                         $343,195
           Outstanding loan balance
             (including $48,026 accrued
             interest)                                  1,380,026
           Recovery of unapplied prepaid
              transportation charges--1984              1,500,491
           Recovery of unapplied prepaid
              transportation charges--1985                358,350
             Total amount received                      3,582,062




     In the subject notice of deficiency, respondent

determined that the portion of the net loss attributable

to the cost of Seaway's capital stock, $2,299,595, is a

nonpatronage capital loss.          The notice describes this

adjustment as follows:
                           - 56 -

     The loss realized on the sale of the Seaway
     Pipeline, Inc., stock must be recognized as
     nonpatronage capital loss and may not be offset
     by patronage income. Accordingly, your non-
     patronage capital losses are increased by
     $(2,299,595); the patronage ordinary loss you
     reported is decreased by $2,082,785; and the
     nonpatronage ordinary loss you reported is
     decreased by $216,810, in your fiscal year
     ending August 31, 1984.


Mex-Am Crude Corp.

     In an attempt to expand its access to crude oil from

sources outside the United States, petitioner became one

of nine equal subscribers to the capital stock of the Mex-

Am Crude Corp. (Mex-Am).   All of these subscribers were

companies that engaged in refining crude oil and required

reliable access to adequate supplies of crude.    Mex-Am was

incorporated on September 17, 1982.    It was organized to

purchase oil in large volumes from Petroleos Mexicanos

(PEMEX) on a collective basis for the benefit of its

shareholders.   Each of Mex-Am's shareholders was obligated

to purchase a portion of the crude oil Mex-Am acquired

from PEMEX.   This obligation terminated if at any time a

shareholder surrendered its stock for no consideration.

     Petitioner did not hold its Mex-Am stock for sale in

the ordinary course of business.    For financial reporting

purposes, petitioner reported its stock in Mex-Am in an

account on its balance sheet labeled “Other Investments”.
                           - 57 -

Petitioner never recorded its Mex-Am stock in an account

identified as an “inventory”, “hedge”, or “hedging”

account.   Petitioner never sold any Mex-Am stock and never

received any dividends from Mex-Am.

     Supply conditions for crude oil improved in late 1983

making it unnecessary for petitioner to obtain crude oil

from Mex-Am.   Accordingly, petitioner surrendered its

stock in Mex-Am for no consideration, thereby relieving

itself of the obligation to purchase a portion of Mex-Am's

crude oil.

     On its Federal income tax return for 1984, petitioner

reported an ordinary loss of $25,000 from the surrender of

its Mex-Am stock.   Petitioner treated $22,643 of this

amount as an ordinary patronage loss and $2,357 as an

ordinary nonpatronage loss.

     In the notice of deficiency, respondent recharacter-

izes the loss as a nonpatronage capital loss that cannot

be offset by patronage income.   The notice of deficiency

describes this adjustment as follows:


     The loss realized on the surrender of the Mex-Am
     Crude Corporation stock must be recognized as
     non-patronage capital loss and may not be offset
     by patronage income. Accordingly, your non-
     patronage capital losses are increased by
     $(25,000); the patronage ordinary loss you
     reported is decreased by $22,643; and the non-
     patronage ordinary loss you reported is
                            - 58 -

     decreased by $2,357, in your fiscal year
     ending August 31, 1984.


Lamont Gas Processing Plant

     For many years, petitioner purchased propane and

gasoline blending stocks from outside suppliers.      The

quality of this fuel was often inconsistent, and there

was often an inadequate supply to meet the needs of

petitioner's patrons.    To address these problems,

petitioner decided to manufacture propane and gasoline

blending stock.   In 1963, petitioner purchased a natural

gas gathering system near Lamont, Oklahoma, to implement

this plan.   After the purchase, petitioner installed an

absorption processing plant on the site.    The facility

also included an extensive pipeline system which provided

petitioner access to numerous natural gas producing wells.

In 1981, petitioner added a cryogenic gas processing plant

to its facilities at Lamont which significantly enhanced

the plant's efficiency.    We refer to the gathering system,

the absorption processing plant, the pipeline system, and

the cryogenic plant collectively as the Lamont gas plant.

     In June 1984, petitioner sold the assets composing

the Lamont gas plant to Union Texas Products Corp. for

$27.1 million.    The sale was an arm's-length transaction.

Petitioner used $16 million of the proceeds to build and
                               - 59 -

expand similar gas gathering and processing plants in

Texas.   The balance of the proceeds was used to reduce

petitioner's outside debt and free up funds for operating

purposes.    Petitioner’s annual report for 1984 describes

the sale as follows:


          Farmland sold its gas products plant at
     Lamont, Okla. Funds generated from the sale are
     being used to expand gas plants at Mertzon and
     Eldorado, Tex.

          The Lamont plant had been processing about
     15 million cubic feet of natural gas per day.
     Eldorado-Mertzon, with a much larger pipeline
     gathering system, processed 75 million cubic
     feet per day in 1984. The expansion, completed
     in October 1984, will boost capacity to 100
     million cubic feet per day in 1985.


The annual report states that the sale took place to

finance the expansion of the Texas plants after “feasi-

bility studies pointed to advantages in expanding the

Mertzon, Texas, natural gas liquids plants.”

     On its Federal income tax return for the year ending

August 31, 1984, petitioner reported a gain of $16,221,675

from the sale of the Lamont gas plant.         This gain

comprised the following components:

     Amount realized in excess of cost basis        $12,852,544
     Sec. 1245 recapture                              3,287,803
     Straight-line depreciation
       on sec. 1250 property                               81,328

         Total reported gain                        16,221,675
                          - 60 -

Petitioner reported the entire gain from the sale of the

Lamont gas plant as ordinary patronage income.

     In the subject notice of deficiency, respondent

reclassifies the portion of the gain representing the

amount realized in excess of cost basis, viz $12,852,544,

as nonpatronage capital gain under section 1231.

Respondent does not take issue with petitioner's treatment

of the portion of the gain equal to depreciation recapture

under section 1245, $3,287,803, or the portion of the gain

equal to the amount of straight-line depreciation on

section 1250 property, $81,328.    The notice of deficiency

describes this adjustment as follows:


     The section 1231 gain realized on the sale of
     the Lamont, Oklahoma, gas plant must be
     recognized as non-patronage capital gain and may
     not be offset by patronage losses. Accordingly,
     your non-patronage capital gains are increased
     by $12,852,544; the patronage ordinary income
     you reported is decreased by $(11,640,781); and
     the non-patronage ordinary income you reported
     is decreased by $(1,211,763), in your fiscal
     year ending August 31, 1984.


Soybean Processing Facilities

     Prior to August 1983, petitioner owned and operated

three soybean processing facilities.    These facilities

were located in Sergeant Bluff, Iowa, St. Joseph,

Missouri, and Van Buren, Arkansas, and are collectively

referred to herein as the soybean facilities.    Petitioner
                             - 61 -

used the soybean facilities to process soybeans purchased

from its patrons into soy oil and soy meal.       Petitioner

sold most of the soy oil it produced to unrelated food

processors for use in products such as margarine.

Petitioner processed the soy meal it produced into formula

livestock feed, all of which it sold to its member

cooperatives.

     Boone Valley and Land O'Lakes, two other Midwestern

cooperatives, also processed and marketed soy products

during the years in issue.    Boone Valley processed soy

meal into livestock feed using petitioner’s proprietary

formulas and technical support.       Boone Valley’s feed

production was marketed directly through petitioner.

Boone Valley is included in a list entitled “subsidiaries

and affiliates” in petitioner’s 1980 annual report.         In

some earlier reports, Boone Valley is described as a

subsidiary of petitioner and some of its member

cooperatives.   The record does not fully disclose the

nature of the relationship of    Boone Valley and

petitioner.

     During petitioner's 1983 fiscal year, consideration

was given to consolidating the soybean operations of

petitioner, Boone Valley, and Land O'Lakes.       Under the

terms of the plan, petitioner was to sell its soybean
                            - 62 -

facilities to Boone Valley for $29.1 million.    Petitioner

was then to purchase Boone Valley's Eagle Grove, Iowa,

feed mill for $10 million, and Boone Valley was to change

its name to Ag Processing, Inc. (API).    Petitioner, Land

O'Lakes, and the former patrons of Boone Valley were to

receive all of the equity in API.    The record does not

disclose the consideration paid by Land O'Lakes for its

interest in API.

     The soybean consolidation plan was effectuated in

August 1983.    Petitioner's annual report for 1983 states

that the consolidation of the three regional cooperatives

into a single entity “would [eliminate] some duplication

of effort and [create] a stronger cooperative soy

processing entity that will improve producers’ return.”

Petitioner estimated that the consolidation would provide

additional savings of 3 to 5 cents per bushel for soybean

farmers.   Following the consolidation, petitioner's

patrons marketed soybeans through API.    API operated the

soybean facilities and sold a substantial portion of its

output to petitioner for resale to its member

cooperatives.
                               - 63 -

     On its Federal income tax return for the year ending

August 31, 1983, petitioner reported a gain of $13,791,615

from the sale of its soybean facilities to Boone Valley.

This gain was composed of the following components:

      Amount realized in excess of cost basis       $501,903
      Sec. 1245 recapture                          9,963,255
      Straight-line depreciation
        on sec. 1250 property                      3,326,457

         Total reported gain                      13,791,615


Petitioner reported $3,828,360 of the gain as patronage

capital gain under section 1231.        This amount consists

of the portion of the gain equal to the amount realized

in excess of the cost basis ($501,903) and the portion

representing the straight-line depreciation taken on

section 1250 property ($3,326,457).        Petitioner reported

the portion of the gain representing section 1245

recapture ($9,963,255) as ordinary patronage income.

     In the subject notice of deficiency, respondent

reclassifies the portion of gain representing the amount

realized in excess of cost basis, $501,903, as

nonpatronage capital gain.      Respondent does not adjust

petitioner's treatment of the portion of the gain

representing section 1245 recapture, $9,963,255 (treated

as ordinary patronage income), or petitioner's treatment

of the portion of the gain representing straight-line
                                    - 64 -

depreciation taken on section 1250 property, $3,326,457

(treated as patronage capital gain).


Miscellaneous Section 1231 Assets

        During the tax year ending August 31, 1983,

petitioner sold in arm's-length transactions, retired, or

otherwise disposed of approximately 525 miscellaneous

business assets.        These included tractors and other

vehicles, livestock, buildings, office furniture, and

office equipment.        All of these assets were depreciable

assets described in section 1231(b), and had been used and

disposed of in the ordinary course of petitioner's

business activities.         On its Federal income tax return for

the year ending August 31, 1983, petitioner reported a net

gain of $2,142,968 from the disposition of these assets.

This gain is comprised of the following components:

           Amount realized in excess of cost basis   $1,210,245
           Aggregate sec. 1245 recapture                932,723

             Total reported gain                     2,142,968


Petitioner reported the portion of gain representing

aggregate section 1245 recapture, $932,723, as ordinary

patronage income.        Petitioner reported the portion of the

gain representing the amount realized in excess of cost

basis, $1,210,245, as patronage capital gain under section

1231.
                          - 65 -

     In the subject notice of deficiency, respondent

reclassifies the portion of the gain representing the

aggregate amount realized in excess of cost basis,

$1,210,245, as nonpatronage capital gain.   Respondent does

not adjust petitioner's treatment of the portion of the

gain representing aggregate section 1245 recapture as

ordinary income from patronage sources.

     In describing the adjustments involving the gain realized

from the sale of petitioner’s soybean facilities and the gain

from the sale of the above miscellaneous section 1231 assets,

the notice of deficiency states as follows:


     The section 1231 gain realized on the sale of the
     soybean processing facilities must be recognized and
     treated as non-patronage capital gain and may not be
     offset by patronage losses. Accordingly, your non-
     patronage capital gains are increased by $1,712,148;
     the patronage ordinary income you reported is
     decreased by $(1,632,724); and the non-patronage
     ordinary income you reported is decreased by
     $(79,424), in your fiscal year ending August 31,
     1983.


The increase in “non-patronage capital gains” of $1,712,148

determined in the notice consists of $501,903, attributable

to the sale of petitioner’s soybean facilities, and

$1,210,245, attributable to the sale of miscellaneous

assets.
                           - 66 -

                           OPINION

     Petitioner is a nonexempt cooperative subject to

subchapter T.   See generally Buckeye Countrymark, Inc. v.

Commissioner, 103 T.C. 547, 554-563 (1994), for an overview

of the taxation of nonexempt cooperatives under subchapter

T.   The principal issue in this case is whether the gains

and losses that petitioner realized from the disposition

of the property described above should be classified as

patronage or nonpatronage gains and losses for purposes of

subchapter T.   The property at issue is petitioner’s stock

in three corporations, Terra, Mex-Am, Seaway, and certain

“property used in a trade or business”, as defined by

section 1231(b), consisting of the assets of petitioner’s

Lamont gas plant, its soybean processing facilities, and

miscellaneous business assets.   The bulk of the

deficiencies determined in the notice of deficiency is

attributable to respondent’s reclassification of the gain

from petitioner’s sale of the stock of Terra.

     The term “patronage dividend” is defined by section

1388(a) as follows:


     (a) PATRONAGE DIVIDEND.--For purposes of this
     subchapter, the term “patronage dividend” means
     an amount paid to a patron by an organization to
     which part I of this subchapter applies--

                (1) on the basis of quantity or value
           of business done with or for such patron,
                           - 67 -

                (2) under an obligation of such
           organization to pay such amount, which
           obligation existed before the organization
           received the amount paid, and

                (3) which is determined by reference to
           the net earnings of the organization from
           business done with or for its patrons.

     Such term does not include any amount paid to a
     patron to the extent that (A) such amount is out
     of earnings other than from business done with
     or for patrons, or (B) such amount is out of
     earnings from business done with or for other
     patrons to whom no amounts are paid, or to whom
     smaller amounts are paid, with respect to
     substantially identical transactions.


By patronage income we mean income derived from “business

done with or for” patrons of the cooperative, such that it

can be included in computing the net earnings from which a

patronage dividend can be paid.     Sec. 1388(a).   By

nonpatronage income we mean income that is derived other

than from business done with or for patrons.     See sec.

1388(a).

     Petitioner argues that the classification of gains and

losses as patronage or nonpatronage income depends on the

factual relationship between the activity producing the

gain or loss and the operations of the cooperative,

regardless whether the gains or losses are capital or

ordinary in nature.   Petitioner argues that, if the

activity producing the gain or loss is “directly related”

to or facilitates the cooperative’s operations, then the
                            - 68 -

gain or loss should be treated as patronage income.

Petitioner asks the Court to reject the per se rule

espoused by respondent under which capital gains and losses

are always classified as nonpatronage.   In the event that

the Court adopts a per se rule for capital gains and

losses, petitioner argues that the gains and losses from

its disposition of the stock of Terra, Seaway, and Mex-Am

are not subject to such rule because they are ordinary

gains and losses “under the long-standing case law

principles relating to ‘source of supply’, noncapital asset

‘surrogacy’ and ‘hedging’.”   Similarly, petitioner argues

that the gains from the disposition of the section 1231

assets, are “‘noncapital’ assets by statutory definition

(under section 1221(2))” and are not subject to

respondent's per se rule.   Finally, petitioner argues that

even if the gains from the sale of Terra stock and the

section 1231 assets are classified as nonpatronage income,

such income can nevertheless be offset by petitioner's

patronage losses which were true operating losses.

     Respondent argues that all of the gains and losses

at issue in this case are capital in nature and must be

automatically classified as nonpatronage under the per se

rule prescribed by section 1.1382-3(c)(2), Income Tax Regs.

Alternatively, respondent argues that even if the Court
                            - 69 -

does not adopt the per se rule for capital gains and

losses, the gains and losses at issue must be classified as

nonpatronage.   In either event, respondent argues that the

subject gains and losses cannot be combined with or netted

against petitioner's patronage losses.

     This and the other courts to have considered whether

an item of income should be classified as patronage or

nonpatronage, have resolved the issue based upon the

relationship of the transaction that generated the income

to the marketing, purchasing, or service activities of the

cooperative.    CF Indus., Inc. v. Commissioner, 995 F.2d

101, 105 (7th Cir. 1993), modifying and affg. T.C. Memo.

1991-568; Cotter & Co. v. United States, 765 F.2d 1102,

1106 (Fed. Cir. 1985); Land O'Lakes v. United States, 675

F.2d 988, 993 (8th Cir. 1982); St. Louis Bank for Coops. v.

United States, 224 Ct. Cl. 289, 624 F.2d 1041, 1050 (1980);

Buckeye Countrymark, Inc. v. Commissioner, 103 T.C. 547,

562-563 (1994); Certified Grocers of Cal., Ltd. v.

Commissioner, 88 T.C. 238, 243 (1987); Illinois Grain Corp.

v. Commissioner, 87 T.C. 435, 459 (1986); Dundee Citrus

Growers Association v. Commissioner, T.C. Memo. 1991-487;

Washington-Oregon Shippers Coop., Inc. v. Commissioner,

T.C. Memo. 1987-32; Twin Country Grocers, Inc. v. United

States, 2 Cl. Ct. 657, 662 (1983); Astoria Plywood Corp.
                           - 70 -

v. United States, 43 AFTR 2d 79-816, 79-1 USTC par. 9197

(D. Or. 1979); Linnton Plywood Association v. United

States, 410 F. Supp. 1100, 1108 (D. Or. 1976).

     As appears from these cases, if the income at issue is

produced by a transaction which is directly related to

the cooperative enterprise, such that the transaction

facilitates the cooperative's marketing, purchasing or

service activities, then the income is deemed to be

patronage income.   See, e.g., Cotter & Co. v. United

States, supra at 1106; Land O'Lakes, Inc. v. United States,

supra at 993; Certified Grocers of Cal., Ltd. v.

Commissioner, supra at 243; Illinois Grain Corp. v.

Commissioner, supra at 459.   On the other hand, if the

income is derived from a transaction that has no integral

and necessary linkage to the cooperative enterprise, such

that it may fairly be said that the income is merely

incidental to the cooperative enterprise and does nothing

more than add to the overall profitability of the

cooperative, then the income is deemed to be nonpatronage

income.   See, e.g., Cotter & Co. v. United States, supra at

1106; Land O'Lakes, Inc. v. United States, supra at 993;

Certified Grocers of Cal., Ltd. v. Commissioner, supra at

243; Illinois Grain Corp. v. Commissioner, supra at 459.
                             - 71 -

     The determination of whether income derived by a

cooperative from a transaction that is directly related to

the cooperative enterprise and, thus, is patronage income

is a determination that is necessarily fact intensive.

Certified Grocers of Cal., Ltd. v. Commissioner, 88 T.C.

238, 244 (1987); Illinois Grain Corp. v. Commissioner, 87

T.C. 435, 459 (1986); Washington-Oregon Shippers Coop.,

Inc. v. Commissioner, T.C. Memo. 1987-32.    In considering

the relatedness of the income-producing transaction to the

cooperative enterprise, it is important to focus on the

“totality of the circumstances” and to view the business

environment to which the income-producing transaction is

related and not to view the transaction so narrowly "as to

limit it only to its income-generating characteristic when

such a characterization is not consistent with the actual

activity."     Cotter & Co. v. United States, supra at 1106-

1107; Dundee Citrus Growers Association v. Commissioner,

T.C. Memo. 1991-487.

     The “directly related” test applied by the courts is

traceable to published rulings issued by the Commissioner,

such as Rev. Rul. 69-576, 1969-2 C.B. 166, and Rev. Rul.

74-160, 1974-1 C.B. 245, that interpreted patronage income

broadly.     See CF Indus., Inc. v. Commissioner, supra at

105; Illinois Grain Corp. v. Commissioner, supra at 453;
                           - 72 -

cf. Land O'Lakes, Inc. v. United States, supra at 993.

In Rev. Rul. 69-576, supra, the Commissioner held that an

amount received by the taxpayer, a nonexempt cooperative,

as a patronage dividend from a bank for cooperatives should

be considered patronage income in the taxpayer's hands.

The taxpayer cooperative became eligible to receive the

patronage dividend from the bank for cooperatives by reason

of the fact that it had borrowed from the bank to finance

the acquisition of agricultural supplies for resale to its

members.   The Commissioner reviewed section 1.1382-3(c)(2),

Income Tax Regs., and articulated the following test for

classifying an item of income as patronage or nonpatronage

income:

          Section 1.1382-3(c)(2) of the Income Tax
     Regulations defines the term “income derived
     from sources other than patronage” to mean
     incidental income derived from sources not
     directly related to the marketing, purchasing,
     or service activities of the cooperative
     association. For example, income derived
     from the lease of premises, from investment
     in securities, or from the sale or exchange
     of capital assets, constitutes income derived
     from sources other than patronage.

          The classification of an item of income as
     from either patronage or nonpatronage sources
     is dependent on the relationship of the activity
     generating the income to the marketing, purchas-
     ing, or service activities of the cooperative.
     If the income is produced by a transaction which
     actually facilitates the accomplishment of the
     cooperative's marketing, purchasing, or service
     activities, the income is from patronage sources.
     However, if the transaction producing the income
                          - 73 -

     does not actually facilitate the accomplishment
     of these activities but merely enhances the
     overall profitability of the cooperative, being
     merely incidental to the association's
     cooperative operation, the income is from
     nonpatronage sources.

          Accordingly, inasmuch as the income received
     by the nonexempt cooperative from the bank for
     cooperatives resulted from a transaction that
     financed the acquisition of agricultural supplies
     which were sold to its members, thereby directly
     facilitating the accomplishment of the
     cooperative's purchasing activities, it is held
     that the allocation and payment of this same
     amount by the nonexempt farmers' cooperative to
     its own patrons (farmers) qualifies as a
     patronage dividend. * * * [Rev. Rul. 69-576,
     supra.]


     Similarly, in Rev. Rul. 74-160, 1974-1 C.B. 245, the

Commissioner ruled that interest income realized from loans

made by the taxpayer, a nonexempt cooperative engaged in

the manufacture and sale of plywood, to the taxpayer's

chief supplier was patronage income.   According to the

ruling, the loans were necessary in order to permit the

supplier to finance equipment needed to carry on its

business operations and, without the loans, the supplier

would have been unable to supply the taxpayer.   Thus, the

Commissioner ruled that the interest income paid by the

supplier to the taxpayer was classified as patronage income

because it “actually facilitated the accomplishment of

taxpayer's cooperative activities, in that it enabled the

taxpayer to obtain necessary supplies for its operations.”
                           - 74 -

     In effect, the Commissioner ruled that the patronage

dividend received by the taxpayer in Rev. Rul. 69-516,

supra, and the interest income received by the taxpayer in

Rev. Rul. 74-160, supra, qualified for inclusion in the

taxpayer’s net earnings from “business done with or for its

patrons”.   Sec. 1388(a)(3).   In neither case were patrons

of the taxpayer cooperative directly involved in the

transaction out of which the income arose.    Compare Rev.

Rul. 73-497, 1973-2 C.B. 18, in which the Commissioner

ruled that interest paid to a bank for cooperatives by

other farm credit banks did not qualify as patronage income

because the payors were “not patrons of the taxpayer”.

This ruling has been criticized by the courts and it has

not been followed.   See St. Louis Bank for Coops. v. United

States, 224 Ct. Cl. 289, 624 F.2d 1041, 1051 (1980); see

also Cotter & Co. v. United States, 765 F.2d 1102, 1106

(Fed. Cir. 1985).

     Generally, under the “directly related” test, as

applied by the courts, transactions with third parties can

qualify as business “with or for” patrons, as long as the

transaction is reasonably related to the business which

the cooperative conducts with its patrons and benefits the

patrons, other than incidentally through the generation of

extra income.   St. Louis Bank for Coops. v. United States,
                             - 75 -

624 F.2d at 1051-1052.    As the court said in Twin County

Grocers, Inc. v. United States, 2 Cl. Ct. 657, 662 (1983):


     A common thread runs through each of the cases
     and rulings above summarized. Although the
     income at issue is generated by transactions
     between nonexempt cooperatives and nonpatrons,
     it is deemed to be patronage sourced because
     those transactions facilitate the basic functions
     of the cooperative in some way other than simple
     money management or overall profitability.


     In applying the “directly related” standard, the

courts have classified dividend income from a subsidiary

of the cooperative as patronage income if the business of

the subsidiary, out of which the dividends are paid, is

reasonably related to the basic purpose of the cooperative.

For example, in Linnton Plywood Association v. Commis-

sioner, 410 F. Supp. 1100 (D. Or. 1976), the court held

that dividends received by the taxpayer, a workers'

cooperative, with respect to the capital stock it held in

a glue manufacturing enterprise constituted patronage

income.   The taxpayer in that case was engaged in the

manufacture and sale of plywood and plywood products.

See id.   To secure a reliable supply of glue, a material

essential to the manufacture of plywood, the taxpayer

and another cooperative organized a glue manufacturing

enterprise.   See id.    Each cooperative owned 50 percent

of the capital stock of the glue manufacturer.    During
                               - 76 -

the year, the taxpayer received dividends from the glue

manufacturer which it included in its net earnings as

patronage income.    See id.    In holding that the dividends

were patronage income, the court stated:


     Glue is essential to the manufacture of ply-
     wood, and the arrangement which [the taxpayer-
     cooperative] made to produce its glue through a
     supplier which it and another plywood workers'
     cooperative organized is reasonably related to
     the business done with or for its patrons.
     [Id.]


Cf. Rev. Rul. 74-160, supra (interest paid on loans made

by taxpayer cooperative to its chief supplier held to be

patronage income).

     Similarly, in Land O'Lakes, Inc. v. United States,

675 F.2d 988 (8th Cir. 1981), the court considered the

patronage classification of dividends received by the

taxpayer, a nonexempt cooperative, with respect to its

stock in a bank for cooperatives.       The court noted that

the taxpayer was required to acquire and hold the stock to

obtain a loan, the proceeds of which were used to finance

cooperative activities on favorable terms.       See id. at 993.

The court found that the subject transaction in which the

taxpayer received the dividends was not “significantly

distinguishable” from the transactions involved in Rev.

Rul. 69-576, supra, and Rev. Rul. 74-160, supra, and held
                              - 77 -

that the dividends should be classified as patronage

income.   Id. at 993.   According to the court, “because the

transactions actually facilitated the cooperative’s

activities by providing financing on terms favorable to

the cooperative, the income from the bank stock was from a

patronage source and therefore was properly deductible as a

patronage dividend.”    Id.

     In the same vein, the Commissioner ruled in Rev. Rul.

75-228, 1975-1 C.B. 278, that the dividends received by the

taxpayer, a farmers' cooperative, from its wholly owned

Domestic International Sales Corp. (DISC), should be

classified as patronage income.        The ruling formulates the

“directly related” test to be used in classifying patronage

and nonpatronage income as follows:


          The classification of an item of income as
     from either patronage or nonpatronage sources is
     dependent upon the relationship of the activity
     generating the income to the marketing, purchas-
     ing, or service activities of the cooperative.
     Thus, if the income is produced by a transaction
     directly, connected with marketing patrons'
     products, the income is from patronage sources.
     [Rev. Rul. 75-228, supra, 1975-1 C.B. 179.]


The ruling notes that the dividends paid by the DISC were

from the selling commissions earned by the DISC from

selling the products of the taxpayer's patrons.

Accordingly, the ruling concludes that the dividend income
                           - 78 -

was produced by a transaction directly connected with

marketing patrons' products.

     The objective of distinguishing between patronage and

nonpatronage income is “bound up with the basic concept of

a cooperative”, that is, transforming the cooperative’s net

income into lower prices for its patrons.    CF Indus., Inc.

v. Commissioner, 995 F.2d 101, 103 (7th Cir. 1993),

modifying and affg. T.C. Memo. 1991-568.    In making this

determination, the courts have recognized that cooperatives

should be permitted to take the action that is reasonably

necessary under the circumstances without suffering the

loss of benefits under subchapter T.   As the court stated

in Cotter & Co. v. United States, 765 F.2d at 1110:

“Subchapter T was also not enacted to require that a

cooperative acting for its patrons function in an

economically unreasonable manner or penalize it for acting

reasonably.”

     The taxpayer in Cotter & Co. v. United States, supra,

was a nonexempt cooperative that purchased, warehoused, and

distributed products for its members, small independent

hardware retailers.   See id.   The court agreed with the

taxpayer that interest income from short-term commercial

paper and certificates of deposit purchased with

temporarily unneeded funds was properly treated as
                              - 79 -

patronage income.    According to the court, by keeping

short-term commercial paper the taxpayer was acting to

retain its liquidity in order to prepay for goods at a

discount and, thus, was “acting as any reasonable business

person”.    Id. at 1107.    The court compared the taxpayer’s

actions “to placing its funds in a bank account.”      See id.

The court also agreed with the taxpayer that rental income

from leasing temporarily excess warehouse space to tenants

should be classified as patronage income.     The court noted

that the warehouse space was rented only as part of the

taxpayer’s “plan to expand its space over its then-existing

needs” and not as apart of a separate warehouse rental

business.    Id. at 1109.    The court set forth the following

guiding principle for application of the directly related

test:

             We agree with the Claims Court that
        Congress did not intend the term "with or for
        patrons" to be "of unlimited scope, [so that]
        all income produced by cooperatives that is
        passed through to patrons would be, in essence,
        income obtained for patrons, and would,
        therefore, be considered patronage sourced."
        Cotter, 6 Cl. Ct. at 227. A cooperative cannot
        merely "clothe its shareholders as patrons and
        its corporate dividends as patronage payments"
        and retain the benefits of Subchapter T.
        Mississippi Valley, 408 F.2d at 835. But
        Subchapter T was also not enacted to require
        that a cooperative acting for its patrons
        function in an economically unreasonable manner
        or penalize it for acting reasonably. Consider-
        ing the income-generating transaction in its
        relation to all the activity undertaken to
                          - 80 -

     fulfill a cooperative function will allow courts
     to distinguish from cooperative activity
     transactions which merely enhance overall
     profitability in a manner incidental to
     cooperative function. Such activity is not to
     receive the benefits of Subchapter T, but other
     activity, which does directly relate to
     cooperative function when considered in its
     actual business environment, cannot properly be
     considered outside “business done with or for
     patrons.” Cotter’s transactions here were not
     merely to gain incidental profits; they resulted
     from activities integrally intertwined with the
     cooperative’s functions. The earnings Cotter in
     this case produced and passed through to its
     members are patronage dividends. [Id. at 1110.]


     Similarly, in Illinois Grain Corp. v. Commissioner,

87 T.C. 435 (1986), the Court agreed that rental income

from two barges that the taxpayer caused to be constructed,

leased from an insurance company, and subleased to a barge

company constituted patronage income.   The Court found that

“petitioner’s leasing and subleasing of barges to its

transportation cooperative was not an ‘investment’ in such

barges, intended to produce merely passive rental income,

but was an integral part of its overall cooperative

activity in moving its patrons’ grain to market.”      Id.

at 461.

     In derogation of the “directly related” test,

described above, respondent argues in this case that

capital gains and losses are always classified as non-

patronage without consideration of the relatedness of the
                           - 81 -

transaction to the cooperative enterprise.   Respondent

argues that section 1.1382-3(c)(2), Income Tax Regs.,

establishes this per se nonpatronage rule for capital gains

and losses.   The regulation provides as follows:


     (2) Definition. As used in this paragraph, the
     term “income derived from sources other than
     patronage” means incidental income derived from
     sources not directly related to the marketing,
     purchasing, or service activities of the
     cooperative association. For example, income
     derived from the lease of premises, from
     investment in securities, or from the sale or
     exchange of capital assets, constitutes income
     derived from sources other than patronage.
     [Sec. 1.1382-3(c)(2), Income Tax Regs.]


     This regulation is expressly applicable only to exempt

farmers' cooperatives.   However, the concept “income

derived from sources other than patronage”, is a concept

applicable to both exempt and nonexempt cooperatives, and

the Courts have applied the regulation to nonexempt

cooperatives as well as to exempt cooperatives.     See

Buckeye Countrymark, Inc. v. Commissioner, 103 T.C. at

547, 563 (1994); see also, e.g., CF Indus., Inc. v.

Commissioner, 995 F.2d 101, 102 (7th Cir. 1993), modifying

and affg. T.C. Memo. 1991-568; Cotter & Co. v. United

States, 765 F.2d 1102, 1106 (Fed. Cir. 1985); Certified

Grocers, Ltd. v. Commissioner, 88 T.C. 238, 244 n.13

(1987).   But see Gold Kist, Inc. v. Commissioner, 104 T.C.
                           - 82 -

696, 717 n.26 (1995) (declining to apply sec. 1.1382-3(b),

Income Tax Regs., to a nonexempt cooperative), revd. on

other grounds 110 F.3d 769 (11th Cir. 1997).

     Section 1.1382-3(c)(2), Income Tax Regs., defines

nonpatronage income as "incidental income derived from

sources not directly related to the marketing, purchasing,

or service activities of the cooperative association."      The

regulation then gives three examples of nonpatronage income

derived from the lease of premises, from investment in

securities, and from the sale or exchange of capital

assets.   See sec. 1.1382-3(c)(2), Income Tax Regs.

According to respondent, “by giving ‘income from the sale

or exchange of capital assets’ as an example of non-

patronage source income, Treas. Reg. section 1.1382-3(c)(2)

establishes a per se rule that the capital gains and losses

of a nonexempt cooperative are to be classified as non-

patronage source items.”   We note that in considering this

regulation, the court in CF Indus., Inc. v. Commissioner,

supra at 106, described it as “hopelessly equivocal”.

     Neither this nor any other court has ever held that

rents, dividends or interest income, or capital gains are

nonpatronage based upon a per se rule found in section

1.1382-3(c)(2), Income Tax Regs.    See, e.g., CF Indus.,

Inc. v. Commissioner, supra (interest from short-term
                            - 83 -

financial investments); Cotter & Co. v. United States, 765

F.2d 1102 (Fed. Cir. 1985) (income from rental of excess

warehouse space); Land O'Lakes v. United States, 675 F.2d

988 (8th Cir. 1982) (dividends); Illinois Grain Corp. v.

Commissioner, 87 T.C. 435 (1986) (dividends and income from

rental of barges); Dundee Citrus Growers Association v.

Commissioner, T.C. Memo. 1991-487 (interest income);

Linnton Plywood Association v. United States, 410 F. Supp.

1100 (D. Or. 1976).

     In fact, the premise of respondent's argument, that

section 1.1382-3(c)(2), Income Tax Regs., requires income

from the lease of premises, from investment in securities,

and from the sale or exchange of capital assets to be

treated as nonpatronage per se was rejected by this Court

in Illinois Grain Corp. v. Commissioner, supra 451.     In

that case, the Court noted that “the apparently clear

language of the regulation”, stating that income from the

lease of premises, from investment in securities, or from

the sale or exchange of capital assets are examples of

nonpatronage income is language that, under the law, as it

has developed, “does not always mean what it literally

says.”   Id.   The Court continued as follows:


          Thus, in the case of interest, both the
     courts and respondent have acknowledged that
     interest income may have the quality of income
                           - 84 -

     from patronage sources, depending upon the
     circumstances. Cotter & Co. v. United States,
     765 F.2d 1102 (Fed. Cir. 1985); St. Louis Bank
     for Coops. v. United States, 224 Ct. Cl. 289, 624
     F.2d 1041 (1980); Rev. Rul. 74-160, 1974-1 C.B.
     245. Dividend income has sometimes likewise been
     held to be patronage-sourced. Land O'Lakes, Inc.
     v. United States, 675 F.2d 988 (8th Cir. 1982);
     Linnton Plywood Association v. United States, 410
     F. Supp. 1100 (D. Ore. 1976); Rev. Rul. 75-228,
     1975-1 C.B. 278. Rental income has also been
     held to be patronage-sourced, on occasion.
     Cotter & Co. v. United States, supra; Rev. Rul.
     63-58, 1963-1 C.B. 109 (semble); and some capital
     gains income has been held to be income from
     patronage sources, under the circumstances
     presented in the particular case. Astoria
     Plywood Corp. v. United States, an unreported
     case (D. Ore. 1979), 43 AFTR 2d 79-1114, 79-1
     USTC par. 9197; contra Rev. Rul. 74-160, 1974-1
     C.B. 245. [Id.]


Significantly, in the last case cited above, in response to

the Government’s argument that “all capital gains are not

patronage source income,” the court stated:    “In my view,

capital gains may be patronage source income.    In each

instance, it depends on whether the income is 'directly

related’ to Astoria's activities.”    Astoria Plywood Corp.

v. United States, 43 AFTR 2d 79-1114, 79-1119, 79-1 USTC

par. 9197, at 86,349 (D. Or. 1979).

     Moreover, the Commissioner has twice ruled that in

appropriate circumstances capital gains can be classified

as patronage income.   See Rev. Rul. 74-24, 1974-1 C.B. 244;

Rev. Rul. 71-439, 1971-2 C.B. 321.    Each of those rulings

involves a nonexempt cooperative engaged in the manufacture
                           - 85 -

and sale of plywood and related wood products.    The

taxpayer in each ruling owned standing timber which had

appreciated in value and served as a source of raw material

for the taxpayer's products.   The issue was whether the

capital gains recognized by each cooperative upon cutting

the timber, pursuant to an election under section 631(a),

could be classified as patronage income.    Section 631(a)

provides an election to certain taxpayers to treat, as gain

or loss from a sale or exchange under section 1231, the

difference between the actual cost or other basis of the

timber cut during the year and its fair market value as

standing timber.   See sec. 1.631-1(a), Income Tax Regs.

In each ruling, the Commissioner took the position that the

capital gains recognized by the cooperative are properly

classified as patronage income.

     The classification of capital gains realized pursuant

to the election under section 631(a) as patronage income

was tacitly approved by this Court in Stevenson Co-Ply,

Inc. v. Commissioner, 76 T.C. 637 (1981).    That case

involved a dispute concerning the computation of the

alternative tax under section 1201(a) with respect to

section 631(a) gains.   We held that, for purposes of

computing the alternative tax, a taxpayer is entitled to
                           - 86 -

reduce its section 631(a) gains by the amounts distributed

to its stockholder employees as patronage dividends.

     The capital gains in Rev. Rul. 74-24, supra, and

Rev. Rul. 71-439, supra, are similar to the capital gain

realized from the sale of Terra stock in the instant case.

In both rulings, the Commissioner recognizes that “the gain

* * * represents the unrealized appreciation in value of

timber cut during the year”.   Rev. Rul. 74-24, supra; Rev.

Rul. 71-439, supra.   Both rulings make the point that the

actual realization of the appreciation in the value of the

standing timber would take place when the finished product

is sold.   Similarly, the gain from the sale of petitioner's

Terra stock was attributable in large measure to apprecia-

tion in the value of the oil and gas reserves held by

Terra.   If petitioner had not been forced to sell the stock

of Terra, the realization of the appreciation in Terra’s

oil and gas reserves would have taken place upon Terra’s

production and sale of oil and gas and would have been

directly related to petitioner’s business of supplying

petroleum products to its patrons.

     Respondent’s argument that capital gains and losses

must always be classified as nonpatronage income implies

that there is no transaction out of which capital gains or

losses arise that can be directly related to the
                            - 87 -

cooperative enterprise of a cooperative.   Of course, this

argument is contrary to Rev. Rul. 74-24, supra, and Rev.

Rul. 71-439, supra, in which the Commissioner ruled that

capital gains recognized by a cooperative pursuant to an

election under section 631(a) are properly classified as

patronage income.   See Rev. Rul. 74-24, supra; Rev. Rul.

71-439, supra.

     According to respondent, under the per se rule set

forth in section 1.1382-3(c)(2), all capital gains and

losses must be classified as nonpatronage.   This includes

not only gains and losses realized from the sale or other

disposition of capital assets, as defined by section 1221,

but also gains and losses from the sale or other disposi-

tion of “property used in the trade or business”, as

defined by section 1231(b).   Section 1231 governs the tax

consequences of gains and losses realized from the

disposition of depreciable property used in a trade or

business.

     Generally, the gains and losses from the sale or

exchange of section 1231 assets that are recognized during

the taxable year are netted together.   See sec. 1231(a).

If the gains exceed the losses for the taxable year, then

all of the gains and losses are treated as long-term

capital gains and losses.   See sec. 1231(a)(1).   If the
                             - 88 -

losses exceed the gains for the taxable year, then all of

the gains and losses are treated as ordinary gains and

losses.   See sec. 1231(a)(2).   Respondent argues that any

gain or loss that is treated as a capital gain or loss

under section 1231 should be classified as from

nonpatronage sources.

     As a threshold matter, respondent’s argument does not

satisfactorily explain why assets that qualify as property

used in the trade or business under section 1231(b) are

subject to a per se rule under section 1.1382-3(c)(2),

Income Tax Regs., which is formulated in terms of “income

derived * * * from sale or exchange of capital assets”.

Assets treated as “property used in the trade or business”,

as defined by section 1231(b), are excluded from the

definition of the term “capital asset”.    Sec. 1221(2).

See St. Louis Bank for Coops. v. United States, 624 F.2d

at 1053, where the Court rejects the Commissioner’s

classification of gain from the sale of a car as

nonpatronage income under section 1.1382-3(c)(2), Income

Tax Regs., and points out that the Commissioner’s treatment

was erroneous “since the car was not a capital asset under

section 1221 of the Code.”

     Respondent’s position is that, if the section 1231

gains and section 1231 losses for the taxable year are
                           - 89 -

treated as “long-term capital gains or long-term capital

losses” under section 1231(a)(1) (by reason of the fact

that the aggregate section 1231 gains exceed the aggregate

section 1231 losses for the taxable year), then each

section 1231 gain and loss realized during the year is

automatically deemed to be a nonpatronage item under the

per se rule.   On the other hand, if the section 1231 gains

and losses for the taxable year are not “treated as gains

and losses from sales or exchanges of capital assets” under

section 1231(a)(2) (by reason of the fact that the

aggregate section 1231 gains do not exceed the aggregate

section 1231 losses for the taxable year), then each

section 1231 gain and loss realized during the year is

deemed to be a patronage item under the per se rule.

Under respondent’s position, therefore, the patronage

classification of gains and losses from the sale or

exchange of property used in the trade or business is

determined by the mathematical result of the netting

process under section 1231.   It has nothing to do with

whether the property or the transactions from which the

gains or losses arose are related to the operations of the

cooperative.   This is contrary to section 1.1382-3(c)(2),

Income Tax Regs., which formulates the distinction between

patronage and nonpatronage in terms of whether the item is
                           - 90 -

“incidental income derived from sources not directly

related to the marketing, purchasing, or service activities

of the cooperative association.”

     In the event that the aggregate section 1231 gains

exceed losses for the taxable year, respondent’s position

is that the gain realized from the sale or exchange of each

section 1231 asset is automatically classified as

nonpatronage, except for the portion of the gain treated as

ordinary income under the recapture rules prescribed by

sections 1245.   According to respondent, the portion of the

gain recaptured under section 1245 is considered patronage

income “because, in effect the taxpayer is merely

recapturing income that otherwise would have been available

for distribution as a patronage dividend.”   Rev. Rul. 74-

84, 1974-1 C.B. 244.   According to respondent, the same is

true with respect to the portion of the gain recaptured

under section 1250.

     A logical inconsistency in respondent’s per se rule

arises in the case of recapture under section 1250.    This

is due to the fact that, generally, section 1250 requires

recapture only of “additional depreciation” or depreciation

in excess of straight-line depreciation.   Sec. 1250(b).

Under respondent’s position, the straight-line depreciation

taken on depreciable real property held for more than 1
                           - 91 -

year would not be recaptured as ordinary income under

section 1250 and, accordingly, would be treated as

nonpatronage income, despite the fact that it is no

different than depreciation recaptured under section 1245.

     Respondent argues that the gain realized in excess of

the portion recaptured as ordinary income under section

1245 or section 1250, is nonpatronage income, assuming that

there is a net section 1231 gain for the taxable year.

Respondent suggests that this portion of the gain is always

attributable to appreciation in the value of the section

1231 assets, “the invisible hand of the market place” and

can never be directly related to the activities of the

cooperative.   Respondent cites Astoria Plywood Corp. v.

United States, 43 AFTR 2d 79-816, 79-1 USTC par. 9197 (D.

Or. 1979), as authority for that position.   That case,

however, involved an entity that had operated for 16 years

as a for-profit corporation before becoming a cooperative.

The machinery that was sold had been used and fully

depreciated before the taxpayer became a cooperative and

it was sold in the same year the taxpayer became a

cooperative.   In that case, there was no factual basis on

which to conclude that the income from the sale of the

machinery was related in any way to the cooperative

activities of the taxpayer.   Thus, that case does not
                           - 92 -

support respondent’s argument that the realization of

appreciation is always unrelated to the activities of a

cooperative.

     Indeed, contrary to respondent’s argument,

respondent’s own rulings suggest that appreciation in the

value of an asset can be taken into account as patronage

income.   As mentioned above, in Rev. Rul. 74-24, supra, and

Rev. Rul. 71-439, supra, the Commissioner ruled that the

capital gain recognized pursuant to an election under

section 631(a) is patronage income.    In those rulings “the

gain * * * represents the unrealized appreciation in value

of timber cut during the year.”     Rev. Rul. 74-24, supra at

244; Rev. Rul. 71-439, supra at 322.     Furthermore, under

respondent’s own position, section 1231 gains attributable

to appreciation in the value of the asset will be treated

as patronage income, if there is a net section 1231 loss

for the taxable year.

     According to respondent, it is also proper to classify

section 1231 losses as from patronage sources.    Respondent

argues as follows:


     The same rationale applies to section 1231 losses
     and results in such losses being quite properly
     classified as patronage-sourced losses unless
     demonstrated otherwise. Section 1231 losses
     occur when the amount realized upon disposition
     of an asset is less than its basis as adjusted
     to reflect appreciation or other cost recovery
                           - 93 -

     mechanism deductions. The result for such a loss
     is that the cumulative effect of the business
     usage of the asset resulted in even greater
     degradation in its value than anticipated and
     provided by the depreciation or other cost
     recovery mechanism which was utilized for the
     asset. As with section 1245 or 1250 recapture,
     such a loss is logically patronage-sourced unless
     proved otherwise. The same conclusion also
     results under the operating versus nonoperating
     focus of the provisions of subchapter T since the
     loss is directly attributable to cooperative
     activities unless proven otherwise. Thus, the
     classification of section 1231 losses as
     patronage-sourced makes economic sense.


The flaw in respondent’s argument, however, is that the

classification of section 1231 gains and losses is based

upon whether there is a net section 1231 gain or loss

for the taxable year.   Thus, section 1231 losses which

respondent asserts are “logically patronage-sourced” will

be treated as nonpatronage income under respondent’s

position if there is a net section 1231 gain for the

taxable year.

     In light of the foregoing, we decline to abandon the

directly related test that has been used by this and other

courts to distinguish patronage from nonpatronage items and

to adopt respondent’s per se nonpatronage rule for capital

gains and losses.   Accordingly, in this case our task is to

determine whether each of the gains and losses at issue was

realized in a transaction that was directly related to the

cooperative enterprise, or in one which generated
                            - 94 -

incidental income that contributed to the overall

profitability of the cooperative but did not actually

facilitate the accomplishment of the cooperative’s

marketing, purchasing, or service activities on behalf of

its patrons.    See, e.g., Cotter & Co. v. United States, 765

F.2d at 1106.   This determination requires an examination

of the factual relationship between the activity producing

the gains or losses and   the cooperative’s patronage

activities.

     Respondent acknowledges that the directly related test

as formulated in Rev. Rul. 69-576, 1969-2 C.B. 166, supra,

has been adopted and applied by the courts.    However,

respondent argues that the directly related test as applied

by the courts “is an overly simplistic approach to the

question at hand.”    Respondent asks the Court to apply a

new 2-part test.    As we understand it, respondent argues

that the Court should not only determine whether the

transaction from which the subject income arose is directly

related to the cooperative enterprise, but it should also

determine whether the type of income at issue is the

“customary operating income of the cooperative.”

Respondent formulates the test as follows:


     The proper test focuses on identifying the
     regular, everyday operating activities of the
     cooperative and the anticipated ordinary profits
                          - 95 -

     therefrom and then determining whether the income
     or loss item in question was an unavoidable
     result of transaction which was an integrally
     necessary part of the regular course of those
     activities.


Under respondent’s new test, gain or loss from the sale of

an asset could never be classified as patronage income,

unless the cooperative is in the trade or business of

selling such assets.

     We agree with respondent that the normal operating

activities of a cooperative and the income realized

therefrom should be taken into account in considering

whether an item of income is patronage or nonpatronage.

However, we do not believe that an item of income is

automatically excluded from classification as patronage

income if it does not match the customary operating income

of the cooperative.


Gain from the Sale of Terra Stock and Losses from the
Liquidation of Seaway and the Surrender of Mex-Am Stock

     We disagree with respondent’s requested finding that

“the Terra, Seaway and Mex-Am, stock were investments.”

From the facts discussed above, it is evident that the

business of each of the three corporations in issue, Terra,

Seaway, and Mex-Am, was closely and directly related to

petitioner’s cooperative business of supplying petroleum

products to its patrons, and that the formation and
                           - 96 -

operation of each of the three corporations facilitated

petitioner’s cooperative enterprise.   In our view,

petitioner’s acquisition of the stock of Terra, Seaway, and

Mex-Am was no more an investment than the taxpayer’s

acquisition of the stock from which the taxpayer received

dividends in Linnton Plywood Association v. United States,

410 F. Supp. 1100 (D. Or. 1976), a case that respondent

relies upon here, no more of an investment than the stock

of the bank for cooperatives that was involved in Land

O’Lakes v. United States, 675 F.2d 988 (8th Cir. 1982), and

no more of an investment than the stock of the DISC that

was involved in Rev. Rul. 75-228, 1975-1 C.B. 278.     The

issue in those cases was whether dividends paid on the

stock should be classified as patronage income.   The issue

here is whether income from the sale of such stock should

be classified as patronage from patronage sources.


Sale of Terra Stock

     Petitioner formed Terra to explore for and produce

crude oil and natural gas for petitioner’s refineries which

used the crude oil to produce petroleum products that were

sold to petitioner’s patrons.   Petitioner sold its stock in

Terra during a time of financial distress to raise cash

necessary to reduce its debt load and restore its financial

stability.   At the time it sold its stock in Terra,
                          - 97 -

petitioner was reacting to extreme economic distress.

Petitioner was on the verge of bankruptcy caused by an

agricultural recession and large debt.   To remain in

business, petitioner needed to reduce its interest expense.

Petitioner’s primary creditor, the Wichita Bank, required

that it sell assets to reduce its debt load.   Petitioner

sold its Terra stock because it was the only asset that

could be sold quickly to raise substantial cash but it

structured the sale to retain a call on the crude oil

produced by Terra.

     We cannot find that this transaction merely enhanced

the overall profitability of the cooperative and was merely

incidental to petitioner’s cooperative operation.    In our

view, the sale of Terra was necessary for petitioner’s

continued operation, and, thus, it was directly related

to petitioner’s cooperative enterprise and actually

facilitated the accomplishment of those activities.


Disposition of Stock of Seaway and Mex-Am

     We also find that the losses petitioner realized on

the disposition of its capital stock in Seaway and Mex-Am

constitute patronage losses.   As with Terra, respondent

mischaracterizes the business relationship between

petitioner and both Seaway and Mex-Am.   Petitioner acquired

its interests in Seaway and Mex-Am in an effort to
                           - 98 -

vertically integrate its petroleum production business.

The fact that Seaway was a common carrier under Federal

law, and that there is no evidence that petitioner ever

received crude oil from Mex-Am, does not convert

petitioner’s interests in those entities to mere passive

investments.   Each corporation was organized to perform

functions that were related to petitioner’s petroleum

business.

      Petitioner’s holding of the stock of each corporation

was directly related to petitioner’s petroleum business.

Petitioner disposed of its interests in Seaway and Mex-Am

because changes in the crude oil market made those

interests unnecessary.   As with the sale of Terra stock,

the losses realized are from transactions that are directly

related to petitioner’s petroleum business.   As such, we

find that the losses realized are from patronage sources.


Gains From the Sale of Section 1231 Assets

     During the years in issue, petitioner disposed of

three groups of assets which are described in section

1231(b) as “property used in the trade or business”.

These include the Lamont gas plant, the soybean processing

facilities, and the miscellaneous section 1231 assets.

Collectively, we refer to these assets as the section 1231

assets.
                            - 99 -

Lamont Gas Plant

     At the outset, we note that petitioner reported the

gain realized from its sale of the Lamont gas plant in 1984

as ordinary income.   In the subject notice of deficiency,

respondent recharacterized the gain as a capital gain,

pursuant to section 1231.   Petitioner does not take issue

with respondent’s determination that the gain from the

sale of the Lamont gas plant is subject to section 1231.

     Petitioner purchased, operated, and expanded the

Lamont gas plant as part of its main cooperative effort of

producing petroleum-based goods for its patrons.   During

the time petitioner owned the plant, virtually all of the

natural gas liquids produced there were either sold to

petitioner’s patrons or used in producing gasoline for sale

to its patrons.

     The sale of the Lamont gas plant took place after

feasibility studies suggested that advantages would be

gained in expanding petitioner’s natural gas liquids plants

in Texas.   The bulk of the proceeds of the sale of the

Lamont gas plant went to expanding the Texas plants in

order to enable petitioner to realize those advantages for

the benefit of its patrons.   Accordingly, we find that the

gain from the sale of the Lamont gas plant was realized in
                           - 100 -

a transaction that is directly related to petitioner’s

cooperative enterprise and, therefore, is patronage income.


Soybean Processing Facilities

     Part of petitioner’s patronage activities during the

years in issue included purchasing soybeans from its

patrons and processing them into soy oil and soy meal.

Petitioner sold the soy oil to unrelated food processors

for use in products such as margarine and processed the soy

meal into livestock feed which it sold to its members.

Petitioner sold its soybean processing facilities as part

of a plan to consolidate its soybean processing operations

with those of Boone Valley and Land O’Lakes.

     The circumstances surrounding petitioner’s sale of the

soybean facilities are similar to those surrounding the

sale of the Lamont gas plant.   Petitioner sold its soybean

facilities as part of a plan to make those operations more

profitable for its patrons.   The consolidation plan was

completed in four steps:   (1) Petitioner sold its soybean

facilities to Boone Valley for $29.1 million; (2)

petitioner purchased Boone Valley’s Eagle Grove, Iowa, feed

mill for $10 million; (3) Boone Valley changed its name to

Ag Processing, Inc.; and (4) the patrons of petitioner,

Land O’Lakes, and the former Boone Valley received all of

the equity interest in Ag Processing, Inc.   The result of
                            - 101 -

these transactions was a consolidation of petitioner’s soy

processing capacity with that of Land O’Lakes and Boone

Valley.

     Petitioner agreed to the consolidation plan based on a

study it had commissioned on methods of improving its

soybean processing efficiency and maximizing savings to

patrons.   In a letter to petitioner’s members printed in

its 1983 annual report, Mr. Kenneth Nielson, petitioner’s

president at the time, and Mr. Francis Gwin, chairman of

petitioner’s board of directors, described the

consolidation as follows:


          [The consolidation plan] will be a good
     thing for farmers, eliminating some of the
     duplication of efforts and creating a stronger
     cooperative soy processing entity to improve
     producers’ return.


Petitioner’s 1983 annual report further describes the

reasons for the consolidation as follows:


          Although its own plants are well-located
     geographically and operationally, to compete with
     industry, Farmland took a leadership role in the
     unification study. President Ken Nielson said
     the unification plan would eliminate duplication
     of some farmer-owned facilities and services and
     create a new organization of a size better able
     to compete to farmers' economic benefit.

          At year end Farmland’s soy operations joined
     those of Land O’Lakes and Boone Valley in the
     newly unified Boone Valley cooperative Processing
                           - 102 -

     Association (a new name is to be later selected),
     headquartered in Omaha, Neb.


     The purpose of the consolidation plan was to serve

patrons better.   Petitioner entered into the transaction

because it believed it could process its members’ soybeans

less expensively after the consolidation.   As such, we find

that petitioner’s sale of the soybean facilities was

directly related to its patronage activities of producing

soybean products for its patrons.


Miscellaneous Section 1231 Assets

     In 1983, petitioner disposed of approximately 525

miscellaneous depreciable assets used in its business.

These included tractors and other vehicles, livestock,

buildings, office furniture, and office equipment.    The

assets in question were miscellaneous depreciable assets

used in the operation of petitioner’s business.   Petitioner

disposed of the assets in the ordinary course of business

when they became obsolete or were no longer useful.

     Petitioner’s sales of the miscellaneous section 1231

assets in this case is similar to the taxpayer’s sale of an

automobile in St. Louis Bank for Coops. v. United States,

224 Ct. Cl. 289, 624 F.2d 1041, 1050 (1980).   In that case,

the taxpayer sold the automobile after it was fully

depreciated and purchased a new one.   In holding that the
                          - 103 -

gain on the sale of the automobile was patronage income,

the court stated:


          The gain on the sale of the automobile was
     patronage-sourced because * * * it was “directly
     related” to the plaintiff’s normal activities.
     The automobile was one of three used in the
     plaintiff’s business, and the cost of operating
     it, including depreciation, was treated as an
     expense of serving plaintiff’s patrons. The
     sale of the car when it was no longer needed
     for plaintiff’s business, was closely related
     to and stemmed from the prior use of the car.
     Depreciable assets used in a business were out
     and become obsolete, and when that happens,
     frequently they are sold or traded in for a
     replacement. * * * [St. Louis Bank for
     Cooperatives v. United States, 624 F.2d at
     1053-1054.]


We believe that the sale of the miscellaneous assets in

this case was closely related to and stemmed from their use

in petitioner’s cooperative enterprise of providing

petroleum products to its patrons.   Accordingly, we find

that petitioner’s sales of the subject assets were directly

related to its patronage activities of supplying products

to and marketing products for its members.   We therefore

find that the subject gain can be classified as from

patronage sources.

     A final note is necessary.   As mentioned above,

petitioner argues, if we adopt respondent’s per se rule,

then the stock of Terra, Seaway, and Am-Mex were noncapital

assets in its hands “under case law ‘surrogacy’, ‘source of
                            - 104 -

supply’, and ‘hedging’ principles” and not subject to the

hedging regulations, section 1.1221-2, Income Tax Regs.

Petitioner’s brief makes it clear that the Court need not

consider that argument if we do not adopt respondent’s per

se rule.    Accordingly, we have not addressed that argument.

Similarly, as mentioned above, petitioner argues, if we

hold that the gains from the sale of Terra stock and the

section 1231 assets are nonpatronage items, then those

gains may nevertheless be offset by petitioner’s patronage

losses.    We have not addressed that argument.

     In light of the foregoing, and to reflect previously

determined issues,


                                Decision will be entered

                           under Rule 155 and an order will

                           be issued denying respondent’s

                           motion for summary judgment.
