Income Taxes

Except as hereinafter noted, since 1926 93 the following provisions, quoted from the Internal Revenue Code,94 have appeared in Federal income tax statutes:

The following organizations shall be exempt from taxation under this chapter

(12) Farmers', fruit growers', or like associations organized and operated on a cooperative basis (a) for the purpose of marketing the products of members or other producers, and turning back to them the proceeds of sales, less the necessary marketing expenses, on the basis of either the quantity or the value of the products furnished by them, or (b) for the purpose of purchasing supplies and equipment for the use of members or other persons, and turning over such supplies and equipment to them at actual cost, plus necessary expenses. Exemption shall not be denied any such association because it has capital stock, if the dividend rate of such stock is fixed at not to exceed the legal rate of interest in the State of incorporation or 8 per centum per annum, whichever is greater, on the value of the consideration for which the stock was issued and if substantially all such stock (other than nonvoting preferred stock, the owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the association, upon dissolution or otherwise, beyond the fixed dividends) is owned by producers who market their products or purchase their supplies and equipment through the association; nor shall exemption be denied any such association because there is accumulated and maintained by it a reserve required by State law or a reasonable reserve for any necessary purpose. Such an association may market the products of nonmembers in an amount the value of which does not exceed the value of the products marketed for members, and may purchase supplies and equipment for nonmembers in an amount the value of which does not exceed the value of the supplies and equipment purchased for members, provided the value of the purchases made for persons who are neither members nor producers does not exceed 15 per centum of the value of all its purchases. Business done for the United States or any of its agencies shall be disregarded in determining the right to exemption under this paragraph;95

(13) Corporations organized by an association exempt under the provisions of paragraph (12), or members thereof, for the purpose of financing the ordinary crop operations of such members or other producers, and operated in conjunction with such association. Exemption shall not be denied any such corporation because it has capital stock, if the dividend rate of such stock is fixed at not to exceed the legal rate of interest in the State of incorporation or 8 per centum per annum, whichever is greater, on the value of the consideration for which the stock was issued, and if substantially all such stock (other than nonvoting preferred stock, the owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the corporation, upon dissolution or otherwise, beyond the fixed dividends) is owned by such association, or members thereof; nor shall exemption be denied any such corporation because

93 44 Stat. 9, 40; 26 U. S. C. A. 101.

94 753 Stat. 4, 53; 26 U. S. C. A. 101.

95 The statement last made was added in 1934. See 48 Stat. 680, 701.

there is accumulated and maintained by it a reserve required by State law or a reasonable reserve for any necessary purpose;

It is clear that Congress has the right to exempt agricultural cooperatives from the payment of Federal income taxes.96

An analysis of the provisions of paragraph (12) quoted above shows that for a cooperative marketing or purchasing association of farmers, or an association engaged in both activities, to be exempt. from liability for the payment of Federal income taxes, the association (a) must be organized and operated on a cooperative basis by farmers; (b) must be formed for the purpose of marketing the products of members or other producers and turning back to them the proceeds of sales, less the necessary marketing expenses, on the basis of either the quantity or the value of the products furnished by them, or for the purpose of purchasing supplies or equipment for the use of members or other persons and turning over such supplies and equipment to them at actual cost, plus necessary expenses; (c) if organized with capital stock "substantially all such stock (other than nonvoting preferred stock, the owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the association, upon dissolution or otherwise, beyond the fixed dividends)"9 must be owned "by producers who market their products or purchase their supplies and equipment through the association"; (d) in fixing a dividend on such stock, it may not exceed the legal rate of interest in the State of incorporation or 8 percent per annum, whichever is greater, on the value of the consideration for which the stock was issued; (e) may accumulate and maintain only reserves that are required by State law, or that are reasonable reserves for a necessary purpose; (f) must treat member and nonmember patrons alike in business dealings; (g) must operate so that the value of the products marketed for nonmembers will not exceed that of products marketed for members and so that the value of the supplies and equipment purchased for nonmembers will not exceed the value of the supplies and equipment purchased for members, provided that the value of the purchases made for persons who are neither members nor producers shall not exceed 15 percent of the value of all its purchases.

The term "like association" as used in the quotation from the statute has been construed by the Bureau of Internal Revenue to

98 Flint v. Stone Tracy Company, 220 U. S. 107, 173, 31 S. Ct. 342, 55 L. Ed. 389; Brushaber v. Union Pacific Railroad Company, 240 U. S. 1, 36 S. Ct. 236, 60 L. Ed. 493, Stanton v. Baltic Mining Co., 240 U. S. 103, 36 S. Ct. 278, 60 L. Ed. 546. "See In re Temtor Corn & Fruit Products Co., 299 F. 326; Schlafly v. United States, 4 F. 2d 195.

402026°-42—17

include a farmers' cooperative organized to establish and operate a roadside or farmers' market for its members.98

The expression "like associations" by reason of its association with the words "farmers" and "fruit growers" is limited by them and refers only to associations of farmers or others engaged in like occupations.99

If an association is not actually organized so as to meet the requirements for exemption, it is ineligible therefor. In a certain case decided by the Board of Tax Appeals, it was said:1

The undisputed proof in this case shows that at least 30 percent of the profit realized by the petitioner from the operation of its elevator department was from nonstockholders to whom it did not and could not turn back anything other than the original price paid them for their grain, which was the market price.

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The petitioner's case is not strengthened by the fact that up to the end of the year 1928 it had not paid any patronage dividends with the exception of certain patronage dividends in the form of shares of stock upon the business of 1918. The simple fact is that the petitioner was not in 1928 organized to come within the exempting provisions of the statute.

In another case decided by the Board of Tax Appeals, the Board declared: 2

In our opinion the petitioner has failed to prove that any of the members are producers or producers' marketing agents within the meaning of the statutory provisions granting tax exemption to farmers' cooperatives.

The Bureau of Internal Revenue has construed the exemption provision previously quoted to include associations which take title to farm products as well as those which act strictly on an agency basis. In addition, the statutory language has been construed to include associations which process products by changing the form of the raw materials furnished by their producer members.3

It is the powers that are exercised by an association and not those possessed which are of controlling importance in determining its right to exemption.3a

98 I. T. 2720, C. B. XII-2, 71.

99

'C. B. X-1, 150; Garden Homes Company v. Commissioner of Internal Revenue, 26 B. T. A. 441, reversed in 64 Fed. 2d 593.

1

1 Farmers Union Cooperative Company v. Commissioner of Internal Revenue, 33 B. T. A. 225, 229, affirmed in 90 F. 2d 488. See also Council Bluffs Grape Growers Ass'n v. Commissioner of Internal Revenue, 44 B. T. A. 152.

2 Co-operative Central Exchange v. Commissioner of Internal Revenue, 27

B. T. A. 17, 20.

8 C. B. X-2, 164.

3a CB III-1, 287; Eugene Fruit Growers Association v. Commissioner of Internal Revenue, 37 B. T. A. 993.

For an association which is engaged in the marketing of farm products and in the purchasing of supplies and equipment to be exempt, it must with respect to each of these functions meet the requirements for exemption.*

Substantially all of the voting stock of an association must be "owned by producers who market their products or purchase their supplies and equipment through the association." The Bureau of Internal Revenue has said: 5

It is impracticable to attempt to define the term "substantially all" as used in the statutes under discussion for the reason that what constitutes substantially all of the capital stock of a cooperative marketing association is a question of fact, which must be decided in the light of the circumstances surrounding each particular case. Any ownership of stock by other than actual producers must be explained by the association. The association will be required to show that the ownership of its capital stock has been restricted as far as possible to actual producers who market their products through the association. However, if by statutory requirement the officers of an association must be shareholders, the ownership of a share of stock by a nonproducer to qualify him as an officer will not destroy the association's exemption; or if a shareholder for any reason ceases to be a producer and the association is unable, because of a constitutional inhibition or other reason beyond the control of the association, to purchase or retire the stock of such nonproducer, the fact that under such circumstances a small amount of the outstanding capital stock is owned by shareholders who are no longer producers will not destroy the exemption. On the other hand, where a substantial part of the stock was voluntarily sold to nonproducers, exemption must, under the statute, be denied as long as such stock is so held.

Where it appeared not only that 12 percent of the outstanding common stock of a marketing association was held by nonproducers but also that over 9 percent of such outstanding common stock was voluntarily sold or issued to persons who were not farmers or producers, "substantially all" the common stock was not owned by producers and the association was not entitled to exemption.

In a certain case the Board of Tax Appeals said:"

Of the 213 shares outstanding in 1925, 194, or 91 percent, were held by persons who were producing owners either directly or on a crop-share basis. Nineteen were owned by persons who were not producers during that year, but of these nineteen individuals seven had been producers when the stock was acquired and one was the widow of a former producer. Of the 194 shares 167, or 79 percent, were held by operating farmers and 27 by persons who operated their farms by tenant farmers and received a crop share (including dairy products).

In view of these facts, the Board held that "substantially all" of the voting stock of the corporation was held by producers.

'C. B. X-2, 164, 167.

5 C. B. X-2, 164.

6 C. B. V-2, 71.

Farmers Co-operative Creamery v. Commissioner of Internal Revenue, 21

B. T. A. 265,

The Board of Tax Appeals has held that: 8

the farm owner who operates his farm by tenants on a crop-sharing basis is entitled to be called a producer. He risks his capital, furnishes seed and takes his chances on profits in much the same manner as he would were he to hire the work done for wages.

Dividends on capital stock may not, if an association is to be eligible for exemption, be fixed at a rate exceeding 8 percent per annum, or the legal rate of interest in the State of incorporation, whichever is higher. In this connection the following quotation is applicable:9

Admittedly, in this case $27,140 of the outstanding capital stock of $45,680 was issued as stock dividends and the shareholders paid nothing therefor. This fact alone bars the petitioner from claiming exemption from income tax; for after the declaration of the stock dividends, the stockholders were receiving from 12 to 18 percent per annum on the amounts invested by them.

It should be noted that the dividends referred to in the foregoing quotation were stock and not patronage dividends.

It is understood that under the practice of the Bureau of Internal Revenue, if an association is unable to pay a dividend in one year, there is no objection to the difference being made up in the next or succeeding years provided the amount of such payments does not exceed the aggregate that might be paid for the number of years in question.

The accumulation and maintenance of a reserve required by State statute, or the accumulation and maintenance of a reasonable reserve or surplus for any necessary purpose, such as to provide for the erection of buildings and facilities required in business or for the purchase and installment of machinery and equipment or to retire indebtedness incurred for such purposes, will not destroy the exemption.10

It is apparent that reserves may be accumulated for what are essentially capital purposes. No reason is apparent why an association may not accumulate reserves for any necessary purpose, provided they are reasonable in amount; and, of course, there is no question but that an association may accumulate reserves which are required by State law. If reserves, other than those required by State statute, are regarded as excessive, this will operate to cause an association to lose its exemption. The reserves which are referred to in the statute include so-called valuation reserves which are made, among other things, for the purpose of meeting depreciation and obsolescence on

Farmers Co-operative Creamery v. Commissioner of Internal Revenue, 21 B. T. A. 265.

9 Farmers Mutual Cooperative Creamery v. Commissioner of Internal Revenue, 33 B. T. A. 117, 125. See also South Carolina Produce Ass'n v. Commis sioner of Internal Revenue, 50 F. 2d 742.

10 United States Bureau of Internal Revenue, Regulations 103, Income Tax, sec. 19.101 (12)−1, 237, 238.