distributions of corporate earnings, and a double tax on the net margins of cooperatives based upon a corporate dividend analogy is not justified. Taxpayers other than cooperatives may exclude or deduct refunds based on patronage in computing their taxable income."

It is theoretically possible for a group of farmers to contribute capital to a corporation in the same proportions as their anticipated patronage and then to obtain the economic benefit of the corporation at cost (either by setting its initial prices at cost or by paying patronage refunds), rewarding the corporation with no profit in return for the value added by its operations, and receiving no direct return on their capital investments. But is this a situation which calls for imposition of a corporate tax based on an assumed rate of profit? Other businesses can use this device without taxable income being imputed to the corporation providing the service, and there would seem to be no basis for discriminating against cooperatives. Certainly where the facilities of the cooperative are made available to nonmember patrons at the same prices and with the same patronage refunds, so that the economic value added by the capital investment of the members is shared with nonmembers, it would not seem necessary or advisable to tax the cooperative on imputed income (whether or not equivalent to its patronage refunds) to prevent use of the cooperative's facilities at cost to avoid corporate tax on its profits. Denial of the exclusion or deduction of patronage refunds paid is. not necessary to overcome a competitive advantage of cooperatives over ordinary, taxable businesses. A cooperative which excludes patronage refunds paid in computing its gross income has no tax advantage by reason of such exclusion. An ordinary taxpayer may achieve the same tax result either by paying patronage refunds on his business or by adjusting the prices he charges. Assuming the same volume and the same costs, a taxable purchasing cooperative pays the same amount of income tax under present law, after exclusion of patronage refunds paid, as does an ordinary corporation which reduces the prices it charges its customers to the same level as these paid by the cooperative's customers, net after receipt of their patronage refunds.

TIMING OF EXCLUSION (OR DEDUCTION) BY THE COOPERATIVE AND INCLUSION IN THE INCOME OF THE PATRON

All of the foregoing analysis deals with patronage refunds actually paid. The same conclusions are by no means true in the case of Cooperatives which retain the amounts set up on their books as patronage refunds and give their members or other patrons certificates of equity or of indebtedness or merely allocate credits to their accounts. It would be incorrect to apply the foregoing analysis to patronage refunds not paid in cash.

Statistics are not available on the net margins of consumer cooperatives. However, since their estimated total volume of business is minor in comparison with that of the farm cooperatives ($170 million compared with $10.4 billion in 1957, or less than 2 percent)

5 I.T. 3633, C.B. 1944, p. 89.

Smith-Bridgman & Co., 16 T.C. 287 (1951).

Fact Book on Cooperatives With 1957-58 Developments," op. cit., p. 22.

8 "Statistics of Farm Cooperatives, 1956-57," by Anne L. Gessner, U.S. Department of Agriculture (1959), p. 1.

it is not likely that their net margins, before or after patronage refunds, are significant for tax revenue purposes. Consequently, figures on net margins and retained earnings will be discussed in terms of farm cooperatives alone, with the assumption that variations by the consumer cooperatives could not be large enough to change the total picture.

In 1954, total volume of business of 9,793 farm cooperatives was estimated at $8.5 billion, and net margins available for dividends or for distribution or allocation to members were estimated at $275 million (net after eliminating intercooperative duplications). A study of a sample of 1,157 farm cooperatives which accounted for $132 million of the net margins, or almost one-half, showed the following disposition of the net margins:

Cash patronage refunds_.

Allocated to the credit of members_
Dividends on common stock__
Dividends on preferred stock_.

Interest on other equity capital_
Unallocated reserves--

Federal and State income taxes_

Total

10

Percent

27.8

57.8

2.8

3.0

.6

2. 4

5.6

100.0

Only 22 percent of the amounts allocated to the credit of members was interest bearing.

Allocated but retained net margins are significant in proportion to other sources of equity capital as well as in proportion to other dispositions of net margins. In 1954, 60.75 percent of the equity capital of the 1,157 cooperatives studied came from patronage refunds which were allocated but retained by the cooperatives.11

The use of allocated but retained patronage refunds as a method of equity financing is frequently coordinated with a revolving fund plan. That is, the allocated but retained patronage refunds are treated as contributions by the patrons to a revolving fund. While revolving fund contributions may have fixed terms, generally the time for their retirement is determined at the discretion of the governing body of the cooperative. The oldest outstanding revolving fund contributions are retired first. Based on its survey of 1,157 cooperatives, the Department of Agriculture estimated total revolving fund capital of 9,793 farm cooperatives at $1,191 million.12 In 1949, the 1,157 cooperatives studied had $313 million of revolving fund capital. During the next 5 years $357 million was added and $159 million was paid out, leaving a balance of $510 million at the close of the fiscal year 1954,13 or a net increase of $197 million.

The interest of patrons in allocated but retained net margins of cooperatives may be evidenced in a number of different ways. The patrons may be given common or preferred stock or revolving fund certificates. They may have book credits allocated to their account, or portions of reserves of the cooperative may be allocated to them. Rights to these retained patronage refunds may vary widely in terms

"Methods of Financing Farmer Cooperatives," U.S. Department of Agriculture (1957), 10 Ibid., table 24, p. 35.

p. 34.

11 Ibid., fig. 4, p. 15.

12 Ibid., p. 39.

13 Ibid., p. 41.

of voting rights, transferability, rate of return (if any), and duration (frequently not specified). In the case of credits allocated to the patron's account, the patron receives no tangible evidence of the retained patronage refund except a letter advising him of the credit. Prior to enactment of the Revenue Act of 1951 it was the position of organizations representing the cooperatives that under existing law the cooperatives were entitled to exclude from their gross income the portions of their net margins which were allocated to members and other patrons, even though not paid in cash at that time, and that the members and other patrons were required to take these allocated amounts into account for tax purposes at their face amounts when allocated (except, of course, for patronage refunds allocated on personal transactions). In theory, the retained patronage refunds would be treated as if they had actually been paid out to the patrons and as though the patrons had, in turn, contributed the amounts represented by the patronage refunds back to the cooperatives in return for stock, revolving fund certificates, credits allocated to their accounts, etc.14

The decisions made by Congress when the tax treatment of cooperatives was before it in 1951 were based on the assumption that this interpretation of the law was correct. In describing its recommended changes in the farm cooperative exemption the report of the Senate Committee on Finance on the Revenue Act of 1951 said:

As a result of this action [changes in the treatment of exempt cooperatives], all earnings or net margins of cooperatives will be taxable either to the cooperative, its patrons, or its stockholders with the exception of amounts which are paid or allocated to patrons on the basis of purchases of personal, rather than business, expense items.15

The Internal Revenue Service likewise took the position that cooperatives were entitled to exclude from gross income patronage refunds allocated to patrons but retained by the cooperatives and that, unless patronage refunds related to personal transactions, the patrons were required to take such patronage refunds into account at their face amount when the allocation was made.16

17

The right under present law to exclude from income net margins which were allocated as patronage refunds but retained by the cooperative has not been changed. Since 1959, however, the courts have held that patron-members are not required to take allocated but unpaid patronage refunds into account at their face amount unless they have a fair market value equal to their face amount.18

As a result of these decisions, the Internal Revenue Service was forced to change its position on the taxability of patronage refunds not paid in cash. Consequently, on March 11, 1959, the Service published proposed amendments to the regulations under both the 1939 code and the 1959 code which would limit the taxability of noncash patronage refunds to the fair market value of the stock certificate, revolving fund certificate, letter of advice, or similar document evidencing the patron's interest in the retained net margin.19

14 Hearings before the Committee on Ways and Means, "Revenue Revision of 1950," testimony of Karl D. Loos, vol. II, pp. 2172-2174.

15 S. Rept. 781, 82d Cong., 1st sess., p. 21.

16 Regs. 118, sec. 39.22 (a)-23 and Reg. sec. 1.61-5 (as adopted Nov. 25, 1957).

17 Colony Farms Cooperative Dairy, Inc., 17 T.C. 688 (1951).

18 Long Poultry Farms, Inc. v. Comm., 249 F. (2d) 726 (CA 4th, 1957), and Comm. v. B. A. Carpenter, 219 F. (2d) 635 (CA 5th. 1955)

19 Federal Register, Mar. 11, 1959, pp. 1750-1753.

The result has been to create a hiatus in the tax treatment of allocated but retained net margins of cooperatives. The cooperative excludes or deducts the portion of its net margins which it allocates to patrons, but the member or other patron is not taxable at that time on more than the fair market value of the documentary evidence he receives of his interest in the retained net margins. Since the patron's interest in the retained net margins may be nontransferable, noninterest bearing, and redeemable at the discretion of the cooperative, it frequently has no market value when received. The result is that no tax will be paid by either the cooperative or the patron until the patron's interest in the retained net margin is redeemed for cash. This tax deferment will frequently be for an indefinite number of years. Meanwhile the net margins (which are admittedly income) are available for reinvestment and expansion of the cooperative's business without being diminished by Federal income tax either in the hands of the cooperative or in the hands of the patron.

Under these circumstances the cooperatives have a definite competitive advantage over their fully taxable competitors-an advantage created by a gap in the tax system. It is a gap which was not contemplated by Congress or by the cooperatives themselves up to the time of enactment of the Revenue Act of 1951. In the light of this background it is disappointing that the cooperatives have not pressed more vigorously for prompt and complete closing of this gap between the tax treatment of the cooperatives and the tax treatment of the patrons.

The Secretary of the Treasury has suggested that Congress consider legislation which would limit the tax-free retention of income by the cooperatives to 3 years by permitting cooperatives to deduct the face amount of patronage refund certificates bearing interest of at least 4 percent and redeemable in cash within 3 years.20 Although this proposal would have left the cooperatives and their patrons with a distinct tax advantage over the remainder of the economy, it is understood that it is opposed by the cooperatives.

The Treasury proposal made last January cannot be considered a solution. It is more in the nature of a modification of an admittedly unfair situation. While Congress may well consider whether the cooperative or the patron is to be taxed when the net margins are earned, it is submitted that there is no justifiable alternative to the imposition of at least one tax on the full amount of the net margin for the year in which it is earned. The Treasury proposal would not accomplish this.

The most important point in determining, first, the proper timing for the exclusion or deduction of patronage refunds by cooperatives and, second, their taxation to the recipient is that both events should occur at the same time. If a statutory rule is adopted which is consistent with this principle, the question of precisely when these two events are deemed to occur is not vital.

The best rule would be to defer the exclusion or deduction by the cooperative until the patronage refund is paid in cash (or its equivalent in merchandise) and, likewise, to defer taxing the member or

20 Jan. 19. 1959, letter by Robert B. Anderson, Secretary of the Treasury, to the chairman of the Committee on Ways and Means.

other patron until he receives cash. Such a rule would not require the patron to use funds from other sources to pay the tax. Furthermore, it would make the cooperative taxable on increases in its retained and reinvested net margins and thus remove the competitive advantage over other taxpayers which is a result of the present capacity of the cooperatives to expand out of earnings retained tax free. Certainly it would be fairer to nonmember patrons who have no voice in setting the cooperative's policy as to the portion of the net margins to be allocated but retained or as to when the retained net margins are to be paid out in cash.

It is not suggested that the right to deduct a patronage refund should be lost forever by failure to pay it in cash in the year in which the net margin was earned. Instead, patronage refunds would be deductible by a cooperative in the year in which paid in cash-deductible against the net margins of the year of such payment. For example, if a patron is given a revolving fund certificate with a face amount equal to his interest in the net margin for 1960, the cooperative will not exclude that amount in determining its gross income for 1960, but it will deduct an amount equal to the cash used to pay off the certificate in say, 1965, and the patron will include the cash received in his gross income for 1965.

An alternative-less desirable, but considerably better than the present situation-would be to provide explicitly by statute that patrons are to be taxable on patronage refunds in the year in which they are allocated by the cooperative, regardless of the market value of the interests in the patronage refunds which the patrons receive at that time. In between these two alternatives, Congress might prescribe certain types of documentary evidence of interests in net margins which would qualify for exclusion by the cooperatives and be taxable at the same time in the hands of the patrons, imposing standards of transferability, term, and rate of return.

TAX COMPLIANCE BY PATRONS

The degree of noncompliance by members and other patrons with tax reporting requirements for taxable patronage refunds has been obscured by the legal dispute over the inclusion of noncash patronage refunds. It is reasonable to suppose that many patrons failed to report the face amount of revolving fund certificates and other similar documents evidencing an interest in retained net margins, but this is not noncompliance in the usual sense of the word since these patrons have been vindicated by the court decisions holding that patronage refunds are not includible if they have no market value.2

21

Fred C. Scribner, Jr., Under Secretary of the Treasury, has said that a recent Treasury study indicates a gap in 1956 between ordinary corporate dividends paid to individuals and those reported on individual tax returns of approximately $1.4 billion, or 14 percent of the amount which should have been reported. He also stated that it has been estimated that in 1956 less than one-half the interest received by individuals was reported by them on their tax returns.22 Figures are

21 Long Poultry Farms, Inc. v. Comm., op. cit., and Comm. v. B. A. Carpenter, op. cit. 22 Remarks by Fred C. Scribner, Jr., at the 42d Annual Convention of the Savings Bank Association of Massachusetts, Portsmouth, N.H., Sept. 19, 1959.