not available on the extent to which taxpayers have failed to report taxable patronage refunds, but the foregoing figures on the reporting behavior of individuals in similar areas are sufficient to indicate that a problem probably exists in the case of patronage refunds as well. A compliance problem of sizable proportions may be anticipated if Congress closes the gap in the present tax treatment of patronage refunds by requiring patrons to report the face amount when received of all evidences of interests in net margins which are retained by the cooperatives.

Tax withholding on patronage refunds on a basis similar to wage withholding offers a fair and practical solution to the problem of compliance by members and other patrons with the tax reporting requirements. Withholding should be at the basic 20 percent rate. Withholding at this rate has a great advantage in terms of administrative simplicity because the recipient of the patronage refund can determine the gross amount of the refund for inclusion in income simply by adding one-fourth of the net amount received after withholding.

The suggested tax withholding would apply to all patronage refunds excludable or deductible by the cooperative in computing its taxable income, other than patronage refunds paid to other cooperatives. Withholding should not be required, however, by purchasing cooperatives most of whose patronage is for personal, nondeductible

uses.

If Congress follows the suggestion of the farm cooperatives that patrons be required to include in income the face amount of allocated but retained net margins, withholding will be particularly important, both in assisting with a difficult compliance problem and in providing a means whereby the patrons can pay at least the basic tax rate on the noncash patronage refunds.

An objection raised against withholding on interest and on corporate dividends was that it would deprive tax-exempt organizations, such as colleges with endowment funds, of the use of the withheld portion of their investment income. Withholding on patronage refunds would not be subject to this objection to any substantial extent. The administrative problems and the hardships on nontaxable recipients would be no greater in the case of tax withholding on patronage refunds than in the case of tax withholding on wages and salaries.

INCOME FROM OUTSIDE SOURCES

In addition to their business of marketing the products of members and other patrons, and in addition to their business of purchasing for resale to members and other patrons, cooperatives may have other earnings from outside sources. This outside source income may include rental income and warehouse charges and other service charges. If nonmember patrons are not entitled to patronage refunds, the net margin earned by the cooperative on nonmember business is also outside source income. A big item of outside source income for farm cooperatives is income received for services performed for the Federal Government in connection with the Government's farm surplus programs.23

23 See Rev. Rul. 59-107, I.R.B. 1959-14, p. 17.

Distributions of this outside source income to members cannot be considered patronage refunds. While the distributions might be proportionate to patronage, they are not refunds of amounts arising from members' patronage. Consequently, there is no basis for treating distributions by cooperatives of income from outside sources any differently from distributions of earnings by other corporations. Since these amounts are not patronage refunds, they should not be excluded or deducted in computing gross income from business with patrons but should be included in full in computing the taxable income of the cooperatives. 24

As was pointed out earlier, since they are dividend distributions of corporate earnings, distributions of income from outside sources to members should be included in the gross income of the recipients even though they may be calculated as a percentage of patronage which related to personal rather than to business uses. Distributions by cooperatives of income from outside sources to nonmember patrons in proportion to their patronage should be treated by the nonmember patrons in the same manner as ordinary patronage refunds-i.e., as adjustments to the price of the items sold to, or purchased from, the cooperative. The source of funds used to pay refunds based on patronage should not be pertinent as far as the nonmember patron is concerned.

EXEMPTION OF FARM COOPERATIVES

The line between exempt farm cooperatives and nonexempt farm cooperatives under present law is a very thin one-both in terms of the types of cooperatives eligible for exemption and in terms of the treatment accorded cooperatives which qualify for exemption. Essentially, exemption under section 521 of the 1954 code permits a farm cooperative to realize tax free an amount sufficient to pay dividends to its shareholders and to avoid tax on income from outside sources which is distributed in proportion to patronage.

Congressional policy toward the tax exemption for farm cooperatives must be determined by weighing the public interest in encouraging the expansion of farm cooperatives on the one hand against revenue needs and the principle of equality of tax treatment on the other hand. The burden of proof of the need for exemption should be on the proponents of exemption. Furthermore, the burden of proof should be a continuous one. That is, exemption should be justified each year in terms of the current tax rates, in terms of the current revenue cost, and in terms of the continuing need for special encouragement.

Applying these standards to the present situation, it is recommended that the present limited exemption of farm cooperatives be eliminated. While farm cooperatives are desirable institutions, they operate directly for the material benefit of their members and other patrons rather than for the good of society as a whole, and a case has not been made for burdening the nonfarm sector of our economy with additional taxes by reason of their exemption. Particularly, it has not been shown that the benefits of an exemption of farm cooperatives would accrue primarily to the low-income farmers and farm

24 Fruit Growers' Supply Co. v. Comm., 56 F. (2d) 90 (CCA 9th, 1932).

workers and the farmers on marginal lands, which the Federal Government might have a special interest in helping.

SUMMARY

In summary, the following Federal income tax treatment is recommended for consumer and farm cooperatives and their patrons:

1. No tax should be imposed on the receipt of patronage refunds on purchases for personal use.

2. Cooperatives should be permitted to exclude or deduct patronage refunds.

3. There should be no gap between the time patronage refunds aro excluded or deducted by the cooperative and the time they are reported as income by the patrons.

4. Patronage refunds should be excluded or deducted by cooperatives and reported as income by patrons when they are distributed in cash.

5. Farm cooperatives should be required to withhold tax at the rate of 20 percent from patronage refunds.

6. Cooperatives should be taxable as ordinary corporations on their income from outside sources.

7. The exemption of farm cooperatives should be eliminated.

TAXATION OF COOPERATIVES

William C. Warren

Under the Internal Revenue Code of 1954, cooperatives fall into two classes. The first category consists of "exempt" farmers' cooperatives which meet the requirements of section 521. All other cooperatives are in the remaining class.

The statutory reference to "exempt" farmers' cooperatives is actu-. ally something of a misnomer, since even these cooperatives are subject to the corporate income tax. However, the so-called "exempt" cooperatives receive the benefit of certain special deductions which are not allowed to corporate taxpayers generally. An "exempt" cooperative is permitted, in computing its taxable income, to deduct amounts paid as dividends on its capital stock and amounts allocated to patrons out of its nonpatronage income (e.g., gains from the sale of property used in trade or business).2 Amounts allocated to patrons from patronage income are not in terms deductible, but these amounts are instead excluded from the gross income of the cooperative, so that the same net result is accomplished.3

The special tax benefits attaching to amounts allocated to patrons, whether by way of deduction or exclusion, are not conditioned upon any actual distribution of these amounts to the patrons. All that is required is that these amounts be credited to the account of the patron,* and eventual payment may be entirely at the discretion of the board of directors. Since mere allocation to a patron's account renders nontaxable any item which would otherwise be subject to tax, cooperatives which qualify under section 521 are, in effect, taxable only on unallocated reserves. As a practical matter, therefore, these cooperatives are virtually exempt from tax, whether they distribute or retain their earnings.

The Internal Revenue Code does not expressly grant tax exemption or other special tax benefits to cooperatives which do not qualify under section 521. Since 1914, however, the Treasury Department and the Internal Revenue Service have taken the position that the allocation of patronage dividends by any cooperative reduces its gross. income, whether or not the dividends are actually distributed. Congressional approval of this position may be implied from section

1 I.R.C., sec. 522(a).

2 I.R.C., sec. 522(b) (1).

3 I.R.C., sec. 522(b) (2); Reg., sec. 1.522-3 (a).

4 I.R.C., sec. 522(b) (1) and (2).

5 According to a survey conducted in 1957 by the Farmer Cooperative Service, 936 of the 1,157 associations considered had some portion of equity capital in the form of allocated book credits without maturity dates. Credits of this nature accounted for more than 39 percent of the total equity capital employed. "Methods of Financing Farmer Cooperatives," Farmer Cooperative Service, General Report 32, at 9 (June 1957). A large portion of these allocated credits consisted of revolving funds. According to the same survey, the funds in marketing associations revolved every 9 years, whereas the funds in farm supply associations revolved every 11 years. Id. at 39-41.

See, e.g., T.D. 1996 (1914); T.D. 2737 (1918): I.T. 1499, I-2 Cum. Bull. 189 (1922); A.R.R. 6967, III-1 Cum. Bull. 287 (1924); S.M. 2595, III-2 Cum. Bull. 238 (1924); I.T. 3208, 1938-2 Cum. Bull. 127.

522(b) (2) of the Code," which provides that patronage dividends of exempt cooperatives—

shall be taken into account in computing taxable income in the same manner as in the case of a cooperative organization not exempt *

Thus, "nonexempt" cooperatives escape taxation almost to the same extent as so-called exempt cooperatives.

PATRONAGE DIVIDENDS REPRESENT A DISTRIBUTION OF PROFITS

Under present law, patronage dividends are taken into account as an increment in the cost of goods sold, in the case of a marketing cooperative, and as reductions in gross receipts in the case of a purchasing cooperative. This treatment arises from the theory that cooperatives have a preexisting obligation to allocate their earnings on the basis of patronage and that the allocation is therefore in the nature of a rebate or refund.

It is submitted that this characterization of patronage dividends, while superficially appealing, seriously conflicts with the fundamental tax policy that the profits of any business operated in corporate form should be subject to the corporate income tax, regardless of the manner in which such profits are distributed. Patronage dividends and ordinary corporate dividends are alike in many essential respects.

First, the recipients of patronage dividends, like the recipients of ordinary corporate dividends, are the owners of the residual equity in the organization. If a cooperative were to be liquidated, its surplus and the appreciation in the value of its assets would be distributable on the basis of patronage.10 Moreover, there is a direct relationship between patronage dividends and capital invested by patrons:

*** There is nothing in the Rochdale plan nor in more recent formulations of cooperative theory that requires member-patrons to maintain stockholding proportionate to patronage. As a matter of fact, however, cooperatives do not raise the major portion of their capital through the sale of capital stock, and, as a result, capital contributions of members are, for the most part, kept proportional to patronage."

Second, many cooperatives which do a substantial amount of business with nonmembers pay patronage dividends only to members. In such cases, the analogy to ordinary dividends is even clearer: only persons having a direct equity interest in the corporation are entitled to receive a share of the profits.

Third, although cooperatives may have a preexisting obligation to allocate patronage dividends, their actual payment is subject to the discretion of the board of directors, just as in the case of ordinary corporate dividends. The patronage dividends may be "allocated" by means of mere book entries if the patrons are notified of the allocation. Although these accounts would be payable upon liquidation of the cooperative, this preferential right would hardly distinguish them from cumulative dividends on ordinary preferred stock.

7 Originally enacted as sec. 101 (12) of the Internal Revenue Code of 1939.

8 Reg., sec. 1.522-3 (a).

9 Cf. I.R.C., sec. 7701 (a) (3).

10 The bylaws of most cooperatives provide that upon dissolution net assets are to be distributed to members in proportion to patronage. See, for example, a typical form of bylaws in Hulbert, "Legal Phases of Farmer Cooperatives" (FCS Bull. 10, January 1958), at 324.

11 Cook, "An Economic Analysis of the Federal Taxation of Income From Cooperative Enterprise" (University Microfilms, Inc., Ann Arbor, Mich., 1954), at 168.