ceipts related thereto. This kind of distinction is the basic language of the code. Flat percentage distinctions of so-called passive income serve as the basis of the personal holding company provisions.28 Limitations on the reasonable accumulation of corporate surplus serve as a guide in restricting receipts to function.29 The distinction between service receipts and investment receipts is also amenable to such statutory treatment. There are two general approaches to the matter. A specific set of code provisions expatiating upon the indicia of the distinction could be drafted, or a general provision referring only to receipts from the service function of cooperative associations could be made. The former approach is reflected in provisions referred to above; the latter is the form of the provisions governing the use of the consolidated return.30 It is apparent that the existing statutory provisions governing cooperative taxation contain many of the structural and functional elements as conditions for exempt treatment. These are, in sum, the restriction to agricultural producers or consumers, the limitation on dividend payment and voting power, the requirement of nondiscriminatory treatment between member and nonmember, the requirement of a preexisting obligation as a condition of excluding patronage dividends, and the requirement that distributions be computed on the basis of patron age. Before embarking upon a new statutory basis for cooperative taxation, the existing scheme ought to be assessed for its adequacy in terms of the analysis developed herein. New departures in tax provisions are often costly in administration, so that revisions within the existing framework merit attention. This is not to abandon the ultimate objective of allowing cooperative tax treatment only to those cooperatives performing the service function, but to suggest that with modification, this objective may, as a technical matter, be substantially achieved within the existing framework. II. DEFECTS OF THE PRESENT STATUTE EXEMPT AND NONEXEMPT COOPERATIVES The present statutory distinction which continues the dual classification of the pre-1951 code is difficult to justify by our criteria of cooperative receipts. Some reference to the history of this classification shows a shift in its function. Prior to 1951, this was a distinction which served an important purpose. The exempt cooperative was entirely free of income tax and could retain unallocated funds with no tax liability." Nonexempt cooperatives were taxed as ordinary corporations with the qualification by administrative and judicial criteria that such cooperatives could exclude from gross income allocated patronage dividends.32 When the 1951 revisions undertook to withdraw the ability of cooperatives to retain unallocated funds with 28 I.R.C., secs. 541 through 547 (1954). 29 I.R.C., secs. 531 through 537 (1954). 30 I.R.C., secs. 1501 through 1505 (1954) see also Treasury Regulations, secs. 1.1501 through 1.1552. 1 I.R.C., sec. 101 (12) (1939). 32 T.D. 2737, 20 T.D.I.R. 433 (1918); I.T. 1499, I-2 Cum. Bull. 189 (1922); I.T. 1566, II-1 Cum. Bull. 85 (1923); S.M. 2288 III-2 Cum. Bull. 233 (1924): G.C.M. 12393, XII-2 Cum. Bull. 398 (1933); G.C.M. 17895, 1937-1 Cum. Bull. 56; I.T. 3208, 1938-2 Cum. Bull. 127. See also Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201, 212 (N.D. Iowa 1949). out tax liability, that act, adopted by the 1954 code, continued the classification of exempt and nonexempt cooperatives.33 However, under the revised statute the classification assumed different consequences. Both the exempt and the nonexempt cooperatives are now taxed in essentially the same way. Both are generally subjected to taxation as ordinary corporations with particular recognition of cooperative operations. The only remaining distinction between an exempt and a nonexempt cooperative lies in the grant of certain statutory deductions and adjustments to the exempt cooperative, and in the deduction of dividends paid. Only an exempt cooperative may deduct the limited dividends paid on capital stock 34 and incidental nonpatronage income when allocated on a patronage basis. The exempt cooperative may also treat as patronage refunds excludable in the year of distribution, amounts retained as reasonable reserves in prior years.36 Until recently, perhaps the most important advantage of exemption was the right to attribute to any taxable year as an exclusion from gross income, any patronage allocation made within 812 months after the close of the taxable year." By the terms of a recent ruling, the Service has granted this same advantage to nonexempt cooperatives for a brief period coupled with a more limited advantage on a permanent basis.38 Thus for tax years ending prior to January 1, 1960, both the exempt and nonexempt cooperative may utilize the full 812-month period previously allowed only to the exempt cooperative. For tax years ending after December 31, 1959, the period of attribution is limited to the due date for filing the cooperative's return plus any period of extension.40 39 The code now offers two categories either of which a cooperative may, in practice, voluntarily assume. A cooperative may abandon its exempt status in order to follow a discriminatory program of paying patronage dividends only to members. The cost of this change in terms of foregone advantages may be slight as compared with the advantages of the discrimination. It is apparent that the statutory classification may encourage voluntary disqualification by exempt cooperatives on this account. It would seem wiser to revise the code in this respect by removing the classification in favor of a statutory reference to a qualifying cooperative. Eliminating the two groupings of exempt and nonexempt cooperatives in favor of a single classification of a qualifying cooperative raises the issue of the treatment to be given a cooperative which fails to qualify. Since the right to exclude patronage dividends has traditionally been extended to nonexempt cooperatives, it merits continuation. This is justifiable insofar as it frankly recognizes that: (1) The 3 I.R.C., sec. 101 (12) (1939), as amended, 65 Stat. 491 (1951). 34 I.R.C., sec. 522 (b) (1) (A) (1954); Treasury Regulations, sec. 1.522-2(c). 28 Revenue Ruling 59–322, I.R.B. 1959-40; T.I.R. 175. 39 Ibid. 40 Ibid. 41 There has been a substantial shift from exempt to nonexempt status for 1953 as compared with 1946. For 1953 the number of exempt returns filed was approximately 1,000 smaller, although the total number of returns for the 2 years of comparison was approximately the same. Treasury Department, Statistics of Income, Farmers' Cooperative Income Tax Returns for 1953, 1 (1957). 47060-59-pt. 3- -24 present restriction of exempt cooperatives to agricultural producers and consumers is probably unduly restrictive, and this is one way of recognizing the validity of the cooperative as a business form while allowing for some variation; (2) that undertaking to tax a cooperative business unit as an ordinary corporation can result in a policy of managing its advance payments and final refunds to minimize taxable income. It is wise to draw the distinction clearly and to bring this settled administrative policy from the underworld of rulings to the status of a statutory provision codifying the present administrative treatment. If it is then appropriate to discourage discriminatory treatment of nonmembers, an ordinary corporation operating on the cooperative principle can be limited in its exclusion of patronage dividends to some fraction of its distribution where the discriminatory practice is present. Leakage through paper distributions 42 Another defect of the existing statute is the treatment of paper distributions. It is now widely recognized that the 1951 revisions of the provisions pertaining to the taxation of cooperatives were less than fully successful. As it has turned out, the reliance of the draftsmen upon the accepted view that patronage allocations were taxable to patrons irrespective of their form was unwarranted. A line of cases which unsettled this position 43 has created the familiar anomaly wherein the patron-recipient of certain paper distributions is taxed only on the market value thereof, while the regulations continue to allow the cooperative to exclude from taxable income the full face value of such paper." This result has served to revive and intensify the controversy over the tax treatment of the cooperative in general and to focus attention on the nature of the patronage refund. To the persuasive arguments for restoring the theme of the 1951 revisions to tax cooperative income in the year earned either at the cooperative level or in the hands of the patron there is no satisfactory rebuttal. The present situation is the result of a not entirely foreseeable judicial position which has created what amounts to a technical defect in the present code provisions. The proposed Treasury solution seems to meet this problem fully. Under this proposal, the cooperative would be allowed to exclude, in computing its taxable income, only the amount of noncash allocations as would be currently taxable to the patron.45 Patronage refunds in cash would continue to be excludable, but in no case would the amount of noncash allocations excluded by the cooperative exceed the amount of such allocation currently taxable to the patron.46 42 Letter dated July 29, 1955, from the Secretary of the Treasury to the chairman of the House Committee on Ways and Means, 101 Congressional Record 12180-1 (1955); See Kassman and Sexton. "The Income Tax Treatment of Cooperatives," 7 National Tax Journal 50, 57 (1954); Ravenscroft, "The Proposed Limitation on the Patronage Dividend Deduction," 12 Tax Law Review 151 (1957). 43 Long Poultry Farms, Inc. v. Comm'r., 249 F. 2d 726 (4th Cir. 1957), acq. T.I.R. 69 (1958); Comm'r. v. Carpenter, 219 F. 2d 635 (5th Cir. 1955), acq. T.Í.R. 69 (1958); President of the United States, Federal budget message for 1960, 105 Congressional Record 753 (1959); letter dated Jan. 19, 1959, from the Secretary of the Treasury to the chairman of the House Committee on Ways and Means, press release, chairman, House Committee on Ways and Means, Feb. 4, 1959; Caswell's Estate v. Comm'r., 211 F. 2d 693 (9th Cir. 1954); Moe v. Earle, 226 F. 2d 583 (9th Cir. 1955); cert. denied, 350 U.S. 1013 (1956) Farmers Grain Dealers Ass'n of Iowa v. United States, 116 F. Supp. 685 (S.D. Iowa 1953); Treasury Regulations, sec. 1.61-5(b). 44 Treasury Regulations, sec. 1.522-1(a) (3) and (4); sec. 1.522-3(a). 4 Letters of the Secretary of the Treasury to the chairman of the House Committee on Ways and Means, July 29, 1955, and Jan. 19, 1959, supra, note 42. 46 Ibid. The recently proposed Simpson bill 47 implements the Treasury solution by gearing the exclusion of patronage allocations to specific conditions in the paper documents and taxability to the patron. The framework of this bill adopts the existing view of patronage distribution, but modifies the conditions of its exclusion. Under the operation of this proposal the prior tax vacuum which arose from the certainty in exclusion for the cooperative, and the uncertain taxability under judicial criteria applied to the paper in the hands of the patron, is avoided. By modifying the terms of the documents distributed, and by requiring their redemption within a 3-year period, the statute achieves taxation of all cooperative income for any year either in the hands of the cooperative or in the hands of the patron. Exclusion (termed "deduction" under the statute by a provision that all patronage allocations are included in the cooperative's gross income) 48 for the cooperative is further tied to the taxability of the paper distribution in the hands of the patron by a provision that a deficiency will be assessed to the cooperative at the end of the 3-year period because of the disallowance of the nonqualifying deduction. Contrariwise, allocation by documents which do not qualify when distributed, and are not deductible in that tax year, may subsequently be deducted to the extent of their value in redemption. This bill offers a workable solution to the leakage on paper distributions and its enactment should not engender any strong objections. The need for a solution to this problem is grounded in the requiremets of sound revenue administration. Unlike many other areas in the code, it is clear that in the 1951 revisions the draftsman sought such an outcome. It is interesting to note that this position is also supported by the earlier characterization of cooperative receipts. One effect of this legislative proposal is to induce the payment of patronage refunds. The emphasis is on payment in cash within the 3-year period. This is reflected in the requirement that the documents of distribution contain an unconditional promise to pay (1) interest on the face amount at a rate of not less than 4 percent (per annum) and (2) to pay the face amount plus interest within 3 years after the close of the taxable year. The stressing of the patronage refund is congruent with the basic service function of the cooperative. Unlike the corporation, the cooperative's shareholders are, as noted earlier, concerned primarily with transactions between themselves and the cooperative in maximizing (in the marketing cooperative) the net return from the sale of their produce.19 In the ordinary corporation the shareholders are principally concerned with the profitable outcome of transactions between the corporation and persons other than shareholders. Since the patronage refund is a functional element in the patrons' relationship with the cooperative, this degree of statutory emphasis on patronage refund is a recognition of a cooperative characteristic. To the extent that the statute may accelerate redemption of paper distributions, it will underline the service function of the cooperative. The position in which the Carpenter and related decisions 50 left the cooperative (in terms of the model developed earlier) was akin to that of the ordinary corporation. The economic effect of those cases was to allow the cooperative to exclude from gross income the face value of documents conditional and discretionary in nature. The cooperative was able by this mode of allocation to retain liquid assets and gain some tax advantage by the distribution of variegated instruments which were nonnegotiable, without market value, and in practice not redeemed for extended periods. This method was open to abuse. To the extent that cooperatives were able to retain capital in excess of needs to execute immediate and foreseeable service functions by this means, such cooperatives were contradicting a basic characteristic of a cooperative. It is only in the ordinary corporation that the managers have broad discretion over the amount of earnings which will be retained and distributed. Contrariwise, it is the nature of the cooperative service function that the related transaction between the patron and the cooperative, reflected in the marketing agreement, statute, and bylaws, requires the return to the patron of all the revenue derived from the sale of his produce at market price, less necessary operating and capital expenses. To the extent that documents allowing the cooperative wide discretion in redemption, and conditioned on various circumstances and interests were introduced into the stream of patronage refunds, the basic premise of the patronage relationship was denied. Irrespective of the theoretical justification for the present tax treatment of cooperatives, this departure in taxation is ultimately grounded in the belief that receipts cloaked with the binding obligation of the patronage fund are not the funds of the cooperative.51 The view that the receipts of the cooperative belong to the patron is negated by the existing tax treatment of paper distributions which effectively increases the dominion of the cooperative over these receipts. Considerations of congressional purpose, of sound revenue administration, and of the economic characterization of the cooperative coalesce to support a proposal to eliminate the present status of paper distribution. CONCLUSIONS In terms of the analysis developed herein, the Revenue Code properly allows for particular tax treatment of the cooperative business unit. The analysis further requires that such treatment be limited in application to those cooperatives whose receipts may be characterized as primarily a return to the performance of services. Where the receipts of a cooperative business unit are largely in the nature of a return to invested capital, the appropriate tax treatment is that of the ordinary business association. Insofar as there are practical limitations in applying the analytical criteria to distinguish between the two classes of receipts and since the present statutory definitions are fundamentally in accord with these criteria, the immediate concern is with removing existing defects in the statute. Two changes are recommended for immediate action: elimination of the muddle surrounding paper distributions and the modification of the existing statutory classification of exempt and nonexempt cooperatives. 51 Kassman and Sexton, op. cit., supra, note 42 at 55. |