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Samuel J. Lanahan, Washington, D.O. Cooperation is a method of doing business. A cooperative is a business organization, usually incorporated, owned, and controlled by shareholders or members, purportedly operated on a cost basis after allowing for expenses. In effectuating its stated purpose of operating at cost for the mutual benefit of its members or shareholders in their capacity as producers or consumers, a cooperative generally returns to them a pro rata share of its profits, or net margins, existing at the year's end. This share is generally determined on the basis of the volume of business each member does with the cooperative and is known as a patronage dividend.
The growth of cooperatives, both in volume of business done and in variety of business activity, has given rise to frequent consideration of how this particular kind of business activity should be treated under our internal revenue laws. A further examination is particularly appropriate at this time because the practical result of recent court decisions has been to place cooperatives and their patrons outside our revenue system. Accordingly, it is now desirable to undertake a fresh analysis of the operation of cooperative associations in order to determine how this particular method of doing business can be fairly, but realistically, taxed.
An appraisal of the operations of cooperatives against the background of our present tax structure is important only insofar as it may demonstrate the need for revision. In other words, the present holiday from the impact of income taxes which has been granted to cooperatives and their patrons should not, on the one hand, result in action which might be unduly harsh, nor, on the other hand, be used as an argument for the continuation of an entrenched status.
OUTLINE OF EXISTING LAW
Our tax laws recognize two distinct types of cooperatives-exempt and nonexempt. Exempt cooperatives are farmers', fruitgrowers', or like associations which, in general, do business on a cooperative basis in the marketing of products or the purchasing of supplies and which meet certain statutory specifications as to their organization and operation. Unlike most exempt organizations, however, an exempt cooperative is taxed on most of its income unless allocated as patronage dividends. Thus, although this type of cooperative possesses certain limited tax advantages over nonexempt cooperatives, most of the income at the cooperative level in the case of both exempt and non
1 See, generally, Farmer Cooperative Service, U.S. Department of Agriculture, Legal Phases of Farmer Cooperatives 1, 220 (F.C.S. Bull. 10, 1958) (hereinafter cited as Legal Phases).
3 Internal Revenue Code of 1954, sec. 521. (Unless otherwise noted, all code citations will be to the Internal Revenue Code of 1954.) 8 Id., sec. 522.
exempt cooperatives currently escapes taxation because, under Treasury rulings, patronage dividends may be excluded from cooperative income to the extent that they are allocated to patrons, if such allocation is made pursuant to a preexisting obligation. Thus, the problem of the patronage dividend is at the core of the problem of taxing both exempt and nonexempt cooperatives, and the distinction for tax purposes between the two types fades in importance.
As a result of this longstanding interpretation of the application of the tax law to cooperatives, both exempt and nonexempt cooperatives may exclude from income amounts allocated to partons. It is not necessary that there be an actual payment of the patronage dividend in order to obtain the benefit of this tax advantage. There need only be an allocation on the cooperative's books or a notification to the patron that the cooperative holds the amount for him by sending him a certificate, letter of advice, or perhaps capital stock.
It should be noted that amounts allocated to members of nonexempt cooperatives, which amounts are derived from business transacted with nonmembers, as well as nonoperating income, such as dividends and capital gains, have never qualified for the exclusion granted patronage dividends.?
In the usual case, the amount retained is to be paid the patron at such time as the directors of the cooperative deem its payment to be consistent with the sound financial operation of the enterprise. The obligation to pay out this amount to the patron is junior to all other obligations of the cooperative. The amounts retained are retired in the order of their seniority and, while these funds are in the possession of the cooperative, they are subject to all the risks of the business. In other words, operating losses of the cooperative can completely wipe out the amount allocated to the patron.10 Thus, the subsequent success of the operation after suffering losses does not mean that the amount of the reduction on account of intervening losses will be added back to the amount eventually payable. It seems fair to infer that
* T.D. 1996 (1914); T.D. 2737, (1918) ; 0.D. 64, 1 Cum. Bull. 208 (1919); 1.T. 1499, 1-2 Cum. Bull. 189 (1922) ; I.T. 1566, I1-1 Cum. Bull. 85 (1923);
S.M. 2288, III-2 Cum. Bull. 233 (1924); S.M. 2595, III-2 Cum. Bull. 238 (1924); A.R.R. 6967, III-1 Cum. Bull 287 (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.
6 Some confusion exists as to whether a patronage dividend is technically, a deduction or an exclusion. Sec. 522(b) (1), states that an exempt cooperative shall be allowed a deduction for dividends paid on its capital stock and amounts allocated to patrons with respect to its income derived otherwise than from patronage. Sec. 522(b) (2) says that patronage dividends of exempt cooperatives shall be “taken into account in computing taxable income" in the same way as in the case of nonexempt cooperatives. The regulations under sec. 522 (Regs., sec. 1.522-3(a)) indicate that patronage dividends are to be treated, either as a reduction of gross receipts or as an addition to cost of goods. These regulations reflect longstanding policy. See G.C.M. 17895, 1937-1 Cum. Bul. 56; I.T. 3208, 1938-2 Cum. Bull. 127.
Where a patronage dividend is allocated or paid to a patron pursuant to a preexisting obligation, it seems properly an exclussion and will be treated throughout this paper for purposes of discussion.
8 As to exempt cooperatives, see sec. 522(b)(1)(B) and Regs., sec. 1.522-1(b) (3) to nonexempt
cooperatives, see, e.g., United Cooperatives, Inc., 4 T.C. 93, 108 (1944). ? E.g., A.R.R. 6967, III-1 Cum. Bull. 287 (1924). See, generally Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201 (N.D. Iowa 1949).
8 For example, the bylaws of the Rockingham Poultry Market, Inc., as set forth in Long Poultry Farms v. Commissioner, 249 F. (20) 726, 727 (4th Cir. 1957), provide :
“In the event the association suffers à loss in any year, the board of directors shall prescribe the basis on which the capital furnished by patrons shall be reduced on account of any such loss, so that it will be borne by patrons on as equitable a basis as the board of directors finds practicable.
9 Legal Phases, 228. See also the Certificate of Interest used by the cooperative in Colony Farms Cooperative Dairy v. Commissioner, 17 T. C. 688, 691 (1951), acquiesced 1952-1 Cum. Bull. 1.
10 See Long Poultry Farms V. Commissioner, 249 F. (20) 726, 727 (4th Cir. 1957.)
the absence of such a rule would make it difficult for the cooperative to attract new patrons.
In these circumstances, the courts have held that the amount of a patronage dividend entered to the credit of the account of the patron, but payable only at the cooperative's discretion and subject to reduction by losses, is not taxable income in the year of allocation—even in the case of a taxpayer reporting its income by the use of the accrual method of accounting 11 The Treasury has recently indicated its acquiescence in this result by publishing proposed regulations which would reflect these decisions. Thus, under the present law, the cooperative is not taxed on its net margins, or net profit, and the patron is not taxed unless his patronage dividend has a market value, which often it does not.
STATEMENT OF PROBLEMS
In making a new appraisal of the cooperative tax problem, it must be recognized that the topic has become a controversial one. Businesses which do not operate in the cooperative manner argue that the special classification for Federal income tax purposes of the cooperative method of doing business is no longer justified. Under this view, our tax system has not kept pace with cooperative activities. The present income tax rates can properly be identified as the source of the charge that what once may have been justifiable special tax treatment for cooperatives has now become preferential tax treatment. The argument is further reinforced by pointing to the kinds of activities in which cooperatives are engaged." In many instances these activities are competitive with businesses conducted, for example, by a corporation operated for profit which may pay a tax at the rate of 52 percent before the distribution of earnings to shareholders.
In behalf of cooperatives, it is argued that they do business at cost; that all their profits, or net margins, belong to their patrons; and that, accordingly, there is no income at the cooperative level for the taxing power to reach.
Congress has already heard a great deal of testimony from witnesses on both sides of the argument. So far it has wisely refrained from adopting extreme measures. Perhaps the sharpness of the controversy has, in itself, suggested caution and given rise to a belief that a proposal could be developed which would
find support from both sides. In addition, the compelling fact that emerges from prior testimony is that there is no simple solution to the cooperative problem.
Thus, while it is true that the controversy over the proper tax treatment of cooperatives has been primarily over whether a cooperative can, or should, be taxed on its profits or net margins, it is also true that the debate has been intensified by the nature of the remedies offered. The purpose here is to offer proposals for revision of the present tax scheme which are responsive in practical terms both to the cooperative method of doing business and the demands of a fair tax system.
It is argued that the patronage dividend is essentially a price adjustment, admittedly a proper exclusion from cooperative income. It appears that such an exclusion for some patronage dividends may be justified on the theory that they are price adjustments. Others, however, are more like a distribution of the profits of a business entity to its shareholders. Therefore, an analysis must include an examination of a patronage dividend. What are its elements? Is it essentially a price adjustment? Or is some part of it a distribution of business profits? The purpose of this paper is to demonstrate that, on analysis, the patronage dividend contains elements of a true price adjustment and something more.
11 Ibid. 12 24 F. R. 1750, 1752 (Mar. 11, 1959).
However, the analysis cannot end here. The ability of a cooperative to exclude a patronage dividend allocated to patrons but not actually paid has resulted in the considerable competitive advantage that cooperatives can accumulate tax-free earnings. Thus, the analysis must also concern itself with the question of what constitutes proper payment of a patronage dividend so that it may appropriately be excluded from income at the cooperative level.
Furthermore, the analysis gains significance when examined against the background of data concerning the size and growth of cooperatives. In 1956, for example, the net business of farmers' cooperatives amounted to $10 billion. This represented an increase of 27 percent from the 1950 level of business done by such cooperatives.13
When the cooperative method of doing business and the variety of cooperative activities are so analyzed, at least two identifiable problems become apparent. The first of these is that our tax laws, tied to the early stages of cooperative development, continue to treat cooperatives in primitive terms so that distributions of business profits in the guise of patronage dividends are still treated as simple price adjustments. Secondly, the present tax law encourages cooperatives to retain their net margins free of tax-which are then used for expansion and the acquisition of new business. This paper is devoted to establishing the existence of these two problems and to proposing solutions.
ACTIVITIES OF COOPERATIVES
Cooperatives originated primarily as a form of group activity carried on for the mutual benefit of individual members in their capacity as producers or consumers. They were based on the proposition that such activity could effect savings for the individual members of the group. Benefits were varied and undeniable. Through cooperative activity, for example, farmers were enabled to average gains and losses among themselves during periods of fluctuating prices; to take advantage of bulk transportation and storage, thus giving the individual farmer a better marketing position at the central exchanges; and to eliminate middleman profit. Additionally, it was hoped that shady practices of distributors would be eliminated if the customers owned and operated the distribution facilities. In the early days, such group activity was largely confined to the actual sale of farm produce and the purchase of farm supplies and equipment. (a) "Factories are free for cooperators"
From these beginnings, farmer cooperatives have expanded both vertically and horizontally. A modern marketing cooperative may handle a farm product from before the time of its harvest to the ulti
18 See, generally, app. A.
mate consumer sale of the processed commodity. For example, cotton cooperatives engage in the ginning of cotton, marketing of the baled lint, oilseed milling and marketing, cottonseed production, and the baling and warehousing of cotton.1Dairy, cooperatives process milk from the cow to the consumer, and one such cooperative even owns a factory for the manufacture of milking machinery.
Nor have purchasing, cooperatives remained static. They have expanded from their initial status as purchasing agents until they are now manufacturers and distributors of nearly
every type of commodity. Fertilizer ingredients are mined, manufactured, processed, mixed, analyzed, bagged, and distributed to farmers.16' Likewise, feed is grown, milled, pelleted, packaged, and distributed.? Seed, too, is a manufactured product, in that many kinds are grown under hothouse conditions, tested, and eventually cleaned in seed-cleaning plants.18
Most striking, however, is the variety of operations engaged in by regional cooperatives. These organizations are owned for the most part by local cooperatives. They manufacture many varieties of products for their member locals. Like other cooperatives, they pay the locals patronage dividends, which are in turn passed on by the locals to the individual members. These enterprises own and operate oil wells, pipelines, refineries, gas-bottling plants, and wholly integrated seed, feed, and fertilizer production facilities.19 They are engaged to some extent in some phase of every activity needed both to provide the farmer with items consumed or used on the farm and to market consumer goods made from farm products.20 Nearly 35 percent of the employees of 18 large regional cooperatives are engaged in manufacturing and processing activities.21
Notwithstanding the enormous growth of cooperatives in manufacturing and processing activities requiring substantial employment of capital, our tax laws continue to treat these organizations as if they were simple purchasing or marketing agents. Through the use of the patronage dividend allocated to patrons, the profits of these organizations escape the current impact of the Federal income tax. Thus, it is with complete justification that a cooperative spokesman can state:
In 1942, the productive departments of Consumers Cooperative Association and the Farm Bureau Cooperative Association (Ohio) produced 72 and 70 percent, respectively, of their entire savings for that year. Midland Cooperative Wholesale reported that over 60 percent of its total earnings in 1947 came from either its own plants or those of the federations of which it was a member. Two-thirds of the 1953 earnings of the Farm Bureau Services of Michigan were derived from its processing and manufacturing departments and only one-third from its wholesaling.
14 Farmer Cooperative Service, U.S. Department of Agriculture, "Farmer Cooperatives in the United States," p. 40 (FCS Bulletin 1, 1955) (hereinafter cited as farmer cooperatives). 15 Id., 159. 16 Id., 155-157. 17 Id., 151-153. 18 Id., 157-158.
19 Id., 153-155. See, generally, Farmer Cooperative_Service, U.S. Department of Agriculture, "Handbook on Major Regional Cooperatives Handling Farm Supplies, 1956 and 1957" (FCS General Report 53, 1959) (hereinafter cited as handbook).
20 Appendix D shows the size and ownership of the fertilizer manufacturing cooperative Central Farmers Fertilizer Co. It should be noted that the aggregate assets of the member cooperatives is about $100 million.
2 of the 17,716 employees of 18 of the regional cooperatives studied in handbook, 6,140 are stated to be engaged in manufacturing or processing activities.