The basic problem concerning these paper-patronage dividends was whether they possessed any market value which could be taxed as income to the recipient patron. For a number of years the Treasury contended that the face amount of the paper distributed should be included in the gross income of the patron. On the other hand, patrons contended that they were only subject to tax on the fair market value of the paper distributed to them. Since, in many cases, the paper did not bear interest and was payable in cash only at the discretion of the cooperative's board of directors, it had no market value. Therefore, the patron was quite correct in asserting that such a paper distribution was not income to him.

The cooperative was able nevertheless to deduct from its gross income the face amount of paper distributions paid pursuant to preexisting contractual obligations. As a result, Congress' expressed intention that at least a single tax should be payable on a cooperative's net margins was frustrated.

14

The first cases in this area to come to the Tax Court were those which the Treasury was most apt to win, involving accrual-basis taxpayers. In Harbor Plywood Corporation, the petitioner, a corporation reporting its income on the accrual basis, was a patron of a marketing cooperative whose bylaws required it, at the close of each year, to return or credit its net margins to the account of its members. The cooperative issued a credit memorandum to the petitioner representing its share of such net margins. Petitioner excluded the face amount of the credit memorandum from gross income. The Tax Court held that since petitioner was on the accrual basis the face amount of the credit memorandum accrued to it at the time it was credited and should be taxed accordingly.

Until the decision of the fourth circuit in Long Poultry Farms, Inc.,15 the Harbor Plywood decision seemed to establish the proposition that cooperative patrons on the accrual basis were required to include in gross income the face amount of paper patronage dividends paid to them by a cooperative pursuant to a preexisting obligation to declare patronage dividends. In the Long Poultry Farms case, however, the fourth circuit held that a letter of advice to a patron of the cooperative, who was on the accrual basis, stating the amount of the patronage refund credit which was entered to the credit of the account of the patron but which was payable only at the cooperative's discretion and which was subject to reduction by future losses, was not taxable income to the accrual basis petitioner in the year of allocation. The Internal Revenue Service has announced that it will follow this decision in similar cases.

16

In the case of cash-basis recipients, the courts have consistently held, in spite of the vigorous opposition of the Treasury, that noncash

1414 T.C. 158 (1950), aff'd, 187 F. 2d 734 (9th Cir. 1951). See, similarly, George Bradshaw, 14 T.C. 162 (1950), acq., 1950-1 Cum. Bull. 1. (Patron was a member of a partnership which reported its income on the accrual basis; interest-bearing notes issued to the patron were held taxable to him.)

15 249 F. 2d 726 (4th Cir. 1957), reversing 27 T.C. 895 (1957).

16 T.I.R. No. 69, Feb. 14, 1958, published at 586 CCH S.F.T.R., par. 6350.

dividends are not includible at face value in computing gross in

Thus, a noncash dividend was excludable from the income of an exempt cooperative by section 101 (12) (B) and from the income of a nonexempt cooperative under Treasury rulings and lower court decisions. The recipient was required to include in his gross income only cash distributions or the fair market value of paper allocation. Since the paper distributions of cooperatives usually had no fair market value, the income represented thereby escaped taxation entirely. In this manner the expressed intent of Congress in enacting section 101 (12) (B) was frustrated. No income tax was collectible in cases in which a cooperative distributed letters of advice or certificates of interest to its patrons pursuant to a preexisting obligation when such certificates were payable only at the uncontrolled discretion of the cooperative.

TAXATION OF COOPERATIVES UNDER THE REVENUE ACT OF 1954

Sections 101 (12) (A) and 101 (12) (B) of the 1939 code were enacted without any relevant substantive changes as sections 521 and 522 of the 1954 code.18 Therefore, the statutory scheme for the taxation of cooperatives developed in the Revenue Act of 1951 still remains in effect.

The Treasury Department published final regulations on the taxation of patrons of cooperatives receiving patronage dividends on November 25, 1957,19 restating the position it had maintained prior to the adverse Long Poultry Farms decision and other decisions cited above. Section 1.61-5 of such regulations required a patron to include in his gross income the face amount of any patronage dividends allocated to him by the cooperative in the form of letters of advice, certificates of indebtedness, etc., if the allocation was made in satisfaction of a valid preexisting obligation of the cooperative to the patron.

On March 11, 1959, however, the Treasury Department published proposed amendments to Regulation 1.61-5, in order to bring existing regulations into conformity with the decisions of the fourth circuit in Long Poultry Farms, Inc., supra, and the fifth circuit in B. A. Carpenter, supra. The proposed regulations provide in part as follows: § 1.61-5 Allocations by cooperative associations; tax treatment as to patrons. (b) Extent of taxability.-(1) Amounts allocated to a patron on a patronage basis by a cooperative association with respect to products marketed for such

17 P. Phillips, 17 T.C. 1027 (1951) (Patronage dividends represented by certificates voluntarily issued by cooperative held not income to recipient because they had no fair market value); Estate of Wallace Caswell, 17 T.C. 1190 (1952); rev'd 211 F. 2d 693 (9th Cir. 1954) (Tax Court decision that transferable, interest-bearing certificates which were customarily redeemed in 5 years were income was reversed on the ground that the certificates were mere evidence of contingent rights in a fund); William A. Joplin, Jr., 17 T.C. 1526 (1952), acq. as to result only, 1954-2 C.B. 4 (preferred stock held taxable to recipient at fair market value, which was found to be face value; book credits held not taxable to recipient); B. A. Carpenter, 20 T.C. 603 (1953), aff'd, 219 F. 2d 635 (5th Cir. 1955) (certificates which had no fair market value held not taxable to recipient); Mary Grace Howey, 13 T.C.M. 399 (1954) (followed Carpenter case in holding certificates were not income to the recipient because they had no fair market value): Moe v. Earle, 55-1 USTC, par. 9180 (D. Ore. 1954), aff'd, 226 F. 2d 583 (9th Cir. 1955), cert. denied, 350 U.S. 1013 (1956) (certificates held not income to patron in year of receipt). 18 H. Rept. 1337, 83d Cong., 2d sess., p. 172.

19 T.D. 6272, 1957-2 C.B. 18.

patron, or with respect to supplies, equipment, or services, the cost of which was deductible by the patron under section 162 or section 212, shall be included in the computation of the gross income of such patron, as ordinary income, to the following extent:

(i) If the allocation is in cash, the amount of cash received.

(ii) If the allocation is in merchandise, the amount of the fair market value of such merchandise at the time of receipt by the patron.

(iii) If the allocation is in the form of capital stock, revolving fund certificates, retain certificates, certificates of indebtedness, letters of advice, or similar documents, the amount of the fair market value of such document at the time of its receipt by the patron. For the purposes of this subdivision, capital stock and any document containing an unconditional promise to pay a fixed sum of money on demand or at a fixed or determinable time shall be considered to have a fair market value at the time of its receipt by the patron. However, any revolving fund certificate, retain certificate, letter of advice, or similar document, which is payable only in the discretion of the cooperative association, or which is otherwise subject to conditions beyond the control of the patron, shall be considered not to have any fair market value at the time of its receipt by the patron.

(2) If any allocation to which subparagraph (1) of this paragraph applies is received in the form of a document of the type described in subparagraph (1) (iii) of this paragraph and is redeemed in full or in part or is otherwise disposed of, there shall be included in the computation of the gross income of the patron, as ordinary income, in the year of redemption or other disposition, the excess of the amount realized on the redemption or other disposition over the amount previously included in the computation of gross income under such subparagraph.

These proposed Treasury regulations make it clear that a patron of a cooperative, whether on the cash or on the accrual basis, need not include in his gross income revolving fund certificates, letters of advice or similar documents received from the cooperative as patronage dividends and which are payable only in the cooperative's discretion, or which are otherwise subject to conditions beyond the control of the patron. Therefore, through the use of patronage dividends in the form of letters of advice, etc., payable at the discretion of the cooperative, it is possible for a cooperative and its patrons to avoid completely any Federal income tax on the cooperative's allocated net margins.

RECENT LEGISLATIVE DEVELOPMENTS

The failure of the statutory framework added to the law by the Revenue Act of 1951 and reenacted as sections 521 and 522 of the 1954 code to provide at least a single Federal income tax either on the cooperative or on its patrons on the cooperative's allocated net margins has resulted in demands for remedial legislation. Secretary of the Treasury Anderson, in a letter dated January 19, 1959, to Wilbur D. Mills, chairman of the Committee on Ways and Means of the House of Representatives, outlined the problem as follows:

In testimony before your committee on January 16, 1958, I pointed out that the proper taxation of cooperatives continues to be a troublesome problem. As you know, a series of court decisions have made largely ineffective the 1951 legislation which was intended to assure that all cooperative income was to be taxed either to the cooperative or to its members as it was earned. Treasury rulings under which all patronage refunds in the form of certificates were held to be taxable at the face value have been held invalid where the certificates do not have a determinable market value. Thus, it is possible for the cooperative to receive a deduction in computing its taxable income while its members are not taxable on the certificates they receive.

As I stated in my testimony, while we are fully aware of the important place which cooperatives occupy in the life of our agricultural and farming com

munities, we believe that, as was contemplated in the 1951 legislation, some single tax liability should be assumed by all who participate in the business activities of the country and that legislation should be developed which imposes such a tax and at the same time is fair and reasonable from the standpoint of the members and the relative availability of retained earnings for expansion. * * *

Secretary Anderson submitted a proposed draft of new tax legislation to the Speaker of the House of Representatives on January 29, 1959. The Secretary summarized his daft as one which—

*** would insure the ultimate payment of a single tax on cooperative income. It limits the tax free retention of income by a cooperative to a period of 3 years. This is accomplished by permitting a cooperative to deduct amounts paid to its patrons during the taxable year if paid (1) in cash or (2) in the form of "qualified" patronage certificates; that is, certificates which bear interest at the rate of at least 4 percent and which are redeemable in cash within 3 years after the close of the year in which issued. The patrons would be required to include in their income only the cash amounts received, either as current cash distributions or on redemption of certificates.

PROPOSED REVISIONS OF THE EXEMPTION

Thus we arrive at the main question: Is there any occasion for change in the exemption of cooperatives? The President and the Secretary of the Treasury have stated that there is need for "corrective amendments." The principal proposition upon which any general revision of the income tax law will be based is that incomes from whatever source should be taxed and exemptions should be granted only if they are clearly in the public interest. Thus, the income of a private school or college may be exempt, but if the school is operated for private profit, it will not be.

Cooperatives originally were organizations of a few farmers banded together for their mutual benefit to buy farm equipment, seed, and other necessities; or to market their produce collectively. Some of these small cooperative organizations in the early days may have been actually the agents of their members. That might be true, for example, of a cooperative corporation which sold the products of a particular member and accounted to him for the profit or loss made on sales of his products.

During the intervening years, however, many cooperatives have become multimillion-dollar enterprises engaged in a wide variety of activities such as marketing, purchasing, manufacturing, and processing. As a result of their growth, largely through the retention of untaxed earnings, cooperatives have been competing effectively with even the largest private business corporations. The present-day cooperative is not technically an agent for the sale, purchase, or manufacture of products for the members; for the patron has no right to control the sale, fix the price and terms, recall the goods, or to demand and receive the proceeds when sold. In addition, there is a total absence of the narrow authority and strict accountability for profit and loss on individual transactions characteristic of the principal-agent relationship.

Patronage dividends received by a member bear no relationship to the gain or loss realized by the cooperative on the individual transactions in which he was involved. The patron's position in relation to the cooperative, initially, is that of a customer who buys or sells at current market prices. Thereafter, his position as to actual or

potential distributions resembles that of a small stockholder in an ordinary business corporation. The methods of operation and expansion of the cooperative's business and the accumulation or distribution of its earnings are controlled by directors, not by patrons. The directors exercise a discretion far removed from the limited authority of an agent.

Another argument often put forth by cooperatives claiming that their net margins do not represent income proceeds along the following lines: Cooperatives operate their businesses at cost and the payment of a patronage dividend, therefore, represents only a final adjustment in the sales price of products bought or sold by the cooperative from or to its members. This argument, often referred to as the price adjustment theory, is based on the proposition that patronage dividends derived from products sold to cooperatives are part of the payment for such products and so are not includible in gross income, and that those derived from purchases by members are "discounts" or "rebates" and, therefore, go to reduce the sales price charged by the cooperative.

The price adjustment theory is completely unrealistic in fact, since it does not take account of the actual methods of operation of large cooperatives. In the usual case, patronage dividends received by an individual bear no relationship to the profits or losses realized by the cooperative in its transactions with that individual member. The price-adjustment theory assumes a calculation of profit or loss on each transaction with every individual member. In fact, however, no such calculations are made. An individual may receive patronage dividends based on overall profitable operations carried on by the cooperative corporation with all of its members even though his own dealings with the cooperative resulted in a loss to the cooperative. Similarly, in the case of selling cooperatives, the distribution of net margins to patrons in the form of patronage dividends cannot be regarded as essentially similar to the rebates, discounts, or refunds granted by some department stores, for example, to their customers. Discounts, rebates, and refunds, based on a percentage of purchases, are designed to achieve such specific purposes as timely payment of bills and increased sales. Such distributions to customers represent only a small fraction of what would otherwise be the business' total profits. On the other hand, distributions of the net earnings of a corporation to its equitable owners, whether stockholders or members, are dividends from any realistic point of view. Cooperatives are operated for profit and have realized very large profits over the years. In an equitable sense those profits belong to the patrons, but only in the sense that a business corporation's profits belong to its shareholders. The corporation, whether business or cooperative, first realizes the profits for itself and then decides whether to retain them for expansion or to distribute them.

On this analysis the current exemption in the statute is unjustifiable. A cooperative should be taxable on its income, whether or not it issues to its patrons certificates evidencing net margins in some amount, such certificates being only payable in the discretion of directors at some wholly indefinite time in the future.

By virtue of the present deduction for distributed income, a cooperative corporation is enabled to reduce its taxable income to an