The fact is that some courts have described the relation of patron and cooperative as that of principal and agent.35 It has also been stated that the relationship was one of beneficiary and trustee.36 It has been stated that the relationship was one of creditor and debtor.37 It has been suggested that the patrons are in effect partners with each other, and the cooperatives analogous to the partnership.38 While those differences in analysis are to some extent based on differences of fact in the case involved, the statements are mainly of analogy. In my view it makes little difference which analogy is used, so long as the point (made by all of them) is understood that money received by the cooperative and distributed at the end of the year is received and held by the cooperative pursuant to binding obligation to hand it over to the patrons as soon as the exact amount has been determined. It is that obligation which, from the moment of its receipt, impresses that money with a trust, agency, bailment, or indebtedness relationship, thus making it neither the property nor the income of the cooperative.

Disregarding entirely my view that net margins cannot be subjected to income taxation, I come to what I consider should be of paramount importance.

Cooperatives are corporations. They do have some of the benefits incidental to the use of that form of business entity, such as insulation of members against corporate liabilities, convenience and economy of operation, etc. But they nevertheless are completely different from the ordinary private profit corporation. Their methods of financing and their objectives are completely different. The cooperative is in business solely for the purpose of benefiting its customers. The private profit corporation is in business solely for the purpose of benefiting its stockholders. The net margins of cooperatives grow exclusively out of produce, goods, or money furnished or paid by its members and patrons. They alone produce the net margins. The stockholders of private business corporations have nothing whatever to do with earning its net margins or profits, or with the transactions which created them. For many years Congress has rightly determined that some corporations which do business on a different basis than ordinary profit corporations should be treated differently for income-tax purposes. Partnerships, which are a legal entity and which in most States have by law certain of the attributes of corporations, such as the right to sue and be sued and to take title to real estate and convey it in the partnership name, always have been treated differently. So too have mutual life, fire, casualty, and other forms of mutual insurance companies, investment companies, personal holding companies, building and loan associations, savings banks, trusts, and other kinds of entities engaged in business. Fairness to farmers, a due regard to the welfare of all of the people, and above all recognition of the obvious and admitted difference in the nature of the cooperative business corporation as compared with the private profit corporation, compellingly requires a continuation of the long-established congres

36 State v. Morgan Gin Co., 189 S.R. 817 (Miss. 1939); Texas Certified Cottonseed Breeders Assn. v. Aldridge, 61 S.W. 2d 79, 82 (Tex. Supp. 1933); Bowles v. Inland Empire Dairy Assn., 53 F. Supp. 210 (D.C. Wash., 1943).

38 Californian & Hawaiian Sugar Refining Corp., 163 F. 2d 531 (C.A. 9, 1947).

37 Valley Waste Disposal Co., 38 B.T.A. 452 (1938); Growers Cold Storage Co., 17 B.T.A. 1279 (1929).

38 Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201, 218 (D.C. Iowa, 1949). 47060-59-pt. 3- -28

sional and Treasury Department treatment of cooperatives for income tax purposes.

V

Finally, the income tax treatment of patronage distributions in the hands of the recipients of such distributions must be considered. In the 1951 amendment of the Revenue Code Congress acted upon the belief that the long-established Treasury treatment of patronage refunds would be continued; i.e., that they would be taxed in full to patrons whether distributed in cash, merchandise, capital stock, promissory notes, letters of advice of allocations to reserves, or in other paper form. I believe, and so I think do all members of cooperatives, that net margins of cooperatives should be taxed once and then to the patron (except as to the small amount of distributions of purchasing organizations involving purchases for personal as distinguished from business use). Incidentally, and while it is neither here nor there so far as this statement goes, I think for entirely different reasons that all corporate earnings actually distributed to shareholders should be taxed only to the shareholders.

Unfortunately, since the enactment of the 1951 amendment, several reputable U.S. appellate courts have flatly held that patronage refunds of cooperatives are taxable to the recipient of the refund only to the extent of their actual market value.39 The Treasury Department has now conformed to these rulings.40 This means, of course, that most paper distributions or allocations are not taxable to recipients because letters of advice, non-dividend-paying preferred stock, certificates of interest, and so forth, have little or no market value; very few securities issued in payment of patronage refunds have a market value equal to their face value; and, most important, to a large extent there is no market for cooperative paper of any type. The result is that earnings of cooperatives not paid in cash or merchandise or securities having a readily ascertainable market value are not taxed either to the cooperative or to the patron. The intent of Congress has been thwarted. The result, too, is that neither the Treasury Department nor patrons of cooperatives know what, if any, part of paper patronage refunds should be treated as income of the patron because, due to the almost entire absence of a market for cooperative paper, nobody knows what is the "market value" of securities of a particular cooperative.

Legislation should be enacted which will accomplish what Congress thought had been done by the 1951 amendment.

The Treasury Department has acted in an effort to correct the situation and has submitted to this committee a bill which Secretary of the Treasury Anderson says will do this. In his letter to the Speaker of the House transmitting the proposed bill the Secretary says:

The enclosed draft of proposed legislation 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

39 Long Poultry Farms, Incorporated v. Commissioner, 249 F. 2d 726 (C.A. 4, 1957); Commissioner v. Carpenter, 219 F. 2d 635 (C.A. 5, 1955).

40 The Treasury Department acquiesced in these decisions by Technical Information Release No. 69, Feb. 14, 1958.

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. The Secretary's description of the bill is accurate. I would, however, say that the bill permits a cooperative to deduct from its gross income for tax purposes only patronage refunds paid in cash but permits the cooperative to defer the cash payment for 3 years tax free, provided it pays to the patron 112 percent of the patronage refund to which the patron was entitled and contracts to do so in the form prescribed by the bill. More important, the inescapable result of the Secretary's proposal is that after 3 years from the effective date of the bill all cooperative earnings will either be paid to patrons in cash or be subject to the regular corporate tax of 52 percent. I know of no other type of organization which under the Revenue Code is permitted to deduct only those expense obligations which are paid in cash. Under the bill, the patron reports as income only patronage refunds actually paid to him in cash. It should be noted that a cooperative, if it does not distribute and pay in accordance with the terms of the bill, will be taxed at regular corporate rates on all of its net income but will be allowed a deduction for patronage refunds in the year in which they are actually paid or redeemed in cash regardless of the year in which that occurs. In the meantime the patron pays no tax. If the cooperative issues the kind of paper prescribed by the bill and fails to pay the required interest or to retire the paper at the end of the prescribed period, provisions are made for assessing a deficiency tax against the cooperative.

I can see no reason why under any circumstances the net margins of a cooperative should be completely exempt from tax for a 3-year period, or any other period. My opinion today is as before stated; i.e., the net earnings of a cooperative should be taxed once and then to the patron in the year following that in which they were earned by the cooperative. My opinion recognizes the reinvestment theory which is still sound even though the Court of Appeals for the Fourth Circuit says it is a fiction.

It is dangerous in the extreme for Congress to determine in effect that a certain type of security has a market value equal to its face merely because it bears interest at a certain rate and is payable within 3 years. That of course is the Treasury theory. If that principle is established, and it never before has been, succeeding Congresses may increase or decrease the interest rate or increase or decrease the redemption period. If the principle is sound, there is no reason why the interest rate should not be 6 or 7 or 8 percent, or 3 or 2 or 1 percent per annum, and the tax-free redemption period 5, 10, or 12 years instead of 3.

The effect of the proposed bill upon cooperatives would be catastrophic. Expansion and improvement plans of both large and small cooperatives would be summarily stopped or badly crippled. The borrowing capacity of all cooperatives would be drastically reduced. Cooperatives which are required by the laws of the State under which they are organized to set aside in a permanent capital reserve a proportion of their net earnings, would be particularly hard hit. Many States have such a requirement. All of the amounts placed in such reserves in any year would be taxed to the cooperative. There are some cooperatives (very few) the nature of whose business is such that they

do not need a large amount of capital and which have little or no funds invested in fixed assets. They might be able to live with the provisions of the bill.

Many cooperatives have outstanding documents issued in payment of patronage distributions which require redemption or payment at fixed periods. They were issued in reliance upon the long-prevailing views of Congress, the Treasury Department, and the courts that the earnings represented by such documents, issued pursuant to a preexisting contract between patrons and the cooperative, were not income of the cooperative. If that treatment is now changed, many cooperatives would be required to retire such documents in the same years in which they were required to either pay out all of their earnings in cash to current patrons or to pay more than half of them to the Government. The result would be either that the cooperative would be unable to meet its legal obligations on the paper or would be deprived of any opportunity to improve its service to its patrons or to do the things for which it was created. Many cooperatives have long followed the practice of revolving the capital contributions of patrons (made through reinvestment of patronage distributions) at fixed periods, but without legal obligation to do so. These practices would have to be abandoned and this would involve a real hardship both to patrons. and to cooperatives.

In his letter which accompanied the bill Secretary Anderson stated that the Treasury would be glad to consider the merits of any other method designed to achieve a single tax liability for cooperative income which was reasonable and fair, and in his testimony before the Ways and Means Committee on January 16, 1958, he said such legislation should be "fair and reasonable both from the standpoint of the availability of retained earnings for expansion [emphasis supplied] and tax benefits to cooperative members." In my judgment a simple, reasonable, and fair method of achieving this objective would be to write into the code provisions which would make effective the longestablished Treasury rule by amending the code so as to provide that all earnings of qualified cooperatives should be included in the gross income of patrons (except those growing out of purely personal purchases) provided they are distributed to patrons pursuant to a preexisting obligation and accepted by the patron in satisfaction of that obligation, and that such distributions should be considered to have been accepted by patrons in satisfaction of the cooperative's obligation if the articles of incorporation, bylaws, or similar documents so provide, or if the cooperative shall have given written notice so providing at or prior to the transaction out of which the refund arises, and thereupon to have been invested in the cooperative. I think such a law would be enforcible and would meet with the approval of most cooperatives and their patrons. Those cooperatives which did not approve of it would not be compelled to accept it nor would their members. A majority of the members could by appropriate action at a membership meeting make the law inapplicable to them and to their cooperative. In such event the amendment would require the cooperative to include as income the rejected distributions. With such congressional blessing of the reinvestment principle I think no court could say the principle was a fiction. I am confident the law would be sustained by the courts.

From time to time it has been suggested to the committee that a withholding tax should be enacted requiring cooperatives to withhold a fixed percentage of their distributable net margins. The percentage suggested has usually been 20. Personally I do not object to the idea, provided that a reasonable floor is fixed; that intercooperative distributions are eliminated and that the tax is made applicable to all dividend distributions of other corporations. However, cooperatives generally have strenuously opposed the suggestion. One strong basis for the objection is that thousands of small producers would be subjected to tax where no tax is due and because of the expense involved would never file claims for refund. In 1950, Karl D. Loos testified before the Senate Finance Committee on behalf of various cooperatives on this subject. His testimony may be found in the report of the hearings. It is an interesting and enlightening statement and well worth reading. Included in it are figures showing the actual patronage distributions of a number of cooperatives for specified years. The proportion of these which is less than $10 per annum is astonishing.

If legislation such as I have recommended, specifically taxing patronage distributions to the recipients, is considered, undoubtedly a withholding tax would again be urged. One of the reasons advanced would be that many farmers have objected to being taxed upon paper patronage refunds. It is not my experience that this is so, but undoubtedly some producers have complained, mostly those engaged in fruit and poultry production upon a large scale. To meet this situation and to facilitate the payment and collection of the tax, and thus to implement the legislation recommended, it has been suggested that all cooperatives, and other corporations, which have been in business for more than 3 years, be required to pay not less than 20 percent of all patronage distributions in cash. The argument is that this would make it simple for patrons to secure funds with which to pay the tax; would avoid untold trouble and expense for both taxpayers and the Government arising out of overpayments and claims for refunds, and would completely avoid injustices which would occur because of retention by the Government of the tax in cases where no tax was due and no claim for refund filed. On the other hand such a requirement might work real hardship on undercapitalized cooperatives. I have had no opportunity to investigate the suggestion and hence do not comment upon it.

If the recommendations I have made in respect to new legislation were approved, I think there would no longer be any doubt concerning the taxability at face value in the hands of recipients of patronage distributions of cooperatives whose members determine that their earnings should be taxed to them and not to the cooperative; that the collection of the tax would be facilitated; that there would be little or no complaint from cooperative members; and that fairness and justice would be done to cooperatives, their members and patrons, and the general public.

In conclusion, in my opinion

(a) The present income tax treatment of cooperatives (including the exemptions granted qualified farmers cooperatives) is sound and fair;

(b) The net margins of cooperatives (except those growing out of purchases made for personal use) should be taxed to patrons