in accordance with the intent of Congress when the 1951 amendment was adopted;

(c) The appropriate provisions of the code should be amended so as to avoid the court decisions which have largely nullified the intent of Congress and the longstanding rule of the Treasury Department.

THE PROPER TREATMENT OF COOPERATIVES

Charles E. Nieman, attorney at law, Minneapolis, Minn.

Mr. Chairman and gentlemen of the committee, my name is Charles E. Nieman; I reside in Minneapolis, Minn. I am a lawyer, and I have practiced in St. Paul and Minneapolis for more than 20 years. After completing the course at the University of Wisconsin Law School in 1936, I was employed by Mr. W. E. Rumble's firm in St. Paul through 1943. During those years, I worked on legal affairs of numerous farmers' cooperatives, including the Farmers Union Grain Terminal Association, which was formed in 1938. In 1944-46 I was the assistant general manager and corporation counsel for that association. In 1947, I opened my own office in Minneapolis and ever since have been in private practice. From 1939 through 1946, I was a part-time lecturer, teaching corporation law, at the St. Paul College of Law. In 1947 and 1948, I was a professor of law in the University of Minnesota Law School where I taught the course in private corporations.

My own clientele includes both business corporations for profit and cooperative associations; and substantially more of my professional income has been derived from clients which are not cooperatives than from those which are. However, I represent a couple of relatively small regional or federated cooperatives, and I have served literally hundreds of local farmers' cooperative grain, creamery, petroleum, shipping, livestock, electric, farm supply, and other kinds of associations in Wisconsin, Minnesota, Iowa, South Dakota, North Dakota, and Montana. I speak for no client in this statement; some of them won't like it. It is my own statement, and the responsibility for it is strictly mine. My interest is that of a lawyer and a citizen who has had an uncommon amount of practical experience with a wide variety of cooperatives, especially on the local, grassroots level, and who desires neither to help nor hinder either farmers or cooperatives or anyone else, but who welcomes this opportunity to try to contribute to the clarification, in the public interest, of the confusion which now beclouds the income tax status of cooperatives and their patrons.

These are my conclusions: (1) The operations of a cooperative association ordinarily result in the realization of income by someone; (2) that income should be reported as such by the taxpayer, either the cooperative or its patron, who derives the income; (3) that both the question of whether income results from the operations of a cooperative and, if so, the further question of who the association or its patrons derives that income should be determined by the same rules which apply to other taxpayers and with a recent regard for fundamental principles of law; (4) that the so-called exemption available to farmer cooperatives under section 521 and the tax treatment prescribed by section 522 are fully justified by the public interest, and my principal criticism of those sections is that they do not provide enough

incentive to induce more cooperatives to accept the limitations and restrictions which are conditions precedent to qualifying for such status and treatment.

1. UNDERLYING PRINCIPLES

Most congressional hearings, Treasury regulations and rulings, and judicial decisions involving cooperatives or their patrons reflect substantially more knowledge of tax law than understanding of what a group of informed farmers are trying to do when they undertake to organize and operate a cooperative association. Further, the combination of taxes and patronage dividends seems to drive many otherwise sensible and informed lawyers to forget or ignore legal principles which are so elementary that a law teacher expects his first-year students to understand and apply them. Yet, they are so consistently overlooked in discussions of income taxes and patronage dividends that we must emphasize them, even at the risk of insulting the reader's intelligence.

First, any two or more persons may simultaneously stand in more than one legal relationship to each other. For example, suppose that your wife drives you and your extra pair of pants to your office in your automobile, and then drops off your extra pants at the cleaner and buys a necktie for you on her way home, all with your authorization. You and she are not only husband and wife; you also are bailor and bailee of your automobile and pants, driver and passenger with respect to her operation of the automobile, principal and agent to incur the expense of cleaning your pants, and principal and agent to incur your debt for the tie which, of course, she charged to you. Although you and your wife are the same persons involved in all of those legal relationships, each is a separate and distinct legal relationship; each has different legal implications for each of you; each resulted from a separate and distinct contract or other agreement or combination of circumstances; and with respect to each such relationship, each of you acts in a different capacity.

A cooperative association is itself created by a contract; and its relationship with its members is a contractual relationship. Having been created by one contract and being governed by that contract in its relationships with its members as such, the association then enters into an infinite variety of other and additional contracts with either the same or different people. Each different kind of a contract creates a different relationship. That is true, even though the same people are parties to many different contracts with the association. Thus, even where the same farmers are both members and patrons of the same cooperative, they become members by one contract and they become patrons by a different contract. They stand in a different legal relationship to the cooperative as members than they bear to it as patrons. They act in one capacity as members, and in a different capacity as patrons. Their rights and responsibilities as members are created and governed by one contract; but their rights and responsibilities as patrons are created and governed by a different contract. Clearly, "member" and "patron" are not synonyms, even when both words refer to the same person. Probably nothing has created more confusion in tax cases and discussions involving cooperatives and their patrons than references to members as patrons and to patrons

as members. When one refers to a "patron" as a "member," he demonstrates that his language is not accurate, and it is difficult to escape the suspicion that his thinking may not be any more accurate than his language.

Sound tax results cannot be achieved without first gaining an accurate understanding of both the membership contract and the patronage contract. With respect to each contract, as is true of all contracts, the fundamental effort must be to ascertain the intention of the contracting parties and, in the absence of contrary public policy or illegality, to give effect to their intention.

However, both the membership contract and the patronage contract frequently are found in the same, instead of separate, documents. More often than not, the language is thoroughly ambiguous or downright contradictory. Seldom is there any evidence that the draftsman had any discernible theory concerning the nature of the legal relationship to be established by those contracts. More often than not, those documents were prepared by an agricultural college professor, an extension agent, an accountant, a group of farmers, or a combination of such laymen, instead of a lawyer; and if any lawyer was involved it frequently was one with little experience in the fields of corporation law and corporate income tax law. Unlike most corporation tax lawyers, however, those draftsmen did understand what farmers intended when they organized and operated a cooperative. The result is that a cooperative's tax case typically involves a contract, which was written by laymen in the fields of law and taxes, being construed by amateurs in the field of agricultural cooperation. Nevertheless, it still is a cardinal rule that, in the construction of a contract, the intention of the parties should be ascertained and given effect.

II. COOPERATIVES GENERALLY

Study and knowledge of the history and development of agricultural cooperation compels these conclusions:

(1) That cooperators stand in at least three separate and distinct contractual relationships to their cooperative; viz, (a) as members under their membership contract, (b) as patrons under their patronage contracts, and (c) as investors under their invest

ment contracts.

(2) That only the "patronage contract" is properly involved in any consideration of the excludability of net margins from the gross income of a taxable cooperative; only confusion of tax consequences can result from failure to distinguish the patronage contract from the membership contract and the investment contract in either the drafting of such contracts, the construction of them, or the application of income taxes to the net proceeds which result from only the patronage contract.

(3) Regardless of whether the cooperative organization was (a) merely an isolated joint venture for a single transaction, (b) a continuing joint venture for a series of such transactions, (c) an unincorporated association to engage in a continuing marketing or procurement business, or (d) an incorporated association to engage in such business, the marketing agency-whether (a) a natural person employed by the joint venturers or the members

of the unincorporated association or (b) the incorporated association itself was a common agent of the patrons as multiple principals.

(4) In recent years, the concept of the corporate association as a common agent for the patrons as multiple principals has greatly deteriorated, and it is increasingly regarded as being a principal in its relationship to its patrons.

(5) So far as the basis for excluding patronage dividends from the gross income of a cooperative association is concerned, it is immaterial whether the association is a common agent for the patrons as multiple principals or is itself a principal in its relationship to its patrons.

The foregoing conclusions can be demonstrated by a study of the history and development of cooperative marketing and procurement during the past century and one-half. Even an abstracted review of that history and development is impossible in this statement if it is to be held to any reasonable length. Consequently, such review has been deleted in the interest of brevity, but the importance of a background knowledge of cooperation and the reliability of the above enumerated conclusions cannot be overemphasized.

III. TAXABLE COOPERATIVES

Prior to the Revenue Act of 1951, certain farmers' cooperative associations were literally "exempt" from Federal income taxes under section 101 (12) of the 1939 code, which is now section 521 of the 1954 code; associations which did not so qualify were, and are, "taxable." Since 1951, however, there has been no such thing as a cooperative which is actually "exempt" from Federal income taxes; those which were "exempt" prior to 1951 were subjected to tax by the provisions of the 1951 act which now appear in section 522 of the 1954 code. Notwithstanding the fact that there now is no such thing as a cooperative which as such is "exempt" from Federal income tax, we will refer to those which are taxable under section 522 as "exempt" cooperatives, and we will refer to all other cooperatives which are taxable as other corporations are taxed as "taxable" cooperatives.1

We designate as a cooperative's "gross receipts" the sum of (1) the gross proceeds of sales of products marketed for its patrons (or gross commissions if the association acts as a broker instead of a principal in its marketing activities), plus (2) the gross proceeds of sales of supplies, equipment, or services to its patrons, plus (3) all income from all other sources. We refer to "gross receipts," instead of the more familiar "gross income," for the reason that the gross receipts include certain receipts which are not income to the association in addition to the receipts which are income to it. We designate as the "net margns" the balance of the gross receipts which remains after deducting the sum of all items which are excludable or deductible from a taxable corporations' gross income for the purpose of determining its taxable income, except the amount of the patrons' net margins. We refer to "net margins," instead of the more familiar "net income" or "net profit," for the reason that the net margins include certain amounts which are not income or profit to the corporate association. We designate as the "association's net margins" so much of the net margins as the association is legally entitled to retain for its own account, and we designate as the "patrons' net margins so much of the net margins as the association is legally obligated to pay to its patrons. We designate as "patronage payments" so much of the net margins, either association's net margins or patrons' net margins or both, which the assciation pays to its patrons on the basis of their respective patronage of it. We refer to "patronage payments," instead of the more familiar "patronage dividends," because "dividends" ordinarily connote a distribution of a corporation's profit or net income, but patronage payments may or may not include corporate profits or net income. We refer to "patronage payments." instead of "net proceeds" or "net savings," because "net proceeds" ordinarily connotes net receipts from marketing activities and "net savings" ordinarily connotes net receipts from procurement activities, but "patronage payments" may include both net proceeds and net savings and sometimes even net income.