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a cooperative's gross income was, for many years, the fact that the association was the common agent for its patrons as multiple principals in the marketing of their products. Consequently, so the explanation runs, the association received the net proceeds of its sales of the patron-principals' products as agent with no claim of right by the association-agent. It undoubtedly is true that the corporate association ordinarily was the common agent of the patrons as multiple principals. But the mere fact that an agency relationship existed was not, in itself, the important factor. The crucial point was that the terms of the agency imposed on the agent an obligation to pay over the net proceeds to the patron-principals. Thus, the obligation to pay over is the significant element. In other words, and somewhat plainer English, when the agent received the net proceeds, he became indebted to the patron-principals for that amount of money. In some cases, the association was referred to as a mere “conduit" through which the net proceeds passed from the association's customer to its patrons. All of the various theories and explanations come down to one hard fact, which is that the net proceeds, as received by the association, constituted debts which it owed to its patrons, rather than income which it owned.

There is a reluctance to refer to the association's obligation as debt, but that four-letter word is more readily understood than obligation.

If all cooperatives' net margins were debts and were paid in cash promptly at the close of each fiscal year, there probably would be no difficulty in applying the above-suggested principles to such taxpay, ers. However, the development of the practice of revolving capital in cooperatives has tended to obscure the application of those principles. So long as cooperatives operate for the financial profit of their patrons, rather than of the association or its stockholders or members as such, and so long as State laws limit each stockholder's voting power and dividend rights as they do, it quite obviously will be necessary for cooperatives to look to their patrons to provide most of the capital which is necessary to finance the association's properties.

The patrons may furnish that capital in either of two ways. They may contract that the association may retain a part of the net margins for capital or they may contract to pay in to the association certain amounts of money as capital. “Capital" and "income” are two different words, and they refer to two different things. There is no tax on capital, but taxable income is subject to tax. Hence, it becomes important to distinguish between money which a corporate taxpayer receives as income and that which it receives as capital.

Before the impact of corporate income taxes became as burdensome as it is today, it was not unusual for cooperatives and their patrons to provide in their patronage contracts simply that the association may retain all or any part of the net margins and pay over to the patrons only so much, if any, of the net margins as the association's board of directors may, in its discretion, decide to pay. Such a provision authorized patronage payments, but it did not legally obligate the association to pay anything to its patrons. Hence, when the net margins were received by the association, they were neither debts then owed by it nor were they capital unless and until they subsequently were capitalized. Consequently, the net margins were not, when received, excludable from gross income, either as debts or capital.

Obviously, they were neither assets nor expenses and, by elimination, they necessarily must have been income. If the association subsequently paid anything to its patrons, it necessarily did so voluntarily and there is no provision for any deduction for patronage payments voluntarily paid. Consequently, the net margins under such a patronage contract properly were gross income when received, were not deductible when paid out, and the association was subject to tax on any resulting taxable income.

Numerous other associations' early patronage contracts purported to require the association to pay patronage payments to its patrons, but further provided that the association, in the discretion of its board of directors, might pay them either in cash, or “in” shares of stock, or “in” various other kinds of interests or credits in various kinds of nonstock capital, or that the board of directors may, in its discretion, defer payment of the net margins until the board determined that sufficient funds had accumulated to permit payment in cash without borrowing. The variety in the forms of such provisions in the different patronage contracts of various cooperatives is so great that it is not possible to catalog all of them. In substance, however, they all add up to the fact that the association was not obligated to pay any patronage refunds in any particular form or manner unless and until its board of directors should voluntarily decide to do so, and that the day when the patron could demand and enforce payment as a matter of right would never arrive prior to the date of the dissolution of the association.

Under all such provisions which reserve to the association the right to determine when, if ever, it actually will pay the net margins to its

, , patrons, the association is not “indebted” to them for any amount of money and the net margins cannot properly be excluded from the association's gross income on the ground that they constitute debts of the association rather than income to it. Under such provisions, however, the associations sometimes successfully argued that the net margins were excludable from gross income because they constituted capital rather than income. Such contention will be considered in connection with the next type of patronage contract provision to be considered.

About 15 years ago, and after various cases had indicated that it was the income or nonincome character of the net margins, rather than whether they were or were not “true patronage dividends," which determined whether or not the net margins were excludable from the association's gross income, still another type of patronage contract provision appeared. Numerous associations expressly provided that it should have the right to "retain" part or all of the net margins "as capital” and that the amounts thus retained shall have the same status as though they had been paid to the patrons in cash in pursuance of a legal obligation to do so and the patrons had then furnished corresponding amounts of capital to the association. That type of provision has generally been recognized as entitling the association to exclude the net margins from its gross income.

However, in a patron's tax case, the Government argued that under implied agreement arising out of those bylaw provisions, the patron in effect received in cash the amount of the credit and then reinvested it in the association's revolving fund. The court rather cavalierly dis

47060—59—pt. 3—29

missed that argument with the curt assertion that, “This is simply to exalt fiction and ignore reality.” Long Poultry Farms, Inc. v. Commissioner (C.A. 4, 1957) 249 F. 2d 726.

However, that court notwithstanding, a corporate bylaw or contract is no mere fiction. The existence of a bylaw or contract is a fact, and the court's primary responsibility is to ascertain and give effect to the parties' intention. However, such a contractual provision states the parties' intention in terms of a legal conclusion rather than in factual terms. Such a bylaw or contractual provision does not expressly obligate the association to pay the net margins to the patrons in cash or its equivalent at any particular time and it, therefore, is arguable that the net margins, when received subject to such a provision, are not debts and excludable from income as such.

A relatively few cooperatives contract with their patrons, at the time when they patronize the association, that it unconditionally promises to pay to each patron in cash, on the last day of each fiscal year, an amount of cash equal to the patron's share of the net margins which result from the association's operations in that year. Under such a provision, the net margins manifestly are received by the association as debts rather than as income to it. If the patrons subscribe for shares of stock, revolving fund credits, or other interests in nonstock capital and unconditionally promise to pay their subscriptions in cash upon acceptance by the association and call for payment at any time in the next succeeding fiscal year, then when the subscribers pay cash to the association for shares of its capital stock or revolving fund credits or other interests in other nonstock capital, that cash is received by the association as capital rather than as income and, therefore, is excludable from its gross income. Where that is done, the association ends up with the cash as capital, and the patron ends up with an investment in the association's capital. Furthermore, the association has realized no income and has incurred no income tax liability, but the patron has realized gross income equal to the full amount of the net margins which were paid to him in cash, and he has incurred liability for income tax on so much of that gross income as remains, after his exemptions and deductions, as taxable income.

As the law now stands, a cooperative association or any other kind of a taxpayer can decide for itself whether and to what extent it will operate so that the net margins will be income to it, and it can decide whether and to what extent it will operate so that the net margins will be income to its patrons. Having made that decision, it then must contract with its patrons accordingly by including appropriate provisions in its bylaws or a separate instrument or whatever piece of paper sets forth its patronage contract with its patrons. It is not in the public interest to try to force all of the multitudinous varieties of taxable cooperatives into a single organizational and operational pattern by enacting an income tax law which includes definitions of cooperatives and their patrons and their net margins and then prescribes some kind of special tax treatment for them different from the tax treatment of other taxable corporate taxpayers in the same line of business.

The present confusion has resulted principally from (1) the Treasury's lack of consistency in applying to taxable cooperatives the same principles which apply to other corporate taxpayers in the same line

of business, (2) the abysmally ambiguous and contradictory provisions in numerous cooperatives bylaws, marketing agreements, and other documents which constitute their patronage contracts with their patrons, and (3) the lack of adequate enforcement which has permitted hundreds of cooperatives to continue, for many years and in completely good faith, to exclude or deduct their net margins from their gross income when their patronage contracts and practices plainly left them subject to tax, and which has permitted many people, who judge what the law is by what they see others doing, to mistakenly assume that such cooperatives were not subject to corporation income taxes.

The existing confusion can best be clarified by your committee and Congress making it plain to the Treasury as well as to the cooperatives and their critics: (1) that taxable cooperatives are subject to precisely the same income tax laws as any other corporate taxpayer; (2) that there is a statutory basis for the exclusion of cooperatives' net mar. gins from their gross income, and that basis is section 61 (a) which defines "gross income" as "all income from whatever source derived”. (3) that debts are not gross income; (4) that no taxpayer is required to report his debts as income; and (5) that whether a taxable cooperative is or is not entitled to exclude its net margins from its gross income depends upon whether and to what extent the net margins, tested by the same rules which apply to anyone else, constitute debts or in

come.

IV. EXEMPT COOPERATIVES

Since 1951, there have been no cooperative associations which, as such, are literally exempt from Federal income taxes. Nevertheless, for convenience and consistency with the statutory terminology, we refer to associations which have qualified, under section 521, for the two special deductions granted by section 522, as "exempt” associations.

During the past 20 years, we have encouraged almost all of our farmer cooperative clients to become exempt, or to maintain their exempt status. In most cases, it has been difficult to demonstrate that the exemption would confer any substantial financial benefit on the association. In several cases, it has been manifest that there was more demonstrable financial benefit to the association as a taxable corporation than as an exempt cooperative association. Nevertheless, we happen to have an abiding faith that it is preferable for either an individual or business organization to perform consistently with what he or it professes to be. Most of the cooperative associations which we advise like to think that they are organizations of farmers which do business substantially at cost and without profit to the association as such but for the profit of their farmer-patrons as farmers. In effect, that is all which they must do in order to qualify under section 521.

However, that imposes some very real limitations and restrictions upon their business activities and opportunities for profit. In the marketing of farm products, they must receive substantially all of their products from farmers. From time to time, they have opportunities to buy farm products from a trucker or other dealer under circumstances which yield a good prospect of substantial profit for the association and its patrons, even after payment of income taxes on such

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profit. Many times, they have capacity for more business than their farmer-patrons can furnish and there is a desire to buy farm products from nonfarmers in order to build volume for the most efficient and profitable use of the existing plant.

In numerous other circumstances, we have had to advise such clients that their acceptance of such nonproducer business would destroy their exempt status; and that if they wished to remain exempt, they would have to pass up that business and leave it to others who engage in such business on a profit basis. In such cases, we have explained that the exemption statute was enacted because the Congress deemed it to be in the public interest to enable farmers, as farmers, voluntarily and under private ownership and operation of their cooperatives, to render farming more profitable by enabling them to get a better price for their own farm products and to reduce their own farming costs and expenses. But the Congress did not deem it advisable to encourage farmers to engage as dealers in the business of dealing in other people's farm products at a profit in competition with dealers who engaged in that business for the purpose of earning a profit, paying income tax on it, and supporting themselves and their families on what was left after taxes. In most cases, we have been able to persuade our clients to forgo such profit opportunities, to retain their exempt status and the essentially nonprofit character of their association as such.

Our observation has been that there is relatively little informed criticism of the so-called exempt cooperatives as such. That probably is because they pretty well restrict themselves to farmers business. After all, who has a better right to sell corn than the man who grew it? There is substantially more criticism of the taxable cooperatives which, being unhampered by the restrictions of section 521, are free to compete for the business of patrons who are not farmers. Consequently, it seems to us that if many critics of the so-called exemption really understood the scope and effect of the exemption, they would realize that it probably is the best statutory protection from competition which they have.

However, the exemption statute could be improved in one respect. Section 521(b)(5) could be improved by amending it to read: “Business done for or with the United States or any of its agencies or any State or political subdivision of a State or public corporation shall be disregarded in determining the right to exemption under this section." (New matter in italics.) The existing statute has consistently been understood to mean that whether a grain cooperative stored grain for the Commodity Credit Corporation or sold grain to it or bought grain from it, such business should be disregarded in determining the right to exemption. However, as a matter of semantics, there surely is a difference between doing business for someone and doing business with him. Surely, the insertion of "or with” would clarify the section. Further, our experience has been that relatively few farmer cooperatives which handle petroleum products, coal, or lumber, especially in small towns, can stay within the 15 percent nonmember-nonproducer limitation. Frequently, that is for the reason that the village or the school wants to buy its fuel or building materials through the local cooperative. There is community pressure on the cooperative to be a good citizen and accommodate the public institution. However, the school and townhall may burn more than

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