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COOPERATIVES AND INCOME TAXES

(By Wilfrid E. Rumble*). Cooperative associations are subject to every real- and personal-property tax and almost every other type of tax, in the same way and to the same extent as ordinary private business corporations. It is in respect to income taxes that their treatment is different. It is to that point that this article is addressed.

In order fairly to judge the point of view of cooperatives as to their incometax status, an understanding of the general nature of cooperatives in necessary. The cooperative corporation is essentially a group of individuals or corporations, or both, organized into corporate form for the purpose of acting collectively in the marketing of their products or the acquisition of their supplies. Almost every State in the Union has statutes expressly providing for the organization of cooperative corporations, and Congress has provided for the organization in the District of Columbia of cooperative associations of consumers. Most of these laws were originally enacted principally to insure to groups of farmers the right to act collectively without violating State antitrust statutes. Congress assured to cooperatives the same immunity from Federal antitrust statutes by enactment of the Capper-Volstead Act in 1922. Neither State nor Federal law grants such immunity to cooperatives in their ordinary commercial transactions and dealings.

A cooperative may be organized under the ordinary business corporation statutes of most States. The Federal Farm Board, acting under the advice of Stanley Reed, then its general counsel, now a Justice of the Supreme Court of the United States, organized its great cooperative marketing and warehousing corporations under the general corporation statutes of Delaware. There are, of course, some advantages in organization under the usual cooperative statutes, but there are also definite restrictions and disadvantages. The Minnesota General Cooperative Act ' is fairly typical. Cooperative associations organized under these statutes differ from business corporations in several important respects, among which are the following:

1. There is a limit on the amount of voting stock a member may own, a common limitation being “not more than one-twentieth of the stock outstanding";

2. Dividends on capital stock may not exceed a stated rate, such as 6 percent per annum, and are not cumulative;

3. Each member has 1 vote only, regardless of the number of shares of stock he owns; and

4. All earnings or savings remaining after payment of expenses of operation, dividends on capital stock, and provision for required reserves must be distributed.

There are in general two types of cooperative association : One engages in marketing or selling the products of property of its members and patrons (customers), and is commonly known as a marketing cooperative. Practically all cooperatives of this type are owned and controlled by farmers, and market only farm products. The other engages in purchasing or buying supplies and goods for its members and patrons, and is commonly known as a purchasing cooperative. Despite the growth in recent years of urban purchasing cooperatives, it is still true that many of the purchasing cooperatives are principally owned and controlled by farmers. Urban cooperatives of this type are frequently referred to as consumer cooperatives. Some farmer-owned cooperatives engage in both marketing and purchasing activities. The principal purpose of any cooperative association is to sell, buy, or furnish products, merchandise, or services, as the case may be, for its patrons at cost. In order further to reduce costs to their patrons, some marketing cooperatives engaged in the first processing, warehousing, and transporting of farm products, and some purchasing cooperatives, for the same purpose and also in order to secure necessary supplies, engage in manufacturing operations and own and operate oil wells, refineries, fertilizer plants, and feed-processing plants.

*Member of the Minnesota bar and of the firm of Doherty, Rumble, Butler, and Mitchell, St. Paul, Minn. ; counsel for several cooperative associations.

District of Columbia Cooperative Association Act, Public Law 642, 76th Cong., 3d sess., ch. 397, approved June 19, 1940.

42 Stat. 388, 7 U. S. C.. sec. 291 (1940). * Minn. Stat. Ann. (1945) secs. 308.05 to 308.18.

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Cooperative associations vary in their actual methods of operation. Generally, however, the marketing cooperative agrees to market all the agricultural prid. ucts of the type handled by it produced and delivered to it by its patrons, and to pay to each patron the entire marketing proceeds after deduction of expenses When a patron delivers products to the cooperative for sale the amount to which he will finally be entitled cannot be known so the cooperative pays to the patron a substantial part of the estimated sales price. At the end of the year when the products have been sold and the costs determined, the cooperative distributes the remainder of the proceeds to its patrons in proportion to the products marketed for them. This distribution is called a patronage refund, but in reality it is further payment of the sales price. In addition to their selling, processing, warehousing, and other activities incident to the marketing of products to the best possible advantage, most farmers' marketing cooperatives employ laboratory and other experts for the purpose of improving the quality of their patrons' products, increasing efficiency in production, and informing members of current developments in production methods, types of product, and equipment.

A purchasing cooperative agrees to buy and deliver to its patrons farm supplies and other goods at cost. Since the actual cost of each purchase cannot be determined in advance, the cooperative usually charges and collects from the patron au amount more than sufficient to cover the expected cost price plus estimate operating expense. At the end of the accounting period the actual cost of goods purchased plus cost of operation is determined, and any excess amount colle tel from the patrons is returned to them in proportion to their purchases. The amount so returned to the patrons is a true patronage refund.

In American Shook Box Erport Association v. Commissioner," the court said: "In order to be a true cooperative, however, the decisions emphasize that there must be a legal obligation on the part of the association

to return to the members on a patronage basis, all funds received in excess of the cost of goods sold. Such an obligation may arise from the association's articles of incorporation, its bylaws, or some other contract."

I would define a true cooperative as one which is legally obligated, by written agreement or by appropriate provisions of its articles of incorporation or bylaws or by the statute under which it is organized (1) to distribute to its members or patrons, or both, in proportion to their patronage, all of its income in excess of its costs of operation, except such as it is authorized to pay in limited dividends upon capital stock and to place in statutory or other necessary reserves, and (2) to allocate or credit all reserves (except consumable reserves) to the patrons who contributed to them, upon the same patronage basis. It is this type of true cooperative to which I refer when using the term “cooperative."

Cooperative associations are organized either on a capital stock or on a membership basis. In the capital-stock cooperatives exclusive voting control is in the common or membership stock and all eligible patrons must acquire at least one share, which may be paid for upon an ordinary subscription basis or br the application of patronage refunds. In most membership cooperatives the patron, if eligible, is required to pay for a membership (usually the fee is nominal) when he first patronizes the cooperative.

Cooperatives need capital, as do private business corporations. Indeed, soine marketing cooperatives need more capital than private business corporations with which they may be in competition, because of their obligation to accept al products tendered by their members, regardless of market conditions. Such cooperatives cannot buy when market conditions are favorable and refuse to buy at other times. Carrying of large inventories and consequent unusual exposure are inevitable during certain periods and seasons.

Cooperatives generally finance themselves through the issuance of preference stock, bonds, notes, certificates of indebtedness, and bank borrowings, and the use of revolving and other reserves. A large part of the securities of cooperatires is sold to members and patrons in the usual fashion, except that sales are direct from the cooperative to the individual purchaser. It is practically impossible for a cooperative to offer a security which is attractive to the ordinary investor. be cause of the usual provisions of State statutes limiting dividends upon capital stock, prohibiting payment of cumulative dividends, requiring that control of the corporation shall always be in members (producer-members in farmer (v operatives), limiting the class from which directors and officers may be chosen,

* 156 F. 2d 629 (C. C. A. 9th 1946). 3 Id. at 630.

and other less important restrictions. Thus cooperatives are practically compelled to secure their capital from their own patrons and members. The result is that this capital has been secured to a considerable extent from the reinvest. ment in capital securities of the cooperative by patrons of their share of the receipts of the cooperative. All the State statutes require cooperatives to distribute net income (after dividends on capital stock and after small required reserves) to patrons annually or oftener, and most of them expressly permit distributions to be made in capital securities. It is principally the methods used by cooperatives to finance their activities which give rise to the present bitter attacks upon the income-tax treatment accorded cooperatives by Congress, the Treasury Department, and the courts.

Since 1916 the Internal Revenue Code has provided an exemption for farmer cooperatives fulfilling certain stated conditions. The Internal Revenue Code contains no other provisions specifically applicable to cooperatives, so that for income tax purposes there are only two classes of cooperatives, one class consisting of those wholly exempt from the payment of income taxes, and the other of those which are not exempt and which are subject to the same rules, regulations, and laws as private business corporations. Orderly treatment requires separate consideration of each class.

EXEMPT COOPERATIVE ASSOCIATIONS

The exemption provisions applicable to cooperative associations appear in section 101 (12) and (13) of the Internal Revenue Code.• Section 101 (13) is not particularly important here. Section 101 (12) is set forth in a footnote."

The statute, in different form, was first enacted in 1916 and has been amended on several occasions, but it has been in substantially the present form since 1926.

It will be observed that the statute offers to certain farmer cooperatives a conditional right to be exempted from the income tax. There are approximately 10,300 farmer cooperatives. Roughly, half of them have been granted exemption.

In order to qualify for exemption under this section a marketing association must limit its marketing operations to the marketing of the agricultural products of its members and patrons, pay to its patrons the proceeds of its sales less the necessary operating expenses on the basis of the products furnished by them, and limit its marketing of nonmembers' products to an amount not exceeding the products marketed for its members. A purchasing association must limit its operations so that the volume of goods purchased for nonmembers will not exceed the volume of goods bought for members, and so that purchases for those who are neither members nor producers will not exceed 15 percent of total pur-, chases. An association of either kind must be both organized and operated on a cooperative basis. All receipts in excess of actual cost must be turned back to patrons on a patronage basis. There may be no discrimination between members and nonmembers. Records must be kept in a manner that will disclose the interest of every patron in any patronage margins. If the cooperative has

8 53 Stat. 876, 26 U. S. C., sec. 101 (12), (13) (1940). ? "Farmers', fruit growers', or like associations organized and operated on a cooperative basis (a) for the purpose of marketing the products of members or other producers, and turning back to them the proceeds of sales, less the necessary marketing expenses, on the basis of either the quantity or the value of the products furnished by them, or (b) for the purpose of purchasing supplies and equipment for the use of members or other persons, and turning over such supplies and equipment to them at actual cost, plus necessary expenses. Exemption shall not be denied any such association because it has capital stock, if the dividend rate of such stock is fixed at not to exceed the legal rate of interest in the State of incorporation or 8 per centum per annum, whichever is greater, on the value of the consideration for which the stock was issued, and if substantially all such stock (other than nonvoting preferred stockthe owners of which are not entitled or permitted to participate, directly or indirectly, in the profits of the association, upon dissolution or otherwise, beyond the fixed dividends) is owned by producers who market their products or purchase their supplies and equipment through the association ; nor shall exemption be denied any such association because there is accumulated and maintained by it a reserve required by State law or a reasonable reserve for any necessary purpose.

Such an association may market the products of nonmembers in an amount the value of which does not exceed the value of the supplies and equipment purchased for members : provided the value of the purchases made for persons who are neither members nor producers does not exceed 15 percent of the value of all its purchases. Business done for the United States or any of its agencies shall be disregarded in determining the right to exemption under this paragraph." Id, sec. 101 (12).

* Revenue Act of 1921, sec. 231 (11) : Revenue Act of 1926, sec. 231 (12) ; Revenue Act of 1928, sec. 231. The Revenue Act of 1928 adied what is sec. 101 (13) of the present Revenue Act.

See also U. S. Treas. Reg. 111, sec. 29.101 (12), (13), (1943). 79120451—pt. 247

capital stock it may not pay dividends in excess of the legal rate of interest in the State of incorporation or 8 percent, whichever is higher. In case of liquidation, stockholders may receive nothing in excess of the value of the consideration paid for the stock plus any unpaid declared dividends. Substantially all the voting stock must be owned by farmers who market their products or purchase their supplies and equipment through the cooperative. It must not maintain any reserves other than those required by the laws of the State of incorporation and reasonable reserves for necessary business purposes.

In order to have its right to exemption recognized a cooperative association must apply for and receive a letter of exemption from the Treasury Department. The exemption is effective only so long as the cooperative's form of organization and business practices conform to the statements made in the application and to the requirements of the Revenue Code. Those requirements are sufficiently onerous that many farmer cooperatives do not seek the exemption.

An exempt cooperative pays no Federal income tax so long as it meets the statutory requirements. It is completely exempt from income tax in its operations. If it fails to comply with any of the statutory requirements, it loses the exemption and becomes subject to taxation as an ordinary corporation. There is no such thing as a partially exempt cooperative.

The exemption option is a special privilege extended to the agricultural industry. Most lawyers for farmer cooperatives make no attempt to justify the exemption upon legal grounds. It was granted by Congress because that body concluded that the best interests of the Nation demanded that farmers be given this benefit in aid of their production of food for the Nation. Or, as was stated by the Committee on Small Business of the House of Representatives,

The enactment and reenactment of section 101 (12) and (13) of the Internal Revenue Act appear to represent a continued attitude on the part of the Congress that the maintenance of a sound agricultural economy is necessary for the preservation of the national well-being.

An exempt cooperative pays no income tax upon dividends paid on its capital stock or upon unallocated reserves created and maintained within the limitations of the exemption section. Practically, these are the only tax advantages of an exempt cooperative over a nonexempt cooperative. It has always been true that the limited dividends on capital stock paid by exempt cooperatives and their unallocated reserves are not of sufficient amount materially to affect the tax revenue, although they are of the greatest importance if such cooperatives are to be of substantial aid to agriculture.

The Under Secretary of the Treasury, A. Lee M. Wiggins, testifying before the Committee on Ways and Means of the House of Representatives in November 1947, stated that, although it was difficult to determine the exact figures, the Treasury would estimate that repeal of the exemption might increase Federal revenue by $10,000,000 to $20,000,000 a year.10 The House Committee on Small Business, in the report mentioned above, found that no appreciable revenue would accrue to the Government if income taxes were levied upon the dividends on capital stock and amounts placed in reserves by exempt cooperatives." The Senate Committee on Agriculture and Forestry in a recent report stated :

"Much of the current criticism to the effect that cooperatives should be taxed more heavily is in reality an attack against cooperatives as such by competing businesses rather than a criticism based upon the merits of the problem. The patronage dividends paid to farmers for savings made through cooperative marketing do not escape taxation, for the individual farmers must pay income taxes upon them. The tax loss to the Government is not great, and insofar as this loss is of concern, it should be noted that funds returned to members in the form of patronage dividends are not the property of the cooperatives but are part of the sales price or savings on the purchase price of individual transactions. In addition, the total amount of patronage dividends of farmer cooperatives is not large compared with the widespread purchase of supplies by employees of industry from the same or related corporations at wholesale prices on which the corporations pay no tax because of lack of profit from the transactions." 'In measuring the value of farmer cooperatives to the agricultural industry, the attitude of the farmer toward his cooperative must be kept in mind. To the

* 12

First Interim Report of the House Committee on Small Business, April 9, 1946.

10 Hearings before the Committee on Ways and Means on proposed revisions of the Inter nal Revenue Code, 80th Cong., 1st sess., 1885 (1947).

11 See note 9, supra. 12 Report of the Committee on Agriculture and Forestry, S. Rept. No. 885, 80th Cong. 2d sess., 42 (1948).

10 million or more American farmers who belong to farmer cooperatives, it is one of the tools of their food factories, as important as their tractors, plows, automobiles, or other farm equipment. The prosperity of their cooperatives is directly reflected in their own economic status. Every farmer is a capitalist. He is in competition with the great marketing and distributing corporations of the country, both in marketing his products and in purchasing his supplies. Operating alone he cannot be successful in his effort to meet such competition. Only by joining with other farmers can he compete in the market places of this country. These are the conditions that brought farmer cooperatives into existence and moved Congress to pass laws for their encouragement. Through his cooperatives the farmer may be placed in a relatively equal competitive position with other capitalistic enterprises.

The exemption is valuable to the farmer cooperatives. They will continue to exist if the exemption is repealed, but their effectiveness as aids to the agricultural industry will be substantially reduced, partly because of the additional cost entailed by repeal, partly because of the increased operating, financing, and administrative burdens, and partly because field and expert services now given their members would be curtailed. There is no reason to believe that the situation of the farmer in the period which lies ahead will be any different from his situation in any other postwar period, with one exception-the demands for his products will be far greater than ever before. The farm population is diminishing, but the number of people for whom the agricultural industry must supply the absolute necessities of life, both here and abroad, is rapidly increasing. The cost of every phase of farm operation has sharply increased. Reduction in those costs will lag far behind the inevitable reduction in the price of farm products. Repeal of the exemption would react badly among farmers, and I think the welfare of the Nation requires that no unneces. sary action be taken which might have that effect. The production of adequate food and fiber supplies is a matter of paramount importance to the people of this country. Production of Government revenue is also important. But the insignificant amount of revenue involved is not worth any risk whatever that the greater effort might be impaired. I believe we should aid Europe. We talk about expending 20 billions of dollars for that purpose. I cannot understand a philosophy which at the same time cavils at foregoing a few million dollars of Government revenue to aid in the continuance of an adequate food and fiber supply for our own people.

NONEXEMPT COOPERATIVE ASSOCIATIONS

The provisions of the Internal Revenue Code applicable to ordinary business corporations apply in their full extent to nonexempt cooperatives. There is no statutory provision which gives to such cooperatives a right to income-tax treatment different from that given to any other business corporation, nor do court decisions or departmental rulings create any such right. Nonexempt cooperatives pay income taxes on the same basis as any other nonexempt corporation. They do pay for lower income taxes in dollars than ordinary business corporations, but that fact is due wholly to the difference between the two methods of doing business. Cooperatives have income. Our whole theory of the Federal income tax, however, is that it is a tax only upon profits and not a tax upon gross income. The important question therefore is : Does a true cooperative have any corporate profit or taxable net income upon which it avoids income taxes. The answer to the question depends largely upon the treatment to be accorded obligatory patronage distributions.

Analysis shows that patronage distributions of a true cooperative are not profits of the corporation and that such distributions must be excluded in determining its net taxable income. (The term "excluded” rather than "deducted" is used because such distributions do not and should not enter into the income account of the cooperative at any time.) This is the position to which the Treasury Department has adhered for many years, and there can be little dispute that the courts have adopted the same view. The position of the Treasury. Department is perhaps best stated in the following quotation from a memorandum of the general counsel :

"So-called patronage dividends have long been recognized by the Bureau to be rebates on purchases made in the case of a cooperative purchasing organization or an additional cost of goods sold in the case of a cooperative marketing organization when paid with respect to purchases made by or sales made on account of the distributees. For purposes of administration of the Federal

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