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.19 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

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 Cong2d 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 unnecessary 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

income-tax laws, such distributions have been treated as deductions in determining the taxable net income of the distributing cooperative organization. Such distributions, however, when made pursuant to a prior agreement between the cooperative organization and its patrons, are more properly to be treated as exclusions from gross income of the cooperative organization (I. T. 1499; S. M. 2595; G. C. M. 12393). It follows, therefore, that such patronage dividends. rebates, or refunds due patrons of a cooperative organization are not profits of the cooperative organization notwithstanding the amount due such patrons cannot be determined until after the closing of the books of the cooperative organization for a particular taxable period."

This view has been approved by the Board of Tax Appeals." In Midland Cooperative Wholesale v. Commissioner," the Board of Tax Appeals said:

there is no

statutory provision for the deduction of pa tronage dividends from the gross income of a cooperative association. Such deductions have been allowed by the Treasury Department, however, in the interest of substantial justice to such associations. Justification for such allowance rests in the fact that such so-called dividends are in reality rebates upon business transacted by the association with members rather than true income." The prevailing rule in the Federal courts" is stated in Uniform Printing & Supply Co. v. Commissioner 18 as follows:

"If it [the distribution to patrons] was a refund or rebate to customers, it was not part of petitioner's taxable income, for the sum should have been included in the stockholders' [patrons'] taxable incomes.

*

"Had the taxpayer given a customer (whether stockholder or outsider) a discount promptly after filling the order, no one would call it a dividend. If a rebate were given promptly upon the customer's business reaching a certain volume, the same conclusion as to its character would follow. To make cost estimates and adjust them at or near the end of each year returning the excess payment to the customer should not change the reasoning which leads to this conclusion. Nor should the fact that the customer is a stockholder materially affect the result.

"It is true the taxpayer is not a nonprofit corporation in a legal sense. It is subject to a tax upon the profits by it made. Nevertheless, net profits in its case must depend upon the facts. Payment to the customers, who are also taxpayers, of sums called refunds based upon the volume of business transacted and in no way dependent upon stock ownership, is the determinative factor."* It is admitted that earnings of a cooperative on the business of patrons to whom there is no contractual obligation to make refunds are profits of the corporation and taxable as such, and of course the cooperatives admit that amounts paid to stockholders as dividends upon capital stock represent corporate profits which are taxable to the cooperative.

It is not necessary that patronage distributions be made in cash. If paid in money or its equivalent-capital stock, certificates of indebtedness, or notes-the distribution must be excluded.20 Although there has been criticism of this rule, there is little ground for it. The Treasury Department has always allowed ordinary corporations to deduct bonuses, salaries, or other operating expenses paid in corporate securities. Dividends upon capital stock so paid are treated as cash payments for the purposes of section 102 of the Revenue Code. For tax purposes there would seem to be little doubt as to either the propriety or the fairness of

the rule.

13 G. C. M. 17895, Cum. Bull. 1937-1, 56, and see I. T. 3208, Cum. Bull. 1938-2. 127. 14 Anamosa Farmers Creamery Co., 13 B. T. A. 907 (1928); Farmers Union Cooperative Ass'n, 13 B. T. A. 969 (1928); Grey Bull Corporation, 27 B. T. A. 853 (1933); Midland Cooperative Wholesale, 44 B. T. A. (1941); United Cooperatives, Inc., 4 T. C. 93 (1944); California Pine Box Distributors, P-H 1943 TC Mem. Dec. Serv. Par. 43,365 (1943). 15 44 B. T. A. 824 (1941).

10 Id. at 830.

17 Cf. San Joaquin Valley Poultry Producers Ass'n v. Commissioner, 136 F. 2d 382 (C. C A. 9th, 1943); Midland Cooperative Wholesale v. Ickes, 125 F. 2d 618 (C. C. A. 8th, 1942), cert, denied, 316 U. S. 673 (1942).

18 88 F. 21 75 (C. C. A. 7th, 1937).

19 Id. at 76.

20 San Joaruin Valley Poultry Producers Ass'n v. Commissioner, 136 F. 2d 382 (C. C. A 9th, 1943);Midland Cooperative Wholesale, 44 B. T. A. 824 (1941); United Cooperatives, Inc., 4 T. C. 93 (1944); G. C. M. 17895 Cum. Bull. 1937-1, 56 and I. T. 3208, Cum. Bull. 1938-2, 127.

There is perhaps some room for doubt concerning the right of a cooperative to exclude net margins distributed to capital reserves and credited or allocated to patrons. The Treasury Department rule is that such distribution, if a certificate of interest or prompt notice of distribution is given to the patron, is excludable." On the theory that distributions so made pursuant to contractual authority are actually capital contributions by the contributing patrons, the. ruling is legally sound; but the conclusion is based upon two assumptions, which might be called constructive receipt and constructive reinvestment, and is not altogether satisfactory. The decision of the Board of Tax Appeals " holding such reserves to be excludable is based upon the fact that the reserves there involved were withdrawable at the will of the patron, so that the reserve was in fact a credit or payment. Actually, most of such reserves are not subject to withdrawal by the patron.

Should Congress tax patronage distributions, assuming that it has power to do so? The principal argument for change is that present income-tax treatment of cooperatives gives them an unfair competitive advantage in their buying and selling operations over other forms of business organizations, such as business corporations, partnerships, and individual proprietorships. The nonexempt cooperative is, of course, treated for all practical purposes as a partnership or as an individual proprietorship. In each only one tax is paid. A majority of the private businesses in this country, and especially of those which compete with cooperatives, are partnerships and individual proprietorships. Whether or not a competitive advantage over corporate competitors may be derived from income-tax treatment, certainly the cooperatives have no material advantage over these competitors. Any competitive advantage the cooperatives may have over an ordinary business corporation is not due to its tax status. The marketing cooperative sells the products of its members in the same market as do the private selling agencies, and usually for about the same prices. It may reach the market with lower costs than the private agencies, but, if so, this is not attributable to the fact that the cooperative is not required to pay a tax upon its patronage refunds. Similarly, the purchasing cooperative cannot obtain merchandise at lower prices than do ordinary wholesalers or retailers merely because it need pay no income tax upon the savings effected on resale. If the purchasing cooperative makes greater savings than its competitors, the greater savings are not attributable to the fact that the cooperative will pay no income tax upon the savings. Income taxes subsequently payable upon profits or savings realized do not determine the amount of the profit or saving. The tax status of a cooperative, therefore, has no direct bearing upon any competitive advantage which it may have in its buying and selling operations.

It is a novel suggestion that the taxing power ought to be used to level off competitive advantages. Stock insurance companies are taxed on a basis different from that of mutual insurance companies. Building and loan associations, although today in active competition with commercial banks, are taxed on a basis different from that of banks. Other illustrations could be given. Perhaps the stock insurance companies and the banks feel that no competitive advantage arises from the tax treatment of their competitors. In any event, they have not urged a change in the Internal Revenue Code designed to level off their competition. Furthermore, this method of minimizing income taxes is open to all other forms of business enterprise and is often used by them. So-called private business establishments frequently adjust prices of both sales and purchases after transactions have been consummated. In many cases of renegotiation, discount rates are revised to reflect reduced costs or results of cumulative quantity sales or purchases in a good period or season. In practice such adjustments are considered as costs of operation to the business enterprise and not as distributions of earnings. Any other business establishment that is willing to serve its customers at cost without making a profit for its stockholders can avoid the payment of income taxes on amounts refunded or rebated in that manner.

Another argument which has been advanced against the present tax treatment of cooperatives is that patronage refunds represent money earned by the same processes of buying, selling, and manufacturing that are employed by other forms of business organizations, and that the taxability of earnings should de

See letters from Commissioner to National Council of Farmer Cooperatives in hearings before Committee on Ways and Means on proposed revisions of the Internal Revenue Code, 80th Cong., 1st sess., 2619. 2620 (1947). "Midland Cooperative Wholesale, 44 B. T. A. 824 (1941).

pend on the way in which those earnings are created and not upon the disposition that is made of them; that there is nothing in the mechanical organization or plan of operation of a cooperative to differentiate it from a business corporation from the tax angle; that patronage refunds represent a distribution of earnings by the corporation itself, and so should be taxed as income of the cooperative; and that the existing exclusion of patronage refunds is based upon a misunderstanding of their true nature. The complete answer to this argument is that a cooperative is bound by a preexisting contractual obligation to return to its patrons, on a patronage basis, the entire net proceeds of its operations, less dividends payable on capital stock and amounts set aside for reserves; that in the case of a marketing cooperative such payment represents the final settlement of the prices the patron is entitled to receive for his products, and in the case of a purchasing cooperative these payments represent a reduction in cost to the patron of the goods purchased by him through the cooperative; and that at no time does any part of such net proceeds either belong to the cooperative or constitute profit or income to it, except that earnings on the business of patrons to whom there is no such obligation do belong to the cooperative and are subject to taxation.

Both the preceding arguments, and as a matter of fact practically all arguments against the present method of taxing cooperatives, stem from the present double tax imposed upon the profits of ordinary business corporations. Most critics, lawyers, businessmen, and farmers agree that this double taxation is wrong, but if patronage refunds were taxed to the cooperative there would be even more vicious double taxation and extension of the wrong.

Should a cooperative be allowed to exclude patronage refunds which are distributed in the form of capital securities? Unquestionably the practice enables the cooperatives to build up capital more easily than would otherwise be possible, but payment of corporate obligations with corporate securities has long been a recognized practice. If the recipient agrees that the security is worth what is due him, there is complete payment. Practically, as the United States Tax Court said in the United Cooperatives case:

"The result of the procedure set up by petitioner's bylaws was as if the stockholder member who was under obligation to purchase additional stock had received, in cash, the "patronage dividend" and had thereupon applied this sum to the payment of his stock. The stock, when thus paid and issued to him, was not in the nature of a stock dividend, but represented an additional investment on his part to the capital of the corporation out of his savings from the annual transactions with petitioner." 23

As to the claim that cooperatives should not be permitted to exclude or deduct patronage refunds distributed or allocated to reserves, where the only evidence of the distribution received by the patron is a so-called certificate of interest or a mere notice of the distribution and allocation, the cooperative argument for exclusion is that these reserves are owned by the patrons to whom they have been allocated, and in any event they represent capital contributions made by the patrons pursuant to a valid contract between the patron and the cooperative. Notwithstanding the validity of this argument, it is somewhat doubtful that there is constructive receipt by the patron. It must be admitted that in all probability many patrons do not include such distributions in calculating their own income tax, so that some income, especially in farmer cooperatives, probably escapes taxation entirely.

One other minor criticism of cooperatives requires a word. It is charged that many patrons of cooperatives have no knowledge of or voice in the manner in which patronage refunds will be made. In a true cooperative there is no legal basis for the charge. The patron either has a formal written agreement with the cooperative covering the point, or, by notice, actual or constructive, is charged with knowledge of the provisions of the articles of incorporation or bylaws of the cooperative, which clearly define the manner in which distributions will be made. Where the formal contract does not exist, patrons as a practical matter may fix the pattern through their control of the corporation. The charge, even if true, has little or nothing to do with the tax problem. In any event, I think few cooperatives would object to a requirement of written revocable authority from individual patrons specifying the manner in which patronage distributions should be made, as a prerequisite to the exclusion or deduction of patronage refunds made in any form but cash.

23 4 T. C. 93, 108 (1944).