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The stamp provision quoted above was amended by section 441 of the revenue act of 1928 so as to make it plain that the provision referred to did not apply to "stocks and bonds and other certificates of indebtedness issued by any farmers' or fruit growers' or like associations organized and operated on a cooperative basis for the purposes, and subject to the conditions, prescribed in paragraph (12) of section 231" of the revenue act of 1926. This provision has been carried forward substantially unchanged in the Revenue Code of 1954.76

It is highly important that every cooperative or subsidiary thereof should carefully ascertain its tax status. In some States the failure of a corporation to pay license or franchise taxes may adversely affect the corporation. For example, in California the powers of a corporation which has failed to pay franchise taxes may be suspended and a corporation whose powers have been so suspended loses the right to defend a suit which has been brought against it."

Under the Constitution of Wisconsin it has been held that money raised by taxation may not be appropriated and used in advising with

* * * individuals or groups of the requirements advisable for consideration in the organization of a cooperative association and so to promote the organization, collect and disseminate such information, and engage in such educational activities as he might deem advisable to make available information relative to the benefits to be derived from the organization of a cooperative association

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in a particular county, as this was regarded as a local and not as a State problem.

Federal Income Taxes

Six times, following the adoption of the 16th (income tax) amendment, the Congress of the United States in tax legislation has enacted provisions dealing specifically with farmer cooperatives. In each instance the distinct character of the cooperative form of doing business has been recognized. The Congress also has clearly manifested a desire to foster these mutual, self-help institutions for farmers.

The Revenue Act of 1913, first after the amendment, did not specifically mention cooperatives. It did, though, exempt certain types of nonprofit concerns, including "agricultural and horticultural organizations." 79

The Treasury Department at first construed this language to include cooperative dairies without capital stock. This ruling was soon replaced by one holding that although cooperative dairies could offset gross income by the amont of patronage refunds "actually paid," any amount retained at the end of the year over and above expenditures was returnable as net income.

An extremely narrow exemption for agency marketing cooperatives which dealt only with members was included in the 1916 act.80 Five years later, in the 1921 act, these provisions were broadened to include farmer cooperatives acting as purchasing agents for members. 81

75 45 Stat. 791, 867; 26 U. S. C. A. 1808.

76 26 U. S. C. A. 4382 (a) (3).

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Boyle v. Lakeview Creamery Company, 9 Cal. 2d 16, 68 P. 2d 968.

78 State ex rel. Wisconsin Development Authority v. Dammann, 228 Wis. 147, 280 N. W. 698, 716, setting aside opinion appearing in 277 N. W. 278.

79 38 Stat. 166, 172.

80 39 Stat. 756, 767. Sec. 11, Eleventh, exempted "Farmers', fruit growers', or like associations, organized and operated as a sales agent for the purpose of marketing the products of its members" and turning back to them, on a patronage basis, the proceeds less selling expenses.

81 42 Stat. 227, 253.

The bare language of this statute required substantial interpretative regulations to accommodate the increasingly complex structures of farmer cooperatives as they were being organized and operated in the early 1920's. Thus, in regulations published in 1921, the issuance to farmer-producers of capital stock having limited dividend rights was authorized. In 1922, regulations under the 1921 act authorized the accumulation of reasonable reserves. The term "producer" rather than "member" appeared in regulations under the 1924 act, clearing the way for limited dealings with nonmembers.

These departmental practices all found their way into the Revenue Act of 1926.82 Except for the addition in 1934 83 of provisions permitting business done with the United States to be disregarded in determining the right to exemption, no change in the 1926 law was made until the Congress enacted section 314 of the Revenue Act of 1951.84

Section 314 repealed none of the existing law, but it added a special tax treatment for all associations qualifying for "exemption" under the existing law. In other words, compliance with the "exemption" statute for taxable years beginning after December 31, 1951, no longer gives complete exemption. It merely authorizes a complying association to make certain additional deductions and other adjustments in the computation of its statutory net income under the Internal Revenue Code. Like nonexempt cooperatives, such complying associations also may exclude from gross income patronage refunds which they are under a prior mandatory obligation to make to their patrons. 85

The complete revision of the Internal Revenue Code in 1954 made no substantive changes in the law as it stood after the 1951 act became effective. The pertinent sections of the Internal Revenue Code of 1954 relating to farmers' marketing and farm supply associations are as follows: 86

SEC. 521. Exemption of farmers' cooperatives from tax:

(a) Exemption from tax.-A farmers' cooperative organization described in subsection (b) (1) shall be exempt from taxation under this subtitle except as otherwise provided in section 522. Notwithstanding section 522, such an organization shall be considered an organization exempt from income taxes for purposes of any law which refers to organizations exempt from income taxes.

(b) Applicable rules.

(1) Exempt farmers' cooperatives.-The farmers' cooperatives exempt from taxation to the extent provided in subsection (a) are 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.

(2) Organizations having capital stock. 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

82 44 Stat. 9, 40. Sec. 231 (12) of this act, in summary, provided that a cooperative might act as principal as well as agent and thus take title to goods marketed and purchased; that it might accumulate reasonable reserves; that it might issue voting stock to producers with limited dividend rights and that it might carry on as much as 50 percent of its business with nonmembers, so long as purchasing business for nonmember nonproducers is limited to 15 percent.

83 48 Stat. 680, 701.

84 65 Stat. 452, 491.

85 See "Taxation of Nonexempt Cooperatives," infra.

86 68A Stat. 176-8; 26 U. S. C. A. 521–522.

percent 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 stock, the 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.

(3) Organizations maintaining reserve.—Exemption shall not 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.

(4) Transactions with nonmembers. Exemption shall not be denied any such association which markets the products of nonmembers in an amount the value of which does not exceed the value of the products marketed for members, or which purchases supplies and equipment for 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.

(5) Business for the United States.-Business done for the United States or any of its agencies shall be disregarded in determining the right to exemption under this section.

SEC. 522. Tax on farmers' cooperatives:

(a) Imposition of tax.—An organization exempt from taxation under section 521 shall be subject to the taxes imposed by section 11 or section 1201.

(b) Computation of taxable income.—

(1) General rule. In computing the taxable income of such an organization there shall be allowed as deduction from gross income (in addition to other deductions allowable under this chapter)

(A) amounts paid as dividends during the taxable year on its capital stock, and

(B) amounts allocated during the taxable year to patrons with respect to its income not derived from patronage (whether or not such income was derived during such taxable year) whether paid in cash, merchandise, capital stock, revolving fund certificates, retain certificates, certificates of indebtedness, letters of advice, or in some other manner that discloses to each patron the dollar amount allocated to him. Allocations made after the close of the taxable year and on or before the 15th day of the 9th month following the close of such year shall be considered as made on the last day of such taxable year to the extent the_allocations are attributable to income derived before the close of such year. (2) Patronage dividends, etc.-Patronage dividends, refunds, and rebates to patrons with respect to their patronage in the same or preceding years (whether paid in cash, merchandise, capital stock, revolving fund certificates, retain certificates, certificates of indebtedness, letters of advice, or in some other manner that discloses to each patron the dollar amount of such dividend, refund, or rebate) shall be taken into account in computing taxable income in the same manner as in the case of a cooperative organization not exempt under section 521. Such dividends, refunds, and rebates made after the close of the taxable year and on or before the 15th day of the 9th month following the close of such year shall be considered as made on the last day of such taxable year to the extent the dividends, refunds, or rebates are attributable to patronage occuring before the close of such year.

It is clear that Congress had the right to exempt agricultural cooperatives from the payment of Federal income taxes.87 The special treatment in the present law is not unusual 88 and likewise is legal.

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At the time this text was prepared, the Internal Revenue Service was in the process of issuing new regulations under the quoted sections of the 1954 Code. In the interim, the regulations under the 1939 Code as

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Flint v. Stone Tracy Co., 220 U. S. 107, 173, 31 S. Ct. 342, 55 L. Ed. 389: Brushaber v. Union Pacific Railroad Co., 240 U. S. 1, 36 S. Ct. 236; 60 L. Ed. 493, L. R. A. 1917 D 414, Ann. Cas. 1917 B 713; Stanton v. Baltic Mining Co., 240 U. S. 103, 36 S. Ct. 278, 60 L. Ed. 546.

88 The Internal Revenue Code is replete with differing rules on differing groups, classes or types of taxpayers. SILVERSTEIN, SPECIAL SITUATIONS UNDER THE FEDERAL INCOME TAX LAW, Mimeo. by National Council of Farmer Cooperatives, 1955, 29 pp. 89 The Internal Revenue Service is the part of the Treasury Department charged with the duty of collecting Federal taxes. Prior to 1953, it was known as the "Bureau of Internal Revenue." All "Internal Revenue" rulings will be cited herein as those of the "Service," although made when the name was "Bureau."

amended in 1951 were continued effective as to taxable years coming after the effective date of the 1954 Code.90

There are at least 10 fundamental conditions embodied in section 521, which have been summarized as follows:

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OPERATING REQUIREMENTS

1. Operating purposes must be restricted.

2. Operations must be of a mutual nature, with equal treatment for all patrons. 3. Business with nonmembers must not exceed that done with members.

4. Financial reserves must have a necessary purpose and must be reasonable in

amount.

5. Patronage and equity records must be maintained and must be permanently preserved.

6. Supplies and equipment purchased for nonmembers who are not producers must be limited.

OWNERSHIP AND CONTROL REQUIREMENTS

7. Substantially all voting rights must be held by actual producers who currently patronize the association.

8. Substantially all capital shares, of participating type, must be owned by actual producers.

9. The rate of dividends (or interest) on capital shares must be limited.

GENERAL REQUIREMENT

10. Legal structure of association must be cooperative in principle and must not contain provisions inconsistent with the foregoing requirements.

Since the changes in the law made in 1951 and 1954 did not alter these requirements in any respect, the basic rulings on these matters are still applicable. These will now be discussed.

The term "like association" as used in the statute has been construed by the Internal Revenue Service to include a farmer cooperative organized to establish and operate a roadside or farmers' market for its members.92

The expression "like associations" by reason of its association with the words "farmers" and "fruit growers" is limited by them and refers only to associations of farmers or others engaged in like occupations.93

If an association is not actually organized so as to meet the requirements for exemption, it is ineligible therefor. In a case decided by the Board of Tax Appeals, it was said: 94

The undisputed proof in this case shows that at least 30 percent of the profit realized by the petitioner from the operation of its elevator department was from nonstockholders to whom it did not and could not turn back anything other than the original price paid them for their grain, which was the market price. * * *

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The petitioner's case is not strengthened by the fact that up to the end of the year 1928 it had not paid any patronage dividends with the exception of certain patronage dividends in the form of shares of stock upon the business of 1918. The simple fact is that the petitioner was not in 1928 organized to come within the exempting provisions of the statute.

90 The new regulations under the 1954 Code will appear in 26 C. F. R. 1.521– 1.522.3, inc. The regulations under the 1939 Code as amended in 1951, published in 26 C. F. R. 39.101 (12)–39.101(12)-4, were continued by C. B. 1954-2, 47. 91 Waas, Geo. J., and White, Daniel G., "APPLICATION OF THE FEDERAL INCOME TAX STATUTES TO FARMERS' COOPERATIVES, Bul. No. 53, p. 22, Farmer Coop. Serv., U. S. D. A. 1942.

92 I. T. 2720, C. B. XII-2, 71.

93 C. B. X-1, 150; Garden Homes Co., 26 B. T. A. 441, 462, reversed on other grounds, 64 F. 2d 593.

Farmers Union Cooperative Company, 33 B. T. A. 225, 229, affirmed in 90 F. 2d 488. See also Council Bluffs Grape Growers Association, 44 B. T. A. 152.

In another case the petitioner failed to prove that any of its members were producers or producers' marketing agents.95

The Internal Revenue Service has construed the exemption provision to include associations which take title to farm products as well as those which act strictly on an agency basis. In addition, the statutory language has been construed to include associations which process products by changing the form of the raw materials furnished by their producer members.96 It is the powers that are exercised by an association and not those possessed which are of controlling importance in determining its right to exemption.97

Moreover, an association engaged in the marketing of farm products and in the purchasing of supplies and equipment must with respect to each of these functions meet the requirements for exemption and it cannot engage in unauthorized activities.98

In the case last cited, the Tax Court held that a fruit growers' association which carried on as one of its principal activities the maintenance and caretaking of citrus groves did not qualify for exemption. It said this activity cannot qualify as "purchasing supplies and equipment for the use of members or other persons

Substantially all the voting stock of an association must be owned by producers who market their products or purchase their supplies through the association. The Internal Revenue Service has said:

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It is impracticable to attempt to define the term "substantially all" as used in the statutes under discussion for the reason that what constitutes substantially all of the capital stock of a cooperative marketing association is a question of fact, which must be decided in the light of the circumstances surrounding each particular case. Any ownership of stock by other than actual producers must be explained by the association. The association will be required to show that the ownership of its capital stock has been restricted as far as possible to actual producers who market their products through the association. However, if by statutory requirement the officers of an association must be shareholders, the ownership of a share of stock by a nonproducer to qualify him as an officer will not destroy the association's exemption; or if a shareholder for any reason ceases to be a producer and the association is unable, because of a constitutional inhibition or other reason beyond the control of the association, to purchase or retire the stock of such nonproducer, the fact that under such circumstances a small amount of the outstanding capital stock is owned by shareholders who are no longer producers will not destroy the exemption. On the other hand, where a substantial part of the stock was voluntarily sold to nonproducers, exemption must, under the statute, be denied as long as such stock is so held. Where it appeared not only that 12 percent of the outstanding common stock of a marketing association was held by nonproducers but also that over 9 percent of such outstanding common stock was voluntarily sold or issued to persons who were not farmers or producers, "substantially all” the common stock was not owned by producers and the association was not entitled to exemption.1

In a certain case the Board of Tax Appeals said: 2

Of the 213 shares outstanding in 1925, 194, or 91 percent, were held by persons

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C. B. III-1, 287; Eugene Fruit Growers Association, 37 B. T. A. 993.

C. B. X-2, 164, 167; Dr. P. Phillips Cooperative, 17 T. C. 1002.

C. B. X-2, 164. Of course, patrons of a stock association who do not own at least one share of stock, may not be counted as “shareholders," but represent "nonmember" business. Producers Livestock Marketing Association of Salt Lake City, 45 B. T. A. 325. Cf. In re Temtor Corn & Fruit Products Co., 299 F. 326; Schlafly v. United States, 4 F. 2d 195. The courts in these cases considered statutory language similar, but not identical, to the "substantially all" stock requirement.

1C. B. V-2, 71.

2

Farmers Cooperative Creamery, 21 B. T. A. 265.

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