27

which were so purchased were not handled at a profit, it was held that this did not operate to deprive the association of its exemption.26 In another case, the association, among other things being challenged by the Commissioner, sold ice and ice cream because it had found it necessary to the refrigeration of the association products to purchase an ice and ice cream factory operating upon property adjoining the cannery it operated, and the continuation of the ice and ice cream business reduced the refrigeration costs which would otherwise have been chargeable to the fruit marketing pools. Likewise, in order to utilize more effectively a machine shop which it ran as a necessary adjunct of a cannery, some custom work was done there on a commercial basis. None of the persons who purchased ice or ice cream or who patronized the machine shop shared in patronage refunds. Passing on this phase of the cooperative's activities, the Board of Tax Appeals said:

Looked upon as a whole it seems to us that these "commercial departments” were purely incidental to petitioner's principal purpose. They were conducted, not for their own sake, but as an adjunct and supplement to the cooperative marketing of farm products. See Producers' Produce Co. v. Crooks, 2 F. Supp. 969. This seems to us to be the test, and not the numerical percentage of petitioner's business attributable to those branches. It may be that the proportion of business done could be so great that it would be unreal to consider such operations incidental. Cf. Hills Mercantile Co., 22 B. T. A. 114. On this point we need express no opinion, since in our view no such contention could prevail on the facts before us. The principle we have stated has been applied in construing other subsections of section 103 and similar provisions, and we see no reason to reach a different result here. Santee Club v. White, 87 Fed. (2d) 5; King County Insurance Association, 37 B. T. A. 288; Trinidad v. Sagrada Orden de Predicadores, 263 U. S. 578; Unity School of Christianity, supra; Sand Springs Home, 6 B. T. A. 198. And it is to be noted that there is no statutory requirement that petitioner be engaged “exclusively," in cooperative marketing, as there was in some of the provisions construed by those decisions, but merely that it be "organized and operated on a cooperative basis (a) for the purpose of marketing the products of members * **" We believe petitioner falls clearly within that definition.

One way of avoiding the effect of the restriction under discussion is to make all purchases other than from members or nonmember producers only from other farmer cooperatives, if this is feasible. Purchases from other cooperatives are considered in the category of purchases from "producers."

If an association buys commodities under special circumstances from nonmembers who are dealers, the question arises as to whether it must pay patronage refunds to such dealers on the same basis as it pays such refunds to patrons generally. The answer is, "No." Since a marketing cooperative should not ordinarily be making such purchases, they are not regarded as part of the cooperative's normal marketing operations.

A more difficult question, however, is what to do about the association's net margins, if any, on such transactions. If the association is able to establish that these transactions were handled at a loss or on a break-even basis, this would seem to furnish a clear justification for not paying a patronage refund to the dealer, and there is no problem as to the disposition of margins.

28

In several unpublished cases, which occurred prior to the 1951 amendment, the Internal Revenue Service allowed "exempt" cooperatives to distribute savings on these dealer transactions among other patrons in pro

26 Producers' Produce Company v. Crooks, 2 F. Supp. 969.

27

Eugene Fruit Growers Association, 37 B. T. A. 993.

Fertile Cooperative Dairy Association v. Huston, 119 F. 2d 274, 277, affirming 33 F. Supp. 712.

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portion to their patronage. They were in effect treated as "income not derived from patronage." Perhaps a good case could be made for concluding that they may still be handled in this way. However, there is an alternate method of handling which would seem less likely to be questioned by the Internal Revenue Service. This method is to exclude the amount of the savings on the transactions with dealers from funds allocated on a patronage basis and, if necessary because sufficient offsets are not available, pay a tax on them.

The term "supplies and equipment" has been construed to include "groceries and all other goods and merchandise used by a farmer in the operation and maintenance of a farm or farmer's household." 29

If an association is owned and controlled by farmers, but a substantial percentage of them are not patronizing the association, this situation might raise a question as to the right of such an association to exemption because it will be remembered that the voting stock of an association must be "owned by producers who market their products or purchase their supplies and equipment through the association."

If an association, in addition to its marketing or purchasing activities, contemplates engaging in other lines of business on a commercial basis, careful investigation should be made to ascertain if this will affect the right of the association to exemption.

If an association processes the commodities which it receives from its members, and in such processing finds it necessary to add certain ingredients, it is believed that the purchase of such ingredients would not be regarded as nonmember business, if the chief function of the association is to market in processed form the commodities which it receives from its members.

Of course, the fact that a cooperative that is exempt acquires all the stock of another corporation does not alone operate to confer exemption on the latter corporation.30

The question whether an association is entitled to exemption is one to be determined solely by reference to the exemption provisions of the Federal statutes and the fact that an association is incorporated under the cooperative act of a State and operates in accordance therewith is immaterial.3

31

The fact that a cooperative which is eligible for exemption is carrying on through a subsidiary corporation certain activities and functions, which the association could not perform directly and retain its exemption, should not operate to cause an association to lose its exemption.32

For many years, the Internal Revenue Service has held that a federated type of cooperative is eligible for exemption. In a certain case 33 upon by the Service, it was said:

passed

The principal members of the company are the local citrus growers' associations, which are cooperative, nonprofit corporations, without capital stock, whose members

29

"C. B. XII-2, 72; 26 C. F. R. 39.101 (12)-1. See also Farmers Union Cooperative Association, 44 B. T. A. 34.

30 Burr Creamery Corporation v. Commissioner, 62 F. 2d 407, certiorari denied 289 U. S. 730, 53 S. Ct. 527, 77 L. Ed. 1479.

31 Farmers Union Cooperative Co. v. Commissioner, 90 F. 2d 488, affirming 33 B. T. A. 225; Farmers Cooperative Co. v. United States, 23 F. Supp. 123.

32 C. B. XII-1, 122. However, in an unpublished ruling, the Internal Revenue Service has said that an "exempt" cooperative cannot utilize reserves to own and operate a subsidiary engaged in activities in "which the cooperative itself could not engage in directly and be eligible for exemption."

33 C. B. III-2, 233, 235. See also C. B. III-1, 290.

are the local fruit growers. Such a company is entitled to the same status as a company whose members are the farmers or the fruit growers themselves.

Even though an organization may in fact meet all requirements for exemption, such "exemption" is not automatic. It must obtain a “letter of exemption" by filing an application on Form 1028 with the District. Director of Internal Revenue Service for the district in which its principal office or place of business is located. Once the letter is granted, it is not necessary to refile unless substantial changes are made in the organization or its activities. An association is required, however, to furnish information annually on Treasury Form 990-C, relating to its status as an "exempt” organization.

The Internal Revenue Service is not precluded from making an investigation of such an organization to determine if it is eligible, or, if not, the amount of its tax liability.34

Exemption continues only so long as the legal setup and the operating methods are in accord with the requirements of the applicable statutes and regulations. Thus a change in status can occur even though the letter of exemption is not withdrawn or canceled by the Internal Revenue Service.

If an association has been erroneously granted exemption, this ruling is not binding on subsequent Commissioners of Internal Revenue who may set the so-called exemption aside and then proceed to collect income taxes for the entire period in question.35 In the case last cited, as no income tax returns had been filed the statute of limitations had not run.

It has also been held that the filing of Form 990 36 will not start the running of the statute, because it is not a tax return and does not supply adequate information from which the amount of tax, if any, can be determined.37 It is believed, however, that Form 990-C, which is the tax return "exempt" farmer cooperatives must file, is sufficient. Accordingly, the filing of this form would start the running of the statute.38

Not only may an exemption which has been improperly allowed be set aside and the association be held liable for income taxes, but if the Service erroneously makes a refund to an association such refund may be recovered by the Government.39

For an organization which was exempt from the tax but subsequently became taxable, it is necessary in computing the gain or loss from the sale or exchange of property to reduce the basis by the amount of depreciation sustained with respect to the property for the period it was held while the taxpayer was exempt, as well as subsequently.40

Under the established practice of the Internal Revenue Service, exemption comes to an end on the day a cooperative ceases operations. Accordingly, even prior to December 31, 1951, if gains were realized on the sale of assets after the association had ceased to operate, the cooperative was required to file an income tax return and pay a tax if one was due. Where a federated wholesale cooperative was composed in part of consumer cooperatives, it was held that it was not entitled to exemption.11

34 United States v. Stiles, 56 F. Supp. 881.

35 Southern Maryland Agricultural Fair Association, 40 B. T. A. 549.

36

37

38

The information return required to be filed by “exempt" organizations after 1943. Automobile Club of Michigan, 20 T. C. 1033, affirmed, 230 F. 2d 585.

For applicable statute, see 26 U. S. C. A. 6501–6533.

39 C. B. XI-1, 223; Producers Creamery Co. v. United States, 55 F. 2d 104.

40 C. B. 1952-2, 221. Since this ruling revoked C. B. XI-2, 105 (1932), which

held to the contrary, it applies only to sales occurring in taxable years beginning after December 31, 1950.

Referring to these consumer cooperatives, the Board of Tax Appeals said:

There is nothing in the record to show that the petitioner's sales to such patrons were less than 15 percent of its total sales in the several taxable years. It follows, therefore, that in this respect the petitioner has failed to establish its claim for exemption.

Apparently, the Board, as shown by the following quotation, was inclined to question whether the cooperative would have been entitled to exemption even though all of the organizations composing it were farmer cooperatives that came within the exemption provisions of the statute:

We are not advised whether these concerns are marketing or purchasing agents or whether all or any of them combine both functions. Certainly there is no evidence that all the members of each of such organizations are producers of commodities that are marketed through the petitioner as their agent. Even if all the individual members of the farmers' cooperatives which enjoyed membership in the petitioner are producers, it does not follow that the organizations themselves are producers, or even agents of producers.

The statute provides that "Business done for the United States or any of its agencies shall be disregarded in determining the right to exemption***" In view of this provision, in any instance in which it has application, the business done by an association for the United States or any of its agencies will not adversely affect the right of the association to exemption. In order for the provisions to have application, however, the association must actually be doing business for the United States or one of its agencies. If an association is merely selling commodities to the United States or one of its agencies, this would not appear to be sufficient. On the other hand, the language would include an association engaged in the acquiring or selling of commodities for the United States or one of its agencies, in accordance with a contract authorizing the association to do so. Likewise, the storage of commodities by an association for the United States or one of its agencies would also appear to come clearly within the terms of the language. The provision has no application to a State or any subdivision thereof. In a

There is no such thing as partial exemption under the statute. certain case the Board of Tax Appeals said:

42

In the first place, we find nothing in the governing statute which provides for a partial exemption from taxation of corporations of the character of the petitioner.

The failure to distinguish between the right to exemption and the right of a nonexempt association to exclude patronage dividends under proper circumstances has led to confusion and has induced the belief by some that there is such a thing as partial exemption. This is not the case.

Taxation of "Exempt" Cooperatives

As previously stated, compliance with the various "exemption" requirements outlined and discussed above, no longer gives complete exemption from income tax.43 It authorizes a complying association to apply section 522 of the Internal Revenue Code of 1954 in computing any taxable net income.

Under section 522, it is clear that any taxable net income of even an "exempt" cooperative is subject to normal, surtax and capital gains taxes imposed on corporations generally. In computing taxable income, an

42 Farmers Union Cooperative Oil Company, 38 B. T. A. 64.

43

An association qualifying under section 521 is exempt from the payment of a documentary stamp tax on the issue or transfer of shares or certificates of stock and certificates of indebtedness. 26 U. S. C. A. 4382 (a) (3).

"exempt" cooperative may take the usual business expense deductions and two other deductions: (1) Amounts paid during the taxable year as dividends on capital stock,** and (2) amounts paid to patrons, or allocated and disclosed to each patron, with respect to revenues not derived from patronage. The amounts covered by the second deduction include, for example, rents received, investment revenues, gain on the sale of depreciable property and capital assets, and amounts from business done with the United States Government.

Section 522 also states that patronage "dividends, refunds, and rebates to patrons" with respect to their patronage in the same or preceding years, and whether paid in cash or several noncash forms, shall be taken into account in computing any taxable net income "in the same manner as in the case of a cooperative organization" not exempt under section 521. Thus, the Congress expressly recognized that farmer cooperatives may exclude true patronage refunds from gross revenues in computing Federal income tax. A true patronage refund is a distribution by a cooperative of the excess margin over expenses which it is under a prior mandatory obligation to make to its patrons. This will be discussed in more detail in the next section.

Such patronage refunds may be excluded by an "exempt" cooperative if the allocation is made on or before the 15th day of the 9th month following the close of the taxable year in which the amounts allocated were received by the cooperative. The regulations make it clear that the prior mandatory obligation, referred to above, must exist. This obligation may be in the cooperative's organization papers, marketing agreements, or other valid contractual form.4 any

45

Taxation of Nonexempt Cooperatives

There is only one respect in which the computation of the taxable statutory net income of a cooperative corporation for Federal income tax purposes differs from a similar computation for a corporation not organized on a cooperative basis, if such cooperative corporation has not qualified for "exemption" under section 521 of the Internal Revenue Code.46 Such a cooperative corporation may exclude from its gross income true patronage refunds for which it makes provision during the taxable year and which it distributes within a reasonable time after the close of the taxable year. During congressional hearings in 1951, Thomas J. Lynch, General Counsel of the Treasury Department, was asked to furnish a memorandum on the Treasury's position with respect to the exclusion of patronage refunds from taxable income. The memorandum 47 he submitted was as follows:

A taxable cooperative is a cooperative other than a farm cooperative specifically exempt from income tax under section 101 (12) of the Internal Revenue Code. It is subject to the corporate tax. However, if a cooperative has agreed at the time of any sale to or purchase from its patrons to allocate or return to them any net proceeds of the current year in proportion to patronage, it can compute its tax only on the amount of its net proceeds which have not been so allocated or returned as "patronage dividends." It should be noted that, if only members of the cooperative

"Defined in the regulations as including "common stock (whether voting or nonvoting) preferred stock, or any other form of capital represented by capital retain certificates, revolving fund certificates, letters of advice, or other evidences of a proprietary interest in a cooperative association.” 26 C. F. R. 39.101 (12)–3 (d). 26 C. F. R. 39.101 (12)-4 (a).

46

See McLean County Service Company and Champaign County Service Company, 45 B. T. A. 1004.

47

Hearings Before House Committee on Ways and Means, 82d Cong., 1st sess., on Revenue Revision of 1951, pt. 3, pp. 2858-2859 (1951).