may receive patronage dividends, the cooperative may not omit from gross income the portion of any distributions to members which represents profits from dealings with nonmembers.

This treatment of patronage dividends has been a long-established practice of the Bureau of Internal Revenue. Such treatment, at the time of its adoption, was based on the theory that amounts allocated or returned as patronage dividends represented a reduction in cost to the patron of goods purchased by him through the cooperative or an additional consideration due the patron for goods sold by him through the cooperative.

One of the earliest Bureau rulings on the matter was under the Revenue Act of 1913. That act exempted from the income tax mutual savings banks not having any capital stock represented by shares. However, it prescribed a rather different treatment for mutual fire insurance companies whose members made premium deposits to provide for losses and expenses. These insurance companies were not required to include in taxable income any portion of the premiums returned to their policyholders as so-called policy dividends. Income from other sources and premium payments retained by these companies for purposes other than the payment of losses and expenses and reinsurance reserves were, however, taxable. The Treasury by analogy adopted in 1914 a similar rule for farm cooperative associations which were not eligible for exemption under the 1913 act and permitted them to exclude patronage dividends from gross income. (See T. D. 1996.) The regulations under the 1916 act, like those under the 1913 act, provided that any cooperative association which could not qualify for the statutory exemption of farm cooperatives because it did not, as then required by the statute, act strictly as agent but purchased produce from members with a view toward selling it for gain, might nevertheless exclude from gross income all amounts paid to members on the basis of quantity of goods handled for them.

Treasury rulings consistent with the above have been issued during that period until the present time. Examples are T. D. 2737 (1918), IT 1499 (1922), IT 1566 (1923), GCM 12393 (1933), GCM 17895 (1937). The present tax treatment of patronage dividends thus represents the long-established administrative practice.

This practice has been recognized by the courts as valid. Examples of recent decisions are Associated Grocers of Alabama v. Willingham, 77 F. Supp. 990; Peoples Gin Company v. Comm'r., 118 F. (2d) 72; and Fountain City Co-op Creamery Association v. Comm'r., 172 F. (2d) 666. In an opinion which exhaustively reviews the administrative and judicial precedents in the matter, the District Court for the Northern District of Iowa concluded: "This practice * * * has been recognized and approved by the courts." (86 F. Supp. 201, 238.) That court also specifically held:

“1. That the Treasury Department rulings providing that under certain conditions a cooperative may exclude from its gross income for Federal income tax purposes amounts allocated as patronage dividends are not so unreasonable or so plainly inconsistent with the Internal Revenue Code as not to be followed" (p. 237).

Moreover, it does not seem unimportant that during this long period of uninterrupted administrative practice, the Congress had not changed the rule by legislation, even though during a period of over 30 years it has often reenacted various revenue acts. It has been indicated by the Supreme Court that where there has been a contemporaneous administrative construction of a congressional enactment followed by long-continued administrative practice, reenactment “amounts to an implied legislative recognition and approval of the executive construction of the statute." (National Lead Co. v. U. S., 252 U. S. 140.)

Farmer cooperative marketing and farm supply associations, whose bylaws set forth a definite preexisting obligation of the association to make distribution to patrons of a portion of net margins as patronage refunds, may exclude such refunds from income for Federal income tax purposes regardless of whether the corporate name contains the word "cooperative." The right to deduct patronage refunds as just outlined is not confined to farmer organizations. This also has been recognized by a spokesman for the Treasury and by the courts.49

48

19 Statement by A. Lee M. Wiggins, Under Secretary of the Treasury, in hearings before the House Committee on Ways and Means, 80th Cong., 1st sess., pt. 4, p. 1881 (1947): "Under present law, farm cooperative associations are authorized to exclude patronage refunds from gross income. This, however, is not the exclusive privilege of cooperative associations. The privilege is available to any corporation which

One of the earliest cases establishing the principle in question is Appeal of Paducah & Illinois Railroad Company 50 In that case a bridge company was organized and completely owned by several railroads. The bridge company borrowed $5 million and built a bridge which was used jointly by the owning railroads. The company was obligated by contract to account to the several owners in preferred stock for any rates, tolls, and charges which the owners paid for using the bridge which were in "excess" of the pro rata shares of such owners for the operating and maintenance expenses of the bridge company. The "excess" was actually used to retire the bonds, for which the owners were also liable, and as bonds were retired a like amount of preferred stock was issued to the owning railroads. The net effect of this contractual arrangement was to make the bridge company operate essentially as a cooperative. Its operations for the year were adjusted to cost with any excess refunded to the patrons (the member railroads which used the bridge) in proportion to their use of the facility. The Board of Tax Appeals held that this resulted in no taxable income to the bridge company from the "excess" charges used as described above. One of the leading cooperative tax cases firmly establishing the principle is United Cooperative, Inc.51 This cooperative was capitalized, in part, out of net margins realized on current operations. It was under contractual obligation to account to its patrons for all amounts received by the cooperative over operating costs and expenses and amounts which the cooperative was permitted to pay as dividends on stock. Under its bylaws the cooperative had a mandatory obligation to return this excess amount in cash or stock. The Tax Court held that all amounts which the cooperative was under a mandatory obligation to return to its patrons in accordance with their patronage was excludable from gross income. Because the board of directors had discretion to determine the amount, if any, of dividends which would be paid on capital stock, the court said that net margins equal to the maximum permissible dividends under the bylaws were not subject to a mandatory obligation, and, therefore, were taxable to the cooperative. Prior to this decision the Board of Tax Appeals had held that where an association in cooperative form had adopted a bylaw creating a definite liability on the part of the association to credit its patrons with net margins, the association was entitled to deduct such amounts in computing its income taxes.52

The Board of Tax Appeals had also held that where an association had an oral understanding that there would be paid to its stockholders in addition to the amount paid to them at the time of the delivery of their grain "an amount equal to the difference between such amount plus the cost of reselling the wheat, and the price at which the wheat was resold," this amount could be deducted in determining the income taxes of the association, although no patronage dividend had been declared and

50

makes payments to its customers under the conditions prescribed by the Commissioner of Internal Revenue and the courts." See, also, the cases cited in the next note. Appeal of Paducah & Illinois Railroad Co., 2 B. T. A. 1001; Uniform Printing and Supply Co. v. Commissioner, 88 F. 2d 75; Clover Farm Stores Corp., 17 T. C. 1265; Broadcast Measurement Bureau, Inc., 16 T. C. 988; Southwest Hdwre. Co., 24 T. C. 75. Cf. Railway Express Agency, Inc. v. Commissioner, 169 F. 2d 193, affirming 8 T. C. 991.

514 T. C. 93 (1944).

52

Appeal of the Trego County Cooperative Association, 6 B. T. A. 1275; Anamosa Farmers Creamery Company, 13 B. T. A. 907; Farmers Union Cooperative Association, 13 B. T. A. 969. In Anamosa the Board said: "In this situation neither the basis of accounting nor the fact that no cash was paid to the patrons in the taxable year is material."

although the amount in question "was eventually wiped out by operating losses. 53

In one case, the board of directors of the association, within the fiscal year, had adopted a resolution under which part of the net margins was to be distributed on a patronage basis in cash and part in a patrons' equity reserve. The latter amounts were apportioned to patrons during the succeeding fiscal year. The action of the board was approved at the annual meeting of stockholders. The Board of Tax Appeals held that the amounts placed in the patrons' equity reserve were excludable from gross income. 54

Later Tax Court and Federal court decisions make it clear, however, that the current rule is that only patronage refunds (or dividends, as they are sometimes called) actually distributed under a preexisting obligation either in the form of cash or by offset against a capital investment in, or loan to, the cooperative (evidenced by capital stock, certificates of indebtedness, notes, book credits or in some other manner which discloses to the patron the dollar amount of his interest) are excludable from gross income.55

To the contrary, where it does not appear that the organization papers or other contractual arrangements between the cooperative and the patrons create the required preexisting obligation, it has been held that the patronage refunds may not be excluded from gross income.56

As one author 57 has observed:

The cooperatives' income tax cases constituted a long course of administrative and judicial wallowing among various theories before the mandatory obligation and reinvestment theory was firmly established.

However tortuous the route, the principle as shown by the cases is now well established in the cooperative tax cases. It is aptly expressed by the Tax Court in United Cooperatives, Inc.58 as follows:

The fact that member patrons were under obligations with regard to the purchase of petitioner's stock under certain circumstances and that petitioner had a right to apply a part_of_the "patronage dividends" to a satisfaction of such obligations, is immaterial. It does not affect the right of the member patrons to receive "patron

53 Home Builders Shipping Association, 8 B. T. A. 903. At p. 909 the Board said: "It is to our minds immaterial that the liability * * * has not, as yet, been paid. There was no evidence that the petitioner never intended to pay it."

54 Midland Cooperative Wholesale, 44 B. T. A. 824.

55

Farmers Cooperative Co. v. Birmingham, 86 F. Supp. 201; San Joaquin Valley Poultry Producers Association v. Commissioner, 136 F. 2d 382; Colony Farms Cooperative Dairy, Inc., 17 T. C. 688; Dr. P. Phillips Cooperative, 17 T. C. 1002; Otsego County Cooperative Association, Inc., C. C. H. Dec. 19, 137 (M), Dkt. No. 28479, July 31, 1952, memorandum opinion by Judge Rice. If an association is under obligation to pay patronage dividends to its members only, it may not exclude amounts which it has made on business done with nonmembers, even though it distributes such amounts in the guise of patronage dividends to its members. C. B. III-2, 238. Cf. Bakers Mutual Coop. Association v. Commissioner, 117 F. 2d 27, affirming 40 B. T. A. 656; Fruit Growers' Supply Co. v. Commissioner, 56 F. 2d 90, affirming 21 B. T. A. 315.

56 Farmers Union State Exchange, 30 B. T. A. 1051; Juneau Dairies, Inc., 44 B. T. A. 759; Cooperative Oil Association, Inc., v. Commissioner, 115 F. 2d 666; Peoples Gin Co. v. Commissioner, 118 F. 2d 72, affirming 41 B. T. A. 343; Associated Grocers of Alabama v. Willingham, 77 F. Supp. 990; Gallatin Farmers Co. v. Commissioner, 132 F. 2d 706; American Box Shook Export Association v. Commissioner, 156 F. 2d 629, affirming 4 T. C. 758; Fountain City Cooperative Creamery Association v. Commissioner, 172 F. 2d 666, affirming 9 T. C. 1077. Cf. Druggists' Supply Corporation, 8 T. C. 1343; Union Fishermen's Cooperative Packing Co. v. Earle (Same v. Maloney), 121 F. Supp. 373.

57 Nieman, Multiple Contractual Aspects of Cooperatives' Bylaws, 39 Minn. L. Rev. 135, 136 (1955).

58 4 T. C. 93, 108.

age dividends," but merely constitutes a permanent directive as to their application. 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.

The fact that under this agreement the cooperative's directors have discretion to determine what portion of the net margins the patrons should invest in capital of the cooperative (be it stock, or certificates of interest or book equities in revolving fund capital) does not preclude the obligation to pay the patronage refund from being mandatory. Nor is it pertinent that the stock, certificates, or equities might not be redeemed until some future time; or that the farmer has put his money in a capital stock or other interest which may have no current fair market value.5 The cooperative has performed the terms of its patronage contract when it allocates the patronage refund to the patron under its preexisting contract to make the distribution.60

59

It is sometimes difficult to work out a method by which an antecedent contract obligating the cooperative to distribute margins to patrons may be created. With respect to members of the cooperative, the State law, the articles and the bylaws constitute the contract among the members one with another and also between the members and the association. It is therefore possible to show that the contract exists by reason of the State law or, if that is not true, to create the necessary antecedent obligation by an appropriate provision in the articles or bylaws. With respect to both member and nonmember patrons marketing products through an association, it is also possible to create the necessary antecedent obligation in the marketing agreement. In both of these cases care must be taken that all members and all marketing patrons actually do execute some formal written instrument by which they become bound to the association and the association becomes bound to them to make patronage distributions. Many cooperatives do a substantial business with nonmembers. It is always a most vexing problem to establish the necessary antecedent contract with such persons. Some cooperatives conspicuously post excerpts from the articles and bylaws in their place of business, others print the applicable excerpts on order blanks, sales receipts, advertising material and other communications between the patrons and the association. If such posters or printed material are properly worded and conscientiously posted or distributed, it is probable that the courts would hold that the cooperative had offered to do business with the nonmember patron on a cooperative patronage basis and that the patron had accepted this offer by doing business with the cooperative.

Some cooperatives follow the plan of making every patron a member at the time of the first transaction between the cooperative and the patron. In this case the patron is required to sign a membership application and agree that his first patronage dividends shall be applied on his membership

59

It may appear unrealistic to some to say that the farmer has realized income of 100 cents on the dollar when his patronage refund is offset by an investment in stock or other capital interests which have no immediate fair market value. The farmer, however, has received the benefit of the service provided by his cooperative and who can say that this has not given him full economic value for his money. Moreover, income does not cease to be income because it has been invested or loaned, even though the investment or loan is a poor one. Cf. Brown v. Commissioner, 220 F.2d 12.

60

See cases cited in n. 55; Nieman, op. cit. supra, n. 57, at 143.

A

fee. This plan, if adhered to and if workable in the business of the cooperative concerned, accomplishes the purpose of making every patron a member.

61

62

Amounts authorized by members to be deducted from sales proceeds in the case of a marketing cooperative or to be added to the cost of purchases made for the express purpose of being used by the cooperative as capital also are not taxable to the cooperative." This is because money furnished to any corporation for capital purposes is not income to the corporation. Such amounts should not be confused with patronage refunds, since the contributions to capital from patronage refunds depend upon the existence of a net margin between a cooperative's gross receipts and its costs and expenses.

63

In determining the net taxable income of a nonexempt cooperative, the Internal Revenue Service has ruled that, in the absence of evidence to the contrary, "the dealings with members and nonmembers are equally profitable." The ruling just cited also shows how a cooperative's net taxable income is to be computed.

Taxability of Patronage Refunds to Patrons

When this manuscript was prepared, the exact tax status of patronage refunds in the hands of patrons had not been clearly determined. Anyone with a specific tax problem should consult the current regulations of the Internal Revenue Service and also ascertain the current status of the court decisions. The following discussion may prove of historical interest, however, in tracing the development of this subject.

The Treasury, in 1953, for the first time included a section on this subject in its formal tax regulations.65 These regulations were supplemented in 1954 by Rev. Rul. 54–10.66

The 1954 ruling reiterated the requirements of the regulations that all patronage refunds must be reported at their face amount if made in fulfillment of a valid preexisting obligation of the association to the patron, except where the patron's business income is not affected. It said that this was merely a reaffirmation of the policy of the Service "which had been long established.'

9967

The ruling pointed out that this treatment is consistent "with the theory under which patronage dividends are treated by cooperative associations"; namely, “* * * that the patron by express contract or by doing business with the cooperative agrees to allow the association to retain funds to which

the patron is entitled. * * * It is considered that the patron has in effect

received in money the face amount of the document and has either rein

61 Rev. Rul. 54–244, I. R. B. 1954–26, 5.

62 See Edwards v. Cuba Railroad Co., 268 U. S. 628, 45 S. Ct. 614, 69 L. Ed. 1124; Appeal of Paducah & Illinois Railroad Co., 2 B. T. A. 1001; L. S. Hulbert, Money Received as Capital Is Not Income, 10 News for Farmer Cooperatives 7 (Jan. 1943). 63 See Patronage Refunds, infra.

C. B. III-1, 287. See also Farmers Union Cooperative Exchange, 42 B. T. A. 1200, Valparaiso Grain & Lumber Co., 44 B. T. A. 125. Cf. Rev. Rul. 54–297, I. R. B. 1954-31, 10. Where certain "wholesale" sales to nonmembers resulted in no profit, such sales were allowed to be excluded before profits were allocated between member and nonmember sales. Producers Crop Improvement Association, 7 T. C.

562.

65 T. D. 6014, approved May 29, 1953; C. B. 1953-1, 110. For later form of this regulation see 26 C. F. R. 39.22 (a)–23.

66 C. B. 1954-1, 24.

67

For a listing and discussion of prior rulings of the Treasury, see Nieman, Multiple Contractual Aspects of Cooperatives' Bylaws, 39 Minn. L. Rev. 135, 151 (1955).