vested such amount in the capital of the association or allowed the association the use of the money.

The ruling recognized the problem presented by the fact that some patrons had failed to report the entire face amount, even though the regulations required such action. It established these rules: If the period of limitations has not expired, the face amount is reportable. If the period of limitations has expired, the difference, if any, between the amount reported in the year of allocation and the amount received on redemption is reportable in the year of redemption. An exception states that, where the Service has notice that the patron has failed to report the entire face amount of an allocation received in document form, after the statute of limitations has expired the Service will not insist that the excess over the reported amount be included in the patron's income in the year of redemption, except for that part of the excess which exceeds the face amount of the document.

Where an allocation was made which was not in pursuance to a preexisting agreement and the document issued was not a negotiable instrument, the amount received upon redemption, sale, or other disposition of the document should be included in gross income for the patron's taxable year in which received. It is assumed that this would apply to allocations of nonpatronage income by an "exempt" cooperative.

Where an allocation not pursuant to a preexisting agreement is a negotiable instrument, it is to be reported at fair market value unless the period of limitations has expired. In the latter case the difference between the amount reported in the year of allocation and the amount later received is reportable.68

The first case involving the taxability of refunds in the hands of patrons was decided by the Tax Court in 1950.69 This case held that certain "credit memoranda" issued by a manufacturing cooperative were income to its accrual basis taxpayer when issued rather than when redeemed. A week later, the Tax Court held that accrual basis patrons of a dealers' wholesale grocery cooperative were required to include in their income, when received and at full face value, certain subordinated, registered notes of the cooperative which were not payable until liquidation although redeemable upon call by the cooperative's board.70

The first cash basis patron case to come before the Tax Court was decided in 1951.71 The cooperative involved in the case was also before the Tax Court in a companion case 72 and the findings of the court in that case were incorporated in the patron's case. The court said:

The cooperative was under no obligation either to return the amounts to the members or to issue revolving fund certificates for the amounts it retained as a reserve from marketing operations. They belonged to and were taxable income of the cooperative. * * * Dr. P. Phillips Cooperative voluntarily issued revolving fund certificates against the amounts retained from marketing operations. Those certificates had no fair market value and did not represent income to the petitioners on that basis. * * *

The situation with respect to the amounts retained by the cooperative from its 1946 caretaking activities is different. It has been held in Dr. Phillips Cooperative, supra, that those amounts never belonged to the cooperative. It was required by

68 For a dissenting view on the treatment to be accorded refunds not made pursuant

to a preexisting obligation see the quotation from Nieman, post, p. 217.

69

Harbor Plywood Corporation, 14 T. C. 158, affirmed, 187 F. 2d 734. For analysis of the theory of this and subsequent decisions mentioned here, see Nieman,

its contracts with its members to issue revolving fund certificates for the funds thus retained. The members agreed in advance that those funds, which continued to belong to them, could be retained by the cooperative for the special purpose of the reserve.

73

On this reasoning, the court held that Phillips was taxable in the year of issue on the face amount of the certificates issued in connection with caretaking activities but not on the certificates issued in connection with marketing operations. This case resulted in a consistent application of cooperative theory as to the status of patronage refunds both from the standpoint of the cooperative and the patron.

Other cases soon followed, however, and began to confuse the situation. In 1952 the Tax Court held in Estate of Wallace Caswell 74 that certain certificates, representing amounts retained by the association for a "commercial reserve" from the proceeds of peaches sold by the Caswell patrons, constituted income to them at the time of issue to the extent of their fair market value, and that the fair market value of these certificates was equal to their face value. Later, the Tax Court followed this case in holding that a taxpayer realized income upon the receipt of certificates of preferred stock from his cooperative to the extent of the fair market value of such certificates, which it determined to be equal to their par value."

75

In 1953 the Tax Court held in B. A. Carpenter 76 that a cash basis taxpayer need not include in gross income the face amount of revolving fund certificates issued by a farmer cooperative at its option in lieu of cash and which were found to have no fair market value at time of issue. Later that year, a Federal district court in Iowa held that the plaintiffpatron was not taxable on credits in a "Reserve for General Contingencies" established by another cooperative which plaintiff patronized."

Although the opinion in this case refers to the patrons' inability to get cash for its credits, examination of the cooperative's articles and bylaws and its directors' resolution creating the reserve indicates that it was not obligated to pay the patrons the money which was transferred to the reserve so that the issuance of credits must have been voluntary and there was nothing to indicate that they had a market value.78

On April 1, 1954, the Ninth Circuit Court of Appeals reversed the Tax Court's earlier decision in the Caswell case.79 It held that the certificates issued by the cooperative were mere evidences of the patrons' contingent rights in the commercial reserve, which rights existed even without the issuance of the certificates. It further said that these rights were subject to the happening of certain contingencies, none of which had occurred. Accordingly, it said that the certificates did not constitute taxable income to the recipients to any extent whatever in the year of issue.

On the last day of that month the Tax Court again held that the recipient of certain “retain certificates" was taxable only on the fair market value of the certificates, and found that the certificates in question had no fair market value capable of being ascertained with reasonable certainty.80 The court also found, however, under the bylaws there involved that the board

77

20 T. C. 603, affirmed, 219 F. 2d 635.

Farmers Grain Dealers Association of Iowa v. United States, 116 F. Supp. 685. 78 Nieman, op. cit. supra, n. 67, 164.

79 Estate of Wallace Caswell v. Commissioner, 211 F. 2d 693.

80

Mary Grace Howey, P-H1954 T. C. Mem. Dec. Par. 54, 125.

of directors had the power to "retain the funds whether or not they chose to issue the certificates." This suggests the absence of a prior mandatory obligation.

In an unreported oral opinion on June 30, 1954, in Moe v. Earle (Civil No. 7074) the United States District Court for the District of Oregon held that the taxpayer there involved realized no income "in the year in which such amounts were deducted from the sums of money payable to the plaintiffs for their fruit, or in the year in which such (revolving fund) certificates were issued to the plaintiffs," but implied that any cash subsequently received upon redemption of the certificates would be income to the taxpayer in the year of redemption. The amounts involved were specific retains from sales proceeds and not patronage refunds.

On March 2, 1955, the United States Court of Appeals (Fifth Circuit) affirmed the earlier Tax Court opinion in B. A. Carpenter.81

Finally, on October 28, 1955, Moe v. Earle was affirmed by a per curiam opinion, and, on April 9, 1956, the Supreme Court of the United States denied certiorari.82

As this is written, there are three views as to the patron's tax responsibility:

1. The position of the Internal Revenue Service, as stated above, is that all noncash allocations of a farmer cooperative's net margins made to a patron pursuant to a prior mandatory obligation must be taken into account in computing gross income of such patron in the year in which the patron is notified of the apportionment, except where they do not affect his business income.

2. The Tax Court has held in several cases that such allocations should be taxed at the fair market value of the document or credit received, and one of these decisions has been affirmed by the United States Court of Appeals (Fifth Circuit).

3. The United States Court of Appeals (Ninth Circuit) has said that such allocations are not taxable at the time evidence thereof is issued to the cooperative patron. Presumably, by implication, the patron would be taxed only if and when he receives cash in redemption of such allocations or retains. A Federal district court in Oregon has applied the same rule to capital retains from the proceeds of the sold crop, even though the patrons in advance of delivery of the crop had authorized the cooperative to make such retains. This decision has been affirmed by the United States Court of Appeals (Ninth Circuit) and the Supreme Court has allowed this decision to stand.

One author has suggested that this confusion can and should be eliminated by a return to the fundamental concepts and principles of cooperation developed in the cooperative tax cases.83 If this were done, the applicable rules would be these:

Where the "patronage contract" precludes the cooperative from ultimately diverting the net margins to its stockholders or members as such, it would seem that it obligates the cooperative to pay them to its patrons. In such cases, the patron's authorization to the cooperative to invest his net margins in capital stock or some other kind of capital for him and to issue to him shares of stock or interests in the nonstock capital in performance of its obligation to pay him his net margins is, in substance and effect, a reinvestment for and by the patron. His income from such a transaction should be measured by the face value of his investment interest.

On the other hand, if the cooperative is free to pay the net margins to its members or stockholders, but if it nevertheless does pay them to its patrons in a noncash "investment contract" which the patron was not previously entitled to receive or obligated to accept, then the cooperative's payment is voluntary. The measure of the patron's income should be the market value of his investment interest without regard to the negotiable or nonnegotiable character of the piece of paper issued as convenient evidence of that interest.

Corporations Organized to Finance Crop Operations

Paragraph (16) of section 501 (c) of the Internal Revenue Code of 1954 84 provides for exemption from Federal income tax of certain corporations set up for the purpose of financing crop operations by organizations which qualify under section 521. It reads as follows:

(16) Corporations organized by an association subject to part III of this subchapter or members thereof, for the purpose of financing the ordinary crop operations of such members or other producers, and operated in conjunction with such association. Exemption shall not be denied any such corporation 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 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 corporation, on dissolution or otherwise, beyond the fixed dividends) is owned by such association, or members thereof; nor shall exemption be denied any such corporation because there is accumulated and maintained by it a reserve required by State law or a reasonable reserve for any necessary purpose.

Mutual Insurance Companies or Associations

Farmers' mutual insurance companies or associations meeting the provisions set forth in paragraph (15) of section 501 (c) of the Internal Revenue Code of 1954 85 may qualify for exemption. The paragraph reads as follows:

(15) Mutual insurance companies or associations other than life or marine (including interinsurers and reciprocal underwriters) if the gross amount received during the taxable year from interest, dividends, rents, and premiums (including deposits and assessments) does not exceed $75,000.

Patronage Refunds

HAT are patronage refunds? Originally they were called patronage

are not dividends at all in the sense in which the term is ordinarily employed, but are savings. The aim of a cooperative, whether marketing or purchasing, is to operate on a cost basis, or as near thereto as practicable. Patronage refunds are simply a means of enabling associations to achieve this result more easily.86

As a Federal district court stated it, in one case: 87

* * * Since October 24, 1844, * * *the so-called Rochdale principles have been recognized. *** While these principles have been variously stated by different authorities, they all agreed upon the inclusion therein of the principle that distribution of the surplus originating in the economic activity of an organization is in direct proportion to the participation of members * * *

Accordingly, he said:

The patronage dividends to be paid to producers in a farmers' cooperative need not be and should not be the same to every patron.

Patronage refunds were held in a Mississippi case not to be a part of

84 68A Stat. 165; 26 U. S. C. A. 501 (c), (16).

85 68A Stat. 165; 26 U. S. C. A. 501 (c), (15).

86

Adcock, PATRONAGE DIVIDENDS: INCOME DISTRIBUTION OR PRICE ADJUSTMENTS, 13 LAW & CONTEMPORARY PROBLEMS 505 (1948); Jensen, THE COLLECTING and reMITTING TRANSACTIONS OF A COOPERATIVE MARKETING CORPORATION, 13 LAW & CONTEMPORARY PROBLEMS 403 (1948).

87 Bowles v. Inland Empire Dairy Association, 53 F. Supp. 210, 216.

the gross income of the cooperative, as it was obligated to return these amounts to the persons to whom they were paid.88

In general, any business concern, whether cooperative or otherwise, may pay patronage refunds. Statutes ordinarily bar the payment of refunds or rebates by railroads and public utilities, but those engaged in private businesses may ordinarily make such payments so long as they do not conflict with the contract rights of shareholders.89 In a case arising in Oklahoma, the proprietor of a commercial cotton gin opposed the granting of a license to a cooperative that desired to engage in the cotton ginning business because, he contended, the cooperative was specifically authorized to pay patronage refunds by the statute under which it was incorporated, while he was barred from doing so. The commercial operator, therefore, contended that he was denied the equal protection of the laws. The Supreme Court of the United States found, however, that inasmuch as no law or regulation of the State had been adduced, which prohibited the commercial operator from the payment of patronage refunds, no discrimination was involved.90 Patronage refunds are dependent on the success of the enterprise and are subject to its hazards. They should be distinguished from rebates.91

The need for using patronage refunds arises principally, if not solely, in associations that have a fixed schedule of charges for the handling of products and associations that pay at the time of receipt for products to be handled. For instance, some cooperative elevators have a fixed charge per bushel for the marketing of the grain they handle, generally the same as the going rate charged by private operators, whereas others aim to pay the current price therefor. In each case it is contemplated that at the end of the year, or of a fixed period, the expenses and costs of operation of the association will be ascertained and that the amount remaining will be distributed among the members on the basis of the quantity of product, or the value thereof, marketed by the association for each of them.

expenses

When associations have a schedule of charges, it is contemplated that the returns therefrom will more than cover all expenses of the association, but obviously it is unknown in advance what the exact amount of the will be. Likewise, in the case of associations that pay the current price for the products handled, it is contemplated that the products will be sold for prices that will leave a balance after meeting all expenses; but the amount of this balance also is unknown in advance. At the end of the year, or of a fixed period, the expenses of the association are ascertained; and this amount, together with any other deductions such as for working capital or reserves, is subtracted from the total amount which has been received by the association for handling charges or from the total sale price of the product. The balance, or such portion thereof as the board

88 State v. Morgan Gin Company, 186 Miss. 66, 189 So. 817. See also Gallatin Farmers Co. v. Shannon, 109 Mont. 155, 93 P. 2d 953; Uniform Printing and Supply Co. v. Commissioner, 88 F. 2d 75.

89

90

But see Midland Cooperative Wholesale v. Ickes, 125 F. 2d 618.

Corporation Commission of Oklahoma v. Lowe, 281 U. S. 431, 50 S. Ct. 397, 74 L. Ed. 945. See also Guthrie Cotton Oil Co. v. Farmers' Custom Gin, 156 Okla. 16, 9 P. 2d 32; Southwestern Cotton Oil Co. v. Farmers' Union Coop. Gin Co., 165 Okla. 31, 24 P. 2d 658; Chickasha Cotton Oil Co. v. Cotton County Gin Co., 40 F. 2d 846, 74 A. L. R. 1070; Choctaw Cotton Oil Company v. Corporation Commission of Oklahoma, 121 Okla. 51, 247 P. 390.

91

Bunn, Charles. CONSUMERS' COOPERATIVES AND PRICE FIXING LAWS. 40 Michigan Law Review 2-165, 1941; Certified Grocers of California, Ltd. v. State Board of Equalization, 100 Cal. App. 2d 289, 223 P. 2d 291; Eaton v. Brock, 124 Cal. App. 2d 10, 268 P. 2d 58.