with the subject. It is an ever-changing picture. And developments continue.8 A number of questions are now pending in the courts, and at the time this material was prepared, the Internal Revenue Service9 was considering regulations under the 1966 and 1969 amendments to the law. Also under consideration was the issuance of additional revenue rulings and revenue procedures intended to clarify several matters of interpretation under the statutes and regulations. 10 The taxation of cooperatives and their patrons under existing law, discussed in more detail in subsequent sections, can best be understood in the context of their past economic and income tax status. Distinctive Characteristics of Cooperatives The tax laws have always recognized the distinctive characteristics of the cooperative form of doing business. Farmers join together in cooperatives to market their products and to purchase their farm supplies and farm business services. They do this to get a better price for their product, to serve themselves at cost, and thereby increase their farm income-not, as we shall see, to obtain a tax advantage unavailable to others. Farmers look upon their cooperatives as extensions of their own farming operations-as the marketing and purchasing departments of their own farms. Although not organized for profit, a farmer cooperative is organized for the financial benefit of its members. It differs, 'See list of published material relating to taxes on p. 469. The listing, by no means exhaustive, is presented by date of publication. Treatment ranges from a consideration of broad policy and constitutional questions to analysis of old as well as current law, rulings and regulations designed to provide detailed guidelines for cooperatives and their advisors. No attempt is made to catalog the material; the reader being left a choice based on author, title, and publication date. 8 See footnotes 5 and 6, in this section. "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." 10 Harmanson, Jr., The Cooperative Tax Picture, Cooperative Accountant, Winter 1968, 4; and Harmanson's reports to the annual meetings of the National Council of Farmer Cooperatives, Hollywood, Fla., Jan. 1970, Washington D.C., Jan. 1971, and Freeport, Bahamas, Jan. 1973. though, from other commercial enterprises because, in a cooperative, the financial benefits flow to the patrons on the basis of their patronage. In other businesses, these benefits go to the owners, who may or may not be patrons of the business, not on the basis of patronage but according to their investment in the enterprise. Cooperatives differ from other business organizations in at least four important ways: 1. Member Ownership and Control.-A first basic principle of a farmer cooperative is that ownership and control be in the hands of the farmers who use its services-for marketing or for obtaining supplies or services. Control is exercised by the owners as member-patrons rather than as investors. No other form of business has a comparable patron-owner relationship. 2. Nonprofit Organizations.-Operations of a cooperative are on a cost basis. Amounts realized from operations over and above expenses belong to the farmers who patronize the cooperative. Since costs cannot be estimated accurately in advance, patrons of a cooperative usually pay the "going or competitive price" for goods or services; and generally receive an advance for products marketed that is less than the actual value of the product. Adjustments are made at the end of the year when costs are known. The amount of any necessary adjustment then goes to memberpatrons as refunds based on patronage. The cooperative thus operates at cost and not to make a profit for itself or for nonpatron investors. 3. Returns on Capital Limited. -Members of a cooperative are primarily interested in the benefits they derive as patrons of the organization. Since benefits in a cooperative are distributed to patrons on the basis of their use of its services, such benefits do not enhance the value of shares of stock or provide a return on invested capital. Hence, members of a cooperative must provide most of its capital either by direct subscription or by investment of their patronage allocations. The incentives which cause persons to invest in corporate stocks are not present in the case of cooperative stock. For this reason the capital of a cooperative can, for the most part, come only from its member-patrons. 4. Obligation to Finance.-While the obligation of members to finance is not listed first, it is of prime importance. A cooperative is organized for the benefit of its members as patrons and not as investors. Member-patrons are thus the persons primarily interested in the success of the enterprise and, as they use its services, they assume the basic responsibility of providing capital. Although differing in many ways from other corporations, farmer cooperatives are an integral part of our private enterprise system. They enable the individual farmer to join with his neighbor to gain the volume and market strength necessary to compete in our business economy. Whether farmers operate their cooperative to market milk, cotton, grain, livestock, vegetables, citrus fruits, or some other commodity; or to purchase fertilizer, seed, insecticides, or other farm supplies or services, they are operating in the best tradition of the American economy. Historical Background The Revenue Act of 1913, the first tax measure enacted after the 16th amendment, did not specifically mention cooperatives. It did, though, exempt certain types of nonprofit concerns, including "agricultural and horticultural organizations."11 The Treasury Department at first construed this language to include, as exempt, cooperative dairies without capital stock making "patrons dividends based on the percentage of butter fat in milk furnished" the cooperative. 12 This ruling was replaced within a few months by one holding that cooperative dairies, whether issuing capital stock or not, were required to file returns of annual net income under the Act since they did not "appear to fall within" any of the exempted classes. In their returns they were allowed to include in their deductions from gross income the amount "actually paid" to members and patrons for milk, but any amount retained at the end of the year over and above expenditures was returnable as net income and taxable.13 Insofar as applicable, this same ruling was also extended to mutual or cooperative telephone companies, farmers' insurance companies, and like organizations. An extremely narrow exemption for agency marketing cooperatives which dealt only with members was included in the 1916 1138 Stat. 166, 172. 12 Art. 92 of Income Tax Regs. No. 33, p. 62 (Jan. 5, 1914), T.D. 1944, filed as Supp. with 16 Treas. Dec. Int. Rev. (1914). 13T.D. 1996, 16 Treas. Dec. Int. Rev. 100 (1914). Act. 14 Five years later, in the 1921 Act, these provisions were broadened to include farmer cooperatives acting as purchasing agents for members, 15 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 practices authorized by the Treasury Department all found their way into the Revenue Act of 1926.16 In 1934, 17 the statute was amended, permitting business done with the United States to be disregarded in determining the right to exemption. The next 17 years brought no further changes in the 1926 law until the Congress enacted section 314 of the Revenue Act of 1951.18 Section 314 repealed none of the existing law, but it added new tax treatment for associations qualifying under the provisions that had theretofore conferred complete exemption. In other words, compliance with the "exemption" provisions of the statute for taxable years beginning after December 31, 1951, no longer gave exemption. It merely authorized a qualifying association to 1439 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. 1542 Stat. 227, 253. 1644 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. 1748 Stat. 680, 701. 1865 Stat. 452, 491. 19It is clear that Congress had the right to exempt agricultural cooperatives from the payment of Federal income taxes. Flint v. Stone Tracy Co., 220 U.S. 107 (1911); Brushaber v. Union Pacific Railroad Co., 240 U.S. 1 (1916), L.R.A. 1917 D 414, Ann. Cas. 1917 B713; Stanton v. Baltic Mining Co., 240 U.S. 103 (1916). The special or different treatment under the 1951 law is not unusual and likewise is make certain deductions and other adjustments in the computation of its statutory net income under the Internal Revenue Code. Like nonexempt cooperatives, such complying associations, now erroneously labeled "exempt," were also authorized to exclude from gross income patronage refunds which they were under a prior mandatory obligation to make to their patrons.20 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, but new section numbers were assigned. Section 101(12)(A) of the 1939 Code became section 521 of the 1954 Code, and section 101(12)(B) of the 1939 Code became section 522 of the 1954 Code. The statutory provisions relating to farmers' marketing and farm supply associations as they appeared following the 1954 revision of the Internal Revenue Code were as follows:21 Sec. 521. Exemption of Farmers' (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 legal. 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. 20See "Taxation of Nonexempt Cooperatives," p. 364. |