business, the cooperative's activities for its patrons must be such that it may "properly be characterized as a farmers' cooperative" within the meaning of that term as defined in section 521 of the Code.

Taxation of Cooperatives and Patrons Under Subchapter T

The purpose of subchapter T is to assure that amounts received by cooperatives in the course of their business activities with their patrons are included in computing the taxable income of either the cooperative or the patron, thus subjecting these amounts to a single current tax. The choice as to who pays the tax and when it is paid is a choice the law allows the patron to make. Subchapter T and the regulations spell out in great detail just how a patron makes the choice and how both the cooperative 193 and the patron194 will be taxed.

Distributions of margins by a cooperative to its patrons, including dividends on stock, are not deductible, and do not otherwise reduce a cooperative's gross income for income tax purposes, unless the distributions qualify for deduction under the law. 195 Their qualification depends, for the most part, on whether the patrons are willing to include the amounts distributed as a part of their income. This willingness has to be expressed in one of several forms of consent authorized by the statute.19% Other requirements must also be satisfied-such as notice, time of payment, and the amount of cash that must be paid currently. But, basically, without patron consent, distributions of patronage refunds by cooperatives would not qualify for deduction under the law.

If patrons give their consent in writing to the inclusion of the face amount of their patronage refunds in their incomes, 197 or if there is a provision in the bylaws of the cooperative clearly indicating that membership in the cooperative represents consent to such treatment, patronage refunds are

193See "Tax on Cooperatives," p. 430.

194See "Tax on Patrons," p. 438.

195 Int. Rev. Code of 1954, §§ 1381 through 1388.

196 Int. Rev. Code of 1954, § 1388.

197 At the patron level, certain amounts are specifically excludable by statute or regulations such as amounts paid or allocated to patrons on the basis of personal, rather than business, expense items. Int. Rev. Code of 1954, § 1385(b)(2).

treated as income to the patrons in the year in which the patronage refunds are made. This means that a cooperative is allowed a deduction for a patronage refund when made, only when the refund qualifies for the specified treatment at that time in the hands of the patron. Otherwise, the amount involved is deductible by the cooperative and taxable to the patron only at the time the patronage refund is paid in cash. 198

Meaning of Certain Terms

Cooperatives have a language of their own in certain business and operational areas. The tax field is no exception. This leads to some misunderstanding by people in other fields who are not familiar with the meaning of specific cooperativeoriented terms. The following paragraphs explain the meaning given to a few of these terms. Also included are some of the special words and phrases subchapter T adds to the basic cooperative vocabulary.

A cooperative is a business organization formed for the purpose of providing goods or services for its patron-owners or marketing their products. Not all cooperatives are farmer cooperatives, there being a number of other types, such as mutual fire or life insurance associations, urban consumer cooperatives, electric and telephone cooperatives, wholesaling businesses owned by retailers, and the like.

The term patron usually includes any person with whom or for whom a cooperative does business on a cooperative basis, whether a stockholder, member or nonmember of the cooperative, and whether a natural person, firm, corporation, or association.

A patronage dividend (cooperatives prefer and normally use the term patronage refund) is defined in section 1388(a) of the Code to mean an amount paid to a patron by cooperative: (1) on the basis of quantity or value of business done with or for such patron, (2) under an obligation of the cooperative to pay such amount which obligation existed before the cooperative received the amount so paid, and (3) which is determined by reference to the "net earnings" of the cooperative from business done with or for its patrons.

The last sentence of section 1388(a) provides that a patron

198S. Rep. No. 1707 (on H.R. 13103), 89th Cong., 2d sess. 70 (1966).

age refund shall not include amounts paid (a) out of earnings other than from business done with or for patrons, or (b) out of earnings from business done with or for other patrons to whom no patronage refunds are paid or to whom smaller amounts are paid, with respect to substantially identical transactions.

The regulations, 199 in discussing item (2) above, use the term valid enforceable written obligation. It is then explained that an amount is paid "under a valid enforceable written obligation" if the payment is required by State law, or is paid pursuant to provisions of the bylaws, articles of incorporation, or other written contract whereby the organization is obligated to make such payment.200

Net earnings, for purposes of item (3) above include the excess of amounts held (or assessed) by a cooperative to cover expenses or other items over the amount of such expenses or other items.201 The regulations also provide that "net earnings" shall not be reduced by any income taxes imposed by subtitle A of the Code, but shall be reduced by dividends paid on capital stock or other proprietary capital interests.

A written notice of allocation means any capital stock, revolving fund certificate, retain certificate, certificate of indebtedness, letter of advice, or other written notice, which discloses to the patron the stated dollar amount allocated to him on the books of the cooperative, and the portion thereof, if any, which constitutes a patronage refund. A credit to the account of a patron on the cooperative's books without disclosure to the patron, is not a written notice of allocation. The written notice may show the patronage refund as a dollar amount or as a percentage of the stated dollar amount of the allocation notice. 202

199Treas. Reg. §1.1388-1(a).

200 This "written" obligation requirement of the regulations seems to be at odds with certain court decisions. Farmers' Elevator Co. of East Grand Forks, Minnesota, T.C. Memo 1962-204 (Dkt. No. 85149), and Georgetown Farmers Elevator Co. v. United States, 8 AFTR 2d 5549 (D. Minn. 1961), appeal dismissed on Government's motion, 305 F. 2d 376 (8th Cir. 1962). These cases hold that an "oral" contract is a sufficient antecedent legal obligation. See also text at footnote 35, in this section.

201 Treas. Reg. § 1.1388-1(a)(1)(iii).

202 Treas. Reg. §1.1388-1(b). But receipts for purchases given to mem

A qualified written notice of allocation203 is a written notice of allocation which the patron can redeem in cash at face value within 90 days after the date of notice, or a written notice which the patron has consented to include in his taxable income upon receipt in the same manner as cash. A written notice will not qualify as a "qualified" notice unless it is distributed as part of a patronage refund together with at least 20 percent or more204 of the amount of the refund in money or a qualified check as defined in section 1388 (c) (4) of the Code. All other written notices of allocation are "nonqualified."

The payment period for a cooperative is the period beginning with the first day of the cooperative's taxable year and ending on the 15th day of the ninth month following the close of such year. 205 For example, the payment period for the taxable year 1972 for a cooperative keeping its books on a calendar year basis would be January 1, 1972 through September 15, 1973.

Patron consent to include the full face value of a written notice of allocation in the patron's taxable income may take any of three forms:

1. It may be by individual written consent which must originally be given to the cooperative before the end of the year in which the patronage occurs. It applies to all patronage in that year and subsequent taxable years until revoked in writing. No special form is necessary so long as the terms of the consent are clear. It may be on a signed invoice, sales slip, delivery ticket, marketing contract, or other paper on which the consent appears.

2. For members of a cooperative, consent may be given by becoming or continuing as a member after the co

bers together with financial statements distributed at annual meetings did not qualify as "written notices of allocation." Seiners Association, 58 T.C. 949 (1972).

203 Int. Rev. Code of 1954, §1388(c).

204 The congressional purpose behind the 20 percent cash requirement was to emphasize to the patrons the taxability of the full amount of the refund in the patrons' hands and to provide the patrons with some cash with which to pay the tax. S. Rep. No. 1881, 87th Cong., 2d sess, 112 (1962), Report of the Committee on Finance on the Revenue Act of 1962.

205 Int. Rev. Code of 1954, § 1382 (d); Treas. Reg. §1.1382-4.

operative has adopted (after October 16, 1962) a bylaw provision stating that membership in the cooperative constitutes such consent. This is called "bylaw consent" and takes effect only after the member has received a copy of the bylaw together with a written statement as to its significance. The written statement or notification must be given separately to each member (or prospective member) before patronage occurs. It is not effective after a patron ceases to be a member or after repeal of the bylaw provision.

3. Where neither (1) nor (2) applies, consent may be obtained by a patron endorsing and cashing a qualified check or other instrument redeemable in money representing at least 20 percent of the total patronage refund on or before a prescribed date, but no later than 90 days after the close of the payment period, provided such check or instrument has clearly imprinted on it that endorsing and cashing it will constitute such consent.

Tax on Cooperatives

Farmer cooperatives, including those that qualify under section 521 of the Internal Revenue Code, are subject to income tax. Their income and expenses for income tax purposes are computed in the same manner as those of other business corporations. Because they are cooperatives operating under strict rules prescribed by law, they may deduct from gross income certain patronage allocations.

The requirements surrounding these allocations by cooperatives and their distribution to patrons are set out in subchapter T of the Code. 206 Any corporation operating on a cooperative basis is accorded the same treatment 207 with respect to patronage distributions. 208 By and large what a co

206 Int. Rev. Code of 1954, §§ 1382, 1383, and 1388.

207 Int. Rev. Code of 1954, §1381(a)(2). Rev. Rul. 70-481, 1970-2 Cum. Bull. 170. See also Rev. Rul. 66-98, 1966-1 Cum. Bull. 200 (department stores formed an association to supply working capital needs of members at cost-held to be operating "on a cooperative basis"), and footnote 30, in this section, and accompanying text.

208 Rev. Rul. 70-481, 1970-2 Cum. Bull. 170; Rev. Rul. 69-389, 1969-2 Cum. Bull. 166. See also Rev. Rul. 66-380, 1966-2 Cum. Bull. 359, discussed on p. 433.