INCOME TAX 

TREATMENT OF 

COOPERATIVES

Background

USDA Rural Development

Business and Cooperative

Services

Cooperative Information 

Report 44, Part 1
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Cooperative Information Report 44-1 i

ABSTRACT

INCOME TAX TREATMENT OF COOPERATIVES:

Background

2013 Edition

Donald A. Frederick

Republished by Stephanie M. Smith and David Chesnick

Cooperative tax rules are a logical combination of the unique attributes of a cooperative and the income 

tax scheme in the Internal Revenue Code. The single tax principle is applied to earnings from business 

conducted on a cooperative basis in recognition of the special relationship between the members and their 

cooperative associations. Cooperatives have been granted a certain degree of flexibility in their financial 

and tax planning and should exercise their options effectively to maximize benefits for members.

Key words: Cooperative, equity, income, patronage, tax

Cooperative Information Report 44, Part I 

June 2013
ii Income Tax Treatment of Cooperatives: Background

PREFACE1

Cooperative taxation does not occur in a vacuum. As business corporations, cooperatives are subject to 

many of the tax rules applicable to other business forms. But cooperatives also have special features that 

justify unique approaches to certain aspects of income taxation.

This report provides important background to understanding present day income tax treatment of cooperatives. Chapter 1 begins with an explanation of key terminology used in the context of cooperative taxation. The role cooperatives play in the agricultural economy is presented. A description of the forms of 

doing business and an overview of the general tax treatment of each organization, including cooperatives, 

is provided. The role played by legislation, administrative rulings, and judicial decisions in establishing 

cooperative tax policy also is described.

Chapter 2 focuses on cooperative organization and operation, and their relationship with taxation. The 

meaning of “operating on a cooperative basis” as the term is used in the Internal Revenue Code is explored. Nontax statutes that guide cooperative businesses and organizational documents used by cooperatives are described. Examples illustrate how cooperatives operate. Sources of equity capital and financial 

planning options are reviewed.

Chapter 3 examines the historical development of cooperative income taxation. A synopsis of the constitutional underpinnings of the power of the Federal Government to levy an income tax and a discussion 

of tax logic and cooperatives precede a review of the two early paths followed in cooperative taxation. 

One covers administrative and judicial rulings establishing the single-tax treatment of cooperatives incorporated in Subchapter T of the Internal Revenue Code. The other is a legislative trail leading to present 

section-521 tax treatment.

1 This report does not represent official policy of the U.S. Department of Agriculture, the Internal Revenue 

Service, the U.S. Department of the Treasury, or any other government agency. This publication is presented only to 

provide information to persons interested in the tax treatment of cooperatives.
Cooperative Information Report 44-1 iii

CONTENTS

 Page

Chapter 1. Tax Principles, Terminology, and Sources 1

Scope 1

Terminology 2

Margins, Income and Earnings 2

Patron Distinguished from Member 2

Patronage Refund Distinguished From a Dividend 3

Facts About Farmer Cooperatives 3

Non-Farm Cooperatives 4

Financial Cooperatives 4

Consumer Service Cooperatives 5

Business Cooperatives 5

Tax Treatment of Noncooperative Businesses 6

Sole Proprietorships 6

Partnerships 6

Limited Liability Companies 6

Corporations 6

S Corporations 7

Cooperative Tax Principles 8

Cooperatives Organized and Taxed as LLC’s and Vice Versa 8

Sources of Tax Law 9

Internal Revenue Code 9

Subchapter T 10

Section 521 10

Other Code Provisions 10

Judicial Decisions 11

IRS Administrative Determinations 11

Regulations 11

Revenue Rulings and Revenue Procedures 12

Private Letter Rulings and Technical Advice Memoranda 12

General Counsel Memoranda and Actions on Decisions 13
iv Income Tax Treatment of Cooperatives: Background

CONTENTS (cont.)

Chapter 2. Cooperative Structure, Operation and Taxation 13

Operating on a Cooperative Basis 13

Any Organization Eligible 13

Code Meaning 14

The”Worker Cooperative“ Controversy 15

The ”Majority Member Business“ Controversy 15

IRS Reliance on Puget Sound Plywood 17

Nontax Statutes That Characterize Cooperatives 19

State Incorporation Laws 19

Federal Statutes 19

Capper-Volstead Act 20

Agricultural Marketing Act of 1929 20

Farm Credit Act of 1971 20

Structure and Operations 20

Articles of Incorporation 20

Bylaws 21

Contractual Agreements with Members 21

General Operational Characteristics 22

Examples of Cooperative Operations 22

Equity Accumulation 25

Sources of Equity Capital for Cooperatives 25

Direct Investment 25

Margins 26

Per-Unit Retains 26

Nonmember/Nonpatronage Earnings 27

Financial Planning Options 27

Cash Refunds 27

Qualified Investments 27

Nonqualified Investments 28

Unallocated Reserves 29

Equity Redemption 29

Revolving Fund Plan 29

Base Capital Plan 29

Special Plans 30

Pooling 30
Cooperative Information Report 44-1 v

CONTENTS (cont.)

Chapter 3. Historical Development of Cooperative Taxation 31

The Power to Tax 31

Tax Logic and Cooperatives 32

Price Adjustment Characterization 32

Agent or Conduit Characterization 33

Pre-1951 Rulings for Nonexempt Cooperatives: The Road to Subchapter T 33

Patronage Refund Tax Status 34

Patronage Refund Requirements 36

Preexisting Legal Obligation 36

Patronage Business Requirement 37

Distributed on a Patronage Basis 37

Computing the Patronage Refund 38

Noncash Refund Payments 39

Pre-1951 Tax Legislation: The Road to Section 521 40

Agricultural and Horticultural Organizations Exemption: 1909-1916 41

Early Cooperative Exemption: 1916-1926 42

Administrative Interpretations of the Early Revenue Acts 42

Purchasing and Dual-Function Cooperatives 43

Revenue Act of 1926 43

Revenue Act of 1951 44

Purpose 45

Judicial Interpretation 45

Revenue Act of 1962 46

Subsequent Legislation 46

Legislative History 47
vi Income Tax Treatment of Cooperatives: Background

HIGHLIGHTS

Familiarity with the special terms associated with any technical subject is a prerequisite to mastering that 

subject. Certain terms take on a precise meaning when used in the context of cooperative taxation. The 

technical differences between words sometimes treated as synonyms in general conversation are explained 

to promote understanding of the nuances of cooperative income taxation.

Cooperatives are a vibrant business form in the agricultural sector of the economy. With net business 

volume near $150 billion on an annual basis, and almost 2.2 million farm memberships, cooperatives are 

big business when measuring their importance to rural America. In 2010, 57 percent of farmer cooperatives reported sales volumes of less than $15 million. They are primarily small businesses serving a local 

community and the surrounding area.

Cooperatives are one of several forms of doing business recognized by the Internal Revenue Code. Like 

sole proprietorships, partnerships, limited liability companies, LLC’s, and Subchapter S corporations, 

single tax treatment is available to cooperatives and their member-owners, on business conducted on a 

cooperative basis. Earnings on noncooperative operations, like those of investor-general corporations, are 

subject to taxation at both the firm and ownership levels.

Several sources contribute to cooperative tax law. The Internal Revenue Code (Code) provides the legislative foundation. The Code contains provisions applicable to all businesses, and other language specifically referring to cooperatives. The Internal Revenue Service (IRS or the Service), through a variety of 

administrative determinations, interprets the Code and applies it to the situation of each taxpayer. Courts 

of law act as final arbiter for any unsettled disputes between the Service and taxpayers over the meaning of 

the Code.

 Cooperative tax treatment is available to any organization that comes within the scope of “operating on 

a cooperative basis” under the Code. Other, nontax statutes establish cooperative characteristics that must 

also be considered in a business plan where tax law is only one external factor. Likewise, a cooperative’s 

organizational documents and contracts with its members set forth how the organization will function.

One major challenge created by the user orientation of a cooperative is raising equity capital. The single 

tax treatment accorded cooperatives facilitates equity accumulation through business operations. Retained 

patronage refunds and per-unit retains are financing tools eligible for single tax treatment.

Cooperative tax rules reflect the unique nature of a cooperative venture. Whether patronage financing is viewed as a price adjustment, or the cooperative is considered an agent or conduit for the members, 

single tax treatment of margins and per-unit retains is analogous to taxation of certain other business forms, 

including investor-oriented firms.

Shortly after ratification of the 16th Amendment answered questions about the constitutionality of an 

income tax, a comprehensive income tax was enacted. Early on, a statutory exemption was created for 

farmer cooperatives that met certain operational tests. Nonfarm cooperatives and farmer cooperatives that 

chose not to operate according to these standards had no special statutory status. Treasury rulings and 

court decisions, however, permitted these cooperatives to exclude patronage refunds from taxable income.

In 1951 the tax law was changed through a repeal of the farmer cooperative exemption and the addition 

of deductions for previously exempt farmer cooperatives for stock dividends and patronage-based distributions on nonpatronage income. When the courts began allowing both cooperatives and patrons to exclude 

patronage refunds from taxable income, the tax law was rewritten in 1962 to ensure that a single current 

tax was paid on these margins.
Cooperative Information Report 44-1 1

Income Tax Treatment of Cooperatives

Background

CHAPTER 1

TAX PRINCIPLES, TERMINOLOGY, AND 

SOURCES

This publication is the first in a series of reports 

about Federal income taxation of farmer cooperatives.1

 The reports are designed as research tools, 

intended to help those making tax decisions with respect to cooperatives in U.S. agricultural and other 

sectors of the economy.2

Persons likely to benefit from these papers include accountants and bookkeepers employed by 

cooperatives, managers, financial officers, corporate 

planners, directors, lenders, accountants advising 

cooperatives, attorneys, scholars studying cooperatives, and public policymakers. The reports’ ultimate beneficiaries will be the user-owners of cooperative enterprises.

SCOPE

Effective tax planning requires a knowledge of all 

pertinent tax law. Tax law distinctive to cooperatives comprises a small portion of the tax spectrum, 

but is, of course, critical to cooperatives.

The reports in this series focus on tax rules 

unique to cooperatives or of special application to 

1 Rural Business-Cooperative Service "shall 

render service to associations of producers of agricultural products, and federations and subsidiaries thereof, 

engaged in the cooperative marketing of agricultural 

products..." and is authorized to "conduct studies of the 

economic, legal, financial, social, and other phases of cooperation, and publish the results thereof." Cooperative 

Marketing Act of 1926, 7 U.S.C. §§ 453(a) and 453(b)

(2).

2 The material in this report, and in all subsequent 

reports in this series, does not represent official policy of 

the U.S. Department of Agriculture, the Internal Revenue Service, the U.S. Department of the Treasury, or 

any other government agency. These publications are 

presented only to provide information to persons interested in the tax treatment of cooperatives.

cooperatives. The reports are not intended to provide information on all aspects of taxation with 

which cooperative advisors and decision makers 

should be acquainted. General rules are discussed, 

however, to the extent necessary to place cooperative taxation in perspective and highlight cooperative-noncooperative differences.

Three guidelines are used to determine subject 

matter covered, depth of analysis, and relative 

length of discussion on each topic. First, most attention is given to situations that affect a large number 

of cooperatives. Sophisticated or highly unusual 

situations generally are not addressed.

Second, the extent of legal authority addressing 

particular issues varies greatly. As a result, some 

topics of relatively less importance may occupy 

more space than important topics simply because of 

the amount of authority to be discussed.

Third, some material is included, even if not 

detailed or even specifically addressed by authority 

now available, to make the end product a more logical and coherent work.

Explanations of tax law are based on interpretation of legal authority. The choice of authority and 

style of interpretation both determine final written 

results. To the extent possible, these reports include 

all available primary authority.3 The reports’ usefulness to researchers, attorneys, and accountants 

mandates full citation of this authority. As a result, 

footnotes are used extensively throughout to identify sources upon which the accompanying exposition is based.

Interpretation of authorities is as “neutral” as pos3 Relevant provisions of the Internal Revenue 

Code and associated regulations, judicial decisions 

and revenue rulings are analyzed. In addition to these 

primary authorities, private letter rulings and technical advice memoranda are discussed. While pursuant 

to Code § 6110(k)(3) letter rulings may not be cited as 

precedent, they give some insight into the IRS's views 

on subject matter addressed. Sources of legal authority 

are described in the subsequent section of this chapter, 

"Sources of Tax Law."
2 Income Tax Treatment of Cooperatives: Background

sible, and no advocacy positions are taken. Where 

disagreement exists on correct application of tax 

laws to cooperatives, the rationale underlying positions taken by various parties is explained to the 

extent articulated by the parties.

TERMINOLOGY

Neither popular nor technical terminology is uniform for many important aspects of cooperative 

operation, accounting, and taxation. The way cooperatives use various terms differs, often to reflect 

the method the cooperative uses to compute and 

allocate patronage refunds. For example, the precise 

meaning of a term for an individual cooperative 

may depend on whether the association employs 

book or tax accounting rules to compute its patronage refunds.

For the sake of clarity, these reports will use 

certain terms as defined in the mini-glossary that 

follows. Other terms with limited application are 

defined when introduced in the text.

Margins, Income, and Earnings

Margins

“Net margins” or “margins” are used in place of 

terms such as “profit,” “net profit,” “income,” “net 

savings,” and “net income” when referring to money a cooperative earns on business conducted on a 

cooperative basis. Margins generally correspond to 

the phrase “net earnings of the organization from 

business done with or for its patrons” used in the 

Code.4

 As explained by the U.S. Tax Court:

“Profits” and “income” are considered somewhat dirty words in the cooperative fraternity. 

Consistent with the broad philosophy that 

cooperatives are intended to operate at cost, 

eliminating entrepreneur profit and returning their net earnings to their patrons on an 

equitable basis, see secs. 1382(b), 1388(a); ... 

cooperatives tend to eschew the words “profits” and “income,” preferring instead the more 

delicate terms “margins” and “savings.”5

4 I.R.C. § 1388(a)(3).

5 Illinois Grain Corp. v. Commissioner, 87 T.C. 

435, 450 note 3 (1986).

Income

As the quote above points out, “income” is sometimes used as a synonym for “profit.”

In this paper “income” means “gross income” 

as defined in the Code.6

 “Income” is all wealth that 

flows into the cooperative from business operations. “Income” includes cash and checks received 

to pay for services rendered and products provided. 

Income also includes interest, rents, and dividends 

received.

Funds obtained as loans or equity investments are 

not considered income for tax purposes.

Earnings

“Earnings” describes what is commonly referred to 

as “profit,” or total income less expenses. This must 

constantly be distinguished from the more limited 

term “margins,” which are earnings from business 

operated on a cooperative basis. Cooperatives can, 

and frequently do, conduct some of their operations 

on a noncooperative basis. This is one of several 

business options available to cooperatives, and 

highlights one of the more complex areas in terms 

of Code interpretation by the Internal Revenue Service7

 and cooperatives alike.

In summary, “income” refers to all funds that 

flow into the cooperative because of its business 

operations. “Earnings” are income less expenses, 

while “margins” are earnings on business conducted 

on a cooperative basis.

Patron Distinguished From Member

The definition of “margin” above is based on a 

Code provision that discusses “earnings ... from 

business done with or for its patrons.” 8

While the Code does not define patron, a Treasury Department regulation describes a patron as 

“any person with or for whom the cooperative 

association does business on a cooperative basis, 

whether a member or a nonmember of the cooperative association....”9

 In other words, a patron is a

6 I.R.C. § 61(a).

7 Internal Revenue Service, a part of the Department of the Treasury, is frequently referred to in this series of publications as "IRS" or "the Service" in keeping 

with common terminology.

8 I.R.C. § 1388(a)(3).

9 Treas. Reg. § 1.1388-1(e).
Cooperative Information Report 44-1 3

 person who shares in the earnings of the cooperative on the basis of the amount of business conducted with the cooperative.

The regulation highlights the important distinction between a member and a patron. A member is 

generally regarded as a person who has the right to 

vote on issues decided by the membership. A patron 

is a person who does business with the cooperative 

and has a right to share in the cooperative’s earnings 

on a pro rata, patronage basis.

There is usually substantial overlap between the 

“members” and the “patrons” of a cooperative. A 

cooperative, however, may do business with members on a nonpatronage basis, and it may conduct 

business on a patronage basis with nonmembers.

The options concerning whom a cooperative does 

business with on a cooperative basis contribute to 

the complexity of the tax treatment of cooperatives.

Patronage Refund Distinguished From a Dividend

A “patronage refund” consists of net margins from 

business done with or for patrons that are allocated 

or distributed to patrons on a patronage basis. For 

example, if a cooperative has a net margin for the 

year of $5,000, and Ms. Jones accounted for 5 

percent of the business conducted on a cooperative 

basis that year, then Ms. Jones receives a patronage 

refund of $250 ($5,000 x .05).

A primary difference between cooperatives and 

other forms of business is the way earnings are distributed. In a cooperative, the margins are returned 

to users as patronage refunds, based on the amount 

of business each user does with the cooperative. In a 

noncooperative, the earnings are returned to investors as dividends, based on the amount of investment in the company. Thus a patronage refund is a 

return based on use, a dividend is a return based on 

investment.

This distinction is complicated by the Code’s use 

of the term “patronage dividend” in referring 

to what is generally called a “patronage refund.”10

10 See, e.g., I.R.C. §§ 1382(b) and 1388(a). In 

a technical sense, a "patronage dividend" (within the 

meaning of the Code) is a "patronage refund" that meets 

certain Code requirements, such as being paid pursuant 

to a preexisting legal obligation on the cooperative to 

make the refund. In most instances, "patronage refunds" 

that do not qualify as "patronage dividends" (for tax pur

poses) are treated as ordinary "dividends" as defined in 

“Patronage refund” is used rather than “patronage 

dividend” in these reports in accord with general 

cooperative preferences and to avoid confusion with 

dividends paid to patrons and other equity holders 

on their capital stock.

A major portion of this series of reports is devoted to the tax treatment of patronage refunds.

FACTS ABOUT FARMER COOPERATIVES

Farmer-owned cooperatives have traditionally 

played a vital role in the production and distribution 

of agricultural products. Cooperatives’ important 

position in agriculture continues undiminished, 

although many changes have taken place in farm 

commodity production, processing, marketing, and 

distribution over the years.

In 2010, 2,310 farmer cooperatives provided marketing, farm supplies, and services to farmers.11 This 

represents a steadily declining number of farmer 

cooperatives, down from about 10,000 in 1950, 

and 6,211 in 1981. This decrease in the number of 

cooperatives reflects the trend of consolidation and 

merger occurring in production agriculture and in 

many segments of the food industry.

Of cooperatives operating in 2010, 1,218 primarily marketed farm products, 975 primarily provided 

farm supplies to farmers, and 117 primarily provided other services. Many cooperatives engage in two 

or all three of these activities.

Cooperatives can also be classified according to 

organization structure. Centralized cooperatives 

have only farmer members. Federated cooperatives 

have only other farmer cooperatives as members. 

The membership of mixed cooperatives consists 

of both farmers and farmer cooperatives. In 2010, 

2,252 cooperatives were centralized, 38 were federated, and 20 were mixed.

In 2010, it was estimated that 2.2 million producers held memberships in farmer cooperatives. This 

number includes duplications for farmers who 

Code § 316 for tax purposes. See, e.g., People's Gin Co. 

v. Commissioner, 41 B.T.A. 343 (1940), aff'd, 118 F.2d 

72 (5th Cir. 1941); Juneau Dairies, Inc. v. Commissioner, 

44 B.T.A. 759 (1941).

11 The data in this section is taken from J. Penn and 

E. Eversull, Cooperative Statistics, 2010, RBS Service 

Report No. 71 (USDA, November 2011).
4 Income Tax Treatment of Cooperatives: Background

The 6 cooperatives in the Top 100 that suffered 

losses in 2010 had total losses approaching $45 million. 

NON-FARM COOPERATIVES

While cooperatives are often most closely identified 

with agriculture, they are found working effectively 

to meet people’s needs in all sectors of American 

life. The National Cooperative Business Association 

reports that in the United States a network of 48,000 

cooperatives directly serve 120 million people -- 

nearly 40 percent of the population.14 Here are some 

examples and facts and figures about non-agricultural cooperatives.

Financial Cooperatives

The largest single segment of the cooperative industry is credit unions. The 8,334 credit unions in the 

United States have more than $760 billion in assets 

and more than 91 million members. Building on 

their base of member savings and consumer loans 

and home mortgages, credit unions now offer additional services to their members including credit 

cards, automated teller machines, tax-deferred 

retirement accounts and certificates of deposit.

Created in 1916, the cooperative Farm Credit 

System is the nation’s oldest and largest financial 

cooperative. It provides real estate loans, operating loans, home mortgage loans, crop insurance 

and various other financial services to more than 

500,000 farmer, small-town resident and cooperative borrowers. It loans roughly $90 billion annually 

to its members.

One element of the Farm Credit System is CoBank. In 2011, CoBank provided a $46.3 billion 

loan portfolio to farmer and rural utility cooperatives and water and waste disposal systems. CoBank 

has become an important financier of exports of 

U.S. farm products as it broadens its role of making 

credit available to enhance farm and rural income.

Since 1969, the National Rural Utilities Cooperative Finance Corporation (CFC) has been a valuable

14 See National Cooperative Business Association, 

www.ncba.coop. Other information in this section is 

taken primarily from the Web sites of individual cooperatives mentioned herein and various associations of 

cooperatives. This information is current as of 2011.

hold membership in more than one cooperative, a 

common situation. The tax treatment of patronage 

refunds paid to patrons and other tax implications of 

farmer membership affect a great number of farmer 

taxpayers.

The gross business volume of all farmer cooperatives in 2010 was $170.1 billion, up from $111.6 

billion in 2002. Marketing represented 59.4 percent 

of the total, farm supplies 37.63 percent, and selected services 3.0 percent. If inter-cooperative business 

transactions are eliminated, net business volume 

was $146.1 billion, up from $96.8 billion in 2002.

Most farmer cooperatives are relatively small 

businesses. In 2010, just over two-thirds of all 

farmer cooperatives reported business volume of 

less than $25 million.

Looking at some balance sheet numbers, combined assets of all farmer cooperatives in 2010 

totaled $65.0 billion, up from $47.5 billion in 2002. 

Total liabilities were $39.2 billion, compared to 

$27.9 billion in 2002. This leaves net worth, or 

member and patron equity, at $25.9 billion, a sizable 

increase over the $19.6 billion of 2002.

The 100 largest cooperatives (the so-called Top 

100 in USDA Rural Development publications) 

usually operate over sizable geographic areas and 

make up an important segment of the farmer cooperative industry. In 2010, the Top 100 accounted for 

$118.0 billion in business volume, 69.4 percent of 

the business volume for all farmer cooperatives.12

They likewise dominated the balance sheet items 

with $40.4 billion in total assets (62.1 percent of the 

total) and $14.6 billion in member and patron equity 

(56.4 percent of the total).

Ninety-four of the 100 had earnings in 2010 totaling $2.4 billion. How a cooperative uses its earnings 

affects tax calculations of both the cooperative and 

its farmer patrons.13

12 All 2010 Top 100 data are from S Ali and D. 

Chesnick, "Largest 100 Ag Co-ops Post Near-Record 

Sales, Margins" Rural Cooperatives March/April 2012 

(pp. 16-23).. Comparisons between data for the Top 

100 over time are of limited value as the make-up of the 

group can fluctuate significantly from year to year.

13 Historical and current statistics on farmer cooperatives are found in RBS publications. Data is collected 

by the agency and reported for all cooperatives combined.
Cooperative Information Report 44-1 5

 source of financing for rural electric and telephone 

cooperatives. With $21 billion in assets and more 

than $19 billion in loans to members, CFC supplements funding provided by USDA’s Rural Utilities 

Service and provides business services to its borrowers.

In a short period of time, the National Cooperative Bank (NCB) has become an important financial 

institution for America’s housing, business and 

consumer cooperatives. Chartered by Congress in 

1978 and private since 1982, NCB has originated 

more than $6 billion in loans to nearly 2,600 member owners throughout the country. NCB has become a leader in providing development funding for 

new, non-agricultural cooperatives and in devising 

methods of attracting outside capital to leverage its 

investments.

Consumer Service Cooperatives

Nearly 930 rural electric cooperatives own and 

maintain 42 percent of the electric distribution lines 

in the United States, serve 2,500 of 3,141 counties 

in the United States, and provide electricity to 42 

million people in 47 states.

Roughly 260 telephone cooperatives are providing a growing portfolio of communications services 

to 1.2 million households in 31 states, including 

wireless technology and high-speed Internet access.

The United States had 2,723 property casualty 

mutual insurance companies in 2007, with $1.3 trillion in cash and invested assets.

The National Co-operative Business Association 

indicates that there are currently 6,400 housing cooperatives in the United States. In January 2003, the 

limited or zero equity housing co-operatives represented 425,000 units and the market rate housing 

co-operatives represented 765,000 units, totalling 

close to 1.2 million housing co-operative units. New 

units are being developed in many other sectors, 

including senior citizen communities, trailer parks, 

low-income complexes, and student housing near 

college campuses.

Millions of Americans receive basic medical care 

through cooperatively organized health care providers. Health maintenance organizations (HMOs) 

serve more than 1 million people coast-to-coast and 

will likely be an increasingly important part of the 

health care system in the years ahead. In several 

major cities--Seattle, Minneapolis, Memphis, Sacramento, Salt Lake City and Detroit--companies have 

formed cooperative health alliances to purchase 

health care for their employees.

Child care cooperatives are meeting the needs of 

families where the parent(s) are employed and want 

affordable care. These centers can be organized by 

parents on their own, by a single employer, or by a 

consortium of businesses providing a single center 

for the group. More than 50,000 families use cooperative day care centers daily.

Business Cooperatives

Some business cooperatives manufacture or otherwise procure products for their retail outlet members. For example, more than 15,000 independent 

grocery stores rely on cooperative grocery wholesalers for identity, brand names, and buying power 

they need to compete with the chains and the discounters. Members also receive training and financing. Several cooperative grocery wholesalers are 

multi-billion-dollar firms rivaling the largest farmer 

cooperatives in sales and assets.

Cooperatively owned hardware wholesalers supply virtually all of the independent hardware stores 

in the United States. As huge warehouse chains 

spread across the nation, the independents are relying more and more on TruServ, Ace Hardware, Doit-Best, and other cooperatives for products, promotions and education to remain viable businesses.

Other business cooperatives negotiate group 

purchase contracts with suppliers and their members 

purchase the goods and services they need directly 

from those suppliers. A leader in this group is VHA. 

More than 2,200 hospitals and other health care 

providers purchase $25.9 billion annually in supplies and services under contracts negotiated by this 

cooperative.

Restaurant supply purchasing cooperatives 

save money and provide quality products for both 

company-owned outlets and franchisees of several 

fast-food chains. These firms include Unified Foodservice Purchasing Co-op (A&W, KFC, Long John 

Silver’s, Pizza Hut, and Taco Bell) and Restaurant 

Services, Inc. (Burger King). Besides their bottomline impact, purchasing cooperatives also offer 

another, less tangible benefit: they help to build trust 

among franchisers and franchisees, particularly on 
6 Income Tax Treatment of Cooperatives: Background

pricing issues.

Cooperatives are leaders in other major industries, including media and news services (Associated Press), outdoor goods and services (Recreational 

Equipment Inc.), lodging (Best Western), carpeting (Carpet One), electrical distributors (IMARK), 

natural foods, and collegiate bookstores.

TAX TREATMENT OF NONCOOPERATIVE

BUSINESSES

Farmer cooperatives are business organizations and 

are taxed as business organizations. All businesses, 

however, are not taxed alike. Tax laws divide businesses into several categories, each with its own 

special tax provisions. An understanding of the tax 

treatment accorded other types of businesses is beneficial to understanding the tax treatment of cooperatives, and to accessing the strengths and challenges 

of operating a business on a cooperative basis.

Sole Proprietorships

A single individual that owns a business may 

choose to have the earnings and losses of that business taxed as part of the individual’s income, not as 

a separate taxable unit. Income from a sole proprietorship is combined with nonbusiness income and 

adjusted for deductions, exemptions, and all other 

appropriate factors to determine the individual’s 

taxable income. The resulting taxable income figure 

is taxed to the individual carrying on the business at 

the individual’s applicable tax rate.

Thus, earnings of a sole proprietorship are not 

taxed as earnings of a separate business and again 

as personal income to the sole proprietor. Rather, a 

single tax is applied to sole proprietorship income at 

the individual owner’s level.

Partnerships

Partnerships are a second way of conducting business. While considered a business form, partnerships are not taxable entities for income tax purposes.15 Partnerships have income and expenses related 

to their operation. Rather than determine taxable 

income at the partnership level, however, partnership income and deductions are passed through to 

15 I.R.C. § 701

the partners. Individual partners receive “distributive shares” of the partnership’s income, deductions, 

and credits based upon the agreement among partners.

Items of income or deduction received from 

the partnership are taken into account by individual partners as income or deductions and combined with partners’ other reported items.16 The 

passthrough occurs whether the partnership actually distributes any money or property or not. Each 

partner incurs whatever tax liability the resulting 

taxable income occasions when the reported items 

are included in the partners’ individual income tax 

return.

Limited Liability Companies

The Internal Revenue Code17 doesn’t specifically 

address taxation of limited liability companies 

(LLCs). However, under IRS’s so-called ”checkthe-box” regulations, LLCs can choose whether 

they will be classified as pass-through entities (sole 

proprietorship or partnership) or as corporations for 

federal income tax purposes.18

The IRS approved the plan of a cooperative organized as a corporation under the laws of one State 

to reorganize as an LLC under the laws of a second 

State and elect to still be taxed as a cooperative 

corporation under Subchapter T.19

Corporations

Unlike sole proprietorships, partnerships, and LLCs, 

corporations are taxable business entities.20 Corporations incur tax liabilities based on their taxable 

income whether distributed to shareholders or not.

A corporation’s taxable income is determined by 

subtracting from its gross income certain items permitted in the Code. The resulting income is taxable. 

Corporate tax rates are applied to this taxable

16 I.R.C. § 702

17 Federal income tax law is contained in the Internal Revenue Code of 1986, codified as Title 26 of the 

United States Code. In the text, it is frequently referred 

to as the “Code.” Convention dictates that in footnotes it 

be represented by the initials I.R.C.

18 Treas. Reg. § 301.7701-1 to 301.7701-3.

19 Priv. Ltr. Rul. 200119016 (February 6, 2001).

20 “A tax is hereby imposed for each taxable year 

on the taxable income of every corporation.” I.R.C. § 11.
Cooperative Information Report 44-1 7

income to find the corporation’s tax liability. The 

corporation itself pays the tax.

When earnings and profits are distributed to 

shareholders, shareholders take the distribution into 

account as dividends received, with certain exceptions, and incur tax liability on that income.

Specific items of income and deduction used by 

the corporation to determine its taxable income are 

not passed through to shareholders. Shareholders 

receive dividend income only when declared by the 

corporation. If no dividend is paid, shareholders receive no income from the corporation, even though 

the corporation has net income for the year. Excessive accumulation of undistributed earnings by the 

corporation is limited by law.

When the corporation pays dividends on capital 

stock, it receives no deduction against its taxable 

income.

Shareholders, who are themselves corporations, receive some relief from the general rule that 

shareholders must recognize dividends as taxable 

income. In general, if a corporate shareholder owns 

less than 20 percent of the distributing corporation’s 

stock, it may deduct 70 percent of the dividends received.21 If a corporate shareholder owns 20 percent 

or more of the distributing corporation’s stock, it 

may deduct 80 percent of the dividends received.22

The special dividends received deduction does not 

apply to dividends received from a farmers’ cooperative that utilizes Code section 521. 23

Payments to shareholders may be of two types--

dividend on stock or a redemption or return of capital. Dividends on capital stock are taxable income. 

A redemption of capital, however, is not a distribution of corporate profit or earnings, but a return of 

the shareholders’ capital contribution to the corporation. Numerous tax law rules distinguish dividends 

on stock from stock redemption, earnings or profits 

from return of capital, and taxable from nontaxable 

transactions with respect to corporate stock.

While there are important exceptions, as a general rule the corporate and individual tax structures 

lead to double taxation of income flowing into a 

corporation and eventually to stockholders as dividends on capital stock. The corporation pays

21 I.R.C. § 243(a).

22 I.R.C. § 243(c).

23 I.R.C. § 246(a)(1).

tax on its income. Any income then distributed to 

stockholders as dividends is taken into account as 

taxable income by those stockholders, whether they 

be individuals or taxable business entities.

S Corporations

Some closely-held business corporations have the 

option to elect to have most or all of their income 

taxed only at the shareholder level. This eliminates 

the double tax burden placed on the corporate form 

of doing business. Electing corporations are called 

“S corporations,” from subchapter S of the Code in 

which they are described and their special tax treatment rules given.

 To qualify for subchapter S tax status, a corporation must be a domestic corporation24 and also meet 

the following requirements:

(A) It may not have more than 100 shareholders 

(all members of a family are counted as one shareholder).

(B) All shareholders must be individuals, estates, 

or certain described trusts. Shareholders cannot be 

corporations or partnerships.

(C) All shareholders must be U.S. citizens or 

resident aliens.

(D) An S corporation must have only one class of 

stock. 25

Subchapter S is designed to give the owners of 

qualifying businesses the option to adopt partnership-like tax status while enjoying certain nontax 

benefits of incorporation, such as limited liability.

In most regards, S corporation taxation is similar to partnership taxation. Items of income, loss, 

deductions, and tax credits are calculated separately 

and passed through to shareholders. Any remaining 

income or loss is calculated and passed on to shareholders.26 Individual items of S corporation income 

or loss are passed to shareholders proportionately, 

based on the amount of stock owned each day during the tax year.27 For the most part, income flowing

24 A “domestic” corporation must be created or 

organized in the United States or under the law of the 

United States or one of the individual States. I.R.C. § 

7701(a)(4).

25 I.R.C. § 1361(b)(1).

26 I.R.C. § 1366.

27 I.R.C. § 1377.
8 Income Tax Treatment of Cooperatives: Background

 through the S corporation to shareholders is taxed 

but once, at the shareholder level.

COOPERATIVE TAX PRINCIPLES

As one form of business corporation, cooperatives 

calculate taxable income and use tax rates like other 

corporations, but with one principal difference. This 

difference reflects cooperatives’ distinct way of 

distributing net margins to its patrons based on use, 

rather than to investors based on investment. This 

report gives the general taxation rules applicable 

to cooperatives. The concepts are quite simple, just 

as are those applied to sole proprietorships, partnerships, LLCs, corporations, and S corporations. 

Actual application of the rules, however, can be 

complex.

The general principle of cooperative income taxation is that money flows through the cooperative 

and on to patrons, leaving no margins to be retained 

as profit by the cooperative. Thus margins are taxed 

only once. The tax is ultimately paid by the final 

recipient (the cooperative patron), although under 

some circumstances the cooperative pays tax on a 

temporary basis, then receives a deduction when the 

money is finally passed on to the patron.

This single tax principle only applies if business 

income sources and distribution methods are “cooperative” in nature. Earnings from sources other than 

patronage and margins not distributed in the manner specified by the Code are generally not eligible 

for single tax treatment. The critical issue in distinguishing patronage- and nonpatronage-sourced 

income is discussed in chapter 5 of this series of 

reports. General corporate income tax rules apply 

to earnings from nonpatronage sources and double 

taxation results.

When statutory conditions are met, cooperatives treat retained patronage refunds and per-unit 

retains as if the funds retained had been paid to the 

patron, deducted by the cooperative, taken into the 

patron’s income as ordinary income, then invested 

in the cooperative. Conditions for this tax treatment 

include agreement by the patron to recognize the 

full patronage refund for tax purposes even though 

not received in cash or negotiable form.

Farmer cooperatives that meet several organizational and operational rules set out in Code section 

521 are allowed to deduct two additional items: (1) 

dividends paid on capital stock and (2) distributions 

of nonpatronage earnings to patrons on the basis of 

their patronage28. The special tax treatment of section 521 cooperatives will be discussed in Part 4 of 

these reports.

COOPERATIVES ORGANIZED AND TAXED 

AS LLCs, AND VICE VERSA

Currently, the Uniform Limited Cooperative Association Act provides a framework for cooperatives 

to organize under a more flexible entity which can 

take advantage of modern finance mechanisms.

This new law sanctions entities that are organized 

and operated much like LLCs. Anyone can own a financial and voting interest in them. Users need only 

have a minimal financial and voting interest. 

The intent of this laws is to attract equity capital 

investments, from both outside investors and member-users, to businesses designed to meet the needs 

of farmers and other rural residents. One of the 

advantages touted for these associations is that they 

have the option to be taxed as a partnership under 

subchapter K or as a cooperative under subchapter 

T.

IRS has issued a letter ruling that a company organized under the Wyoming law is an entity eligible 

(under the ”check-the-box“ regulations) to be taxed 

as a partnership under subchapter K. The Service 

said:

Company A is organized as an unincorporated association under the Act, which does 

not refer to an association as incorporated or 

as a corporation, body corporate, or body public. In addition, Company A is not classified 

as a corporation under (Treas. Reg.) section 

301.7701-2(b). Therefore, it is an eligible entity and not a per se corporation under section 

301.7701-2(b)(1). 29

At this time, this is the only ruling dealing with 

the tax status of these new associations. The remainder of this series of publications deals with tax 

issues specific to traditional cooperatives taxed as 

corporations and using Subchapter T.

28 I.R.C. §§ 521(b), 1381(a)(1), and 1382(c).

29 Priv. Ltr. Rul. 200139020 (June 29, 2001).
Cooperative Information Report 44-1 9

On the other hand, the Service has also said that a 

properly organized LLC can be taxed as a cooperative under Subchapter T.30 In this instance, a cooperative corporation was having difficulty legally 

redeeming old patronage paper because it could not 

comply with a unique provision in its State corporation law which permits a corporation to redeem its 

own shares only when retained earnings equal or 

exceed the amount of the cash to be distributed.

To continue to revolve its patronage paper, the 

cooperative proposed to form an LLC. The LLC 

would adopt the name, organizational documents, 

and financial structure of the co-op. The cooperative 

would be merged into the new LLC, which would 

exercise its option under section 301.7701-3 of the 

Treasury Department regulations to be an Aassociation” taxable as a Acorporation” (not as a partnership, the normal LLC treatment).

Subchapter T tax treatment is only available to 

a Acorporation operating on a cooperative basis.”

(emphasis added).31 The cooperative was concerned 

that the Service might deny its patronage refund deductions on the basis that an LLC that checked the 

box could not qualify for cooperative tax treatment 

since it is technically not a Acorporation.” However, the Service found that since the LLC chose to be 

taxed as a corporation it will be treated as a corporation for all federal tax purposes, including access to 

Subchapter T, so long as it Acontinues to operate on 

a cooperative basis.”32

When non-tax advantages favor the LLC form, 

this ruling gives cooperatives helpful guidance for 

converting to an LLC without sacrificing Subchapter T tax status.

SOURCES OF TAX LAW

At every stage of tax planning and decision making, cooperative advisors, directors, management, 

and other employees must make judgments about 

tax implications of cooperative actions. Tax law is 

derived from several sources, including the Internal 

30 Priv. Ltr. Rul. 200119016 (Feb. 6, 2001).

31 I.R.C. § 1381(a)(2).

32 The cooperative asserted that the transaction 

would qualify as a tax-free reorganization under Code § 

368(a)(1)(F).

Revenue Code, its interpretation by IRS, and the 

courts. The resolution of specific tax questions can 

require looking at a number of sources.

This section describes the principal sources that 

give and clarify tax laws applied to cooperatives.

Internal Revenue Code

Income tax law is contained in the Internal Revenue Code of 1986,33 commonly referred to as the 

“Code.”

Prior to 1939, the statutory provisions relating to 

taxes were contained in numerous individual revenue acts. Because of the inconvenience and confusion that resulted from dealing with many separate 

acts, Congress codified all of the Federal tax laws 

in 1939. Known as the Internal Revenue Code 

of 1939, the codification arranged all Federal tax 

provisions in a logical sequence and placed them 

in a separate part of the Federal statutes. A further 

rearrangement took place in 1954 and resulted in 

the Internal Revenue Code of 1954.

With some exceptions, neither the 1939 nor the 

1954 Codes substantially changed the existing tax 

law. Much of the 1939 Code, for example, was 

incorporated into the 1954 Code. The major change 

was the reorganization and renumbering of the tax 

provisions. This point is important in accessing rulings and court decisions interpreting earlier versions 

of the Code. If the same provision was included in 

the subsequent Code(s), the rulings and decisions 

relating to that provision remain valid.

The Code was given its present name by the Tax 

Reform Act of 1986.34

The periodic statutory amendments to the tax law 

are integrated into the Code. The American Jobs 

Creation Act of 2004,35 for example, became part of 

the Internal Revenue Code of 1986.

The Code is divided into chapters, subchapters, 

parts, sections, etc. The Code includes all income 

tax rules applicable to individuals, partnerships (and 

LLC=s), corporations, cooperatives, estates, trusts, 

exempt organizations, specially treated organizations, and all laws related to tax law administration.

33 Title 26 of the United States Code.

34 Pub. L. No. 99-272, 100 Stat. 82 (1986).

35 Pub. L. No. 108-357, 118 Stat. 1418 (2004). See 

§ 1(b).
10 Income Tax Treatment of Cooperatives: Background

Most parts of the Code apply to cooperatives and 

patrons by virtue of the fact that cooperatives and 

patrons conduct business and have income. A few 

provisions, however, relate specifically to cooperatives and their patrons. This publication focuses on 

these parts of the Code.

Subchapter T

Subchapter T of the Code, “Cooperatives and Their 

Patrons,”36 contains most of provisions directly 

related to cooperative taxation and the taxation of 

patrons.

Part I of subchapter T consists of three sections. 

Section 1381 describes cooperative organizations to 

which subchapter T applies. Subchapter T applies to 

all farmer cooperatives, including farmer cooperatives qualifying under section 521.37

A business need not be a farmer cooperative to 

qualify for subchapter T tax status. Any business 

“operating on a cooperative basis” uses subchapter 

T when computing its tax liability.38

Section 1382 describes how cooperatives calculate their taxable income. This provision explains 

how cooperatives may reduce their gross income by 

the amount they pay in noncash patronage refunds 

and per-unit retains. Section 1382 also covers the 

time period within which patronage refunds and 

per-unit retains must be paid, special accounting 

rules for pooling arrangements, and the problem of 

earnings received after patronage has occurred.

 Section 1383 describes how a cooperative is 

to compute taxes in the year it redeems nonqualified written notices of allocation and nonqualified 

per-unit capital retains. The cooperative makes two 

alternative calculations described in the section and 

uses the more favorable of the two.

Part II of subchapter T consists only of section 

1385. This section addresses patron taxation. It 

describes how patrons are to account for patronage 

refunds and per-unit retains received from a cooperative. Section 1385 authorizes patrons to exclude 

from gross income patronage refunds properly taken 

36 I.R.C. §§ 1381-1388.

37 I.R.C. § 1381(a)(1).

38 I.R.C. § 1381(a)(2). Language in section 

1381(a)(2) specifically excludes mutual savings banks, 

insurance companies, and utility cooperatives from the 

scope of subchapter T.

into account as an adjustment in the basis of property, or attributable to personal, living, or family 

items.

Part III of subchapter T also contains but one 

section, section 1388. This section contains an important set of definitions including such key cooperative tax terms as “patronage dividend (refund),” 

“written notice of allocation,” “qualified written 

notice of allocation,” “per-unit retain allocation,” 

and “qualified per-unit retain certificate.” Section 

1388 also provides rules for obtaining consent from 

patrons to include noncash allocations in taxable 

income and for the netting of patronage gains and 

losses.

Section 521

Section 52139 defines the kind of organization 

frequently called an “exempt” farmer cooperative. 

The term “exempt” is misleading as these cooperatives are not truly exempt from all taxation, but only 

entitled to additional deductions for dividends on 

capital stock and patronage-based distributions of 

nonpatronage income. They are referred to as “section 521 cooperatives” in these reports.

Section 521(b) establishes the basic requirements 

to qualify for the additional deductions:

(1) Qualifying organizations must be farmer 

cooperatives operated for the purpose of marketing 

farm products and returning margins back to patrons, or for purchasing supplies and equipment for 

farmers at cost plus expenses. 

(2) Section 521 cooperatives may have capital 

stock, but substantially all voting stock must be in 

the hands of farmers who use the cooperative. Dividends on capital stock are limited.

(3) Section 521 cooperatives may maintain certain reserves.

(4) Such cooperatives must conduct a majority 

of their business with members and may make no 

more than 15 percent of their supply sales to persons who are neither members nor producers.

Other Code Provisions 

The bulk of all special cooperative tax principles 

and applications is contained in subchapter T and 

39 Found in subchapter F, Exempt Organizations, 

of the Code.
Cooperative Information Report 44-1 11

section 521. Other Code provisions also apply specifically to cooperatives.

Tax returns. A cooperative described in section 

6072(d)40 has 82 months after the close of the taxable year to file its tax return. This extended filing 

period is available for section 521 cooperatives and 

other subchapter T cooperatives with an obligation 

to pay patronage refunds on at least 50 percent of 

their net earnings from business done with or for 

patrons.41

Farmer cooperatives file on form 990-C. Other 

cooperatives file form 1120.

Reporting of patronage-based allocations.

Reporting requirements for cooperatives paying 

patronage refunds and per-unit retains are described 

in section 6044.42 Cooperatives must report such 

distributions to IRS (form 1096) and to the patron 

receiving the distribution (form 1099-PATR). Section 6044(c) provides an exemption from reporting 

for certain consumer cooperatives.43

Dividends Received Deduction. Section 246 provides that the deduction for dividends received by a 

corporation from another corporation is not allowed 

when the dividends are received from a section 521 

cooperative.44

JUDICIAL DECISIONS

Courts decide disputes between IRS and taxpayers through analysis and interpretation of the Code, 

regulations, and the IRS’s application of the tax 

laws. Courts give the final judgment on Code interpretation and, unless changed by legislation, court 

opinions stand as the source of highest authority. In 

addition to their precedent value, judicial decisions 

also provide guidance on applying Code provisions 

to specific circumstances. The reasoning used to 

reach conclusions can also be quite helpful.

Tax disputes usually reach the courts after a 

taxpayer has exhausted some or all of the administrative remedies within the IRS. The case is first 

considered by a court of original jurisdiction (fre40 I.R.C. § 6072(d).

41 Most business corporations only have 22 months 

after the close of the taxable year to file their tax returns. 

I.R.C. § 6072(b).

42 I.R.C. § 6044.

43 I.R.C. § 6044(c).

44 I.R.C. § 246(a)(1).

quently referred to as a trial court), with any appeal 

by either the taxpayer or IRS taken to the appropriate U.S. Court of Appeals. Only a small number of 

tax cases are accepted for review by the U.S. Supreme Court.

In most situations, the taxpayer has a choice 

of three courts of original jurisdiction: a Federal 

District Court, the U.S. Court of Federal Claims, 

or the U.S. Tax Court (formerly the Board of Tax 

Appeals). While the first two courts decide a wide 

spectrum of cases, the Tax Court hears only tax 

cases. Choosing the best forum for a particular tax 

case is a matter of strategy to be determined by taxpayers and their counsel.

Decisions of all of the trial and appellate courts 

mentioned have precedential value for future cases 

with the same or similar facts. Unless an issue has 

been settled by a decision of the U.S. Supreme 

Court, the IRS, as a part of the executive branch, 

can disregard the court’s reasoning when handling 

the same issue with other taxpayers in the future.

If IRS loses a case before the Tax Court, it frequently announces its acquiescence (agreement) or 

nonacquiescence (disagreement) with the decision. 

IRS can retroactively revoke its acquiescence. IRS 

also will occasionally announce whether or not it 

will follow a decision of another Federal court on 

similar issues.

A nonacquiescence puts taxpayers on notice that 

reliance on the court’s decision may be risky and 

that IRS may litigate the issue again.

IRS ADMINISTRATION DETERMINATIONS

In many situations, the Code does not provide a 

precise answer to the issue raised. Code provisions 

therefore must be interpreted. The Commissioner of 

Internal Revenue, with the approval of the Secretary 

of the Treasury, prescribes all necessary rules and 

regulations for the interpretation and enforcement of 

the Code. 45

Regulations

The Treasury Department, through IRS, issues regulations in connection with most provisions of the 

Code. Regulations are interpretations of the Code 

and provide taxpayers with guidance on the mean

45 I.R.C. § 7805; Treas. Reg. § 301.7805-1.
12 Income Tax Treatment of Cooperatives: Background

ing and application of the Code. Although not law 

as such, regulations carry considerable weight and 

are an important factor to consider in complying 

with the tax law.

Some regulations carry more weight than others. Sometimes when passing a tax law, Congress 

will specifically instruct the Treasury Department to 

develop regulations to implement parts of the new 

law. These “legislative” regulations have virtually 

the force and effect of law.

A regulation’s validity is also enhanced if it accurately reflects the intent of Congress. Thus, a regulation that draws on legislative language or language 

in a Congressional committee report explaining the 

underlying legislation is often given special credence by a court.

In any challenge to the validity of a regulation, 

the burden of proof is on the taxpayer to show the 

regulation is wrong.

New regulations and changes in existing regulations usually are issued in proposed form so that 

taxpayers and other interested parties can comment 

on the propriety of the proposal. Proposed and final 

regulations are published in the Federal Register 

and reproduced in the major commercial tax reporting services.

Revenue Rulings and Revenue Procedures 

Revenue rulings are official pronouncements of the 

National Office of the IRS. Like regulations, revenue rulings provide interpretation of Federal tax law 

from the IRS perspective.

Revenue rulings typically describe a set of facts, 

then analyze how tax law should be applied. Taxpayers generally may rely on published revenue 

rulings, and published revenue rulings generally 

are not revoked retroactively. These rulings do not 

have the force and effect of the Code, regulations, 

or court decisions. They can be used and cited as 

precedent in situations where the facts or issues are 

similar and the logic of the ruling can be applied; 

but in litigation the courts usually do not give any 

special deference to revenue rulings.46

A revenue procedure is an official statement of 

procedure from the IRS National Office. They guide 

IRS personnel and taxpayers in handling routine tax 

46 Conway County Farmers’ Ass’n v. United States, 

588 F.2d 592, 600 (8th Cir. 1978).

matters.

Both revenue rulings and revenue procedures are 

published weekly in the Internal Revenue Bulletin. 

Every 6 months the recent rulings and procedures 

are organized by Code sections and republished in 

the Cumulative Bulletin.

Private Letter Rulings and Technical Advice 

Memoranda 

Both private letter rulings (LTR=s) and technical 

advice memoranda (TAMs) are written interpretations from the IRS National Office of how the tax 

law applies to a specific set of circumstances. LTRs 

are issued in response to requests for advice from 

taxpayers. TAMs arise from audit controversies and 

are issued as responses to requests for guidance 

from IRS District Directors and Appeals Officers.

Prior to 1976, IRS treated these rulings as confidential information to be made available only to 

the requesting party. That position was successfully 

challenged as being in violation of the Freedom of 

Information Act.47

The Tax Reform Act of 1976 included a provision 

stating that written determinations by IRS shall be 

open to public inspection.48 Information disclosing 

the identity of the taxpayer is deleted before the 

documents are made available to the public.

LTRs and TAMs respond only to the facts presented. According to the Code, they may not be 

cited as precedent,49 but some uncertainty exists 

about how and when they can be used by other taxpayers.50 LTRs and TAMs are used in this publication to help describe the IRS position on a variety of

47 Tax Analysts and Advocates v. Commissioner, 

505 F.2d 352 (D.C. 1974).

48 I.R.C. § 6110.

49 Unless the Secretary otherwise establishes by 

regulations, a written determination may not be used or 

cited as precedent. I.R.C. § 6110(k)(3).

50 See H. Massler, “How to Get and Use IRS 

Private Letter Rulings,” 33 Pract. Lawyer 11 (1987); G. 

Portney, “Letter Rulings: An Endangered Species?” 36 

Tax Lawyer 751 (1983); and J. Holden and M. Novey, 

“Legitimate Uses of Letter Rulings Issued to Other Taxpayers - A Reply to Gerald Portney,” 37 Tax Lawyer 337 

(1984).
Cooperative Information Report 44-1 13

situations requiring tax implication analysis.51

General Counsel Memoranda and Actions on 

Decisions 

General Counsel Memoranda (GCMs) are legal 

analysis prepared by the IRS Office of the Chief 

Counsel, usually drafted in connection with proposed LTRs, TAMs, or revenue rulings. Actions on 

Decisions (AODs) are legal memoranda that are 

prepared when the IRS loses an issue in a litigated 

tax case. AODs offer a suggested IRS course of action in response to the decision and legal analysis to 

support the recommendation.

Historically, the IRS resisted disclosure of GCMs 

and AODs as internal memoranda not prepared for 

public use. In 1981, however, litigation under the 

Freedom of Information Act forced IRS to begin 

releasing GCMs and final AODs. 52

Unlike LTRs and TAMs, no specific statutory language prohibits GCMs and AODs from being used 

as precedents. Although such documents are now 

publicly available, IRS contends GCMs and AODs 

remain nothing more than internal memoranda 

and are not elevated to the status of official agency 

documents that can be cited as precedent.

CHAPTER 2

COOPERATIVE STRUCTURE, OPERATION, 

AND TAXATION

No simple and all-encompassing definition exists to 

distinguish an organization called a “cooperative” 

from other forms of business enterprise. As Justice 

Louis Brandeis once noted, “[N]o one plan of organization is to be labeled as truly cooperative to the 

exclusion of others.”53

A wide range of business operations are eligible 

for the tax benefits provided in subchapter T. This 

51 An interesting discussion of what IRS regards 

as authority is found in the regulations interpreting the 

accuracy-related penalty provision of the Code, Treas. 

Reg. § 1.6662-4(d)(3)(iii).

52 Taxation with Representation Fund v. Internal 

Revenue Service, 646 F.2d 666 (D.C. Cir. 1981).

53 Dissenting opinion in Frost v. Corporation Commission, 278 U.S. 515, 546 (1929), quoted in Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213, 1217, n.3 

(1980).

chapter discusses eligibility for subchapter T, other 

laws that govern cooperative conduct, various 

structures and methods of operation used by cooperatives, and the relationship between cooperative 

equity accumulation and tax treatment.

OPERATING ON A COOPERATIVE BASIS

According to the Code, “any corporation operating 

on a cooperative basis” may receive the tax benefits 

of subchapter T. Specifically excluded from the application of subchapter T are mutual savings banks, 

insurance companies, and organizations furnishing 

rural electric energy or providing telephone service 

to persons in rural areas. 54

The Code does not include any specific definition 

of “operating on a cooperative basis.” The regulations repeat the Code language and add the phrase 

“and allocating amounts to patrons on the basis of 

the business done with or for such patrons.”55

Any Organization Eligible

Although these reports focus on cooperatives whose 

members are farmers, subchapter T tax treatment 

is also available for cooperatives whose members 

are not farmers. The House and Senate Reports accompanying passage of subchapter T noted, “the tax 

treatment outlined here applies to the so-called taxexempt farmers’ cooperatives, to other farm cooperatives, to consumer cooperatives, and also to other 

corporations operating on a cooperative basis.”56

The tax law is replete with examples of nonfarm 

businesses operated as subchapter T cooperatives. 

Retail stores, particularly grocery stores, have used 

cooperatives to purchase, manufacture, warehouse, 

and transport groceries and related items.57 Savings 

54 I.R.C. § 1381(a)(2).

55 Treas. Reg. § 1.1381-1(a).

56 H.R. Rep. No. 1447, 87th Cong., 2d Sess. 

(1961), 1962-3 C.B. 405, 483, and S. Rep. No. 1881, 

87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 819, 1962 

U.S. Code Cong. & Admin. Serv. 3304, 3416.

57 Affiliated Foods, Inc. v. Commissioner, 98-2 

U.S.T.C. (CCH) & 50,750 (5th Cir. 1998), rev=g in 

part and aff=g in part 72 T.C.M. 1226 (1996); Certified 

Grocers of California, Ltd. v. Commissioner, 88 T.C. 

238 (1987); Twin County Grocers, Inc. v. United States, 

2 Cl. Ct. 657 (1983); and United Grocers, Ltd. v. United 

States, 308 F.2d 634 (9th Cir. 1962), aff’g, 186 F. Supp. 
14 Income Tax Treatment of Cooperatives: Background

facility and pay themselves from margins derivedfrom their labor;66 fishermen provide themselves 

ice, tackle, gear, fuel and other needs;67 taxi services provide dispatching, repair, auto sup-plies, 

taxi car rentals and other services to drivers and 

mechanics;68 and restaurants purchase products and 

supplies in volume. 69

Code Meaning

The fact that the Code provides that “any corporation” can be a cooperative indicates an intent by 

Congress to accommodate within the scope of subchapter T the special nuances, regulatory requirements, financial arrangements, and other factors 

unique to a wide variety of industries.

The only statutory limits to the benefit of qualifying as a cooperative, access to single tax treatment 

of patronage refunds and per-unit retains, are found 

in the definitions of a patronage refund (dividend)70

and per-unit retain allocation.71 To be excluded from 

taxable income, a patronage refund must be paid (1) 

on the basis of the business each patron conducted 

with the cooperative, (2) under a pre-existing legal 

obligation to make the payment, and (3) out of earnings of the cooperative from business with patrons. 

In addition, refunds must be computed on the same 

basis for patrons who engaged in substantially identical transactions with the cooperative. The Code requires a per-unit retain also be made pursuant to an 

agreement between the cooperative and the patron.

66 Harbor Plywood Corp. v. Commissioner, 14 

T.C. 158 (1950), aff’d without opinion, 187 F.2d 734 

(9th Cir. 1951); Linnton Plywood Ass’n v. United States, 

236 F. Supp. 227 (D. Ore. 1964); Puget Sound Plywood, 

Inc. v. Commissioner, 44 T.C. 305 (1965), acq., 1966 

2 C.B. 3; Linnton Plywood Ass’n v. United States, 410 

F. Supp. 1100 (D. Ore. 1976); Stevenson Co Ply, Inc. v. 

Commissioner, 76 T.C. 637 (1981); and Astoria Plywood 

Corp. v. United States, 1979 1 U.S.T.C. P.9197 (D. Ore. 

1979); Rev. Rul. 74 160, 1974 1 C.B. 245; Rev. Rul. 74 

84, 1974 1 C.B. 244; Rev. Rul. 71 439, 1971 2 C.B. 321; 

Tech. Adv. Mem. 7746003 (Aug. 2, 1977).

67 Seiners Ass’n v. Commissioner, 58 T.C. 949 

(1972).

68 Priv. Ltr. Rul. 8129050 (Apr. 22, 1981).

69 . Ltr. Rul. 9313016 (Dec. 23, 1992).

70 I.R.C. § 1388(a).

71 I.R.C. § 1388(f).

in volume discounts and favorable terms of purchase, as well as inventory supply and control make 

cooperative purchasing attractive in these situations. 

Similar arrangements are beneficial for hardware 

stores, particularly where uniform or specially designed or formulated product is desirable;58 builders 

who need supplies and transportation services;59 and 

other retailers. 60

Cooperatives are not limited to marketing and 

purchasing, they may also perform services as their 

primary activity. An example of a service cooperative is an association formed by a variety of members to consolidate and distribute freight.61 The firm 

combined small, less-than-truckload sized shipments for coordinated shipments in a more efficient 

manner. A group of banks formed a cooperative to 

provide on-line computer services and management 

consulting services.62 So did companies processing 

claims for injuries caused by a hazardous substance 

they manufactured. 63

Revenue Ruling 66 9864 describes a financing 

corporation formed by department stores to purchase their accounts receivable, thus supplying 

member patrons with working capital. The corporation charged a discount and made refunds at 

year’s end based on the total discounts charged each 

patron as a proportion of total discounts charged 

for the year. Payments based on discounts satisfied 

the requirement that distributions must be paid to 

patrons on the quantity or value of business done 

with the cooperative, and the finance corporation 

was operating on a cooperative basis for purposes of 

subchapter T.

Nonfarmer corporations operating a clearinghouse to facilitate settlement orders among members may qualify for subchapter T.65 So may a 

cooperative in which workers own a manufacturing

724 (N.D. Cal. 1960).

58 Cotter and Co. v. United States, 765 F.2d 1102 

(Fed. Cir. 1985), rev’g, 6 Ct. Cl. 219 (1984); and Priv. 

Ltr. Rul. 8006112 (Nov. 20, 1979).

59 Tech. Adv. Mem. 8118012 (Jan. 28, 1981).

60 Tech. Adv. Mem. 8130001 (Mar. 24, 1981).

61 Washington Oregon Shippers Cooperative, Inc. 

v. Commissioner, 52 T.C.M. (CCH) 1406 (1987).

62 Priv. Ltr. Rul. 7731017 (May 4, 1977).

63 Priv. Ltr. Rul. 200444004 (Oct. 29, 2004).

64 Rev. Rul. 66-98, 1966 1 C.B. 200.

65 Rev. Rul. 70 481, 1970 2 C.B. 170.
Cooperative Information Report 44-1 15

The “Worker Cooperative” Controversy

Disputes between the IRS and cooperatives over 

whether a business was “operating on a cooperative 

basis” predate codification of that phrase with the 

enactment, in 1962, of subchapter T.

Beginning in the 1920s, it became common in the 

Pacific Northwest for workers to purchase plants 

that produced plywood and other wood products 

and operate them on a cooperative basis. A board 

of directors, composed of the workers, assigned a 

wage rate to each job in the plant.72 At the end of 

the fiscal year, earnings were allocated to all of the 

workers based on the number of hours worked during the year.

In 1961, a brief revenue ruling was issued holding that amounts distributed by a workers’ cooperative association to its members on the basis of 

man-hours worked are not true patronage dividends 

eligible for deduction at the cooperative level.73

The Service said this holds true even when a State 

law provides that work performed as a member of a 

worker=s cooperative is deemed to be patronage of 

the cooperative. It concluded that to be deductible 

as a true patronage dividend, the return had to be “...

either an additional consideration due the patron for 

goods sold through the association or a reduction in 

the purchase price of supplies and equipment purchased by the patron through the association.” 74

During floor debate on the legislation that became subchapter T, a colloquy between Senator 

Kerr (floor manager of the bill) and other senators 

attempted to establish legislative history that worker 

cooperatives were entitled to exclude patronage 

refunds.75 The Service, however, continued to press 

its position in litigation.

The courts rejected the IRS position. In 1964, the 

U.S. District Court in Oregon issued a brief opinion, 

devoid of any reference to Subchapter T, simply 

72 Sometimes all jobs earned the same wage. In 

other instances, jobs perceived by the members to be less 

desirable were assigned a higher wage to induce enough 

workers to take those jobs to keep the plant operating 

smoothly.

73 Rev. Rul. 61-47, 1961-1 C.B. 193, revoked by 

Rev. Rul. 71-439, 1971-2 C.B. 321.

74 Id.

75 108 Cong. Rec. 18,322 (1962), quoted in Puget 

Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 321 

(1965), acq., 1966 2 C.B. 3.

deciding a worker cooperative could exclude its 

retained patronage refunds from gross income for 

federal income tax purposes to the same extent as a 

purchasing or marketing cooperative.76

In 1965, the U.S. Tax Court issued a more thorough opinion on essentially the same facts, which 

referred to the “operating on a cooperative basis” 

language in Code sec. 1381(a)(2), and reached the 

same conclusion, that worker cooperatives could 

deduct their patronage refund allocations.77 The 

Puget Sound Plywood opinion settled the issue of 

the status of worker cooperatives under Subchapter 

T.78 As is explained shortly hereafter, it also became 

the bellwether opinion in the long-running and continuing controversy between the Service and cooperatives over the proper interpretation of the phrase 

“operating on a cooperative basis.”

The “Majority Member Business” Controversy

In 1972, a second dispute arose between cooperatives and the IRS over the meaning of “operating 

on a cooperative basis.”79 A revenue ruling was 

issued concerning a marketing cooperative that 

had 10 member-patrons but which also handled the 

production of 90 nonmembers with whom it did 

business on a nonpatronage basis. The 10 memberpatrons were the larger producers of the product and 

provided 75 percent of the product handled by the 

cooperative.

The issue the IRS National Office was apparently 

asked to answer was whether the fact that most of 

the users of the association were not members or 

patrons disqualifies it from the benefits of subchapter T. After citing the “operating on a cooperative 

basis” language, the Service noted that Subchapter 

76 Linnton Plywood Ass’n v. United States, 236 F. 

Supp. 227 (D.C. Ore. 1964).

77 Puget Sound Plywood, Inc. v. Commissioner, 44 

T.C. 305 (1965), acq., 1966-2 C.B. 6.

78 In 1971, the IRS issued a new Revenue Ruling on the issue, Rev. Rul. 71-439, 1971-2 C.B. 321. It 

cited the Linnton Plywood and Puget Sound Plywood 

decisions and said that amounts distributed by a worker 

cooperative to it member shareholders on the basis of 

man-hours worked did meet the definition of a patronage 

dividend in Code § 1388(a)(1) and are deductible from 

the gross income of the association to the extent provided in Code § 1382. Revenue Ruling 61-47 was revoked.

79 Revenue Ruling 72-602, 1972-2 C.B. 511.
16 Income Tax Treatment of Cooperatives: Background

T does not preclude a cooperative from dealing 

with nonmembers on a for-profit basis, nor does it 

require that members and nonmembers be treated 

equally.

But then it said, “If, however, a cooperative does 

operate on a for-profit basis with its nonmember, 

then in order for it to be considered a corporation 

‘operating on a cooperative basis’ (cite omitted), it 

must do more than 50 percent in value, of its business with members.”80 As the cooperative in this 

instance was doing 75 percent of its business with 

members, it was found to be “operating on a cooperative basis.” So while the ruling was, in this sense, 

favorable for cooperatives, it was framed in a manner that opened a new front in the battle over the 

scope of “operating on a cooperative basis.”

This issue also wound up in litigation and, as in 

the worker cooperative cases, the courts rejected 

the IRS position. In the first case to be decided, a 

farm supply cooperative, in the years under review, 

conducted just over 60 percent of its business with 

nonmembers. Net income was first allocated to preferred stock in an amount not to exceed 6 percent 

per year. Income attributable to nonmembers was 

set aside in a tax-paid reserve. Remaining income 

was allocated to member patrons in proportion to 

the volume of business each conducts with the cooperative each year.

The IRS denied the cooperative’s claimed patronage refund deduction for the allocations to member 

patrons. The cooperative paid the assessment and 

penalties for taxes allegedly due and sued for a 

refund.

The district court judge who heard the case ruled 

for the Service.81 He reasoned that while a subchapter T cooperative could do business with nonmembers on a nonpatronage basis, it could not stray too 

far from the operational model of a “true” cooperative, which he interpreted to mean a cooperative 

eligible for section 521 tax status. As a section 521 

cooperative has to do a majority of its business with 

or for members82 and the Service had issued an official ruling taking the same position with

80 Id.

81 Conway County Farmers Ass=n v. United States, 

1978-1 U.S.T.C. (CCH) & 9334 (E.D. Ark. 1978), rev=d, 

588 F.2d 592 (8th Cir. 1978).

82 I.R.C. § 521(b)(4).

regard to other cooperatives (Rev. Rul. 72-602), the 

court held that a subchapter T cooperative that did a 

majority of its business with nonmembers may not 

deduct distributions made to its members as patronage dividends.

The cooperative appealed and the U.S. Court 

of Appeals for the 8th Circuit reversed the district 

court and ruled in favor of the cooperative.83 The 

court noted that Congress intended for true patronage dividends to be deductible by a cooperative. It 

stated that if Congress intended for other cooperatives to be limited to a percentage of nonmember 

business to deduct its true patronage dividends, it 

would have done so specifically as it did for section 

521 cooperatives. The court concluded that Rev. 

Rul. 72-602 “...is an unreasonable interpretation of 

the statute, making an unwarranted exception to the 

intent expressed in 1382(b) by adding as it does a 

quantitative requirement in conflict with the intent 

of Congress.”84 The cooperative was allowed to 

deduct patronage refunds based on the amount of 

business it did with its member patrons.

Notwithstanding the Conway County decision, 

the Service insisted that Rev. Rul. 72-602 was the 

correct statutory interpretation and continued, on 

audit, to disallow patronage dividend deductions 

claimed by cooperatives that did less than a majority of their business with members.

In 1985, two more disputes reached the courts 

and were decided within weeks of each other. The 

first involved a marketing cooperative the members 

of which provided only 24 percent of the produce it 

sold.85 The second concerned a farm supply cooperative that did about 45 percent of its business 

with members.86 In each instance, the court noted 

the public policy support for favorable tax treatment of patronage refunds, cited with approval in 

the Conway County decision, and held the cooperative could deduct the patronage refunds paid to its 

members. 87

83 Conway County Farmers Ass’n v. United States, 

588 F.2d 595 (8th Cir. 1978), rev’g 1978-1 U.S.T.C. 

(CCH) & 9334 (E.D. Ark. 1978).

84 588 F.2d at 600.

85 Columbus Fruit and Vegetable Cooperative 

Ass=n v. United States, 7 Cl. Ct. 561 (1985).

86 Geauga Landmark, Inc. v. United States, No. 81-

942 (N.D. Ohio 1985).

87 The Claims Court found the IRS position in 
Cooperative Information Report 44-1 17

Eventually, the IRS agreed to modify its position 

on cooperatives that did less than half their business 

with members. First, it released an Action on Decision acquiescing in the Conway County decision. It 

did not entirely agree to disregard the issue, saying:

...the Service will no longer assert that an 

organization is not “operating on a cooperative basis” solely because it does more than 

50 percent in value of its business with nonmembers. The Service will consider all facts 

and circumstances, including the nature and 

value of business conducted with nonmembers, in determining whether the organization 

is operating on a cooperative basis.88

Then IRS issued a revenue ruling acknowledging 

that a cooperative that operates on a nonpatronage 

basis with nonmembers is not precluded from being 

considered as “operating on a cooperative basis” 

simply because it does less than 50 percent in value 

of its business with members on a patronage basis. 

IRS concluded that whether a corporation is operating on a cooperative basis “...will be determined 

from all the facts and circumstances and the cooperative principles enunciated in Puget Sound Plywood.” Rev. Rul. 72-602 was modified to the extent 

it required conducting more than 50 percent in value 

of business with members to be considered “operating on a cooperative basis.”89

IRS Reliance on Puget Sound Plywood

In concluding that worker cooperative associations 

were cooperatives for tax purposes, the court in 

Puget Sound Plywood v. Commissioner listed “three 

guiding principles...as the core of cooperative economic theory:”

(1) Subordination of capital,

(2) Democratic control by the members, and

(3) Allocation of margins on the basis of patronage. 90

the Columbus Fruit case so unreasonable that legal fees 

were awarded to the cooperative-taxpayer. 8 Cl.Ct. 525 

(1985).

88 AOD CC-1991-018 (October 22, 1991).

89 Rev. Rul. 93-21, I.R.B. 1993-1 C.B. 188, modifying Rev. Rul. 72-602, 1972-2 C.B. 510.

90 Puget Sound Plywood, Inc. v. Commissioner, 44 

Throughout the 1980s, IRS issued a number of 

private rulings that decided whether a cooperative association was “operating on a cooperative 

basis” by measuring compliance with the list of 

cooperative principles referred to in Puget Sound 

Plywood.

91

In the early 1990s, the Service issued a series of 

private rulings that added four “additional factors” 

to its list of issues to be considered in ascertaining whether a taxpayer qualifies as a coop-erative: 

(i) existence of some joint effort on behalf of the 

members; (ii) a minimum number of patrons; (iii) 

member business should exceed nonmember business; and (iv) upon liquidation, present and former 

patrons must share in the distri-bution of any remaining assets in proportion to the business each 

did with the cooperative over some reasonable 

period of years.92

In 1993, when the Service issued Revenue Ruling 93-21 conceding that a cooperative could do 

less than half its business with members and still 

be “operating on a patronage basis” with regard to 

the business it did conduct with or for members, it 

concluded:

The cooperative principles stated in Puget 

Sound Plywood...provide the basis for determining whether a corporation is operating on 

a cooperative basis for purposes of subchapter 

T of the code. ...

T.C. 305, 308 (1965), acq., 1966-2 C.B. 6

91 Tech. Adv. Mem. 8219821 (Mar. 18, 1982); 

Tech. Adv. Mem. 8225013 (Mar. 18, 1982); Priv. Ltr. 

Rul. 8324108 (Mar. 17, 1983); Priv. Ltr. Rul. 8505001 

(May 15, 1984) and Tech. Adv. Mem. 8707005, (Nov. 

7, 1986), both substituting “operation at cost” for (3); 

Priv. Ltr. Rul. 8744007 (July 21, 1987); Priv. Ltr. Rul. 

8748015 (Aug. 27, 1987); Priv. Ltr. Rul. 8823032 (Mar. 

8, 1988); Priv. Ltr. Rul. 8842034 (July 26, 1988); and 

Priv. Ltr. Rul. 8850027 (Sept. 16, 1988).

92 Priv. Ltr. Rul. 9117037 (Jan. 28, 1991); Tech. 

Adv. Mem. 9303004 (Oct. 7, 1992). Only additional 

factors (ii) and (iii) were considered in Priv. Ltr. Rul. 

9141028 (July 11, 1991), Priv. Ltr. Rul. 9235011 (May 

21, 1992), Priv. Ltr. Rul. 9237013 (June 10, 1992). Additional factors (ii), (iii), and (iv) were mentioned in Priv. 

Ltr. Rul. 9313016 (Dec. 23, 1992). While several of 

the rulings state these additional factors are considered 

important by the courts, no citations are provided.
18 Income Tax Treatment of Cooperatives: Background

Whether a corporation is operating on a 

cooperative basis under section 1382(a)(2) of 

the code will be determined from all the facts 

and circumstances and the cooperative principles enunciated in Puget Sound Plywood.

93

In Puget Sound Plywood, the Tax Court said a cooperative association with certain attributes clearly 

comes within the scope of “operating on a cooperative basis” under subchapter T. The Service appears 

to be reading that decision to say only cooperatives 

with those specific traits can be considered as “operating on a cooperative basis.”

Cooperatives assert that the IRS interpretations 

of subordination of capital (returns on equity capital 

must be limited) and democratic control (one-member, one-vote)94 are unduly restrictive. They further 

contend that the only Code requirement to single tax 

treatment of patronage refunds and per-unit retains 

is that they be returned or allocated to patrons on 

the basis of patronage, pursuant to a pre-existing 

legal obligation.

In CF Industries v. Commissioner, the 7th Circuit 

Court of Appeal bolstered the view that the obligation to pay patronage refunds is the predominant 

characteristic of a cooperative when it began its 

opinion by stating, “The principal difference between the cooperative form of doing business and 

the ordinary corporate form is that the shareholders 

of a cooperative share in the cooperative’s income 

in proportion to their purchases from the cooperative rather than to the number of shares they own.”95

93 Rev. Rul. 93-21, 1993-1 C.B. 188.

94 See, for example, P.L.R. 200224017 (March 15, 

2002).

95 CF Industries, Inc. v. Commissioner, 995 F.2d 

101 (7th Cir. 1993). But see Thwaites Terrace House 

Owners Corp. v. Commissioner, 72 T.C.M. (CCH) 578 

(1996), where the Tax Court held a housing cooperative, whose tenant-stockholders were eligible to deduct 

their pro rata share of certain expenses incurred by their 

cooperative under I.R.C. § 216, was Aoperating on a 

cooperative basis@ even though the member owners did 

not have a right to receive patronage refunds. This is the 

last in a series of interesting decisions holding housing 

cooperatives are eligible for Subchapter T tax treatment 

that are discussed in the portion of Part 5 of these reports 

dealing with I.R.C. § 277 and cooperatives, Donald A. 

Frederick, Income Tax Treatment of Cooperatives: Handling of Losses, RBS Cooperative Information Report 

 The argument then suggests that the various 

expressions of cooperative principles and practices 

in the literature should not be read into the Code 

as additional mandatory restraints on organizations 

wishing to qualify for subchapter T tax treatment.

This approach is supported by the Tax Court 

opinion in Ford-Iroquois FS, Inc. v. Commissioner.

96 After quoting a textbook definition of a 

cooperative, the court said, “The definition is of 

value as a matter of clarification but should not be 

used for substantive exclusion or for limitation or 

analysis.”97 Similarly, the court said “The ‘operation at cost’ principle describes a feature of a cooperative’s relation with its members, not a codified 

requirement of tax accounting.”98

In the early 21st century, the Service has only 

considered the three standards mentioned in Puget 

Sound Plywood in determining whether an entity 

is “operating on a cooperative basis.” In each 

instance, the Service has found the entities under 

review were operating as a cooperative:

• An agricultural cooperative that merged into 

a new entity formed solely as a vehicle to 

change the association=s statute of incorporation and restructure the make-up of the board 

of directors (change from each member having a director to a nine-member board elected 

on a district basis by the members). 99

• Both an association of credit unions to support their credit card operations and its wholly 

owned subsidiary (a one-member cooperative) formed to offer its members collection 

services while shielding the parent coopera

44, Part 5 (2005), pp. 97-101.

96 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 

1213 (1980).

97 Id. at 1217, note 3. The court then quoted the 

language from Frost v. Corporation Commission, 278 

U.S. 515, 546 (1929), found in the first paragraph of this 

chapter.

98 Id. at 1222. In this case IRS alleged that a cooperative principle stating cooperatives “operate at cost” 

barred a cooperative from carrying a loss forward for tax 

purposes. The court rejected the IRS position and permitted the cooperative to carry the losses forward under 

I.R.C. § 172. See also, Associated Milk Producers, Inc. 

v. Commissioner, 68 T.C. 729, 740 (1978).

99 Priv. Ltr. Rul. 200042013 (July 20, 2000
Cooperative Information Report 44-1 19

tive from possible litigation exposure under 

the Fair Debt Collection Practices Act. 100

• A federated cooperative that develops software for its rural electric cooperative members that changed its governance structure 

from each member having a director to a ninemember board elected on a district basis by 

the members and began permitting members 

to vote by written mail-in ballot and by proxy, 

both of which are specifically permitted under 

applicable State law.101

• A cooperative formed in the United States, 

but owned entirely by nonresident corporations headquartered in a foreign country, to 

market their products in the United States. 102

NONTAX STATUTES THAT CHARACTERIZE

COOPERATIVES

Tax law does not operate in a vacuum. Many other 

laws provide privileges and place responsibilities 

on cooperatives that impact on the way cooperatives conduct their business operations. This section 

summarizes laws outside the tax area that influence 

cooperative structure and operations. An understanding of these laws is critical to overall business 

planning for a cooperative, a process where taxation 

is only one of several key elements.

State Incorporation Laws

Virtually all cooperative businesses are incorporated.103 Incorporation offers advantages over other 

forms of doing business where a large number of 

persons may become involved in the venture.

Incorporation facilitates the orderly succession 

of ownership. The entity has a perpetual life. As 

some members resign and new people join, redemption and issuance of a share of common stock or a 

membership certificate is a relatively simple means 

of clarifying each person’s status and rights in the 

association.

100 Priv. Ltr. Rul. 200209024 (November 29, 2001).

101 Priv. Ltr. Rul. 200210003 (December 4, 2001).

102 Priv. Ltr. Rul. 200224017 (March 15, 2002).

103 Recently enacted laws creating unincorporated 

associations called cooperatives are discussed above at 

pages 29-31.

Incorporation will also generally limit the personal liability of each member, for losses suffered 

by the cooperative, to the members’ equity in the 

cooperative.

All States have recognized cooperatives’ unique 

characteristics by enacting statutes specifically 

designed for incorporating cooperatives. The 50 

States have approximately 85 such statutes.104 Some 

are broad, permitting the incorporation of virtually 

any business as a cooperative. Others are limited in 

scope. Many States have an Agricultural Cooperative Associations Act specifically written to authorize incorporation of associations of agricultural 

producers.

An organization need not be formed pursuant to 

a cooperative incorporation statute to qualify as a 

cooperative under subchapter T of the Code or the 

other Federal acts mentioned in the next subsection of this report. Every State also has a general 

business corporation statute. A cooperative may be 

incorporated under this law and have its cooperative 

character established through proper drafting of the 

articles of incorporation and bylaws.

While most cooperatives are organized under a 

law of the State where the principle office is located, this is not a legal requirement. A number of 

cooperatives are organized under a cooperative law 

or general business act of a different State.

The different laws have various rules on such 

key issues as who can be a member, voting rights 

of members, the extent of permissible nonmember 

business, and who can be a director or an officer. 

The primary consideration in selecting an incorporation statute is that the act permits a structure that 

meets the needs and desires of the members.

Federal Statutes 

Three nontax Federal laws that effect cooperatives 

have more detailed eligibility requirements than 

does the Internal Revenue Code (Code). These statutes are the Capper-Volstead Act, the Agricultural 

104 State cooperative laws are analyzed in detail in 

J. Baarda, State Cooperative Incorporation Statutes for 

Farmer Cooperatives, ACS Cooperative Information Report. No. 30 (USDA 1982). A brief history of their development is given in J. Baarda, Cooperative Principles 

and Statutes: Legal Descriptions of Unique Enterprises, 

ACS Research Report. No. 54 (USDA 1986) at 5-9.
20 Income Tax Treatment of Cooperatives: Background

Marketing Act of 1929, and the Farm Credit Act 

of 1971. The descriptions found in these Federal 

laws are adopted by reference in other statutes and 

regulations. Cooperatives that wish to utilize legal 

rights conferred under these laws must meet their 

qualification standards, regardless of whether the 

organization is operating on a cooperative basis for 

tax purposes.

Capper-Volstead Act

The Capper-Volstead Act,105 enacted in 1922, provides a limited antitrust exemption for agricultural 

producers to market their products on a cooperative 

basis. To qualify for Capper-Volstead protection, the 

producers must adhere to these organizational and 

operational standards:

1. Membership must be limited to agricultural 

producers.

2. The association must be operated for the mutual benefit of the members as producers.

3. Either no member may have more than one 

vote because of the amount of equity owned 

or dividends on equity cannot exceed 8 percent per year.

4. The value of products handled for members 

must exceed that handled for nonmembers.

Agricultural Marketing Act of 1929

The Agricultural Marketing Act of 1929106 created 

the Federal Farm Board, with the joint missions 

of stabilizing farm prices and financing cooperatives. A forerunner of the Farm Credit Acts, this law 

includes a definition of “cooperative association” 

virtually identical to the one in the Capper-Volstead 

Act. The Agricultural Marketing Act of 1929, however, has broader application, covering farm supply 

as well as marketing cooperatives.107

105 42 Stat. 388 (1922), codified at 7 U.S.C. §§ 291-

292 (1988).

106 46 Stat. 11 (1929), codified at 12 U.S.C. § 1141 

(1988).

107 12 U.S.C. § 1141j.

Farm Credit Act of 1971 

The Farm Credit Act of 1971108 includes a definition 

of a cooperative eligible to borrow from Banks for 

Cooperatives.109 This definition is similar to, though 

somewhat more flexible than, the definition in the 

other two statutes:

1. The borrower must be an association of farm 

or aquatic producers. At least 80 percent (60 

percent in some specific instances) of the voting control of the association must be held by 

farm or aquatic producers, or associations of 

such producers.

2. No member may have more than one vote 

because of the amount of equity owned or 

dividends on equity can not exceed a rate 

established in regulations of the Farm Credit 

Administration.

3. The value of products handled for members 

and supplies provided members must exceed 

that handled and provided for nonmembers.

STRUCTURE AND OPERATIONS

Statutes provide the general framework within 

which cooperatives must operate. The primary 

sources of information about the structure and 

operation of a particular cooperative are its organizational documents. Like other corporations, the 

basic legal documents of a cooperative will be its 

articles of incorporation and bylaws. Many cooperatives also have special membership, marketing, and/

or purchasing agreements with their members that 

set out rules for how the cooperative venture will 

conduct itself.110

Articles of Incorporation

The articles of incorporation, when accepted by the 

State government, establish the cooperative as a le

108 85 Stat. 583 (1971), amended 89 Stat. 1060 

(1975), 94 Stat. 3437 (1980), 100 Stat. 1877 (1986), 

codified at 12 U.S.C. § 2001 et seq. (1988).

109 12 U.S.C. § 2129.

110 For an explanation of the key provisions in each 

of these documents, and sample drafting language, see 

D. Frederick, Sample Legal Documents for Cooperatives, RBS Cooperative Information Report No. 40 

(USDA 1990).
Cooperative Information Report 44-1 21

gal entity. Each incorporation statute, whether written specifically for cooperatives or for corporations 

in general, lists subjects the articles of incorporation must address. Articles of incorporation usually 

contain the following kinds of information about the 

cooperative:

1. The cooperative’s purposes. These are usually 

stated quite broadly. Any service the cooperative may someday provide its members is frequently authorized, at least in a general way.

2. The cooperative’s powers. The State statute 

authorizing formation of a cooperative usually 

sets out in detail the activities the cooperative 

may engage in. This provision is often a virtual verbatim copy of the statutory language.

3. The cooperative’s term of existence, which is 

usually perpetual.

4. The number of directors and the names and 

addresses of the initial directors.

5. The amount of capital stock, number of 

shares, par value, and descriptions of preferred stock, if any.

6. Special stock provisions such as limitations 

on transfer, common in cooperatives.

7. For cooperatives without capital stock, articles of incorporation will describe the relative 

rights of members.

Bylaws

A cooperative’s bylaws are the most important 

source of information about how the cooperative 

operates. Most methods of distributing net margins 

as patronage refunds (and otherwise) are found in 

cooperatives’ bylaws. Bylaws are tailored to each 

cooperative’s particular situation, and no single 

provision is universally useful.

 Bylaw provisions are more detailed than articles 

of incorpor-ation. A typical set of bylaws might contain information about the following:

1. A description of who can be a member.

2. Entrance, organization, service, and membership fees.

3. Cessation or suspension of membership; reasons and procedures.

4. Members’ interest when membership is terminated, including an appraisal if needed or 

required by State law.

5. Member meetings, annual and special.

6. Voting procedures, including the number 

making up a quorum of members and provisions on proxy or mail voting.

7. Qualification, election, and duties of directors.

8. Directors’ terms of office.

9. Director quorum, board of director committees, and other board conduct items.

10. Marketing contracts, requirements, and liquidated damages clauses.

11. Descriptions of the distribution of net margins as patronage refunds, form of distribution 

as cash or other forms.

12. Reserves and their investment.

13. Stock and membership transfer restrictions.

14. Payment of dividends on capital stock, conditions and rates.

Key provisions of the business relationship 

between the members and the cooperative are often 

contained in the bylaws, a practice unique to cooperatives as compared to most for-profit corporations.

Contractual Agreements with Members

Cooperatives often find it useful to have a contract 

with each member specifying in more detail the 

relationship between that member and the association. These agreements are usually executed at the 

time of application for membership. They deal with 

special provisions concerning membership, marketing, purchasing, or other services provided through 

the cooperative. For example, a marketing agreement might describe the member’s obligation to 

deliver product to the cooperative and the cooperative’s responsibilities concerning the marketing of 

that product.

These contracts sometimes duplicate and thereby 

reinforce provisions of the bylaws. It is usually 

preferable not to use a contractual provision in lieu 

of an appropriate bylaw.

As the material covered in these contracts varies 

greatly, the importance of such agreements for tax 

purposes depends on their individual provisions.111

111 For an explanation of the types and formats of 

marketing agreements, common provisions, and sample 

drafting language, see J. Reilly, Cooperative Marketing Agreements: Legal Considerations, ACS Research 

Report No. 106 (USDA 1992).
22 Income Tax Treatment of Cooperatives: Background

General Operational Characteristics

Cooperatives are owned and controlled by the 

people who use their services. Control is typically 

evidenced by the ownership of a share of common 

stock in the case of stock cooperatives or a membership certificate in the case of membership or nonstock cooperatives. Owners of common stock in a 

stock cooperative are often simply called members. 

Restrictions on transfer, directly or indirectly, are 

common.

Members elect a board of directors that is predominantly, if not exclusively, composed of members. This is true not only for small cooperatives 

but for the largest cooperative corporations in the 

country. Unlike noncooperative business corporations, coopera-tive directors are users of the services 

of the cooperative and recipients of net margins 

as users. Thus their interests are the same as other 

owner-users for whose benefit cooperatives exist.

The number of directors serving on a cooperative’s board ranges from three to many. Directors 

may be chosen at large or elected by geographical 

districts. A delegate system sometimes is used to 

help choose representative directors.

In the annual membership meeting, which is open 

to all members, directors are elected and other business is conducted. Annual financial reports may be 

presented at the membership meeting or distributed 

to members by some other means if permitted.

The most noteworthy characteristic of a cooperative, distinguishing it from other forms of business enterprise, is how it distributes its net margins 

or earnings. Margins generally are distributed to 

patrons in proportion to their use of the cooperative 

rather than on the basis of capital investment in the 

cooperative.

Examples of Cooperative Operations

No definitive set of examples can convey the variety 

of ways cooperatives do business with and for their 

patrons. The following examples, however, demonstrate the general principles of operation commonly 

found in simple circumstances.

Example 1

 A marketing cooperative engages in the sale of 

member-patrons’ products only. The operation is a 

simple buy-sell arrangement in which patrons bring 

the product to the cooperative and the cooperative 

purchases it. This is a typical practice for many 

marketing cooperatives.

The price paid upon purchase by the cooperative 

may be the current market price for that commodity, may be established at a certain percentage of the 

current market price, or may simply be an advance 

based on financial considerations. The price may 

vary depending on the time of delivery and the 

quality of the product delivered. The commodity is 

commingled with all other deliveries of like goods. 

The cooperative sells the product. Under expected 

circumstances, the sale price will exceed the price 

that was paid to members at delivery.

The cooperative determines its net margins at the 

end of the fiscal year by normal accounting procedures. Total revenue received is reduced by the 

expenses of doing business, including the payments 

to patrons made when the cooperative purchased 

their production.112

Assume the cooperative’s key financial results are 

reflected in the following simplified income statement:

Gross income from 

sale of commodities $100,000

Cost of goods sold (payments/advances 

to member-patrons) 80,000

Other expenses 10,000

Net margins $10,000

Net margins of $10,000 are available for payment as patronage refunds. Each patron’s share of 

total net margins is calculated by determining each 

patron’s share of total patronage during the year.

In this example the cooperative deals with five 

patrons. The patrons delivered and the cooperative sold 2,000 units of product during the year. A 

percentage of total patronage is established for each 

patron:

112 Some cooperatives do not purchase member 

product, but rather serve as an agent to sell that product 

for member-patrons. The cooperative may make advance payments to patrons, as in example 1. The patronage refund allocations are the same as example 1.
Cooperative Information Report 44-1 23

tion of margins allocated to each patron remains the 

same. Based on proportion of the product delivered 

to the cooperative, each patron’s patronage refund 

would be:

Patron Percentage of Patronage

Total Refund

A 25.00 $3,750

B 12.50 $1,875

C 31.25 $4,687

D 15.00 $2,250

E 16.25 $2,438

Example 3

 In this example, the cooperative described in example 2 has the same $15,000 income from business done with its patrons but, in addition, generates 

$1,000 of net income not related to business done 

with or for its patrons.

Net margins from patronage business $15,000

Nonpatronage-sourced income $1,000

Assume the cooperative does not qualify for 

section 521 tax status, and therefore cannot deduct 

patronage-based distributions of nonpatronage income.113 Also assume the corporate income tax rate 

is 15 percent on the first $50,000 of taxable income.

The patrons each receive patronage refunds in the 

same amount as in example 2.

The cooperative pays tax of $150 on $1,000 and 

will likely retain the $850 as earned surplus (an 

unallocated reserve).

Example 4

This example reverts to the situation described in 

example 1 (the cooperative has a $10,000 margin), 

but with one exception. Patrons A, B, and C are 

members of the cooperative. D and E do business 

with the cooperative, but are not members. The 

cooperative’s member and nonmember business are 

equally profitable. 

The cooperative does not pay patronage refunds 

to nonmembers, but keeps the earnings on nonmember business as a tax-paid reserve. Individual 

113 The qualification requirements and special tax 

treatment of farmer cooperatives qualifying for section 

521 tax status are discussed in detail in Part 4 of these 

reports.

Patron Sales to Percentage of

Cooperative Total Sales

A 500 units 25.00

B 250 units 12.50

C 625 units 31.25

D 300 units 15.00

E 325 units 16.25

Net margins are distributed by allocating the 

amount available for distribution ($10,000) by 

the proportion of total business attributed to each 

patron.

Patron Percentage of Patronage

Total Refund

A 25.00 $ 2,500

B 12.50 1,250

C 31.25 3,125

D 15.00 1,500

E 16.25 1,625

Example 2

In this example the cooperative adds value to the 

farm product delivered to it by such means as processing or manufacturing. Gross income is derived 

from the sale of the finished product. Expenses include costs of other ingredients, labor, costs of fixed 

assets, any other expenses incurred in processing, 

marketing, etc.

Any increase in margins from value-added activities are returned to patrons on the same basis as 

their deliveries. Thus, the percentage of total sales 

will remain the same.

The assumed income statement is modified to 

reflect this expanded cooperative effort and the 

hoped-for higher margin:

Gross income from

sale of processed products $200,000

Cost of goods sold 

(payments/advancesto member-patrons) $80,000

Processing expenses $80,000

Other expenses $25,000

Net margins $15,000

The amount available for distribution is $15,000 

instead of $10,000 in example 1, and the propor-
24 Income Tax Treatment of Cooperatives: Background

producer sales to the cooperative are the same as in 

example 1.

Patrons A, B, and C provide 1,375 of the 2,000 

units of product sold to the cooperative (68.75 percent). Therefore 68.75 percent of the $10,000 total 

earnings, or $6,875, is available for distribution as 

patronage refunds. The proportion of total member 

patronage conducted by each patron is calculated 

and applied to the $6,875 to determine individual 

patronage refunds.

 Patron Percentage Patronage 

Refund

A 36.36 $2,500

B 18.18 1,250

C 45.46 3,125

The cooperative pays tax of 15 percent on the 

$3,125 in earnings from nonpatronage business 

($469) and retains the remaining $2,656 as surplus.

Example 5

 The cooperative in this example is in the same situation as in example 4. The cooperative, however, 

decides to return margins earned on nonmember 

business to its member patrons on a patronage basis. 

It pays tax of $469 on the amount earned on nonpatronage business and allocates the remaining $2,656 

to its members in proportion to business done with 

the cooperative.

Patron Percent Patronage Other Total

Payments

A 36.36 $2,500 $966 $3,466

B 18.18 1,250 483 1,733

C 45.45 3,125 1,207 4,332

The three members collectively receive $9,531, 

the $10,000 in earnings less the $469 tax paid on 

the nonpatronage portion of the earnings.

Example 6

 A cooperative may perform different services for 

different patrons. This example shows one way a 

cooperative may handle the income from two units 

and how it may distribute net margins.

The cooperative markets product X for patrons 

A, B, C, and D. It markets product Y for patrons C, 

D, and E. As the cooperative is marketing different 

products with different values and characteristics, 

it computes patronage on the basis of value rather 

than volume.

The cooperative calculates the percentage of total 

combined deliveries of X and Y. The total value of 

X and Y delivered to the cooperative is $100,000.

Patron Product X Product Y Total Delivered

A $20,000 $20,000

B $10,000 $10,000

C $25,000 $10,000 $35,000

D $12,000 $13,000 $25,000

E $10,000 $10,000

The percentage of total product delivered to the 

cooperative attributed to each patron is calculated.

Patron Percentage of Total

A 20.00

B 10.00

C 35.00

D 25.00

E 10.00

The cooperative in this example calculates a 

single net margin for its entire business. The total 

net margin, $15,000, is allocated to patrons without 

regard to division between units. Each patron’s percentage of business is applied to the margin available for distribution.

Patron Percentage Patronage Refund

A 20.00 $3,000

B 10.00 1,500

C 35.00 5,250

D 25.00 3,750

E 10.00 1,500

Example 7

In this example, the cooperative engages in the 

same activities as the co-op described in example 6. 

The cooperative, however, pays net margins derived 

from product X activities only to patrons delivering 

product X to the cooperative ($67,000 in product). 

Margins from product Y activities are distributed 

only to those patrons delivering product Y ($33,000 

in product). Percentages for net margins are calculated for product deliveries separately.
Cooperative Information Report 44-1 25

Patron Percentage, Percentage, 

Product X Product Y

A 29.85

B 14.93

C 37.31 30.30

D 17.91 39.40

E 30.30

Assume the cooperative generated a margin of 

$8,000 from marketing product X and a $7,000 

margin from marketing product Y. Applying the 

allocation percentages to net margins available for 

refund from each activity ($8,000 for product X, 

$7,000 for product Y), the patrons’ patronage refund 

allocation from each activity is determined.

Patron Refund, Refund, Total

Product X Product Y Refund

A $2,388 $2,388

B 1,194 1,194

C 2,985 $2,121 5,106

D 1,433 2,758 4,191

E 2,121 2,121

EQUITY ACCUMULATION

One of the greatest challenges facing cooperatives 

is raising equity capital. As businesses operated 

primarily to flow through earnings on a patronage 

basis to the users of their services, cooperatives cannot attract equity from outside sources to the same 

extent as investor-owned businesses.

Cooperatives are not alone. Sole proprietorships, 

partnerships, LLC=s, and closely-held corporations 

all face similar problems acquiring equity. For these 

entities, equity capital usually is raised from a limited number of owners or from retained earnings.

The single tax treatment accorded these entities tends to help alleviate the capital accumulation 

problem. Earnings of investor-owned corporations 

are subject to taxation twice, once at the corporate 

level when earned and a second time at the ownership level if an when distributed as dividends. 

Owner(s) of a sole proprietorship, partnership, LLC, 

closely-held corporation, or cooperative can generally reduce tax liability at the firm level if they meet 

specific Code requirements. A greater portion of 

income is therefore available for reinvestment in the 

business.

The fact that user-owners of a cooperative receive 

the margins in proportion to their use of its services, 

not according to the level of their investment, is 

a significant difference between cooperatives and 

other forms of business. Less incentive exists for 

the owners and other potential investors to make 

equity available to cooperatives compared to other 

business forms.

In addition to single tax treatment, subchapter 

T responds to the unique features of a cooperative 

with certain flexibility, such as the option to have 

the single tax on internally generated equity assumed at the corporate level until such time as that 

equity is paid out to the owners.114

Sources of Equity Capital for Cooperatives115

The three primary ways members provide equity 

to their cooperative are direct investment, retained 

earnings, and per-unit retains. Cooperatives may 

also acquire equity through direct investment by 

persons outside the membership and retained earnings on nonmember, nonpatronage business. This 

section explains the nature of each source of equity.

Direct Investment

Direct investment refers to cash purchases of membership certificates, common and preferred stock, or 

other equity.

Most cooperatives require a member to make a 

direct payment when joining the cooperative. This 

generally is evidenced by the cooperative issuing 

the member a membership certificate in a nonstock 

cooperative or a share of common stock in a stock 

cooperative. The membership certificate or common 

stock usually conveys to the owner the right to vote 

on matters submitted for decision to the cooperative 

embership, and the owner is generally referred to as 

a member of the cooperative.

114 This is accomplished through the use of nonqualified retained patronage refunds and per-unit retains. 

The mechanics on nonqualified retains are explained in 

Part 3 of these reports, pages 51-53 and 82-83.

115 This section is based on material in D. Cobia 

et al., Equity Redemption: Issues and Alternatives for 

Farmer Cooperatives, ACS Research Report No. 23, 

(USDA 1982) at 12-15 and M. Matthews, Financial 

Instruments Issued by Agricultural Cooperatives, ACS 

Research Report No. 68, (USDA 1988) at 7-33.
26 Income Tax Treatment of Cooperatives: Background

Direct investment by members is often a minor 

source of equity to a cooperative. Most cooperatives are trying to retain current members and attract 

more members and member business. And members generally prefer the cooperative to generate its 

own equity, rather than solicit checks from them. 

Thus the cost of a membership certificate or share 

of common stock is usually modest, $100 or less. 

Equity that evidences membership usually does 

not pay a dividend, if for no other reason than the 

administrative expense of issuing a large number of 

small checks would be substantial.

Direct investment can be a major source of equity 

in two instances. Direct investment is often the primary means for a new cooperative to acquire equity 

capital. Once the cooperative is functioning, it then 

can accumulate additional equity from operating 

funds in the form of retained earnings or per-unit 

retains.

A number of cooperatives also acquire equity 

by selling nonvoting stock or equity certificates to 

members and nonmembers. This nonvoting equity 

usually pays a limited dividend as an inducement 

for persons to make capital available to the cooperative.

Generally, the tax treatment of direct investments 

in a cooperative follows the same rules as a direct 

investment in an investor-owned corporation. The 

payment to the cooperative is a nontaxable event. 

While the value of cooperative equity is usually 

constant, any gain or loss realized by the equity 

holder is generally a capital gain or loss. And cooperative earnings used to pay dividends on equity are 

subject to taxation at both the cooperative and the 

recipient levels.116

Margins

While cooperatives are sometimes characterized 

as businesses that operate “at cost,” few if any can 

do so on a day-to-day basis. Rather, cooperatives 

seek to generate income that exceeds expenses on 

an ongoing basis. Then, usually after the close of 

the fiscal year, they return earnings from business 

116 An exception is dividends paid on capital stock 

by a cooperative that qualifies for I.R.C. § 521 tax status. 

Such dividends are deductible by the cooperative under 

I.R.C. § 1382(c)(1). This special deduction is discussed 

more fully in the report covering section 521 tax status.

conducted on a cooperative basis, called margins, to 

the persons responsible for the business generating 

those earnings, who are called patrons. These returns, based on the amount of business each patron 

does with the cooperative during the year, are called 

patronage refunds. The net result is “at cost” operations.

Business conducted on a cooperative basis is 

called patronage sourced. Earnings realized on 

patronage-sourced business may be returned to the 

patrons as cash patronage refunds. Or the members 

may decide to let the cooperative retain some or all 

of their patronage refunds as an equity investment 

in the cooperative. Single tax treatment is available 

only for patronage-sourced earnings that are returned to the patrons as cash or “other property,” or 

retained under procedures set out in the Code.

Determining what portion of a cooperative’s 

earnings qualify for distribution as tax-deductible 

patronage refunds has evolved into an exercise 

in distinguishing patronage- from nonpatronagesourced income.117

Patronage-sourced earnings are not eligible for 

single tax treatment when the cooperative chooses 

not to meet the applicable Code requirements. An 

example of this situation would be a cooperative 

placing patronage-sourced income into an unallocated reserve. In this case the earnings are treated 

just as earnings of an investor-owned firm. They are 

taxable income to the cooperative when earned and 

taxed a second time to the recipients when distributed by the cooperative.

Per-Unit Retains

Cooperatives that market products produced by 

their members have a third means of acquiring 

equity capital, per-unit retains. Per-unit retains are 

capital investments based on either the number of 

physical units handled by the cooperative or on a 

percentage of sales revenue. Per-unit retains are deducted from sales proceeds due the members from 

the cooperative.

The patronage/nonpatronage source issue, so 

important in determining the tax status of retained 

earnings, has little significance to per-unit retains. 

117 Differentiating patronage and nonpatronage 

income are thoroughly discussed in Part 2, Chapter 5, of 

these reports.
Cooperative Information Report 44-1 27

As per-unit retains can only be collected from the 

proceeds of marketing products for patrons, the 

patronage nature of the underlying business transaction has not been subject to challenge. Thus the 

material in these reports on per-unit retains is relatively short. But this reflects the lack of controversy 

concerning their tax status. It does not diminish 

their value as a source of cooperative equity.

As with retained patronage refunds, single tax 

treatment is discretionary. A cooperative may place 

some or all per-unit retains into an unallocated 

reserve, thereby forfeiting access to single tax treatment under subchapter T.

People sometimes blur the distinction between 

patronage refunds and per-unit retains. Patronage 

refunds are based on the earnings of the cooperative, per-unit retains on the volume or value of business done with the cooperative. Thus, a cooperative 

can acquire capital, even in a year of limited margins or a loss, through the use of per-unit retains.

Nonmember/Nonpatronage Earnings

Non-tax laws, such as the Capper-Volstead Act and 

State cooperative incorporation statutes, frequently 

require affected cooperatives to do a majority of 

their business with members. This still leaves those 

associations free to do up to 49 percent of their 

business with nonmembers on a noncooperative basis.118 Earnings on this business are not eligible for 

single tax treatment. But the after-tax earnings can 

be used to build the equity base of the cooperative 

to improve its balance sheet and finance services it 

provides to members.

Cooperatives that market products on a noncooperative basis, usually for nonmembers, sometimes collect the equivalent of a per-unit retain on 

this nonpatronage-sourced business. They usually 

call the moneys retained by another name, such as 

service fees. These funds are subject to double taxation.

118 IRS has conceded that subchapter T does not require an association to do a majority of its business on a 

cooperative basis to qualify for cooperative tax treatment 

on the patronage refunds it does distribute. Rev. Rul. 93-

21, 1993-13 I.R.B. 5. Thus, if free of other legal impediments, a “cooperative” may do more than 50 percent of 

its business on a noncooperative basis without forfeiting 

access to single tax treatment of its margins.

Financial Planning Options

As Table 1 illustrates, cooperatives have flexibility 

in designing an equity accumulation program to 

meet their individual needs. An understanding of the 

alternatives is especially important when allocating the patronage-based sources of equity, retained 

margins and per-unit retains.

Direct investments usually are made to purchase 

membership equity, the membership certificate, or a 

share of common voting stock.

Nonpatronage income is likewise usually placed 

into a single type of account, an unallocated reserve.

Patronage-based sources of equity can be used 

for at least four purposes: cash refunds, qualified 

retained patronage allocations, nonqualified retained 

patronage allocations, and unallocated reserves.

Cash Refunds

Cooperatives can distribute their margins and perunit retains as cash refunds to the patrons. Cash 

distributions are generally tax deductible by the 

cooperative in the year of distribution and taxable 

income to the recipient in the year of receipt. Cash 

refunds do not add to the equity of the cooperative, 

but rather provide an immediate additional return to 

the patron on his or her use of the cooperative.

Qualified Investments

Cooperatives can retain margins and per-unit retains 

and allocate the retained funds to equity accounts of 

the patrons, based on the amount of business each 

patron did with the cooperative during the year. If 

the equity is qualified as defined in the Code, the cooperative can deduct the amount of the allocations 

from its taxable income in the year the margins and 

retains were realized. Patrons include the amount 

allocated in their taxable income in the year they 

receive a required written notice of the allocation. 

The retained funds become an equity investment by 

the patron in the cooperative.

The Code requires at least 20 percent of a 

qualified patronage refund be paid in cash. But the 

cooperative can still retain up to 80 percent of its 

margins on a tax-free basis. There is no 20-percent 

cash distribution requirement for qualified per-unit 

retains, so a cooperative can keep the entire amount 

free of tax liability.
28 Income Tax Treatment of Cooperatives: Background

The redemption of qualified equity is a tax-free 

event for both the cooperative and the patron.119

The tax treatment of qualified retained equity is 

similar to the passthrough procedures that provide 

single tax treatment for partnerships and subchapter 

S corporations. But, cooperatives have additional 

flexibility not generally available to other passthrough entities.

Nonqualified Investments

Cooperatives have the option to delay the passthrough. Cooperatives can hold margins and perunit retains at the firm level without forfeiting 

access to single tax treatment of those moneys.

With retained equity that is nonqualified, cooperatives allocate margins and per-unit retains to the 

equity accounts of the patrons, but pay corporate 

income taxes on the funds retained. The patron has 

no tax obligation in the year of allocation.

119 Assuming redemption is for full face value. 

Redemptions at less than face value are discussed in 

Chapter 9 of these reports.

When nonqualified investments are 

redeemed, the cooperative then recaptures 

the tax paid at the 

time of allocation. At 

this time, the patron 

is obligated to pay income tax on the funds 

received.

Nonqualified allocations have particular 

appeal to cooperatives 

with member-patrons 

in high marginal tax 

brackets. If the cooperative uses qualified 

allocations, it must 

make substantial 

cash payouts or high 

income patrons may 

suffer a negative cash 

flow on the margins 

they generate. This 

occurs when the total 

tax owed on the allocation (Federal and State) exceeds the amount of 

cash paid out as part of the distribution.

By using nonqualified allocations, no tax is due 

from patrons until the allocation is redeemed. Also, 

there is no 20 percent cash payout rule for nonqualified allocations.120

Cooperatives are free to use a combination of 

cash payouts, unallocated reserves, and qualified 

and nonqualified allocations.121 This makes it pos

sible for the leadership to develop a program that 

reflects the best interests of the membership.

Unallocated Reserves

120 The temporary Federal and State tax obligations 

to the cooperative on its nonqualified allocations, depending on its marginal tax rate, may be greater than 20 

percent. This limits the amount of equity a cooperative 

can accumulate using nonqualified allocations.

121 The applicable Treasury Department regulations 

include an example of a cooperative that makes a patronage refund partly in cash, partly as a qualified allocation, 

and partly as a nonqualified allocation. Treas. Reg. § 

1.1388-1(c)(1).

Table 1—Sources and Types of Equity

Sources of Direct Margins Per-Unit Nonpatronage

Equity Investment Retains Income

 Cash

 Refund

Types of Stock

Equity or

Membership

Certificate

Qualified	 Qualified

Investment Investment

Nonqualified	 Nonqualified

Investment Investment

Unallocated Unallocated Unallocated

Reserve Reserve Reserve
Cooperative Information Report 44-1 29

Cooperatives can treat margins just as a noncooperative firm would treat earnings, put them into an 

unallocated reserve and pay corporate income tax. 

Under this approach, single tax treatment is forfeited. If the funds are later distributed, the recipients 

must pay a second income tax at the recipient level.

Equity Redemption 122

One of the tenets of cooperative theory is that 

cooperatives will not only be substantially funded 

by member-patrons, but that they will be funded, to 

the extent possible, by current patrons on the basis 

of patronage. But practical considerations make this 

goal difficult to attain. Capital contributions will 

continue to build as time passes and patronage occurs. Membership will also change over time.

One tool developed by cooperatives to bring 

responsibility for providing equity more in line 

with current patronage is systematic equity redemption. In other corporations, an equity investment is 

normally held for the life of the business or resold 

to another investor. In many cooperatives, the firm 

uses new patronage-based equity acquired each year 

to redeem for cash the patronage-based equity holdings of member-patrons whose equity investment 

is likely to be greater, on a proportional basis, than 

their current use of the cooperative=s services.

Three methods of redeeming member equity have 

achieved general acceptance: the “revolving fund 

plan,” the “base capital plan,” and “special plans.” 

Although the systems are often viewed as unrelated, 

they may, in fact, operate together.123

Revolving Fund Plan

“Revolving fund financing” is a term used for 

systems in which patrons make capital contributions on an annual basis, typically through retained 

patronage refunds or per-unit retain allocations. The 

cooperative, in turn, redeems earlier capital contri122 For a thorough discussion of cooperative equity 

redemption programs, see D. Cobia, et al., Equity Redemption: Issues and Alternatives for Farmer Cooperatives, RBS Research Report No. 23 (USDA 1982).

123 The structure of a cooperative’s equity redemption program is usually set out in its bylaws. For sample 

bylaw language pertaining to each method discussed 

herein, see D. Frederick, Sample Legal Documents for 

Cooperatives, RBS Cooperative Information Report No. 

40 (USDA 1990).

butions on a regular basis. Redemption is usually on 

a first-in, first-out basis. The cooperative determines 

what its total capital requirements are, and the excess is redeemed each year, the earliest or “oldest” 

equity being revolved out first.

A revolving fund plan is frequently described as 

“systematic” if older equities are retired on a regular 

basis, usually a given number of years after they 

were issued. In a systematic plan, member investment is related to recent and current use. Newer 

members usually add equity to their account during 

their early years in the cooperative. The accounts of 

established members are adjusted each year to better reflect current patronage. They make new investments based on current year’s patronage and have 

their earliest year’s equity redeemed. The accounts 

of former members are paid off during the life of 

the revolving cycle beginning the year after they 

cease patronizing the cooperative.

Balance sheet classification as equity rather than 

debt makes it important to condition payment on 

the board of directors determining that funds for 

revolvement are available. Director discretion also 

insures that there is room for flexibility if the situation warrants it. For instance, if there is a shortfall 

in new equity or a need exists to increase the cooperative’s total equity, current equity can be protected 

by lengthening the revolving cycle (the cooperative 

keeps equity for a longer period of time).

This tactic should be used sparingly, as it deviates 

from the objective of having current users finance 

the cooperative. Also, it can create member relations problems if the members have the expectation 

that their oldest equities will be redeemed on a fixed 

schedule, sometimes without regard for the cooperative’s financial condition.

Base Capital Plan

“Base capital plan” is a general term given to a 

financing system that focuses more directly on the 

current proportion of capital a patron should have 

in the cooperative at a particular time, based on the 

degree of use.

Development of the base capital plan involves 

several accounting steps.

1. The cooperative determines what its total 

equity capital needs are.

2. The equity capital needs are allocated among 
30 Income Tax Treatment of Cooperatives: Background

patrons based on the proportion of the cooperative’s business each patron did with the 

cooperative during a base period, usually the 

past 3 to 7 years.

3. Each year the cooperative’s equity requirements are reviewed and adjusted as the board 

of directors finds appropriate. Each patron’s 

share of the equity requirement is also adjusted to reflect (a) any change in the total 

requirement of the cooperative and (b) any 

change in the patron’s proportional share in 

the new base period.

4. Underinvested patrons must add to their 

equity account, usually through the current 

year’s retained patronage refunds or per-unit 

retains, or by direct contribution.

5. Fully invested and overinvested patrons 

generally are paid a cash rebate of current 

year’s patronage refunds and per-unit retain 

allocations. Overinvested patrons may receive 

an additional payment in redemption of their 

excess share of the equity.

The association will also have a plan to redeem 

equity investments of former patrons whose proportional share will fall each year until reaching zero 

at the end of the base period beginning the first year 

after they cease patronizing the cooperative.

Special Plans

A special plan is one in which a specific event or 

condition, such as a member’s death, triggers equity 

redemption. The most common events covered are 

death, retiring from farming, or reaching a specified 

age. Once the condition is verified, the member’s 

equity may be returned at once or over a prescribed 

number of years.

Special plans are often popular with members, 

who see redemption of their equity investments 

supplementing retirement income or their estates. 

But special plans can complicate financial planning 

for the cooperative. One complication is forecasting 

how much equity will be callable in a given year.

Another difficulty is dealing fairly with members 

who are partnerships or corporations and whose 

farming activity or life may continue well beyond 

that of individual partners or shareholders. One approach is for the association to redeem that portion 

of the member firm’s equity equal to the ownership 

interest in the firm of the person meeting the special redemption condition. Then the firm would be 

expected to make up the difference just as if it had 

been under invested by the amount of the redemption.

Special plans are sometimes combined with revolving fund or base capital plans.

Pooling

Some marketing cooperatives do business under a 

unique arrangement called pooling. Cotton, fruits 

and vegetables, grain, milk, rice, and sugar are 

among the commodities pooled for marketing purposes.

The textbook “Cooperatives in Agriculture” contains a cogent description of pooling:

Pooling is a distinctive cooperative practice.... Products of many producers are commingled and, after deducting expenses, the 

average net price received is paid to producers. Key elements of a pool are the sharing of 

risks, expenses, and revenues and the payment 

of an average price, with possible adjustments 

for product quality and for time and location 

of delivery.

Each cooperative pool has its own operating procedures. However, most have 

the following characteristics. Farmers sign 

marketing contracts... with the cooperative 

that guarantees delivery of all or part of their 

production to the pool. The contract transfers 

all authority over marketing decisions (including timing, pricing, and further processing) to 

the cooperative and its professional management. An initial advance is paid to members 

upon delivery of the product. The advance is 

generally a percentage of the government support price or an estimated market price if no 

support price is available. One or more progress payments may be made as the product is 

sold out of inventory.

When all or most of the product has been 

sold, generally within 12 months of delivery, 

the pool is closed. A total value, including an 

estimated value of any remaining inventory, 

is determined for the pool. Operating and 

administrative expenses are allocated and sub-
Cooperative Information Report 44-1 31

tracted. Any excess over previous payments is 

then distributed to patrons. This final payment 

results in zero net income for the cooperative 

or business at cost.124

Pooling cooperatives, to some, truly embody the 

concept of operating at cost. By intentionally accounting for their funds to avoid generating earnings, cooperatives that pool achieve a nonprofit 

result on an annual basis.

Advances paid during the year, and the final payment when the pool is closed, are deducted by the 

cooperative as cost of goods sold and recognized 

as income by patron recipients. For tax purposes, 

a final pool payment is hard to distinguish from a 

patronage refund payment made entirely in cash. 

Both are deductible by the cooperative and taxable 

to the recipient.

CHAPTER 3

HISTORICAL DEVELOPMENT OF

COOPERATIVE TAXATION

This chapter traces the evolution of tax law specifically applicable to cooperatives. Two important 

paths developed from enactment of the first modern income tax law in 1909 until 1951. In one, the 

basic single tax treatment for cooperative patronage 

refunds, paid pursuant to a prior legal obligation, is 

established. This path leads to provisions on cooperatives found in subchapter T of the current Internal 

Revenue Code (Code). A statutory exemption for 

qualifying farmer cooperatives existed until 1951. 

This path leads to the present section 521.

In 1951, the complete exemption for eligible 

farmer cooperatives was eliminated and a legislative scheme for taxing all margins and previously 

exempt farmer cooperatives put in place. The 1951 

law’s purposes, however, were defeated by subsequent judicial interpretation. In 1962, enactment of 

the present subchapter T preserved the basic single 

tax concept but added a mechanism for inclusion 

of cooperative net margins in the current income of 

either the patrons or the cooperative.

124 D. Cobia (ed.) Cooperatives in Agriculture, 

(Prentice Hall 1989) at 198.

THE POWER TO TAX

The foundation for cooperative tax treatment was 

built early in the development of the Federal income 

tax system. A brief history of the tax system is presented as background for the material that follows 

on taxation of cooperatives.

 The power to tax is essential for the maintenance 

of any governmental system. A serious weakness 

of the Articles of Confederation was that Congress 

could not levy and collect taxes.125 Not surprisingly, 

the power to tax is the first authority of Congress to 

be enumerated in article I, section 8 of the Constitution , which grants Congress the power: “To lay and 

collect taxes, duties, imposts and excises, to pay 

the debts and provide for the common defense and 

general welfare of the United States.”126

The Constitution imposes two limits on Congressional taxing power. First, duties, imposts, and 

excises must be levied uniformly throughout the 

United States.127 Second, direct taxes must be apportioned among the States according to population.128

The rule of uniformity found in article I, section 8, does not prohibit different taxes on different 

goods or activities. Nor does it bar a progressive tax 

system. All that is required is that “whatever plan or 

method Congress adopts for laying the tax in question, the same plan and the same method must be 

made operative throughout the United States.”129

Applying the rule of proportionality for direct 

taxes proved troublesome. The term “direct tax” did 

not have an established meaning when the Constitution was drafted, and none evolved in the years 

thereafter.130 This uncertainty played a key role in 

the development of the power of Congress to implement an income tax.

The first income tax was an emergency measure 

125 R. Tresolini, American Constitutional Law (2d 

ed.), The Macmillan Company (New York 1965), at 288.

126 U.S. CONST. art. I, § 8, cl. 1.

127 Id.

128 U.S. CONST. art. I, § 2, cl. 3; art. I, § 9, cl. 4.

129 Knowlton v. Moore, 178 U.S. 41, 84 (1900) 

(inheritance tax); Brushaber v. Union Pacific R. R. Co., 

240 U.S. 1 (1916) (income tax).

130 A. Gunn, Cases and Other Materials on Federal 

Income Taxation, West Publishing Company (St. Paul 

1981) at 2.
32 Income Tax Treatment of Cooperatives: Background

enacted to finance the Civil War.131 A taxpayer 

challenged the constitutionality of the tax on the 

grounds that it was a direct tax, not apportioned 

among the States. The U.S. Supreme Court, in a 

unanimous decision, found only capitation taxes 

and taxes on real estate were direct taxes. The validity of the Civil War income tax was upheld.132

The Civil War income tax was allowed to expire in 1872, but in 1894 another income tax was 

passed.133 The 1894 tax was strongly opposed by 

business interests, which sought a prompt judicial 

determination of its legality. In Pollack v. Farmers’ Loan and Trust Co., the U.S. Supreme Court 

declared an income tax on rental income from real 

estate and interest income from State and municipal 

bonds was a direct tax, unapportioned among the 

States, and therefore invalid.134 With one Justice absent because of illness, the Court was divided on the 

broader issue of the overall propriety of the income 

tax.135

After a rehearing, the Supreme Court voted 

5-4 that a tax on income generated from personal 

property was also an improper direct tax. The Court 

concluded that since the entire scheme of income 

taxation was tainted by the various invalid sections, 

the income tax as a whole was unconstitutional.136

Chief Justice Fuller’s opinion in Pollock on 

rehearing observed that the direct tax provisions of 

the Constitution were subject to amendment so that 

if, on the “sober second thought of every part of the 

country,” an income tax was thought desirable, it 

could be obtained.137

131 Act of August 5, 1861, ch. 45, § 49, 12 Stat. 292, 

309 (1861); Act of July 1, 1862, ch. 119, § 90, 12 Stat. 

432, 473 (1862); Act of June 30, 1864, ch. 183, § 116, 13 

Stat. 223, 281 (1864); Act of March 3, 1865, ch. 78, 13 

Stat. 469, 479 (1865).

132 Springer v. United States, 102 U.S. 586, 602 

(1881). Lengthy tax litigation is hardly a modern phenomenon. Note that this case, which involved a dispute 

over taxes owed for 1865, took over 15 years to resolve.

133 Act of August 27, 1894, ch. 349, §§ 27-37, 28 

Stat. 509, 553-560 (1894).

134 Pollock v. Farmers’ Loan and Trust Co., 157 

U.S. 429 (1895).

135 Tresolini, at 295.

136 Pollock v. Farmers’ Loan and Trust Co., 158 

U.S. 601 (1895).

137 Id. at 635 (1895).

On June 16, 1909, President Taft recommended 

to Congress the adoption of an amendment to the 

Constitution authorizing an income tax.138 The 

Senate,139 and then the House,140 debated and approved a resolution authorizing the amendment in 

early July 1909. The requisite three-fourths of the 

States ratified the 16th Amendment, which became 

part of the Constitution February 25, 1913. The 

amendment reads: “The Congress shall have the 

power to lay and collect taxes on incomes, from 

whatever source derived, without apportionment 

among the several States, and without regard to any 

census or enumeration.”141

The amendment removed income taxes from both 

limits on the taxing power of Congress. The 63rd 

Congress immediately made income taxation a part 

of American life as the Revenue Act of 1913 portion 

of the Tariff Act of 1913.142

TAX LOGIC AND COOPERATIVES

Cooperative tax principles can best be understood 

by analyzing their logic rather than treating them as 

arbitrary rules unrelated to the scheme of Federal 

income taxation. Cooperatives are given different 

tax treatment because of their distinctive form of 

operation, not because they are thought to deserve 

special privileges, with the exception of additional 

deductions given farmer cooperatives qualifying 

under section 521. A simple analysis is given here 

to provide some perspective to the considerable 

complexity of cooperative taxation.

Price Adjustment Characterization

Patronage refunds are often viewed as adjustments 

to prices that cooperatives pay patrons for the product delivered for marketing or prices received for 

supplies provided patrons. For example, a cooperative may receive the product and make an advance

payment. Then, following sale of the product, the 

138 Reprinted as S. Doc. No. 98, 44 Cong. Rec. 

3344-45 (June 16, 1909).

139 44 Cong. Rec. 4105-4121 (July 5, 1909).

140 44 Cong. Rec. 4389-4441 (July 12, 1909).

141 U.S. CONST. amend. XVI.

142 Act of October 3, 1913, ch. 16, section II, 38 

Stat. 114, 166-181 (1913).
Cooperative Information Report 44-1 33

cooperative pays an additional amount to the patron 

as a patronage refund.

Under general tax law, a business usually can 

deduct expenses incurred. This includes costs of 

goods purchased. The price adjustment concept simply says the total cost to the cooperative for goods 

received, for purposes of determining deductible 

business expenses, includes both the advance paid 

immediately and the patronage refund paid later. 

So the deductibility of patronage refunds by cooperatives is merely an extension of general tax law 

allowing all businesses to deduct the cost of goods 

purchased.

The IRS has long recognized the price adjustment 

concept. As IRS stated in an early ruling:

Under long established Bureau practice, 

amounts payable to patrons of cooperative 

corporations as so called patronage dividends 

have been consistently excluded from the 

gross income of such corporations. The practice is based on the theory that such amounts 

in reality represent a reduction in cost to the 

patron of goods purchased by him through the 

corporation or an additional consideration due 

the patron for goods sold by him through the 

corporation.143

Agent or Conduit Characterization

A second justification for patronage refund deduction (or, more accurately, exclusion) is based on the 

idea that the cooperative functions as an agent of the 

patrons. In general, an agent who receives money 

for sale of someone else’s property does not earn 

income. The income belongs to the seller, not the 

seller’s agent. If the cooperative is an agent of its 

patrons, then the patrons are entitled to any income 

received by the cooperative. As the funds never 

belonged to the cooperative, the patrons, not the 

cooperative, recognize the income for tax purposes.

143 I.T. 3208, 1938 2 C.B. 127. See also, Rev. Rul. 

83-135, 1983-2 C.B. 149, 150, wherein the Service’s justification was based on the theory that “these patronage 

dividends represent either an additional consideration 

due the patron for goods sold through the cooperative or 

reduction in the purchase price of supplies or equipment 

purchased by the patron through the cooperative.”

The United States Tax Court has embraced this 

line of reasoning--that the income should be taxable 

only at the patron level since the money never belonged to the cooperative--for some time: “The reason for this rule is that the patronage dividends or 

rebates are at all times the property of the member 

stockholders, and nonmembers, and that the selling 

association is an agent or trustee or mere conduit for 

the income.”144

This concept is sometimes referred to as the conduit approach:

Although the Commissioner has held that 

the petitioner is not exempt under section 

101(12) [the predecessor of section 521 of the 

1954 Code], nevertheless he has allowed the 

petitioner as a cooperative to exclude from 

income for tax purposes the amounts which 

it has distributed in cash as patronage dividends. There is no express statutory authority 

for this action but for many years the practice 

has been followed by the Treasury Department and it has received judicial sanction. The 

theory is that the cooper-ative is merely a conduit for the patronage dividends.145

The price adjustment characterization and the 

agency or conduit characterization both depend 

upon the underlying obligation of the cooperative to 

distribute net margins to patrons on a patronage basis. The following sections explain how this obligation has become codified in existing tax law.

Pre 1951 u

Co

The oad

Only a limited class of cooperatives qualified for 

tax exempt status as it existed before 1951--farmer 

cooperatives that conformed to all the conditions 

prescribed in the applicable statutes. Other farmer 

cooperatives and nonfarmer cooperatives, even 

though they paid patronage refunds “to members or 

144 Harbor Plywood Corp. v. Commissioner, 14 T.C. 

158, 161 (1950), aff’d without opinion, 187 F. 2d 734 

(9th Cir. 1951).

145 Dr. P. Phillips Cooperative v. Commissioner, 15 

T.C. 1002 (1951).
34 Income Tax Treatment of Cooperatives: Background

to prospective members or to patrons generally,” did 

not come “within any of the exceptions or exemptions” of the revenue acts in effect at that time.146

These nonexempt associations had no statutory 

authority to exclude or deduct patronage refunds 

from taxable income. No “partial exemption” existed for an organization operating on a cooperative 

basis but for some other reason was not eligible for 

exemption.147 Nevertheless, patronage refunds were 

generally exempted from taxation by early administrative rulings. Courts approved the practice and 

discussed reasons why the administrative holdings 

were justified.

Early rationales for the treatment of patronage refunds absent statutory authority relied on tax theory 

and practice. This logic is useful when thinking 

about the treatment of patronage refunds under the 

current Code.

Three aspects of this early treatment of patronage 

refunds are important:

1. The practice as developed in administrative 

rulings and judicial decisions,

2. The characteristics required of a patronage 

refund before it could qualify for exclusion, 

and

3. Variations in payment form, particularly 

where noncash patronage refunds were paid 

as part of a cooperative’s equity financing 

plan.

Patronage Refund Tax Status

The unique nature of the patronage refund, and the 

resultant application of the single tax principle, 

were acknowledged early in the process of developing rules to implement the income tax.

A Treasury Department pronouncement in 1918 

provided:

Cooperative societies, associations, or 

corporations which make a periodic refund--

sometimes called a dividend--to members or

146 T.D. 2737, 20 Treas. Dec. Int. Rev. 441-442 

(June 19, 1918) (cooperative merchandising organization); See also, Off. Dec. 65, 1 C.B. 208 (1919) (cooperative university book store).

147 Farmers Union Cooperative Oil Co. v. Commissioner, 38 B.T.A. 64 (1938).

to prospective members or to patrons generally, in proportion to the purchases made by 

the recipient, are not (totally tax exempt).

Where such refund payments are made in 

accordance with by-laws or published rules 

regularly adhered to, they are to be regarded 

as discounts or rebates, tending to reduce the 

taxable net income of the organization. Like 

discounts generally, they should appear as an 

added item of cost in the detailed schedule of 

cost items submitted with the organization’s 

return of income.

This ruling is in accordance with settled 

practice in the administration of the incometax laws, adopted because the real purpose 

of such organizations is to furnish goods at 

cost.148

This ruling sets out important tenets that have remained consistently valid and are currently reflected 

in Subchapter T of the Code.

First, cooperatives as a class are not “tax exempt.”

Second, if patronage refunds are to be excused 

from tax, they must be paid pursuant to a legal obligation to make the payment.

Third, the patronage refund system permits cooperatives to generate earnings from ongoing operations and still operate “at cost.”149

The 1918 ruling makes an interesting observation in noting the deduction of patronage refunds 

as a “settled practice in the administration of the 

income-tax laws.”150 This practice was subsequently 

described as “consistent” in 1922,151 and “long established” in 1938.152

The courts also consistently permitted nonexempt 

cooperatives to deduct or exclude patronage refunds 

from taxable income, if certain conditions were 

met, even though no statutory provision specifically 

148 T.D. 2737, 20 Treas. Dec. Int. Rev. 441-442 

(1918).

149 These points are reiterated in I.T. 1499, I-2 C.B. 

189 (1922).

150 T.D. 2737, 20 Treas. Dec. Int. Rev. 441, 442 

(1918).

151 I.T. 1499, I-2 C.B. 189, 191 (1922).

152 .T. 3208, 1938-2 C.B. 127.
Cooperative Information Report 44-1 35

excepted such refunds from taxation.153

This administrative practice remained in effect 

until the deductibility of patronage refunds by all 

cooperatives was codified in the Revenue Act of 

1962. In 1959, the U.S. Tax Court adroitly summarized the rationale and requirements for exclusion of 

patronage refunds:

The basis for the Commissioner’s policy 

in allowing the exclusion of patronage dividends by nonexempt cooperatives is that such 

dividends in reality represent either rebates to 

patrons of a part of the price initially paid by 

them on purchases made through a cooperative purchasing organization, or an additional 

cost paid by a cooperative marketing organization to its patron for products sold to it. 

The propriety of the respondent’s practice in 

per-mitting such exclusions by non-exempt 

cooperative associations has been recognized 

and sustained by this and other courts (cites 

omitted).

The foregoing decisions indicate that an 

alloca-tion of earnings by a cooperative to 

its patrons cannot qualify as a true patronage 

dividend unless (1) the allocation was made 

pursuant to a legal obligation which existed at

 the time the participating patrons transacted 

their business with the cooperative, (2) the 

allocation was made out of profits or income 

realized from transactions with the particular 

patrons for whose benefit the allocation was 

made, and (3) the allocation of earnings was 

made ratably to the particular patrons whose 

patronage created the income from which the 

allocated refund was made (cites omitted).154

153 Homebuilders Shipping Ass’n v. Commissioner, 

8 B.T.A. 903 (1927); Anamosa Farmers Creamery Co, v. 

Commissioner, 13 B.T.A. 907 (1928); Midland Cooperative Wholesale v. Commissioner, 44 B.T.A. 824 (1941); 

San Joaquin Valley Poultry Producers Ass’n v. Commissioner, 136 F.2d 382 (9th Cir. 1943); United Cooperative 

v. Commissioner, 4 T.C. 93 (1944); Farmers Cooperative 

Co. v. Birmingham, 86 F. Supp. 201 (N.D. Iowa 1949); 

Colony Farms Cooperative Dairy v. Commissioner, 17 

T.C. 688 (1951); Southwest Hardware Co. v. Commissioner, 24 T.C. 75 (1955).

154 Farmers Cooperative Co. v. Commissioner, 33 

The Farmers Cooperative Co. decisions refer to 

the nontax status of patronage refunds as an exclusion, not a deduction. An early Treasury Decision 

suggested patronage refunds should be deducted as 

a cost of goods.155 For some time, neither Treasury 

nor the courts seemed concerned about whether 

patronage refunds were excused from taxation as a 

“deduction” or an “exclusion.” The terms were used 

virtually interchangeably. As the distinction had no 

impact on the tax due from the cooperative of the 

recipient, this indifference is understandable.

As an exercise in understanding taxation and cooperatives, the proper classification of the patronage 

refund would be as an exclusion from income of the 

cooperative. A deduction is an amount includable 

in the income of a taxpayer and then excused from 

taxation under a specific provision of tax law. An 

amount is excluded from taxable income of a taxpayer if it was never really income to the taxpayer 

in the first place. As no statutory provision provided 

for the deduction of patronage refunds by nonexempt cooperatives, their nontax status would rest on 

their never having been income to the cooperative.

Treasury recognized this distinction in a 1938 ruling, when it stated:

Under long established Bureau practice, 

amounts payable to patrons of cooperative 

corporations as so called patronage dividends 

have been consistently excluded from the 

gross income of such corporations. The practice is based on the theory that such amounts 

in reality represent a reduction in cost to the 

T.C. 266 (1959). The Tax Court denied the cooperative’s 

patronage refund deduction because the cooperative 

did not provide a timely written notice to patrons explaining the allocation. The Eighth Circuit, quoting the 

above language with approval, reversed the Tax Court 

on the grounds the neither a statute nor a valid regulation required a written notice. Farmers Cooperative Co. 

v. Commissioner, 288 F.2d 315, 317 (1961). Congress 

clarified the issue when it wrote the written notice of 

allocation requirement into subchapter T as part of the 

Revenue Act of 1962.

155 T.D. 2737, 20 Treas. Dec. Int. Rev. 441, 442 

(1918). See also, A.R.R. 6967, holding a patronage 

refund “should be allowed as a deduction....” III-1 C.B. 

287, 290 (1924).
36 Income Tax Treatment of Cooperatives: Background

patron of goods purchased by him through the 

corporation or an additional consideration due 

the patron for goods sold by him through the 

corporation. As such amounts are not includable in gross income of the corporation, they 

are obviously not deductible by it, though, 

where they have been erroneously included in 

gross income in the first instance, the correcting adjustment is sometimes loosely termed a 

deduction.156

The courts were somewhat slow in recognizing 

this distinction.157 By the early 1950’s, the status of 

the patronage refund as an exclusion was generally 

accepted.158

Patronage Refund Requirements

The most important information to be learned from 

administrative rulings and judicial decisions permitting exclusion of patronage refund payments 

for cooperatives prior to statutory definition is the 

set of requirements or elements a patronage refund 

had to have before it was afforded that treatment. 

These same requirements have found their way into 

subchapter T of the Code, under which cooperatives 

are presently taxed.

Preexisting Legal Obligation

 The preexisting legal obligation was recognized as 

a basic patronage refund requirement early in the 

development of patronage refund exclusion practices.159 The preexisting legal obligation could be 

156 I.T. 3208, 1938-2 C.B. 127-128. See also Gen. 

Couns. Mem. 17,895, 1937-1 C.B. 56.

157 See, e.g., Midland Cooperative Wholesale v. 

Commissioner, 44 B.T.A. 824 (1941) Patronage refunds 

were referred to as a “deduction” throughout the opinion.

158 Colony Farms Cooperative Dairy, Inc. v. Commissioner, 17 T.C. 688 (1951); Dr. P. Phillips Cooperative v. Commissioner, 17 T.C. 1002 (1951); Southwest 

Hardware Co. v. Commissioner, 24 T.C. 75 (1955); 

Pomeroy Cooperative Grain Co. v. Commissioner, 288 

F.2d 326 (1961), rev’g, on other grounds, 31 T.C. 674 

(1958).

159 Patronage refunds were excepted from taxation 

where made “in accordance with by-laws or published 

rules regularly adhered to....” T.D. 2737, 20 Treas. Dec. 

Int. Rev. 441, 442 (1918). See also I.T. 1499, I-2 C.B. 

189, 191 (1922).

created by a state statute,160 the articles and bylaws 

of the cooperative,161 or a contract between the 

producers and the cooperative.162 The preexisting 

legal obligation was found when cooperatives were 

obligated to make patronage refunds without additional corporation action.163

Cooperatives were denied exclusion for amounts 

paid as patronage if the required preexisting legal 

obligation did not exist. A provision in a cooperative’s articles of incorporation requiring that bylaws 

provide, in whole or in part, for distribution of net 

margins on the basis of business done with the cooperative failed to provide the necessary obligation 

where the bylaws were silent and there was no other 

action.164

Adoption of a resolution declaring payment after 

the underlying margins were earned was held to be 

an insufficient obligation because no preexisting 

obligation existed.165 Obligations not legally binding 

upon the cooperative were insufficient, even though 

members and the cooperative had an “understanding” that surplus would be returned at year’s end.166

In one case, the court held that where a cooperative could pay dividends on capital stock up to 

160 Midland Cooperative Wholesale v. Commissioner, 44 B.T.A. 824 (1941).

161 San Joaquin Valley Poultry Producers Ass’n v. 

Commissioner, 136 F.2d 382 (9th Cir. 1943); Colony 

Farms Cooperative Dairy, Inc. v. Commissioner, 17 T.C. 

688 (1951); Albany Creamery Ass’n v. United States, 

1951 1 U.S.T.C. & 9526 (D. Ore. 1950).

162 Dr. P. Phillips Cooperative v. Commissioner, 17 

T.C. 1002 (1951) (written contract); Southwest Hardware Company v. Commissioner 24 T.C. 75 (1955) 

(binding oral agreement implied).

163 United Cooperatives, Inc. v. Commissioner, 4 

T.C. 93 (1944), acq., 1945 C.B. 6.

164 Farmers Union State Exchange v. Commissioner, 30 B.T.A. 1051, 1066 (1934) (“...there should have 

been some declaration or act on the part of the directors 

with respect to payment of patronage dividends.”). See 

also Fruit Growers’ Supply Co. v. Commissioner, 21 

B.T.A. 315 (1930), aff’d 56 F.2d 90 (9th Cir. 1932) (The 

bylaws required the board to declare patronage refunds 

and the board did not do so)

165 Peoples Gin Co. v. Commissioner, 118 F.2d 72 

(5th Cir. 1941), aff’g, 41 B.T.A. 343 (1940).

166 American Box Shook Export Ass’n v. Commissioner, 4 T.C. 758 (1945), aff’d, 156 F.2d 629 (9th Cir. 

1946).
Cooperative Information Report 44-1 37

8 percent, but paid all net margins as patronage 

refunds, only the refunds in excess of the potential 

stock dividend payment qualified as being paid 

under a preexisting legal obligation.167

If the obligation is too vague, it may be held to 

be nonexistent.168 Likewise, a poorly drafted article 

of incorporation can defeat a legitimate attempt to 

create the preexisting condition.169

In one instance the court questioned whether 

the failure to have a preexisting legal obligation to 

return net margins as patronage refunds called into 

question the status of the organization as being a 

cooperative.170 Because the status of “cooperative” 

conveyed no exclusion in and of itself, the failure 

to be a cooperative had the same consequence as 

a simple disqualification of the patronage refund 

exclusion for failure to establish the pre-existing 

obligation.

Patronage Business Requirement

Patronage refund exclusion was historically, as 

now, extended only to refunds based upon business 

done with or for patrons on a cooperative basis. 

Numerous early rulings recognized that a cooperative could have income not eligible for exclusion 

as a patronage refund. These amounts, even if 

distributed to members on a patronage basis, could 

not qualify as an excludable patronage refund.171

Thus,the distinction between income from patron

167 United Cooperatives, Inc. v. Commissioner, 4 

T.C. 93 (1944), acq., 1945 C.B. 6

168 See, e.g., Farmers Union Co-op Co. of Guide 

Rock, Neb. v. Commissioner, 90 F.2d 488 (8th Cir. 

1937). State law and the cooperative’s organizational 

papers required only some undefined “part” of net margins be distributed as patronage refunds.

169 Associated Grocers of Ala. v. Willingham, 77 F. 

Supp. 990 (N.D. Ala. 1948). The cooperative’s charter 

provided only that it had the “right in the discretion of 

the board of directors” to pay patronage refunds, not a 

straightforward obligation.

170 American Box Shook Export Ass’n v. Commissioner, 4 T.C. 758 (1945), aff’d, 156 F.2d 629 (9th Cir. 

1946).

171 I.T. 1499, I-2 C.B. 189 (1922); I.T. 3208, 1938-2 

C.B. 127; Rev. Rul. 57-59, 1957-1 C.B. 24; Pomeroy 

Cooperative Grain Co. v. Commissioner, 288 F.2d 326 

(8th Cir. 1961), rev’g in part, aff’g in part, 31 T.C. 674 

(1958).

age and nonpatronage sources was a part of early 

cooperative tax considerations.172

Administrative and judicial refusal to extend patronage refund exclusion to nonpatronage earnings 

rested on the fact that the character of nonpatronage 

income was such that it actually belonged to the 

cooperative entity. Suppose a cooperative dealt with 

nonmembers at a profit and attempted to exclude 

from its income all amounts refunded to memberpatrons, including the margins from nonmember 

business. Nonmember business net income could 

receive no special treatment no matter how it was 

distributed. As the court in Fruit Growers Supply 

Co. v. Commissioner said:

The simple fact is that, to the extent to which 

the [cooperative] engaged in the business 

of purchasing supplies and furnishing such 

supplies to nonmembers, it was not doing 

the type of business exempted by law, and its 

profit thus derived was taxable as income under the general provision of the revenue law, 

regardless of the disposition made of these 

profits by the corporation. We cannot believe 

that the method by which this income is distributed to the members detracts in anywise 

from the fact that the profit is essentially an 

income to the corporation....173

Distributed on a Patronage Basis

The early rulings permitting exclusion of patronage 

refunds recognized cooperatives made some payments that were not based on business done with 

the cooperative. An example frequently cited was 

dividends paid on capital stock. Dividends were 

usually distributed in proportion to stock ownership 

rather than on the basis of business done with the 

cooperative.

Net margins available for distribution as excludable patronage refunds were reduced by dividends 

on capital stock. As stated in A.A.R. 6967, “From 

[gross income] deduct the fixed dividend paid or 

payable on any outstanding capital stock. The 

172 Distinguishing patronage and nonpatronage 

income is the subject of chapter 5, in part 2 of these 

reports.

173 Fruit Growers’ Supply Co. v. Commissioner, 56 

F.2d 90, 93 (9th Cir. 1932), aff’g, 21 B.T.A. 315 (1930).
38 Income Tax Treatment of Cooperatives: Background

amount of such fixed dividend is the portion of net 

income properly attributable to the investment made 

in the association by the holders of any outstanding 

capital stock.”174

Dividends on capital stock were not deductible 

for a non-exempt cooperative any more than for a 

noncooperative corporation.175

Under some circumstances, cooperatives that 

paid dividends on stock lost their exclusion for a 

portion of their patronage refunds. A preexisting 

legal obligation was held not to extend to any net 

margins that could have been, by cooperative decision, paid out as dividends on capital stock rather 

than as patronage based refunds.176

The courts have addressed whether a payment 

to member shareholders was a dividend on capital 

stock, thus nondeductible, or a cost of goods sold. 

Juneau Dairies, Inc, v. Commissioner held that contracts between a cooperative and its four members 

to pay a bonus of the cooperative’s entire net profits 

“as and when declared by the directors” were contracts to pay dividends. The distribution was “made 

to shareholders because they were shareholders,” 

not because they patronized the cooperative. The 

court rejected an argument that because payments 

were not made in proportion to shares of stock held, 

payments could not be dividends.177 A similar result 

was reached when distributions failed to meet the 

preexisting obligation test when made as a result of 

board resolution at the end of the year.178

The courts were sometimes reluctant to support 

patronage refund status when the cooperative failed 

to clearly establish a distribution from the cooperative to its patrons had taken place. Exclusion was 

174 A.R.R. 6967, III-1 C.B. 287, 289 (1924).

175 Gallatin Farmers Co. v. Commissioner, 132 F.2d 

706 (9th Cir. 1942); Appeal of the Trego County Cooperative Ass’n, 6 B.T.A. 1275 (1927); Juneau Dairies, Inc. 

v. Commissioner, 44 B.T.A. 759 (1941).

176 United Cooperatives, Inc. v. Commissioner, 4 

T.C. 93 (1944), acq., 1945 C.B. 6. Under subchapter T, 

the amount remaining after the actual dividend is paid, 

even though bylaws permit a larger dividend payout, 

qualifies for distribution as a patronage refund from tax 

purposes. Rev. Rul. 69-621, 1969-2, C.B. 167.

177 Juneau Dairies, Inc. v. Commissioner, 44 B.T.A. 

759, 763 (1941).

178 Peoples Gin Co. v. Commissioner, 118 F.2d 72 

(5th Cir. 1941), aff’g, 41 B.T.A. 343 (1940).

not permitted where some net margins were not 

allocated or distributed to patrons but were placed 

instead in a working capital reserve.179 Patronage 

refund status was also denied when the court was 

not convinced the patrons had sufficient interest in 

funds placed in an allegedly allocated reserve to 

establish the funds belonged to the patrons and not 

to the cooperative.180

In another case, however, amounts allocated and 

credited to patrons’ accounts were excluded from 

the cooperative’s income where patrons’ rights in 

the reserve were established and no further action 

by the cooperative was required to bind the cooperative to payment.181

Computing the Patronage Refund

Early administrative instructions (1924) outlined 

computation of patronage refunds as follows:

First compute the apparent net income of 

the cooperative association. From this amount 

deduct the fixed dividend paid or payable on 

any outstanding capital stock. The amount 

of such fixed dividend is the portion of net 

income properly attributable to the investment 

made in the association by the holders of any 

outstanding capital stock.

The balance consists of (1) the amount 

available for refund to the members of the 

association and (2) the profits made from nonmembers. In the absence of evidence to the 

contrary, it will be assumed that the dealings 

with members and nonmembers are equally 

profitable, and, accordingly, that the amount 

available for refund consists of that proportion 

of the apparent net profits, after deducting the 

fixed dividend on outstanding capital stock, 

which the amount of business transacted with 

members bears to the entire amount of business transacted. Up to the amount available 

for refund thus computed, a distribution by 

179 Cooperative Oil Ass’n v. Commissioner, 115 

F.2d 666 (9th Cir. 1941).

180 Fountain City Co op Creamery Ass’n v. Commissioner, 172 F.2d 666 (7th Cir. 1949), aff’g, 9 T.C. 

1077 (1947).

181 Midland Cooperative Wholesale v. Commissioner, 44 B.T.A. 824 (1941).
Cooperative Information Report 44-1 39

a cooperative association to its members, 

upon the basis of the business transacted with 

them, will be deemed to be a true patronage 

dividend, deductible by the association in 

computing its taxable net income for Federal 

income and profits tax purposes.182 

This ruling was an early recognition that a cooperative could have income not eligible for exclusion 

as a patronage refund where it did business with 

nonmembers and did not pay patronage refunds to 

nonmembers.

This approach was applied in Farmers Union 

Cooperative Exchange v. Commissioner.183 The 

cooperative paid no stock dividends. The association divided its net income between patronage and 

nonpatronage categories on the basis of the percentage of business it conducted on each basis.

The Commissioner assessed the association with 

a deficiency, arguing a cooperative had to reduce 

net book earnings by the amount of Federal income 

taxes due before applying the percentage rates to 

determine deductible patronage-sourced income. 

This argument was summarily dismissed by the 

Board of Tax Appeals, which found:

The purpose of the computation provided 

by the regulation (A.R.R. 6967) is clear. What 

is sought is the segregation of the earnings 

from business done with members. These are 

available for return in rebates to them and, as 

such, constitute a proper deduction by petitioner, leaving subject to tax only the profit 

accruing from nonmember business.

...If Federal taxes and penalties, which are 

a burden borne by the profits accruing from 

nonmember business, are deducted from the 

total net income before application of the percentage of the member business to total business, in determining the amount of the profit 

from the total business returnable in rebates 

to members, it may be readily seen that the 

result of the computation is to include with 

the taxable profit accruing from nonmember

182 A.R.R. 6967, III-1 C.B. 287, 289 (1924).

183 Farmers Union Cooperative Exchange v. Commissioner, 42 B.T.A. 1200 (1940).

business a portion of that derived from sales 

to members.184

Noncash Refund Payments

The unique role of patrons as the principal source of 

capital for cooperatives led to the development of 

special financing techniques, most notably the issuance of an equity interest instead of cash as a form 

of patronage refund payment. While the Treasury 

Department was at times reluctant to recognize noncash allocations as excludable patronage refunds,185

the courts were generally supportive.

In Anamosa Farmers Creamery Co. v. 

Commissioner,

186 the cooperative, pursuant to a 

bylaw provision, retained its entire margin and 

credited it to patrons’ accounts in proportion to the 

amount of cream delivered during the year. The 

cooperative was assessed a deficiency for taxes 

allegedly due on the entire allocation. The Board 

of Tax Appeals held the allocation should not be 

included in the taxable income of the cooperative, 

even though no cash was paid to patrons. 

The exclusion of noncash patronage refunds was 

attacked again in Midland Cooperative Wholesale v. 

Commissioner.187 Treasury asserted the cooperative 

knew earnings placed in an unallocated, permanent 

reserve would be included in taxable income. Therefore placing them into a patronage-based, allocated 

reserve should be treated as an unauthorized tax

avoidance scheme. In contrast, the Board of Tax Appeals found that so long as the underlying patronage 

refund met the requirements for exclusion, whether 

the refund was in cash or noncash form was not 

material. The noncash patronage refund was excludable from the taxable income of the cooperative.

In another case, the U.S. Court of Appeals for the 

Ninth Circuit reached the same conclusion, stating: “The fact that the sums were not payable to the 

members on demand, or at any fixed time,

184 Id. at 1202.

185 The Service did acknowledge patronage refund 

status of funds retained pursuant to a State law in the socalled “Iowa ruling,” I.T. 3208, 1938-2 C.B. 177.

186 Anamosa Farmers Creamery Co. v. Commissioner, 13 B.T.A. 907 (1928). See also Growers Cold 

Storage Co. v. Commissioner, 17 B.T.A. 1279 (1929).

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

(1941). See also United Cooperative, Inc. v. Commissioner, 4 T.C. 93, 108 (1944), acq., 1945 C.B. 6.
40 Income Tax Treatment of Cooperatives: Background

does not alter the fact that they were their property 

and not [the cooperative’s]. [The cooperative] held 

them, not as owner, but as agent or trustee for the 

members.”188

In Colony Farms Cooperative Dairy, Inc. v. Commissioner, the Service again challenged the exclusion of noncash patronage refunds from a cooperative’s taxable income. The court, in rejecting the 

Service’s position, discussed the nature of a noncash 

patronage refund:

It must be kept in mind that the funds 

represented by these certificates of interest are 

retained by the corporation with the consent 

of its members and represent an investment 

by each of them in the business to the same 

extent as if the distribution had been made 

in cash and the amount in each instance had 

been repaid by the member to the association 

for its use as working capital.

 That the distributions in the form of 

certificates of interest effected a distribution 

of the earnings just as effectively as though 

made in the form of cash, it is thought, cannot 

be disputed.189

In Farmers Cooperative Co. v. Commissioner,

190

the Service made one more challenge to the exclusion of noncash patronage refunds shortly before the 

enactment of Subchapter T in 1962. Certain court 

decisions had held that noncash patronage refunds 

were not taxable income to the patron recipients.191

The Service argued that cooperative earnings are 

income to someone, and if the noncash patronage 

refunds are not taxable income to the patrons, they 

188 San Joaquin Valley Poultry Producers Ass’n v. 

Commissioner, 136 F.2d 382, 385 (9th Cir. 1943).

189 Colony Farms Cooperative Dairy v. Commissioner, 17 T.C. 688, 693-694 (1951). See also Dr. P. 

Phillips Cooperative v. Commissioner, 17 T.C. 1002, 

1011 (1951); Southwest Hardware Company v. Commissioner, 24 T.C. 75, 84-86 (1955).

190 Farmers Cooperative Co. v. Commissioner, 288 

F.2d 315 (8th Cir. 1961, rev’g 33 T.C. 266 (1959).

191 Commissioner v. Carpenter, 219 F.2d 635 (5th 

Cir. 1955), aff’g, 20 T.C. 603 (1953) (cash basis taxpayer); Long Poultry Farms, Inc. v. Commissioner, 249 F.2d 

726 (4th Cir. 1957), rev’g, 27 T.C. 985 (1957) (accrual 

basis taxpayer

must remain taxable income to the cooperative. The 

U.S. Court of Appeals for the 8th Circuit acknowledged the logic of the Service’s position. Nonetheless, it noted noncash refunds had been excluded 

from taxable income of cooperatives for decades 

and Congress had taken no action to alter this fact. 

Therefore they would remain a proper exclusion.192

 Noncash patronage refunds could be issued as 

debt instruments rather than equity instruments. 

When promissory notes were credited to patrons 

in specific amounts to represent patronage refund 

amounts and were carried at that value as cooperative liabilities, the face amount was accrued income 

to patrons.193

In summary, prior to enactment of subchapter T 

in 1962, the law was firmly established that cooperatives could exclude patronage refunds from 

income for tax purposes. The exclusion was not 

based on statutory authority, but rather a recognition 

that such refunds belonged to the patrons and not to 

the cooperative. To qualify for exclusion, the refund 

allocation had to be made (1) pursuant to a legal 

obligation which existed at the time the participating patrons transacted their business with the cooperative, (2) out of earnings from transactions with 

the particular patrons to whom the refunds are paid, 

and (3) on the basis of the amount of business each 

patron conducted with the cooperative.194

PRE-1951 TAX LEGISLATION:

THE ROAD TO SECTION 521

The first Federal tax statute to refer to farmer 

cooperatives was the Revenue Act of 1898. That 

law had a section providing for stamp taxes, which 

contained the following exception:

...the provisions of this section shall not 

apply to any fraternal, beneficiary society, or 

192 Farmers Cooperative Co. v. Commissioner, 288 

F.2d 315 (8th Cir. 1961), rev’g 33 T.C. 266 (1959). See 

also Pomeroy Cooperative Grain Co. v. Commissioner, 

288 F.2d 326 (8th Cir. 1961), rev’g 31 T.C. 674 (1958).

193 Bradshaw v. Commissioner, 14 T.C. 162 (1950); 

Southwest Hardware Co. v. Commissioner, 24 T.C. 75 

(1955).

194 Farmers Cooperative Co. v. Commissioner, 288 

F.2d 315, 317 (8th Cir. 1961), rev’g 33 T.C. 266 (1959).
Cooperative Information Report 44-1 41

order, or farmers’ purely local cooperative 

company or association, or employees’ relief 

associations operated on the lodge system, or 

local cooperation plan, organized and conducted solely by the members thereof for the 

exclusive benefit of its members and not for 

profit.195

This exemption was the first step in creating true 

tax-exempt status for certain farmers’ cooperatives 

that lasted until 1951, and continues in modified 

form today as section 521 tax status.

Agricultural and Horticultural Organizations

Exemption: 1909-1916

Section 38 of the 1909 Tariff Act provided a tax on 

the net income of every corporation, organized for 

profit and having capital stock. That law contained a 

specific exemption for “agricultural and horticultural organizations...no part of the net income of which 

inures to the benefit of any private stockholder or 

individual.”196

In Flint v. Stone Tracy Co.,197 the U.S. Supreme 

Court distinguished Pollack198 and upheld the constitutionality of the corporate tax. The Court noted:

As to the objections that certain organizations, labor, agricultural, or horticultural...are 

excepted from the operation of the law, we 

find nothing in them to invalidate the tax. As 

we have had frequent occasion to say, the decisions of this court from an early date tothe 

present time have emphasized the right of 

Congress to select the objects of excise taxation, and within this power to tax some and 

leave others untaxed, must be included the 

right to make exemptions such as are found in 

this act.199 

The Revenue Act of 1913, enacted shortly after 

ratification of the 16th amendment, established a 

195 30 Stat. 448, 461 (1989

196 Act of August 5, 1909, ch. 6, § 38, 36 Stat. 11, 

113.

197 Flint v. Stone Tracy Co., 220 U.S. 107 (1911).

198 Pollack v. Farmers’ Loan and Trust Co., 158 

U.S. 601 (1985).

199 Flint v. Stone Tracy Co., 220 U.S. at 173.

comprehensive personal and corporate income tax 

scheme. The 1913 act did not specifically mention 

cooperatives. It did, however, contain a general exemption for all farm organizations, based on section 

38 of the 1909 act. The 1913 act stated, “[N]othing 

in this section shall apply to labor, agricultural or 

horticultural organizations....”200

In discussing these exemptions, the Supreme 

Court said:

The statute provides that the tax should 

not apply to enumerated organizations or 

corporations, such as labor, agricultural or 

horticultural organizations...and the argument 

is that as the Amendment authorized a tax on 

incomes ‘from whatever source derived,’ by 

implication it excluded the power to make 

these exemptions. But this is only a form of 

expressing the erroneous contention as to the 

meaning of the Amendment, which we have 

already disposed of. And so far as this alleged 

illegality is based on other provisions of the 

Constitution, the contention is also not open, 

since it was expressly considered and disposed of in Flint v. Stone Tracy Co.201

In 1914, the Treasury Department, in its first 

interpretation of this language in a cooperative context, issued a regulation finding cooperative dairies, not issuing stock and paying patronage refunds 

based on the percentage of butter fat in milk furnished, were tax exempt under this provision.202

This regulation was supplanted within a few 

months by Treasury Decision 1996, holding cooperative dairies, “no matter how organized, do not 

appear to fall within any of these exempted classes” 

under the act. Insofar as applicable, this ruling was 

extended to mutual or cooperative telephone 

200 Subsection G, section 2, Act of October 13, 

1913, 38 Stat. 172 (1913).

201 Brushaber v. Union Pacific Railroad Co., 240 

U.S. 1, 21 (1916).

202 Art. 92 of Income Tax Regulations No. 33 (Jan. 

5, 1914), published at 16 Treas. Dec. Int. Rev. 29, 62 

(1914).
42 Income Tax Treatment of Cooperatives: Background

companies, farmers’ insurance companies, and like 

organizations.203

In late 1914, the Treasury Department published 

a synopsis of rulings on the income tax act of 1913. 

In describing the exemption for agricultural and 

horticultural associations, Treasury found it was 

limited to “associations as county fairs, or like 

organizations, not themselves engaged in agricultural or horticultural pursuits, but which, by means 

of awards, premiums, etc., are intended to encourage better production and no part of whose income 

inures to the benefit of any private stockholder or 

individual (emphasis added).”204

Since these early rulings, farmer cooperatives 

have been denied use of the agricultural organizations exemption. An attempt by a cooperative to 

qualify for tax exempt status as a business league 

was also unsuccessful.205

Early Cooperative Exemption: 1916-1926

The first specific statutory exemption for agricultural cooperatives was contained in the Revenue Act 

of 1916. Exempt status was provided to:

Farmers’, fruit growers’, or like association, organized and operated as sales agent for 

the purpose of marketing the products of its 

members and turning back to them the proceeds of sales, less the necessary selling expenses, on the basis of the quantity of produce 

furnished by them. 

203 T.D. 1996, 16 Treas. Dec. Int. Rev. 100 (June 15, 

1914) (Art. 92 revoked). In their returns, such cooperatives 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 expenses was regarded as net 

income and taxable to the cooperative

204 T.D. 2090, 16 Treas. Dec. Int. Rev. 259, 276 

(Dec. 14, 1914). This ruling was based on a Treasury 

Decision holding a corporation engaged in agricultural 

pursuits for profit was not exempt under § 38 of the 1909 

Act. T.D. 1737, 14 Treas. Dec. Int. Rev. 118 (1911).

205 The agricultural and horticultural organizations 

exemption is currently codified at I.R.C. § 501(c)(5). An 

attempt by a cooperative to revive the issue and use the 

exemption to avoid paying employment taxes under the 

Social Security Act was unsuccessful. Squire v. Sumner 

Rhubard Growers’ Ass’n, 184 F.2d 94 (9th Cir. 1950).

This language was repeated, with insignificant 

editorial changes, as section 231(11) of the Revenue 

Act of 1918, the Revenue Act of 1921, and the Revenue Act of 1924. 

Administrative Interpretations of the

Early Revenue Acts

On its face, the exemption appeared quite narrow. 

Early Treasury Department interpretations of the 

“marketing cooperative” language held marketing 

activity was covered only if (1) the cooperative did 

all its marketing business with members and (2) 

functioned strictly as a sales agent. 

The early 1920’s were a period of significant 

growth in the number, size, and complexity of cooperative organizations. Regulatory decisions during 

this period facilitated that growth by broadening the 

scope of the tax exemption for agricultural cooperatives. 

Capital stock

A 1920 opinion of the Solicitor of Internal Revenue found nothing in the statutory language to bar 

exemption for a farm marketing cooperative “having capital stock on which it pays a fixed dividend 

amounting to the legal rate of interest, and all of 

which capital stock is owned by such farmers.” In 

early 1921, the Solicitor’s language was added virtually verbatim to article 522 of the regulations. 

 A 1923 regulatory amendment modified the rule 

that all capital stock had to be owned by farmer-patrons to only require “substantially” all stock be so 

owned. Regulations published in 1924 first relaxed 

this standard to only require that “voting control is 

retained by the shareholders who are actual producers,” and then reinstated the “substantially all” rule. 

An 8 percent upper limit on dividends payable by 

an exempt cooperative was added to the regulations 

in 1924. 

Reasonable reserves

Regulations issued in 1922 authorized the accumulation of reasonable reserves “for depreciation or 

possible losses or a reserve required by State statute.” The list of purposes for which permissible reserves could be accumulated was subsequently expanded to also include “a reasonable sinking fund or 

surplus to provide for the erection of buildings and 
Cooperative Information Report 44-1 43

facilities required in business, or for the purchase 

and installation of machinery and equipment, or to 

retire indebtedness incurred for such purposes.” 

Resale cooperatives 

The requirement that exempt cooperatives operate 

strictly as agents for their farmer-patrons was relaxed in 1923 to permit exempt associations to take 

title and directly market farm products. 

Nonmember business. The term “member” was 

deleted or replaced with “producer” in several 

places in the 1923 regulations, clearing the way for 

limited dealings with nonmembers. 

Federated cooperatives

In 1924, the Treasury Department issued a brief 

statement to the effect that federated farmer cooperatives were entitled to exemption from taxation. 

This ruling was not reflected in the regulations, nor 

is the status of federated cooperatives mentioned in 

subsequent legislation.

Purchasing and Dual-Function Cooperatives

Regulations promulgated to implement early versions of the farmer cooperative exemption noted 

that cooperative associations acting as purchasing 

agents were not expressly exempt from tax. Such 

associations were, however, permitted to exclude 

patronage refunds from taxable income. 

In 1921 the farmers’ cooperative exemption was 

broadened to cover cooperative purchasing of farm 

supplies. The new language covered cooperatives:

...organized and operated as purchasing 

agents for the purpose of purchasing supplies 

and equipment for the use of members and 

turning over such supplies and equipment to 

such members at actual cost, plus necessary 

expenses. 

 After the cooperative exemption was expanded 

to include purchasing cooperatives, the regulations 

were updated to acknowledge that supply cooperatives also qualified for exempt status, provided they 

only acquired farm supplies for members and had 

no net income for their own accounts. The regulations were further amended to permit purchasing 

cooperatives to accumulate reasonable reserves for 

the same purposes as marketing cooperatives and to 

do business with nonmember farmers. 

The regulations also recognized that the same 

cooperative association could provide both marketing and purchasing services for its members. These 

dual-function cooperatives were permitted exempt 

status, provided each function met the requirements 

for exemption applicable to that function. 

Revenue Act of 1926

Legislative history leading to enactment of the 

Revenue Act of 1926 indicates general agreement 

existed that the regulations were somewhat more 

generous to cooperatives than the underlying statutes. The record also suggests that revenue bureau 

agents were ignoring the regulations and denying 

applications for exempt status if the cooperative, for 

example, had any outstanding stock owned by persons other than producer/patrons or did even limited 

nonmember business. 

At the urging of cooperatives, these regulatory 

opinions were all written into law in the Revenue 

Act of 1926. Section 231(12) of the 1926 act introduced the definition of a farmer cooperative contained in section 521 of the current Code, with the 

exception of the “government business” provision. 

The government busi-ness calculation provision 

was added in 1934. 

In summary, the section 231(12) of the Revenue 

Act of 1926 and the subsequent re-enactments provided these guidelines for cooperatives qualifying 

for tax-exempt status:

1. They must be organized by farmers on a cooperative basis.

2. A cooperative may act as principal as well as 

agent and thus take title to goods marketed or 

purchased.

3. Proceeds in excess of expenses and permitted reserves must be returned to all patrons 

(members and nonmembers alike) on the basis 

of the proportion of the cooperative’s business 

attributable to each patron.

4. A cooperative may issue capital stock, provided the dividend rate on such stock does not 

exceed the legal rate of interest in the State 

of incorporation, or 8 percent, whichever is 

greater.
44 Income Tax Treatment of Cooperatives: Background

5. Substantially all stock except nonvoting, nonprofit-sharing preferred stock must be owned 

by producers who market their products and 

purchase their supplies through the cooperative.

6. Reserves required by State law, and reasonable reserves for any necessary purpose, may 

be accumulated.

7. Nonmember business is permissible. The 

value of member marketing business and 

member purchasing business must exceed 

like nonmember business. Also, purchases for 

person who are neither members nor producers must not exceed 15 percent of the value of 

all purchases. 

In applying the language of the 1926 act, the 

courts held that for a cooperative to be exempt, it 

must not only be organized as required by the Code, 

it must be operated that way. The fact that a cooperative was organized and operated under a State 

statute governing farmer cooperative associations 

did not make the cooperative a tax-exempt entity. 

Whether an association qualified for tax-exempt 

status depended solely on meeting the requirements 

of Federal tax law. 

The definition of a farmer cooperative found in 

the Revenue Act of 1926 has remained unchanged, 

although complete exemption gave way to limited 

exemption in 1951. This consistency permits citation of administrative rulings and judicial decisions 

predating the current tax scheme for cooperatives to 

explain present day requirements in the Code.

REVENUE ACT OF 1951

The exclusion of patronage refunds by cooperatives was the subject of vigorous attack in the late 

1940’s. In spite of this attack, Congress passed 

legislation in 1951 only affecting the exemption 

for agricultural cooperatives, but rejecting efforts 

to include patronage refunds in gross income of 

cooperatives. In doing so, Congress recognized and 

retained the long-established single tax concept on 

the assumption that noncash allocations were taxed 

to patrons as if distributed in cash and reinvested in 

the cooperative.

The Revenue Act of 1951 retained the definition 

of farmer cooperative previously used to describe 

qualification for tax exemption, the definition found 

in the current section 521. Qualifying cooperatives 

were, however, no longer exempt from all tax. A 

new tax system for previously exempt cooperatives 

was introduced, and longstanding administrative 

practice related to treatment of patronage refunds 

made by nonexempt cooperatives was recognized, 

although in passing, in statutory language.

The Revenue Act of 1951 made several changes 

in the existing statutory law on cooperative income 

tax treatment. First, it made previously exempt 

cooperatives subject to corporate income tax, while 

still referring to them, now erroneously, as “exempt.” 

The 1951 act granted previously exempt cooperatives two deductions that still distinguish section 

521 cooperatives’ taxation from other cooperatives. In computing its taxable income, a previously 

exempt cooperative could deduct from gross income 

“amounts paid as dividends during the taxable year 

on capital stock,” and “amounts allocated during the 

taxable year to patrons with respect to its income 

not derived from patronage (whether or not such income was derived during such taxable year).” These 

two deductions were “in addition to other deductions allowable under this chapter.” 

The act acknowledged the exclusion of patronage refunds from taxable income by nonexempt 

cooperatives. Patronage refunds made by previously 

exempt cooperatives were to be “taken into account 

in computing taxable income in the same manner as 

in the case of a cooperative organization not exempt 

under subparagraph (A).” 

The act described noncash distributions in terms 

foreshadowing written notices of allocation. Patronage refunds could be “paid” in “capital stock, 

revolving fund certificates, retain certificates, certificates of indebtedness, letters of advice, or in some 

other manner that discloses to each patron the dollar 

amount of such dividend, refund, or rebate.” 

The concept now called the “payment period” 

was noted in the act by saying allocations made 

after the close of a co-op’s taxable year but by the 

15th day of the 9th month following the close of 

the taxable year were to be considered made on the 

last day of the taxable year, but only to the extent allocations were attributable to income derived before 
Cooperative Information Report 44-1 45

the close of the taxable year. 

The 1951 act also introduced the term “patronage 

dividend” into the tax code. 

Purpose

The Revenue Act of 1951 was intended to implement a single tax principle for all cooperative organizations. It was thought the act, along with existing 

rulings on nonexempt cooperatives, would combine 

to achieve that goal. As stated in the Senate Report 

on the legislation:

As a result of this action, all earnings or 

net margins of cooperatives will be taxable either to the cooperative, its patrons or its stockholders with the exception of amounts which 

are paid or allocated to patrons on the basis 

of purchase of personal, rather than business, 

expense items. With this exception, funds 

which are allocated to the accounts of patrons, 

or paid in cash or merchandise, are taxable to 

them. This is true in the case of either taxable 

or tax-exempt cooperatives. 

This purpose was implemented by IRS rulings 

holding that because cooperatives were permitted 

to deduct or exclude the full amount of patronage 

refunds, even if retained as capital, the full face 

amount of distributions, cash or otherwise, should 

be includable in the patrons’ gross income. 

Judicial Interpretation

A series of judicial decisions in the mid-1950’s are 

usually said to have defeated the general tax scheme 

for cooperatives apparently intended by the Revenue Act of 1951.

The Ninth Circuit Court of Appeals decision in 

Caswell’s Estate v. Commissioner suggested the 

taxation of noncash patronage refunds was not as 

established as might be expected from the phrase 

in the Revenue Act of 1951 that refunds were to 

be treated “in the same manner as in the case of a 

cooperative organization not exempt under section 

521.”

Caswell’s Estate concerned “commercial reserve 

fund certificates” representing refunds withheld 

from patrons in 1945. The court held the certificates 

were mere evidences of patrons’ contingent rights 

in the commercial reserve fund. Distribution of the 

fund was to be made on the happening of certain 

events, none of which had occurred. No distribution 

to patrons was ever made, and patrons received no 

income “to any extent whatever.” 

In Commissioner v. Carpenter, a cooperative 

member accounting on a cash basis received “revolving fund certificates” from a cooperative for 

fiscal years 1946-49. Such certificates were redeemable only at the board of directors’ discretion, bore 

no interest, were of limited transferability, were 

subordinated to debt, and could be redeemed only 

by consent of a lending bank. The court found the 

certificates had no fair market value when issued, 

and therefore did not constitute income to the recipient patron.

Two years later, in Long Poultry Farms, Inc. v. 

Commissioner , the Fourth Circuit Court of Appeals 

reached a similar conclusion in the case of a corporate member on the accrual basis of tax accounting. 

In this instance the patronage refunds were issued in 

1953, after enactment of the Revenue Act of 1951. 

In discussing the 1951 act, the court said:

Congress while granting the right to the 

deductions by the cooperative left the matter 

of taxing the dividends to the recipients to be 

dealt with by existing law, making no change 

with regard thereto, with the result that cash 

basis taxpayers will report as income patronage dividends such as are here involved in 

the year when payment thereof is received 

and accrual basis taxpayers will report them 

as income for the year in which the right to 

receive payment becomes reasonably definite 

and certain. 

Regulations to implement the Revenue Act of 

1951 provided that noncash patronage refunds, such 

as revolving fund certificates, were taxable to the 

patrons at face value. This regulation, “to the extent 

(it) attempts to tax as income what is not income 

under law,” was held void in Long Poultry. 

After its acquiescence in Carpenter in 1958, the 

Service amended its corresponding regulations. 

Under the amended provisions, if the allocation was 

in cash, the patron included the amount of cash received in reportable income. Allocation in the form 
46 Income Tax Treatment of Cooperatives: Background

of capital stock was included in the patron’s gross 

income at its fair market value, if any, at the time of 

receipt by the patron. 

The most critical provision in the 1959 amendments to the regulations addressed the status of 

revolving fund certificates, retain certificates, certificates of indebtedness, letters of advice, or other 

similar documents issued to evidence a temporary 

investment in the cooperative based on patronage. 

The patron was to include the fair market value of 

the document as gross income.

The regulations defined circumstances under 

which a document was considered to have a fair 

market value. “Any document containing an unconditional promise to pay a fixed sum of money on 

demand or at a fixed or determinable time shall be 

considered to have a fair market value at the time 

of its receipt by the patron.” Documents were not 

considered to have a fair market value if they were 

payable “only in the discretion of the cooperative 

association, or which is otherwise subject to conditions beyond the control of the patron. ... unless it is 

clearly established to the contrary.” 

The Service also responded to the Carpenter 

and Long Poultry Farms cases by urging the courts 

to permit the Service to reverse its longstanding 

position that noncash patronage refunds were excludable by nonexempt cooperatives. The Service 

asserted the income should be taxable to someone, 

and since the courts had held it was not taxable to 

the patrons, it should be taxable to the cooperative. This issue reached the Eighth Circuit Court 

of Appeals, which rejected the Service’s argument 

and sustained the exclusion of noncash patronage 

refunds. 

REVENUE ACT OF 1962

In an April 1961 message to Congress, President 

Kennedy included the following, “I recommend that 

the law be clarified so that all earnings are taxable 

to either the cooperatives or to their patrons, assessing the patron on earnings that are allocated to him 

as patronage dividends or refunds in script or in 

cash.” 

The Revenue Act of 1962 responded to this call. 

Section 521 of the Revenue Act of 1951 was retained as a definition for so-called “exempt” farmer 

cooperatives. Section 521 tax preferences were 

continued, including the special deductions for dividends on capital stock and nonpatronage-sourced 

income allocated on a patronage basis.

Section 522 of the 1951 act was repealed and 

replaced with subchapter T of the current Code. 

Qualifying patronage refunds of “any corporation 

operating on a cooperative basis” were not to be 

taken into account in computing taxable income, 

thus continuing single tax treatment of cooperative 

patronage refunds. Either the cooperative would pay 

the tax on the amount or the patron would.

Effective dates were generally for taxable years 

beginning after 1962. Pre subchapter T law would 

continue to apply to distributions made prior to the 

effective dates of subchapter T, and in some instances to associations not covered by subchapter T. 

Subchapter T continues the statutory authorization found in the Revenue Act of 1951 for the exclusion of patronage refunds from the taxable income 

of nonexempt cooperatives. “Although Congress 

did not speak to the question of how the exclusion is 

to be computed, it chose to treat the patronage dividend concept in essentially the same manner as did 

prior administrative interpretations and decisional 

law.” 

 The bulk of cooperative taxation discussed in 

subsequent reports in this series is based on subchapter T. However, as a matter of statutory interpretation, the legislative intent was to continue the 

basic pre-1962 single tax treatment within a new 

patron consent structure to assure current inclusion 

of all cooperative margins in the taxable income of 

either the patrons or the cooperative.

SUBSEQUENT LEGISLATION

With limited exceptions, subchapter T and section 

521 remain as enacted in 1962. This does not mean 

tax law has remained static. In the years since 1962, 

a number of dramatic changes in enforcement and 

interpretation have provoked discussion and thought 

about some important issues in cooperative taxation.

Two subchapter T amendments clarified treatment of per-unit capital retains. The Revenue Act 

of 1966 affirmed prior administrative recognition 

of per-unit retain allocations. The Tax Reform Act 

of 1969 confirmed the exclusion of per-unit retains 

paid in money. 
Cooperative Information Report 44-1 47

Persons who think cooperative taxation is somehow above question are reminded that in 1969 the 

House of Representatives passed a provision to 

require that patronage refunds and per-unit retains 

be revolved out over a period not to exceed 15 years 

and that at least 50 percent of a patronage refund 

be paid in cash. The proposed limitations were not 

included in the Senate version of the legislation. 

The conference that produced the Tax Reform Act 

of 1969 concurred with the Senate. 

In 1978, two special situations were addressed—

cooperative use of the completed crop pool method 

of accounting and the investment tax credit. 

Cooperatives serving different groups of farmers 

faced a major challenge to the way many elected 

to combine revenues, expenses, resources, and 

finances when the Service sought to limit such 

unitary cooperative effort where one group suffered 

a loss and another realized net margins. Legislation 

was sought to give cooperatives a range of choices 

in how they would handle these internal matters. 

The Consolidated Omnibus Budget Reconciliation 

Act of 1985 permitted interunit netting of gains and 

losses under defined circumstances.

LEGISLATIVE HISTORY

The following list gives statutes directly dealing 

with Federal income taxation of cooperatives. The 

list includes references to the more important Congressional reports associated with the recent acts.

Revenue Act of 1916, ch. 463, § 11(a)Eleventh, 39 

Stat. 756, 767 (1916)

Revenue Act of 1918, ch. 18, § 231(11), 40 Stat. 

1057, 1076 (1919)

Revenue Act of 1921, ch. 136, § 231(11), 42 Stat. 

227, 253 (1921)

Revenue Act of 1924, ch. 234, § 231(11), 43 Stat. 

253, 283 (1924)

Revenue Act of 1926, ch. 27, § 231(12), 44 Stat. 9, 

40-41 (1926)

Revenue Act of 1928, ch. 852, § 103(12), 45 Stat. 

791, 813-814 (1928)

Revenue Act of 1932, ch. 209, § 103(12), 47 Stat. 

169, 193-194 (1932)

Revenue Act of 1934, ch. 277, § 101(12), 48 Stat. 

680, 701 (1934)

Revenue Act of 1936, ch. 690, § 101(12), 49 Stat. 

1648, 1674-75 (1936)

Revenue Act of 1938, ch. 289, § 101(12), 52 Stat. 

447, 481-82 (1938)

Internal Revenue Code of 1939, ch. 2, § 101(12), 53 

Stat. 1, 33-34 (1939)

Revenue Act of 1951, ch. 521, § 314, 65 Stat. 452, 

491-493 (1951), reprinted in 1951 U.S. Code Cong. 

& Admin. Serv. 308, 371-372

S. Rep. No. 781, 82nd Cong., 1st Sess. (1951), 

reprinted in 1951-2 C.B. 458 and 1951 U.S. Code 

Cong. & Admin. Serv. 1969, 1988-1990

Internal Revenue Code of 1954, ch. 736, §§ 521-

522, 68A Stat. 3, 176-178 (1954)

Revenue Act of 1962, Pub. L. No. 87-834, § 17, 76 

Stat. 960, 1045-1052 (1962), reprinted in 1962-3 

C.B. III

H.R. Rep. No. 1447, 87th Cong., 2d Sess. (1962), 

reprinted in 1962-3 C.B. 402

S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), 

reprinted in 1962-3 C.B. 703 and 1962 U.S. Code 

Cong. & Admin. News 3304, 3414-3420

Revenue Act of 1966, Pub. L. No. 89-809, § 211, 80 

Stat. 1539, 1580-1584 (1966)

H.R. Rep. No. 13103, 89th Cong., 2d Sess. (1966), 

reprinted in 1966-2 C.B. 1107

S. Rep. No. 1707, 89th Cong., 2d Sess. (1966), 

reprinted in 1966-2 C.B. 1055 and 1966 U.S. Code 
48 Income Tax Treatment of Cooperatives: Background

Cong. & Admin. News 4446, 4514-4517

H.R. Rep. No. 1450, 89th Cong., 2d Sess. (1966), 

reprinted in 1966-2 C.B. 1108

Tax Reform Act of 1969, Pub. L. No. 91-172, § 911, 

83 Stat. 487, 722 (1969)

H.R. Rep. No. 413, 91st Cong., 1st Sess. (1969), 

reprinted in 1969 U.S. Code Cong. & Admin. News 

1645, 1652, 1820-1823

S. Rep. No. 552, 91st Cong., 1st Sess. (1969), 

reprinted in 1969-3 C.B. 608 and 1969 U.S. Code 

Cong. & Admin. News 2027, 2331-2332

Conf. Rep. No. 782, 91st Cong., 1st Sess. (1969), 

reprinted in 1969 U.S. Code Cong. & Admin. News 

2392, 2438

Act of August 15, 1978, Pub. L. No. 95-345, § 3, 92 

Stat. 481, 483-484 (1978)

S. Rep. No. 762, 95th Cong., 2d Sess. (1978), reprinted in 1978 U.S. Code Cong. & Admin. News 

1286, 1296-1297

Revenue Act of 1978, Pub. L. No. 95-600, § 316, 92 

Stat. 2763, 2829-2830 (1978), reprinted in 1978-3 

C.B. (Vol.1)

S. Rep. No. 1263, 95th Cong., 2d Sess. (1978), 

reprinted in 1978 U.S. Code Cong. & Admin. News 

6761, 6881-6884

H.R. Conf. Rep. No. 1800, 95th Cong., 2d Sess. 

(1978), reprinted in 1978-3 (Vol.1) C.B. 521 and 

1978 U.S. Code Cong. & Admin. News 7198, 7229-

7230

Consolidated Omnibus Budget Reconciliation Act 

of 1985, Pub. L. 99 272, § 13210, 100 Stat. 82, 323-

324 (1986)

S. Rep. No. 146, 99th Cong., 1st Sess., (1985), 

reprinted in 1985 U.S. Code Cong. & Admin. News 

43, 334-337

Taxpayer Relief Act of 1997, Pub. L. 105-34, § 968, 

111 Stat. 895-896 (1997)

American Jobs Creation Act of 2004, Pub. L. 108-

357, §§ 101, 102, 312, 313, 316, 317, 339; 118 Stat. 

1418, 1423-1427, 1467-1470, 1481-1484 (2004)

H.R. Conf. Rep. 108-755, 108th Cong., 2d Sess. 

(2004)
Cooperative Information Report 44-1 49
50 Income Tax Treatment of Cooperatives: Background