INCOME TAX TREATMENT OF

COOPERATIVES: Background

Cooperative Information Report 44, Part 1

2005 edition

Donald A. Frederick
Abstract

INCOME TAX TREATMENT OF COOPERATIVES:

Background

2005 Edition

Donald A. Frederick, Program Leader

Law, Policy & Governance

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 

April 2005
 This report does not represent official policy of the U.S. 1

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.

3

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 singletax 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.
4

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 business volume well over $100

billion on an annual basis, and almost 3 million farm

memberships, cooperatives are big business when measuring

their importance to rural America. Yet with 85 percent of farmer

cooperatives reporting sales volumes of less than $25 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 RevenueService (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
5

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 perunit 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.
6

Contents

Page

Chapter 1. Tax Principles, Terminology,

and Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Margins, Income and Earnings . . . . . . . . . . . . . . . . . . . 13

Patron Distinguished from Member . . . . . . . . . . . . . . . . 15

Patronage Refund Distinguished From a Dividend . . . . 15

Facts About Farmer Cooperatives . . . . . . . . . . . . . . . . . . . 16

Non-Farm Cooperatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Financial Cooperatives . . . . . . . . . . . . . . . . . . . . . . . . . 19

Consumer Service Cooperatives . . . . . . . . . . . . . . . . . . 21

Business Cooperatives . . . . . . . . . . . . . . . . . . . . . . . . . 22

Tax Treatment of Noncooperative Businesses . . . . . . . . . . 23

Sole Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Limited Liability Companies . . . . . . . . . . . . . . . . . . . . . . 24

Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Cooperative Tax Principles . . . . . . . . . . . . . . . . . . . . . . . . . 28

Cooperatives Organized and Taxed as LLC’s,

and Vice Versa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
7

Sources of Tax Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Internal Revenue Code . . . . . . . . . . . . . . . . . . . . . . . . . 32

Subchapter T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

Section 521 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Other Code Provisions . . . . . . . . . . . . . . . . . . . . . . 35

Judicial Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

IRS Administrative Determinations . . . . . . . . . . . . . . . . 37

Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Revenue Rulings and Revenue Procedures . . . . . . 38

Private Letter Rulings and

Technical Advice Memoranda . . . . . . . . . . . . . . 38

General Counsel Memoranda and

Actions on Decisions . . . . . . . . . . . . . . . . . . . . . 40

Chapter 2. Cooperative Structure, Operation,

and Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

Operating on a Cooperative Basis . . . . . . . . . . . . . . . . . . . 41

Any Organization Eligible . . . . . . . . . . . . . . . . . . . . . . . 42

Code Meaning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

The “Worker Cooperative” Controversy . . . . . . . . . . . . . 45

The “Majority Member Business” Controversy . . . . . . . . 47

IRS Reliance on Puget Sound Plywood . . . . . . . . . . . . 50

Nontax Statutes That Characterize Cooperatives . . . . . . . . 55

State Incorporation Laws . . . . . . . . . . . . . . . . . . . . . . . . 55

Federal Statutes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Capper-Volstead Act . . . . . . . . . . . . . . . . . . . . . . . . 57

Agricultural Marketing Act of 1929 . . . . . . . . . . . . . . 57

Farm Credit Act of 1971 . . . . . . . . . . . . . . . . . . . . . 58
8

Structure and Operations . . . . . . . . . . . . . . . . . . . . . . . . . . 58

Articles of Incorporation . . . . . . . . . . . . . . . . . . . . . . . . . 59

Bylaws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

Contractual Agreements with Members . . . . . . . . . . . . . 60

General Operational Characteristics . . . . . . . . . . . . . . . 61

Examples of Cooperative Operations . . . . . . . . . . . . . . 62

Equity Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Sources of Equity Capital for Cooperatives . . . . . . . . . . 70

Direct Investment . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Margins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Per-Unit Retains . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

Nonmember/Nonpatronage Earnings . . . . . . . . . . . 73

Financial Planning Options . . . . . . . . . . . . . . . . . . . . . . 74

Cash Refunds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Qualified Investments . . . . . . . . . . . . . . . . . . . . . . . 75

Nonqualified Investments . . . . . . . . . . . . . . . . . . . . 76

Unallocated Reserves . . . . . . . . . . . . . . . . . . . . . . . 77

Equity Redemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

Revolving Fund Plan . . . . . . . . . . . . . . . . . . . . . . . . 78

Base Capital Plan . . . . . . . . . . . . . . . . . . . . . . . . . . 79

Special Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Pooling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Chapter 3. Historical Development of Cooperative

Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

The Power to Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

Tax Logic and Cooperatives . . . . . . . . . . . . . . . . . . . . . . . . 86

Price Adjustment Characterization . . . . . . . . . . . . . . . . 87

Agent or Conduit Characterization . . . . . . . . . . . . . . . . 88
9

Pre-1951 Rulings for Nonexempt Cooperatives:

The Road to Subchapter T . . . . . . . . . . . . . . . . . . . . . . 89

Patronage Refund Tax Status . . . . . . . . . . . . . . . . . . . . 90

Patronage Refund Requirements . . . . . . . . . . . . . . . . . 94

Preexisting Legal Obligation . . . . . . . . . . . . . . . . . . 94

Patronage Business Requirement . . . . . . . . . . . . . . 97

Distributed on a Patronage Basis . . . . . . . . . . . . . . 98

Computing the Patronage Refund . . . . . . . . . . . . . 100

Noncash Refund Payments . . . . . . . . . . . . . . . . . . . . 102

Pre-1951 Tax Legislation: The Road to Section 521 . . . . . 105

Agricultural and Horticultural Organizations

Exemption: 1909-1916 . . . . . . . . . . . . . . . . . . . . . 106

Early Cooperative Exemption: 1916-1926 . . . . . . . . . . 109

Administrative Interpretations of the

Early Revenue Acts . . . . . . . . . . . . . . . . . . . . . . . . 109

Purchasing and Dual-Function Cooperatives . . . . . . . 112

Revenue Act of 1926 . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Revenue Act of 1951 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

Judicial Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . 119

Revenue Act of 1962 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Subsequent Legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

Legislative History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
10
 Rural Business-Cooperative Service "shall render service to 2

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).

 The material in this report, and in all subsequent reports in this 3

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.

11

CHAPTER 1

TAX PRINCIPLES, TERMINOLOGY, AND SOURCES

This publication is the first in a series of reports about Federal

income taxation of farmer cooperatives. The reports are designed 2

as research tools, intended to help those making tax decisions with

respect to cooperatives in U.S. agricultural and other sectors of the

economy.3

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.
 Relevant provisions of the Internal Revenue Code and associated 4

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."

12

The reports in this series focus on tax rules unique to

cooperatives or of special application to 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. The reports' 4

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.
 I.R.C. § 1388(a)(3). 5

13

Interpretation of authorities is as "neutral" as possible, 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. As 5

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
Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 450 note 3 6

(1986).

 I.R.C. § 61(a).

7

 Internal Revenue Service, a part of the Department of the 8

Treasury, is frequently referred to in this series of publications as "IRS"

or "the Service" in keeping with common terminology.

14

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."6

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. "Income" is all wealth that flows into the cooperative from 7

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 Service and cooperatives alike. 8

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.
 I.R.C. § 1388(a)(3). 9

 Treas. Reg. § 1.1388-1(e).

10

15

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."9

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...." In other words, a patron is a person who shares 10

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
See, e.g., I.R.C. §§ 1382(b) and 1388(a). In a technical sense, a 11

"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 purposes) are treated as ordinary

"dividends" as defined in 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).

16

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." "Patronage refund" is used rather than 11

"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
 The data in this section is taken from C. Adams, et al., Farmer 12

Cooperative Statistics, 2002, RBS Service Report No. 62 (USDA, June

2004).

17

commodity production, processing, marketing, and distribution

over the years.

In 2002, 3,140 farmer cooperatives provided marketing, farm

supplies, and services to farmers. This represents a steadily 12

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 2002, 1,559 primarily marketed

farm products, 1,201 primarily provided farm supplies to farmers,

and 380 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 2002, 3,060 cooperatives

were centralized, 53 were federated, and 27 were mixed.

Just under 2.8 million producer memberships in farmer

cooperatives were reported in 2002. This number includes

duplications for farmers who 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 2002

was $111.6 billion, up from $90.8 billion in 1991. Marketing

represented 69.0 percent of the total, farm supplies 28.3 percent,

and selected services 2.7 percent. If inter-cooperative business

transactions are eliminated, net business volume was $96.8 billion,

up from $76.6 billion in 1991.
 All 2002 Top 100 data are from D. Chesnik, "Financial Profile of 13

Largest 100 Agricultural Cooperatives, 2002" RBS Research Report

204 (USDA, October 2004). 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.

18

Most farmer cooperatives are relatively small businesses. In

2002, 83.8 percent 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 2002 totaled $47.5 billion, up from

$31.3 billion in 1991. Total liabilities were $27.9 billion,

compared to $17.2 billion in 1991. This leaves net worth, or

member and patron equity, at $19.6 billion, a sizable increase over

the $14.1 billion of 1991.

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 2002, the Top 100 accounted for $64.0

billion in business volume, 57.3 percent of the business volume

for all farmer cooperatives. They likewise dominated the balance 13

sheet items with $27.2 billion in total assets (57.2 percent of the

total) and $8.6 billion in member and patron equity (43.9 percent

of the total).

Eighty-nine of the 100 had earnings in 2002, totaling $817.0

million. How a cooperative uses its earnings affects tax

calculations of both the cooperative and its farmer patrons.

These earnings were accounted for in several ways. Cash

patronage refunds totaled $194.5 million (23.8 percent). Retained

patronage refunds were $394.6 million (48.3 percent). Thus $72

out of every $100 in margins realized by the Top 100 were

distributed or allocated as patronage refunds.

The eighty-nine cooperatives in the Top 100 for 2002 with

earnings paid $74.3 million in corporate income taxes (9.1

percent). Dividends on stock amounted to $1.6 million (0.2 per-
 Historical and current statistics on farmer cooperatives are found 14

in RBS publications. Data is collected by the agency and reported for

all cooperatives combined. Separate data collection and analysis

provide more detailed information about the financial profile of the

largest 100 farmer cooperatives. Updated information on all farmer

cooperatives, and on the Top 100, can be obtained from the agency.

 See the Web site for the National Cooperative Business 15

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 2004.

19

cent) and $152.0 million (18.6 percent) were placed in unallocated

reserves14

The 11 cooperatives in the Top 100 that suffered losses in

2002 had total losses approaching $675 million. Close to $35

million was covered with tax benefits and approximately $300

million was set off against unallocated equity. The remainder is

either being carried on the cooperatives’ books or being recovered

from patronage equities.

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. Here are some examples and facts 15

and figures about non-agricultural cooperatives.

Financial Cooperatives

The largest single segment of the cooperative industry is credit

unions. The roughly 10,000 credit unions in the United States

have more than $600 billion is assets and 83 million members.
20

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. It has

about $25 billion in outstanding loans and leases 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 source of financing for

rural electric and telephone cooperatives. With $21 billion in

assets and almost $21 billion in credit outstanding, 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 2,000 cooperatives

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.
21

Consumer Service Cooperatives

Nearly 1,000 rural electric cooperatives own and maintain

nearly half of the electric distribution lines in the United States,

cover 75 percent of the land mass, and provide electricity to 36

million people.

Roughly 270 telephone cooperatives are providing a growing

portfolio of communications services to 2 million households,

including wireless technology and high-speed Internet access.

More than 1,000 mutual insurance companies, with more

than $80 billion in net written premiums, are owned by their

policyholders.

America has about 1 million units of cooperative housing,

nearly 600,000 of them in New York City. 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.
22

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 relyingmore and more on TruServ, Ace Hardware, Do-it-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 $20 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 bottom-line impact, purchasing

cooperatives also offer another, less tangible benefit: they help to

build trust among franchisers and franchisees, particularly on

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.
 I.R.C. § 701. 16

23

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. Partnerships have income and expenses 16

related to their operation. Rather than determine taxable income

at the partnership level, however, partnership income and
 I.R.C. § 702. 17

 Federal income tax law is contained in the Internal Revenue Code

18

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.

 Treas. Reg. § 301.7701-1 to 301.7701-3. 19

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

20

24

deductions are passed through to 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. The 17

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 Code doesn’t specifically address 18

taxation of limited liability companies (LLCs). However, under

IRS’s so-called “check-the-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.19

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.20
 "A tax is hereby imposed for each taxable year on the taxable

21

income of every corporation." I.R.C. § 11.

 I.R.C. § 243(a). 22

25

Corporations

Unlike sole proprietorships, partnerships, and LLCs,

corporations are taxable business entities. Corporations incur tax

21

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 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 itstaxable 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. If a 22

corporate shareholder owns 20 percent or more of the distributing

corporation's stock, it may deduct 80 percent of the dividends
 I.R.C. § 243(c). 23

 I.R.C. § 246(a)(1).

24

 A "domestic" corporation must be created or organized in the 25

United States or under the law of the United States or one of the

individual States. I.R.C. § 7701(a)(4).

26

received. The special dividends received deduction does not 23

apply to dividends received from a farmers' cooperative that

utilizes Code section 521.24

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 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 corporation and also meet the following 25
 I.R.C. § 1361(b)(1). 26

 I.R.C. § 1366. 27

 I.R.C. § 1377. 28

27

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 can not 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.26

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. Individual items of S corporation income or loss

27

are passed to shareholders proportionately, based on the amount

of stock owned each day during the tax year. For the most part,

28

income flowing through the S corporation to shareholders is taxed

but once, at the shareholder level.
28

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, LLC’s, corporations, and S corporations. Actual

application of the rules, however, can be complex.

The general principle of cooperative income taxation is that

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

29

 Wyoming Processing Cooperative Law, Wyo. Stat. Chap. 10,

30

Article 2, §§ 17-10-201 to 17-10-253.

 Minnesota Cooperative Associations Act, Minn. Stat. Chap. 31

308B, §§ 308B.001 to 308B.975.

 Tennessee Processing Cooperative Law, Tenn. Code, Title 43, 32

Chapters 38-70, §§ 43-38-101 to 43-70-202.

29

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 patronage. The special tax treatment of section 521 29

cooperatives will be discussed in Part 4 of these reports.

COOPERATIVES ORGANIZED AND TAXED AS

LLCs, AND VICE VERSA

At the time this report is being prepared for publication, three

States have enacted laws authorizing unincorporated associations

that are labeled “cooperatives” – Wyoming, Minnesota., and 30 31

Tennessee. These new laws sanction entities that are organized 32

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. Several other States are considering similar

laws.

The intent ofthese lawsis 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”
 Priv. Ltr. Rul. 200139020 (June 29, 2001).

33

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

34

30

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).33

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.

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

organized LLC can be taxed as a cooperative under Subchapter

T. In this instance, a cooperative corporation was having 34

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 “association” taxable as a

“corporation” (not as a partnership, the normal LLC treatment).
 I.R.C. § 1381(a)(2). 35

The cooperative asserted that the transaction would qualify as a

36

tax-free reorganization under Code § 368(a)(1)(F).

31

Subchapter T tax treatment is only available to a “corporation

operating on a cooperative basis.” (emphasis added). The 35

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 “corporation.” 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 “continues to operate on a cooperative

basis.”36

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 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.
 Title 26 of the United States Code. 37

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

38

 Pub. L. No. 108-357, 118 Stat. 1418 (2004). See § 1(b). 39

32

Internal Revenue Code

Income tax law is contained in the Internal Revenue Code of

1986, commonly referred to as the "Code." 37

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 1986.38

The periodic statutory amendments to the tax law are

integrated into the Code. The American Jobs Creation Act of

2004, for example, became part of the Internal Revenue Code of 39

1986.

The Code is divided into chapters, subchapters, parts, sections,

etc. The Code includes all income tax rules applicable to

individuals, partnerships (andLLC’s), corporations, cooperatives,
 I.R.C. §§ 1381-1388.

40

 I.R.C. § 1381(a)(1). 41

 I.R.C. § 1381(a)(2). Language in section 1381(a)(2) specifically 42

excludes mutual savings banks, insurance companies, and utility

cooperatives from the scope of subchapter T.

33

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

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,"40

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 521.41

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.42

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
 Found in subchapter F, Exempt Organizations, of the Code. 43

34

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 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 521 defines the kind of organization frequently called 43

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.
 I.R.C. § 6072(d).

44

 Most business corporations only have 21⁄2 months after the close 45

of the taxable year to file their tax returns. I.R.C. § 6072(b).

 I.R.C. § 6044. 46

 I.R.C. § 6044(c).

47

35

(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 section 521. Other

Code provisions also apply specifically to cooperatives.

Tax returns. A cooperative described in section 6072(d) has 44

81⁄2 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.45

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. Cooperatives must report 46

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.47

Dividends Received Deduction. Section 246 provides that

the deduction for dividends received by a corporation from another
 I.R.C. § 246(a)(1).

48

36

corporation is not allowed when the dividends are received from

a section 521 cooperative.48

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

(frequently 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.
 I.R.C. § 7805; Treas. Reg. § 301.7805-1. 49

37

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 Administrative 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.49

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 meaning 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.
 Conway County Farmers’ Ass’n v. United States, 588 F.2d 592, 50

600 (8th Cir. 1978).

38

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.50

A revenue procedure is an official statement of procedure from

the IRS National Office. They guide IRS personnel and taxpayers

in handling routine tax 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 (TAM's) are written interpretations from the IRS

National Office of how the tax law applies to a specific set of
 Tax Analysts and Advocates v. Commissioner, 505 F.2d 352

51

(D.C. 1974).

 I.R.C. § 6110. 52

 Unless the Secretary otherwise establishes by regulations, a 53

written determination may not be used or cited as precedent. I.R.C. §

6110(k)(3).

See H. Massler, "How to Get and Use IRS Private Letter 54

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).

 An interesting discussion of what IRS regards as authority is 55

found in the regulations interpreting the accuracy-related penalty

provision of the Code, Treas. Reg. § 1.6662-4(d)(3)(iii).

39

circumstances. LTR's are issued in response to requests for advice

from taxpayers. TAM's 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.51

The Tax Reform Act of 1976 included a provision stating that

written determinations by IRS shall be open to public inspection.52

Information disclosing the identity of the taxpayer is deleted

before the documents are made available to the public.

LTR’s and TAM's respond only to the facts presented.

According to the Code, they may not be cited as precedent, but 53

some uncertainty exists about how and when they can be used by

other taxpayers. LTR’s and TAM's are used in this publication 54

to help describe the IRS position on a variety of situations

requiring tax implication analysis.

55
 Taxation with Representation Fund v. Internal Revenue Service, 56

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

40

General Counsel Memoranda and Actions on Decisions

General Counsel Memoranda (GCM's) are legal analysis

prepared by the IRS Office of the Chief Counsel, usually drafted

in connection with proposed LTR's, TAM's, or revenue rulings.

Actions on Decisions (AOD's) are legal memoranda that are

prepared when the IRS loses an issue in a litigated tax case.

AOD's 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 GCM's and AOD's

as internal memoranda not prepared for public use. In 1981,

however, litigation under the Freedom of Information Act forced

IRS to begin releasing GCM's and final AOD's.56

Unlike LTR's and TAM's, no specific statutory language

prohibits GCM's and AOD's from being used as precedents.

Although such documents are now publicly available, IRS

contends GCM's and AOD's remain nothing more than internal

memoranda and are not elevated to the status of official agency

documents that can be cited as precedent.
 Dissenting opinion in Frost v. Corporation Commission, 278 U.S. 57

515, 546 (1929), quoted in Ford-Iroquois FS, Inc. v. Commissioner, 74

T.C. 1213, 1217, n.3 (1980).

 I.R.C. § 1381(a)(2). 58

 Treas. Reg. § 1.1381-1(a).

59

41

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."57

A wide range of business operations are eligible for the tax

benefits provided in subchapter T. This 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.58

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."59
 H.R. Rep. No. 1447, 87th Cong., 2d Sess. (1961), 1962-3 C.B. 60

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.

 Affiliated Foods, Inc. v. Commissioner, 98-2 U.S.T.C. (CCH) ¶

61

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. 724 (N.D. Cal. 1960).

 Cotter and Co. v. United States, 765 F.2d 1102 (Fed. Cir. 1985),

62

rev'g, 6 Ct. Cl. 219 (1984); and Priv. Ltr. Rul. 8006112 (Nov. 20, 1979).

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

63

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

64

42

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 tax-exempt

farmers' cooperatives, to other farm cooperatives, to consumer

cooperatives, and also to other corporations operating on a

cooperative basis."60

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. Savings in 61

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; builders who need

62

supplies and transportation services; and other retailers.

63 64

Cooperatives are not limited to marketing and purchasing, they

may also perform services as their primary activity. An example
 Washington-Oregon Shippers Cooperative, Inc. v. Commissioner, 65

52 T.C.M. (CCH) 1406 (1987).

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

66

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

67

 Rev. Rul. 66-98, 1966-1 C.B. 200. 68

 Rev. Rul. 70-481, 1970-2 C.B. 170. 69

 Harbor Plywood Corp. v. Commissioner, 14 T.C. 158 (1950), 70

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.

43

of a service cooperative is an association formed by a variety of

members to consolidate and distribute freight. The firm

65

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. So did companies 66

processing claims for injuries caused by a hazardous substance

they manufactured.67

Revenue Ruling 66-98 describes a financing corporation 68

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.69

So may a cooperative in which workers own a manufacturing

facility and pay themselves from margins derived from their

labor; fishermen provide themselves ice, tackle, gear, fuel and 70
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).

 Seiners Ass'n v. Commissioner, 58 T.C. 949 (1972). 71

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

72

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

73

 I.R.C. § 1388(a).

74

 I.R.C. § 1388(f).

75

44

other needs; taxi services provide dispatching, repair, auto sup- 71

plies, taxi car rentals and other services to drivers and mechanics;72

and restaurants purchase products and supplies in volume.73

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) and per-unit retain allocation. To be 74 75

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.
 Sometimes all jobs earned the same wage. In other instances, 76

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. 

Rev. Rul. 61-47, 1961-1 C.B. 193, revoked by Rev. Rul. 71-439, 77

1971-2 C.B. 321.

Id.

78

45

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. At the end of the fiscal year,

76

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. The 77

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.”78

During floor debate on the legislation that became subchapter

T, a colloquy between Senator Kerr (floor manager of the bill) and
108 Cong. Rec. 18,322 (1962), quoted in Puget Sound Plywood, 79

Inc. v. Commissioner, 44 T.C. 305, 321 (1965), acq., 1966-2 C.B. 3. 

 Linnton Plywood Ass'n v. United States, 236 F. Supp. 227 (D.C. 80

Ore. 1964).

 Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), 81

acq., 1966-2 C.B. 6.

 In 1971, the IRS issued a new Revenue Ruling on the issue, Rev. 82

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.

46

other senators attempted to establish legislative history that worker

cooperatives were entitled to exclude patronage refunds. The 79

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 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.80

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. The Puget Sound 81

Plywood opinion settled the issue of the status of worker

cooperatives under Subchapter T. As is explained shortly 82

hereafter, it also became the bellweather opinion in the longrunning and continuing controversy between the Service and

cooperatives over the proper interpretation of the phrase

“operating on a cooperative basis.”
 Revenue Ruling 72-602, 1972-2 C.B. 511. 83

Id.

84

47

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.” 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 member-patrons were the larger producers of the 83

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 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.” As the cooperative in this instance was doing 75 84

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
 Conway County Farmers Ass’n v. United States, 1978-1 U.S.T.C. 85

(CCH) ¶ 9334 (E.D. Ark. 1978), rev’d, 588 F.2d 592 (8th Cir. 1978).

 I.R.C. § 521(b)(4).

86

 Conway County Farmers Ass'n v. United States, 588 F.2d 595

87

(8th Cir. 1978),rev'g 1978-1 U.S.T.C. (CCH) ¶ 9334 (E.D. Ark. 1978).

48

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. He reasoned that while a subchapter T cooperative 85

could do business with nonmembers on a nonpatronage basis, it

couldn’t 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 members and the Service 86

had issued an official ruling taking the same position with 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. The court noted that Congress intended for true 87

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
 588 F.2d at 600. 88

 Columbus Fruit and Vegetable Cooperative Ass’n v. United 89

States, 7 Cl. Ct. 561 (1985).

 Geauga Landmark, Inc. v. United States, No. 81-942 (N.D. Ohio

90

1985).

 The Claims Court found the IRS position in the Columbus Fruit 91

case so unreasonable that legal fees were awarded to the cooperativetaxpayer. 8 Cl.Ct. 525 (1985).

49

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.” The cooperative was allowed to deduct 88

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. The second concerned a farm

89

supply cooperative that did about 45 percent of its business with

members. In each instance, the court noted the public policy 90

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.

91

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

92

 Rev. Rul. 93-21, I.R.B. 1993-1 C.B. 188, modifying Rev. Rul. 72-

93

602, 1972-2 C.B. 510.

 Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305, 308 94

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

50

...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.

92

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.”93

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.94
 Tech. Adv. Mem. 8219821 (Mar. 18, 1982); Tech. Adv. Mem. 95

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).

 Priv. Ltr. Rul. 9117037 (Jan. 28, 1991); Tech. Adv. Mem. 96

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.

51

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.

95

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 cooperative: (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 distribution of any remaining assets in proportion to the business each

did with the cooperative over some reasonable period of years.

96

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
 Rev. Rul. 93-21, 1993-1 C.B. 188. 97

 See, for example, P.L.R. 200224017 (March 15, 2002).

98

 CF Industries, Inc. v. Commissioner, 995 F.2d 101 (7th Cir.

99

1993). But see Thwaites Terrace House Owners Corp. v.

Commissioner, 72 T.C.M. (CCH) 578 (1996), where the Tax Court held

52

corporation is operating on a cooperative basis for

purposes of subchapter T of the code. ...

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.

97

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) are unduly 98

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.”99
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 “operating 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 44, Part 5 (2005), pp. 97-101.

 Ford-Iroquois FS, Inc. v. Commissioner, 74 T.C. 1213 (1980).

100

Id. at 1217, note 3. The court then quoted the language from 101

Frost v. Corporation Commission, 278 U.S. 515, 546 (1929), found in

the first paragraph of this chapter.

Id. at 1222. In this case IRS alleged that a cooperative principle

102

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).

53

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 FordIroquois FS, Inc. v. Commissioner. After quoting a textbook 100

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." Similarly, 101

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."102

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
 Priv. Ltr. Rul. 200042013 (July 20, 2000).

103

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

104

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

105

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

106

54

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).103

! Both an association of credit unions to support their

credit card operations and its wholly owned subsidiary (a onemember cooperative) formed to offer its members collection

services while shielding the parent cooperative from possible

litigation exposure under the Fair Debt Collection Practices

Act.104

! 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.105

! 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.106
Recently enacted laws creating unincorporated associations 107

called cooperatives are discussed above at pages 29-31.

 State cooperative laws are analyzed in detail in J. Baarda, State

108

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

55

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.107

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.

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.108
Report. No. 54 (USDA 1986) at 5-9.

56

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.

Whilemost 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 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
 42 Stat. 388 (1922), codified at 7 U.S.C. §§ 291-292 (1988).

109

 46 Stat. 11 (1929), codified at 12 U.S.C. § 1141 (1988).

110

 12 U.S.C. § 1141j. 111

57

qualification standards, regardless of whether the organization is

operating on a cooperative basis for tax purposes.

Capper-Volstead Act

The Capper-Volstead Act, enacted in 1922, provides a 109

limited antitrust exemption for agricultural producers to market

their products on a cooperative basis. To qualify for CapperVolstead 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 1929 created the Federal 110

Farm Board, with the joint missions ofstabilizing farm prices and

financing cooperatives. A forerunner ofthe 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.111
 85 Stat. 583 (1971), amended 89 Stat. 1060 (1975), 94 Stat. 3437 112

(1980), 100 Stat. 1877 (1986), codified at 12 U.S.C. § 2001 et seq.

(1988).

 12 U.S.C. § 2129.

113

 For an explanation of the key provisions in each of these 114

documents, and sample drafting language, see D. Frederick, Sample

Legal Documents for Cooperatives, RBS Cooperative Information

Report No. 40 (USDA 1990).

58

Farm Credit Act of 1971

The Farm Credit Act of 1971 includes a definition of a 112

cooperative eligible to borrow from Banks for Cooperatives.113

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.114
59

Articles of Incorporation

The articles of incorporation, when accepted by the State

government, establish the cooperative as a legal 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 incorporation. A typical set of bylaws might contain information about the
60

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
 For an explanation of the types and formats of marketing 115

agreements, common provisions, and sample drafting language, see J.

Reilly, Cooperative Marketing Agreements: Legal Considerations, ACS

Research Report No. 106 (USDA 1992).

61

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.115

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, cooperative 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.
62

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 memberpatrons' 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
 Some cooperatives do not purchase member product, but rather 116

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.

63

the payments to patrons made when the cooperative purchased

their production.116

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 80,000

to member-patrons)

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:

 Patron Sales to Cooperative Percentage of 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.
64

 Patron Percentage of Total Patronage 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/advances

to 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 proportion 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:
The qualification requirements and special tax treatment of

117

farmer cooperatives qualifying for section 521 tax status are discussed

in detail in Part 4 of these reports.

65

 Patron Percentage of Total Patronage 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. Also assume the corporate income tax 117

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.
66

The cooperative does not pay patronage refunds to

nonmembers, but keeps the earnings on nonmember business as a

tax-paid reserve. Individual 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 Refunds Other Payments Total

 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.
67

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.
68

 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.

 Patron Percentage, Product X Percentage, 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, Product X Refund, Product Y Total 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
 This is accomplished through the use of nonqualified retained 118

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.

69

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 investorowned 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 untilsuch time as that equity is paid

out to the owners.

118
 This section is based on material in D. Cobia et al., Equity

119

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.

70

Sources of Equity Capital for Cooperatives119

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 membership, and the owner is

generally referred to as a member of the cooperative.

Direct investment by members is often a minor source of

equity to a cooperative. Most cooperatives are trying to retain

current members and attract moremembers andmember 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.
 An exception is dividends paid on capital stock by a cooperative 120

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.

71

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 equityis 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.120

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 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.
 Differentiating patronage and nonpatronage income are

121

thoroughly discussed in Part 2, Chapter 5, of these reports.

72

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.121

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. 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
 IRS has conceded that subchapter T does not require an 122

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.

73

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.

122

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
74

usually call the moneys retained by another name, such as service

fees. These funds are subject to double taxation.

Financial Planning Options

As the flow chart 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.

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
75

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 per-unit 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.
 Assuming redemption is for full face value. Redemptions at less 123

than face value are discussed in Chapter 9 of these reports.

 The temporary Federal and State tax obligations to the 124

cooperative on its nonqualified allocations, depending on its marginal

tax rate, may be greater than 20 percent. This limits the amount of

76

The redemption of qualified equity is a tax-free event for both

the cooperative and the patron.123

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 pass-through.

Cooperatives can hold margins and per-unit 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.

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.

124
equity a cooperative can accumulate using nonqualified allocations.

 The applicable Treasury Department regulations include an 125

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).

 For a thorough discussion of cooperative equity redemption 126

programs, see D. Cobia, et al., Equity Redemption: Issues and

Alternatives for Farmer Cooperatives, RBS Research Report No. 23

(USDA 1982).

77

Cooperatives are free to use a combination of cash payouts,

unallocated reserves, and qualified and nonqualified allocations.

125

This makes it possible for the leadership to develop a program that

reflects the best interests of the membership.

Unallocated Reserves

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 Redemption126

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 equitymore 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-
 The structure of a cooperative's equity redemption program is 127

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).

78

based equity acquired each year to redeem for cash the patronagebased 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.

127

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

contributions on a regular basis. Redemption is usually on a firstin, 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.
79

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 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.
80

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.
81

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 subtracted.

Any excess over previous payments is then distributed to
 D. Cobia (ed.) Cooperatives in Agriculture, (Prentice Hall 1989)

128

at 198.

82

patrons. This final payment results in zero net income for

the cooperative or business at cost.128

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.
 R. Tresolini, American Constitutional Law (2d ed.), The 129

Macmillan Company (New York 1965), at 288.

83

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.

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. Not surprisingly, the power to tax is the first authority of 129
 U.S. CONST. art. I, § 8, cl. 1. 130

Id.

131

 U.S. CONST. art. I, § 2, cl. 3; art. I, § 9, cl. 4. 132

 Knowlton v. Moore, 178 U.S. 41, 84 (1900) (inheritance tax);

133

Brushaber v. Union Pacific R. R. Co., 240 U.S. 1 (1916) (income tax).

 A. Gunn, Cases and Other Materials on Federal Income 134

Taxation, West Publishing Company (St. Paul 1981) at 2.

 Act of August 5, 1861, ch. 45, § 49, 12 Stat. 292, 309 (1861); Act 135

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).

84

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."130

The Constitution imposes two limits on Congressional taxing

power. First, duties, imposts, and excises must be levied

uniformly throughout the United States. Second, direct taxes

131

must be apportioned among the States according to population.132

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."133

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. This uncertainty played a key role in the 134

development of the power of Congress to implement an income

tax.

The first income tax was an emergency measure enacted to

finance the Civil War. A taxpayer challenged the constitu- 135

tionality of the tax on the grounds that it was a direct tax, not
 Springer v. United States, 102 U.S. 586, 602 (1881). Lengthy tax 136

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.

 Act of August 27, 1894, ch. 349, §§ 27-37, 28 Stat. 509, 553-560 137

(1894).

 Pollock v. Farmers' Loan and Trust Co., 157 U.S. 429 (1895). 138

 Tresolini, at 295. 139

 Pollock v. Farmers' Loan and Trust Co., 158 U.S. 601 (1895). 140

Id. at 635 (1895). 141

85

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.136

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

in 1894 another income tax was passed. The 1894 tax was 137

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. With one Justice absent because of 138

illness, the Court was divided on the broader issue of the overall

propriety of the income tax.139

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.140

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.141
 Reprinted as S. Doc. No. 98, 44 Cong. Rec. 3344-45 (June 16, 142

1909).

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

143

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

144

 U.S. CONST. amend. XVI. 145

 Act of October 3, 1913, ch. 16, section II, 38 Stat. 114, 166-181 146

(1913).

86

On June 16, 1909, President Taft recommended to Congress

the adoption of an amendment to the Constitution authorizing an

income tax. The Senate, and then the House, debated and 142 143 144

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."145

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 1913.146

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.
I.T. 3208, 1938-2 C.B. 127. See also, Rev. Rul. 83-135, 1983-2 147

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."

87

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

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 consistentlyexcluded 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.147
 Harbor Plywood Corp. v. Commissioner, 14 T.C. 158, 161

148

(1950), aff'd without opinion, 187 F. 2d 734 (9th Cir. 1951).

 Dr. P. Phillips Cooperative v. Commissioner, 15 T.C. 1002 149

(1951).

88

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.

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."148

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 cooperative is merely a conduit for the patronage dividends....149
 T.D. 2737, 20 Treas. Dec. Int. Rev. 441-442 (June 19, 1918) 150

(cooperative merchandising organization); See also, Off. Dec. 65, 1

C.B. 208 (1919) (cooperative university book store).

 Farmers Union Cooperative Oil Co. v. Commissioner, 38 B.T.A. 151

64 (1938).

89

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 Rulings for Nonexempt Cooperatives:

The Road to Subchapter T

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 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.150

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. Nevertheless, patronage refunds were generally 151

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.
 T.D. 2737, 20 Treas. Dec. Int. Rev. 441-442 (1918).

152

90

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 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 income-tax laws, adopted because the

real purpose of such organizations is to furnish goods at

cost.152
 These points are reiterated in I.T. 1499, I-2 C.B. 189 (1922). 153

 T.D. 2737, 20 Treas. Dec. Int. Rev. 441, 442 (1918). 154

 I.T. 1499, I-2 C.B. 189, 191 (1922). 155

 I.T. 3208, 1938-2 C.B. 127. 156

 Homebuilders Shipping Ass'n v. Commissioner, 8 B.T.A. 903

157

(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).

91

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."153

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." This practice was

154

subsequently described as "consistent" in 1922, and "long 155

established" in 1938.156

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 excepted such refunds from taxation.157

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
 Farmers Cooperative Co. v. Commissioner, 33 T.C. 266 (1959). 158

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

92

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 permitting 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 allocation 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).158
1962.

T.D. 2737, 20 Treas. Dec. Int. Rev. 441, 442 (1918). See also,

159

A.R.R. 6967, holding a patronage refund "should be allowed as a

deduction...." III-1 C.B. 287, 290 (1924).

93

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. For some time, neither Treasury 159

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 patron of goods purchased by him

through the corporation or an additional consideration due

the patron for goods sold by him through the corporation.
 I.T. 3208, 1938-2 C.B. 127-128. See also Gen. Couns. Mem. 160

17,895, 1937-1 C.B. 56.

See, e.g., Midland Cooperative Wholesale v. Commissioner, 44 161

B.T.A. 824 (1941) Patronage refunds were referred to as a "deduction"

throughout the opinion.

 Colony Farms Cooperative Dairy, Inc. v. Commissioner, 17 T.C. 162

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).

94

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.160

The courts were somewhat slow in recognizing this

distinction. By the early 1950's, the status of the patronage 161

refund as an exclusion was generally accepted.162

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 refunds were excepted from taxation where made "in 163

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).

 Midland Cooperative Wholesale v. Commissioner, 44 B.T.A. 824 164

(1941).

 San Joaquin Valley Poultry Producers Ass'n v. Commissioner,

165

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).

 Dr. P. Phillips Cooperative v. Commissioner, 17 T.C. 1002 166

(1951) (written contract); Southwest Hardware Company v.

Commissioner 24 T.C. 75 (1955) (binding oral agreement implied).

 United Cooperatives, Inc. v. Commissioner, 4 T.C. 93 (1944),

167

acq., 1945 C.B. 6.

 Farmers Union State Exchange v. Commissioner, 30 B.T.A. 168

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).

95

patronage refund exclusion practices. The preexisting legal 163

obligation could be created by a state statute, the articles and 164

bylaws of the cooperative, or a contract between the producers 165

and the cooperative. The preexisting legal obligation was found 166

when cooperatives were obligated to make patronage refunds

without additional corporation action.167

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.168
Peoples Gin Co. v. Commissioner, 118 F.2d 72 (5th Cir. 1941),

169

aff'g, 41 B.T.A. 343 (1940).

 American Box Shook Export Ass'n v. Commissioner, 4 T.C. 758 170

(1945), aff'd, 156 F.2d 629 (9th Cir. 1946).

 United Cooperatives, Inc. v. Commissioner, 4 T.C. 93 (1944),

171

acq., 1945 C.B. 6.

See, e.g., Farmers Union Co-op Co. of Guide Rock, Neb. v. 172

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.

 Associated Grocers of Ala. v. Willingham, 77 F. Supp. 990 (N.D. 173

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.

 American Box Shook Export Ass'n v. Commissioner, 4 T.C. 758 174

(1945), aff'd, 156 F.2d 629 (9th Cir. 1946).

96

Adoption of a resolution declaring payment after the

underlying margins were earned was held to be an insufficient

obligation because no preexisting obligation existed.169

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.170

In one case, the court held that where a cooperative could pay

dividends on capital stock up to 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.171

If the obligation is too vague, it may be held to be

nonexistent. Likewise, a poorly drafted article of incorporation 172

can defeat a legitimate attempt to create the preexisting

condition.173

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. Because the status of 174
 I.T. 1499, I-2 C.B. 189 (1922); I.T. 3208, 1938-2 C.B. 127; Rev. 175

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).

 Distinguishing patronage and nonpatronage income is the subject 176

of chapter 5, in part 2 of these reports.

97

"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. Thus, the distinction between income from patronage 175

and nonpatronage sources was a part of early cooperative tax

considerations.

176

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 member-patrons, 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
 Fruit Growers' Supply Co. v. Commissioner, 56 F.2d 90, 93 (9th 177

Cir. 1932), aff'g, 21 B.T.A. 315 (1930).

 A.R.R. 6967, III-1 C.B. 287, 289 (1924). 178

 Gallatin Farmers Co. v. Commissioner, 132 F.2d 706 (9th Cir.

179

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).

98

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....177

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 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."178

Dividends on capital stock were not deductible for a nonexempt cooperative any more than for a noncooperative

corporation.179

Under some circumstances, cooperatives that paid dividends

on stock lost their exclusion for a portion of their patronage
United Cooperatives, Inc. v. Commissioner, 4 T.C. 93 (1944),

180

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.

 Juneau Dairies, Inc. v. Commissioner, 44 B.T.A. 759, 763 181

(1941).

Peoples Gin Co. v. Commissioner, 118 F.2d 72 (5th Cir. 1941),

182

aff'g, 41 B.T.A. 343 (1940).

 Cooperative Oil Ass'n v. Commissioner, 115 F.2d 666 (9th Cir.

183

1941).

99

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.180

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. A similar result was reached when distributions 181

failed to meet the preexisting obligation test when made as a result

of board resolution at the end of the year.

182

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 not permitted where some net margins were not

allocated or distributed to patrons but were placed instead in a

working capital reserve. Patronage refund status was also 183

denied when the court was not convinced the patrons had
 Fountain CityCo-op Creamery Ass'n v. Commissioner, 172 F.2d 184

666 (7th Cir. 1949), aff'g, 9 T.C. 1077 (1947).

 Midland Cooperative Wholesale v. Commissioner, 44 B.T.A. 824

185

(1941).

100

sufficient interest in funds placed in an allegedly allocated reserve

to establish the funds belonged to the patrons and not to the

cooperative.184

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.185

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
 A.R.R. 6967, III-1 C.B. 287, 289 (1924). 186

 Farmers Union Cooperative Exchange v. Commissioner, 42 187

B.T.A. 1200 (1940).

101

distribution by 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.186

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. The cooperative paid no stock 187

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,
Id. at 1202. 188

 The Service did acknowledge patronage refund status of funds 189

retained pursuant to a State law in the so-called "Iowa ruling," I.T. 3208,

1938-2 C.B. 177.

 Anamosa Farmers Creamery Co. v. Commissioner, 13 B.T.A. 190

907 (1928). See also Growers Cold Storage Co. v. Commissioner, 17

B.T.A. 1279 (1929).

102

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 business

a portion of that derived from sales to members.

188

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, the courts were 189

generally supportive.

In Anamosa Farmers Creamery Co. v. Commissioner, the 190

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.
 Midland Cooperative Wholesale, 44 B.T.A. 824 (1941). See also 191

United Cooperative, Inc. v. Commissioner, 4 T.C. 93, 108 (1944), acq.,

1945 C.B. 6.

 San Joaquin Valley Poultry Producers Ass'n v. Commissioner,

192

136 F.2d 382, 385 (9th Cir. 1943).

103

The exclusion of noncash patronage refunds was attacked

again in Midland Cooperative Wholesale v. Commissioner.

191

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, 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."192

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.
Colony Farms Cooperative Dairy v. Commissioner, 17 T.C. 688, 193

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).

 Farmers Cooperative Co. v. Commissioner, 288 F.2d 315 (8th

194

Cir. 1961, rev'g 33 T.C. 266 (1959).

 Commissioner v. Carpenter, 219 F.2d 635 (5th Cir. 1955), aff'g,

195

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).

 Farmers Cooperative Co. v. Commissioner, 288 F.2d 315 (8th

196

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).

104

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.193

In Farmers Cooperative Co. v. Commissioner, the Service 194

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. The Service

195

argued that cooperative earnings are income to someone, and if the

noncash patronage refunds are not taxable income to the patrons,

they 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.196

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
Bradshaw v. Commissioner, 14 T.C. 162 (1950); Southwest 197

Hardware Co. v. Commissioner, 24 T.C. 75 (1955).

 Farmers Cooperative Co. v. Commissioner, 288 F.2d 315, 317

198

(8th Cir. 1961), rev'g 33 T.C. 266 (1959).

 30 Stat. 448, 461 (1989). 199

105

refund amounts and were carried at that value as cooperative

liabilities, the face amount was accrued income to patrons.197

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.198

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 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.199
 Act of August 5, 1909, ch. 6, § 38, 36 Stat. 11, 113. 200

 Flint v. Stone Tracy Co., 220 U.S. 107 (1911). 201

 Pollack v. Farmers' Loan and Trust Co., 158 U.S. 601 (1985). 202

 Flint v. Stone Tracy Co., 220 U.S. at 173. 203

106

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."200

In Flint v. Stone Tracy Co. , the U.S. Supreme Court 201

distinguished Pollack and upheld the constitutionality of the 202

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 to the 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.203

The Revenue Act of 1913, enacted shortly after ratification of

the 16th amendment, established a comprehensive personal and

corporate income tax scheme. The 1913 act did not specifically
 Subsection G, section 2, Act of October 13, 1913, 38 Stat. 172

204

(1913).

 Brushaber v. Union Pacific Railroad Co., 240 U.S. 1, 21 (1916).

205

 Art. 92 of Income Tax Regulations No. 33 (Jan. 5, 1914),

206

published at 16 Treas. Dec. Int. Rev. 29, 62 (1914).

107

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...."204

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.205

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.206

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 ex-
 T.D. 1996, 16 Treas. Dec. Int. Rev. 100 (June 15, 1914) (Art. 92 207

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.

 T.D. 2090, 16 Treas. Dec. Int. Rev. 259, 276 (Dec. 14, 1914).

208

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).

 The agricultural and horticultural organizations exemption is 209

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).

 Growers Cold Storage Co. v. Commissioner, 17 B.T.A. 1279 210

(1929).

108

tended to mutual or cooperative telephone companies, farmers'

insurance companies, and like organizations.

207

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)."208

Since these early rulings, farmer cooperatives have been

denied use of the agricultural organizations exemption. An 209

attempt by a cooperative to qualify for tax exempt status as a

business league was also unsuccessful.210
 Revenue Act of 1916, ch. 463, § 11(a) Eleventh, 39 Stat. 756, 211

767 (1916).

 Revenue Act of 1918, ch. 18, § 231(11), 40 Stat. 1057, 1076 212

(1919).

 Revenue Act of 1921, ch. 136, § 231(11), 42 Stat. 227, 253

213

(1921).

 Revenue Act of 1924, ch. 234, § 231(11), 43 Stat. 253, 283

214

(1924).

 Article 75, Regulations No. 33 (revised), published as T.D. 2690, 215

20 Treas. Dec. Int. Rev. 126, 175 (Jan. 2, 1918); Article 522(a),

109

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.211

This language was repeated, with insignificant editorial

changes, as section 231(11) of the Revenue Act of 1918, the 212

Revenue Act of 1921, and the Revenue Act of 1924. 213 214

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.215
Regulations No. 45, published as T.D. 2831, 21 Treas. Dec. Int. Rev.

170, 287-288 (Apr. 16, 1919). "The reference in the statute is to

associations operating exclusively as sales agents for their members.

Where an association departs from this purpose and engages in an

ordinary business pursuit--such as the buying and selling of fruit--it is

thereby removed from the exempted class." Sol. Memo. 952, 1 C.B.

207, 208 (1919).

 The various Treasury Department promulgations were issued as 216

interpretations of the revenue act in effect at the time. Since the

language of the cooperative exemption was stable throughout this

period, a ruling was applicable to subsequent revenue acts until the

cooperative exemption was rewritten in 1926.

 Sol. Op. 57, 3 C.B. 241, 243 (1920). 217

 Article 522(a), Regulations No. 45 (1920 ed.), published as T.D. 218

3146, 23 Treas. Dec. Int. Rev. 352, 492 (Jan. 28, 1921).

 Article 522(a), Regulations No. 62 (amended), T.D. 3511, 25 219

Treas. Dec. Int. Rev. 298-299, II-2 C.B. 201-202 (Sept. 6, 1923).

110

The early 1920's was 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.216

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

217

1921, the Solicitor's language was added virtually verbatim to

article 522 of the regulations.

218

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 219

1924 first relaxed this standard to only require that "voting control
 Article 522(a), Regulations No. 65, published as T.D. 3640, 26 220

Treas. Dec. Int. Rev. 745, 899 (Oct. 6, 1924).

 Article 522(a), Regulations No. 65 (amended), published as T.D. 221

3658, 26 Treas. Dec. Int. Rev. 1234 (Dec. 20, 1924).

 Article 522(a), Regulations No. 65, published as T.D. 3640, 26 222

Treas. Dec. Int. Rev. 745, 899 (Oct. 6, 1924).

 Article 522(a), Regulations No. 62 (1922 ed.), published as T.D. 223

3295, 24 Treas. Dec. Int. Rev. 207, 363-364 (Feb. 15, 1922).

 Article 522(a), Regulations No. 62 (amended), published as T.D. 224

3511, 25 Treas. Dec. Int. Rev. 298-299, II-2 C.B. 201 (Sept. 6, 1923).

Id.

225

 T.D. 3511, II-2 C.B. at 201-202. 226

111

is retained by the shareholders who are actual producers," and 220

then reinstated the "substantially all" rule.221

An 8 percent upper limit on dividends payable by an exempt

cooperative was added to the regulations in 1924.222

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

223

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

facilities required in business, or for the purchase and installation

of machinery and equipment, or to retire indebtedness incurred for

such purposes."224

Resale cooperatives. The requirement that exempt

cooperatives operate strictlyas agents for their farmer-patrons was

relaxed in 1923 to permit exempt associations to take title and

directly market farm products.225

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.

226

Federated cooperatives. In 1924, the Treasury Department

issued a brief statement to the effect that federated farmer
 I.T. 2000, III-1 C.B. 290 (1924). 227

 Article 522(b), Regulations No. 45, published as T.D. 2831, 21 228

Treas. Dec. Int. Rev. 170, 288 (Apr. 16, 1919); Article 522(b),

Regulations No. 45 (1920 ed.), published as T.D. 3146, 23 Treas. Dec.

Int. Rev. 352, 492-493 (Jan. 28, 1921). The tax treatment of patronage

refunds issued by nonexempt cooperatives during this period is

discussed in a prior section of this chapter.

 Revenue Act of 1921, ch. 136, § 231(11), 42 Stat. 227, 253

229

(1921).

112

cooperatives were entitled to exemption from taxation. This 227

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.228

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.229

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 onlyacquired farm supplies for members and
 Article 522(b), Regulations No. 62 (1922 ed.), published as T.D. 230

3295, 24 Treas. Dec. Int. Rev. 207, 364 (Feb. 15, 1922).

 Article 522(b),Regulations No. 62 (amended), published as T.D. 231

3511, 25 Treas. Dec. Int. Rev. 298-299, II-2 C.B. 201-202 (Sept. 6,

1923).

 Article 522(b), Regulations No. 62 (1922 ed.), published as T.D. 232

3295, 24 Treas. Dec. Int. Rev. 207, 364 (Feb. 15, 1922), and all

subsequent regulations published through 1926.

 Revenue Act of 1926: Hearings on H.R. 1 Before the Senate

233

Committee on Finance, 69th Cong., 1st Sess. (July 1926), 261-274.

Testimony of George R. Wicker, representing the Illinois Agricultural

Association, and testifying on behalf of several national and State

cooperative and farm organizations.

113

had no net income for their own accounts. The regulations were 230

further amended to permit purchasing cooperatives to accumulate

reasonable reserves for the same purposes as marketing

cooperatives and to do business with nonmember farmers.

231

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.232

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.233

At the urging of cooperatives, these regulatory opinions were

all written into law in the Revenue Act of 1926. Section 231(12)
 Revenue Act of 1926, ch. 27, § 231(12), 44 Stat. 9, 40-41 (1926). 234

The language of the 1926 act was repeated in the Revenue Act of 1928,

ch. 852, § 103(12), 45 Stat. 791, 813-814 (1928), and the Revenue Act

of 1932, ch. 209, § 103(12), 47 Stat. 169, 193-194 (1932).

 The Revenue Act of 1934, ch. 277, § 101(12), continued the

235

previous provisions and added, "business done for the United States or

any of its agencies shall be disregarded in determining the right to

exemption under this paragraph." 48 Stat. 680, 701 (1934). The

language of the 1934 act was repeated in the Revenue Act of 1936, ch.

690, § 101(12), 49 Stat. 1648, 1674-75 (1936); the Revenue Act of

1938, ch. 289, § 101(12), 52 Stat. 447, 481-82 (1938); and the Internal

Revenue Code of 1939, ch. 2, § 101(12), 53 Stat. 1, 33-34 (1939).

114

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- 234

ness calculation provision was added in 1934.235

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 ofthe proportion ofthe 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.

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.
 Some aspects of the Revenue Act of 1926 were borrowed from

236

the Capper-Volstead Act of 1922 (7 U.S.C. §§ 291-292, establishing

limited antitrust exemption for farmers who market on a cooperative

basis), notably the 8-percent limit on capital stock dividends and the

requirement a majority of business be for members. Revenue Act of

1926, Hearings on H.R. 1 Before the Senate Committee on Finance,

69th Cong., 1st Sess. (July 1926), 267-268. The nuances of these

various requirements will be discussed in more detail in a separate

report on section 521 tax status.

 Burr Creamery Corporation v. Commissioner, 62 F.2d 407, 409

237

(9th Cir. 1932), cert. denied, 289 U.S. 730 (1933).

 Farmers Union Co-op Co. of Guide Rock, Neb., v. 238

Commissioner, 90 F.2d 488, 492 (8th Cir. 1937).

 The definition was re-designated as section 101(12)(A), but

239

otherwise unchanged, when true tax exempt status was removed in the

Revenue Act of 1951, 65 Stat. 452, 491-493 (1951). When the Internal

Revenue Code was recodified in 1954, the definition of an "exempt"

cooperative, with immaterial technical changes, was relocated as § 521.

68A Stat. 3, 176-177 (1954). This section was left alone when

115

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.236

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 237

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.238

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 239
Subchapter T was enacted as part of the Revenue Act of 1962. 76 Stat.

960 (1962).

 For example, there were 17 days of Congressional hearings on 240

the subject in 1947. Part 4 Tax-Exempt Organizations (Cooperative

Organizations), Hearings Before The Comm. on Ways and Means,

House of Representatives, 80th Cong., 1st Sess. (3,161 pages of

transcript of hearings on this subject).

 Revenue Act of 1951, ch. 521, § 314, 65 Stat. 452, 491-493 241

(1951).

 The definition was designated § 101(12)(A) in the Revenue Act 242

of 1951. It was renumbered § 521 in the Internal Revenue Code of

1954.

 Section 314(a)(2) of the Revenue Act of 1951, 65 Stat. 452, 492 243

(1951). This provision was recodified, with immaterial technical

116

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 240

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 241

cooperative previously used to describe qualification for tax

exemption, the definition found in the current section 521.242

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 243
changes, as I.R.C. § 522 in the Internal Revenue Code of 1954, 68A

Stat. 3, 177-178 (1954). Section 522 was repealed and replaced by

subchapter T in the Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat.

960 (1962), reprinted in 1962-3 C.B. 111.

 Section 314(a)(2) of the Revenue Act of 1951, codified as §

244

101(12)(B) of the Internal Revenue Code of 1939, and recodified as §

522(a) in the Internal Revenue Code of 1954.

 Section 314(a)(2) of the Revenue Act of 1951, codified as § 245

101(12)(B) of the Internal Revenue Code of 1939, and recodified as §

522(b)(1)(A) in the Internal Revenue Code of 1954.

 Section 314(a)(2) of the Revenue Act of 1951, codified as §

246

101(12)(B) of the Internal Revenue Code of 1939, and recodified as §

522(b)(1)(B) in the Internal Revenue Code of 1954.

 Section 314(a)(2) of the Revenue Act of 1951, codified as § 247

101(12)(B) of the Internal Revenue Code of 1939, and recodified as §

522(b)(1) in the Internal Revenue Code of 1954.

117

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."244

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

245

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 246

deductions allowable under this chapter."247

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
 Section 314(a)(2) of the Revenue Act of 1951, codified as §

248

101(12)(B) of the Internal Revenue Code of 1939, and recodified as §

522(b)(2) in the Internal Revenue Code of 1954.

Id. 249

Id. 250

Id. 251

118

account in computing taxable income in the same manner as in the

case of a cooperative organization not exempt under subparagraph

(A)."248

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."249

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 the close of the taxable year.

250

The 1951 act also introduced the term "patronage dividend"

into the tax code.251

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
S. Rep. No. 781, 82nd Cong., 1st Sess. 20-21 (1951), reprinted 252

in 1951 U.S. Code Cong. & Admin. News 1969, 1989-1990. This

viewpoint that the intent of the 1951 Act was to create a single tax at

either the cooperative or the patron level is also reflected in the

legislative history of the Revenue Act of 1962. H.R. Rep. No. 1447,

87th Cong., 2d Sess., reprinted in 1962-3 C.B. 405, 482; S. Rep. No.

1881, 87th Cong. 2d Sess.,reprinted in 1962-3 C.B. 707, 817, and 1962

U.S. Code Cong. & Admin. News 3297, 3414-3415.

 T.D. 6014, 1953-1 C.B. 110; Rev. Rul. 54-10, 1954-1 C.B. 24. 253

 Caswell's Estate v. Commissioner, 211 F.2d 693 (9th Cir. 1954),

254

rev'g, 17 T.C. 1190 (1952).

119

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.252

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.253

Judicial Interpretation

A series of judicial decisions in themid-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 254

patronage refunds was not as established as might be expected

from the phrase in the Revenue Act of 1951 that refunds were to
Id. at 696. 255

 Commissioner v. Carpenter, 219 F.2d 635 (5th Cir. 1955), aff'g,

256

20 T.C. 603 (1953), acq. 1958-1 C.B. 4.

 Long Poultry Farms, Inc. v. Commissioner, 249 F.2d 726 (4th

257

Cir. 1957), rev'g, 27 T.C. 985 (1957).

120

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."255

In Commissioner v. Carpenter, a cooperative member 256

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 257

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
 249 F.2d at 731. 258

 Treas. Reg. 111 § 29.22(a)-23, T.D. 6014, 1953-1 C.B. 110, 117; 259

Treas. Reg. 118 § 39.22(a)-23, Rev. Rul. 53-226, 1953-2 C.B. 500.

 249 F.2d at 731. 260

 T.D. 6428, 1959-2 C.B. 26 (amendment to regulations issued 261

under the I.R.C. of 1954) and T.D. 6429, 1959-2 C.B. 452 (amendment

to regulations issued under the Revenue Act of 1951).

 Treas. Reg. 1.61-5(b)(1)(i), T.D. 6428, 1959-2 C.B. 26. This 262

note and the related ones that follow cite the amendment to the

regulations for the I.R.C. of 1954. Identical changes were made in

superseded regulations for years covered by the Revenue Act of 1951.

 Treas. Reg. 1.61-5(b)(1)(iv), T.D. 6428, 1959-2 C.B. 26. 263

121

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.258

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 259

regulation, "to the extent (it) attempts to tax as income what is not

income under law," was held void in Long Poultry.

260

After its acquiescence in Carpenter in 1958, the Service

amended its corresponding regulations. Under the amended

261

provisions, if the allocation was in cash, the patron included the

amount of cash received in reportable income. Allocation in the 262

form 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.263

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.
 Treas. Reg. 1.61-5(b)(1)(iii), T.D. 6428, 1959-2 C.B. 26. 264

 Farmers Cooperative Co. v. Commissioner, 288 F.2d 315 (8th

265

Cir. 1961), rev'g 33 T.C. 266 (1959); Pomeroy Cooperative Grain Co.

v. Commissioner, 288 F.2d 326 (8th Cir. 1961), rev'g 31 T.C. 674

(1958).

 President's 1961 message to Congress on Our Federal Tax Sys- 266

tem, reprinted in 1961 U.S. Code Cong. & Admin. News 1129, 1137.

122

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."264

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.265

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."266
 Revenue Act of 1962, Pub. L. No. 87-834, 76 Stat. 960 (1962), 267

reprinted in 1962-3 C.B. III.

 Pre-subchapter T continues to apply to nonexempt rural electric

268

cooperatives and telephone cooperatives (Rev. Rul. 83-135, 1983-2 C.B.

149) and governs the tax treatment of patronage refunds paid by exempt

farm credit institutions (Rev. Ruls. 71-556, 71-557, and 71-558, 1971-2

C.B. 79, 80, and 81).

 Geauga Landmark, Inc. v. United States, Docket No. 81-942 269

(N.D. Ohio, April 29, 1985).

 Des Moines County Farm Service Co. v. United States, 324 F. 270

Supp. 1216, 1219 (S.D. Iowa 1971), aff'd, 448 F.2d 776 (8th Cir. 1971).

123

The Revenue Act of 1962 responded to this call. Section 267

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.268

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 269

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."270
 Revenue Act of 1966, Pub. L. No. 89-809, § 211, 80 Stat. 1539, 271

1580 (1966).

 Rev. Rul. 54-10, 1954-1 C.B. 24. 272

 Tax Reform Act of 1969, Pub. L. No. 91-172, § 911, 83 Stat. 273

487, 722 (1969).

 H.R. Rep. No. 413, 91st Cong., 1st Sess. (1969), reprinted in 274

1969 U.S. Code Cong. & Admin. News 1645, 1652, 1820-1823.

124

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 271

administrative recognition of per-unit retain allocations. The 272

Tax Reform Act of 1969 confirmed the exclusion of per-unit

retains paid in money.273

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.274

The proposed limitations were not included in the Senate version
 Conf. Rep. No. 782, 91st Cong., 1st Sess. (1969), reprinted in 275

1969 U.S. Code Cong. & Admin. News 2392, 2438.

 Act of August 15, 1978, § 3, 92 Stat. 481, 483-484 (1978).

276

 Revenue Act of 1978, § 316, 92 Stat. 2763, 2829-2830 (1978). 277

Repealed by the Revenue Reconciliation Act of 1990, Title XI of the

Omnibus Budget Reconciliation Act of 1990, Pub. L. 101-508, § 11813,

104 Stat. 1388-536 (1990).

 Tech. Adv. Mem. 8521003 (Jan. 25, 1985).

278

 Pub. L. 99-272, § 13210, 100 Stat. 82, 323 (1985). 279

125

 of the legislation. The conference that produced the Tax Reform

Act of 1969 concurred with the Senate.

275

In 1978, two special situations were addressed--cooperative

use of the completed crop pool method of accounting and the 276

investment tax credit.

277

Cooperatives serving different groups of farmers faced a major

challenge to the waymany 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 278

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 279

losses under defined circumstances.
 Of course, all statutes relating to businesses and business 280

transactions affect cooperatives. They are not identified in this list, and

even the history of some laws directly affecting cooperatives are not

listed, such as all special provisions for investment tax credit, return

filing, alternative minimum tax, etc.

126

LEGISLATIVE HISTORY

The following list gives statutes directly dealing with Federal

income taxation of cooperatives. The list includes references to 280

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)
127

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 Cong. & Admin. News

4446, 4514-4517
128

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)
129

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)
130