Revised September 28, 1998

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

_______________________

No. 97-60504

_______________________

AFFILIATED FOODS, INC.,

Petitioner-Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee,

_________________________________________________________________

Appeal from the decision of the United States Tax Court

_________________________________________________________________ September 25, 1998 Before POLITZ, Chief Judge, and JONES and DUHÈ, Circuit Judges.

EDITH H. JONES, Circuit Judge:

Affiliated Foods, Inc. (“Affiliated”), the organizational

company for a non-exempt cooperative of small grocery stores,

instituted the present action for a refund of al leged tax

deficiencies for taxable years 1989 and 1990. Following a trial on

the merits, the Tax Court found that Affiliated had earned income

through its management of certain advertising funds destined for

its shareholders. Affiliated has appealed. For the reasons stated

below, this court affirms in part, reverses in part, and remands

the case to the Tax Court.1 Two of these promotional accounts were maintained through

formal written contracts. Otherwise, the promotional accounts were

r etained, free of charge, based on oral agreements betwe e n

Affiliated and the individual Vendor.

2 I. FACTS

Affiliated operates a wholesale food purchasing

c ooperative for the purpose of supplying food and other consu mer

products to retail grocery stores owned by Affiliated shareholders

(“Members”). By pooling their resources and using Affiliated as

their purchasing agent for thousands of manufacturers and suppliers

(“Vendors”), the Members achieve econom i es of scale otherwise

unattainable by them through independent operation.

A. The Promotional Accounts

In order to increase the retail sales of Members, the

Vendors encou rage promotion of their products. Often, Vendors

reimburse Members directly for the costs of these promotions.

However, Vendors also maintain promotional accounts with

Affiliated. 1 When received, the promotional account funds are

deposited in Affiliated’s general operating account with Amarillo

National Bank. While the promotional account monies are commingled

with funds used by Affiliated in day-to-day operations, meticulous

records are maintained with respect to the promotional ac counts.

Indeed, each Vendor receives a regular statement itemizing receipts

and disbursemen ts of its promotional account funds from

Affiliated’s account.3 The manner in which the promotional a ccount funds were

disbursed was contes ted in the Tax Court. Adopting the

Commissioner’s theory of the case, the court found that Affiliated

essentially provided advertising services to Vendors in exchange

for the promotional acc ount funds. In particular, the court

focused on the size of Affiliated’s advertising department and the

amount of promotional account funds ultimately direc ted to that

departmen t. The court discredited the testimony of Affiliated’s

witnesses re garding when and why promotional account funds were

released. The court did, however, recognize that release of the

funds i n the promotional accounts was contingent upon compliance

with standards placed on Affiliated by Vendors

-- either written or

oral.

B. The Food Show

Each year, Affiliated conducts a Food Show open only to

Members. At these Food Shows, Vendor representatives promote

Vendor products by setting up booths, offering product samples, and

providing special discounts for products. In order to participate

in this event, Affiliated requires that Vendors offer special cash

discounts for Members. Many Members agree to purchase an entire

year’s requirement of a Vendor’s products at the Food Show. For

this reason, Vendor represe ntatives must have an ample supply of

available cash.4 Vendors supply the funds for the cash rebates in several

different ways. Vendors may directly supply the cash to

representatives. More often than not, however, Vendors write

checks to Affiliated or use the funds in their promotional accounts

as a means of supplying Vendor representatives with the necessary

rebate ca sh. The Vendors’ checks are deposited in Affiliated’s

general operating account. When the Food Show begins, the Vendor

funds are dispensed from Affiliated’s general operating account to

the Vendor representatives. At the conclusion of the Food Show,

the Vendor re presentatives return the remaining funds to

Affiliated. Affiliated returns these funds to Vendors or accounts

for the funds in the respective Vendor’s promotional account. As

with the promotional accounts, Affiliated maintained meticulous

records on the amount of funds received from Vendors and the

amounts returned to each Vendor’s promotional account.

The Tax Court found that the Food Show cash rebates were

act ually disguised patronage dividends. Distinguishing the cash

rebates as payments made from Vendors to Members, the court

determined that Affilia ted retained substantial control over the

funds before, during, and after the Food Show. The court construed

the deposit of Vendor funds in Affiliated’s general operating

account as “earnings of the cooperative from business done with or

for its patrons.” The Tax Court noted that normally the income

received from the Food Show rebates would have been deductible as2 See 26 U.S.C. § 1388(a).

5

a “patronage dividend” when returned by Affiliated to the Members.

Howev er, because Affiliated was unable to meet the statutory

requirements for a pa tronage dividend deduction, 2 the adjusted

income was not deductible.

II. DISCUSSION

Affiliated is a non-exempt cooperative taxed pursuant to

26 U.S.C. §§ 1381-83. At year-end, Affiliated may avoid taxation

by distributing income to Members in the form of patronage

dividends. See 26 U.S.C. §§ 1382(b), 1388. Once these patronage

dividends are paid, Members must re port the dividends as income.

See 26 U.S.C. § 1385(a). To the extent Affiliated retains income

at year-end, the cooperative must report the amount as gross

income.

The IRS adjusted Affiliated’s 1989 and 1990 gross income

to include the year-end balances of the promotional a ccounts and

the total amount of cash distributed by Vendors to Members at the

Food Shows. The IRS construed all monies paid into the Affiliated

promotional accounts as income. However, Affiliated was allowed a

deduction for the amount of funds expended on promotions. Thus,

only the year-end balances remained as taxable income. With

respect to the Food Show payments, all of the mon ey which passed6

through Affiliated’s general operating account to Members was

included as gross income.

A. Standard of Review

The Tax Court’s resolution of the disputed factual issues

in this matter is subject to the clearly erroneous standard of

review. S ee Fed. R. Civ. P. 52(a). Under the clearly erroneous

standard, this court will reverse the decision of a lower court

only if “left with the definite and firm conviction that a mistake

has been made.” S treber v. Commissioner

, 138 F.3d 216, 2 19 (5th

Cir. 1998). So long as there is evidence which supports a court’s

plausible account of the evidence, this c ourt must affirm “even

though convinced that had it been sitting as the trier of fact, it

would have weighed the evidence differently.” Justiss Oil Co. v.

Kerr-Mcgee Ref. Corp. , 75 F.3d 1057, 1062 (5th Cir. 1996).

The imposition of tax by the Commissioner is

presumptively correct; therefore, the petitioner must shoulder the

burden of proving that the tax assessment was improper. S ee W elch

v. Helvering

, 290 U.S. 111, 115 (1933). Because the Tax Court’s

discussion of Affiliated’s promotional accounts fundamentally

misconstrues the operations of the cooperative, this court reverses

the Commissioner’s imposition of tax on the year- end balances of

the promotional accounts. However, because Affiliated was unable

to present record s detailing the amount of Food Show rebates

payable to individual Members, this court affirms the Tax Court’s3 The manufacturer made no specific commitment regarding the

ultimate use of the funds other than the following:

Exp enditures for national advertising are a matter of

public record, in advertising and business journals. Our

books on advertising receipts and expenditu res will be

open to any bottler at any time.

Seven-Up , 14 T.C. at 978.

7 decision regarding the adjustment to Affiliated’s gross income for

the Food Show rebates.

B. The Promotional Accounts

1. The Tax Treatment of Promotional Accounts

In a line of cases beginning with Seven-Up Co. v.

Commissioner

, the Tax Court set forth the standard controlling the

present dispute. 14 T.C. 965 (1950). In S even-Up

, the

manufacturer of 7-Up extract establish ed a national advertising

fund for the beverage produced from the extract. See id. at 968-

69. 7-Up bottlers that participated in the national advertising

program 3 made payments to the manufacturer based o n the number of

gallons of extract purchased. S ee id. at 974. The manufacturer

placed these funds in one or more regular operating accounts

--

commingling the advertising funds with operating funds. S ee id.

Although no separate bank account was established for the funds,

the manufacturer maintained the advertising funds separately on its

books as accounts payable. S ee id. The advertising funds were

viewed by the manufacturer as a whole

-- no individual bottler8

retained the right to the funds after payment. S ee id. The

advertising agency i n charge of the campaign billed the

manufa cturer; however, the parties involved understood that the

advertising funds remitted from bottlers actually paid the

advertising expenses. S ee id. at 972. If a balance remained in

the advertising fund at year-end, the amount was carried over as an

account payable for the next tax year. See id. at 975.

On these facts, the Tax Court found that the advertising

funds channeled through the manufacturer to the advertising agency

did not constitute gross income. S ee id. at 979. The court noted,

The payments made by the participating bottlers were not

for services rendered or to be rendered by [the

man ufacturer]. Neither were they part of the purchase

price of the extract. They did not, therefore,

c onstitute earnings received by the petitioner under a

claim of right without restriction as to disposition,

which petitioner would have had to include in its gross

income. . . .

Id. at 977. Finding the manufacturer merely constituted a conduit

for the passing of funds from bottlers to the advertising agency,

the court determined that the restrictions placed on the use of the

advertising funds and the manner in which the manufacturer

consistently treated the advertising funds precluded the imposition

of additional tax on the manufacturer. See id. at 977-79.

The Tax Court has confirmed the vitality of Seven-Up in

other settings. Two instances are of particular note. In Ford

Dealers Advertising Fund, Inc. v. Commissioner

, the Tax Court9

overturned the imposition of tax on the contributions of Ford and

local dealers to a fund designed to increase advertising of Ford

automo biles. S ee 55 T.C. 761, 772-74 (1971). Even though some

fund resources were used to finance a n incentive program for

salesmen and a car-locator service, the court held that,

[A]n intermediary may be employed as a depository for

funds in trust which are destined for an ultimate use

that is speci fied within defined limits. The benefit,

profit, or gain is not to accrue to the intermediary but

rather to some other entity.

Id. at 773. Even though the Advertising Fund held significant

discretion regarding the ultimate disposition of the contributions,

the parties involved intended that the Fund merely serve as an

intermediary for the channeling of resources to a third-party --

without any resulting gain to the intermediary. Accordingly, the

Tax Court refused to tax the year-end balance of the advertising

fund as income.

In Florists’ Transworld Delivery Ass’n v. Commissioner

,

the Tax Court further defined the relevant inquiry. 67 T.C. 333

(1976). A cooperative of florists -- similar to Affiliated --

received funds from member florists for the purposes of supporting

a Clearing House Division and a Marketing Di vision. S ee id. at

335. The contributions to the Marketing Division funded national

advertising for members. S ee id. However, the Marketing Division

also performed services such as the printing an d acquisition of

promotional materials and office supplies for members, the10

processing of customer billing, the compilation and distribution of

market research, and the arrangement of customer gifts. S ee id. at

340. The Tax Court found that any benefit or gain received by the

cooperative by virtue of the allocation of a portion of member

contributions to the general administrative and operating expenses

of the Marketing Division were merely “incidental and secondary.”

Id. at 346 (citing Angelus Funeral Home v. Commissioner

, 47 T.C.

391, 395 (1967)). Thus, although the Marketing Division supplied

members with services and used member advances for expenses other

t han national advertising, the Tax Court rejected the

Commissioner’s argument that member contributions should be

included as gross income in the taxable year received. S ee

Florists’ Transworld , 67 T.C. at 347.

In its opinion, the Tax Court compared the Affiliated

arrangement to Krim-Ko Corp. v. Commissioner

, 1 6 T.C. 31 (1951).

Krim-Ko manufactured chocolate syrup for use in the production of

chocolate milk. S ee id. at 32. Krim-Ko and its customers engaged

in an advertising program whereby customers paid Krim-Ko a certain

amount per gallon of syr up, and, in return, Krim-Ko furnished

“advertising features and sales promotion services.” I d. at 33-34.

Although the payments were commingled in Krim-Ko’s general

oper ating account, Krim-Ko maintained separate records for each

customer’s contribution to the advertising pool. S ee id. at 34-35.

The Tax Court found that Krim-Ko was not a cting as a mere4 See Angel us Funeral Home , 47 T.C. at 395; S even-Up

, 14 T.C.

at 977.

11 repository for the advertising funds. Instead, the court

characterized the advertis ing arrangement as follows: “At most,

Krim-Ko, as an adjunct to its principal business, had undertaken to

sell special advertising material and services to its customers.”

Id. at 39. “[The advertising funds] were paid in consideration for

Krim-Ko’s promise to furnish designated advertising m aterial and

services.” I d. at 40. Significantly, no restrictions were placed

on the use of the funds, and Krim-Ko treated the funds as its

property. See id.

2. The Proper Tax Treatment of the Affiliated

Promotional Accounts

The Tax Court fundamentally misconstrued the operation of

Affiliated’s promotional accounts an d, in so doing, improperly

assessed tax on the year-end balances of the promotional accounts.

As the Tax Court’s determination rested on an examination of the

facts and circumstances surrounding the promotional accounts, 4 this

court carefully reviewed the Tax Court’s findings. Based on the

stipulations of the parties and the uncontroverted testimony of the

witnesses, Affiliated merely served as an intermedia ry for its

Members with respect to the funds placed in Vendor promotional

accounts. Accordingly, Affiliated was not required to report these

amounts as income during the 1989 and 1990 tax years.12 The Tax Court characterized the inner workings of the

promotional accounts as follows: (1) a Vendor informs Affiliated of

a promotional program; (2) Affiliated chooses which promotions to

perform; (3) the Vendor then deposits an amount in the promotional

account representing a cost plus allowance for performing the

promotion; (4) upon proof of performance, the Vendor releases the

funds from its promotional account as reimbursement and payment for

Affiliate d’s advertising services. The court further found that

the promotio nal account funds were rarely, if ever, refunded to

participating Vendors. Specifically, the court seemed to focus on

the revenue generated by Affiliated’s advertising department.

These findings , however, do not comport with the evidence and

stipulations.

While Vendors informed Affiliated of the promotions and

advertising that would trigger release of the promotional account

funds, Affi l iated neither controlled the ultimate decision to

participate in the programs nor mandated the amount of funds a

Vendor placed in the promotional accounts. Vendors deposited funds

in the promotional accounts at their convenience and in increments

of their choosing. Subsequently or as provided by contract, the

Vendor would inform Affiliated of the promotion required to trigger

the release of the funds. Affiliated would then place all of these

promotional opportunities in a weekly “deal sheet.” The deal sheet

was forwarded to Members. Members then chose which promotions to5 See Schochet v. Commiss ioner , 44 T.C.M. (CCH) 556, 565 (Tax

Court 1982) (“Our use of terms such as ‘trustee,’ ‘agent,’ and

‘conduit’ serves for purposes of analogy, not as a requirement of

a specific legal relationship.”).

13 implement. Once the Members performed these promotions, proof of

performance was submitted, through Affiliated, to the responsible

Vendor. Upon receipt of proof of performance, the Vendor would

authorize Affiliated to release funds from the promotional account

as proposed in the advertising program.

The Tax Court’s prima ry concern with the promotional

account arrangement was Affiliated’s advertising department. While

Affiliated did maintain a large advertising department, no gain

accrued d irectly to the advertising department bas ed on

Affiliated’s receipt of promotional account funds. After choosing

to perform a promotion, Members were not required to use the

department. More often than not, however, Members did take

advantage of the cost savings ass ociated with using Affiliated’s

advertising department. Though Affiliated generated revenue

through the advertising department, this revenue was earned by

providing services to Members -- not to Vendors.

Under Seven-Up and its progeny, Affiliate d was not

required to enter formal trusts with Vendors in order to avoid the

accrual of income. 5 As the Tax Court stated in Ford Dealers

,

[W]hen a taxpayer receives trust funds, which he is

obligated to expend in entirety for a specified purpose

and no profit, gain, or other benefit is to be received6 Although the Tax Court dis counted the testimony of several

witnesses as vague and imprecise, no testimony or documentary

evidence contradicts the essentially consistent testimony of these

witne sses. Thus, while the court afforded this testimony little

weight, no evidence was presented by either party to rebut the

testimony.

14 by him in so doing, the funds are not includable in gross

income.

55 T.C. at 771. The fact that Affiliated commingled the funds in

its general operating account and retained the funds at year-end,

without refunding them to t he Vendors, does not alter the

appropriate tax treatment of the promotional accounts. S ee SevenUp

, 14 T.C. at 974. Similarly, reporting the interest earned on

the promotional accounts as income does not affect the status of

the funds under the tax laws. S ee Schochet

, 44 T.C.M. (CCH) at 566

n.20; Florists’ Transworld , 67 T.C. at 346 n.18.

Vendors retained control of all the funds placed in

Affiliated’s promotional accounts. See Schochet , 44 T.C.M. (CCH)

at 564. No evidence, testimony, or stipulation controverts this

fact. 6 Affiliated reported the promotional accounts on its

corporate books as liabilities to Vendors and would not release the

funds until ordered to do so by Vendors. Any discretion vested in

Affiliated regarding the use of the funds does not destroy the most

important operative facts in this dispute. Namely, Affiliated had

no right to receive the promotional account funds, supplied no

service to Vendo rs based on the receipt of the funds, and was7 In Buckeye C ountrymark, Inc. v. Commissioner , the Tax Court

defined a patronage dividend as follows:

In general, a patronage dividend is an amount that is

allocated or paid to a patron out of the net earnings of

the cooperative from business done with or f or patrons

and that is based upon the quantity or value of business

done w ith or for the patron, under a preexisting

obligation to pay such amount.

103 T.C. 547, 555 (1994) (citing 26 U.S.C. § 1388(a)).

15 sufficiently constrained in the disposition of the funds. S ee Ford

Dealers

, 55 T.C. at 771-73. Under these circumstances, the Tax

Court clearly erred by including the promotional account funds in

Affiliated’s gross income for the 1989 and 1990 tax years.

C. The Food Show

Based on this court’s review of the record, the Tax Court

p roperly found that the Food Show cash rebates were actually

disguised patronage dividends. 7 Vendors participated in the yearly

Food Show by permission of Affiliated. In order to participate, a

Vendor was required to offer special discounts to Members. Instead

of passing on these discounts through the cooperative, Affiliated

required Vendors to offer these discounts directly to M embers at

the Food Show. By structuring the transaction in this manner,

Affiliated sought to avoid the proper method of accounting for

patronage dividends.

Tax is assessed according to the economic substance of a

transaction

-- form is not controlling. S ee Gr iffiths v.16

Helvering

, 308 U.S. 355, 356-57 (1939). In this manner, a taxpayer

is unable to subvert the tax laws based merely upon the structure

of a transaction. S ee Mississippi Valley Portland Cement Co. v.

United States , 408 F.2d 827, 833 (5th Cir. 1969). By negotiating

for Food Show rebates, Affiliated provided for the direct payment

of monies from Vendors to Members that would otherwise have accrued

to Affiliated as earnings, i.e., rebates from Vendors to Affiliated

for product purchased for sale by Affiliated. Moreover, a Member

received Food Show rebates based on the amount of product purchased

at the show. Thus, greater product purchases meant more Food Show

rebates. The product, however, was not purchased directly from the

Vendors at that time. Members committed to make purchases at the

Food Show and subsequently bought the product through Affiliated.

In th is manner, a Member received rebates based on the amount of

product purchased through Affiliated, and Affil iated was able to

provide a patronage dividend without complying with the statutory

requirements. S ee 26 U.S.C. § 1388; see generally Buckey e

Countrymark , 103 T.C. at 558 (“Patronage dividends are considered8 As the 1989 and 1990 Foo d Show rebates will now have been

ta xed, potentially, to both Affiliated and its Members, this

holding effectively imposes a dual tax on the cooperative’s

patronage dividends. Normally, with proper supporting

documentation, a patronage dividend would be reported as income and

then deducted by Affiliated. In the case of the Food Show rebates

involving Western Family Foods, Affiliated was able to

substantiate, throug h bookkeeping entries, the extent of the

rebates, and the Tax Court allowed Affiliated an appropriate

deduction for business expenses. With respect to the other

rebates, however, because Affiliated destroyed the only

documentation, the cooperative was unabl e to meet its burden of

proof regarding the patronage dividend deduction. The Tax Court

also found that Affiliated had conceded that the rebates were not

deductible as business expenses and, moreover, that Affiliated had

failed to support such a deduction with appropriate evidence at

trial. As such, Affiliated cannot support a deduction for the

amounts that, based on the Tax Court’s holding, must be included in

gross income.

17 rebates on purchases.

. . .”). 8 As such, this court affirms the

decision of the Tax Court with respect to the Food Show rebates.

III. CONCLUSION

The court finds no clear error with respect to the Tax

Court’s rulings o n the Food Show rebates and, therefore, A FFIRMS

the court’s decision for the reasons stated.

The Tax Court impermissibly erred by characterizing the

funds deposited in Affiliated’s promotional accounts as payment for

services it performed for the Vendors. Affiliated merely served as

a clearinghouse

-- receiving information and funds from Vendors and

passing on the information and funds to M embers. Any gain that

accrued to Affiliated as a direct result of its role as

intermediary was incidental. On this issue, this court R EVERSES18

the decision of the Tax Court. We R EMAND to the Tax Cour t for

recalculation of the Commissioner’s deficiency assessments on

income realized by Affiliated in 1989 and 1990 and such further

proceedings as are appropriate and consistent herewith.

AFFIRMED in part, REVERSED in part, and REMANDED

.