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it is soliciting business from veterinarians in every State in the country to my knowledge and also dealing with 60 veterinary wholesalers, so it is a going business on a big scale, all built up on tax exemption.

The CHAIRMAN. Your entire statement will appear in the record.

Mr. WILLIAMS. Thank you. I would like to say this: that this may appear to some of you as a small matter. The effects these 13 companies have taken 30 to 40 years to build up the competence to do business that these people have done in 5 years. That is something to do think about. They built it up after payment of taxes.

I thank you very much. This statement here has a suggestion that we would like to see amended to the law that at least cut out trade people and trade persons and entities from tax favoritism.

You may think that farmers are entitled to some special consideration. I will not argue the general, overall merits of this. What excuse is there for having trade people come in as a cooperative! Is there any? I don't know. I don't think there is, Mr. Chairman.

The CHAIRMAN. Thank you, Mr. Williams. Are there any questions? Mr. Mason. Yes, sir. The CHAIRMAN. Mr. Mason will inquire. Mr. Mason. Mr. Williams, all you have given us is an illustration of the tremendous growth of these cooperatives that are not farm co-ops and their effect upon the private industry that is doing the same thing and these are nothing but a group of professional men who have gotten together in order to avoid the tax and compete with other businessmen doing the same kind of work.

Mr. WILLIAMS. That is right, sir. This letter that Hon. Sidney Simpson read to you says that was their express purpose in organizing.

Mr. Mason. I have a copy of that letter that was sent me a year or two ago.

The CHAIRMAN. Are there any further questions of Mr. Williams!

If not, we thank you, sir, for coming to the committee and giving us this information. (The following statement was received by the committee :)

THE TAX EXEMPTION OF COOPERATIVE ASSOCIATIONS A Statement by Robert T. Patterson, Associate Professor of Public Finance,

Claremont Men's College and the Claremont Graduate School The earnings or net margins of cooperative associations are at present largely exempt from the corporation income tax. This is because such associations are permitted to deduct or exclude from gross income the dividends paid or credited to patron-members on the basis of their transactions with the associations It is the purpose of this statement (1) to show that the exemption is inequitable and uneconomic, and that it permits a substantial loss of revenue to the Federal Government, and (2) to suggest remedial legislation.

THE SIGNIFICANCE OF THE EXEMPTION When, in 1909, the corporation tax statute imposed a 1-percent tax on the income of corporations, various organizations, including cooperatives, which "operated exclusively for the mutual benefit of their members," were exempted.'

There was little objection to so slight a tax advantage for this particular form of business. The exemption was of small significance, either for the

136 Stat, 11, 113.

accumulation of capital through tax savings or for competitive price advantage over the cooperatives' corporate rivals.

Successive Federal revenue acts exempted certain farmer cooperatives, and the income of all others was made largely tax exempt by liberal rulings of the Treasury Department and court decisions. These rulings allowed them to deduct from their earnings the patronage dividends paid or credited to their members. This meant, in most cases, that only a small part of the earnings need be subject to tax.

As tax rates on corporation income rose, what had been a slight tax saving to the cooperatives became a source of funds which afforded many of them a marked financial advantage over their corporate competitors. The differential gave leverage to cooperative expansion, enhancing the ability of such organizations to retain earnings as additional capital and to compete vigorously and sometimes destructively. The increment from tax-free income enabled many not only to increase their facilities and services, but, in some instances, to buy out their competitors.

Moreover, where surplus accrued to a cooperative through tax savings, it could offer better prices and pay larger patronage dividends than would otherwise have been possible. The attraction of patronage to a business that has such an advantage can, of course, be irresistible, particularly if the business is reasonably efficient and is able therefore to approximate the cost of operations of its strongest competitors.

In recent years the trend of cooperative business has been markedly upward. Estimates of the Department of Agriculture, made solely for farmer cooperatives, show that between 1940-41 and 1953-54 their volume of business increased from $2.3 billion to $9.5 billion per year. Although this was a period in which the value of farm products and the amount of farm income rose substantially, it is a fair conjecture that a part of the increase in cooperative business was due to competitive advantage through the leverage of tax exemption."

Better data are available for farmer cooperatives than for consumer cooperatives. In 1953-54 there were 10,058 farmer cooperatives having 7.6 million memberships and transactions of $9.5 billion. In 1954 there were some 18,000 consumer cooperatives having over 20 million memberships and transactions well over $1 billion."

The present tax on the income of ordinary corporations begins at 30 percent and rises to 52 percent. According to estimates of the Joint Committee on Internal Revenue Taxation the average rate that would apply to the earnings of cooperatives, were they taxable on the same basis, would be about 40 percent. But it is possible for the cooperatives, through disbursement of patronage dividends, to reduce their taxable income to a nominal amount. Besides this taxfavored status of the cooperatives themselves is the tax treatment of their members. Under present judicial determination, patronage dividends can be distributed in such forms that they are not currently taxable income to the recipients.

This opportunity for double escape from income taxation is in marked contrast with the tax situation of ordinary corporations and their dividend-receiving stockholders. In their case most of the earnings which are distributed as dividends are subject, also, to the personal income tax. Thus the income of ordinary corporations can be taxed at two levels—corporate and individual-while the earnings of cooperatives can be largely tax free at both income levels.

Under the present tax exemption of cooperatives and their patron-members at least $150 million is lost to the Federal Government each year. That amount of added revenue could, of course, lighten somewhat the burden of other taxpayers or permit some reduction of the Government's debt.

A cooperative, when it lacks monopoly power or special privilege, is a competitive business entity. Its survival and growth depend, then, upon its efficiency, which in turn depends upon the wisdom of its directors in larger matters of decision and upon the ability of its management at the operational level. Its value to the Nation is determined by the real costs at which it provides its seryices. Like any firm in a freely competitive situation, its survival depends upon

2 Anne L. Gessner, Statistics of Farmer Cooperatives, 1953-54 (Washington : Farmer Cooperative Service, U. S. Department of Agriculture, 1956), pp. 65, 69.

: Farm income rose from $5.5 billion (1940-41 average) to $12.1 billion (1953-54 average). U. S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United States : 1956 (77th edition ; Washington: Government Printing Office, 1946), p. 295. Comparable data for the value of farm products are not available. * Many individuals belong to two or more associations.

Data are based on Gessner, op. cit., p. 65; Statistical Abstract of the United States : 1956, p. 868; and the author's estimates.

relatively low unit cost of output; that is, upon the economical application of labor, capital, and managerial effort to the particular productive processes in which it engages. The cooperative way of doing business is as good a way as any other when it has no special privilege and can survive under competitive conditions. In fact, in some instances the cooperative may be a superior form of enterprise.

If, however, to a greater or lesser extent a firm-whether it is a cooperative or any other form of enterprise-is subsidized by tax exemption, a part of its real costs of operation is borne elsewhere in the economy, directly by government and indirectly by all who contribute to pay the expenses of government. The subsidization of cooperatives by tax exemption is conducive to the establishment and survival of higher cost, less efficient business units throughout the economy than would otherwise be possible. This is not to say, however, that all cooperatives, because they enjoy tax exemption, are high-cost, inefficient businesses. Subsidization of one particular form of business organization, whether by tax exemption or by other means, is certain to cause the displacement of other forms by the one favored. Businesses that are superior through efficiency and economy may succumb to those which are aided by an arbitrary tax advantage. To what length the cooperative movement may be carried by the impetus given it from the present tax laws, court decisions, and regulations cannot be clearly predicted. If cooperatives were to continue to broaden the scope and increase the volume of their business, thereby displacing the business of ordinary corporations, there would be a correspondingly larger area of revenue loss to the Government.

All businesses-including cooperatives—that operate above the break-even point, before equity capital is rewarded, have earnings. It simply cannot be said that cooperatives, because of the nature of their organization, do not have income. As Albert W. Adcock has pointed out

“When comparisons are made, it is clear that cooperative corporations possess all of the essential attributes of ordinary business corporations except as to the basis of distribution of their net earnings. * * * The patronage dividends distributed by a cooperative corporation are in the usual case distributions of corporate income which only superficially resemble refunds or additional price payments."?

The member-patrons of a cooperative are the owner enterprisers of a business seeking a profit. They are attempting through the transactions of their mutual organization to save or to gain. Though their savings may be hidden or obscured by the complex relationship of owner-patron, prices, and patronage dividends, those savings or earnings are there, nevertheless, to the extent that the association operates economically. It is in no true sense a nonprofit association, for it has none of the typical characteristics of nonprofit organizations. As Prof. Lorne D. Cook has expressed it:

“The gains from cooperative enterprise are found to be in the nature of corporation profits, which, although they are distributed according to patronage, accrue to member-patrons in proportion to investment and entrepreneurial risks undertaken."

According to Prof. O. Glenn Saxon:

"There is no basis in law, equity, economics, or logic for any cooperative corporation to deny that it absorbs risks, creates economic capital, income, and profits through the use of its own management, labor, and capital. If successful, it has both gross and net profits which are not its members' profits, and, if unsuccessful, has gross profits less than its operating costs, or net losses which are not it members' losses. Nor can it deny that it creates, in addition to profit and new wealth, new jobs, as does any ordinary corporation, unless it merely replaces other organizations. It, therefore, produces dollar income, economic income, and taxable income. * * * The ownership of the income or profits of a cooperative corporation or any other legal entity turns not upon how that income or profit is distributed, but how it is produced and by whom it is produced.” •

There are three conditions, each of them essential, which must prevall to make the establishment of a cooperative practical : "First, there must be geographical contiguity among the members ; second, it is necessary that the members have significant economic interests in common; and third, the patron relationship should be a continuing one and one involving regular exchanges with the enterprise (Lorne D. Cook, An Economic Analysis of the Federal Taxation of Income From Cooperative Enterprise, doctoral dissertation, University of Michigan, 1954 (typewritten, on microfilm), pp. 50-51).

* Patronage Dividends : Income Distribution or Price Adjustment, Law and Contemporary Problems. XIII (summer, 1948), pp. 524, 525. 8 Op. cit., p. 1..

statement of Prof. O. Glenn Saxon, U. 8. Congress, House of Representatives, Committee on Ways and Means, hearings. Revenue Revision of 1951, pt. 8, 828 Cong., 1st sess., 1951, p. 1850.

The tax exemption has a substantial capital value to the cooperatives. It can be observed when a cooperative desires to buy up an ordinary corporate firm. Let us assume, for example, that the firm's net earnings after taxes are $1 million annually and that the capitalized value of those earnings is $10 million (the going rate of return for that kind of an investment being assumed to be 10 percent).

Let us assume, also, that before payment of the corporation income tax its earnings were $2 million. If the cooperative regards a 10-percent return as satisfactory it can afford to pay as much as $20 million for the firm, because it can receive tax-free the full $2 million of annual earnings. Another ordinary corporation seeking to buy this firm could wisely pay no more than the aftertax capitalization value of $10 million. This illustrates why it is possible, in many cases, for cooperatives to compete ordinary corporations out of business or buy them up at far less than the full capital value of their earnings before taxes.

THE STATUTORY AND ADMINISTRATIVE NATURE OF THE EXEMPTION Until 1951, farmer cooperatives which met certain requirements were exempt both from filing returns and from paying Federal income tax. From the elaborate definition of those that qualified as fully tax exempt it might be supposed that cooperatives, whether farmer or otherwise, which did not meet the requirements would be fully subject to the corporation income tax. That was not the case, however, for the dividends which they paid or allocated on the basis of patronage were excludable from gross income, and only the remainderwhatever that might be was subject to the income tax.

Associations that did not comply with the statutory requirements for tax exemption—the nonexempt cooperatives—were obliged to file income tax returns and, under certain circumstances, to pay some tax, although such payments ordinarily were small compared with those that would have been made by similar ordinary corporations. The fact is that the nonexempt cooperatives were almost as fully exempt from the Federal income tax as those that met the conditions for exemption. Their nearly tax-exempt position was ascribable not to any act of Congress but to rulings of the Treasury Department which had for many years permitted them to deduct or exclude that part of their earnings which was paid or allocated as dividends to their patrons. The courts, simply confirmed this administrative practice.

In the Revenue Act of 1951 Congress undertook to end the fully tax exemption privilege of the exempt cooperatives and to place them more nearly, but not exactly, on the same basis as the nonexempt associations. This legislation made the exempt cooperatives subject to the income tax to the same extent as the nonexempt cooperatives, except that they were allowed to deduct from gross income dividends which they paid on their capital stock and the amount of nonpatronage income which they allocated to patrons. The statute made it clear that the patronage dividends of both exempt and nonexempt cooperatives should be treated alike; that is, should be deductible or excludable in computing income. This, rather oddly, was done merely by reference to the prevailing taxexempt status of the patronage dividends of the nonexempt cooperatives, which had come about not through legislation but by means of administrative determinations upheld by court decisions. The present law merely declares that the patronage dividends of the exempt cooperatives "shall be taken into account in computing taxable income in the same manner as in the case of a cooperative organization not exempt under section 521." 11

The Treasury Department is helpless to revise its practice. As far back as 1914,” it had allowed nonexempt cooperatives to deduct or exclude from their taxable income amounts paid or allocated according to patronage. A longaccepted administrative practice is regarded as having congressional approbation, and only the most exceptional circumstances can justify its reversal." Thus the Treasury Department is obliged to wait upon Congress to block this avenue of escape from the Federal income tax. Until Congress acts, it cannot be denied, the managers of cooperatives are legally justified in taking the ex

10 Sec. 101 (12) of the Internal Revenue Code of 1939, which provided for the exemption of certain farmer cooperatives, was left unchanged except that it was redesignated sec. 101 (12) (A). In the Internal Revenue Code of 1954 it became sec. 521. The exemption that it granted, however, had been to a great extent removed by sec. 314 (a) (2) of the Revenue Act of 1951, which became sec. 101 (12) (B) of the amended Internal Revenue Code of 1939, and subsequently sec. 522 of the Internal Revenue Code of 1954. 11 Internal Revenue Code of 1954, sec. 522.

Treasury Decision 1996 (1914). uci. Farmers' Cooperative Co. v. Birmingham, 86 F. Supp. 201 (D. C. Iowa, 1949).

emption; and in terms of their duty to their organizations they are bound to make the most of this tax privilege.

THE "PRICING OUT" PROBLEM The possibility of minimizing earnings or net margins if they were made taxable raises a problem that has long troubled those who favor taxing the cooperatives in some way similar to that in which ordinary corporations are taxed. The process is sometimes referred to as "pricing out." There seems to be no practicable way of preventing it as a means of tax avoidance. Cooperatives cannot be compelled to set prices at such a level that their net margins will be just the equivalent of the earnings of ordinary corporations operating under like circumstances.

It has sometimes been suggested that a theoretical market price could be established at the time the cooperative's transaction with its patron takes place and that any deviation from that price in the direction of "pricing out” would be regarded as an advance distribution of the cooperative's earnings and the tax liability of the cooperative would be adjusted accordingly. Such a method, however, would be highly impractical. Any attempt to put the idea into practice would certainly be a failure.

But the possibility of "pricing out” is probably not as great an obstacle to the taxation of cooperatives' income as it at first seems. Undoubtedly the method would be used to some extent to avoid taxation, and the management of cooperatives would have to take it into consideration in formulating their organizations' policies. Enlightened cooperative management knows, however, that "pricing out," if carried very far, can be extremely dangerous. It can lead to the destruction of a cooperative if the margin of earnings allowed for uncertainty and error is too small. Some cushioning excess of receipts over expenditures must be assured if, sooner or later, through unanticipated changes in costs and prices as well as in general economic conditions the business is not to find itself in financial straits. The history of the cooperative movement is replete with failures due to pricing that resulted in too small a difference between recepits and expenditures. That price policies would be adopted, to some extent, to mitigate the taxation of net margins seems certain, but it is unlikely that the change would be extreme or that it would by any means do away with net margins.

Not only would sound financial policy require the achievement of net margins, but the personal motives of coperative management would also be conducive to it. Their salaries, positions, and careers depend upon the financial strength and stability of their associations. And the improvement of their positions may de pend upon the capacity of their firms to expand. Motivations of managerial power, too, would be favorable to price policies which resulted in substantial net margins that, even though subject to the income tax, could be plowed back into the business by merely allocating the net margins after taxes to the patrons.

THE EXEMPTION FOR RECIPIENTS OF ALLOCATED PATRONAGE DIVIDENDS With respect to patronage dividends, whether paid in cash or credited to the patron in one form or another, the Treasury has consistently held that the recipients are subject to tax in the same way that other income is taxed. As many cooperatives allocated their earnings to patrons in paper that was far from being the real equivalent of cash, and as the recipients were expected to pay tax on such dividends in actual cash, the unreality of the Treasury's theory that such payments represented immediate reinvestment was evidenced by many protests and much evasion. Nonnegotiable certificates payable at some far distant and indefinite time appeared to farmers and others as anything but cash, and certificates or credits for small amounts were regarded as practically worthless.

In recent years the theory, as it was applied by the Treasury Department, has not stood up under the scrutiny of the courts. They have upheld the more realistic view that such payments, under definitely described conditions, do not meet the test of realization that determines taxable income.Certificates which allocate cooperatives' earnings to patrons, but which have no fair market value, were held not to be taxable income to the patrons at the time the certificates were issued. If later they were to acquire a fair market value they would then become taxable income.

1 Carpenter v. Commissioner, 219 F. 2d 635 (5th Cir. 1955; Caswell's Estate v. Commissioner. 211 F. 2d 693, 9th Cir. 1954); Joplin v. Commissioner, 17 T. C. 1526 (1952): Farmers Grain Dealers A88ociation v. United States, 116 F. Supp. 685 (D. C. Iowa, 1953): Phillips v. Commissioner, 17 T. C. 1027 (1951).

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