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The Carpenter case, which was decided by the Tax Court in 1953 and by the court of appeals in 1955, is a good example of the attitude of the judiciary. In its decision the Court of Appeals declared :

"It is abundantly clear that the taxpayer's receipt of revolving fund certificates was not the equivalent of the actual receipt of cash, because the certificates had no fair market value. Furthermore, it is obvious that the funds withheld by the cooperative were not subject to the demand of the respondent. The respondent could control neither the amount of the funds that he would ultimately receive nor the time at which he might receive them."

The effect of these decisions has been to make it possible for cooperatives to allocate their earnings in such forms that they are not taxable income to their patrons. Even where the assumption is made that cooperatives' income should not be subject to tax, the question has been raised whether cooperatives should be allowed to exclude from gross income the patronage allocations which are in such form that they are not currently taxable as income to the patrons.

ESTIMATES OF REVENUE LOSS There is no accurate way in which the loss of revenue to the Federal Government through the tax exemption of cooperatives can be calculated. Estimates, however, give some indication of the magnitude of that loss in grossly approximate figures. Much depends, of course, upon the assumptions which underlie the calculations.

If, for example, we assume that the total annual volume of cooperative business, after adjusting for duplications, is $11 billion, that 5 percent of this amount becomes net margins of $550 million, that the average corporation income tax rate that would be applicable is 40 percent, and that no price adjustment to minimize net margins occurs, the revenue yield, if the net margins were subject to tax, would be $220 million. If it were assumed too that the remainder of the net margins—$330 million after tax-were distributed or allocated to ownerpatrons and were subject to an average 20-percent personal income tax there would $66 million additional revenue. The total revenue to be obtained through the double taxation of cooperatives' income, under these assumptions, would be $286 million.

If, to be conservative, we assume that 3 percent (instead of 5 percent) of cooperatives' net transactions became net margins of $330 million and that that amount became subject to the corporation income tax at an average rate of 40 percent, the revenue yield would be $132 million. And if the remaining net margins of $198 million, after tax, were to become income to the patron-owners and subject to an average tax rate of 20 percent to them, $39.6 million additional revenue would be obtained. Through taxation at both levels of income, a total revenue to the Federal Government of $171.6 million would be obtained.

But cooperatives now pay some income tax, and patron-owners (except in consumer cooperatives) are taxable on the cash distributions and the allocations having fair market value received by them. In 1953 the revenue yield from farmer cooperatives alone was $9.8 million. Something more was derived from nonfarmer cooperatives. Personal income tax paid on patronage dividends is conjectured at $5 million, although probably this is a high figure since the Carpenter and other decisions, before which $10 million would have been a fair estimate. Thus a present total revenue yield under the prevailing exemptions must be allowed for. This should be subtracted from the estimates made above. Under the assumption that net margins average 5 percent the present revenue loss would approximate $271 million, while under the assumption that net margins are 3 percent of transactions the estimated revenue loss would be $156.6 million. These figures can, of course, be adjusted in accordance with the acceptability of the assumptions upon which they are estimated.

One need not be highly critical to perceive that these estimates are rough figuring. They take no account of the pricing out possibility. Also, not all recipients of patronage dividends will report them as income. But whatever method of estimate is used, the fact is that the loss of revenue to the Federal Government is a fairly considerable amount.

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

1 U. S. Treasury Department, Internal Revenue Service, Public Information Division, news release, January 19, 1957.

20675—58-pt. 221

SUMMARY AND RECOMMENDATION In summary, we may note several points. Cooperatives are not eleemosynary associations, but are businesses seeking gain for their members; they are not partnerships or agencies, but are corporate enterprises ; they have income of the same kind as ordinary corporations have, and Congress has the power to tax it in the same way that other corporation income is taxed. The exemption cannot be shown to be in the public interest, for it leads to less than the fullest use of the Nation's resources by permitting the survival of inefficient business units. It is inequitable because it permits heavy taxes to be taken from one form of corporate business and not another, giving a marked competitive advantage to businesses that assume the cooperative form. Also to be taken into account is the loss of revenue to the Federal Government.

Since the corporation income tax, under present circumstances, cannot be done away with, the next best solution to the problem is to levy that tax on coop eratives' earnings or net margins. A bill which undertakes to do this was introduced by Representative Mason, of Illinois, in the 1st session of the 85th Congress. The measure (H. R. 501) is described as "A bill to equalize taxation and provide revenue." Its purpose is to tax cooperative corporations, their stockholders, and their patrons in exactly the same manner as ordinary corporations and their stockholders are taxed. It provides for the repeal of sections 521 and 522 of the Internal Revenue Code and disallows the deduction of patronage dividends for tax purposes. Under its provisions a cooperative would pay tax at the corporate rates on all its earnings before any distribution of dividends on stock and dividends on patronage. Stockholders and patrons would pay tax at the full individual rates on their receipts of dividends on stock and dividends on patronage, with the exclusion of $50 and the tax credit of 4 percent which is now given to the recipients of dividends from ordinary corporations. The objectives and provisions of this bill are recommended to your committee.

Enactment of H. R. 501, or similar legislation, it must be acknowledged, would not establish full tax equality, for cooperatives could adjust their prices in order to reduce net margins, and patronage dividends having no fair market value would not be taxable to patrons until some indefinite future time. Nevertheless, it would provide the most practicable and equitable treatment of cooperatives earnings and dividends that is possible within the present tax structure.

The CHAIRMAN. Our next witness is Mr. Joseph J. O'Connell.

Mr. O'Connell, will you give us your name, address, and the capacity in which you are appearing for the benefit of the record, please, sir?

STATEMENT OF JOSEPH J. O'CONNELL, JR., ON BEHALF OF THE

NATIONAL TAX EQUALITY ASSOCIATION Mr. O'CONNELL. Mr. Chairman and members of the committee, my name is Joseph J. O'Connell. I am an attorney, with offices in New York and in Washington, and I appear before this committee today as the spokesman for the National Tax Equality Association, an association of businessmen of some 6,000 members who for some years bave been giving a major portion of their attention to what they consider to be instances of lack of equality in our tax system.

The CHAIRMAN. Mr. O'Connell, is it possible for you to complete your statement in 5 minutes?

Mr. O'CONNELL. It is not, Mr. Chairman. May I suggest that my statement be accepted for the record without my reading it? I made a few notes which I am sure I can complete within less than 5 minutes.

The CHAIRMAN. Without objection, the entire statement will appear in the record.

(The statement is as follows:)

STATEMENT ON BEHALF OF THE NATIONAL Tax EQUALITY ASSOCIATION BY JOSEPH

J. O'CONNELL, JR.

PART I. STATEMENT OF POSITION All taxpayers have a large stake in an equitable solution of the vexatious problem of determining the proper tax treatment of cooperative corporations. The wisdom of a taxing policy which accords a large segment of American business treatment which is preferential to their competitors is a matter of grave concern to such competitors. Even more important, a taxing policy that opens the door to the decimation of the Federal income tax by the cooperatization of more businesses and industries is a matter of deepest concern to all taxpayers. This committee should take the lead in restoring equity and protecting the revenues.

It would be well to summarize the position that the National Tax Equality Association is taking and the basis for that position, as hereinafter more particularly set forth.

First, and foremost, it should be emphasized that it is not the purpose of the proponents of cooperative taxation to destroy or punish the cooperative movement. Their purpose is merely to bring about equality of taxation and to eliminate competitive inequities. It cannot be seriously disputed that the cooperatives are not dependent upon their tax privileges to exist and prosper. Nor will taxation prevent cooperatives from growing and expanding; they will merely be limited to a rate of growth and expansion more comparable to that of their business competitors. Cooperatives can grow and prosper under tax equality to the same extent as their business competitors. Tax equality does not imply disapproval of the cooperative movement. Cooperatives are performing a necessary and desirable function. They can still perform it without their unfair tax advantages.

Second, the inequity which is sought to be remedied is that which allows the deduction of patronage dividends paid to cooperative members and applies to the exempt and nonexempt cooperatives alike. While there are certain special privileges enjoyed by exempt cooperatives, these are relatively minor compared to the patronage dividend loophole.

Third, any solution that would have the small individual farmer-member bear the brunt of the taxation of cooperative earnings would be obviously unfair. The Revenue Act of 1951 was aimed in that direction. It granted to cooperatives the right to deduct patronage dividends merely allocated to patrons without giving such members anything of real value. The result has been, in many cases, that patrons have been required to pay tax on worthless paper or mere book credits without receiving cash to pay the tax. Recent court decisions have overruled the Treasury regulations on this point and the patron has escaped taxation where his allocable share of cooperative earnings has been assigned to him in a form without market value. Now, some cooperative leaders are supporting proposals to get around these court decisions and tax patrons on distributions deductible to the cooperative whether such distributions have value in the patrons' hands or not. The interest of the individual farmer are not served by this legislation. A recent observation by the Court of Appeals for the Fourth Circuit in Long Poultry Farms, Inc. v. Comm. (F. 2d (4 Cir., Nov. 8, 1957)) is of real significance in this regard :

*** * * Apart from the question of constitutionality of such a requirement, which would be a serious one, it is a safe assumption that Congress never intended to impose upon the patrons of cooperatives the hardship and burden which the taxability of these contingent credits would involve."

The NTEA believes the proper solution is tax equality. If this cannot be achieved, then the essential element of any compromise solution is tax equality at the corporate level with any concession being given to the member.

Fourth, the heart of the cooperative problem is the retention of earnings which have never been subjected to the Federal corporate income tax. Cooperatives are permitted to escape tax on retained earnings by issuing capital stock, and these earnings are never taxed to it. Cooperatives can escape tax on retained earnings merely allocated to members by "letters of advice," and these earnings are never taxed. And while their corporate competitors are paying 52 percent on their earnings, cooperatives are using theirs to purchase new capital facilities, modern machinery, equipment, expanding vertically and horizontally and acquiring taxpaying competitors. Taxpaying businesses cannot keep up with taxprivileged businesses whose accumulation of additional capital is twice as great as their own.

Fifth, the rapid expansion of cooperatives poses a serious problem of loss of revenue. Each year additional business income is being taken off the tax rolls and placed under tax-sheltered protection of the cooperative form. A list of some cooperative outright acquisitions of previously taxable businesses is set forth in a succeeding section of this statement. In addition, cooperatives are acquiring a consistently larger share of the national market by their ability to modernize, equip, and finance themselves with tax-free dollars. This, too, results in lower revenue from the Federal corporate tax. Such losses, perhaps as much as $400 million can only result in higher taxes for everyone else.

Sixth, a clear precedent exists for imposing a tax to cure competitive inequality and protect the revenues. The Revenue Act of 1950 contained a series of provisions designed to revoke the exempt status of certain income of religious, educational and scientific organizations. Despite the worthy nature of these organizations and their high standing, the Congress determined that they should not be permitted to earn unrelated business income without the payment of a tax. The essential thinking behind this change in law was that serious competitive inequalities were produced by a tax-exempt organization competing with a taxable organization. Then, too, Congress was not unmindful of the substantial revenues which were escaping the tax collector's net. The Revenue Act of 1950 was corrective rather than punitive legislation and did not represent congressional disapproval of the business activities of exempt organizations. It merely decreed that as businesses they must pay the same tax as any other business.

The same considerations apply to cooperatives. Seventh, there exists no genuine justification for the present exempt status of cooperatives.

A whole host of distortions and half-truths have been advanced. Perhaps the most plausible justification is purely historical--they have never been taxed, so why start now? However, history also provides an ironic insight into the need for a change in this area. One need only compare the rate of tax, revenue needs, the size and strength of cooperatives when the exemption was first granted with these same factors as they exist today to realize how essential it is to give this problem a completely new look.

Another so-called justification is the claim that cooperatives pay the same taxes as anyone else and that taxable businesses are in a position to do the same thing by distributing their profits to their customers. This is absurd on its face. Ordinary corporations are run primarily for the benefit of their stockholderswho supply the necessary capital. The cooperatives are able to distribute their profits to their patrons because their patrons are also their owners. Where this identity between ownership and patronage does not exist, the profits in our system must be distributed to the owners. This so-called right of business to do the "same thing" is an empty one indeed.

A number of quasi-legal arguments have been advanced. Some have questioned the constitutionality of taxing net margins. Others claim that cooperatives are merely agents of partnerships. The most commonly advanced legal argument is that patronage dividends are mere price adjustments made to customers. These arguments are all taken up in detail in a later portion of this statement. They do not provide a basis for the exemption as a matter of law or policy.

Finally, as a matter of policy, every corporation doing business in this country should be expected to bear its share of the tax burden and should not oppose tax equality. This is a time of international crisis and the revenue needs are great. This is no time to continue outmoded historical exemptions which have long lost whatever validity they once had. No one should want such an exemption and certainly Congress should not grant it.

PART II. LEGAL ANALYSIS OF THE PROBLEM The legal bases upon which the cooperatives have enjoyed special tax privileges have their origins in both statutory and "Treasury made" law. Cooperatives are generally divided into two categories for the purposes of the internal revenue laws-the exempt and the nonexempt, although these terms are no longer completely descriptive. The statutory tax privileges of the exempt cooperatives are now contained in section 522 of the Internal Revenue Code. These privileges consist of the right to deduct dividends on capital stock and patronage allocations of income not derived from patronage, as well as to enjoy the nonstatutory privilege of patronage dividends.

The nonexempt cooperatives, like exempt cooperatives, enjoy the nonstatutory privilege of deducting patronaged dividends. They do not derive their special tax

treatment from any provision of the Internal Revenue Code but solely from a longstanding administrative determination that allocations to members pursuant to patronage dividend contracts are deductible from gross income. This determination rests on the assumption that these contracts give rise to bona fide price adjustments between seller and buyer which must be reflected in gross income. The same assumption apparently underlies the allowance of the patronage dividend deduction to exempt cooperatives.

The succeeding portions of this discussion are devoted to a demonstration of the invalidity of that assumption.

It is essential to a proper understanding of the exemption and its effect on the whole fiscal structure to trace the history of the current co-op tax exemption. Two points may be observed from tbis brief historical summation:

First, the present virtually complete exemption of cooperative enterprises from a 52-percent corporate tax rate goes far beyond the intent and purposes of the framers of the original exemption. That original exemption, which provided a shelter against a most modest rate of tax, was intended to assist small groups of individual farmers struggling to exist in a hostile economic and political climate. The totally different tax structure and economic condition of 1957 demand a new approach to cooperative taxation.

Second, the exemption bas been spread to nonagricultural cooperatives by means of liberal Treasury regulations permitting the deduction of earnings distributed to members as patronage dividends. This phase of the problem has never been passed on by the Congress and cannot be said to represent congressional intent, unless it be by mere congressional inaction.

The earliest ancestor of the present exemption is found in the Corporate Excise Tax Act of 1909 which imposed a tax of 1 percent on net income above $5,000. Section 38 of that act provided for the exemption of "labor, agricultural, or horticultural organizations." This provision was carried over into the income-tax laws enacted in the Revenue Act of 1913.

The Revenue Act of 1916 made the first specific reference to the cooperative form. Section 11 (a) (11th) of that act exempted "Farmers, fruitgrowers or like associations, organized and operated as a 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."

The tax provided in the 1916 act was 2 perecent of net income and, as noted above, the exemption was limited to associations, acting solely as sales agents, returning the proceeds of sales to their members. This language apparently contemplated the remittance in cash of the entire proceeds less necessary expenses.

The exemption continued to broaden. In 1921, the exemption was extended to include purchasing cooperatives which operated as purchasing agents of supplies and equipment for the use of members at cost. The statutory exemption was even further broadened by the Treasury regulation promulgated thereunder." These regulations provided that the maintenance of reasonable reserves for depreciation or possible loss or a sinking fund or surplus to provide for added facilities or to pay indebtedness would not terminate the exemption. It was also provided that cooperatives would not lose their exemption by virtue of having capital stock upon which they paid dividends not exceeding the legal rate of the state of incorporation or 8 percent per annum whichever was greater, or by doing business with nonmembers. Thus, the regulation took several steps away from the single original agency concept. Reserves for depreciation, expenditures, indebtedness and capital stock dividends all contributed to the recognition of the cooperative as an independent business entity. It was not merely the sum of its members. Even more explicit recognition of this was provided by that portion of the regulation which permitted business with nonmembers, The Revenue Act of 1926 in effect ratified the extension made to them by the Treasury Regulations. It also eliminated the agency concept and referred simply to associations organized and operating on a cooperative basis for marketing or purchasing activities. Substantially all the stock of an exempt cooperative had to be owned by producers and, in the case of a purchasing cooperative, not more than 15 percent of its business could be transacted with persons who were neither members or producers.

* Regulation 63, art. 522.

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