The exemption remained in the form enacted by the Revenue Act of 1926 for 25 years. The requirements for exemption might be summarized as follows: (1) An exempt cooperative must be organized on a cooperative basis. (2) It must operate on a cost basis, ultimately turning back net proceeds to members and nonmember patrons.

(3) Substantially all stock, except nonvoting, non-profit-sharing preferred stock, must be owned by producers or member patrons.

(4) Dividends could not exceed 8 percent or the legal rate in the State of incorporation, whichever is greater.

(5) Reserves required by State law, or alternatively reasonable reserves, could be accumulated.

(6) Neither the cooperatives nor its member patrons may gain a discriminatory advantage over nonmember patrons.

Before going in to the changes wrought by the Revenue Act of 1951, it would be well to trace briefly the parallel development of the patronage dividend deduction. The establishment of this deduction is of the greatest importance in that it accorded all cooperatives most of the benefits enjoyed by exempt cooperatives without the necessity of qualifying for the statutory exemption. The principal consequence was that the cooperative movement spread from the farm to the factory, mine, retailer, wholesaler, service enterprise and indeed into every conceivable type of business enterprise.

Prior to 1951, the patronage-dividend deduction had never been recognized in any congressional action. It originated in administrative grace and without the benefit of court decisions or statutory enactment. In a series of rulings from 1914 to 1930, the Treasury spelled out the theory upon which patronage dividends paid to members have been eliminated from the taxable income of cooperatives. Sometimes this elimination takes the form of a deduction and in other cases it is included as "cost of goods sold" or excluded from gross receipts. The Treasury's idea has been that patronage dividends are to be regarded as discounts or rebates and it entertains the theory that their reality is that of an adjustment, contractually required, in the prices of goods sold to or purchased from the cooperative. The contractual requirement may be in the form of an express contract with the patron or merely a provision in the State corporation statute, articles of incorporation, bylaws, or published rules.

The theory of the patronage dividend appears to be that the cooperative is doing business at cost. The cooperative arrives at cost by charging or paying a tentative price above or below cost, as the case may be, depending on whether it is a purchasing or a marketing cooperative, and then paying a patronage dividend at the end of the year to arrive at "true cost." The fallacies in this theory are many and are discussed in a later portion of this memorandum. Suffice it to say at this point that if ordinary business corporations were to attempt to do business with their stockholders at cost, even by agreement, the Treasury would disregard such agreement as not at arm's length disguising a distribution of its earnings to its stockholders.

The forms which the payment of patronage dividends may take are many and varied. It is clear that under the regulations payments need not be in cash, merchandise, or in the form of paper with a readily realizable market value. Dividends may be "paid" in the form of scrip, stock, certificates, of indebtedness. revolving-fund credits, letters of advice, or mere book allocations. These can be nontransferable, nonnegotiable, and, for all practical purposes, without market value. Actual payment of dividends can easily be deferred indefinitely or at least until the cooperative is ready to be liquidated or dissolved.

The courts have never had occasion to make an independent analysis of the validity of the Treasury's regulations in this area. In such litigation that has arisen, the taxpayer and the Treasury have been in agreement that the regulations should be applied and the only issue is their application to the individual case. The courts have honored the well-established regulations without passing upon them. For example, in Cooperative Oil Assn. v. Comm. (115 F. 2d, 666) the court stated, at page 668:

"*** petitioner points to no statute authorizing any deduction whatever, and we are in effect asked to hold that a practice of respondent permitting a deduc tion not authorized by statute, is not liberal enough. We know of no manner

T. D. 1996 (1914); T. D. 2737 (1915); O. D. 64, 1 CB 208; I. T. 1499, I-2 CB 189; I. T. 1566, II-1 CB 85; SM 2288, III-2 CB 233; SM 2595, III-2 CB 238; ARR 6967, III-1 CB 287; GCM 12393, XII-2 CB 398; GCM 13895, 1937-1 CB 56; I. T. 3208,

1938-2 CB 127.

in which such liberality may be reviewed in this court *** Whether respondent should have allowed the deduction he did allow is a question upon which we express no opinion."

The courts have been extremely generous toward cooperatives in applying the constructive receipt and reinvestment doctrines. They have allowed deduction for patronage dividends "paid" where the cooperative never distributed the money but applied it, pursuant to a bylaw, to the purchase of capital stock for the patron. In United Cooperatives (4 T. C. 93) the court stated:

"The fact that member patrons were under obligations with regard to the purchase of petitioner's stock under certain circumstances and that petitioner had the right to apply a part of the 'patronage dividends' to a satisfaction of such obligations, is immaterial. It does not affect the right of the member patrons to receive 'patronage dividends', but merely constitutes a permanent directive as to their application. The result of the procedure set up by petitioner's bylaws was as if the stockholder member who was under obligation to purchase additional stock had received, in cash, the 'patronage dividend' and had thereupon applied this sum to the payment of his stock. The stock, when thus paid and issued to him, was not in the nature of a stock dividend, but represented an additional investment. ***"

Other decisions have permitted the allocation of reserves set aside out of earnings to be treated as patronage dividends, where the patrons' interests were evidenced in certificates of indebtedness or "revolving fund" certificates. At least one case has gone so far as to allow the exclusion of net proceeds or earnings from corporate income where such earnings were placed in general reserves without a pretense of distribution. Moreover, the courts seem to hold that patronage dividends have been "received," even where certificates evidencing such dividends are nontransferable, nonmarketable, and give no right to assets of the cooperative until the liquidation of the cooperative.

The Revenue Act of 1951 put the patronage-dividend deduction into statutory form albeit in a somewhat oblique manner. It permitted the exempt cooperative to take patronage dividends into account in computing taxable income "in the same manner as in the case of a cooperative organization not exempt under section 521." Patronage dividends could be paid in the form of cash, merchandise, capital stock, revolving-fund certificates, retainer certificates, certificates of indebtedness, letters of advice or "some manner that discloses * * * the dollar amount of such dividend, refund or rebate." Moreover such dividend need not be paid until 81⁄2 months after the close of the taxable year.

The avowed purpose of the Revenue Act of 1951 was to impose a tax on the so-called exempt cooperatives on their unallocated earnings and to impose a tax on the member patrons on the allocated earnings. If this was indeed the purpose of the 1951 act, it has substantially failed on both counts. On the first count it has proved to be a relatively simple matter for a farmers' cooperative to make book allocations of all its earnings and leave little, if anything, to the tax collector. As indicated by the statute, a mere "letter of advice" informing the patrons of the amount allocated to them is sufficient to support the deduction. There is no certainty as to whether the patrons will ever receive it. On the second count, the member-patrons have continued to successfully resist taxation on allocations without market value (Comm. v. Carpenter, 219 F. 2d 635; Caswell v. Comm., 211 F. 2d 693; Bernard B. Carter, par. 57,005 P-H Memo TC; F. Wendell Miller, par. 57,098 P-H Memo T. C.; Mary Grace Howey, par. 54,125 P-H Memo T. C.). In short, the objective of taxing all cooperative earnings either to the cooperative or to the patron has been thwarted. Indeed, it would be a relatively simple matter for a cooperative to so arrange its affairs that none of its earnings would be taxable either to it or to the patron while still retaining all the cash representing its earnings. One of the proposals to remedy the 1951 law has been to provide specifically for the taxation of the patron wherever the cooperative is entitled to a deduction, regardless of the market value of the distribution. Not only would this be grossly unfair to the patron but probably be unconstitutional as well. When there is no value received, there is no income to be taxed. See Long Poultry Farms v. Comm., supra.

The failure of the 1951 law to operate as it was perhaps intended should not obscure its more basic defect. For the first time, it provided a semblance of statutory recognition to the wholly fallacious idea that patronage dividends are essentially price adjustments or rebates which should be deducted.

Midland Cooperative Wholesale (44 B. T. A. 824).

San Joaquin Valley Poultry Producers' Assn. v. Comm. (136 F. 2d 382 (C. C. A. 9th, 1943)).

In the final part of this section it would be well briefly to examine such legal "justifications" as have been advanced to defend the present state of the law. Most of them can be disposed of by merely stating them. For example, at one time it was frequently said that it was not constitutional to tax cooperatives on their net margins. This theory was finally and effectively exploded by a study prepared in 1951 by the staffs of the Treasury and the Joint Committee on Internal Revenue Taxation entitled "The Power of Congress to Tax Cooperatives on Net Margins." It was found that cooperatives were corporate entities and that their net margins were income which could be reached by the Federal taxing power under the 16th amendment. One need look no further than the legion of cases denying deductions to corporations making so-called contractual payments to their stockholders to see that net margins can be constitutionally reached as income. If the agreement is not at arm's length and is intended to give the entire profit from the transaction to the stockholder, it is crystal clear that the payment is in substance a mere distribution of earnings. These factors exist with respect to patronage dividends.

It has also been asserted that cooperatives, although corporate in form, are really agencies, partnerships, or trusts and are not subject to tax in their own right. Cooperatives are incorporated under State statutes, have all the legal characteristics of corporations and have none of the legal characteristics of true partnerships, or trusts. This contention can be best answered by a brief quotation from Moline Properties v. Comm. (319 U. S. 436), as follows:

"The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. * * * In Burnet v. Commonwealth Imp., Co. 287 U. S. 415, 53 S. Ct. 198, 77 L. Ed. 399), this Court appraised the relation between a corporation and its sole stockholder and held taxable to the corporation a profit on a sale to its stockholder. This was because the taxpayer had adopted the corporate form for purposes of his own. The choice of the advantages of incorporation to do business, it was held, required the acceptance of the tax disadvantages. [Emphasis added.]

Two other contentions of even less weight that have been advanced are: (1) Cooperatives do not really enjoy any special tax privileges as regular business corporations can do the same thing as cooperatives, i. e., reduce their taxes by rebating their profits to their customers; and (2) If cooperatives were to be taxed on their net margins, they could frustrate such program by doing business at cost.

The first contention is obviously absurd in view of the fact that business corporation lack the identity between their patrons and their owners maintained by cooperatives. It is beyond the realm of reason to cite this as a real possibility. Moreover, if all business were to be done in this form, little, if any, income would remain subject to the corporate income tax and a new system of taxation would be in order. Furthermore, to the extent ordinary business corporations do business with their stockholders (particularly closely held corporations), they are held to a standard of arm's-length dealing that would preclude the usual patronage dividend from being treated as a reduction of income.

As to the threat to do business at cost, it is economically impracticable for any business. Any cooperative attempting it would court certain bankruptcy. In any event, competitive businessmen would welcome such a turn of events as it would eliminate the power of cooperatives to expand and grow on tax-free dollars.

Only one contention remains to be discussed. Considerably more space is devoted to it than the others not because of any great intrinsic merit but only because the Treasury appears to have embraced it. This is the "priceadjustment" theory.

The cooperatives maintain that patronage dividends are properly excludible or deductible from the gross income of a cooperative corporation on the theory that such dividends represent rebates, discount, price adjustments or refunds made pursuant to contract by such corporations to their member-patrons. In fact, patronage dividends are not substantially akin or even similar to bona fide price adjustments; to the contrary, they are earnings of cooperatives distributed as profit to members.

Many differences between a price adjustment and a patronage dividend can be noted even on the most cursory examination.

(1) Price adjustments or rebates are generally regarded in the commercial world as payments made for the encouragement of quick cash payments, quantity purchases, or continued future patronage. These considerations are obviously absent in the case of patronage dividends which serve solely as a vehicle for the distribution of profits.

(2) Patronage dividends are paid only in the event of profit; price rebates are generally independent of profit.

(3) Patronage dividends are paid months and even years after the sales involved.

(4) Patronage dividends are paid in the form and the amount selected by the cooperative in its discretion, a discretion not available to ordinary businessmen called upon to make a price adjustment.

(5) Patronage dividends are subordinated to the payment of creditors and even of dividends on capital stock.

(6) Patronage dividends are not recognized as price adjustments under various pricing laws.

(7) Patronage dividends bear no relation to the profit realized by the corporation in its transaction with the individual member to whom the dividend is dstributed. The price adjustment or rebate theory assumes a calculation of profit on each individual member's business, but in fact, no such calculation ever takes place. An individual member's transaction may result in a loss to the cooperative but he still receives a dividend based on profits gained in another wholly unrelated segment of the business. His transaction may result in profits much greater or much smaller than the average margin and yet his dividend is determined by reference to the average margin. The cooperative may realize profits upon transactions with its members and such profits may become nondistributable due to corporate losses in other enterprises. These factors point up the fact that patronage dividends are paid not out of profits from each member's dealings, but out of corporate earnings as a whole.

(8) As previously noted, the contractual agreements pursuant to which patronage dividends are paid are not entered into or carried out at arm's length. Tax-avoidance is a dominant motive for these agreements.

(9) Patronage dividends reflect the earning power of activities carried out solely by the cooperative itself. A marketing cooperative will not only market but it may store, process, and manufacture. All their activities have commercial value, the profits from which belong to the cooperative and the cooperative alone. To treat these amounts as price adjustments is plain nonsense.

Thus, the price adjustment theory, the only semblance of support to the patronage dividend deduction, disintegrates on examination. Adopted by the Treasury some 40 years ago and never tested in the courts, it is overdue to be eliminated from the tax system.

PART III. THE DEVELOPMENT OF COOPERATIVES IN THE AMERICAN ECONOMY

Cooperation in the United States has been largely an agricultural movement. It originated a century ago in response to the need of farmers to find an efficient method of marketing their crops. Since many crops were produced for distant markets, individual farmers could not ship in carlot quantities and had little chance of attracting buyers for their small quantity of produce. By engaging in group selling, farmers could attract buyers and obtain better prices for their produce. The goal of cooperation has always been to obtain a larger share of the consumer's dollar for the farmer.

There have been five definite stages in cooperative development in the farm field. The first period, in the years preceding 1870, was one of experimentation which met with little success. The second period was largely promoted by the National Grange as a solution to the agricultural depression which followed the Civil War. The Grange contemplated cooperation in both the sale of the farmer's produce and the purchasing of his supplies. The third period was one of gradual expansion and lasted until World War I.

The fourth period of development occurred during World War I and lasted through the 1920's. This period was characterized by favorable Federal legislation as cooperation had come to be considered a cure for the farmer's economic ills. Federal income-tax exemption was granted cooperatives in 1913 and was soon followed by section 6 of the Clayton Act of 1914 which removed certain authorized cooperative activities from the antitrust laws. In 1922 Kentucky adopted the Bingham Cooperative Marketing Act which became the pattern for similar acts in other States. In the same year the Capper-Volstead

Act authorized the formation of cooperative associations and clarified their status under the antitrust laws.

The Federal Farm Board, predecessor to the present Farm Credit Adminis tration, was created by the Agricultural Marketing Act of 1929 "to promote, protect, and stabilize the marketing of agricultural commodities." A revolving fund of $500 million was available for lending to cooperative businesses. The board organized many national cooperatives to sell commodities purchased from farmers by local cooperative associations. Under this impetus the number of associations increased from 5,424 in 1915 to 12,000 in the 1929-30 season and their volume of business jumped from $635 million to over $2.5 billion in the same period. Following this period of expansion, the cooperatives were beset by economic failure during the depression years of the early thirties in spite of Government aid and encouragement.

From 1929-30 to 1939-40 the number of farmers marketing and purchasing associations declined from 12,000 to 10,700; and their total business fell from $2.5 billion to $2.0 billion.

The final period, from World War II to date, has been one of great coopera tive growth and expansion. It is significent that the expansion began during a period of high excess-profits tax and continued during a period of relatively high corporate tax rates.

Since 1940 the number of co-ops has declined from 10,700 to 9,887 at the end of the 1954-55 marketing season. For the most part this decline represented a consolidation of the movement through mergers. In the same period of time business volume increased from $2 billion to $9.6 billion. In the past. cooperative business volume reported by the farmer cooperative services of the United States Department of Agriculture has been confined to transactions at the local cooperative level. It has not included the business volume of cooperative wholesales and in many cases manufacturing plants. Recent data show that this business amounted to $2.8 billion in the 1954-55 season, making total farmer business volume $12.4 billion.

Statistics of farmer cooperatives: Number and annual business volume, 1913–55

1 Beginning 1925, data compiled for marketing seasons.

? Includes successive business volume as products pass through multiple ownerships in the channels of cooperative processing and distribution.

3 Not available.

Source: Farmer Cooperative Service, USDA General Report 31.

GROWTH OF COOPERATIVE COMPETITION

Under the present income-tax law, cooperative corporations escape all or nearly all of the Federal income taxes which regular corporations are required to pay. This favoritism in the payment of taxes gives them a tremendous advantage over their fully taxed competitors.

The difference in the treatment of proprietary corporations and cooperative corporations lies largely in the difference in the methods of determining their taxable income. Treasury regulations, having the force of law, permit cooperatives to exclude from taxable income the profits allocated to members on a patronage basis. Since the cooperative can retain its earnings in cash when it allocates its earnings to its owners, it can retain 100 percent of income for expansion. This ability to retain 100 percent of earnings tax free for expansion and acquisitions is obviously reflected in the growth of cooperative competition during the past years.