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age allocations when they were redeemed in cash because they believed this was proper under the law.

It was not until April 13, 1950, that the Internal Revenue Service issued a special release, Income Tax Information Release No. 2, to its field personnel stating the policy to be followed by patrons of cooperatives in including noncash patronage allocations in their income-tax returns currently. This special release of the Internal Revenue Service to its field personnel was apparently prompted by the lack of uniformity followed in the various regions of the Service with respect to the tax consequences to patrons of noncash patronage allocations.

So we find that much confusion has developed with respect to this matter, and the confusion has been compounded rather than simplified by the patrons' tax cases to which reference has already been made. This confusion has resulted in large part not from any lack of desire on the part of the farmer-patrons of cooperatives to comply with the law and to bear their proper share of our national tax burden, but has resulted from failure of the Treasury Department, until the late 1940's and early 1950's, to make clear to the general public and the affected taxpayers the Government policy, and failure of some of the field personnel of the Service to follow the policy laid down in Washington.

Many farmers on a cash basis have changed over since 1950 and are now reporting their noncash patronage allocations for the year in which the allocation is made. The Service, however, is in many instances following a course which would result in the same farmers currently paying a tax on the face amount of the current certificates and on the cash received currently in redemption of certificates of prior years not previously reported.

This situation is extremely burdensome, and the only way now that farmers can protect themselves in such situations is to resort to litigation which they can ill afford. We believe that some sound and practicable policy can be developed which would give the patron an option to pay the tax either for the year in which he receives the noncash allocation or the later year in which it is redeemed or satisfied.

Under proper safeguards no tax would be avoided. In effect, only the time of payment would be extended. But during the period of extension, patrons would be receiving cash in redemption of allocations of prior years. This cash would in many cases, through the option exercised, go into the income tax returns of the patrons and taxes be paid thereon.

We believe that a careful study of the problem and the statistical information now available on a national scale, by your committee staff, the joint committee staff, and the Treasury Department would reflect that the revenue interests of the Federal Government would not be adversely affected by the granting of such an option. It would be entirely consistent with other taxing provisions of the code. We have had special tax counsel examine this problem, and we would like to submit for your consideration and the consideration of your staff his views and findings.

Mr. Chairman, we ask that the brief Mr. Leonard Silverstein presented be included in the record at this point.

The CHAIRMAN. Without objection, it will be included.

(The brief referred to is as follows:) STATEMENT OF LEONARD L. SILVERSTEIN ON BEHALF OF AND SUPPLEMENTARY TO

STATEMENT OF NATIONAL COUNCIL OF FARMER COOPERATIVES My name is Leonard L. Silverstein. I am an attorney of Washington, D. C., appearing before this committee on behalf of the National Council of Farmer Cooperatives. My purpose is to review very briefly the technical background underlying the present problem in the tax treatment of farmer patrons of cooperatives. Thereafter, some concrete suggestions will be made to resolve the problem equitably in principle.

PRESENT TREATMENT OF COOPERATIVES AND PATRONS Economic background

Preliminarily, and even at the risk of restating principles well known to this committee, there should first be emphasized the special economic context in which the farmers' cooperatives of this country operate,

There are two basic elements: First, the owners of a cooperative are in the main its customers or suppliers, that is, its patrons. In other words, there is identity between those who utilize the services and faciilties of a cooperative and those who derive the savings, if any, resulting from that utilization.

Secondly, it is these same persons, that is, the suppliers and customers, the patrons, who furnish the capital with which the cooperative is enabled to operate. This capital finds its source not from independent subscriptions but rather is derived as a necessary concomitant to the cooperatives' operation. Thus, the patrons, as a normal part of doing business wtih a cooperative, know and recognize that among the responsibilities entailed therein is the requirement that a portion of the cooperatives' savings realized for their account will be reinvested by the cooperative on their behalf for varying periods. The terms of this understanding, which in fact provide virtually the sole effective financial means for cooperative operation for the benefit of their patrons, are normally embodied in the bylaws or similar corporate papers of the cooperative, or in the actual marketing or other agreement with the patron. Congress and the Treasury position

Congress and the Treasury have fully appreciated the above pattern. Traditionally, this pattern authorized the cooperative to exclude from its gross income the full amount of patronage allocations made in satisfaction of the cooperatives' obligation to its patrons to do their business at cost. This right of exclusion has been recognized for years by the Treasury."

A similar understanding on the part of both the Congress and the Treasury formed the basis for the presumed tax treatment of the recipient of the patronage allocation. Under the Treasury Regulations, such patron is taxable on the full amount of profits realized as a result of his patronage. The amount so taxable is not reduced because the patron has also agreed, as one of the conditions of doing his business through the cooperative, to place a portion of those profits at the disposal of the cooperative via a capital contribution or loan to the organization.

Thus, if the cooperative earned 10 cents per bushel upon the sale of a patron's produce, the profit-income, if you will—so realized by the cooperative for the patron's account remains taxable to the same extent even though the patron additionally agreed to make a portion of that profit available to finance the cooperative's continuing operation.

1G. C. M. 17895, 1937-1, CB 56; I, T. 3208, 1938-2 CB 127; see also TD 2737, June 1918; see current proposed regulations appliable to exempt cooperatives (sec. 1.522-3) wherein allocations are treated as an addition to cost of goods sold in the case of marketing cooperatives) or as a reduction in gross receipts (in the case of purchasing cooperatives).

Treas. Regs. 118, sec. 39.22 (a)-23.

It is essential to emphasize that taxability to the patron arises not later than the moment of realization of the income for the patron's account ( that is, when he is notified of the allocation). It is often a fact, however, that when the patron receives documentary evidence of his capital contribution or loan, the use of the funds has been restricted for cooperative purposes. Although this may operate to depress the market value of the document below its face amount, this factor cannot alter the fact, however, that the point of taxability to the patron has previously arisen.

Such a position was early established by the Treasury in a ruling issued to the National Council in 1943.

While the 1951 legislation related technically to exempt cooperatives only, it presupposed and reinforced the above system of tax consequences for all cooperatives, and from both the patrons' and cooperatives' standpoint.

Thus, in the words of the Senate Finance Committee,

“* * * all earnings or net margins of the cooperatives will be taxable either to the cooperative, its patrons, or its stockholders * * * a single tax (should be secured] with respect to substantially all of the income of cooperatives • * *» *

As the cooperative provisions explained in the joint committee's report on the act as finally enacted:

"* * * funds which are allocated to the accounts of patrons, or paid in cash or merchandise, are taxable to them. This is true in the case of either taxable or tax-exempt cooperatives." Secretary Anderson has now verified this understanding in his testimony concerning cooperatives before this committee on January 16. Judicial position

Notwithstanding what appears to be a relatively clear congressional intention and settled administrative interpretation of the cooperative-patron tax pattern, the courts have thus far failed to reflect fully the principles above discussed. While there is an imbedded judicial recognition of the right of a cooperative to exclude the face amount of noncash patronage allocations. There has been an equally firm denial of the Government's right to exact tax from the patron on the earnings excluded by the cooperative.

Much of the earlier attitude of the courts toward the problem can perhaps be traced to the manner in which the issues were presented to the bench by the Government. Thus, the reinvestment theory as described did not originally appear to have been set forth by the Government. The earliest cases were accordingly decided on legal theories unrelated to the basic problem, such as whether the patron-taxpayer was on the cash or accrual basis and in terms of the amount realized by him from the sale of his produce. Most recently, while the reinvestment theory has been squarely presented to the tax court and a few courts of appeal, it has not yet been accepted. The decisions continue to view the question from the standpoint of its second phase--that is, by reference to the fair market value of the certificate evidencing the patron's investment. Totally

3 See letter from T. C. Mooney, Deputy Commissioner of Internal Revenue, dated Norember 23, 1943, to National Council of Farmer Cooperatives. Revenue revision 1947-48 hearings, Ways and Means Committee, 80th Cong., 1st sess.. pt. 4, p. 2619; see also Internal Revenue press release No. S-520, 19, October 31, 1947, and Internal Revenne income-tax information release No. 2, April 13. 1950, to same effect.

+ Senate Report 781, 82d Cong., 1st sess., p. 21.

5 Report. Revenue Act of 1951, Staff of Joint Committee on Internal Revenue Taxation (Otober 1951), p. 15.

• See e. g., Colony Farms Cooperative Dairy, Inc., 17 T. C. 688 (1951); note that the right to excludability is not limited to farmers' cooperatives ; Uniform Printing & Supply Co., 33 B, T. A. 1073 (1936), revised 88 F. 2d 75 (CA 7, 1937), but that in all events the patronage allocation must be made pursuant to a contractual obligation to the patron. Compare the related cases of Dr. P. Phillips, 17 T. C. 1002 (1951) with P. Phillips, 17 T. C. 1028 (1951). In the latter case, the cooperative was under no obligation to distribute patronage allocations and accordingly no right of excludability existed nor did any doctrine of reinvestment.

7 See e. g., Wallace Caswell, 17 T. C. 1190 (1950), which discussed the issue in terms of measuring the certificates themselves as part of the profits.

* See B. A. Carpenter, 20 T. C. 603 (1953), afirmed 219 F. 2d 635 (C. A. 5, 1955) ; Mary Grace Howey, P. H. memo. T. C. par. 54, 125; Long Poultry Farms, Inc., 27 T. C. 988 (1957), revised - F. 2d (C. A. 4, November 8, 1957).

ignored are the tax effects of the first phase-that is, what is the amount of income realized by the cooperative for the patron's account in the first instance?

The courts, however, look solely to the paper certificate at the time of receipt, ignoring the prior accomplished economic fact that by the time that certificate has been issued to the patron, income has already been realized for the patron's account. The certificate, whatever its value at the moment of receipt, merely gives evidence of the amount of that income which the patron, by reason of his contractual arrangement with the cooperative, has agreed to reinvest with the cooperative for a period of time.

RECOMMENDED LEGISLATION The combined impact of all the foregoing—that is, the courts' recognition of the excludability of non-cash-patronage allocation, coupled with the judicial refusal to tax the amount so excluded to the patron-has produced an obvivous gap in the congressionally intended taxing pattern. In effect, there is now removed from the tax stream that portion of farm earnings which are realized by the cooperative for the account of a patron but which are allocated to him in noncash form. Such a consequence can best be remedied through enactment of specific and reasonable legislation which will spell out clearly the patron's responsibility of inclusion in his income of amounts realized for his account and for his benefit which he has contractually agreed to contribute to the cooperative for its financing. A8 to amount of taxability

To accomplish this, it is suggested that the Internal Revenue Code adopt language which reflects the normal tax consequences which flow from the patron's contractual relationship with the cooperative. Thus, if a patron does business with a cooperative whose bylaws, marketing, or other agreement provides that a portion of the earnings realized for his account must be contributed to or loaned to the cooperative for its capital purposes, such patron will be taxed in those terms. He will accordingly be considered, for income tax purposes, to have received earnings in cash in the year in which they were realized for his account, that is, in the year in which there is delivered to him documentary evidence of his capital contribution or loan to the cooperative.

While it is generally a fact that patrons who do business with a cooperative recognize the terms of their relationship, including the fact of their responsibility to reinvest a part of their earnings, the statute could additionally require that evidence of this fact for tax purposes be made available to the patron.

. The force of many of the decisions is weakened by the varying circumstances under which they arose. Thus, in Moe v. Earle (USDC Oregon, October 12, 1954, 55-1

USTC, par. 9180. affirmed, 226 F. 20 483 (9th Cir. 1955), cert. denied, 350 U. S. 1013 (1956)) the Government took a position contrary to its initial one. In that case the patrons had failed to include the certificates in the year of their receipt and the Government imposed a tax when the cash was distributed. This lack of consistency has doubtless weakened the Government's case and has served only to further becloud the problem. In B. A. Carpenter (supra, n. 9), the issue was framed upon the fact that the taxpayer had no dominion or control over the funds represented by the certificates which had no fair market value. This fact made irrelevant the question of whether the cooperative was obligated to issue the certificates. Certain later cases have depended, in large part, upon the Carpenter case rationale (see e. g., Mary Grace Howey, supra, n. 9), F. Wendell Miller, T. C. memo 1957--98). Moreover, the irrelevant distinction between a cash and accrual basis taxpayer has also been reflected in the decided cases (see Harbor Plywood Corp., 14 T. C. 158 (1950), affirmed - F. 2d 734 (9th cir. 1951) and George Bradshaw, 14 T. C. 162 (1950), acquired 1950-1 CB-1) in which the face amount of the certificate was taxed to an accrual basis recipient, compare, however, Long Poultry Farms, Inc. (supra, n. 9) which reaches a contrary result as respects the accrual basis taxpayer on the theory that substantial uncertainties and contingencies existed (not present in Harbor Plywood and George Bradshaw). It is also significant to note that in Estate of Wallace Caswell, 17 T. C. 1190 (1952), revised 211 F. 28 693 (9th cir. 1954) the court held for the taxpayer that in view of the facts the certificates had no fair market value stating that

the certificates did not give* any new right or any greater rights than they had before the certificates were issued." The best analysis of the problem by the court is reflected in P. Phillips (supra, n. 7) which takes not of an agreement "in advance" that earnings realized for the patrons' account and retained by the cooperative pursuant to contract constituted income to the extent of the face amount of the certificates. This result was contrasted by the court with certificates issued voluntarily by the cooperative which were held not taxable since these certificates were without market value.

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Thus, if the patron is in fact a member of the cooperative and in that sense a person entitled to vote in the management of its affairs, provision in the bylaws, certificates of incorporation, membership agreement, or other written notice of the cooperative relating the requirement of reinvestment should be sufficient to charge him with knowledge of his responsibility of contribution. On the other hand, as to patrons who are not members but merely do business with a cooperative, the Congress may well consider it appropriate to set forth additionally the condition that the cooperative must give the patron written notice of his responsibility of reinvestment at or before the time the patron does any business with the cooperative. If necessary, this requirement could be carried out pursuant to regulations.

For the record, it should be clearly understood that there is ample authority to support the constitutional power of the Congress to adopt a cooperative patron taxing policy framed in the above terms--that is, one which will exclude noncash patronage allocations to the cooperative, and tax the amount so excluded to the patron. The bedrock constitutional issue, if there really is one, concerns the question of the power of Congress to tax the shareholders of a corporation, partners of a partnership, or other persons for whose benefit income has been realized by a business entity, even though such business did not or, for that matter, could not distribute the income so realized. In other words, the constitutional issue does not cover questions of constructive receipt and need not reach the question of whether a patron can be taxed on a certificate having a fair market value less than its face amount since it arises before that point, at the time of realization by the cooperative of savings or profits—income-for the patron's account.

In this respect, it has long been established that constitutionally the income of a corporation may be taxed to its shareholders, even though there was not (nor in fact could not have been) a distribution to shareholders of that income either in cash or noncash form. A similar rule applies in the case of partnership where the partners are taxable on partnership income without regard to whether a distribution has occurred."

Applying these principles to the proposed legislation, it is submitted that its constitutionality cannot be seriously doubted. Congress has the power to measure the single tax liability of the cooperative patron economic activity by reference to the actual amount earned for the patron's account. Even though no distribution is made, tax is clearly authorized both where the distribution is made in cash and, to the same extent, where it is reflected in noncash docu

10 There is a lengthy history of precedent sustaining the imposition of the tax resulting from corporate profits upon shareholders. See e. 5. Revenue Act, 1917,

sec. 209; Revenue Act, 1918, sec. 218 (c); Revenue Act, 1921, sec. 218 (a); and Revenue Act, 1940, see 502. Under all of these provisions, shareholders of personal service corporations are taxed upon undistributed earnings of the corporation. Additionally, under sec. 502 of the Revenue Act of 1940, sec. 394 (a) and (e) I. R. C. (1939), the "receipt and reinvestment" rationale regarding undistributed earnings is specifically expressed. Thus, an amount equal to the undistributed income is considered as paid in to the corporation whose earnings and profits are correspondingly reduced (sec. 394 (d)). Such amount of income is "*°. treated (for purposes of determining the adjusted basis

of the

shareholder's stock) as having been reinvested by the shareholder as a contribution to the capital of the corporation" (sec. 394 (e)). Čr. as to present treatment, sec. 312 (h), I. R. C. (1954). Cf. Collector F. Hubbard, 12 Wall. 1, 16, which upheld as constitutional the Income Tax Act of June 30, 1864, taxing shareholders upon the proportionate share of corporate savings whether or not distributed. While the force of this decision was blunted somewhat by the Supreme Court's disapproval in Eisener v. Macomber, 252 U. S. 189, its significance was reinstated in Helvering v. Bruun, 309 U. S. 461. Another comparable situation in which Congress has taxed shareholders in disregard of the corporate entity involves foreign personal holding companies, the shareholders of which are taxed (currently under sec. 551) on the cor poration's undistributed income. Authority for such a tax has been specifically upheld. See Eder v. Commissioner, 138 F. 2d 27 (2 C. A. 1943). Here the question presented was the taxability of the shareholders of a personal holding company incorporated under the laws of Colombia. Notwithstanding that in this instance, the laws of Colombia "blocked" distribution of the income, the court held that shareholders taxable.

"We do not agree with taxpayers' argument that inability to expend income in the United States, or to use any portion of it in payment of income taxes, necessarily precludes taxability. In a variety of circumstances it has been held that the fact that the distribution of income is prevented by operation of law, or by agreement among private parties. is no bar to its taxability.".

See, to the same effect, Rodney, Inc. v. Hocy, 138 F. 2d 27 (2 C. A. 1944) specifically holding taxation of the shareholders of a foreign personal holding company is a constitutional exercise of the congressional power. See, also, Helvering v. National Grocery Co., 304 U. S. 282, 288, which sustained imposition of the penalty tax on unreasonable accumulation of surplus. The court, per Justice Brandels, holds that tax could have been imposed directly on the shareholders, and therefore was valid when exacted from the corporation.

11 See Heiner v. Mellon, 304 U. S. 271, 281.

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