1944 U.S. Tax Ct. LEXIS 53">*53
Petitioner was incorporated under the Indiana General Corporation Act, but carried on business as an agricultural cooperative association. By its bylaws its patrons were entitled to a distribution in proportion to the patronage furnished by them of all the net income of petitioner remaining after payments to a reserve for depreciation, in such amount as the directors should determine but not less than 5 percent of the cost of its property, and after the payment of such dividends upon its common stock as the directors might declare but not in excess of 8 percent of the par value of the stock. During the taxable years no dividends were declared by petitioner's directors on its stock, and practically all of its net income was refunded by "patronage dividends" to its patrons.
4 T.C. 93">*94 This cause involves income and excess profits taxes for the fiscal years ended October 31, 1937, 1938, and 1939, together with delinquency penalty for the fiscal year 1937, as follows:
| Excess | ||||
| Year | Income tax | Penalty | profits | Penalty |
| tax | ||||
| 1937 | $ 34,198.42 | $ 1,709.92 | $ 14,354.56 | $ 717.73 |
| 1938 | 24,945.98 | 10,873.40 | ||
| 1939 | 25,904.26 | 18,583.05 |
The only question raised is whether "patronage dividends" or "patronage refunds" distributed by petitioner to its patrons were includible in its gross income.
FINDINGS OF FACT.
Petitioner was incorporated on October 28, 1930, under the General Corporation Act of Indiana, as amended; an act approved March 16, 1929, which is entitled "An Act Concerning Domestic and Foreign Corporations for Profit." The original name of petitioner was "Farm Bureau Oil Company," but in September 1936 the corporate name was changed to United Cooperatives, Inc. Its business is "oil blending" and purchase of farm supplies. Its books of account are maintained and its tax returns filed on an accrual basis.
The petitioner was originally incorporated by1944 U.S. Tax Ct. LEXIS 53">*55 three agricultural cooperative associations, to wit: Farm Bureau Services, Inc., Lansing, Michigan; Indiana Farm Bureau Cooperative Association, Inc., Indianapolis, Indiana; and Farm Bureau Cooperative Association, Inc., Columbia, Ohio.
Although designed and intended to function as a federated type of agricultural cooperative association for purchasing and distributing farm commodities and supplies to its stockholders and other patrons, the petitioner was incorporated under the Indiana General Corporation 4 T.C. 93">*95 Act because the Indiana Cooperative Marketing Law required nine incorporators, whereas originally there were only three contemplated incorporators or stockholders of the petitioner.
Federal tax returns for the fiscal years ended October 31, 1937, 1938, and 1939, were filed by petitioner with the collector of internal revenue at Indianapolis, Indiana. The return for the fiscal year ended October 31, 1937, was filed February 2, 1938. Capital stock tax returns for the fiscal years ended June 30, 1937, 1938, and 1939, were filed by petitioner under the respective dates of August 2, 1937, July 21, 1938, and August 26, 1939. These income and excess profits tax returns disclose1944 U.S. Tax Ct. LEXIS 53">*56 claimed deductions from gross income for 1937, 1938, and 1939 in the respective amounts of $ 122,461.29, $ 90,622.30, and $ 154,921.28. The sum for 1938 is $ 100,693.31 less $ 10,071.01 "commissions and inventory adjustments."
The deduction from gross income claimed by taxpayer for the year 1937 ($ 122,461.29) appears as item 25 (c) upon its Federal tax return and is captioned "Patronage Dividend Rebates" and there treated as a deduction from gross income in computing net income subject to tax.
The deduction from gross income claimed by taxpayer for the year 1938 ($ 90,622.30) is included in the item of $ 100,693.31 appearing upon schedule L of the return, captioned "Patronage Rebates Allowable Deductions," and the latter figure is carried to page 2 of the return (together with other items on schedule L aggregating $ 33,302.46) as item 26 in the amount of $ 133,995.77 and there treated as a deduction from gross income in computing net income subject to tax.
The deduction from gross income claimed by taxpayer for the year 1939 ($ 154,921.28) is included in the item of $ 280,384.70 appearing upon schedule M of the return, captioned "Patronage Refund allowable deduction," and the latter1944 U.S. Tax Ct. LEXIS 53">*57 figure is carried to page 1 of the return, together with all other items on schedule M, aggregating $ 280,384.70, and there treated as a deduction from gross income in computing net income subject to tax.
Petitioner's 1937 return discloses (a) gross sales of $ 646,438.67; (b) gross income of $ 140,438.29; (c) deductions of $ 140,065.74; and (d) net income of $ 372.55. It shows capital stock (all common) outstanding as of October 31, 1936, and October 31, 1937, in the respective amounts of $ 124,300 and $ 148,500.
Petitioner's 1938 return discloses (a) gross sales of $ 646,813.39; (b) gross income of $ 189,322.44; (c) deductions of $ 189,268.65 and (d) net income of $ 53.79. It shows capital stock (all common) outstanding as of October 31, 1938, in the amount of $ 186,600.
Petitioner's fiscal 1939 return discloses (a) gross sales of $ 1,019,599.13; (b) gross income of $ 280,384.70; (c) deductions of $ 280,384.70 4 T.C. 93">*96 and (d) net income of zero. It shows capital stock (all common) outstanding as of October 31, 1939, in the amount of $ 273,000.
The Commissioner, in the notice of deficiency, disallowed the above deductions from gross income of $ 122,461.29, $ 90,622.30, and $ 154,921.281944 U.S. Tax Ct. LEXIS 53">*58 for the years 1937, 1938, and 1939, respectively, and computed the tax liabilities, deficiencies, and penalties here in controversy accordingly.
The increase in petitioner's outstanding common capital stock from 1933 through 1939 results from the purchase, pursuant to its bylaws and corporate resolutions, by petitioner's stockholder-patrons of its common capital stock (the only class then authorized, issued, and outstanding at all times here material) and the application to its purchase price of "patronage dividends" distributed by petitioner. From the date of incorporation through the close of petitioner's fiscal year 1933, its common stock was issued at par as follows:
| Indiana Farm Bureau Cooperative Ass'n | $ 27,600 |
| Farm Bureau Cooperative Ass'n (Ohio) | 6,600 |
| Farm Bureau Services (Michigan) | 5,600 |
| Total | 39,800 |
Additional stock was issued at par in subsequent years to these stockholders and others and some stock was reacquired at par; the total outstanding at the close of petitioner's several fiscal years being as set forth below:
| 1934 | $ 98,600 |
| 1935 | 116,100 |
| 1936 | 124,300 |
| 1937 | 148,500 |
| 1938 | $ 186,600 |
| 1939 | 237,000 |
| 1940 | 340,000 |
Petitioner's articles of1944 U.S. Tax Ct. LEXIS 53">*59 incorporation read in part as follows:
2. The purpose or purposes for which it is formed are as follows:
A. On a cooperative basis, to purchase for and distribute to farmers and others, and to engage in any activity in connection with the production, preparing for market, marketing, purchasing, transportation, storing, or distribution of, oil, gasoline, greases, or minerals, and in connection with any one or more of the same.
* * * *
D. To acquire, buy, own, build, lease, erect and operate wells, mines, refineries, mixing or blending plants, warehouses, elevators, storage, shipping or manufacturing facilities necessary or expedient in connection with the aforesaid purposes or any of the same and to purchase, acquire, own, hold, lease and control, operate, sell, convey, transfer or otherwise dispose of any real or personal property necessary or expedient for the transaction of the business of this corporation and to contract with respect to the same.
* * * *
G. To purchase or otherwise acquire, and to hold, own and exercise all rights of ownership in, and to sell, transfer or pledge, or guarantee the payment of dividends or the interest on, or the retirement or redemption of, shares1944 U.S. Tax Ct. LEXIS 53">*60 of capital 4 T.C. 93">*97 stock or bonds of any corporation or association engaged in any related activity or in the warehousing or handling or marketing of any of the products handled by this association.
H. To establish reserves and to invest the funds thereof in bonds or in other property such as may be provided in the by-laws.
* * * *
J. To do each and everything necessary or proper for the accomplishment of any one or more of the purposes or the attainment of any one or more of the objects hereinbefore enumerated; or conducive to or expedient for the interest or benefit of the corporation; and to contract accordingly; and in addition to exercise and possess all powers, rights and privileges necessary or incidental to the purposes for which this corporation is formed or to the activities in which it is engaged; and, in addition, any other rights, powers and privileges granted by the laws of this state to corporations organized under the aforesaid act, except such as are inconsistent with the express provisions of these articles; and to do any such thing anywhere in the world.
* * * *
6. The common stock of this corporation shall be entitled to only such dividends as the directors may1944 U.S. Tax Ct. LEXIS 53">*61 from time to time declare, but such dividends shall not exceed 8% of the par value per annum. The common stock shall have the sole voting power so long as dividends upon the preferred stock outstanding are not in arrears; when such dividends are in arrears more than three years the holders of the outstanding preferred stock shall, holder for holder, have equal voting power with the holders of the outstanding common stock. Each holder of common stock shall have one and only one vote on each question or measure, irrespective of the number of shares held, except that, in all elections of directors each holder of common stock shall have one vote for each director then to be elected and may apply all the same to one nominee or distribute the same among two or more nominees.
The common stock shall be issued or transferred to, and owned or held by, only persons or associations or organizations which shall have obtained the consent of the board of directors of this corporation that it or they may hold such common stock.
Originally, the number of directors of petitioner was six, composed of two members from Farm Bureau Services, Inc. (Lansing, Michigan); two members from Ohio Farm Bureau1944 U.S. Tax Ct. LEXIS 53">*62 Service Co. (Columbus, Ohio); and James Mason and I. H. Hull of the Indiana Farm Bureau Association.
The original authorization of capital stock was 1,500 shares, divided into 1,000 shares of common stock of $ 100 par value and 500 shares of preferred stock of $ 100 par value. By amendment to the articles of incorporation filed December 28, 1935, the authorization of capital stock was changed to 6,500 shares, divided into 6,000 shares of common stock of $ 100 par value and 500 shares of preferred stock of $ 100 par value.
Under date of November 28, 1936, the articles of incorporation were amended as to 2 (A),
Resolved, That the Articles of Incorporation be amended by substituting for Subsection A of Section 2, the following: 2 A. "On a cooperative basis, to purchase 4 T.C. 93">*98 for and distribute to farmers and others, and to engage in any activity in connection with the production, preparing for market, marketing, purchasing, transportation, storing and/or distribution of, oil, gasoline, greases, and minerals and to purchase manufacture or distribute any other goods, wares or merchandise and/or provide any services used or desired by any of the members, stockholders1944 U.S. Tax Ct. LEXIS 53">*63 and/or patrons of any of the corporation's stockholders."
Under date of December 6, 1938, the articles of incorporation were again amended as follows:
12 * * *
(b) This corporation shall be operated for the mutual benefit of its patrons and all net earnings not needed to pay dividends or to establish or maintain reasonable reserves for the operation or contingencies shall be refunded annually to patrons of the corporation upon the basis of the business furnished to the corporation by such patrons respectively, and such patronage refunds shall at all times be the property of the patrons and not the property or profits of this corporation.
* * * *
(e) at the end of any fiscal year, the board of directors may, by a majority vote, determine to readjust the stock holdings or stock purchase deposits of all stockholders or patrons in proportion to their several percentages of patronage in connection with the distribution of patronage refunds and by minimum stock purchases as hereinafter described.
If the board of directors by resolution shall so decide, such resolution shall state:
(1) The amount of capital of the corporation before such adjustment, and the amount held by each stockholder.
1944 U.S. Tax Ct. LEXIS 53">*64 (2) The per cent of patronage of each stockholder or patron in the fiscal year just closed.
(3) The total number of outstanding shares which the corporation ought now to have issued and outstanding, and the number of shares thereof which each stockholder ought to hold, by taking for each stockholder the per cent of the total number of shares to the nearest full share, using for each stockholder the percentage determined according to the last preceding subsection.
(4) The number of shares which ought to be bought from any stockholder in order to reduce its holdings, or the number of shares which ought to be issued to any such stockholder, in order that each stockholder shall have its proper percentage of stock, as in paragraph 3 determined.
(5) A call on each stockholder having such an excess of stock to surrender such excess for redemption at par, and cancellation or reissue, before any cash refund is paid to such stockholder; authority being hereby granted the board of directors to make and carry out such order and said readjustment of stock.
It is understood that the distribution of stock as payment of all or a part of patronage refund may, in some cases, be insufficient to accomplish1944 U.S. Tax Ct. LEXIS 53">*65 the purposes hereinbefore set forth. In case any stockholder shall not have its full determined proportion of stock after distribution in stock of its patronage refund, each stockholder agrees that it will purchase the same in cash; provided, that where any stockholder desires, the corporation will loan such stockholder not more than the amount of such new stock purchase, with interest as agreed not more than 6% per annum until paid, and secured by pledge of its old and new stock and its first future patronage refunds, or otherwise adequately secured to the satisfaction of the board of directors.
4 T.C. 93">*99 It is, nevertheless, understood that the total of each stockholder's refund in stock and/or cash shall equal its per cent patronage applied to the total patronage refund to all to whom such refund is duly distributed; provided, that nothing shall prevent the board of directors from making a readjustment of stock without adhering strictly to the percentages herein, by order of a two-thirds vote of the board of directors and the written consent of any stockholder from which no representative director attended the board meeting at which such action is taken.
Petitioner's bylaws contain, 1944 U.S. Tax Ct. LEXIS 53">*66
Article I. Capital Stock.
Section 1. Any and all capital stock of this corporation shall be issued when and to the extent as authorized by the board of directors and all the same shall be sold at not less than par value.
* * * *
Section 4. Whenever any holder of common stock of this corporation desires to dispose of the same, he or it shall offer it first to the cooperative association from which he or it acquired the same if there be such and if he or it did not acquire such stock through another cooperative association, he or it shall offer such common stock to this corporation and give this corporation at least thirty days in which to purchase the same at the book value thereof before offering to sell it to any other association.
Article II. Stockholders meetings.
* * * *
Section 6. The holders of the common stock shall elect directors at each annual meeting, in the manner provided in Article III.
Article III. Directors.
Section 1. All nominations and elections of directors shall be by ballot. Each such director shall be a producer of some agricultural products or an officer, director or employee of an association or organization1944 U.S. Tax Ct. LEXIS 53">*67 which holds some of the common stock of this corporation but no director need be a stockholder of this corporation. In all elections of directors, it shall be the policy to elect the same so that each and all holders of common stock may have, as nearly as possible, equal representation on the board of directors and for that purpose in such elections each holder of common stock shall have one vote for each director then to be elected and may apply all the same to one nominee or distribute the same among two or more nominees.
* * * *
Article V. Operation.
Section 1. This corporation shall be operated for the mutual benefit of its patrons and in so far as possible without profit to itself.
Section 2. Near the beginning of each fiscal year, the directors of this corporation shall estimate and state by resolution the amount of additional working capital which this corporation will need during the coming fiscal year, and authorize the opening of the books of this corporation for subscription to the common stock.
Section 3. Each large patron of this corporation shall be requested promptly after the estimate mentioned in Section 2 is made to make a subscription to the capital stock which1944 U.S. Tax Ct. LEXIS 53">*68 subscription shall not exceed the amount of the savings of such patron through its dealings with this corporation during the ensuing fiscal year as estimated by it and the directors of this corporation, and which subscription shall not be less than that proportion of the total amount to be subscribed 4 T.C. 93">*100 for by the large patrons of this corporation which the estimated patronage of such subscriber for the ensuing fiscal year shall bear to the total estimated patronage of all subscribing patrons during such year.
Section 4. Each such patron subscriber shall make subscription in the form of contract prescribed by the directors of this corporation whereby this corporation will be authorized and instructed to apply the amount of the subscriber's respective savings to the payment of such stock subscription until the same be fully paid, with the same force and effect as though such savings were in the full possession and control of the subscriber and by it voluntarily paid to this corporation as payment upon such subscription.
Section 5. At the time of every sale made to, and of every purchase made for, a patron subscriber whose subscription is not fully paid, the amount paid or to1944 U.S. Tax Ct. LEXIS 53">*69 be paid by such patron to this corporation shall be composed of two parts, viz: one part known as the price which shall be composed of the gross cost of the goods sold or purchased including all expenses of this corporation incidental to the particular transaction and including also the transaction's share of the total overhead expenses of this corporation for the fiscal year; the other part shall be an amount estimated to be equal to the patron's saving on such transaction. By saving is meant the difference between the aforesaid gross cost of the goods involved in the transaction and the gross amount which such goods would have cost the patron if simultaneously purchased in the open market without the aid of this corporation, and this saving shall be estimated and fixed at an amount per unit or percentage of the aforesaid price by the board of directors at the time it makes its estimate of needed working capital under section 2 of this article. When the patron's subscription is fully paid, this saving shall not be included in the amount paid or to be paid by such patron.
Section 6. The amount to be retained by this corporation from the moneys received from any sale made by it for1944 U.S. Tax Ct. LEXIS 53">*70 any of its patrons who have subscribed to its capital stock on which subscription any amount is yet due, shall be composed of two parts, viz: one part shall be the gross cost to this corporation of the transaction including all incidental expenses and the transaction's proper proportion of the overhead of this corporation for the fiscal year; the other part shall be an amount estimated to be equal to the patron's saving in such transaction, and this saving shall be estimated and fixed at an amount per unit or percentage of the aforesaid price by the board of directors at the time it makes its estimate of needed working capital under section 2 of this article. By saving is meant the difference between the net amount which patron could have obtained for the said goods in the open market without the aid of this corporation at the time the same were sold through this corporation and the amount received by this corporation for said goods minus the gross cost as aforesaid. When the patron's subscription is fully paid, this saving shall not be retained by this corporation but shall be paid to the patron.
* * * *
Section 10. Soon after the close of each fiscal year, there shall be determined1944 U.S. Tax Ct. LEXIS 53">*71 how much has been retained from each patron in excess of such patron's portion of the overhead of, and payment to reserves made by, this corporation during the fiscal year just closed; such amount shall belong to the respective patron and shall be refunded direct to the patron unless he or it shall still owe this corporation something upon a stock subscription or upon any other indebtedness and in such event it shall be applied, in so far as necessary, to such subscription or indebtedness with like effect and extent as though actually remitted to said patron and voluntarily sent by it back to this corporation to be applied upon the respective subscription.
4 T.C. 93">*101 Article VI. Application of income.
The savings, earnings, margins, interest or other income received by this corporation shall be used and distributed as follows:
* * * *
Section 3. Third, there shall be paid such dividends as may be declared by the board of directors on the outstanding common stock; but such dividend shall not exceed 8% of the par value thereof in any one year.
Section 4. Fourth, whenever there shall be preferred stock or certificates of indebtedness outstanding, the board of directors may direct that1944 U.S. Tax Ct. LEXIS 53">*72 a fund be set up and maintained for the retirement of the same. To the respective fund there shall be placed each year, when possible, an amount of money bearing the same rate to the whole amount necessary to retire such preferred stock or certificates of indebtedness as one year bears to the total number of years during which said retirement shall be made; said number of years shall be determined by the express resolutions of the board of directors.
Section 5. Fifth, a reserve for depreciation shall be established by the board of directors. To it each year shall be paid such amount as the board of directors shall determine but not less than an amount equal to five per centum of the cost price of all property of the corporation which is subject to depreciation.
Section 6. Sixth, all the net income of this corporation remaining after meeting the foregoing provisions of this article shall be distributed to the patrons of this corporation in proportion to the patronage furnished by them respectively in the commodity or commodities from which the income so distributed shall have been derived during the preceding fiscal year.
Minutes of the meeting of petitioner's board of directors 1944 U.S. Tax Ct. LEXIS 53">*73 held November 30, 1937, contain,
The next order of business was the distribution of earnings which amounted to $ 122,461.29.
In his report the manager brought out that the ownership of the United Cooperatives was becoming out of line in comparison to the amount of stock owned and the amount of business done by the various members of the United Cooperatives and suggested that a plan be worked out that each year when the division of earnings was made that there would be an equalization of ownership in proportion to the volume of business done by each member.
* * * *
Resolved, That patronage refunds for the current fiscal year shall be made in cash and/or stock of the corporation provided that no cash refund shall be paid unless and until each stockholder shall have fully paid for the amount of stock which shall equal its proper percentage of the total capital stock presently to be issued and outstanding, as determined by the board of directors.
* * * *
Resolved, That the officers are hereby directed to determine the proper amount of capital stock to be held by each stockholder patron according to the foregoing resolution, and if any stockholder shall have1944 U.S. Tax Ct. LEXIS 53">*74 already acquired more stock than its proper minimum as so determined, then the officers are directed to purchase from funds of the corporation as treasury stock enough of such stockholder's issued and outstanding stock as will reduce its holdings to the minimum as thus affixed or the next even share above such minimum.
Resolved, That after the purchase of stock as provided in the foregoing resolution, the officers are directed to pay a patronage refund in stock and/or cash in proportion to patronage in the total amount of the savings to patrons for the current year, to-wit,
Minutes of the meeting of petitioner's board of directors held December 6, 1938, contain,
That the earnings be paid out fifty percent in cash and fifty percent in stock on the basis as prescribed by the articles of incorporation of the United Cooperatives.
Minutes of the meeting of petitioner's board of directors held August 1, 1939, contain,
Resolved that net margins realized for the year to end October 31, 1939, as they may appear after provision for necessary reserves, be and hereby are declared payable to patrons as a patronage dividend, to be payable in such form, and at a date to be determined by the board of directors; and further, that the treasurer of this corporation be directed to set up the amount thereof as a liability on its books of account as of October 31, 1939.
Minutes of the meeting of petitioner's board of directors held November 3, 1939, contain,
Next item for discussion was distribution of earnings. After considerable discussion it was moved by Vance, second by George that a committee be appointed to study our capital requirements in connection with our anticipated operations for the next year and bring in a recommendation later. * * *
The committee on the distribution of earnings made the following report. That a sum sufficient to raise the capital stock to $ 260,000 be declared in stock and the balance to be paid in cash on the same basis as it had been in the past. * * *
The bylaws provide that each stockholder shall be represented by two directors. 1944 U.S. Tax Ct. LEXIS 53">*76 Stockholders of petitioner, at all times here material, were as follows: Indiana Farm Bureau Cooperative Association Farm Bureau Cooperative Association (Ohio) Farm Bureau Services (Michigan) Pennsylvania Farm Bureau Cooperative Association Cooperative G. L. F. Farm Supplies Consumers Cooperative Oil Co. Farmers Cooperative Exchange Southern States Cooperatives
The stockholders of the petitioner are agricultural cooperative associations operating within the limits of the states wherein they are domiciled. The members or stockholders of these associations consist of local or county units or cooperatives, which are owned by the individual farmers. Supplies purchased by the petitioner for its stockholders are by said stockholders distributed to the local or county units or cooperatives, and the local or county units or cooperatives, in turn, distribute such supplies to the individual farmer.
Patrons of petitioner at all times here material, and exclusive of the stockholders (above set forth), were as follows: 4 T.C. 93">*103 Cooperative Farm Services (W. Va.) Cooperative Trading Co. (Ill.) Consumers Cooperative Assn. Inc (K. C.) Consumers 1944 U.S. Tax Ct. LEXIS 53">*77 Cooperative Midlands Cooperative Wholesale Pacific Supply Cooperative Miscellaneous Cooperative Farm Services (W. Va.) Cooperative Trading Co. (Ill.) Consumers Cooperative Assn. (K. C.) Midland Cooperative Wholesale Pacific Supply Co. (Wash.) Miscellaneous United Farmers Cooperative Ltd. -- Canada Farmers Union Central Exchange Producers Cooperative Exchange (Ga.) Cooperative Farm Services (W. Va.) Cooperative Trading Co. (Ill.) Midland Cooperative Wholesale Pacific Supply Cooperative Miscellaneous Farmers Union Central Exchange Producers Cooperative Exchange (Ga.) Dunlop Tire & Rubber Co. Central Cooperative Wholesale Farmers Union Jobbing Assn. Farmers Union Cooperative Brokerage
During the fiscal years 1937, 1938, and 1939 the number of stockholders patrons and nonstockholder patrons with whom petitioner transacted business was as follows:
| Stockholders | Nonstockholders | Total | |
| 1937 | 8 | 7 | 15 |
| 1938 | 8 | 9 | 17 |
| 1939 | 8 | 12 | 20 |
Patrons of petitioner who are not stockholders have no voice in the management of petitioner's affairs. During the fiscal years 1937, 1938, and 1939 petitioner issued common1944 U.S. Tax Ct. LEXIS 53">*78 stock at par to its then common stockholders, which was paid for by the application of patronage dividends in the following amounts:
| 1937 | $ 40,880.49 |
| 1938 | 43,076.07 |
| 1939 | 95,147.00 |
| Total | 179,093.56 |
4 T.C. 93">*104 No stock was issued to nonstockholder patrons during any time here material.
The amounts of oil and grease (gallons) and steel and wire (pounds) handled by petitioner during the fiscal years 1937 and 1938 were as follows:
| Oil and | Steel and | |
| grease | wire | |
| Gallons | Pounds | |
| 1937 | 1,240,434 1/4 | 31,113,918 |
| 1938 | 1,419,154 1/4 | 24,319,049 |
During the fiscal year 1939 the money value of petitioner's sales was $ 817,355.41 for oils and greases and $ 289,114.36 for steel, wire, and miscellaneous.
These amounts were divided between stockholders and nonstockholders as follows:
| Stockholder | Nonstockholder | |
| 1937 | ||
| Units oil | 1,235,237 | 5,247 1/4 |
| Units steel and wire | 29,587,088 | 1,546,830 |
| 1938 | ||
| Units oil | 1,411,311 | 7,843 1/4 |
| Units steel and wire | 23,506,477 | 812,572 |
| Volume lubricating oil | 795,850.57 | 10,796.98 |
| 1939 | ||
| Volume oil | 806,647.55 | 10,796.98 |
| Volume fuels | 10,707.86 | 0 |
| Volume steel | 82,694.23 | 5,062.13 |
| Volume small tools | 201,352.09 | 5.91 |
1944 U.S. Tax Ct. LEXIS 53">*79 The financial records and accounts of the petitioner during the years in question were kept in such a manner that the annual net margins or savings were credited to accounts payable and set up as a liability of the petitioner in accordance with the requirements of the bylaws. A credit was established on the records to the account of each patron setting forth the amount of patronage refund due each patron. The credits set up to the account of each patron were liquidated first by an application to any debts owing by the patron to the petitioner. Such debts, if any, consisted of either unpaid stock subscriptions or open accounts for supplies furnished. When any outstanding indebtedness owing to the petitioner by a patron was so liquidated, the remaining portion of the patronage refund credit was paid to the patron in cash. During the fiscal year ended October 31, 1937, the petitioner realized net margins or savings in the aggregate amount of $ 122,461.29, which were allocated and distributed to its patrons ratably in proportion to their patronage with the petitioner. Of this amount $ 40,880.49 was applied to unpaid stock subscriptions and $ 81,580.80 was either paid in cash or 1944 U.S. Tax Ct. LEXIS 53">*80 applied to open accounts owing to the petitioner by its patrons.
During the fiscal year ended October 31, 1938, the petitioner realized 4 T.C. 93">*105 net margins or savings in the aggregate amount of $ 90,622.30, which were allocated and distributed to its patrons ratably in proportion to their patronage with the petitioner. Of this amount $ 43,076.07 was applied to unpaid stock subscriptions and $ 47,546.23 was either paid in cash or applied to open accounts owing to the petitioner by its patrons.
During the fiscal year ended October 31, 1939, the petitioner realized net margins or savings in the aggregate amount of $ 154,921.28, which were allocated and distributed to its patrons ratably in proportion to their patronage with the petitioner. Of this amount $ 95,147 was applied to unpaid stock subscriptions and $ 59,774.28 was either paid in cash or applied to open accounts owing to the petitioner by its patrons.
During the years in question the petitioner maintained a ledger account designed "Profit and Loss Account. Patronage Refunds. Accounts Payable." Each year when the closing entries for the year were prepared the net margins or savings for the year appeared in this account as1944 U.S. Tax Ct. LEXIS 53">*81 a credit. As a final closing entry for the year this account was debited with the amount of the balance therein, and a contra credit was made to accounts payable, the accounts payable being the net amount owing by the petitioner to its patrons by way of patronage refunds.
OPINION.
This case involves income and excess profits taxes for the petitioner's fiscal years ended October 31, 1937, 1938, and 1939.
The ultimate question here is whether certain "patronage dividends" and "patronage refunds" constitute a part of the gross income of the petitioner, or are, in reality, not the property of petitioner but of its several "patrons." There is no question involved of "deductions" in the technical sense of the statute, for the petitioner's claim is the broad one that it is an agricultural cooperative, doing business not for its own profit but for the cheaper buying of agricultural and other goods by its members and, as such, is a mere conduit of their moneys. Incidental to the question of merit is that of the delinquency penalties demanded by respondent, which will attach if we hold for respondent on the essential question.
Petitioner makes no contention that it is exempt from taxation; 1944 U.S. Tax Ct. LEXIS 53">*82 it merely contends that because of the nature of its organization and operation the amounts distributed to its patrons are not properly includible in its taxable income. The first question, therefore, which confronts us in our consideration of this case is whether petitioner is organized and operated as an agricultural cooperative association, on a cooperative basis. It is true that it was incorporated under the Indiana General Corporation Act, but this, of itself, is not controlling.
Having decided that petitioner is, in substance and reality, organized and operated as an agricultural cooperative association on a cooperative basis, it would follow in the usual case that the so-called patronage dividends would be treated for tax purposes by the Treasury Department as rebates upon the business transacted with its members, and would therefore be excluded from gross income in computing net income subject to tax.
However, this practice of excluding patronage dividends from gross income has been limited to those cases in which the right of patrons to such dividends arises by reason of the corporation charter, or bylaws, or some other contract, and does not depend upon some corporate action taken subsequent to its receipt of the money later so distributed, such as the action of the corporation's officers or directors. This limitation recognizes that if the money later distributed to patrons is received by the corporation without a legal obligation existing at the time of its receipt to later distribute it, it must be considered as the gross income of the corporation and, since there is no deduction permitted by statute of the amounts later distributed to patrons, it is taxable as 1944 U.S. Tax Ct. LEXIS 53">*85 such. See
4 T.C. 93">*107 Therefore, we must first determine whether additional corporate action is required to be taken before petitioner becomes definitely liable to pay so-called patronage dividends to its members and patrons. Such a liability can arise from the corporate bylaws.
After concluding as we have done that petitioner's patrons were entitled by reason of its charter and bylaws to so-called patronage dividends without further corporate action on its part, there still remains the question of whether its patrons were thus entitled to all of the patronage dividends here involved in the total amounts deducted by petitioner from its taxable income. Under article VI of petitioner's bylaws, the board of directors could cause the payment of dividends on the outstanding common stock in amounts not exceeding 8 percent of the par value thereof and could cause the payment to a reserve for depreciation of "such amount as the board of directors shall determine but not less than an amount equal to five per centum of the cost price of all property * * * subject to depreciation." The patrons of petitioner were entitled by the terms of section 6 of article VI of the bylaws1944 U.S. Tax Ct. LEXIS 53">*87 to "all the net income of this corporation remaining after meeting the foregoing provisions of this article," referring to those provisions which authorized the payment of dividends and payments to the reserve for depreciation, as well as other payments. Thus the amounts to be distributed to patrons pursuant to the petitioner's bylaws could not be ascertained until after the petitioner's board of directors had acted with regard to dividends and reserve, or had refrained from acting. If, for example, the board of directors authorized the payment of 8 percent dividends on the common stock, the net income to be distributed to its patrons would be correspondingly diminished. On the other hand if the directors determined that no dividends should be paid on its stock and therefore took no action with regard to declaring such dividends, the patrons were entitled to all of the net income of petitioner.
4 T.C. 93">*108 The right of the petitioner corporation to allocate a part of its receipts to a reserve for depreciation need not concern us. The establishment and maintenance of a depreciation reserve and periodic additions thereto in reasonable amounts constitute a proper operational expense, 1944 U.S. Tax Ct. LEXIS 53">*88 and the net income of petitioner available under its bylaws for distribution to its patrons would have been calculated by subtracting from gross income the amounts reserved for depreciation even without the express provisions of article VI of the bylaws.
However, the right of petitioner's board of directors to declare dividends upon its common stock is radically different. These dividends, if paid, would be paid out of net income. If dividends were not paid, then the net income of petitioner available for distribution to its patrons would be accordingly greater. The choice of whether so much of its net income as equaled 8 percent of the par value of its common stock should be distributed to its stockholders as a dividend or to its patrons as rebates was in the corporation. Therefore, it can not be said that all of the money eventually distributed to its patrons as so-called patronage dividends was received by petitioner with a legal obligation existing at the time of its receipt to later so distribute it.
We conclude that petitioner's patrons were entitled by reason of its bylaws to that part of the so-called patronage dividends distributed to them which was in excess of 8 percent1944 U.S. Tax Ct. LEXIS 53">*89 of the par value of petitioner's common stock outstanding and to that extent these patronage dividends were properly excluded from the taxable income of petitioner. However, that part of these patronage dividends which could have been distributed in the discretion of petitioner's board of directors as dividends upon petitioner's common stock must be considered as the property of petitioner and taxable to it as its income.
The fact that member patrons were under obligations with regard to the purchase of petitioner's stock under certain circumstances and that petitioner had a 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 additionel 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 represented1944 U.S. Tax Ct. LEXIS 53">*90 an additional investment on his part to the capital of the corporation out of his savings from the annual transactions with petitioner.
Respondent contends that the charter and bylaws of petitioner can not be considered as a contract with its stockholders and those doing 4 T.C. 93">*109 business with it, citing
Respondent also relies upon
